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Capital Gains and Inflation

November 22nd, 2013
money, inflation

Dollars become worth less over time, but we don't adjust capital gains rates to take this into account. If you invested $1,000 fifteen years ago and cashed out yesterday at $1,433 you didn't actually make any money: inflation over this time period was 43%. [1] The IRS doesn't see it this way, however, because they don't adjust for inflation. To them you gained $433 and owe 15% of that as tax. The higher inflation is, the more imaginary gain the IRS sees, which means there's substantial pressure from people who make money from investments to keep inflation low.

This has been recognized as a problem for a while and the obvious fix would be to adjust for inflation. This seems like a reasonable solution, though it does worry me that we'd be giving the government an additional incentive to understate inflation. Capital gains taxes are ~4% of total federal revenue, or about $0.1T/year, so this seems like it might be enough to pressure the BLS.

[1] If you had invested in low-fee index funds you would have done better than this, ending up with $1,927. That's a 2% annual return after inflation.

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