Larry Kudlow, the new director of the National Economic Council for President Donald Trump, wants to change capital-gains taxes by indexing them to inflation. He has raised the possibility that Trump could implement that change by executive order. Kudlow is right about the policy, but it would be a mistake for Trump to implement it unilaterally.
The capital-gains tax has always applied to both real gains and inflationary gains. But taxing inflationary gains makes little sense. It causes effective tax rates to rise when inflation does. And it means that two people who make the same real gain on their investments pay different effective tax rates if one of them holds his investments in a higher-inflation period than the other.
Say you buy stock for $1,000 and sell it for $2,000 a decade later. The tax rate is 23.8%, so you’ll pay $238 in tax on the $1,000 capital gain. If inflation has averaged 2% per year, however, roughly $219 of your gain reflects inflation and your real gain is $781. The $238 tax will be 30.4% of that real gain.
If inflation averages 3% per year, the effective tax rate would be even higher: 36.3%. You can end up paying a tax on an entirely illusory gain — or even on a loss.
Indexing the tax to inflation would mean applying it only to the real portion of the gain. So, in our 2% inflation example, the tax would apply to $781 rather than to $1,000. The effective tax rate would be the same regardless of the inflation rate.
There are four chief arguments against indexing. One of them is that some other provisions of the tax code are not indexed for inflation, either. But that’s a reason to index those provisions, too, not to refrain from indexing capital gains. Three other arguments against indexing are that it would lower federal revenue, unfairly benefit rich people, and make the disparity between tax rates on income and capital gains even bigger.
Whatever force those arguments have, they can all be addressed by raising the capital-gains tax rate by enough to make up for the revenue losses that come from indexing. That way rich people would not pay less as a group, but taxes would be apportioned among them in a more rational way.