Index Capital Gains Realizations to Inflation

Capital gains (losses) are the increase (decrease) in the value of a capital asset between the time it was purchased and the time it was sold without any adjustment for inflation. Without an inflation adjustment, the capital gains tax falls on real gains as well as inflationary gains, which increases the effective tax rate on saving. If indexing capital gains were done alone without indexing other aspects of the tax code to inflation, it could worsen other distortions and create opportunities to shelter income.

This option indexes all capital gains to inflation, removing the tax on “fictitious” income, or gains driven by increases in the price level, and taxing real gains only. Indexing gains would lower the tax burden on saving and increase the incentive to save. Domestic saving would rise, and more of the returns to domestic investment would flow to Americans. However, the larger budget deficit would increase federal government borrowing, and more interest payments would flow to foreigners, resulting in a decline in GNP.

On a conventional basis, this option would increase the primary deficit by $796.5 billion over the budget window. Long-run GDP would be unchanged, while long-run GNP would fall by 0.1 percent. Incorporating changes in interest costs, the publicly held debt-to-GDP ratio would be higher than baseline, reaching 182.3 percent by 2056.

On average, in 2036, taxpayers would see increases in their after-tax incomes of 0.4 percent. The top quintile of taxpayers would experience a 0.6 percent increase, whereas the bottom quintile would experience a less than 0.05 percent increase. On a long-run dynamic basis, taxpayers would see a 0.4 percent increase on average.