May 22, 2006

Kudlow on the Cruelest Tax of All, and a Solution

Filed under: Economy,Taxes & Government — Tom @ 11:40 am

Quick: You bought 500 shares of stock in Company A ten years ago at $20 a share, investing $10,000. Monday, before the market dipped, you sold it for $60, pocketing $30,000 (assuming no transaction costs, which would be minimal in any case).

Your profit was $20,000, right?

Wrong, says Larry Kudlow, who of course is correct (HT Club for Growth):

Since the capital gains tax remains unindexed for inflation, the effective tax rate on real stock market profits has been gradually rising from 22.5 percent to 28.6 percent, over the past two years, as the chained CPI has increased to 3.2 percent from 1.7 percent.

This means that investors keep $71.40 cents of every hundred-dollar capital gain today, but they kept $77.50 cents two years ago. That comes to an 8 percent disincentive, or drag, on stock market wealth.

All the more reason for the Fed to strengthen the dollar by withdrawing greenbacks from the financial system. Otherwise, the cruel inflation tax will continue to exact a stock market toll.

Making it tangible, let’s assume in the original example that inflation was consistently 3% during the 10-year period involved. The purchasing-power adjusted (i.e., “real”) gain would not be $20,000, it would be $16,600, or $30,000 minus $13,400, which is the amount of the original investment adjusted for 10 years of inflation. Running the numbers with consistent 4% inflation would reduce the real gain to about $15,200.

The reduced capital-gains tax rates put into place in 2003 compensate to an extent for this situation, but not wholly, or even fairly, by any stretch of the imagination.

Imagine an investor in a fast-food franchise who plunks down $500 grand for a couple of locations. He runs the franchise for 20 years, and sells out for $995,000. Under current law, he owes capital gains tax on the $495,000 “gain.” But if inflation has been 3-1/2% during those 20 years, he should owe ….. nothing, as the franchise’s purchasing power value has not increased at all.

What’s the answer? Index capital gains (AND losses, though there would be problems in allowing excessive losses) to inflation. I would even support making capital gains tax rates the same as those for ordinary income, IF true indexation were put into place.

The reporting would not be as difficult as you might think, as the Turbotaxes of the world would simply build the inflation tables into their cap-gains reporting modules. More importantly, investors would finally pay taxes based on real instead of mythical gains.

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2 Comments

  1. Outstanding post and reference!

    Comment by Porkopolis — May 22, 2006 @ 2:43 pm

  2. #1 Thx.

    Comment by TBlumer — May 22, 2006 @ 3:10 pm

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