The Inflation Tax on Capital

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June’s 5.4% inflation highlights one of

President Biden’s

more damaging and quixotic economic proposals: to raise the top tax rate on capital gains. Nominally, he would pull it up to match the tax rate on ordinary income. But the real rate, taking inflation into account, would be so high that investors could dramatically change their behavior, badly harming the economy and job market.

While soaking the rich might sound attractive, the president’s proposal is more like drowning them. On paper, the president’s proposal would raise the nominal capital-gains rate from the current 20% to 39.6%, plus the ObamaCare 3.8% Medicare surcharge. Many investors who would be subject to the proposal live in places like California and New York City, where the combined federal, state and local tax rates would reach 56% and 58%, respectively. Capital-gains taxes on corporate shareholders are already a double tax, since income is taxed at the corporate level before being remitted to shareholders. The total federal, state and local income taxes paid by corporations and shareholders on corporate income would be as much as 75% under the Biden proposals.

That’s all before inflation. Capital-gains taxes apply to nominal returns. If you bought a stock decades ago for $100 and sell it today for $1,000, you’ll pay taxes on the $900 profit, never mind that a substantial part of it reflects the dilution of the dollar’s value. As inflation accumulates, savers’ assets are driven up in price. But inflation-induced appreciation doesn’t raise real wealth, which erodes as these phantom gains are taxed. This problem, which exists in the current tax code, could be solved by indexing the basis on which the gain is calculated—in our example, revaluing the $100 purchase price in 2021 dollars before calculating the profit.

For the past 20 years, the nominal average annual total return on the S&P 500 index has been about 8.6%. If this continues in the future and the Federal Reserve succeeds in hitting its 2% inflation target—an optimistic prospect, given wildly excessive fiscal policies this year—total real returns, after inflation, will be about 6.6%. A 58% tax rate on an 8.6% nominal return is the equivalent of a 76% tax on after-inflation returns of 6.6%. An investor would keep less than a quarter after-inflation gain.

This risk calculus looks even dicier considering how the Fed has defined inflation. The central bank’s definition—the price index on personal-consumption expenditures—includes services the government pays for, like Medicare reimbursements to doctors, which have nothing to do with what Americans pay for out of their own pockets. The consumer-price index, which relates more directly to what consumers pay for themselves and what Americans intuit as the cost of living, tends to run about 0.4 points above the Fed’s inflation measure. Using this more realistic understanding of the cost of living, the real marginal tax rate would be about 80.5%.

And what if the Biden administration’s profligate fiscal policies induce several years of disappointing equity returns? Excessive fiscal spending, combined with the Fed’s explicit policy of aiming for above-target inflation, makes it likely the U.S. will see some inflation overshooting. With, say, a nominal equity return of 7% and 0.5-point overshooting of the Fed’s inflation target, this real marginal tax rate becomes an astonishing 99%. Reduce those equity returns to 6%, and the real rate becomes 112%, which eats into principal.

If inflation continues at a pace near 5% (without boosting nominal equity returns any higher than their longer-term average of 8.6%, as high inflation tends to lead to poor performance), the real marginal tax rate jumps to an investment-crushing 139%. Younger Americans are blessed never to have experienced the impact of high inflation, but they will suffer if policy makers ignore its potential dangers.

The Biden proposal will hit families with average income as well as the wealthy. A household could invest in and hold an asset for decades, which appreciates in nominal value because of inflation. Even if the asset’s real value were to remain the same, the gain in the sticker-price value would be taxed and the one-time sale could push them into a high capital-gains bracket.

Real tax rates this high would encourage savers to take money out of productive investments, making it more difficult for entrepreneurs and businesses to take risks and conduct operations. Fewer dollars funding business operations means less job creation, innovation and growth. And while the top tax rate would affect relatively few taxpayers, these taxpayers provide a disproportionate amount of savings and capital which businesses use to conduct operations and pay employees. The wealthy can weather this economic stultification; the harshest impact will be on the poor and disenfranchised, the people the Biden administration purports to want to help.

The real way to give those Americans a lift is by creating strong and sustainable demand for U.S. workers—as the previous administration demonstrated, with its tax reform, trade renegotiation and cuts to government regulation. Boosts to labor demand from stimulative government spending will eventually fizzle out, while the accompanying tax-rate hikes will permanently harm job creation.

Mr. Miran is a former senior adviser for economic policy at the U.S. Treasury. Mr. Friedman is a director and senior tax counsel at the Federal Policy Group and a former senior adviser for tax policy at the Treasury.

Wonder Land: Behold the Democrats and GOP locked in a deadly tango over Biden’s $4 trillion. Images: De Agostini via Getty Images

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