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End the Tax on Phantom Gains

The dramatic increase in the inflation rate in the last year should lead those who care about capital formation and economic growth to reform the capital gains tax. 

Economists, including this one, have pointed out that the capital gains tax is implicitly a tax on savings. Consider two people who each make $80,000 a year, have the same deductions and the same number of children, and live in the same state. They will pay the same income tax. 

But now imagine that one of the two people spends all his money while the other person saves $5,000 and invests it in stocks. The person who spends all his money gets taxed further, but only a little further, in the form of a sales tax. And in some states, such as Oregon, there is no sales tax. 

But the person who invests in stocks pay two extra taxes if the investment is successful. When the company he invests in pays dividends, he pays taxes on those dividends. That’s the first extra tax. Then, if the stock he buys appreciates and he sells it, he pays taxes on the capital gains. That’s the second extra tax. So you could say that the tax on dividends represents double taxation and the tax on capital gains is triple taxation. 

Both the tax on dividends and the tax on capital gains reduce the incentive to invest and, therefore, cause people to save less.   

The tax on capital gains is even worse than that. The reason: inflation. If inflation is more than zero, then the taxation of capital gains is, to some extent, a tax on “phantom” gains. And the phantom gains are huge when inflation is running high, as it is now. 

Imagine that in January 2021 you bought 100 shares of a company at $100 per share. Since then, the consumer price index, one of the standard measures of inflation, has risen by 11.74 percent. Coincidentally, the stock price has kept pace with the inflation rate, rising from $100 to $111.74. Your shares are now worth $11,174. Their value, adjusted for inflation, has stayed the same. 

But the IRS doesn’t see it that way. If you sell today, you will get a capital gain of $1,174. The federal government will tax you on that whole gain. If you’re in the 15 percent bracket for capital gains income, you will pay $176 in capital gains taxes. 

So you paid $176 on a phantom gain, which means that you lost money. 

Whatever you think of capital gains taxes, basic fairness dictates that people who get capital gains should be taxed on the real gains, not the phantom gains.