Schansberg: Capital Gains and Inflation
by Eric Schansberg, Ph.D.
Ahh, it’s that time of the year again: the weather is (usually) warming; the flowers are blooming; and income tax forms are due. Everyone knows about the IRS and their W-2’s — whether they fill out their taxes by hand, use software, or pay a professional. State and local taxes hit most workers. But at least if you have a family, federal income taxes don’t get rolling until you’re making $50K or so.
In contrast, few people think about the FICA federal payroll taxes on income, even though 80 percent of taxpayers lose more to that tax than the April 15th version of income taxes. FICA has no IRS or tax forms. The money is simply vacuumed out of your paycheck, while we pretend that the employer pays the other half of the tax, instead of passing that burden to employees through lower compensation.
One good thing about both types of income taxes: they’re “indexed” for the effects of inflation. FICA is a 15.3 percent flat tax with no deductions. So, with inflation, you make more money; they take more money; but the percentage is the same. And income taxes (at least the federal version) are “indexed.” You can see this by comparing this year’s deductions and the tax table to the previous year.
The same thing happens with Social Security benefits — and in essence, with cost-of-living raises at work. In these cases, you get more green pieces of paper to accommodate the inflation of needing more green pieces of paper to buy things. Really important. But indexing a tax code for inflation is also great news — and a key reform from Ronald Reagan’s presidency. This ensures that the government doesn’t get a higher percentage from us. Without it, their inflation would push more of our income into higher tax brackets.
So, let’s talk about an important tax that is not indexed (and thus, is impacted by inflation): capital gains taxation. With the inflation of 25 percent from 2020-2025, if the value of your home (or other investments) increased 25 percent from $200,000 to $250,000, the “real value” (accounting for inflation) is the same. (You have 25 percent more green pieces of paper when you sell, but it takes 25 percent more green pieces of paper to buy stuff.)
Unfortunately, the government will treat this as a $50,000 “capital gain”, even though your wealth is the same in real terms. In the case of your primary residence, you are artificially exempted from this tax — after a change in the tax law in 1997. (Before then, there was no capital gains taxation if you bought a house with equal or greater value. If you’re old enough, you may remember how this perversely influenced some decisions about houses to buy.)
In the case of all other investments — whether rental housing or anything else — the government will apply the capital gains tax to your “gain”. This is yet another reason for the federal government to use subtle inflation taxes to finance its profligate spending and debt. It also helps to explain the shenanigans you occasionally see in the news about what constitutes one’s primary residence. (Similarly, your property taxes will increase as the assessment of your home is increased by inflation.)
Inflation is painful enough on its own. But a failure to index the tax code for the effects of inflation causes even more pain for taxpayers and puts more money in the government’s coffers. Let’s ask our politicians to index every tax for the impact of inflation.
D. Eric Schansberg is Professor of Economics at Indiana University Southeast is the author of “Poor Policy: How Government Harms the Poor” and an adjunct scholar of the Indiana Policy Review Foundation.
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