Getting Real About Taxes

As AIER Research Director Phil Magness recently pointed out, a wealth tax on unrealized capital gains like that recently proposed by the Biden administration would be blatantly unconstitutional. Because the Constitution’s checks and balances have looked tattered of late, and a constitutional amendment allowing such a tax could be ratified, just as the Sixteenth Amendment rendered a federal income tax constitutional, it is important to point out that the suggested tax would also be bad policy because it would increase Americans’ real (inflation-adjusted) tax burden.

The Sixteenth Amendment took effect in 1913, the same year that the government chartered the Federal Reserve System, which went into operation in 1914. Twenty years after that, the US moved off the gold standard and onto a gold exchange standard that ended about forty years after that, ushering in the current free-floating exchange rate regime and a dollar that by design loses value every year. (For details, see AIER’s The Gold Standard.)

The timing of those seminal events is important. America remains under a nominal income tax regime because the supporters of the Sixteenth Amendment were creatures of the gold standard and hence long-term price stability. While they knew that the price level might increase or decrease for a few years, they expected a return to the mean. Had they foreseen a future where the dollar would lose value, never to regain it, they may well have insisted on adjusting income taxes for inflation.

When income taxes are not marked-to-market, by which I mean the price level, major problems result. One, well understood, is called bracket creep. That occurs when taxpayers get bumped into higher tax brackets, or in other words when they must pay a higher percentage of their incomes in taxes solely because the price level went up. 

For example, maybe taxpayers had to pay a 10 percent tax when they made $20,000 per year when a liter of Diet Mountain Dew cost $1. In other words, their real salary was 20,000 liters of Diet Dew (20,000/1) and their real tax was 2,000 liters (20,000*.1). But maybe next year, due to inflation and bracket creep, they will have to pay a 20 percent tax on $40,000 even though a liter of Diet Dew now costs $2. In other words, their real salary remained 20,000 liters of Diet Dew (40,000/2) but their real tax jumped to 4,000 liters (20,000*.2).

Ad valorem excises, tariffs, and, most importantly today, sales taxes also creep when inflation hits. With a 7 percent sales tax, a $100 grocery bill costs consumers an extra $7 (100*.07). When consumers have to pay $120 for that same bag of groceries, government suddenly wants an extra $8.40 (120*.07). Yes, government costs have increased too, so its nominal revenues “must” increase, but it takes the extra $1.40 regardless of real incomes, which often lag inflation by months or even years. Social Security and many union contract cost-of-living adjustments, for example, are annual and backward looking, as are many private employment contracts. That is why average real incomes fell in America in October of this year despite the large number of unfilled jobs.

Fixed-income savers are also hard hit by unexpectedly high inflation. In the 1970s, many savers had to pay income taxes on bond or certificate of deposit interest that was less than the rate of inflation. “What good is 8% and even 9% interest on your money on which you have to pay taxes,” one financial broadcaster queried, “when the price of food is going up 20%?” That same journalist, the spunky Wilma Soss (1900-1986), repeatedly called for an inflation tax credit to soften the blow. The Great Moderation in inflation and macroeconomic instability more generally, however, rendered such sentiments seemingly irrelevant.

Inflation, nonetheless, has returned to front page news. Whether transitory in any sense, or the start of something horrific, prices definitely increased much faster than expected in 2021. Government policies — monetary, fiscal, and covidic — undoubtedly caused the price increases. If Wilma Soss were still around, she would wonder aloud why the government should be allowed to benefit from its own mistakes, especially those that fall disproportionately hardest on the poorest.

Now imagine that a tax on unrealized capital gains is in place such that taxpayers owe the IRS two percent of the increase in nominal asset prices. Imagine that a portfolio of stocks worth $100,000 at the beginning of the year is worth $110,000 at the end not because the companies comprising the portfolio are more productive or profitable but solely because inflation is running at 10 percent. A tax of $200 ([110,000-100,000]*.02) would be incurred solely due to inflation. Worse yet, imagine if a portfolio of stocks would have decreased in price due to decreased earnings but increased in nominal terms due to inflation, turning a loss/deduction into a tax liability.

For better or, more likely, worse, our government has chosen not to constrain its ability to increase the money supply faster than money demand, forcing all Americans to live with a unit of account that constantly declines in value vis-a-vis goods and services. The power of compounding means that even small annual losses soon become quite large and periodic bouts of rapidly rising prices, like the present, will certainly recur. 

It is high time, therefore, that the federal government recognizes the creepy tax effects of inflation and gets real about taxes. It should forget about taxing unrealized capital gains, compensate victims of its inflationary policies, and begin to inflation-index everything, except of course government salaries and pensions and the federal minimum wage. If Americans must lower their expectations, so too must Washington.

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