The cruelest tax

In all the discussion of proposed increases in the capital gains tax, I have not seen any mention of the fact that capital gains are not adjusted for inflation for tax purposes. This is important, because by definition long-term capital gains come from assets that are held long enough for inflation to erode their value.

For example suppose I buy stock today for $100, and five years from now I can sell it for $120. Suppose that in the meantime the cost of living has gone up at total of 15 percent, and that the capital gains tax rate is 40 percent. That means that I can keep 60 percent of my $20 gain, or $12. So I will have $112 in five years, even though I would need $115 just to keep up with inflation.

So even if the Democrats do not increase the tax rate on capital gains at all, they can still end up taxing the heck out of capital gains by causing a lot of inflation. Which I believe they will do.

Investors, have a nice day.

22 thoughts on “The cruelest tax

  1. Chamath Palihapitiya had a rather interesting alternative proposal which would see a de-escalating tax rate based on time vested. (i.e. tax capital gains after sale @ 1yr far higher than a capital gain at 5yr or 10yr).

    I could debate him on the numbers but it seems this correction would solve both the inflation issue, as well as incentivize long term investment while taxing more speculative trading gains.

    At a surface level I like the idea, it would target “day traders” more than those who provide important capital investment into the economy.

    https://twitter.com/chamath/status/1386709356704530436?ref_src=twsrc%5Egoogle%7Ctwcamp%5Eserp%7Ctwgr%5Etweet

    • Why “target” “day traders?” If I buy Apple and hold it for 10 years why have I helped the economy more than someone who buys Apple today and sells apple tomorrow and buys Samsung, repeating every day for 10 years?

  2. You can exclude $500k in home appreciation upon sale. Makes it a tax free way to protect against inflation.

    • Yes, but that’s also not indexed. We’ll probably that when we sell sometime in retirement, but people who bought and sold multiple homes over the same time period would not.

      • Bingo. Not indexed. So, I’m not sure why that protects against inflation specifically. And do we want even more bias towards housing?

  3. I’m not sure if the tax is cruel but it’s certainly unreasonable.

    The strategy is to try to avoid realizing any net capital gains. If you need to sell your $120 asset, ideally you have another $80 asset (originally $100) which you can sell to offset the gains.

    If the tax rate is small, it’s not that big of a consideration, but if the tax rate approaches the size of your real return, using losses to offset gains will be an important part of your total return strategy. Pair winners with losers so that the government gets little to nothing.

    Use selloffs to reposition your portfolio and build up some capital losses to carry forward. One advantage of using single names in taxable portfolios, rather than one or several index funds, is that usually you have a few duds to sell.

    • A consumption tax, in which all reinvested capital gains would remain untaxed (as they are in a 401k), would be much more efficient.

    • “Pair winners with losers so that the government gets little to nothing.”
      It seems to me, that means you are also getting little to nothing. Unless you have large amounts of unrealized gains, in which case that’s the real issue.

      • That’s right, and while it’s not an ideal strategy if your portfolio isn’t very large, you probably also won’t be at the 40% tax bracket if you have to spend down your whole portfolio.

  4. Maybe so, but I read we have capital gluts and labor shortages. Show how to adjust taxes?

    But the larger scale question is, why ever tax income? Taxing income has become a domestic and international shell game.

    Tax property, tax imports, tax fuels. Shrink government.

    PS: The Democrats are going to cause inflation? This is Donald Trump’s Federal Reserve , more or less. I did not notice much fiscal austerity in recent Republican administrations.

    • “I did not notice much fiscal austerity in recent Republican administrations.”
      Absolutely true, but no matter how bad Republicans are about spending, I think you can count on Democrats to be even worse.

  5. Is Kling implicitly claiming that the Fed is going to allow inflation to rise above 2% on an annualized basis for long periods of time? I think markets may be too bullish on the US economy, but I suspect that their prediction for a long run average rate of 2% inflation is very sensible. Their expectations that this can be achieved without some some pretty deep recessions speaks to an optimism about productivity growth that I am not sure is warranted.

    • I think it’s a binary set of potential outcomes.

      There is some dollar limit of borrowing at which there will be no takers for government bonds, and yields will need to rise sharply higher.

      If that limit isn’t hit, then it’s business as usual: high-ish deficits, moderate GDP growth and moderate inflation. Right now I see this as the most likely scenario.

      If that limit is hit, then the Federal Reserve has a choice to make. It either allows a sharp increase in market interest rates which would cause a severe recession, or it monetizes the debt, buying bonds above and beyond what it would buy in support of 2% inflation. I’m not sure how we’d have overt debt monetization without some sort of epic financial crisis, unless the Fed’s monetization effort was explicitly short-term and limited, and paired with an extremely quick move by Congress to balance the budget to avoid future increases in borrowing.

      The real question is where the limit is.

  6. Biden is just starting. It is going to get worse.

    Historically, taxation was planned with the goal of raising revenue somewhat efficiently if progressively. There were basic principles of equalizing deferred vs immediate consumption, ensuring that dollars should be taxed once with as much path independence as possible, and at least some some lip service paid  to structural neutrality and avoiding distortions (eg minimize marriage penalty as much as possible, balance debt vs equity financing, avoid govt crowding out private debt issuance, and try to limit marginal rates). Also, the code reflected some basic practicalities  — the step up in basis and estate tax worked jointly to avoid the mess of having an executor try to piece together a deceased’s cost basis in order to tax gains at death.  (The stepped up auditing just announced is not accidental — it will be aggressive,  eg it will  be assumed that in absence of documentation, cost basis is zero).  The step up in  basis was also an incentive not to spend down assets in old age, thereby limiting  Govt expenditure for long term care and support, and to leave capital for heirs (also a good thing as it incentivizes risk taking and family formation in the following generation — not everyone is Paris Hilton). 

    Of course the existing tax code is a massive mess, but one could squint and see some thought and principles.

    Biden and Co clearly view breaking these norms as a way to do a massive grab to reduce inequality by simple wealth transfer – this is all about redistribution and screwing the wealthy for revenue maximization NOW. It is the Saez/Pikkety/Zucman program, which sees wealth and growth destruction as secondary to inequality and political power concerns.

    At top end a dollar invested in a C-corp long term now faces at least

    – Corporate tax (Fed, State)
    – Inflation tax
    – Cap gains (on sale or at death) (Fed/State)
    – Estate tax  (Fed, State)
    – Inheritance tax (by State)

    Note how Biden is avoiding this conversation by FIRST hitting corporate tax in one bill, THEN getting rid of the step up in basis in another, THEN he will talk about upping estate tax in a third. Bottom line is they should all be addressed in tandem.

    Cash income is also on the block. Definite increases:

    – Federal income tax + SALT will stay at high incomes modulo small changes. As NY,NJ have shown, SALT had paused local tax raises only for a few years, increases are back. 

    – Biden is adding 15% tax for Social Security on cash earned income without limitation above 400k **without expanding benefits** – this breaks Social Security contract and turns SS into a straight 15% wage income tax (if you fool yourself into thinking you pay 7.5% then add this to the corp income tax). Of course, re-filling the SS ‘Trust me’ pot will offer a chance for congress to raid it some more. 

    – Massively increased marriage penalties at the top.

    There are a myriad other taxes coming as well from Bernie and co, with spending attached.

    Aside from the outright wealth grab the distortions are going to be huge. The tax rates are very high — often higher than in EU — and it is definitely worth now spending at least as much time and investing  risk on avoiding taxes as it is building value. Some things which will show knock on effects:

    – Startups will be heavily hit, serial entrepreneurs especially (eg Elon Musk). This will require raising more outside funding, making control by founders harder to maintain.

    – Privately owned companies will be much more attractive than public cos due to being harder to value. The quality of companies going public will be even worse than now when it is already a problem.

    – Corporate financing equity, debt, capital gains/dividend, offshoring tax shifting decisions will become of more importance to investors. Corporations, pick your investors. 

    – Capital will be further misallocated to  muni debt and real estate

    – Massive disincentives for lower quantiles to save for college, retirement, children, and long-term care, and massive incentives for them to consume.

    etc,etc

    If all this was done one time to spend in a competent way it may be worth it, but there is no attempt to solve underlying structural problems. Eg.  College prices too high – just pay more. No attempt to limit cost growth or bloat, or address poor career selection amongst US citizens (75% of graduate engineering students are now foreign). Infrastructure will be bought at top dollar without concern for future maintenance costs.

    And on top of all this revenue, the structural deficits will STILL be massive. The average maturity of Treasury debt is 7 years. We have to roll the existing debt and their multi-trillionfuture deficits. If we roll the existing 30T in at a 1% higher rate that will roughly be an additional 200 – 300B/yr on-budget.  And  if inflation takes off it can be multiples of that. And I do not see Yellen channeling her inner Volcker in the face of a screaming horde of citizens asking for their new cash benefits.

    Finally, after 40 years of low inflation, markets are not set up for inflation. Eg.  long maturity  bond holders will face serious capital losses – and who holds those maturities? All the insurance cos and retirees who stretched for yield the past ten years, and care about capital preservation.  Only John Cochrane is sounding the alarm about US debt structure, I have yet to hear Yellen make a sound she is aware of and capable of managing these risks.

    As for those saying the US will siphon off the global savings ‘glut’. Maybe. But enjoy working for your foreign boss. Just don’t look to closely at what he is doing to his Uighur employees (NBA rule). And his debt situation ain’t looking so hot either… so. 

      • Yup. I think they may take off 5% here and there on a tax rate, or defer it for a few years to make Manchin happy — but in the end most of it will go through reconciliation. Only thing that will sink it is if Biden has a scandal or something that dings his 50%+ approval. But people want to party, the economy will boom short term and no one wants bad news when MMT is in bloom.

        Biden clearly learned from Social Security, Medicare, and especially *Obamacare*. The Republicans running on repeal for years, getting in power and then not being able to repeal it, sent a massive signal for Biden.

        Raise taxes significantly, then tie an even larger spending program to it, with a lot of short term direct -often cash – benefits that people see – and these are very large benefits. Free college – worth a lot. Child credits ditto.

        It will be 4 years at least before it can be repealed, likely eight, and only if the other party wins. But by that point the beneficiaries will make it impossible to repeal, so fact it passed via reconciliation on a party line does not matter.

        Eg good luck repealing these child care benefits a lot of people will claim little Johnny is only there b/c they counted on these.

  7. To Ben Cole

    “PS: The Democrats are going to cause inflation? This is Donald Trump’s Federal Reserve , more or less. I did not notice much fiscal austerity in recent Republican administrations.”

    Yup, Trump was driving with three whiskies under the belt.

    Does not justify Biden throwing back two bottles of Vodka before jumping behind the wheel of his Corvette.

    Scale is remarkably different.

      • The spending accompanying these taxes is even more massive, and spending is undercounted (eg COVID bill has a lot of one-time spending that congress has said they will make permanent). The CBO cannot keep up, yet even the most recent study showed 2T deficit by end of 2020s, and that does not include most of the spending of these first three bills.

        As to how the Fed will react in an inflationary crisis – I no longer view the Fed as fully independent, and not simply because of ideology. Whether run by Powell or someone else Biden appoints – just don’t see them being able to raise interest rates to inflation crushing levels given debt level + coming deficits. Collateral damage in the induced recession will be monstrous and congress will not dial back.

        I lived through a government debt crisis/ currency collapse when young. Yes, USA is different, it has a reserve currency, biggest markets etc. But we are running a pretty big experiment here on a non-linear dynamic system. I don’t think a country should run its finances priced for perfection.

  8. This is not some new insight or revelation; in fact it also applies to discussion about the estate tax. All tax rhetoric is about politics and not economic efficiency.

  9. It seems to me that some public employees stand to benefit from this. I am a public employee. I can put about about $50k per year into various tax advantaged accounts, including my self managed retirement plan.
    I think this policy will reduce the value of equities but also increase their nominal rate of growth (because for a given rate of growth they are less attractive now). So I will be able to buy assets more cheaply and see them grow more quickly, but I won’t have to pay the capital gains tax. Am I right in my reasoning?

  10. One of the jobs of the Federal Reserve is to provide a stable currency. It seems outrageous to penalize citizens by taxing them for the Federal Reserves failures.

    I saved a dime I threw aside as a 10 year old in 1955. At that time I could have bought 3 1/3 first class postage stamps with it, but a chose to save it. Since it was made of silver, today I could sell it for about $1.90.. If I bought first class stamps with the $1.90, it would buy about 3 5/11 first class stamps.

    There is a very strong case that I made nothing on saving the dime for 65 years, but accounting wise there would be a $1.80 capital gain. Why would even a penny tax be justified for the entity that did nothing but make economic calculation impossible by inflating the currency?

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