The Hidden Consequence of Inflation: Higher Taxes

It’s easy enough to see the consequences of inflation at the checkout counter. But the hidden cost of inflation — one that few see and just about nobody talks about — is the increased tax burden that flows directly from rising prices. For example, Minnesota is currently sitting on a $9.25 billion budget surplus. To be clear, this is state and federal taxpayers’ money, collected and disbursed over and above the budget needs of the state.

How could this happen at a time when businesses across Minnesota and the nation were shuttered and most employees were ordered to stay home? It happened because trillions of additional spending power was put directly into the hands of Americans and, not surprisingly, they spent it.

Don’t forget that sales taxes are based on the cost of goods and services purchased. When the costs go up, sales-tax revenues go up. In Minnesota, for example, general sales-tax revenue was projected to be $6.169 billion during 2020-2021. When all the chips were counted, total sales-tax revenue actually collected was $13.611 billion — and that’s without a tax hike.

At the federal level, this phenomenon is even harder to spot and perhaps even more financially debilitating. It comes in the form of capital-gains taxes on the sale of appreciated assets. The tax is calculated based on the difference between the purchase price of an asset (its “basis”) and the sales price. The difference is the gain or loss.

To illustrate, suppose I buy XYZ, Inc. stock in 2010 for $5 per share. I sell the stock in 2020 for $10 per share. I realize a profit of $5 per share. The profit, and resulting tax liability, do not take into account the question of how much of the $5 per share increase is attributable to inflation.

The calculation of basis in capital assets (stocks, bonds, savings accounts, real estate) is not indexed to inflation. The only thing that is measured is the nominal gain or loss. As far as the IRS is concerned, if you sell an asset for more than you paid for it, you have a taxable gain, period. And this is true regardless of the fact that all gains may be purely attributable to inflation over the holding period.

There are dozens of provisions of the tax code that are indexed to inflation, including the income-tax brackets themselves. The idea is that one’s income-tax rate should not necessarily increase simply because inflation pushed his income up. But capital gains do not benefit from the same treatment.

In 2019, Senator Ted Cruz and about 20 other senators pushed then-Treasury secretary Steven Mnuchin to use the Treasury’s regulatory authority to redefine the term “gain” by taking inflation into account for exactly the reasons I express above. In his letter to Mnuchin, Cruz used the following example to illustrate how non-indexed capital gains result in taxes on phantom income:

Imagine, for example, a taxpayer who purchased one share of Coca-Cola in 1998 for $32.28. If they sold the stock earlier this year [2019] at $48.13, they would have a nominal gain of $15.76 and be taxed $3.75. The inflation-adjusted basis [stock cost] in today’s dollars, however, would be $50.50. That means the taxpayer would have to pay $3.75 in taxes on a $2.39 loss.

Cruz’s example takes into account inflation during a period in which the rates were relatively low and stable. We are now in a period when inflation rates are high and are likely to be so for the foreseeable future. This clearly leads to the unjust enrichment of the Treasury, just as we see with the coffers of Minnesota.

The current era of inflation promises to slam more than just phantom gains in securities.

Consider what’s now happening with real-estate markets. Home prices are at all-time highs and are experiencing year-over-year double-digit growth. This growth makes the idea of selling a home quite attractive (if we forget about the cost of replacing it) to those who have owned a home for decades. But without careful tax planning, seniors may wake up to find that inflation eviscerates much of their apparent gains, the last thing they need either in or approaching retirement.

Current law exempts from taxation the first $250,000 of capital gains ($500,000 for married filing jointly) from the sale of one’s main home under certain circumstances. For example, a single person owns a home with a basis of $100,000. She sells it for $300,000. Her profit, $200,000, is under the limit and not taxed. But this exclusion is not indexed for inflation. It was fixed in 1997, and has not been changed since.

If, for the sake of argument, inflation alone has pushed the home’s value to, say, $450,000, now the nominal profit is $350,000. The seller is taxed on her gain of $100,000 over the exclusion. This tax applies regardless of the fact that all the gain is (in this case) purely attributable to the failing dollar. Adding insult to injury, if she wishes to buy a similar home in another town because, say, she has a new job, she will have to pay the inflated price for that, but will have fewer dollars with which she can do so. Other than the inherent unfairness of this, it’s not hard to see how this might discourage job mobility. It is also not hard to see that this phenomenon will cause many to opt not to sell their appreciated homes, thus locking in the capital, making it unavailable for other uses.

The income-tax system generally and the capital-gains tax in particular punish savings, investment, and productivity. But these are the very things needed to generate a stable, growing economy. Now more than ever we need to get the boot off the neck of economic productivity because that will go a long way to cure the inflation pandemic that’s infected America. (For more from the author of “The Hidden Consequence of Inflation: Higher Taxes” please click HERE)

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