Here’s a trick question for you: How much has the stock market gone up this past year?
The S&P is up 12%, the narrower Dow Jones Industrial Average 10%, the much wider Wilshire 11%. The capitalists are doing well — that makes me happy. Except, however, that stock market indices are not indexed for inflation. Inflation was 7.5% over the past 12 months. The indices are therefore up in real terms by 4.5%, 2.5%, and 3.5%. Maybe those investors who create that richer future for us by their investments aren’t doing so well.
Consider, also, that Jeff Bezos and Elon Musk are, apparently, worth around $200 billion each. That begs a question: How much do they need to make in one year in order to not be losing money? The answer is a stunning $15 billion each. For them to be in the same place at the end of the year as they were at the beginning of it, their fortunes have to rise by 7.5% each at a time of 7.5% inflation — obviously. So, if they make less than $15 billion each, then they’re actually losing money. That is to say, they have negative incomes.
This is more than just a strange observation. It strikes at the heart of how we can organize our tax system.
Long-term capital gains are taxed at lower rates than working for a living. There are those who demand that this be changed, that the two sources of income be equally taxed. But that then brings us to this problem of how we deal with inflation.
Taxing the increase in value simply from inflation itself seems somehow wrong. This becomes obvious if we consider several years of significant inflation. Because it compounds, a decade of 7.5% inflation, just to use today’s rate, would turn $100 into $206. So we tax that gain at income tax rates and the person is poorer than when they started. Which sounds like a strange way to tax the income from an investment!
In the real world, there have been two methods of dealing with this — both used by my native Britain at different times. One is to apply tax at income tax rates but with an inflation allowance. The other is to provide no inflation allowance but lower tax rates. It’s also true that either approach produces about the same amount of tax revenue.
A conclusion: While it would be both populist and popular to increase capital gains tax rates to those of income tax, the necessary inflation adjustment mechanism means it doesn’t, in fact, do very much.
Or to return to Bezos. In a time of 7.5% inflation, like this past year, a $15 billion increase in his stock value isn’t in fact an income nor profit — it’s just keeping up with inflation. So how and why are we going to try and tax him on that?
Remember, the best investors are ultimately investing to our benefit also.
