A portion of the “capital gains” on any investment is the price appreciation due to inflation. It follows that a part of the capital gains tax is an “inflation tax.” So, why don’t we separate and call it what it is: INFLATION TAX!

Let’s say that you bought a house in the Bay Area for $200,000 in 1975 (lucky you!). Now it is worth $1,500,000 (not unrealistic for some places in the Bay Area). If you sold it next year at that price, you would incur capital gains of $1,300,000. If you are married, you would be allowed an exemption of $500,000. That would bring your taxable gains to $800,000. At 20% tax rate (I assume that is what it will be next year) you would owe Uncle Sam $160,000.

Using the “Implicit Price Deflators for GDP” from the Bureau of Economic Analysis, I figured that inflation has caused prices to go up 3.375 times since 1975, and the inflation-adjusted purchase price of your house should really be $675,000. Using this adjusted purchase price, your taxable gain would be $325,000 and you would owe Uncle Sam a “real” capital gains tax of $65,000. Your inflation tax would come to $95,000, which corresponds to an inflation tax rate of 29% based on the real capital gains, or 12% based on the “fictitious” capital gains.

Now, let’s say that you invested your money into stocks and “made some money” by buying 100 shares of SPY (an ETF that reflects S&P 500) at the end of 2001 for $114.30 and sold it at the end of 2011 for $125.50. You would incur capital gains of $1,120 and pay a tax on it of $224 (I am still using the 20% rate). In reality, however, the inflation-adjusted price of SPY would be $142.81 at the end of 2011 and you would have lost $1,731. As if it was not bad enough that you did not even recover the principal you invested in the stock market, you would be “punished” by your government for being a bad investor!

With all the discussion going on whether the “capital gains” tax should be 15%, 20%, or some other rate, I wonder why nobody is asking why we have to pay an inflation tax.