Inflation and capital gains

The taxation of capital gains has always created difficulties for experts and governments. An economic definition of income of the Schanz-Haig-Simons type, which is the most accepted one for taxation, would call for the inclusion of capital gains in taxable income on an accrual basis, inasmuch as the ability to pay of the taxpayer is clearly enhanced by these gains. In practice, however, various difficulties have prompted most countries to either exempt them or tax them only when they are realized. Even then, only part of the gains are generally included in taxable income; or, alternatively, they are taxed at lower rates than other incomes. In the absence of inflation, this preferential tax treatment definitely favors those who receive these gains.

When inflation is present, capital gains will be distorted and, as normally measured, will no longer conform to the Schanz-Haig-Simons definition of income. As Goode has put it, “Appreciation in the price of an asset that reflects only a general rise in prices is a fictitious gain because it gives the investor no increased command over goods and services.” The tax laws generally do not make a distinction between gains that reflect an actual real increased command over economic resources (real gains) and those that do not (fictitious gains). Thus, during inflationary periods, at least part of the capital gains tax will inevitably become a tax on wealth, rather than income, because it will be levied on the fictitious gains.