capital gains tax: a modest proposal

I have a little idea here. I make no claim that I am the first to suggest this -- or at least this general idea. I haven't seen it suggested anywhere else, but I haven't actively searched.

Anyway, I see people argue that capital gains should be taxed as regular income rather than at lower capital gains rates. As background, capital gains is the money you made on investments you held for more than a year. If I buy stock for $1000 and sell it for $1,500, I've made a $500 profit, and have to pay taxes on it. If I held the stock for less than a year, the that profit is taxed as regular income. So if I'm in a 22% marginal bracket, I have to pay $500 × 22% = $110 extra tax on it. But if I held the stock for more than a year, the profit is a capital gain, which may be taxed at 15% -- in this example, that would be $75 in tax.

At first glance, there's a certain intuitive appeal to taxing capital gains as regular income. It's income, so why treat it differently? But that treatment completely ignores the effects of inflation. Consider a world with a constant 3% inflation. Because of inflation my actual gain is less than the difference between what I paid for an investment and what I sold it for. If I buy stock for $1000 and sell it fifteen years later for $1500, I've actually lost money. To break even (after inflation), I'd have to sell the stock for $1558. And yet, despite breaking even I have to pay taxes.

In fairness, I should acknowledge that I have no idea if inflation is the reason for capital gains being taxed at lower rates than regular income. If so, what we have is a piss-poor arrangement. The effect of inflation can be very different in times of high inflation than in low. And the effect can be very different for a security held for just over a year than for a security held for decades.

Which brings me to my idea. The tax code should be changed to include adjustments for inflation when securities are held for more than a year. This could be accomplished by having an index with one value for each year -- to reflect inflation. If you buy a security in year X and sell it in year Y, the cost basis would be multiplied by the ratio of the index in year X to the index in year Y. That way, you would only be taxed on the gain after accounting for inflation.

I realize that the above is kind of a broad-stroke prescription, and a lot of details would have to be filled in. But it's a start. or at least it would be if the congresscritters would see it.