An interesting property of a capital gains tax that isn't adjusted for inflation is that it can, in times of high inflation, turn gains into losses after adjusting for inflation. For example, suppose that inflation in a particular year is 7.6%. If you earn an 8.6% return on your investment and face a capital gains rate of 39%, then your nominal return, post-tax, is only 5.2%, which is a real loss of greater than 2%.

This is not merely theoretical; the numbers I gave are for 1978, when inflation was 7.6% and 6-month CDs returned 8.6%. There were similar results for other years around that time. And actually, I think a 6-month CD might be taxable as ordinary income, which would mean an even greater real loss for people in the higher brackets.

If investment income were indexed to inflation, this would not be possible, as you would only be taxed on your returns above and beyond inflation. I would propose that all investment income be adjusted for inflation, but it would be unwise to give the government any further incentive to understate inflation. I think the wisest course is to abolish tax on investment income altogether, especially given the nation's dismal savings rate.

By the way, what would be the correct word to use if I wanted to give this post a non-ironic title? Is there a word that describes two bad things which combined are worse than the sum of the parts?

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I have some graphs on after-tax, after-inflation returns here.