Capital gains taxation, a seemingly straightforward concept, is riddled with complexities that often result in taxpayers shouldering more than their fair share of the burden. When selling capital assets, such as real estate or company shares, taxpayers are generally taxed on their net earnings (capital gains). Conversely, net losses can usually be deducted from income when calculating tax liability. However, the current policy has a significant flaw: it fails to account for inflation when calculating capital gains.
Under the current system, the original purchase price of an asset (tax basis) is subtracted from the selling price in nominal terms, without any adjustment for inflation. This means that capital gains taxes are applied to nominal, not real, increases in wealth. In some cases, this results in taxpayers paying taxes on what appears to be a capital gain but is, in real terms, a net loss due to inflation.
The federal tax code attempts to address this issue by applying a different rate schedule to long-term capital gains (net gains on assets held for more than a year) than to ordinary income. Depending on a taxpayer’s overall taxable income, a rate of either 0 percent, 15 percent, or 20 percent applies to all their taxable long-term capital gains. However, this accommodation is far less common at the state level.
Thirty-one states and the District of Columbia overtax capital gains income by subjecting it to the same rate schedule as ordinary income. Two states, Minnesota and Washington, even impose higher rates on capital gains than on ordinary income. Only nine states, like the federal government, apply lower effective individual income tax rates to long-term gains than to ordinary income.
Lower rates on long-term capital gains income can seem like preferential tax treatment. However, when inflation and other layers of taxes are considered, it becomes clear that this is not the case. The failure to adjust for inflation, combined with most states’ failure to adjust rates accordingly, results in the widespread overtaxation of capital gains income in the United States.
As savings and investment are critical for both individual financial security and the health of the national economy, policymakers should consider how they can mitigate, rather than exacerbate, tax codes’ biases against saving and investment. For more detailed information on state capital gains tax rates, visit here.