Taxes on capital gains need to be adjusted for inflation. Here’s why:
This example envisions $1,000 invested on Jan. 1 of year 1 and remains invested with dividends reinvested for 10 years. The investment returns 5 percent every year and inflation is 3 percent every year. At the end of the 10th year, the investment has a value of $1,629 (that’s the 5 percent), but over the same ten years, the same $1,000 has inflated to $1,598 (that’s the 3 percent). So if prices have increased by 3 percent per year to match inflation, what would have cost $1,000 at the beginning of year 1 would cost $1,598 at the end of year ten. In terms of buying power, the investment has yielded an increase of $31 ($1,629 minus $1,598). So if a capital gains tax of more than $31 is imposed, the investor will have lost actual buying power from the investment. In this example, no part of the investment is tax exempt.