Don’t Index Capital Gains. Fix Inflation.

After several years of above-target inflation, policymakers in Washington are weighing whether to index capital gains for inflation. The Trump administration, for example, is considering indexation, and earlier this year, Senator Ted Cruz introduced legislation that would amend the tax code to index capital gains taxes to inflation. As things currently stand, capital gains are not indexed to inflation, so when inflation rises, so does the real tax burden investors face. While there are reasons to address this distortion, one overlooked benefit of the current system is that it concentrates the costs of inflation on investors, giving them a powerful reason to demand price stability. Indexation, therefore, may reduce investors’ reason to lobby for lower inflation in the first place, and may, inadvertently, lead to higher inflation.

The case for indexing 

Consider an investor who purchased $1,000 worth of the Vanguard Total Stock Market ETF on January 2, 2020, and sold it on July 31, 2026. At the time of the sale, those shares were worth roughly $2,236, so the investor realized a nominal capital gain of roughly $1,236. Note, however, that over the same period, the Consumer Price Index rose 29.4 percent. Just to preserve the purchasing power of the initial investment would have required the shares to appreciate by $294, so the investor’s real gain was roughly $942. 

Yet, because the current system taxes nominal gains, the investor owes taxes on the full $1,236, despite nearly a quarter of it being compensation for inflation. At a 20 percent statutory capital gains tax rate, our investor would owe about $247, but since his real gain was only $942, his effective tax rate was 26 percent, despite the statutory rate remaining constant. In other words, taxing the inflationary portion of his nominal gains raises his real tax burden.

The investor in our example was fortunate. Over the same period, he realized a cumulative real return of roughly 73 percent. Had his real return been lower, the inflationary component of his tax burden would have accounted for a larger share of his nominal gain, pushing his effective tax rate even higher. Suppose he had earned a 3 percent annual real return over the same period. In this case, his effective rate would have risen to 41 percent. At a 1 percent real return, his effective tax rate would have risen to nearly 87 percent. Figure 1 illustrates how the effective rate rises as the real return falls, despite the statutory rate remaining steady at 20 percent.

Figure 1: Inflation and Effective Tax Rates

Higher effective taxes on capital gains discourage capital formation. The resulting decline in investment leads to a smaller capital stock, leaving output, and therefore living standards, lower than they otherwise would have been, and the effect is far from trivial. In evaluating the benefits of price stability, Martin Feldstein estimated that even 2 percent inflation imposes substantial economic costs when capital income taxes are unindexed. He calculated that reducing inflation from 2 percent to zero would generate annual welfare gains ranging from 0.76 to 1.04 percent of GDP. Assuming those gains persisted as GDP grew at 2.5 percent each year, the present value of these gains at a 5 percent discount rate could be as large as 42 percent of current GDP. 

It is worth noting that the higher effective tax burden also complicates one common objection to indexation—namely that it is regressive. The Budget Lab at Yale, for example, estimates that indexing would deliver a six-figure tax cut to the top 0.1 percent while providing nothing to those at the bottom. This type of analysis identifies who would receive the immediate benefit from indexation, but it does not tell us anything about the long-run incidence of the reform. Capital taxes depress investment, reducing labor productivity and, by extension, wages. Thus, at least part of the higher effective tax burden brought about by the interaction between inflation and unindexed capital gains taxes is borne by workers.

The case against indexing

If we take Feldstein’s estimates seriously, the case for indexing seems obvious. But, like anything, it involves tradeoffs. For one, if the policy applies only to capital gains, it would leave other nominal features of the tax code, including the taxation of interest income and the deductibility of interest expense, untouched, potentially replacing one distortion with another. Indexation creates other problems. For example, policymakers must determine if it applies retroactively or only after the reform goes into effect. This may explain why some countries that have tried indexation, like the United Kingdom, subsequently abandoned it. 

But there is another issue with indexation that goes beyond these technical considerations. By reducing the costs of inflation, indexing may make inflation more likely by reducing support for anti-inflationary policies.

While the proximate cause of inflation is economic—nominal spending growth persistently outpacing the economy’s productive capacity—its persistence reflects underlying political and institutional issues. Inflation, especially unexpected inflation, creates both winners and losers. With fixed nominal debt contracts, for example, unexpected inflation reduces real debt burdens, transferring wealth from creditors to debtors. The distributional effects of inflation create incentives for interest groups with a stake in monetary policy to influence it. We can think of inflation, therefore, as partly a political contest over who bears its costs and which groups have the incentive to influence and resist it.

Since the tax code taxes nominal rather than real gains, investors, as we have seen, bear part of the cost of inflation. While this leaves them worse off—especially as inflation rises—the lack of indexing also concentrates part of inflation’s cost on investors, strengthening their incentive to demand price stability. Indexation would weaken this incentive, and, with it, the political pressure investors put on policymakers for low inflation.

This insight, while counterintuitive, isn’t new. Stanley Fischer and Lawrence Summers argued in 1989 that policies designed to reduce the costs of inflation could themselves lead to higher inflation by making it less costly to tolerate it. For that reason, they viewed indexation with considerable skepticism. Perhaps surprisingly, Feldstein raised the same concern, warning that indexation could erode “public support for anti-inflationary policies,” in which case “the net effect of indexing on economic welfare may be negative.” 

There is some evidence suggesting these concerns are valid. Adam Posen examined the link between low inflation and central bank independence to uncover what was driving the well-known link between the two. He observed that de jure independence alone did not deliver price stability. Instead, Posen found that what mattered more was the strength of organized financial opposition to inflation. In those instances where influential financial interests stood to lose from rising prices, central banks enjoyed both greater effective independence and the political support necessary to use it. Where such a constituency was weak or absent, Posen found that formal independence did much less to restrain inflation. In short, delivering low inflation depends, at least in part, on the political support of interest groups with a strong stake in stable prices. Without it, low inflation is unlikely.

Supporters of indexation and low inflation might reasonably ask why we shouldn’t do both. The trouble with this approach is that it treats tax and monetary policy as though they are determined independently of one another. The argument above suggests they are not. Fischer and Summers warned that it would be a mistake for governments unable to credibly maintain low inflation to adopt policies that make inflation less costly on the grounds that doing so would likely lead to higher inflation. Although the Federal Reserve still enjoys a great deal of credibility, inflation has remained above target for five years. It would be a mistake, in my view, to weaken the incentive investors have to lobby for price stability. Indexing capital gains would do exactly that.

Fix inflation, not the tax code 

The distortions caused by the interaction of inflation and taxes on nominal capital gains are a real problem. The solution, however, is not to make inflation easier to live with. It is to keep inflation low. If policymakers want to fix these distortions, they should focus instead on monetary reform. A credible monetary rule, such as a nominal GDP level target, would give the Federal Reserve room to look through temporary supply shocks while constraining sustained growth in total dollar spending. Doing so would make persistent inflation less likely, and, as a result, reduce the problems caused by a lack of indexing.