Inflation On Investment Decisions Through Gains Tax

First, inflation must be addressed. Inflation is the rate at which the price of goods and services is rising, meanwhile weakening the purchasing power of a particular currency. Money subjected to inflation will be able to buy less goods and services over time. The inflation rate is usually 2-3%.

Decision Making Under Inflation:
Inflation is a common problem that complicates investment decision-making. It is important to treat inflation in the cash flow statements and discount rates. Business owners recognize the existence of inflation however they do not act to incorporate inflation in capital investment analysis. The executives generally estimate cash flows assuming unit cost and profit prevailing in year zero to stay constant. The argument is that if inflation occurs, then prices can be adjusted to cover rising costs. This way the effect on projected profitability will be the same if a rate of inflation is assumed to be zero. This argument fails when two points are brought into view. First, the discount rate for cash flows is shown in nominal terms. It would be inconsistent to utilize a nominal rate for constant cash flow discounting. The second issue is that selling prices show different reactions to inflation. In some instances; prices may be government regulated. Also prices can be controlled by competition where a long-term contract to supply goods at a fixed price exists.

Capital Gains Tax and Inflation:
Capital Gains tax is a tax charged on capital gains, which is the profit gained on the sale of a non-inventory asset purchased at a lower price. The large capital gains tax is believed to actually lower revenue rather than increase it. Revenue would increase under lower gains tax because investors would be more interested in selling assets frequently.A fair taxation system indicates that two people with the same income should pay the same tax. The primary sources of capital gains however are inflation and retained earnings.

Example:
1. An investor bought $12,000 worth of stock options, and sold the stocks for $18,000 the following month with the transaction not being subjected to inflation. The investor paid no gains tax. The following investor paid a large gains tax as a result of inflation.
2. An investor bought $10,000 worth of stocks in 1973 in a diversified portfolio. The investor held on to the stock for 20 years at a 3% inflation rate and sold it in 1993 for $42,019 and would be responsible for $32,019 tax on that nominal gain. The reality is that the rise in consumer price-index means that it took $32,545 in 1993 to buy the same amount of goods as purchased for $10,000 in 1973.
It is inflation that created a fake gain of $22,545 the doesn’t correspond to an increase in wealth. The only real gain realized is $9,474 in 1993 when inflation-adjusted. (The difference between $42,019 value and the initial $10,000 investment in 1993 prices). The “real” gain was only 30% of the taxable nominal gain: $32,019.
 Therefore, taxing the entire nominal gain violates the principle of fairness, because a nominal gain is not real income. Theoretically of the investor spent the $32,019, the real value of the remaining assets would far less than they were 20 years earlier. So taxing the nominal value is like taxing someone who withdrew money from a bank account. It isn’t real income.
Fortunately, some investors are smart enough or lucky enough to outperform the overall share price index. Then they have gains which exceed the combination of inflation and retained earning. It is appropriate to tax such gains.

A high capital gains tax discourages savings and risk taking. Since the tax is levied only when the asset is sold, investors lock into old investments even when returns on investments is higher elsewhere. Finally, past experiences prove that reduction in current capital gains tax rate would raise tax revenue since there would be an increase in volume of realized gains, and would outweigh the lower tax rate.

Bibliography:
www.seekingalpha.com, “Inflation, Deflation and Your Investment Decisions”, David Merkel December 6th, 2007.
www.professional-edu.blogspot.com/2010/06/196-investment-decisions-under.html, “Investment Decisions Under Inflation” June 4th, 2010.

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