ay taxes on a capital gain of $800, when the real gain was not that high. Assuming, for purposes of illustration, that the applicable tax rate on the capital gain was 28 percent, the income tax liability on the gain would be $224. If the same tax rate were applied to the capital gain applicable to the valuation of both the acquisition cost and the sales price in year one dollars ($350), the income tax liability on the gain would be only $98, while, if the same tax rate were applied to the capital gain applicable to the valuation of both the acquisition cost and the sales price in year one dollars ($700), the income tax liability on the gain would be $196.
Proponents of the concept of an inflationary distortion on taxes would contend that the preceding example illustrates that the effective tax rate, when the capital gain is determined by the difference between nominal values only ($800), is 64 percent ($224/$350) on the real capital gain based on adjusting the sales price to year one dollars, or 32 percent ($224/$700) on the real capital gain based on adjusting the acquisition price to year ten dollars (Schall, 1989; von Furstenberg, 1976). This contention, however, overlooks the fact that the taxes paid on the capital gain recognized in year ten are paid in depreciated year ten dollars. Thus, in real terms, the $224 tax payment represents only $112 in year one dollars. Considering the depreciated value of the taxes paid, the effective tax rate, when the capital gain is determined by the difference between nominal values only ($800), is 32 percent ($112/$350) on the real capital gain based on adjusting the sales price to year one dollars. The effective tax rate would remain at 32 percent ($224/$700) on the real capital gain based on adjusting the acquisition price to year ten dollars, because the taxes would also be paid in year ten dollars.
Thus, as the preceding example illustrates, inflation does distort taxes, but not to...