Inflation can significantly affect investment returns, raising questions about the fairness of current capital gains tax policies. Consider an investor who puts $10,000 into a stock with no dividends, achieving a 10% annual return over 20 years. By the end of that period, the capital gain would be $57,275. However, if inflation averaged 3% during those two decades, roughly half of that gain reflects an increase in prices rather than a real rise in purchasing power.

This scenario has prompted calls, including recent proposals in Congress, to adjust capital gains taxes for inflation. Proponents argue that taxing nominal gains penalizes investors on "phantom" profits that do not translate into actual increases in wealth. However, opponents caution that indexing capital gains to inflation could create significant economic distortions.

One concern is how inflation-indexed gains might affect investors’ required yields on other assets, such as bonds. If stocks—typically perceived as appreciating assets—were shielded from inflation taxes, investors might demand higher returns on bonds or other fixed-income instruments to compensate, potentially driving up borrowing costs for governments and corporations. This is especially relevant given that long-term interest rates are currently near multi-decade highs across many markets globally.

Additionally, the value of tax-deferred retirement accounts may come into question. While contributions to plans like 401(k)s defer taxes until withdrawal, distributions are taxed as ordinary income, which includes the inflation component. This could disadvantage retirees who have built substantial savings, as well as lower-income individuals with limited retirement assets. Capital gains already enjoy preferential tax rates compared to wage income, and some analyses suggest that indexing these gains for inflation would disproportionately benefit higher-income taxpayers. For example, data from the Tax Foundation indicate that the top 20% of earners could see after-tax income increases more than ten times greater than that of the bottom 20% if gains were adjusted for inflation.

From a fiscal standpoint, indexing capital gains to inflation poses a substantial challenge. The Yale Budget Lab estimates that applying such a measure retroactively could reduce federal revenues by $1 trillion over a decade, a significant concern amid ongoing budget deficits.

Despite these complexities and the unlikelihood of immediate policy changes, the discussion highlights a broader issue for savers. The recent bull market, while generating strong nominal returns, has been partially buoyed by inflation, which erodes the real value of investment gains. For instance, the S&P 500’s annualized return over the past five years stands at 14.3% nominally, but only 9.5% after adjusting for inflation, which has generally exceeded the Federal Reserve’s target during this period. Over the previous decade, nominal returns averaged 13.8% annually, but the inflation-adjusted figure was closer to 11.8%.

Investors should be aware that inflation, often dubbed the "cruelest tax," subtly diminishes the purchasing power of their savings, independent of legislative action. This ongoing impact underscores the importance of considering inflation’s role in investment planning and tax policy discussions.