There is considerable support, both inside and outside govern-
ment, to make some adjustment for inflation in the tax system. In 1986,
the U.S. Treasury proposed the indexation of capital gains, but this pro-
vision was never enacted into law. In 1997, the House of Representatives
included capital gains indexation in its tax law, but it was removed by
House-Senate conferees under threat of a presidential veto. Under these
plans, investors would pay taxes on only that portion of the gain (if any)
that exceeded the increase in the price level over the holding period of
the asset. Although this legislation is currently dormant, in recent years
the Federal Reserve has kept inflation low, and this has reduced the im-
pact of the inflation tax.
INCREASINGLY FAVORABLE TAX FACTORS FOR EQUITIES
In recent years there have been some very favorable tax developments
for stocks. They include the following:
- Reduction in dividend and capital gains tax rates
- Lower inflation, which reduces the inflation tax imposed on
nominal capital gains, - Switch to capital gains from dividends, which increases the de-
ferral benefit
The capital gains tax rate has been reduced from a maximum of 35
percent in 1978 to 15 percent in 2003. Until 2003, when the tax rate on
dividends was for the first time decoupled from the tax rate on ordinary
income, the tax rate on dividends ranged from a high of 90 percent in the
immediate post–World War II years to 33 percent in 1998 and then to the
special rate of 15 percent in 2003. (See the appendix at the end of the
chapter for the history of the tax code.)
Since the tax law is based on only nominal values uncorrected for
inflation, inflation imposes an additional tax on capital gains. The infla-
tion rate has fallen from double-digit levels in 1979 to the 2 to 3 percent
level in 2007. Since tax brackets are indexed to inflation, the tax rate on
dividends is not directly affected by inflation. Furthermore, since the
capital gains tax is based on realizations instead of accruals, firms have
been buying back shares in lieu of paying dividends and generating
more capital gains income. As a result, the average dividend yield has
fallen from about 5 percent before 1980 to only 2 percent in 2007.
It can be calculated that all these factors have increased the real
after-tax return on stocks by more than 2 percentage points over the past
30 years for a givenbefore-tax return. Although the real after-tax return
72 PART 1 The Verdict of History