On many different occasions, I have argued that, from an economics perspective, North Carolina should abolish its tax on capital gains. But leaving economic analysis aside, assuming that the state is going to tax capital gains, what would be the fairest way to do it?

It seems to me that, regardless of the standard of fairness invoked, most people would agree that only actual gains should be taxed. But the reality is that, in the state of North Carolina and most other places including at the federal level, taxes can be levied on capital gains even if no actual gains have been realized. In fact, capital gains taxes can be levied, and often are, in situations where there are losses.

To understand how this can be the case, we must first understand that “capital gains” refers to the difference between two prices—the price that an asset or piece of property is purchased for and, subsequently, the price for which that asset or property is sold. Capital gains taxes are applied to the difference between the two.

So, how can something be taxed when there is no gain or even when there is a loss? The answer is inflation. Inflation is a general rise in the average level of prices across the economy and, as I explained here, in a growing economy is caused by too much money creation on the part of the Federal Reserve. The taxation of capital gains takes no account of inflation and therefore often taxes what are called “phantom gains,” that is, gains that have occurred, not because the asset has become more valuable, but because the price of everything has increased.

This can be illustrated with a simple example. If I purchased a plot of land today for $100,000 and sell it in 10 years for $110,000, this sale, for tax purposes, would show a 10 percent capital gain. In North Carolina, where capital gains are taxed at the personal income tax rate of 5.49 percent, this rate would be applied to the gain of $10,000 and the taxpayer would pay a tax of $549. But if over that same 10-year period the general price level rose by 10 percent, the reality would be that there was no real gain in the value of that land. Its price simply rose by the same amount as all other prices. In other words, the real, inflation-adjusted capital gain would be zero. Despite this, the state would still tax the gain as if there were no inflation and the value actually rose by 10 percent. Clearly, the fair thing for the state to do would be to adjust that gain for inflation, in which case no tax would be due.

I noted above that a person could even be taxed on a capital loss. If prices generally rose by more than 10 percent over the 10-year period, for example by 12 percent, then the asset owner in the situation described above would actually lose 2 percent on his or her investment. Despite this, the investor would still pay the full 5.49 percent on $10,000. Of course, an asset’s price can go up by an amount that is more than the general rise in prices. If there is a 5 percent increase in prices over the 10-year period, then the taxable gain after, after the $10,000 is adjusted for 5 percent inflation, would be $5,000.

The point is that a simple notion of fairness would dictate that all capital gains should be adjusted for inflation before they are taxed. As it stands, North Carolina state government is taxing phantom capital gains income. It is easy to understand why, from the perspective of the state treasury, this might be viewed as a nice windfall.  In reality, it is a blatantly unfair practice that punishes people who invest in capital gains-yielding assets.