Bitcoin’s Hidden Tax Problem: How Inflation Could Inflate Investors’ Capital Gains Bills

• After Bitcoin's 22% weekly increase in price, investors are debating whether to pay capital gains tax on nominal gains.
• The US Treasury Capital Gains Indexing Authority has unclear rules regarding it.
• Bitcoin investors are still liable to pay taxes on nominal gains.

Bitcoin (BTC) has rallied over 22% this week, after the U.S. Treasury Department announced plans to double the size of liquidity buybacks, an operation meant to help the plumbing of the government bond market rather than the cryptocurrency. While the move pushed the coin to its highest level in three months. It also added a new piece of evidence to a long-running tax argument.

Senators Ted Cruz (R-TX) and Tim Scott (R-SC) urged Treasury Secretary Scott Bessent in March to index capital gains to inflation through executive action rather than a congressional act. House Republicans responded with a similar letter a few days later. Americans for Tax Reform, whose president, Grover Norquist, has publicly argued the case, contacted the White House directly.

Conservative economists and tax reform groups have been making the argument for decades that when an asset's dollar price rises due to the dollar's weakness, taxing the full nominal increase takes a bite out of wealth that never existed. It has traditionally focused on homes, farms, and small businesses. Bitcoin is its most recent illustration.

The Problem With Capital Gains Tax

The Treasury Department's new program added liquidity support buybacks for longer-dated nominal coupon securities, increasing it from $2 billion to at least $4 billion per operation, on Wednesday. 

Bitcoin did not change internally, however. Ever since the announcement, the market has taken it as rather bullish news. In effect, investors who bought the rally on the logic were making the same claim that the tax reformers have continued to make: that the number went up because the dollar index also went down, with the US Dollar Index (DXY) falling below the 200-day moving average the first time in three months. 

Bitcoin's price was trading at $77,198, up 0.1% in the last 24 hours. On Stocktwits, retail sentiment around BTC remained in the 'extremely bullish' zone, while chatter stayed at 'extremely high' levels over the past day.

Inflation Can Turn Nominal Gains Into Taxable Illusions

This has prompted investors to question the distinction at the center of the capital gains tax debate, between a nominal gain and a real one. For instance, an investor who bought bitcoin at $50,000 to $100,000 and sold at $75,000 recorded a $25,000 nominal gain and owes tax on it. 

Now, whether the investor is $25,000 wealthier depends on what the dollar did in the interim. If consumer prices rose considerably during the holding period, some of that gain did not buy anything new. The distinction therefore is not made in the tax code. It is taxed on the difference between the price paid and the price received in whatever dollars are in use at that time.

President Of Americans for Tax Reform Warns of Inflation Tax Burden

Speaking to Fox Business, President of Americans for Tax Reform Grover Norquist said “The government creates inflation, the government shouldn’t profit by the inflation they create by raising taxes on people who own crypto, or the more than fifty percent of people who have houses, the more than sixty percent of Americans who have their life saving in stocks and bonds, or the millions of Americans with farms, small businesses, and land.” He added that, “Go straight down the middle of Main Street, and you see people who are damaged by the inflation tax for small businesses.”

The same department that collects the receipts when assets rally in response is expanding buybacks to keep the long end of the Treasury curve liquid. The Treasury created its buyback program in part because the magnitude of coupon issuance has stressed liquidity in the second market for off-the-run securities. Earlier in the week, Michael Howell, Cross-border capital founder, saw yields rising higher testing 6%, which he said could end in further liquidity crunch, which would leave less room for investors to buy risk assets like Bitcoin.

Why Capital Gains Indexing Still Faces Legal Hurdles

The Economic Recovery Tax Act of 1981 indexed federal income tax brackets to inflation, and the provision went into effect in 1985, putting an end to Bracket creep, which previously forced taxpayers to pay higher rates on flat real incomes. However, capital gains were left out, and supporters of indexed tax have argued that the same logic applies to taxing the increase in real wealth rather than the erosion of currency.

It is not up to the treasury to decide whether to extend the principle. In 1992, the George H.W Bush administration investigated indexing by regulation but abandoned it after the Department of Justice and White House counsel determined that it lacked authority to do so, according to an analysis by Elena Patel, co-director of the Urban-Brookings Tax Policy Center. Cruz pushed Treasury Secretary Steven Mnuchin to do the same back in 2019, but Mnuchin left it up to Congress. The final objection has not been altered either.

Where Do We Stand?

For the time being, long-term Bitcoin holders will have to calculate their liabilities in nominal dollars, including profits from weeks such as this, when the price fluctuated based on the cost of money rather than anything Bitcoin did.

Read also: Standard Chartered’s Kendrick Says Bitcoin Has ‘Turned The Tide,’ Keeps $500K Target

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