Inflation and its impact on capital gains tax in El Salvador

It may sound obvious, but historically, economics has recognised that the profits of any business are obtained after selling or transferring an asset, at a higher value than the cost of acquiring it by the transferor. This profit margin, or greater value, has always represented income and indicates that the recipient has gained something (hence “profit”).

In a simple example, if a car costs 30 tyres to buy, and then sells for 40, the profit is 10. To know if this was a good deal, we have to consider that maybe the cars now cost 40 tyres and not 30, so no one would sell them for less than that amount. So did the car go up in value, or did the tyres lose their value?

The introduction of currency as a measure of the value of things made it possible to standardise what could not be achieved with barter, that all things should have something to compare their value with. This is the origin of monetary theory. Every asset has a price and this price is the currency value of that good, which allows a fair comparison with other assets.

However, the problem arises when the currency (as a measure of value) changes its scale. In the example, by exchanging tyres for coins, the car is no longer worth 30 coins, but 40 coins, and this may be because the good is worth more, or because the coin is worth less.

In a market economy, if the car is worth more, it may be because demand for the car has increased, or because availability has decreased, or a mixture of both. The same situation applies to currencies: if there is a lot of demand for them, the price may go up, if there is little available, the price may go up, and vice versa.When there are too many currencies available, or if nobody wants to have them, their value decreases. This is inflation.

Prices “inflate” across the board because the currency given in exchange loses its value in the same way. So, in an inflationary regime, if the car was purchased for 30 tyres and is now transferred for 40 coins, is that difference effectively a gain or just the loss of value of the coins, being a mere correction of the monetary value of the car?

For as long as history has recorded, the rulers of nations have demanded the cooperation of their subjects/servants/citizens to finance government expenditures. Without dwelling on its historical development, let us stay with contemporary tax theory. Today, indirect taxes shift the financial burden of paying the tax to a third party (VAT is financed by the final consumer in the value chain, and the seller receives the contribution to pay the tax, deducting what he has already paid to his suppliers).Direct taxes are levied on the person who owns or obtains an asset (wealth tax or income tax).

Among the latter is capital gains tax.Returning to the example, if the car cost 30 coins and was sold for 40, the capital gain (the higher value) obtained is 10, and on that difference, 1 coin is paid to the Treasury, leaving 9 as the final profit of the businessman. But now, the big question arises again: are those 10 coins effectively a profit (on which it seems fair to pay taxes), or is there really no profit, but only the readjustment of the value of the good?

In the latter case, the tax appears to be levied not on income but on the recovery of the value of the asset, unwittingly turning it into a wealth tax.

In part, modern economics tried to overcome this by linking the value of the currency to the general value of goods, indexing inflation to the change in prices of certain basic goods and services.In this way, an attempt was made to minimise the loss of value of the currency and, in some international experiences, to try to use this index to establish prices that were not affected by inflation.

A clear example of this is the Chilean Unidad de Fomento (UF), whose variation is daily, indexed to the variation of the previous month’s inflation. Again in the example, the car cost 30 coins equivalent to 3 UF at that date, and on selling it for 40 coins, if the value of the UF at that new date is 3.5 UF, there would effectively be a gain equivalent to 5 coins, since the other 5 are only the readjustment of the price of the car.Capital gains tax should be levied on these 5 currencies, since they are the ones that effectively correspond to the higher value of the transaction.

In short, when the tax rules do not have provisions to detect how much of the sale price of an asset (subject to capital gains tax) corresponds to inflation, and how much of it actually corresponds to a higher value, the specific legal nature of capital gains tax can change from a kind of income tax (not on the loss of value of the currency that reflects the price of an asset), to a kind of wealth tax (which taxes the ownership of an asset regardless of whether there was a gain on the sale). Thus, if the car that cost 30 coins is now sold for 40 coins because that is the correction in the value of the car (due to inflation), any tax charged on the sale will be a tax on the fact of owning the asset, and not on the gain – not – made.