Consider the case in which 100 adults each own an antique stamp, purchased for $1 each in 1972, and these individuals value the the stamp. Each owner values the stamp differently, between $1 and $100 (i.e., one person values his stamp at $1, a second values hers at $2, and so on, with each additional person valuing the stamp by $1 more, until the 100th person values it at $100).
The Museum decides to set up an exhibit on the the stamp, offering to buy the stamps for $51 each. This is a one-time offer, and, since there is not an active market in these stamps, owners of the stamps face the choice of selling their stamps to the museum or holding on to the stamps forever. The only catch is that profits made by selling stamps (that is, the difference between sales price and original purchase price) represent taxable capital gains to the seller.
Question:
One way to eliminating the tax on capital gains is to index gains for inflation. According to recent U.S. government statistics, $1 in 1972 had the purchasing power of about $3 in 2012. What would be the effect of adjusting capital gains for inflation, by allowing sellers of the stamps to adjust their purchase prices for inflation in calculating their gains? What would be the effect of allowing sellers of the stamps instead to adjust their sales prices for inflation? As a general matter (that is, outside of the context just of this problem), which adjustment – purchase price or sales price – makes the most sense in indexing capital gains for inflation?