The Taxation of Treasury Inflation Protected Securities Are They Tax-Disadvantaged?

Abstract

Inflation is back, causing problems for taxpayers looking for safe, inflation-protected investments. This Article engages in an in-depth analysis of an understudied part of the Internal Revenue Code and associated Treasury Regulations section 1.1275-7, the inflation-indexed debt rules, asking whether Treasury Inflation Protected Securities (TIPS) can act as a suitable hedge against inflation for taxable investors. TIPS are often considered tax-disadvantaged instruments, and this Article questions the extent to which that is true. I examine TIPS relative to inflation, nominal Treasuries and I Bonds, and in doing so make three important contributions to tax scholarship. First, I present original empirical analysis on financial data from the 2003-22 period, finding that TIPS are taxed at least as favorably as nominal Treasuries on a buy-and-hold basis. Under certain assumptions, like interest withholding, the section 1.1275-7 regime imposes less onerous tax consequences on TIPS than on nominals. Second, my results confirm that the performance of TIPS relative to nominal Treasuries depends on how unanticipated inflation deviates from expected inflation. Analysis of the 2003-21 period shows that nominals outperformed TIPS on both a pre-and a post-tax basis, while analysis of the 2003-22 period shows that 10-year TIPS issued between 2012 and 2022 generally outperformed nominals precisely because of the rise in unanticipated inflation in 2021 caused by the response to COVID-19. Third, I find that since 2011 all riskless bonds have generally had negative real yields on an after-tax basis. These findings have important implications for current tax policy since they show that taxpayers cannot access positive real riskless returns on an after-tax basis. With the world in a period of rising interest rates and high inflation, this suggests that it may be time to reconsider the canonical emphasis on nominal rather than real taxation.