Surging inflation is intensifying all sorts of economic worries. Now, you can add to that list the distinct prospect of capital gains being eaten up by the debilitating duo of inflation and taxation.
Just maintaining the real value of an asset will require a hefty return this year. Doing so over the stretch of a decade will create a significant paper gain, even if the real value of the underlying asset hasn’t changed that much.
So, if and when it comes time to sell, the resulting tax bill could turn that paper gain into an after-inflation, after-tax loss. That is a constant problem, but one that grows sharper as inflation ramps up.
A new research paper from the Montreal Economic Institute takes aim at that problem, proposing that capital-gains taxation be reformed to account for the distortions of inflation. In effect, real capital gains, rather than nominal, would be taxed, with the cost base of an asset adjusted upward in step with changes in the consumer price index.
Valentin Petkantchin, senior fellow at the MEI and one of the study’s authors, says inflation-driven increases in asset values are “fictional gains.” Taxing those gains discourages investment at a time when Canada is already struggling to attract capital, and trying to figure out how to boost productivity.
The MEI research paper lays out a scenario in which a $10,000 investment doubles in value over 10 years to $20,000, with annual inflation running quite hot at 5 per cent. On paper, that’s a $10,000 capital gain. But then the tax bill comes due: $2,666 at the top combined capital gains rate of 53.31 per cent, and with the current inclusion rate of 50 per cent. (Only half of capital gains are generally taxable as income.)
But the inflation-adjusted capital gain is significantly smaller: just $3,711. The tax bill would be much smaller, too, just $989. To look at it another way, the original tax bill of $2,666 is taxing the real gains (at a 50 per-cent-inclusion rate) at 149 per cent. Or, if you’d prefer, that $2,666 in taxes is equivalent to a 72-per-cent tax rate with 100 per cent of capital gains included.
There are a couple of obvious issues with the MEI proposal. One is that capital gains are already inflation-proofed, somewhat, with the indexing of personal income tax brackets. The much bigger fly in the ointment is the question of the inclusion rate. The inclusion rate already favours capital gains over employment income. And there are already rumblings in left-leaning circles about boosting the inclusion rate for capital gains.
Mr. Petkantchin notes that other countries already have inflation-proofed capital gains, most notably Israel. That country, he says, has combined the indexing of capital gains, with a 100-per-cent inclusion rate and a lower tax rate. That could be an example for Canada to follow, but the imperative to remain competitive with the U.S. tax regime means Ottawa would need to proceed cautiously in adopting the Israeli model.
Taxing questions
Responding to coverage of the recent federal budget, one online reader wondered about the growth rate for gross domestic product that the government is using in its projections, saying that they felt a projection under 2 per cent would be realistic.
The Finance department doesn’t produce year-by-year long-term forecasts for GDP, but buried in the far reaches of the budget’s annexes, there are some numbers that shed some light on what the government expects in coming decades.
In the next four years, the department forecasts average growth in real GDP of 2.5 per cent, only slightly lower than the 2.6 per cent average from 1970 through to 2021. That seemingly narrow gap is a bit misleading, however, since it includes the forecasted blockbuster growth of 4.2 per cent in 2022.
Over the longer haul, real GDP growth is projected to slow dramatically, dropping to an average of 1.7 per cent between 2027 and 2055. That growth projection flows from a growth in labour supply (accounting for 0.7 percentage points) and labour productivity growth, contributing the remainder. And it’s that second category that my budget analysis called into question. The department is assuming that labour productivity will be much higher than its 0.8 per cent average since 2008.
Why is that difference of 0.2 percentage points high? Because to close that gap, productivity would need to rise by 25 per cent. And that would need to be happening at a time when the work force is aging, and Canada is transitioning away from its most productive sector, the fossil fuel industry.
So is a projection of 1.7 per cent realistic? Only if you believe that actions will be taken by government, and by the private sector, to engineer a turnaround in Canada’s productivity performance that will overcome those strong negative currents.
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Worry like it’s 2008: There is a sobering statistic in a recent note from Capital Economics on the Bank of Canada’s new-found hawkish streak: Household debt as a percentage of disposable income reached 170 per cent at the end of 2021 – matching that of the United States just ahead of the 2008 financial crisis. For that reason, Capital’s chief North America economist, Paul Ashworth, thinks it is unlikely that Canada’s central bank will push its benchmark rate to the neutral range of 2 per cent to 3 per cent. It’s more likely, he writes, that the bank will increase its rate only to 2 per cent, up from the 1-per-cent mark it hit last week.
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