How to Keep Inflation and Taxes From Eating Capital Gains

Soaring inflation intensifies all sorts of economic worries. Now you can add to that list the distinct prospect of capital gains being swallowed up by the debilitating duo of inflation and taxation.

Simply maintaining the real value of an asset will require a high return this year. Doing this over a period of a decade will create a large paper gain, even if the actual value of the underlying asset hasn’t changed 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. This is an ongoing problem, but one that gets worse as inflation rises.

A new research paper from the Montreal Economic Institute tackles this problem by proposing that the taxation of capital gains be reformed to account for the distortions of inflation. In effect, real, rather than nominal, capital gains would be taxed, with the cost base of an asset being adjusted upwards according to changes in the consumer price index.

Valentin Petkantchin, principal researcher at the MEI and one of the authors of the study, says increases in the value of assets induced by inflation are “fictitious gains”. Taxing these 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 document presents a scenario in which an investment of $10,000 doubles in value over 10 years to reach $20,000, with fairly high annual inflation of 5%. On paper, that’s a capital gain of $10,000. But then the tax bill comes due: $2,666 at the highest combined capital gains rate of 53.31% and with the current inclusion rate of 50%. (Only half of capital gains are generally taxable as income.)

But the inflation-adjusted capital gain is much smaller: just $3,711. The tax bill would also be much smaller, just $989. To put it another way, the initial tax bill of $2,666 taxes actual earnings (at a 50% inclusion rate) at 149%. Or, if you prefer, that $2,666 in taxes equals a tax rate of 72% with 100% of capital gains included.

There are some obvious problems with the MEI proposal. The first is that capital gains are already sheltered from inflation, to some extent, through the indexing of personal income tax brackets. The biggest problem is the question of the inclusion rate. The inclusion rate already favors capital gains over employment income. And there are already rumors in leftist circles about raising the capital gains inclusion rate.

Petkantchin notes that other countries already have inflation-proof capital gains, including Israel. This country, he says, has combined capital gains indexation, with a 100% inclusion rate and a lower tax rate. This could be an example for Canada to follow, but the imperative to remain competitive with the US tax system means that Ottawa should proceed with caution in adopting the Israeli model.

Tax issues

In response to coverage of the recent federal budget, an online reader questioned the growth rate of gross domestic product the government is using in its projections, saying he felt a projection of less than 2% would be realistic. .

The Ministry of Finance does not produce long-term annual forecasts for GDP, but buried in the confines of budget schedules are some figures that shed light on the government’s expectations for decades to come.

Over the next four years, the department forecasts average real GDP growth of 2.5%, only slightly below the 2.6% average from 1970 to 2021. This seemingly narrow gap is somewhat misleading, however, as it includes forecasts of exceptional growth of 4.2% in 2022.

Over the longer term, real GDP growth is expected to slow significantly, falling to an average of 1.7% between 2027 and 2055. This growth projection stems from a growth in labor supply (representing 0 .7 percentage point) and labor productivity growth, contributing the rest. And it is this second category that my budget analysis has called into question. The ministry assumes that labor productivity will be well above its average of 0.8% since 2008.

Why is this difference of 0.2 percentage points high? Because to close this gap, productivity would have to increase by 25%. And that should happen at a time when the workforce is aging and Canada is moving away from its most productive sector, the fossil fuel industry.

So is a projection of 1.7% realistic? Only if you believe that action will be taken by government and the private sector to bring about a recovery in Canada’s productivity that will overcome these strong negative currents.

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Worry like it’s 2008: There’s a sobering statistic in a recent Capital Economics note on the Bank of Canada’s new hawkish streak: Household debt as a percentage of disposable income hit 170% at the end of 2021, which is equal to that of the United States just before the financial crisis of 2008. For this reason, Capital’s chief economist for North America, Paul Ashworth, thinks that the central bank of Canada is unlikely to push its rate reference in the neutral range of 2 to 3%. It is more likely, he writes, that the bank will only raise its rate to 2%, from 1% reached last week.

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