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Adjusting capital gains for inflation: A source of prosperity and attractiveness

Montreal, April 14, 2022 – The inflation rate in Canada has been rising constantly for several months now. Expansionary monetary policies, as well as the economic sanctions accompanying the Russia-Ukraine war, suggest that significant inflation may be with us for the medium to long term. High inflation erodes consumers’ purchasing power, and also has a negative impact on Canadian taxpayers—including through the capital gains tax, an issue the MEI’s researchers examined in their latest publication.

This tax has a direct effect on investment, and multiple ramifications on the engagement of angel investors, on entrepreneurship, and especially on the mobility of capital to finance innovation in the economy. After having noted how much inflation depreciates the value of investments as time goes by, our researchers conclude that adjusting the capital gains tax to account for inflation should be at the heart of the debate in Canada.

“Taking inflation into account in the calculation of this tax is not a new proposal, but it has become increasingly important under our current inflationary conditions to keep Canada fiscally attractive,” points out Valentin Petkantchin, Economist and Senior Fellow at the MEI. “This is an indispensable reform if we want to favour investment and prosperity.”

“Accounting for inflation is essential for taxpayers who invest. For example, an individual who buys $10,000 of shares on the stock market, and then sells them ten years later for $20,000, will be taxed $1,676 too much, or nearly 170%, compared to the real value of the gain if the average annual inflation rate is 5%,” explains Olivier Rancourt, Economist at the MEI.

The Israeli model and an American bill

Several solutions exist elsewhere in the world in order to adjust the purchase price of an asset for inflation. In Israel, for example, the purchase price is indexed to the consumer price index. Thus, the portion of the nominal capital gain that is due to inflation is not considered when it is taxed. Moreover, once the asset has been liquidated, and after indexation, the remaining amount, representing the real gain, is taxed at a fixed, non-progressive rate.

In the United States, American senators have tabled a bill to take inflation into account in the calculation of capital gains. This method, which consists of taxing only the real gain, would not penalize those who hold assets for the long term more than those who hold them for a shorter period.

“If the United States goes ahead with this bill, Canada will have to follow suit to maintain its fiscal competitiveness. But the main benefit of such a reform, beyond the attractiveness of Canada for international investment, is to promote wealth creation. According to estimates from the Tax Foundation in the United States, a tax reform to adjust capital gains for inflation would among other things result in a cumulative increase in American GDP of 0.11% in the long run,” concludes Valentin Petkantchin.

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The Montreal Economic Institute is an independent public policy think tank. Through its publications, media appearances, and advisory services to policy-makers, the MEI stimulates public policy debate and reforms based on sound economics and entrepreneurship.

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