With high inflation, capital gains are overtaxed even more

The 5.7 per cent year-on-year inflation Canada registered in February has not been seen since the early 1990s. Expansionary monetary policies and the economic sanctions accompanying the Russia-Ukraine war suggest that significant inflation is here for a while.

High inflation not only erodes our purchasing power, which is bad enough, it also distorts the application of the capital gains taxes that many of us pay. Moreover, policies being bruited in both Canada and the United States would exacerbate these distortions.

The root of the problem is that capital gains are often realized over the long or even very long term. Several decades may elapse between the purchase of an asset and its sale, which is usually when any capital gain is realized and applicable taxes are collected.

With no adjustment for inflation, taxable capital gains systematically overstate the real capital gains the taxpayer has actually enjoyed. A basic principle of taxation is that we want to tax real, not fictitious increases in people’s well-being.

Consider the example of stock market shares bought for $10,000 and sold two years later. With an annual inflation rate of five per cent, which is lower than the current rate, that $10,000 is actually worth $11,025 two years down the road. The purchase price of the shares should therefore be adjusted to $11,025. Supposing the shares are sold for $20,000, the nominal gain will be $10,000 (or $20,000 less the unadjusted purchase price of $10,000). The real gain, however, after adjusting for inflation, will be just $8,975 — the sale price of $20,000 less the adjusted purchase price of $11,025.

With no adjustment for inflation, however, the taxable gain would be $10,000 even though the real gain was only $8,975, and the tax to be paid would also be overstated by the same roughly 11 per cent. After five years, the gap between nominal and real climbs to nearly 40 per cent, and after ten years, to 170 per cent. Under our current system, a Quebecer in the highest tax bracket (paying a combined marginal rate of 53.31 per cent) would thus pay $273, $736, or $1,676 too much in tax depending on whether the shares were held for two, five, or ten years, respectively.

Correcting this inflation distortion is all the more critical given that some of our competitors for capital, like Israel, already index their tax systems while others, like the U.S., are considering doing so. If the U.S. acted and we didn’t, our tax system would become much less competitive.

President Biden’s recent proposal to adopt a minimum tax on very high incomes — namely those over US$100 million, including unrealized gains on liquid assets like shares — could very well heighten the problem. If this kind of measure were adopted and if Canada followed suit, perhaps raising the inclusion rate to 75 per cent, as the NDP proposed last fall, the tax distortion on inflation would punish taxpayers and discourage investment even more — in both countries.

Considerations of both tax fairness and tax competitiveness therefore suggest Canadian governments need to adjust for inflation in calculating capital gains taxes. Doing so would allow Canada to remain attractive to foreign investment and improve the allocation and efficiency of capital in the economy. It’s exactly the policy we need right now in order to encourage investment, prosperity and growth.

Valentin Petkantchin is Senior Fellow at the MEI and Olivier Rancourt is an Economist at the MEI. They are the authors of “The Capital Gains Tax and Inflation: How to Favour Investment and Prosperity” and the views reflected in this opinion piece are their own.

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