With high inflation, capital gains are even more overtaxed

By Valentin Petkantchin
and Olivier Rancourt

The 5.7% year-on-year inflation recorded in Canada in February has not been seen since the early 1990s. Expansionary monetary policies and economic sanctions accompanying the Russian-Ukrainian war suggest that significant inflation is there for a while.

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

The bottom line is that capital gains are often realized over the long or even the very long term. Several decades can elapse between the purchase of a property and its sale, which generally corresponds to the moment when a capital gain is realized and when the applicable taxes are collected.

Without adjusting for inflation, taxable capital gains systematically overestimate the real capital gains that the taxpayer actually benefited from. A basic tenet of taxation is that we want to tax real, not fictitious, increases in people’s well-being.

Take the example of stocks on the stock market bought for $10,000 and sold two years later. With an annual inflation rate of 5%, which is lower than the current rate, that $10,000 is actually worth $11,025 in two years. The purchase price of the shares should therefore be adjusted to $11,025. Suppose the shares are sold for $20,000: the nominal gain will be $10,000 (or $20,000 minus the unadjusted purchase price of $10,000). The actual gain, however, after adjusting for inflation, will only be $8,975 – the sale price of $20,000 minus the adjusted purchase price of $11,025.

Without adjusting for inflation, however, the taxable gain would be $10,000 even though the actual gain was only $8,975, and the tax payable would also be overstated by approximately 11%. After five years, the difference between the nominal and the real rises to almost 40%, and after ten years, to 170%. In our current system, a Quebecer in the highest tax bracket (paying a combined marginal rate of 53.31%) would therefore 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 as some of our competitors for capital, such as Israel, are already indexing their tax systems while others, such as the United States, are considering doing so. If the United States acted and we did not, our tax system would become much less competitive.

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

Considerations of tax fairness and tax competitiveness therefore suggest that Canadian governments should take inflation into account when calculating capital gains tax. This would allow Canada to remain attractive to foreign investment and improve the allocation and efficiency of capital in the economy. This is exactly the policy we need right now to encourage investment, prosperity and growth.

Valentin Petkantchin is a Senior Fellow and Olivier Rancourt is an economist at the Montreal Economic Institute. They are the authors of The Capital Gains Tax and Inflation: How to Favor Investment and Prosperity.

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