U.S. reopens debate over indexing of capital gains to inflation — how does it work and who benefits
This week’s announcement by the Trump administration that it is considering indexing capital gains to inflation has renewed debate in tax circles about how it would work, the cost of the potential tax break and exactly who would be the primary beneficiary of this tax cut.
A capital gain occurs when you sell a capital asset, such as a stock, bond or a piece of real estate, for a profit. Both the U.S. and Canada tax capital gains more favourably than ordinary income such as employment or interest income. Of course, prior to 1972, Canada didn’t tax capital gains at all, but that year the government introduced a tax on 50 per cent of capital gains. This 50 per cent inclusion rate remains in place today, although it did fluctuate over the years, reaching a high of 75 per cent in 1990 before being lowered back down to 50 per cent in 2000.
While many have speculated that one of the reasons for the lower inclusion rate on capital gains stems from an attempt to account for inflation in the price increase of an asset, this is “merely a rationalization that has developed over the years,” wrote Frank Lochan, a former tax executive at Brookfield Asset Management Inc., in his award-winning 2002 paper on whether inflation should be a factor in computing taxable gains in Canada. Indeed, Lochan concludes that “the major factor in determining the inclusion rate was to tax capital gains on a basis that was competitive with that in the United States.”
To understand how gains are impacted by inflation, consider Michael, who in 2008, bought a portfolio of securities worth $100,000 in his non-registered account. Today, the value of that portfolio has doubled to $200,000. If he were to sell all his securities today, he would have a capital gain of $100,000, of which 50 per cent is taxable. If Michael is in the top marginal tax rate of, say, 50 per cent, he would pay $25,000 of tax on his capital gain.
But the truth is that Michael is paying tax, albeit at a 50 per cent inclusion rate, on an increase in the value of his portfolio that can be partially attributed to inflation. In other words, as a result of inflation, the nominal value of Michael’s portfolio has increased relative to its real value, measured in terms of purchasing power.
We can calculate the inflation component of a price increase between any two periods by using the latest Consumer Price Index (CPI) rates from Statistics Canada. For the 10-year period ended June 2018, the inflation rate was approximately 16 per cent. This means that the $100,000 “cost” of stocks purchased back in 2008 are worth about $116,000 in 2018 dollars. Yet Michael is forced to pay about $4,000 of tax on this inflation gain of $16,000 even though his purchasing power would be unchanged in that Michael is unable to use this $16,000 “profit” to purchase any more goods and services in 2018 than he would have been able to purchase back in 2008.
The Trump proposal would allow U.S. taxpayers to take inflation into account when computing their capital gains tax. The measure could potentially be enacted by the U.S. Treasury Department, rather than via Congress, by changing the definition of “cost” for the purpose of calculating capital gains. It would allow a U.S. taxpayer to adjust the original value of an asset for inflation when the asset is sold. Under this system, using the example above, Michael would adjust the cost of his $100,000 portfolio to $116,000 and thus would pay capital gains tax on the remaining gain of $84,000 ($200,000 – $116,000).
Of course, this relatively straightforward calculation assumes that Michael bought all his securities on Day One and sold them 10 years later, doing no portfolio rebalancing during the interim period, nor reinvesting any dividends received. But what if Michael had purchased a mutual fund with quarterly distributions, which were automatically reinvested? Using 40 different inflation factors over a decade to calculate an inflation-adjusted tax cost at the time of sale is not only daunting, but may prove to be practically impossible for the average investor.
This complexity alone may be enough to kill the proposal’s chance of ever becoming reality. In addition, inflation-adjusting capital gains tax without doing the same to interest income would give rise to further inequity among investments. After all, if your bond pays 3.7 per cent interest annually and inflation is currently running at 1.7 per cent shouldn’t you pay tax only on your “real” return of 2 per cent?
Since its announcement, the U.S. proposal has been met with widespread criticism in that it will primarily benefit the uber-wealthy, who typically reap most of the benefits of a capital gains tax cut. According to a budget model prepared by the University of Pennsylvania’s Wharton School, indexing capital gains to inflation would cost the U.S. government about US$10 billion annually in lost revenues, resulting in more than US$102 billion added to the deficit over the next 10 years. It estimates that nearly 90 per cent of the benefits of capital gains tax cut would go to the top one per cent of income earners.
As for Canada, the most recent income statistics from the Canada Revenue Agency show that less than 10 per cent of personal tax returns in 2016 reported any taxable capital gains. And of the $26 billion in aggregate taxable capital gains reported in 2016, three-quarters of those gains were earned by the top eight per cent of filers while 51 per cent of the total dollars in reported capital gains were realized by the top one per cent. In all, about 2.6 million individuals reported capital gains in 2016.
According to the Report of Federal Tax Expenditures (2018), the current 50 per cent partial inclusion of capital gains for individuals and corporations will result in a tax cost to Ottawa in 2018 estimated at $14.9 billion. The report says that the lower inclusion rate provides “incentives to Canadians to save and invest, and ensures that Canada’s treatment of capital gains is broadly comparable to that of other countries.”