Should Inflation Be a Factor in Computing Taxable Capital Gains in Canada?

Frank Lochan*

PRÉCIS L’impôt sur les gains en capital a vu le jour au Canada en 1972, avant l’une des plus fortes périodes inflationnistes qu’ait connue l’Amérique du Nord depuis fort longtemps. Le gouvernement avait décidé de n’imposer qu’une partie des gains en capital plutôt que leur plein montant. Cette politique a été maintenue jusqu’à ce jour malgré que l’on ait de temps à autre et, plus récemment en 2000, rajusté la tranche des gains en capital à inclure dans le revenu imposable. Certains commentateurs ont laissé entendre que l’une des raisons qui expliquent cette inclusion partielle est la prise en compte de l’inflation. Le présent article porte sur l’incidence de l’inflation sur l’imposition des gains en capital au Canada. L’auteur décrit d’abord le contexte général de l’imposition des gains en capital, en indiquant dans quelle mesure on avait tenu compte de l’inflation lors de la conception originale des règles sur le sujet. Il évalue ensuite l’incidence de l’inflation, en montrant qu’elle entraîne une hausse du taux réel de l’impôt, même si seule une partie des gains en capital est incluse dans le revenu imposable. L’auteur décrit deux méthodes qui permettent de tenir compte de l’inflation lors du calcul des gains en capital — l’imposition des gains en capital sur une base de comptabilité d’exercice et le rajustement du prix de base des biens (indexation). Dans chaque cas, il évalue les problèmes pratiques et de politique fiscale qui se posent. L’auteur affirme en conclusion que l’indexation signifie une convergence accrue de la politique gouvernementale et qu’elle constitue une méthode appropriée. L’indexation exigerait cependant des changements à tout le régime fiscal actuel afin d’en assurer la cohérence et de réduire les possibilités d’arbitrage, ce qui risque toutefois d’en accroître la complexité. Selon l’auteur, les Canadiens ne sont pas prêts à accepter de tels changements au régime fiscal. Qui plus est, l’indexation est contraire à la tendance actuellement observée dans le monde relativement à l’imposition des gains en capital. À la lumière de ces inconvénients, l’auteur formule un certain nombre de suggestions visant à améliorer les règles canadiennes d’imposition des gains en capital, qui pourraient appuyer les objectifs de la politique gouvernementale sans nécessiter pour autant de changements majeurs dans d’autres secteurs du régime fiscal.

ABSTRACT The capital gains tax became effective in Canada in 1972, just before a period of inflation that was one of the highest in North America in recent times. The government

* A managing partner of Brascan Financial Corporation, Toronto.

(2002) vol. 50, no 5 ■ 1833 1834 ■ canadian tax journal / revue fiscale canadienne (2002) vol. 50, no 5 decided that only a portion of capital gains would be subject to tax, rather than the full amount. This policy has been maintained to the present day, although the specified portion of capital gains to be included in taxable income has been adjusted from time to time, most recently in 2000. A number of commentators have suggested that one of the reasons for this partial inclusion is to take account of inflation. This paper explores the treatment of inflation in the taxation of capital gains in Canada. The author first presents the background to the taxation of capital gains, highlighting the extent to which inflation was considered in the original design of the tax. He then examines the effect of inflation, showing that it causes the real rate of tax to increase, despite only partial inclusion of capital gains in taxable income. The author discusses two methods of dealing with inflation in calculating capital gains—the taxation of capital gains on an accrual basis and adjustment of the cost base of the asset (indexing). He evaluates the practical and tax policy issues involved in each case. The author concludes that indexing brings sharper focus to government policy and is a sound approach. However, indexing would require widespread changes to the existing tax system in order to ensure consistency and to reduce arbitrage opportunities, and it may result in greater complexity. In the author’s view, Canadians are not ready to accept such sweeping changes to the tax system. Moreover, indexing is contrary to the current international trend in taxing capital gains. In light of these drawbacks, the author offers a number of suggestions for improvement of Canada’s capital gains tax legislation, which would support the government’s policy objectives without necessitating major changes in other areas of the tax system.

KEYWORDS: CAPITAL GAINS ■ INDEXING ■ INFLATION ■ REALIZATION ■ TAX POLICY ■ TAX RATES

INTRODUCTION This paper examines the treatment of inflation in the taxation of capital gains in Canada. While the government appears to have attempted to take inflation into account, by providing for partial rather than full inclusion of capital gains in income, inflation nevertheless causes the real rate of tax on capital gains to increase. Two alternative methods of dealing with inflation are discussed—taxation of capital gains on an accrual basis and indexing (the adjustment of the cost base of the asset). Indexing is the preferred choice, but there are several practical obstacles to its implementation, at least at this time. Accordingly, some suggestions are made for improvement of the current approach to capital gains taxation in Canada, which would be more effective in achieving policy objectives but would not require extensive changes to the broader tax system.

BACKGROUND A Brief History of the Capital Gains Tax Canada introduced the taxation of capital gains in 1971, following the recommen- dations of the Carter report.1 Starting in 1972, taxpayers were required to include each taxable capital gain in income in the year of realization. A taxable capital gain is the portion of the capital gain calculated in accordance with the Income Tax Act.2 should inflation be a factor in computing taxable capital gains? ■ 1835

The introduction of a capital gains tax reflected the view that all income should be subject to taxation, an approach developed by Robert M. Haig and Henry Simons in the 1920s and 1930s.3 Under the Haig-Simons approach, a taxpayer’s income for a year consists of consumption expenditures during the year, plus the change in the value of the taxpayer’s net wealth in that period. There is no difference between income derived from labour (wages) and income derived from capital (interest, dividends, or capital gains). In Canada, this approach gave rise to the popular slogan of the day that “a buck is a buck is a buck.”4 The pure application of the Haig-Simons approach has proven to be difficult in practice. 5 The Canadian system departed from the Haig-Simons ideal by adopting the principle that no capital gains arose until realization.6

Alternative Inclusion Measures In designing the capital gains tax, policy makers had to consider whether gains from the disposition of all kinds of property should be subject to tax and whether such gains should be fully taxed. If a preference was warranted, it was also necessary to decide whether this should be accomplished by including only part of the gain (the “partial inclusion” method) or by applying a reduced rate of tax. Table 1 illustrates the differences between these two approaches. In this example, full inclusion and a standard rate of 45 percent yields the highest tax revenue of $338. When there is a preference in the form of partial inclusion at 50 percent, the tax rate must be doubled to yield the same amount of revenue. When there is a preference in the form of a reduced tax rate, full inclusion and a tax rate of 22.5 percent provides the same amount of revenue ($169) as partial inclusion and the standard rate. Canada’s system has two major preferences. It exempts gains from the disposition of a principal residence, and it includes only a portion of the capital gain in taxable income.

CURRENT RULES The Partial Inclusion Method and How It Works Current Canadian rules require taxpayers to include 50 percent of the capital gain realized in the year.7 The inclusion rate was reduced in 2000 from 75 percent.8 This reduction was introduced in recognition that capital gains were subject to a high rate of taxation in Canada as compared with other countries, particularly the United States. 9 The portion of the gain included in income, subject to provisions that allow a reserve to be taken if the taxpayer has not received the sale proceeds in full, is taxed at the rates prevailing in the year of disposition.

The Role of Inflation in the Untaxed Portion of Gains Some writers suggest that the untaxed portion of the capital gain is an allowance to compensate for a variety of factors. Canada’s Technical Committee on Business Taxation notes three factors: consistency with the partial integration of taxation of income at the corporate and shareholder levels; adjustment for the effect of inflation 1836 ■ canadian tax journal / revue fiscale canadienne (2002) vol. 50, no 5

TABLE 1 Effects of Full Inclusion and Partial Inclusion at Various Tax Rates

Full Partial inclusion inclusion

dollars Proceeds of disposition ...... 1,000 1,000 Less adjusted cost base ...... (250) (250) Capital gain ...... 750 750 Full inclusion ...... 750 Partial inclusion at 50% ...... 375 Tax payable at rate of 22.5% ...... 169 Tax payable at rate of 45% ...... 338 169 Tax payable at rate of 90% ...... 338 on taxation; and maintaining a balance between the individual income tax rates on dividends from resident corporations and those on capital gains.10 Boadway, refer- ring to the partial inclusion, also suggests that “it is argued that it protects investors in time of inflation from being taxed on illusory gains.”11 The Carter report, however, had rejected any adjustment for inflation on the basis that it was an “over-emphasized argument” and that many members of society with fixed incomes suffered losses in economic power because of inflation and were unable to protect themselves against it.12 The House of Commons debates on the 1971 proposals for tax reform also do not support the proposition that inflation protection was one of the reasons for partial inclusion of capital gains.13 Robert Kaplan’s response to a question is illuminating in that it clearly shows 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.14 I believe that the identification of inflation as one of the reasons for partial inclusion is merely a rationalization that has developed over the years.

The Adequacy of the Present System in Dealing with Inflation Since inflation is taken into account implicitly under the partial inclusion method, the current system is an improvement over full taxation of capital gains. However, some proponents of the partial inclusion method as a substitute for indexing concede that it is a “rough justice” alternative.15 When inflation is taken into account explicitly, under the current rules the tax rate on a capital gain is higher than the stated rate, as illustrated in table 2. In this example, the investor realizes a capital gain of $2,000 over a 10-year period, representing a compound annual rate of return of 11.6 percent. Ignoring inflation and assuming a tax rate of 45 percent, with full inclusion the after-tax return falls to 7.7 percent; partial inclusion at 50 percent increases this return to 9.8 percent. When inflation is taken into account, the impact is dramatic. At 2 percent annual inflation, the return declines by 21 percent to 7.7 percent—the same return as under should inflation be a factor in computing taxable capital gains? ■ 1837

TABLE 2 Effect of Adjusting for Inflation

Annual rate of inflation 2% 5% 10% 15% Facts Investment in year 1 ...... $1,000 $1,000 $1,000 $ 1,000 Proceeds of disposition in year 10 . . . . $3,000 $3,000 $3,000 $ 3,000 Capital gain ...... $2,000 $2,000 $2,000 $ 2,000 Pretax return on investment ...... 11.6% 11.6% 11.6% 11.6% Full taxation Taxes at 45% ...... $ 900 $ 900 $ 900 $ 900 Net after-tax gain ...... $1,100 $1,100 $1,100 $ 1,100 Effective tax rate ...... 45% 45% 45% 45% After-tax return on investment ...... 7.7% 7.7% 7.7% 7.7% Partial inclusion Taxable capital gain (50%) ...... $1,000 $1,000 $1,000 $ 1,000 Taxes at 45% ...... $ 450 $ 450 $ 450 $ 450 Net after-tax gain ...... $1,550 $1,550 $1,550 $ 1,550 Effective tax rate ...... 23% 23% 23% 23% After-tax return on investment ...... 9.8% 9.8% 9.8% 9.8% Adjustment for inflation Investment adjusted for inflation . . . . . $1,219 $1,629 $2,594 $ 4,046 Capital gain adjusted for inflation . . . . $1,781 $1,371 $ 406 $(1,046) Net after-tax gain: full taxation ...... $ 881 $ 471 $ (494) $(1,946) Tax rate: full taxation ...... 51% 66% 222% −86% After-tax return on investment ...... 5.6% 2.6% −2.1% −6.3% Net after-tax gain: partial inclusion . . . $1,331 $ 921 $ (44) $(1,496) Tax rate: partial inclusion ...... 25% 33% 111% −43% After-tax return on investment ...... 7.7% 4.6% −0.2% −4.5% full taxation. At annual inflation rates of 5 percent, 10 percent, and 15 percent, the decline is 53 percent, 102 percent, and 146 percent, respectively, and the returns are 4.6 percent, negative 0.2 percent, and negative 4.5 percent, respectively. In this example, at inflation rates of 10 percent and above, the investor suffers a decline in real purchasing power. Mintz and Wilson note that even at a low inflation rate of about 2 percent annually, the value of assets held for 20 years will decline by one-third in real terms.16 Cunningham and Schenk note that for assets held for a long period of time, partial inclusion may provide the wrong outcome because there may be no problem.17 They indicate that, in most cases, inflation becomes a smaller and smaller percentage of the nominal gain, and taxation of the inflation component of the gain generally offsets the benefits derived from deferral.18 The advantage of deferral increases over time and ultimately exceeds the disadvantage of taxing inflationary gains.19 Cunningham and Schenk also suggest that if the asset were held long enough, no partial inclusion would be necessary. 20 However, this is not true in the Canadian context of 50 percent inclusion, where partial inclusion is generally more beneficial. 21 In some cases, partial inclusion may not be sufficient to compensate 1838 ■ canadian tax journal / revue fiscale canadienne (2002) vol. 50, no 5 for the inclusion of inflationary gains in income. For example, where A holds an asset for one year that appreciates in value by 10 percent, of which 6 percent is attributable to inflation, a 50 percent inclusion (that is, 50% × 10% = 5%) would not offset the effects of inflation. On the other hand, in this example, if inflation is below 5 percent, the 50 percent inclusion overcompensates for inflation. In the context of a 50 percent inclusion, when the inflation rate is below about 9 percent, there is equivalency between the partial inclusion method and adjustment of the cost base for inflation, if the inflation rate is roughly equal to the return on investment multiplied by 1 minus the tax rate. Under the present system of partial inclusion, in a low inflation rate environment such as that which Canada has experienced over the last decade, short-term capital gains are taxed at significantly lower real tax rates than longer-term capital gains.

Summary of the Arguments For and Against Partial Inclusion Partial inclusion has several advantages:

■ It is simple to apply. Once the policy of preference for capital gains is established, and the amount of that preference is determined, the amount of the preference is incorporated into the taxing statute. The simplicity of partial inclusion also makes it easy to understand. ■ The amount of the preference can be easily amended, should it become necessary to do so for tax or other policy reasons. An amendment based on well-established principles can be automatic. However, in the Canadian system, amendments have not been automatic, but have been made at the whim of the minister of finance.22 ■ The simplicity of partial inclusion also makes it transparent. The resulting ease of communication and understanding helps to promote investment.

However, there are also disadvantages:

■ Partial inclusion can be arbitrary. Where there is no well-established basis for policy review and adjustment of the inclusion rate, it can become entrenched at an inappropriate level and fail to meet the policy objectives. A fixed inclusion rate does not work adequately to deal with inflation because the rate of inflation is variable, and a fixed inclusion rate will rarely meet all circumstances. ■ Partial inclusion is also capable of being manipulated by politicians. This appears to have occurred during the 1980s, when the inclusion rate was increased from 50 percent to 75 percent, even though inflation increased over the decade. The reduction in 2000 took place despite reduced inflation, when it was recognized that Canada’s competitive position had declined seriously. 23 ■ Partial inclusion can be inequitable, since it does not take into account the holding period of an asset. A person holding an asset that increases in value by 50 percent receives the same exclusion whether the asset has been held for 1 year or 10 years. The one-year asset holder suffers less deterioration because should inflation be a factor in computing taxable capital gains? ■ 1839

of inflation than the 10-year asset holder. Further, partial inclusion does not deal adequately with economic losses since it limits both the amount and the method of utilization of capital losses. It can be argued that this provides a barrier to risk taking and entrepreneurship.

THE IMPACT OF INFLATION ON CAPITAL GAINS IN CANADA Bartlett notes that if one defined income in present value terms, there would be no taxation of capital at all, even under a Haig-Simons definition of income.24 He suggests that, as a minimum, capital gains should be fully adjusted for inflation. He further observes that this is “a position endorsed by Haig, Simons, and virtually all tax experts.”25 Taking these comments as a point of departure, in the following section, I examine Canada’s inflation experience over the past 29 years and then consider how taxpayers have fared in respect of their return on investments.

Canada’s Inflation Experience Appendix 1 shows the consumer price index (CPI) for all items for the period 1971 to 2000. The CPI indicates changes in the price of a basket of goods and services over a given period, reflecting Canadian consumption patterns on a weighted basis. Prices have more than quadrupled in the period, resulting in an average inflation rate of 5.4 percent. If the CPI is a guide to the inflation component in asset values,26 an asset with a value of $100 on valuation day (V-day)27 would have had to increase to at least $456 (after tax) for the holder to have merely maintained real purchasing power. This does not provide a return on investment. Appendix 1 also shows that inflation was more pronounced in the 1970s (at an average for the decade of 8.6 percent), and it has declined to an average of 2 percent in the 1990s. This declining trend suggests that inflation is not a problem that we should be concerned about. On the contrary, I believe that, even at low rates, inflation has a debilitating effect on real asset values.

Inflation and Real Asset Values Common Shares An investment in common shares usually enables the investor to benefit from the growth of the company. This growth is reflected in retained earnings and in dividends paid by the company. For purposes of this analysis, it is assumed that the investor has a portfolio of common shares that mirrors performance on the To- ronto Stock Exchange (TSE). Appendix 2 shows the performance of the TSE from 1971 to 2001 as represented by the TSE 300.28 Column (A) indicates that a person who invested $1,000 in 1971 would have a portfolio valued at $7,762 in December 2001—a cumulative annual return of 7 percent. With an annual inflation rate of 5.4 percent over that period, the common share investor would have a real return of 1.6 percent. Without the relief provided by partial inclusion, on disposition in December 2001, a taxpayer in 1840 ■ canadian tax journal / revue fiscale canadienne (2002) vol. 50, no 5 the 45 percent tax bracket would have had an after-tax return of 3.85 percent on a nominal basis, but a negative 1.55 percent return on a real basis.29 When partial inclusion is taken into account, the results are better, but hardly rewarding. The after-tax return is 5.43 percent on a nominal basis and 0.03 percent on a real basis.30 The above analysis understates the true return because the investor would have received dividends during the period. An individual investor would have been subject to the dividend gross-up and tax credit rules. If we assume that the dividend yield was 2 percent, the taxpayer had an after-tax return of 6.8 percent without partial inclusion and 1.4 percent with partial inclusion.31 Appendix 2 also demonstrates the insidious effect of inflation on common share investments for dispositions during the period. Column (F) shows that an investor disposing of a portfolio of investments that simulated the TSE 300 would have been taxed on illusory gains in every year but 1972. This represents a reduction in the purchasing power of individuals and a transfer of wealth from investors to the taxing authorities. This conclusion is similar to Bucovetsky’s in a 1977 essay in which he analyzed a much shorter period.32

Bonds, Preferred Shares, and Land An investment in bonds allows the bondholder to receive income in the form of interest. Under Canada’s present system of taxation, such interest is included in income and taxed on a current basis. Inflation affects bonds in two ways. First, in a time of inflation, interest rates increase so that the interest received represents in part a real return and in part compensation for inflation. In this connection, Bradford points out that “[i]t is difficult to overstate the corrosive effect of present rules for taxing interest in a time of inflation.”33 Second, rising interest rates cause the market value of previously issued bonds to decline. In these circumstances, the only way the investor can recover his investment, in nominal terms, is to hold the bond until maturity. Repayment of the principal amount is then in inflated currency—the purchasing power will have declined. Table 3 illustrates the impact of the taxation of interest income on bonds. It shows that an investor in the 25 percent tax bracket with a 4 percent bond that is held to maturity would have an increase in purchasing power of 9 percent at a modest inflation rate of 2 percent, and a decline of 16 percent at an inflation rate of 5 percent. If the investor disposed of the bond during the holding period, the decline in purchasing power would be the same only if the price of the bond had not declined, as could be the case if the stated rate of interest correctly anticipated actual inflation. If the rate of inflation were higher than that priced into the interest return, the price would be lower and the decline in purchasing power greater than that shown above. The same analysis can be used for preferred shares, and the conclusion is similar. The primary difference is the fact that the return on preferred shares is in the form of a dividend instead of interest. Dividends are subject to the gross-up and tax credit rules. should inflation be a factor in computing taxable capital gains? ■ 1841

TABLE 3 Effect of Inflation on the Purchasing Power of a 10-Year Bond at a Yield of 4 Percent

Inflation with no adjustment Individual 2% 5% 9%

Principal only Present value ...... $820 $614 $422 Loss in purchasing power ...... $180 $386 $578 Percentage decline in purchasing power ...... 18% 39% 58% Principal and interest Present value (25% tax rate) ...... $1,089 $845 $615 Loss (gain) in purchasing power ...... ($89) $155 $385 Percentage decline (increase) in purchasing power ...... (9%) 16% 39% Value (45% tax rate) ...... $1,018 $784 $564 Loss (gain) in purchasing power ...... ($18) $186 $436 Percentage decline (increase) in purchasing power ...... (2%) 19% 44%

Land is a non-depreciating asset that has unique characteristics. In the absence of inflation, theoretically it will not appreciate in value. However, various economic factors, such as location, economic growth, and demand, can lead to an increase in real value. Thus, the sale proceeds of land will include a component of real growth and a component for inflation. Because of this, the inflation component should be excluded in determining taxable income.

Depreciating Assets The purchase of a depreciating asset allows the business to obtain a current tax deduction based on the capital cost allowance system. For most depreciating assets, the asset is sold for an amount that is lower than its original cost. Where the sale proceeds exceed the undepreciated capital cost, there is recapture of previously claimed depreciation, up to the original cost, and a capital gain for proceeds above that cost. Inflation has two effects. First, the charge to income each year, based on cost, does not reflect the true (economic) depreciation of the asset. Since revenues are stated in current (inflated) dollars, this understatement gives rise to higher taxable income. While it can be argued that the higher depreciation charge is generated when the asset is replaced, there remains a permanent timing mismatch. Second, where there is a capital gain, the result is similar to the sale of a non-interest-bearing bond or land, as discussed above.

How Inflation Affects Real Tax Rates With inflation, the nominal value of capital assets increases relative to their real value. For example, consider a taxpayer who purchased a capital asset for $10,000 in 1981 and sold it in 2001 for $20,000. Since prices almost doubled in that period 1842 ■ canadian tax journal / revue fiscale canadienne (2002) vol. 50, no 5

(see appendix 1), the real capital gain would be minimal. Purchasing power would be unchanged, and the taxpayer would be unable to purchase any more goods and services in 2001 than he or she would have been able to purchase in 1981. Under current rules with a 50 percent inclusion, there would be a taxable capital gain of $5,000, on which tax paid would be $2,250 at a 45 percent marginal tax rate, leaving the taxpayer less well off. Now let us assume that the taxpayer sold the asset for $25,000 and made a real gain of $5,000. The taxable capital gain of $7,500 would attract tax of $3,375—a tax rate of 67.5 percent, based on the real gain. Table 4 shows the impact on the tax rate for an asset held for five years at different rate of return levels, in a 2 percent and a 5 percent inflation rate environment. The current system taxes capital assets that yield lower returns at a higher rate than assets with higher returns. This is the same conclusion that was reached by the United States Joint Economic Committee in 1997, in considering taxation of capital assets under the US system of full inclusion but with a 28 percent tax rate.34

The Impact of Deferral in Recognition of Capital Gains In Canada, capital gains are taxed primarily upon realization. The capital gain on a personal residence is not subject to tax.35 This concession has had an impact on the investment choices of Canadians. Statistics Canada indicates that the total assets held by Canadians in 1999 was $3.5 trillion.36 Principal residences, at about one- third, represented the largest category. 37 There are certain mechanisms that affect the timing of tax payments on the disposition of various assets. For example, rollover provisions enable deferral of tax in certain circumstances, while deemed disposition provisions accelerate the payment of tax.38 Tax-favoured investments such as private pension assets39 provide a current deferral of tax in the form of a deduction when contributions are made. When the plan eventually makes payments to the participant, the full amount of the receipt (part of which represents a capital gain) is included in income and taxed.40 The argument has been made that deferral in the payment of tax is an adequate offset for the impact of inflation over the longer term.41 The premise is that where a capital gain arises only on realization, the timing for triggering the gain is at the discretion of the taxpayer. The longer the tax burden is deferred through post- ponement of realization, the greater the benefit to the taxpayer, particularly since there is no interest penalty. This ability to defer taxes is a violation of the principle of horizontal equity. One writer has argued that “deferral is not a cure for the ill of inflationary taxes, [but] rather that it is an advantage that the capital gain taxpayer has over the income tax payer.”42 Taxpayers earning employment or investment income do not have the discretion to defer tax.43 The incentive to defer is greater during times of higher inflation. This “lock- in” arises because the taxpayer will require a much larger return on investment on the reinvestment of the after-tax proceeds of disposition. Bucovetsky suggests that the use of an inflation-adjusted basis to define future taxable income would reduce the lock-in.44 should inflation be a factor in computing taxable capital gains? ■ 1843

TABLE 4 Rate of Return and Variation in the Rate of Capital Gains Taxationa

Inflation rate Asset purchased for $10,000 2% 5% Annual Nominal Nominal Taxable Real Real Real Real rate of value of capital capital Tax at capital tax capital tax return (%) asset gain gain 45% gain rate gain rate

dollars percent dollars percent 4 ...... 12,167 2,167 1,083 487 1,126 43 −596 −82 5 ...... 12,763 2,763 1,381 622 1,722 36 nil 100 6 ...... 13,382 3,382 1,691 761 2,341 33 619 123 7 ...... 14,026 4,026 2,013 906 2,985 30 1,263 72 10 ...... 16,105 6,105 3,053 1,374 5,064 27 3,342 41 15 ...... 20,114 10,114 5,057 2,276 9,073 25 7,351 31 25 ...... 30,518 20,518 10,259 4,616 19,477 24 17,755 26 a Assumes that the asset is held for five years.

Relevance of the Analysis The Tax Yield from Illusory Gains Table 5 shows an analysis of taxable income and taxes paid in Canada for 1999. I have estimated combined federal and provincial taxes on capital gains to be about $4.3 billion.45 Of this amount, $3 billion is estimated to be federal taxes for an average tax rate of 21 percent and $1.3 billion from provincial taxes for an average tax rate of 9 percent. Federal taxes represented about 3.7 percent of the total personal tax revenues of $72.5 billion and about 1.8 percent of total federal revenues of $147.7 billion.46 The tax expenditure accounts for 2001 indicate that the “tax cost” associated with the partial inclusion of capital gains was $940 million in personal taxes for 1999.47 At a 75 percent inclusion rate, the total personal capital gains tax collected for the year was $2.8 billion. In that year, the total taxable capital gains were $14.2 billion.48 This gives an average federal tax rate on taxable capital gains of 19.8 percent, slightly (but not significantly) lower than the rate calculated above. Now let us examine the sources of capital gains. Table 6 suggests that the total taxable capital gains of $14.2 billion in 1999 were derived from net capital gains of $16.5 billion. Taxable capital gains are estimated to comprise $2.6 billion from information slips; $5.5 billion from small business shares, qualified farms, and real property; and $6.2 billion from shares, bonds, and other items. 49 The net gains from information slips probably represent mainly mutual funds and brokerage accounts. There is little information available in Canada on holding periods, but information from the United States for 1993 suggests that the holding period for mutual funds is about 2 years, for shares about 2.9 years, and for real estate about 10 years or longer.50 Using these holding periods and assuming that the rates of return on the various assets were 12.1 percent, 18.7 percent, and 1844 ■ canadian tax journal / revue fiscale canadienne (2002) vol. 50, no 5

TABLE 5 Estimated Capital Gains Taxes for 1999

Taxable Estimated Taxable Taxes Average gains taxes on Tax rate Income level income paid tax rate (CG) CGa on CG

$ millions percent $ millions percent Under $60,000 ...... 376,557 54,786 14.5 3,146 458 14.5 $60,000 to $250,000 ...... 150,480 43,245 28.7 5,027 1,445 28.7 $250,000 and over ...... 43,189 17,257 40.0 6,074 2,427 40.0 570,226 115,288 20.2 14,248 4,330 30.4 a Assumes that the rate of tax on capital gains is equal to the average rate. Source: Canada Customs and Revenue Agency, “Income Statistics 2001—1999 Tax Year, Final Basic Table 2—All Returns by Total Income Class” (available on the Web at http://www.ccra- adrc.gc.ca).

20 percent, respectively,51 I calculated the inflation component of gains by reference to the CPI index in appendix 1. My estimate is that approximately $411 million or 9.5 percent of the $4.3 billion of taxes paid on capital gains in 1999 related to inflation. This figure represents less than 0.6 percent of all personal taxes.

Current Trends in Investing Appendix 3 shows the components of household assets in 1989 and 1999. The data were derived from different sources and may not be strictly comparable. Neverthe- less, they show two interesting trends. First, the proportion of assets held in personal residences has increased from 34.4 percent to 38 percent. Second, the investment in mutual funds, while relatively small, has more than doubled to 2.8 percent. Mutual fund statistics show significant growth in total assets. For example, total mutual fund assets grew almost tenfold from $2.5 billion in 1971 to $23.5 billion in 1989 and then almost exponentially to $426.4 billion at the end of 2001.52 At the end of 2001, there was significant weighting toward equities, which constituted 55 percent of assets; 16 percent of assets were in balanced funds, 15 percent in money market funds, and the remainder in a combination of bond, dividend, mortgage, and other funds.53 More Canadians are investing significant amounts in assets such as residences and mutual funds. The former are not taxed. However, capital gains arising from the latter are taxed, either on a current basis (with partial inclusion) in the case of non-registered funds, or on a deferred basis (fully) in the case of registered funds. Under current tax rules, these funds have no inflation protection.

HOW INFLATION CAN BE TAKEN INTO ACCOUNT EXPLICITLY I will now turn to the issues that arise in developing a method that would explicitly consider inflation. Two alternatives will be explored—taxation of capital gains on should inflation be a factor in computing taxable capital gains? ■ 1845

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301

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3,158

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−

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Sources of Capital G

......

Source: Canada Customs and Revenue Agency

adrc.gc.ca).

Gain or loss.

TABLE 6 TABLE

Qualified farm property Information slips ......

Other and adjustments Taxable capital gains Taxable a Real property ......

Bonds

Small business shares 1846 ■ canadian tax journal / revue fiscale canadienne (2002) vol. 50, no 5 an accrual basis and adjustment of the cost base of the asset for inflation (indexing). Some commentators have suggested a third method, adjustment of the tax rate. Since the results of adjusting the tax rate are similar to those under partial inclusion, I have not considered this alternative separately.

The Accrual Method One way to avoid the problem of taxing illusory gains is to tax capital gains on a current basis. Under this method, the taxpayer would include the amount of real capital gain that accrued in the year. Disposition would not be a precondition. Taxation of capital gains on a current basis would be consistent with the Haig- Simons ideal model. The failure to tax capital gains on an accrual basis has been described as “the achilles’ heel of... income tax.”54 Krever and Brooks, writing in 1990 in the context of New Zealand, noted some issues in trying to introduce such a system.55 While they made a good prima facie case for the tax, it was never implemented in New Zealand. Bradford and US Treasury tax policy staff note that “[a]ccrual taxation of capital gains poses three problems that taken together, appear insurmountable. These are (1) the administrative burden of annual reporting; (2) the difficulty and cost of determining asset values annually; and (3) the potential hardship of obtaining funds to pay taxes on accrued but unrealized gains.”56 Some assets, such as shares of private corporations, are difficult to value on an accrual basis and would entail significant additional taxpayer costs to obtain accurate valuations.57 In addition, to the above list I would add another item—the determination of the adjustment to account for inflation during the year.58 Suggestions have been made of ways to deal with these objections. Bradford points out that one method is to require formal valuations of assets on a periodic basis, and that with the choice of a long enough period—say, every five years—the cost of implementation might be brought within acceptable bounds.59 This method was considered in Canada in 1969 in the context of taxing publicly traded shares on an accrual basis every five years.60 Another suggestion for dealing with the issue of the lack of funds to pay the tax is to assess an interest charge on the deferred tax.61 The problems cited above may be surmountable in today’s environment. The accrual basis is now well accepted in other areas of the tax system. For example, interest is accrued, financial statements of businesses include accruals, foreign accrual property income is an accrual, there are potential accruals in connection with loans to non-residents, and the foreign investment entity rules as proposed in 1999 were based on accruing income. In addition, for public companies and mutual fund investments, there are ready sources of values. For large blocks of public company shares and for private companies, valuations are required in a number of situations where no transaction has yet taken place. For example, non-arm’s-length transactions, certain rollover transactions, and deemed dispositions on death or emigration all require that values be established. should inflation be a factor in computing taxable capital gains? ■ 1847

The significant problem of liquidity would, however, remain. This could be accommodated only by introducing the additional complexity of an interest accrual on deemed taxes to be satisfied upon ultimate disposal of the asset.

Reasons Why the Accrual Method Is an Unlikely Prospect In the Canadian context, at this particular time, it is difficult to contemplate using an accrual system that requires valuations. In 1984, Canada attempted to implement accrual-based taxation in the form of an “indexed security investment plan”; however, the experience proved unsatisfac- tory. These plans were available on an elective basis for publicly listed common stock of Canadian corporations. A participant was required to recognize annually a portion of the accrued appreciation (or decline in value) of the stock, measured after an adjustment to the stock’s basis to reflect inflation. The plans were revoked in 1985 with the introduction of the lifetime capital gains exemption. More recently, the government has been attempting to finalize and implement legislation for foreign investment entities (FIEs).62 The 1999 draft legislation provided that, where a taxpayer so elects and has sufficient information to comply, the taxpayer shall include in income his share of income of an FIE that is not a controlled foreign affiliate63 or, in other cases, the taxpayer shall take into income the annual increase or decrease in the fair market value of the interest in the FIE. This legislation attracted significant negative comment on grounds of equity, incongru- ity with other rules, and complexity.64 Implementation has been postponed twice, with the new proposed implementation date being 2003. The 2002 draft legislation has replaced the requirement to use the change in fair market value and requires instead that the taxpayer include in income an amount derived by applying the prescribed rate to the cost of investment. Until the issues that have delayed implementation of this legislation are fully resolved, it would be difficult to contemplate another tax proposal with similar potential problems. Further, there are no countries that have introduced an accrual method for the entire tax system. It is unlikely that Canada would want to be a pioneer in this area.

Adjusting the Cost Base Another method of taking inflation into account is to adjust the cost base for inflation. This method is commonly referred to as “indexing,” and it involves a three-step calculation. First, the cost base of the asset must be defined; second, the inflation factor must be determined; and third, the inflation factor is applied to the cost base to derive the adjusted cost base.

Determining the Cost Base The Act already prescribes how the cost of an asset is to be determined. No changes should be required to accommodate basis adjustment because of inflation. Where there is one property, such as a parcel of land or a building, it should be relatively easy to maintain a running total of the original cost, additions, and inflation 1848 ■ canadian tax journal / revue fiscale canadienne (2002) vol. 50, no 5 adjustments. However, where there are separable identical properties, such as shares, it may be difficult to continue the current pooling concept because each addition would occur at a separate time. In this case, there would have to be rules to determine, for example, the order of dispositions, and these would determine what cost records would be required.

Determining the Inflation Factor All governments that have adopted a form of indexing currently provide the inflation adjustment factors, usually on a quarterly basis.65 Thus, it would be expected that Canada’s minister of finance would provide the inflation factor. The question arises as to what measure should be used to determine the adjustment. One suggestion is the CPI. It provides timely information on price movements since it is available on a monthly basis with only a short time lag. As noted earlier, this index is used to measure the change in the price of a basket of goods and services that is representative of Canadian consumption patterns on a weighted basis. Crawford notes that the CPI may be susceptible to various types of measurement bias.66 These biases are caused by the fixed composition of the CPI basket of goods, which does not take into account consumers’ ability to substitute cheaper goods, the delay in incorporating new types of products into the basket, the introduction of new brands of existing goods, the changing quality of products, and shifts in market shares between retail outlets with different quality-adjusted prices. There are a number of other indices that could be used to measure inflation.67 Each of these indices attempts to refine the measure so that it is more meaningful. The technical problems related to the choice of inflation rate for the purpose of indexing capital gains are not unique to Canada. For example, Bartlett notes that “the consumer price index might not be appropriate for this purpose because of the relatively limited number of goods included in the index. Also, widely known problems with the index are believed to substantially overstate the true rate of inflation.”68 Hall notes the method proposed in the Job Creation and Wage En- hancement Act of 1995 in the United States, using the gross domestic product deflator.69 Edelstein also notes that the New York Bar Association authored a strongly worded opinion against indexing in which it argued that “there is no real way to accurately measure inflation, and so any indexing would, thus, by extension, be inaccurate.”70 Nevertheless, the CPI remains a good choice for several reasons. It is readily available and easily recognizable, and it measures inflation that has a direct effect on both businesses and consumers. Further, the impact of the biases noted above is estimated to about 0.5 percent71—not a significant amount. Finally, the CPI is already accepted in the Canadian tax system. It is the measure used as the basis for adjustment of personal and other allowances in personal income taxation.

Illustrating the Result of Indexing Assume that A purchases an asset for $1,000 at the beginning of year 1 and that the inflation rates, as published by the Department of Finance, in years 1, 2, and 3 are should inflation be a factor in computing taxable capital gains? ■ 1849

2 percent, 2.5 percent, and 3 percent, respectively. Further assume that the asset is sold at the end of year 3 for $1,200. At the end of year 1, the cost base is adjusted by a factor of (1 + inflation rate) (that is, 1.02), to give a new base of $1,020. At the end of year 2, the new cost base is adjusted by the new factor of 1.025, to give a new base of $1,045.50. Similarly, at the end of year 3, the new cost base is adjusted by the new factor of 1.03, to give a new base of $1,076.86. Under the current system of partial inclusion, the gain would be $200.00, of which $100.00 (50 percent) would be taxable. Under a system of indexing, the gain on the disposition would be $123.14, all of which would be subject to tax, in the absence of partial inclusion for factors other than inflation. If the other factors gave rise to partial inclusion of 57.7 percent, only $71.04 would be taxable.72 There would have to be an inclusion factor of 81.2 percent to produce the same result as the current system.73

POLICY ISSUES ASSOCIATED WITH METHODS OF DEALING WITH INFLATION Revenue Generation An accrual basis of taxation would provide increased revenues in the short term. Since this would be a transfer of revenues from the future to the present, there would be a reduction in future revenues, unless behavioural responses resulted in dispositions and reinvestment in higher-yielding assets. Given governments’ pro- pensity to spend, rigorous cost-benefit analysis would be necessary to evaluate the results of such revenue transfers. For a transfer to be beneficial, the present value of the benefits of increased government expenditures in the collection periods would have to exceed the present value of the tax revenues generated without the accrual method. There are difficulties in attempting such analysis, including measurement of the benefits of government expenditures. Under a system of indexing, realization remains the basis for the liability for tax. Accordingly, there is no earlier collection of tax revenues unless the fact of indexing changes the behaviour of taxpayers. This may occur if the adjustment is considered to be sufficient to more than offset the benefits of further deferral. In this case, realization will take place earlier than it would in the absence of indexing. Revenues may decline if the sum of indexing and partial inclusion is greater than 50 percent, unless investor behaviour changes. Indexing may remove the lock-in effect, one of the barriers to early realization. This could result in shorter holding periods of indexed assets and therefore the earlier payment of taxes. However, as indicated above, this is not necessarily a good result. Consider taxpayer A who has an asset that cost $1,000 in year 1. Assume that without indexing, A holds the asset for 10 years and earns a 10 percent pretax return on investment. Therefore, A sells the asset at the end of 10 years for $2,594. At a 45 percent tax rate and with no partial inclusion, A’s tax will be $717. Assume that a system of indexing is in effect and the inflation rate is 2 percent. If A sells at the end of 3 years instead, earning the same 10 percent before tax during that period, the selling price is now $1,331 and the tax is $121 if there is no partial inclusion for other factors. The true result from a government perspective depends 1850 ■ canadian tax journal / revue fiscale canadienne (2002) vol. 50, no 5 on two factors: (1) how A uses the net proceeds and (2) how the government uses the taxes collected in year 3. If A reinvests in an equally rewarding investment, future government revenues will benefit, but to a lesser extent than under the 10- year scenario because the amount reinvested is after tax. The government would need a return of about 13 percent to be in an indifferent position. If, however, A purchases a personal residence or incurs some other personal expenditure, the only benefit will be through the multiplier effect in the economy. The government would have to earn a return on investment of 29 percent per annum to compensate for the revenue lost. When compared with 50 percent inclusion, with reinvestment, indexing yields the same total revenues if there is continued 37 percent partial exclusion for other factors. At this level of exclusion, if A reinvests in non- income-earning assets, the government will still need to earn a return on investment of 25 percent per annum.

Equity Taxing real capital gains as they accrue would be more equitable than taxing them only when realized. Some commentators suggest that the failure to collect tax is tantamount to an interest-free loan to the extent of the deferred taxes—a benefit to wealthier taxpayers and those who defer realization.74 This is not entirely true; for example, Engler has argued that the loan bears an implicit interest rate that is equal to the rate of inflation.75 Indexing capital gains is also likely to be seen as benefiting the wealthy and, in our progressive tax system, leading to greater vertical inequity. The widely held view that only the wealthy pay capital gains taxes needs to be examined. It is true that the wealthy account for most capital gains. Table 7 shows that taxpayers with incomes above $100,000 in 1999 represented 10 percent of those reporting taxable capital gains and accounted for almost two-thirds of all such gains. However, it also shows that taxpayers at all income ranges have taxable capital gains. Taxpayers with incomes below $60,000 represented 75 percent of those reporting taxable capital gains, accounting for 22 percent of all such gains. The proportion shown for the higher income levels is likely to be overstated because capital gains are taxed only on realization or deemed realization. Thus, the taxable capital gains reported in any year represent the gains accumulated over many years. For example, taxpayers in the over-$60,000 income range reported $5.1 billion of net capital gains for small business shares and qualified farm property in 1999.76 It is inconceivable that these gains did not accrue over a lengthy period. However, there is no information on these holding periods. The accrual method also provides the ability to use unrealized losses.77 This opportunity, not otherwise available, enables the taxpayer to obtain an earlier benefit from these tax attributes.

Neutrality The taxation of real capital gains on an accrual basis would remove the bias in the present system to defer the realization of assets with accrued gains in order to defer should inflation be a factor in computing taxable capital gains? ■ 1851

TABLE 7 Taxable Capital Gains, 1999

Income range Taxpayers Taxable capital gains

number percent $ millions percent Under $20,000 ...... 542,740 27.6 691.2 4.9 $20,000-$40,000 ...... 547,070 27.8 1,198.4 8.4 $40,000-$60,000 ...... 381,870 19.4 1,256.9 8.8 $60,000-$80,000 ...... 209,300 10.6 1,027.5 7.2 $80,000-$100,000 ...... 97,200 4.9 782.6 5.5 $100,000-$250,000 ...... 144,630 7.3 3,216.7 22.6 Over $250,000 ...... 45,160 2.3 6,074.5 42.6 1,967,970 100.0 14,247.8 100.0

Source: Canada Customs and Revenue Agency, “Income Statistics 2001—1999 Tax Year, Final Basic Table 9” (available on the Web at http://www.ccra-adrc.gc.ca). the tax. Thus, tax considerations would no longer be a factor in the decision of whether an asset should be held or sold. This would lead to greater efficiency in the use of capital. Under the current system, investors are unlikely to sell a winner unless they have to. As long as capital gains are taxed on a preferential basis, there will be a tendency to utilize capital in a way that produces an economic return in the form of capital gains rather than in the form of current income. This is an inefficient use of capital, especially since much time and effort will likely go into planning to avoid current income treatment. Earlier realization may also facilitate the movement of capital from mature industries to newer, faster-growing industries, which require capital in their formative years.78

Simplicity There are three types of complexity in the tax system: first, discerning and inter- preting the rules; second, arranging transactions that satisfy the requirements of the rules; and third, creating, collecting, analyzing, and maintaining the necessary records and information required by the tax rules. With an accrual system, the current complex rules to determine when realization takes place and to prevent avoidance would not be necessary. This is because all capital assets (perhaps with the exception of a personal residence, within limits— see the discussion below) would be treated the same. The current emphasis on transactions to circumvent the rules would also diminish. However, there would be an increase in the administrative burden for taxpayers, particularly relating to valuation issues. With regard to indexing, Hall has suggested that once the existing body of rules and regulations is used to calculate the sale price of an asset, the indexing of capital gains will add one multiplication calculation to each capital gain transaction reported by the taxpayer.79 Grubel has suggested that it would be very simple for the government to send “to all taxpayers a table that allows them to read off the 1852 ■ canadian tax journal / revue fiscale canadienne (2002) vol. 50, no 5 cumulative inflation in the consumer price index experienced during the time that they bought and sold their assets.”80 Other commentators are of the view that the indexing of capital gains would add significant complexity to the tax system.81 They argue that figuring out exactly what inflation adjustment should apply to shares that may have been acquired at different dates over a long period of time would be a nightmare. In the case of tangible assets, such as buildings, any improvements would have to be indexed separately. In addition, the matching of indexed gains against losses would be made more difficult. However, Bartlett notes that many foreign countries with far less administrative capability than the United States have successfully implemented inflation indexing for capital gains.82 On the other hand, Australia’s Ralph report indicates that the removal of indexing in Australia would simplify the law and reduce compliance costs.83

A COMPARISON OF INDEXING AND PARTIAL INCLUSION Compared with the partial inclusion method as currently practised in Canada, a system of indexing offers a number of advantages:

■ Adjusting for inflation through indexing would give specific attention to, and provide a more exact adjustment for, the inflation factor. The fixed inclusion method is not an accurate reflection of inflation and would be accurate only in the unlikely event that the portion of gain excluded was equal to the rate of inflation. Even if the measure used for indexing were less than perfect, it would be a better measure than arbitrary percentage inclusion. ■ Adjusting for inflation would be automatic once the system was implemented. The only requirement would be publication of the inflation adjustment factor by the government. Since statistics are already published for the CPI on a monthly basis, this should pose no hardship. The partial inclusion method could be made equally responsive by changing the inclusion rate more frequently. However, in practice, this approach has not been favoured by Canadian ministers of finance. ■ Adjusting for inflation would explicitly allow policy makers to focus on the measures needed in the tax system to make investment in Canada competitive. Under the partial inclusion system, there are too many implicit factors in the specified inclusion rate. Under current rules, it appears that a 50 percent inclusion could represent between 6 percent and 22 percent for inflation and between 28 percent and 44 percent for other factors.84 Canada’s investment climate and the tax measures necessary to promote international competitiveness are too important for these factors to be buried in this manner. ■ The addition of indexing to other adjustments could result in greater effective exclusion than the current 50 percent. This would likely reduce the propen- sity to hold on to assets. As a result, there would be an increase in government should inflation be a factor in computing taxable capital gains? ■ 1853

revenues. In this respect, the same issues arise as were noted for the accrual method discussed above. ■ Indexing would result in a more equitable system for taxing capital gains. A system of fixed partial inclusion treats all taxpayers the same, irrespective of the holding period and pattern of development of their gains. Since a system of indexing would take both of these into account, it would be more equitable between taxpayers. ■ Indexing would provide incentives for entrepreneurship and risk taking. Where investors are guaranteed protection for inflation, investment in capital assets becomes more attractive. This leads to more efficient use of capital.

There are also disadvantages:

■ Many capital assets are bought with borrowed funds. Borrowing must also be indexed for inflation; otherwise, capital gains indexing would simply become a tax benefit for those who had access to borrowed funds. ■ Indexing capital gains would lower government revenues if it were provided in addition to the current partial inclusion. Such reduced revenues, in the Keynesian model, would reduce the budget surplus (or increase the budget deficit) and exacerbate inflation. ■ Adjusting capital gains for inflation without providing similar indexing for everything else (such as depreciation) would create unfairness and misallocate investment. ■ Indexing could lead to greater complexity.

ISSUES ARISING FROM INDEXING Administrative Issues Where there was only one asset that was held for a period, very little administration would be involved. As mentioned above, only one simple additional calculation would be required to arrive at the taxable capital gain. However, where there were multiple purchases of identical property, the taxpayer would have to maintain records for each purchase separately. There are two methods for dealing with this requirement. One is to keep each set of purchases separately, with each having its unique cost base and adjustment factors. In this case, it would be necessary to establish rules for the order of disposition; each sale would come from a specified year of purchase on a first in, first out or a last in, first out basis, as determined. A simpler system would be to adjust the cost base each year and maintain a running updated cost base. Additions would go into the pool and be subject to inflation adjustments in future periods, and dispositions would be treated in a similar fash- ion to the treatment under the current Act. An overall issue is the cost of compliance and of administration. Citing research from the United Kingdom and Australia, Evans has noted that the increased incidence of capital gains and increased complexity have raised compliance costs.85 1854 ■ canadian tax journal / revue fiscale canadienne (2002) vol. 50, no 5

Treatment of Different Types of Assets Growth assets are expected to provide future appreciation. An example is an investment in common shares. Since such assets are also likely to be held for longer periods, they are more likely to be subject to inflationary gains. Fixed-return assets provide a current fixed return each year. Examples are preferred shares and long-term bonds. On maturity, the investor recoups the full amount of the investment. Since the amount received on maturity is in inflated dollars, this asset also should be adjusted for inflation. There is a counterargument that the annual return, and the opportunity to reinvest this return each year, have already provided offsets to inflation. This is only partially true since the return is a fixed return based on conditions at the time the asset was purchased. Full indexing of interest would resolve this issue. Variable-return assets provide a current variable return each year. Examples are floating-rate preferred shares and variable-rate long-term bonds. Again, on maturity, the investor recoups the full amount of the investment. This type of investment is different from fixed-rate securities discussed above, in that the return is always based on current interest rates. This feature suggests that variable-rate assets are better protected from inflation. Depreciable assets decrease in value over time. To the extent that depreciation is deductible for tax purposes, the rules for recapture should give rise to full taxation of inflationary gains. This can arise when a depreciating asset, such as a building, is sold for an amount greater than the undepreciated capital cost. The original cost should be adjusted for inflation in calculating any amount that is subject to capital gains.

The Principal Residence Exclusion The exclusion from the tax base of the capital gain on a principal residence is a major departure from the Haig-Simons ideal. This issue was considered in the Carter report and found its way into the tax reform proposals in the form of an exemption of $1,000 per year of occupancy, together with various rollover provisions in the event that the taxpayer moves as a result of a change of job.86 The Standing Senate Committee on Banking, Trade and Commerce had recommended a lifetime exemption of $50,000.87 McGregor noted that the decision to exempt gains on the sale of a principal residence was “based on emotion rather than logic, and on public opinion rather than equity (either horizontal or vertical).”88 Canadians have always preferred to own their homes, and this exemption has been beneficial to taxpayers. It has been used to such an extent that, as noted earlier, in 1999 principal residences represented the largest asset class, at 38 percent of all personal assets (excluding employer-sponsored registered pension plans).89 The policy rationale for this exemption is to encourage Canadians to pursue home ownership, perhaps for a sense of well-being and self-sufficiency. This objec- tive is laudable, but the exemption lends itself to abuse. I believe that a case can be made for reintroducing the taxation of capital gains on personal residences on a basis similar to the tax reform proposals. Both the amount of the exemption and should inflation be a factor in computing taxable capital gains? ■ 1855 the cost base should be adjusted for inflation. Such a measure would also be more neutral as it would remove the incentive for certain individuals to speculate, trade, or overinvest in residences for tax reasons.

Treatment of Capital Losses Under current law, capital losses can be deducted only against capital gains. A capital loss arises when the proceeds of disposition of a capital property are less than the adjusted cost base. An adjustment for inflation will increase the adjusted cost base and could convert a nominal gain into a loss or increase a nominal loss. The result is that the loss under a system of indexing would be larger than that under partial inclusion. The following example illustrates this. Assume that a taxpayer purchases an asset for $10,000 and sells it two years later for $9,000. The nominal loss is $1,000, of which $500 is deductible from capital gains. If inflation is at an annual rate of 2 percent, the adjusted cost base increases to $10,400 and the loss increases to $1,400. Loss limitation results in increased government revenues. However, it seems unfair that capital gains are added to taxable income, but capital losses are not deducted from taxable income. The rationale for this anomaly appears to be that, in a realization system, taxpayers would realize losses to offset other income, but defer realization of assets with gains.90 Nevertheless, taxpayers do not invest to make losses; the losses are real. Since higher-income taxpayers are often in a better position to plan their affairs so as to match taxable gains and losses, the burden of the loss limitation is borne mainly by middle-income and lower-income taxpayers. This result constitutes vertical inequity. Mintz and Wilson also note that the inability to fully write off losses is a significant barrier to risk taking and entrepreneurship.91 Nevertheless, the removal of the loss limitation would probably lead to too great a reduction in government revenues.

Treatment of Debt Taxpayers always look for opportunities to exploit anomalies in the tax system. The use of debt to finance the purchase of capital assets gives rise to two such opportunities. One relates to the value of the debt and the other to the deductibility of the interest. If capital assets were subject to adjustment for inflation, the failure to adjust for the borrower’s gains resulting from the decreased value of the debt would provide double relief to the taxpayer—once on the upward adjustment of the cost base, which reduces the capital gain, and then again on the untaxed gain on the debt through repayment in inflated currency. Adjustment of the debt in this manner makes sense since the holder would have the benefit of the cost base adjustment on the asset. Interest incurred for the purpose of earning income from investments also would need to be adjusted for inflation. Inflation not only increases the value of assets; it also raises interest rates. But interest paid on money borrowed for earning 1856 ■ canadian tax journal / revue fiscale canadienne (2002) vol. 50, no 5 income from investments is tax-deductible.92 Thus, people who borrow to purchase capital assets are already compensated for inflation through the deduction of interest that includes an inflation component. If gains were indexed, borrowers should be allowed to deduct only interest less the rate of inflation.

Dealing with Deflation While deflation has not been an issue in Canada, it has occurred recently in other countries, such as Japan. This possibility raises the question whether the cost base should be adjusted downward for deflation. I have not found any proponents of such an adjustment. Edelstein notes that an imbalance exists since the investor’s basis is adjusted to its “real” value during inflationary periods, but it is not counterbal- anced with a downgrade during deflationary periods.93 He also adds that such an adjustment would amount to a property tax on cash or personal property and would be very unpopular. I am not aware of any country that makes such an adjustment.

THE EXPERIENCE OF OTHER COUNTRIES Australia Australia introduced the taxation of capital gains in 1985. Taxation is based on realization. Death does not trigger a deemed realization. Assets held for less than 12 months were taxed on nominal gains. Assets held for more than 12 months were indexed according to quarterly movements in the general CPI. There was also an averaging provision for individuals. However, only nominal losses, not real losses, could be used to offset real capital gains. Taxation is at the marginal rate. Following a review, the indexing of capital gains was frozen at the end of September 1999. As a result, after that date, nominal rather than real capital gains became taxable. The following reasons for making this change were cited: improving rewards for risk and innovation; better allocation of resources; improved equity; greater conformity with the taxation of capital gains in other countries; and increasing international competitiveness.94

Great Britain Capital gains taxation was introduced in Great Britain in 1965. The rate was set at 30 percent, compared with a top marginal rate of 97.5 percent. In 1982, an indexing allowance was introduced for inflation after that year. In 1985, this relief was ex- tended backward to the date of acquisition. In 1988, the rate of capital gains tax was made equal to the rates of tax on individual incomes and corporate profits. In 1998, indexing for individuals was frozen and a system of “tapering” introduced, whereby the rate of tax is a decreasing function of the time during which the asset is held. In commenting on the British system, Gale notes that indexing does not achieve the goal of taxing real income for most taxpayers with capital gains. 95 He argues that the gains are fully exempt from taxation either because of the large exemption level or because assets such as housing are exempt from capital gains taxation. Very few people pay capital gains tax in Britain: in 1993-94, it accounted for 0.4 percent should inflation be a factor in computing taxable capital gains? ■ 1857 of all taxes and 1.6 percent of taxes raised by the income tax plus the capital gains tax.96 By comparison, in the United States, federal capital gains taxes alone account for 2.5 percent of all tax revenue and 7 percent of federal income taxes.97

Ireland Ireland introduced the taxation of capital gains in 1975, at a preferential tax rate of 26 percent.98 Between 1978 and 1992, various changes were made, including a tiered rate structure based on length of ownership. Indexation was introduced in 1978. In 1992, a 40 percent rate was introduced, and the previous tiered system was replaced by a single-rate system. The current rate is 20 percent. Personal residences are exempt. A recent discussion paper has suggested that if consideration were to be given to the abolition of indexing for future years, now would be an appropriate time because of recent low inflation.99 The paper noted that there could be strong criticism of the move.

The United States The United States has had a capital gains tax regime since at least 1942, when it had a 50 percent exclusion of the capital gain from income taxation. The Revenue Act of 1978100 allowed taxpayers to exclude 60 percent of capital gains from taxation. The Economic Recovery Tax Act of 1981101 reduced the top rate on regular income from 70 percent to 50 percent, yielding a maximum tax rate on capital gains of 20 percent. Under the Tax Reform Act of 1986,102 the 60 percent exclusion was eliminated, and the statutory rate for capital gains was capped at 28 percent. This maximum rate remains in place, although a variety of proposals have been introduced to lower the rate below 20 percent. The United States does not have indexing for capital gains taxation. It does have a lower rate of tax for capital gains and distinguishes between short-term and long-term gains. A number of proposals have been put forward for the introduction of indexing. These proposals have given rise to a number of studies, but to date indexing of capital gains has not been adopted.103 Implications The countries considered above that have introduced indexing of capital gains either have removed it or amended it, or are considering its discontinuance. Aus- tralia has adopted a system that closely resembles the Canadian system. The tax system in the United States, from which Canada seems to take its guidance, has not adopted indexing of capital gains despite careful study. The current Canadian system appears to be roughly in conformity with the direction taken by these countries. CONCLUSION Indexing of capital gains would be a preferred alternative to the partial inclusion system. Adjusting the cost base through indexing would bring sharper focus to government policy and would be a sound approach to dealing with a real problem. 1858 ■ canadian tax journal / revue fiscale canadienne (2002) vol. 50, no 5

It would give specific attention to, and provide a more exact adjustment for, the inflation factor; would be automatic once the system was implemented; would explicitly allow policy makers to focus on the measures needed in the tax system to make investment in Canada competitive; would result in a more equitable system for taxing capital gains; and would provide incentives for entrepreneurship and risk taking. However, it could not be implemented in isolation. Widespread changes would be required to deal with asset pools, loss utilization, debt, interest, and deflation; to ensure consistency; and to reduce arbitrage opportunities. Complex- ity could remain an issue. Indexing capital gains may also be too far-reaching a move for the perceived advantages. Canadians have become accustomed to the present system; any steps to amend it, even on grounds of equity and neutrality, would be viewed with suspicion. Indexing is also contrary to the direction that other major countries are taking. It would be difficult to introduce and justify in the context of comparing tax systems and maintaining a competitive capital gains tax structure. Accordingly, the timing and environment do not favour its introduction.104 There are, however, some changes that could be made to the present system in order to improve equity and neutrality, without having any significant negative impact on revenues and simplicity:

1. Recognition of the inequity between the taxation of short-term and long- term gains. 2. Recognition that deferral of capital gains in a system based on realization confers a benefit that increases with time.

The first and second measures could be accommodated through a system of tapering. Full taxation would apply to gains from assets held for a short term—for example, one year. For assets held over a longer term, the inclusion rate would decline each year by, say, 5 percent, until year 10. Thereafter, 50 percent inclusion would apply. This system, while not perfect, would better reflect inflation, remove the undertaxation of short-term gains, and recognize the benefit of deferral, without impeding incentives for long-term investment.

3. Revision of the limitations on the utilization of capital losses to permit greater flexibility. The concern about schemes to trigger losses selectively could be addressed through a system that would increase the future gain by an amount to compensate for the early loss utilization. Applying an interest factor to the loss utilized against other income could accomplish this result. 4. Introduction of the taxation of gains, above a specified limit, on the sale of a principal residence. The limit could be defined by reference to the taxpayer’s average taxable income, years of ownership, or both. Such a system would need to incorporate a minimum exemption to protect lower-income homeowners, as well as a mechanism to ensure that those who purchased their homes and then suffered an income reduction would not be penalized. should inflation be a factor in computing taxable capital gains? ■ 1859

5. Exclusion of capital gains taxation for persons with lower incomes or provision of a minimum exemption.

On balance, I believe that the proposals would improve the tax system. Items 1, 2, and 4 above would likely be positive for revenues, while items 3 and 5 would likely be negative for revenues. On balance, they are expected to be revenue neutral, but more work is required to determine this with certainty. All proposed measures would increase equity and neutrality in the tax system, but would introduce mar- ginally increased complexity.

NOTES 1 Canada, Report of the Royal Commission on Taxation (Ottawa: Queen’s Printer, 1966). 2 RSC 1985, c. 1 (5th Supp.), as amended (herein referred to as “the Act”). Unless otherwise stated, statutory references in this paper are to the Act. Sections 38 to 55 contain the rules for calculating taxable capital gains. 3 Robert Murray Haig, “The Concept of Income—Economic and Legal Aspects,” in Richard A. Musgrave and Carl S. Shoup, eds., Readings in the Economics of Taxation (Homewood, IL: Irwin, 1959), 54-76, reprinted from R.M. Haig, ed., The Federal Income Tax (New York: Columbia University Press, 1921); and Henry C. Simons, Personal Income Taxation: The Definition of Income as a Problem of Fiscal Policy (Chicago: University of Chicago Press, 1938). 4 E.J. Benson, Proposals for Tax Reform (Ottawa: Queen’s Printer, 1969), 36. 5 There has been much debate about whether the Haig-Simons approach is an appropriate standard. Discussion of this issue is beyond the scope of this paper. I note, however, that the Haig-Simons approach appears to be accepted as the starting point for income taxation in most countries. 6 While the general principle is one of realization, in a number of situations the Act provides for a deemed realization, primarily for anti-avoidance purposes. 7 Paragraph 38(a). 8 The inclusion percentage was set at 50 percent when the taxation of capital gains was introduced in 1972. This percentage was increased to 662⁄3 percent in 1988 and then to 75 percent in 1990. In 2000, the percentage was first reduced to 662⁄3 percent and then to 50 percent. 9 The Standing Senate Committee on Banking, Trade and Commerce, for example, specifically recommended “that the Canadian capital gains tax rate should quickly be lowered to match the rate in the United States.” See Canada, Standing Senate Committee on Banking, Trade and Commerce, The Taxation of Capital Gains, fifth report to the Senate, 36th Parl., 2d sess., May 3, 2000, recommendation. 10 Canada, Report of the Technical Committee on Business Taxation (Ottawa: Department of Finance, April 1998), 7.17. 11 Robin W. Boadway, “The Economic Rationale for Integration,” in Business Tax Reform, 1998 Corporate Management Tax Conference (Toronto: Canadian Tax Foundation, 1998), 21:1-26, at 21:21. 12 Supra note 1, vol. 3, at 349. 13 Canada, House of Commons, Debates, June 22, 1971, 7226. The Honourable Marcel Lambert raised the point as follows: “There is one difficulty about the capital gains tax. It still is there and will always be there. The difficulty is that the tax does not take into account the effects of inflation.” 1860 ■ canadian tax journal / revue fiscale canadienne (2002) vol. 50, no 5

14 Ibid., at 7246: “It had become clear that we did not believe that the capital gains rate on public corporations could be higher than the American rate.... We were, therefore, reluctantly driven to conclude that half rate capital gains was the only way we could introduce it, given our relationship to the American market and taking into consideration the access the Americans have to ours.” 15 See, for example, Edward Yorio, “The President’s Tax Proposals: A Major Step in the Right Direction” (1985) vol. 53, no. 6 Fordham Law Review 1255-89, at 1259, where Yorio notes that a capital gains preference can be justified as an “admittedly crude” method of excluding inflationary gains. 16 Jack M. Mintz and Thomas A. Wilson, Capitalizing on Cuts to Capital Gains Taxes, C.D. Howe Institute Commentary no. 137 (Toronto: C.D. Howe Institute, February 2000), 5-6. 17 Noël B. Cunningham and Deborah H. Schenk, “The Case for a Capital Gains Preference” (1993) vol. 48, no. 3 Tax Law Review 319-80, at 338. 18 Ibid., citing Daniel Halperin and Eugene Steuerle, “Indexing the Tax System for Inflation,” in Henry J. Aaron, Harvey Galper, and Joseph A. Pechman, eds., Uneasy Compromise: Problems of a Hybrid Income-Consumption Tax (Washington, DC: Brookings Institution, 1988), 347-83, at 353-56. 19 Supra note 17, at 338, citing Leonard Burman and Larry Ozanne, “Indexing Capital Gains,” in J. Andrew Hoerner, ed., The Capital Gains Controversy: A Tax Analysts Reader (Arlington, VA: Tax Analysts, 1992), 318. 20 Supra note 17, at 338, note 71. 21 This can be illustrated by considering an asset owned by A, with a cost of $1,000, held for 20 years, and earning an annual return of 10 percent. Assume that inflation is 4 percent, resulting in a real return of 6 percent. The asset is sold in year 20 for $6,727, for a gain of $5,727. Under the partial inclusion system, at a 50 percent inclusion rate and a 45 percent tax rate, tax is $1,289, leaving $5,438 after tax. Under an accrual system, the after-tax real return is 6% × (1 − 0.45) = 3.3%, which gives a value of $1,914 in year 1 dollars; this is equivalent to $4,194 in year 20 dollars. It is only at a high inflation rate of 7.17 percent, which leaves net proceeds of $5,440, that partial inclusion and accrual are equivalent. 22 For example, a form of indexing of the personal tax system was introduced in 1973. This was later suspended and reintroduced only in 2001. On both occasions, there was no indexing of capital gains. 23 As inflation increases, there is need for greater relief in order to avoid taxing inflationary gains. Thus, in a rational world, one would expect the inclusion rate to decrease with rising inflation and increase with declining inflation. 24 Bruce Bartlett, “The End of Tax Expenditures As We Know Them?” (2001) vol. 92, no. 3 Ta x Notes 413-22, at 417, citing several sources. 25 Ibid., citing Bruce Bartlett, “Inflation and Capital Gains” (1997) vol. 75, no. 9 Tax Notes 1263-66. 26 One can argue about the appropriate measure for inflation. This is briefly discussed below under the heading “How Inflation Can Be Taken into Account Explicitly—Adjusting the Cost Base.” 27 V-day is December 31, 1971, the day before the tax on capital gains became effective in Canada. Gains accruing before that date are not subject to tax. 28 The TSE 300 is an index that represents the value of a basket of 300 common shares that are traded on the Toronto Stock Exchange. This basket of securities is variable since the stock exchange reviews the composition periodically to eliminate low-volume securities and to add securities that represent new industries. 29 The nominal after-tax return is derived by 7% × (1 − 0.45) = 3.85%. The real after-tax return is derived by 1.6% − (7% × 0.45) = −1.55%. should inflation be a factor in computing taxable capital gains? ■ 1861

30 When 50 percent partial inclusion is taken into account, the after-tax return on a nominal basis is derived by 7% − (7% × 0.5 × 0.45) = 5.43%. The real after-tax return is derived by 1.6% − (7% × 0.5 × 0.45) = 0.03%. 31 The after-tax return on the annual dividend is estimated to be 1.37 percent. 32 Meyer W. Bucovetsky, “Inflation and the Personal Tax Base: The Capital Gains Issue” (1977) vol. 25, no. 1 Canadian Tax Journal 79-107, at 84. 33 David F. Bradford, Untangling the Income Tax (Cambridge, MA: Harvard University Press, 1986), 42. 34 United States, Congress, Joint Economic Committee, Optimal Capital Gains Tax Policy: Lessons from the 1970s, 1980s, and 1990s (Washington, DC: Joint Economic Committee, June 1997), 17-18. 35 Paragraph 40(2)(b). This concession was made at the time the capital gains tax was introduced, with the intention of reducing resistance to the new tax. While the principal residence exemption was a departure from the Haig-Simons model, it was acceptable because it enabled ordinary Canadians to continue to own their own homes. In this sense, the premise that “a buck is a buck is a buck” no longer applied. 36 Statistics Canada, Canadian Statistics, Families, Households and Housing, “Composition of Assets and Debts, Canada and Provinces, 1999” (available on the Web at http://www.statcan.ca). 37 Ibid. 38 Deferral mechanisms are mainly provided for in sections 51 and 85 to 88. Deemed disposition provisions are scattered throughout the Act; one example is subsection 128.1(4), which provides for a deemed disposition on emigration. 39 Private pension assets include registered retirement savings plans (RRSPs), registered retirement income funds (RRIFs), locked-in retirement accounts (LIRAs), employer-sponsored registered pension plans (EPPs), and other private pension assets such as deferred profit-sharing profit plans (DPSPs) and annuities. 40 Private pension assets represent the second-largest category of assets at 29 percent. 41 For example, see Shimon B. Edelstein, “Indexing Capital Gains for Inflation: The Impacts of Recent Inflation Trends, Mutual Fund Financial Intermediation, and Information Technology” (1999) vol. 65, no. 3 Brooklyn Law Review 783-825, at 794-95. 42 Ibid., at 795, citing Reed Shuldiner, “Index the Code, Not Capital Gains” (1998) vol. 79, no. 2 Tax Notes 225-41, at 237. 43 Investment income can be deferred in tax-sheltered plans. Otherwise, there are rules that provide for the accrual of investment income. For example, interest on compound Canada savings bonds is taxable on a current basis. 44 Supra note 32, at 90. The reason given is that on the sale of an asset, the proceeds are used to purchase another asset; basis compensation for future inflation will be applied to the net-of-tax sale price of the current holding. 45 This estimate is derived by using the analysis of provincial and federal taxes paid by income group as provided in the income statistics. The calculated average federal and provincial rates, respectively, for the different income groups are as follows: under $60,000, 10.8 percent and 3.8 percent; $60,000 to $250,000, 20.5 percent and 8.2 percent; and over $250,000, 26.7 percent and 13.3 percent. 46 The total personal tax revenues and total revenues are derived from the Public Accounts of Canada, 2000-2001 (Ottawa: Public Works and Government Services, 2001), 2.3, table 2.2, “Government of Canada: Detailed Statement of Revenue Transactions.” 1862 ■ canadian tax journal / revue fiscale canadienne (2002) vol. 50, no 5

47 Canada, Department of Finance, Tax Expenditures and Evaluations 2001 (Ottawa: Department of Finance, 2001), 18. I have chosen to use 1999 because there is other information available for that year that enables the calculations. 48 Canada Customs and Revenue Agency, “Income Statistics 2001—1999 Tax Year, Final Basic Table 9—Sample Data, All Returns with Taxable Capital Gains by Total Income and by Major Source of Income” (available on the Web at http://www.ccra-adrc.gc.ca). 49 It is assumed that the losses are deducted in the year. 50 Leonard E. Burman and Peter D. Ricoy, “Capital Gains and the People Who Realize Them” (1997) vol. 50, no. 3 National Tax Journal 427-51, at 434-35. 51 The change in the TSE 300 index between December 1996 and 1999 (see appendix 2) is used as a proxy for returns for shares and mutual funds. The 20 percent for real estate and small business is based on my expectation that the return on these assets would exceed the return on shares. 52 Data compiled by the Investment Funds Institute of Canada. 53 Ibid. 54 William D. Andrews, “The Achilles’ Heel of the Comprehensive Income Tax,” in Charls E. Walker and Mark A. Bloomfield, eds., New Directions in Federal Tax Policy for the 1980s (Cambridge, MA: Ballinger, 1983), 278-85. 55 Rick Krever and Neil Brooks, A Capital Gains Tax for New Zealand (Wellington, NZ: Victoria University Press for the Institute of Policy Studies, 1990). At 132, Krever and Brooks note, “At present, no country we are aware of taxes capital gains generally on an accrual basis; therefore, introducing such a tax would be risky since the experience of other countries could not be relied upon. Nevertheless, the potential gains in terms of equity, economic efficiency and simplicity are so great that the introduction of such a tax should be given the most serious consideration. Naturally, such a change would require a high degree of public consensus and understanding. Also, all potential problems and details would have to be worked out in advance of implementing the tax.” 56 David F. Bradford and the United States Treasury Tax Policy Staff, Blueprints for Basic Tax Reform, 2d ed. rev. (Arlington, VA: Tax Analysts, 1984), 73. 57 Private company shares are unique, have no established benchmarks, and are illiquid. 58 This is discussed further below in the section “How Inflation Can Be Taken into Account Explicitly—Adjusting the Cost Base.” 59 Bradford, supra note 33, at 48. 60 Proposals for Tax Reform, supra note 4, at 40-41. The Standing Committee on Finance, Trade and Economic Affairs indicated that it found that the proposal, “while meritorious for some of the reasons mentioned in the White Paper, produces unfair results in certain circumstances for control-block resident shareholders and non-resident controlling shareholders.” See Canada, House of Commons, Eighteenth Report of the Standing Committee on Finance, Trade and Economic Affairs Respecting the White Paper on Tax Reform (Ottawa: Queen’s Printer, 1970), 26. A particular concern was the possibility of liquidity problems in the “thin” Canadian equity markets. The committee recommended that the proposal be abandoned, and it never found its way into the final legislation. 61 For example, see Cynthia F. Blum, “New Role for the Treasury: Charging Interest on Tax Deferral Loans” (1988) vol. 25, no. 1 Harvard Journal on Legislation 1-111, at 100-1; and Bucovetsky, supra note 32, at 92. 62 On December 17, 2001, the minister of finance announced a one-year delay in the effective date of these proposals: Canada, Department of Finance, Release no. 2001-120, December 17, 2001. On October 11, 2002, the minister of finance released revised legislative proposals: Release, no. 2002-084, October 11, 2002. should inflation be a factor in computing taxable capital gains? ■ 1863

63 A controlled foreign affiliate is defined in subsection 95(1) of the Act. Generally, it is a foreign corporation that is controlled by the taxpayer and/or related parties. 64 For example, see the Canadian Tax Foundation’s letter to the minister of finance dated September 1, 2000 and The Tax Executive Institute’s submission dated February 22, 2001. 65 Australia and England are two examples of such countries. 66 Allan Crawford, “Measurement Biases in the Canadian CPI: An Update” [Spring 1998] Bank of Canada Review 39-56. 67 For a discussion of alternatives, see Seamus Hogan, Marianne Johnson, and Thérèse Laflèche, Core Inflation, Technical Report no. 89 (Ottawa: Bank of Canada, January 2001), 4 and 14-18. 68 See Bruce Bartlett, “Don’t Index Capital Gains, Abolish It,” opinion editorial, November 13, 1996, National Center for Policy Analysis (available on the Web at http://www.ncpa.org); and Michael R. Baye and Dan A. Black, Indexation and the Inflation Tax, Policy Analysis no. 39 (Washington, DC: Cato Institute, July 12, 1984) (available on the Web at http://www.cato.org). 69 Arthur Hall, “Issues in the Indexation of Capital Gains,” Tax Notes Today, May 4, 1995. The gross domestic produce deflator is a (US) government price index similar to the CPI. 70 Supra note 41, at 801. 71 Supra note 66, at 53. 72 The inclusion factor of 57.7 percent is calculated by increasing the present inclusion rate of 50 percent by the impact of inflation over the period. Said another way, the present exclusion of 50 percent is reduced by the impact of inflation. This is calculated only for illustrative purposes. This rate should be the focus of government policy. 73 $100.00/$123.14 = 81.2%. 74 Krever and Brooks, supra note 55, at 137. 75 Mitchell L. Engler, “Partial Basis Indexation: An Implicit Response to Tax Deferral” (2000) vol. 53, no. 2 Tax Law Review 177-224, at note 86. 76 See table 6. 77 This assumes that there are gains against which losses can be offset. Current rules permit the use of capital losses only against capital gains, although they can be carried back three years and forward indefinitely. See the discussion on losses below under the heading “Issues Arising from Indexing.” 78 Jane G. Gravelle, Capital Gains Tax Issues and Proposals: An Overview, Congressional Research Service Report (Washington, DC: Congressional Research Service, March 28, 1995), suggests that it is unclear to what extent entrepreneurs take tax considerations into account and that much of the venture capital is supplied by investors that are not subject to the capital gains tax—for example, pension funds and foreign investors. 79 Supra note 69. 80 Herbert G. Grubel, “The Case for the Elimination of Capital Gains Taxes in Canada,” in Herbert G. Grubel, ed., International Evidence on the Effects of Having No Capital Gains Taxes (Vancouver: Fraser Institute, 2001), 3-36, at 28. 81 For example, New York State Bar Association Tax Section Ad Hoc Committee on Indexation of Basis, “Report on Inflation Adjustments to the Basis of Capital Assets” (1990) vol. 48, no. 6 Tax Notes 759-75; and Edelstein, supra note 41, at 804. 82 Bartlett, “Inflation and Capital Gains,” supra note 25. 83 Australia, Review of Business Taxation, A Platform for Consultation—Building on a Strong Foundation, Discussion Paper 2, vol. 1 (Canberra: Australian Government Publishing Services, February 1999) (commonly referred to as “the Ralph report”), 306. 1864 ■ canadian tax journal / revue fiscale canadienne (2002) vol. 50, no 5

84 At an average inflation rate of 2 percent for the last decade, with a holding period of 10 years, the allowance for inflation would be (1.02)10 = 21.9%; with a holding period of 3 years, this allowance would be (1.02)3 = 6.1%. 85 Chris Evans, “The Operating Costs of Taxing Capital Gains: A Conspectus,” a draft paper for the ATAX Compliance Costs Symposium, Sydney, April 26-27, 2000, 15. 86 Supra note 4, at 38-39. 87 Canada, Standing Senate Committee on Banking, Trade and Commerce, Report on White Paper Proposals for Tax Reform Presented to the Senate of Canada (Ottawa: Queen’s Printer, September 1970), 58. 88 Gwyneth McGregor, “Principal Residence: Some Problems” (1973) vol. 21, no. 2 Canadian Tax Journal 116-26, at 116. 89 Supra note 36. 90 Ralph report, supra note 83, at 311. 91 Supra note 16, at 5. 92 Paragraph 20(1)(c). 93 Supra note 41, at 807. 94 Australia, Review of Business Taxation, A Tax System Redesigned—More Certain, Equitable and Durable (Canberra: Australian Government Publishing Services, July 1999), 595-96. 95 William G. Gale, “What Can America Learn from the British Tax System?” (1997) vol. 50, no. 4 National Tax Journal 753-77, at 764. 96 Ibid. 97 Burman and Ricoy, supra note 50, at 428. 98 Personal tax rates were as high as 77 percent at the time. 99 Government of Ireland, Department of Finance, “Capital Gains Tax,” July 24, 2001. 100 Pub. L. no. 95-600, enacted on November 6, 1978. 101 Pub. L. no. 97-34, enacted on August 13, 1981. 102 Pub. L. no. 99-514, enacted on October 22, 1986. 103 For example, see Indexing Capital Gains, Congressional Budget Office Reports (Washington, DC: Congressional Budget Office, September 1990). 104 See the report of the Standing Senate Committee on Banking, Trade and Commerce, supra note 9, under the heading “The Taxation of Illusory Income”: “[a]lthough most witnesses recognized the impediments to wealth creation of not indexing capital gains, they also acknowledged that such indexation would be hard to implement. Most countries do not adjust the tax treatment of capital gains for inflation, and the few countries that did are now reversing that because of the technical difficulty in carrying out indexation.” Also see Krever and Brooks, supra note 55. should inflation be a factor in computing taxable capital gains? ■ 1865

APPENDIX 1 Consumer Price Index (All Items)

Index Index Year 1992 = 100 1971 = 100 1971 ...... 24.9 100.0 1972 ...... 26.1 104.8 1973 ...... 28.1 112.9 1974 ...... 31.1 124.9 1975 ...... 34.5 138.6 1976 ...... 37.1 149.0 1977 ...... 40.0 160.6 1978 ...... 43.6 175.1 1979 ...... 47.6 191.2 1980 ...... 52.4 210.4

Average increase per annum over decade ...... 8.6%

1981 ...... 58.9 236.5 1982 ...... 65.3 262.2 1983 ...... 69.1 277.5 1984 ...... 72.1 289.6 1985 ...... 75.0 301.2 1986 ...... 78.1 313.7 1987 ...... 81.5 327.3 1988 ...... 84.8 340.6 1989 ...... 89.0 357.4 1990 ...... 93.3 374.7

Average increase per annum over decade ...... 5.9%

1991 ...... 98.5 395.6 1992 ...... 100.0 401.6 1993 ...... 101.8 408.8 1994 ...... 102.0 409.6 1995 ...... 104.2 418.5 1996 ...... 105.9 425.3 1997 ...... 107.6 432.1 1998 ...... 108.6 436.1 1999 ...... 110.5 443.8 2000 ...... 113.5 455.8

Average increase per annum over decade ...... 2.0%

29-year average ...... 5.4%

Note: The information provided was based on 1992 = 100. It has been recalculated to 1971 = 100 for ease of reference. Source: Statistics Canada, Canadian Economic Observer: Historical Statistical Supplement 2000/2001, catalogue no. 11-210-XPB, table 12. 1866 ■ canadian tax journal / revue fiscale canadienne (2002) vol. 50, no 5

APPENDIX 2 Calculation of Capital Gains Tax on a Common Share Investment of $1,000, 1971-2001

Undertaxed/ Value Cumulative gain (overtaxed) Year TSE 300 Nominal Adjusted Nominal Taxable Real amount (A) (B) (C) (D) (E) (F) dollars 1971 ...... 990.5 1,000 1,000 1972 ...... 1,226.6 1,238 1,048 238 119 190 71 1973 ...... 1,193.6 1,205 1,129 205 103 76 (26) 1974 ...... 844.5 853 1,249 (147) (74) (396) (323) 1975 ...... 953.5 963 1,386 (37) (19) (423) (405) 1976 ...... 1,011.5 1,021 1,490 21 11 (469) (479) 1977 ...... 1,059.6 1,070 1,606 70 35 (536) (571) 1978 ...... 1,310.0 1,323 1,751 323 161 (428) (590) 1979 ...... 1,813.2 1,831 1,912 831 415 (81) (497) 1980 ...... 2,268.7 2,290 2,104 1,290 645 186 (459) 1981 ...... 1,954.2 1,973 2,365 973 486 (392) (879) 1982 ...... 1,958.1 1,977 2,622 977 488 (645) (1,134) 1983 ...... 2,552.4 2,577 2,775 1,577 788 (198) (987) 1984 ...... 2,400.3 2,423 2,896 1,423 712 (473) (1,184) 1985 ...... 2,900.6 2,928 3,012 1,928 964 (84) (1,048) 1986 ...... 3,066.2 3,096 3,137 2,096 1,048 (41) (1,089) 1987 ...... 3,160.1 3,190 3,273 2,190 1,095 (83) (1,178) 1988 ...... 3,390.0 3,423 3,406 2,423 1,615 17 (1,599) 1989 ...... 3,969.8 4,008 3,574 3,008 2,005 434 (1,571) 1990 ...... 3,256.8 3,288 3,747 2,288 1,716 (459) (2,175) 1991 ...... 3,512.4 3,546 3,956 2,546 1,910 (410) (2,319) 1992 ...... 3,350.1 3,382 4,016 2,382 1,787 (634) (2,420) 1993 ...... 4,321.4 4,363 4,088 3,363 2,522 275 (2,247) 1994 ...... 4,213.6 4,254 4,096 3,254 2,441 158 (2,282) 1995 ...... 4,713.5 4,759 4,185 3,759 2,819 574 (2,245) 1996 ...... 5,027.0 5,075 4,253 4,075 3,056 822 (2,234) 1997 ...... 6,699.1 6,763 4,321 5,763 4,323 2,442 (1,880) 1998 ...... 6,485.9 6,548 4,361 5,548 4,161 2,187 (1,974) 1999 ...... 8,413.8 8,494 4,438 7,494 5,621 4,056 (1,564) 2000 ...... 8,933.7 9,019 4,558 8,019 6,015 4,461 (1,553) 2001 ...... 7,688.4 7,762 4,649 6,762 3,381 3,113 (268) (B) represents (A) adjusted by the indices in table 3. (C) represents (A) minus $1,000. (D) represents (C) multiplied by the inclusion factor for the year. See infra note 8. (E) represents (C) adjusted for the inflation component. (F) represents (E) minus (D). Source: TSE 300 index from the Toronto Stock Exchange. should inflation be a factor in computing taxable capital gains? ■ 1867

APPENDIX 3 The Components of Household Wealth, 1989 and 1999

Assets 1989 1999

$ billion % $ billion % Private pension assets ...... 312 11.2 420 14.5 Financial assets Deposits: financial institutions ...... 348 12.5 161 5.6 Mutual and investment funds ...... 38 1.4 80 2.8 Stocks and bonds ...... 308 11.1 118 4.1 Other financial assets ...... 23 0.8 71 2.4 Non-financial assets Principal residence ...... 959 34.4 1,104 38.1 Other real estate ...... 252 9.1 235 8.1 Vehicles ...... 70 2.5 126 4.3 Other non-financial ...... 176 6.3 228 7.9 Equity in business ...... 298 10.7 355 12.2 Total assets ...... 2,783 100.0 2,897 100.0

Less Mortgages ...... −212 −355 Line of credit and other personal indebtedness ...... −93 −103 2,478 2,439

Sources: 1989: Ernst & Young, “The Wealth Report: The Wealth of Canadian Households,” 1990, cited by Satya Poddar and Morley D. English, “Canadian Taxation of Personal Investment Income” (1999) vol. 47, no. 5 Canadian Tax Journal 1270-1304, at 1286. 1999: Statistics Canada, Canadian Statistics, Families, Households and Housing, “Composition of Assets and Debts, Canada and Provinces, 1999” (available on the Web at http://www.statcan.ca).