From the Fraser Institute

By Jake Fuss and Grady Munro

Following the recent plunge in Canadian and U.S. stock markets, many Canadians likely saw a sharp decline in the value of their investments. Yet as Canadians reckon with this sudden change, other factors help reduce the return on their investments—namely, higher capital gains taxes.

When an investor sells a capital asset (i.e. stocks) for a higher price than they originally bought it, they realize a capital gain. Prior to this year, investors would pay tax on 50 per cent of any gain (based on their highest marginal personal income tax rate), but the Trudeau government recently increased that inclusion rate to 66.7 per cent for capital gains above $250,000.

This increase will cause economic damage and increase taxes for many middle-class Canadians—despite being framed by the government as a tax increase on the wealthy. And the effect is even more harmful than it first appears because capital gains taxes don’t adjust for inflation.

Inflation, the general rise in the prices of goods and services in the economy, erodes the purchasing power of money. For example, if a basket of goods costs $100 in Year 1, and annual inflation is 4 per cent, that exact same basket would cost $104 in Year 2. The Bank of Canada maintains a target inflation rate of 2 per cent per year, but in recent years the rate has well-exceeded that target.

From 2021 to 2023, Canada experienced an average annual inflation rate of 4.7 per cent. And though inflation is easing and fell to 2.5 per cent last month, by the end of this year prices are still expected to be 17.5 per cent higher than they were in 2020. For comparison, prices increased 6.7 per cent from 2016 to 2020.

While inflation erodes the purchasing power of one dollar, it also erodes the returns people receive from their investments. If an asset increases in value by 5 per cent over one year, but inflation is 4 per cent, the asset’s real value has increased by just 1 percentage point. In other words, of the total 5 per cent gain, 4 percentage points are the “inflationary” gain while 1 percentage point is the “real” gain.

Which takes us back to the Trudeau government’s tax hike on capital gains. Unlike income thresholds for federal personal income taxes, which are adjusted to account for inflation, capital gains taxes don’t distinguish between “inflationary” and “real” gains. Therefore, even if a realized capital gain is solely inflationary—meaning there’s no increase in real wealth—the federal government will still levy the same amount of tax as it would if there was no inflation at all.

This is what’s happening right now. After years of high inflation, inflationary gains represent a significant share of the capital gains Canadians are currently realizing. For example, from the beginning of 2020 to the end of 2023, the S&P/TSX Composite Index (Canada’s benchmark stock market index) increased 22.6 per cent. However, after adjusting for inflation (a cumulative 14.7 per cent), that 22.6 per cent represents a real gain of less than 8.0 per cent. As such, a large portion of revenue the Trudeau government expects to generate from raising capital gains taxes will originate from inflationary gains rather than actual increases in asset values.

As Canadians struggle with a weak economy, the Trudeau government’s recent capital gains tax hike will only add to the problem. But after years of high inflation, the effect is even worse than you might think.