Is Tax on Capital Gains Fair? It Depends

The current scheme of reporting capital gains, by including 50% of taxable gains in income, may be increased to 75% depending on the results of the next election. Does it make sense for the economy and its Canadian investors to do so? Not in the absence of inflation adjusting. Here’s how the math works.

A capital gain represents the increase in value of a capital asset between the date of acquisition and the date of disposition. However, the simple difference between the proceeds and cost does not measure the increase in value. Unlike other types of “income”, capital gains are not taxed as they are earned and the measured price increase represents both an increase in value and inflation.

Once inflation is taken into account, the tax rate on the real gain turns out not to be a bargain at all.

Let’s look at a simplistic example. Say you purchased a piece of real estate and it increased in value by 5% annually, while inflation runs at 3% annually. The following table shows the sales price, increase in value after inflation, and the taxes payable on the gain (assuming a 40% marginal tax rate) if the property is sold in 1, 5, 10, 20, or 30 years.

 Years Held 

 Proceeds 

 Inflation Adjusted Cost 

 Actual Value Increase 

 Taxes @20% of CG 

 Tax Rate on Actual Gain 

1

$105,000

$103,000

$2,000

$1,000

50%

5

$127,628

$115,927

$11,701

$5,526

47%

10

$162,889

$134,392

$28,498

$12,578

44%

20

$265,330

$180,611

$84,719

$33,066

39%

30

$432,194

$242,726

$189,468

$66,439

35%

Had the taxpayer earned ordinary income instead, the tax rate applicable would be 40% so the rate paid on real capital gains is higher than on ordinary income until the capital asset is held for a very long time. However, when the computed gain increases (such as when the property is held for a longer period of time), the investor may actually pay more tax because the gain will move him into a higher tax bracket.

Would it be fair to increase the inclusion rate to raise more revenue? In our view, only if the adjusted cost base is adjusted for inflation over the holding period. What’s your thought on this important matter?

Be sure to weigh in with your opinion in this month’s poll Should the capital gains inclusion rate be increased to 75% as some advocates are proposing?

Additional educational resources: Help clients navigate corporate taxation as an MFA™-Business Services Specialist .

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