Inflation has been on the top of many Canadians’ minds recently, with the year-over-year increase in the consumer price index (CPI) hitting a four-decade high of 8.1 per cent in June 2022. While inflation has started to cool, when the effects of higher inflation are combined with tax provisions that essentially ignore it, “the pain for earners, savers, and recipients of benefits,” can be multiplied, according to a new report issued this week by the C.D. Howe Institute.
In “Double the Pain: How Inflation Increases Tax Burdens,” the C.D. Howe Institute’s William Robson and Alex Laurin identify problematic interactions between inflation and taxes and highlight some fixes, notably indexing various thresholds and amounts to the CPI, and not making matters worse for investors by potentially increasing the capital gains inclusion rate.
Before delving into some of the specific findings of the report, let’s take a step back and review the current indexing system and how various tax items are adjusted for inflation.
Most (but not all) income tax and benefit amounts are indexed to inflation. You’ll recall that in November 2022, the Canada Revenue Agency announced the inflation rate that would be used to index the 2023 tax brackets and benefit amounts would be 6.3 per cent. Increases to the tax-bracket thresholds and various amounts relating to non-refundable credits took effect on Jan. 1, 2023. But increases for certain benefits, such as the GST/HST credit and Canada Child Benefit, only took effect recently, as of July 1, 2023, which coincides with the beginning of the program year for these benefit payments.
All five federal income tax brackets for 2023 were indexed to inflation using the 6.3-per-cent rate. This makes Canada pretty unique. The C.D. Howe report notes that a recent survey of 160 countries revealed that 131 of them do not index tax thresholds so they rise with inflation. In fact, only nine countries, Canada among them, have legislation or regulations in place mandating automatic periodic adjustments in line with inflation.
Each province also has its own set of provincial tax brackets, and most do index them to inflation using their respective provincial indexation factors. But, not all provinces are on board. For example, the report noted that Alberta did not index its thresholds in 2020 and 2021. Manitoba did not index its tax system to inflation before 2017. Nova Scotia and P.E.I. do not index any of their thresholds, and Ontario doesn’t index its top two income thresholds of $150,000 and $220,000, amounts that were fixed in 2014. The result is that for higher-income Ontarians, inflation has eroded their value to $120,000 and $176,000 in 2014 dollars.
While most credits and some deductions, such as the basic personal amount, spouse amount, age amount, etc. are also indexed to inflation, others are not. For example, the authors note that the maximum dollar limits under the child-care expense deduction, although raised periodically since the deduction was first introduced back in 1972, are not adjusted for inflation. The maximum amount of child-care expenses that can be claimed per child under seven years old is currently $8,000. Twenty-five years ago, the maximum was … $7,000. Adjusted for inflation, parents would potentially be able to deduct up to $12,000 per child in 2023, an amount that is 50 per cent higher than the amount they can currently deduct.
Other examples of amounts that haven’t been indexed include the federal pension income credit (stuck at $2,000) and the maximum tuition credit that can be transferred to a spouse or partner or parent (still at $5,000).
On the corporate side, the small business deduction, which is available to private corporations (including professional corporations), provides small businesses with a lower federal and provincial corporate tax rate on the first $500,000 of net income. This $500,000 threshold hasn’t been changed since 2009, meaning its real value has been cut by more than a quarter.
In a similar vein, back in 2019, the government introduced rules to claw back the small business deduction for private companies that earn over $50,000 in passive income (essentially, investment income). The $50,000 threshold hasn’t been adjusted in five years.
The lack of inflation adjustments also impacts consumption taxes, such as the goods and services tax/harmonized sales tax (GST/HST). For example, the GST/HST systems have thresholds that determine whether a business must collect the taxes or whether a transaction is taxable, and inflation erodes the real value of these thresholds.
The authors astutely point out that the $30,000 small-supplier threshold for registering and collecting the GST has not changed since the establishment of the GST back in 1991. After more than 30 years, inflation has cut its real value almost in half. And, each year, as inflation further erodes the threshold, more businesses must register and collect GST. Notwithstanding the potential benefits of registering to claim input tax credits, the falling real value of the registration threshold creates administrative and compliance costs for many small businesses who may otherwise choose not to register.
Finally, the authors note that inflation and taxes also play a role in reducing the real returns investors net, “turning nominal gains into real losses.” They cite the example of a one-year guaranteed investment certificate (GIC), with a current yield of about 4.4 per cent. With inflation also recently at 4.4 per cent, that produces a real return of zero. But because investors are taxed on the nominal interest, at a tax rate of, say, 40 per cent, the GIC’s after-tax yield drops to about 2.6 per cent — a return that, in real terms, is a loss of 1.8 per cent.
A similar analysis can be made with respect to capital gains tax. In 2018, former U.S. president Donald Trump floated the idea of indexing capital gains to inflation, but it was ultimately abandoned as it was perceived to mostly benefit upper-income taxpayers.
As for Canada, the authors readily acknowledge that providing tax recognition of the inflation component of interest and dividends is “technically daunting,” and they discourage the government from increasing the capital gains inclusion rate (currently at 50 per cent), “which would be a particularly bad move when inflation has already increased the real burden of capital gains taxes.”