Indexation and the Taxation of Business and Investment Income

This paper reviews the issues raised by inflation and the taxation of business and investment income under an income tax. Some evidence on the tax-induced distortions caused by inflation are presented. This includes estimates of the marginal real tax rates on new investment and the user cost of capital for the various categories of taxable corporations given different assumptions about the rate of inflation and proportion of the investment financed by debt. Comprehensive indexation of business and investment income is considered in the paper as a solution to the problems caused by inflation-induced tax distortions. For business income, this would encompass an indexation of capital consumption allowances, the cost of goods sold, and interest income and expenses. For investment income, it would involve the indexation of capital gains on all financial and real assets and the indexation of interest income and expense. In this context, the new accounting standards of the CICA designed to reflect changing prices are reviewed and the preliminary experience with these standards is assessed. Another related issue that is addressed is the choice of an index. The benefits and cost of comprehensive indexing are considered. The paper concludes its overview of comprehensive indexation with some comments on the experience of other countries, and a review of the U.S. Treasury Department's recent proposals for indexation. A more detailed analysis of the indexation of business income is also included in the paper. Evidence on the impact of indexation, if it were to be adopted, on the real effective tax rate and user cost of new investment is presented for the various categories of taxable corporations given different assumptions about the rate of inflation and the proportion of the investment financed by debt. The reduction in the variance of the real effective tax rate and user cost across categories resulting from indexation is compared with the reduction resulting from the elimination of tax preferences. The difficulties likely to be encountered in any effort to index capital consumption allowances, inventories, and debt are surveyed. Several proposals for partial indexation of business income put forward by John Bossons, the Canadian Manufacturers' Association in Canada and by Auerbach and Jorgenson in the United States are discussed. The paper also contrasts the current capital gains tax with an ideal system based on accrual taxation of real gains and highlights the distortions involved in the current tax treatment of capital gains. The government's proposals for a Registered Shareholder Investment Plan and the Lortie Committee's conclusions and recommendations are reviewed. The ensuing Indexed Security Investment Plan is described and analyzed. Estimates of effective tax rates for securities held within and outside of an ISIP are compared. Statistics indicating the poor public acceptance of ISIPs are cited. Some explanations are offerred. The issues arising from inflation and interest income are also covered in the paper. This includes a discussion of the White Paper's proposal for indexed term loans and deposits and the reasons that it was rejected by the Lortie Committee. The paper ends with my conclusions that, given the recent decline in inflation, indexation of the taxation of business and investment income should not be a tax reform priority. It should only become a priority in two circumstances. The first would be if inflation resurges to double-digit levels and inflation-induced distortions again become a more serious problem. The second would be if the Treasury Department proposals for indexation of business and investment income are implemented in the United States and it becomes advantageous to index to preserve the current degree of tax harmonization between Canada and the United States. If inflation continues to decline, however, there is no reason to introduce indexation in Canada regardless of whether indexation is adopted in the United States. It would just add another unnecessary element of additional complexity to the tax system.