National Post

The return of stealth taxation

- Jack m. mintz

One item in last week’s U.K. budget especially caught my eye: de-indexing the tax system. From 2022 through 2026 there will be no inflation adjustment­s of income, inheritanc­e and capital gains tax brackets, of pension lifetime allowance or of value-added tax (VAT) small-business thresholds.

Stealth taxation has been used in the past — in Canada until Finance Minister John Turner indexed the federal income tax system in 1973 – as government­s let inflation push up nominal incomes while freezing tax brackets. In the U.K., de-indexing will reap an additional £25 billion in tax revenues over four years, with 1.3 million new taxpayers added to the tax rolls by 2026 — all of them at the bottom end.

Call this the fiscal price of the extraordin­ary relief packages used to counter the pandemic recession. Eventually, fiscal discipline sets in as public net debt ramps up — it’s now 94 per cent of U.K. GDP — and £45 billion in debt interest crowds out spending on hospitals and education.

De-indexing has bad economic effects. As inflation pushes up incomes, more people face higher marginal tax rates, which discourage work, investment and risk taking. When benefits are no longer indexed for inflation, those on fixed incomes are unable to afford basic necessitie­s. I will never forget seeing poor people rummaging through garbage for recycled material after Bulgaria’s 1997 hyperinfla­tion.

Politicall­y, de-indexing the tax system is probably the easiest way for government­s to raise taxes. At roughly two per cent, the U.K.’S inflation rate is low enough that most taxpayers won’t notice tax brackets have been frozen. Yet, it is a powerful tool to generate revenues, as the numbers show.

Expect more government­s around the world to do the same. Alberta’s government has already figured this one out, freezing its income tax brackets last year to deal with its eye-popping deficits. Other provinces might soon follow as they grapple with ballooning debts. I suspect the federal government won’t hold off forever. De-indexation probably won’t be part of this pre-election budget but could well become policy later.

If inflation rises higher than expected, de-indexation would be an even greater revenue grab. As the $1.9 trillion Biden plan winds through Congress this week, inflation surpassing two per cent becomes more likely in the U.S. — and could well be imported into Canada if we keep our exchange rate from rising.

“Not worried” Federal Reserve Chairman Jerome Powell and other central bankers, including Bank of Canada Governor Tiff Macklem, seem convinced inflation will not reassert itself. Not everyone agrees, however, including former Harvard president and Bill Clinton Treasury Secretary Larry Summers. Almost a century ago, economist Irving Fisher recognized that interest rates rise by a point for every point increase in expected inflation. The bond market certainly is starting to believe inflation is rising — U.S. long bond interest rates have risen by almost a full point in the past six months.

Although Canada’s inflation rate is currently just 1.4 per cent, that reflects this year’s downturn in energy, transporta­tion and mortgage interest costs, all of which reversed sharply this past quarter. Some prices are rising as much as double the two per cent rate: in particular, for food purchases, housing replacemen­t costs and vehicles. And inflation could get worse. With the pandemic having disrupted supply chains, fiscal and monetary stimulus in 2021 could cause demand to outstrip supply in our exceedingl­y low-investment environmen­t.

Beyond the effects of de-indexation inflation causes buoyancy in other revenues, too. With higher nominal interest rates, government­s collect more tax on both investment income and higher RRSP and pension withdrawal­s. They also reap more taxes on higher nominal capital gains — though there is a partial offset as borrowers deduct higher nominal interest expenses.

Sales and excise tax revenues also provide a bonanza in government revenues when prices rise faster. With inflation, GST/HST revenues get an additional bump from the month’s delay in claiming input tax credits against sales taxes collected from consumers.

On the other hand, higher bouts of inflation widen public deficits through more spending. Transfers to persons account for almost a third of non-pandemic federal spending and these are indexed for inflation. Labour compensati­on and transfers to provinces also follow inflation. It will be tempting for government­s to try to curb indexation on the spending side, especially for higher-income earners or, in the case of the federal government, for transfers to the provinces. Outright spending cuts or hikes in visible taxes could be much more difficult politicall­y.

If inflation expectatio­ns do shift higher, central banks may eventually step in to raise interest rates to get them back down to two per cent, where they have been for the last two decades. That will only slow down the economy and result in higher public deficits. Higher inflationa­ry expectatio­ns are a no-win outcome.

 ?? THE CANADIAN PRESS FILES ?? Stealth taxation was used in Canada until John Turner
indexed the federal income tax system in 1973.
THE CANADIAN PRESS FILES Stealth taxation was used in Canada until John Turner indexed the federal income tax system in 1973.

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