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What Can Be Done About Rising Inflation and Taxes in Canada?

July 18, 2022, 8:45 AM

One of the difficulties in dealing with high inflation is that most policy experts have no practical experience on how to do it. They manage it in sometimes conflicting theories, which at least partially explains why the public arena is beset by contradictory advice on how to deal with it.

To try to combine theory and practice, this article is a collaboration between tax professor Brigitte Alepin and economist Vito Tanzi, who is the instigator of the Tanzi effect, a phenomenon that might become manifest in public finances during periods of very high inflation.

Higher taxes reduce disposable income and thereby aggregate demand and inflationary pressure. But significantly higher tax rates may also induce some workers to refuse to work overtime, contributing to the supply-side problem. Moreover, for the middle class and others who are less well off—those hit hardest by rising food, gas, and housing prices and who can’t afford a tax hike—it may even be necessary to consider a tax reduction or the payment of some lump sum.

As the Tanzi effects explains, an ever-accelerating rate of inflation may dramatically reduce a country’s ability to raise revenue from income taxes.

For the super-wealthy and several very large corporations, it’s a different story. They became richer during the pandemic, and their effective tax rate is often well below the statutory rate and society’s tax expectations.

The top 0.01% of the wealthiest Canadians—these 2,875 citizens who earned an average total annual income of CA$8.9 million in 2019—were taxed at an effective tax rate of 30%, according to Statistics Canada, while their statutory tax rate was 50%.

The financial statements of Enbridge Inc., the largest Canadian energy company, indicates that it has accumulated pretax earnings of CA$43 billion since 2000, and its total cash paid for income taxes during the same period is CA$4.4 billion, yielding a ratio of tax effectively paid of 10.4%. This ratio is also low for many American companies. Inc., the world’s largest online retailer, has accumulated pretax earnings of US$102 billion since 2000, and its total cash paid for income taxes during the same period is US$9.8 billion, yielding a ratio of tax effectively paid of 9.8%. Many average workers and small- and mid-size enterprises workers paid higher rates.

There is also the possibility of eliminating tax loopholes and excessive subsidies. For example, is it necessary to permit a taxpayer to pay zero tax on the gains realized on the sale of a multimillion-dollar home? These transactions are not negligible. In Toronto, 465 luxury sales worth more than CA$4 million took pace in 2021, with 19 of those selling for more than CA$10 million.

Another example is the subsidy for the purchase of electric cars. In many Canadian provinces, this subsidy is at least CA$10,000. With the price of gasoline exceeding CA$2 per liter in Canada, such an important subsidy may no longer be as necessary to encourage Canadians to buy electric cars. When set beside the 4 million people living in poverty in Canada, CA$10,000 is a lot—the social assistance some of them receive to support themselves for an entire year is often less than that. Reducing this subsidy could instead help allocate funds to those people living in poverty. The funds could also encourage Canadians to make the environmental choice to abandon the car for bicycles and public transit.

If Canada is heading for much higher and persistent inflation, we must consider that the phenomenon described by the Tanzi effect might begin to manifest itself. This phenomenon occurs due to the time difference between when the tax is calculated and when the tax is collected. For example, income tax may take several months to be collected. In a significant inflationary context, this time gap can lead to substantial losses in the real value of the taxes paid and of public revenue.

Currently, the main work to be done to counter inflation rests with the central banks, which could use the “cold turkey” approach that Paul Volcker applied in the US in 1982. It stopped inflation but at the cost of a steep recession. However, Nobel economist Joseph Stiglitz believes that even the more modest rise in interest rates being implemented by central banks will slow down the investment that is necessary to increase supply and will not reduce inflation. If the work of central banks is insufficient, or if it is excessive, might not the tax authorities have some role to play in battling inflation?

One thing experts and politicians agree on: It would help to increase supply. Measures such as accelerated depreciation, investment tax credits, or tax measures better suited to distance working and retirees returning to work—but they might take time and may increase the fiscal deficit in the short term.

Most experts also seem to agree that expansionary monetary policy is one of the factors that creates inflation. To counter this, the state must either cut spending, raise taxes, or do a combination of the two.

The keep the confidence of citizens who have already been over-promised and under-delivered on inflation during the past months, let’s under-promise and over-deliver. At this point, it is preferable to surprise them with an inflation lower than predicted, than the opposite. Fighting inflation will not be easy or short—it will be a marathon.

This article does not necessarily reflect the opinion of The Bureau of National Affairs, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Brigitte Alepin is a tax professor at the Université du Québec en Outaouais. She is also an author and moviemaker.

Vito Tanzi is former head of the IMF’s Fiscal Affairs Department and the author of several books, including “Fragile Futures: The Uncertain Economics of Disasters, Pandemics, and Climate Change,” which is on the Financial Times Summer Books 2022 list.

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