The Fundamental Flaws of Taxing Unrealized Gains
Modern income tax systems operate on a foundational principle that has stood the test of time: taxation occurs when economic gains are actually realized, not when they are merely predicted or anticipated. This realization-based approach forms the bedrock of tax systems worldwide, ensuring fairness, predictability, and economic stability. The concept of taxing unrealized gains represents a significant departure from this established framework, introducing numerous practical and theoretical problems that Canada should carefully consider before adopting any similar measures.
The Core Principle of Realization-Based Taxation
Income taxation requires that gains be measurable, real, and liquid before they become subject to government levies. This principle protects taxpayers from being forced to pay taxes on money they haven't actually received. Imagine your employer promises you a substantial raise and bonus totaling $50,000, but you won't receive this compensation for twenty-four months. Under a system that taxes unrealized gains, you would be required to pay approximately $15,000 in taxes immediately, despite having no actual access to the promised funds. This creates obvious liquidity problems and potential financial hardship.
The situation becomes even more problematic if the employer fails to deliver on the promised compensation. Would taxpayers receive refunds for taxes paid on income that never materialized? These questions highlight the fundamental impracticality of taxing anticipated rather than actual economic gains.
The Haig-Simons Theory and Its Limitations
The Haig-Simons theory of income proposes taxing annual changes in net worth, which would include both realized and unrealized gains. While theoretically comprehensive, most nations have wisely rejected this approach in favor of realization-based taxation. The reasons are practical and significant: realization preserves taxpayer liquidity, provides certainty in tax obligations, and maintains economic stability. When taxpayers must pay taxes on paper gains that haven't been converted to cash, they may be forced to sell assets prematurely or borrow money simply to meet tax obligations.
Existing Exceptions and Their Rationale
Certain exceptions to realization-based taxation already exist in various jurisdictions, but these serve specific policy purposes rather than representing a wholesale abandonment of the realization principle. Many countries implement taxation regimes upon death or when individuals exit a tax jurisdiction through loss of residency or citizenship renunciation. These measures prevent tax avoidance through timing strategies.
Similarly, some nations have implemented deemed income inclusions for specific types of foreign investments to prevent targeted tax avoidance. Canada's foreign investment entity and foreign accrual property income rules represent examples of such targeted measures. New Zealand employs similar foreign investment fund rules. These exceptions are carefully crafted to address specific avoidance opportunities while maintaining the overall realization principle for most economic activities.
The Dutch Experiment and Its Implications
The Dutch House of Representatives recently approved a proposal that would tax residents at 36 percent on actual investment returns, including unrealized gains on stocks, bonds, and cryptocurrencies. If passed by the Dutch Senate and implemented in 2028, this would represent a significant departure from traditional tax principles. Under this system, a Dutch resident holding Apple stock that increased in value by 50,000 euros during the year would owe taxes on that paper gain, even if the stock remained in their portfolio.
This approach raises serious concerns about loss treatment. If investments decline in value after taxes have been paid on unrealized gains, can taxpayers recover those payments? The Dutch proposal appears to allow only forward loss carryforwards, not backward adjustments to recover taxes already paid on gains that subsequently disappeared. This creates potential for double taxation of the same economic value and penalizes normal market fluctuations.
Wealth Taxes and Their Ineffectiveness
Wealth tax regimes represent another departure from realization principles, though they remain relatively rare globally. Despite advocacy from some political quarters, wealth taxes have proven largely ineffective due to their violation of fundamental tax principles. They often fail to account for liquidity constraints, create valuation challenges, and encourage capital flight. The basic pillars of measurable, real, and liquid income remain essential for effective tax administration.
Why Canada Should Maintain Its Current Approach
Canada's tax system has developed carefully balanced approaches to various economic activities while maintaining the core realization principle. The country should resist calls to adopt taxation of unrealized gains for several compelling reasons. First, such a system would create significant liquidity problems for investors and asset holders. Second, it would introduce tremendous uncertainty into financial planning and investment decisions. Third, it would complicate tax administration and compliance. Fourth, it could potentially discourage investment and economic growth.
The existing Canadian system, with its targeted anti-avoidance measures and specific exceptions for particular circumstances, represents a more balanced approach. It addresses genuine concerns about tax deferral and avoidance without abandoning the fundamental principles that make taxation workable and fair. As other nations experiment with more radical approaches, Canada should observe outcomes carefully while maintaining its proven, stable tax framework that has served the country well for decades.
