Easing inflation

The main macroeconomic theme of 2024 was until quite recently that of misbehaving inflation. After a happy decline from the middle of 2022 through the end of 2023, U.S. inflation staged an especially concerning revival between January and March of this year. Overall and core prices rose at an annualized rate consistent with 5%+ inflation rather than the desired 2% target. This, in turn, sent bond yields higher and pared the amount of rate cutting anticipated for this year.

Fortunately, the April inflation data and other recent signals appear to have broken this malevolent trend.

U.S. inflation

In the U.S., headline and core prices decelerated to +0.31% and +0.29%, respectively. This is still too fast, but it is progress (see next chart).

U.S. inflation is decelerating

As of April 2024. Shaded area represents recession. Source: U.S. Bureau of Labor Statistics (BLS), Macrobond, RBC GAM

Service inflation is still running too hot – both the shelter and non-shelter portions (see next table). But at least these service-side components are a bit less heated than before.

Service inflation is starting to ease

As of April 2024 for Consumer Price Index (CPI) and Producer Price Index (PPI) measures, March 2024 for Personal Consumption Expenditures (PCE) measures. Sources: U.S. Bureau of Economic Analysis (BEA), BLS, Federal Reserve Bank of Cleveland, Federal Reserve Bank of Dallas, Macrobond, RBC GAM

Looking forward, there are several helpful inflation forces fitting into place.

Part of the strength in the U.S. Consumer Price Index (CPI) in the first quarter may have been the result of seasonal distortions that do not apply to the second quarter.

The breadth of inflation continued to narrow even as overall inflation refused to cooperate in the first quarter (see next chart).

Breadth of inflation continues to narrow

As of April 2024. Shaded area represents recession. Sources: BLS, Federal Reserve Bank of Cleveland, Macrobond, RBC GAM

The cost of oil and thus gasoline has declined nicely in May. This was a big part of the upward pressure on headline inflation in April. Using this fact as its primary input, the Federal Reserve Bank of Cleveland’s inflation nowcast anticipates a sharp slowing in U.S. headline inflation to just +0.1% month over month (MoM) in May.

U.S. inflation to continue to ease in May

Actual as of April 2024, Federal Reserve Bank of Cleveland Inflation Nowcast as of 05/15/2024. Sources: BEA, Federal Reserve Bank of Cleveland, Macrobond, RBC GAM

There remains room for a moderate deceleration in shelter costs (see next chart), which represents the largest single driver of inflation. We also believe fast-moving insurance inflation should turn fairly soon, as argued in the last #MacroMemo.

U.S. shelter inflation has only moderate room to slow

As of April 2024. Shaded area represents recession. Sources: Zillow, BLS, SAP Global, Macrobond, RBC GAM

The ongoing cooling of the U.S. labour market should also help to incrementally tame inflation, with a particular relevance for service-sector costs. Wage growth is edging lower, the unemployment rate is rising and job openings are falling.

As U.S. consumers start to become more selective in their purchases – more on that in a later section – some prominent retailers are announcing price cuts, including Walmart, Target and McDonald’s. This could mark a new downtrend in the fraction of U.S. businesses planning to raise prices (see next chart).

Fraction of U.S. businesses planning to raise prices remains high

As of April 2024. Shaded area represents recession. Sources: National Federation of Independent Business, Macrobond, RBC GAM

Overall, the Daily PriceStats Inflation Index argues that the rate of inflation is continuing to decelerate since the last monthly CPI release (see next chart).

U.S. Daily PriceStats Inflation Index shows inflation slowing

U.S. Daily PriceStats Inflation Index as of 05/21/2024, CPI as of April 2024. Sources: State Street Global Markets Research, RBC GAM

Developed-world inflation

In the rest of the developed world, inflation never re-accelerated as much in early 2024 as it did in the U.S., but the forward progress was nevertheless slower than would have been ideal for a few months.

Fortunately, the April inflation numbers also show some helpful progress:

• UK CPI plummeted from +3.2% to just +2.3% year over year (YoY) (though this improvement was not as great as expected).

• In the Eurozone, annual inflation is now just +2.4% YoY.

Granted, these two regions don’t capture shelter costs in their price index to the same extent as in North America. For the average person, that’s a consequential fact. But for central banks tasked with meeting their inflation targets, it doesn’t matter what’s in or left out of the price basket – that’s where their mandate lies.

• In Canada, CPI fell from 2.9% to 2.7% YoY in April, as did the ex-food and energy formulation.

• Median CPI fell from 2.9% to 2.6%.

• Trimmed-mean inflation fell from 3.2% to 2.9%. 

The bottom line is that inflation is coming down again nearly everywhere. However, it is not yet where it needs to be, and the journey ahead is unlikely to be linear.

Central banks in motion

In turn, the long-awaited central bank easing cycle is now underway. Quite a number of emerging-market central banks have already cut rates. Switzerland and Sweden in the developed world have also now done so.

The month of June is very likely to bring a first rate cut from the European Central Bank on June 6. The market now prices a 93% probability of a 25bps rate cut from the 4.50% starting point. This means that only a major economic, market or geopolitical surprise over the next week would dislodge the central bank from probing lower rates.

The Bank of England (BoE) had appeared to be plausibly on track for a late-June first rate cut of its own before inflation fell by less than expected and a July 4 national election was called. The BoE has now cancelled all non-essential public statements between now and the election, likely precluding a June 20 easing. Reflecting this, the market went from pricing 55% of a June cut on May 20 to just 8% of that rate cut today. It isn’t quite impossible, but it isn’t very likely.

Instead, the market is now straddling the August 1 and September 19 meetings, unsure of which is more likely. Our sympathies lie more toward August 1, especially if the ECB rate cut and market response proceed smoothly.

Bank of Canada

Markets are strikingly divided on the Bank of Canada, assigning 61% of a rate cut to June 5 and the remainder to July 24. This is to say, the market fully anticipates a 25bps rate cut this summer but isn’t sure whether it will happen in June or July.

When it comes to anticipating the granular timing of central bank decisions, it is less about what the economy is doing than what the central bank is signaling and what its historical behaviour suggests. No economic model will tell you that a 25bps rate cut in June is a disaster and a cut in July is a stroke of brilliance. They are almost the same thing, with implications on the order of 0.1ppt of gross domestic product (GDP) and 0.1ppt of CPI for an eighth of a year.

Arguments for a June rate cut in Canada include:

• The Bank of Canada mentioned June as a distinct possibility for a rate cut in its last press conference.

• Given the country’s high degree of interest-rate sensitivity, mortgage pain is mounting by the month, and it would be nice to ease that pain before it creates broader economic or financial problems.

• Interest rates are presently quite restrictive, and that is becoming less appropriate.

• Inflation is cooperating in that it is falling and has now been within the central bank’s broad 1-3% range for four consecutive months.

• Somewhat uniquely, Canadian inflation is significantly elevated by mortgage interest costs, which definitionally becomes less of a problem when the Bank of Canada cuts rates.

• The Canadian economy is operating modestly below its potential, meaning that the Bank of Canada should be interested in supporting growth.

• Financial markets have significantly priced in a June rate cut, meaning the central bank can deliver a cut without any market turmoil.

Arguments for a July rate cut in Canada include:

• The Bank of Canada only recently abandoned its tightening bias and has not yet introduced an explicit easing bias into its statement. Most peer central banks considering rate cuts have already done this (the U.S. Federal Reserve (the Fed) via its dot plots, the ECB via its statement and the BoE via dissenting votes for easing). The Bank of Canada may wish to signal an easing bias before actually easing.

• The July meeting is attractive in that it also plays host to the Bank of Canada’s quarterly Monetary Policy Report. Presuming a pattern of easing at roughly every second meeting, this would also line up future easing with Monetary Policy Reports.

• Waiting until July would allow for the release of an additional month of CPI data to further confirm inflation progress. It would also provide additional time to see what real-time inflation indicators are saying about June and July. Inflation has fallen, but it is still too high.

• Canada’s latest hiring number was extremely strong. Another month of data would clarify whether the economy is accelerating or merely enjoyed a good month.

• Waiting until July prevents the Bank of Canada from “getting too far ahead” of the U.S. Federal Reserve, presuming the Fed begins its own rate cutting in September. This reduces the risk of a major currency move.

• The Bank of Canada is famously unconcerned with market expectations. It doesn’t mind surprising markets. There is no rule like in the U.S. about the Fed “always” doing something if the market pricing is high enough.

• It would be fitting if Canada began easing after Europe but before the U.S. given the relative state of inflation and economic activity across the three jurisdictions; a July rate cut threads that needle.

On balance, we find the July arguments slightly more persuasive, though the Bank could easily go either way. For what it is worth, markets take the opposite view. For everyone other than fixed income traders, the important point is arguably that the Canadian overnight rate is likely to fall from 5.00% to 4.75% by the end of July. Further progress after that should be gradual, with great sensitivity to perturbations in the economy, inflation and U.S. monetary policy.

The Fed, of course, is in a slightly different position than the other central banks given that it has more ground to cover to unwind its recent inflation excesses, leaving it in a position to cut rates no sooner than September.

For all countries, the initial rate cutting should be small, tentative, and slow-moving. There may be long pauses, though we ultimately believe that a “normal” policy rate is multiple percentage points below current levels, implying considerable easing over the next few years.

Economic convergence

After 18 months of U.S. economic exceptionalism in which the U.S. economy outmuscled the rest of the developed world, the past few months have been marked by the opposite: a convergence theme as the U.S. comes down to earth at the same time as other countries continue to deliver upside surprises (see next chart).

Global economic surprise gap reverses

As of 05/24/2024. Sources: Citigroup, Bloomberg, RBC GAM

Signs of a U.S. economic deceleration include:

• a more muted GDP growth rate (+1.6% annualized in the first quarter)

• a more moderate rate of hiring (+175K)

• flat retail sales

• the Institute for Supply Management’s Manufacturing PMI and Services PMI slipped below the 50 threshold.

Overall, U.S. economic surprises have shifted from positive to negative.

Conversely, global economic surprises are still positive. The German ZEW (Zentrum für Europäische Wirtschaftsforschung) expectations component increased substantially in May. UK and Eurozone GDP both returned to the land of the living in the first quarter. Canadian May employment grew by a large 90,000 positions. Japan’s Tankan survey continues to rise.

But the U.S. is okay

Despite its recent deceleration, the U.S. economy is still likely fine. Its deceleration so far looks more like a soft landing than a hard landing (though we mustn’t pretend that the two scenarios appear radically different than one another in the early going).

What makes us think the U.S. economy is still ultimately fine? Several things.

1. Second-quarter GDP is tracking more than 3% annualized growth, arguing that the first quarter’s anemic 1.6% gain was an outlier.

2. After a worrying leap higher a few weeks ago (largely due to a few distortions including a seasonal rise in school-related layoffs in New York State), jobless claims have since settled back down to a low and roughly sideways trajectory (see next chart).

U.S. jobless claims remain low

As of the week ending 05/18/2024. Sources: U.S. Department of Labor, Macrobond, RBC GAM

1. U.S. core capital goods orders were again rising in April after a dip in March.

2. Demand for freight is beginning to rise again after a period of depression (see next chart).

U.S. freight demand has been rising since end of 2023

As of the week ending 05/17/2024. Market Demand Index is the ratio of loads posted to trucks posted by equipment type. Van rate excludes fuel surcharges. Sources: Truckstop.com, Bloomberg, RBC GAM

1. While the amount of commercial and industrial credit provided by banks is still fairly muted, it isn’t collapsing, and it might even be picking up slightly in recent months (see next chart).

U.S. credit bottoming?

As of the week ending 05/15/2024. Sources: U.S. Federal Reserve, Macrobond, RBC GAM

1. Businesses aren’t using the sort of language that would signal imminent trouble. The words ’recession’ and ’layoff’ in S&P 500 company transcripts are appearing less and less, reaching their lowest usage in several years in the second quarter (see next two charts).

Mentions of ‘recession’ in S&P 500 company transcripts have fallen steadily

As of Q2 2024 (partial data used for the quarter). Includes transcripts from all investor calls, investor days and capital markets days for S&P 500 companies. Sources: Bloomberg, RBC GAM

Mentions of ‘layoff’ in S&P 500 company transcripts trending downward

As of Q2 2024 (partial data used for the quarter). Include transcripts from all investor calls, investor days and capital markets days for S&P 500 companies. Sources: Bloomberg, RBC GAM

U.S. consumer worries

All of that said, it is easy to be nervous about the consumer outlook right now, especially in light of recent retail sales weakness. This concern is for four main reasons:

1. Higher interest rates are starting to bite consumers, as evidenced by rising household loan delinquencies (see next chart). In turn, credit card usage is beginning to rise less quickly – limiting spending (see subsequent chart).

U.S. consumer loan delinquency is now rising

As of Q4 2023. Sources: Federal Reserve Bank of New York, Macrobond, RBC GAM

Growth of U.S. credit card balances is slowing

As of Q1 2024. Sources: Federal Reserve Bank of New York, Macrobond, RBC GAM

1. U.S. households have now spent all of their pandemic-era excess savings – according to the San Francisco Fed (see next chart).

U.S. pandemic-era excess savings are gone?

As of March 2024. Sources: BEA, U.S. Federal Reserve Bank of San Francisco, RBC GAM.

1. The U.S. personal savings rate is now just 3.2%. This is well below the pre-pandemic norm and just 1.8 percentage points above its all-time low from 2005 (see next chart). This doesn’t leave a lot of margin for error, and certainly doesn’t leave much scope for spending growth to outpace income growth going forward.

U.S. personal savings rate is low

As of February 2024. Shaded area represents recession. Sources: BEA, Macrobond, RBC GAM

1. Consumer confidence has dropped somewhat, arguing that consumers should be disinclined to spend (see next chart).

U.S. consumer sentiment weighed by high prices and interest rates

University of Michigan Consumer Sentiment Index as of May 2024. The Conference Board Consumer Confidence Index as of April 2024. Shaded area represents recession. Sources: Macrobond, RBC GAM

So what happens next for consumers given these headwinds? We concur that it is indeed likely to be a time of more muted spending growth over the remainder of 2024 and into 2025. However, we reject the idea that a consumer recession (or even a consumer-led economy-wide recession) is necessary or likely.

Let us start by shooting some holes in the aforementioned problems.

Some households are indeed struggling with higher interest rates, but the majority are handling them reasonably well, as evidenced by the fact that the vast majority of loans are continuing to be paid and the cost of servicing household debt as a share of income is still in line with the pre-pandemic norm (see the blue line on the next chart).

U.S. household debt servicing costs in line with pre-pandemic norm

Debt service ratio as of Q4 2023, interest payments as of March 2024. Sources: U.S. Federal Reserve, BEA, Macrobond, RBC GAM

A bit of perspective on this is that more than 40% of household spending comes out of the top income quintile. This group is unlikely to be too adversely affected by higher interest rates.

Estimates vary as to the whether accumulated pandemic savings are genuinely all gone. Much depends on one’s definition of a ‘normal’ pre-pandemic savings rate. Only minor tweaks to those assumptions can yield the view that there are still hundreds of billions of dollars left to be spent.

But even this isn’t that useful because the entire construct is artificial. Households never stopped saving throughout the pandemic. Over the past few years as the pandemic savings glut was theoretically drawn down, what actually happened was that households continued to accumulate assets, just at a slower rate than normal. Households continued to get richer every day, not poorer.

Additionally, there is more than one way to accumulate wealth. Even as households save less of their income than before, their wealth has still continued to rise thanks to a soaring stock market and home prices that are greatly higher than they were five years ago (see next chart). This means that households are still in a position to spend if they want to.

U.S. household net worth is high and rising (ex-pandemic distortions)

Note: As of Q3 2023. Shaded area represents recession. Source: U.S. Federal Reserve, Haver Analytics, RBC GAM

Low consumer confidence is not ideal, but of debatable importance. This real-time consumer sentiment index constructed from Twitter (now X) tweets, argues that confidence is still pretty normal. This is a more optimistic view than what traditional surveys are saying (see next chart).

Twitter Economic Sentiment in the U.S. is normal

Twitter Economic Sentiment Index as of 05/15/2024. University of Michigan Consumer Sentiment as of May 2024. Sources: Goldman Sachs Global Investment Research, University of Michigan, Macrobond, RBC GAM

But even more importantly, consumer confidence has been nearly useless in predicting spending behaviour in recent years. Consumers indicated that they planned to curtail their big-ticket spending sharply during much of the post-pandemic period, yet they spent with abandon. Today, big-ticket spending intentions are actually rising (see next chart), even though confidence is falling. Which to heed is anyone’s guess. We would argue it is best to focus on other variables altogether.

Buying conditions for large durable household goods improving?

As of April 2024. Sources: University of Michigan, Macrobond, RBC GAM

How to explain the lack of useful information coming from confidence metrics? There is presently a strong partisan divide in household opinions on the economy. American Democrats are fairly optimistic about the economy now that Biden is in power, while Republicans are verging on the apocalyptic. When Trump was in power, it was precisely the opposite. If people are letting their politics so strongly colour their assessment of the economy, the only reasonable conclusion is that these assessments are nearly meaningless.

There may also be a misconception about how rapidly retail sales grew over the prior several years, and thus how far retail sales growth has fallen, or may have to fall. Yes, on a nominal basis, retail sales grew robustly in recent years. But the great majority of that was the result of higher prices. People were paying more, but not actually getting much more.

It is more appropriate to look at real retail sales, which show that consumers actually retrenched slightly when inflation was especially problematic. More recently, real retail sales have been moving moderately higher (see next chart).

U.S. real retail sales have returned to trend growth

Real retail sales as of February 2024, nominal retail sales as of March 2024. Shaded area represents recession. Sources: BEA, Macrobond, RBC GAM

We track two different measures of real-time U.S. consumer spending, and neither shows much of a change (let alone a deceleration) in recent weeks or months (see next two charts). It is still the usual story.

U.S. aggregated daily card spending remains flat

As of 05/18/2024. Total card spending includes total Bank of America card activity which captures retail sales and services paid with cards. Does not include Automated Clearing House (ACH) payments. Sources: Bank of America Global Research, RBC GAM

U.S. aggregated card spending also holding steady

As of the week ending 03/07/2023 (partial week). Based on card transaction data of brick-and-mortar merchants collected by Fiserv. Excludes gasoline stations. Sources: BEA, Macrobond, RBC GAM

Despite anecdotal reports of weaker vacation spending, U.S. hotel occupancy rates appear to be rebounding for the summer season in an entirely normal way (see next chart).

U.S. hotel occupancy springs back

For the week ending 05/18/2024. Sources: STR (CoStar Group), Wall Street Journal, RBC GAM

Lower inflation could yet unleash inflation-adjusted spending that has been sitting on the sidelines. Retailers and the tourism sector are now reportedly feeling pressure to cut prices. That could induce a return to spending.

But all of this misses the main point. The best predictor of consumer spending isn’t interest rates or inflation or confidence, but household income. That, in turn, is informed by job creation and wage growth. Job creation remains healthy and wage growth, while slowing, is still strong. Both of these forces support further consumer spending. Our large-scale econometric model factors in a wide range of economic and market variables, with the conclusion that healthy employment, wages and wealth should offset higher debt-servicing costs. In turn, modest to moderate consumer spending growth is achievable over the next few years.

This, by the way, is probably the ideal scenario. We need slightly slower economic growth out of the U.S. to assist in the effort to tame inflation and reduce interest rates.

It also stands to reason that capital expenditures may contribute more to economic growth than usual over the coming years due to government industrial policies, onshoring, climate-change investments and the rapid rate of technological change. This may help to offset a more subdued consumer.

What’s really happening in China?

China’s official GDP is on track to grow by a little over 5% this year. The Chinese economy isn’t doing great, but stories of its demise have been overstated.

A frequent rebuttal to this claim is that China’s official economic statistics are sometimes questionable, and so the economy may actually be weaker than it looks. There is undeniably much to be skeptical of, given historical anecdotal reports of the falsification of economic data at the local level to meet government targets, and in light of the unusually smooth performance of the Chinese economy versus other countries.

This has motivated a cottage industry of alternative estimates of China’s economic performance. Most of these are anchored in data that is harder to manipulate, such as international trade data (which can be cross-referenced with China’s trading partners) and other “hard” indicators like electricity usage and train shipping statistics.

When we evaluate three alternative Chinese economic composites, it is notable that two of the three argue that the economy is actually growing faster than it looks. Only one claims the economy is moving more slowly (see next chart).

So it is not a slam dunk that China is exaggerating its rate of economic growth right now – or at least not by more than the norm of the past two decades. The three alternative indicators are admittedly rough-hewn: one says the Chinese economy is accelerating, one says it is bottoming out, and one says it is decelerating! These are not finely tuned instruments, and due to their design, most miss out on much of the service sector. But it seems reasonable to conclude that the Chinese economy is probably growing at a rate not radically dissimilar to the official estimate.

China’s GDP appears consistent versus alternative indicators

Li Kegiang Index as of April 2024. GDP as of Q1 2024. China Cyclical Activity Tracker (CCAT) as of Q4 2023. Economic Activity Index as of April 2024, constructed using 8 indicators as proxy of economic activities. Sources: Clark, Pinkovskiy, and Sala-i-Martin , "Is Chinese Growth Overstated?", Federal Reserve Bank of New York Liberty Street Economics, 2017, Federal Reserve Bank of San Francisco, Haver Analytics, Macrobond, RBC GAM

It should be conceded that the Chinese consumer is weaker than normal, as demonstrated by our Chinese Consumer Activity Index. This includes 11 proxies for Chinese consumer activities (see next chart – note “normal” is zero). But this is not a surprise given Chinese households’ exposure to a weak real estate market, and Chinese retail sales are still rising modestly despite this.

Chinese consumer is weaker than normal

As of April 2024. Index constructed using 11 proxies for Chinese consumer activities. Sources: National Bureau of Statistics of China (CNBS), China Association of Automobile Manufacturers (CAAM), People’s Bank of China, Soufun-CREIS (China Real Estate Index System), Haver Analytics, Macrobond, RBC GAM

Chinese housing stimulus

China’s housing market is struggling due prior excesses. These have led to very poor affordability, diminished demand for additional properties and insolvent builders. The result has been falling home sales and falling home prices.

The central government has been nibbling away at the problem for some time, cutting interest rates, reducing required downpayments and instructing banks to provide loan support for select construction projects.

Now, the government is tackling the housing problem from a brand new angle, creating a major policy to help digest the large number of completed but unsold housing units in the country. A total of 500 billion yuan is being directed toward local governments to purchase these units, clearing inventory and allowing builders to restore their balance sheets. The expectation is that the local governments will deploy the apartments as affordable housing. However, the sum of money is not nearly enough to mop up the excessive inventory of homes all by itself. One estimate puts the value of available Chinese housing inventory at 27 times larger than the new stimulus package!

Other new initiatives include a further 500 billion yuan as a lending facility to encourage the redevelopment of older dwellings.

The best bet remains that China manages to stabilize its housing market over the coming year, but that the sector remains subdued for a period of several years thereafter as underlying structural issues are gradually resolved.

Japan’s symbolic threshold

Japan’s 10-year yield now exceeds 1.00% for the first time in 11 years. This was motivated by several factors:

• the country’s positive inflation rate and reasonable economic prospects

• the Bank of Japan’s actions in March

• the prospect of a 10bps rate hike at the upcoming July 31 meeting

• the possibility of a reduction in the central bank’s bond purchase program.

Note that longer-dated Japanese bond yields were already well above 1.00%, with the country’s 30-year bond already above 2%.

The implications of this development extend in a number of directions.

• From a fixed-income perspective, it means that investors in Japanese bonds can increasingly earn a proper coupon for their efforts.

• From an economic standpoint, the higher yields are a promising sign of revival after a multi-decade period in which Japan was effectively hibernating.

• From a risk angle, Japan has an awful lot of public debt it now needs to pay serious interest on, presenting a financial stability danger.

• From an investment standpoint – and admittedly only tangentially linked to the 10-year yield – we are optimistic about the Japanese stock market as its companies appear to be finally prioritizing profit maximization in a way that was strangely absent for several decades.

Canada’s capital gains inclusion rate

Canada’s recent budget proposes a higher capital gains inclusion rate for certain Canadian parties. For those unfamiliar with Canada’s system, it is not the capital gains tax rate that has directly risen, but rather the fraction of capital gains that is subject to tax. For the past two decades, the inclusion rate was 50%, meaning that only half of capital gains were taxed at one’s marginal income tax rate. Effectively, the capital gains tax rate was half of the income tax rate.

The proposed legislation will increase the capital gains inclusion rate from 50% to two-thirds for all Canadian corporations and trusts, and on individual capital gains above $250,000 per year.

The budget estimates that this tax hike will apply to just 0.13% of all tax filers in 2025 given the lofty income threshold. But this understates the fraction of the population who will likely become ensnared in the new tax over time, as many middle-class households encounter large one-time capital gains due to the sale of a cottage or investment property, or on the liquidation of an estate. University of Calgary policy expert Jack Mintz estimates that around 3% of Canadians will have an encounter with the higher inclusion rate at some point in their lifetime. This is not a huge fraction, but neither is it trivial.

Furthermore, many doctors, lawyers and small businesses operate within a corporate structure that renders the proposed changes relevant to them as well, even if they are earning far less than a quarter million dollars per year in capital gains.

While the proposed tax obviously raises revenue and so would seem to strengthen the country’s fiscal position, its side-effects could ultimately have the opposite effect, mainly via reduced investment:

• Business investment may be incrementally weaker given that corporate profits will be taxed slightly more heavily (about 8% of Canadian corporate profits come from capital gains), reducing the capacity to reinvest money productively into the economy.

• Due to the higher effective corporate tax rate, Canada may become a less attractive destination for investment flows from foreign investors.

• Small business formation and the rate at which small businesses expand may be slightly impeded by the higher effective tax rate.

• Those earning high incomes in Canada may be marginally less inclined to extend their careers if their effective tax rate rises as their savings accumulate. They may also be slightly less inclined to save their money, and marginally less inclined to pursue growth-oriented investments (as opposed to interest-bearing or dividend yielding ones) – reducing the tax base and the pool of funds for productivity-enhancing investments in Canada.

• Canada’s shortage of medical professionals could worsen slightly as the after-tax income available to doctors.

Granted, the net damage from each of these forces isn’t enormous at the level of the aggregate economy. But all it takes is the loss of 0.2% of Canada’s economic capacity to more than offset the extra $4 billion in projected revenue per year.

Furthermore, the implications of a higher capital gains inclusion rate have an outsized symbolic importance. Canada is already viewed by some as a challenging place to do business given the difficulty in implementing major corporate infrastructure projects, a marginal tax rate of above 50% on individuals (which applies at a relatively low income-threshold), and a sense that the government has opportunistically levied new taxes against industries that are enjoying success. This proposal is the latest addition to that list.

At a time when productivity has stagnated for the better part of eight years, Canada would ideally be introducing economic policies that do the opposite: encourage more capital expenditures, more research & development, more business-enhancing bank lending and a bigger venture-capital industry. Indeed, as a small open economy abutting the world’s dominant economic unit, one can argue it is not enough to simply match U.S. economic policies. Canada may need to be significantly more welcoming to businesses and capital than the U.S. to properly compete and grow.

-With contributions from Vivien Lee, Vanita Maharaj and Aaron Ma