The trouble with capital gains taxes
And why we’re likely still stuck with them
Canada’s capital gains tax should be reduced or abolished as a number of countries have done, according to an economic note published this week by the Montreal Economic Institute, an independent, non-partisan, not-for-profit research and educational organization.
“Capital formation is one of the foundations of economic growth. Yet investment in Canada has fallen 18 per cent since 2014. Now that the oil industry boom is behind us, it’s obvious that Canada has a chronic problem. The capital gains tax reduces the availability of capital, and makes it more expensive for companies. Who ends up paying the price? Workers in particular, through fewer jobs and lower wages,” explains Mathieu Bédard, economist at the MEI and author of the publication.
Prior to 1972, Canada didn’t tax capital gains at all. The Carter Commission Report recommended 100 per cent taxation of capital gains. But the law, as originally introduced, ultimately decided to tax only 50 per cent of gains. Subsequent governments increased the inclusion rate to 66 2/3 per cent in 1988, then increased it again to 75 per cent in 1990. A decade later, it was dropped back down again to 66 2/3 per cent on Feb. 28, 2000 and then further reduced on Oct. 18, 2000 to 50 per cent, the inclusion rate that still applies today.
These rates are only relevant for gains outside of registered accounts. And some capital gains are still entirely tax-free, such as the gain on your principal residence or the gain where appreciated publiclytraded securities are donated to a registered charity. In addition, the lifetime capital gains exemption exempts $835,714 on the sale of qualified small business corporation shares and $1 million of lifetime capital gains for farmers and fishermen.
But for taxable investors, Mr. Bédard claims that the capital gains tax hurts innovation by reducing the appetite of investors for riskier startups. He argues that the abolition of our capital gains tax “could encourage productivity growth in Canada, which would in turn improve the living standards of all Canadians.” In his report, he quotes a 2004 Finance Department study that shows that each dollar reduction in capital gains taxes would lead to economic gains of approximately $1.30. New Zealand, Switzerland, and Hong Kong do not tax capital gains at all. “In these places, positive effects from the absence of capital gains taxation have been documented,” says Mr. Bédard.
Another problem with capital gains tax is that it encourages investors in taxable accounts to lock in their investments. Unlike most types of income, such interest earned on bonds or GICs and quarterly dividends received on equities, the decision to realize a capital gain today versus at some date in the future is generally a matter of choice and thus taxation can be deferred indefinitely or at least until death, when there is a deemed disposition.
This makes capital gains much more sensitive than other types of investment income to changes in the tax rate. When tax rates are high, such as our current environment where top marginal rates on regular income exceed 50 per cent in more than half the country, individuals who own capital assets are generally more reluctant to sell them as they require greater benefits to outweigh the capital gains tax burden they will incur when they sell. For these investors, the capital gains tax effectively reduces the probability that a given stock will be sold. This, in turn, hurts economic growth because it essentially discourages the otherwise natural reallocation of capital to its most productive uses. Indeed, U.S. research suggest that for every one per cent drop in the tax rate, capital gains realizations — and thereby the flow of capital — increases by one per cent.
Mr. Bédard also points out that the capital gains tax is “rather regressive.” While some investors can indeed easily avoid paying this tax by delaying the realization of their capital gains, not everyone can do so easily. He argues that other groups, such as low- and middle-income taxpayers, the elderly, and less successful investors, typically have low financial flexibility, and therefore have much less discretion over when to realize capital gains as they need the cash flow generated by these asset sales. They are therefore, in a sense, much more affected by capital gains taxation than high-income earners.
Yet it seems unlikely that the current government, which has been focused on increasing the tax rate on Canada’s richest one per cent while at the same time putting in place measures to ensure that private corporations aren’t inappropriately being used to sprinkle income and retain passive income, would actually consider lowering the inclusion rate, much less abolishing it altogether.
After all, as I’ ve discussed here before, capital gains are earned primarily by the rich. Income statistics show that less than 10 per cent of personal tax returns report any taxable capital gains. And of the $25 billion in aggregate taxable capital gains reported in 2014, three-quarters of those gains were earned by the top eight per cent of filers while 50 per cent of the total dollars in reported capital gains were realized by the top one per cent. About 2.6 million individuals and 190,000 corporations reported capital gains in 2014.
According to the Report of Federal Tax Expenditures (2017), the partial inclusion of capital gains for individuals and corporations will result in a tax cost to the government in 2017 estimated at $12.2 billion. The report says that the lower inclusion rate provides “incentives to Canadians to save and invest, and ensures that Canada’s treatment of capital gains is broadly comparable to that of other countries.”
Of course, not all economists agree on whether a low rate on capital gains tax is justified. A report authored earlier this year by Peter Spiro of the Mowat Centre, a public policy think-tank located at the University of Toronto, questioned whether a reduced capital gains tax rate really improves economic performance. Calling it “questionably targeted,” Mr. Spiro wrote that, “it provides just as much of a tax break to Canadians who speculate on foreign stock markets as to those who create new businesses in Canada.”
POSITIVE EFFECTS DOCUMENTED IN PLACES LIKE HONG KONG.