Getting the facts straight on capital gains tax

Arecent Fraser Institute study on capital gains, reviewed by Jamie Golombek in the Financial Post on Jan. 22, seems aimed at dissuading policy-makers from raising the capital gains tax in the next federal budget. But the study, titled “Correcting common misunderstandings about capital gains taxes,” succeeds only in further muddling our understanding of this topic, with errors at the levels of fact, concept and method.

In terms of facts, the study asserts the Canadian capital gains tax is already too high relative to other countries. It cites, for example, a top rate of 20 per cent in the United States, our primary fiscal comparator, versus a top rate of 27 per cent here. But that comparison is flawed, like comparing apples with bananas.

The cited 27 per cent for Canada includes the federal rate plus the rate in the highest-rate province (Nova Scotia). In contrast, for the U.S. the study cites the federal rate alone, ignoring the fact that most states also tax capital gains. In the highest-rate state (California) the top rate is 13.3 per cent; add the 20 per cent federal rate, plus a federal surtax of 3.8 per cent, and top-paying American taxpayers bear 37.1 per cent on their capital gains — 10 percentage points more than the top rate anywhere in Canada.

Moreover, U.S. tax rates on top earners are even higher than that for sales of assets held less than one year. Canada has no minimum holding period in order for the taxpayer to receive the 50 per cent tax exclusion on capital gains. In the U.S., in contrast, an asset held short term faces the full maximum 37 per cent federal rate in the top bracket, plus state tax and the extra federal levy, for a maximum 54.1 per cent — double the 27 per cent rate in Canada.

Other differences between the two countries tell a similar story not mentioned in the study. Canada provides small-business owners a lifetime exemption from tax on capital gains of $892,000 when selling their shares ($1 million for farmers and fishers); the U.S. has nothing comparable. It also taxes homeowners on gains realized from the sale of their homes exceeding US$250,000 (double for couples); Canadians selling their homes typically face no capital gains tax however large their gain.

The Fraser study also makes various claims about how taxing capital gains hurts the economy more than other types of taxes. For instance, it argues that a “lock-in” effect that deters shareholders from selling appreciated shares in order to defer capital gains tax “prevents that capital from being reallocated to better, more productive uses.”

The conceptual error here is to confuse financial capital and newly created physical capital — machinery, buildings, mines, and so forth. The physical capital that corporate shares are title to is already fixed in particular forms and industries. Selling the shares that financed its purchase does not free the already embedded physical capital to move to a newly buoyant industry. A steel foundry cannot be converted into a semiconductor foundry. Only the issuance of new shares would supply the funds needed to underwrite investment in tangible capital for startup or expanding firms.

The Fraser Institute study further suggests that less wealthy taxpayers pay more capital gains taxes than the official statistics show. But it relies on an unsupported methodological assumption, thus undermining its finding. Canada Revenue Agency tax return data show that capital gains are highly concentrated among top earners. The top 1.1 per cent of all returns filed in 2017, with incomes above $250,000, reported $20.2 billion or 55 per cent of all capital gains, thus garnering an estimated 61 per cent of the total tax savings from favourable capital gains tax treatment.

The study asserts that capital gains received in any given year are a faulty measure of a taxpayer's true income because many gains are received only sporadically. Thus, they reclassify taxpayers by their income excluding capital gains receipts. Using a statistical model with a single year's data, they estimate that “those earning less than $150,000 a year pay a much larger portion of capital gains taxes than many believe” — just over half. But knowing exactly how sporadic capital gains are would require data on capital gains over several years. Using data for only a single year, business owners and wealthy investors who reap large gains most years but have limited salary or other income would be wrongly reclassified as lower earners, distorting the picture of who actually benefits.

Increasing the capital gains inclusion rate from 50 per cent to a higher figure would be one of the most direct and effective ways of improving equitable treatment of Canadian taxpayers across the income spectrum. It would also reduce the payoff to tax planning and complex financial arrangements and thus reduce the costs of taxpayer compliance. If the Fraser Institute is truly interested in protecting ordinary investors, it could recommend raising the tax inclusion rate only for gains exceeding a relatively high level.

My advice to Fraser Institute researchers is simple. Remain faithful to your institute's maxim “if something matters, measure it” — but for heaven's sake, measure it properly!

THE STUDY SUCCEEDS ONLY IN FURTHER MUDDLING OUR UNDERSTANDING OF THIS TOPIC.