For the past couple of years, clients have asked in the run-up to federal budget season whether the current federal government could increase the inclusion rate for capital gains, which is currently at 50%.
There’s a good reason for this: The rich are the ones who earn capital gains primarily, and the current Liberal government has been targeting highest income-earners. Specifically, Ottawa is increasing the tax rate on the top 1% while at the same time putting in place measures to ensure that private corporations aren’t being used inappropriately to sprinkle income and retain passive income.
Indeed, income statistics show that less than 10% of personal tax returns report any taxable capital gains. And of the $25 billion in aggregate taxable capital gains reported in 2014, the top 8% of filers earned three-quarters of those gains while the top 1% realized 50% of the total dollars in reported capital gains. About 2.6 million individuals and 190,000 corporations reported capital gains in 2014.
Yet, rather than increasing the effective tax rate on capital gains, it should be reduced or abolished as several countries have done, according to an economic note the Montreal Economic Institute (MEI) — an independent, non-partisan, not-for-profit research and educational organization — published recently.
“Capital formation is one of the foundations of economic growth. Yet, investment in Canada has fallen [by] 18% since 2014,” explains Mathieu Bédard, an economist with the MEI and author of the note. “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.”
The capital gains tax hurts innovation by reducing the appetite of investors for riskier startups, Bédard claims in the note. 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 the report, Bédard quotes a 2004 Department of Finance Canada study showing that each dollar reduction in capital gains taxes would lead to economic gains of approximately $1.30. New Zealand, Switzerland, and Hong Kong don’t tax capital gains at all. “In these places, positive effects from the absence of capital gains taxation have been documented,” he says in the note.
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 as interest earned on bonds or guaranteed investment certificates and quarterly dividends received on equities — the decision to realize a capital gain today vs 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’s 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, 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 1% drop in the tax rate, capital gains realizations — and thereby the flow of capital — increases by 1%.
Bédard also points out in the note that the capital gains tax is “rather regressive.” Although some investors can easily avoid paying this tax by delaying the realization of their capital gains, not everyone can do so that 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 these asset sales generate. They are, therefore, in a sense, much more affected by capital gains taxation than high-income earners.
Whether the government would actually lower the inclusion rate in the upcoming budget is highly doubtful, but not increasing it would certainly be a step in the right direction.