Michael Smart teaches economics at the University of Toronto and is co-director of the Finances of the Nation project.
Recent months have seen increased chatter about the idea of an annual “wealth tax” to help fund public services and make our tax system more progressive. The problem is that such a tax would have significant administrative costs and enforcement problems, and may well harm productivity.
These shortcomings of an explicit wealth tax don’t mean we should give up on the idea of collecting more revenue from well-off Canadians. It just means we should seek better strategies for doing so. Amongst the most promising of these strategies is increasing the tax rate on capital gains. This policy change would increase fairness in our tax system and boost business productivity, while raising substantial new revenue for federal and provincial governments.
That’s a win-win-win scenario. Finance Minister Chrystia Freeland should be looking carefully at this reform as she plans for the next federal budget.
Capital gains are income flows that result from the rise in value of corporate shares and other assets. Certain gains like those earned on the sale of a primary residence, from selling a small farm or business are excluded.
But capital gains are taxed quite differently than other kinds of income. Only 50 per cent of realized capital gains are included in taxable income. That means a dollar earned from the profit of selling a stock is half as high as that on a dollar earned through labour.
Unsurprisingly, this preferential treatment of income from capital gains is unequally distributed, as wealthy Canadians enjoy the vast majority of all capital gains. According to estimates compiled by Finances of the Nation, more than half of all taxable capital gains in 2017 were declared by people in the top one per cent of income earners.
Of course because capital gains are tilted so heavily to high income Canadians, so too are the benefits from the preferential treatment of this type of income. The chart below illustrates who gets the benefit of the current policy that treats capital gains differently from other forms of income. We see that 61 per cent of the benefits flow to individuals with incomes over $250,000. Another 23 per cent of the benefits flow to those earning between $100, 000 and $250, 000. Just 16 per cent of the benefits flow to individuals with incomes under $100, 000—a group that constitutes about 90 per cent of tax filers.
What does this look like at the individual level? For tax filers in the $250,000-plus category with taxable capital gains, the average tax savings from preferential treatment of capital gains averaged $64,000 in 2017. For those earning less than $100, 000 with taxable capital gains, the savings from preferential tax treatment averaged just $1,179.
It is clear that the preferential tax treatment of capital gains is highly regressive and benefits the richest among us. What is entirely unclear is what economic benefits are derived from this inequitable tax measure.
The federal Department of Finance says the rationale is “to encourage or attract investment [and] to support competitiveness.” But a tax benefit for only domestic shareholders is unlikely to have much impact on investment in Canada’s open economy.
It is sometimes suggested that capital gains taxes discourage risky investments. But, as economist Jack Mintz has argued, a capital gains tax that treats losses and gains symmetrically should have no impact on risk taking.
The economic arguments for such strong preferential treatment for capital gains don’t withstand much scrutiny. In fact, it creates harmful economic distortions for both large corporations and small businesses as they face incentives to make business decisions that distribute benefits in the form of capital gains instead of dividends or salaries. It is almost never good news for productivity when business decisions are driven by tax planning considerations.
So the effective tax rate on capital gains inclusion rate should rise. But how much? Raising capital gains tax rates across the board by 50 per cent would approximately eliminate the tax advantage for gains over dividends, for both large corporations and small private businesses. Under this change, the tax advantage of income earned on capital gains compared to labour income would also shrink dramatically, making our tax system fairer.
It would also raise substantial new revenue. With accompanying changes in the taxation of corporate capital gains, I estimate the reform would increase federal and provincial income tax revenue by as much as $16 billion annually.
Trying to make our tax system more progressive is a reasonable objective, but increasing the tax rate on capital gains is a much better way to do it than an annual wealth tax. It would be simpler and cheaper to implement, while reducing the economic costs of tax avoidance behaviour. And it would raise far more revenue than the wealth tax recently proposed by the NDP. The case for an increase in capital gains taxation seems clear.
For wealthy Canadians, January is capital gains season. If you are one of the lucky few who realized gains this year, then congratulations. Now, would you mind paying your fair share in taxes?