Canada's capital-gains tax change continues decades-old debate ...

Deputy Prime Minister and Minister of Finance Chrystia Freeland responds to a question during a news conference, in Ottawa, on May 1.Adrian Wyld/The Canadian Press

In February, 2000, then-finance minister Paul Martin tabled a tax-cutting budget which, among other things, lowered the proportion of capital gains eligible for taxation.

For the preceding decade, the federal government had collected tax on 75 per cent of capital gains – money made by selling stocks, investment properties and other assets for more than the purchase price.

In a new century, in which economic growth would be driven by innovative businesses, it made sense to lower the inclusion rate back to the pre-1990 level of 50 per cent, to “encourage entrepreneurship and risk taking,” Mr. Martin told the House of Commons.

Twenty-four years later, Finance Minister Chrystia Freeland delivered a very different message after tabling her latest budget on April 16. Housing has become unaffordable, young Canadians are falling behind and democracy itself is at risk owing to rising inequality, Ms. Freeland told Parliament.

“The job of our tax system is to lean against this structural inequality,” she said, announcing an increase in the capital-gains inclusion rate to 66 per cent for corporations and trusts, and for individuals on gains above $250,000.

Ottawa expects the change to raise nearly $20-billion over five years to pay for a raft of new spending, mostly on housing initiatives. The rules are expected to come into force on June 25.

In these two changes – from different Liberal governments, a quarter-century apart – you have the opposite poles of a debate that has been simmering ever since capital-gains taxation was first proposed in the 1960s and introduced in 1972.

Many business groups and private-sector economists argue that raising taxes on capital gains disincentivizes investment and entrepreneurship – an unwise move at a time when the Bank of Canada has declared weak productivity growth and lacklustre business investment a national emergency.

And there are real questions about how to tax money that’s already been dinged by corporate income taxes, and how to account for the fact that some asset price appreciation is simply the result of inflation. These are key reasons for the less than 100-per-cent inclusion rate for capital-gains taxation.

At the same time, taxable capital gains are highly concentrated among wealthy individuals and certain types of businesses that buy and sell assets. That means boosting taxes on this type of income tends to make the tax system more progressive, especially if the changes only apply over a certain threshold.

Moreover, many academic economists argue that higher capital-gains taxation involves a reasonable trade-off between equity and efficiency – that is, between the sometimes competing goals of making the tax system more fair and encouraging economic growth.

That doesn’t mean raising taxes to pay for more government spending is necessarily the right move. That’s a political question. But if the government does want to raise revenue, leaning on capital gains is a relatively targeted and effective way to go, many academics argue.

“I hate to use this phrase, but this might be the best worst approach,” said Kenneth McKenzie, an economics professor at the University of Calgary.

Debates about tax changes aren’t just theoretical. They’re intensely political and tend to draw the ire of affected groups, especially ones that have been targeted repeatedly. Since 2015, the Liberal government has leaned on high-income earners and certain businesses, raising the top income tax rate to 33 per cent from 29 per cent, taxing share buybacks, and hiking corporate taxes on banks and insurance companies.

Since the April 16 budget, the Council of Canadian Innovators has collected nearly 2,000 signatures from entrepreneurs and venture capital funders opposed to the change. The VC business model is based around founding and selling companies, and higher capital-gains taxes directly affect the return for founders and investors, as well as for employees who receive much of their compensation in the form of company shares.

The Canadian Medical Association also came out against the change, with a dire warning that it could force doctors out of the profession at a time when many Canadians can’t find family physicians.

Doctors are often incorporated and use their professional corporations as savings and investments vehicles to benefit from preferential tax rates. Increasing the capital-gains inclusion rate for corporations and trusts – without the $250,000 threshold – makes this a less attractive strategy.

Len Farber, a former general director of tax policy for the federal government, said the Liberals are fumbling their latest tax increase by not offering meaningful relief elsewhere in the tax system as an offset.

In the late 1980s, Brian Mulroney’s Progressive Conservative government raised the capital-gains inclusion rate to 75 per cent from 50 per cent. However, this was part of a larger reform that brought down income-tax rates for high earners.

“I think successful reforms occur when there’s a package of changes, and you justify what you’ve done with the other measures that compensate for either an increase or a decrease in any particular measure,” Mr. Farber said.

The budget does increase the lifetime capital-gains exemption for small businesses to $1.25-million from $1-million. And it introduced a new incentive that will lower the amount of tax that entrepreneurs in some industries pay when they sell their businesses, up to a lifetime limit of $2-million.

But these two changes “will only affect very minor segments of the population. Whereas notwithstanding what the government is saying, there are a lot of people that could get hit by the increase in the inclusion rate,” Mr. Farber said.

According to numbers in the budget, around 40,000 individuals – only 0.13 per cent of the population – are expected to make more than $250,000 in capital gains next year. The implication is that the higher inclusion rate won’t affect personal income taxes for the other 99.87 per cent of Canadians.

Around 307,000 companies – 12.6 per cent of all businesses – had net capital-gains income in 2022. These include professional corporations, holding companies and businesses that invest in real estate, among others.

The budget numbers may be accurate, but they’re also somewhat misleading.

By only looking at one year, the budget undercounts the number of people who may receive more than $250,000 in capital gains on a one-time basis. This could happen, for example, if someone sells a cottage or investment property, which is not exempt from capital-gains taxation the same way primary residences are.

“There’s a non-insignificant number of people who are actually pretty middle-of-the-road earners who make one big capital gain,” said Antoine Genest-Grégoire, an economics professor at the University of Sherbrooke.

However, it’s important not to overstate this point, he said. The vast majority of Canadians won’t be affected by the change, and “many of the people who are going to breach that threshold are actually people who died and that’s going to figure on their last tax return.”

A paper published last year by the late Simon Fraser University economics professor Jonathan Rhys Kesselman found 80 per cent of Canadians did not report a taxable capital gain between 2009 and 2018. And for those who reported in just one of those years, their total gains averaged $26,800, compared with average total gains of $328,300 for people who reported in every year.

The second leg of the debate revolves around the impact of capital-gains taxation on economic growth, investor behaviour and business creation.

Here, the economics literature is mixed. Studies in the U.S. and Europe found that lower capital-gains taxes lead to more investment in early-stage technology companies, while higher capital-gains taxes lead to fewer startups being funded.

This is a major concern for startup founders and investors, said Brigitte LeBlanc-Lapointe, a partner with the law firm Norton Rose Fulbright.

“Even before this, I talked to clients all the time about whether they want to establish their business in Canada or in the United States, and in the U.S., they have a lot greater access to capital. So, this might just be one more factor that tips the scales.”

At the same time, there is less clear-cut evidence that higher capital-gains taxes have a negative impact beyond the venture capital space.

“When you look at the impact on the economy writ large – I mean this is a big economy, venture capital is part of it – I would say quite simply, the evidence isn’t conclusive,” said Prof. McKenzie of the University of Calgary.

That compares with corporate income taxes, he said, where the evidence is “much more compelling” that higher taxes lead to lower business investment.

Indeed, some academic economists argue that raising the capital-gains inclusion rate could have a positive economic impact by shrinking the gap between higher-taxed dividends and lower-taxed on capital gains, which distorts corporate investment decisions. Although this would work best, the argument goes, if the increased revenue from capital gains was used to lower other taxes rather than to fund more government spending.

There is evidence that raising capital-gains taxes changes investor behaviour in the short run.

Adam Lavecchia, an assistant professor of economics at McMaster University, studied an episode in 1994 when the federal government scrapped a $100,000 exemption on capital-gains taxes. This prompted people to sell assets before the change came into effect.

However, Prof. Lavecchia found almost no permanent change in investor behaviour.

“While we found this big short-run response to the 1994 announcement, we actually found no adverse response in the medium to long run,” Prof. Lavecchia said. Recent studies of capital-gains tax changes in the U.S. have found similar results, he said.

The federal government is betting on this response. The budget projects $6.7-billion in additional tax revenue from capital gains this year. This drops to $3.3-billion next year and only $375-million the following year, before rising again.

Ultimately debates about taxes aren’t won or lost by economists. They play out in the public sphere where impressions matter.

“People, to a large extent, don’t really engage with the factual arguments … [they] generally lack a reference point to understand the details about what’s a good tax or a bad tax,” said Darrell Bricker, the chief executive of Ipsos Public Affairs, a polling company.

What matters is how much the public trusts the government on economic issues, he said. And here, the unpopular Liberal government is on its back foot, after nine years in power and a period of high inflation, high interest rates and widespread housing affordability problems that are at least partially the result of government decisions.

“This government, at this time, on these types of policies, is not seen as particularly trusted,” Mr. Bricker said.

“The second thing is it depends on who complains,” he said, noting that outraged investment bankers are less likely to arouse public sympathy than family doctors and small business owners.

Shirley Tillotson, emeritus professor of history at Dalhousie University, said the current debate resembles the one that happened in the 1960s and early 1970s, when capital-gains taxes were first introduced.

The 1966 Royal Commission on taxation, known as the Carter Commission, proposed taxing 100 per cent of capital gains on the principal that “a buck is a buck,” and all income should be taxed the same no matter how it’s generated. This was lowered to 50 per cent by the time legislation was introduced in 1972.

At that time, mining companies were the ones warning about the negative impact on business investment, while poor clergyman became the “ethically appealing” face of the opposition to capital-gains taxes, similar to the role doctors are playing today, Prof. Tillotson said.

“Once you have heated moral discourse around tax reform, then you as a tax reforming government have probably lost,” she said.

“I think the option of doing tax reform quietly and technically is not on the table any longer. So double down on the moral discourse that suits you. Tax experts, put your shoulder to the wheel and try to make [the factual evidence] clear. It will play out in some sort of modification, compromise, partial measure would be my guess.”

The government has carved the capital-gains proposal off from the rest of its budget bill and will hold a separate vote on the measure, suggesting the contentious tax debate will remain at the centre of Canadian politics heading into the summer.