Personal income taxes and the capital gains tax
Numerous studies have demonstrated the high costs imposed on economies that maintain capital gains taxes, particularly those such as Canada that are relatively small and trade-oriented. The source of these costs is that capital gains taxes have especially strong effects on entrepreneurship, the foundation for successful, thriving economies. But why consider capital gains taxes when considering Canada’s personal income tax?
Until 1972, capital gains were not taxed. For Canada’s first 105 years, we avoided taxing capital in part because as a small, developing country, we understood the need to attract investment. When the capital gains tax was introduced in January 1972, it was based on personal income tax rates. Thus, when personal income tax rates change, so too does the taxation of capital gains.
A capital gain (or loss) occurs when an asset such as a stock or ownership in a business is sold for more (or less) than it was purchased for originally. A portion of the gain—50 per cent—is included in the person’s regular income. This means that the effective capital gains tax rate is half of the top personal income tax rate. Principal residences and certain types of investments in Canada are exempt from capital gains.
Capital gains taxes are, unfortunately, on the rise in Canada because various provinces, and most recently the federal government, have all increased their personal income tax rates. Table 1 summarizes the increase in the applicable capital gains tax rates, by province, between 2010 and 2016. It shows the top combined federal and provincial personal income tax rate adjusted to reflect that only half of a capital gain is included in personal income. The increases in the capital gains tax range from a low of 8.0 percent in Nova Scotia to a high of 23.1 per cent in Alberta and New Brunswick.
The defenders of capital gains taxes claim that such taxes are needed to improve economic efficiency, achieve a fairer income distribution, and raise revenue. All three arguments are flawed.
The efficiency rationale
The efficiency rationale is that owners of capital will have an incentive to shift income from employment, which is taxed at normal income tax rates, to businesses or other entities in order to enjoy lower or even no taxes. Economists worry about both the resources lost to the tax planning needed to achieve these shifts and the potential for inefficient levels of capital within firms, which would lower the overall returns to capital. Both of these effects would lower overall economic growth.
While these arguments may make sense conceptually, they do not coincide with the experiences of countries that have no capital gains taxes. If concerns about loss of efficiency due to the absence of capital gains taxes were valid, then such costs would be apparent in countries such as Switzerland, New Zealand, and Hong Kong, which impose no capital gains taxes. However, studies of these countries have consistently shown that such costs are immaterial.
This argument also seems to misunderstand that the owners of financial assets, land, and real estate, the appreciation of which represents the vast bulk of all capital gains, have virtually no ability to make the shifts in income discussed above—from employment income to other forms. Only the owners of small businesses have any real opportunity to avoid capital gains taxes. Again, the evidence from countries with no capital gains taxes suggests that this problem is minor.
It is also critical to consider the costs of “locked-in capital,” which capital gains tax proponents seem to ignore. The “lock-in” effect stops capital from moving to other investment opportunities with higher returns because of the punitive nature of the capital gains tax. In other words, capital gains taxes create a barrier to capital by locking it in and preventing it from flowing to its highest end use. Former Federal Reserve Chairman Alan Greenspan, in testimony before the U.S. Senate Committee on Banking, Housing, and Urban Affairs in February of 1997, was clear about the net costs of capital gains taxes:
... the major impact (of capital gains taxation) is to impede entrepreneurial activity and capital formation. While all taxes impede economic growth to one extent or another, the capital gains tax is at the far end of the scale... the appropriate capital gains tax rate [is] zero.
Fairer income distribution
The second argument from proponents of capital gains taxes is that such gains accrue mainly to those with high incomes. Taxing capital gains, therefore, results in a more equal distribution of income. However, in Canada, most who pay the capital gains tax have modest incomes in years prior to and after they realized those gains. For many, the capital gain is an infrequent or even one-time event, such as happens from the sale of a business. Canadians with consistently high incomes paid only about a quarter of all the capital gains taxes collected.
The fairness argument is further flawed by the fact that historically, much of the increase in the value of assets has been due to inflation. Under these conditions, the taxation of realized capital gains results in a tax on the real value of the assets, which unfairly taxes property rather income.
Source of revenue
The final argument used to support the capital gains tax is that it is an important source of revenue. Unfortunately, the federal government does not regularly report revenue from capital gains taxes since it appears as part of the overall personal income tax revenues. However, in 2011, the Fraser Institute formally requested that data and was able to determine that the federal government collected about $2.8 billion, or roughly 1.1 per cent of total federal revenues, from capital gains taxes. More important than the amount of revenue raised, though, is that the tax decreases the total revenue raised through personal income and value-added taxes. This is due to the inefficiencies that the capital gains tax causes, which reduce economic growth and, with it, taxable personal income.
This point is driven home by an analogy, which considers the economy to be like a fruit-bearing tree. The taxation of income is equivalent to the government claiming a part of the fruit harvest, allowing the tree to grow and produce larger harvests in later years. Capital gains taxation is equivalent to trimming the annual increase in tree branches on which the fruit grows so that the size of future harvests is reduced correspondingly.
Studies looking at the effects of variations in the capital gains taxation rate have produced results with important implications for politicians and policy makers. When the rate is increased, wealth holders postpone the realization of capital gains and pay fewer taxes than had been projected. When rates are decreased, wealth holders increase the realization of capital gains and tax revenues rise by more than expected. In the longer run, the real economic effects of the tax are the reduction of economic growth and living standards, as discussed above.
The preceding summary has shown how capital gains taxation lowers economic growth and ultimately living standards in Canada. Furthermore, the key justifications used for taxing capital gains are not only not compelling, but in at least one case, are simply incorrect. Canada has benefitted from not taxing capital gains for most of its history and like other countries including Switzerland, New Zealand, and Hong Kong, would again benefit from returning to a capital gains tax rate of zero.
Read more essays on Canada’s personal income tax here.