Jonathan Rhys Kesselman
This commentary, an executive summary of the full report, considers the case for increasing taxes on capital gains in Canada and the implications for the upcoming reform of the alternative minimum tax (AMT), slated for release in the 2023 federal budget. Read the full report.
Motivation for the report
In Canada today, only 50 per cent of net capital gains are taxable income. This favourable tax treatment of capital gains is a key contributor to a top-tail income inequality and it can facilitate tax avoidance by high-income taxpayers. For many years, public finance and tax policy experts have proposed various reforms to capital gains taxation, with some calling for lower and others for higher tax rates. Recent publications of the Canadian Tax Foundation have included articles with arguments and evidence on both sides of the debate, with a majority of them advocating an increase in the gains tax inclusion rate, typically to 75 per cent. This report assesses the positions taken in these articles and in the broader literature, finding that both proponents and opponents of reform have missed much of the relevant evidence and that neither side has considered the other conditions needed to make increased taxation of gains possible. I find that a variety of mitigation measures should accompany such reforms to blunt any adverse economic impacts. Targeting the tax increases at those with the largest capital gains would best address top-tail inequalities, while facilitating public acceptance and political palatability.
Recent calls for increased taxation of capital gains in Canada culminated in the 2022 federal budget’s announcement of a forthcoming proposal to revise the alternative minimum tax (AMT). The AMT has not been significantly reformed since its introduction in 1986. It now affects fewer than 50,000 taxpayers per year with an average liability of less than $7,000. The AMT is a complex overlay to the ordinary income tax system and — unless radically tightened and simplified — would seem a weak basis for addressing top-end concentration of incomes. This report reviews the arguments and evidence related to increased taxation of capital gains (and other forms of investment income) and presents alternative reform pathways that would be simpler and more effective than AMT reform and more targeted than a broad increase in capital gains taxes. It also addresses both the economic and political barriers to reform.
Capital gains and inequality
Some arguments about a potential increase in taxation of capital gains revolve around fairness or equity. Proponents of a general increase in the inclusion rate for gains argue that all sources of income should be taxed more equally for all taxpayers. Yet, moderate- and middle-income earners already have many vehicles — such as RRSPs, RPPs and TFSAs — for limited amounts of their income to be taxed on a preferential basis, without evoking charges of inequity. Rather, it is the unbounded scope for tax-favoured capital gains accessible to high-earners and wealth-holders that would seem most objectionable. Capital gains are highly concentrated among top-earners, as has been shown in annual statistical data for many years. Opponents of increased taxation of capital gains have argued that much of these gains are received by taxpayers with moderate incomes and irregularly, so that the impact of higher gains taxation, if applied across-the-board, would be borne widely. Thus, a key question is how concentrated are receipts of capital gains, which requires analysis of longitudinal data to obtain a clear picture.
|No. of years with TCGs a||All filers excluding years with TCGs < $500||Average annual total income||Average annual total income excluding TCGs||Average TCGs totals over 10 years||Share of all TCGs over 10 years|
Source: Corrections and extensions of the original Table A4 in Gagné-Dubé et al. (2021, 1192) generously extracted by those authors from the longitudinal administrative databank, as well as calculations by this author.
Notes: a Filers receiving taxable capital gains (TCGs) of $500 or less in any given year
Several examples of the extreme concentration of capital gains at high-income levels in Canada can be drawn from this report and elsewhere. As shown in Table 1, which covers the 10-year period 2009–18, just 19 per cent of filers reported a taxable capital gain (TCG) of any size in at least one year, and this figure falls to 14 per cent if we exclude only trivial gains (TCGs less than $500 in any year). Thus, nearly one out of five filers reported at least occasional gains over the 10 years, though most received only small and infrequent gains. But they still would have been affected by a general increase in the inclusion rate. Those reporting TCGs in just one or two years constituted nearly 60 per cent of all TCG filers, but they accounted for just one-third of total TCGs. Moreover, total TCGs that filers reported over the 10 years rise from an average of $26,800 for those with gains in a single year by more than 12-fold to $328,000 for those with gains in all years. Those reporting TCGs in four or more of the years accounted for more than 56 per cent of all TCGs over the period.
If we consider shorter time intervals or annual data, the extreme concentration of TCGs and hence of the tax benefit of the partial inclusion provision is even more striking. Michael Smart has estimated that in 2017 alone, of individual filers with incomes under $100,000, nine per cent reported some gains, with an average savings in tax of $1,179 or 16 per cent of the total tax savings, contrasted with those having incomes of $250,000 and up, of whom 52 per cent reported gains, with an average tax savings of $64,063 or 61 per cent of the total tax savings. Using longitudinal data on family incomes for the five-year period 2014-18, Smart and Sobia Jafry estimated that the top one per cent of income groups garnered 41 per cent of the total tax benefits from preferential tax on gains, while the top 10 per cent by income reaped 72 per cent of the total savings. The top one per cent had average annual incomes of $1.5 million or higher and average annual TCGs exceeding $800,000.
The preceding figures illustrate the high concentration of TCGs among relatively few taxpayers and at very high incomes. Targeting an increased tax inclusion rate on gains received in large amounts or by filers with very high incomes would sharply reduce the affected numbers of filers, easing both administration and compliance as well as public acceptance. Nevertheless, the “bunching” of capital gains received by some filers — through the infrequent sales of assets or in decedent estates — suggests the advisability of companion measures such as allowing carryover of gains for tax purposes relative to the use of an annual threshold (whether based on total income or total TCGs in the year) or else the restoration of income tax averaging provisions. The latter approach would also benefit many self-employed, small businesses and workers in volatile sectors so as to enhance equitable treatment and bolster support for the measure. AMTs in both Canada and the United States offer carryover provisions to address a similar issue.
Capital gains and economic efficiency
Other arguments about increased taxation of capital gains revolve around the potential impact on the economy’s efficiency and long-run growth. Opponents of increased taxes have cited several studies suggesting adverse outcomes, while proponents have tended to minimize these findings or discount them entirely. This report provides an extensive review of studies on the estimated or likely impact in areas such as venture capital, startups, tax evasion and avoidance, tax-favoured accounts, lock-in of asset holdings, and diversion of capital or savings via housing investment, corporate activities and donation of appreciated shares. The overall impact of existing and increased capital gains taxes on the economy’s efficiency and growth are mixed and not easily quantified. However, contrary to common claims, some of these impacts would be economically favourable, while others that might be economically adverse could be mitigated through appropriate concomitant reforms.
Several examples illustrate the potential positive and negative economic impact of increased taxation of capital gains. Narrowing the gap between the effective tax rate on gains and that on ordinary income should reduce both the incentive and the incidence of tax-avoidance activities. This will improve the efficient allocation of resources while also reducing the waste of time and skills on tax and financial planning. Limiting the extent of avoidance through use of the principal-residence exemption from capital gains tax would reduce the diversion of capital and savings from productive business investment. On the other hand, an increased gains inclusion rate would increase the extent of inefficient lock-in of real properties from their sale for more productive alternative uses and the diversion of appreciated assets from productive investment to charitable contributions. Relatively simple reforms to other provisions (such as the charitable contributions tax credit for top-bracket donors) could neutralize those impacts. Similarly, targeted carve-outs for venture capital and business startups could offset adverse impacts that might arise in those areas.
Remaining competitive with the U.S. is important for Canada because of our extensive business, financial, trade and labour ties. In general, effective tax rates on capital gains are lower for most taxpayers in most of the U.S. Despite some blatant deficiencies of the capital gains tax system in the U.S., Canada can still learn from American provisions in the areas of like-kind exchanges, limits on deductibility of investment expenses, venture capital and startups, and tax on gains from the sale of principal residences. While the AMT format has been critiqued in both countries as complex and ineffective, the U.S. net investment income tax (NIIT) could serve as a possible model for a Canadian surtax on large capital gains and dividend incomes. Both countries abolished income averaging when income tax rates were flattened in the 1980s and capital gains became taxed more like ordinary income. But a restoration of averaging could be justified with an increased inclusion rate, given the rise in Canada’s top marginal tax rates in recent years. This would also widen the appeal of the overall package of tax reforms.
If the tax inclusion rate for capital gains were to be increased on a targeted basis, several alternatives would be feasible. The report first considers a threshold for the higher rate based on the total amount of TCGs reported by the filer in a given year. This approach could be combined with various types of carrybacks or carryforwards or a more general averaging provision. An option would be to allow couples to combine or transfer their threshold amounts, given that the Canadian tax system already offers various channels by which spouses are readily able to split their capital gains and investment incomes. Next considered is a threshold linked to the filer’s income; i.e., only capital gains (and possibly dividends) on the portion of income above that threshold would be subjected to the higher tax inclusion rate. This approach is analogous to the surtax format of the US NIIT. A third approach would be an inflation-indexed threshold based on lifetime cumulative gains. Even with a very high threshold, top recipients of capital gains would quickly exceed it and be subjected to the increased inclusion rate on all subsequent TCGs received.
A viable package of reforms
As much as the design and choice of good tax policy should satisfy the criteria of good economics, it is equally vital that it meet the requisites of public acceptance and sound politics. Using a relatively high threshold for the application of an increased tax inclusion rate — thus insulating the great majority of gains recipients from its impact — only modestly reduces the revenue yield while focusing the change on taxpayers perceived as not “paying their fair share.” Combined with carryover provisions and the various mitigating provisions, the pathway proposed here should satisfy the needs of broad public acceptance. In fact, Canada’s AMT was originally motivated by perceptions (and realities) that some high-income taxpayers were paying relatively little tax through extensive use of tax preferences, including capital gains. The same concern was invoked in the 2022 budget presaging a rework of the AMT. Yet, a complaint against the existing AMT is that it was crafted to create the political optics that all high-earners were paying some minimum amount, without substantively raising the liabilities of very high-earners.
Both federal and provincial governments have increased their top marginal rates for filers with high incomes but have done comparatively little to tighten up the tax base. Further increases in already high top marginal tax rates — above 50 per cent for most of the country — will be limited in their ability to extract more revenue from high-earners who extensively rely on capital gains, dividends and strategies that often rely on capital gains. With such a porous tax base, raising tax rates on high-earners will mainly stimulate greater efforts and resources in tax avoidance. For nearly a decade commencing in 1990, the inclusion rate for capital gains was raised to 75 per cent, without creating discernable adverse impacts on economic performance. Any assessment of the Finance Department proposals for AMT reform will need to await their release. Only then will we be able to determine whether it is merely polishing up the optics or making a serious attempt to reduce high rates of top-tail income inequality. That will enable us to assess whether proposals of the kinds sketched in this report (summarized below) would constitute a superior pathway.
|Increase the tax inclusion rate for capital gains when above a specified threshold such as:|
|Gains-linked threshold (annual or multi-year)|
|Income-linked threshold (annual or multi-year)|
|Lifetime indexed cumulative gains threshold|
|Alternatively, increase the effective tax rate on capital gains for higher incomes via|
|Reform of the alternative minimum tax (AMT)|
|Introduce a surtax for capital gains like the U.S. Net Investment Income Tax (NIIT)|
|Limit the tax credit for eligible dividends (or achieve via threshold scheme, AMT or NIIT)|
|Limit and simplify investment expense deductibility|
|Phase out unlimited principal residence exemption (PRE)|
|Reduce charitable tax credit rate for top-bracket filers|
|Tighten laws to limit tax avoidance of capital gains via CCPCs|
|Restore income averaging (depends in part on gains carryover provisions)|
|Broaden scope for like-kind exchanges but limit rollovers to half of the gain|
|Provide carve-outs for gains on venture capital, startups and employee stock options|
|Introduce limited rollover for gains and RRIF/LIF/TFSA of single senior decedent estates|
|Temper PRE phase-out via cost rebasing, limited exemption, and/or gains rollover|