The days of tax-free capital gains are long gone.
But how much tax, if any, should we pay on capital gains?
This question has received renewed attention recently in light of the discussions south of the border regarding whether taxes should be raised on the wealthiest 1%, who generate a significant portion of their annual earnings through tax-preferred capital gains.
In the United States, long-term capital gains (i.e. gains on property held more than one year) are currently taxed at a flat rate of 15% (as are dividends) versus the top U.S. federal tax rate of 35% payable on ordinary income. U.S. President Barack Obama's proposed Buffett Rule would impose a 30% tax on anyone earning more than US$1-million annually, no matter what the source of that income is, including long-term capital gains.
You'll also recall the fury that erupted over the release of likely Republican presidential nominee Mitt Romney's tax returns this year. His 2010 return showed an effective federal tax rate of only 13.9% on gross income of US$21.6-million, attributed largely to the fact that he earned more than half of this income in the form of dividends and carried interest (his share of profits from his private equity interests, which are taxed under U.S. law as long term capital gains), both taxed at 15%.
Canada's rate on capital gains varies based on your marginal tax bracket, but is 50% of your ordinary income rate. For high-income Canadians who earn more than $132,406 in 2012, the top federal tax rate on capital gains, whether the property is held for a day or a decade, is 14.5%, just slightly below the general long-term U.S. federal capital gains rate. State or provincial taxes vary widely, but typically increase the total combined capital gains tax rate for top income earners to 20% or slightly higher.
Recall that Canada didn't use to tax capital gains at all. The genesis of our capital gains tax began with the Carter commission report, which led to major tax reform in 1971 that meant capital gains became taxable as of Jan. 1, 1972.
While the Carter commission recommended full taxation of capital gains, the law, as originally introduced, only taxed 50% of capital gains. The inclusion rate was increased to 75% in 1990 and that inclusion rate stayed constant for about a decade. In February 2000, the rate was reduced down to two thirds, which lasted until October 2000, when it was dropped back to 50%, where it has remained to this day.
Some capital gains are still entirely tax-free. Consider the principal residence exemption, introduced as part of tax reform, which exempts the full gain on your residence from tax. Similarly, in 2006, the government introduced a permanent exemption from capital gains tax for donations of appreciated securities to a registered charity.
The other category of tax-free gains is in the form of the lifetime capital gains exemption. While each Canadian used to be entitled to a $100,000 lifetime exemption from capital gains tax, this general exemption, introduced by the Conservatives in 1984 lasted for only 10 years, until being repealed by the Liberals in 1994.
Today, the lifetime capital gains exemption is only available to farmers, fishers or shareholders of qualified small business corporations who can avoid tax on up to $750,000 of capital gain on the sale or disposition of these properties.
So, why the favourable rate for capital gains?
While it's widely believed that the primary reason for taxing capital gains at favourable rates is to encourage individuals to take risks with their accumulated capital, thereby growing the economy in the process through job creation and a lower cost of capital, there may be far more fundamental reasons for having a preferred rate.
Consider inflation. Theoretically, the inflation component associated with a growth in an asset's value shouldn't be taxed since it doesn't truly represent an economic increase in the owner's real wealth. For example, say you buy stock that pays no dividends but is expected to grow in value by 5%. Given our 10-year average inflation rate of 2%, the real yield, pretax, is 3%. But our capital gains system taxes the entire 5% gain, not just the real gain of 3%, so effectively, you end up paying tax on the inflation component of the stock's appreciation.
Of course the same inflation argument can be made to justify a lower rate of taxation on interest income. Prior to 1988, Canada used to exempt the first $1,000 of annual Canadian interest income from tax. Lower-income Canadians, who tend to have more of their investments in fixed income than equities, were unduly penalized by the repeal of this deduction and continue to face full taxation of interest income, with no inflationary adjustment.
Another reason to favour a lower tax rate for capital gains, particularly on common shares, has to do with the double taxation inherent with corporately earned income. While this problem is generally solved for corporate income that is taxed inside the corporation and subsequently paid out as a dividend by way of the gross-up and dividend tax credit mechanism, it's more of an issue with corporate retained earnings.
A company that chooses to retain, rather than distribute its after-tax corporate profits to shareholders in the form of a dividend will, all things being equal, grow the value of the company by the amount of retained earnings. This increase in value would be reflected in the share price, meaning that a shareholder who faced full taxation on that gain, would essentially be paying tax a second time on the same corporate earnings. Taxing such gains at 50% attempts to mitigate this double taxation.
At the end of the day, it's clear that the capital gains tax, just like any other tax on investment income, is essentially a double tax on savings, such that the choice to defer consumption to a later period in one's life is subject to tax in a way that current consumption is not. Strategic saving through an RRSP or TFSA can avoid this double tax problem altogether.