Nearly every day, I’m asked to speculate about whether the capital gains inclusion rate, currently set at 50 per cent, could be increased to 75 per cent (or some other amount) in the next federal budget to help the government pay for its massive COVID-19 relief spending. While I’ve tackled this question numerous times in this space, including suggesting some strategies that could be implemented if one fears an imminent increase in the inclusion rate, new research out this week from the Fraser Institute suggests that not only could such a tax hike be “economically damaging,” it would be felt by a broader swath of the population than previously believed.
Who pays capital gains tax?
Most observers (including this one) have posited that it’s largely the rich who earn capital gains and that hiking the tax on those gains would seem well within the fiscal playbook of a government that already seems intent on taxing the highest-income earners with confiscatory marginal rates of more than 50 per cent in much of Canada.
Not so fast, caution Alex Whalen and Jason Clemens, authors of the new report entitled Correcting Common Misunderstandings about Capital Gains Taxes. As Whalen explains, “Despite what many Canadians believe, most capitals gains taxes are paid by ordinary Canadians and not the super wealthy, and raising this tax, would weaken Canada’s economic recovery.”
At first glance, the raw data seems to suggest otherwise, and that it’s high-income earners who pay the majority of capital gains tax. Indeed, the latest Canada Revenue Agency income tax statistics (for the 2017 tax year) show that only about 3 million of the 28.5 million personal tax returns filed that year reported any taxable capital gains. And of the $37 billion in aggregate taxable capital gains reported, over three-quarters of the gains (almost $30 billion) were earned by the 10 per cent of taxpayers with income over $100,000 (roughly 760,000 filers), while 55 per cent ($20 billion) of the total gains were realized by the one per cent of taxpayers with income over $250,000 (about 160,000 filers).
But the new Fraser Institute report says the problem with this type of analysis is that the capital gains themselves are included in the measurement of income, which inflates the income of the very people reporting capital gains. According to the report, for some Canadians, capital gains taxes are incurred irregularly, or perhaps even just once. For example, consider a small business owner who sells her business as she prepares for retirement. She would report a one-time, large capital gain in the year of sale. But is she otherwise rich?
A similar conclusion was reached by C.D. Howe’s director of research, Alexandre Laurin, in a 2017 memo which found that while top income-earners do enjoy a relatively larger share of investment income and capital gains, a proper comparison shows that capital gains are “clearly much less concentrated at the top than is widely assumed.” Laurin agrees with the need to correct for capital gains when doing a distributional analysis, since “capital gains are lumpy, more than they are a regular stream of income.”
Rather than look at the CRA income statistics, the Fraser Institute authors turned to Statistics Canada’s Social Policy Simulation Database and Model (“SPSD/M”), a micro-analysis system that includes detailed information drawn from a number of specialized databases for more than one million Canadians in over 300,000 households. It includes approximately 600 variables for each individual including earnings, taxes paid, transfers received from government and demographic characteristics.
According to their SPSD/M modelling, the share of capital gains taxes paid by those earning more than $150,000 per year (in 2020) falls from 77.4 per cent when the capital gain is included in income to 48 per cent when it is excluded. In other words, those earning less than $150,000 a year pay a larger portion of capital gains taxes than many believe. In addition, the share of capital gains taxes increases from 12.8 per cent for those earning less than $100,000 when the capital gain is included in income to 38.4 per cent when it is excluded.
What is still unclear from this research, however, is whether by excluding capital gains from income, we are excluding individuals whose primary source of income annually is significant capital gains, who arguably are the so-called “rich,” as opposed to the small business owner (or real estate owner) who sold their business (property) and reported a one-time, significant capital gain that moved them into a higher tax bracket for that single year alone.
Canada vs. the world
The Fraser Institute report also compared Canada’s capital gains tax rate to that of other countries and found that Canada’s top capital gains tax rate (27 per cent) is currently above the average for countries in the Organization of Economic Co-operation and Development (OECD), and substantially above the rate in Britain (20 per cent) and the United States (20 per cent).
That being said, with the inauguration of U.S. President Joe Biden this week, and Democratic control of both the House and Senate now established, it’s quite possible that Biden’s pre-election platform to effectively increase the tax on capital gains by treating them as ordinary income for taxpayers earning more than US$1 million could actually be passed. Combined with his plan to raise the top rate on ordinary income back up to 39.6 per cent (from 37 per cent), it would nearly double the current long-term capital gains tax rate.
As for Canada, “raising the capital gains tax rate would weaken Canada’s ability to attract investment and adversely affect our economic recovery,” concluded Clemens. “Canadians across the income spectrum — and the economy as a whole — would benefit from a lower, not higher, capital gains tax rate.”