By Rhys Kesselman

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Opinion: It’s past time to reform capital gains tax. But how exactly? Back to video

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Fulfilling a campaign pledge, in 2016 the incoming Liberal government hiked the top federal income tax rate to 33 per cent. But because of the porous nature of the tax base — particularly for capital gains — the move yielded less revenue than anticipated. The motivation behind the higher rate was to get high earners to pay their “fair share.” A similar goal is driving the government’s plan to amend the alternative minimum tax in its upcoming budget.

Recent studies confirm that capital gains and dividends are highly concentrated in the top tail of incomes. And they receive very favourable tax treatment: only 50 per cent of realized capital gains are included in taxable incomes, and corporate dividends receive a special tax credit. A study I’ve just published for Finances of the Nation (“Pathways to reform of capital gains taxation in Canada”) confirms that, while nearly one in five tax-filers benefits from capital gains relief over a 10-year period, the total tax benefits are extremely concentrated at very high incomes.

Consider what the exclusion of 50 per cent of capital gains from taxable income means for a high-income filer. The top federal rate of 33 per cent currently applies to taxable incomes above $235,000. With only half of gains included, such people face an effective rate of just 16.5 per cent. That is only modestly higher than the bottom-bracket rate of 15 per cent on wages and salaries faced by filers with taxable incomes below $53,000.

Reform of capital gains tax has been debated for years, and an increase in the inclusion rate has been rumoured in the run-ups to recent budgets. Financial and tax advisors have written about how investors might best prepare for it, while tax policy and economic experts have argued its merits both pro and con.

My study takes a deep dive into the equity and efficiency effects of raising the inclusion rate. In terms of fairness, higher capital gains tax would be the most effective way to make those with the highest incomes bear a larger share — much more productive than further increases in top-bracket marginal rates. And by targeting the increase on taxpayers above a high threshold of incomes or capital gains, most lower-income recipients of gains could be spared.

In terms of efficiency and growth, a large empirical literature shows offsetting results. Many channels for tax avoidance — and the waste of tax planning and real resources it entails — would be curtailed if the payoff to garnering income as a capital gain were reduced. Similarly, the diversion of resources from productive business investment would be reduced if tax-free gains on homes were curbed. On the other hand, the evidence does suggest that business startups, venture capital and other economic drivers might be adversely affected — which is why my study proposes measures that could offset most such impacts. The potential economic impact shouldn’t be overstated, however. In 1990 the inclusion rate was raised to 75 per cent, where it stayed for nearly a decade, and no discernible harm to the general economy was observed.

As for the alternative minimum tax (AMT) Ottawa is proposing to amend, it was introduced in 1986 to ensure that taxpayers who made extensive use of tax shelters, including capital gains relief, paid at least some tax. But from the outset analysts have panned the AMT as less a genuine attempt to curb top-tail incomes than an exercise in political optics. In recent years, it has affected fewer than 50,000 taxpayers, with an average hit of $7,000, and it raises less than one in every 800 dollars of federal personal income taxes. Yet many filers must endure the complex Schedule T691 just to determine they are not liable for AMT.

My study proposes various alternatives to the AMT that would be simpler and collect far more revenue from top-end filers. These all involve a threshold of some kind (annual income, amount of gains, or lifetime cumulative gains). Above that threshold a higher inclusion rate would apply to gains while dividend tax credits would be capped. Given the high year-to-year variability of people’s realized gains, with many filers’ incomes shifting temporarily above the threshold, the schemes I look at would restore income averaging, which was abolished in 1988 when tax rates were flattened and the inclusion rate began rising.

Some advocates of increased capital gains tax would direct the revenues to unrelated uses, but another possibility would be to use part of them to abolish the 33 per cent top-bracket rate or to raise the threshold at which it applies, thus improving productive incentives for many high earners. In any case, policies of the kinds sketched here would be far more effective in addressing top-tail inequalities. Let’s see what AMT reform the upcoming budget offers: real advances toward that goal or just more polishing of the optics?

Rhys Kesselman is professor emeritus at the School of Public Policy, Simon Fraser University.