As we get closer to the federal budget date each year, people start speculating about a possible increase in the capital gains inclusion rate. Currently, individuals only pay tax on 50 per cent of their capital gains, leaving the other 50 per cent tax-free. There are legitimate policy reasons for not taxing 100 per cent of capital gains (e.g., inflation, risk), but the intention of this article is not to debate the policy behind full or partial taxation on capital gains.
Instead, let’s focus on the issue at hand: the need for increased government revenue to finance continued expansion of government expenditures. If the government wishes to implement some of its campaign promises, increased taxes will become a necessity. Without increased tax revenue, the government will need to increase its deficit financing even further than it already has. Given the Liberals’ promise to gradually reduce the debt-to-GDP ratio, they have to be mindful of the deficit each year.
That brings us back to our 50 per cent inclusion rate on capital gains. Throughout the ’90s, the inclusion rate was 75 per cent. The Carter Commission – which brought about major tax reform in 1971 – actually recommended a 100 per cent inclusion rate on capital gains. Given these precedents for a higher inclusion rate on capital gains, why hasn’t the government simply increased it? That is the million-dollar question or, one might say, the multi-billion-dollar question.
In 2015, Canadian taxpayers reported approximately $27 billion in taxable capital gains, which means there was approximately $27 billion of untaxed capital gains. If the government increased the capital gains inclusion rate by 25 per cent, bringing the taxable portion of capital gains to 75 per cent, this would result in approximately $14 billion of additional taxable capital gains, generating an estimated $6 billion of additional government revenue.
An increase in the capital gains inclusion rate seems like a forgone conclusion, especially since the NDP included this tax measure in its 2019 election platform. Also, looking at 2015 personal tax data, 52 per cent of the total capital gains was reported by individuals with taxable income above $250,000. As a result, 62 per cent of the estimated $6 billion of additional government revenue would be financed by those individuals with taxable income in excess of $250,000, which is consistent with the Liberals’ campaign promise to ask the wealthiest Canadians to pay a little bit more.
However, before we concede that the capital gains inclusion rate will automatically be increased this coming federal budget, we need to consider another factor that could influence this decision. The Liberals are focused on “the middle class and those working hard to join it.” The “middle class” has yet to be defined by the Liberals, so it is difficult to measure how it would be affected by a change in the capital gains inclusion rate. Using 2015 personal tax data, 95 per cent of all Canadian taxpayers reporting capital gains had taxable income below $250,000. This means any change in the capital gains inclusion rate will affect a significant majority of the voting population.
Here lies the dilemma. An increase in the capital gains inclusion rate will generate a significant amount of revenue for the government, with the wealthiest Canadians financing 62 per cent of the resulting tax bill. However, this increase will affect approximately 95 per cent of all voting Canadians, with the remaining 38 per cent of the tax bill being split by those who are not among the wealthiest Canadians. As a result, those individuals in the middle class, whoever that middle class is, may also experience some degree of frustration.
With all that in mind, what will the government do? If only we had a crystal ball. Over the past four years, the government has implemented a number of tax measures that were income-tested, allowing targeted benefits to the exclusion of the wealthiest Canadians. The government could implement a two-tiered capital gains inclusion system based on income. For example, there could be a 50 per cent inclusion rate for taxable income below $250,000 and a 75 per cent inclusion rate for taxable income of $250,000 and above, as this would allow the government to target the increased revenue at the wealthiest Canadians.
Alternately, the government could go a completely different route and mirror the United States tax system, varying the tax rate based on length of time holding the property, an approach that distinguishes between business income and capital gains. Of course, the government could do nothing with the capital gains inclusion rate and focus entirely on other revenue-generating tax measures like a luxury tax, a vacant residential property tax or a digital tax.
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