A fairer capital gains tax

For the most part. our tax system does not arouse great passions amongst Canadians. We generally accept that there should be personal income taxes and consumption taxes and corporation taxes, and we argue dutifully about what the rates, brackets, and exemptions should be, but on the whole, there is a rough consensus on the structure and only modest divergence across the mainstream political spectrum as to the rates. The range of divergence is modest compared to other nations because every caricature has a grain of truth in it, and the old joke about “Why did the Canadian chicken cross the road?” (Answer: to get to the middle) does contain a nugget of truth about the general absence of extremes in most Canadian debate, including debate on tax policy.

However, there is one tax in Canada where the rule we currently live with was a saw-off between two widely held but quite incompatible extreme views. And that tax is the tax on capital gains.

One school held to the view that capital gains was just a form of business income earned by fat cats, and ought to be taxed like the ordinary income of the common folk.

The other school held to the view that most capital gains were earned by the middle class, which was just trying to avoid losing ground to inflation by investing some earnings they had already paid income tax on and were saving for their old age, and that it ought not to be taxed at all.

The odd compromise between the extremes which resulted left us with a complex system in which most capital gains are taxed as if half of the gain was income. But a number of hot button items were exempted. Gains on a principal residence are untaxed. To tax that would be a fatal political mistake that no government is likely to make. You can just imagine legions of homeowners shouting, “But it’s the same house it always was! I already paid for it! Why should I pay the government more to be allowed to move?” 

Other exemptions were settled on for ease of administration, so, for example, no capital gains tax is charged on items disposed of for less than $1,000.

And charities were given a nod, so that no capital gains are charged upon securities or some designated cultural property gifted to charities.

To be fair, the two extreme camps I mentioned above each have a point. There are almost two separate paradigms of capital gains. Some capital gains are, indeed, made by high flyers who look for big gains, take a few chances with money they can afford to risk, and can end up with gains far exceeding inflation. But most capital gains are made by the middle class just trying to have their later-in-life nest egg keep pace with inflation, and they tend to invest very conservatively, and are often happy just not to lose ground to inflation.

This latter group would argue that if instead they had put their money into (say) a supply of long-lived canned food, no-one would charge them tax when they later opened a can just because the price of that item had gone up in the stores over the years. The same would be true of pre-purchasing a lifetime supply of socks or firewood. So why, they ask, should they be taxed on protecting their saved wages from inflation? Yes, RRSP’s are a partial answer, but even those who have taken full advantage of RRSP room would have great difficulty living on just the RRIF that those RRSP’s would eventually be converted to.

The inclusion rate of 50% of capital gain as taxable income is not wildly unfair, and it has been argued that, being less than 100%, it partially addresses the “saving for retirement” argument. But there is one big elephant in the room. The capital gains tax as currently structured is a harmful tax in another way. It damages the national economy because of the “locked-in” effect.

Economists engage in plenty of esoteric debates (insert your favourite economist joke here). But we would still do well to look at some of their more interesting concepts from time to time. One relates to the idea of the efficiency of investment. What on earth is the efficiency of investment? It is the idea that capital does best for the economy when it is free to move from less productive investments to more productive ones. The notion is that each dollar invested in a productive concern is a more efficient booster of economic activity than a dollar invested in a company that is somewhat stagnating.

But the capital gains tax is a huge disincentive for middle class investors to sell a less productive investment in order to redeploy the money into a more productive one. And that is because the tax is only triggered by disposing of an investment. So imagine someone who has had a long-term investment that has just barely kept pace with inflation. If they sell it, even though it has not performed especially well, they will still pay capital gains tax, which will reduce their net gain to much less than inflation. If it has been a long-held asset, the tax may be quite substantial. They will then have a much smaller pool to reinvest, after adjusting for inflation, than they started with. No surprise, then, that many will hold on to a poorly performing investment that is still making some modest gains, rather than moving their dollars to something expected to do better going forward. This is the “locked-in effect”.

The locked in effect is frequently cited by some economists as an argument against any capital gains taxes whatsoever. Such relatively conservative voices justify their stance by pointing out that the capital gains tax is not a major source of revenue for the Government of Canada. Only about 2.3% of all income tax collected is capital gains tax. And only about 1.1% of all federal government revenue comes from the taxation of capital gains.

But given the costs of the social safety net during the pandemic, no federal government will be keen on abandoning a non-trivial income source. And abandoning a capital gains tax entirely could be seen as pandering to the so-called fat cats. It might also draw too much capital out of the lending market.

But I would suggest that there is a way to minimize the locked-in effect while preserving the revenue stream for government and the integrity of the tax system. It is simple, it relies on data already available, and has an inherent logic that makes sense to both factions of the capital gains tax debate.

So what are those data already available? Well, first there are the facts already known about any individual capital gain, which are essentially the answers to four simple questions: when did you buy it, how much did it cost you, when did you sell it, and how much did you get for it? And one other fact is needed, which is the official Government of Canada inflation number for the period you held the asset. This is a well-known parameter, currently used to index tax brackets and CPP pensions, among other things.

My simple proposal, therefore, is as follows: for every capital gain on a non-exempt asset, the portion of that gain equal to the official inflation during the period the asset was held would be exempt from tax. And all gain above the inflation component would be taxed as ordinary income.

This paradigm should satisfy everyone. The cautious middle-class investors making conservative investments to protect assets for their retirement and whose gains only keep pace with inflation would pay no tax on their gains, and the high flyers who did much better than inflation would pay the full tax rate on the portion of their gains that exceeded inflation. Psychologically it satisfies too, because the investor who did much better than inflation probably feels flush enough to bear the taxes.

But it also resolves the greatest part of the “locked-in effect”, as most investments that an economist would class as “inefficient” likely have not done better than inflation. The investor who wishes to dispose of those investments to invest in something more “efficient” would pay no tax to make the transfer. So there would be no impediment to seeking a more efficient use of the capital.

Furthermore, rudimentary modelling of this approach suggests that initially it does not reduce the amount of capital gains tax collected. Exempting the basic inflationary gain and taxing the additional gain as regular income should produce at least as much tax revenue from capital gains as the current one-size-fits-all inclusion rate that decrees than half of all capital gain is taxed as income. Some simulations suggest it would actually yield more revenue than at present, which, if true, could open the door to an inclusion rate somewhere between 50% and 100% for the gains above inflation, while remaining revenue neutral. But it apportions the tax more fairly, virtually eliminates the locked-in effect, and thereby stimulates the economy.

Such a modified capital gains tax is also amenable to the same kind of aggregating of realized gains and losses that is currently used to simplify tax returns. Under the existing system, all realized gains are added together, from which the taxpayer then subtracts all realized capital losses for the year. It is the aggregated resulting net gain that is currently subject to the 50% inclusion rate.

Under my proposed new system, all realized gains above the amounts exempted by the inflation calculation could be aggregated, and then reduced by any aggregated outright capital losses. The net remainder would be taxed as regular income (or at whatever new inclusion rate is decided upon).

There is, however, one related idea that is clearly “a bridge too far”.  A colleague asked me whether I would advocate that, to be consistent, any realized gain less than inflation should create a deductible “virtual loss”, being the difference between that paltry gain and the one which would have countered inflation. I would be strongly opposed to allowing such a deduction, as it would be tantamount to having the government guarantee return rates on private investments. That would seem to be profoundly unwise both politically and economically, and would work against efficiency in capital deployment.

But the simple device of exempting inflationary gain and taxing the gain above that as income also has the further advantage of relieving government of the constant pressure to invent new minor measures to protect savings. The rather limited Tax Free Savings Account (TFSA) springs to mind as a classic example of a minimalist band-aid solution that pays lip service to the problem without solving it.

And lastly, the overarching political and social benefit of my plan is that it fixes the one part of the system about which Canadians are really not “middle of the road”, but are divided by a wide gulf, with each camp obdurate and unimpressed by the soulless compromise of the current rule. As we have seen in our neighbour to the south, a too great political divergence can lead to dangerous polarization where each side is utterly tone deaf to the other. The rule change which I propose would give each camp a component of the system that accurately reflects their social and economic outlooks. One size fits all doesn’t work for shoes. It doesn’t work for investments. And it doesn’t work for taxation of both gradual (inflation-like) and rapid capital gains. 

Photo: AndreyPopov, istock