In Defence of the Capital Gains Inclusion Rate

Since 1972, Canada has imposed a capital gains tax. As defined by the Canada Revenue Agency (2022), “You have a capital gain when you sell, or are considered to have sold, a capital property for more than the total of its adjusted cost base and the outlays and expenses incurred to sell the property.”

In other words, it is a tax on any proceeds earned from selling an investment. Most countries impose a tax of this sort; however, what makes Canada’s capital gains tax different from most is that only 50% of a capital gain is taxable at the normal marginal income tax rates. The impact of this inclusion rate on an individual’s tax burden is illustrated below in Example 1.

When the capital gains tax was first imposed in 1972, the exemption rate was 50%. It later rose to 66.6666%, then to 75%, and in 2001 was decreased back to its original rate of 50% (Canada Revenue Agency, 2023). Since then, this 50% inclusion rate has held steady – although not without considerable speculation from the media and tax planning community of a looming increase. This speculation is mostly due to the government’s need to fund new spending and the Liberal & New Democratic Party (NDP)’s “supply-and-confidence agreement” (Barton et al., 2022). As part of this ongoing agreement, the NDP has committed to supporting the Liberal’s minority government in return for the Liberals implementing some of the NDP’s desired policies and social programs (Barton et al., 2022). The NDP have long pushed for increasing the capital gains inclusion rate to 75%, arguing that it is a tax loophole (NDP, 2019).

The illusion of being a “high-income earner”

Unlike in some countries, the tax rates in Canada do not change based on how long an individual has held an investment for. Because of this, a capital gain that is realized may cause the illusion that an individual is a high-income earner, since they would be pushed into a higher income tax bracket for the year in which they realized a capital gain. Despite the return on investment likely compounding over a longer time horizon, the Canada Revenue Agency taxes capital gains as if the entirety of the gain was only earned in the year of sale. Now, I am not advocating for unearned income being taxed, as this comes with its own set of problems which I discussed in my blog post “Wealth Taxes – A promising solution to wealth inequality or a form of expropriation” (Ross, 2023). I am simply trying to illustrate that the government’s current method of not allowing proceeds to be allocated over the duration of the investment’s time horizon has a punitive impact on taxpayers’ after-tax capital gains. Increasing the inclusion rate would make the impact that the illusion of being a high-income earner has on taxpayers even more pronounced. The tax implications of this illusion are illustrated below in Example 2.

The federal government and some provincial governments index income tax brackets each year to account for inflation (Laurin & Robson, 2023). This helps to avoid purchasing power being eroded over time due to taxation, by increasing the minimum amounts needed to qualify for each tax bracket. Because income is taxed in the year it is earned, the impacts of inflation on income earned during the year are minimized. Also, because the capital gains inclusion rate is linked to the income tax brackets, some relief from inflation is also provided – depending on the province of course. However, where this differs is the way in which a capital gain is determined. Unlike income taxes where you may be pushed into a higher bracket (due to indexing and the illusion of being a high-income earner), much of your gain may have already been taxed in one of the top brackets. When this occurs, the benefits of indexing tax brackets are less helpful than they are for ordinary income, such as a salary. The longer the investment was held for, the more that an individual’s capital gain is negatively impacted by inflation. For provinces that do not index brackets at all or only index certain brackets, this impact is even more profound.

A capital gains tax is an instance of double taxation

Although a capital gains tax is not a conventional example of double taxation (since the same income source is not directly being taxed twice), the amount of tax on the original stream of income (ordinary income) used to invest can greatly impact the size of an individual’s eventual capital gain. This is because the investment principal that an individual starts with to earn the capital gain is decreased, since income tax had to be paid first on the money used to invest. Increasing the capital gains inclusion rate amplifies the impact that double taxation has on capital gains.

Canada’s capital gains tax rate is not actually that low

The capital gains tax rates that countries impose vary widely. Some impose no capital gains tax at all, while others tax capital gains closer to, or at the same rates that they tax ordinary income. When compared to other OECD countries, Canada’s top marginal capital gains tax rates are somewhat higher than the average of 19.19% in 2021 – the most recent data compilation available (Asen & Bunn, 2021). Using EY (2023)’s tax calculator I have constructed the graph “Top Capital Gains Tax Rates” below, which displays the top tax rates on capital gains for all provinces and territories at different inclusion rates.

Top Capital Gains Tax Rates

As we can see from the “50% Inclusion Rate” column, Canada’s current top marginal tax rates on capital gains are between 22.25% – 27.40% depending on the province or territory. Although these rates are above the OECD average, they are not necessarily high given the large variance in rates among countries. Using the top capital gains tax rate of Canada’s most populous province, Ontario, Canada places 13^th out of 37 OECD countries. However, if the inclusion rate were to increase to 66.6666%, Canada would place 3^rd out of the 37 countries for highest tax burden. Additionally, if the inclusion rate were to increase even further to 75%, Canada would place 2^nd out of 37 countries, only behind Denmark for the highest top capital gains tax rate (Bloomberg Tax & PWC, 2021, as cited in Asen & Bunn, 2021). In other words, increasing the inclusion rate to either 66.6666% or 75% would mean that Canada would become considerably less competitive on an after-tax basis, with regards to investment attraction.

Increasing the capital gains inclusion rate would not impact only wealthy Canadians

One of the most common points that is mentioned when reading arguments in favour of increasing the capital gains inclusion rate is that it is primarily utilized by richer Canadians. What I believe is also important to point out, however, is that if the capital gains inclusion rate were increased, many Canadians who are not wealthy would also see their tax burden rise. In fact, any Canadian who realizes a capital gain outside of a Registered Investment account such as a TFSA or RRSP would face a higher tax burden, regardless of if they are a high-income earner or not. Yes, an individual would pay a lower effective tax rate if they earned less because of the marginal income tax brackets, but they would still have to pay more tax than when the capital gains inclusion rate was lower. The contribution limits of many of the Registered Investment accounts can be relatively low and exclude many types of investments (such as private business ownership and real estate investments), meaning that many Canadians’ capital gains would not be tax exempt (Government of Canada, 2023).

Because of this, I believe that an increase to the capital gains inclusion rate would have an outsized impact on Canadian entrepreneurs and business owners, as many of them rely on proceeds from selling their business to help fund their retirement. Increasing the capital gains inclusion rate could leave them with less money than they planned on retiring with, or simply delay their retirement until the value of their business or investments grow further, to account for the increased tax burden. This decrease in after-tax proceeds is illustrated below in Example 3.

Increasing the inclusion rate may yield less revenue that expected and hurt investment in Canada

Although taxation is not the sole factor to consider when making an investment, it is certainly a consideration that is important to many investors, given that the main objective of investing is to grow your wealth. If an increase were to occur, it would be reasonable to assume that some investors may choose to relocate and invest in jurisdictions outside of Canada that provide greater after-tax investment returns. With that being said, the degree of capital flight that would occur specifically due to a capital gains inclusion increase is challenging to determine given the microeconomic nature of an individual making decisions to relocate and/or invest elsewhere (hence the italicisation of the words some and may).

What has been observed specific to capital gains tax increases, however, is that taxpayers may decide to change the timing of when they realize their capital gains. Prior to an increase in the inclusion rate (potentially the period we are in now), some may choose to sell their investment now while it will still be taxed at a lower rate. This avoids the risk of paying higher taxes that waiting until later to sell poses (Bouw, 2017). After an increase in the inclusion rate occurs, some may choose to hold onto their investment since the tax implications of selling become even greater than before. Additionally, those who anticipate the inclusion rate eventually returning to its lower level may choose to let their investment continue to compound until the inclusion rate decreases. This deferral of sale is described as the “lock-in” effect and may mean that less government tax revenue materializes than expected, due to a decline in the number of taxable capital gains in the years following the inclusion rate increase (Laurin, 2021).

Given the impact that an increase in the capital gains inclusion rate would have on taxpayers of all income levels in return for a potentially lackluster or marginal increase in government revenues, increasing the inclusion rate may not be the best means of raising government revenue.

Increasing the inclusion rate to previous levels does not mean it would achieve previous tax burdens

Given the fluctuations in marginal income taxes rates over the years, the tax burden individuals face on capital gains is not necessarily the same as in previous years – despite the same inclusion rate in effect. Because top marginal income tax rates are at a generational high, an increase in the inclusion rate would increase effective tax rates on capital gains more than an increase in the inclusion rates would have when top income tax rates were lower. For example, if the inclusion rate had been increased from 50% to 75% back in 2014, Alberta’s top marginal tax rate on capital gains would have gone from 19.5% to 29.25% (Deloitte, 2014). However, if the inclusion rate were to be increased from 50% to 75% in 2023, Alberta would go from having a top marginal tax rate on capital gains of 24% to 36% (EY, 2023). This would mean a 9.75% increase in the top capital gains tax rate in 2014 compared to a 12% increase in 2023 – despite the capital gains inclusion rate rising by the same amount.

Conclusion

Increasing Canada’s capital gains inclusion rate above its current rate of 50% risks further eroding many of the benefits that the inclusion rate currently provides – which helps to mitigate the punitive impacts unique of capital gains taxation, such as double taxation, inflation and the illusion of being a high-income earner. Keeping the inclusion rate at its current level will ensure that the capital gains of Canadians from a variety of financial backgrounds are justifiably taxed differently and at considerably lower rates than ordinary income.