Challenge for the Upcoming Budget: Capital Gains Tax Reform

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The upcoming federal budget is slated to amend the Alternative Minimum Tax toward the goal of ensuring that the wealthy pay their “fair share.” It will also provide insight into whether the government is pursuing a genuine exercise to restrain top-tail incomes or merely another gambit to polish the political optics. The AMT has long been critiqued as a toothless tiger and designed mainly to assuage the public that the wealthy pay at least some minimum level of tax.The AMT was instituted in 1986 and has done little to address top-tail inequality. In recent years the federal AMT has affected fewer than 50,000 tax filers annually, with an average liability of less than $7,000, and even this sum can be recovered in years when the filer is no longer liable. The AMT was intended as a backup for the ordinary income tax for persons who use tax concessions extensively, but it garners less than one dollar out of every 800 of federal income tax.The extreme concentration of income and wealth in the top tail of the distribution is a matter of concern for most Canadians. A public opinion poll by Abacus Data found that 70% of respondents felt that the wealthy pay less than their fair share of taxes, while only 7% felt the wealthy pay more than their fair share. Ninety-two percent supported closing tax “loopholes” that primarily benefit the wealthy, while just 8% were opposed.This top-tail inequality is the result not only of evolving economic forces but is abetted by explicit provisions of Canada's income tax. Implicated are the concessionary tax treatment for capital gains, corporate dividends, and various aspects of small business corporations. Only 50 per cent of realized capital gains are included in taxable income, dividends receive a special tax credit, and private corporations can be used to defer income, split incomes, and exploit extra capital gains tax relief.Present and previous governments have taken only gingerly steps to address this situation. In 2016 the incoming Liberal administration fulfilled a campaign pledge by hiking the top federal income tax rate from 29% to 33%. However, due to the porous tax base—primarily for capital gains—the change yielded less federal revenue than forecast and was offset by reduced provincial revenue. That initiative was motivated by the goal of getting high earners to pay their “fair share,” and a similar goal is also driving the Liberals' plan to amend the AMT in the upcoming budget.Recent research using longitudinal data confirms that capital gains and dividends are highly concentrated in the top tail of incomes. While nearly one out of five tax filers received some capital gains in one or more years between 2009 and 2018, the majority of them had gains only in one or occasional years and in smaller amounts. The largest tax benefits of the preferences for gains and dividends are captured overwhelmingly by the top tail of earners.Consider what the 50% of capital gains excluded from taxable income means for a high-income filer. The federal top bracket rate of 33% now applies to filers with incomes from $235,000 up to millions, so with half inclusion their gains face an effective rate of just 16.5%. That is only 1.5 percentage points higher than the bottom-bracket rate of 15% faced by taxable filers with incomes below $53,000 on all their wages and salaries.Reform of the tax treatment of capital gains has been debated over many years, and an increase in the capital gains inclusion rate has been rumoured in the runups to recent budgets. Financial and tax advisors have even opined on how investors might best prepare for such a change to minimize the cost. Tax policy and economic experts have debated both sides of the issue: whether Canada's taxation of capital gains should be reduced or increased.A warning commonly cited by opponents of higher tax on capital gains is the risk that it will adversely affect the economy's efficiency and growth. I have undertaken a study with analysis of extensive research on this topic and find evidence for both positive and negative economic impacts, with no definitive finding for the net impact. But it is telling that for a decade commencing in 1990 the gains inclusion rate was raised to 75% with no discernable adverse effects on the general economy.One example of a positive effect would be reduced effort and resources devoted to tax avoidance, with benefits to economic efficiency and savings in reduced distortions. I also find potential adverse economic effects, such as in the areas of business startups and venture capital. Drawing in part on American tax experience, I propose a set of companion reforms that could address and mitigate any such negative effects.Past advocacy for increased taxation of capital gains has failed to consider the various mitigating measures to address the potential economic impacts. But equally problematic is advocates' common stance that the gains inclusion rate be increased across-the-board, thus affecting the one-fifth of filers who declare any gains regardless of frequency or magnitude over a ten-year span. That ignores the prerequisites of political acceptance and public support for a major tax reform such as one affecting capital gains.My study proposes various alternatives to the AMT that would collect far more revenues from top-tail filers. All these schemes involve a threshold of some kind—be it based on annual income, amount of gains, or lifetime cumulative gains. Above the threshold a higher inclusion rate such as 75% would apply to gains and dividend tax credits would be capped. The great majority of taxpayers receiving gains and dividends would be insulated from this surtax, and it would be far simpler and more transparent than reforming the AMT.Given the high degree of public support for increased taxation on the top tail and the ability to fashion a reform that is both economically and politically viable, it is time for action beyond rate increases on a porous tax base or fiddling with the AMT. Taxing capital gains more highly for those who garner the great bulk of them would be far more effective in curbing top-tail incomes.Jonathan Rhys Kesselman is a professor emeritus at Simon Fraser University's School of Public Policy, where he held the Canada Research Chair in Public Finance. He has a Ph.D. in economics from MIT. His study is published at Finances of the Nation; see the executive summary and full report