REAL ECONOMY BLOG | August 26, 2024

For nearly a quarter century, Canada’s capital gains tax rate has remained largely the same, at 50 per cent. But that changed this year when the federal government, in its current budget, called for the new inclusion rate to be set at 66.7 per cent.

While the move might help the government boost revenue, it could delay the economic recovery that Canada needs by temporarily discouraging investment.

The reason for the tax increase is simple: The government needs the money. It is facing a $40 billion deficit for the current fiscal year.

The tax applies to all sales of capital property by corporations and most trusts, and to capital gains for individual taxpayers, Graduated Rate Estates and Qualified Disability Trusts that exceed an annual threshold of $250,000. The tax went into effect on June 25 but the effective date and final legislative language are subject to change pending completion of the legislative process.

In the end, the rate increase has renewed the debate over the capital gains tax and its role in promoting economic growth and raising revenue for the government.

Opponents of the tax say that two years of elevated interest rates have dampened the appetite for investment and slowed the economy, making the capital gains tax increase and its drag on growth ill-timed. But those in favour of the increase note the growing government budget deficit and the need for more revenue.

Economic impact

One intent of the legislation was to boost revenue by encouraging businesses and individuals to sell their assets and realize their capital gains between April and June 10 under the lower tax rate rather than continuing to wait. Under the provision, the government hoped to generate several billions of extra tax dollars to help reduce the deficit.

Over the longer term, the government hopes to raise revenue through the higher tax rate. The government said the higher rate would increase revenue by $19.4 billion over five years, as well as improve tax fairness by targeting large businesses and the wealthiest individuals.

After all, government spending has grown as the economy has cooled.

Expansions of social services, such as subsidies to move toward $10-a-day child care or increased health care funding, are critical for the functioning of society and the economy. But these programs cost money, and inflation has increased costs across the economy, from infrastructure to wages.

Then, there is the toll of restrictive interest rates. Businesses and households have felt the squeeze of higher costs in the form of higher interest payments on commercial loans or mortgages, and so has the government, which is facing higher interest payments on its debts under elevated interest rates.

In adopting the plan, the government is taking the view that the increase in the capital gains inclusion rate is unlikely to significantly hurt productivity, which has already been lagging, and investments.

Historical data supports this view: During the 1990s, the capital gains inclusion rate was 75 per cent, yet innovation and investments flourished and were higher than they were after the year 2000 with the lower inclusion rate of 50 per cent.

Investment decisions by businesses are influenced by tax rates, interest rates, expected growth, the regulatory environment and economic stability. While taxes are a consideration, they are just one piece of the puzzle.

However, the Canadian economy is in a crunch in the short term. The economy has had little growth this year as restrictive monetary policy restrained spending and investment.

Increased investments are necessary for economic recovery, and a rate-easing cycle could facilitate this. Yet the increased inclusion rate of the capital gains tax might deter some businesses from investing in the near term.

It’s also unclear whether the additional $20 billion in tax revenue will be realized. Businesses and investors might move their investments offshore to avoid higher taxes, undermining the revenue-raising goal. While improving fairness by taxing the wealthiest individuals is a goal, those individuals often have the most means to shift their investments offshore.

An alternative

A potentially more effective approach to improving fairness and raising revenue would be to target offshore tax avoidance. The Canada Revenue Agency estimates that the government could lose billions annually because of offshore investing. Focusing on closing these loopholes could provide a more stable and fair revenue increase.

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