Historical Analysis of Capital Gains in Canada

However, in 1972, the country started to tax capital gains just before a period that had one of the highest inflation rates in North America. The genesis of taxing capital gains in Canada was the Carter Commission report of 1971 which led to an introduction of major tax reforms (Berdad, 2017a). The report initially recommended that full taxation of capital gains commences by the start of 1972. The government decreed that only a portion of capital gains would be taxed, not the full amount. Taxpayers were hence required to list each taxable gain in income on their financial returns in the year the gains are realized. The application of that approach proved difficult in practice, prompting the Canadian government to depart from the approach by taking on the principle that capital gains do not arise until realization.

In the process of designing the capital gains tax, Canadian policymakers had to determine whether gains from selling all forms of property would be subjected to taxation and whether they should be fully taxed. Making a determination would require them to settle on whether it would be accomplished by including only a part of the gain (partial inclusion) or reducing the tax rate (Harding, 2013). Table 1 shows the difference between the two options. In the example shown in the table, reducing the tax rate to 45 percent and including full gains yields a maximum tax revenue of $338. The norms, rates, and exceptions that relate to capital gains tax in Canada have changed and evolved over time since they were introduced. The following section elucidates the reasons why the Canadian government enacted capital gains tax in 1972.

Reasons for the Introduction of Capital Gains Tax in Canada There are three primary reasons why the Canadian government introduced the capital gains tax. The government wanted to raise revenue mainly to fund social security, level income distribution in the country by adopting a more equitable taxation system, and avoid the loss of economic efficiency. Raising Revenue The capital gains tax was primarily designed to finance the increasing costs of government spending and the social security system. As such, the concept of horizontal equity ensures that both pay the same amount of tax. Under the concept, Steve’s capital gain should be taxed along with his annual salary. Eschewing the Loss of Economic Efficiency The efficiency rationale posits that those with capital will shift their incentives from income from employment, which is taxed at normal rates, to personal enterprises so that they may enjoy lower tax rates or no taxes at all and increase their capital value.

In drafting the capital gains tax, the Carter Commission identified the ineptitudes caused by having a high personal income tax and no capital gains tax (Hungerford, 2010). Such an investment results in loss of output. It is worth recalling that Canada did not tax capital gains until only 46 years ago. The Carter Commission’s report led to a major overhaul of the Canadian taxation system with the result of capital gains being subject to tax as of New Year’s Day, 1972 (Canadian Broadcasting Corporation, 2000). While the report recommended full inclusion in the taxation of capital gains, the enacted law required taxation of 50 percent. It implied that if one makes $10,000 profit on taxable property, they would be required to pay tax on $5,000 of that gain on top of the marginal tax rate (The Government of Canada, 1980).

The rate stayed constant for 26 years until 1988, when the government increased the inclusion rate sharply to 66. In 1984, the Conservative government exempted entitled each Canadian to a $ 100,000-lifetime exemption from capital gains tax. However, the exemption lasted only a decade before the Liberal government repealed it in 1994 (Hungerford, 2010). Today the exemption only applies to qualified fishers, farmers, or shareholders of QSBCs (qualified small-business-corporations). Shareholders of QSBCs can avoid capital gains tax on up to $835,716 of their shares while qualified farm or fishing property owners can avoid capital gains tax on up to $1,000,000 (Hungerford, 2010). The above cannot be taxed by virtue of deduction in accordance with the Canadian Income Tax Act, Division C. Another possible reason for the favorable tax rates, especially on stocks, is the fact that corporately-earned income is often double-taxed.

If a company chooses to retain its post-tax profits, rather than issue it to shareholders as dividends, it grows its value by the amount of earnings it retains ceteris paribus. The rise in value reflects in the corporation’s share price, implying that shareholder will be subjected to taxation on that gain and the corporate earnings (Berdad, 2017b). As such, favorable rates on capital tax gains try to minimize the impact of this double taxation. It is imperative to note that the issue here is only with corporate retained earnings. Opponents of capital gains taxes propose that the tax has the likelihood to affect the ability of an entrepreneur to attract top-level managers. A start-up cannot offer the emoluments to compete with established firms and often opt to hire managers through equity stakes.

As such, they argue, capital gains tax tends to reduce the managers’ returns, thereby diminishing the ability of start-ups to attract the talent required to facilitate their growth. A lower capital gains tax has the propensity to attract and retain both entrepreneurs and investments (Hungerford, 2010). The Canadian capital gains tax rate is one of the highest among the 34 OECD countries, 11 of which do not tax capital gains. Capital gains are only taxed once they are realized. It implies that the tax is only imposed when one sells their appreciated asset or opts to withdraw their stock investments. Thus, it creates incentives for people and businesses to retain their current investments even in the availability of more profitable opportunities (Grubel, 2000). Economists call this the “lock-in” effect of the capital gains tax.

Capital gains taxes make investors lock capital in sub-optimal investments rather than reallocating it to more productive opportunities. Capital gains are taxed when they are realized. Canada has a progressive tax system and under the system, if one holds stocks or an asset for several years, taxing all its appreciation in one year pushes an individual to a higher tax bracket. If the gains had been realized as the investment appreciated, this would not happen. The second drawback is the inflationary component of the capital gains tax. The component affects the willingness of investors to take risks. (2017a). It’s the worst tax: Other countries are eliminating it and Canada should, too. Financial Post. Retrieved 3rd April 2018 from http://business. financialpost.