Capital gains tax increase will bring in less revenue than expected

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The federal government will collect far less revenue from the proposed increase to the capital gains inclusion rate than it originally predicted, according to a new report released by the C.D. Howe Institute on Thursday.

The report, titled Uncertain Returns: The Impact of the Capital Gains Hike on Ottawa’s Personal Income Tax Revenue by C.D. Howe staffers Alexandre Laurin and Nicholas Dahir, estimates the government will collect $5.5 billion less in personal income tax than it originally estimated, owing to a variety of factors, including the cyclical nature of capital gains realizations, and the adjustments corporations and individuals may make in response to the tax change.

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As a refresher, this year’s federal budget announced a hike in the capital gains inclusion rate to 67 per cent, up from 50 per cent, for individuals with gains over $250,000 in the year. Corporations and most trusts are subject to the higher 67 per cent inclusion rate from the first dollar of gains. The new 67 per cent inclusion rate is effective as of June 25, although the legislation to implement the change has not yet been passed.

In the budget document, the government predicted that this tax measure would bring in a total of $10.6 billion in additional corporate income tax revenues, and $8.8 billion in new personal income tax revenues over the next five years, for a total of $19.4 billion in new tax revenue.

The C.D. Howe report focuses exclusively on the personal income tax projection, and predicts the inclusion rate increase will only bring in $3.3 billion over the next five years. It did not attempt to model the corporate income tax revenues, calling the budget’s estimated cumulative five-year increase of $10.6 billion in revenues “plausible when considering historical data on capital gains earned by corporations, particularly (private corporations) which earn the lion’s share.”

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The Institute isn’t alone in questioning the government’s revenue projections. In August, the Parliamentary Budget Officer (PBO) estimated that the federal government will collect $17.4 billion, $2 billion dollars less in revenue than originally estimated.

In response to the PBO’s August estimate, the Montreal Economic Institute (MEI) said in a press release that the increase in the capital gains inclusion rate will bring in even less money than the government projected, due to investor behaviour.

“This tax increase is a cynical measure, relying on a fire sale of assets before it came into effect,” explained Emmanuelle B. Faubert, economist at the MEI. “The analysis by the (PBO) confirms what we thought: this tax increase will never again bring in as much revenue as it will (in) its first year, as it reduces the incentive to invest in our startups.”

In the C.D. Howe report, the authors built their own estimate of the additional federal personal income tax revenues generated by the capital gains change by using Statistics Canada’s Social Policy Database and Model, enhanced with additional non-model estimates.

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The authors point out that the annual value of capital gains realizations depends on asset market conditions, and the most recent data available (from the 2021 tax year) reflect a “peak year,” in which near-zero interest rates, combined with fiscal stimulus and quantitative easing, created conditions in which demand for assets was greater than normal. The authors adjusted for this in their projections “to avoid extrapolating from an exceptionally high year.”

In addition, the authors note that taxpayers generally respond to changes in capital gains taxation by altering the timing and amount of their realizations. They suggest that taxpayers will react to the tax increase in two ways.

The first behavioural reaction is transitory, and relates to individuals who accelerated their capital gains transactions to avoid the June 25th rule change and benefit from the lower inclusion rate. This acceleration will boost realizations and revenue in the first year but result in lower revenues due to correspondingly reduced realizations in subsequent years.

The second behavioural reaction is permanent. In the long run, the authors argue, the level of capital gains will decrease as capital owners react to the tax. Capital owners often delay selling appreciated assets to defer tax liability, a behaviour known as the “capital gains lock-in effect,” which hinders efficient capital allocation in the economy. Increasing the inclusion rate amplifies this effect by further discouraging investors from realizing gains.

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As well, capital gains taxes deter entrepreneurial activity and risk-taking by reducing the after-tax return on equity-financed investments. This impact is compounded by the fact that capital losses can only offset capital gains, limiting their usefulness.

These views echo those raised by the Fraser Institute in its July bulletin entitled Measuring Progressivity in Canada’s Tax System. The report’s authors, Jake Fuss and Nathaniel Li, note that, although raising taxes on top income-earners is often thought of as a way to increase government revenue, this approach tends to ignore the economic consequences of tax-rate increases and the associated behavioural responses of taxpayers when faced with higher tax rates.

They cite a substantial body of evidence that finds that high marginal income tax rates discourage productive economic activity because they reduce the reward individuals receive from the next dollar of income earned. Furthermore, higher tax rates can discourage individuals from engaging in desirable economic activities such as work, savings and investment.

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Fuss and Li point out that top income-earners facing high marginal tax rates have a stronger incentive to invest time and money to avoid higher tax rates. They cite evidence of such a behavioural response to the 2016 Canadian federal tax increase on upper-income earners, where the government hiked the top federal tax rate to 33 per cent from 29 per cent.

The higher personal income tax rate took effect in 2016, but it was announced in 2015, so in anticipation of the tax change, individuals were incentivized to bring their income forward to the 2015 tax year (particularly by realizing capital gains and paying themselves dividends from their private company) in order to avoid the new, higher income tax rate coming in 2016.

We won’t have the 2024 tax data for a couple of years, but once it is available, it will be interesting to study the impact of whether the government’s decision to give taxpayers ten weeks from the April 16th budget announcement to the June 25th inclusion increase date played a significant role in the amount of tax revenue that will ultimately be realized from this tax increase.

Jamie Golombek, FCPA, FCA, CFP, CLU, TEP, is the managing director, Tax & Estate Planning with CIBC Private Wealth in Toronto. Jamie.Golombek@cibc.com.

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