Taxing Capital Gains

The following also appears in The Globe and Mail’s Economy Lab:

Earlier this week, Kevin Milligan questioned proposals to increase the tax on capital gains. Currently, Canadian income tax applies to only 50 per cent of capital gains.

Milligan argues that light personal taxation is justified for income that has already been subject to corporate tax. He quickly expands the discussion from capital gains to capital income,which also includes dividends.

If a company pays out some or all of its after-tax profits as dividends to shareholders, it is arguably unfair to fully tax the money again at the personal level. Therefore, Canadian shareholders receive a dividend tax credit equal to the statutory corporate tax rate.

I do not know of anyone proposing to eliminate the dividend tax credit. The implicit crux of Milligan’s case is that capital gains are analogous to dividends.

In fact, capital gains do not necessarily come from after-tax corporate profit. They are frequently realized by buying and selling assets that are never subject to corporate income tax: bonds, real estate, precious metals, foreign currencies, etc.

Capital gains that are from shares in taxable corporations might reflect the retention of after-tax profits over time or the myriad of other variables that influence share prices. The existence of corporate tax does not justify exempting half of all capital gains from personal tax.

Even those capital gains that do represent retained profits are under-taxed. A recent Department of Finance study of taxes on the three major sources of business finance noted that interest on debt is subject to a top personal tax rate of 45 per cent.

Dividends on new equity are subject to both corporate and personal tax, minus the dividend credit, for a combined tax rate of 47 per cent. But capital gains from retained profits are favoured by a lower combined rate of 43 per cent.

If 60 per cent of capital gains were subject to personal income tax, this combined rate would be 46 per cent. In other words, somewhat increasing the tax on capital gains would make Canada’s tax system more neutral among the different sources of business finance.

Inflation provides a stronger rationale for light taxation of capital gains. Long-term asset holders should not be taxed for price appreciations that simply reflect inflation over time. Proponents of higher taxes on capital gains, such as the Alternative Federal Budget, have consistently recognized the need to adjust capital gains for inflation.

Perhaps capital gains from shares held long enough to reflect the accumulation of after-tax profits by the underlying company could receive a further discount. However, there is no justification for the 50 per-cent tax discount currently given to all capital gains.