Published in the Financial Post.
April’s federal budget announced significant changes to capital gains taxes, projecting an additional $10.6 billion in corporate income tax (CIT) and $8.8 billion in personal income tax (PIT) over the next five years. But our recent analysis shows these estimates are highly uncertain and rest on a number of assumptions that may not hold true. As Parliament considers enshrining these tax changes into law, legislators should look beyond projected revenues and focus on ensuring that tax policy supports the healthy and dynamic economy Canadians need.
Effective June 25, the capital gains inclusion rate for corporations rose from one-half to two-thirds. For individual taxpayers, only gains above $250,000 face the higher two-thirds inclusion rate. Though this may seem like a straightforward revenue booster, the reality is more complex.
To begin with, the tax change is not yet enshrined in legislation. The budget’s tax announcement surprised everyone: there was no prior consultation or accompanying draft legislation. This complex change requires careful legislative drafting and although a third set of draft amendments was tabled in Parliament at the end of September, we still don’t know when they will be included in a bill to be enacted. Given the current turmoil in Parliament, the future of the tax hike remains uncertain.
Our analysis suggests that once the change is finally implemented the additional federal PIT revenues resulting from the higher inclusion rate are likely to be much lower than the government’s estimate. We project around $3.3 billion over the next five years — less than half the budget’s forecast of $8.8 billion. A few factors are mainly responsible for the discrepancy.
First, capital gains realizations are highly cyclical and heavily dependent on asset market performance. The most recent data reflect a peak year, influenced by near-zero interest rates and fiscal stimulus that boosted asset demand and prices. Extrapolating from such an exceptional year without accounting for the cyclical nature of capital gains overestimates future revenues.
Second, taxpayers and firms often adjust their behavior in response to increased capital gains taxes. Revenue projections are highly sensitive to assumptions about the extent of these adjustments. Higher taxes discourage investors from selling appreciated assets, leading to deferred or decreased capital gains realizations and, as a result, lower tax revenues than anticipated. Higher capital gains taxes can also deter entrepreneurial activity and risk-taking by reducing after-tax returns on investments.
Third, a significant portion of the anticipated PIT revenue from the tax increase would have been collected by the new Alternative Minimum Tax (AMT) even without the inclusion rate change. In Budget 2023, the AMT was reformed to include 100 per cent of capital gains when calculating tax liability. The additional revenue from increasing the inclusion rate on personal capital gains over $250,000 is therefore largely offset by a corresponding reduction in AMT revenues — thus reducing the net increase in projected revenues from the capital gains tax change.
We find that the owners of Canadian-controlled private corporations (CCPCs) — ranging from doctors and lawyers to entrepreneurs and large-scale operators — are the main source of the net increase in revenues. CCPCs can distribute the non-taxable portion of their capital gains to shareholders tax-free as capital dividends. The higher corporate inclusion rate will shrink the non-taxable portion of capital gains income, which means more of that income will now be taxed at the personal level. We estimate that most of the net PIT revenue gains will come from this increased tax burden on CCPC owners.
These are just three of many factors that complicate projecting revenue gains from changes to the capital gains tax. If we’ve learned anything from this exercise, it’s that revenue estimates are inherently uncertain. Projections depend critically on assumptions about future asset values, taxpayer behaviour and economic conditions. Policy-makers should exercise caution in relying on these projections when making decisions about taxes and spending.
“Don’t count your chickens before they hatch” perfectly captures the uncertainty surrounding the revenues the proposed capital gains tax changes will generate. Legislators should not base their decisions on uncertain revenue forecasts alone. Tax policy has consequences that go beyond generating revenue. Striking the right balance between fairness and the wider economic fallout — on investment, entrepreneurship and capital allocation — demands serious attention and careful consideration.
Generating revenue does not happen in a vacuum. Some taxes do more collateral damage than others. Decision-makers need to look beyond what could be soft revenue projections and consider the likely damage to long-term prosperity. As Parliament debates these changes, it’s crucial to focus on the whole picture and build a tax system that supports growth and prosperity for all Canadians.
Alex Laurin is vice-president and director of research at the C.D. Howe Institute, where Nick Dahir is research officer.
