03/30/2017 04:21 EDT | Updated 03/30/2017 04:22 EDT

The Hidden Costs Of Canada's Capital Gains Tax Exemption

Leading up to the federal government's 2017 budget, there was speculation about an increase in the tax on capital gains. The current tax exemption is disproportionately beneficial to the wealthy, and it has little in the way of general economic benefits.

Only half the value of capital gains is currently taxed. This costs $5 billion in annual tax revenue just for the federal government (and more for the provinces). About 50 per cent of the tax saving goes to the top one per cent of income earners, who earn the bulk of capital gains.

Nothing was done in this year's budget, but an increase in capital gains tax may still come in the future. In his speech, Finance Minister Morneau declared that "going forward, we will close loopholes that result in unfair tax advantages for some at the expense of others. We will eliminate inefficient tax measures, especially those that disproportionately benefit the wealthy."

bill morneau

Finance Minister Bill Morneau delivers the federal budget in the House of Commons on Parliament Hill in Ottawa, Ontario, Canada, March 22, 2017. (Photo: Chris Wattie/Reuters)

Proponents make two arguments in favour of the exemption for capital gains, but neither succeeds in justifying this tax giveaway.

One claim is that it encourages risk taking and investment. In fact, much of it goes to people who make money by speculation in real estate or foreign stock markets, neither of which is beneficial to the Canadian economy.

Capital gains tax is generally levied based on where you live, not where you invest. Therefore, the capital gains tax charged by the Canadian government has little effect on Canada's ability to compete for capital from foreign investors. A foreign investor who invests in Canadian companies listed on stock markets does not pay Canadian capital gains tax. A lower capital gains tax may be justified for investments in small, new enterprises that are financed locally. Those may deserve some special treatment, but it does not justify an across-the-board exemption.

The other argument for exempting capital gains is inflation. Some of the increase in the price of assets is due to general inflation, and it would be unfair to tax it. That is true, but the current regime is not a good way to deal with it. A capital gain earned from a thirty day speculation gets the same treatment as a long-term investment that has been held for thirty years. That is not fair to the long-term investor, who may in fact have no real capital gain at all once inflation is taken into account.

The cost in foregone tax revenue amounts to tens of billions of dollars per year.

The proper approach is to adjust the gains for inflation. Charge tax on the real increase, after inflation has been factored out.

Indexing to remove the effects of inflation before capital gains are calculated would be an important reform if the government goes ahead with an increase in the capital gains inclusion rate. Otherwise, it would lead to an unfair situation where people who have held property for a long time are taxed on illusory capital gains due to inflation. This is particularly significant when a person dies. At that time, the tax code deems all his property to have been sold, and capital gains tax has to be paid on it. This is a hazard for the middle class. The wealthy have access to tax planning tools such as trusts and estate freezes that help them avoid tax when they die.

The federal government has set up an expert panel to review a range of tax expenditures. The cost in foregone tax revenue amounts to tens of billions of dollars per year. Curtailing inefficient tax expenditures would free up money for spending on infrastructure, and for balanced reductions in the general tax rate, as I suggested in a recent paper for the Mowat Centre for Policy Innovation at the University of Toronto. It may not be politically easy, but it is the best way to significantly improve Canada's economy.

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