As we usher into mid-2024, we are witnessing a contentious proposal to increase the inclusion rate for capital gains exceeding a quarter of a million dollars from the past one half (50%) to a whopping two thirds (75%). This report will explore the details of this proposition, the projected benefits, and the challenges or drawbacks it entails. Finally, I will try to conclude this with my own notions.

New Capital Gains Tax Canada-Understanding the Proposition

Budget 2024 announced an increase in the capital gains inclusion rate from one-half to two-thirds for corporations and trusts. For individuals, the rate applies to the portion of capital gains realized in the year that exceeds $250,000, effective June 25, 2024.

To fully grasp this new tax rule, we need to understand the terms “capital gains” and “capital gains inclusion rate.” Capital gains are the profits made from selling an asset for more than its purchase price, including acquisition costs or commissions. These can apply to any asset, such as stocks, bonds, real estate, precious metals, options contracts, or even cryptocurrency.

Previously, only half of the capital gains were included in taxable income. For instance, a $700,000 capital gain would have $350,000 reported as taxable income. This one half is the capital gain inclusion rate which is now increased to two thirds for the given conditions. The given conditions as clearly mentioned in the above paragraph is the capital gains achieved for more than $250,000 for a given year for individuals. Up until $250,000 the inclusion rate is still one half.

To illustrate this further, consider the following example:

Initial Purchase: Last year, you bought a house for $600,000.
Sale Price: This year, you sold the house for $900,000, resulting in a profit of $300,000.

Under the Old Tax Regime:

You would report one half of the capital gain as taxable income.
Capital gain: $300,000
Taxable income: $300,000 * 0.5 = $150,000

Under the New Tax Rule (Post-June 25, 2024):

You would report one half of the first $250,000 and two thirds of the remaining $50,000 as taxable income.
First $250,000: $250,000 * 0.5 = $125,000
Remaining $50,000: $50,000 * 0.667 = ~$33,000
Total taxable income: $125,000 + $33,000 = $158,000

This new rule means you would report $158,000 as taxable income, which is $8,000 more than under the old regime.

New Capital Gains Tax Canada-The Debate

This new tax rule has sparked significant debate among government officials, policymakers, economists, business leaders, and Canadian residents, creating two polarized groups: those in favor and those against the proposition.

Figure 1: Supporters vs Opposition of the new hike in Capital Inclusion Rate in Canada

New Capital Gains Tax Canada-Supporters

Supporters, including the incumbent government and some economists, argue that the proposed increase promotes tax fairness and infuses investments in the economy.

The International Monetary Fund (IMF) supports ^[1]the new monetary stance by quoting that it would help improve the tax system’s neutrality with respect to different forms of capital income and is likely to have no significant impact on investment or productivity growth.

The government emphasizes that the current tax system is unfair as the average professionals like plumbers, electricians, or cooks pay more marginal taxes compared to the wealthier individuals.

The latter also employs various loopholes and tactics to get exempted further from the hefty taxes. The new rule aims to ensure the wealthy contribute more equitably.

Additionally, the government projects that this tax increase will generate approximately $20 billion, which will be invested in housing, affordability programs, healthcare, dental care, artificial intelligence, job creation, and growth.

The argument for tax fairness rests on the principle that all income should be treated equally under the tax system. In practice, this means that income from capital gains should be taxed at the same rate as income from labor.

The current disparity allows wealthy individuals to exploit the lower tax rates on capital gains, effectively reducing their overall tax burden compared to individuals who earn their income solely through labor. By increasing the inclusion rate for capital gains, the government aims to close this gap and ensure that high-income earners pay their fair share of taxes.

Moreover, the projected revenue from this tax hike is substantial. The government plans to channel these funds into critical areas such as housing, which is facing a severe affordability crisis; healthcare, which requires significant investment to improve accessibility and quality; and education, particularly in implementing a national school food program.

These investments are expected to have a multiplier effect, boosting economic growth and improving the standard of living for all Canadians.

New Capital Gains Tax Canada-Opposition to the New Rule

Conversely, the Conservative Party strongly opposes the tax hike, labeling it a “job-killing tax increase.” They argue that the timing is poor, given the current cost-of-living crisis for Canadians. They contend that the new tax legislation not only impacts the business houses but also the farmers, builders and even individuals who own a second investment property as a mean to secure their retirement.

The higher taxes on farmers and builders will further exacerbate food and housing crises and taxing small businesses will hinder economic growth, driving businesses to more tax-friendly environments like the U.S.

The opposition’s argument hinges on the belief that higher taxes on capital gains will discourage investment and entrepreneurship. They argue that individuals and businesses are more likely to invest and take risks when they can retain a larger share of their profits.

By increasing the tax burden on these gains, the government could inadvertently stifle innovation and reduce the overall competitiveness of the Canadian economy.

Furthermore, the Conservative Party suggests that the government’s proposal is an attempt to address a self-inflicted budget deficit resulting from previous economic decisions.

They argue that the government has been fiscally irresponsible, leading to a ballooning deficit that now requires higher taxes to manage. According to the opposition, this approach is shortsighted and fails to address the underlying issues of government spending and economic mismanagement.

Detailed Analysis of the Issues

The Impact on Housing and Affordability

One of the most critical areas where the proposed tax increase could have a significant impact is housing. Canada is currently facing a housing affordability crisis, with prices and rents rising rapidly, making it difficult for many Canadians to find affordable housing. The government’s plan to invest the additional tax revenue in housing is commendable, but it needs to be carefully managed to ensure it addresses the root causes of the crisis.

The primary challenge in the housing market is the supply-demand imbalance. There are simply not enough affordable homes to meet the growing demand. Increasing the capital gains tax could potentially deter investment in real estate, further exacerbating the supply shortage. However, if the revenue generated is used effectively to increase the supply of affordable housing, it could help mitigate this issue.

To achieve this, the government should focus on direct investments in housing projects, subsidies for affordable housing developments, and policies that encourage private sector participation in building affordable homes. Additionally, as mentioned earlier, simplifying the regulatory framework and reducing bureaucratic hurdles can expedite the construction process and increase the housing supply more quickly.

Healthcare and Social Programs

Healthcare is another critical area where the additional revenue from the tax hike could be beneficial. Canada’s healthcare system, while robust, faces challenges such as long wait times, understaffed facilities, and rising costs. Investing in healthcare infrastructure, hiring more medical professionals, and implementing technology solutions can significantly improve the quality and accessibility of healthcare services.

The government’s plan to use the additional funds for a national school food program is also a positive step. Ensuring that children have access to nutritious meals can have far-reaching benefits, including better academic performance, improved health outcomes, and reduced socioeconomic disparities. However, the success of such programs depends on efficient implementation and adequate funding.

The Role of Small Businesses and Startups

Small businesses and startups are the backbone of the Canadian economy, contributing significantly to job creation and innovation. However, these enterprises often operate on tight margins and are particularly sensitive to tax changes.

A substantial increase in the capital gains inclusion rate could discourage investment in startups and small businesses, hindering their growth and reducing their contribution to the economy.

To counteract this, the government should consider targeted tax incentives for small businesses and startups. For example, offering tax credits for investments in early-stage companies, reducing the corporate tax rate for small businesses, and providing grants for research and development can stimulate entrepreneurship and innovation.

Additionally, creating a supportive ecosystem with access to funding, mentorship, and resources can help small businesses thrive despite the increased tax burden.

Balancing Fiscal Responsibility with Economic Growth

The government faces the challenging task of balancing fiscal responsibility with the need to stimulate economic growth. While raising taxes can generate much-needed revenue, it can also slow down economic activity if not managed carefully. Therefore, it’s crucial to adopt a holistic approach that includes prudent fiscal management, targeted investments, and structural reforms.

One of the key areas for reform is government spending. By identifying and eliminating wasteful expenditures, the government can free up resources for more productive uses. This involves conducting thorough audits of government programs, cutting down on bureaucratic inefficiencies, and ensuring that funds are allocated to high-impact areas.

Another critical aspect is promoting economic growth through policy measures that encourage investment, innovation, and job creation. This includes simplifying the regulatory framework, reducing the tax burden on businesses, and investing in infrastructure and education. By creating a conducive environment for economic activity, the government can stimulate growth and generate additional revenue without relying solely on tax increases

A Balanced Approach

In my view, a balanced approach incorporating the best aspects of both arguments is essential. While funding is needed for healthcare, startups, technology, affordable housing, and other critical areas, merely raising funds through taxes or debt isn’t sufficient. Complementary measures are necessary to ensure effective use of these funds. I discuss these complementary measures below:

Moderate Capital Gains Inclusion Rate Increase: Rather than a substantial hike from 50% to 75%, a more modest increase (e.g., from 50% to 55%) might be more acceptable and less disruptive for businesses and startups. This would still generate additional revenue for the government while minimizing the potential negative impacts on investment and economic growth.
Reforming the Economic and Social Framework: Beyond raising funds, it’s crucial to ensure that investments reach the right stakeholders. For instance, in housing, a large chunk of the funds should go directly to builders, carpenters, electricians, and laborers rather than being lost in bureaucratic expenses. I was reading that one third of the expenditure on a house in Ontario is spent on the bureaucratic middlemen. A cut on this share can remarkably reduce the housing costs. Similar cost-cutting measures could be applied in other sectors like healthcare and technology. Streamlining the distribution of funds would maximize their impact and ensure that the intended beneficiaries receive adequate support.
Creating a conducive Business Environment: Policies should be amended to increase support for businesses and startups by offering incentives, R&D funds, and possibly physical infrastructure like office spaces. This approach would provide tangible benefits to businesses and instill confidence among entrepreneurs that the government supports economic growth, thereby fostering entrepreneurship and job creation. Specific measures could include:
Tax Credits for Research and Development: Offering tax credits for R&D can encourage innovation and investment in new technologies.
Grants for Startups: Providing financial support to early-stage companies can help them overcome initial barriers and scale their operations.
Investments in Technology Hubs: Establishing and funding technology hubs can create ecosystems that nurture startups and attract investment.

These measures would not only boost business growth but also contribute to a vibrant, innovative economy.

Eliminating Unnecessary Spending: The government should focus on fiscally responsible investments and eliminate spending on mere vote-winning schemes. This approach would ensure that funds are used effectively and sustainably. By cutting down on unnecessary expenditures and prioritizing high-impact investments, the government can achieve better economic outcomes without placing undue burden on taxpayers.

Conclusion

In conclusion, the proposed hike in the capital gains inclusion rate by the Trudeau Government is a contentious issue with significant implications for the Canadian economy. While it aims to promote tax fairness and generate revenue for critical investments, it also raises concerns about its impact on investment, entrepreneurship, and economic growth.

A balanced approach that incorporates moderate tax increases, targeted investments, and structural reforms is essential to achieve the desired outcomes. By focusing on fiscal responsibility, supporting businesses and startups, and ensuring that funds reach the right stakeholders, the government can address the current economic challenges and pave the way for sustainable growth.

This nuanced approach recognizes the importance of raising revenue for essential public services while also fostering a conducive environment for economic activity. It is only through such a comprehensive strategy that Canada can achieve its long-term economic and social goals.

[1] https://www.imf.org/en/News/Articles/2024/06/10/61024-canada-staff-concluding-statement-of-the-2024-article-iv-mission