With capital gains change, the Liberals grasp the tax reform nettle again

In the fall of 2021, the editors of the Canadian Tax Journal devoted several dozen pages to the "hotly debated" topic of capital gains.

On balance, the editors wrote, their selected contributors were in favour of raising the inclusion rate for capital gains — the share of an individual's capital gains that are subject to income tax rates. But they acknowledged that putting such a change into practice would not be easy.

"Opposition to capital gains tax increases among affected taxpayers is apt to be vociferous," Michael Smart and Sobia Hasan Jafry wrote in one of the featured papers, "precisely because such a reform would act like a lump ­sum tax that would be difficult or impossible for taxpayers to avoid in the long run by changing their behaviour."

Whatever its exact causes or motivations, "vociferous" opposition to tax hikes may be as old as taxation itself. But the Liberals already have firsthand experience of how loud that opposition can get, having watched one set of reforms struggle to survive an onslaught of confusion and controversy in the summer of 2017. 

Now they're taking another swing at it — and one big question is whether they're better prepared for the blowback this time.

WATCH: The capital gains tax changes, explained   

If the Liberals are hoping to look reasonable and measured, they can at least point to the fact that they haven't gone nearly as far as some wanted them to go.

In their 2001 paper, Smart and Hasan Jafry proposed increasing the inclusion rate from 50 per cent to 80 per cent for all capital gains. In her third budget, tabled last week, Finance Minister Chrystia Freeland proposed an inclusion rate of 67 per cent for capital gains of $250,000 or more.

In their 2021 analysis, Smart and Hasan Jafry pointed out that the wealthiest families benefited disproportionately from the preferential tax treatment afforded to capital gains (though there is some debate over exactly how disproportionately the benefits are distributed). That's now a key aspect of the government's argument.

"The government is asking the wealthiest Canadians to pay their fair share," last week's budget document said, adding that only about 0.13 per cent of Canadians would be affected by the change.

As Freeland noted, her changes also aren't unprecedented. From 1990 to 2000, the inclusion rate was 75 per cent for all capital gains. Freeland is also promising a special carve-out aimed at entrepreneurs.

"There are a lot of reasons why the inclusion rate should go up for capital gains," Smart said in an interview this week.

For one thing, Smart argues, "it's fairer for all Canadians if taxpayers with capital gains pay the same rates of tax as the rest of us do right now." Also, he says, "it's better for the economy if every investor is paying the same tax rate on everything she or he invests in," pointing to differences in the way dividends and capital gains are taxed.

The fight over what these changes will mean

While condemning the budget, Pierre Poilievre's Conservatives have been noticeably quiet on the issue of capital gains. That might be because they sense — correctly — that the Liberals would be happy to accuse them of supporting tax breaks for the rich.

For the time being, other voices are filling the void — including doctors, who came forward with their own concerns this week. The technology sector has been the loudest in its objections. The Council of Canadian Investors has sponsored an open letter that has now been signed by hundreds of tech executives.

WATCH: CMA president slams changes to capital gains tax  

In an op-ed for the National Post, the council's president, Benjamin Bergen, warned that the changes would hurt Canada's economic "vibes." Specifically, he argued that a higher inclusion rate would discourage business investment.

"Capital gains are taxed at a different rate because they are taxes on investment," he wrote. "Every investment comes with risk … [t]he tax code takes this into account."

But other figures in the investment community have come forward to say the backlash is confused and unwarranted.

There does not seem to be a clear consensus on the economic impact of changes to the capital gains tax. In a paper published last year, the economist Jonathan Rhys Kesselman wrote that "the overall impact of existing and increased capital gains taxes on the economy's efficiency and growth are mixed and not easily quantified."

"When the gains inclusion rate was raised to 75 per cent in 1990 for nearly a decade, adverse economic impacts were not observed, though this is at best weak evidence," Kesselman wrote. "Contrary to common claims about higher taxes on gains, some impacts would be economically favourable, and others that might be adverse could be mitigated through appropriate concomitant reforms."

LISTEN: Tech entrepreneurs break down federal budget's impacts on their sector   

It might be fair to assume the change will have some downside. But every policy choice involves a trade-off.

In an email this week, University of Calgary economist Trevor Tombe — who argues it makes sense to hike taxes on capital gains — wrote that while it would not be controversial to suggest the capital gains changes will have some kind of negative effect, "all policy choices come with costs and benefits, so we also have to then compare the costs to the benefits of the government's spending choices."

What the Liberals might have learned from 2017

Compared to the tax fight of 2017 — when the Liberals sought to change the rules on private incorporation — the government has been far more explicit and purposeful this time about connecting the tax changes to new spending proposals, particularly those related to ensuring that younger Canadians can find affordable places to live.

"I understand for some people this might cost more if they sell a cottage or a secondary residence, but young people can't buy their primary residences yet," Prime Minister Justin Trudeau said Tuesday.

In total, the changes are projected to produce $19.4 billion in additional revenue for the federal government over five years. In her budget speech, Freeland connected asking wealthy Canadians to pay more with federal programs to provide dental care, school lunches and free contraception.

The goal of reducing income inequality might be worthy in and of itself, but it's more abstract than the tangible things the Liberals are pointing to now.

An internal review conducted by the Finance Department after the tax storm of 2017 concluded that the government had been slow to respond to concerns and criticism and that there was a "need to more rapidly adjust communications strategies and messaging to effectively address misconceptions." Scott Clark, a former senior finance official, observed at the time that there were no "winners" — people who would benefit from the changes — to whom the federal government could point. 

The early returns might suggest the government learned some things from the 2017 experience. For one thing, Freeland openly acknowledged from the outset that some people were likely going to be upset.

But if 2017 is any guide, the opposition is unlikely to pass quickly or quietly.