David Duff is a professor and director of the Tax LLM program at the Peter A. Allard School of Law at University of British Columbia.
In his first budget in March, 2016, Finance Minister Bill Morneau promised to review personal income tax expenditures, fulfilling the Liberal Party's election promise to review and target tax breaks that particularly benefit Canada's highest-income taxpayers. Following a review by the Department of Finance and a panel of experts, Mr. Morneau should make good on this promise in his second budget, expected later this month.
Based on income tax statistics from 2013, Canada's highest-income taxpayers – those with taxable incomes of $250,000 or more – comprise roughly 1 per cent of Canadian tax filers and together account for almost 11 per cent of all taxable income reported in the year.
Although these taxpayers benefit disproportionately from several tax expenditures, the three from which they obtain the greatest relative benefit are the deduction for employee options in shares and other securities, the partial exclusion of capital gains and the lifetime capital-gains deduction.
The deduction for options and the partial exclusion of capital gains effectively exempt half of these amounts from tax, while the lifetime capital-gains deduction exempts all gains on the sale of qualified small-business corporations shares up to a lifetime limit of a little more than $800,000.
The estimated cost of these tax expenditures in 2013 were $630-million, $4.5-billion and $1.1-billion, respectively, while the shares of the resulting tax benefits obtained by Canada's highest-income taxpayers were 90.3 per cent for the options deduction, 51.5 per cent for the partial exclusion of capital gains and 58 per cent for the lifetime capital-gains deduction – much higher than the 11 per cent share of taxable income reported by these taxpayers.
Since the tax benefits from these tax expenditures are so heavily skewed to the highest-income taxpayers, the onus to demonstrate that these tax subsidies provide a social or economic benefit to Canadians as a whole should be very high.
Recognizing that the deduction for options disproportionately benefits a small number of high-income taxpayers, the Liberal Party's election platform promised to cap this deduction at $100,000 of stock options each year. In response to concerns from high-tech startups, which rely on stock options to attract qualified employees, however, the Liberal government backed away from the promise last March, apparently regarding the tax subsidy as money well spent. Since the deduction is not limited to options issued by high-tech startups, however, it is also enjoyed by employees of established firms, including high-income chief executives who receive substantial compensation in this tax-preferred form. Since there is no compelling reason why established firms and their CEOs require this subsidy, the upcoming budget should amend the options deduction to provide a more targeted benefit that is limited to high-tech startups.
Partial taxation of capital gains has been a feature of the Canadian income tax system since 1972, though the capital-gains "inclusion rate" has varied, increasing to three-quarters in the 1990s before decreasing to one half in 2000. The main arguments for partial taxation are to reduce the impact of the tax on inflationary gains and to take account of corporate income taxes that are assumed by shareholders.
In recent years, however, inflation has been low and corporate income taxes have been substantially reduced, so that half-taxation of capital gains provides a more generous adjustment than is required for these purposes. Increasing the capital-gains inclusion rate to 80 per cent would provide adequate compensation for current inflation and better correspond to federal and provincial corporate tax rates for small businesses, for which concerns about offsetting corporate taxes are greatest.
Finally, there is no sound justification for the lifetime capital-gains deduction, which disproportionately benefits high-income shareholders of private corporations, which already enjoy substantial tax benefits in the form of a low corporate rate.
Introduced in the 1980s and expanded over the past decade, the structure of this tax expenditure perversely encourages taxpayers to sell small enterprises rather than grow them into larger enterprises, and to engage in sophisticated transactions to convert otherwise taxable dividends into non-taxable capital gains. In the absence of any compelling evidence that this deduction encourages job creation or economic growth, this tax expenditure should be repealed.