Tax capital gains like other income, yes – but tax all kinds of income less

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There is a good argument for increasing the tax on capital gains, and it goes like this. The foundation stone of sound tax policy is neutrality. The tax system should treat every dollar of income the same, no matter how it is earned, from what source, or in what form: wages, interest, dividends or capital gains.

Why? Because as a matter of efficiency, we want people to make decisions based on the real costs and benefits of the choices before them. Favouring one form of income or another through the tax system encourages them to arrange their affairs, not in the way that makes the most economic sense, but that offers the juiciest tax breaks.

As a matter of fairness, moreover, it’s all income: No matter how it is earned, it all contributes to a taxpayer’s ability to pay. A buck is a buck is a buck, as they say.

For these sorts of comparisons, however, it’s not just the personal income tax rate that counts, but the combined rate, corporate and personal income taxes together. That’s because corporations make distributions to individuals out of income on which they have already paid tax.

The tax system tries to take account of this. To make the tax on dividends, for example, comparable with the tax on wages, investors can claim a dividend tax credit, to compensate them for the tax paid at the corporate level.

With capital gains, it is done through the inclusion rate. If 100 per cent of a capital gain were taxable, without regard for the corporate tax already paid on that income, the effect would be to tax capital gains more heavily in the hands of the individual than other sources of income. But at some smaller percentage, they level out.

What is that percentage? At 50 per cent, the current i.e. prebudget rate, the effective tax rate on capital gains is actually lower than it is on other sources of income. (The math: At a corporate tax rate of 26 per cent, a shareholder receives 74 cents of every dollar of capital gain. Take the half of that that’s taxable, apply the top personal income tax rate of about 53 per cent, and you’re left with 54 cents, for an effective tax rate of 46 per cent.)

But at the 66-per-cent inclusion rate proposed in the budget, they are more nearly equalized. (I’ll leave you to do the math here.) A buck is almost a buck is appreciably closer to being a buck. QED.

That is not, however, how the government has sold the change. Instead, it has relied exclusively on two talking points: soak-the-rich (“The government is asking the wealthiest Canadians to pay their fair share”), and we-need-the-money, as if the billions of dollars in new spending in the budget could only be financed with new taxes – and not, say, with cuts in other spending.

There is a good argument against increasing the tax on capital gains, or at least against how the government has gone about it, and it goes like this. Raising the inclusion rate, on its own, may move the system closer to neutrality, but that’s not all it does. It also raises taxes. At a time when Canada needs to be doing all it can to encourage new investment (see: productivity crisis), is this really the signal we want to send?

Would it not have been better, then, to have combined an increase in the inclusion rate – taxing capital gains more like other income – with a reduction in tax rates across the board?

That is not, however, how the tech bros and other critics of the move have made their case. Instead, the public has been treated to a lot of tone-deaf caterwauling about the terrible hardship this will impose on people with second homes, or on professionals who shelter their income in private corporations.

Possibly aware of how hideously self-interested they appear, some have resorted instead to the sort of cowboy economics that is always trotted out in favour of the special treatment of capital gains: seed corn of prosperity, heroic role of the entrepreneur, how will we ever get people to take risks again etc.

I don’t know how much more simply I can put this: The incentive for taking risks is the return. Riskier investments, as a rule, pay higher returns. If they don’t – if they don’t pay a high enough return to justify the risk, without a special tax break – they shouldn’t be made. There is such a thing as an optimal level of risk-taking, after all, and no more case for subsidizing it than for subsidizing anything else.