The Pivotal Role of Capital Gains in Efficient and Progressive Tax Reform

Abstract

Increased, targeted taxation of capital gains is key to making the personal income tax more progressive, and it can also contribute to a more efficient system. This article assesses a two-tier capital gains tax that would apply a second, higher inclusion rate for gains above a specified threshold. Relative to a general increase in the inclusion rate—widely promoted by tax analysts—a two-tier scheme would focus on high-income, high-wealth taxpayers, forgo limited revenue, and be more publicly acceptable and politically viable. Relative to reforms to the alternative minimum tax (AMT), the two-tier scheme would be simpler, cover more taxpayers, capture more revenue, and conform more closely to the notion that “the rich pay their fair share.” The article explains how capital gains are an amalgam of capital and labour inputs, often containing supernormal returns that are an efficient target for increased taxation. The article further details the high concentration of recurrent large capital gains at top income levels and critically assesses arguments commonly made against raising the gains inclusion rate. It also identifies desirable companion measures for a two-tier gains tax—including restoration of income averaging and abolition of the federal 33 percent top tax bracket and the AMT itself. In short, the current 50 percent capital gains deduction serves as a gateway for endless tax-minimizing and economy-distorting stratagems. Closing that gate even partway for those most prone to enter into such planning would be pivotal in making Canada’s tax system both more efficient and more progressive.

Keywords: Capital Gains, Tax Reform, Alternative Minimum Tax, Tax Avoidance, Deferral Method, Canada-US