In the weekend edition of the Financial Post, an article by tax expert Jamie Golombek speculated that Justin Trudeau’s government might raise the tax rate on capital gains in the upcoming March 22 federal budget.

Capital gains taxes are applied to the sale of assets (property, stocks, bonds, etc.) when the selling price exceeds the original purchase price. Canada currently taxes capital gains at half an individual’s marginal income tax rate. So for someone living in Ontario, their top combined federal and provincial capital gains rate is 26.8 per cent. (There are, of course, exemptions for capital gains in a tax-sheltered savings vehicle or if the source of the gain comes from selling your primary residence.)

Nonetheless, increasing the tax rate on capital gains is misguided for three key reasons:

Reason #1: Capital gains taxes impede the flow of capital to higher end uses, what economists call the “lock-in effect.”

Indeed, a key reason why capital gains taxes are so harmful is that they discourage the sale of assets for reinvestment in new, more productive assets because the sale of old assets triggers a capital gains tax. A wealth of research shows that (partly because of this lock-in effect) capital gains taxes decrease the supply and raise the cost of capital for new and expanding firms, leading to lower levels of entrepreneurship, economic growth, and job-creation—all things Canada needs more of.  

Reason #2: Capital gains taxes reduce the financing available for entrepreneurs.

For a government that has expressed a commitment “to ensure tax measures are efficient and encourage innovation, trade and the growth of Canadian businesses,” increasing capital gains taxes would work at cross purposes. The harmful effects on entrepreneurship deserve special attention, given the government’s stated commitment to encouraging innovation and the growth of Canadian businesses. Financiers take on enormous risk when they invest in unproven ventures. And entrepreneurs help drive innovation by taking risks, often accepting lower wages for a period in hopes of future benefits. Capital gains taxes reduce those potential benefits, and reduce the attractiveness of entrepreneurship and economic risk-taking. The government says it wants more entrepreneurship and innovation but higher capital gains rates would have exactly the opposite effect.

Reason #3: A capital gains tax hike announced in the budget would effectively be the third in recent months.

The federal government has effectively hiked capital gains taxes through two separate policy changes since coming into power last October. First, the Trudeau Liberals added a new income tax bracket this year, raising the top tax rate from 29 to 33 per cent effective Jan. 1, 2016. Because the capital gains tax rate is half an individual’s marginal income tax rate, this has the effect of potentially increasing the capital gains tax paid (all other things equal) or contributing to the lock-in effect. Second, the Liberals slashed the amount Canadians can invest annually in their Tax-Free Savings Accounts (TFSAs), a popular savings vehicle that shelters an investor from capital gains taxes. Specifically, the maximum allowable contribution each year has declined from $10,000 to $5,500. Given the harmful effects of capital gains taxes, these changes impose unnecessary economic challenges.

One of the most important ways the government could use tax policy to promote innovation and entrepreneurship is by enacting capital gains tax relief. As a recent Fraser Institute study showed, reducing capital gains taxes improves the incentives for entrepreneurs and assists those financing business start-ups. The study found Canada can “supercharge its entrepreneurial environment” by cutting the capital gains tax rate, or simply by eliminating the capital gains tax as has been done in many countries around the world.

This is the type of evidence-based policy the government should adopt in the upcoming budget.