How raising Canada’s capital-gains rate could hobble long-term growth

A version of this article appeared in the Globe & Mail

I have read a lot lately about a potential change to the inclusion rate on capital gains in the upcoming federal budget. The popular view seems to be that the federal government will increase it to 66 per cent or even 75 per cent from its current position at 50 per cent – probably not in this week’s budget, but in future years.

This idea has been mostly met by indifference – with a lot of commentary dismissing the potential tax increase as merely another way to ensure the 1 per cent pay their fair share. That’s just not true. It has potentially far-reaching economic and growth consequences for all of Canada.

First is the issue of investor behaviour and investment capital. Such a tax change would put dividend payments and capital gains from growth of a stock on similar or equal footing from a tax standpoint. In theory this may seem fair; in reality, not all returns are created equal.

Investments have varying levels of risk. Tax policy needs to be structured in a way that compensates investors for taking on more long-term uncertainty, or else we will see significant changes to capital formation and flows.

Already, the search for yield in the current environment of low interest rates has driven more capital into dividend-paying stocks, driving up their valuations relative to growth-oriented companies. If the capital gains rate is aligned with that of dividends, flows into “pay me now” stocks will intensify, effectively discouraging patient capital and removing incentives offered to long-term investors.

But there are serious ramifications to capital-gains-tax changes beyond growth stocks trading at lower valuations. We already know earlier-stage Canadian growth companies are suffering from a $4-billion funding gap when compared with their U.S. peers. This is one reason we’re less competitive than our neighbours to the south, which directly affects our employment and economic growth prospects.

If tax structure drives capital to prefer current income over long-term growth, then capital investment in innovation and R&D will shrivel even more than it has in the past decade. Not only will depressed valuations make it less viable for growth companies to raise capital, but more established companies will be coerced into distributing earnings to shareholders rather than reinvesting them back into the company for longer-term growth projects.

Second, such a policy would contradict what government and corporate leaders have been positioning Canada to achieve. This is a pivotal time for Canada: Over the past few years, we’ve seen some gains that provide a lot of hope for the future of Canadian business.

More innovation and technology companies are starting up or relocating here and we’ve seen a significant influx of highly-skilled talent – a trend that we could see continue in the face of restrictive immigration policies in the United States.

This is happening despite the aforementioned funding gap and the wide disparity between the Canadian and U.S. personal tax rates.

Many of these talented individuals are attracted and retained by equity incentives that companies currently provide.

However, if we remove the tax advantage on what is essentially a deferral of employee compensation, Canadian businesses will lose.

Although I disagree with the notion of ever raising the capital-gains rate, raising it now would be just terrible timing. The United States – our biggest competitor for both talent and capital – is in the midst of policy changes that will likely include major cuts to personal and corporate taxes.

For Canada to raise taxes on capital gains while the U.S. is shifting course would be irresponsible.

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