Capital Gains: Tax Policies Actually Do Have Economic Consequences

By Laurent Carbonneau
CCI Director of Policy and Research

I don’t think I need to say much, by way of an intro, about the capital gains tax hike proposed in the 2024 federal budget. I like to think of Mooseworks readers as the best of the best, the most innovative innovators, and nerdiest of the nerds.

And frankly, you’d have to be living under a rock to miss out on the duelling op-eds, open letters, and general uproar we’ve seen in recent weeks.

But, what does it all mean? You don’t come to Mooseworks for strident commentary. This series is about sober policy analysis. 

I don’t profess to understand the full economic impacts on family doctors or cottage owners, but there are some early findings we can share about the potential innovation impacts.

First, a brief description of what’s changed. Starting in June, every dollar in capital gains earned by a corporation or trust will be treated as 66% of a dollar for the purposes of assessing tax liability. The same goes for capital gains dollars earned by individuals after the first $250,000, which will continue to be assessed at a 50% inclusion rate. 

The federal budget wanted to cushion the blow somewhat, and also included an increase to the Lifetime Capital Gains Exemption (from about $1 million to $1.25 million) and created a new Canadian Entrepreneurs’ Incentive, which will allow owners of some assets in certain conditions to claim a lower inclusion rate (33%) on the proceeds from selling them.

The government has been keen to suggest that these changes will only impact 0.13% of Canadians. This is, to begin with, a bit of rhetorical sleight of hand – what we’re talking about here is really capital gains events, not individuals. And some research shows that increasing the capital gains inclusion rate would actually touch something like 20% of taxpayers over a ten-year period. Now, the current policy is more complicated than that, so it's much more difficult to say exactly how many people will be impacted, but we can confidently say it is far more than a fraction of one percent of the population.

The other thing the government has claimed about these changes is that they keep Canada’s overall income tax picture competitive with California and New York, but as I’ll explain a bit later, this comparison needs some close scrutiny. 

There is consensus in the economics literature that innovative firms are really important to long-run economic growth. Capital gains taxes hit the formation and growth of these companies in a few important places. 

Venture capital

First, capital gains tax impacts a company when they’re seeking growth capital — often from venture capital funds. With higher capital gains tax, VC funds are now looking at smaller returns after tax, which means less funding or smaller shares left over for founders. A recent paper found that an increase in effective taxes for VCs reduces patent quality and quantity, and reduces the amount and intensity of innovation exchanges – cooperation and exchange on technological or business problems – among their portfolio companies. Capital gains tax increases also reduce the number of companies that venture capitalists fund and the size of their investments.

Returns for Founders

Second, there is the return for founders on the work they put into their companies. Taxes will now bite more heavily, especially for larger exits and IPOs. This is where the government’s new Canadian Entrepreneurs’ Incentive is supposed to help, but that tool has some drawbacks. 

When it is fully phased in, entrepreneurs will be able to claim $2 million of capital gains income at a lower rate, but that figure starts at $200,000 this year and will gradually increase for 10 years before capping out at $2 million. The tax hike is not being phased in, though. That comes into full force right away.

The CEI also requires the founder to own over 10% of the company, hold their shares for at least 5 years, and requires that the company be private and Canadian-controlled. These are all tripwires that can easily disqualify a founder in the world of venture-backed companies. The impact of increasing the Lifetime Capital Gains Exemption is similarly mitigated by comparable rules around qualifying small business corporation shares.

Talent & Taxes 

Finally, higher capital gains taxes can make it harder to hire top talent. Tech companies, especially smaller ones, often attract, motivate and retain talent with stock options because early stage companies can’t afford to pay large salaries. These highly-skilled individuals are the kinds of people you need to solve big technological challenges and scale-up a business. But stock options are treated like capital gains for tax purposes. 

I mentioned the comparison to the US above, particularly New York and California. These are high-tax states by American standards; they get to do that because they are the financial and technological capitals of the world. So they can afford to charge you a premium to locate there. They are also growing more slowly than states like Washington, Nevada, Florida and Texas, which have lower tax rates, decent weather and lower cost of living. The US also has the Qualified Small Business Stock exemption, which is structured similar to the new Entrepreneurs’ Incentive but is capped at $10 million. (If I were a government looking to rebuild some goodwill and confidence, I might look to that as a starting point for reworking the Canadian Entrepreneurs’ Incentive.)

The Big Picture

Now, to be sure, the budget includes some offsetting measures, like accelerated depreciation for investments into assets like patents, and new money for the Venture Capital Catalyst Initiative. Which is great. But new incremental subsidies just aren’t worth as much as potentially transformative upside for entrepreneurs.

The reality is that all of these changes are happening in the real world, where people don’t make easily quantifiable or economically rational decisions all the time (thank goodness). There are lots of reasons that Canadians want to stay in Canada that have little to do with small tax advantages.

But! A lot of young Canadians are voting with their feet on this question. A 2018 paper found that 1 in 4 STEM graduates were leaving Canada after graduation, a figure that rose to 2 in 3 for software engineering graduates. 80% of them were going to the US. The recent victory in the budget for graduate student funding was due in part to a sustained campaign impressing upon the government the risk of brain drain among Canada’s most talented researchers. Once you lose those people, you don’t usually get them back.

There’s a more subtle element here about technological cycles here that hasn’t seen a lot of comment. Technology is defined by general purpose technologies (like electricity) and platform technologies (like the internet). AI and quantum technologies (despite the hype) have real potential to be important platforms with outsized impact on the economy over the next generation. Missing the boat on these, or degrading our capacity to innovate in those spaces, is going to look like a big mistake.

So are these tax changes going to be the death of innovation in Canada? Probably not. No single change in a complex system really can. But we have real economic problems in this country that we’ve touched on here before – our productivity gap with peer countries, our lagging research and development investments – and the reality is that those metrics are not headed in the right direction at the moment.

‍

Mooseworks is an ongoing project of the policy team at the Council of Canadian Innovators. To receive Mooseworks directly to your inbox, sign up for the CCI newsletter. And join us on Thursday, May 9 for a special Mooseworks Live event, where we'll be talking about Canada's growth and productivity challenges with Vass Bednar and Brett House. RSVP here.

‍