Finance Minister Chrystia Freeland said a hike in the capital gains tax for the wealthiest will fund an ambitious housing program and other expensive social programs. “The responsible way to pay for those investments is to ask those at the top to contribute a little bit of money.”–Reuters, June 10, 2024
What is capital?
Capital is a factor of production—the tools, instruments, machines, buildings, and other constructions that businesses use to produce goods and services. Households own business capital indirectly by holding stocks and bonds—financial capital. Households also own some capital directly such as homes.
What is a capital gains tax?
A capital gains tax is a tax paid by owners of financial assets. The market price of stocks and homes fluctuate around a rising path. When a household sells a stock or a home for a higher price than its purchase price, the household receives a capital gain. A capital gains tax is a tax on the increase in the market value of financial capital.
Is a capital gains tax paid by the wealthiest?
The wealthiest do not pay most of the capital gains tax: Average households pay this tax as they transition from work to retirement and through their retirement years. The reason is that capital gains taxes are paid on realized capital gains, and not paid on the increase in the value of capital that is held. The wealthiest don’t sell all their capital. But average households do sell their capital, and it is what they live on in older age.
Is “a little bit of money” from the wealthiest going to pay for the housing and social programs?
It is not! Expenditure on these programs incurs an opportunity cost—the highest valued alternative forgone. To “pay” for these programs, some other goods and services must be forgone. Canada faces a tradeoff between housing and social programs and other goods and services: Canada faces a production possibilities frontier—a PPF.
How does Canada’s PPF illustrate the opportunity cost of the government’s programs?
Figure 1 illustrates Canada’s PPF for housing and social programs on the x-axis and for other goods and services on the y-axis.
Initially, the economy is at point A producing $2 billion worth of housing and social programs and $50 billion worth of other goods and services. When the increase in the capital gains tax is spent on housing and social programs, the economy moves down along the PPF to point B and produces $3 billion worth of housing and social programs and $40 billion worth of other goods and services. The opportunity cost of the extra $1 billion worth of housing and social programs is $10 billion worth of other goods and services forgone. [The numbers are not real and are chosen to illustrate the key point.]
Will the increased capital gains tax change Canada’s PPF?
As capital depreciates, firms must decide whether to replace it. And this decision is influenced by the after-tax rate of return. With an increase in the capital gains tax, business decisions to replace depreciated capital might move from Canada to the United States, or Mexico, or some other country, where capital gains are taxed at lower rates or not taxed.
If this movement happens, the increased capital gains tax will decrease Canada’s PPF and shift the PPF downward over time as Figure 2 illustrates.
When businesses move capital to another economy, Figure 2 shows Canada’s PPF shift downward to PPF1 and capital gains tax moves production from point A to point C. When Canada is producing $3 billion worth of housing and social programs, it can produce only $36 billion worth of other goods and services. The cost of an extra $1 worth of housing and social programs is $14 billion worth of other goods and services forgone.
In this case, the increase in the capital gains tax is unlikely to have the effects the government is expecting.
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