The Perspective Blog
Tax Landscape Post COVID-19
The COVID-19 pandemic has quickly changed healthcare systems, the economy and daily life for virtually everyone around the world. We are living in a period of deep uncertainty around the short and mid-term impacts of the pandemic and the longer-term structural changes to society.One area where we could see significant change in Canada is tax policy. While the pandemic brings ambiguity, one thing is certain: government spending has increased dramatically in an effort to minimize the health and economic consequences of COVID-19. And it appears current stimulus levels will continue into 2021, based on recent announcements.
Given projected deficits, the federal debt-to-GDP ratio will likely rise from 31% to 48%1 according to the Parliamentary Budget Officer (“PBO”). Similarly, in Ontario, the debt-to-GDP ratio will climb 10% to just under 50%2.Interestingly enough, this level of government debt levels compared to GDP is not unchartered territory. In 1995 Canada’s ratio was nearly 73%3 and interest rates were also very high (long term bond rates averaged 7.9% in the 1990s4). For Ontario residents in the 1990s, top personal tax rates were as high as 58% and the capital gains inclusion rate was 75%5.It is not known whether the government will introduce significant changes to tax policy before the pandemic has subsided; the general consensus is they will wait until we have turned the pandemic corner economically.
While today’s low interest rates offer a different picture than the 1990s, it would take significant economic growth for Canada to “grow its way” out of the debt situation and therefore we can likely expect some tax policy changes in 2021 and beyond.Here are some of the potential changes we could see and their effectiveness:
Wealth Tax
The NDP raised the idea of a wealth tax during the 2019 federal election and went on to request the PBO study its potential impact. The PBO estimated that a 1% tax on the net wealth above $20 million would generate $5.6 billion in revenue in 2020-21 (13,800 Canadian families would pay the tax, or about $400,000 per family on average)6.There are many lessons to be gleaned from Europe where in 1990 twelve countries had a wealth tax and today only four still do (Switzerland, Spain, Norway, Belgium). It’s not a direct comparison (as Europe is unique in that tax competition between countries allows investors to easily shift tax residency and shift assets between countries), but it can offer lessons. One of the main concerns with wealth taxes is the impact on investment and innovation; many opponents claim that it will detrimentally impact both. Given investors can so easily shift capital, they may look to countries without wealth taxes.
France abolished its wealth tax of 1.5-1.8% in 2017 after opponents claimed the tax was leading to capital flight, brain drain, loss of jobs, and, ultimately, a net loss in tax revenue7.Proponents of a wealth tax in Canada argue that it’s impossible to move to another country as freely as in the EU and note that Canada’s “exit tax” would help limit tax residency departures. An exit tax applies to unrealized gains when departing Canada for tax purposes.There are also inherent difficulties in measuring wealth when many of Canada’s wealthy families utilize trusts with discretionary, contingent beneficiaries. It is further challenging to value illiquid assets on an annual basis. The challenge in administering and enforcing wealth taxes is in part why some European countries abolished them.It’s critical to note that in a survey conducted by Abacus Data for the Broadbent Institute, 75% of Canadians said they support a wealth tax of 1% to 2% on the assets of Canada’s wealthiest to help pay for the country’s recovery8. While it may not be the most efficient tax (and may even be counterproductive), it could be an easy target for governments looking to shore up deficits.
Principal Residence Tax
Home value appreciation has long been considered sacred in Canada and impervious to taxation, but in recent months, numerous articles have discussed the possibility of a tax on principal residences. This has been further exacerbated by continuing concerns about housing affordability in Canada and could make taxation on primary residences an easy mark.Many Canadians have used their home as a retirement savings vehicle and plan to rely on the value of their home to help fund retirement; a tax policy change could significantly impact these families. We could see a proposal where tax is only imposed on the appreciation in value after a certain date (2021 and beyond). We could also see a policy similar to the US where a gain of $250,000 per taxpayer is exempt from taxation on a primary residence. Amounts in excess of these limits are subject to capital gains tax rates in the US.
This change has the potential to impact all Canadian homeowners, and could be very damaging politically. The move could also significantly dampen real estate investment as less Canadians utilize their homes as an investment tool. A tax on all principal residences is unlikely, however given the unprecedented fiscal situation, we could see a targeted tax on principal residence gains above a certain threshold, similar to the US.
Capital Gains Inclusion Rate
The current capital gains inclusion rate is 50%, meaning only half of a capital gain is taxable. In 1988/89 the inclusion rate was 66.7% and from 1990-1999 it was 75%9. The 50% inclusion rate for capital gains has led to a disparity in tax rates compared to eligible (public company) dividends: top capital gains tax rates in Ontario are 26.7% vs. 39.3% for dividends10. Increasing the inclusion rate to 75% would increase the top rate to approximately 40%, in line with dividends. However, opponents argue any increase to the inclusion rate would dampen investment in Canada and reduce capital available to re-invest.
We could see an increase in the inclusion rate or a hybrid solution where the inclusion rate increases for taxpayers above a certain income threshold. It’s important to note any change to the capital gains inclusion rate would likely be effective on the date of an announcement.
Consumption Taxes (GST, HST)
OECD research observes that shifting taxation towards consumption (sales) taxes could help improve resource allocation and improve productivity11. Proponents of consumption taxes argue they are efficient, meaning they do not alter spending habits or behavioral patterns. The IMF has suggested Canada should look to rely more on sales taxes. The non-Canadian G7 countries raise 30.7% of overall tax revenue via value-added and sales taxes. Canada as a whole is at only 13.4%10.We could see an increase in the GST rate in order to align Canada with our G7 peers. Introduced in 1991 at an original rate of 7%, the GST rate has been lowered twice and currently sits at rate of 5% since 2008. A 2% increase in the GST rate would lead to a 15% HST rate in Ontario. An increase would be fairly easy administratively (as opposed to a whole new wealth tax system), but historically quite difficult politically.
Personal Taxes
Top personal tax rates are already above 50% in most provinces12. In Europe, top rates in some countries are above 60% (Sweden, Belgium, and Slovenia)13. On top of the European precedent for higher tax rates, Joe Biden is currently campaigning in the US for an increase in the tax rate for incomes above $400,000/year14. It’s unclear if raising top personal tax rates would increase tax revenue given the flexibility for top earners to utilize other structures to help manage their income levels. As such, raising personal taxes is typically less effective and likely a less reliable source of additional tax revenue.
Speculative Tax Planning
Some wary investors will restructure in advance of official announcements. However, speculative tax planning can have adverse consequences. Here’s an example. A real estate investor firmly believes the capital gains inclusion rate will increase. The investor crystallizes the gain at the current 50% inclusion rate, and incurs a current tax liability. If there is no increase to the inclusion rate, the investor will have prepaid tax without actually selling the property. If the inclusion rate increases at some point in the near future, the investor may be ahead depending on a variety of factors (inclusion rate, tax rates, opportunity cost of investing the tax paid, interest rates, etc.). If the rate does not increase, tax will have been speculatively paid years earlier than necessary. Only time will tell who wins in this example.
Conclusion
CPA Canada has long been calling for a complete review of the tax system, claiming “Canada's last thorough review of the tax system was concluded in 1967. Since then it has become bloated, complex and inefficient, having accumulated a patchwork of credits, incentives and narrow fixes. This dated, inefficient system is holding Canadians back.”15
A complete review of the system could lead to some major changes to the tax landscape. And with the drastic government spending measures related to COVID-19, managing the higher deficit levels may be a further catalyst for tax policy changes.
1 PBO, September 29, 2020 Economic and Fiscal Outlook
2 https://www.fao-on.org/en/Blog/media/MR-EBO-SP2020
3 https://www.fraserinstitute.org/sites/default/files/federal-fiscal-history-canada-1867-2017.pdf
4 https://www150.statcan.gc.ca/n1/pub/11-210-x/2010000/t098-eng.htm
5 Fraser Institute, 2002, Ontario Prosperity
6 PBO, July 7, 2020, Net wealth tax on Canadian resident economic families
7 https://www.wsj.com/articles/where-wealth-taxes-failed-11572910833
8 https://abacusdata.ca/what-kind-of-recovery-broadbent-institute/
9 https://www.canada.ca/en/revenue-agency/services/tax/individuals/topics/about-your-tax-return/tax-return/completing-a-tax-return/personal-income/line-127-capital-gains/you-calculate-your-capital-gain-loss/inclusion-rates-previous-years.html
10 https://www.taxtips.ca/taxrates/on.htm
11 CPA Canada, 2018, Canada’s Tax System: What’s so Wrong and Why it Matters
12 https://www.taxtips.ca/marginaltaxrates.htm
13 https://taxfoundation.org/top-individual-income-tax-rates-in-europe/
14 https://joebiden.com/two-tax-policies/
15 https://www.cpacanada.ca/en/the-cpa-profession/about-cpa-canada/key-activities/public-policy-government-relations/policy-advocacy/cpa-canada-tax-review-initiative