When my kids got their first paycheques, they each had one thing to say “Wow, Dad, look at all the money the taxman gets!”
“Yup, social programs and the privileges of our great country are not free.”
What I didn’t add was “except if you own stocks.”
Income taxes vs capital gains taxes are greatly, vastly different things - as different as apples and oranges. This blog looks into the details of how the tax system favours the wealthy among us and thereby contributes to social inequity.
On income, we understand that we pay a certain percent as a tax on the first chunk of income per year, and as our income increases, we rise to pay larger and larger percentages of tax on the subsequent portions. Graduated income tax leverages the idea that the less well off should not pay as much as the higher income group.
All that seems quite fair and straightforward until you come to taxation on stock portfolios. Stocks or equities are financial ways the general public can own a ‘share’ of companies. Let’s see how taxation applies differently here:
First, understand that stocks are owned mainly by the wealthy. The chart below of wealth concentrations in Canada illustrates the concentration of net worth. Net worth means the difference of your total assets less your total debts.
Per the above table, if your family happens to be in the Middle 40% net worth category on average your family's net wealth (after all debt) is $460,000. That's pretty good going, but your family most likely mainly owns real estate, not financial products like equities.
Compare that with those families having a net worth in the top ten percent, which average $4.16 Million as net family wealth. While in Canada, little available data exists, but we are similar to the U.S., where Federal Reserve data shows that the wealthiest top 10 percent of American households own about 84 percent of the value of all households' stock ownership. Ok you say, the rich can afford some stocks, so what? Well, that is what gives them the edge. Let's dive into that thought a bit.
Canadian corporations earn about $909 B in 2019 Canada, compared to $938 B made by employees. These elements are about equal in size, profits and labour, but that is where equality ends.
The wealthiest ten percent earns much more from their stock ownership, which at eighty-four percent equals $763 B of the corporate earnings. This additional source of income permits purchases of still more equities by the top ten percent. The bottom ninety percent can share the remaining $145 B. (unequally, of course)
The taxes on equities are either from income received as dividends or as income received from capital gains. Dividends are payments declared by a company and paid out to shareholders. Capital gains are the amount you earn when you sell the stocks.
How do these forms of tax compare to income taxes?
First, the taxes on dividends and capital gains are graduated like earnings from income (the higher the income, the higher the tax) as all sources of income combine first before calculating the taxes owed.
That is about where the similarities end.
Remember, you don’t have any physical limits on how many dividends or capital gains you may earn, unlike the physical limitations of how many hours you can work. So the upper end of equity ownership has no natural boundaries. That is how Amazon owner Jeff Bezos went from $100 B to 200 B in net worth in one year, 2020.
Dividends from Canadian corporations are taxed first at the corporate level and then at the individual level. To offset this double taxation on corporate profits, the individual gets about a twenty percent reduction of the dividend taxes payable.
Taxes on capital gains, though, is where the wealthy mainly get ahead. Here are some of the ways:
First of all, only the increases in the value of stocks you sell create capital gains to be taxed. If a stock value grows by fifty percent, only that portion is taxable. In comparison, if your employment income goes up, all of it is taxable, not just the increase.
The argument is that the cost of acquiring the stock cannot be part of the income.
On the surface, this makes sense. However, as an employee, I have to first earn my wages by learning a skill or years of experience. I do not get to deduct the cost of my education every time I earn income. Yes, there are incentives to reduce taxes for students, but these apply to students with very low-income levels.
Costs to acquire a stock form part of costs of a stock, such as brokerage fees. In comparison, I do not get to deduct the expenses of finding a job or the lost wages.
That would be nice.
Costs to hold and manage stocks called 'carrying costs' are also part of the deductions, with one notable exception. So costs for the professional that decides which stocks to buy and sell, a critical component of any portfolio, offset income each year. In contrast, to earn income, most individuals cannot claim travel costs or other employment-related costs.
Interest costs are also categorized as carrying costs for stocks, but in contrast, Canadians' house mortgages (that carry the income-earner) are normally not deductible from income.
The notable exception on carrying costs is that inside an RRSP or TFSA, such carrying costs are not deductible. How odd! Could it be because most Canadians if they own stocks directly at all, would have most of them in an RRSP or TFSA?
Gains must be realized
Owners of stocks do not pay tax if their stocks go up, only if they sell stocks that have gone up. So Jeff Bezos doesn’t have to pay any tax on his gain of $100 B last year. That is because until any stock is sold, the gain is not 'realized'.
This realization requirement perpetuates inequality severely, as Mr. Bezos only pays tax on what he cashes in. Let’s say Jeff only needed a billion dollars walking-around-money to ‘scrape’ by last year. He would only have had to cash in a small portion of his two hundred billion dollars, leaving the rest of his gain in the year un-taxable. This rule gives a lot of wiggle room for the wealthy to avoid tax, at least for a while.
I am not done yet. I wish I were. The next two points massively tip the scales for the wealthy.
Any capital gain can be offset by capital losses incurred in this or prior years. So it is prudent to cash in stocks that have gained and cash in stocks that have lost value. In this way, the gains are offset by losses, and only the total net capital gain is taxable.
Wow, it would be great to deduct the income lost while unemployed, or as a student, from income earned later! Too bad, worker, that’s not for you.
Finally, as if all the above was not enough to make a massive difference in the incomes of the wealthy vs the incomes of working stiffs, net capital gains are calculated at fifty percent of income tax rates. Gee, wouldn’t most employees like that if some of their income was at only half the tax rate?
In summary
I have shown how our tax regime favours those who own stocks. How did this happen? Well, maybe it's because those who own stocks are the people who can either afford to run as representatives in government or who can pay to have lobbyists that argue their case for government laws in their favour.
I do not see a change in this dynamic unless most people eventually own the majority of stocks, which is my argument made earlier about how we can tame capitalism.
No, I don’t think we need to throw out capitalism, but there are some easy ways to limit the runaway wealth of the top one percent, for example, by taxing change in wealth over say, $100 Million.
Another easy way to equalize the income impacts would be to tax all net capital gains fully at the same rate that income from employment is taxed.
Until something changes, the bulk of our society will always remain in the lower wealth bracket, and social inequality will widen.
Photo by Volkan Kaçmaz on Unsplash