Could Reducing Canada’s Capital Gains Tax Help Solve Some of Our Economic Problems?
According to the OECD, Canada's innovation performance lags behind that of peer countries, and high-potential startups routinely fail to scale despite high public investment in research and development (R&D). As innovation drives growth and competition, weak innovation in Canada contributes to stagnant productivity and a lack of competitiveness.
At the same time, Canada has one of the highest average capital gains taxes among OECD countries, ranking 34th out of 38 on capital gains tax competitiveness. The current capital gains inclusion rate is at 50%, even in spite of the March 2025 cancellation of a planned increase to 66.7%.
Thus, could reducing Canada’s capital gains tax help solve some of our economic problems?
“Lock-in Effects”
As capital gains are taxed upon realization rather than on an accrual basis, investors have strong incentives to hold appreciated assets even when higher-return opportunities are available. This "lock-in effect" distorts capital allocation by encouraging investors to hold onto performing assets solely to defer tax, producing portfolios driven by tax timing rather than optimal risk-adjusted returns. Empirical research consistently finds negative realization elasticities, meaning that as tax rates rise, individuals defer selling their appreciated assets. Putting off appreciated assets leads to capital being “locked into suboptimal investments and not reallocated to more profitable opportunities [which] hinders economic output,” showing how individual portfolio distortions weaken the whole economy. Additionally, investors in taxable accounts are far less likely to sell appreciated assets due to capital gains taxes than those in tax-deferred accounts. The reduced willingness to sell assets to rebalance a portfolio constrains diversification relative to tax-deferred accounts, thereby suppressing capital mobility into emerging sectors.
Evidence from a natural experiment in Korea underscores how the distortion suppresses investment. Following a firm-level capital-gains tax cut, treated firms increased investment by 34 log points and issued more equity, with even larger responses among cash-constrained firms. The experiment also found that lower taxes encouraged private firms to go public. These public listings deepen capital markets by attracting institutional investors, increasing liquidity and lowering the cost of capital. Firms which went public after the reform exhibited substantially stronger investment responses than those already public, amplifying the effect of the tax cut. This demonstrates that at the firm level, lock-in can keep businesses privately held when they would otherwise go public, causing them to miss scale-up opportunities and contributing to broader economic distortions. For Canada, the evidence illustrates how capital gains taxation and its lock-in effects trap capital in inefficient uses, weaken dynamism, and suppress investment needed to scale up innovation.
Distorting Entry Decisions
Moreover, entrepreneurship increases competition and long-run growth by introducing innovations that challenge established firms. As founders realize most of their returns only at exit, the capital gains tax rate directly determines the expected payoff from innovation and thus influences the decision to launch new firms. Capital gains taxes significantly alter individuals’ decisions to become entrepreneurs by lowering the after-tax return to creating a new business. The distortion occurs through capital gains tax rates, generating large welfare distortions by reducing the incentive to start new firms and pursue high-risk, high-return ventures. Additionally, capital gains tax revenues rise sharply at low rates but peak at roughly 15 percent before declining, indicating that higher rates discourage entrepreneurial formations and exit to such an extent that they shrink the tax base itself.
Distorting Capital Supply
Finally, a robust supply of venture capital (VC) is essential for startup formation and scale-up, which, in turn, increases innovation. The federal government recognizes this: the 2025 Budget states that “Investing in Canada's venture capital sector is essential to empowering entrepreneurs with the capital and networks they need to launch and scale resilient, high-impact companies.” Venture capitalists provide not only funding but also monitoring, industry networks, and managerial expertise, which increase the probability of startup success and help meet the scale-up and innovation goals of the Canadian Government. Early-stage financing supports startups before they have revenue, while growth-stage financing allows firms with proven products to expand, hire, and compete at scale. Capital gains taxation reduces the after-tax returns to VC partners, which lowers the capital they are willing to commit across both stages. Evidence also suggests that raising taxation levels reduces both the quantity and quality of innovation in the startups firms fund.
Capital scarcity pushes many Canadian founders to sell early or relocate to U.S. markets to access more capital. As attracting specialized talent often requires stock options taxed under capital gains treatment, higher capital gains taxes also weaken startups' ability to recruit and retain highly skilled workers. The evidence suggests that higher capital gains taxes reduce venture capital supply, suppressing investment and undermining the scale-up capacity necessary for innovative growth.
Therefore, Canada's lack of innovation stems in part from distorted incentives embedded in the capital gains tax system. Highlighting that a reduction in the tax should be considered.
What Would a Reduction Entail?
A uniform lower rate rewards risk-taking without distorting incentives towards specific sectors or firm sizes. The uniform rate avoids tax-driven restructuring, which encourages entrepreneurs to structure deals and ownership to qualify for relief, rather than to maximize growth, innovation or efficiency. Also, a lower inclusion rate reduces lock-in effects and makes it easier for firms to reallocate capital to higher-return ventures, spurring innovation. The uniform approach also fits Canada's broader economic challenges. Canadian markets are becoming increasingly concentrated, with entry rates falling and exit rates rising, and stable rank stability. In this setting, a broad reduction in the cost of risk capital can help new firms enter and mid-size firms scale, exerting competitive pressure on existing firms.
Opponents may argue that lower capital gains taxes mainly benefit high-income individuals, worsen inequality, and reduce government revenue. But several points qualify these concerns.
First, across OECD countries, capital gains taxes make up a very small share of government revenue, accounting for only 1.2%-2.0%, partly as gains are already taxed favorably and only upon realization. This means that lowering Canada's inclusion rate would not erode the revenue base to an unsustainable amount, especially given that most existing foregone revenue, about $18.5 billion, is driven by the principal residence and lifetime capital gains exemptions, not by the general inclusion rate.
Second, while high-income Canadians do benefit disproportionately from capital gains preferences, recent OECD analysis finds that most people realizing large gains would remain in the top income tax brackets even if all capital gains were removed from their taxable income. Thus, these individuals earn high wages and business income regardless of capital gains, meaning that lowering the inclusion rate does not pull middle-income Canadians into top brackets or materially shift the distribution of tax incidence.
Third, the relationship between capital gains tax rates and revenue is not linear.
Quantitative work demonstrates that revenues peak at an effective rate of roughly 15% and decline at higher rates of taxation in the United States, as higher rates suppress realizations and lock capital into low-productivity uses. Additionally, analysis of state-level U.S. data found a long-run revenue elasticity of -0.3 to -0.5, meaning that raising capital gains tax rates reduces revenue once behavioural responses are taken into account.
Thus, a reduction in Canada’s capital gains tax should be considered.