In the lead up to today’s federal budget there have been on-going rumours that the federal government will raise capital gains taxes. Despite misperceptions that hiking capital gains taxes will only affect “rich” Canadians, in reality this policy will further drain the pocketbooks of many middle-class Canadians and impose significant economic costs in the process.

Capital gains taxes are applied to the sale of assets (such as a business or stocks) when the selling price exceeds the original purchase price. Canada currently taxes capital gains income, with some exemptions, at half an individual’s marginal income tax rate. If the capital gains tax rate is increased to three-quarters of an individual’s marginal tax rate, as some have speculated, the combined top federal and provincial rate for someone living in Ontario, for example, would increase from 26.8 per cent to 41.1 per cent.

Raising the capital gains tax rate would damage the economy for many reasons. For starters, it will encourage investors to hold on to low performing assets since capital gains are only taxed once an asset is sold. To avoid paying capital gains taxes, investors retain existing investments rather than selling them and re-investing in more productive assets.

A higher tax rate will also reduce the rewards to entrepreneurial endeavours. Entrepreneurs risk their own capital and time in hopes of profiting from a new product or unproven service. Raising the tax diminishes the potential payoff of taking these risks, thereby discouraging entrepreneurship and innovation—the engine of our economy.

Why, then, would the federal government—which wants to improve economic growth and foster innovation—consider raising a damaging tax that currently raises less than two per cent of all federal revenues?

One of the assumptions underlying the push to raise the capital gains tax is the perception that only the “rich” pay this tax. At first blush, the soak-the-rich rhetoric seems plausible since data from Statistics Canada show that 82 per cent of capital gains taxes are paid by Canadians with taxable incomes over $150,000.

The problem, however, is this data overlooks the important fact that realizing a capital gain inflates one’s income, often for a single year if the source is a one-time asset sale. In other words, an individual is temporarily pushed into a higher income group for the year capital gains are triggered. Since these gains are often rare events, they create a misleading picture about the income levels of those who pay the bulk of capital gains taxes.

To illustrate this point, consider what happens when we exclude capital gains income from total income to see the impact on the distribution of capital gains taxes paid by income groups. Canadians with incomes over $150,000 (excluding net capital gains income) now pay 47 per cent of capital gains taxes—significantly less than the 82 per cent figure if capital gains are included in income.

Or look at the data another way. When considering all taxable income, Canadians with incomes of $75,000 or less pay just 6 per cent of capital gains taxes.

Again, if we strip out capital gains income, the distribution of capital gains taxes changes. Canadians with incomes of $75,000 or less (excluding net capital gains income) now pay 37 per cent of capital gains taxes. This suggests that middle-class Canadians pay a significant share of capital gains taxes.

So while proponents of increased capital gains taxes may want to soak “rich” Canadians, in reality a rate hike will lighten the wallets of many middle-income Canadians who realize a large one-time capital gain.