Changes to the Canadian Entrepreneurs’ Incentive in Budget 2024

Tweaks to the margins of bad tax policy will not be enough to mitigate Budget 2024's harm to the Canadian innovation ecosystem

After an uproar over proposed changes to the capital gains inclusion rate in Canada, the government has announced some tweaks to the approach. The changes center around the entrepreneurship incentive, which is a carveout that exempts company founders from a portion of the additional taxation.

This week’s article is quite brief, but in this case there is really only a single point that needs to be made.

Canada’s issues with productivity are structural and deeply rooted. Changing this legacy of underperformance in innovation will require more than playing with numbers at the margins of tax policy. These incremental changes do little to reverse the harm that will be done by the capital gains tax as a whole, and reads as policy breadcrumbing, an attempt to appease the innovation community without actually making any substantive change.

The original Canada Entrepreneurs’ Incentive reduces capital gains inclusion rate to just 33% on a lifetime maximum of $2,000,000 in gains arising from the same of a business in which one owns a founding stake. It was originally subjected to a huge number of caveats (such as duration of ownership) that would have prevented many entrepreneurs from actually using it. The more recent changes relax some of these restrictions, making it more generally accessible. In a vacuum, there is nothing bad about the recent announcement. It just will not be enough to counterbalance the harm of the capital gains proposal taken as a whole.

The journey from founder to exit is so long and complex and unlikely to succeed that decisions at the founding stage are not made based on tax implications in the unlikely event of long term success, meaning that these changes are not going to do anything to improve the chances that a founder will found their company in Canada. The changes are certainly nice to have in the sense that we should be rewarding people who take risks like this, but it will have no impact on company founding activity.

Rather, a founder starting a company that has the luxury of being able to operate anywhere will make the decision of where to start based on their estimation of what will maximize their chance of success at all. One of the factors that makes that decision is availability of capital, and investment capital deployment is very sensitive to taxation. Capital deployment is a zero-sum game in the sense that capital allocated for one asset class is not available to be allocated into another. Tax disincentives for investment in Canadian innovation just pushes capital at the margin into other asset classes, including real estate.

It is also interesting to note the language on the announcement page around the announcement itself. In particular, the government continues to push the claim that the proposed changes will only impact 0.13% of Canadians, when in fact the changes will impact 0.13% of taxation events, which translates to a much larger proportion of individuals (more than 15%) taken over a lifetime. While startup founders are typically not thinking about long-term tax implications of where the start their business, a whole class of professionals that rely on small businesses for their incorporation do in fact base their business decisions on tax considerations. lawyers, doctors, dentists, and a long list of consulting-type businesses that rely on a corporation with one shareholder are negatively affected by capital gains tax issues, and are not addressed at all with this incremental tweak to the rules. Continued use of a statistic that has been thoroughly debunked further reinforces the perception that this change is nothing more than lip service to sound innovation policy.

The capital gains inclusion rate changes remain a deeply flawed policy initiative. All else being equal this boost to the Canadian Entrepreneurs’ Incentive is nice to have, but it completely, if not deliberately, misses the point of the objections being raised to the capital gains tax changes as a whole. While this change to the entrepreneur’s incentive is certainly better for the innovation ecosystem than the original proposal, let’s not conflate “better” with “good”. When the bar is this low, it’s difficult to contemplate how any change could have gone the other way.