Unlocking Canadian Capital - Policy Recommendations
In my view, the preceding analysis makes a powerful case for very fundamental changes to the capital gains regime in Canada.
First-best policy: abandon the tax
There are three basic reasons for this recommendation:
- Capital would be more efficiently allocated if the lock-in effect of appreciated assets caused by the capital gains tax was eliminated. The drain of entrepreneurial brains and financial angels would be reduced. The excessive reinvestment of capital alleged to be a serious problem in the absence of a capital gains tax can be dealt with through a differential tax on distributed and undistributed profits.
- The economic growth induced by eliminating the tax almost certainly would increase revenues collected from other sources to more than match the relatively small net revenues collected presently from the capital gains tax.
- The fairness of the distribution of after-tax income would be affected only slightly. Presently, capital gains taxes are paid predominantly not by the rich, but by middle- and lower-income Canadians. The principle of horizontal equity is breached in the current tax code in several different ways when it serves other fiscal and social objectives well. It could and should be breached again in the name of the greater good for all Canadians.
Second-best policy: lower the rate
If politicians cannot be persuaded that it is in their and the public interest to eliminate the capital gains tax completely, the second best policy would be to make Canada's rate equal to that existing in the United States.
Under this policy, Canada would enjoy some of the benefits of the more efficient allocation of capital and greater economic growth mentioned above. In addition, the proposed rate deals with the fact that in today's world of high mobility of capital and people, Canada cannot afford to have policies that make investment and entrepreneurial activities less attractive than they are in the United States.
Canada has suffered long enough from a tax regime more inimical to economic growth than that in the United States. We cannot afford to continue policies that will further widen the gap in income between the two countries. The fiscal surpluses expected in Canada during the first years of the new century offer a splendid opportunity to make the Canadian tax system more competitive.
Third-best policy: return to the original 50 percent inclusion rate
Ranking third on my list of recommended changes is lowering the effective capital gains tax rate by lowering the inclusion rate for realized gains from 75 percent to 50 percent. Such a change would return the rate of taxation to the one adopted in 1972 after much public inquiry into its costs and benefits. Fiscal contingencies and emergencies motivated the subsequent increases in the rate. The increases were undertaken without a full understanding of the adverse consequences they would bring for economic growth and revenues. The fiscal problems have now passed, and the above analysis shows that lower rates would increase rather than decrease revenues.
Fourth-best policy: lower the inclusion rate to 65 percent
The House of Commons Finance Committee in its 1999 report (pp. 62 and 74) has recommended lowering the inclusion rate to 65 percent; rumours have it that this option will be accepted in the 2000 budget. The recommendation is undoubtedly based on testimony given by Professor Jack Mintz, one of Canada's foremost academic taxation experts at the University of Toronto, and President of the CD Howe Institute. He argues that at this rate of inclusion, the effective rate of taxation for capital gains is equal to the tax rate applicable to small business profits. While this policy eliminates an efficiency-decreasing distortion in the tax system, in my view this effect is minimal in relation to all of the other efficiency costs of the tax discussed above.
Minor policy changes
If the capital gains tax is eliminated, I recommend the differential taxation of retained and distributed earnings of companies. The difference in the rate can be set at a level that discourages the excessive reinvestment of profits and the use of other methods to shift wages, royalties, interest, and other income into company earnings. This policy has been in effect in Germany and while it complicates the tax code, at the very least it deserves in-depth study.
If the capital gains tax is retained, at whatever level, I recommend indexing capital gains to inflation. The reasons for this recommendation have been discussed at length in chapter 3. This policy may be cumbersome to enact, and require much difficult administration. However, the benefits are potentially so large that at least the policy deserves careful further study.45
If the capital gains tax is retained, at whatever level, I recommend creating what some refer to as Registered Investment Plans. Such investment vehicles are used widely in the United States and offer a tax shelter for investors. They involve investing after-tax income, but allow the tax-free accumulation of dividends, interest, and capital gains. In effect, assets in such an investment vehicle are not locked in. These Registered Investment Funds are desirable for government since they raise tax revenue at the beginning, while the Canadian RRSP plans raise it at the end when the funds are withdrawn. This characteristic of the proposed investment vehicle should make it attractive to some politicians and those concerned about the present taxation capacity of the economy.
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