Unlocking Canadian Capital - Mr. John Dobson and Mr. Ian Soutar
THE STANDING SENATE COMMITTEE
ON BANKING, TRADE AND COMMERCE
EVIDENCE, OTTAWA
Wednesday, February 23, 2000
Senator Leo E. Kolber (Chairman) in the Chair.
The Chairman: Honourable senators, this afternoon we are resuming our study on capital gains tax. We have two groups of witnesses. Our first group is from the Formula Growth Fund and Pembroke MGMT. I will first introduce John Dobson, the chairman and founder of Formula Growth Limited, in Montreal. Parenthetically, I am an investor in that fund and it is doing extremely well.
Senator Angus: That sounds like a conflict.
The Chairman: Mr. Dobson is a graduate of McGill University and the Harvard Business School. He is president of the John Dobson Foundation and was appointed a member of the Order of Canada in April 1997.
Joining Mr. Dobson is Ian Soutar, an officer and partner with Pembroke Management Ltd. of Montreal. He is a graduate of McGill and the London School of Economics. He has been with Pembroke Management since 1968. Before that, he worked for All Canadian Funds and for Sun Life Assurance Company of Canada. Welcome, gentlemen. You have some prepared statements, so please proceed.
Mr. Ian Soutar, Chairman, Pembroke Management Ltd.: Honourable senators, Mr. Dobson and I are pleased to have the opportunity to appear before your committee to discuss the issue of capital gains taxation. Although we have very strong convictions about this topic, we were hesitant to make a submission to this committee because of the generally perceived view that the comments of successful investment professionals about capital gains are self-serving. However, having been encouraged by Senator Angus to speak out on this issue, we concluded that we should appear before you.
Capital gains taxes took effect in Canada at the beginning of 1972. Since that time, Mr. Dobson and I have vehemently believed that it was a bad idea for Canada. We continue to believe that the economy and our citizens have suffered significant economic consequences as a result of this action. Canada was one of the best performing nations in economic terms before 1972. Since that time, the economic level of our people has slipped substantially relative to the US and many other nations. We believe that a substantial cut in the capital gains tax would be the single most important action that our government could do to improve the economic well-being of all Canadians.
We believe that is why Australia recently decided to cut its top marginal capital gains tax from 47 percent to 23.5 percent for assets held for one year, and why Germany has just announced an elimination of capital gains taxes applying to stock sales by corporations. That follows the significant US cuts of recent years.
We applaud your committee's study of this important issue and urge you to use whatever authority you have to get the message to all Canadians that a high rate of capital gains tax is bad for all Canadians, not just the privileged few.
By way of background, Mr. Dobson and I have been investors in emerging public growth stocks since the 1960s. Pembroke invests in both Canada and the US. Formula invests only in the US. Formula used to invest in Europe and had one-third of its fund in Japan in the early 1970s. We have each invested in thousands of companies over the years. Formula has a compound annual return of 17 percent for 39.5 years. To give you an idea of what that means in terms of the power of compounding, $9 invested at the start of the fund is now worth $4,700.
We believe that our most useful contribution to the committee would be to present a number of actual investment cases that were affected by capital gains tax. Before doing so, we would like to comment on several macro areas where we differ significantly from the academic economists and, we believe, the federal Department of Finance.
First, as investors, we are interested in wealth creation. That appears to be a bad term in Canada - so bad that it is neither used nor discussed. In short, Canadians appear not to want successful creators of wealth, as Americans clearly do. For example, there are only five Canadian foundations with assets over $100 million, two of which are institutional. Bill Gates is a hero in the US, but he would not be in Canada. To sell capital gains reduction, we thus have to replace discussion of wealth creation with discussion of the positive role of capital on the creation of jobs. Everyone accepts that the creation of jobs in the private sector requires someone to have capital.
Second, economic models and academic economists seem to give no credit to the effect of changed personal behaviour of investors if the incentive system is changed. Their models are static and show the same results for the growth of the economy if the capital gains tax is 40 percent, 20 percent, or zero. We see from our investing experiences that that is clearly untrue in practice. In fact, only recently have some orthodox economists in academia begun to recognize the role of innovation and technology in economic growth theory.
On January 24, 1963, President Kennedy said: "The tax on capital gains directly affects investment decisions, the mobility and flow of risk capital ... the ease or difficulty experienced by new ventures in obtaining capital, and therefore the strength and potential for growth in the economy."
Third, Ottawa and academic economists like Jack Mintz appear to us to be obsessed with the technical issue of the tax relationship between capital gains, dividends, and the small business tax. In the world of public investors, this is not an issue. Today, the Dow Jones yields 1.4 percent. Most investors in equities invest for capital appreciation or at least a combination of yield and growth."
In the last sentence of his presentation to your Senate hearings, Jack Mintz said: "I know that in terms of my recommendation I am driven by a technical issue, which is the conversion of income into capital gains, but I am very sympathetic with the argument that we should try to lower capital gains tax rates."
Our number one question, which appears rarely to be addressed, is what is the correct capital gains tax rate to provide maximum economic growth for the benefit of all Canadians. Our answer is zero, or at least no higher a rate than our nearest competitor, the United States, and that view is shared by Alan Greenspan. As noted on page 15 of this submission, Mr. Greenspan said: "The point I made at the Budget Committee was that if the capital gains tax were eliminated, that we would presumably, over time, see increased economic growth which would raise revenues for the personal and corporate taxes as well as the other taxes we have. The crucial issue about the capital gains tax is not its revenue-raising capacity. I think it is a very poor tax for that purpose. Indeed, its major impact is to impede entrepreneurial activity and capital formation. While all taxes impede economic growth to one extent or another, the capital gains tax is at the far end of the scale. I argued that the appropriate capital gains tax rate was zero."
I will conclude this section with a quote by Bruce Bartlett, a well-known US expert with the National Center for Policy Analysis:
While there are many people who argue for a capital gains preference, and even support lowering the tax to zero, few have grounded their case on the fundamental principle that capital gains are not income. They should make this argument consistently because it raises the case from the realm of political expediency or even economic efficiency to the level of principle. Doing so at least gives advocates of lower capital gains a firmer foundation when confronted by those making a principled argument for not doing so, on the grounds that the capital gains should really be taxed like ordinary income.
In appearing before your committee, Mr. Dobson and I wish to stress that at our age we are not so concerned with any benefit to us. We are concerned with giving younger generations of Canadians the same great opportunities that we have enjoyed. As you will see, a 40 percent capital gains tax seriously eliminates opportunity and significantly contributes to the brain drain. It also reduces the incentive to create wealth that we believe is a benefit to all Canadians.
Mr. Dobson will now give you a number of examples.
Mr. John Dobson, Chairman, Formula Growth Limited: I will discuss this topic from my perspective of a very fortunate Canadian, and I will give you several case examples.
I got involved in investing at a young age because my father put $100 in my account every year. I was never allowed to touch either the capital or the dividends. From that, I learned the value of investing. I should like to pass this principle on to younger generations. I want young Canadians to have the same advantage that I had. To that end, I have come up with these exhibits.
As you will see from Exhibit 1 [following this transcript], the power of compounding interest and the effect of negative capital policies is one of the great wonders of the world, and many people do not appreciate it. This exhibit sets out the time factor with which we are dealing. The conclusion is that $1,000 compounded at 20 percent for 40 years untaxed becomes $1.5 million, while $1,000 compounded at 20 percent for 40 years with annual capital gains tax at 40 percent becomes $93,000.
Over 40 years the government receives, if taxed annually, $22,000. I might add that if the government only collected the tax at the end they would have $600,000. This excludes the devaluation of the currency - the Canadian dollar has gone to 25 cents over the last 25 years - and also the buying power in international currency, which was 72.5 cents in terms of the US dollar when I did this in 1997. This is at the centre of everything that we think of and what we want to teach people about long-term investment and, if you invest in savings, understanding what you can have, what the country can have, and the growth. What has happened here is that an individual ends up with $1.4 million of wealth creation and the government gets $22,000. It is not a very good deal for Canada.
The case is very extreme. We have taken many years, but we are looking at someone over a longer time period. Forty years is reasonable. Some people start at age 25 and we want to see what has happened by the time they are 65 years old.
Senator Meighen: Did you say the individual ends up with $1.4 million or loses $1.4 million?
Mr. Soutar: Sorry, senator. He ends up with $93,000.
Mr. Dobson: Instead of $1.5 million.
Senator Meighen: The government only gets $22,000.
Mr. Dobson: That is right. I apologize. I should read more carefully.
This example is extreme from two points of view: First, 20 percent is a lot, but we have done it at 17 percent; second, we are taking it every year you pay the capital gains tax. That is not that likely to happen. We build a case that is extreme in order to show the absolute importance of savings, growth, and compounding. A 17 percent rate is a much higher than most people would have, but I can give you figures at 12 percent or something else in the question period.
Let us turn to Exhibit 2 [following this transcript]. I take out of that two things. In case A, a compound return of 7.9 percent over 25 years with 5 percent inflation, 40 percent capital gains tax, and portfolio turnover every three years would produce zero real gain, or 100 percent capital gains tax.
Mr. Soutar: That is very close to the return that one has had by investing in Canadian stocks over that period of time. I think the return has been approximately 9 percent or 10 percent. In effect, after taxes and after inflation, there is no real return.
Mr. Dobson: If you made less than 7.9 percent you lost real value. As Mr. Soutar says, not many people have done much better than that.
Case B looks at wealth creation over 25 years. What happens if the individual lives in Hong Kong, in Canada, or in the US? The answer is that he has 4.7 times more money in Hong Kong than in Canada, and 2.2 times more in the US than in Canada, because of capital gains tax.
You may wish to turn now to Exhibit 3 [following this transcript]. I start with a child who gets $1,000. I got $100 a year from my father. You might be interested in this question of inflation, which does go on. My father got paid $100 a year in 1900 when he started out. That shows you what happens to the dollar over a period of time.
Investor No. 1, the child, receives $1,000 for 21 years, reinvests at 20 percent return, and turns the portfolio every three years. We picked three years because serious investors like John Templeton or Peter Lynch or our fund feel it is necessary to change in and out at an average of every three years. That gets into a bit of lock-up later on. The child would get $270,000 after 20 years, but the taxes eat down to $177,000. The capital forfeited to tax and lost return is $92,000; in other words, 37 percent of the investment gain has been lost, partially because the child paid taxes, but equally because there have been fewer chips available to be invested because the money has been taken out and paid to the government. I would have that much less if I were coming along now compared to when I started. I was lucky because there was no capital gains until 1972 and I was born in 1928.
What about a graduate coming out of school? Interestingly enough, the average guy graduating out of McGill School of Commerce gets $41,000 this year.
The Chairman: Where are we?
Mr. Dobson: We are at the bottom of page 6, and I am talking about Exhibit 3.
Investor No. 2 is the McGill commerce graduate. He saves and invests $5,000 a year for three years, invests with 20 percent return and pays a capital gains tax of 30 percent. In Quebec we pay 39 percent at the maximum, but he would pay less because he is in the $41,000 bracket, not in the $60,000 bracket, although he will get up to there pretty soon. That graduate would have $21,800, but with tax payments he has $19,700. Really, 30 percent of what he makes on his investment in his first three years he loses because of the capital gains tax.
Investor No. 3 is a secretary, and we try to deal with a secretary whom some of you might know or know of who was referred to in some of the hearings. A high-level secretary, like she was, starting today, might get a $40,000 salary. She invests $5,000 for 10 years with 20 percent investment returns. With zero tax, the secretary would have $155,000 versus her actual after-tax total of $113,000. She forfeits $42,000 - 37 percent of her investment gain.
Senator Angus: That is 39.7 percent.
Mr. Dobson: Right. There is no inflation factor in here. Only 27 percent of that is to taxes. What we are trying to show is that many of the people we have in our fund, or in our society, are lower-income people who are working their savings. They are generally not considered to be the people who are making capital gains. These are real people. We are not talking just about rich tycoons.
Now I move to real cases from our fund; these are actual figures. The first fellow, investor No. 4, is a golf pro. He invested $3,612 in our fund in January 1971. You can see that he had a market value this year of $340,883. Now, he had to pay a capital gains tax of $63,200. This is very important to understand because he had to get that money from some place. He actually saved it outside and did not take the money out of the fund. If he had used the fund to pay his capital gains tax, he would have had taxes on selling the fund. He has an unrealized gain of $71,772. Total taxes paid were $134,920. It looks large. Again, we are not talking about what is lost on the value of the currency or the international buying power?
The next investor is a doctor friend of mine who started when we started in 1960. He had $4,000. In 1971 this fellow was worth $23,500. That was before there was any particular capital gains tax. This year he is worth $2.5 million. He had to pay $410,000, which he had to find some place, and he has an unrealized gain of $466,000, for total tax of 39.6 percent.
Again, the real returns for investors 4 and 5 are much lower because of inflation and currency losses. In addition, they have had to save up that money. I am repeating myself but it is important to understand how we crucify long-term people by this process.
Investor No. 6 is the sort of case you get if you wander around the community. This is a retired doctor, highly respected. He had an argument with his trust company because, over the years, it managed his money very conservatively and his assets were not growing. He finally got rid of the trust company with a lawsuit and then he had advice in the form of a financial planner, although not us. For a while the portfolio was in balance, but then a couple of years ago a bank stock went up a tremendous amount and so did a US pharmaceutical. Both he and his financial planner felt that both stocks should be sold. However, his capital gain was so large that he decided not to make the change, and both stocks declined significantly. This locked-in factor is enormous and experienced by many portfolio owners and managers.
At Formula, we consider keeping a stock that will grow at 12 percent to be equal to selling it and replacing it with a stock that will grow at 20 percent. As a professional portfolio manager, I think that is grim. If we sell the stock, we can replace only a certain number of dollars. We can put 60 percent back into the gain, but we must pass 40 percent to the government. Therefore, we have that many fewer assets. There is a big economic loss from staying invested in lower investments and not switching to newer, faster growing companies. There are dozens of cases involving that. Wherever we go, we hear that kind of thing.
The next example involves the son of one of my friends. He was a computer geek. He went to the University of Waterloo and then moved to Kanata. At one point, he and two of his friends started their own computer software company that specialized in computer security. Recently, it was sold to a big company that helped finance it: Newbridge. The entrepreneur was asked by his father: "How much money did you make, son?" The son responded to the father: "Before tax or after tax?" The father then asked: "I guess after you have had your 18-month stay-in and earn-out period, you will probably start again?" His son replied: "I made a lot of money. I might start again, but I will not start in Canada because of the capital gains tax." Those are good young guys in the modern world and that is an actual case from highly respected people in our community.
We play golf and we talk about some of these cases. In fact, that is where the previous story was heard. There is also the dentist and MBA from Concordia who wants to be heard. He entered our discussion by stating that he did not want to follow the lead of many of his friends who say that he is foolish not to take his funds offshore. He is upset and dumbfounded by the number of them who tell him he is stupid not to do what the rest of the people are doing. That is pretty sad, but it is realistic with the 40 percent rate. Again, like the lock-in effect, the government gets no revenue when money is moved into the tax-free areas. If you take your money offshore, the government gets nothing.
The Chairman: When you bring the money back, do you not have to pay tax?
Mr. Dobson: Yes, but you can use the internal buildup in the meantime. You pay 100 percent. They are trying to get an internal buildup, like the British system. You definitely pay the tax when it comes back, but you have all that money working for you. You get the $1.5 million as opposed to the $93,000 in our earlier case, and the government would get $600,000.
Senator Angus: What do you mean by "internal buildup"?
Mr. Dobson: You pay a certain amount of tax to the government, but then the funds available to you have been lost to earn on in future years. That is roughly equal to the taxes. It is a very big factor. You have $100 on day one and you pay 20 percent to the government. You then start with $80. You have lost some of the assets, which will compound at whatever rates we use.
Investor No. 9 is an example of probably the biggest negative of all, which is the loss from entrepreneurs who never get started because of the effects of high capital gains tax. First, for those who choose to remain in Canada, there are not enough angels to finance start-ups because of the lack of wealth creation. Second, Canada loses when Canadians set up in the US rather than in Canada because of the perceived uncompetitive climate suggested by a 40 percent versus 20 percent capital gains tax. That correlates directly with job creation. Either we have jobs in the private sector created by entrepreneurs and accountable to them for what they are paying people - hopefully productive jobs - or we look to government to create jobs with questionable economic value and accountability. The current Human Resources debacle is a case in point.
Senator Angus: It is shameful.
Mr. Dobson: Investor No. 10 is next. In our fund and all mutual funds, new entrants must assume the unrealized gain in the fund upon entry. If you entered our fund on January 1 this year, at $4,400, you would know we have approximately $2,200 of unrealized gains. At the end of this year, our fund might be $4,400, or it might show a loss from purchase price. If the managers sold all stocks with unrealized gains, the new investor would get a tax slip for his percentage of $2,200, even if the value of the fund did not increase.
It is interesting to note that unit trusts in the UK are not required to pay capital gains taxes. In other words, the fund manager can change the portfolio and the investor will pay capital gains tax only once he sells his underlying units in the fund. The significance of that can be seen in Exhibit 1. The individual would end up with $900,000 versus the $93,000 that was given in the example - that is, if the 40 percent tax payment were deferred to the end of 40 years. If that happened, the government would get $600,000, as we saw in that earlier case. While this example is extreme, the lock-in factor is serious. It is hurting wealth creation because it keeps investors in old holdings instead of newer ones. Many of these things hurt investors because of this capital gains tax that they must either defend against or do something about.
Concerning cost and regulations, the revenue that the federal government receives from capital gains stocks is not very significant. Your committee no doubt knows all the figures from the Finance Department. The cost for collections and policing must be subtracted against the revenue. The problem is that you have an asset. You must keep track of the date of the asset, whether it goes up or down or sideways, within one year or five years. Because the capital gains tax is applied over a long time period, it is very complicated to score and to keep.
For individuals, look at the unproductive costs for the material in the private sector. You have H&R Block doing tax returns, lawyers, accountants, administrative costs of the RRSP, and so on.
Senator Hervieux-Payette: What about job creation?
Mr. Dobson: I am talking against the service we provide. While we receive fees, we are saying that it is wrong to have so many intermediaries who add to the unproductive cost.
RRSPs are better than nothing, but they often provide for bad investment performance because of small amounts and administrative costs, plus the 80 percent Canadian content. Other troubling problems arise, such as investor-owned units in the fund in a personal holding company. The geniuses tell us that you should have your own personal holding company when you have US assets. If you do, then you pay a capital tax. If you have it in your own name, you do not. I have it in both, and so does Mr. Soutar. On one account, we pay a capital tax; on another account, we do not. Things like that go unsaid but in the real world add up to the total cost and annoyance that is caused by the capital gains tax.
Mr. Soutar: In conclusion, Canadians' well-being has been substantially lessened by the high capital gains tax that has been imposed by our government. First, the tax significantly reduced the wealth creation process. Second, the lock-in effect of the capital gains tax has badly affected returns by keeping Canadians from switching into higher-returning assets. Third, this high tax has either prevented our most talented entrepreneurial business people from getting started in Canada because of a lack of angel financing, or has driven them from the country. It is important that this message is communicated successfully to the people of Canada. Our reduced capital gains tax will not just help the rich. It will materially help all Canadians to enjoy a higher standard of living by creating the wealth that is needed to provide our citizens with better education, health care, or whatever else we choose collectively to spend it on.
Senator Angus: Mr. Dobson and Mr. Soutar, we appreciate your coming up here today and the excellent paper and appendices that you have presented. We have been engaged in this study for several months now. We have had a variety of what you referred to as "academic tax economists." Some of their evidence has been conflicting and also confusing. Perhaps you can help - as you already have - in terms of clarifying some points.
I have two questions. First, you spoke about the lock-in effect created by this punitive capital gains tax in Canada. You are advocating an abolition of the capital gains tax, which would obviate the lock-in effect. If that happened, where would those locked-in funds go? What would happen to those funds?
Mr. Soutar: Those funds will not go under the mattress or disappear. This money will be reinvested in higher-returning assets. It will be invested in business formation. It will be supplied to various charitable organizations. It will be spent on consumer goods. It will go back into the Canadian economy.
Three things will happen when the capital gains tax is either substantially reduced or eliminated. First, there will be a surplus of money that will go to the government because lower tax rates will encourage a number of investors to turn in their investments. They have been sitting back, reluctant to pay the capital gains tax. The funds will go into higher-earning assets. Second, money will be invested in higher-earning assets, which will create more wealth for the good of all Canadians. Third, the funds will be recycled into all kinds of economic activity, which will benefit all Canadians. Locked-in funds have an enormous adverse impact on the economy, on job creation, and on the prosperity of all Canadians.
Study after study in the United States has shown that when capital gains tax rates are cut, there is a substantial improvement in economic activity generally as a result. The economies of Ireland and New Zealand are cases in point. I do not believe there is any case in the world where capital gains tax rates were reduced without resulting in a substantial improvement in economic activity and well-being for all citizens. That is why politicians reduce capital gains. Politicians do not reduce tax rates because they do not want to get access to funds. Politicians love to have hold of the money so they can control it. They do not understand what a destructive process that is. Leaving money to accumulate and create greater wealth, in the hands of productive individuals, benefits economies substantially.
Canadians do not have a choice. We are totally non-competitive with the vast majority of our Western competitors. If we do not reduce capital gains tax rates, we will continue to lose our best and most talented people to the United States and other countries. Our citizens will not benefit as they should.
Believe me, if tax rates on capital gains are reduced, people will think they are in the midst of an economic miracle. In my opinion, you will almost immediately see an improvement in our currency. You will see a substantial increase in capital investment in this country and a substantial improvement in our domestic economy.
Senator Angus: You have made some very positive and adamant statements. You have referred to studies and texts. Are you comfortable that the evidence is out there? Is this a wish list that you have? Can you affirm that there is concrete evidence to sustain the points you are making?
Mr. Soutar: Absolutely.
Mr. Dobson: I agree with that. I would also cite Germany as a good example for our proposition. Germany has a banking system and there is interlocking money backwards and forwards. Germany has also totally removed the capital gains tax rates on companies. They have done that because they want the money to flow around and be re-addressed from the old economy to what is now referred to as the new economy. Countries will be efficient and modern. To do that, you must get the money out of the old economy and move it into the new economy. You must find the money some place.
When a country like Germany finds it necessary to go to that extreme, they are not fiddling with the capital gains - from three-quarters inclusion to two-thirds inclusion, or 65 percent - the figure is zero in Germany. I do not live in Germany, but that is a piece of evidence other people in the world have found. To be competitive and to deal with unemployment, that is what they must do.
Senator Angus: On the subject of the new economy versus the old economy, or the restructuring in Canada, we want to get away from being hewers of wood and drawers of water and to advance into this new economy. We have heard that said repeatedly in another study done by this committee with respect to the availability of equity capital for start-ups and for new business in this country. Canada is apparently lagging behind our neighbours, partners, and other OECD countries in participating in the new economy. Even in our traditional resource-based companies, we have lagged behind in retooling to take advantage of the new economy's technology and to make companies more efficient. Is that what you are referring to basically? Would the removal or the reduction of the capital gains tax help to alleviate that situation?
Mr. Dobson: That would do a great deal to alleviate the situation. In Canada we have the problem of what we refer to as "angels." There is venture capital money available, often institutionalized. If you want to start up something you go around, as we did in the Montreal community, and raise funds. We collected $134,000 and that is how we started. You cannot do that today with all the regulations. Rather, money in the hands of friends and relations is made available to move into this area.
Senator Angus: You say that is not there today in Canada?
Mr. Dobson: There is some, but nowhere near the degree that is available in other places, particularly in the United States. We just do not have that much wealth in our country. If you want to start a team like the Expos, you had better have, in year one, a Charlie Bronfman. We had 30 of them, but Mr. Bronfman ended up with almost sole control, along with Hugh Hallward and Lorne Webster. Money is needed to get things going.
The second issue is something many people lose sight of. If one is to invest in something like that, one must be able to come up with a second and a third round. Mr. Soutar and I are not usually in the start-up business but occasionally we do get into it. We know from experience that if you put money into such things, you must be prepared to give a second shot and a third shot. If you are going to put in some money, you need to look and see who else in the community might take you out.
The Expos are a good illustration. They had 30 investors at the beginning who dropped by the wayside, one by one, and eventually they all went out. On day one, it was great and 30 players were ready to tee up, but one must be able to find the future equity. If one cannot find future financing and take-out, then one must decide whether to go in at all.
Senator Angus: We hear time and again that Canada, being so close to our large neighbour to the south, should have a comparable regulatory system, be it in banking or taxation or in other economic conditions. If we follow that lead, using the US as a model, I suppose we would conclude that their approach to capital gains might be instructive. What would you have to say about that proposition?
Given Canada's relatively small size, our open economy and the fact that we are apparently more than 18 months behind in taking advantage of Internet commerce, and given that we do live next door to the world's largest economic engine - the elephant - should we have a lower capital gains tax in Canada in order to attract new money and to increase the wealth and prosperity of all Canadians?
Mr. Dobson: At The Fraser Institute symposium on capital gains, they gathered 20 or 25 experts, including two or three Americans. They asked, should Canada have the same system as the United States? The answer from them was clearly no.
Senator Angus: Why not?
Mr. Dobson: We should have our own system. What are our needs?
Senator Angus: I take it you agree with those who say we should not have the same system? Is that your evidence?
Mr. Dobson: I do not think it matters. What matters is the rate of the capital gain, because that is what the decision whether or not to invest in Canada will be based on. The issue is not whether to copy their system but, rather, how we can compete for overseas investments and retain Canadian investment.
Senator Angus: Rather than the Americans getting it?
Mr. Dobson: Or whoever else. Today our people are going to Ireland because that is currently the hot place. We must look at what is good for Canadians and what is needed. If we need capital for jobs, someone must have the capital. As Alan Greenspan said, the worst thing to penalize is capital and capital gains. You need that to get it going. Do not buy the American system holus-bolus, but, directly on your point, if our capital gains tax was 3 percent to 5 percent less than the American tax, that would signal to the world that this country wants to grow and to move from the stages that you spoke of earlier.
Senator Furey: I wish to follow up on a point that Senator Angus made earlier. Mr. Soutar, do you think we would get the same results with tax deferral rather than total elimination of the tax? Would we get the same capital mobility and hence the same investment opportunities with tax deferral?
Mr. Soutar: Any substantial reduction in the capital gains tax would have a positive impact on the country.
Senator Furey: Would you consider a deferral a substantial reduction?
Mr. Soutar: Deferral of the tax through a vehicle with a rollover provision that would allow the accumulation of wealth, which is the important factor here, would be a substantial improvement. It should be done over a long period of time so that greater wealth can be created, because that will benefit government revenues as well as the individual citizens of our country. That would be a substantial improvement.
If I were fashioning the tax myself, I would cut the rate very substantially. I would not get too technical in terms of creating vehicles for deferral, because that complicates life. The simpler, the better. However, a substantial or total deferral of taxes over a substantial period of time, such as the career of an individual, for example, would be a substantial plus in terms of the wealth-creation process and the encouragement of entrepreneurial activity.
Senator Furey: That would probably be easier to sell to the general public.
Mr. Soutar: That may well be. Our mission is to make this appealing to people and to educate people about the benefits. It is always perceived, even in the United States where they really believe in capitalism, to be a sop to the rich. It is generally thought to be such because people do not think about the implications. I strongly believe that this is a very unfortunate perception caused by lack of understanding of the process. Once you understand the wonderful power of compounding over long periods of time, you realize that the nation is losing enormously by not letting the egg grow to a great size. A deferral would definitely help in that process.
Senator Oliver: You said in response to other senators that you welcome reducing capital gains tax to zero. The Minister of Finance is not interested in increasing allowable foreign content quickly up to 10 percent, but would prefer to move 2 percent a year.
Could you explain to the Canadian public whether there is any danger in jumping from 75 percent to zero? What negative effects can possibly come to the Canadian economy, or Canadians, by suddenly, in one fell swoop, removing the tax?
Mr. Soutar: There are bound to be some minor negatives. There has always been a concern that people will attempt to turn income into capital gains through various tax mechanisms in order to avoid paying income taxes. However, I believe that the negatives associated with the elimination of the capital gains tax are so minor in relation to the benefits that all Canadians would enjoy that they are not worth worrying about. I do not get caught up in the technicalities that the tax experts do about the fairness of one versus the other. I think there would be minor cheating in the system, but the benefits would be so enormous to all Canadians in terms of job creation and general prosperity that it is really not worth worrying about.
Mr. Dobson: In the deferral mechanism there are two things to consider. The first, about which we do not know enough, is the British model of unit trusts. In that model, the manager can buy and sell stocks within the mutual fund without triggering capital gains for the investor until he redeems from the fund. That defers the tax and would be of benefit to many lower-income people in Canada.
Second, Jack Mintz is very interested in what he calls a rollover. Like Mr. Soutar, I do not like vehicles. I prefer to have it clean and simple and for people to own their own stocks. However, if we must have vehicles, we could put all our stocks in a vehicle, switch them from the old to the more aggressive, if that is what we want, in order to build up wealth for Canada, and any time we take it out we pay tax on it. We can devise vehicles to do that. The starting point, however, is to realize that we have a big problem because Canadians are not educated in the ramifications.
Senator Kenny: Mr. Dobson and Mr. Soutar, I should also declare that I am an investor in Formula Growth.
You have made the point about the value of compound interest and about the impact of the erosion of inflation. You made the case for reduced or no capital gains tax: benefits to the investor, benefits to the government, benefits of keeping entrepreneurs at home.
I am struck with your statement on page 1 where you say: "We believe that a substantial cut in the capital gains tax would be the single most important action that our government could do to improve the economic well-being of all Canadians."
I assume that you have considered income tax and the GST. You have not really addressed that question here, unless I have missed it. Would you explain why you feel that this action would be preferable to other actions that the government might take?
Mr. Soutar: Neither Mr. Dobson nor I is an economist and we are really not capable of giving you any kind of quantitative study that could justify that statement. We have seen the incredible response in Ireland, New Zealand, and other countries when they cut capital gains tax. One of the reasons we quoted Alan Greenspan, who has much credibility throughout the world, is that he believes this is probably the most important thing that can be done for the good of an economy, and he is a highly qualified economist.
That is a feeling we have. We have that feeling because we have been in the investment business for 40 years and have seen the enormous ramifications of compounding wealth over many years and what that does in terms of wealth creation. We think that that wealth creation process will happen faster with lower capital gains tax and that it will have a dramatic impact on capital investment in this country, and that is where we think the whole wealth-creation process takes place. However, I cannot prove that with any degree of satisfaction for you.
Mr. Dobson: A few years after his term, the British chancellor who put that ruling in for the mutual funds was asked by the head of the Adam Smith think tank in London what his biggest regret was. He said his biggest regret was that he did not change - either completely eliminate or very significantly reduce - the capital gains tax for individuals. He did it for the pool accounts but not for individuals. After he was out of office, that was his biggest regret, so there is evidence.
Senator Kenny: For the purpose of my next two questions, let us assume you are right. Let us posit that. I think it is important and useful that you have come forward and said that the creation of wealth is a desirable thing. You do not hear that very often in Canada. It is not part of the culture here. Why do you think it is not part of the culture? Why do you think people feel fundamentally uncomfortable with the idea that creation of wealth is a good thing? They do not think it is necessarily a bad thing but they are not prepared to say it in the positive. Why are so few people prepared to come forward, as you have today, and speak out in favour of it?
Mr. Soutar: That is an excellent question. We believe part of it is the fact that people are not educated at an early stage about the benefits of wealth creation. There is a perception generally that, if people get rich, they are getting rich by some shady activity, whatever it may be. I also think there is a mentality in this country of envy - if the government does not do it for us it is not right - and a mentality of dependence, where people would rather have the government do things for them than do them themselves. However, it is unfortunate that we do not have a more positive attitude about this issue. We seem to pride ourselves on writing articles in newspapers about people's salaries, about how much money they are making and about their stock options, and it is a very negative spin that we seem to put on it collectively, rather than putting a positive spin on it and saying is it not wonderful that someone is getting rich because, if he or she gets rich, it will benefit all of us.
Mr. Dobson: The capital gains tax started in 1972, and one of the interesting question is this: Why did it start and who started it? We have our senator here from Nova Scotia. My parents come from Nova Scotia. One night I was having dinner with Bob Stanfield, and I said, "Mr. Stanfield, you are a good Nova Scotian. You were in the Conservative Party at a time when the capital gains tax was put in, and you encouraged or did not speak about the damaging effect of the capital gains tax." He said that while he did not believe in the capital gains tax, when he came from Nova Scotia and went to Toronto, they persuaded him that this was a very rich country and that, in fairness, the riches should be spread around partly by charging a capital gains tax.
I think that has a lot to do with it. We had the world by the tail in the earlier years, with Expo ‘67 and even before that. When I came out of Harvard Business School in 1952, this was the country in the world young people went to. All of a sudden, it got a little overdone and people felt, "Gee, it is not quit fair. Let us share it." Little consideration was made of the damage or the significance to a young country when you discouraged and blocked capital in the early stage. That led to the attitude Mr. Soutar is talking about.
I might add that a big part is in our schools and colleges. Economics, in particular entrepreneurship, is not taught in most schools, although they are starting to in Nova Scotia. There is little education. The economists - my dear friends - are giving a tremendously misleading statement about facts of life to our students in the schools. I will be specific on that because I am making quite a strong statement. We, back CIAR - the Canadian Institute of Applied Research - put up some money from our foundation, for the economic growth part. A meeting was held here in Ottawa. I came to the meeting. Learned economists were there talking to each other and they came up, about five years ago, with the astounding idea that, in economic growth theory, innovation and technology were not part of it and did not appear. I said, "Give me a break. We have been investing for 30 years or 40 years in companies that are growing. Here is what is going on in the practical world. You are telling me that the economists have now discovered that this is what is right?"
We also talked in the paper about static growth, including the American budget office. If you change the incentive system, allowance must be made for the result - that is, lower taxes, increased GNP and revenues. The thinking is so entirely different from the concept here, with people like us who are dealing with the dynamic growth companies. I was referring to Fonorola Inc. and other growth companies a few minutes ago. We have to have people who do that.
Senator Kenny: You have led right into my third question, which is with respect to the implication that wealth creation is a zero-sum game to some extent. If someone is getting wealthy, they are doing it at the expense of someone else. The principal argument for a capital gains tax has traditionally been fairness and equity. You have touched on that, but why not hit it directly now for us? How do you answer the criticism that comes forward that it is only fair and only just? That is why we have capital gains now and that is why we are likely to continue to have it, because no one is answering that question.
Mr. Dobson: It has to do with an increased size of the pie. If you talk to the taxi drivers of Montreal, they want business to boom. They want to see some more fat cats. There are not enough of them around. If you talk to the beggars and the various people in the street, for them to get off welfare they need someone making the pie bigger, particularly in the private sector. The problem we have in Canada today is that we have far too much percentage of the gross national product going to governments. If you change the system and you expand the pie and have everything booming, you help the poorer people whom we want to help, many of whom need help. We have to make the safety net better and bigger, and the only way we can do that is to increase the pie. So what are we going to do to increase the pie? We have to create some more productivity, wealth, whatever you call it, and to do that we have to have some capital, if we are going to do it in the private sector.
I heard in the Senate, and this afternoon in the House of Commons, words about the government investing in this, that, and the other thing - and how the money was being spent. The government then decides they are going to solve the problems. We have many unemployed people so they are going to make their best efforts to do it. In my society, I would have much less government, and an incentive system where the private sector would significantly increase the amount they do, and I have no doubt in my mind, at the age of 71, that the poorer people in Canada would be much better off because we would have a bigger pie to divide up.
Mr. Soutar: Is it fair that the citizens of Canada have fallen substantially behind their neighbours to the south over the last 30 or 40 years? Is it fair that our currency has declined substantially over the last 25 years? Is it fair that we as Canadians feel impoverished when we visit Western Europe or Asia?
This issue about fairness gets in the way of what Mr. Dobson is talking about, which is making the economic pie larger for everyone. I believe that, if Canadians understood the process of wealth creation and the benefits they would derive from it, they would overwhelmingly vote in favour of a reduction in capital gains tax, even if some individuals benefited more than others. Let us face it, in the world, all is not fair.
Senator Angus: Nor equal.
Senator Meighen: I share the views of our witnesses today. You have put it very well in response to good questions from Senator Kenny. It is necessary that people get out and articulate this. Let us look at other countries - even leaving the United States aside, although it is staring us in face. Let us look at all the evidence. Countries like Germany, New Zealand, and Ireland may have just as much reason as we have to be suspicious. Nevertheless, they went ahead and did it. Do you have any information to bring to us as to how that came about? I do not think it was a referendum or a plebiscite. They did not have the example of the United States being next door. Perhaps they had good vision across the Atlantic, or maybe it was political leadership. I do not know. Do you?
Mr. Soutar: In the case of New Zealand and Ireland, they were so desperate that they were prepared to try anything.
Senator Meighen: I hope you are not saying that we should wait until that happens here?
Mr. Soutar: Economically, we have been getting very close to that. It is a tragedy that we are losing our best and brightest people. They are going outside of this country. Much of that is motivated by the opportunities that they have in other countries because of the tax situation.
If we are talking about keeping a country going over the next 20 or 30 or 40 years, then this is something that we all must think about seriously. All of us here are concerned about this country; that is, the well-being of this country, the well-being of our citizens, and having this country around for the next 50 or 100 years. If we cannot keep our best and our brightest people here, we run a serious risk of becoming irrelevant in terms of a key economy and maybe even one day becoming part of the United States. I think we are facing a crisis of proportion that requires us to move decisively on this issue.
Senator Meighen: I agree. Given that scenario, what would you say about the possibility of a reduction in this budget - and this seems to be mooted about in the press and leaked by the government - from an inclusion rate of 75 percent down to 66 percent? Will that have a negative effect, no real significant effect at all, or a very positive effect?
Mr. Soutar: I think it will have a positive effect. Any move in the reduction of capital gains tax will help. If what is being leaked in the press is to take place in the budget, it is nowhere near enough to do the kind of good that we need to do in this country. We must move decisively on this issue. If the government moves in a minor way, we should reinforce our efforts to make this issue better understood by all Canadians. It will have a benefit - there is no question about that. However, it is not enough. It is fiddling at the margin and will not do what we should be doing for the good of our citizens.
Senator Meighen: I have a more technical question. It is my understanding that, although the Americans have a capital gains rate of 20 percent now, they have a state tax or death tax, which we do not. Is that the trade-off? Suppose you could wave your magic wand and tomorrow we would have no capital gains tax. Would you add an estate tax?
Mr. Soutar: First, we do in effect have an estate tax because of the deemed realization upon death. If we had to make that trade-off - and we are already paying estate duties here because of that deemed realization - an elimination of capital gains tax and some form of estate tax is in the best economic interest of all Canadians. Sure, it stops people passing money from one generation to another, but it is not necessarily good for the children to be passed money anyway. I should like to see the government encouraging the people who are out there creating wealth, building businesses, and doing things such as employing people. That is where the activity will benefit our country the most.
Senator Meighen: I wish to ask you about your investor No. 10. I think Senator Furey touched on this with his questions about deferral. That is similar to what we are told - and I hope you will pardon me for referring to yet another leak - may occur in the budget with respect to options, whereby taxes will only be payable on an option when it is sold rather than when it is invested.
Mr. Soutar: The move on options is being forced on the government. It is reluctantly doing this because we are moving so many people out. High profile businessmen who head up companies such as Nortel are saying, "If you do not do something about this, we are going to move more jobs than we are moving right now out of this country." This is a reaction to that reality as opposed to saying, "Let us do something of a positive nature. Let us make this place really attractive. Let us get Americans to come to Canada and build jobs and businesses and invest in the new economy. Let us get this place going." What do we do? We sit back and fiddle at the margin and react in a negative way when we are being forced in a crisis as opposed to taking a positive, proactive attitude and doing something that is really positive for the country. It is simple. Everyone sitting around this table knows how easy it would be to get this country really booming again. It was booming before we imposed this capital gains tax and it has been suffering ever since. It is almost as simple as that.
Senator Meighen: There may have been one or two other factors.
Mr. Soutar: Of course, there were other factors.
Senator Meighen: What about the different rate of capital gains tax depending upon the length of time the asset is held, as is case in the United States and some other jurisdictions? You would not be in favour of it in principle, since you prefer no capital gains tax, but what advantages and disadvantages do you see for that? In some quarters, it is said to address the question of fairness. People who flip assets would not get the same benefit as those who hang on to them for a considerable period of time.
Mr. Soutar: If I had my druthers, I would not worry about the difference between a day trade and a 10-year trade. Let us face it. There are some significant differences. If someone owns a foreign or growth fund for 40 years and gets and pays tax on that fund over a 40-year period of time, when the value of the currency has gone from $1 to 25 cents over that period of time and they are paying on the nominal amount of dollars to start with, it is a very unfair thing. That is one of the problems you have and it is one the reasons that people talk about different tax rates depending on length of time.
To us, investing is not day trading. To us, investing is backing good people and providing capital for businesses to grow over the long term. I am sympathetic to the idea of having a lower tax rate on a longer-term gain because of the inflation effects, et cetera. Frankly, when you start doing those things, you complicate the process and add enormous numbers of people who have to police and audit the activity on the part of the government and set all kinds of workloads on the part of individual investors. I would try to keep it as simple as I could.
Mr. Dobson: We have that now. If you are making a large amount of your money by trading or your main business is deemed to be trading, then you have another situation. There is a vehicle now that deals with that. It is a very hazy vehicle that has a lot of personal judgment as to whether the guy is a trader or not a trader. Traders pay one thing; investors pay another thing. You must decide which camp you are in. It is a grey area.
Senator Kroft: I had several outstanding questions, most of which were covered by Senator Meighen. We all want to get to the same place. The rigour of the debate and the discipline is very important. A recasting of your paragraph on page 1 would be helpful on future performances because it overstates, perhaps, the importance of capital gains.
I have an observation combined with a question. Basically, we are all in agreement on this point. I do not think you are trying to convince us on this particular issue, and we have quite a bit of consensus within our group. This concerns the cultural issue about wealth, which is so fascinating to me. Somehow, we tend to blame this on government. I want to test a proposition on you. Governments have a tendency to take polls and respond to what they learn in them. Perhaps that is the form of leadership in the 20th century, and that is the real world. Over the last year or two I have been interested to learn that the meaning of the word "wealth" is very different from what it was even a decade ago. There is not one financial institution that does not now offer "wealth management services." We never saw that before. If there was such a thing, it was down at the end of the hall and it was called "private client services." Now there are ads that tout "wealth management." There are even some ads that talk about "wealth creation."
We are frustrated with why governments do not do what seems to us to be obvious. The question I want to put to you - and incidentally I am lumping you in generally with the investment industry and investment management - is the following: Is the reticence of the marketing of what you do not a big part of the root of the issue? As I say, I think we have come some way. But, if the investment industry was saying more aggressively, "Let us create wealth for you. Wealth is good," I think more might be done in a cultural sense, which is very much at the root of what we all agree we are talking about here. Government will not suddenly decide that wealth is good. However, if all of you are out there running full-page ads saying, "Let us help you create wealth," do you not think it would have an enormous impact on the cultural problem we have?
Mr. Soutar: Our industry has done a bad job of selling the benefits of wealth creation to all Canadians. We have a responsibility to do it. I agree with you entirely.
Mr. Dobson: I would add that you have to watch out for those obstacles. If in 25 years you have to make 7.9 percent to break even because someone made those the rules of the game, it is hard to convince people to go out and play with those extreme factors. That is based upon 5 percent inflation. The actual rate of inflation is 5.3 percent, which is what I pay when I sell something today that I have owned for 25 years.
The current inflation factor that Jack Mintz uses is 2 percent for 20 years. At that rate, you still lose one-third of your money over 20 years. There are structural things, such as penalties, including the regulatory authorities whose job it is to ensure that somebody does not get stung for doing something. All that interferes with progress. We sit on conference call after conference call, and the lawyers in the US refer to the Safe Harbor Act. You have to ensure that you pay no attention to what they say because it may not be right.
The regulatory authorities, which I have touched on a bit, and the taxation make it unattractive for a certain number of people. I probably could not start Formula Growth Fund today. I came out of industry; I had not been in the business. The Quebec Securities Commission would have thought that I probably would not be very suitable to run a fund. So you see there are these regulations that interfere with the people who want to go.
The Chairman: You cannot be arguing against regulatory bodies. Perhaps not everyone is as honest as you are.
Mr. Dobson: The question would be overkill. What they gain is better than what they lose by having it there, economically.
Senator Kroft: The bulk of my questions have been pursued. I was delighted with Mr. Soutar's response. I am coming to the conclusion that this cultural issue will be changed much more dramatically outside government than inside government.
Senator Hervieux-Payette: Between lowering the percentage and holding it for one year so that the money does not start to roll too fast, which do you prefer? Would you prefer that it go down quite low and have a cooling off period of one year? Do you consider the criterion of holding the stock for one year to be a negative? It seems that it is the case in some OECD countries.
Mr. Soutar: The most important thing is a substantial reduction in the rate. If there were a time period of one year, it would not bother me.
Senator Hervieux-Payette: Let us say we are overjoyed next week with a massive reduction in rates. In light of globalization, what is there to assure us that all the money will be invested in our country? More and more, with globalization, more production can be done at much cheaper rates with the manpower in countries where there are no labour laws, no minimum wages, and where there are some educated people. I think of countries like India that have many computer science experts, engineers and so on. How do we ensure that if all this money is moving around it is not moving out of the country?
Mr. Soutar: I do not think we can be assured that all the money being made will be invested in Canada. Some of it will go outside the country. The most important thing is to make us competitive with other countries. Let us face it - Canada has a lot to offer people. We have a very small population, lots of fresh air, lots of good water, a low crime rate, and a population that is generally sympathetic to looking after the poor. There are a many wonderful things about Canada that have kept us all here, not just money.
At the same time, we have fallen behind very substantially on the economic front. In my opinion, cutting the capital gains tax rate will mean more money invested in Canada than is invested right now. I do not know how many millions or billions of dollars have gone offshore; however, I suspect that it is a fairly substantial amount, because of taxes. Some of that will come back. Certainly, other people will look to Canada as a great place to come and invest if the capital gains taxes are reduced.
We have well-educated people and a great labour force. Many people here speak more than one language. We have all kinds of advantages. This is a very attractive place. The OECD tells us that all the time. However, in my opinion, where we are really uncompetitive is on this issue of capital gains tax. Yes, some of the money will go out, but more of it will be invested here. In general, I am very certain that we will be better off as a result of a lower capital gains tax rate.
Senator Hervieux-Payette: Our interest rates were always higher than those of the United States. Our rates are now lower. Do you not think that is also creating a distortion in the whole system? What is the rationale? We were told that interest rates would go down when we had low unemployment and low inflation, which we now have. Now, of course, the interest rate is very low, lower than the rate in the United States. They have lower unemployment than we have, as well as lower inflation. What is prompting us to have these interest rates?
Mr. Soutar: I am not an expert on that issue. However, in my opinion, the reason our interest rates are lower than the rates in the United States is the fact that our unemployment rate is still higher than it is in the United States. We still have available resources here, although they are shrinking very rapidly. Our rate of inflation is lower. Therefore, our central bank feels that the risks of inflation are lower here than they are in the United States. I think that the US Federal Reserve is quite concerned about inflationary prospects, which is one reason they are moving quite aggressively in terms of trying to tighten up monetary policy and increase interest rates. However, I am not an expert on that subject.
The Chairman: Thank you, gentlemen. You make your points in such a way that the public can understand them, which is very helpful.
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