The RRSP Iron Curtain

The ink is still drying on those RRSPs. You have invested in Canada. You are helping Canadian companies. And if you put your money in labour union venture capital funds, every five dollars invested get you almost four dollars back in tax credits. It looks good on the Quicken balance sheet, but there are problems.

The problem with RRSPs is that to get the tax break, Canadians are limited to investing 20 percent of their money in foreign assets. Most people sense that limiting where you can put your money also limits your returns. What is less obvious is that limits on where you can put your money also limit a person’s ability to manage risks.

Financial markets have arisen to help people guard their money against the face-whitening g-force of economic swings. Financial markets are insurance markets. You park your money in a diversified portfolio to cover your backside from the downside. This is the fundamental principle of insurance. In an economy some people will do well, and others poorly, for reasons beyond their control and their abilities to predict. Everyone breathes easier by pooling their incomes and spreading the risks.

The financial market is an income pool where you invest in companies whose profits come from parts of the world other than your own. The problem with RRSPs is that they blind investors to those other parts of the world. Investors in Canada are willing to ignore foreign investments which could increase their diversification because the RRSP gives them a tax deduction for investing 80 percent of their money in Canada.

Without the 20 percent foreign content clause on RRSPs, investors could lower their risk from an economic downturn. Financial markets allow investors to seek insurance by putting their money in countries where national income will rise when Canadian national income falls. Think of it as an equalization program without government. In good times, Canadians save and put their money into other countries not doing so well. When the economy here stutters, our part of our investments abroad will do well.

If Canadians could freely put their money in the US, they could benefit from a financial market that in the last three decades has helped US investors protect themselves from nearly two thirds of all unanticipated shifts in national income. This remarkable conclusion comes from a 1998 Federal Reserve Board study by Yale economist Stefano Athanasoulis and Federal Reserve Bank of New York economist Eric van Wincoop.

They looked at how US financial markets helped to protect investors when income was low by investing when income was high. Athanasoulis and Wincoop came to their conclusion about financial markets by measuring the unexpected variability of a person’s income before and after that person had protected himself from risk. Unprotected income is simply the income you earn from your salary or from your personal business or from rentals. Protected income is the income you get after you have taken your unprotected income and invested some of it in the financial market. Over the last 26 years US financial markets have allowed individuals to reduce the variability of their incomes by roughly 66 percent. If Canadians had not been distracted by the RRSP tax deduction and the 20 percent foreign content rule, they could have taken advantage of this huge US market in risk spreading.

But then, who needs financial markets to protect us from risk when we have government equalization programs? The main reason for these programs has been to make sure that when fortune smiles on one part of the country, other parts of the country share in the chuckles. A 1995 study in the prestigious International Economic Review by Tamin Bayoumi and Paul Masson of the International Monetary Fund suggests that Ottawa is doing less than a stellar job as our national insurance broker. These IMF economists compared how governments in Canada and the US spread over the whole country the economic rises and dips of different regions. They found that in the US, when pre-tax-and-transfer income changes by one dollar, post-tax-and-transfer income only changes by 70 cents. This means that the US tax system spreads 30 percent of the risk of income fluctuations. The Canadian system only spreads 17 percent of these risks. Not only does Ottawa do a worse job of protecting us from risk than Washington does for its citizens, Ottawa also discourages us from hedging risks by putting our money abroad.

Instead of relying on government equalization programs to insure us from risk, we should rely on international financial markets. Governments are poor insurance agents. Lift the 20 percent foreign content rule on RRSPs, and allow individuals to take the whip and chair into their own hands and tame the financial lions before which our governments have fled.