The Costs of Capital Gains Taxes
Reliable sources have it that this year's budget will lower the inclusion rate for capital gains from 75 to 65 percent. This is a step in the right direction, but there are strong arguments that the tax should be eliminated completely.
The most compelling reason for this suggestion became obvious to me recently when I compiled a list of countries without capital gains taxes: New Zealand, Singapore, Switzerland, Hong Kong, Luxembourg, Mexico and the Netherlands. During the 1990s, the economies of these countries grew 2.2 percent annually per capita in real terms. Member countries of the OECD that do have capital gains taxes averaged a growth rate of only 1.2 percent.
A difference of one point in the growth rate may not seem like much, but it makes a great deal of difference to future living standards. If you earned $50,000 this year, in 30 years your income would be $71,500 at the 1.2 percent growth rate, but $96,000 at the 2.2 percent rate.
Also consider the effect of taking money away from investors. At a recent Fraser Institute symposium, John Dobson, one of Canada's most successful portfolio managers, presented the following illustration. Assume you have an investment that grows through capital gains at 20 percent per year. It is worth $1.5 million in 40 years. If the government taxes the annual capital gain at 40 percent, the investment grows only at 12 percent, and in 40 years is worth only $93,000. This capital gains tax brings the government only $22,000 during this period. But when this relatively paltry sum is withdrawn from the powerful process of compounding interest, there is an astoundingly large negative impact on the growth of capital in society.
Another reason for the poorer economic record of countries with capital gains taxes is that the tax causes people to lock in their investments. Thus, if you have a stock worth $1,500, yielding 7 percent, with a capital gain of $500, the sale of that asset leaves you with $1,300 in cash after you pay $200 in taxes on the capital gain at the present 40 percent rate. You will cash out the 7-percent-yielding asset only if you have an alternative, which you are willing to hold for 6 years, and which yields 10 percent.
By locking in capital in this manner, Canada loses profitable investment opportunities. If you have a million dollars invested, 7 percent brings a return of $70,000. If the money were invested to yield 9 percent, it would bring an income of $90,000. In this example, the country loses output worth $20,000 annually because the funds are locked into the less profitable investment. Multiply this by all the investments that face capital gains taxes upon realization, and you get an idea of the economy-wide consequences of the lock-in effect.
Growth is slowed not only by the inefficient use of capital caused by the tax, but also because it encourages the brain drain of the best and the brightest entrepreneurs whose main income stems from capital gains realized when they sell their inventions and start-up companies. Often neglected in the debate over the brain drain is the effect that the high taxes have on Canada's historic brain gain. Statistics Canada recently released its revised downward estimate of immigration during the 12 months ending in July 1999. Only 148,000 people came to Canada - 22,000 fewer than had been reported originally.
If the capital gains tax is cut to zero, this will have important implications for other tax revenues. For instance, before long, the government will take in more money than it did from the capital gains tax. If this fiscal surplus is used to lower personal and corporate income tax rates, economic growth would raise revenues even further, and permit additional tax cuts, and so on in a virtuous cycle.
So why is there this resistance to eliminating the capital gains tax? It stems from Canadians' love for the politics of envy, which is hidden behind the sacred principle of "fairness" of the tax system. It is considered "fair" that the rich pay a larger proportion of their income than the poor, and since most people believe that only the rich have capital gains, the capital gains tax must stay in place.
This fairness argument should be exposed for what it is. It is a power grab by politicians. They know well that most people consider themselves to be poor. So an election platform promising higher taxes for the rich and lower taxes for the poor is a sure-fire vote-getting ploy.
Indeed, raw statistics support the idea that the tax hits only the rich. People who make over $100,000 pay 80 percent of capital gains taxes. But these numbers are highly misleading. Many of these "rich" people are rich only in the year they paid their capital gains taxes. They tend to be small business owners selling their asset in order to finance their retirement after a lifetime of low wages and reinvestment of profits, living on low or moderate annual incomes before and after that year. Some of the high incomes and capital gains are those reported by the estates of deceased persons. The taxes are due because the assets in RRSPs are "deemed realized" at death, and have to be paid before heirs can receive their due.
Aside from the actual capital gains themselves, it turns out that people with less than $50,000 of regular income pay over 50 percent of all capital gains taxes in Canada. Those with incomes over $100,000 pay only 27 percent. It is a myth that capital gains taxes are paid by the rich. They fall mostly on lower- and middle-income Canadians.
Of course all Canadians should be treated fairly by their friends in Revenue Canada. They are not. Capital gains taxes to a considerable degree fall on phantom profits and amount to a confiscation of property. If you had made an investment of $100,000 in the 300 stocks in the Toronto index in 1972, it would have been worth $290,000 in 1991. Your wealth and ability to pay would have increased, and it would only be fair that you should share this with Revenue Canada. Right?
Wrong. Your wealth would not have increased. It would have fallen in real terms - the only relevant measure of your ability to pay - because the Consumer Price Index rose 380 percent during the same period. You would have lost 24 percent of your real wealth before any capital gains tax. If you deduct the capital gains tax of $56,000, equal to 40 percent on your nominal gain of $290,000, your real wealth would have fallen 44 percent. You would have ended with $56,000 from your $100,000 investment in 1972 dollars. How many Canadians believe that this confiscation of wealth through inflation and capital gains taxation is "fair"?
It is time that Canadians note how the capital gains tax lowers their incomes and is unfair to so many. It is time that they tell politicians about it. Politicians listen. They want to be elected.
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