Nipping wealth in the bud: The effect of capital gains taxes

Governments in Canada, and particularly in Quebec, have for years relied on taxes levied on capital gains to a greater extent than American governments have. The average Canadian rate, at 40%, is at twice the American level. Portrayed as a tax on wealthy people, it has proved easier to keep it at a high level. Yet the tax does a great deal of damage, we think, to our prospects of creating wealth and raising real incomes, as a recent MEI publication explains.

A quick look at the economic history of the past fifty years reveals that the most prosperous societies are those in which business organizations abandon old ideas, methods and markets in favour of new ones that offer more promise. One of the most important means of achieving that transition is the transfer of capital resources from yesterday’s industries to those of the future. New sources of wealth emerge from the freedom to conduct experiments. This is what new business ventures are all about. Some experiments will succeed, most will fail. All will need to be financed.

This re-allocation entails a risk, but it allows resources – human, physical and financial – to be taken away from mistaken, value-destroying projects to initiatives with better prospects. If this switch is taxed – and capital gains taxes in Canada are a tax on just such a switch – the incentives to shift resources out of the old and toward a better match diminish. Society pays a hefty price as a result, because capital becomes scarcer and dearer, and because those people who can make the best use of it figure out they are better off doing that elsewhere.

These are the key findings of a document recently published by the Montreal Economic Institute, entitled Capital Gains Tax: A Huge Social Burden, by McGill Professor Reuven Brenner. A prolific author, speaker and columnist, Prof. Brenner is also a partner at Secor, a Montreal strategy-consulting firm, and a consultant to many corporations in Canada, the US and Mexico.

Trying to grow new ventures in barren soil

The crux of the study’s argument is that, when capital is mobile, the after-tax return on capital has to rise to the internationally competitive level. Because of this tax wedge, capital must become relatively scarce for the international rates to become roughly equalized. This occurs in part through a reduction of the rewards for investing and taking risks. Increased scarcity then means that entrepreneurs have greater difficulty financing their ventures.

Some react by lowering their expectations, which results in lower capital formation. Some decide to leave the country and take their bright ideas to fiscally sunnier destinations. Since it is the “vital few” who attract financing to build up capital, this also diminishes capital formation. Both effects lead to a lower tax base for governments, and poorer prospects for all of us.

The consequence of this tax wedge is best illustrated by the example of David Huber, who invented fibre optics while working for General Instruments. For years, he tried to convince his employer to support the commercialization of his idea, to no avail. He then left General Instruments and, with the help of a financial “angel” who gave him a few hundred thousand dollars, established his own company called Ciena. When the firm first went public on the stockmarket, Mr. Huber’s stake alone was valued at $200 million. Had Mr. Huber been a Canadian engineer, it is most likely that no “angel” would have backed him. Not because he had a bad idea, but simply because said “angel” faced a 40% tax on any future reward in Canada, compared to 18% a 20 minutes drive to the South. Had Mr. Huber been a Canadian, he would still be drawing an engineer’s salary instead of creating all the goods, jobs and added wealth attributable to Ciena.

Driving away our “best and brightest”

The 100,000 highly-skilled people who left for the US in 1997 allow one to make a rough estimate of how much capital is being lost as a result of the “brain drain” high capital gains taxes lead to. Say their average annual income was $100,000. At five percent discount rate, that is equivalent to $2 million in capital. Multiply that by the approximately 100,000 who left, and the figure comes to a $200 billion transfer of wealth from Canada to the US. Those who link the move to a search for greater opportunities rather than differential taxes are on the wrong track. The two things are directly linked. Our “best and brightest” find greater opportunities down south precisely because the tax burden on capital gains is much lighter.

Some would admit to the negative consequences of capital gains tax, but argue that governments cannot afford to get rid of a tax “on rich people.” But the incidence of taxes is not the same thing as their burden. The burden always falls on those who cannot escape it, rather than on the legal entity targeted by governments. Because capital is scarce and dear, the “vital few” people who are the source of the best investment opportunities also become scarce. And so the burden of Canada’s higher capital gains taxes is shifted to lower skilled employees, who are less mobile.

Based on comparative evidence gathered in the United States and Great Britain, where rates were lowered dramatically in the 1980’s, Prof. Brenner makes a compelling case for the economic benefits of bringing taxes on capital gains in line with American rates. Bringing the rates down to zero, needless to say, would be even better, and would give Canada a badly needed chance to catch up.

The history of the tax in the United States provides an excellent reference point in the debate. The tax rose sharply between 1970 and 1977, and the real revenues collected from this tax source actually fell. In 1978, and again a few years later, the rate was cut sharply and revenues soared. In 1987, the rate was raised again, and revenues stagnated for the next 10 years. Finally, the rate was again cut in 1997, back into the 10%-20% range, and the revenues from the tax have jumped 40% since. In other words, this is a clear-cut case where cutting taxes actually leads to a rise in government revenues. Making the best of investment opportunities is the closest thing to a goose laying golden eggs for a market economy. Continued high capital gains tax may cut the bird’s life short.


Michel Kelly-Gagnon is President of the MEI.

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