Ending the worst tax of all

While Canadian economic growth is still strong, business investment has been dropping rapidly for several years. It is now 18-per-cent lower than it was in 2014. Prior to that, the energy boom concealed for some time the fact that Canada’s investment levels are low relative to comparable countries. But with the boom now long gone, it’s becoming obvious that policies with a negative effect on investment are holding Canada back.

The capital gains tax, in particular, is affecting investment levels, while bringing in negligible revenues for the federal government. As some other countries have done, we should either substantially reduce it or simply abolish it.

Just as taxes on tobacco and alcohol reduce their consumption, the capital gains tax hinders capital formation, which is one of the basic foundations of all economic growth. Reducing the supply of capital affects job creation and wages throughout the economy, as one of the functions of capital is to make workers more productive through technological and other improvements, which is a prerequisite for wage increases.

In Canada, half of any capital gain is taxed as income when an investment is sold, with some exceptions like a primary residence. Moreover, the tax does not take inflation into account, which increases its impact, especially for long-term projects since they are taxed on partly illusory gains from inflation rather than on the real value that has been created.

In one study, the federal Department of Finance found that each dollar reduced from taxes on capital income would lead to economic gains of approximately $1.30, making it the tax whose elimination would bring the most gains. On the flipside, the tax cannot be justified by the meagre revenues it generates for government: approximately $4.3 billion, or just 1.5 per cent of total government revenues.

Some countries have followed drastically different courses than Canada in terms of capital gains taxation. Many countries do not tax long-term capital gains for individuals, and New Zealand, Switzerland, and Hong Kong do not tax them at all. In these places, positive effects from the absence of capital gains taxation have been well documented.

One study looked at the case of Switzerland, where in addition to the central government, some districts (or cantons) eliminated the capital gains tax. It found that elimination increased the size of the economy by between one and three per cent.

Another study, this one of Hong Kong, found that thanks to the absence of a capital gains tax, the territory’s savings rate is well above that of similar industrialized economies.

In the case of New Zealand, the elimination of the capital gains tax was part of the sweeping reforms that started in the 1980s and shifted from taxing capital and savings to taxing consumption, which has less deleterious effects on economic growth. These reforms were important in improving the economic situation of the country relative to its neighbours.

Other countries, like Israel, have moved to minimize the negative impact of capital gains taxation by taking the effects of inflation into account.

It is sometimes argued that all income should be taxed at the same rate on grounds of equity, but also for the sake of simplicity, neutrality, and to avoid creating opportunities for arbitrage between different kinds of income. Yet the cost of taxation is not uniform; it is highest for those taxes that can easily be avoided, and the capital gains tax is the easiest tax to avoid. An investor can simply choose not to realize his or her gains.

Moreover, countries with no capital gains tax have found ways to deal with such income shifting that are remarkably simple. New Zealand, for instance, tackles the opportunities for income shifting on an ongoing basis, if and when they pose a threat to government revenues. Switzerland has been following a similar strategy. Hong Kong has taken a more expeditious route, and chosen not to tax dividends either, thereby removing the impetus for this kind of arbitrage.

Capital gains are derived from the efforts of investors and entrepreneurs to grow the economy, which is the basis of our prosperity. Taxing these gains entails a whole slew of adverse effects, yet does not generate all that much revenue for the government.

International examples show that eliminating our capital gains tax could help improve productivity growth in Canada, which would in turn improve the living standards of all Canadians. It is the path that Ottawa should follow.

Mathieu Bédard is Economist at the Montreal Economic Institute and author of “The Capital Gains Tax: It Should Be Reduced, Not Increased.” The views reflected in this op-ed are his own.

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