A Capital Idea: Study shows cutting capital-gains taxes would increase government revenues

Governments in Canada, and particularly in Quebec, have for years relied on capital-gains taxes to a greater extent than U.S. governments. The average Canadian rate, at 40 per cent, is 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 to our prospects of creating wealth and raising real incomes.

A quick look at the economic history of the past 50 years reveals the most prosperous societies are those in which business abandons old ideas, methods and markets in favour of 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 tomorrow’s.

The reallocation 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 this 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.

As a result, society pays a hefty price because capital becomes scarcer and dearer, and 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 report recently published by the Montreal Economic Institute, titled Capital Gains Tax: a Huge Social Burden, by McGill University professor Reuven Brenner.

When capital is mobile, the after-tax return on capital has to rise to the internationally competitive level. Because of tax wedge, capital must become relatively scarce in the higher-taxed country for the international rates to become roughly equalized. The cost of capital goes up. And increased scarcity then means that entrepreneurs have greater difficulty financing their ventures.

Some react by lowering their expectations. Some decide to leave the country and take their bright ideas to fiscally sunnier destinations. 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 U.S. entrepreneur 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 stock market, Huber’s stake alone was valued at $200 million. Had 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 the angel would have faced a 40-per-cent tax on any future reward in Canada, compared to 18per cent a 20-minute drive to the south. Had Huber been a Canadian, he would still be drawing an engineer’s salary instead of creating all the good jobs and added wealth attributable to Ciena.

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 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 Britain, where rates were lowered dramatically in the 1980s, Brenner makes a compelling case for the economic benefits of bringing taxes on capital gains in line with U. S. 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 capital-gains 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 to the 10 –20-per-cent range, and the revenues from the tax have jumped 40 per cent since.

This is a clear-cut case where cutting taxes actually leads to a rise in government revenues as well as better investment opportunities and economic prospects for all.

Michel Kelly-Gagnon est président de l’IEDM.