Proceedings of the Standing Senate Committee on
Banking, Trade and
Commerce
Issue 1 - Evidence for November 25, 1999
OTTAWA, Thursday, November 25, 1999
The Standing Senate Committee on Banking, Trade and Commerce met this day at 11:05 a.m. to examine the present state of the domestic and international financial system.
Senator E. Leo Kolber (Chairman) in the Chair.
[English]
The Chairman: Honourable senators, on your behalf I should like to welcome Professor Jack Mintz, who is the Arthur Andersen Professor of Taxation at the Joseph L. Rotman School of Management at the University of Toronto. He has been the President and Chief Executive Officer of the highly esteemed C.D. Howe Institute since September 6, 1999. He has been a visiting scholar with the International Monetary Fund in Washington; a visiting economist with the Department of Finance in Ottawa; Chair of the Technical Committee on Business Taxation, Government of Canada from 1966 to 1967; Editor-in-Chief of International Tax and Public Finance; and author of numerous publications on tax policy, corporate taxation and the comparative tax system. Mr. Mintz probably holds a view diametrically different from the witness we heard yesterday.
Welcome, Professor Mintz. Please proceed.
Mr. Jack Mintz, President and Chief Executive Officer, C.D. Howe Institute: Mr. Chairman, thank you for having me once again to your committee. I enjoyed my last visit very much. I am looking forward to our discussions today. In fact, I had promised the committee's former chairman that I would come back to talk about business taxation some time down the road. I just want to say to you, Mr. Chairman, that my commitment stands. If you ever get to the matter of business tax, I will be quite happy to talk about those issues as well.
Today, however, I will talk about capital gains taxation in Canada. I will make some recommendations as to where I think we in Canada should go on this issue. Capital gains taxation is probably one of the most difficult areas of tax policy in the tax system, not just in this country but in any country. Why is this so? Let me give you some normative arguments that have been given for and against taxation of capital gains.
I will talk about some of the practical problems that are involved with taxing capital gains, and then I will talk a about the inconsistency of world wide experience when it comes to taxing capital gains. Finally, I will describe where I think Canada should go with respect to some of these issues.
First, let me turn to the normative argument for taxing capital gains. The proponents of taxing capital gains follow what have been well known principles in income taxation, which has been based on the concept of comprehensive income, which would include all sources of income, including capital gains as another source of income. This was argued by Simons in the United States in the early 20th century. It has been an important principle of income taxation. It was adopted by the Carter report in Canada when it recommended the taxation of capital gains in the 1960s.
The income tax proponents argue not only that capital gains should be taxed, but that they should be taxed on what is called an accrual basis, not a realized basis -- in other words, when the value of assets changes from one period to the next, the argument being that this gives economic power to individuals to purchase goods and services, and therefore, should be captured as part of the income base and be fully taxed.
That is one particular view, and it has been challenged over the past number of years. There are two sorts of challenges that are important, at least in terms of the normative discussion of taxing capital gains.
The first view, which gives a very different argument, is one given by consumption tax proponents. These are individuals, and I would fall more into this camp, who argue, or at least recognize, that the taxation of the return to savings is a double tax on earnings of individuals. In other words, when people earn income, they pay tax on their wages and salaries. If they then consume their income right away, they will not pay further income tax. However, if they put their money into a bank account or into an equity share, and earn income, either as capital gains, interest income or dividends, they will pay tax on that income. So they are paying additional tax on their savings. Therefore, savers are discriminated against under an income tax compared to consumers.
Thus, the consumption tax proponents would argue that one should eliminate the double tax on savings, which is therefore not just having no capital gains tax but having no tax on dividends and no tax on other forms of savings. An alternative base, which is the one we currently use in the Canadian tax system, is to allow people to deduct their savings from the income base. They earn the income within a plan that would be subject to no taxation; then, when they withdraw money from that plan, they are subject to tax. That, of course, is what we do under our pension and registered retirement savings plan systems in Canada. It is a form of consumption taxation under the so-called income tax system that we have today. So one normative view that goes against the taxation of capital gains is based on consumption tax principles.
A second argument goes back probably to the historical argument about the fruit on the tree. It is the argument that you want to tax the fruit and not tax the tree, which is a legal argument about taxation of capital gains. The concept behind that argument is that capital gains reflects the income being earned on assets. If that income is subject to tax, then in principle, if there is any increase in the income, or any expectation that the income will rise, then since that income is already being taxed, capital gains is also being taxed at the same time.
That is an argument to suggest that capital gains should not be subject to tax at all, as long as you are fully taxing other sources of income. Otherwise, you would have a double tax on the gains that are being received from assets.
In principle, we have actually recognized that in the Canadian tax system, through the integration of corporate income and personal taxes; we have not fully recognized it, but at least recognized it in part. In Canada we have a corporate income tax that applies to income earned by businesses. Let us say that there could be income taxation of real estate income. However, at the small business level the corporate income tax rate is approximately 20 per cent. That is the average rate for federal and provincial purposes.
When people reinvest their profits, share values will go up by the after-tax profits of the firm. Those share values may be subject to personal tax. However, we set the exclusion rate for capital gains so that, in principle, a person will be subject to corporate income taxes and capital gains taxes. The combined rate would be equivalent to the top personal rate when it comes to small business income.
Therefore, we have a rough approach for integration. We do the same thing with dividends by having a dividend tax credit as an offset for the corporate income tax paid by corporations. So when you look at the total corporate income tax and personal income tax on dividends, it is also roughly equal to the top personal tax rate on other sources of income. Therefore, the capital gains exclusion rate and the dividend tax credit rate are set in order to accomplish rough integration at the small business level.
The problem is that many corporations are taxed at higher rates. Income above $200,000 in a Canadian controlled private corporation may be subject to a higher rate. Therefore, the integration mechanisms that we have, which are the dividend tax credit and the exclusion of capital gains from income, are too little relative to the higher corporate income tax rates in the system. I will come back to that point later on.
Let me talk about some of the practical problems involved with capital gains taxation, at least the accrual approach that has been suggested by the income tax proponents. One of the first points that we must recognize is that no country in the world taxes capital gains on an accrual basis for all taxpayers and for all sources of capital gains. There is some accrual taxation that is market-to-market value rules for financial institutions and insurance companies. We use it in Canada, and there are a few other countries that use it as well. Generally, however, we tax capital gains on a realized basis -- in other words, only when the assets are actually sold.
Why do we do that? If we try to tax people on an accrual basis, people may have to sell assets in order to meet their tax liabilities. In other words, let us say I am holding some shares of Bell Canada, for example. The value goes up over the coming year, and I will be getting an accrued capital gain. However, I do not want to sell the assets right away. If I have to pay taxes on the accrued value of capital gains, but I do not have enough income to pay those taxes, I may have to sell some Bell Canada shares just to meet those tax liabilities. That could certainly be a problem for small businesses and farmers, et cetera, in terms of their assets.
For that reason, no country has accrued capital gains taxation. Another reason is that it is very difficult to value all assets on a market value basis from one period to the next to do accrued capital gains taxation, particularly when you are talking about private company shares, real estate, and other things. There is a lot of subjective evaluation involved, and we do not have observed market values to easily measure those things. As a result, the valuation problems suggest that you would never go to accrued capital gains taxation.
We tax capital gains on a realized basis. This has actually two important impacts, and this should be understood. First, because people only get taxed when they actually sell assets, there is an incentive not to sell the assets <#0107> in other words, to defer any capital gains taxes that might be held in order to avoid any taxes on that income. This is referred to as the lock-in effect. As a result of the lock-in effect, people sometimes end up holding inefficient portfolios of assets in order to avoid paying capital gains taxes on some assets that they might otherwise dispose of in order to buy other assets. That can have an economic cost.
In Canada, we also have another aspect that mitigates some of the lock-in effect. We have deemed realization of capital gains at death, rather than having the estate taxes. As a matter of fact, all OECD countries have one or the other: either they have deemed realization of capital gains at death or they have an estate tax.
The United States does not have deemed realization of capital gains at death. They do have an estate tax, but the estate tax is on a smaller group of taxpayers than you would find if you applied deemed realization of capital gains at death in the United States. As a result, the U.S. experience, as well as studies on the impact of capital gains taxes on government revenues and the economy, cannot easily be used in the Canadian case. The Canadian tax system is somewhat different than the U.S. system and that has to be taken into account. For example, reducing capital gains tax rates in Canada would not have the same impact on realizations as it would in the United States because we have deemed realization of capital gains at death.
However, I do not want to understate the importance of the lock-in problem, because I do think that it is something we must worry about.
Another problem under capital gains taxation is the treatment of losses. Most countries do not allow full refundability of losses. In other words, you cannot deduct capital losses from other sources of income. Most countries will usually limit it to other capital gains. Because we only tax capital gains on a realization basis, people can time their losses and their gains in order to minimize tax liabilities. In fact, if we did have full refundability of losses against other sources of income, people might try to time their sales of assets in order to create losses that could then shelter other forms of income from taxation.
That is the reason we do not have refundability. Once that is recognized, a problem is created in the system in that we then discriminate, under the capital gains tax, against risky investment and entrepreneurship. The reason for that is that the government is quite happy to share the winnings, or gain, that a person may realize through the disposal of a capital asset. However, the government is not there to fully share the losses. The government may allow you to write off the losses over time, but that is only if you have future gains. There is a time value loss associated with an inability to achieve a complete write-off of those losses right away. Thus the capital gains tax actually discriminates against risk-taking and entrepreneurship. That is one reason it is important to achieve a lower capital gains tax rate.
The last important issue is inflation. We must remember that even though we do have relatively low rates of inflation, we tax that nominal gain associated with inflation. If you bought an asset even just 20 years ago, the real gain, once you correct for the impact of inflation on the purchasing power of your money, is reduced significantly. That does increase the effective rate on capital gains. It is only partially mitigated or maybe even fully mitigated for those taxpayers who can borrow money to purchase assets that are subject to capital gains taxation. When you borrow money, you are able to write off your interest expense without any adjustment for inflation. This interest also reflects payment to compensate the lenders for the erosion of the purchasing power of those borrowed funds as a result of inflation. Thus we see a partial shelter against the impact of inflation on capital gains taxation. As a result, most countries have not indexed capital gains for inflation at all or, if they have indexed, they have worried about what do in the case of leveraged purchases of assets.
Those are four difficulties that I am attempting to explain. There are some important problems to be dealt with in the capital gains tax system. These problems create difficulties when formulating tax policy. There is no simple solution. When we look at actual international experience and what other countries do, we see that there is no consistency with respect to tax policy. I will give examples. Some countries have, either today or in the past, fully taxed capital gains. The United Kingdom still fully taxes capital gains as part of income. They are now looking at proposals to lower the capital gains tax rate in the United Kingdom. Interestingly enough, the United Kingdom taxes dividends at a lower rate than capital gains. Thus, one could actually make a very strong argument that the United Kingdom should lower its capital gains tax rate and move away from full taxation as an effective method to integrate corporate and personal taxes.
The United States went to full taxation of capital gains in 1986 as part of the reform measures. We must remember that in the American system there is no integration of corporate and personal taxes so dividends are fully taxed. Therefore, when they moved to full taxation of capital gains, they were attempting to eliminate the differences between dividend and capital gains taxes. That elimination of differences was necessary in order to curb the strong incentive to shift income from dividend forms into capital gains, thus reducing tax payable.
The United States retained that system until the early 1990s when they raised personal income tax rates. However, they did not raise the capital gains tax rate, which stayed at 28 per cent. In 1997, to be applied in 1998, the United States moved to a system in which they reverted to a pre-1986 system of different tax rates based on the length of time assets are held.
Some countries actually impose a tax penalty on the length of time an asset is held. The longer the asset is held, the greater the tax penalty or the higher the tax rate imposed on that asset will be. That system can be seen in Japan and Korea with respect to land assets. They use that system to capture the deferral advantage of holding assets longer under the capital gains category. In other words, they are attempting to move to the concept of accrual taxation of capital gains but, since they cannot use the accrual method, they have chosen instead to tax the longer-held assets at a higher rate.
We have had systems that have had some indexation for inflation. The United Kingdom and Australia are examples of that. The United Kingdom abandoned indexation for inflation for the capital gains tax system a few years ago. Australia, in its recent reform, eliminated indexation for inflation as well.
Some countries will tax gains at a lower rate than other forms of income. Canada is an example of that. We have our exclusion for capital gains. Some countries will have tax rates that vary by the holding period of the asset. I have mentioned the United States where there is full taxation of gains if the disposed assets are held less than one year. There is a 28 per cent rate if the assets are held from 12 months to 18 months. The 20 per cent rate will be changed to, I believe, 18 per cent next year with respect to assets that are held for more than18 months.
The Chairman: They are bringing the time frame from 18 months to a year and the rate from 20 per cent to 15 per cent. That is the proposal.
Mr. Mintz: France and Italy also have rates that vary by the length of time the assets are held. However, this system can be problematic.
Tax rates that vary by the holding period make the financial derivative industry very happy. That was the experience in the United States prior to 1986. I would suspect that many exotic financial derivatives are now being considered in the United States with their new system. Those derivatives occur because one can time the losses and gains in such a way as to take advantage of the full write-off of losses against the half taxation of any capital gains, depending on the length of time assets are held. Thus, it is possible to drive down or eliminate altogether the capital gains tax.
The United States in 1986 was so concerned about this that they went to the full taxation of capital gains. Now, they have returned to a system in which they have placed restrictions on losses whereby the losses can only be written off against gains that are fully taxed. Therefore, they are protecting the capital gains tax by restricting claims for allowable losses to the gains being held. This has been an interesting change because this is something quite different from the pre-1986 system.
We can talk about this system later but it is a far more complex system and leads to greater complexity in the tax system when there are differential tax rates dependent on the length of time the assets have been held.
Another aspect of the capital gains tax system is the rollover treatment. Most countries will have at least some form of rollover treatment that allows the taxpayer to defer the payment of taxes on capital gains. This will occur, for example, in share for share exchanges, amalgamations and certain mergers.
Germany has a very interesting system. They tax capital gains. Although I do not know all the details of their system, I know that they have a roll-over type of provision whereby you are allowed, within a year, to purchase another type of asset that allows you to defer the capital gains on the asset rather than pay the full tax on it. In the Canadian system, and in most systems, if I am holding Toronto Dominion Bank shares, for example, and I sell them to buy Royal Bank shares, I will pay my capital gains tax on the Toronto Dominion Bank shares, even though I exchanged them for another form of bank shares. In Germany, that would be allowed to go as a deferral of capital gains tax. In my example, the Toronto Dominion shares would be used as the cost basis for determining the capital gains tax to be paid eventually on the Royal Bank shares, if they are used for consumption purposes.
That is an interesting system. I have not given my full thought to the implications of that in terms of tax planning. However, it is one that you might want to think about.
When you see what goes on across countries there is absolutely no consistency in the approach to capital gains taxes. In large part, you must look at the capital gains tax and try to do the best you can to keep efficiency and equity in the tax system and not let compliance and administrative costs get so high because of all sorts of things you must do to protect the tax system or to improve fairness in it.
Prior to 1972, Canada did not have a capital gains tax. As a result, there was a tremendous amount of legislation and problems in the system. People would try to convert dividend income into capital gains income that would not be subject to taxation. That was referred to as surplus stripping. As a result, the main reason Canada went to taxation on capital gains in 1972 was to create some balance and efficiency in the system, as well as to minimize the compliance and administrative costs of trying to run a system with differential tax rates on income and capital gains.
The other important principle in Canada is that we try to integrate corporate and personal income taxes, as I have already mentioned.
I will conclude with four or five proposals that should be considered in Canada today. First, I suggest that, in the next budget, we immediately move to a two-thirds inclusion rate for capital gains. The reason for that is that next year in Ontario the top rate will be 48 per cent. The dividend tax rate will be about 32 per cent. At an inclusion rate of three-quarters, the capital gains tax rate will be 36 per cent, which is higher than the dividend tax rate. If we go to a two-thirds inclusion rate, we would bring rough parity, at least in Ontario, to dividends and capital gains tax rates. I recognize that these numbers vary by province depending on the tax system. However, given the size of Ontario, and the fact that many of the other provinces are in similar positions, except for a few cases, Quebec being one of them, there is a strong argument to move to a two-thirds inclusion rate next year.
Second, we need a comprehensive approach to the whole issue of capital gains taxes, personal income taxes and corporate income taxes. First, we will be lowering personal income taxes in this country. I suspect that in a few years' time we will be looking at rates in the 40 per cent to 45 per cent range. In two years' time, Alberta will have a top rate of about 42 per cent, which assumes no action will be taken by the federal government.
However, I suspect we will see some changes at the federal level over the next two years. Thus, a 40 per cent top rate for income in this country is not an inconceivable concept. If that is true, then the question is: Can we afford a further exclusion of income from capital gains? This partly depends on the dividend tax credit. If we keep it where it is, which provides rough integration for the small business level but underintergrates large corporate income, then we cannot do very much on the capital gains exclusion rate unless we create a large imbalance between capital gains tax rates and dividend tax rates.
However, if we start looking seriously at the business tax system and we lower general corporate income tax rates, consider increasing, perhaps, the small business tax rate and have just a single corporate income tax rate in Canada of 25 per cent and we move up the dividend tax credit to reflect that 25 per cent tax rate, we could have a one-half exclusion of capital gains from income.
In other words, I can see a very good reform whereby we would have a single corporate income tax rate in the system, just as many countries have today, and have much lower personal income taxes, which I think many people in the small business sector would find favour with. Eventually, we could have a one-half exclusion rate with an approximate 20 per cent capital gains tax rate in this country. That is a reform that is, I think, quite possible to achieve over the next several years. I suggest that we have to look at that within the balance of what we are doing in terms of the whole tax system.
My third proposal is to consider some special incentives for capital gains. The lifetime capital gains exemption is not working well. It is being abused in some cases. It was meant for small businesses. However, it applies to all Canadian-controlled private corporations. Many companies have been converted from public to private corporations, in part to take advantage of the lifetime capital gains exemption, as well as the small business deduction. Basically, we have a system that does not encourage the growth of businesses.
If you look at the United States, you will see a system that does encourage such growth. They have a partial taxation of capital gains on initial public offerings of shares. One-half of the capital gains tax rate will apply to the initial public offering of shares. By the way, they define small businesses as those with roughly $55 million to $58 million in assets. In Canada, we define a small business as one with $15 million in assets.
We should try to change the labour-sponsored venture capital corporate fund system. The system has not been working well. There is a great deal of data that show that the returns on funds have been inadequate, except for a few. In fact, they have been well below the market. This is partly because the credit has encouraged too much investment in ventures with high risk and very low returns. In my view, a better system would be to enhance our RRSP system by creating a new fund that would not impact on the limits for RRSPs. In other words, this would give another opportunity for people to have tax-sheltered savings. They could invest in venture capital funds. If there are any changes in those venture capital funds, they would not be subject to tax. As long as it stays within the fund, there would be no capital gains tax for that purpose. This would also give a new form of retirement savings for individuals. There would be some limit on how much would be allowed.
My last recommendation is on stock options. I spoke to this committee last year on this topic. My argument is to move to the U.S. treatment for stock options and to eliminate the current tax penalty in the tax system against stock options. At the moment, this is less favoured compared with cash distributions to workers.
Senator Hervieux-Payette: Mr. Chairman, since we will have to be doing a great number of comparisons, it is important that we have all the data with respect to the major players in the market.
Professor Mintz, we had one of your papers on taxation of businesses distributed to us. We will need that in order to continue our study, and sooner than later if possible. I do not know if that will come from you, but it would help us. Indeed, it is crucial information.
The pension fund does not pay capital gains. It would be interesting to see the statistics on how much capital gain is not taxable because it is in pension funds, compared to the savings held by individuals who are paying personal taxes on whatever is left in their pockets to invest. That amount is shrinking. It is perhaps 20 per cent. Do you have an answer to that?
Mr. Mintz: Those numbers are available and can be downloaded from the Department of Finance web site. Some papers were written by Tom Wilson, Steve Murphy, Michael Smart and Jim Pesando for the Technical Committee on Business Taxation. The papers deal with income trusts but contain some data on stocks in trustee pension plans -- and in RSPs, which is the same argument -- versus stocks that are subject to tax. Unfortunately, I cannot remember those numbers right now. I am sure you can get more up-to-date numbers from Tom Wilson or from the Department of Finance.
You are correct that there has been a growth in assets that are in the form of pension plans and registered retirement savings plans. As a result, capital gains in those plans, in principle, are not subject to taxation, at least not on an accrued basis. The only time tax is paid on the increase in the value of those assets is when the funds are withdrawn from the plan. That data is available.
Senator Hervieux-Payette: We need an accurate picture on how much tax is being paid. We always have the impression that the poor minister of finance will go bankrupt.
My pet project is the employee stock-ownership program. Links have been shown to productivity, to participation and to transparency of the technical information given to the employees. You mentioned stock options, too. Taxation there applies both to the company, on what it can deduct, and to the employees. The young generation of entrepreneurs in the high-tech companies may resist the so-called brain drain if they can stay here and participate in the growth of their companies.
Do you think we have a competitive framework for ease-up in Canada compared to the U.S.? There they have a much larger distribution of shares to their employees. Is that because of their culture or is their taxation system acting as an influence?
Mr. Mintz: I have not looked at the degree to which Canadians hold employee stock ownership relative to the United States, or at the factors that might cause differences between the two. I cannot comment specifically on that.
In the Canadian tax system, the stock option is not deductible from the corporation, as you have mentioned. It is effectively subject to capital gains tax at the individual level. In the United States, a granted stock option is not deductible or taxable in the hands of the individual; and that is also true in Canada, I should mention.
Income gain, which is the difference between the value of the grant and the exercised price, is treated in two ways in the United States. First, the difference between the exercised price and grant price is fully deductible for the corporation. It is fully taxable in the hands of the individual. The second treatment is called a stock ownership incentive plan, where the difference between the exercised price and the grant price is not deductible for the corporation and not taxable in the hands of the individual.
When you go through the calculations in Canada for small businesses, it is not a problem, because the corporate income tax rate and the capital gains tax rate achieve rough integration. At the small business rate, in fact, you are allowed to defer. You do not have to pay tax at the time the stock option is exercised. You are allowed to defer it at the small business level.
For large corporations that is an issue, because the large corporate tax rate, of course, is much higher than the small business tax rate. There is no incentive in Canada for large, tax-paying corporations to issue stock options, at least for tax purposes. That does not mean they will not do it. They may do it for other reasons. However, there is a tax disincentive.
Senator Hervieux-Payette: So the Nortels of this world are not very encouraged by our tax system. That size of company has no big incentive to go through that program?
Mr. Mintz: Such companies do not actually pay much corporate income tax, because of the R&D tax credit. If the corporation is not paying tax, it has an incentive to issue stock options, rather than paying wages or cash to the employees.
Senator Angus: Mr. Mintz, you have confirmed that we had no capital gains tax in Canada prior to 1972. This tax came out of the Carter reform study. We seemed to be doing very well before we had a capital gains tax. There seemed to be a greater incentive for entrepreneurship and start-ups of businesses and industrial development.
I have read your material. It seems that you are not in favour of abolishing the tax. Perhaps you could put your reasons on the record. Why not get back to what I thought was a very constructive climate for our economy in pre-1972?
Mr. Mintz: To compare pre-1972 and today, you must factor in many aspects, not just the capital gains tax system. Other things were benefiting the Canadian economy at that time, such as the rising resource prices during the 1950s. I would agree that there are still lessons to be learned from that time.
My big problem on moving to the elimination of the capital gains tax is the creation of tax-planning problems. How do we convert income into capital gains if it is tax free? This goes back to 1972 and the reason for bringing in a capital gains tax then. We wanted rough parity between dividend taxes and capital gains taxes. Corporate re-organizations, estate planning and a whole slew of other tax issues can become very complicated if we open up the differences between dividend taxes and capital gains taxes.
I would not argue for higher capital gains taxes relative to dividends; however, as soon as we open up the differences in those tax rates, we open up quite significant problems in terms of tax planning. Then the government must address that through very complicated tax legislation. It could also lead to an undesirable erosion of the tax base.
To address our problems in Canada, we should not simply eliminate the capital gains tax. I do worry that the capital gains tax rate is too high now relative to dividends. I also worry that the tax rates are too high. Tax rates must come down in this country. Lowering tax rates and undertaking some serious business tax reform in combination could lead to a significant reduction in the Canadian capital gains tax rate. The tax should not be eliminated; I am not going that far. However, we could have a much better system with much lower capital gains taxes similar to those found in the United States.
By the way, people keep referencing the 15 per cent or 20 per cent tax rate in the U.S., but one must remember that there are also state taxes on capital gains there. I am not sure how much more, but something should be added to that number.
Senator Angus: As a general statement, is it fair to conclude that eliminating the capital gains tax in a vacuum, and absent those very complicated measures, would lead to an abuse of the conversion of regular income into capital gains in order to beat the system? You used the more civilized phrase of "tax planning." So you agree that the tax base would be eroded by a straight-across-the-board abolition?
Mr. Mintz: Right. There has not yet been a good study completed in Canada. Tom Wilson and I are doing at least one study, which we hope to have finished very soon.
When the U.S. looks at realizations, they often do not fully take into account the problems involved with converting income into capital gains as part of the loss in revenues that might occur if the capital gains tax rate is driven below the dividend tax rate. They have done that in the United States. That is an issue. You might want to check with people in the U.S. who worked extensively on that topic about some of the actual calculations.
Senator Angus: That is helpful.
On another point, you mentioned that our treatment of deemed realizations upon death is integral to the Canadian approach to things. In other words, it is not necessarily good or bad, but it is part of the package that came with our 1971 tax reform. It strikes me that a deemed realization is unfair given the way families are set up. A traffic accident or an unfortunate happening can wipe out pools of capital in the country that have been developed by sweat and toil and hard work. I have never thought that the concept of deemed realization of capital gains is good public policy. In fact, I think it is very bad. I should like your comments.
Mr. Mintz: Clearly, I would disagree with that as long as we try to maintain an income tax system. That is why I like consumption-based systems. I agree with you somewhat that it is wrong that if you earn income, save it and then earn more money, you will end up being subject to tax again on that, whereas if you consume it right away, you are not subject to tax the second time on that income.
But leaving that issue aside, as long as we maintain an income tax base in this country, we must have, in my view, something at the time of death. All of the OECD countries have either a deemed realization of capital gains at death or an estate tax. In Canada, prior to 1972 we did not have deemed realization of capital gains at death, but we did have an estate tax. That estate tax was abolished at the federal level at the time that deemed realization came into effect.
It would be unfair to have both estate tax and deemed realization of capital gains at death because that is a double tax at that precise time. I believe there are only two countries that have both. One of them is Spain. Most countries will do one or the other.
Senator Angus: Does the United States have deemed realization?
Mr. Mintz: No, they do not. They do have estate tax, which is on a much narrower group of individuals.
Senator Meighen: I want to ask you about your preference for a so-called flat rate of capital gains taxation versus a variable rate. For example, pursuing the line Senator Angus was discussing, would there be any particular advantage, in your view, to having a lower rate of capital gains deemed realization upon death as opposed to the normal rate?
As you know, the Minister of Finance already started down the track of different rates when he, in my view, very wisely lowered the rate of capital gains taxation on gifts of shares to charities in Canada. I only wish that he would listen to the overwhelming anecdotal evidence <#0107> and you may have empirical evidence -- that this has unlocked a great deal of money for hospitals, universities and charities.
In Canada, we tax 75 per cent of the gain at a relatively high rate, while other countries tax 100 per cent of the gain. What is your opinion of taxing 100 per cent of the gain at a lower rate? Or do you prefer 75 per cent or 50 per cent of the gain at a higher rate?
Mr. Mintz: The problem with differential rates goes back to the tax planning opportunities that are created with it. Prior to 1986, people could set up, for example, a hedge. They could have two assets, one held more than a year and one held less than a year. Some losses are realized that are fully included in the income, and half the capital gains are subject to tax on an asset held for more than a year. A simple financial derivative was constructed that effectively eliminated all capital gains taxes. That would be a good thing for people who want to get rid of capital gains taxes.
Senator Meighen: These derivatives seem to accomplish that, and in other fields too. We have heard overwhelming evidence that in the area of foreign content, which is limited, as you well know, to 20 per cent in this country in pension funds,derivatives get around that now. The mutual fund companies are out selling this to everyone.
Mr. Mintz: With the system that we now have, there is not much incentive to try to create derivatives in order to convert income into capital gains or to eliminate capital gains taxes altogether. It is not as easy in our system.
Some thought must be given to the concern about the tax planning opportunities that are created. I do not think that anyone should make recommendations without giving some thought to the potential erosion of the capital gains tax in its entirety, unless that is really what you want to accomplish in the first place.
The second point is in regards to the 75 per cent rate versus the 100 per cent rate. In my view, the exclusion rate should be driven by trying to get some rough parity between the dividend tax rate and capital gains tax rate. There is nothing sacred about the 75 per cent rate.
Bringing personal income tax rates down, which happened in Ontario recently, actually allows an increase in the exclusion rate for capital gains. In Ontario, when the personal tax rates were lowered, the dividend tax rate went down faster than the capital gains tax rate. Therefore, you must increase the exclusion rate for that purpose.
I will return to my previous point. We have driven our capital gains tax rate based on the dividend tax rate, in which the dividend tax credit plays an important role. If we still try to maintain a low small-business tax rate and a low tax credit for dividend purposes, then it does not give much room on the capital gains exclusion rate. However, I would argue for a much more sensible system of having a higher corporate income tax rate on small businesses and a higher dividend tax rate. I would argue further for a recommendation in the technical committee of a corporate distribution tax. It would then be possible to have a higher dividend tax credit and to move to a much higher exclusion rate for capital gains. That would be good, sensible tax policy.
The Chairman: This is a study about capital gains and what good that tax can do. I am slightly worried that we are getting a little too technical in our questions. I may be wrong. I understand that it is a technical area.
Senator Kroft: I have a simple question that I was going to ask before the chairman's remarks. My independence should be understood. We have been talking about technical elements of the tax. What conclusions have you drawn from your study regarding the relationship between capital gains tax levels and effective investment and risk-taking activity? Would you indicate your thinking in that area?
Mr. Mintz: First, past studies have not shown a large impact on the effect of capital gains taxes on aggregate investment, and that is because most investment is undertaken by large public corporations that operate in a world economy and fund their investments not only from Canadian savings but from foreign savings as well. Changing the capital gains tax rate has an impact on domestic savings and increases it, but that does not necessarily translate into more domestic investment. It may lead to more Canadian ownership of investments and assets and drive out some of the foreign ownership, but it does not necessarily lead to more investment, because investment will be determined by the world interest rate or the world return rather than the domestic return. That is just in the case of public corporations.
The bigger issue is in the case of entrepreneurship. That is the important one. The studies have been too few and far between to get a handle on that. More work needs to be done, particularly in the Canadian case, to understand the impact of capital gains taxes on things like venture capital and others. A couple of studies have been done on venture capital and the impact of R&D and small business deductions. There was a study done for the technical committee, which you can also download off the Department of Finance Web site, that looked at the growth of small businesses and the small business deduction. However, no one has really looked at the capital gains tax rate in detail in that particular case. That is an area for further study.
The Chairman: Who could we invite here to tell us about it?
Mr. Mintz: Tom Wilson and I are doing a study using the Institute of Policy Analysis model. We are looking at the impact of cuts in capital gains taxes on government revenues, employment, investment, et cetera, keeping in mind some of these impacts. However, when looking at the aggregate economy, the impacts tend to get muted because of the issue about large public corporations and the difference between their behaviour and the smaller entrepreneurial economy; but we will try our best to take that into account.
Senator Kroft: What is your timetable for this study?
Mr. Mintz: We are almost finished.
The Chairman: Could you contact us as soon as it is finished?
Mr. Mintz: Yes, I will.
Senator Tkachuk: If there was a relatively significant reduction in the capital gains tax, would that have an effect on the Canadian dollar?
Mr. Mintz: Let me think that through a bit. First, if you cut the capital gains tax rate and encourage more equity ownership and more ownership of domestic assets in Canada, that will lead to less foreign savings coming into the country or greater export of foreign savings. That will have some impact on the Canadian dollar in the sense that it would reduce the demand for Canadian dollars. It would lead to some devaluation, but that would allow us to export more and import less.
Senator Tkachuk: I got lost at the end.
Mr. Mintz: The point is that, if you have more domestic savings, you will have less capital inflow from abroad. That would cause the Canadian dollar to depreciate somewhat, but that would allow companies to export more and the trade balance would improve.
Senator Tkachuk: Therefore, a decrease in capital gains tax would cause our dollar to go down?
Mr. Mintz: Yes.
Senator Tkachuk: Now we have two economists disagreeing on that. That is interesting.
Mr. Mintz: I am just using the basic macro-trade balance model.
The Chairman: One of our problems in trying to achieve what we are hoping to achieve is how to sell it. That is the big problem for the people who have to get elected.
Senator Kelleher: How to sell what?
The Chairman: How to sell what we are hoping to achieve.
Mr. Mintz: Are you talking about increases in capital gains taxes or decreases in capital gains taxes?
The Chairman: Decreases. Are there any studies that show that a decrease in capital gains taxes redounds not only to fat cats but to middle-income people and even lower-income people?
Mr. Mintz: Most capital gains are actually in the upper-income groups in the economy.
The Chairman: What do you call an "upper-income group"?
Mr. Mintz: I define that as $100,000 or above.
The Chairman: We were told that 85 per cent of people who pay capital gains earn less than $100,000 a year.
Mr. Mintz: That is right, but I am speaking of the aggregate amount of capital gains. Certainly there are capital gains earned by lower-income people. There are also a lot of capital losses in the economy, which means that the impact on risk-taking, which I mentioned earlier, is very important.
I would think that cutting the capital gains tax rate would encourage more entrepreneurship and risk-taking, and I think that would have a positive impact on the economy.
The Chairman: What study can we look at that says that?
Mr. Mintz: I am just going basically by the application of theory. One must look at the total effect. I agree that there is no empirical study to give numbers on that. This is simply the impact that I would expect.
The Chairman: The Department of Finance says that if we cut capital gains to what they are in the United States, in the first year there would be a windfall because of unlocking profits, and that would persist for about three years. They say that in the fourth year there would be a cost of $1 billion. However, I do not know what the basic premises are. What about all the money that will be made by reinvestment? I do not even know if you can get such a number.
It seems to me that those kinds of studies are destined to die because they are not taking into account the full effect.
Mr. Mintz: So far, the studies on realizations that have been done in the United States suggest that you do get some more reinvestment, and people would agree with that, but you do not necessarily make up for the total potential loss experienced by moving realizations up early and having fewer realizations in the future.
The Chairman: Is there nothing about job creation?
Mr. Mintz: I am only saying that these are studies that have been done in the United States. In the study that we are currently doing through the Institute of Policy Analysis we will be able to take into account aggregate investment impacts and employment impacts in terms of the impact on the revenues of the government, which will mean that we will make up some of the loss in capital gains taxes in the future through more investment in the economy.
Senator Meighen: There is a 1994 U.S. study that, I am informed, said that after five years there would be a $300 billion rise in the U.S. in GDP and an increase of some 877,000 jobs. Even applying a 5 per cent factor, that is still pretty good.
Mr. Mintz: I suggest that you try to get a survey done of all the studies done in the United States. We have just done such a survey and have found that they are somewhat over the map. However, you will generally find that you do get increases in investment that can measure and can be factored into the realizations and revenues that governments get. Most of the studies in the United States show that, if you do not take into account behavioural impacts, you will get a certain long-term loss in capital gains tax revenues by lowering the rate. You may get some short-term pick up and long-term loss in capital gains. That is assuming no behavioural impact.
Senator Meighen: That is not only capital gains. You are not talking about other forms of taxation.
Mr. Mintz: Other taxes too. I am saying "without behavioural impacts." Once you take behavioural impacts into account, you will get some pickup in tax revenues, although it does not make it up fully. I can make that survey available to you right away, because we have that done.
The Chairman: Would it have the same effect if you just cut capital gains and forgot about the integration you talk about?
Mr. Mintz: The same effect as what?
The Chairman: Increase in investment, increase in entrepreneurship, increase in jobs.
Mr. Mintz: It depends. If you carry out some of the reforms I have suggested, such as lowering tax rates, and improving the tax system, you will have a much bigger impact on the economy compared to doing only one thing.
The Chairman: Well, we will not get anything done on capital gains if they do not do something about everything else.
Mr. Mintz: I agree on that.
Senator Tkachuk: I had an intervention on your comment, Mr. Chairman, on the effect of eliminating a part of capital gains and how that affects the ordinary worker in Canada. I do not think that is a big stretch. Right now, our capital gains tax is high because it is tied to income. Taking 75 per cent on a 50 per cent tax rate makes it an effectively high rate of 37 or 38 per cent in my province.
The ordinary income-earner pays no capital gains on his savings for old age. He puts his savings into an RRSP and they are tax-protected. Surely, he would not want that taxed. Pension funds, as Senator Hervieux-Payette pointed out, are not taxed, but no one would argue that such a huge accumulation of capital has not had a profound effect on our Canadian economy. Many of our companies in Canada are effectively owned by large accumulations of capital.
With capital gains, we want to spread that out so we can promote entrepreneurship. Reducing the capital gains tax, we hope, is a reward for risking one's capital rather than saving it or simply earning income by working for a living. Hopefully, any extra money will be put into entrepreneurship and risk to provide the same benefits as saving in tax shelters. We can make a very strong argument that reduction of capital gains provides jobs, opportunities and still pays a tax even though we are arguing for a lower tax. A person who wants no risk can pay no capital gains at all by saving in an RRSP and hopefully paying a lower rate when spending those funds after the age of 65.
Mr. Mintz: I agree with your statement about the capital gains tax rates and I am including the integration issues. If you try to tax capital gains like other sources of income, you do deter risk-taking, because we do not and we never will have capital losses being fully deducted from other sources of income. You put a very high penalty on risk-taking arising from taxes. That argues for a lower tax rate on capital gains compared to other sources of income because you want to at least take away the tax penalty on risk-taking. On that part, I do agree with you.
I know that in terms of my recommendations I am driven by a technical issue, which is the conversion of income into capital gains, but I am very sympathetic with the argument that we should try to lower capital gains tax rates. However, I suggest doing that through good tax policy. Good tax policy would mean right now reducing the capital gains tax rate to bring parity between dividends and capital gains and then adding further reforms to get the best "bang for the buck" as you are suggesting.
The Chairman: Thank you, Mr. Mintz. Please send us the additional information that you have available and we will invite you back later to discuss it.
The committee continued in camera.