Proceedings of the Standing Senate Committee on
Banking, Trade and
Commerce
Issue 3 - Evidence of December 8, 1999
OTTAWA, Wednesday, December 8, 1999
The Standing Senate Committee on Banking, Trade and Commerce met this day at 3:40 p.m. to examine the present state of the domestic and international financial system (Capital Gains Tax).
Senator E. Leo Kolber (Chairman) in the Chair.
[English]
The Chairman: We have a quorum. We are delighted to have as our witness today Professor Vern Krishna. He is a tax counsellor. He holds a Bachelor of Commerce from Manchester University, an M.B.A. and an LL.B. from the University of Alberta and an LL.M. from Harvard Law School. In addition he has a Diploma of Comparative Law from Cambridge University. He teaches business and taxation law at the University of Ottawa Law School. He is the director of the CGA Tax Research Centre. He is a commissioner of the Ontario Securities Commission and the author of several leading works in taxation, including the Fundamentals of Canadian Income Tax. He is the editor of Canada's Tax Treaties, and managing editor of Canadian Current Tax, a monthly publication on tax matters. He was formerly Chief of Tax Policy and Legislation in the Department of Finance. Welcome and please proceed.
Professor Vern Krishna, Q.C., Faculty of Law, University of Ottawa: I am delighted to be afforded the opportunity to address you today. I have distributed a paper which is an amalgam of some other pieces that I had done and some new material with some new statistics. I thought that I would speak to this paper itself and let the paper become part of the record.
The issue that we have in front of us is a very old one. I want to talk about what the problem is and some of the policy considerations that go into balancing the issue. I want to argue a case as to why there should be a preference for capital gains and what the trade-offs are, touch up on some international issues and competitive considerations, and then offer some tentative solutions which should be considered.
Our tax law has always preferred capital gains. For example, capital gains are taxed at a lower rate than other forms of income. At the inception of our tax system we did not tax capital gains at all, so the preference was 100 per cent. We moved from there to the Carter Commission study back in 1970 or 1971 -- January 1, 1972, really -- to a system of 50 per cent of inclusion. Since then we have raised the tax on capital gains to two-thirds in 1988-1989 and then to three-quarters in 1990 where it is today.
There is no ideal capital gains tax. There never has been and there never will be. One hundred years from now, the question of what is the ideal capital gains tax will be debated in this Chamber. There is no ideal income tax because all tax law involves a compromise between competing values. Those competing values carry different weight amongst different members of the population and legislators, and at different times in our history.
There are basically only five competing values in any tax system. First and foremost, a tax system exists to generate revenue for public spending, and therefore revenue generation is an important consideration, or the converse of that, the revenue loss from a proposal.
Second, there is the issue of fairness, however we describe it. Most people will agree that a tax system should be fair. There are points of departure of opinion as to what actually constitutes fairness, but most people will agree that it should be fair. I have never in my professional or academic life over 25 years ever heard anyone say that the tax system should be unfair. I have heard many differing opinions as to what each person thinks fairness is.
Third, a tax system should be neutral and it should not distort economic decisions merely for tax purposes.
Fourth, tax systems should be sensitive to economic considerations and, in the context of our discussion today, particularly to competitive considerations and international tax models. That has become increasingly important over the years. It was not an important issue when the tax system was initially devised in the First World War. It was not even that important an issue when the Carter Commission reported in the 1960s and the new tax system came in, in 1972. It is absolutely imperative today because the world has become closer, trade more mobile and global, and capital is moving at a very rapid rate in either direction and can move very quickly over electronic systems.
The final consideration we need to take into account is administrative complexity and the amount of time, energy and cost that both government and taxpayers must put into administering a tax system. Those five considerations need to be balanced in some way. In any room made up of any constituency, different people will balance those five considerations in different ways. I am not here to suggest to you that I have any ideal tax system in mind for the capital gains tax or any other tax, but I will try to suggest an optimum system, one that works better than it does not; it may not be the best, but it balances the various considerations in an optimal manner.
I will now take you through the theories of income because I know from prior testimony that you have been exposed to this. In essence, there are different meanings of income in different branches of the field. What we are concerned with here today and in our existing tax system is a legal definition of income as opposed to an economic definition of income. There is an important difference between the two. An economist talks about income as an accretion in wealth. A lawyer talks about income as the realization of wealth. In fact, if I may put this into a wider context, we do not in Canada or in any other country have an Income Tax Act, in the pure sense of the term. We call it an Income Tax Act, but we actually have a tax on transactions. By that we mean we only recognize income when it is realized and a transaction occurs. Until that time, there is no tax on any accretion of wealth, which an economist would call income and which is widely recognized as income all the way down to Haig and Simons, the famous economists who first thought in those terms.
Page 4 of my material has a table. We start with the proposition that income is a surrogate measure of ability to pay. It is not the best measure of ability to pay. It is merely a surrogate measure of ability to pay. If we look at who is paying the capital gains tax in the country, you will see that income levels all the way down from those who report no income to those who report income in excess of $250,000 all have capital gains. It is distributed right through the system.
Approximately 83 per cent of the people reporting capital gains are in income levels below $70,000. In the column of $60,000 to $70,000, 83.2 per cent of individuals reported capital gains. The distribution of capital gains is substantially in the bottom, up to $70,000. However, the other observation is that, on the last line, 37 per cent of the value of capital gains is attached to people with income levels over $250,000.
Although everyone realizes some amount of capital gains, the greatest single component is realized by people with incomes over $250,000. That is neither surprising nor new. People with capital generally realize capital gains, and people need capital in order to trigger a capital gain and to invest to make income. Nevertheless, it is an issue that affects more than simply a single constituency of society or the rich. It affects income levels all the way through, albeit with different effect.
Naturally, the converse is that there will be some revenue lost if one reduces the capital gain. There will possibly be some revenue increase from unlocking capital gains. I will come to that in a moment.
The next issue I have, and these are not in any particular sequence, is the administrative complexity. The United States has said that in their estimates -- and we do not have comparable estimates here so I cannot quote Canadian figures to you -- more administrative time and effort is spent on capital gains than on any other single provision of the internal revenue code. There is no reason to believe that our experience would be substantially different. It is a source of considerable complexity in the tax system. Inevitably, as soon as you draw a line between two forms of income, one taxed at a higher rate than the other, that line will be attacked. People will want to cross that line to get from the higher income to the lower income. That is to some extent inevitable.
Senators, I think the meat of the issue is whether we want a preference for capital gains. What is the alternative? The alternative is we tax capital gains at 100 per cent and treat it like any other form of income and there will be no preference. The second alternative is to give it preferential treatment, which we do right now; we tax it at 75 per cent. The third issue is what the amount of preference should be. Is 75 a good number? Or is 50, towards which Australia is going, a better number? Or is 20 or 15, to which the United States is headed, an even better number? Perhaps the best number is back where we started at zero.
There are three problems with capital gains as opposed to other forms of income. Before I mention the problems, however, there is first of all an attitude that capital gains do not actually constitute income. I have described that. It was an attitude early on in the tax system, but it is not one that I want to dwell too much upon. Capital gain is a form of wealth. It comes about through the appreciation of capital and it is now pretty well accepted. So the real question is, should we give it preferential treatment?
The first problem with capital gains, which I describe at page 6, is the bunching effect. The bunching effect means if you buy shares in year one for $20 and sell the shares in year five for $120, the gain of $100 reflects the unrealized accrual of gains over five years. The triggering event is the transaction of selling the shares, which then triggers the capital gain. Until that time, the gain is simply accruing and developing and it has no adverse consequences on the taxpayer.
That can be unfair to some taxpayers, and particularly lower-income taxpayers, because is it bumps you up from one rate bracket to another at the lower income brackets. We have seen in the numbers that everyone has capital gains going all the way down to zero income. The bunching effect can bump you up from the 17 per cent bracket to the 26 per cent bracket, or from the 26 per cent federal bracket to the 29 per cent bracket simply because the income is bunched and is realized at one time. That is a very real problem. I will describe later how some countries address that problem and what the possible approaches are. It is an identifiable problem and characteristic of the capital gains tax, unlike other forms of income which generally flow more evenly and without that lumpiness or bunching effect.
The second problem with capital gains is that it has a lock-in effect. If you have an accrued capital gain, you have a real incentive not to sell and move your capital into another use. For example, a taxpayer with an unrealized gain of $100 or $100,000 or whatever, would trigger a tax of approximately 40 per cent in Ontario at this time if he or she sold the underlying security, which means in order to justify the economic decision, you have to pay the tax and reinvest $60 and get back to your $100 in order to be in the same position. Unless you have an investment that will appreciate at that rapid rate, you will very seriously consider lock-in and not sell.
Indeed, that is why some people, like Warren Buffet, when asked what is the best time to sell a security has answered, "Never." Our system does permit that to some extent. We trigger capital gains on debt. There is a deemed realization on debt, but we have an exception for that, and we allow a rollover of the assets to our spouses until the time that the spouse dies. Then the realization is deferred to the second death unless the spouse remarries and leaves the property to his or her next spouse in which case you have a second generation.
The Chairman: Could you give that example one more time? I am having some difficulty with it.
Mr. Krishna: Assume that you purchase stock at $1 and it now has a value of $101, so you have an accrued gain of $100. If you sell that stock at that time and realize the gain of $100, you must pay a capital gains tax of approximately $40 immediately. If you pay $40 immediately, that means you have only $61 in effect left to reinvest because you have bartered with $40.
The Chairman: Yes, but that is $60 more than you had before.
Mr. Krishna: Yes, it is $60 more than you had in cash before, but not in wealth before.
The Chairman: It is not really wealth if it is taxable at some point.
Mr. Krishna: Here is the nub of the problem. Once you have given away $40 to the government and you have only $60, in order to come back to the level that you were at before you sold at $101, with the first $40 of recovery in your appreciation you are just getting back to where you were before you even sold, insofar as gain is concerned. The problem with that and why it has a lock-in effect is that you will be very hesitant to sell that security unless you can be assured that your subsequent appreciation will rise at a much more rapid rate; otherwise you are no further ahead, if you merely go back to $100.
Senator Kenny: That assumes that all of your decisions are tax driven.
Mr. Krishna: I would not go so far as to say that all of your decisions are tax driven, but for most commercial decisions regarding stock ownership, one of the serious factors to consider will be your tax effect.
This lock-in effect is generally regarded as being inefficient because it does not allow capital to move such that it can be put to the most effective usage.
The third problem with capital gains is that part of the gain is illusory. This is related to the bunching effect and the timing effect. If you bought a share for $1 in 1972 when the system came in and you own it to this day -- and let us assume that the gain and the share is worth $100 so it has appreciated 100 times -- your accrued gain is $99. You will be taxed on the $99 or three-quarters of it. However, your gain is not $99 because the purchasing power of $99 when you realize the gain is nowhere near the purchasing power of the dollar back in 1972 when you acquired the asset; there is an inflationary component in the gain that is triggered at the time you sell the asset and you have to pay taxes. The problem is that you are taxing an illusory gain.
Different countries have taken different approaches to resolving this problem. They continue to do so. There are basically three broad solutions to the problem. Each variation of these three solutions has existed in Canada and elsewhere. One, you can allow averaging of gains. Australia, for example, under its existing regime allows an averaging of your gains over five years. The purpose of their rule is to move away from the bunching effect and spread it out over five years.
Two, you can allow indexation of capital gains. If you bought a share at $1 in 1972 and you sell it for $100 in 1999, you can index the $1 cost up to its inflated value today and then tax only the real gain. For example, suppose that $1 has a purchasing power equivalent to $30, then your real gain is only $70, and not $99. That is just an estimate; I have not done the calculations.
Australia uses an indexation system at this time. Back in the late 1970s and early 1980s, Canada had a form of indexation for capital gains in our system because inflation was running so high at that time. We had inflation rates of 12 per cent, 14 per cent or 15 per cent. This problem was exacerbated at that time. It is obviously not as acute today with inflation being fairly benign. However, the cumulative effect of inflation is quite substantial, even though in each individual year it might be quite small.
There is another way to address all of these problems, and that is the way that we have right now. In a rough and ready form of justice we simply say we will address bunching and we will address indexation and all of these problems with mobility of capital by taxing a lesser amount of the gain, so we choose a number. There is no magic in the number. The number was 50 per cent in 1972. It went to two-thirds in 1988. It is up to three-quarters now. It is a rough and ready form of justice. You say, "All right, we know there is an inflationary component. We know there is a bunching effect. To keep the whole thing simple, let us tax a lesser portion of it."
Interestingly, Australia has a bill proposing to do away with averaging, do away with indexing and go back to 50 per cent inclusion. That bill has cleared the lower house but I hear it has run into some difficulty in the Australian Senate. They are attempting to negotiate a resolution to the problem.
Our situation is more difficult and exacerbated because apart from all of the problems that we have discussed, we have one other very real concern and consideration to take into account. That is international competitiveness. When we talk about international competitiveness we look at Australia, Britain and Sweden and all those other systems that have similar problems, but the reality is that our neighbour to the south is our principle trading partner. We are their largest trading partner. The mobility of capital and human resources across the border is enormous and very fluid. Therefore, we cannot completely ignore what is happening in the United States in respect to this matter.
Let me read to you an e-mail I received from Vancouver dated Tuesday, December 7. It says, "Vern, here is what" -- name -- "and I hope to achieve with an offshore trust. Shelter our shares that will be issued to us in January. Have them assigned to a trust initially rather than to us. Even if the proposed federal tax laws come into play, we would hopefully still recognize some benefits to the taxation issue. My situation is such that I own nothing in Canada and I have no problem having no ties in Canada." That last sentence is the key.
This young man, about 28 or 29 years old, is the son of a person who lives in Ontario. He was born in this country, his parents and grandparents lived in this country, and he has lived in this country all his life, yet he is quite willing to move out of the country. Why? Because, he says, "I will have 2,942,500 shares to deal with in January 2000. That is why I need to understand what can be done with it." He is afraid that if he sells those shares when he is tied to Canada, he will be taxed on 75 per cent of the gain -- approximately 40 per cent. My job is to get him out of that situation and I will have him out of the situation by January.
Now he is moving to the United States. The United States has a very accommodating capital gains rate of approximately 20 per cent. They are talking about moving down to 15 per cent. That will place a great deal of pressure on the Canadian tax system in respect to capital gains.
Much has been said and I have read much in the newspapers on this issue. The chairman of Nortel and other very distinguished people in the high technology industry state that there should be some preferential form of treatment for the high tech sector. I disagree. I do not think you can have a preferential form of system for any one sector. It would create inordinate problems. It is target inefficient and you would never be able to contain the sector itself let alone define what is high technology, which is always changing.
I think it would be better if Canada had a more competitive capital gains tax system across the board in respect of shares, regardless of sector. A reduction of the inclusion rate to 50 per cent, back to where Carter started in 1972, would bring us in line with Australia but not in line with the United States. A reduction of the inclusion rate to 20 per cent would be that much more significant. Of course there would be a revenue loss, but economists tell us there might also be some revenue enhancement from the releasing of capital gains and the unleashing of capital gains. Certainly the United States experience suggests that when President Reagan reduced the rates in that country, there was no substantial revenue loss. In fact, some argue that there was quite a revenue gain.
A reduction of the inclusion rate to 50 per cent or 20 per cent -- and that is a question of picking a number based on revenue considerations in part -- is a balancing of competitive considerations against revenue loss. There is some loss in equity of fairness -- the lower the rate goes, the higher the unfairness to high-income groups. There is no doubt about that. However, our tax system already has certain preferences in respect of capital gains on shares.
We exempt shares of small business corporations to a maximum of $500,000 now from tax. Properly structured, a family can take advantage of that and increase that exemption of $500,000 per taxpayer quite easily to $2 million to $2.5 million in an average family of two spouses and two children.
The concept of exempting capital gains is already entrenched in the system. We exempt certain forms of capital gains, the most famous of which is the principle residence exemption. That is a capital property on which we have no difficulty whatsoever saying that the gain is entirely exempt. Similarly, we exempt capital gains on family farm corporations up to a maximum of $500,000. So the notion of exempting capital gains is not alien or foreign to our system. It is simply a question of defining the exact boundaries and parameters of the exemption.
Canada would, in the trade-off of these five considerations, enhance its competitiveness and retain its talent -- perhaps on a revenue neutral basis though I will not be dogmatic about that; it depends on the level -- at no increase of administrative complexity, which will remain a constant, and admittedly with some minor trade-off in the fairness and equity of the system as certain income groups will benefit more than others.
It would be a difficult task to devise any system that is perfect; in my judgment it is an impossible task. The best we can do is arrive at an optimal solution that meets the needs of the country at the present time.
Senator Tkachuk: My first question is about the statistics on the income groups that realize capital gains. I am referring to the chart on page 4 of your brief. You say that 37 per cent of the value of the gains accrued to individuals with income of more than $250,000. Would those statistics be skewed because of the accrual method of capital gain?
In other words, when young people start small businesses or begin accumulating stocks or investments, their income level is low but they are still involved in capital investments. At some future time when their businesses are successful they will realize a capital gain. The figures in your chart represent those people who file actual returns that have value now. That does not mean that there is not a whole bunch of lower-income people in their 30s and late 20s who are in enterprises and businesses and are saving through buying stock or maybe accumulating stock options -- and hopefully they are not being forced to sell them because of the income tax laws. Those people will of course dispose of their stocks when they are ready to retire or when they want to make other business investments. In other words, it is not just high-income people who have investments, they just happen to be high income by the time they realize those capital gains. Would that skew the numbers?
Mr. Krishna: That is a perceptive way of looking at the numbers. It is absolutely correct. It goes back to the two issues I identified with the problem of capital gains. One is realization: the gain is triggered only when you realize it. Two, income is bunched so that it is all realized in the year of the disposition. That is true in the case of a small-business person who starts off at a young age, builds up a business and at age 65 sells off the business. The gain is then all realized in that particular year. By that time the person is very successful and the gain itself will put him or her into an over $250,000 bracket. For example, if you have taken a gain over a lifetime of $3 million in the sale of your business and what have you, you are automatically kicked into that category and appear to be wealthier than you are, because that gain has accrued over 30 years. That is right.
Senator Tkachuk: I believe capital gains are too high. That aside, there are two things that bother me on the fairness issue. I want to know what your feelings are and what you recommend to the committee. The first is the question of options. Most committee members know how options are dealt with, but I will review it quickly for the record. The option is a way to pay your employees or your board of directors or your top management. You want them to become part of the company, yet when they exercise an option they must sell their shares rather than accumulate them because they have a tax problem.
It was reported in the paper today that there was quite a sell off of options at Nortel. That is bound to happen because if you exercise them when the stock goes high, which is when you want to exercise them, you are automatically taxed, and therefore you are forced to sell them to pay the tax.
Senator Meighen: Do you mean sell, rather than exercise the options?
Senator Tkachuk: If the stock is $20 and if you have an option of $10, you will want to exercise, so you must sell it to keep the stock.
Senator Furey: First you exercise, and because of the tax implications you are forced to the next step.
Senator Tkachuk: Maybe I did not say it correctly, but thank you. That is the first point. The second issue is the question of how we treat the capital gain. We really say that 25 per cent of that gain is set aside for risk or whatever reason and we treat the other 75 per cent as income. For example, if Senator Oliver makes $1,000 capital gain, after you take off the 25 per cent off, at his tax rate he would be paying 50 per cent of $750. If he loses it though, he cannot treat it the same. In other words, if it had gone the other way and he had lost $1,000, he could not deduct that $750 from his income. Right?
Mr. Krishna: That is true.
Senator Tkachuk: Only against future tax gains. Would you advise that those things be changed? Would that make a big difference in the revenue of the country? Those are small measures that I think we could do in a minute if the minister does not want to go to big measures.
Mr. Krishna: I try to address this issue at the bottom of page 8 and the top of page 9 with a small example. It goes back to the triggering event, which is realization. What you have identified is absolutely right. The Nortel situation is very fortunate for those who are in it. The employees of Nortel will have a very pleasant Christmas. However, the reality is that when they exercise that option, not only are they taxable, but they are taxable on it as employment source income, not as capital gains. That is a very hard hit for the reason you mentioned. They took their compensation in the form of stock options at a time when they were undertaking risk. They did not realize at the time how enormously wealthy they would become, but with the benefit of hindsight we know what Nortel has done in only six months. That is a factor to take into account in fairness.
On the last page of my paper I state that "The equal treatment of those in fundamentally unequal circumstances is unfair. Competitive considerations warrant different rules if the underlying economics justifies differentiation." By that I mean the equal treatment of employees in regular source employment income. For example, working in town here with the government with an indexed pension plan is not the same as working in the high tech sector.
But we should not use only the example of Nortel because that is the successful one. There are many in that industry who do not see the success that employees of Nortel have been lucky enough to see, and many who take risks may not realize the value of their stock options. We know for example that only about two years ago Corel had to reduce the exercise price on their options because the stock had fallen so low that nobody could exercise their options and make money. People who had sacrificed their regular compensation in exchange for options were now being deprived on both sides.
I agree with you that that is an issue that goes to fairness. One suggestion I have is to defer the tax consequence until the sale of the stock, and not upon the exercise of the option. That is a part-way measure that alleviates the problem. Then, do not treat it as employment source income, which is fully taxable, but treat it as a capital gain at whatever rate you choose to recommend for capital gain. That will help a lot.
Senator Tkachuk: What about the second issue on the question of the loss?
Mr. Krishna: The problem of the loss is very acute because of our entire income tax system. It will take you well beyond the capital gains arena into many other areas of the tax law. Under our income tax system, unlike the United States, we compartmentalize income and losses into particular pigeonholes that are very tight, and you can only apply capital losses against capital gains. That is endemic and systemic in the system. It can cause enormous harm.
For example, a taxpayer makes an investment, loses half a million dollars, goes bankrupt, has a capital loss, goes and works in employment. The tax system says, "We will allow you to use the $500,000 loss you suffered, but only against capital gains." The taxpayer says that he has been wiped out. He does not have $5 in the bank. He is on unemployment income now. But in his pigeonhole he can only offset one against the other. He will pay full tax on his employment source income. That is systemic in our tax act. It takes the issue much beyond capital gains. This confinement of income by source is a very real problem.
Senator Kenny: You demonstrate clearly in your chart that most of society pays capital gains. You do not mention anywhere it in your paper, but I wonder if you have come across studies anywhere that you could share with the committee that would indicate what percentage of Canadians earning $30,000 to $35,000 or less, for example, understand that they pay capital gains tax.
Mr. Krishna: I suspect that 30 per cent to 35 per cent of Canadians do not understand what kind of tax they pay in so many different guises -- the income tax, the employment tax, CPP and all of these. At the end of the day, I think it is fair to say that even most educated Canadians and sophisticated Canadians do not understand the full amount of the tax they pay. I know no particular study on what that percentage would be, but it would be a good percentage.
Senator Kenny: My point is that most people see capital gains as a rich person's issue. I was wondering if you could direct the committee to any studies that would indicate what the awareness is of capital gains or whether the typical Canadian understands that they are paying a capital gains tax.
Mr. Krishna: I cannot direct you to any particular study. I can observe that most Canadians pay it and do not know about it, and where they pay it and do not know about it is actually through their mutual fund holdings. Ordinary Canadians buy a mutual fund or a monthly subscription plan to a mutual fund. All those people must pay their capital gains on an annual basis and they receive their reporting slips. Some of them may be quite surprised, particularly in years where their funds do very well and they get these large numbers, that they are actually taxable. Unfortunately, I am not aware of any study that provides the exact numbers.
Senator Kenny: The answer to that question has a major impact on the political dynamics of how one treats it.
You have made the case here -- to use your words -- that a preferential adjustment of capital gains tax would be a valuable step forward. You were comfortable that there would be no loss in revenue and in fact you thought the government would achieve an increase in revenue. A previous witness suggested to us that to mess with the capital gains tax in any way, whether to increase it or decrease it or move it in anyway, would be counterproductive in that there is such extensive tax planning in the country right now that you cannot deal with the capital gains tax as a separate entity. The only way to address it is with comprehensive tax reform. Would you comment on that please?
Mr. Krishna: Each of us is born to live through three tax reforms. I have been through two of them, back in 1972 with the Carter commission when I was a very young man, then in the mid-1980s when we went through tax reform. I am waiting for one more to occur. Reforming an entire tax system, taking the entire statute and changing it as we did back in 1971, is such an enormous task that I would be surprised if any government would want to undertake it soon. Changing bits and pieces of it is more realistic.
I do not subscribe to the view that the reduction of the capital gains rate of inclusion from 75 per cent to 50 per cent, just to select of a number, will cause any greater disruption than a reduction of the normal tax rate, as we have witnessed in the province of Ontario over the last three or four years, has done. It is simply an effective reduction in the tax rate. If your tax rate drops from a normal rate of 40 per cent in the case of capital gains to 35 per cent, it will have no adverse effect.
There is one area though that will need a consequential adjustment if you reduce the capital gains inclusion rate. Our system is designed in such a way that we try to keep the taxation of dividend income and capital gains income approximately equal at the top end of the scale. There is about a 3 per cent difference between the two even now. In Ontario in 1999, ordinary income is taxable at 48.75 per cent. Dividend income is taxable at 32.92 per cent, and capital gains are taxable at 36.57 per cent. There is a difference of approximately 3.5 percentage points between dividends and capital gains. Now, it is not very large, but I do not think you would want it to be much larger. A consequential adjustment to dividend inclusion and tax rate would be required.
Senator Meighen: Do you have any idea from any academic work you may have done what percentage of total capital gains revenue comes from the sale of publicly traded shares -- in other words, from the sale of property or the sale of paintings or the sale of whatever would it be? Can you tell me whether it would be a large or a small proportion?
Mr. Krishna: No, sir, I cannot tell you that. Under our reporting system, taxpayers do report the disposition of shares on a form, but Revenue Canada does not report or print that statistic out that way. There is no way of getting at that information.
Senator Meighen: What would be your opinion on taxing capital gains at a different rate depending upon the length of time that the asset has been held? Some jurisdictions, like the United States, apply a lower rate if the asset has been held over a longer period of time.
Mr. Krishna: Australia is moving that way. They are moving to this reduced inclusion rate of 50 per cent provided that the asset is held one year. That is quite normal. The philosophy is that you want it to be a capital gain, not an income gain. You do not want people who are flipping and day trading to get all these benefits. Those are not the people to whom this is targeted. I think a one-year horizon is reasonable, and of course you can become more sophisticated than that and say that you will have a graduated decline depending on how the time increases. The trade-off is between complexity and competitive considerations at that time. In my judgment the Australian-U.S. experience, a one-year test, is as good as any.
Senator Meighen: It would not add that much complexity, would it?
Mr. Krishna: Not the one year.
Senator Meighen: It might do something to help the perception that the individual who is engaged in flipping -- which is legal but nevertheless seems wrong to some people -- should make a great deal of money having put their money at risk for a very short period of time. I do not pass judgment on that, but certainly that is a feeling that they do not deserve to keep all those gains.
My next question has to do with the whole area of locked-in capital and rollovers. In talking about Mr. Roth's speech the other day, you said that you did not think it was appropriate in capital gains application to favour one area over another. In one of our studies, we had some testimony to the effect that in the United States there are rollovers permitted provided you stay within the same defined class of assets. If you started a high tech company, did extremely well and sold it and then reinvested that in the high tech industry, you would not be taxed or would be taxed at a lower rate on your capital gain. There are those who strongly favour that, particularly in areas such as high tech if we want, as Mr. Roth mentioned, to encourage people to stay in this country. Do you have any comment on that?
Mr. Krishna: To repeat my earlier balancing of various considerations, we do have in the present income tax system many rollovers. The Income Tax Act is littered with rollover provisions where we do not pay capital gains tax on many transactions.
Senator Meighen: Such as?
Mr. Krishna: Transfer of a business from a sole proprietorship to a taxable Canadian corporation. We do that on a tax-free basis. An exchange of shares we do on a tax-free basis. Mergers. Winding up. We spend 90 per cent of our professional life arranging transactions to avoid the capital gains tax. I speak against my own best interests here this afternoon. The Act is littered with them: rollover on the purchase of a replacement property; rollover on transfer property to a spouse; rollover on debt to a spouse.
Senator Meighen: Are there too many or one more would not make a difference?
Mr. Krishna: No. I am saying it is not a foreign concept at all. The United States has done it with the principle-residence exemption. That exemption is available only if you reinvest in another residence and only up to the amount that you reinvest, so you do not receive a rollover for the excess that you put in your pocket and walk away with.
I have no difficulties with the concept of rolling over. There is some merit to it. The difficulty is in defining the boundaries of what is loosely called the high tech sector. I have lived with the statute long enough to know that when you put pencil to paper and try to define a particular sector, the system will run into inordinate administrative complexity giving rise to litigation and uncertainty. That is my only concern. It is not that I do not agree conceptually with it. I think a broader reference available to all achieves the same result with less of a price.
Senator Meighen: With regard to the argument of more revenue, less revenue, my own anecdotal evidence is that since the finance minister very wisely, in my view, reduced the rate of capital gains tax on gifts of appreciated shares of publicly traded companies to charitable organizations, this has had a terrific unlocking effect. Certainly, in those charitable organizations that I have some knowledge of, it has been of immeasurable help in dealing with a situation where the government is pulling out of support and they are looking to the private sector to replace that support. The sooner we can get some hard data on that and hopefully expand that measure so that there is no capital gains on such a transfer, the better we will be. Do you have a comment on that?
Mr. Krishna: I believe it was a very good proposal. At the University of Ottawa and in the Faculty of Law -- and this is anecdotal evidence as well -- we have been the beneficiaries of that type of transfer of shares to us from successful entrepreneurs. Some of our graduates have done very well in various sectors -- the markets have been very strong over the last five years -- and some of those people have come back and donated appreciated shares to us. I agree. Without going into minute scientific study, there is enough evidence out there to suggest that it is having a beneficial result.
The Chairman: It is not as good as the United States though?
Mr. Krishna: No, it is not. However, our rules are not as generous as those in the United States, in part. The other part is that the United States has a very long tradition of donor giving, particularly to educational and artistic institutions.
The Chairman: When our Department of Finance gave the example to show how well we had done vis-à-vis the United States, did they not skew the figures to the extent that their basic premise was that Canadians who give to educational and medical facilities have an average base cost of 40 per cent of the stock they are giving, when in fact the largest givers have a zero cost? We have not scratched the surface on this question and we will come back to it.
Senator Fitzpatrick: In Canada, a large amount of the investment has been locked in for a considerable period of time. I presume there has been a significant appreciation in value. Have you done any studies or do you have an opinion on what kind of an impact unlocking those funds by a reduced capital gains tax, or no capital gains tax for that matter, would have? As a result of unlocking funds, people could take a gain and those funds could enter into the equity market in new equity opportunities in Canada. What effect could that have on our economy?
Mr. Krishna: There have been studies on this, particularly in the U.S. because they went through this exercise under the Reagan administration, and there was evidence of a sufficient outpouring of capital gains when the unlocking occurred. Again, there is no reason to suspect that our behaviour would be substantially different.
The lock-in effect has no beneficial consequences to society. Unleashing the lock-in effect does two things: it triggers the tax, albeit at a lower rate, that otherwise would have been deferred; and it diverts the capital into its most efficient use. Both of those are advantageous so I would be hard pressed to argue a case against unleashing the lock-in effect.
Senator Fitzpatrick: I think an argument can be made for two levels of taxation so that investments are held for a certain period of time, rather than having a continual rollover or disinvestment, so that there is an opportunity to create an asset value or a wealth value.
Mr. Krishna: Yes, I think that would be better. You should have one or the other. If you have a time test of one year, as was suggested a few moments ago by Senator Meighen, then you do not have the rollover to supplement that, because then you are giving a double-barrelled benefit, so to speak; you are giving the lower rate with one year and then deferring that by rolling over into a new asset. By that time, you might as well not be taxing it at all.
The Chairman: On Senator Meighen's question to you about people flipping stock, is it a fact that if you flip stock often enough you are classified as a trader and you will pay regular tax no matter what you do?
Mr. Krishna: That is probably true. I have written on that issue. The law is fairly clear on that. Day traders do not read the law though; they go into their computers and they trade away. The Wall Street Journal from yesterday has a wonderful article on the life of a day trader that is well worth reading. They would not be investors; they would not be eligible for the capital gains rate. They would be traders. Their income would be regular income. The difficulty is that it takes so much administrative effort to distinguish between those two categories and so much time in our courts is spent fighting the issue that it is a very inefficient way to resolve the problem. It is very expensive for society to resolve that problem.
Senator Angus: Have you had occasion to read any of the transcripts of our hearings thus far?
Mr. Krishna: I have read two of them.
Senator Angus: The first one?
Mr. Krishna: I have read Jack Mintz and Professor Brenner.
Senator Angus: When Professor Brenner was here we discussed what Senator Kenny has referred to as the political dynamic, which is very key to this whole exercise we are doing. Can you suggest to us a road map or some ways, some new language or code words that could be used in describing the process of reduction or removal of the capital gains tax that would make it acceptable to the people at large? As you know better than most, perception is 99 per cent of the reality.
I used the phrase "no brainer" in one of those hearings the other day. I am persuaded that the freeing up of all this capital that would otherwise be freed up except for the tax on it would be good for all Canadians at all levels of this society. It would increase employment, encourage investment in new industry and so forth, particularly the new economy. Then it would be part of what some are calling the new prosperity for all Canadians. That seems to be a desirable thing. Yet when we talk about this subject, we get back sort of a gut reaction, "It is a sop for the rich. It is good for only 2 per cent of Canadians or less. Why would you even consider it?" With that kind of an atmosphere, politicians, even the less skilled ones, stay away from this issue. Could you be helpful there at all? We will be able to bring quite a bit of evidence out in our study. I am hopeful that we will be able to show that it is not a retrograde thing. But how do we sell it? How do we dress it up or explain it?
Mr. Krishna: You are now drawing me into your arena, senator. There I am not an expert and I am very timid to enter. You are right; it is an issue of perception and misperception. If society will do anything in this regard, it must educate its press, its media, who do not have an understanding or do not come to the subject with an innate understanding of it. This is a large, complex subject, and even students of mine back at the university shudder when they enter the class. It is not a subject that they like. It is difficult. They stay away from it. They do not understand it, and that is true of society in general.
The other misconception that we must move away from is nomenclature. Part of this is the government's fault, particularly in the days when government was raising taxes a few years ago. Every time the government wanted to raise taxes, it would say, "We are taxing only the rich and the very rich," and it would introduce a surtax. Then it would introduce a surtax on the surtax. Ontario has done that and the federal government has done that and every other government has done that. The population and the media would read this and think, "That is okay because they are taxing only the rich. They are not coming after me."
The reality is that what governments call rich starts at $65,000. In Ontario today, the 48.75 per cent bracket starts at $65,000. At that amount you have two surtaxes. That is not an income level that I would call rich. There are fairly ordinary people earning that amount of money.
Senator Angus: That is why senators are paid $64,000. We are ordinary people. We want to identify with all Canadians.
Mr. Krishna: You are just avoiding the surtax.
Senator Angus: You have it right. I think nomenclature is the key word. My question really was whether you have any suggested nomenclature to help us deal with this. I thought I might suggest one word that seems to work in public policy areas, and that is the word "fairness". We should start using the word "fairness" in reverse and demonstrate in a dialectical way how the tax that we are talking about is not fair. The deemed realization, for instance, is dreadfully unfair to a whole body of people who are affected directly or indirectly by for example a car accident, when suddenly a whole business is destroyed and there are employees and workers. That is not fair. We as a committee need help with the nomenclature we use.
Mr. Krishna: I can think about that and get back to the committee. Off the top of my head, on the way up we indoctrinated the population that if they were earning $65,000, they were super rich. Even the Harris government, which has reduced taxes over the last number of years, has only reduced the rate to 48.75 per cent on the rich down from about 54 per cent, yet the public thinks that the reduction is 30 per cent. It is not 30 per cent because what he did was reduce the rate, reduce the threshold levels and jack up the surtaxes. So the net effective rate has only dropped about 5 percentage points -- which is good and I do not criticize him for it -- but it is not as enormous a reduction as the public perceives. There again is the gap between reality and perception.
Risk-taking, entrepreneurship, is a value that society treasures and that the country has been founded upon. It is something ordinary Canadians can identify with because they want to be afforded opportunities to take risk and to derive the benefits of their risk-taking in the form of financial reward. That strikes a cord with ordinary as opposed to simply an exclusive group of people. I would be inclined to promote that.
Senator Angus: That is right. I am looking for further buzzwords or phrases. One that occurs to me is "standard of living". If we could establish the direct link between our diminishing overall standard of living in this country and this kind of tax, if we could get people at all levels of income to understand that their shrinking disposable income and the relative purchasing power of that shrinking income are diminished by this kind of tax, or, in reverse, would be enhanced if we removed the tax, we could start to get somewhere, but today nobody wants to touch it for those very reasons.
Mr. Krishna: It is a difficult issue. You have more experience in this area than I do. I think back to the standard of living I enjoyed at a modest income level of $18,000 when I was first teaching at Dalhousie University. I look to the standard of living that I now have with a slightly higher income, and I am not quite sure that there has been much change. The numbers have changed, but the living standard perhaps was even a little better when we were younger at Dalhousie.
Senator Angus: Another thing that happens with the diminishing standard is the brain drain. People are definitely leaving because of the tax structure. We have the evidence on that. Somehow we have to find a package that fits together with the nomenclature.
Senator Hervieux-Payette: Here is something to consider when you reflect on how to sell the package: I have the feeling that with the Caisse de dépôt et placement du Québec, the Fonds de solidarité FTQ and some other institutions in Quebec, owning shares and making capital gains is less dramatic than in other places and has been supported by the labour union movement. We have had a tax exemption for those who invest in the Fonds de solidarité, and that has created a new dynamism for ordinary workers to invest in the economy of their province. Like Quebec, Alberta has some kind of tax incentive to invest in small cap. Perhaps there is a difference between those two provinces and the rest of the country in people's attitudes towards capital gains. If people understand better, they are more likely to invest in their own economy and of course realize some capital gains.
Senator Furey: My understanding is that your suggestion regarding rollovers is really a deferral, not only of the tax, but of all the problems that have been associated with the tax -- the illusory gains and the failure to index cost. Would such a mechanism be so attractive to investors that it would have a significant impact on mobility?
Mr. Krishna: I do not understand your question.
Senator Furey: When you talk about the ability to rollover investments from investment A to investment B without attracting immediate taxes, you are really talking about deferring the tax until an actual sale of the asset; correct? That is essentially just a deferral, not only of the tax, but also a deferral of the problems that you have highlighted as being associated with the tax -- the illusory gains, the failure to index costs, and all the other things you talked about. Would that be attractive enough to investors to have a significant, positive impact on mobility?
Mr. Krishna: In my view, it would have a very substantial impact on mobility. About 95 per cent of all tax planning energy and time is spent on deferral. To us, time is money. If I can devise a plan to defer something by five years, it is very useful; by 10 years, it is more useful. By 30 years, I have in fact mathematically eliminated it. We do not want to make things disappear. All we want to do is delay them so inordinately that by the time you come to pay the tax, you have earned income, the time value of money, the time value of deferral, and you are paying with inflated dollars. By the time you pay your tax 30 years from now, the dollar's purchasing power will be comparatively modest.
Senator Furey: You do have the off-setting effect that you spoke of earlier -- illusory gains, not having a rapid cost index, all those other problems as well.
Mr. Krishna: That is right, so you balance out the numbers. To conclude where I started, the solution Australia is now considering of moving back down to 50 per cent or lower, which we did in 1972, is probably the most optimal compromise of a complex array of issues.
The Chairman: Thank you for being with us today.
The committee adjourned.