Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce

Issue 3 - Evidence of December 9, 1999


OTTAWA, Thursday, December 9, 1999

The Standing Senate Committee on Banking, Trade and Commerce met this day at 11:00 a.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: This morning we welcome Professor Herb Grubel of the Department of Economics, Simon Fraser University. Herb Grubel is a senior fellow at the Fraser Institute and holds the institute's David Somerville Chair in Taxation and Finance.

Welcome, Professor Grubel. We are delighted to have you here with us again. Please proceed.

Professor Herb Grubel, Department of Economics, Simon Fraser University: I should like to thank you for inviting me here again.

If I am going to try to influence the opinion of people who hold a certain position, I try to put myself in their shoes and find out why they believe what they believe. That is the most effective way of marshalling the arguments and empirical information necessary to persuade them that their ways are wrong. Therefore, I will first present you with the three reasons given in the literature by individuals who think that we need a high capital gains tax.

The first argument is that we need it to raise revenue. The latest increase in the inclusion rate to 75 per cent took place when we had the fiscal crisis in the early 1990s.

Second, we need it in order to have a fairer distribution of income. The figure that is always cited is that people who make more than $200,000 a year pay over 50 per cent in capital gains tax. Taken at face value, that is a powerful argument for people who are concerned about the equity of the distribution of income. The rationalization is often that, after all, capital gains taxes are paid by people who can afford to pay. They have that income, so we might as well take it away from them to prevent the kind of inequalities that prevail in the United States.

The third argument used to defend the existence of a capital gains tax was at the core of all the remarks made by Mr. Jack Mintz when he visited with you last week. I read his testimony and I underlined where he said at the end that virtually all of his recommendations are motivated by the idea -- and it is a complex idea -- that if we have a high personal income tax but no capital gains tax, that opens up the opportunity for capital markets, lawyers, and accountants to shift working income into capital income. That income is then taken out as capital gains, and the people who take advantage of that loophole escape all taxation.

Not only is that unfair, but, most important for economists, you get a misallocation of resources. One of the most prominent ways you can achieve that capture of capital gains in place of earnings is for companies to reinvest all of their earnings. You would have excessive reinvestment of earnings to increase the capital value of a company, then you sell shares that have increased in value and, bingo, you pay no income tax, but you also have too much capital in the companies that do the reinvesting. While this is a somewhat technical issue, as far as the officials in the Department of Finance are concerned, and as far as Jack Mintz, the specialist, economist and taxation expert, is concerned, that is one of the most serious problems.

Having sketched for you why we have the tax, I wish to use those three cornerstones to criticize each of those arguments. My presentation contains several parts, and there are charts in my paper that explain everything in detail. The first chart shows all sources of revenue for all levels of government in 1992.

The first criticism concerns revenue. Before I get into that, though, I must tell you that we went through publications by the Department of Finance and by international organizations, but we could not find any publication where Canada says how much money is raised in the form of capital gains taxes. It is discouraging that the OECD statistics show that information for 80 per cent of the countries, while we do not have that statistic in Canada. My assistant at the Fraser Institute called the Department of Finance, but obviously did not get to the right person. He was told, "Why not estimate it yourself?"

We got a tax simulator from Revenue Canada, and we estimated it. We found that, for 1992, the personal capital gains taxation revenue was $716 million. That is 0.3 per cent of the total government revenue of $277.5 billion. Personal income tax is 37 per cent, and all other taxes account for 58 per cent.

Since then, Don Drummond from the Department of Finance, whom many of you may know, a very intelligent and conscientious, thoughtful person, handed to me their revenue estimate. It is considerably higher. Let us assume for a moment that it is three times or four times higher. It still represents a relatively small proportion of total revenue.

The important point is that evidence from around the world, especially the United States, shows that, if you lower capital gains tax rates, you will raise revenue through the capital gains tax in the short run. Even the Department of Finance agrees that, over three to four years, there would be a huge windfall of extra taxes paid if you lowered the rate. In the United States they have found that whenever you raise the rate, while the government predicts there will be an increase in revenue, there is not an increase in revenue. There is a decrease in revenue. That is in the short run.

The reasons are quite clear. You have now heard from enough experts to realize that the capital gains tax is a voluntary tax. Most people do not have to pay it. You pay it when you feel like it, and the evidence is that you feel like it when the rates are low. You do not pay it if the rates are high. It is as simple as that.

In the recent issue of the budget preview that the Department of Finance produced, they estimate that if we cut the inclusion rate from 75 per cent to 70 per cent -- a relatively small decrease -- we would have something like a $170-million loss. They then showed some other numbers. When I asked what behavioural assumptions they used in the calculations that underlie those estimates, they said, "We have no behavioural assumptions." They conclude that this short-run increase in revenue will end after two, three, or four years, and then you will go back down to where you simply get lower revenues because you have lowered the taxes.

In the United States, there is raging debate over this. They have enough experimental data, because they changed rates all the time, to answer the question on whether or not we have a long-run decrease in tax revenue. Only one estimate -- and I review this in the text I gave you -- says that the revenue will decrease. All the others said that maybe the revenue on capital gains will go down, but, for Canada's fiscal situation, if there is a stimulation in output and economic growth, we will get increases in revenue from the personal income tax, from the corporation income tax, and from the GST. Thus, the vast majority of American economists agree and believe strongly that, in the longer run, there will also be no revenue loss.

That is a curious proposition. In fact, some people are going so far as to say that if we got rid of the capital gains tax, the stimulation to economic activity would be so great that the revenue increases from all those other sources would be greater than the couple of billion that we are collecting at the moment. You can easily see where that would happen.

The appendix of my text explains this difficult concept. I have a lot of trouble explaining it, even to myself or, worse, so that my mother can understand it. I tell my students: "When you write a paper, always remember your mother, and think that you will have to explain it to her."

The lower the capital gains tax is, the greater the value put on stock market shares will be. It has been argued that in the United States, the lower capital gains tax rate and the lowering of the rate in the early 1990s were responsible for the increase in the value of the stock market. You know what kind of a multiplier effect that has had on the entire economy. People feel wealthier, they decide they do not have to save more for their retirement, and they start spending on consumption goods, on homes and everything else, which, in turn, has a multiplier effect and leads to more investment, producing an overall boom in the United States today that is almost unprecedented.

I believe we missed that boom to a considerable degree because we have high tax rates on capital gains. If that is so, you can see that high capital gains tax rates have an implication not only for the longer run, but also cyclically.

In my judgment, the revenue argument is dead, especially now that we have a surplus. We do not need that revenue. Assuming that there will be no revenue loss in either the long run or the short run, what, then, are the arguments for having a capital gains tax? What are the arguments against getting rid of it or lowering the rates considerably? In response to those questions, a high-ranking official in the Department of Finance told me, "Well, we have to think about fairness of the tax system." What does that mean? Do they mean that some people do not pay taxes, that the rich escape taxes? What is there to that argument?

The second chart shows taxable capital gains. Mr. Poddar, who prepared the information for that chart, estimated that in 1996, total federal taxes paid on investment income amounted to $4.3 billion. He estimated that capital gains taxes were $903 million, which is a bit higher than our estimate, but ours was for 1992 and his was for 1997, so that is consistent. As you can see, capital gains taxes are only 21 per cent of total taxes paid on investment. Therefore, even if you want to tax investment, it is not a significant number.

Chart 3 supports the argument I have made about the short-term response of revenues to changes in tax rates. The maximum tax rate on capital gains in the United States was about 27 per cent in the 1950s. It was raised in the late 1960s and into the 1970s, then it came down to where it is now, around 28 per cent. I am not sure whether it is 20 per cent or 28 per cent in the United States. I received those numbers from the American authority.

The Chairman: It depends on who is holding it.

Mr. Grubel: That is right. I must tell you, in contrast to trying to pull the data on capital gains revenue out of the Canadian Department of Finance, one phone call to the U.S. Treasury was enough to get, an hour later, a fax with a table of their revenues and the information I have plotted here.

You can see that, when the rates rose in the mid-1960s, revenues declined. They are all defined as a percentage of national income to keep inflation and all those kinds of things constant. When a law was passed in 1985 or 1986 that a year later the tax rate would be raised, everyone tried to get in and there was a spike in the capital gains tax revenue for the year before.

Chart 4 documents are interested Canadian phenomenon. People do not believe this figure, but I have had it recalculated several times. In Canada, in 1967, we had a marginal tax rate of 80 per cent on personal income. At that point, the top 1 per cent of income earners paid, in personal income taxes, approximately 18 per cent of all the taxes collected by the government. Throughout the following years, we had a lowering of the highest marginal tax rate, but the percentage of personal income taxes paid by the top 1 per cent remained virtually unchanged.

How is that possible? It is exactly the kind of substitution that I have argued would exist if we had a capital gains tax. The same is true for the top 10 per cent of income earners. They pay at least the same and sometimes a higher rate, if you lower the top margin of personal income tax.

I must defend this, though. There is a little twist to it. Every time we lowered the top marginal tax rate we also closed tax loopholes that were available to the rich. Therefore, they ended up paying the same. However, there is less incentive to participate in the underground economy or to cheat by shifting money abroad. The lower the tax, the lower the incentive. That is a very powerful graph.

When I brought that to the attention of the professional economists who are my colleagues at Simon Fraser University, 90 per cent of them did not believe it could be possible that the top 1 per cent pay 18 per cent of all income taxes and have done so whether the marginal tax rate was 80 per cent or 50 per cent. Think about that. It is amazing.

Returning to the issue of equity, we constructed Chart 5 with computers and found the first figure that I gave you, put even more starkly: People who make over $100,000 a year pay 78 per cent of all income taxes and capital gains taxes. Those politicians and special interest groups that are concerned about poverty are right that we have a tax that falls on those who are able to pay it.

Let me now introduce you to an idea that I think we should promulgate all over the world. People show up in this high-income group because in the year in which they sell their business, or in which deemed realization is taking place in an estate, they have a big income, including the capital gains.

Families who own restaurants or small stores work very hard and have very little personal income. Most of the profits are reinvested in the business. They may have an annual income of $30,000. When they retire and sell the business, they may have an income, including the capital gains, over $200,000. After that, their income goes down. If it is an estate that has paid a deemed realization gain, it goes down to zero, and that is highly misleading. Therefore, take out of the income the capital gains for that year, which were paid only once in their lifetime, and recalculate on what percentage of the capital gains are paid by people who have an income other than capital gains in that year. If you do that, you find that over 50 per cent of the capital gains taxes are paid by people who normally make less than $50,000 a year. Therefore, the argument that we need a capital gains tax to equalize income distribution is totally false, as demonstrated by the numbers I have just given you.

On page 28 of my paper there is a table that gives the same information for the United States. Again, it is interesting to note that people making less than $30,000 a year pay 30 per cent of the capital gains taxes in the United States.

If you have ever owned mutual funds, you know that every year you get a slip saying that you owe capital gains taxes. That is because the managers of the mutual funds have sold some shares, and they do not have to pay the capital gains tax; you have to pay it.

It is still true that people earning over $100,000 are paying 46 per cent of all capital gains taxes, even if you take out the capital gains in making this table. Nevertheless, it is a phenomenon that is worth looking at. In the United States, they have data that allows them to look at individuals who earn these capital gains once only, both before they got the capital gain and after the capital gain. It turns out that normally their much lower incomes continue after that.

Senator Meighen: I wish to ask for a clarification on the difference between your Chart 6 and the U. S. figures. Are the assumptions the same?

Mr. Grubel: Yes.

Senator Meighen: Do I read it correctly that, in Canada, 26.8 per cent of capital gains taxes are paid by those who earn above $100,000, while in the United States it is 45.5 per cent?

Mr. Grubel: That is right.

Senator Meighen: There is quite a difference.

Mr. Grubel: Yes.

Senator Meighen: Do we know why?

Mr. Grubel: I have no idea. Scholars should look at that, but it has not been done in Canada. This is a first stab, and I hope it is right, but you know how these things go. We do our best. I have a man at the Fraser Institute who specializes in these things. It is a highly technical exercise requiring the computer, and he consults with the Department of Finance and Revenue Canada.

The American data strongly support the point that, in fact, it is not a tax that primarily falls on the rich.

Let us talk about the equity of what we have done for those who happen to own capital. They worked very hard to earn some money, paid taxes on it and then, instead of blowing it on consumption, they decided wisely to put it aside for retirement and the children. Then the government says, "Is that not interesting? You have extra income." The guy who blew his money, on the other hand, does not have any extra income, and he does not have to pay anything. He nourishes himself. He has the enjoyment of the holidays he took in the Caribbean, and the other people have nothing but their dividend income.

What is fair about that? What is fair about taxing the corporation and then, with dividends paid after taxes on the income, you have to put those dividends into your own personal income again? In Canada, you get the dividend tax credit, which helps. Nevertheless, it is not very fair.

If you happen to be lucky enough, and if you invested properly, you have a capital gain, which is taxed again. Not only is that unfair, in my judgment, but it is also a disincentive to save and invest. We all know that the higher the disincentive, the lower the return to investment, the less there will be. Economists are unanimous in the opinion that if we want a higher living standard in Canada, we must invest more capital, better capital, and capital with the latest technology. Therefore, the practice of penalizing those who sacrifice to invest makes no sense.

Finally, I come to something that I found truly startling. If, 30 years ago, you had bought shares in an average, representative company in the Toronto stock market, those shares would have increased three and a half times. I have it written in my brief but for now I will approximate the numbers. Let us say that it increased three times. Do you realize what happened to consumer prices during that same period? They increased more than the value of your stock. In real terms, your investments fell because of inflation. Talk about adding insult to injury! If you sold that stock now, you would pay capital gains on twice the amount that you paid when you bought the stock. The government takes 40 per cent away from it. You will have had your wealth confiscated.

If you examine the Haig-Simons debate of the Carter commission, you see that it was never the intention of the system to confiscate wealth. The idea was that if you had an increase in resources available to you, which you could use for consumption or investment, you should be asked to share this with others who have not been lucky enough to make an investment. That is their rhetoric. However, there was never the position that nominal capital gains, capital gains that just allow you to keep up with inflation, should be taxed.

Just as economists are all in favour of Free Trade, there is unanimous agreement among economists that the taxation of fictitious capital gain is an injustice and is highly inefficient. Nevertheless, it is so difficult to put this into the tax code that almost no country in the world has it in their tax code, although I am told that England had it. Next year I will conduct a symposium at the Fraser Institute to bring in people from different countries to discuss with them their experiences with this kind of indexation of capital gains to inflation.

Let me conclude with my comments on the argument that is used, and stressed, by Jack Mintz. There is no doubt in my mind that with all the clever accountants and lawyers we have, if there were no capital gains, all kinds of tricks would be developed to shift labour income into capital income so as to avoid paying any taxes at all. There is also no doubt in my mind that, in the process, that would lead to a misallocation of resources. Some investments would be profitable only because they provided tax advantages, not because they were genuinely profitable.

That thinking is still dominant among our best academics, like Jack Mintz. It is also the religion in the Department of Finance. We have to fight that if you want any change, and I am going to give some ammunition with which to do it.

Whenever the government passes a law to fix something, there are always unintended consequences. In fact, some people say economics is the study of the law of unintended consequences.

During my tenure on the Finance Committee, Jim Peterson was the chair. He always let me take on special interest groups arguing in favour of more money for them. It would be my job -- and I enjoyed it very much -- to question them on whether they had thought about the consequences that would flow from something. Jim Peterson once told me, after I decided not to run again, that if he had learned anything in those four years that we were together on the Finance Committee, he had learned that you cannot mess around with the market without facing adverse consequences.

What are those adverse consequences? There is the lock-in effect, which is like the other side of the coin. On the suggestion of an economist who is very concerned about this, I entitled my paper "Locking in Canadian Capital."

I ask you to bear with me through this technical matter, because if you understand this graph, you will understand the issue. In Chart 7, I make the assumption that you have an investment of $1,500 that will yield 7 per cent forever into the future. That dark heavy line on the graph tells you what it is worth. In 10 years, it would be worth $20,700. Assume that you are considering selling this investment, but there is a capital gain of $500. You pay 40 per cent of that in taxes; therefore, you are left with only $1,300.

The Chairman: Did you mean $2,700, not $27,000?

Mr. Grubel: Yes. Thank you. In the family of graphs that I have labelled with percentages, look at the lowest, at 7.5 per cent. It grows at a faster rate than the 7 per cent starting at $1,300, but it takes probably 30 years -- although I have not done the calculation -- for the investment growing at 7.5 per cent to be half caught up to the investment growing at 7 per cent. If you have an investment growing at 10 per cent and follow the line second from the top, only if you hold your investment for six years will you be better off by selling your asset, paying the capital gains tax, and making that investment at 10 per cent. For a holding period of six years, you need a gap of three percentage points to make selling the low-yielding asset and investing it into a higher, more productive asset worthwhile.

That is all practical people talk about. They say, "I have these tremendous profit opportunities out there, but over the length of time that I think I need to hold these assets it does not pay for me to sell the asset that I have now and pay the capital gains tax. I will never make that up."

Therefore, investment opportunities get lost. That is why economies that have no capital gains are more efficient than economies that have high capital gains. The lower the capital gains, the higher the productivity. If you understand that, even intuitively, you see that that is also why the stock market value averages in Canada would rise if we lowered the capital gains tax rate, with all the benefits that I have just discussed.

As far as I am concerned, the efficiency argument stressed by the Department of Finance should compare the losses to society from the incentives that exist when we make too much reinvestment of profits. I asked if there were studies to measure this cost. They do not exist. I asked if we had any measures of what it costs society to have a lock-in effect. The answer is that we do not. I asked if we had an estimate on what it costs to administer the capital gains tax that we have right now. The answer is no.

My memory may be incorrect, but this is a startling number. When I was at the Finance Committee, someone from Revenue Canada or the Department of Finance said, "Over one-half of our tax code consists of regulations applied and related to capital gains taxation. They deal with specific issues of valuation and timing of investments. In order to be fair, we have that many things." You can imagine how many people out there are working to avoid the rules and stay ahead of loophole-fixing by the Department of Finance. I should like to see those revenues in light of the total government and social cost.

The Chairman: Can we open the floor to questions now?

Mr. Grubel: Yes.

Senator Kenny: Professor Grubel, speaking on behalf of your mother for a moment, I wonder if I could put a few questions to you. You are the second witness in a row to make the point quite graphically that a capital gains tax is not a rich person's tax but, in fact, covers the spectrum of incomes.

You addressed specifically two particularly egregious areas. One was where individuals, often of modest means, have invested in mutual funds and have to pay the capital gains tax before they have actually received any income. The other was the singular occasion, perhaps close to death or at the time a family business is sold, when there is a spike in the capital gains payment. Do you have a remedy for those two issues?

Mr. Grubel: I have not yet said what my recommendations are. If I were the Minister of Finance, I would eliminate the capital gains tax on my way to making Canada a tax haven -- the Switzerland of North America. We would be prospering like all the other countries that have low taxes, such as Hong Kong, Switzerland and Ireland. Just listen to what has happened in Ireland. The poor cousin of England now has a per capita income greater than that of England because they have lowered their taxes. We could do exactly the same thing.

Senator Kenny: I take it your answer is not a specific solution but rather a global solution in relation to capital gains in general.

Mr. Grubel: I do not have any easy answers. However, I think we should take care of those who are concerned about the losses from the shifting of labour income into capital income -- all the tricks that the lawyers can devise. Germany used one measure, although I do not know whether they still have it. When I was a management trainee there, Germany had a higher tax rate on income generated by the corporation but not distributed in the form of dividends, and they had a lower tax rate on what was distributed. You counterbalance that incentive to try to keep reinvesting. Whenever I mention that to people who know something about it, they quite like the idea.

In response to your question, my answer is deal with it directly. I do not think there would be as many costs as we have now with a big lock-in effect.

Senator Kenny: Given the economic case that we have heard made yesterday and today, it seems to me that much of the solution relates to how people perceive capital gains to be a rich person's tax. We repeatedly hear CEOs talk about it, and your discussion of Chart 7 leads to the same problem. When people talk about lower capital gains causing higher productivity, Joe Lunchbucket turns off. He associates that with him being laid off or something to that effect.

Have you seen any studies that you could share with the committee indicating why people believe capital gains taxes affect only wealthy people? Do you have any suggestions for how the committee can communicate to the public that this issue affects income earners of $15,000, $20,000 or $30,000? The committee so far has been focusing much more on arguments that we might make to officials in the Department of Finance. Frankly, ministers of finance respond to voters. Some of us in the room are old enough to remember the NDP campaign about corporate welfare bums. It had a lot of resonance with voters. They focused at the time on the capital gains tax and the fact that people at the high end were not carrying their share of the burden. You are making the case to the committee now that these very same people are carrying a disproportionate share of the burden, but it appears to me that you have not given us the language to communicate that point.

Mr. Grubel: When I was a Reform Party M.P., we had perhaps 15 researchers on staff. Do you know how many economists we had? One. Do you know how many people we had specializing in communications? There were 14. They are supposed to be able to do that. I do not know what to say.

Senator Kenny: You were in the House of Commons. That is too many.

Mr. Grubel: They tell me now in the Department of Finance that they had the information I have just given to you, but it was not in the public domain. When the Fraser Institute publication comes out on that subject, it will be the first time in Canada that a graph shows that information on public record. It is now up to the political process and the media to run with it.

I will do my best. An article in today's Financial Post makes all of those points. In the United States the numbers are fairly new also. People had not thought about this. It was not in the public domain. I give some thoughts at the end of my paper as to how we can get a movement in Canada going in this direction. We need a champion. Perhaps your committee is doing that.

Senator Kenny: My small point is this: When the argument is put in economic terms, it does not have much resonance with the public. Unless they find some way to communicate their argument in a context that people who do not read the Report on Business will understand, the converted will be preaching to themselves.

The Chairman: Apropos of that, I had an hour-long meeting this morning trying to get something going in communications, and last night Senator Angus approached our other witness with the exact same line of questioning. That is our major problem.

Senator Tkachuk: I have a supplementary question regarding the problem that you have with communications. There seems to be a general consensus that decreasing tax rates and decreasing capital gains rates will be good for the economy. In the political forum, you will not have any problems from the Tory side on this question; you certainly will not have any problems from the Reform side. You may have some problems from the NDP side. Therefore, it seems to me that the question falls on one part of the political spectrum, which is an internal battle that you need to deal with.

Senator Kenny: Nice try.

Senator Tkachuk: It is kind of true.

The Chairman: Who set the capital gains in the first place?

Senator Tkachuk: You will be surprised, I think, at the farm community and the small-business community, who understand the economics of this. I think we underestimate what has happened in the last 10 years, part of which is a result of the job the Minister of Finance has done controlling the deficit and giving us a surplus and an opportunity to actually talk about the question of lower taxes. I suspect we would be surprised at the Canadian people's reaction to this. Except for a few interest groups, I do not believe that it will be a big political problem in the long term.

Senator Kenny: If you just focus on capital gains?

Senator Tkachuk: Yes.

The Chairman: We must do that as a committee.

Senator Tkachuk: That is one point. Senator Kenny asked about the communications aspect and I wished to point out that not many people are opposed.

Senator Fitzpatrick: Professor Grubel, I believe I got your message that you are in favour of reducing or eliminating capital gains.

Mr. Grubel: You are very observant. I am glad you listened.

Senator Fitzpatrick: You said that you pay capital gains tax only when you feel like it, and I appreciate what you are saying, but you probably do not feel like it when you die. I believe the United States has an estate tax, which we do not have. Our deemed capital gain takes the place of that. How would you handle that if your thesis were accepted and proceeded with?

Mr. Grubel: Let me put on two hats. First, as a conservative economist, I say that we need the accumulation of wealth that, with our work and savings ethic, will all go back to investment, thereby increasing the productivity of labour. It will also continue to provide incentives for people to save and leave as much for their children as possible, and good for them. That is my answer as a conservative economist. Milton Friedman is on record as saying inheritance taxes are detrimental to the overall well-being of society.

Let me put on my politician's hat now. If I were to give advice to the leader of a party, I would suggest that we institute an inheritance tax like the Americans have, which no one pays. The revenue collected is trivial, but the politicians can tell their constituents that we have a way of getting at the wealthy people in our society. Rich people do not pay; they put their money into foundations.

Foundations are a great thing. Private foundations direct their resources to hospitals, education and direct aid to the needy. The system they have in the United States is tremendous. Harvard has an endowment of $20 billion. That is enormous relative to what the University of Toronto has.

The Chairman: The University of Toronto has $1 million.

Mr. Grubel: Yes. We had hearings on that in the Finance Committee. We were pushing hard in the House of Commons to get a better treatment of that. If you wish to have an inheritance tax in order to take care of it, pass it, but model it after the inheritance tax in the United States.

The Chairman: I have heard economists say that one of the real weaknesses Canada faces in the future is its lack of foundations.

Mr. Grubel: Yes.

The Chairman: With underfunding for education, health, et cetera, we have a real dearth of charitable foundations in our country. As a matter of fact, I am told that the per capita comparison between Canada and the United States on foundations is well over 50 to 1.

Mr. Grubel: The decisions made by these foundations are all very much closer to the people. When we decide on education and welfare spending, we take much of that from Ottawa, or we take it from the provincial capital, whereas these foundations are very careful when they place their money to ensure that it is spent wisely, and so on. I believe we are at a serious disadvantage.

In the United States, the very rich can escape the estate tax. By the way, none of them, apparently, want their children to have so much money that they never need work. They give them enough to be comfortable, but they know that too much money destroys their character. Therefore, they give the money to foundations.

The Chairman: That involves another question.

Mr. Grubel: I have heard that. It is an important motive for people. They do not want their children to be so wealthy that they need never work again or worry about money, because, they believe, that is not in their best interest. Many extremely wealthy people do not make their children's inheritance available to them until they are in their 30s.

The Chairman: That is not clear-cut.

Senator Meighen: I wish to continue with the question that Senator Kenny raised regarding communication, but I will go at it in a different manner. Communication is confounding us all here. How do we get across what seems to be the overwhelming opinion that it would be better for the country if we had fewer taxes in general and no capital gains or lower capital gains tax in particular?

I am perhaps being unfair, but obviously ministers of finance, for good reason, tend to take the advice of Department of Finance officials. Finance officials may not have had the opportunity to enjoy the experiences and garner the information that some of us have out in the private sector. They seem to be reluctant to proceed with anything that cannot be totally quantified. My information, rightly or wrongly, is that they were terribly reluctant to support any reduction in capital gains tax with respect to gifts of shares of public companies to charitable operations, which is now in its second or third year.

My anecdotal evidence is that that reduction has unleashed a great deal of money for charitable organizations such as hospitals, universities and artistic organizations. I know personally of some examples. The Government of Ontario put forward an endowment challenge. That has released more money because the money could be given to those organizations at a lower rate, and the endowments to which you just referred are being built up.

How quickly can we get the information from tax returns with respect to increased giving? Is the Department of Finance, or any other department, subject to access to information requests in this regard? In your experience or knowledge, are these amounts easily quantifiable? If we can get the information, will we get the answer?

Mr. Grubel: I can already envision myself drawing a graph of the donations, through time, as a percentage of something like national income or total taxes paid. I would not be surprised if you got a big uptake after the liberalization.

I went through this legislation in the Finance Committee of the House of Commons. I tried very hard, but I still do not understand how it works and what the details are and why we do not just allow people to give what they want to give and let the universities have it.

There is a question of how big the capital gains are and to what extent you can offset them against other income, but I am sure we would have that result. I thought we were driving at something else, something that I have noticed. When people get elected and become ministers, they go into portfolios. While they are all very smart, have the right instincts and lots of contacts with the world and what the people out there want, when they get in, they are essentially at the mercy of the bureaucracy, right? That is one side.

I also know that strong ministers can nevertheless cut through the bureaucracy cobwebs and their belief system and say, "This is what I want." Fortunately, Mr. Martin has been around long enough that he has done some of these things. It is not impossible to do that.

At the moment, I think Mr. Martin is being advised that there will be terrible consequences from having a zero or low capital gains tax rate. If he became a champion of it, he could cut through that and say, "You guys are going to do what I want you to do. I am justified on the basis that probably the social and economic cost of the lock-in effect is greater than the social and economic cost of having excessive reinvestment of dividends and other ways of trying to shift money into capital gains taxes out of labour income." They would do it.

However, you need to find a champion for that cause high up enough that he can take the powerful instruments of persuasion, rationalization and documentation available in the relevant ministry. With your connections and your influence, senators, you are well positioned to do that. First, you must persuade yourselves that this is the course you want.

The Chairman: We have proven that by being here and having these hearings.

Mr. Grubel: Exactly. Perhaps not all, but I hope that the presentations that have been made are moving in that direction. Then work on the kinds of people that you wish to persuade.

Senator Meighen: You said, in a more articulate fashion and more definitely, what I was thinking and did not say, because, notwithstanding Senator Angus's help on two occasions, the public made it clear that I should stay in private life and not become an elected individual, so I have not had the opportunity of watching elected people in ministries the way you have. However, you are probably right. I think there are other factors -- leadership campaigns and things like that -- that probably interfere with one's ability to slash and cut intellectually and say, "This is what I want." You know the reasons; you have articulated them.

You said that if you were Minister of Finance for a day and could do anything, you would abolish capital gains and make Canada the tax haven of North America. Let us suppose that night fell before you were able to accomplish all of that, and you could not do that in your one day. What, in your view, would be a significant enough cut to capital gains taxes to make a real difference? How long would it take for us to be able to demonstrate that it had made a real difference? Two years, three years, five years?

Hearkening back to the change in the rate applicable to gifts of appreciated shares, I think a five-year horizon was put on that, I suspect at the behest of officials at the Department of Finance who were not convinced that it would be useful or helpful. They wanted to ensure that nothing more would happen in the five years, and at the end of the five years they would get rid of it. That is an editorial comment.

Mr. Grubel: I sense that the public opinion and the people who count in the relevant department are accepting the idea that a 75 per cent inclusion rate is too high, and it should go probably to 60 per cent or 70 per cent.

Senator Meighen: Do you think that would make a difference?

Mr. Grubel: Of course it would. Every little bit helps. However, I do not think it goes nearly far enough.

The Chairman: It cannot make a huge difference, if our neighbours have 27 per cent and we have 35 per cent.

Mr. Grubel: Exactly. I did not discuss this in my short presentation, but it is all in the brief. One of the biggest disadvantages of the current system is that we have entrepreneurs and angels who go to the United States.

We had a brain-drain conference at the Fraser Institute. We heard from a young man who had started an e-commerce business two years ago; his sales had doubled every two or three months and he had gone from two people in his business to 36 people. He said, "Good-bye, next month I am moving to Bellingham." When he gets bought out by one of the big companies, he will make a capital gain and when that capital gain tax has to be paid, he will pay half of what he would pay here. Can you blame him?

The Chairman: We will endeavour to come out with a report on this, and it must be as credible as we can make it. I have spent some time, as have members in this room, meeting with the Department of Finance officials. I am repeating what you said, really. They say that if they cut to 20 per cent, or whatever, there will be a windfall at first and then there will be a deficit. However, they only take into account the buying and selling of assets.

Mr. Grubel: Exactly.

The Chairman: They do not say one word about the spill-over effect, that is, the jobs created, the investment and the productivity -- all those things we hear about endlessly. I have asked why they do not take the spill-over effect into account, and they say that they quantify it. That does not seem to me to be a good enough reason not to take it into account. Surely you can make some educated guesses based on Ireland, the United States or a whole bunch of other countries.

Is any work being done in this country attempting to quantify all those other effects? We are looking at this with tunnel vision.

Mr. Grubel: It has to be a leap of faith. The economy is so complex.

The Chairman: It is hard to make a report on a leap of faith.

Mr. Grubel: I understand. However, in your statement you have all the ingredients of what I would say. The empirical evidence from the United States and other countries is so strong that the leap of faith has little risk. It is almost certain to result as it did in those other countries. We are not different from those countries, especially if you want to placate those who believe that we would have huge losses from shifting income into capital and adopt at the same time the regulation that reinvested earnings are taxed at a higher rate than those that are distributed.

Senator Furey: You went from Chart 5 to Chart 6. The charts have total income minus capital gains. Do you mean minus the one-time capital gains to which you referred earlier?

Mr. Grubel: The only information available on that statistical database is the amount of income from capital gains in one year. Then there is "other income", and it is that "other income" that provides the basis for the classification on the horizontal axis.

Senator Furey: They were not restricted to $30,000-per-year income earners?

Mr. Grubel: I am told that by next year we will have a database, which the Americans already have, where you can trace individuals through time by their tax returns. That is called panel data and it is refreshed by taking out 10 per cent each year and putting in new people. It is a huge, rich database that the United States has been building for a number of years. We have just begun and will have it next year.

Without such data, I cannot really answer that question. There is no doubt in my mind that we will find the same thing as the Americans did, namely, that those people go back down to their old level. Even though they have a capital gain, they no longer have a business to generate income and they consume the dividends from their investment.

Senator Furey: It is such a huge shift.

Mr. Grubel: It is, but it makes absolute sense, does it not?

Senator Furey: Yes.

Mr. Grubel: I do not know how to convey this. The cut-off of $50,000 is the average income in Canada. We are not talking about people making $10,000 or $20,000 a year. However, I do not think we should make our policies on the basis of those.

Senator Kroft: Various countries keep running into roadblocks. We talk about capital gains being so intuitively and instinctively clear. I am continually led to say that if it is so good, why not go to zero? However, there appears to be enormous restraint, including in the United States, against that. You get to some mid level but at some point the strength of the principle breaks down for other considerations.

I should like to ask for your guidance for the committee. Given that we were all co-conspirators in trying to achieve this objective, what is sustainable in argument? Is there a reason that we stopped at the level we now have while the Americans, through their analysis, politics or whatever, have reached a level half of ours, or is the case strong enough and the logic more in favour of going all the way?

I go beyond that to your tax haven idea. If there is nothing fundamental to say that we should equate with the American experience, could we do better by doing them one better? I am trying to understand if there is something that systemically that brings this to a halt part way.

Mr. Grubel: That is a very good question. When I started this research project, even though I was an economist I knew very little about it. However, after having discussed for one day at Simon Fraser University with 17 economists from the United States and Canada and with entrepreneurs the proposition of having the same capital gains tax rate as the United States, and after having reading the literature that was brought to my attention, I have come to the view that I have articulated in this paper, which is that it would be best if Canada went to zero.

The second best choice is to go to the American rate and keep it there in order to keep in Canada some of the entrepreneurs and angels that are now going to the United States and taking with them a lot of spill-over economic effects. That incentive will be reduced and it must have some effect.

After the Carter commission report in 1972, we set the rate at 50 per cent. Then, under the fiscal pressure of deficits, we raised it to 75 per cent. Therefore, my third choice would be to say that, based on all the criteria that were relevant in 1976, let us go back to 50 per cent.

If you were to ask me what would happen, I would say that with the dividend tax credit you want to have neutrality and an equal rate so that there are no more distortions. The other side of the coin of eliminating that distortion is creating another distortion, and that other distortion is the lock-in effect, which keeps people from giving money to charities and from selling and going into higher paying products. Much capital is stuck at a low yield. That is in the interest of no one.

If I were the Minister of Finance, I would have my officials do those calculations. The department has the resources to do that and you should insist that the Minister of Finance do so. Mr. Martin is a very intelligent man. He once told me that when he ran for election in 1993, he had no idea how close this country was to bankruptcy. He thought that slightly improved management would take care of it, until Department of Finance officials were able to show him that it was a serious problem. He changed his mind and he became the champion of a balanced budget that will make him go down in history as a very important figure in Canada.

Mr. Martin's officials should estimate the cost of people shifting their income into capital gains before this tax and compare that with the cost of the lock-in effect, the cost of administration in the Department of Finance and Revenue Canada, and the cost of all the lawyers working around the clock on this. Then he should determine whether Canada is not better off.

Once we have that intellectual understanding and Mr. Martin persuades Mr. Chrétien of that, the government can use its huge resources to persuade the public. They have persuaded them on all kinds of other issues, including, as recently as 1993, not having to worry about the deficit and the debt.

I went into politics because I saw the country going down the drain. I was really worried for my children and my own savings because no party except the Reform Party said, "We have a fiscal problem." A few years later, the rest have said, "Yes, we have a real problem." I think it was simply accumulating evidence, evidence presented by the people. They got a champion in Paul Martin who, with the support of Mr. Chrétien, did what had to be done. They can do it again.

Senator Kroft: We read about the power of computers and computer analysis and programming. One thing that seems not all that difficult is the application of an inflation factor to capital gains. As I understood you, 80 per cent of the countries in the OECD do not do it. Is it really that huge a hurdle?

Mr. Grubel: Next June I will have another symposium and bring in people from England. England actually had a rule whereby nominal capital gains were exempted and only real capital gains were taxed. The disappointing fact is that a year or so ago they eliminated that provision. We must find out why that is the case. This is the kind of stuff that, again, the Department of Finance, with a huge budget and lots of economists and researchers, should be able to do for you. They can determine which countries have that and what difficulties there were and how difficult it is to enforce and so on. I am totally against paying taxes on accrual.

The Chairman: You do that when you go to a mutual fund.

Mr. Grubel: That is right, but it is not usefully done for the entire economy. Even though the Carter Commission recommended it, it was rejected at that point, and we should stay away from it.

Senator Angus: Professor Grubel, this is great stuff. I am sure you have not noticed too much hostility to your views this morning. There is a theme running through the questioning about how to sell these theories and these arguments of yours and others who have been to the committee. I had a new idea.

Last night members of this committee were exposed to some people in the real world. One of them said that Canada is already, in December 1999, 18 months behind the United States in electronic commerce and that the gap will increase. It is going so fast, and we have missed the boat. That will have grave effects on our capital markets and on our economy generally. Are you familiar with that argument?

Mr. Grubel: No. That is not something I have followed.

Senator Angus: It occurred to me while listening to that that it could be part of our punitive tax system, particularly capital gains and the disincentives here either to build new businesses in the new economy or to raise capital for them. Perhaps using real-world, day-to-day illustrations of what is happening might be a different kind of a tack we could take. Yesterday I questioned the witness about the lowering of our standard of living. In real terms, it is happening. It is a fact. It is not a theory of a professor. Our purchasing power is going down, and yet we are alleged to be the greatest place in the world to live. We must dispel these myths. Do you agree?

Mr. Grubel: Look at how the United Nations constructed the index. They constructed the index by giving a certain amount of weight to per capita income measured in GDP such that the developing countries do not look too bad. The fact that the United States has a 10 per cent or 15 per cent higher per capita income than we do is a fudge factor that is taken out. That should be in there in terms of standards of living because it also affects the standards of living of the people at the bottom.

Senator Angus: I hesitate to embrace all my colleagues with this statement, but, for some element at least, you are preaching to the converted here. For quite a few years, Mr. Dobson and others have said we must do a study. Now that the study is happening, Mr. Dobson has shown some reluctance to come here and testify. I think he should attend. He is not a professor. He is a practical person who has had to deal with the realities, and he has hundreds of examples. I ask you to urge him and the Adam Smith Institute and their ilk who are making all the noise about how lousy our government and our system is to get out of their cozy, high-rent, 40th floor offices in Montreal or wherever and get down here and share with us the real facts.

That will convince any politician, regardless of party. Frankly, at this point in the game, if it is politically saleable, everyone will do it. As Senator Tkachuk has said, the people out there are not that dumb. People who want to get into the new economy and the high-tech industry and take advantage of what is going on are missing the boat, and Canada is being hoisted with its own petard. Do you agree that that would be a productive thing for us to do?

Mr. Grubel: Yes. You must be careful, though. We have found at the university that practical people are very good at the narrow field of their competence. They spend a lot of time on what they personally are doing. Clearly this subject is important for people for understand, but it is not enough for two hours. Professors have stopped bringing in people from the practical world, except perhaps every once in a while to get a taste for what companies are doing and so on. It is a bit of a risk.

The other political risk I see is that if you bring in people who would individually benefit, or whose firms would benefit, greatly from such changes, you give the left, the opposition to those ideas, an easy way out. They say, "We do not even have to look at that because we know where it is coming from." Even the Fraser Institute suffers to some degree from that. "Oh, you are from the Fraser Institute. We already know what you are going to say." That is awful.

You have been kind enough to have me here, and it will now be in print. The people in the middle who are rational will listen to the evidence. Mr. Dobson and others who are concerned about this should have the opportunity to put their thoughts into the record in the hope that other people will read it.

Senator Angus: Exactly. I urge you to get rid of this defeatist attitude. We are troubled by the idea that it is only a sop for the rich. You have proven that, and many academics like you are giving testimony. We need those individuals, and they have hundreds of clients out there. They have real stories that they could tell us.

My next question has to do with Professor Mintz. I know you disagree with him on some issues. I took from his evidence that at the end of the day it may well be a good thing to abolish or reduce the capital gains tax, but you cannot do it alone in a vacuum. Our tax system is complex, and every little comma or word that is changed triggers an unbelievable crescendo of consequences. There is such a delicate balance that the minute you take something away from Peter to pay Paul, the whole thing collapses.

I do not agree with that, and I believe that you do not agree either. I think it is fundamental to our study that we do not come out with a recommendation that makes no sense. In other words, we must not reduce the capital gains to 20 per cent and have it screw up the whole tax system.

Mr. Grubel: I fully agree with you. I have made all my points, but to reiterate what you said, I will read here from the record what Jack Mintz said in the last paragraph of his testimony:

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.

I suggest to you that he is correct. There would be incentives to do so, but there are two answers to this suggestion. One would be to introduce a tax that differentiates between reinvested earnings and distributed earnings. It may complicate the code, but the code is already complicated enough that a little more will not make much difference.

The second answer would be to determine the economic costs from this technical problem that he identifies in terms of the lock-in effect relative to the benefits brought about by reducing the incentive. I noticed from the evidence that he is now looking at some of these issues. We must have a cost benefit analysis. You cannot simply choose a policy and say, "Here are the benefits."

I have always told my students a startling fact: the airlines have a national monopoly and can rip off the public if there is no regulation. In the post-war years we had strong regulation of the airline industry. They may have fixed a market failure, but they introduced a huge government failure. In the end, it manifested itself through the discovery, in the1970s, that the flight between Boston and Washington cost twice as much as the flight between Los Angeles and San Francisco. That occurred because one was an interstate flight, regulated by the Federal Aviation Administration, and other one was an intrastate flight that was de-regulated. When it was realized that that is the cost of trying to fix a market failure, or a technical problem, they said, "Forget the technical problem, we will let the market take over again." You are familiar with events since that time in the airline industry and its market.

In the same way, we have a problem with the shifting of income into capital gains. We must deal with it and that is the dominant ideology currently. Those people who are familiar with the system probably took their courses from Jack Mintz and me because that was the dominant subject in the past. Now, however, we see unintended consequences, such as high rates on the airlines. We should focus on these issues with those people. As a person with some political antennae that have developed since I have been here, I believe we must also deal with the concept that it is a way to get at the rich who do not pay their fair share. In the process, you must consider our numbers as well as those from the United States. In fact, much of the tax burden falls on the middle and lower income classes. It is highly unfair to tax nominal gains.

Senator Angus: I am bothered by the business of the two hours. You have given us a terrific paper with good graphs to support your arguments, and that has been more than two hours. Then we heard your testimony for approximately two hours. That combination has given us a lot of meat. I suggest that those individuals with whom you have an indirect association and with whom you sympathize in respect of the capital gains structure should come here. They will have more than two hours if their presentations are similar to yours. Those people care. I do not want to read about this on the cocktail circuit. There is an opportunity and a forum that our chairman and this committee have created. Let them come or forever hold their peace.

Mr. Grubel: I think you are too hard on them. They are excellent money managers. They have spent their lives using good noses, friends and associates to find good investment opportunities. The Formula Growth Fund heads the list of the funds with the highest rates of return over the last 25 or 30 years. That is an unbelievable accomplishment, but it does not necessarily mean that a person who has those skills, praiseworthy as they are, can make these graphs.

Senator Angus: No, but you have made the graphs. You are giving academic arguments and economic facts and theory to substantiate. We need the practical side. I can assure you that the unit holders of the Formula Growth Fund, some of whom are in this room, agree with you. There are stories to be told from the little people.

Mr. Grubel: Try to obtain those stories.

Senator Angus: As an example, I have a secretary who lives on a fixed income and she is a unit holder. She plowed every extra nickle that she could manage over the 38 years that she worked for me into Formula Growth Fund. Now, she is in need of the money but there is the issue of capital gains tax. There are many such examples that must be brought forward by the people who have them at their fingertips. Those people have been making a lot of noise behind the scenes, complaining about the lack of a hearing in Ottawa to get the job done. We will have that hearing and we will study the results, and we will get the job done if the facts justify it and we obtain the evidence to sustain it -- and I am convinced the evidence is out there. I am not being hostile toward them. We want them to come here, but Mr. Levy has been unable to get them to come.

The Chairman: Point well taken. I did meet with John Dobson, at his request, and he presented extremely interesting statistics that indicate how high capital gains taxes really are. It was astonishing. I will call Mr. Dobson and ask him to come before the committee.

The committee adjourned.


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