Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 6 - Evidence
OTTAWA, Wednesday, February 16, 2000
The Standing Senate Committee on Banking, Trade and Commerce met this day at 3:30 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: Senators, let me welcome our witness, Mr. Satya Poddar. Mr. Poddar is a tax partner in the Toronto office of Ernst & Young. He is a tax policy and planning issues advisor to several industry groups, corporations, and federal and provincial governments. He has undertaken a major research project on behalf of the European Commission, and from 1990 to 1994 was Commissioner to the Ontario Fair Tax Commission. He has served as a tax policy expert for the Harvard Institute for International Development, the International Monetary Fund, and the World Bank. He has written many papers on tax policy and contributes a tax column to the Financial Post.
Mr. Poddar, please proceed.
Mr. Satya Poddar, Partner, Corporate Tax, Ernst & Young: Mr. Chairman, it is a pleasure and privilege to be here this afternoon. My plan is to make an initial presentation with the use of overheads, after which I will be happy to answer any questions.
In 1993, Ernst & Young published a bulletin. At that time, the taxation of capital gains was very controversial, as it has always been. I reproduce the words from that bulletin:
The taxation of capital gains represents perhaps the most contentious and complex element in the Canadian income tax system.
Capital gains are the tax system equivalent of abortion and capital punishment.
For all these, there are two strongly-held and diametrically-opposed viewpoints subscribed to by sizeable groups in the population, and compromise solutions are appealing to neither.
I will begin by summarizing the main points that I will emphasize in my presentation today.
First, Canadian rules for capital gains taxation are complex and are a source of economic distortion. This complexity, and the distortions that arise, are an unavoidable part of political compromises that have been made in a complex area like capital gains taxation.
Taxation of capital gains should be viewed in the broader context of taxation of all capital income. Capital income can arise in the form of interest, dividends, capital gains, business profits and corporate profits. As an economist, I feel that these are all substitutes, and if you pick one element of capital income you create more distortions in the system.
A large part of the capital gains realized by individuals are on account of real property. Real property capital gains must be looked at differently from capital gains on share investments, because the policy considerations that go into the design of capital gains taxation rules for shares are different from those for real property. Real property gains are historically approximately one-half of the total. The percentage of total gains varies from year to year, but in a 10- to 15-year period real property gains would be close to one-half of the total.
The current system has very high marginal tax rates on capital income but low average tax rates. The average tax burden is low because, as we found in a study that we published about six months ago, approximately three-quarters of individual personal investment income is held in tax shelters in the form of RRSPs and homes, which are not taxable. In fact, only one-quarter of individual wealth or investment income that is wealth generating is outside registered plans, which are taxable. Three-quarters of that wealth is tax exempt. However, on the one-quarter that is outside, tax rates are quite high. Those tax rates can reach 35 per cent to 50 per cent. There is a view that economic conditions are affected not by the three-quarters, which are tax sheltered, but by the one-quarter, which are the margins moving in various parts of the economy.
There is significant scope for simplification and economic rationalization, but in order to do that we must go to a pure tax model. The pure tax model could be a pure income tax model or a pure consumption tax model. In Canada, we currently have a hybrid, and that hybrid leads to complexity.
Rapid changes are taking place in the economic environment because of e-commerce and the increased mobility of capital that has been facilitated by it. As a result of these changes, the Canadian tax system is no longer competitive. In order to make the Canadian tax system competitive we need radical changes; changes of a minor nature will not help.
In designing the taxation of capital gains the most important criteria is tax neutrality. If you do not have a neutral application of tax, you basically enrich the accountants and lawyers who serve the needs of the taxpayers.
If the government is not prepared to do major surgery on the tax system, there are certain changes that can be made in the interim. These involve reducing the capital gains inclusion rate from 75 per cent to two-thirds and reducing overall personal and corporate income tax rates.
I will go into these points in some detail.
In 1999, in Ontario, the personal marginal tax rate on interest income was 48.75 per cent. The top tax rate on dividends was 32.9 per cent. On capital gains, the top tax rate was 36.57 per cent. I will be referring to this gradation in the tax rates in my subsequent comments.
Total gains for 1996, which is the latest year for which figures are readily available, were $13.5 billion. Of these gains, shares accounted for $6 billion and real property for $1.1 billion. In 1999, the real property share was low, but in some earlier years real property gains were 70 per cent to 80 per cent of the total gain and share gains were very small.
Gains in small business shares and farm property up to $500,000 are exempt from tax, as are gains in principal residences and investments in registered pension plans, such as RRSPs and RPPs, as well as some other types of plans, such as deferred profit-sharing plans. These exempt gains, as well as all other types of exempt investment income, account for 75 per cent of total personal investment income.
You have heard from previous witnesses that the issues that arise in the taxation of capital gains present a conundrum for policy makers. The Carter commission said that a buck is a buck, that everything should be taxable. Carter was talking about tax neutrality. He said that capital gains should be taxable in a neutral fashion, as are other types of income.
Another aspect of taxation of gains to be considered is fairness. There is a view that capital gains are predominantly concentrated in higher income brackets and that, therefore, if you exempt or provide any concessions in the taxation of capital gains you are providing benefits that are regressive or, at least, not progressive.
I believe it was Mr. Grubel who, in his presentation to you, said that a large part of capital gains that are reported are reported by those with incomes of less than $50,000. When looking at single-year data, it is very difficult to evaluate who these people are. Are these truly low-income individuals, or is it that they have reported low income in that particular year?
One meaningful way of identifying the true wealth status of these individuals is to go to their life history as opposed to the single-year data on income and capital gains. Fortunately, Canada has information available on the life history of individuals. When I was in the Ministry of Finance, we collected data with the help of Revenue Canada. Every tenth individual was captured in a data file from tax returns, and the returns were kept for each year. Therefore, we have a life profile of those individuals in the 10 per cent sample. On the basis of that profile, you can find out the lifetime income of these individuals, or at least their income for more than a single year. You can find their average income over a five- or ten-year period and how much capital gains they reported over that period. You will get a much better picture of the concentration of capital gains by looking at the longitudinal file as opposed to single-year data.
From an economic efficiency point of view, economists are on both sides of the fence. Some argue that when you provide selective tax preferences you create economic distortions. It is true that any time you tax any type of income it will hurt, but when you provide relief from that hurt on a selective basis you worsen the economic condition. Therefore, if any concessions are to be provided, they must be broad-based and not selective.
Those who are against taxation of capital gains argue, first, that capital gains are only taxable when the gains are realized; that they are not taxed on an accrual basis as they are earned -- which creates a lock-in effect because if you have a gain on your portfolio you are reluctant to sell that portfolio and trigger the tax. You want to postpone the realization as long as possible. That is called the lock-in effect and it may be inefficient from an economic point of view.
There has been much debate on this in the U.S. When the U.S. capital gains tax rate was reduced to 20 per cent, many studies were done that concluded that, because of the reduction in the capital gains tax rate, the lock-in effect would be reduced, that many more people would cash in their gains and, as a result, the government would gain revenue as opposed to losing it.
Those who are against capital gains taxation also argue that a large part of the gains are the result of lack of inflation indexing. If you measure and index gains properly for inflation, the taxable portion declines dramatically.
The third argument is that of double taxation on savings. When you earn, you pay tax; when you save that money and earn capital gains on it, you pay tax on it again.
Another argument against the taxation of capital gains is the economic growth argument; that is, if you do not tax capital gains, or if you reduce taxation, you will generate additional savings and investment, which will lead to more economic growth. It will also make Canada more competitive, allowing us to attract more investment from other jurisdictions.
Both sides have some valid arguments. It is like talking about abortion and capital punishment. You cannot conclude objectively which is right and which is wrong, which is why we need bodies like the Senate and the House of Commons to reach a conclusion.
My own perceptions as are as follows: Disparity in the taxation of different types of income leads to inappropriate tax avoidance, which is difficult to control and leads to tax complexity. I have two examples. First, prior to 1972, when there was no tax on capital gains, there was a tremendous amount of planning activity called dividend stripping, wherein you convert dividend income into capital gains, which were tax free. That was an important consideration in the recommendation of the Carter commission to make capital gains taxable. The system was designed to have a rough uniformity in the taxation of dividends and capital gains.
Another example of massive tax planning that can arise from this lack of uniformity is over-integration. In 1976, the dividend tax credit was increased quite significantly.
As a result, the tax on dividends became low as compared to the tax on wages and salaries. There was a tremendous move to incorporate employees into companies. They will take very little as wages. They will get all the income as dividends and benefit from over-integration the large increase in dividends tax credit.
I recall journalists who became incorporated journalists. The government brought in massive changes in 1976 and 1981 to prevent conversion of employment income into dividends income.
In fact, even today, many small business companies are one-person operations that are providing services to perhaps no more than one or two clients, even though there are rules to block the tax benefits it. However, it demonstrates that when there is a benefit, people will do any planning necessary to make use of those benefits.
The arguments against taxation of capital gains previously were economic growth, inflation indexing, and double taxation savings. These arguments are not unique to capital gains. They are equally applicable to taxation of interest income, taxation of dividends and business profits, and other forms of capital income.
If I am clipping coupons and getting my interest income, I am as much affected by lack of inflation indexing as someone realizing a capital gain on their portfolio. If relief must be applied because of the lack of inflation indexing, that relief should extend not only to capital gains but also other types of investment income, including interest, dividends and business income.
These arguments about economic growth and double taxation of savings are not applicable to the same extent for real property gains. In fact, there is punitive taxation of real property gains in some countries. For example, Japan has an acute shortage of land. The last thing they want to do is encourage investment in real property. They have a generous treatment of capital gains in general but punitive treatment of capital gains on real property.
I was involved in the Ontario Fair Tax Commission. One of the key election platforms of the NDP that year was to impose a land speculation tax designed to discourage investment in real property. Fortunately, that recommendation did not go far.
The lock-in effect and lack of inflation indexing effects of taxation on capital gains can be addressed without abandoning taxation of capital gains. In 1983 or 1984, the government introduced an indexed security investment plan. That plan was designed to provide indexing of capital gains. It also had the feature of removing the lock-in effect because if your investment was in the plan you could buy shares any time you wanted them without triggering the immediate capital gains tax on those. If people are concerned about the lock-in effect and indexing, there are ways of addressing those problems without abandoning taxation of capital gains.
This index security investment plan was abolished in 1985 or 1986, when the Conservative government introduced $500,000 capital gains exemption. They said that there was no need for indexing adjustment because gains would be exempt anyway for the vast majority of taxpayers.
The current system of high marginal tax rates but low average tax rate is economically inefficient. Economic decisions are made not on the basis of average tax rates but on the amount of tax paid on the last dollar of investment. We have a very high tax rate on the last dollar of investment, but we try to reduce that tax rate by giving an average relief through RRSPs and things of that nature. This system is not efficient.
There is a significant pressure internationally to lower the marginal tax rates on investment income. For example, Sweden, Denmark, Norway and Finland, the four Nordic countries, had very high tax rates on investment income. They had a special tax on investment; income that was over and above the tax that applied under the progressive income tax system on wages and salaries. They thought that investment income was passive income. It did not require a work effort to earn it so they could tax it at very high tax rates. The U.K. also had a special punitive tax on passive investment income. Something happened in 1991, 1992 or 1993. There was a tremendous movement of capital out of those countries.
Currently, they have a system called the dual income tax system. They apply a flat rate of 28 or 29 per cent on investment income. Interest income, capital gains, dividends, and corporate profits are all taxable at a flat rate of 29 per cent. It is not even a part of the progressive tax system, which only applies to earned income, which is predominantly rooted in salaries and pensions.
The tax rate on pension income goes up to 60 per cent, greater than on salaries. However, a tax on capital investment income is flat at 29 per cent.
These are the countries that believe in a very progressive tax system, to the point of being punitive. The market dictated for them to get away from that system. Now they have a reverse arrangement, a very low tax rate on investment income and a very high tax rate on wages and salaries.
I was involved in a study for the European Commission. I was looking at how much investment income is avoiding tax through the purchase of Euro bonds and secret accounts in Luxembourg, Sweden, Switzerland, and other offshore jurisdictions. An article in The Globe and Mail -- and I do not have the exact numbers -- indicated that, in 1992 or 1993, Germany collected $52 billion in tax on investment income from individuals. In the first quarter of 1996, that $52 billion investment income tax became minus $15 billion -- a turnaround of almost $60 billion over a period of four years.
What happened? It was not because the economy collapsed. No one has done a detailed study as to what happened, but based on some research that I have done for the European Commission a part of that income disappeared in non-resident accounts or in bearer securities where there was no reporting of investment income. It was the same force that forced the Nordic countries to go to this dual income tax system of a 28 per cent tax rate on investment income.
Canada has been fortunate. Canadians are known for a very high degree of compliance. There are good controls, and politicians are not very tolerant with regard to non-compliant taxpayers. Let us hope that this system continues. However, in European countries that system collapsed.
The Canadian personal tax rates were about 14 per cent of GDP in 1997, compared to 11.6 per cent in the U.S.A. Historically, the rates were about the same, around 10 per cent. However, the Canadian personal taxes have really gone up. This 2.5 per cent point gap represents $25 billion of additional taxes on individuals in Canada, on a comparable basis. That is going to have an impact.
I will discuss the significant economic benefits from adopting a pure consumption tax model or a pure income tax model. You can go to the pure consumption tax model by essentially allowing more room for RRSP contributions, where there is no tax on investment income. The limits would be removed and other things done to go to the pure consumption tax model. There could also be a pure income tax model.
There is hesitancy on the political side to adopt these extreme solutions because they want a compromise solution, a middle-ground approach. I believe that if you go to these incremental marginal solutions you are engaging in a damage-control exercise at best.
If you want to seize the market and derive the benefits, you must go beyond what the market is forcing you to do. Ireland did this. Ireland has now become a Celtic Tiger. The tax rates are very low and the economy is booming. Two or three weeks ago, Germany reduced its corporate tax rate from 40 per cent to 25 per cent. It will have a dramatic impact on international flows of corporate taxable income. They did not do it voluntarily; they saw where the market was going and they had no choice.
In the newly emerging economies of India and China, there is virtually no capital income tax. Historically, the Indian and Chinese economies could be ignored. However, today they cannot be ignored. They are becoming very significant forces, ones that are going to compete with enterprises in North America. The competition cannot be ignored.
There are rapid changes taking place in the economic environment. Five years ago, the Canadian tax system looked good. Today, it is not very competitive.
To deal with these pressures, what you need are major changes, not incremental changes. What was considered radical five years ago is now not even adequate.
There are three policy options. First, the pure income tax model, where you can go to a purer form of income tax. If that option is to be considered, it means that it will lower the marginal tax rates. The only way to do that is by going to a very broad base, perhaps by abolishing all RRSP and pension plan deductions and other types of concessions in the tax system. You use that increased revenue to drop the tax rate dramatically. You might be able to come down from the current tax rate of 50 per cent to 25 per cent if you abolish all the incentives. Countries like New Zealand have gone in this direction. They are aiming at a pure income tax model by broadening the base and using the revenues to drop the income tax rates overall.
Second, the pure consumption tax model, where you would go in the opposite direction. You would want to liberalize incentives even further for investment income and only tax consumption.
Third, there are interim incremental measures, which is like walking in the mud -- you lift one foot and the second foot sinks. Politically, if you wanted to go that way, you must ensure that any fiscal surplus you have is used to lower the personal and corporate marginal tax rates. In my judgment, they must be immediately lowered by approximately 10 percentage points; otherwise, you will see a massive shift of income out of Canada and into other jurisdictions.
You must reduce the inclusion rate of capital gains from 75 per cent to at least two-thirds, perhaps no more than two-thirds, if possible, even 50 per cent. You may wish to consider reintroduction of the Index Security Investment Plan, ISIP, which provides indexing of capital gains and removes the lock-in effect. You may also consider other selective changes in the area of capital gains or investment income generally.
Senator Meighen: Mr. Poddar, I think you almost answered your own questions, in the sense that you too feel that politicians, being politicians, are likely to choose the third option. I will not argue with you on that.
Let me ask you this: Within the realm of incremental walking in the mud, timid measures -- assuming that is where we must walk -- you mentioned that at the very least you would urge government to lower personal and corporate marginal tax rates by 10 per cent. As a public policy matter, or for any other more specific reasons, such as employment that you care to cite, do you have a greater preference for reducing personal income tax or corporate income tax?
Mr. Poddar: I think both must be reduced. You cannot have an imbalance in the top personal and corporate rate. Suppose you drop the top corporate rate to 30 per cent, for example, from 45 per cent where it is today. What will happen tomorrow? People will begin to park all of their income in corporations and avoid the top personal tax rate. You really have no choice. The top personal tax rate must move in tandem with the top corporate tax rate.
Senator Meighen: There was one aspect that you did not touch on when you were discussing the lock-in effect. It seems to me that one of the stated and unstated criticisms of capital gains is that it smacks of speculation and, as such, why should people pocket all that gain on a speculative initiative? It is ironic that, for the greatest speculation of all, the lottery, the winnings are not taxed; however, that is a question for another day. What could be worse speculation than buying a lottery ticket?
As you know, in the United States, the rate of capital gains taxation is different, if I am not mistaken, depending upon the length of time that you hold the security, at least. What would be your comment on that?
At the risk of being overruled by those who are far more successful politically than I, it seems that it might take some of the sting away from the idea of speculation if you said: "A person who flips a stock in 24 hours and makes a great profit will be taxed at a higher rate than the person who inherits 100 shares of CPR and must sell those shares in order to pay the rent." Politically there may be some argument for that route; economically, what would be your comment?
Mr. Poddar: There are two aspects to that. First, once you distinguish short-term and long-term gains, you have created a second lock-in effect. If you have held your stock for 363 days, you are locked in for two more days to get the lower tax rate as opposed to the higher.
The law becomes very complex, because then you must segregate your portfolio into short-term and long-term holdings. Any time you cross the border, the portfolio moves from one pocket to the second. The rules in the U.S. are not that simple for defining short-term versus long-term portfolios.
Economically, again, you could ask why speculation stops at one year. Why not at 12 months, 13 months or two years? It is an arbitrary rule and, like most such rules, it is difficult to argue that economically it is necessarily the best rule.
The Chairman: Canada has a kind of a stop-gap. If you have a pattern of flipping lots of stocks, National Revenue will say you are a trader and charge you regular tax on it. There is some of that.
Senator Meighen, you are a lawyer Would you not agree?
Senator Meighen: That does exist. You could do one or two trades in a year, and with the way some of our stocks have been acting recently, people have been making a significant amount of money in a short time. I am just trying to address this.
I received a letter the other day from someone who commented on a letter I had written to one of the newspapers supporting lower capital gains. The person who wrote me said that lower capital gains is like speculation and that we should not encourage speculation.
There is some arbitrariness, though, is there not? Even in something such as a year-end, you may not sell your stock in the middle of December because you want to hold it until the beginning of the New Year and have 12 months' benefit.
I do not think it is so shocking to pick a period of time that you consider a reasonable holding period and consider applying a different level of tax if you hold it for that period. However, I am not yet convinced that system would be of some good.
Mr. Poddar: Senator, of all of the schemes I have seen to remove the lock-in effect and allow some degree of targeting, I am really enamoured by the ISIP plan. ISIP basically means putting your entire portfolio in a segregated account. You can pick any portfolio you want. There are benefits and some costs.
The benefits include receiving the indexing; the costs are that you pay tax on an accrual basis. The year-end effect and the lock-in effect do not matter.
Once you have segregrated the portfolio, you can pick and chosse. You do not have to apply the full tax rate, you can aply the a lower tax rate. When ISIP was introduced, there was a significant amount of fine-tuning done to make the overall plan attractive.
Senator Meighen: You pay at the end of each year, just as you pay tax on interest accrual?
Mr. Poddar: Yes, but then the government had allowed some averaging rules.
Senator Meighen: We are all too young to remember this. It was back in 1972.
Mr. Poddar: It operated like a mutual fund: you make your investment and you find out the closing value at year-end. That is the accrued gain. The accrued gain was reduced by an indexing adjustment in order to determine your total gain in that year. On that gain, the government had a moving average that said you report half this year and the remaining half will go to the following year.
In that way, you smooth out year-to-year variations. Sometimes you can have a huge gain and then a huge loss. That was a very effective plan from an economic point of view.
Senator Meighen: Would I not still need to come up with the cash, even though I have not sold the security?
Mr. Poddar: For the liquid portfolio, there is a fair amount of turnover taking place inside.
Senator Meighen: Are you in favour of changing the method of taxation of options, as has been suggested, and moving it to the point where the stock is sold rather than the point at which the stock is exercised?
Mr. Poddar: The stock option for the employees?
Senator Meighen: Yes.
Mr. Poddar: Yes, that would be a given. If we have to continue with our current high marginal tax rates on investment income and employment income, you have to do something to address the disparity in the U.S. and Canadian tax rates of mobile employees, and providing that relief would be a welcome change.
Senator Meighen: In the realm of incremental half-measures, what about tax-free roll-overs within a specified industry or field? It has been suggested to us in the information technology field, I believe. If you cash out your investment in one company and roll it into another in the same field, it would be exempt from taxation.
Mr. Poddar: I think it may depend upon how you design and structure it.
Senator Meighen: The Americans have such a plan.
Mr. Poddar: Even in Canada, of course, within the same company you are allowed to exchange one stock for another. There is a lot of flexibility allowed for rollovers. For the company investment in real property, we allow the rollover.
The Chairman: His question was if you cash out and then you buy.
Mr. Poddar: I see. I would need to look at the details of the proposal to have an informed view on it.
Senator Kroft: I am interested in your analysis or observation that the Nordic countries abandoned all their principles in order to do what they had to do. After many years of a highly progressive left-wing type of approach to their economy, they moved to a very aggressive treatment of capital income. This is perhaps asking you to tread a bit on political ground, but, in Canadian terms, what would be the indicators that you would look for that would suggest when we might be in a position of having to make that kind of fundamental re-evaluation?
Perhaps you can look at that by saying what the triggers were in those countries. You pointed out the European Community appeared to have loss of revenue basically because of disappearance of capital into other places. Let us look at the Nordic countries. What drove them to that? Can you try to relate it to our own situation somewhat?
Mr. Poddar: Essentially, it was disappearance of personal investment income and, at the corporate level, very significant activity in the area of transfer pricing, shifting income to lowest tax jurisdictions, which basically can be done through appropriate planning of your tax affairs without shifting bricks and mortars. Sometimes the bricks and mortar also move.
In Canada, I think you do hear differences in investment in certain sectors. If you look at the venture investment pool in Canada versus the U.S., the U.S. venture investment pool is moving up very rapidly. It has gone up by several hundred per cent. In Canada, it is almost $2 billion. It has gone up somewhat, but nothing dramatic. Is that because of the tax rates? I definitely see more and more clamour for going to the U.S. Of course, part of that is based on opportunities, but obviously the taxes have a big role to play. A 5- or 10-percentage-point gap in the tax rates is quite a noticeable gap. In the case of capital gains, it is almost double -- 20 per cent versus 40 per cent.
I must confess that I do not think we are facing the same crisis in terms of the revenue shortfall. In the Nordic countries, the impression I have is that there was a massive outflow of investments into Luxembourg and Swiss bank accounts and even other offshore jurisdictions. In countries like Denmark, they have strict enforcement, and they could do that. Other countries could not have the same enforcement mechanism. When Sweden and Norway went to the dual income tax system with a top rate of 28 per cent, Denmark had no choice but to copy that model.
Senator Kroft: I should like to pick up on the last part of your remarks and go to an area where Senator Meighen was questioning but from a different perspective. You and he were exchanging views on the idea of the length of the hold from the perspective of the investor, the business person or professional person or whoever, who has had a investment activity as part of their savings program. I should like to turn more to the venture capital investor, both the entrepreneur and the investor, and ask you whether you think that there is not a very strong case for substantially preferred treatment on capital gains for longer-term holds rather than the one year, reaching out three to five years, in order to encourage the entrepreneurial commitment to the building of a business and encourage the investment commitment to the building of that business and focusing on the people, either investors or entrepreneurs, who are actually involved in the business rather than just buying securities on an exchange. It seems to me it then leads you into the question of options.
One thing that we would want to do and that the Americans seem to be doing very well is getting both investment and entrepreneurial commitment into actually getting in and building the businesses rather than just as a portfolio investor. Would you see anything wrong with giving dramatic encouragement to the person, investor or entrepreneur who would put the money into building a business up for a longer time? It may be a drop in the rate each year, sequentially, so that when you get out to the fourth or fifth year you come out to no tax.
Mr. Poddar: You have to look at taxation of capital gains in the broader context of taxation of capital income. The U.S. system is different from the Canadian one. The U.S. does not provide corporate shareholder tax integration. They have no equivalent to the divident tax credit. They can have any system they want for capital gains taxation because it is not linked to taxation of dividends. In Canada, suppose you do go to a differentiated tax system for long-term and short-term capital gains. Then you ask the question: How will you link that differentiation through the taxation of dividends?
On top of that, you also asked how you treat the corporate taxable income in the first place. Will you keep your corporate tax rate at 43 per cent to 44 per cent right now, or will you drop it? If you drop all those rates down to 25 per cent to 30 per cent, and those are not rates that are out of range in today's discussion, then perhaps your capital gains tax rate will be no more than 20 per cent to 25 per cent. At that rate, do you worry about differentiating between short- and long-term gains? At the 36 per cent or 37 per cent tax rate you have, yes, it is worth considering any mechanism for reducing the tax on capital gains, but if the overall rates come down to the 30 per cent range, perhaps the differentiation is not warranted.
Senator Kroft: On the question of the absence of an integrated dividend tax credit system, it strikes me that it would be not unreasonable -- and we all have to pay a price for the benefit we receive -- if you had a greatly enhanced capital gains benefit for investing in a business for a longer period, that perhaps through a tax rate it might be made unattractive for you to take a dividend out. In other words, you might pay a dividend at an ordinary income rate.
The whole incentive that we seem to be missing and which I am seeking is the incentive to get investment in there to build the business, not to flip it and run with it.
I am searching for a sense of the potential for the capital gains mechanism to achieve some of these purposes.
Mr. Poddar: It will be good for business. I am really of the view that, in the interest of simplicity, you should keep one set of rules for all gains. Will you be differentiating real estate gains from the share gains? Will you provide this special preference only for the share gains or also for land, for real property? You have the questions of short-term/long-term, real property versus other types of property, domestic and foreign shares.
Currently, we have one single tax rate applicable to the entire portfolio, regardless of what it represents. It might bring some simplicity, but when you are doing that distinction, will that simplicity be maintained?
Senator Kroft: I would be less preoccupied with it if it were a piece of real estate involved in a business that you were building. If it happened to be another asset or a piece of machinery or anything else, I would be less preoccupied. It could be an apartment block you happen to own as an investment. I am searching for what you have asked us to search for, the more radical step rather than the incremental foot-in-the-mud step.
Mr. Poddar: Just to differentiate, short term and long term will not be in my definition of radical. It will be extremely complex and radical in that sense, but economic radicalism really means bringing the overall tax rates down to the 30 per cent range.
Senator Kroft: My proposal would have it go to nothing or to go dramatically lower, but the price you would pay would be a committed investment.
Mr. Poddar: But again confined to capital gains only?
Senator Kroft: That is my question.
Mr. Poddar: I personally prefer as much action on corporate tax rates and personal tax rates in general.
Senator Angus: As a matter of interest, in lecturing at Harvard, do you lecture on Canadian taxes or taxation policy generally?
Mr. Poddar: It is a bit of everything.
Senator Angus: Is it in the fiscal area?
Mr. Poddar: Yes, it is all on taxation systems, comparative taxation. I also do a lot of lecturing on VAT.
Senator Angus: I had the impression in listening to you -- and it is hard to generalize, I appreciate -- that the current American system is more conducive to a productive economy in the modern environment. Am I correct?
Mr. Poddar: The U.S. is now almost the lowest-taxed country among OECD member countries. Their tax-to-GDP ratio is in the range of 30 per cent. I just gave a paper two weeks ago at the Canadian Tax Foundation. There are some dramatic events taking place. Defence spending in the U.S. was about 29 per cent of the budget; it is now down to 19 per cent. That means they now have 10 per cent more room either to spend on other priorities or to reduce taxes, which are already low.
Canada's tax-to-GDP ratio is about 37 per cent; the U.S. is 29.5 per cent. That 7 per cent gap represents $70 billion of extra taxes in Canada. If the U.S. uses any part of that cut in Defence spending for reduction in taxes, God help us. It is an alarming situation. I was in the Ministry of Finance for 20 years. I know the pressures that government face but, in the past five years, the world has moved dramatically.
Senator Angus: We are not keeping up.
Mr. Poddar: That is right. Canada, from being an average-taxed country, is now moving to the point of being the highest-taxed country.
Senator Angus: I am looking at your options and listening as well to your evidence about them. I am not sure I would agree that they are the only options. Let me try you, for example, on this one. Given the environment you have described and the relatively small amount of money that flows into the Consolidated Revenue Fund from capital gains tax and the patterns of behaviour today, what would be wrong with simply abolishing the capital gains tax right away?
Mr. Poddar: I have an even more generous solution. Perhaps I can share with you this paper, which was presented at the Canadian Tax Foundation.
Senator Angus: We would love to have a copy.
Mr. Poddar: In 1996 or 1997, the total tax collected by the Government of Canada from investment income of individuals was in the range of $6 billion to $8 billion.
Senator Angus: I have seen the tables that are in that article. They are very graphic.
Mr. Poddar: Yes.
Senator Angus: You are saying that, if you had a magic wand, you would abolish the capital gains tax entirely and we would be better off all around?
Mr. Poddar: Politically, I may sound stupid.
Senator Angus: That is another subject. People with magic wands do not do well politically, I am afraid. Maybe that will change, too.
Some say that, if the capital gains tax were reduced to zero in Canada, then you must make concomitant changes in the tax structure. I do not agree with that, but I would like to have your comments.
Others say that as soon as we abolish capital gains tax in Canada we will end up with estate taxes like the U.S., which are punitive. I do not agree with that because we already have the concept of the deemed realizations upon death.
Mr. Poddar: If you just abolish the tax on capital gains, it will be a heyday for tax practitioners. We are very busy. I do not know what will happen to us if you do that. There will be tremendous tax-planning opportunities created if you abolish the capital gains tax. If you want to go that way, go with your eyes open.
Senator Angus: You find that that would be okay, do you not?
Mr. Poddar: No.
Senator Angus: To abolish the capital gains tax?
Mr. Poddar: I will not endorse it economically nor will I endorse it for the stability of the tax system.
Senator Angus: You would do other things?
Mr. Poddar: I would want to maintain neutral treatment of different types of investment income.
Senator Angus: What about your proposition that only 25 per cent of investment income, as opposed to earned income, is taxed in Canada? How accurate is that, really, given all the tax planning that is out there? You mentioned Belgium and Lichtenstein and the Cayman Islands. It seems that a lot of money is invested by Canadians, money that is not reflected in those percentages.
Mr. Poddar: These are all estimates. In my judgment, they are pretty reasonable. Ernst & Young has a wealth database of individuals by income bracket, where we take the value based on Statistics Canada surveys of housing starts and number of homeowners. The RRSPs and RPP wealth is fairly well documented and aggregate. We reconcile individual data collection through the aggregate totals, which are available through Statistics Canada. I do not think you will find much disagreement with the fact that, overall, for the nation as a whole, close to 75 per cent or even 80 per cent of the total wealth is tax-sheltered. This is not illegal avoidance in the non-resident accounts.
Within Canada, if you take all the money in RESPs, RRSPs, in housing stock and in small business capital gains, you can easily arrive at that 75 per cent number. In fact, it is higher than 75 percent.
Senator Angus: The number that forms the totality in your calculation, I believe, and I suggest, would be considerably higher if there were no capital gains tax. That is because, first of all, the lock-in effect would disappear, there would be a much greater turnover of investments, people would feel free to invest in businesses, and there would be capital projects of all kinds without fear of having this tax.
Mr. Poddar: Once you remove the tax on investment income, naturally, the pie will be bigger. In that sense, the savings and wealth would be bigger.
Senator Angus: You have talked about your three options, and the one you like the least is the "foot in the mud." In the last three days, there have been many articles in the newspapers, which is the current government's way of having a dry run of the budget before February 28. We are told, for example, that the exclusion rate on capital gains will go down from 75 per cent, to some people 65 per cent, others 62.5 per cent. Whatever it is, in your mind does that constitute de minimis change?
Mr. Poddar: That is a marginal change that is justifiable on technical grounds because the tax on dividends is now approximately 32 per cent and the tax on capital gains is 37 per cent. That disparity can be eliminated if you go to two-thirds inclusion rate for the capital gains.
Senator Angus: In terms of benefits derived from the reduction of the capital gains tax, does that not do anything?
Mr. Poddar: No, that is a minor tinkering adjustment.
Senator Angus: In like manner, the 20 per cent going to 30 per cent over a period of how many years? Would it be 2 per cent a year for five years on U.S. or foreign content for RRSPs and pension funds? How would you quantify that?
Mr. Poddar: There is no benefit immediately to the Canadian economy for increasing the foreign content rule. It is designed to ensure that pensioners, or potential pensioners, are able to invest portfolios in productive international investments. As it is, my impression is that those who are able to make some inquiries through the clone funds can go to 100 per cent RRSPs anyway for foreign securities.
Senator Angus: You have very nicely made the point that we are living in extraordinarily different times than we were five years ago and that the tax structure is quite critical to our future prosperity in Canada and the well-being of our citizenry, given that we seem to be faced with a declining standard of living in real terms.
Mr. Poddar: I will give you one example that graphically illustrates my point. Even for me it was shocking news. A client came to us and said, "My Canadian tax is too high. I would like to find low-cost alternatives." Through some planning, the income was shifted to a U.S. state and the taxpayer saved only 6 percentage points. The differential in the Canadian corporate tax rate and the tax rate in the U.S., federal and state taxes combined, was 6 percentage points lower in the U.S. than in Canada. Therefore, the taxpayer only benefited by 6 percentage points. However, Canada lost the full 44 percentage points. Thirty-eight percentage points went to the U.S government. The taxpayer received 6 percentage points. Even though we like to help the clients, I came away sad and morose. I said, "My God, I hate to shift the Canadian tax dollar to the U.S. just to save the client 6 percentage points in tax." This is what is happening.
Senator Tkachuk: I agree with much of your presentation, however, I got a little lost. You mentioned that Professor Grubel talked about this statistic of $50,000 being the average salary of a person who had capital gains. You mentioned that that was a one-year statistic rather than a long-term statistic. I am not sure whether Professor Grubel was right or wrong.
Mr. Poddar: I do not know. Looking at the one-year statistics, you can get a misleading picture, particularly for an income component like capital gains, which is not regular. You should be able to request from the Department of Finance data based on the longitudinal file, where you can look at the time profile of individuals, not on the basis of a single year but over a five-year or ten-year period. That statistic is not published and I have no information as to what the answer will be.
There were one or two reports published when I was in Finance -- for farmers, for example. We looked at their profile on the basis of a 10-year history as opposed to a single year. Some fascinating observations come out of that profile. If you want to form any views about the distribution of capital gains by income bracket, I strongly recommend that you request the Department of Finance to provide that profile.
Senator Tkachuk: You talked about tax neutrality. I think that income tax, business tax and capital gains tax must be reduced substantially and I have argued for it in the Senate for four or five years. I am always amazed at the tremendous creativity of man to do his due citizen's duty and avoid tax wherever possible, and in as legal a way as possible. Are you advocating a flat tax for income tax?
Mr. Poddar: Flat tax is purely a political choice. Whether you have a flat tax or a progressive tax, I do not think it matters. What matters is the overall burden of taxes; flat versus progressive is your decision. As a tax engineer, my opinion is that the foundation can only bear so much load. How you distribute the load across low and high income brackets is your judgment. Economically, I do not think it will make a big difference if you have a flat tax versus a progressive tax, as long as the top progressive rate is internationally competitive.
Senator Angus: This question is not a fairly profound one but it may have far-reaching consequences for this study. You made an allusion yourself to what is politically acceptable and what is not. It is said time and time again that the reduction and/or abolition of the capital gains tax is just a sop to the privileged, to the wealthy, to people with a high net worth. Yet there seems to be an abundance of evidence to show that it would be of great benefit to all levels of Canadian society, that it would bring great prosperity to all Canadians, and that the fact that it would only benefit the rich is a big lie. I do not know whether it is true or not, but it seems to be that if it would benefit all sectors of our society we should try to do away with that false perception so that it would be more politically acceptable. In today's environment, as you suggest, governments are a little reluctant to fool around with capital gains tax rates.
Mr. Poddar: I would like to answer your question by saying that there are many things you can do that would benefit the whole society. Is this necessarily the most efficient tool for benefiting society? I would like to say that one must give due recognition to stability in the tax system. A tax system of an income type with no tax on capital gains, or a very low tax rate on capital gains and full taxation on other types of investment income, in my judgment would not be a stable solution technically.
It may not even be stable politically. A good example is the half-million-dollar capital gains exemption that was introduced in 1984 by then finance minister Wilson. How long did it last? It was taken away very quickly. The only component that lasted was for small business shares and farm property. That is an example of political views that do not fully support that outcome.
If you just reduce the tax on capital gains and keep the tax rates on business profits, interest and dividend income where they are now, you will require frequent changes in the tax laws to prevent a haemorrhage.
Senator Angus: We have read recently that Germany, with a view to adapting to these very changed circumstances that you describe, is abolishing the capital gains tax entirely for corporate capital gains. What do you think of that?
Mr. Poddar: In Europe, several countries do not tax capital gains. If I recall correctly, Netherlands has no tax on capital gains, and there are a few others.
Senator Angus: Germany has just announced their plan.
Mr. Poddar: Yes, at the corporate level. My impression was that that change in the capital gains side may have been just to remove the lock-in effect, because some of the companies were sitting on shares that were acquired at the time of World War II. They were not able to sell them because they had gone up in value dramatically, so if they had sold them that would have triggered the capital gains tax. I do not have all the details as to how it will affect the tax structure in Germany. They may not be fully available yet. I cannot really comment as to whether that system would be stable or not.
Since they are part of Europe, they also face the competition of neighbouring jurisdictions that do not tax capital gains at all. Perhaps they have chosen to take the risk of giving this concession for the capital gains and face the consequences.
Senator Angus: Australia also has made radical changes in response to the conditions you have described. Is that not right?
Mr. Poddar: Yes. Their tax rates are low now, but I am not aware of the changes in the capital gains area.
Senator Meighen: Mr. Poddar, going back to the lock-up effect for a second, I understand that Mr. Russel from the IDA commented on your paper in the Canadian Tax Journal. He pointed out that individuals in Canada reported that they held over $400 billion in stocks, yet there was only $9 billion reported in capital gains. These are 1996 figures. That is about 2.25 per cent, which seems to underline a very dramatic lock-up effect. Do you have any comparative figures for other countries?
Mr. Poddar: No. Of the $400 billion in stock, you ask the question how much was held in RRSPs and RPPs, because most of the portfolios held through RRSPs and RPPs will be part of that $400 billion, and there is no lock-in effect there at all. The only gains that get reported are those that are held directly by the individuals, and even there, if you are holding a mutual fund portfolio, those will not be reported as share gains but as mutual funds unit gains.
Senator Meighen: So we cannot make any comparison in terms of the lock-up effect under our tax regime here compared with other countries?
Mr. Poddar: No, nor can you draw any inference from that statistic that Mr. Russel quoted.
The Chairman: You gave the example of a Canadian you were advising who was shifting income to the United States to save tax. Do you have any idea how much of this is done? Is Canada a big loser in this kind of thing?
Mr. Poddar: Increasingly so, Mr. Chairman. That is because as our tax rates diverge from the rates prevailing in other jurisdictions, more and more tax planning is taking place. It is not only tax planning but also shifting of activities outside the country. To give you an example, I do a lot of work in India. India has zero income tax on export profits. The software industry is moving massively into India. Not only do they get low-cost labour and a very good infrastructure for building a software base, but there is an icing on the cake -- that is, no income tax on the profits. Many companies cannot believe it. They were not even aware that you can earn all those profits in India without any income tax at all.
The Chairman: Then why are most of the engineers -- the good ones, I am told -- in Silicon Valley all Indian?
Mr. Poddar: They may come from India, but that is a minority. In cities like Bangalore and so on in India, for every engineer who is in Silicon Valley, there are 10 times that many in India. Many are in the film animation industry. You may have heard the story about Disney closing down the studios in Vancouver two or three days ago. India is becoming a very big centre for animation, because of the local talent, and all of that income in India is tax-free.
The Chairman: Mr. Poddar, thank you very much for your visit. It was illuminating and interesting.
The committee adjourned.