Proceedings of the Standing Senate Committee on
Banking, Trade and Commerce
Issue 7 - Evidence, February 23, 2000
OTTAWA, Wednesday, February 23, 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 Leo E. Kolber (Chairman) in the Chair.
[English]
The Chairman: Honourable senators, this afternoon we are resuming our study on capital gains tax. We have two groups of witnesses. Our first group is from the Formula Growth Fund and Pembroke MGMT. I will first introduce John Dobson, the chairman and founder of Formula Growth Limited, in Montreal. Parenthetically, I am an investor in that fund and it is doing extremely well.
Senator Angus: That sounds like a conflict.
The Chairman: Mr. Dobson is a graduate of McGill University and the Harvard Business School. He is president of the John Dobson Foundation and was appointed a member of the Order of Canada in April 1997.
Joining Mr. Dobson is Ian Soutar, an officer and partner with Pembroke Management Ltd. of Montreal. He is a graduate of McGill and the London School of Economics. He has been with Pembroke Management since 1968. Before that, he worked for All Canadian Funds and for Sun Life Assurance Company of Canada. Welcome, gentlemen. You have some prepared statements, so please proceed.
Mr. Ian Soutar, Chairman, Pembroke Management Ltd.: Honourable senators, Mr. Dobson and I are pleased to have the opportunity to appear before your committee to discuss the issue of capital gains taxation. Although we have very strong convictions about this topic, we were hesitant to make a submission to this committee because of the generally perceived view that the comments of successful investment professionals about capital gains are self-serving. However, having been encouraged by Senator Angus to speak out on this issue, we concluded that we should appear before you.
Capital gains taxes took effect in Canada at the beginning of 1972. Since that time, Mr. Dobson and I have vehemently believed that it was a bad idea for Canada. We continue to believe that the economy and our citizens have suffered significant economic consequences as a result of this action. Canada was one of the best performing nations in economic terms before 1972. Since that time, the economic level of our people has slipped substantially relative to the U.S. and many other nations. We believe that a substantial cut in the capital gains tax would be the single most important action that our government could do to improve the economic well-being of all Canadians.
We believe that is why Australia recently decided to cut its top marginal capital gains tax from 47 per cent to 23.5 per cent for assets held for one year, and why Germany has just announced an elimination of capital gains taxes applying to stock sales by corporations. That follows the significant U.S. cuts of recent years.
We applaud your committee's study of this important issue and urge you to use whatever authority you have to get the message to all Canadians that a high rate of capital gains tax is bad for all Canadians, not just the privileged few.
By way of background, Mr. Dobson and I have been investors in emerging public growth stocks since the 1960s. Pembroke invests in both Canada and the U.S. Formula invests only in the U.S. Formula used to invest in Europe and had one-third of its fund in Japan in the early 1970s. We have each invested in thousands of companies over the years. Formula has a compound annual return of 17 per cent for 39.5 years. To give you an idea of what that means in terms of the power of compounding, $9 invested at the start of the fund is now worth $4,700.
We believe that our most useful contribution to the committee would be to present a number of actual investment cases that were affected by capital gains tax. Before doing so, we would like to comment on several macro areas where we differ significantly from the academic economists and, we believe, the federal Department of Finance.
First, as investors, we are interested in wealth creation. That appears to be a bad term in Canada -- so bad that it is neither used nor discussed. In short, Canadians appear not to want successful creators of wealth, as Americans clearly do. For example, there are only five Canadian foundations with assets over $100 million, two of which are institutional. Bill Gates is a hero in the U.S., but he would not be in Canada. To sell capital gains reduction, we thus have to replace discussion of wealth creation with discussion of the positive role of capital on the creation of jobs. Everyone accepts that the creation of jobs in the private sector requires someone to have capital.
Second, economic models and academic economists seem to give no credit to the effect of changed personal behaviour of investors if the incentive system is changed. Their models are static and show the same results for growth of the economy if the capital gains tax is 40 per cent, 20 per cent, or zero. We see from our investing experiences that that is clearly untrue in practice. In fact, only recently have some orthodox economists in academia begun to recognize the role of innovation and technology in economic growth theory.
On January 24, 1963, President Kennedy said:
The tax on capital gains directly affects investment decisions, the mobility and flow of risk capital ... the ease or difficulty experienced by new ventures in obtaining capital, and therefore the strength and potential for growth in the economy.
Third, Ottawa and academic economists like Jack Mintz appear to us to be obsessed with the technical issue of the tax relationship between capital gains, dividends and the small business tax. In the world of public investors, this is not an issue. Today, the Dow Jones yields 1.4 per cent. Most investors in equities invest for capital appreciation or at least a combination of yield and growth.
In the last sentence of his presentation to your Senate hearings, Jack Mintz said:
I know that in terms of my recommendation I am driven by 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.
Our number one question, which appears rarely to be addressed, is what is the correct capital gains tax rate to provide maximum economic growth for the benefit of all Canadians. Our answer is zero, or at least no higher a rate than our nearest competitor, the United States, and that view is shared by Alan Greenspan. As noted on page 15 of this submission, Mr. Greenspan said:
The point I made at the Budget Committee was that if the capital gains tax were eliminated, that we would presumably, over time, see increased economic growth which would raise revenues for the personal and corporate taxes as well as the other taxes we have. The crucial issue about the capital gains tax is not its revenue-raising capacity. I think it is a very poor tax for that purpose. Indeed, its major impact is to impede entrepreneurial activity and capital formation. While all taxes impede economic growth to one extent or another, the capital gains tax is at the far end of the scale. I argued that the appropriate capital gains tax rate was zero.
I will conclude this section with a quote by Bruce Bartlett, a well-known U.S. expert with the National Center for Policy Analysis:
While there are many people who argue for a capital gains preference, and even support lowering the tax to zero, few have grounded their case on the fundamental principle that capital gains are not income. They should make this argument consistently because it raises the case from the realm of political expediency or even economic efficiency to the level of principle. Doing so at least gives advocates of lower capital gains a firmer foundation when confronted by those making a principled argument for not doing so, on the grounds that the capital gains should really be taxed like ordinary income.
In appearing before your committee, Mr. Dobson and I wish to stress that at our age we are not so concerned with any benefit to us. We are concerned with giving younger generations of Canadians the same great opportunities that we have enjoyed. As you will see, a 40 per cent capital gains tax seriously eliminates opportunity and significantly contributes to the brain drain. It also reduces the incentive to create wealth that we believe is a benefit to all Canadians.
Mr. Dobson will now give you a number of examples.
Mr. John Dobson, Chairman, Formula Growth Limited: I will discuss this topic from my perspective of a very fortunate Canadian, and I will give you several case examples.
I got involved in investing at a young age because my father put $100 in my account every year. I was never allowed to touch either the capital or the dividends. From that, I learned the value of investing.I should like to pass this principle on to younger generations. I want young Canadians to have the same advantage that I had. To that end, I have come up with these exhibits.
As you will see from Exhibit 1 on page 12 of our brief (see exhibit following the transcript, page 7«1»:1), the power of compounding interest and the effect of negative capital policies is one of the great wonders of the world, and many people do not appreciate it. This exhibit sets out the time factor with which we are dealing. The conclusion is that $1,000 compounded at 20 per cent for 40 years untaxed becomes $1.5 million, while $1,000 compounded at 20 per cent for 40 years with annual capital gains tax at 40 per cent becomes $93,000.
Over 40 years the government receives, if taxed annually, $22,000. I might add that if the government only collected the tax at the end they would have $600,000. This excludes the devaluation of the currency -- the Canadian dollar has gone to 25 cents over the last 25 years -- and also the buying power in international currency, which was 72.5 cents in terms of the U.S. dollar when I did this in 1997. This is at the centre of everything that we think of and what we want to teach people about long-term investment and, if you invest in savings, understanding what you can have, what the country can have, and the growth. What has happened here is that an individual ends up with $1.4 million of wealth creation and the government gets $22,000. It is not a very good deal for Canada.
The case is very extreme. We have taken many years, but we are looking at someone over a longer time period. Forty years is reasonable. Some people start at age 25 and we want to see what has happened by the time they are 65 years old.
Senator Meighen: Did you say the individual ends up with $1.4 million or loses $1.4 million?
Mr. Soutar: Sorry, senator. He ends up with $93,000.
Mr. Dobson: Instead of $1.5 million.
Senator Meighen: The government only gets $22,000.
Mr. Dobson: That is right. I apologize. I should read more carefully.
This example is extreme from two points of view: First, 20 per cent is a lot, but we have done it at 17 per cent; second, we are taking it every year you pay the capital gains tax. That is not that likely to happen. We build a case that is extreme in order to show the absolute importance of savings, growth and compounding. A 17 per cent rate is a much higher than most people would have, but I can give you figures at 12 per cent or something else in the question period.
Let us turn to Exhibit 2, on page 13 (see exhibit following the transcript, page 7«1»:2). I take out of that two things. In case A, a compound return of 7.9 per cent over 25 years with 5 per cent inflation, 40 per cent capital gains tax and portfolio turnover every three years would produce zero real gain, or 100 per cent capital gains tax.
Mr. Soutar: That is very close to the return that one has had by investing in Canadian stocks over that period of time. I think the return has been approximately 9 per cent or 10 per cent. In effect, after taxes and after inflation, there is no real return.
Mr. Dobson: If you made less than 7.9 per cent you lost real value. As Mr. Soutar says, not many people have done much better than that.
Case B looks at wealth creation over 25 years. What happens if the individual lives in Hong Kong, in Canada, or in the U.S.? The answer is that he has 4.7 times more money in Hong Kong than in Canada and 2.2 times more in the U.S. than in Canada, because of capital gains tax.
You may wish to turn now to Exhibit 3, page 14 (see exhibit following the transcript, page 7«1»:3). I start with a child who gets $1,000. I got $100 a year from my father. You might be interested in this question of inflation, which does go on. My father got paid $100 a year in 1900 when he started out. That shows you what happens to the dollar over a period of time.
Investor No. 1, the child, receives $1,000 for 21 years, reinvests at 20 per cent return and turns the portfolio every three years. We picked three years because serious investors like John Templeton or Peter Lynch or our fund feel it is necessary to change in and out at an average of every three years. That gets into a bit of lock-up later on. The child would get $270,000 after 20 years, but the taxes eat down to $177,000. The capital forfeited to tax and lost return is $92,000; in other words, 37 per cent of the investment gain has been lost, partially because the child paid taxes, but equally because there have been fewer chips available to be invested because the money has been taken out and paid to the government. I would have that much less if I were coming along now compared to when I started. I was lucky because there was no capital gains until 1972 and I was born in 1928.
What about a graduate coming out of school? Interestingly enough, the average guy graduating out of McGill School of Commerce gets $41,000 this year.
The Chairman: Where are we?
Mr. Dobson: We are at the bottom of page 6, and I am talking about Exhibit 3 on page 14.
Investor No. 2 is the McGill commerce graduate. He saves and invests $5,000 a year for three years, invests with 20 per cent return and pays a capital gains tax of 30 per cent. In Quebec we pay 39 per cent at the maximum, but he would pay less because he is in the $41,000 bracket, not in the $60,000 bracket, although he will get up to there pretty soon. That graduate would have $21,800, but with tax payments he has $19,700. Really, 30 per cent of what he makes on his investment in his first three years he loses because of the capital gains tax.
Investor No. 3 is a secretary, and we try to deal with a secretary whom some of you might know or know of who was referred to in some of the hearings. A high-level secretary, like she was, starting today might get $40,000 salary. She invests $5,000 for 10 years with 20 per cent investment returns. With zero tax, the secretary would have $155,000 versus her actual after-tax total of $113,000. She forfeits $42,000 -- 37 per cent of her investment gain.
Senator Angus: That is 39.7 per cent.
Mr. Dobson: Right. There is no inflation factor in here. Only 27 per cent of that is to taxes. What we are trying to show is that many of the people we have in our fund, or in our society, are lower-income people who are working their savings. They are generally considered to be the people who are making capital gains. These are real people. We are not talking just about rich tycoons.
Now I move to real cases from our fund; these are actual figures. The first fellow, investor No. 4, is a golf pro. He invested $3,612 in our fund in January 1971. You can see that he had market value this year of $340,883. Now, he had to pay a capital gains tax of $63,200. This is very important to understand because he had to get that money from someplace. He actually saved it outside and did not take the money out of the fund. If he had used the fund to pay his capital gains tax, he would have had taxes on selling the fund. He has an unrealized gain of $71,772. Total taxes paid were $134,920. It looks large. Again, we are not talking about what is lost on the value of the currency or the international buying power.
The next investor is a doctor friend of mine who started when we started in 1960. He had $4,000. In 1971 this fellow was worth $23,500. That was before there was any particular capital gains tax. This year he is worth $2.5 million. He had to pay $410,000, which he had to find someplace, and he has an unrealized gain of $466,000, for total tax of 39.6 per cent.
Again, the real returns for investors 4 and 5 are much lower because of inflation and currency losses. In addition, they have had to serve up that money. I am repeating myself but it is important to understand how we crucify long-term people by this process.
Investor No. 6 is the sort of case you get if you wander around the community. This is a retired doctor, highly respected. He had an argument with his trust company because, over the years, it managed his money very conservatively and his assets were not growing. He finally got rid of the trust company with a lawsuit and then he had advice in the form of a financial planner, although not us. For a while the portfolio was in balance, but then a couple of years ago a bank stock went up a tremendous amount and so did a U.S. pharmaceutical. Both he and his financial planner felt that both stocks should be sold. However, his capital gain was so large that he decided not to make the change, and both stocks declined significantly. This locked-in factor is enormous and experienced by many portfolio owners and managers.
At Formula, we consider keeping a stock that will grow at 12 per cent to be equal to selling it and replacing it with a stock that will grow at 20 per cent. As a professional portfolio manager, I think that is grim. If we sell the stock, we can replace only a certain number of dollars.We can put 60 per cent back into the gain, but we must pass 40 per cent to the government. Therefore, we have that many fewer assets. There a big economic loss from staying invested in lower investments and not switching to newer, faster growing companies. There are dozens of cases involving that. Wherever we go, we hear that kind of thing.
The next example involves the son of one of my friends. He was a computer geek. He went to the University of Waterloo and then moved to Kanata. At one point, he and two of his friends started their own computer software company that specialized in computer security. Recently, it was sold to a big company that helped finance it: Newbridge. The entrepreneur was asked by his father: "How much money did you make, son?" The son responded to the father: "Before tax or after tax?" The father then asked: "I guess after you have had your 18-month stay-in and earn-out period, you will probably start again?" His son replied: "I made a lot of money. I might start again, but I will not start in Canada because of the capital gains tax." Those are good young guys in the modern world and that is an actual case from highly respected people in our community.
We play golf and we talk about some of these cases. In fact, that is where the previous story was heard. There is also the dentist and MBA from Concordia who wants to be heard. He entered our discussion by stating that he did not want to follow the lead of many of his friends who say that he is foolish not to take his funds offshore. He is upset and dumbfounded by the number of them who tell him he is stupid not to do what the rest of the people are doing. That is pretty sad, but it is realistic with the 40 per cent rate. Again, like the lock-in effect, the government gets no revenue when money is moved into the tax-free areas. If you take your money offshore, the government gets nothing.
The Chairman: When you bring the money back, do you not have to pay tax?
Mr. Dobson: Yes, but you can use the internal buildup in the meantime. You pay 100 per cent. They are trying to get an internal buildup, like the British system. You definitely pay the tax when it comes back, but you have all that money working for you. You get the $1.5 million as opposed to the $93,000 in our earlier case, and the government would get $600,000.
Senator Angus: What do you mean by "internal buildup"?
Mr. Dobson: You pay a certain amount of tax to the government, but then the funds available to you have been lost to earn on in future years. That is roughly equal to the taxes. It is a very big factor. You have $100 on day one and you pay 20 per cent to the government. You then start with $80. You have lost some of the assets, which will compound at whatever rates we use.
Investor No. 9 is an example of probably the biggest negative of all, which is the loss from entrepreneurs who never get started because of the effects of high capital gains tax. First, for those who choose to remain in Canada, there are not enough angels to finance start-ups because of the lack of wealth creation. Second, Canada loses when Canadians set up in the U.S. rather than in Canada because of the perceived uncompetitive climate suggested by a 40 per cent versus 20 per cent capital gains tax. That correlates directly with job creation. Either we have jobs in the private sector created by entrepreneurs and accountable to them for what they are paying people -- hopefully productive jobs -- or we look to government to create jobs with questionable economic value and accountability. The current Human Resources debacle is a case in point.
Senator Angus: It is shameful.
Mr. Dobson: Investor No. 10 is next. In our fund and all mutual funds, new entrants must assume the unrealized gain in the fund upon entry. If you entered our fund on January 1 this year, at $4,400, you would know we have approximately $2,200 of unrealized gains. At the end of this year, our fund might be $4,400, or it might show a loss from purchase price. If the managers sold all stocks with unrealized gains, the new investor would get a tax slip for his percentage of $2,200, even if the value of the fund did not increase.
It is interesting to note that unit trusts in the U.K. are not required to pay capital gains taxes. In other words, the fund manager can change the portfolio and the investor will pay capital gains tax only once he sells his underlying units in the fund. The significance of that can be seen in Exhibit 1 on page 12. The individual would end up with $900,000 versus the $93,000 that was given in the example -- that is, if the 40 per cent tax payment were deferred to the end of 40 years. If that happened, the government would get $600,000, as we saw in that earlier case. While this example is extreme, the lock-in factor is serious. It is hurting wealth creation because it keeps investors in old holdings instead of newer ones. Many of these things hurt investors because of this capital gains tax that they must either defend against or do something about.
Concerning cost and regulations, the revenue that the federal government receives from capital gains stocks is not very significant. Your committee no doubt knows all the figures from the Finance Department.The cost for collections and policing must be subtracted against the revenue. The problem is that you have an asset. You must keep track of the date of the asset, whether it goes up or down or sideways, within one year or five years. Because the capital gains tax is applied over a long time period, it is very complicated to score and to keep.
For individuals, look at the unproductive costs for the material in the private sector. You have H&R Block doing tax returns, lawyers, accountants, administrative costs of the RRSP, and so on.
Senator Hervieux-Payette: What about job creation?
Mr. Dobson: I am talking against the service we provide. While we receive fees, we are saying that it is wrong to have so many intermediaries who add to the unproductive cost.
RRSPs are better than nothing, but they often provide for bad investment performance because of small amounts and administrative costs, plus the 80 per cent Canadian content. Other troubling problems arise, such as investor-owned units in the fund in a personal holding company. The geniuses tell us that you should have your own personal holding company when you have U.S. assets. If you do, then you pay a capital tax. If you have it in your own name, you do not. I have it in both, and so does Mr. Soutar. On one account, we pay a capital tax; on another account, we do not. Things like that go unsaid but in the real world add up to the total cost and annoyance that is caused by the capital gains tax.
Mr. Soutar: In conclusion, Canadians' well-being has been substantially lessened by the high capital gains tax that has been imposed by our government. First, the tax significantly reduced the wealth creation process. Second, the lock-in effect of the capital gains tax has badly affected returns by keeping Canadians from switching into higher-returning assets. Third, this high tax has either prevented our most talented entrepreneurial business people from getting started in Canada because of a lack of angel financing or has driven them from the country. It is important that this message is communicated successfully to the people of Canada. Our reduced capital gains tax will not just help the rich. It will materially help all Canadians to enjoy a higher standard of living by creating the wealth that is needed to provide our citizens with better education, health care or whatever else we choose collectively to spend it on.
Senator Angus: Mr. Dobson and Mr. Soutar, we appreciate your coming up here today and the excellent paper and appendices that you have presented. We have been engaged in this study for several months now. We have had a variety of what you referred to as "academic tax economists". Some of their evidence has been conflicting and also confusing. Perhaps you can help -- as you already have -- in terms of clarifying some points.
I have two questions. First, you spoke about the lock-in effect created by this punitive capital gains tax in Canada. You are advocating an abolition of the capital gains tax, which would obviate the lock-in effect. If that happened, where would those locked-in funds go? What would happen to those funds?
Mr. Soutar: Those funds will not go under the mattress or disappear. This money will be reinvested in higher-returning assets. It will be invested in business formation. It will be supplied to various charitable organizations. It will be spent on consumer goods. It will go back into the Canadian economy.
Three things will happen when the capital gains tax is either substantially reduced or eliminated. First, there will be a surplus of money that will go to the government because lower tax rates will encourage a number of investors to turn in their investments. They have been sitting back, reluctant to pay the capital gains tax. The funds will go into higher-earning assets. Second, money will be invested in higher-earning assets, which will create more wealth for the good of all Canadians. Third, the funds will be recycled into all kinds of economic activity, which will benefit all Canadians. Locked-in funds have an enormous adverse impact on the economy, on job creation and on the prosperity of all Canadians.
Study after study in the United States has shown that when capital gains tax rates are cut, there is a substantial improvement in economic activity generally as a result. The economies of Ireland and New Zealand are cases in point. I do not believe there is any case in the world where capital gains tax rates were reduced without resulting in a substantial improvement in economic activity and well-being for all citizens. That is why politicians reduce capital gains. Politicians do not reduce tax rates because they do not want to get access to funds. Politicians love to have hold of the money so they can control it. They do not understand what a destructive process that is. Leaving money to accumulate and create greater wealth, in the hands of productive individuals, benefits economies substantially.
Canadians do not have a choice. We are totally non-competitive with the vast majority of our Western competitors. If we do not reduce capital gains tax rates, we will continue to lose our best and most talented people to the United States and other countries. Our citizens will not benefit as they should.
Believe me, if tax rates on capital gains are reduced, people will think they are in the midst of an economic miracle. In my opinion, you will almost immediately see an improvement in our currency. You will see a substantial increase in capital investment in this country and a substantial improvement in our domestic economy.
Senator Angus: You have made some very positive and adamant statements. You have referred to studies and texts. Are you comfortable that the evidence is out there? Is this a wish list that you have? Can you affirm that there is concrete evidence to sustain the points you are making?
Mr. Soutar: Absolutely.
Mr. Dobson: I agree with that. I would also cite Germany as a good example for our proposition. Germany has a banking system and there is interlocking money backwards and forwards. Germany has also totally removed the capital gains tax rates on companies. They have done that because they want the money to flow around and be re-addressed from the old economy to what is now referred to as the new economy. Countries will be efficient and modern. To do that, you must get the money out of the old economy and move it into the new economy. You must find the money someplace.
When a country like Germany finds it necessary to go to that extreme, they are not fiddling with the capital gains. From three-quarters inclusion to two-thirds inclusion, or 65 per cent, the figure is zero in Germany. I do not live in Germany, but that is a piece of evidence other people in the world have found. To be competitive and to deal with unemployment, that is what they must do.
Senator Angus: On the subject of the new economy versus the old economy, or the restructuring in Canada, we want to get away from being hewers of wood and drawers of water and to advance into this new economy. We have heard that said repeatedly in another study done by this committee with respect to the availability of equity capital for start-ups and for new business in this country. Canada is apparently lagging behind our neighbours, partners and other OECD countries in participating in the new economy. Even in our traditional resource-based companies, we have lagged behind in retooling to take advantage of the new economy's technology and to make companies more efficient. Is that what you are referring to basically? Would the removal or the reduction of the capital gains tax help to alleviate that situation?
Mr. Dobson: That would do a great deal to alleviate the situation. In Canada we have the problem of what we refer to as "angels". There is venture capital money available, often institutionalized. If you want to start up something you go around, as we did in the Montreal community, and raise funds. We collected $134,000 and that is how we started. You cannot do that today with all the regulations. Rather, money in the hands of friends and relations is made available to move into this area.
Senator Angus: You say that is not there today in Canada?
Mr. Dobson: There is some but nowhere near the degree that is available in other places, particularly in the United States. We just do not have that much wealth in our country. If you want to start a team like the Expos, you had better have, in year one, a Charlie Bronfman. We had 30 of them but Mr. Bronfman ended up with almost sole control, along with Hugh Hallward and Lorne Webster. Money is needed to get things going.
The second issue is something many people lose sight of. If one is to invest in something like that, one must be able to come up with a second and a third round. Mr. Soutar and I are not usually in the start-up business but occasionally we do get into it. We know from experience that if you put money into such things, you must be prepared to give a second shot and a third shot. If you are going to put in some money, you need to look and see who else in the community might take you out.
The Expos are a good illustration. They had 30 investors at the beginning who dropped by the wayside, one by one, and eventually they all went out. On day one, it was great and 30 players were ready to tee up, but one must be able to find the future equity. If one cannot find future financing and take-out, then one must decide whether to go in at all.
Senator Angus: We hear time and again that Canada, being so close to our large neighbour to the south, should have a comparable regulatory system, be it in banking or taxation or in other economic conditions. If we follow that lead, using the U.S. as a model, I suppose we would conclude that their approach to capital gains might be instructive. What would you have to say about that proposition?
Given Canada's relatively small size, our open economy and the fact that we are apparently more than 18 months behind in taking advantage of Internet commerce, and given that we do live next door to the world's largest economic engine -- the elephant -- should we have a lower capital gains tax in Canada in order to attract new money and to increase the wealth and prosperity of all Canadians?
Mr. Dobson: At the Fraser Institute symposium on capital gains, they gathered 20 or 25 experts, including two or three Americans. They asked, should Canada have the same system as the United States? The answer from them was clearly no.
Senator Angus: Why not?
Mr. Dobson: We should have our own system. What are our needs?
Senator Angus: I take it you agree with those who say we should not have the same system? Is that your evidence?
Mr. Dobson: I do not think it matters. What matters is the rate of the capital gain, because that is what the decision whether or not to invest in Canada will be based on. The issue is not whether to copy their system but, rather, how we can compete for overseas investments and retain Canadian investment.
Senator Angus: Rather than the Americans getting it?
Mr. Dobson: Or whoever else. Today our people are going to Ireland because that is currently the hot place. We must look at what is good for Canadians and what is needed. If we need capital for jobs, someone must have the capital. As Alan Greenspan said, the worst thing to penalize is capital and capital gains. You need that to get it going. Do not buy the American system holus-bolus but, directly on your point, if our capital gains tax was 3 per cent to 5 per cent less than the American tax, that would signal to the world that this country wants to grow and to move from the stages that you spoke of earlier.
Senator Furey: I wish to follow up on a point that Senator Angus made earlier. Mr. Soutar, do you think we would get the same results with tax deferral rather than total elimination of the tax? Would we get the same capital mobility and hence the same investment opportunities with tax deferral?
Mr. Soutar: Any substantial reduction in the capital gains tax would have a positive impact on the country.
Senator Furey: Would you consider a deferral a substantial reduction?
Mr. Soutar: Deferral of the tax through a vehicle with a rollover provision that would allow the accumulation of wealth, which is the important factor here, would be a substantial improvement. It should be done over a long period of time so that greater wealth can be created, because that will benefit government revenues as well as the individual citizens of our country. That would be a substantial improvement.
If I were fashioning the tax myself, I would cut the rate very substantially. I would not get too technical in terms of creating vehicles for deferral, because that complicates life. The simpler, the better. However, a substantial or total deferral of taxes over a substantial period of time, such as the career of an individual, for example, would be a substantial plus in terms of the wealth-creation process and the encouragement of entrepreneurial activity.
Senator Furey: That would probably be easier to sell to the general public.
Mr. Soutar: That may well be. Our mission is to make this appealing to people and to educate people about the benefits. It is always perceived, even in the United States where they really believe in capitalism, to be a sop to the rich. It is generally thought to be such because people do not think about the implications. I strongly believe that this is a very unfortunate perception caused by lack of understanding of the process. Once you understand the wonderful power of compounding over long periods of time, you realize that the nation is losing enormously by not letting the egg grow to a great size. A deferral would definitely help in that process.
Senator Oliver: You said in response to other senators that you welcome reducing capital gains tax to zero. The Minister of Finance is not interested in increasing allowable foreign content quickly up to 10 per cent, but would prefer to move 2 per cent a year.
Could you explain to the Canadian public whether there is any danger in jumping from 75 per cent to zero? What negative effects can possibly come to the Canadian economy, or Canadians, by suddenly, in one fell swoop, removing the tax?
Mr. Soutar: There are bound to be some minor negatives. There has always been a concern that people will attempt to turn income into capital gains through various tax mechanisms in order to avoid paying capital gains tax. However, I believe that the negatives associated with the elimination of the capital gains tax are so minor in relation to the benefits that all Canadians would enjoy that they are not worth worrying about. I do not get caught up in the technicalities that the tax experts do about the fairness of one versus the other. I think there would be minor cheating in the system, but the benefits would be so enormous to all Canadians in terms of job creation and general prosperity that it is really not worth worrying about.
Mr. Dobson: In the deferral mechanism there are two things to consider. The first, about which we do not know enough, is the British model of unit trusts. In that model, the manager can buy and sell stocks within the mutual fund without triggering capital gains for the investor until he redeems from the fund. That defers the tax and would be of benefit to many lower-income people in Canada.
Second, Jack Mintz is very interested in what he calls a rollover. Like Mr. Soutar, I do not like vehicles. I prefer to have it clean and simple and for people to own their own stocks. However, if we must have vehicles, we could put all our stocks in a vehicle, switch them from the old to the more aggressive, if that is what we want, in order to build up wealth for Canada, and any time we take it out we pay tax on it. We can devise vehicles to do that. The starting point, however, is to realize that we have a big problem because Canadians are not educated in the ramifications.
Senator Kenny: Mr. Dobson and Mr. Soutar, I should also declare that I am an investor in Formula Growth.
You have made the point about the value of compound interest and about the impact of the erosion of inflation. You made the case for reduced or no capital gains tax: benefits to the investor, benefits to the government, benefits of keeping entrepreneurs at home.
I am struck with your statement on page 1 where you say:
We believe that a substantial cut in the capital gains tax would be the single most important action that our Government could do to improve the economic well being of all Canadians.
I assume that you have considered income tax and the GST. You have not really addressed that question here, unless I have missed it. Would you explain why you feel that this action would be preferable to other actions that the government might take?
Mr. Soutar: Neither Mr. Dobson nor I is an economist and we are really not capable of giving you any kind of quantitative study that could justify that statement. We have seen the incredible response in Ireland, New Zealand and other countries when they cut capital gains tax. One of the reasons we quoted Alan Greenspan, who has much credibility throughout the world, is that he believes this is probably the most important thing that can be done for the good of an economy, and he is a highly qualified economist.
That is a feeling we have. We have that feeling because we have been in the investment business for 40 years and have seen the enormous ramifications of compounding wealth over many years and what that does in terms of wealth creation. We think that that wealth creation process will happen faster with lower capital gains tax and that it will have a dramatic impact on capital investment in this country, and that is where we think the whole wealth-creation process takes place. However, I cannot prove that with any degree of satisfaction for you.
Mr. Dobson: A few years after his term, the British chancellor who put that ruling in for the mutual funds was asked by the head of the Adam Smith think tank in London what his biggest regret was. He said his biggest regret was that he did not change -- either completely eliminate or very significantly reduce -- the capital gains tax for individuals. He did it for the pool accounts but not for individuals. After he was out of office, that was his biggest regret, so there is evidence.
Senator Kenny: For the purpose of my next two questions, let us assume you are right. Let us posit that. I think it is important and useful that you have come forward and said that the creation of wealth is a desirable thing. You do not hear that very often in Canada. It is not part of the culture here. Why do you think it is not part of the culture? Why do you think people feel fundamentally uncomfortable with the idea that creation of wealth is a good thing? They do not think it is necessarily a bad thing but they are not prepared to say it in the positive. Why are so few people prepared to come forward, as you have today, and speak out in favour of it?
Mr. Soutar: That is an excellent question. We believe part of it is the fact that people are not educated at an early stage about the benefits of wealth creation. There is a perception generally that, if people get rich, they are getting rich by some shady activity, whatever it may be. I also think there is a mentality in this country of envy -- if the government does not do it for us it is not right -- and a mentality of dependence, where people would rather have the government do things for them than do them themselves. However, it is unfortunate that we do not have a more positive attitude about this issue. We seem to pride ourselves on writing articles in newspapers about people's salaries, about how much money they are making and about their stock options, and it is a very negative spin that we seem to put on it collectively, rather than putting a positive spin on it and saying is it not wonderful that someone is getting rich because, if he or she gets rich, it will benefit all of us.
Mr. Dobson: The capital gains tax started in 1972, and one of the interesting question is this: Why did it start and who started it? We have our senator here from Nova Scotia. My parents come from Nova Scotia. One night I was having dinner with Bob Stanfield, and I said, "Mr. Stanfield, you are a good Nova Scotian. You were in the Conservative Party at a time when the capital gains tax was put in, and you encouraged or did not speak about the damaging effect of the capital gains tax." He said that while he did not believe in the capital gains tax, when he came from Nova Scotia and went to Toronto, they persuaded him that this was a very rich country and that, in fairness, the riches should be spread around partly by charging a capital gains tax.
I think that has a lot to do with it. We had the world by the tail in the earlier years, with Expo 67 and even before that. When I came out of Harvard Business School in 1952, this was the country in the world young people went to. All of a sudden, it got a little overdone and people felt, "Gee, it is not quit fair. Let us share it." Little consideration was made of the damage or the significance to a young country when you discouraged and blocked capital in the early stage. That led to the attitude Mr. Soutar is talking about.
I might add that a big part is in our schools and colleges. Economics, in particular entrepreneurship, is not taught in most schools, although they are starting to in Nova Scotia. There is little education. The economists, my dear friends, are giving a tremendously misleading statement about facts of life to our students in the schools. I will be specific on that because I am making quite a strong statement. We back CIAR, the Canadian Institute of Applied Research. We put up some money from our foundation, for the economic growth part. A meeting was held here in Ottawa. I came to the meeting. Learned economists were there talking to each other and they came up, about five years ago, with the astounding idea that, in economic growth theory, innovation and technology were not part of it and did not appear. I said, "Give me a break. We have been investing for 30 years or 40 years in companies that are growing. Here is what is going on in the practical world. You are telling me that the economists have now discovered that this is what is right?"
We also talked in the paper about static growth, including the American budget office. If you change the incentive system, allowance must be made for the result -- that is, lower taxes, increased GNP and revenues. The thinking is so entirely different from the concept here, with people like us who are dealing with the dynamic growth companies. I was referring to Fonorola Inc. and other growth companies a few minutes ago. We have to have people who do that.
Senator Kenny: You have led right into my third question, which is with respect to the implication that wealth creation is a zero-sum game to some extent. If someone is getting wealthy, they are doing it at the expense of someone else. The principal argument for a capital gains tax has traditionally been fairness and equity. You have touched on that, but why not hit it directly now for us? How do you answer the criticism that comes forward that it is only fair and only just? That is why we have capital gains now and that is why we are likely to continue to have it, because no one is answering that question.
Mr. Dobson: It has to do with an increased size of the pie. If you talk to the taxi drivers of Montreal, they want business to boom. They want to see some more fat cats. There are not enough of them around. If you talk to the beggars and the various people in the street, for them to get off welfare they need someone making the pie bigger, particularly in the private sector. The problem we have in Canada today is that we have far too much percentage of the gross national product going to governments. If you change the system and you expand the pie and have everything booming, you help the poorer people whom we want to help, many of whom need help. We have to make the safety net better and bigger, and the only way we can do that is to increase the pie. So what are we going to do to increase the pie? We have to create some more productivity, wealth, whatever you call it, and to do that we have to have some capital, if we are going to do it in the private sector.
I heard in the Senate, and this afternoon in the House of Commons, words about the government investing in this, that and the other thing, and how the money was being spent. The government then decides they are going to solve the problems. We have many unemployed people so they are going to make their best efforts to do it. In my society, I would have much less government, and an incentive system where the private sector would significantly increase the amount they do, and I have no doubt in my mind, at the age of 71, that the poorer people in Canada would be much better off because we would have a bigger pie to divide up.
Mr. Soutar: Is it fair that the citizens of Canada have fallen substantially behind their neighbours to the south over the last 30 or 40 years? Is it fair that our currency has declined substantially over the last 25 years? Is it fair that we as Canadians feel impoverished when we visit Western Europe or Asia?
This issue about fairness gets in the way of what Mr. Dobson is talking about, which is making the economic pie larger for everyone. I believe that, if Canadians understood the process of wealth creation and the benefits they would derive from it, they would overwhelmingly vote in favour of a reduction in capital gains tax, even if some individuals benefited more than others. Let us face it, in the world, all is not fair.
Senator Angus: Nor equal.
Senator Meighen: I share the views of our witnesses today. You have put it very well in response to good questions from Senator Kenny. It is necessary that people get out and articulate this. Let us look at other countries -- even leaving the United States aside, although it is staring us in face. Let us look at all the evidence. Countries like Germany, New Zealand and Ireland may have just as much reason as we have to be suspicious. Nevertheless, they went ahead and did it. Do you have any information to bring to us as to how that came about? I do not think it was a referendum or a plebiscite. They did not have the example of the United States being next door. Perhaps they had good vision across the Atlantic, or maybe it was political leadership. I do not know. Do you?
Mr. Soutar: In the case of New Zealand and Ireland, they were so desperate that they were prepared to try anything.
Senator Meighen: I hope you are not saying that we should wait until that happens here?
Mr. Soutar: Economically, we have been getting very close to that. It is a tragedy that we are losing our best and brightest people. They are going outside of this country. Much of that is motivated by the opportunities that they have in other countries because of the tax situation.
If we are talking about keeping a country going over the next 20 or 30 or 40 years, then this is something that we all must think about seriously. All of us here are concerned about this country; that is, the well-being of this country, the well-being of our citizens, and having this country around for the next 50 or 100 years. If we cannot keep our best and our brightest people here, we run a serious risk of becoming irrelevant in terms of a key economy and maybe even one day becoming part of the United States. I think we are facing a crisis of proportion that requires us to move decisively on this issue.
Senator Meighen:I agree. Given that scenario, what would you say about the possibility of a reduction in this budget -- and this seems to be mooted about in the press and leaked by the government -- from an inclusion rate of 75 per cent down to 66 per cent? Will that have a negative effect, no real significant effect at all, or a very positive effect?
Mr. Soutar: I think it will have a positive effect. Any move in the reduction of capital gains tax will help. If what is being leaked in the press is to take place in the budget, it is nowhere near enough to do the kind of good that we need to do in this country. We must move decisively on this issue. If the government moves in a minor way, we should reinforce our efforts to make this issue better understood by all Canadians. It will have a benefit -- there is no question about that. However, it is not enough. It is fiddling at the margin and will not do what we should be doing for the good of our citizens.
Senator Meighen: I have a more technical question. It is my understanding that, although the Americans have a capital gains rate of 20 per cent now, they have a state tax or death tax, which we do not. Is that the trade-off? Suppose you could wave your magic wand and tomorrow we would have no capital gains tax. Would you add an estate tax?
Mr. Soutar: First, we do in effect have an estate tax because of the deemed realization upon death. If we had to make that trade-off -- and we are already paying estate duties here because of that deemed realization -- an elimination of capital gains tax and some form of estate tax is in the best economic interest of all Canadians. Sure, it stops people passing money from one generation to another, but it is not necessarily good for the children to be passed money anyway. I should like to see the government encouraging the people who are out there creating wealth, building businesses and doing things such as employing people. That is where the activity will benefit our country the most.
Senator Meighen: I wish to ask you about your investor No. 10. I think Senator Furey touched on this with his questions about deferral. That is similar to what we are told -- and I hope you will pardon me for referring to yet another leak -- may occur in the budget with respect to options, whereby taxes will only be payable on an option when it is sold rather than when it is invested.
Mr. Soutar: The move on options is being forced on the government. It is reluctantly doing this because we are moving so many people out. High profile businessmen who head up companies such as Nortel are saying, "If you do not do something about this, we are going to move more jobs than we are moving right now out of this country." This is a reaction to that reality as opposed to saying, "Let us do something of a positive nature. Let us make this place really attractive. Let us get Americans to come to Canada and build jobs and businesses and invest in the new economy. Let us get this place going." What do we do? We sit back and fiddle at the margin and react in a negative way when we are being forced in a crisis as opposed to taking a positive, proactive attitude and doing something that is really positive for the country. It is simple. Everyone sitting around this table knows how easy it would be to get this country really booming again. It was booming before we imposed this capital gains tax and it has been suffering ever since. It is almost as simple as that.
Senator Meighen: There may have been one or two other factors.
Mr. Soutar: Of course, there were other factors.
Senator Meighen: What about the different rate of capital gains tax depending upon the length of time the asset is held, as is case in the United States and some other jurisdictions? You would not be in favour of it in principle, since you prefer no capital gains tax, but what advantages and disadvantages do you see for that? In some quarters, it is said to address the question of fairness. People who flip assets would not get the same benefit as those who hang on to them for a considerable period of time.
Mr. Soutar: If I had my druthers, I would not worry about the difference between a day trade and a 10-year trade. Let us face it. There are some significant differences. If someone owns a foreign or growth fund for 40 years and gets and pays tax on that fund over a 40-year period of time, when the value of the currency has gone from $1 to 25 cents over that period of time and they are paying on the nominal amount of dollars to start with, it is a very unfair thing. That is one of the problems you have and it is one the reasons that people talk about different tax rates depending on length of time.
To us, investing is not day trading. To us, investing is backing good people and providing capital for businesses to grow over the long term. I am sympathetic to the idea of having a lower tax rate on a longer-term gain because of the inflation effects, et cetera. Frankly, when you start doing those things, you complicate the process and add enormous numbers of people who have to police and audit the activity on the part of the government and set all kinds of workloads on the part of individual investors. I would try to keep it as simple as I could.
Mr. Dobson: We have that now. If you are making a large amount of your money by trading or your main business is deemed to be trading, then you have another situation. There is a vehicle now that deals with that. It is a very hazy vehicle that has a lot of personal judgment as to whether the guy is a trader or not a trader. Traders pay one thing; investors pay another thing. You must decide which camp you are in. It is a grey area.
Senator Kroft: I had several outstanding questions, most of which were covered by Senator Meighen. We all want to get to the same place. The rigour of the debate and the discipline is very important. A recasting of your paragraph on page 1 would be helpful on future performances because it overstates, perhaps, the importance of capital gains.
I have an observation combined with a question. Basically, we are all in agreement on this point. I do not think you are trying to convince us on this particular issue, and we have quite a bit of consensus within our group. This concerns the cultural issue about wealth, which is so fascinating to me. Somehow, we tend to blame this on government. I want to test a proposition on you. Governments have a tendency to take polls and respond to what they learn in them. Perhaps that is the form of leadership in the 20th century, and that is the real world. Over the last year or two I have been interested to learn that the meaning of the word "wealth" is very different from what it was even a decade ago. There is not one financial institution that does not now offer "wealth management services". We never saw that before. If there was such a thing, it was down at the end of the hall and it was called "private client services". Now there are ads that tout "wealth management". There are even some ads that talk about "wealth creation".
We are frustrated with why governments do not do what seems to us to be obvious. The question I want to put to you -- and incidentally I am lumping you generally with the investment industry and investment management <#0107> is the following: Is the reticence of the marketing of what you do not a big part of the root of the issue? As I say, I think we have come some way. But, if the investment industry was saying more aggressively, "Let us create wealth for you. Wealth is good," I think more might be done in a cultural sense, which is very much at the root of what we all agree we are talking about here. Government will not suddenly decide that wealth is good. However, if all of you are out there running full-page ads saying, "Let us help you create wealth," do you not think it would have an enormous impact on the cultural problem we have?
Mr. Soutar: Our industry has done a bad job of selling the benefits of wealth creation to all Canadians. We have a responsibility to do it. I agree with you entirely.
Mr. Dobson: I would add that you have to watch out for those obstacles. If in 25 years you have to make 7.9 per cent to break even because someone made those the rules of the game, it is hard to convince people to go out and play with those extreme factors. That is based upon 5 per cent inflation. The actual rate of inflation is 5.3 per cent, which is what I pay when I sell something today that I have owned for 25 years.
The current inflation factor that Jack Mintz uses is 2 per cent for 20 years. At that rate, you still lose one-third of your money over 20 years. There are structural things, such as penalties, including the regulatory authorities whose job is to ensure that somebody does not get stung for doing something. All that interferes with progress. We sit on conference call after conference call, and the lawyers in the U.S. refer to the Safe Harbor Act. You have to ensure that you pay no attention to what they say because it may not be right.
The regulatory authorities, which I have touched on a bit, and the taxation make it unattractive for a certain number of people. I probably could not start Formula Growth Fund today. I came out of industry; I had not been in the business. The Quebec Securities Commission would have thought that I probably would not be very suitable to run a fund. So you see there are these regulations that interfere with the people who want to go.
The Chairman: You cannot be arguing against regulatory bodies. Perhaps not everyone is as honest as you are.
Mr. Dobson: The question would be overkill. What they gain is better than what they lose by having it there, economically.
Senator Kroft: The bulk of my questions have been pursued. I was delighted with Mr. Soutar's response. I am coming to the conclusion that this cultural issue will be changed much more dramatically outside government than inside government.
Senator Hervieux-Payette: Between lowering the percentage and holding it for one year so that the money does not start to roll too fast, which do you prefer? Would you prefer that it go down quite low and have a cooling off period of one year? Do you consider the criterion of holding the stock for one year to be a negative? It seems that it is the case in some OECD countries.
Mr. Soutar: The most important thing is a substantial reduction in the rate. If there were a time period of one year, it would not bother me.
Senator Hervieux-Payette: Let us say we are overjoyed next week with a massive reduction in rates. In light of globalization, what is there to assure us that all the money will be invested in our country? More and more, with globalization, more production can be done at much cheaper rates with the manpower in countries where there are no labour laws, no minimum wages and where there are some educated people. I think of countries like India that have many computer science experts, engineers and so on. How do we ensure that if all this money is moving around it is not moving out of the country?
Mr. Soutar: I do not think we can be assured that all the money being made will be invested in Canada. Some of it will go outside the country. The most important thing is to make us competitive with other countries. Let us face it -- Canada has a lot to offer people. We have a very small population, lots of fresh air, lots of good water, a low crime rate and a population that is generally sympathetic to looking after the poor. There are a many wonderful things about Canada that have kept us all here, not just money.
At the same time, we have fallen behind very substantially on the economic front. In my opinion, cutting the capital gains tax rate will mean more money invested in Canada than is invested right now. I do not know how many millions or billions of dollars have gone offshore; however, I suspect that it is a fairly substantial amount, because of taxes. Some of that will come back. Certainly, other people will look to Canada as a great place to come and invest if the capital gains taxes are reduced.
We have well-educated people and a great labour force. Many people here speak more than one language. We have all kinds of advantages. This is a very attractive place. The OECD tells us that all the time. However, in my opinion, where we are really uncompetitive is on this issue of capital gains tax. Yes, some of the money will go out, but more of it will be invested here. In general, I am very certain that we will be better off as a result of a lower capital gains tax rate.
Senator Hervieux-Payette: Our interest rates were always higher than those of the United States. Our rates are now lower. Do you not think that is also creating a distortion in the whole system? What is the rationale? We were told that interest rates would go down when we had low unemployment and low inflation, which we now have. Now, of course, the interest rate is very low, lower than the rate in the United States. They have lower unemployment than we have, as well as lower inflation. What is prompting us to have these interest rates?
Mr. Soutar: I am not an expert on that issue. However, in my opinion, the reason our interest rates are lower than the rates in the United States is the fact that our unemployment rate is still higher than it is in the United States. We still have available resources here, although they are shrinking very rapidly. Our rate of inflation is lower. Therefore, our central bank feels that the risks of inflation are lower here than they are in the United States. I think that the U.S. Federal Reserve is quite concerned about inflationary prospects, which is one reason they are moving quite aggressively in terms of trying to tighten up monetary policy and increase interest rates. However, I am not an expert on that subject.
The Chairman: Thank you, gentlemen. You make your points in such a way that the public can understand them, which is very helpful.
We will now hear from Professor Neil Brooks. Professor Brooks, all I know about you is that you are from Osgoode Hall Law School, although that is a very good credential. Welcome. Do you have an opening statement?
Professor W. Neil Brooks, Osgoode Hall Law School: I thank the committee for inviting me to appear on this important issue of the appropriate treatment of capital gains tax. When Senator Angus invited me, I told him that I was busy with a number of other things and would not have an opportunity to prepare a written statement, for which I apologize. I have been ill the last few days, and although I thought I might get something in writing, I have not been able to do so. I am anxious to be as helpful as I can to the committee, so if there are aspects of my presentation on which you would like a written statement or more evidence, I would be pleased to collect that for you.
It is the case that I am a tax lawyer, neither an economist nor a businessperson, and it is also the case that I will represent the other side on this issue. Indeed, I feel very much like I am representing the devil's side, but that of course is what lawyers do, I suppose.
Not only do I not think capital gains should be given more preferential treatment in the income tax system, but I also think the preferential treatment they now receive ought to be repealed. I had assumed the committee knew that when they invited me and wanted to hear the other side, or perhaps it was a mistake that you invited me.
Senator Angus: It is reverse brain drain.
Mr. Brooks: I do present the other side, so I put simply put you on notice of that.
I will make five points. I invite the committee to interrupt me as I go along. It will take 10 or 15 minutes to make the points. I will list them and then briefly elaborate on each of them.
The first point is just the obvious point that it is inequitable not to tax capital gains at the same rate as ordinary income. In making that point, I will suggest that not taxing capital gains not only obviously violates horizontal equity but also tends overwhelmingly to favour high-income taxpayers. I will also suggest on the question of tax equity that the concern sometimes expressed about the need to provide preferential treatment for capital gains because they are not indexed for inflation is simply misguided.
Second, I will argue that not taxing capital gains as ordinary income very likely leads to increased economic inefficiencies. Related to that, I will argue that the so-called lock-in problem caused by taxing capital gains only when investors sell their assets and not every year as the gain accrues is not nearly as serious as it is made out to be.
The Chairman: How do you feel about capital punishment?
Mr. Brooks: I am quite prepared to speak on any issue, as you will see, senator. We can pursue that one, if you like, as well.
Third, I will argue that a preference for capital gains adds enormous complexity to the tax system. In particular, it imposes a large dead-weight loss on the economy because of the transactional complexities that it introduces and because of the wasteful tax planning that it encourages.
Fourth, I will argue that it makes absolutely no sense to try to subsidize small, risky businesses by providing a tax break for all capital gains.
Finally, I will argue, contrary to what some others have suggested, that reducing the tax on capital gains will result in a considerable loss of tax revenue.
First, on the equity issue, I want to say this very strongly: Considerations of just elemental fairness provide the most compelling rationale for taxing capital gains at the same rate as other ordinary income. Indeed, one of the most fundamental axioms of social justice is that equally circumstanced people ought to be treated the same. It is the consistent application of that principle that gives our laws legitimacy. Everyone is treated the same if they are in the same circumstances.
In tax law, the notion that two individuals with the same ability to pay should pay the same amount of tax is indeed the underlying ethical justification for taxing income in the first place. It is simply the case that an individual who earns $30,000 of capital gains has the same ability to pay as the individual who receives $30,000 of interest income or the individual who receives $30,000 of business income. Therefore, they all ought to pay the same tax.
The idea that, for income tax purposes, all income ought to be taxed at the same rate is not an outdated idea. As I mentioned, it is the very ethical foundation of having an income tax system in the first place. Without that baseline, the definition of income becomes simply the result of the exercise of political power and not the result of the application of overriding moral principles.
The problem of horizontal equity with respect to capital gains is compounded by the fact that in any given year only 5 per cent or 6 per cent or 7 per cent of people realize capital gains. Indeed, the great majority of taxpayers never realize more than a trivial amount if any capital gains over their lifetime.
In terms of vertical equity, there is no question that any preference for capital gains will benefit primarily -- indeed, almost exclusively -- high-income individuals. In 1996, for example, the last year for which we have numbers, tax filers earning over $250,000, who constituted less than 0.3 per cent of taxpayers, realized over 40 per cent of the taxable capital gains. Taxpayers earning over $100,000, who represented less than 2 per cent of tax filers, reported over 65 per cent of the capital gains. Put it this way: The average person who earned between $20,000 and $40,000 reported capital gains of $150. The average person who earned over $250,000 reported on average a capital gain of $74,000. That is to say that high-income taxpayers on average earned about 500 times as much capital gains as middle-income taxpayers.
Those who argue that we ought to give preferential rates to capital gains suggest that those figures are not really a problem because the inequity is not as great on its face as those figures would suggest, and they make a number of points. They note that, indeed, if you look at low- and middle-income tax payers, they account for the vast majority of people who report capital gains, and that is the case. For example, of the 1.5 million taxpayers who reported capital gains, about half were earning under $40,000. However, that number is simply meaningless in assessing the fairness of a cut in the taxation of capital gains. More people in low- and middle-income groups report capital gains than in high-income groups simply because there are so many more people in those income groups. Moreover, for those folks in that group who do realize capital gains, the average amount reported is utterly trivial compared to the amount reported by high-income people.
We are not certain about this, and you cannot tell who they are from the published data. The committee might try to get some data about the people who are reporting capital gains, even though it is trivial because most middle-income people cannot even take maximum advantage of the contribution to the RRSP -- that is, they have substantial RRSP room. It is difficult to know why they are realizing capital gains outside of that. I think the answer is that of those lower income people who are reporting capital gains, many are elderly and, therefore, holding small amounts of mutual funds outside their pension plans. Many of them would be spouses or other family members of high income and individuals who are benefiting from income splitting. Many of them might be wealthy individuals who have been able to reduce their taxable income through the use of tax shelters.
Second, the proponents of a tax preference for capital gains argue that those distributional data I suggested are misleading because the category of "high-income individuals" includes people who have had fairly modest incomes all their life and then sell a small business or farm in one year and realize a large capital gain. That might be described as the "king for a day" theory. In fact, the committee might usefully look into this. In Canada, we do not have the kind of panel data that would let us make a judgment about that. However, in the United States, many studies have attempted to compute distribution of capital gains upon the same taxpayer's average income over a number of years. Those studies have found that distribution of capital gains across income classes changes very little when it is computed over a 10-year period as opposed to a one-year period. While there might be a few people who have modest incomes and have realized a large one-time capital gain in their lifetime, most high-income individuals realize capital gains year after year. Also, if the individuals are owners of small businesses, they may have been receiving substantial salaries or dividend incomes over their life and then they sell their small businesses.
For example, in one American study covering a 10-year period from 1979 to 1988, almost 60 per cent of capital gains were found to be realized by taxpayers whose average income over that period put them in the top 1 per cent of taxpayers. That should not be counterintuitive. I am surprised that anyone would question that result. In this country, wealth is distributed much more unequally than income. In fact, the wealthiest 1 per cent of Canadians own about 30 per cent of personal wealth in this country and even a much greater percentage of the financial wealth. Naturally, they are the ones who are realizing capital gains. Indeed, the wealthiest 1 per cent of families in this country own more wealth than the bottom 80 per cent of Canadians. The bottom 40 per cent of Canadians own only about 2 per cent of the personal wealth in this country, and most of that is owned in the form of homes, so it is hard to know where they could find any property upon which to realize capital gains.
Sometimes people say, "We have to give capital gains a preference in order to make it equitable because we tax nominal gains, not just real gains. Therefore, the taxation of the inflation component of capital gains is unfair. As a proxy for indexing capital gains for inflation, we ought to give preferential tax treatment for it." It is the case in an ideal world that all income from capital would be indexed for inflation. However, there is no major industrialized country in the world that has a comprehensive tax base indexation and they are unlikely to do so. It is not only technically difficult but, because of problems with the application of the foreign tax credit and other interactions between our international tax systems, also requires a degree of international cooperation that is unlikely to be achieved in the immediate future.
Given the absence of absolutely comprehensive indexation, there are a number of reasons why it makes little sense to provide some relief for capital gains as a crude proxy for indexing the tax base of capital property from inflation. First, under our realization-basis capital gains tax, taxpayers have the ability to defer paying tax on capital gains until they sell their assets. For almost all historical periods, that deferral advantage has more than offset the tax payable on nominal gains.
Second, many taxpayers who realize capital gains will have financed the acquisition of their capital property with debt. Consequently, they will experience two competing effects of inflation. On one hand, their real economic income will be less than their purely nominal income because the real value of their capital property will be diminished by inflation. On the other hand, however, they will enjoy economic income from the shrinkage in the real value of the repayment obligations.
A third consideration suggests that the tax system should not contain indexation only for capital gains or exclusion as a proxy for indexing in terms of partial exclusion. The recipients of all forms of income from capital suffer an extra tax due to inflation, including, for example, savings account depositors. It would seem grossly unfair to tax the nominal gains of those realizing interest income but not tax the nominal gains of those realizing capital gains, particularly because capital gains are often unanticipated and heavily concentrated among upper income individuals and will have benefited from deferral. If a case can be made for indexing income from capital, income in the form other than capital gains has the strongest claim to indexation.
Finally, all sorts of government payments are not indexed for inflation, including the child tax credit and the GST tax credit. It seems incongruous to be concerned about sheltering from inflation a single group made up mainly of affluent owners of capital assets while millions of Canadians are victims of inflation and they go unprotected.
In addition to equity, the other reason that capital gains should not be given preferential tax treatment is that giving capital gains preferential tax treatment leads to economic inefficiencies. The economic efficiency case for taxing capital gains is straightforward and rests on the most fundamental proposition underlying a free market economy: in order to ensure the efficient allocation of resources and to spur economic growth, capital should be encouraged always to seek its highest rate of return. If capital gains are not taxed, capital will flow to those assets and those sectors of the economy in which tax-free capital gains can be realized and away from investments that promise a higher before-tax rate of return. Such distortions interfere with the efficiency of the economy and, thus, lower the living standards of all Canadians. The empirical question about how big that cost is has not received much attention from economists, but a number of factors suggest it might be quite large. For example, if capital gains are provided with preferential treatments, individual investors can borrow to make uneconomic investments and still come out with an after-tax gain. For example, if individuals borrow to invest in growth security that, say, is realized in five years, even though the eventual gain will not exceed their interest expenses, they will make money because they will be able to deduct their interest expenses from their ordinary income at the ordinary income tax rate. They will be able to deduct their interest expenses currently, as they are incurring them, although they do not have to pay any tax on their capital gains for five years. When they eventually realize their capital gain, they will only be taxed at three quarters. That preferential agreement means that Canadians can make uneconomic investments and still make money. The larger the preference, the more serious the problem.
The Americans have recognized the time, value and money problem in this example. In an attempt to discourage investors from making uneconomic investments and then relying on the tax system to convert their pre-tax losses into an after-tax gain, they have a rule that says that in any one year you cannot deduct interest expenses in excess of your investment income. If our Department of Finance was truly concerned about making our tax system promote the efficient allocation of economic resources in this country, they might consider a rule like that.
Second, of course, if you give preferential treatment to capital gains, it not only encourages investments in assets that some people might argue yield a social rate of return, but it also encourages it in all investments that realize a capital gain, such as antiques and other collectibles, commodity futures, real estate and ingenious tax shelters. It seems to me that, for most of that whole range of investments, no one would argue there is a social rate of return beyond that gained by the investor. One might argue that the enormously wasteful boom and bust in the real estate market in the late 1980s was fed in part by the $100,000 capital gains exemption, which encouraged people to make unproductive investments or speculate in real estate.
The third point is that giving preferential treatment to capital gains is quite incongruous if you are concerned about economic efficiency, because it distorts economic financial policy. For example, it provides a tax advantage in favour of the accumulation of corporate earnings. If capital gains are given preferential treatment, it means that shareholders would rather realize the return on their investments in the form of equity appreciation rather than dividends. Consequently, it encourages corporations to accumulate capital, which makes them less dependent on new stock issues to finance growth, and the security marketplace is less able to perform its function of allocating capital to projects where a fast rate of return is earned. Somewhat ironically, if you give capital gains preferential treatment, the bias is in favour of existing firms accumulating their capital rather than paying out in dividends. Of course, the bias is a system in favour of existing firms over new firms, even though the capital gains exemption is frequently justified as a means of providing assistance to new and small firms.
Those who argue in favour of giving preferential tax treatment to capital gains argue that while not taxing them might lead to the misallocation of resources, taxing them at the full rate leads to a more serious efficiency problem -- namely, the locked-in effect. They say that investors will be discouraged from seeking investments they think will run the highest rate of return because they will have to pay tax on their capital gains if they sell their existing holdings.
There are two issues here, both of which have been subject to a substantial amount of study, although the results are still controversial and uncertain. One issue is the question of the extent to which the lock-in effect actually influences investor behaviour. The second issue is whether, even if investor behaviour is influenced, that has an effect on economic efficiency.
In terms of whether or not the capital gains tax actually has a lock-in problem, one can think of all sorts of taxpayers that it cannot have any effect or have very little effect on. It obviously has no application to tax exempt institutions such as pension funds. It does not apply to those situations where shareholders are forced to liquidate their assets because of mergers or acquisitions. It is unlikely to affect investors who are liquidating their assets for consumption. It does not apply to situations where business is selling assets and acquiring other assets, because there is a rollover in the act for that. It does not apply with much force to assets in which the gain is not large. It is unlikely to apply to someone who has a diversified portfolio, because they likely would be able to sell an investment, realize a gain, and then sell some of their losses to shelter the gain.
It applies with much less force in Canada than it does in the United States. Even if it is a problem in the United States, it is likely to be much less of a problem in Canada, because we unlock those gains when the investor dies, and the Americans do not. They give the investor a stepped-up cost based on death, thus there is an enormous incentive in the United States to hang on to your invesments that is not present in Canada.
There is a raft of studies on the impact of the lock-in effect in the United States. I do not want to take up your time by going through those. I am quite willing to submit those studies to the committee. They show that when you reduce the capital gains rate, in the short term you might get realizations as people unlock their investments, but in the long term, the rate on capital gains does not appear to affect realizations.
Even assuming that the capital gains tax does lock-in some investors, how serious is that for economic efficiency? We do not have good evidence of this in Canada, and the committee might want to dig out whatever studies are available. Intuitively, I would argue that it cannot be very serious. It cannot be very serious, because those who make the argument that the lock-in effect has some serious effect on the efficient allocation of resources are contemplating, presumably, an investor who makes an investment that is yielding a low rate of return and who thinks he can earn a higher rate of return in some other investment. An economic inefficiency will result only where the person who is locked in to an investment has some special knowledge of a more lucrative alternative investment. Otherwise, the person that investor would be selling to would make the other investment.
In other words, it is difficult to see how capital formation can be affected because some investors have locked in to particular investments. While one investor might be tied up, it means that other persons who might otherwise have purchased that investment now have funds available to use elsewhere. There are always two investors on both sides of the stock market transaction, and while of course individual investors have different aspirations and ability, generally it is likely that the potential buyers of a locked-in investment would use their available funds in much the same way that the locked-in investor would. You cannot create investment. To unlock that person, someone must consume some investment. That money might well have found its way into the very investment the unlocked person would have invested in.
The case for taxing capital gains at the same rate as ordinary income can be made in terms of equity. It can be made in terms of economic efficiency. It can be made in terms of simplicity. No one I know who is familiar with the technical operation of the tax system argues that not taxing capital gains simplifies it. It enormously complicates the tax system. We can talk about that, and I can give you all sorts of folks who are familiar with the topic. Indeed in the United States, commentator after commentator says that giving capital gains preferential treatment is the single factor that most complicates the tax system and leads to all sorts of transactional waste in the economy.
Finally, let us assume that there are good tax arguments for taxing capital gains at full rates, or at least not giving them a preference. Aside from the tax arguments, some people argue we should give them a preference, not for reasons of tax justice or economic efficiency or because it will make the system simpler. We should give them a preference because it is necessary in order to channel investments into small, risky businesses -- start-ups and high-tech businesses. If capital gains are taxed at ordinary rates, it will discourage people from making those high-risk investments.
To me, that argument is absolutely without merit for the following reasons. First, what is so great about financial risk taking? There is no reason a priori to think that risky investments are more productive than prudent ones. Given the enormous rate of return that taking some financial risks obviously yields, why not let the market decide where capital should be allocated? Why do we need an implicit industrial policy to encourage risk taking?
Second, even if the government should intervene in the marketplace to divert capital to risky investments or to encourage entrepreneurship, providing a subsidy for capital gains is not a cost-effective way of doing that. A subsidy is enormously, ridiculously target inefficient. Indeed, it makes the government jobs fund program look like a cost-effective and tightly administered program by comparison.
Subsidy is both over- and under-inclusive. On the one hand, preferential tax treatment for capital gains benefits many investments that do not involve taking risks at all. Moreover, many of those are non-productive, and the supply is inelastic. A prime example is speculation on unapproved land. Although land is the most obvious case, it also gives unjustified benefits to artworks, antique furniture, precious metals, currency, cottages, ski chalets -- a whole range of investments. Even if the subsidy could be restricted to corporate stock...
The Chairman: Your two minutes were up about five minutes ago.
Mr. Brooks: I am quite prepared to stop and answer questions. I will just make this one point. Even if it could be restricted to stock, studies in the United States have shown that stock that might be described as stock of high-risk venture capital companies makes up about 2 per cent or 3 per cent of the total trading in stock. Therefore, if you try to target a subsidy of those companies, you are, in effect, giving the subsidy to everyone out there who is trading in blue chip securities. It is enormously target inefficient if the justification for it is to encourage risky venture taking. As well, you lose a lot more revenue than people have predicted, but maybe people will raise that in questions.
In conclusion, for those interested in raising the real standard of living of all Canadians, reducing the tax on capital gains is a false step. It would largely be a windfall to the rich, since all investors would get it. They would get it even on their existing investments. Therefore you would not be altering their behaviour in any way. You would be giving them all a windfall. Furthermore, it would be bad for the economy and bad for the budget.
The Chairman: Speaking for myself, I think you have missed the point completely. However, my colleagues may not agree with me. I also think that you are taking a basic premise that Canada is an island and we do not have to compete with the rest of the world.
Senator Angus: I notice that you are a professor at Osgoode Hall. Could you give us more detail on that?
Mr. Brooks: I teach tax law and policy at Osgoode Hall Law School. I have been there for 25 years.
Senator Angus: Is that your full-time job?
Mr. Brooks: That is my full-time job, absolutely.
Senator Angus: What are your academic credentials?
Mr. Brooks: I do not have a Ph.D. I have a degree in law, and I have been teaching there for 25 years. I do what all academics do: I consult with governments, I write and publish academic papers, and I teach.
Senator Angus: Where were you before you taught at Osgoode?
Mr. Brooks: I have been teaching there for 25 years. Before that, I graduated from law school, clerked for a judge at the Supreme Court of Canada for a year, taught in the United States for a few years, and worked at the Federal Law Reform Commission for a few years.
Senator Angus: Were you here when the last two witnesses were here?
Mr. Brooks: I came in near the end of their testimony.
Senator Angus: I saw you sitting in the back. Was there anything at all that they said that you agreed with?
Mr. Brooks: Nothing -- but I did not hear it all. They might have said something at the beginning.
Senator Angus: We will give you a copy of their statement. If there is anything, by chance, please let us know. I appreciate your candour because it makes our job so much easier in terms of questioning you. We have had other professors here, like yourself, who are dedicated Canadians and thoughtful academics and we listened very carefully to what they had to say. One of them was Professor Grubel. Do you know him?
Mr. Brooks: I know Herb Grubel because he was on the House of Commons Finance Committee for a number of years and I used to appear before that committee from time to time. If you would like to know, I never agreed with anything he said either. Or put it this way: he never agreed with anything I said.
Senator Angus: It is good of you to put it in that perspective. There are two sides to every issue.
I was absolutely stunned with the degree to which you were able to articulate your thoughts, apparently without a note or anything. I admire wordsmiths and people who can express themselves clearly. I had the clear impression that your issue is preferential treatment of capital gains, as opposed to other issues such as the brain drain of our best and brightest to the U.S. or our adaptation to the new economy. Those are the buzzwords out there that I gather are the objects of a legitimate debate that is going on in public policy circles, in government and even in law schools.
On the subject of preferential taxation, you were making the point that only the very rich are affected, as addressed by these other witnesses. Mr. Grubel estimated that about half the people who declare capital gains have an income of less than $50,000 per year.
Mr. Brooks: I agree with that. That is correct. That is just because the people who earn less than $50,000 include about 80 per cent of Canadians. The capital gains they realize are utterly trivial. My hypothesis would be that they are primarily elderly people realizing a bit of capital gains on mutual funds that they hold.
Senator Angus: So that is not a big issue really in terms of revenues. You also said that the revenue lost to the fisc would be much greater than we are being told by other witnesses.
Mr. Brooks: Exactly.
Senator Angus: We are told that it is de minimis. Can we explore that a little more? Why do you say that?
Mr. Brooks: Presently, the best estimate is that the government collects about $1 billion from capital gains. The number you see is $900 million. The number is that low because approximately $1 billion is sheltered by the $500,000 lifetime capital gains exemption. Also, quite a bit of it is not taxed because people are offsetting interest expenses against their capital gains. There was over $9 billion of taxable capital gains reported in 1996, which is the last year for which we have data. Since most of that was reported by high-income earners, one might have assumed that the total tax collected would be half of that number. Yet it is only at $900 million, and that shows only the federal loss, incidentally, and not the provincial losses. About $1 billion is sheltered by the lifetime capital gains exemption.
Senator Angus: I suppose that amount is in RRSPs. That is all sheltered, is it not?
Mr. Brooks: Yes. Those investments will not be reported as taxable capital gains, but lots of investments are held in there, particularly by middle-income people. Why would they not be holding all their investments in RRSPs?
It is important not to give a preference to capital gains. Otherwise, you will lose more revenue than you might think. Here is the reason. If you give a preference to taxable capital gains, all taxpayers now have an enormous incentive to convert other types of investment income, even labour income, into capital gains. Even though the capital gains revenue might not look like it has been affected much by this preference, you will in fact lose all sorts of revenue from other kinds of income. If you reduce it very much, why would corporations ever pay dividends?
Senator Angus: It may create some jobs and do some good things for the economy.
Mr. Brooks: It might, but if you want to do that, then reduce the corporate tax rate. All corporations get the same break and they get it on all forms of income. If you want to jig with your tax system in order to encourage economic activity, you should do it in a way that is broadly based so that you do not distort investment decisions.
Senator Oliver: It is distorted now.
Mr. Brooks: That is my point. It should not be. You should remove those preferences. The reason that taxing capital gains is so important is to act, in effect, as a backstop for your tax system. Ask any tax lawyer, "Can you convert dividend income into capital gains or labour income?" They will tell you in a minute that they can do it. They get paid enormous sums to do that and they will do that.
If you give a preference for capital gains, so much pressure is placed on the margin between capital gains and other types of incomes that everyone will place their income in capital gains. It may look like you are not losing much revenue, because lots of capital gains are still being realized; yet you will have lost a significant amount of revenue on these other points.
Senator Meighen: Is that what happened before 1972?
Mr. Brooks: That is exactly it. Here is a good example from pre-1972. The rate on ordinary income then was 80 per cent. Incidentally, as some people keep pointing out, that is what I call the good old days when high-income people really had to pay tax, but we all know they did not pay tax back then. When the top rate on income was 80 per cent, we had the highest rates of economic growth and the lowest rates of unemployment. Why not go back to 80 per cent? Maybe that is what did it. We know that most people were not paying that rate because they were able to convert their otherwise taxable income into non-taxable capital gains.
When the Carter commission recommended bringing the tax rate down to 50 per cent and taxing capital gains, the tax burden on high-income people went up enormously. That is why the government did not do it. There is no question that, before 1972, very little income was taxed at 80 per cent because it was so easy to convert it into taxable gains and make it tax-free.
Senator Angus: Germany has just reduced their capital gains tax rate to zero. Australia, New Zealand and Ireland have made big changes. I take it they are all making a terrible mistake?
Mr. Brooks: They are making a terrible mistake. First, we have to get the facts right. New Zealand did not reduce its capital gains rate. It has never taxed capital gains, even back when it was governed by socialists.
I do not think Ireland had much of a capital gains tax but, even if they did, Ireland is growing because they are attracting foreign investment, not because their own people are investing. It has nothing to do with the local tax rate.
Senator Oliver: What about Germany?
Mr. Brooks: I do not know the German case. Think of it this way. Many European countries do not have much of a capital gains tax and never have. One reason is their net-wealth tax. They tax people on the value of their wealth every year. Furthermore, they tax them on their wealth again when they die. They have never worried much about a capital gains tax. When you compare across countries, you must compare all aspects of the tax system or the comparison will be misleading.
The United States has always had one of the highest capital gains tax rates. Clinton cranked up the top rate in 1993, but between 1986 and 1993, the Americans taxed capital gains at the same rates as ordinary income. The federal government taxed about 28 per cent. Some of the individual states hit gains with another 7 per cent. Combined, that would almost reach the Canadian rate. Yet that is the period when the high-tech industry in the United States just boomed.
If capital gains make such a difference to capital investors, why are all these Western European countries not brimming with venture capitalists? They are not and they have never had capital gains taxes. That tells us that something else is operating here, other than the rate on capital gains tax.
Senator Meighen: This committee is studying capital gains tax because it is considered by some people to be a significant reason for this country's perceived lack of entrepreneurship, perceived lack of capital formation, lack of inflow of foreign capital, the so-called brain drain, et cetera. You have made a forceful case that capital gains has not caused the problems. What is the problem? Is it the level of taxation across the board or are there other factors?
Mr. Brooks: It is not level of taxation across the board, because, for example, Ireland has about the same percentage of their GDP in taxes as we do. What made Ireland unique is that they reduced the taxes on foreign corporations to 10 per cent. The tax on local corporations was 35 per cent. Some people say that is why they attracted all this foreign investment. The OECD got upset and said that that is harmful tax competition and that they had to get in line with the other countries. Ireland has now proposed that their corporate tax rate be 12.5 per cent for all corporations. The OECD is clearly unhappy about that as well, because Ireland probably did not generate any new investment. They only attracted investment from other countries. That is a game only one country can win.
They won in part because of the taxes, but also in part because the European Union was dumping billions of dollars of subsidies into Ireland in the 1980s and Ireland has always put a lot of money into education. There was a confluence of factors. Some would argue that, in terms of international comity, industrial countries ought not to be doing a run on one another's treasuries in the way that Ireland did. Most industrial countries were pretty upset by that. If Germany had done it, you can be sure that we would be upset.
It has nothing to do with the capital gains rate.
Senator Meighen: What does it have to do with?
Mr. Brooks: Canada is one of the wealthiest countries in the world. In the late 1980s, in ranking of wealth there were Luxembourg, Switzerland, the United States and then Canada. Over the last decade, we have dropped into sixth or seventh place in purchasing power parity with other countries.
The most important reason we dropped behind the United States is simply that in the 1980s and early 1990s the labour participation rate in both Canada and the United States was about 63 per cent. By 1997, the American rate was still 63 per cent but ours had dropped to 59 per cent. They had 4 per cent more of their population working. If you have 4 per cent more of your population working, you will generate a lot of economic activity and your standard of living, on average, will go up.
I believe that most people would say our labour participation rate dropped because of our monetary policy. In the late 1980s and early 1990s, we had a historically unprecedented differential between Canadian and U.S. interest rates. That threw us into a recession that went on for much longer than the American recession. It had nothing to do with our tax rate. We were throwing people out of work quite deliberately by manipulating our monetary policy, and the price we paid for it was a lower standard of living.
One of the previous witnesses said that if everyone becomes better off, the poor will become better off as well. That is just wrong. While it is the case that the average American is better off than the average Canadian, which you hear all the time, that is in fact a meaningless number. There is no average person. The way you get the average is to divide the total national income by the population. The reason the American average is higher than the Canadian average is that they have a whole bunch of obscenely rich people, which drags up the average.
Two studies have been done on the relative purchasing power of Canadians and Americans and they show that right up to the sixtieth percentile, Canadian families are better off than American families. The median Canadian family is today better off than the median American family in terms of purchasing power.
Senator Oliver: Is that after tax?
Mr. Brooks: That is after tax, and it does not even count the additional government services that the Canadian family gets in terms of education and health care. That goes right up to the sixtieth percentile.
In the United States, there is an enormous divide between obscenely wealthy and very poor Americans. That, of course, puts their average above ours, but that is just a statistical construct.Why would we want to emulate a society in which the typical family is worse off than ours even now?
The Chairman: I really think you have that upside down.
Mr. Brooks: I will be pleased to send you those studies.
The Chairman: In the last ten years, average family income in Canada has gone down 2 per cent and in the United States it has gone up 18 per cent.
Mr. Brooks: That is just wrong. Again, the average numbers do not mean anything because to get the average you just take total income and divide it. What about the person who is right in the middle? What is happening to the median person? I assert that the median Canadian family is better off in terms of purchasing power than the median American family.
Senator Oliver: Why do we have a brain drain?
Mr. Brooks: We can all make a political choice about the kind of society we want to live in, but the most recent United Nations Human Development Report developed an index of human deprivation based on literacy rates, social exclusion, long-term unemployment, poverty rates, et cetera. Of the 17 industrialized countries, the Americans came right at the bottom; that is to say, there is more human deprivation in the United States than there is in any other industrialized country. Why would we want to emulate that?
Senator Angus: There seem to be many people who do.
Mr. Brooks: I do not know if that is correct, senator.
Senator Angus: There is a large influx into the U.S. There must be something good about it.
Senator Hervieux-Payette: My interest in this subject started long ago. I come from Quebec, where those who profited were the entrepreneurs while the poor employees were deprived. The entrepreneurs walked away with all the benefits of the company and bought a house and boat in Miami. We started to understand our economic system when we introduced the Quebec savings plan. We learned then that it was better to finance companies with good equity and less debt in order to be less at risk. We do not all think that it is a dream world for rich people to have capital gains. Through that process, many people bought shares and were initiated. The day that my friend who is a social worker bought shares was a good day for me, because my friend had joined the modern economy.
In the 1980s, I chaired an employee stock ownership committee. In our report we said that it is a good thing for employees to be associated with the success of a company and to be rewarded with both salary and stock. If we accept your argument that everything should be taxed the same, my scheme of employee stock ownership is meaningless. Why not pay only salary if everything is taxed in the same way? I do not advocate forcing people to buy stock. It is a matter of changing the mentality. When employees buy stock, it creates a sense of partnership and belonging. The Americans have followed that route to a much larger extent than Canada. Some say that capital gains are just for the rich, but employee stock ownership programs have been useful in the United States to ensure that employees own a piece of the enterprise. That is how they participate to a greater extent in their economy than the Europeans do. In Canada, we are coming slowly to that.
I agree with many of your arguments and I follow you on the issue of participation rate. How do you motivate the new generation to have initiative, take the risks and open new companies if they are not rewarded with a little bit of an incentive?
Mr. Brooks: Interestingly enough, I am arguing that you ought to let the markets operate. I am showing some confidence in the ability of markets to allocate resources. That is what I have against employee stock options, if the government wants to give more favourable tax treatment. If it made sense for companies to issue stock options to their employees because their employees were more committed to the firm or more productive, then companies would do it without a government subsidy because it would make economic sense. If it makes economic sense, do it. If it does not make economic sense, do not have other workers subsidizing you. What is that all about?
The Chairman: I do not understand. What do you mean by "other workers subsidizing you"?
Mr. Brooks: I am saying that if you do not tax employees' stock options so that people who receive them have to pay tax based on their ability to pay, and if you allow them to defer paying tax, or if you give them a one-quarter exemption as we do under the present rules, then, in effect, you are subsidizing them.
Senator Furey: You are saying it is a subsidy if you have to pay on exercise rather than on sale.
Mr. Brooks: The present subsidy is that when you exercise your employee stock option you get a one-quarter deduction under the Income Tax Act.
Senator Furey: If I exercise my options and I have to pay on exercise rather than on sale, how can you call that a subsidy?
Mr. Brooks: Under the present law, you do not have to pay tax on the whole gain. If you buy $10 worth of stock from your employer and only pay $1 for it, you are $9 better off. You are equivalent to someone who has received $9 worth of salary and you should pay tax on that $9.
Senator Furey: That is on the straight purchase of a stock, that is, exercising a stock option. If I exercise my option, I have to pay the capital gains at the point of exercise, not at the point of sale. Is that what you are calling the subsidy?
Mr. Brooks: No. The subsidy in the present act is this: When you exercise your option, when you buy the stock from your employer, and you get to buy stock worth $10 for only $1 because that is the strike price of the option, at that point under the present law, generally, you then have to pay tax on that $9 because you are $9 better off. You are $9 better off and you should have to include it in your income, and you do under the present system. However, you are also entitled to exclude one-quarter of it from your income. That is a subsidy.
The Chairman: You have not answered Senator Hervieux-Payette.
Mr. Brooks: Even if you wanted to subsidize employees in a way that would encourage them to buy more stock of their employer, and even if you thought that markets are not operating perfectly out there -- let us say the employer is irrational or the employee is irrational, because they do not appreciate that they will be better off if they get stock -- and if you thought you wanted to do that, you thought that was good government policy and you wanted to interfere in the marketplace in that way, exempting capital gains would not be the way to do it. The way to do it would be to set up the kind of ESOP funds that the Americans have.
The Chairman: That was not the question. How do you motivate people?
Mr. Brooks: You pay them for their work. That is how you do it.
Senator Hervieux-Payette: We have two big labour unions in Quebec. One is a public service union and the other is in the private sector representing the construction people. They started buying shares. They started investing in companies where employees were working. Of course, their pension fund is also invested in that. We see the big difference. On one side, you have strikes that are going on over and over again. In the other group, strikes have practically disappeared. When people have a stake in their enterprise, there is a very different pattern in terms of their behaviour. There is more productivity. Employees are more willing to sacrifice their own time to ensure that the company survives when there is some problem. I say this is a reward for taking the risk as a group and going as a venture in the competitive world. You seem to deny the fact that employee stock ownership has created a different attitude. If you do not give them any incentive in terms of taxation, then I agree with you, what is the point of owning any shares? You say, "Just pay them." You just pay them, except the onus of making a success of the company falls only on the one that has invested in it.
My experience is that employee stock ownership has produced a significant amount of good productivity in companies that have it. There are many studies proving that.
The Chairman: May I suggest to you that you are missing a major point. You say, "Just pay them." What happens if you are a young company and you do not have the money to pay them? All you have is stock and hopes for the future.
Senator Angus: Why is the witness laughing?
The Chairman: Do not laugh so easily. In 1957, I founded a company called Fairview. By 1972, it had become Cadillac Fairview. I can tell you that during the 1950s and the 1960s we did not have money to pay people. I also needed entrepreneurs. How was I to get an entrepreneur?
Mr. Brooks: Give them stock options, then. That does not mean we have to subsidize you, does it? If it makes sense to you and your employees, then give them options. When they exercise them, make them pay their fair share of tax.
The Chairman: Instead of a high salary, they have the hope of making a capital profit maybe 20 years down the line.
Mr. Brooks: Sure.
The Chairman: If they are fully taxed, there is no profit at all.
Mr. Brooks: Why not?
The Chairman: Do you have any more questions, Senator Hervieux-Payette?
Senator Hervieux-Payette: No.
The Chairman: We are bringing this to an end.
Mr. Brooks: Do you not want me to answer?
The Chairman: No. Thank you.
The committee adjourned.