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

Issue 4 - Evidence, December 16, 1999

OTTAWA, Thursday, December 16, 1999

The Standing Senate Committee on Banking, Trade and Commerce met this day at 11:10 a.m. to examine the present state of the domestic and international financial system (Capital Gains Tax).

Senator E. Leo Kolber (Chairman) in the Chair.


The Chairman: This morning we will continue our study of the pros and cons of capital gains tax and what to do about it. With us today is Margo Thorning, from the American Council for Capital Formation. She has a Ph.D. in Economics from the University of Georgia. She writes and lectures on tax policy and economics and is frequently quoted in the national and local press. Dr. Thorning has testified before various House and Senate congressional committees. I am an avid reader of what she writes. This is her first trip to Ottawa. Welcome, Dr. Thorning. Please proceed.

Ms Margo Thorning, Senior Vice-President and Chief Economist, American Council for Capital Foundation: Thank you very much for the opportunity to discuss capital gains and tax reform with you. I am very honoured to be here. I should like to submit my written testimony for the record, as I intend to refer to a few of the tables in it as we proceed.

First, I should like to give you some background on the American Council for Capital Formation. The council was started back in 1975 by a group of business executives, CEOs of companies like Warehouser and Motorola, and by a Deputy Secretary of the Treasury, Charles Walker, who felt that there was a need in the U.S. for a group that would focus on how to encourage saving investment, capital formation and economic growth. We were started with the purpose of focusing on issues like capital gains. Capital gains taxation was very high back in the mid-1970s.

Table 2 shows that our capital gains rates have varied from around 35 per cent for individuals down to the current 20 per cent top marginal rate for individuals. However, back in 1975, when the council was started, the tax rate for individuals was 35 per cent, and it was 30 per cent for corporate capital gains. So one of the early focuses of the American Council for Capital Formation was the amelioration of the very high taxation on capital gains.

Subsequently we broadened our focus. Now we do a lot of work on various tax issues, including corporate taxes, foreign taxes, environmental issues like climate change, and other public trade issues, but in the early years, we were primarily focused on saving and capital gains taxes. We are non-profit and we are bipartisan. We have republican and democratic members on our board of directors. We are supported by a wide range of industries: finance, insurance, banking, manufacturing, utilities. We have about 25 trade association members from all spheres of U.S. industry, as well as numerous individuals who care about issues like death taxes. We do a lot of work on death taxes, too.

We have a centre for policy research, which has stars from the academic world, such as Dale Jorgenson from Harvard, who is the incoming president of the American Economics Association, and people from MIT and Stanford -- the top scholars. It is my great honour to draw on their expertise as I try to shape the policies that the council will focus on.

Before I move into capital gains taxation in the U.S., let me set the stage and explain to you why capital gains tax reform fits into the solution to one of the long-term U.S. problems. You probably think from the papers that all is well in the U.S. It is true; we are doing pretty well right now with a very good rate of economic growth and record low unemployment. You might ask, then, why the council would be focused on further tax policy changes. The answer is that some big problems will hit the U.S. in about 15 years, as the baby boomers begin to retire. We will be faced with two workers supporting every retiree, versus the current three workers. That will mean either big cuts in social security benefits or significant increases in taxes. We are in a golden period right now, but there is no guarantee that in 10 years or 15 years we will not be struggling with difficult social and tax issues.

We also have a low saving and investment rate compared to the rest of the world. We save less than everybody, and we invest a relatively small amount of GDP compared to our international competition and compared to the past, in the 1960s and early 1970s.

One of the things I want to talk to you about is how we see capital gains tax reform and tax cuts fitting into the goal of developing a modern tax system that can deal with the challenges of the 21st century and encourage more saving and investment.

In 1997, the Joint Committee on Taxation asked 10 of our top public-finance scholars and modellers to compare the economic impact of a pure consumption tax with that of a pure income tax. A pure income tax eliminates all personal deductions and exemptions. It taxes labour and capital at a single rate, which would mean that capital gains would be taxed on accrual, most likely, rather than on realization.

With a pure consumption tax, in contrast, all saving is tax exempt at the individual level, including capital gains. You would not pay tax on that. All investment is expensed -- first year write off -- which of course would lower the cost of capital in the U.S. If we had expensing, it would lower the cost of capital for new investment by around 25 per cent to 30 per cent.

The modellers that the Joint Committee on Taxation convened examined the long-run economic impact of those two alternatives. Table 1 in my testimony shows the different results the modellers got in terms of the impact on real gross domestic product, real GDP, and on the capital stock. The consumption tax in the majority of cases provides much stronger GDP growth and much greater increase in the capital stock. For example, Dale Jorgenson's results show that over the long run, after 2010, GDP growth would be 3.3 per cent higher per year. That is not trivial. In today's terms, that is around $300 billion a year to enjoy if we switched to a pure consumption tax.

He shows the capital stock as being about 0.3 per cent higher, whereas, in his estimation, the capital stock would shrink, relative to the baseline under the unified income tax, by 2.6 per cent. Of course, real GDP growth is much smaller. I throw that in as an example of the work done by top scholars in the U.S. trying to find the optimal tax system in terms of stimulating economic growth. The preponderance of scholarly research suggests that we would all fair better under a consumption tax.

There have been a few proposals for a consumption tax. For example, the head of our budget committee has repeatedly introduced a pure consumption tax that would fit right in with the models that the Joint Committee on Taxation estimated. Steve Forbes, one of our presidential candidates, also has a pure consumption tax proposal out there. Those do have some foundation in political reality. People are talking about them.

We see capital gains tax reductions, such as the ones we had in 1997, as a way of helping to move the U.S. tax system toward a consumption tax where the tax on saving is lighter. We believe that the less you tax something, the more you get of it, and we think that the tax changes we saw in 1997 and 1998 were favourable.

Table 2 is a comparison of the top rate on individual income and the top capital gains rate. For example, under the individual section of that table, the ordinary tax rate in 1942 was 88 per cent on top rate on ordinary income. The capital gains rate in 1942 was 25 per cent. I present this to you just so you can see the enormous variation that the U.S. has experienced in capital gains tax rates. They have changed 11 times in the 58 years since 1942.

Right now we have a top marginal federal tax rate of 20 per cent for individuals and 35 per cent for corporations. Many states also tax capital gains, but not at nearly the rate that your provinces tax capital gains. We have experienced great fluctuations in rates, and we can document that during periods of lower rates there are very positive impacts.

This summer, David Wyss of Standard & Poor's DRI, McGraw-Hill, undertook to try to examine the macroeconomic consequences of the capital gains rate changes that we experienced in 1997, when we cut the top marginal individual rate from 28 per cent down to 20 per cent. He has a large general equilibrium model that takes account of the differential impact of price changes throughout the system. His results are encapsulated in Table 3 in my testimony.

They show that the 1997 tax cuts, where we took the rate down from 28 per cent to 20 per cent, had a positive impact on real GDP, increasing it by about 0.4 per cent over the 1998-2009 period. Investment is increasing and will continue to increase by about 1.5 per cent per year. Capital stock is higher, productivity is increasing, and the cost of capital for new investment went down by about 3 per cent. His estimates also show that federal tax revenues increased by about $5 billion over that period. The tax cut not only increased investment and GDP and so forth, but it paid for itself.

Capital gains tax receipts are a fairly significant share of tax receipts in the U.S. About 8 per cent of all income taxes stems from individual capital gains. In 1996, the capital gains tax revenues flowing into the U.S. Treasury, the federal tax revenues, were $62 billion. In 1997, when the rate was cut, they went up to $80 billion. In 1998, the Treasury estimates we will receive $84.6 billion from individual capital gains tax receipts. Revenues are rising; even though we have cut the rates, we are receiving more tax revenue.

David Wyss's results show that maybe a quarter of the increase in the value of stocks is attributable to the cutting of the rate in 1997. You can see in Figure 2 about a quarter of the increase is due to changes in asset prices because the tax on the investment is lower.

I was privileged to read the testimony from some of the previous witnesses. Part of your focus is on how capital gains rate changes might impact entrepreneurship and new business start-ups. We at the council have gathered data and done research on that for the last 12 years or 15 years. Since I have been at the council that has been one of our focuses. It is difficult to document. However, Professor Wetzel at the University of New Hampshire has done many studies, including ones that analyze where new high-tech companies obtain their start-up funding. His research suggests that a significant portion of seed money comes from taxable individuals.

One of the arguments we hear in the U.S., when we try to make the case that entrepreneurship and start-ups really do depend on taxable individuals who care what the capital gains rate is, is that so much money that flows into venture capital funds comes from non-taxable sources, pension funds and so on. That is true. The formal venture capital network does get a lot of money from non-taxable sources, maybe as much as 60 per cent according to the latest estimates from the National Venture Capital Association. Nonetheless, even the formal network is getting 15 per cent or 20 per cent of its funds from taxable individuals. Most of the start-up situations do not tap into the former venture capital network. Usually, an entrepreneur goes first to friends and family for money to start up a new venture. Then he may try to find wealthy individuals who would like to be part of the enterprise, and that is where the angels come in.

Angels are very sensitive to the tax rate, given that start-ups are very risky and two out of three fail. Anecdotal evidence, along with a bit of survey evidence from Professor Wetzel, shows that angels are very sensitive to tax, and the lower the tax rate, the more they are inclined to provide start-up money.

Stephen Prowse, an economist at the Federal Reserve Board of Dallas, did a survey of high-tech firms and found that more than half of them had relied on angels for part of their seed money just to get off the ground. It is clear that in the U.S., the high-tech start-up companies do depend on taxable individuals. For them, the difference between a 28 per cent tax rate and a 20 per cent rate is quite significant.

Furthermore, David Wyss looked at this issue and concluded that venture investment really does need incentives from the tax code, because investors are tax- or risk-averse, but society gains. If one out of three new start-ups is a big success, that will more than offset the losses of the two that failed. Society gains when a Microsoft or an Apple takes off. Those sorts of enterprises need to be encouraged through favourable tax policy.

In the U.S., we have also questioned the equity of cutting capital gains tax rates. What about middle-income taxpayers? Is this just a giveaway to the rich? However, it is evident from the data that reducing capital gains tax rates is not just a giveaway to the rich.

A recent study shows that three-fourths of all U.S. households have capital assets and that 30 per cent of the value of the assets are held by families with income of $50,000 or less. The latter number comes from Leonard Burman, who is a deputy assistant secretary for tax policy at the U.S. Treasury. He documents that the ownership of capital assets is widespread. The latest data we have from the Security Industries Association shows that almost half of all U.S. households own equities. In the U.S., stock ownership is growing. Ownership of other types of capital assets is very widespread; therefore, everybody benefits when capital gains tax rates are taken down.

Further, new work by the Congressional Research Service, a branch of the U.S. Congress, suggests that our current capital gains tax system, which has a top marginal rate of 20 per cent, a 10 per cent rate for individuals and a 15 per cent tax bracket, adds to the progressivity of our current tax system. One research economist at CRS concluded that our current system of capital gains taxation is adding to progressivity and helping to redistribute income. Thus, the argument that lowering capital gains tax rates is just a boon for upper-class, fat-cat taxpayers is not accurate.

How do other countries tax capital gains? We commissioned Arthur Andersen a year or so ago to look at 24 countries, including Canada, to see how individual and corporate capital gains are taxed. Tables 4 and 5 show the average for the 24 countries. These are just federal taxes, so I know your rate looks artificially low here, 23.5 per cent, because the provincial taxes are not counted. In Ontario, the provincial tax brings the rate up to 40 per cent, I think; is that right?

Most of the world is taxing long-term capital gains at an average of less than 15 per cent on the sale of the asset, so the U.S. rate, at 20 per cent, the top marginal rate, is still above the international average. Of course, we still have a one-year holding period in order to qualify for long-term capital gains treatment, Most other countries do not have that.

Australia has just lowered its capital gains tax rate. It went from a high of 48.5 per cent on long-term gains, with indexing, down to 24 per cent. I am not sure what date that takes effect, because their Web site is not up and running. They did agree to cut their individual rates from 48 per cent to 24 per cent and to cut their corporate rate from 36 per cent down to 30 per cent on long-term gains.

This table shows that many countries do not tax capital gains at all. For example, in Hong Kong and Germany, long-term capital gains are tax exempt. The Netherlands, Mexico and Singapore have very high growth rates. The same is true for corporate capital gains. It seems the U.S. ought still to be taking a look at the prospect of further capital gains reductions, because we have such a low rate of saving. Most analysts conclude that capital gains rate reductions have some positive impact on saving.

Let me talk a bit about the prospect and some of the proposals for further capital gains tax reductions. There have been some bloody battles in the U.S. Congress this year about tax reform. In the Republican-approved tax proposal that was sent to President Clinton in September, there was a tax proposal to reduce individual capital gains from a top rate of 20 per cent down to 18 per cent, and 8 per cent top rate for the taxpayers who were in the 15 per cent tax bracket. That bill was vetoed by President Clinton. The point is that the Republicans, and many credible senior tax policy researchers, think we still have a way to go because our saving and investment still need further shoring up.

We asked Allen Sinai to take a look at what the macroeconomic consequences would have been had this proposed tax bill been agreed to by President Clinton. Table 6 has some preliminary numbers that Allen Sinai's firm, Primark Decision Economics, produced. Even though the proposed tax cut was small -- a drop from 20 per cent to 18 per for the top rate cent is not a huge decrease in the capital gains tax rate -- it would have had positive, measurable, quantifiable impacts on the U.S. economy.

Mr. Sinai shows that over the next five years we would have had an extra $65 billion in real GDP. We would also have had an increase in employment. Those 112,000 new jobs would have come from the formation of new businesses. He has in his model the ability to look at the impact of capital gains rate changes on start-ups. He concluded that new business incorporations would have increased by 200,000. By the way, there is a typo in my testimony there; it should read 200,000, but we are missing a zero. He included the impact of the rate changes on people's willingness to finance start-ups and on individual's willingness to undertake risk, and he concluded that we would have seen about 200,000 new business incorporations over that time period. Employment would have gone up. Capital spending for equipment and structures would have risen by about $18 billion, and the cost of capital would have fallen by 0.13 per cent. That last figure is not a great amount, but every change downward in the case of capital helps increase people's willingness to invest.

The stock price index would have gone up by about 0.8 per cent each year. National saving, the combination of business, personal and government saving, would have increased by about $84 billion a year. Even though the proposed change was rather small, it would have had quantifiable, positive impacts on the economy. It was, in effect, a free lunch.

It seems to me that the U.S. needs to continue to examine options to increase our growth rate and our saving rate. A sound, carefully crafted capital gains tax cut, not only for individuals, but also for corporations, really ought to be part of the next President's agenda. We at the council are working to make sure that it is part of the next President's agenda. We are working with people who work for Governor George Bush. We are trying to work with some of the other presidential candidates to make sure that whoever is elected does not forget about the need to increase saving, to increase business investment, and to provide the U.S. with a tax code that will carry it into the 21st century.

We can document that that would be helpful. It would in effect be a free lunch. I hope that the U.S. experience I have related to you may in some way be useful to you as you go forward with your debate about tax restructuring.

The Chairman: It was a privilege to listen to you. Who will be your next President?

Ms Thorning: Most people in the U.S. think that Governor Bush will probably get the nomination, but John McCain is coming up strong, so it is hard to say. Both of them are fine candidates. Most people feel that likely one of those two will get it. Who knows? So much depends on what the state of the U.S. economy is next November.

Senator Angus: Congratulations, not only on an excellent presentation, but also on a very diplomatic response. We are political junkies up here and we are all interested in what is happening down your way.

You described succinctly the various effects of the 1997 cut in the individual capital gains tax rate from 28 per cent to 20 per cent. You said that the net tax revenues for the fisc actually increased from $62 billion to $80 billion, and it has subsequently gone up another $4.6 billion.

We have been trying to say that here. As a matter of fact, I have in my hand an article that appeared in yesterday's Montreal Gazette. It states that a study shows that cutting capital gains taxes would increase government revenues. That headline emanates from some writings by a witness we had earlier in these hearings. It is a hard message to send out with credibility.

Why, in your opinion, does the fisc in fact get more tax revenue with a lower capital gains rate?

Ms Thorning: You must look not only at the impact on capital gains tax revenues themselves, but also at the overall macroeconomic consequences of the capital gains rate change. First, consider the impact on capital gains tax receipts. When you lower the rate, there is a big unlocking effect. People who have not wanted to realize a capital gain or to sell a capital asset at 28 per cent may feel that at 20 per cent they are willing to bite the bullet and pay the tax in order to free up their capital, which they can put it into something they consider a more productive investment. The unlocking effect tends to encourage people to go ahead and sell an asset and put the money in something else.

In addition to the unlocking effect, which initially brings more revenue, as we can see from our own series of capital gains tax receipts, you also get stronger economic growth, because of the second-order effects that David Wyss, Allen Sinai and others have examined. More people work, and they pay more in individual income tax and in payroll taxes. More businesses make more money, so you get more in corporate tax receipts. Clearly, it is not fair to look at the impact of a rate change only in terms of how it effects the particular tax revenues from that stream. You need to look at the overall economic impact.

Our Joint Committee on Taxation does not do that. It looks only at the first-order static effects, not the dynamic impact of a capital gains rate change on overall macroeconomic activity. However, someone with a general equilibrium model, such as Allen Sinai or David Wyss, can take a look at how all the other revenues are affected. That is why you have to consider the goal of tax policy and the long-run, overall, macroeconomic effects.

Senator Angus: To be able to say with confidence and to establish that indeed the overall revenues for the tax collector increase with a lowering of the capital gains tax rate is very positive. You provided a detailed description, which makes me a little nervous because when we ask the officials of our Department of Finance for the figures, we are left with the impression that the potential effects of reducing the capital gains tax rate are very hard to measure. That is not necessarily the case, it seems. Can we say with confidence in your opinion as an economist who has studied this that, in all cases, and certainly in a case like the Canadian economy, we would increase revenues by reducing the tax capital gains tax?

Ms Thorning: In the long run, you would certainly increase overall tax revenues, even if you cut capital gains tax rates to zero. Obviously, if you did not tax capital gains at all, you would not receive any direct revenue from the sale of a capital asset, but if you took a look at tax receipts over a 10 year or 15 year period, I think you would see that even a very significant rate cut would probably pay for itself.

Sometimes, when we model a small rate change in the U.S., we may see that the increased productivity and employment are not quite enough in the short run to pay for the tax cut. On the other hand, if you were running budget surpluses, you could cut taxes enough to increase employment, increase GDP and increase new business start-ups, and you could pay for it out of the surplus. That is certainly something you would want to do, because it would add to your growth.

Senator Angus: Other witnesses have also said there are a number of jurisdictions, such as Hong Kong, Singapore, Belgium and Mexico, that have zero capital gains tax and have growth economies. I am somewhat troubled because I notice that all of those examples are smaller countries. They are not the major players in the OECD or in the G-7, for example. I am trying to presage the kinds of counter-arguments we will face if we use those examples as an argument for reducing. We could say that here is an opportunity for the Canadian economy, which has been in a relatively non-growth mode compared to your country. Why do we not get on with it? Is there some reason why all the big countries have a capital gains tax, while the smaller ones do not? I have even heard Singapore and Hong Kong referred to almost as tax havens.

Ms Thorning: Look at where the growth is. Singapore and Taiwan have had strong economic growth and high rates of saving. They are the Pacific tigers. They have a smart, well-educated work force and a favourable tax code. In the long run, they will benefit greatly from the fact that they tax saving and investment very lightly.

Some of the developed countries, including the Netherlands, do not tax capital gains at the individual level. Some of the European countries, such as Germany, do tax capital gains more lightly than we do. However, if I were looking at ideal tax codes, I certainly would not look to the Europeans for guidance in all cases. In some ways they are more advanced -- in terms of how they tax foreign source income, for example -- but in terms of how they tax income, I am not sure that I would hold them up as a model.

We ought to look at what works. The council spends a lot of money on macroeconomic estimations, and I included the work of the Joint Committee on Taxation in my testimony because I wanted to show you what public-finance scholars from every stripe of university think will help U.S. economic growth. One could most likely make the case that if a consumption tax, where saving and investment are exempt, would help the U.S. economy grow faster, it would probably help the Canadian economy or the Swiss economy also.

I would not be troubled by the fact that many of the major industrial countries have higher rates. Australia has just brought their rate down to 24 per cent, so the trend around the world may be to move toward lighter taxation of capital gains and other forms of saving.

Senator Angus: We had no capital gains tax in Canada before 1971. Do you have any evidence in your studies of a greater economic growth rate in this country before we instituted this draconian tax?

Ms Thorning: No, I am afraid I do not.

Senator Angus: That is not to say that there is no evidence out there.

Ms Thorning: I would guess that you probably had more money flowing into riskier start-ups prior to the imposition of the high capital gains taxes, but you would know that better than I.

Senator Hervieux-Payette: What is a unified income tax? Knowing that would help my comprehension of Table 1.

Ms Thorning: The pure or unified income tax is one under which you are not allowed any deductions -- no mortgage deduction, no personal exemption. You pay a flat percentage of all the income you receive in that particular year with no deduction for saving, no deduction for RRSP. All corporate income and capital gains are taxed when the gain occurs, whether or not the asset is sold under the accrual system; corporate income is flowed through to the individual and taxed at the individual's rate. Under that system, corporations do not have expensing. They have annual depreciation attempting to match the economic life of the asset with an annual depreciation allowance. Basically, there are no exemptions for saving.

Senator Hervieux-Payette: It is almost a synonym for the pure income tax.

The Chairman: It is a flat tax.

Senator Hervieux-Payette: Is there an optimal period to hold an asset in order to enjoy the better rate -- six months, a year, 18 months? Various periods are listed. Which benefits from the best rate?

Ms Thorning: Many economists would make the case that there should not be a holding period for capital assets. When you throw in a holding period, you slow down the mobility of capital and you add a cost to doing business. The one-year holding period we have now adds to the cost of capital. Most other countries do not have a holding period. It exists for political reasons. It is a way of addressing the issue of speculation. However, in my view, the economy would probably work better without a holding period. Like everything, it is a political compromise.

The 18-month holding period that was in place for a short time was a political compromise. In order to move through the rate cuts, we had to extend the holding period. That was a trade-off between the Republicans and the Democrats. It was about to bollix up the works. It was so unpopular that it was repealed in 1998.

The Chairman: You must be aware of the fact that in Canada there is no holding period, but there is the concept that a trader cannot take advantage of the capital gains rates. I am not sure which is better or worse.

Senator Hervieux-Payette: Most of the G-7countries have quite a substantial consumption tax on most goods. When we consider the capital gains tax, we isolate it from the consumption tax and also from the income tax, but I think we must look at the global picture. Would you say that Germany and France exempt even on the short term or on a longer term because they have quite a high income tax and a pretty stiff consumption tax?

Did you consider the impact on the economy of having the capital for start-ups and to support the entrepreneur? I do not see a faster, higher growth rate, and we must be sure that we make the right decision, because that is only one of at least three major factors.

Ms Thorning: I wish I believed that economies in Europe had thought through their tax policy as carefully as you are trying to. What has happened is more a matter of historical accident -- who happened to be in power, who happened to favour a particular policy.

One shortcoming in U.S. tax policy is that we do not step back and think things through. Rather, things are done for political expediency. We managed to move the capital gains rates down in 1997. I should like to think that it went through because the members of Congress realized that it would help offset our very harsh taxation of saving in the U.S. We do not have a dividend exclusion or anything else. It is a way of addressing a wrong because we do tax savings so harshly.

I have a feeling most of the countries in the OECD probably approach their tax policy on a piecemeal basis too, without stepping back and thinking, "How can we move to where we need to be?" Taxes are very high in Germany -- 50 per cent of GDP. The policy of no tax on securities on long-term gains obviously helps offset some of the other heavy tax burdens they are facing, including the very high consumption taxes. Such a high consumption tax does tend to nudge you towards saving. On balance, the German saving rate is higher than the U.S. saving rate.

Senator Oliver: Writers have said that we are losing a lot of our good people to the United States and elsewhere as a result of our high tax on gains and capital. We spend millions of dollars a year training people to become specialists, particularly in the high-tech area, and after they graduate and get a year's experience, Microsoft and other American companies pick them up and take them down there. What do you think lowering the capital gains tax would do to stem that problem?

Perhaps this is part of the answer. In the final paragraph of your paper, you state:

A soundly structured, broad-based cut in individual and corporate tax rates on capital gains would significantly benefit all taxpayers. By reducing the cost of capital, it would promote the type of productive business investment that fosters growth in output and high-paying jobs.

Could you explain what you meant by the "high-paying jobs"? Is part of the answer?

Ms Thorning: You are exactly right. My guess would be that, if you had a significant reduction in capital gains rates bringing your total provincial and federal rate down to somewhere around 20 per cent to 25 per cent, you would see much less of a brain drain.

Obviously, in the U.S., people who start high-tech firms are paid in stock options. They hope to realize capital gains ultimately. A 20 per cent rate, with a little more added on for the state capital gains rate, is a big draw. I think you would see more entrepreneurial activity here in Canada and the creation of more high-paying, high-tech jobs, if you had a significantly lower rate. Capital gains is not everything. It is not the end of the world, but it makes a difference, especially as it compounds over the years. The extra jobs, the extra growth really have a material, significant impact on a country's well-being.

Senator Oliver: How do you quantify the influence of your institute on capital formation, and how do you go about influencing the bureaucrats? As you know from reading our transcripts, although a number of academic writers, businessmen and business groups agree that our capital gains tax is too high, the real question is how to sell it to the public. How has your institute done that successfully?

Ms Thorning: I have been at the council for 18 years. Good quality academic work does make a difference, but it may take more than one research study. We began in 1986, after the capital gains tax increases of the 1986 tax bill. We began to fund credible academic scholars. We began to try to get Hill staff to do studies, working with members of Congress who were sympathetic to our view. We began to work with credible macroeconomic forecasters, Allen Sinai, for example, to have them analyze capital gains. With their results, they would go before Congress and they would do press interviews. We would use their results in testimony.

We have a newsletter and a Web site, so everything is on that. We have one thing many think tanks do not have: there is a dinner every month at our president's house with about eight members of Congress from the Senate and the House, about 10 or 12 business leaders from around the country, and eight or 10 national press.

Senator Oliver: Is there a speaker?

Ms Thorning: No, it is all off the record. We have been doing this since 1982, and there have been 95 or so of these dinners. We have what some people call the last economic salon in Washington. We sit down and have drinks and talk. We send out a little memo in advance talking about some aspect of tax policy or environmental policy or trade policy. Then we all come together, maybe 25 or 30 of us, and chew over the issue. There is a seated dinner. The press really gets into it. It is a chance to have an impact on someone like Alan Murray, the editor of the Wall Street Journal or Rick Stevens from the New York Times.

We use every tool we can think of to influence people in the press and members of Congress, but it takes good quality work and absolute credibility. You cannot fudge the numbers. You must be absolutely impeccable. That is what we have done.

We do not have a pack. We do not give anybody any money. We do not pay them to come to dinner, for example. I notice the level of intellect of members of Congress is improving. They are truly concerned about really good, sound policy. It is fun to work with people like that.

Senator Oliver: That is very helpful.

Senator Meighen: You said earlier that in the U.S., capital gains taxes account for a reasonably significant percentage of total revenue.

Ms Thorning: Of the individual tax receipts.

Senator Meighen: I guess we are comparing apples and oranges. In Canada, the figure was 0.3 per cent, as compared to total revenue. I suspect that that is lower than in the United States, if we compare apples to apples. It might be because of the lock-in effect. If you have a high capital gains tax, obviously your inclination is not to trigger it. Any comment you have on that would be welcome.

In addition, I understand that in the United States capital gains tax is lower or non-existent in certain prescribed areas, if you roll over. For example, in the high-tech sector, we heard some evidence that if you stay in the same sector you can roll over without attracting tax.

Ms Thorning: There are some provisions about the share of capital gains taxes. The share of capital gains taxes as a percentage of total individual taxes ranges around 8 per cent to 9 per cent. With our relatively low tax rate, we do not have such a lock-in effect. Who wants to pay 40 per cent on something unless it is done awfully well? That very low percentage is due to people being simply locked in.

There is a provision in the tax code that allows firms with assets of $100 million or less to roll over part of that tax-free. That was expanded a bit in the 1997 act. People I have talked to in the venture capital community suggest that the provisions are so narrow and tightly drawn that most firms do not even try to use them. A rollover is something to be looked at, and if we had a rollover rather than the current capital gains tax upon realization, we would probably see a lot more mobility of capital and probably faster growth, because we would be on a consumed-income tax system. If you can roll over your capital gain and not pay tax, that is the same as being under a system where all saving is exempt from tax and you pay tax only when you spend the money. A rollover is worth the look. There has been a lot of interest in it in the United States, but we have never done much more than carve out a little bit of gains from relatively small companies under tightly drawn circumstances.

Senator Meighen: Would you have any comment on capital gains tax with respect to the cost of collection as compared to other tax? Would I be right in thinking that the more you add things, such as rollover provisions or a different rate depending on the length of time held, the higher the cost of collection?

Ms Thorning: Certainly it adds to complexity. Is the additional complexity worth it in terms of any extra saving or economic growth you receive? In our system, the capital gains provisions add a whole lot to the tax code. It clearly is a complex matter, but with increased computerization, it is a bit easier for the IRS and for mutual funds and so forth to track what your capital gains are. Technology has helped to drive down the cost of collecting the tax, so if complexity is the price we must pay to receive a differential rate on capital gains compared to ordinary income, that is the way to go.

A simpler way would be the pure consumption tax. The Treasury published a study back in 1984 outlining how to take the U.S. to a consumption tax and how we would track people's accounts so that we would know how much they are spending and saving. That could be monitored fairly easily.

Senator Meighen: Do you have any information or comment about the encouragement that is given in the United States to the gifting of property to foundations or charitable institutions, which is exempt from capital gains? I do not know how long the United States has had that. We have just started it in this country. Two years ago the Minister of Finance reduced the rate of capital gains tax for gifts to charitable institutions of publicly traded securities. The anecdotal evidence is overwhelming that that has unlocked a great deal of money for those institutions. Do you have any information on that?

Ms Thorning: I will pass. I am not an expert on that.

Senator Meighen: Should the individual capital gains rate and the corporate capital gains rate be relatively the same, or should one be higher or lower than the other?

Ms Thorning: Most of the research we have seen suggests that it would be better if there were not such a spread between the 35 per cent corporate capital gains rate and the 20 per cent top individual rate; that spread tends to distort how people plan their business. It makes them wrench around and do things for tax purposes that they would not otherwise do. Some industries are more affected than others. However, the 35 per cent rate also adds to the corporation's cost of trying to do business, to invest in a risky start-up. A 35 per cent tax rate on something that may not pay off at all tends to be a deterrence. Increasingly, we are finding that the 35 per cent rate is a deterrent to the corporate sector when they are considering how to allocate their investments between something relatively straightforward and something that is more risky.

You can make the argument that our rates are really out of line and we ought to bring the corporate rate down. At the council, we have tried for years to make that case. We have done a lot of work on it. However, it is politically very unpopular. It is seen as a tax break for the corporations. People do not realize that corporate income flows through to individual shareholders and that when you hurt a corporation, you are really hurting the shareholders who own stock in it. It has been a tough sell. We do not give up, though.

Senator Kroft: I am just looking for a clarification. When you are talking about a pure consumption tax, you are talking about a tax piece based on the measurement of actual expenditure of what?

Ms Thorning: Annual expenditure. You would take annual income, and anything you save out of that is tax-exempt, right off the top. Anything you consume would be taxed at some rate. It could be a progressive rate. David Bradford at Princeton University has worked out a system where he has a progressive tax rate on a consumption tax.

Senator Kroft: You commented that your taxing authorities are reluctant to go beyond the direct impact of lost revenue; is that right?

Ms Thorning: They will not.

Senator Kroft: Then the problems we are having with addressing the broader economic ramifications of some of these changes are not unique to Canada, but are shared problems with bureaucrats.

Ms Thorning: Right. To be fair to the bureaucrats, if you change the tax system in four ways at once, how do you measure the differential impact of each of those changes in a macroeconomic sense? They feel, justifiably, that their duty to provide a revenue estimate for an individual item would be more difficult, if not impossible.

One counter-argument we make is that at least you ought to consider what the overall macroeconomic consequences are. People like Martin Feldstein, President of the National Bureau of Economic Research and former head of the Council of Economic Advisors under President Reagan, has long made the case that we need to keep our eye on the long-term goal. To do that, you need to know the overall macroeconomic consequences. That ought to guide the people at Treasury as well as the members of Congress. It is not enough just to look at a piece of legislation in isolation.

Senator Kroft: So the battle goes on?

Ms Thorning: Exactly.

Senator Kroft: One of our leading tax experts makes a strong point that one real problem is that the more you create tax differentials between different types of income, the more you open the door to a costly type of planning that is not really economically productive. Do you have a comment on that?

Ms Thorning: We faced that problem in 1986 and tried to address it with our passive loss legislation, which is included in the 1986 tax bill. Much of that potential abuse has been cleaned out of the U.S. tax code. I think most people do not see that as a major problem in the U.S. now, because of the legislation we have on the books.

In the other hand, when you see the funds pouring into the stock market and more and more young people in their teens and 20s investing in equities, thinking about their future, you can see that the fact that capital gains are taxed at a relatively low rate compared to the rest of the world has probably had a favourable impact. As far as I can tell, there is no longer that much gaming of the system in the United States.

Senator Kelleher: Table 6 graphically shows the cumulative impact of capital gains tax reduction. You mentioned that it was Professor Sinai's model. Are these models available to the Canadian Department of Finance? Are they available to researchers up here? Could we take Canadian data and feed it into his model?

Ms Thorning: You could have him to do it for you. He would have to run the model. He would probably have to gather some special data for Canada if he did not have it on file, but certainly he could do that, as could David Wyss or some of the macroeconomic modellers. You could definitely have a macroeconomic simulation. It would probably be worth doing.

Senator Kelleher: Obviously I am no expert in this area, but I do not know how many models we have in Canada. It seems to me that you are ahead of us with your modelling. That model indicated clear, decisive reports and results. It might be helpful if some of our researchers, or some of our people in the finance departments, would perhaps take a look and utilize those models. Have your models become quite refined in the last couple of years?

Ms Thorning: Yes, particularly Allen Sinai's model, which includes so many financial variables. He has something like 500 equations in it. Because of the work we have done with him over the years, he has beefed up the capital gains side. He can better analyze changes in capital gains legislation. These are probably the most sophisticated models in the world, because we have had the resources to put into people such as Mr. Sinai and David Wyss and others.

I used someone at Stanford University back in the 1980s to look at the impact of the increase of capital gains taxes on the cost of capital. His model showed that when we raised the rate from 20 per cent to 28 per cent in 1986, the cost of capital went up 6 per cent to 8 per cent. I also used an academic at Ohio State to do the same thing. His results also showed a 6 per cent to 8 per cent increase. I had somebody else at another think tank do the analysis. I had DRI do it.

All those different academic and think tank people came up with roughly the same number for the impact of an increase in capital gains taxes on the cost of capital. The academics and think tanks that we have had do the analysis on the rate cut also show similar size rate cuts. They come at it with slightly different macroeconomic models, but arrive at the same results. That provides me with a comfort factor. We have not used just one person.

Senator Kelleher: Have you any knowledge of Canadian models being used in the area of capital gains?

Ms Thorning: No, I honestly do not.

The Chairman: Doctor Sinai is coming here on February 24. We will call him, as a result of Senator Kelleher's excellent suggestion, and see if there is some way that he can run a model for us using Canadian numbers. Maybe it is pie in the sky, but we will give it a shot.

Senator Tkachuk: This has been a very good presentation. I know people require models. I am of the view that less tax is a good thing, so it is not as important to me. They estimate that in Canada we will have somewhere in the area of $7 billion to $10 billion surplus. Some of us are very concerned that that surplus will be spent by government.

Ms Thorning: I saw the article in the paper today.

Senator Tkachuk: Others advocate that perhaps it should start paying the debt, or that a percentage of it should go towards less taxation for Canadian businesses and the Canadian population. It is all about efficiency of expenditure. Where is it better spent? I believe it is better spent by individuals and businesses rather than by government.

Our individual tax rate is very high. In a $45,000 income bracket, you are hitting about a 45 per cent tax rate federally and provincially, and you pay a consumption tax on top of it. A person in a higher income bracket, which we consider $65,000 or thereabouts, with consumption tax and income tax, probably pays somewhere in the area of 60 per cent or 65 per cent of income in taxes.

If you were advising our government, would you say that it would be better to reduce both capital gains and individual income tax, or just one or the other? Where would you fit the priorities, knowing the high tax rate in our country?

Ms Thorning: I would probably try to do both. I would give a little more weight to the capital gains rate cut. It is hard to believe it would cost you that much. You are not obtaining much from it right now.

Senator Tkachuk: That is true, we are not.

Ms Thorning: Given Canada's desire to stimulate productive investment, especially in new technology and the high-tech sort of ventures, and given your desire to compete with the rest of the world and to keep talent here, it seems to me that it would be very important to bring the combined provincial and federal capital gains rate down to something comparable to or even better than the U.S. rate.

Senator Kroft: Now we come to the ultimate moment of truth -- death taxes and that end of the process. You may be aware that we have no Canadian estate tax, but you are deemed at the moment of your death to have realized all of your capital gains. That is the final shot at you. Along the way, we have a free ability to pass property and assets between people, subject to attribution. Has the estate tax been a trade-off in arriving at the capital gains rates in the U.S? Is it figured into the equation?

Ms Thorning: It would be nice to think that people thought that far ahead about the interactions of different tax provisions, but I do not think that is the case in the United States. I do not think we are that smart. Also, the fact that you do not have an estate tax as stiff as we have and that you can make those gifts is a different issue than the capital gains on a new venture. Your system does not have the incentives to undertake a risky investment. It is nice that you can make those gifts, but it does not provide the kind of incentive that our 20 per cent rate provides to undertake a risky investment.

Maybe you are following the debate in the U.S. Congress about the death tax. There is a strong movement, which we are helping along, either to repeal the death tax or to cut it way back, because some of the work we have had done shows that our death tax does retard investment and slow growth. It is a tax on saving.

The Chairman: Can you not also postpone it with a series of trusts?

Ms Thorning: With enough tax planning, some people can avoid part of the death tax, but you cannot evade it totally. Even if you have a family limited partnership, which a lot of wealthy individuals have set up, when your children sell the assets, they will still pay some tax, but at their own tax rate, not at the 55 per cent marginal estate tax. Again, I think the death tax is another issue that does not really bear on how you ought to tax investments and risky assets.

Senator Kroft: You commented that you regret that nobody ever looks at the whole thing together. The only time we did was in the late 1960s and early 1970s. The result of that total and holistic look was our capital gains tax. Looking at the big picture does not necessarily guarantee the right answer.

The Chairman: We had the quaint idea that a buck is a buck is a buck. Thank you for coming. It was totally fascinating and perhaps we will try to have you back.

The committee adjourned.

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