Capital gains amnesia
As the Liberal government finalizes its 2017 budget, there are increasing rumours that it might increase taxes on capital gains. For a government squarely committed to improving economic growth and fostering innovation, doing so might just be the single most damaging policy change it could implement.
Unlike most taxes, capital gains are only incurred when a person sells an asset above its nominal purchase price. The fact that this makes them, to some extent, voluntary is the explanation for one of the most damaging aspects of capital gains taxes — they create an incentive for people to hold on to low performing assets. This “lock- in” effect, as it’s known, means that investors and entrepreneurs will often hang on to investments rather than selling them and investing in something new, such as an emerging business, in large part just to avoid the capital gains tax.
But that’s not all. Perhaps one of the least understood economic effects of capital gains taxes is its impact on entrepreneurship and innovation. Entrepreneurs risk their own capital and time in the hopes of profiting from the creation of a new product, an unproven service, or the introduction of a new technology.
Entrepreneurs typically accept low pay in the early stages of their enterprise so company revenues can be reinvested to meet the needs of their growing business. In return, they expect to be compensated when the business matures and is taken public or is bought by another company, or becomes profitable enough to afford higher wages.
But higher capital gains taxes reduce the reward that entrepreneurs and invest- ors receive from the sale of a business. Lower those potential rewards and you’ll discourage entrepreneurs and investors.
But don’t take our word for it. Here’s what then finance minister Paul Martin said about capital gains in the Liberal government’s 2000 budget: “The hightechnology sector and other fast- growing industries are particularly important to Canada’s future economic growth. Our t ax system must be conducive to innovation, and must ensure that businesses have access to the capital they need in an economy that is becoming increasingly competitive and knowledge- based. An examination of the taxation of capital gains in Canada suggests that this objective would be better achieved with a reduction in the inclusion rate of capital gains”
The Chrétien/ Martin Liberals reduced the capital gains inclusion rate (i.e., the amount of capital gains subject to tax) from 75 to 50 per cent as part of a larger initiative to improve Canada’s competitiveness and attractiveness to investors. They understood that a lower, more competitive capital gains tax rate was essential to attracting and retaining both investment and entrepreneurs.
In his 2000 budget address, Martin highlighted that: “A key factor contributing to the difficulty of raising capital by new start-ups is the fact that individuals who sell existing investments and reinvest in others must pay tax on any realized capital gains.”
However, despite t he deduction in capital gains taxes by the previous Liberal government, Canada still maintains one of the highest capital gains tax rates among OECD countries. And what’s more, 11 of the 34 OECD countries do not impose any capital gains tax.
Other small, open economies such as Switzerland and New Zealand recognize the economic benefits of having no capital gains tax. Not only does the absence of the tax improve the allocation of investment in countries, it creates stronger incentives for entrepreneurship and investment, both of which are critical to improving any economy.
At a time when both the rate of business startups and the expectations for long-term economic growth are declining in Canada, increasing the capital gains tax is exactly the opposite of what this government should be contemplating.
If Prime Minister Justin Trudeau and Finance Mini ster Bill Morneau were t ruly dedicated to longterm economic growth and fostering innovation, they would follow the l ead of their Liberal predecessors and reduce — rather than increase — the capital gains tax rate.
THE CHRÉTIEN LIBERALS UNDERSTOOD A LOWER CAPITAL GAINS TAX IS ESSENTIAL TO HELP INVESTMENT AND ENTREPRENEURS.