Lessons from Abroad for Capital Gains Tax Reform

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Appeared in the Financial Post

Like the late 1990s, the federal government is about to balance its budget after a period of consistent deficits and debt accumulation. While a variety of voices are sure to offer up ways to use the coming surpluses, Canada could encourage investment, entrepreneurship, and ultimately a stronger economy if the federal government replicated the decision by the then-governing Liberals in the late 1990s and reduced capital gains taxes.

Capital gains taxes are applied to the sale of assets when the selling price exceeds the original purchase price. One of the main economic costs of capital gains taxes is that they reduce the efficiency of capital by discouraging the sale of assets for reinvestment in new, more productive assets because the sale of old assets triggers a capital gains tax. Economists call this the “lock-in effect” and it imposes real and significant costs on economies.

Indeed, there is a large and growing body of research showing that low or no capital gains taxes increase the supply and lower the cost of capital for new and growing firms, leading to higher levels of entrepreneurship, economic growth, and job creation. These are all things Canada needs more of.

But despite the wealth of evidence on the benefits of lower capital gains taxes, the federal rate has gone unchanged for nearly 15 years. Today, Canadian governments tax capital gains income at half an individual’s marginal income tax rate. For someone living in Ontario, their top combined federal and provincial capital gains rate is 24.77%.

That makes Canada’s top personal capital gains tax rate the 14th highest among the 34 countries comprising the OECD. Interestingly, 11 OECD countries impose no capital gains taxes at all.

These countries undoubtedly benefit from a zero-rated capital gains tax policy and three in particular (Hong Kong, Switzerland, and New Zealand) are profiled in a collection of essays released today by the Fraser Institute. As small, open economies – similar to Canada – they understand the need to encourage domestic savings and attract international capital. After all, capital provides the life blood for new and growing businesses, which are the engines of job growth, innovation, and economic prosperity.

The economic benefits from zero capital gains taxes are notable. Hong Kong, for instance, has a higher savings rate than most developed countries (including Canada) and has emerged as a major financial centre and location for regional corporate headquarters. Switzerland is also an attractive and popular investment destination for global investors and companies.

Canada’s federal government currently collects $2.8 billion or just 1.1% of total revenues from capital gains taxes. It’s hard to justify the current capital gains tax regime with its high economic costs in exchange for such a relatively small amount of revenue. Completely eliminating capital gains taxes would offer considerable economic bang for the buck.

But that may be a step too far in the current political environment, particularly with the 2015 federal election on the horizon. So there is an important alternative option worth considering.

As described in an essay by Stephen J. Entin, former deputy assistant secretary for economic policy at the U.S. Department of the Treasury, the United States successfully implemented a “roll-over” provision. Rollover mechanisms mitigate the “lock-in effect” by allowing for a tax deferral of the capital gains if the proceeds from the sale of an asset are reinvested within a certain timeframe, perhaps six months. The Canadian federal government actually discussed this option in 2006 but has not yet implemented it.

At a time of sluggish economic performance, all governments should be considering ways to bolster long-term growth. In this regard, capital gains tax reform warrants serious consideration. Implementing a roll-over provision as was done in the United States, lowering the tax rate as the federal Liberals did in the late 1990s, or more dramatically following the lead of 11 other industrialized countries by eliminating the tax altogether are possible options.

Put simply, capital gains tax reform is a low-cost, high-impact measure that would provide enormous benefits in the form of increased investment, entrepreneurship, economic activity, and job creation in Canada.

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