A low-cost, high-impact measure to bolster investment, entrepreneurship, economic activity, and job creation
With the federal government likely to soon release its annual fiscal update, marking the unofficial lead-up to next year’s federal budget, Finance Minister Joe Oliver is bound to hear different ideas about how to use expected future surpluses. Oliver has said his government’s top priority is “prudent” new measures that encourage economic growth and “boost job creation.”
An important policy reform that fits the bill and one that would boost economic activity now and in the future is capital gains taxation. This may not be the sexiest policy topic heading into an election year but a wealth of research shows that capital gains tax reform can increase the supply and lower the cost of capital for new and expanding firms, leading to higher levels of entrepreneurship, economic growth, and job creation.
A capital gain refers to the price of an asset when sold compared it to its original purchase price. For instance, if you sell a stock investment at a higher price than what you purchased it, you experience a capital gain.
Canada currently taxes capital gains income at 50 per cent of an individual’s marginal income tax rate. For someone living in Ontario, their top combined federal and provincial capital gains rate is 24.77 per cent. There are, of course, exemptions, such as if the capital gains are in a tax-sheltered savings vehicle such as a TFSA or if the source of the gain comes from selling your primary residence.
Where capital gains taxes do apply, research shows they have detrimental effects on the economy. The primary reason relates to what economists call the “lock-in effect.” Because capital gains are only taxed upon realization (when investors sell their investment), high tax rates on capital gains encourage investors to hold on to their current investments even if more profitable, productive opportunities are available. Such distortions have a substantial impact on the reallocation and availability of capital in the economy.
The magnitude of the lock-in effect depends on a number of factors, but empirical studies consistently find a negative relationship between capital gains taxes and capital investment (including asset sales, share prices, and other proxies for investor activity). The result is less capital available to new and expanding Canadian businesses, which are the engines of productivity, employment, and wealth creation. Capital gains tax reform could reduce the lock-in effect and the deleterious consequences that stem from it.
The federal capital gains tax rate was last changed nearly 15 years ago as the government eliminated its deficit and returned to a balanced budget. The reduction in the capital gains tax rate – along with other fiscal reforms across the country – helped usher in a period of strong economic performance in the years that followed.
We now find ourselves in a similar situation. After running budget deficits for seven consecutive years, the federal government is poised to return to balance in 2015 and has signaled that tax relief is a top priority. Capital gains taxes warrant a hard look.
Canada’s top personal capital gains tax rate is 14th highest among the 34 countries comprising the OECD. In fact, 11 OECD countries currently impose no capital gains taxes at all. So there’s room for reform and improving our international competitiveness.
According to estimates by the Department of Finance, the federal government collects $2.8 billion or just 1.1 per cent 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. Capital gains tax reform would be a productive use of future budget surpluses offering considerable economic bang for the buck.
With economic growth remaining sluggish and below historical norms, the federal government’s transition from a budgetary deficit to a surplus represents an opportunity to lay the foundation for long-term growth. Put simply, capital gains tax reform is a low-cost, high-impact measure that would bolster investment, entrepreneurship, economic activity, and job creation in Canada.
By Charles Lammam and Jason Clemens
Charles Lammam and Jason Clemens are economists with the Fraser Institute and co-editors of Capital Gains Tax Reform in Canada: Lessons from Abroad available at www.fraserinstitute.org.