By Jason Clemens
and Niels Veldhuis
The Fraser Institute
As the Liberal government finalizes its 2017 budget, there are increasing rumours that it may increase capital gains taxes. 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 other taxes, capital gains are only incurred when a person sells an asset. Capital gains taxes are applied to the sale of an asset when its sales price is nominally (not adjusted for inflation) above its purchase price.
The fact that capital gains taxes are, 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 retain existing 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 so that earnings 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.
The bottom line – capital gains taxes reduce the reward that entrepreneurs and investors receive from the sale of a business. Lower the potential rewards and you’ll discourage entrepreneurs and investors.
But don’t take our word for it. Here’s what the Liberal government of then-Prime Minister Jean Chrétien and Finance Minister Paul Martin said about capital gains in their 2000 budget:
“The high-technology sector and other fast-growing industries are particularly important to Canada’s future economic growth. Our tax 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 per cent 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, Finance Minister 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 the 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 a capital gains tax.
Other small, open economies such as Switzerland and New Zealand recognize the economic benefits of having no capital gain 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 start-ups 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 Trudeau and Finance Minister Bill Morneau were truly dedicated to long-term economic growth and fostering innovation, they would follow the lead of their Liberal predecessors and reduce – rather than increase – the capital gains tax rate.
Jason Clemens and Niels Veldhuis are economists at the Fraser Institute.