STUDIES IN ENTREPRENEURSHIP MARKETS · Entrepreneurship and risk-taking Capital gains taxes have a detrimental impact on the number of entrepreneurs and risk-takers in Canada . Entrepreneurs

A publication of The Fraser Institute

STUDIES IN

&ENTREPRENEURSHIPMARKETS

Number 4 / February 2007

The Economic Costs of Capital Gains TaxesNiels Veldhuis, Keith Godin, and Jason Clemens

Contents

Executivesummary . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 3

Introduction . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 5

1 Definingcapitalgainstaxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 6

2 Governmentrevenuefromcapitalgainstaxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 11

3 Economiccostsofcapitalgainstaxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 12

4 Recommendation—eliminatecapitalgainstaxes . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 23

Conclusion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 25

References . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 27

Abouttheauthors . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 32

Acknowledgments . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . 33

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The Fraser Institute / Studies in Entrepreneurship and Markets 4

The Economic Costs of Capital Gains Taxes / �

Executive summary

Capitalgainstaxes,likeallformsoftaxation,raiserevenuesforthegovernmentbutalsoimpose

economiccosts .Unfortunately,thecostofcapitalgainstaxesisnotlimitedtotheamountof

taxcollected .Capitalgainstaxesimposeadditionalcostsontheeconomybecausetheyreduce

returnsoninvestmentand,thereby,causeindividualsandbusinessestoaltertheirbehaviour .

Asaresult,capitalgainstaxeshaveasubstantialimpactonthereallocationofcapital,thestock

ofcapital,andthelevelofentrepreneurshipinCanada .

Reallocation of capital

Capitalgainstaxessignificantlyimpedethereallocationofcapitalfromolder,lessprofitable,

investmentstothosewithhigherratesofreturn .Numerousacademicstudieshavefoundthat

investorsdoindeedlockintheircapitalinthepresenceofcapitalgainstaxesandthatthe“lock-in

effect”significantlyimpedeseconomicgrowth .Withouttheefficientflowofcapital,thedevel-

opmentofnew,potentiallyprofitable,businessesislimited .Giventhatthesenewventuresare

theenginesofproductivity,employment,andwealth-creation,capitalgainstaxesreducethe

economicwell-beingofallCanadians .

Stock of capital

CapitalgainstaxeshaveasignificantimpactonthestockofcapitalinCanadabyincreasingthe

costofcapitaltoCanadianbusinesses .Capitalgainstaxesmakecapitalinvestmentsmoreexpen-

siveandthuslessinvestmenttakesplace .Areducedamountofcapitalhasanumberofnega-

tiveconsequencesincludingdecreasesintheproductivityofCanadianworkersand,ultimately,

lowerCanadianlivingstandards .

Entrepreneurship and risk-taking

Capitalgainstaxeshaveadetrimentalimpactonthenumberofentrepreneursandrisk-takersin

Canada .Entrepreneursandtheirfinanciersarecriticaltoasuccessfuleconomyinthattheychal-

lengethestatusquo,advancetechnology,developnewproductsandservices,createjobs,and

increasewealth .Theseindividualstrade-offlowcurrentcompensationbecausetheyexpectto

generatesignificantfuturereturns .Capitalgainstaxesreducethereturnthatentrepreneurs,ven-

turecapitalists,andotherinvestorsreceivefromrisk-taking,innovation,andworkeffort .Lower

expectedreturnsdecreasesthenumberofentrepreneursandrisk-takersandultimatelyreduces

investment,technologicaladvances,employment,andoveralleconomicgrowth .


4 / The Economic Costs of Capital Gains Taxes

Compliance costs, administrative costs and tax evasion

Inadditiontothedamagingeconomiccostsofcapitalgainstaxesresultingfromchangesinthe

incentivesfacedbyindividualsandbusinesses,capitalgainstaxesalsoimposecomplianceand

administrativecosts .Compliancecostsareincurredbyindividualsandbusinesseswhentheyful-

filltherecordingandfilingrequirementsassociatedwithpayingatax .Administrativecostsare

expensesincurredbygovernment—andultimatelypaidforbycitizens—tomanageandmain-

tainthetax-collectionsystem .Finally,therearealsocostsarisingfromtheevasionofcapitalgains

taxes:theresourcesspentinevadingthetaxcouldbeputtomoreproductiveuses .

Marginal efficiency cost (MEC) of capital gains taxes

Estimatesofthemarginalefficiencycost(MEC)ofbothAmericanandCanadiantaxesindicate

thatpersonalcapitalincometaxes(dividends,capitalgains,andinterestincome)imposesub-

stantialcostsontheeconomy .RecentestimatesfromthefederalDepartmentofFinanceshow

thata$1reductioninpersonalcapitalincometaxes(dividends,capitalgains,andinterestincome)

increasessociety’swell-beingby$1 .30 .Inaddition,thesetaxeswereshowntobemuchmore

costlythanothertypesoftaxessuchasconsumptionandpayrolltaxes .Asaresult,thereareeco-

nomicgainsavailabletoCanadiansfromshiftingawayfrompersonalcapitalincometaxes .

Recommendation—eliminate capital gains taxes

Giventherelativeefficiencyofothertypesoftaxes,Canadiangovernments,bothfederaland

provincial,shouldeliminatecapitalgainstaxes .Therevenuelossfromsuchamovewouldbe

smallgiventhatcapitalgainstaxesaccountedforlessthanonepercent(0 .8%)oftotalfederal

andprovincialgovernmentrevenuein2005/06 .Iflostrevenuesmustbereplaced,other,less

costly,formsoftaxationshouldbeused .

EliminatingcapitalgainstaxeswouldsubstantiallyincreaseprosperityinCanada .Inthe

wordsofformerFederalReserveChairmanAlanGreenspan,“[t]hemajorimpact[ofthecapital

gainstax]istoimpedeentrepreneurialactivityandcapitalformation .Whilealltaxesimpede

economicgrowthtooneextentoranother,thecapitalgainstaxisatthefarendofthescale .I

arguedthattheappropriatecapitalgainstaxwaszero .”



Introduction


economiccosts .Unfortunately,thecostoftaxationisnotlimitedtotheamountoftaxcollected .

Capitalgainstaxesimposeadditionalcostsontheeconomybecauseindividualsandbusinesses

altertheirbehaviourinresponsetothesetaxes .[1]Thepurposeofthisstudyistoexaminethe

economiccostsofcapitalgainstaxes[2]andtoproviderecommendationsthatwillmaximize

investment,workeffort,risk-taking,andentrepreneurshipinCanada .

Organization of the study

Section 1 definescapitalgainstaxesandprovidesinformationontheapplicableratesofcapital

gainstaxatthefederalandprovinciallevelsinCanada .Italsoprovidesacomparisonofinterna-

tionalratesforthecapitalgainstax .

Section 2 presentsinformationaboutgovernmentrevenuesgeneratedbycapitalgainstaxesat

boththefederalandprovinciallevelsofgovernmentinCanada .

Section 3 examinestheeconomicimpactofcapitalgainstaxesonthereallocationofcapital,

thestockofcapital,andthelevelofentrepreneurship .Italsoexaminesthecomplianceand

administrativecostsassociatedwithcapitalgainstaxesandconcludesbyshowinghowmuch

morecostlyitistoraiserevenueusingcapital-basedtaxeslikecapitalgainstaxesratherthan

othertypesoftaxes .

Section 4 providesrecommendationsthatwillmaximizeinvestment,workeffort,risk-taking,

andentrepreneurship .

1 Alltaxesoncapitalfromindividualdividend-andinterest-incometaxestocorporatecapitaltaxes,salestaxes on business inputs, and corporate income taxes reduce the returns on investment . Froman eco-nomicpointofview,therearelargeefficiencygainstobeachievedbymovingawayfromtaxesoncapitaltowardstaxesonconsumption(seeClemensetal .,2007) .

2 Itisimportanttonotethatthereareconsiderationsotherthaneconomiccostsindeterminingtaxpolicy .Forinstance,equity(oftenreferredtoasfairness)andsimplicityarecritical .However,thisstudyfocusesontheeconomiccosts,whicharealltoooftenignored .


� / The Economic Costs of Capital Gains Taxes

1 Defining capital gains taxes

A capital gain (or loss) generally refers to the price of an asset when it is sold compared to its

purchase price. A capital gain occurs if the value of the asset at the time of sale is greater than

the original purchase price. [3] On the other hand, a capital loss occurs if the value of the asset

at the time of sale is less than the original purchase price. [4]

Canada does not maintain a separate and distinct capital gains tax as capital gains

are considered normal income and subject to income taxes. [5] Depending on who holds the

asset (individual or business), capital gains are taxed at either personal or corporate income-

tax rates. However, capital gains are provided a preferential tax rate through what is referred

to as an inclusion rate, the portion of a capital gain that is subject to income tax. [6] The inclu-

sion rate in Canada is currently 50%, which means that only half of capital gains are subject to

income taxes. [7]

Because Canada has a progressive personal income-tax system (tax rates increase as

income increases), the most important rate is the taxpayer’s marginal tax rate—the rate that

must be paid on the next dollar of income. [8] Table 1 shows for 2006 (1) federal and provincial

top marginal rates for personal income tax and the thresholds at which they apply; (2) federal

and provincial top marginal rates for capital gains tax; (3) in the last column, the combined fed-

eral-provincial top marginal rates for capital gains tax. Since 50% of capital gains are included as

taxable income, the marginal tax rate for a capital gain is half the applicable income-tax rate.

While Canadians in all provinces face the same federal top personal tax rate on capital

gains (14.5%), provincial rates vary greatly. Alberta had the lowest provincial top marginal capital-

gains tax rate in Canada at 5.0% (2006). [9] Newfoundland and Labrador, on the other hand, had

the highest top provincial marginal capital-gains tax rate at 9.8% (2006).

The level of income at which the top provincial income-tax rate applies also differs greatly

among the provinces. For instance, Quebec had the lowest threshold at which the top rate applied

($57,431) while New Brunswick ($108,769) and Saskatchewan ($107,368) had the highest thresholds.

3 This is typically called a capital gain realization.

4 In most countries, including Canada, taxpayers are able to offset capital gains with capital losses to reduce the capital gains tax paid. In Canada, taxpayers who have a capital loss in one year can use it to reduce any capital gains in the year, to a balance of zero. If capital losses are more than the taxpayer’s capital gains, he has a net capital loss for the year. Taxpayers are able to apply their net capital losses to taxable capital gains of the three preceding years and to taxable capital gains of future years. For more information, see <http://www.cra-arc.gc.ca/E/pub/tg/t4037/t4037-06e.pdf>.

5 There is debate in the literature about whether or not capital gains are normal income (see Bartlett, 2001).

6 The inclusion rate also determines allowable capital losses. Taxpayers multiply their capital loss for the year by 0.5 to determine their allowable capital loss.

7 See Lochan (2002) for an explanation of the rationale for the inclusion rate. The inclusion rate has changed over time (see Sandler, 2004 and Richardson and Moore, 1995).

8 Grubel (2000) found that, in Canada, most capital gains are taxed at the top marginal personal income-tax rate.

9 Alberta is the only province with a single personal income-tax rate, which applies to all levels of income.



Inotherwords,Quebec’srelativelyhightopmarginaltaxrateoncapitalgainsappliesatnearly

halfthelevelofincomeasthatinNewBrunswickorSaskatchewan .Albertaistheonlyprovince

thathasasinglepersonalincome-taxrate,whichappliestoalllevelsofincome .

Figure1showsthecombinedfederal-provincialtopmarginalpersonalcapital-gainstax

ratesinCanadaforeachprovincein2006 .Thethreewesternprovinceshadthelowestcom-

bined(federal-provincial)topmarginalcapital-gainstaxratesin2006 .Specifically,Albertahad

thelowestfederal-provincialtopmarginalcapital-gainstaxrateinCanadaat19 .5%(2006),fol-

lowedbyBritishColumbia(21 .9%)andSaskatchewan(22 .0%) .[10]NewfoundlandandLabrador,

ontheotherhand,hadthehighestcombined(federal-provincial)topmarginalcapital-gains

taxrateat24 .3% .

International capital gains taxes

Thestructureandratesofcapitalgainstaxesvaryconsiderablybycountry .Somecountrieshave

aseparateanddistincttaxoncapitalgainswhileothers,likeCanada,taxcapitalgainsthrough

theirincome-taxsystems .Inaddition,boththeratesoftaxandlevelsofincomeatwhichthose

ratesapplydifferamongcountries .

10 Thecombinedfederal-provincialratesapplytoincomeabove$118,286(thetopfederalthreshold)asthetopfederalthresholdishigherthanallofthetopprovincialthresholds .

Table 1: Top marginal rates and thresholds for personal income tax

and top marginal rates for capital gains tax, 2006

Personal income tax Capital gains tax

Top marginal rate [a]

Threshold for top marginal rate

Top marginal rate

Combined federal-provincial top marginal rate [d]

Federal 29 .0% $118,286 14 .5% —

British Columbia 14 .7% $94,122 7 .4% 21 .9%

Alberta 10 .0% N/A[b] 5 .0% 19 .5%

Saskatchewan 15 .0% $107,368 7 .5% 22 .0%

Manitoba 17 .4% $65,001 8 .7% 23 .2%

Ontario 17 .4% $69,518 8 .7% 23 .2%

Quebec [c] 19 .2% $57,431 9 .6% 24 .1%

New Brunswick 17 .8% $108,769 8 .9% 23 .4%

Nova Scotia 19 .3% $93,001 9 .6% 24 .1%

Prince Edward Island 18 .4% $61,510 9 .2% 23 .7%

Newfoundland & Labrador 19 .6% $59,181 9 .8% 24 .3%

[a]Ratesincludeallsurtaxes .[b]Albertahasasingle10%incometaxforallpersonalincome;therefore,thethresholdforthetopratedoesnotappply .[c]Quebec’sratesareadjustedforabatements .[d]Thecombinedfederal-provincialratesapplyatincomeabove$118,286asthisamount,thetopfederalthreshold,ishigherthanalloftheprovincialthresholds .Source: CanadaRevenueAgency,2006;calculationsbyauthors


� / The Economic Costs of Capital Gains Taxes

Figure2showsthetoppersonalcapital-gainstaxratesin2005for30countriesbelong-

ingtotheOrganisationofEconomicCo-operationandDevelopment(OECD) .[11]Elevenofthese

countriesdonotlevypersonalcapitalgainstaxes .Canadahastheninthhighestpersonalcapital-

gainstaxrateamongcountriesat23 .2% .[12]TheUnitedStatesranks21stwithacapitalgainstax

rateof20 .3% .[13]Denmarkhasthehighestcapital-gainstaxrateof43 .0% .

AsinthediscussionofCanadianprovinces, it is importanttonotethatcapital-gains

taxratespresentedinfigure2applyatdifferentlevelsofincomeindifferentcountries .Thatis,

whilethetaxratescouldbeidenticalintwocountries,thelevelofincomeatwhichthoserates

applycouldbemarkedlydifferent .Unfortunately,nointernationalcomparisonofthresholdsfor

capitalgainstaxesexists .

11 Theratespresentedarelong-termratesofcapitalgainstax .Long-termratesofcapitalgainstaxareratesthatapplytoassetsheldforatleasttenyears .Itshouldbenotedthatsomecountrieshavedif-ferentratesofcapitalgainstaxdependingonthelengthoftimeanassetisheld(holdingperiod) .Forexample,intheUnitedStates,federalcapital-gainstaxonassetsheldlessthanoneyeararesubjecttotheindividual’stopapplicabletaxrate .Iftheassetisheldmorethanoneyear,thenafederaltaxrateof15 .0%applies(5 .0%tothoseinthelowesttwoincome-taxbrackets) .Similarly,DenmarkandtheUnitedKingdomhavehighershort-termratesoftaxoncapitalgains(definedasassetsheldmorethanoneyearbutlessthantwoyearsinthestudy)of62 .9%and40 .0%,respectively .SeeErnst&Young(2004)foradetaileddelineationofinternationalratesofpersonalcapital-gainstaxandtheholdingperiodsforwhichtheyapply .

12 ThisrateisbasedontherepresentativeprovinceofOntario .Thenationalaverageofthetenprovincialtopmarginalratesoftaxoncapitalgainsforthe2005taxyearis22 .9% .

13 Includesfederal,state,andcitytaxes .StateandcitytaxesarebasedonratesinMichiganandDetroit .TheUSfederalrateoncapitalgainsis15 .0% .





Conclusion

Capitalgainsandlossesoccurifthevalueoftheassetatthetimeofsalediffersfromtheoriginal

purchaseprice .InCanada,50%ofcapitalgainsaresubjecttotaxes .Capitalgainstaxesvarycon-

siderablyamongtheprovinceswiththethreewesternprovinceshavingthelowestcombined

(federal-provincial)capital-gainstaxrateswhileQuebec,NovaScotia,andNewfoundlandand

Labradorhavethehighestrates .Canadahasarelativelyhighcapital-gainstaxratecompared

toothercountries .


The Economic Costs of Capital Gains Taxes / 11

2 Government revenue from capital gains taxes

Thissectionpresentsinformationontheamountofrevenueraisedthroughcapitalgainstaxes

byCanadiangovernments,bothfederalandprovincial .Unfortunately,theamountofrevenue

raisedthroughcapitalgainstaxesisnotprovidedtothepublicingovernmentpublications .

Canadiangovernmentslumpcapital-gainstaxrevenueswithinthelargerpersonalandcorpo-

rateincome-taxcategoriesintheirbudgetsandannualreports .Theinformationpresentedin

thissectionisbasedonaspecialdatarequestfromthefederalDepartmentofFinance .

In2005/06,Canadiangovernmentsraisedapproximately$3 .5billionthroughcapital

gainstaxesintotal .Thefederalgovernmentraised$2 .2billionwhiletheprovincescollecteda

combined$1 .3billion .[14]Figure3showsthepercentageoffederalandprovincialgovernment

revenuecollectedthroughvarioustypesoftaxes .In2005/06,totalconsolidatedfederaland

provincialgovernmentrevenuewas$443 .1billionofwhich37 .2%wascollectedthroughper-

sonalincometaxesand11 .1%wascollectedthroughcorporateincometaxes .[15]Incomparison,

capitalgainstaxesaccountedforlessthanonepercent(0 .8%)oftotalfederalandprovincial

governmentrevenue .Inotherwords,revenuescollectedintheformofcapitalgainstaxesare

verysmallcomparedtothemainsourcesofgovernmentrevenue—personalandcorporate

incometaxesandsalestaxes .

14 Theprovincialportionofcapital-gainstaxrevenuewasestimatedbyapplyingtheratiobetweenfederalcapital-gainstaxrevenueandtotalfederalincometaxcollectedtoprovincialincome-taxrevenue .

15 Personalandcorporateincometaxesareadjustedforcapital-gainstaxrevenue .



3 Economic costs of capital gains taxes

This section examines the economic impact of capital gains taxes on the reallocation of capi-

tal, the stock of capital, and the level of entrepreneurship. It also examines the compliance and

administrative costs associated with capital gains taxes and concludes by showing how much

more costly it is to raise revenue using capital-based taxes like capital gains taxes rather than

other types of taxes.

1 The reallocation of capital and the “lock-in effect”

One of the most significant economic effects of capital gains taxes is the incentive it creates for

owners of capital to hold on to their current investments, even if more profitable and produc-

tive investment opportunities are available. Economists refer to this result as the “lock-in” effect.

Capital that is locked into current investments and not reallocated to more profitable opportuni-

ties reduces economic performance. Consider an investor who wishes to sell an asset and rein-

vest the proceeds in a new project. The amount of money received from the sale of the asset is

reduced by the capital gains tax. In order for the investor to reallocate his capital, the new invest-

ment project must provide a rate of return high enough to recoup the funds paid in taxes plus

yield a reasonable rate of return.

Suppose an investment currently worth $1,500 yields an annual rate of return of 7.0%

per year. Over five years, this investment will grow to $2,103.83 if all income is reinvested and no

taxes are paid on the income generated. Now suppose that, if the $1,500 asset were sold today,

the owner would receive a $500 capital gain (the original cost of the investment was $1000). If

the owner resides in Ontario and is currently in the highest income-tax bracket, he would face

a 23.2% capital-gains tax rate (see figure 1) resulting in $116.00 in capital gains taxes. After the

sale of the asset and payment of the tax, the investor has $1,384.00 to place in a new investment.

For an investment of $1384.00 to grow to $2103.83 (the amount received after five years from the

original investment), a return close to 9.0% annually must be achieved. An investor with a time

horizon of five years will hold on to the original investment (will lock in the investment) yielding

7.0% per year unless a new investment yields at least 9.0%. [16] In other words, in our example,

an investment project yielding between slightly more than 7% and 9% is not funded.

While the magnitude of the lock-in effect depends on numerous factors (the rate of

return on the original and new investments and investor’s time horizon), economic costs result

16 In 2002, Professors Sarath Abeysekera and Earl Rosenbloom of the University of Manitoba wrote an article in the Canadian Tax Journal titled “The Capital Gains Lock-in Effect: Deciding Whether to Hold or Switch.” The authors present formulas for determining the break-even rate of return for investments subject to capital gains taxation. This is the rate of return at which an investor is indifferent when deciding whether to hold a given investment asset or to switch to an alternative investment asset with capital gains taxation. Depending on a given rate of capital gains taxation, holding period, and expected capital growth rates, readers can use the tables provided and calculate their break-even rate of return. The tables illustrate the lock-in effect through the practical decisions investors must make in the presence of capital-gains taxa-tion. The tables are available on line in an interactive version at <http://www.umanitoba.ca/asper/faculty/sarath.abeysekera/research.htm>.

<http://www.umanitoba.ca/asper/faculty/sarath.abeysekera/research.htm>

<http://www.umanitoba.ca/asper/faculty/sarath.abeysekera/research.htm>


The Economic Costs of Capital Gains Taxes / 1�

becausecapitalgainstaxespreventthereallocationofcapitalfromlowertohigheryielding

uses .Thatis,capitalgainstaxescausetheeconomytolosetheextraoutputthatthereallo-

cationofcapitalwouldhaveproduced .Thelock-inofcapitalpreventsthedevelopmentof

somenew,potentiallyprofitable,businessesthatareenginesofproductivity,employment,

andwealthcreation .

Numerousacademicstudieshaveinvestigatedthelock-ineffect .[17]Forexample,an

influentialpaperbyHarvardProfessorMartinFeldsteinandhiscolleaguesJoelSlemrodand

ShlomoYitzhaki(1980)wasoneofthefirsttoprovideanempiricalanalysisoftheeffectoftaxa-

tionontherealizationofcapitalgains(saleofcorporatestocksataprofit) .[18]Theauthorsfound

thattherealizingofcapitalgainsisverysensitivetothemarginaltaxrate .Theyfoundasignificant

lock-ineffect:a10 .0percentage-pointincreaseinthemarginaltaxratereducedtheprobability

ofsellingastockby6 .5percentagepoints .[19][20]

PaulBolster,LawrenceLindsey,andAndrewMitrusi(1989)evaluatedtheimpactofthe

eliminationin1986ofthelower,long-termtaxrateoncapitalgainsonstockmarketactivityin

theUnitedStates .[21]TheauthorsexaminedtradingvolumeontheNewYorkStockExchange

(NYSE)andtheAmericanStockandOptionsExchange(AMEX)from1976to1987 .Theyfoundthat

tradingvolumesignificantlyincreasedinthemonthsleadinguptothetaxchangeandthattrad-

ingvolumesignificantlydeclinedafterthetaxchange:tradingvolumewas15 .0%lowerinthe

Januaryof1987comparedtopreviousJanuaries .Theempiricalresultssuggestthattheexpected

increaseinthecapital-gainstaxrateinducedinvestorstoreallocatecapitalpriortothechange .

AmorerecentstudybyPeterKuglerandCarlosLenz(2001)examinedtheimpactofthe

lock-ineffectontheoveralleconomybystudyingtheeffectofcapitalgainstaxesindifferent

jurisdictionswithverysimilareconomicconditionsandtaxsystems .Theauthorsexaminedthe

17 Manystudiesprovideempiricalevidenceoftheexistenceofalock-ineffect .Forinstance,Jog(1995)findsevidenceofalock-ineffectinCanadabyexaminingthechangeincapitalgainsrealizationsafterthe1985introductionofacapitalgainsexemption .Also,seeLandsmanandShackelford,1995,Shackelford,2000,Blouinetal .,2000,andDaietal .,2006forempiricalevidenceofthelock-ineffect .

18 AnearlierstudybyMartinFeldsteinandShlomoYitzhaki(1978)examinedtherelationshipbetweencapitalgainstaxesandstock-marketactivitybutdidnotextendtheanalysistocapitalgainsrealizations .

19 Inanearlierstudy,Yitzhaki(1979)estimatesthathigh-incomeinvestorssacrificeanannualreturnofap-proximately1 .5%ofthevalueoftheirstockasaresultofthelock-ineffect .

20 Itisimportanttonotethedifferencebetweenapercentage-pointchangeandapercentchange .If,forex-ample,thecurrentcapitalgainstaxratewereincreasedfrom30%to35%,thechangecouldbeinterpretedasa5percentage-pointincreaseora16 .7%increase[(35−30)/30×100] .

21 AnearlierstudybyLindsey(1987)simulatesthebehaviouralresponseofinvestorstotheUSTaxReformActof1986(whichincreasedtheaveragetaxrateoncapitalgainsfrom15 .0%to27 .0%) .Theauthorestimatesthatthefirst6 .0percentage-pointincreasewouldreducecapitalgainsby30 .0%whilethesecond6 .0per-centage-pointincreasewouldreducecapitalgainsbyatotalof50 .0% .Lindseyconcludesthat,atleastintheshort-term,thisevidencesupportsthelock-ineffect .AstudybyDonaldKiefer(1990)usesacomputersimulationtotesttheimpactonstock-marketactivityofthereintroductionofalower,long-termrateofcapitalgainstax .Usingthe1989proposaltoreducetaxonlong-termcapitalgainsfrom28 .0%to15 .0%,heestimatesthattheaverageholdingperiodofinvestorswouldincreasefrom2 .24yearsto2 .81years .Thisisconsistentwithotherstudiesthatconcludeinvestorslock-intheircapitaltoqualifyforthelower,long-termrateoftax .Inaddition,therateatwhichinvestorswouldsellandrepurchasestocksyear-over-year(theturnoverrate)wouldincreasefrom19 .7%to22 .9% .Putdifferently,reducingcapitalgainstaxesencour-agesinvestorstounlockcapitalgainsandincreasestheflowofcapital .



experienceofregionalgovernments(“cantons”)inSwitzerlandthateliminatedthecapitalgains

tax .Theauthors’statisticalanalysisshowedthattheeliminationofcapitalgainstaxeshada

positiveandeconomicallysignificanteffectonthelong-termlevelofrealincomein7ofthe8

cantonsstudied .Specifically,theincreaseinthelong-termlevelofrealincomerangedbetween

1 .1%and3 .0%;thismeansthatthesizeoftheeconomywas1%to3%largerduetotheelimina-

tionofcapitalgainstaxes .

Whilemostresearchhasexaminedthelock-ineffectfromtheperspectiveoftheinvestor,

arecentpaperbyCharietal .(2005)arguedthatthelock-ineffectalsoexistedforentrepreneurs

andventurecapitalists .Theytoo,mayholdontotheirinvestmentstoolongbecauseofthe

inabilitytofindinvestmentsthatcompensatethemfortaxespaid .Thatis,entrepreneursstayin

projectslongerthanexpectedorisoptimalbecauseshiftingtonewprojectsistoocostly .The

authorsconcludedthatpotentiallymoreprofitableprojectsgounfundedbecauseentrepre-

neurslock-intheircapitalincurrentprojects .

Conclusion


investmentstothosewithhigherratesofreturn .Numerousempiricalstudieshavefound

thatinvestorsdoindeedlockintheircapitalinthepresenceofcapitalgainstaxesandthat

thelock-ineffectdamagesaneconomy .Withouttheefficientflowofcapital,thedevelop-

mentofnew,potentiallyprofitable,businessesislimited .Giventhatthesenewventuresare

theenginesofproductivity,employment,andwealth-creation,capitalgainstaxesreduce

economicwell-being .

2 The “user cost of capital” and the stock of capital

Capitalgainstaxeshaveasignificantimpactonthestockofcapital .Areducedamountofcapital,

inturn,hasanumberofnegativeconsequencesincludingdecreasesintheproductivityofCana-

dianworkersand,ultimately,lowerCanadianlivingstandards .[22]Therelationshipbetween

capitalgainstaxesandthestockofcapitaldependsbothontheimpactofcapitalgainstaxes

onthecostofcapitaltousers(i .e .businesses)andhowsensitivetheseusersaretochangesin

thecostofcapital .

Capital gains taxes and the cost of capital

The“usercostofcapital”isthecosttoabusinessofraisingoneadditionaldollarforinvestment .

ThetermwasoriginallyintroducedbyHarvardeconomistDaleJorgenson(1963)torefertothe

totaleconomiccostofcapitalinvestmentincludingthemarketpriceofraisinganadditionalunit

ofcapital,interestcosts(ifcapitalispurchasedusingdebt),requiredrateofreturntoequityown-

ers(ifcapitalispurchaseusingretainedearningsormoneyraisedthroughshareofferings),and

thetaxesthatfirmsmustpayontheprofitthatthecapitalinvestmentgenerates .

22 SeeVeldhuisandClemens,2006foradetaileddiscussionoftheimpactofcapitalaccumulationonproduc-tivityandprosperity .



InvestorshavemanyinvestmentopportunitiesinCanadaandinternationally .Toattract

investors,Canadianbusinessesmustpossessthehighestrisk-adjustedrateofreturnavailableto

investors .Capitalgainstaxesincreasetherateofreturnthatbusinessesmustgeneratefortheir

investorsbecauseinvestorsmustpaytaxonanygainsinthevalueoftheirshares .[23]Inother

words,capitalgainstaxesrequirefirmstoprovidehigherpre-taxratesofreturntotheirown-

ersbecausethereturnswillbeloweredwhenthecapitalgainstaxisapplied .Because,asnoted

above,therequiredrateofreturnthatinvestorsdemandispartofthetotaleconomiccostof

capital,capitalgainstaxesincreasethe“usercostofcapital .”

Numerousempiricalstudieshaveexaminedtheimpactofcapitalgainstaxesonfirms’

usercostofcapital .[24]Forinstance,McKenzieandThompson(1995)estimatethata10 .0percent-

age-pointreductionintherateofcapitalgainstaxesinCanadadecreasesthecostofcapitalby

3 .0%to6 .0% .[25]AllenSinai(1997)estimatedtheimpactupontheAmericaneconomyofhalv-

ingthecapitalgainstaxforindividuals(50%capitalgainsexclusion)andreducingtherateto

businessesfrom35 .0%to25 .0% .Hefoundthatthecapital-gainstaxreductionwouldreducethe

costofcapitaltobusinesses,onaverage,by2 .7%peryearfrom1997to2002 .Similarly,astudy

byDRI/McGraw-Hill(1997)estimatesthatthesamecapital-gainstaxreductionwouldlowerthe

netcostofcapital(total,1998to2007)by3 .0% .

Cost of capital and the stock of capital

Thedegreetowhichcapitalgainstaxeslowerthestockofcapitaldependscriticallyonhowsen-

sitivebusinessesaretothecostofcapital .Thatis,towhatextentdofirmschangetheircapital

investmentwhentheircostofcapitalchanges .RobertChirinkoandAndrewMeyer(1997)quan-

tifythesensitivityofinvestmentspendingtotheusercostofcapitalandestimatethata1%

increaseintheusercostofcapitalresultingfromanincreaseinbusinesstaxeswoulddecrease

capitalinvestmentby0 .05to1 .7% .[26]Milliganetal .(1999)estimatethesensitivityofinvestment

tochangesintheusercostofcapitalinCanada .Theyestimatethatageneraldecreaseintheuser

costofcapitalofabout1 .2%isassociatedwitha1 .0%increaseininvestmentandthata4 .0per-

centage-pointreductionincapitalgainstaxesleadstoa1 .0%to2 .0%increaseininvestment .

23 It is important tonote thatCanada’s taxsystemcontainsnumerousmeasures toexcludesomecapitalgainsfromimmediatetaxation .Forexample,capitalgainsrealizedinRRSPsandotherregisteredplansarenotimmediatelytaxed .

24 Milligan,Mintz,andWilson(1999)claimthattheresponseofsharepricestochangesincapitalgaintaxesprovides “direct evidence” that these changes have an impact upon firms’ user cost of capital . That is,changesincapitalgainstaxeschangetherateofreturnrequiredbyinvestorsandthushaveanimpactuponthepricethatinvestorsarewillingtopayforsharesofthecompany .Numerousempiricalstudieshaveexaminedtheimpactofcapitalgainstaxesonshareprices:seeAmoako-Aduetal .,1992;McKenzieandThompson,1995;GuentherandWillenborg,1999;Shackelford,2000;andBlouinetal .,1999,2003 .

25 Itisimportanttonotethedifferencebetweenapercentage-pointchangeandapercentchange .If,forex-ample,thecurrentcapital-gainstaxratewereincreasedfrom30%to35%,thechangecouldbeinterpretedasa5percentage-pointincreaseora16 .7%increase[(35−30)/30×100] .

26 AmorerecentpaperbyRobertChirinkoandcolleagues(1999)investigatestheresponsivenessofbusinesscapitalformationtoitsusercost .Theauthorsfindthathigherusercostsdoindeedreducecapitalforma-tion .Specifically,theyestimateausercostelasticityofapproximately−0 .25,meaningthata1%increaseintheusercostofcapitalwoulddecreasecapitalformationby0 .25% .Inaddition,theyconcludethatreduc-ingthecapital-gainstaxratewouldhaveapositiveimpactuponthelong-runcapitalstock .


1� / The Economic Costs of Capital Gains Taxes

Conclusion

CapitalgainstaxeslowerthestockofcapitalinCanada .ByincreasingthecostofcapitaltoCana-

dianbusinesses,capitalgainstaxesmakecapitalinvestmentsmoreexpensiveandreducesthe

amountofinvestmentthattakesplace .Asmalleramountofcapitaldecreasestheproductivity

ofCanadianworkersandultimatelylowersCanadianlivingstandards .

3 Entrepreneurship and risk-taking

Entrepreneursandtheirfinanciers[27]arecriticaltoasuccessfuleconomyinthattheychal-


increasewealth .Unfortunately,capitalgainstaxeshaveanegative impactontheleveland

financingofentrepreneurship .

Entrepreneursrisktheirowncapitalandtimeinhopesofprofitingfromanunproven

product,service,ortechnology .Inaddition,manyentrepreneursdeveloptheirinnovationswith

thehelpofventurecapitalistswhoprovidefinancing,industryknowledgeandmanagerialknow-

how .Typically,entrepreneursandtheirfinanciersacceptlow,ifany,currentcompensationinthe

hopeofsubstantialfuturereturns .Thatis,theyagreetoalowpayoutearlyintheventureinorder

toincreasethevalueoftheircompanythroughthereinvestmentofearnings .Bothentrepreneurs

andfinanciersexpecttobecompensatedwhenthebusinessmaturesandgeneratessignificant

returns,istakenpublicandlistedonthestockmarket,orisboughtoutbyanothercompany .

Capitalgainstaxesreducethereturnthatentrepreneursandinvestorsreceivefromthe

saleofthebusiness,thereturnforrisk-taking,innovation,hardwork,andlowcurrentcompen-

sation .Thenumberofsuchrisktakersandfinanciers,andtheamountofmoneytheyarewilling

toinvest,decreaseswhenthepotentialreturnsdecrease .Theresultisalowerlevelofeconomic

growth,lowerlevelofjobcreation,andultimatelyalessprosperouseconomy .

Capitalgainstaxesalsohaveanimpactupontheabilityofentrepreneurstoattractkey

managersfromthetraditionalbusinesssector .Sincestart-upscannotusuallyofferwagesthat

arecompetitivewiththoseinthetraditionalbusinesssector,managersarerecruitedtostart-ups

throughownershipstakesinthebusiness .Capitalgainstaxesreducethereturnthesemanagers

receive,whichreducesthelikelihoodthatstart-upswillbeabletoattractthenecessarytalent

growthrequires .

Thereisagrowingbodyofacademicresearchinvestigatingtheimpactofcapitalgains

taxesonentrepreneurship .Moststudiesfocusonhowalowerrateofreturnresultingfrom

capitalgainstaxesaffectstheactorsintheentrepreneurialprocess—theentrepreneursand

theirfinancers .Inaddition,somerecentstudiesexaminetheimpactofcapitalgainstaxeson

whatisperhapsentrepreneurs’mostsignificantcontributiontoeconomicgrowth,innovation

andthecreationofideas .

27 I .e .“venturecapitalists .”Venturecapitalismoneyinvestedinnew(“start-up”),andpotentiallyhigh-growth,smallbusinesses .Venturecapitalderivesfromseveralsources:(1)formalventurecapital,whichconsistsprimarilyofventurecapitalfundswhereindustryexpertsmanageaportfolioofventureinvestments;(2)informalsources,suchas“love”capitalfromfriendsandfamily,and;(3)wealthyindividualswithbusinessexperience(“Angels”),whoprovidecapitalandbusinessexpertisetonewfirms .



ProfessorJamesPoterba(1989)providedthetheoreticalgroundworkforexaminingthe

impactofcapital-gainstaxpolicyonentrepreneurship .Poterbahighlightedanimportantlink

betweencapitalgainstaxesandthedemandforventurecapitalfunding:potentialentrepre-

neurscomparedthecompensationobtainedfromemploymentatanestablishedfirmwiththe

expectedpayofffromastart-upwherealargershareoftheircompensationwouldconsistofa

capitalgain .Poterbaconcludedthatbychangingtherelativetaxburdens,areductionincapital

gainstaxesattractsmoremanagersofhigherqualitywhobecomeentrepreneursanddemand

venturecapital .

HarvardeconomistsPaulGompersandJoshLerner(1998)madeanempiricalexamina-

tionofPoterba’sargumentbyexploringthekeydriversofventurecapitalfunding .Analyzing

thestockofventurecapitalandtaxratesoncapitalgainsfrom1972to1994,GompersandLerner

foundthataonepercentage-pointincreaseintherateofcapitalgainstaxwasassociatedwith

a3 .8%reductioninventurecapitalfunding .[28]

Morerecently,ChristianKeuschniggandSorenBoNielsen(2004a),writingintheJour-

nal of Public Economics,investigatedtheimpacttaxesandotherpublicpolicies(i .e .subsidiesto

supportnewfirms)hadonthecreationandsuccessofbusinessesthatwerefinancedbyventure

capital .Intheiranalysis,theauthorsincludedthemanagerialeffortandadvicethatventure

capitalistsprovidedtoentrepreneursinadditiontofinancing .KeuschniggandNielsenfound

that“evenasmallcapitalgainstax…diminishesincentivestoprovideentrepreneurialeffort”

(2004a:1033) .

Morerecently,DonaldBruceandMohammedMohsin(2006)presentedanempirical

analysisoftaxpolicyandentrepreneurshipintheUnitedStates .Theauthorsexaminedper-

sonalincome-taxrates,capitalgainstaxes,andcorporateincome-taxratesonself-employment

rates(aproxyforentrepreneurship) .[29]BruceandMohsinfoundthataonepercentage-point

reductioninthecapital-gainstaxrateisassociatedwitha0 .11to0 .15percentage-pointincrease

inself-employmentrates .

DaRinetal .(2006)examinedtheimpactanumberofgovernmentpolicieshadonnew

ventures(start-upbusinesses)in14Europeancountriesfrom1988to2001 .Theauthorsusedtwo

measurestodeterminewhetherpoliciesweresuccessful:theproportionofhigh-technology

investmentstototalventureinvestments(high-techratio)andtheproportionofearly-stage

investmentstototalventureinvestments(early-stageratio) .Theauthorsfoundthatthreepoli-

ciesworkedwelltoincreasetheproportionofhigh-techandearly-stageventures:(1)openinga

newventurestockmarket,(2)reducingthecapitalgainstaxand,(3)reducinglabourregulation .

28 DanielSandler(2004)foundthatmuchoftheresearchstemmingfromPoterba(1989)didnotincludetheinformalventure-capitalmarket .HeexplainedthatPoterba(1989) ignoredthe38 .0%offirmslaunchedwithoutoutsideinvestorsandfinancedby“lovecapital”(fundingfromfriendsandfamily)ordebtfinanc-ing .WhilethereiscurrentlylittleempiricalresearchonhowmuchindividualsacrossCanadaarecontribut-inginformallytoentrepreneurship,estimatesoftheimpactofcapitalgainstaxonentrepreneursandtheirdemandforventurecapitalislikelyunderstated .

29 Theauthorsusefourdifferentmeasuresofentrepreneurship:(1)thenumberofindividualincome-taxre-turnswithincomefromasmallbusiness/professionorfarm,asashareofallindividualincome-taxreturns(fromInternalRevenueService);(2)sameas(1)butaddingincome-taxreturnsfrompartnershipsandsmallbusinesscorporations(fromIRS);(3)thenumberofallnon-agriculturalworkersaged16andolderwhoareself-employed(fromtheBureauofLaborStatistics);and(4)sameas(3)butincludingtheagriculturalsector(fromBLS) .



Conclusion

Capitalgainstaxeshaveadetrimentalimpactonthenumberofentrepreneursandrisk-takers .

Entrepreneursandtheirfinanciersarecriticaltoasuccessfuleconomybecausetheychallengethe

statusquo,advancetechnology,developnewproductsandservices,createjobs,andincrease

wealth .Theseindividualstradeofflowcurrentcompensationbecausetheyexpecttogener-

atesignificantfuturereturns .Capitalgainstaxesreducethereturnthatentrepreneurs,venture

capitalists,andotherinvestorsreceivefromrisk-taking,innovation,andwork .Lowerexpected

returnsdecreasesthenumberofentrepreneursandrisk-takersandultimatelyreducesinvest-

ment,technologicaladvances,employment,andoveralleconomicgrowth .

4 Other costs associated with capital gains taxes

Theeconomiccostsoutlinedinthepreviousthreesub-sectionsresultbecausecapitalgains

taxeschangetheincentivesforproductivebehaviour .Inadditiontothesecosts,capitalgains

taxesalsoimposecomplianceandadministrativecosts .Compliancecostsareincurredwhen

individualsandfirmsconsumeresourcestocomplywithtaxregulations .Administrativecosts

arethoseexpensesincurredbygovernment—ultimatelypaidforbycitizens—tomanageand

maintainthetaxcollectionsystem .Finally,therearealsocostsassociatedwiththeevasionof

capitalgainstaxesinthatresourcesspentofevadingthetaxcanbeputtomoreproductive

uses .Thecomplianceandadministrativecostsandevasionofcapitalgainsarediscussedin

moredetailinthissection .

Compliance costs

Taxcompliancecostsareincurredwhenfulfillingtherecordingandfilingrequirementsassoci-

atedwithpayingatax .Thesecostsincludesuchexpensesasbookkeeping,reporting,calculat-

ing,andremittingtaxpayments .Unfortunately,therearenoCanadianstudiesthatmeasurethe

compliancecostsassociatedwithcapitalgainstaxes,presumablybecausecapitalgainsaretaxed

asnormalincomeinCanada .However,thereareafewstudiescoveringothercountriesthatare

relevanttoouranalysisofcompliancecostsinCanada .

BlumenthalandSlemrod(1992)foundthatAmericantaxpayerswhoreceivedcapital

gainsincomeincurredhighercompliancecoststhanthosewhodidnot .Fromasurveyof2,000

Minnesotahouseholds,theauthorsfoundthathavingcapitalgainsincreasedthetimeindividu-

alsspentonpayingtaxesby7 .9hours,increasedthemoneytheyspentonprofessionaltaxassis-

tancebyabout$21,andincreasedthetotalcostofcomplianceby$143pertaxpayer(allfiguresin

1989USdollars) .Tran-Nametal .(2000)foundthatcapitalgainstaxesimposedsignificantcompli-

ancecostsonAustralianfirms:6 .8%oftotalincometaxrevenuecollected(includingincometax

revenuegeneratedfromcapitalgains) .

Vaillancourt(1989)examinedcomplianceandadministrativecostsforpersonalincome

taxesinCanada .Sincecapitalgainsaretaxedthroughtheincome-taxsysteminCanada,this

studyprovidessomeusefulinsightsintothecompliancecostsforcapitalgainstaxes .Villain-

courtfoundthatcomplianceandadministrativecostsforpersonalincometaxes(thetwocosts



werenotdelineated)weresome6 .9%oftaxescollected,whichhedeemedtobeinlinewith

internationalstudies(1989:83) .[30]

Whileveryfewstudiesmeasurecompliancecostsassociatedwithcapitalgainstaxes,

thestudiesreviewedaboveclearlyindicatethattherearepositivecompliancecostsincurredby

individuals,families,andbusinessesinadditiontothedirectcostsoftaxation .Thesecostsmust

betakenintoconsiderationwhenassessingtaxpolicy .

Administrative expenses

Inadditiontocompliancecostsindividuals,families,andbusinessespaywhencomplyingwith

capital-gainstaxregulations,therearealsocostsassociatedwithcollecting,administering,and

managingthecollectionofcapitalgainstaxes .Thesecostsaredirectlyincurredbygovernments

thatcollecttaxesbutareultimatelybornebycitizens .Aswasthecaseforcompliancecosts,evi-

denceforadministrativecostsisgenerallylimitedandunfortunatelynostudiesspecificallyana-

lyzethecostsassociatedwithcapitalgainstaxes .

Vaillancourt(1989)examinestheadministrativecostsassociatedwithpersonalincometax-

esandtwopayrolltaxes(CPP/QPPandUI) .Thecostsincludeprocessingcosts,administrationand

accommodationcosts,capitalexpenses,andlitigationcosts .Vaillancourtconcludedthatthetotal

administrativecosttothefederalgovernmentforthesethreetaxesin1986/87was$642million .These

costsrepresentedroughly1 .0%ofthegrossrevenuescollectedbythesethreetaxsources .[31]

Theadministrativecostsassociatedwithcapitalgainsmustalsobetakenintoconsider-

ationwhenconsideringthetotalcostsoftaxes .Whilenodirectestimatesforthesecostsexistfor

capitalgainstaxes,thenumerousregulationsinCanada’staxcodetodeterminethevaluation

andtimingofcapitalgainsindicatethatadministrativecostssurelyexistasCanadaRevenue

Agencyusesmanyagents,auditors,andlawyerstomonitorandenforcetheseregulations .

Tax evasion

Capitalgainstaxeshavealsoledsometaxpayerstoevadethepaymentofthetax .Thelevelof

taxevasionistheextenttowhichactualtaxrevenuecollectedbygovernmentdiffersfromthat

whichwouldhavebeencollectedifeverytaxpayerpaidexactlywhatisrequiredbylaw .Taxeva-

sionhasimportantimplicationsfortheefficiencyoftaxes,sinceresourcesspentonevadingthe

taxcouldbeputtomoreproductiveuses .

ProfessorJamesPoterba’sstudyintheAmerican Economic Review(1987b)wasapath-

breakingworkinmeasuringtherelationshipbetweencapitalgainstaxesandtaxevasion(see

alsoPoterba,1987a) .Hefoundthatcapitalgainstaxeshaveasignificantimpactontaxevasion:

30 MajaKlun(2004)providesareviewoftheempiricalliteratureofcompliancecostsassociatedwithpersonalincometaxinCanada .Inaddition,ProfessorBrianErard’sreport(1997b)fortheTechnicalCommitteeonBusinessTaxationconcludedthatthecomplianceburdenforincomeandcapitaltaxesforlargecompaniesinCanadaequalledroughly5%oftaxespaid .

31 Vaillancourt(1989)didnotcalculateadministrativecostsasapercentageofgrossrevenues .Thiscalcula-tionwascompletedbytheauthorsofthisstudy .Revenuesfrompersonalincometaxes,CPP/QPP(CanadaPensionPlanandQuebecPensionPlan),andUI(UnemploymentInsurance,now‘EI’orEmploymentInsur-ance)arefromtheNationalEconomicAccounts .Administrativecostsaredividedbyrevenuesfromthesethreesourcestoobtainthe1 .0%figure .



a1 .0%decreaseinthecapitalgainstaxrateincreasesthereportedtaxbaseby0 .4% .[32]Inaddi-

tion,heestimatesthatforataxpayerwithanincomeof$100,000andcapitalgainsof$20,000,a

reductioninthetaxpayer’staxratefrom45 .0%to33 .0%(e .g .theUnitedStates’TaxReformAct

of1986)wouldreducetheprobabilityofthetaxevasionfrom72 .0%to55 .0% .

AmorerecentstudybyWayneLandsman,DouglasShackelford,andRobertYetman

(2002)buttressthisconclusionwithevidencefromauniquedatasetofshareholderinforma-

tionfromthe1989leveragedbuyoutofRJRNabisco .Theyestimatethataonepercentage-point

increaseinthemarginaltaxrateoncapitalgainsisassociatedwitha0 .42%increaseinevasion .In

addition,theauthorsfindthattheaveragelevelofevasionwas11 .0%ofthetotalcapitalgains .

Unfortunately,therearenospecificestimatesoftowhatdegreetaxpayersevadecapital

gainstaxesinCanada .StudiescoveringtheUnitedStates,however,showthatthereisindeed

somedegreeofevasionassociatedwithcapitalgainstaxes .

Conclusion

Inadditiontothedamagingeconomiccostsofcapitalgainstaxesresultingfromchangesin

theincentivesfacesbyindividualsandbusinesses,capitalgainstaxesalsoimposecompliance

andadministrativecosts .Compliancecostsarethoseexpensesassociatedwithcomplyingwith

taxregulationsandadministrativecostsarethoseexpensesincurredbygovernment—andulti-

matelypaidforbycitizens—tomanageandmaintainthetaxcollectionsystem .Finally,thereare

alsocostsassociatedwiththeevasionofcapitalgainstaxesinthatresourcesspentofevading

thetaxcanbeputtomoreproductiveuses .Whileveryfewdirectstudieshavebeendone,the

estimatesavailableclearlyindicatethattherearepositivecomplianceandadministrativecosts

andsomedegreeofevasionassociatedwithcapitalgainstaxes .

5 Efficiency costs of capital gains taxes

Alltaxesimposeefficiency(economic)costsonsocietybecausetheydistortthebehaviourof

individuals,families,andbusinesses .Asdiscussedabove,capitalgainstaxesreducetheafter-tax

rateofreturnoncapitalinvestments;theycreateanincentiveformanyinvestorstoholdonto

theirinvestmentseventhoughmoreprofitableopportunitiesexist;andtheyreducethereturn

thatentrepreneurs,venturecapitalists,andotherinvestorsreceivefromrisk-taking,innovation,

andworkeffort .Ultimately,thechangesinincentivescausedbycapitalgainstaxesimpedethe

turnoverofolder,lessprofitable,investments,reducethesupplyofentrepreneursandtheinves-

torsthatfinancethem,andreducetheoveralllevelofaccumulatedcapital .

Numerousstudies,bothacademicandcommissionedbygovernment,haveestimated

theeconomiccostofdifferenttypesoftaxes .[33]Theresearchreliesonwhatisreferredtoas

32 Poterba’sworkisuniquebecausehefocusseduponcapitalgainstaxationalone .Therehasbeenmuchworkdoneonincometaxcomplianceandevasioningeneral:seeAllinghamandSandmo,1972andYit-zhaki,1974foratheoreticalreview;seeFeinstein,1991foranempiricalanalysisofincometaxevasion .

33 AcriticalcontributiontothisfieldwasbyNobelLaureateJamesMirrleeswhointheearly1970sdevelopedthetheoryofoptimaltaxation .ThecoreofMirrless’watershedworkwasthatgovernmentsshouldachievegivenrevenuerequirementsbychoosingtaxesthathavethebestsocialwelfareoutcome(Mirrlees,1971,1972;DiamondandMirrlees,1971) .



the“marginalefficiencycost”(MEC) .TheMECmethodologyprovidesamechanismbywhichto

estimatethecostofdifferenttaxesbycalculatingtheefficiencycostofraisingoneadditional

dollarofrevenue .[34]

OneofthemostwidelycitedcalculationsofMECsarethosebyDaleJorgensenandKun-

YoungYun(1991) .TheauthorsestimatetheMECsofselectUStaxesandfindthatcapital-based

taxes(suchascapitalgainstaxes)imposesignificantcostsontheeconomy .Theyconcludedthat

capitalincometaxes(dividend,interest,&capitalgains)imposedamarginalcostof$0 .92(MEC)

foroneadditionaldollarofrevenue(table2) .Incomparison,itcoststheeconomyonly$0 .26to

raiseanadditionaldollarofrevenueusingconsumptiontaxes .

TheCanadiangovernment’sDepartmentofFinancerecentlypublishedastudybyBaylor

andBeauséjour(2004)thatcalculatedthelong-termeconomiccostsimposedbythemaintaxes

usedinCanada .[35]BaylorandBeauséjourestimatedthebenefitsfroma$1taxreductionfor

anumberofdifferenttypesoftaxesandtheirresultssupportJorgensenandYun’searlierMEC

estimatesfortheUnitedStates .[36]BaylorandBeauséjour’sresults(table3)showthatthere

aresignificantbenefitstosocietyfromdecreasingcapital-basedtaxessuchaspersonalcapital

incometaxes(dividends,capitalgains,andinterestincome) .[37]Specifically,a$1decreasein

personalincometaxesoncapitalincreasessociety’swell-beingby$1 .30 .Comparatively,the

smallestbenefit($0 .10)isgeneratedfromareductioninconsumptiontaxes .[38]

Conclusion


thattaxesonpersonalcapitalincome(dividends,capitalgains,andinterestincome)imposesub-


thata$1reductionintaxesonpersonalcapitalincome(dividends,capitalgains,andinterest

income)increasessociety’swell-beingby$1 .30 .Inaddition,thesetaxeswereshowntobemuch

morecostlythanothertypesoftaxessuchasconsumptionandpayrolltaxes .

34 ItiscriticaltonotethattheMECofataxisanestimateofthecostofraisingoneadditionaldollarofrevenue .ThismeansthattheMECisameasureofmarginalorincrementalcostandshouldbeusedtomeasurethebenefitsofsmallorincrementaltaxshifts .TheMECcannotbeusedtomeasurethetotalorevenaveragecostoftaxes .

35 BaylorandBeauséjourcalculatedthebenefitsfromreducingtaxesandassumedthatthetaxrevenueslostduetothetaxcutswereoffsetbyanon-distortionary,lump-sum,taxincrease .Inotherwords,thetaxchang-eswererevenueneutral .Inaddition,lump-sumtaxesareassumednottodistortthebehaviourofindividualsandfirmsbecausetheydonotalterrelativeprices .SeeMankiw,2005forfurtherdetailsonlump-sumtaxes .

36 EstimatesoftheMECforCanadiantaxeshavebeencalculatedbythefederalDepartmentofFinanceandpublishedbytheOrganisationforEconomicCo-operationandDevelopment (OECD,1997)butunfortu-natelydonotspecificallyestimatetheMECofindividualcapitalincometaxes .However,thestudydidfindthatcapital-basedtaxes,becauseoftheirincentiveeffects,tendtoimposemuchhighercostsonsocietythanothertaxessuchasconsumptiontaxes .Forexample,corporateincometaxes(MEC=$1 .55)andper-sonalincometaxes(MEC=$0 .56)imposemuchhighercoststhanother,moreefficient,typesoftaxessuchasthesalestax(MEC=$0 .17) .

37 Ultimately,Canadashouldmovetowardsan integratedflat-taxthatexcludestaxationonthereturntosavings(interestincome,dividendincome,&capitalgains) .SeeEmesetal .,2001foradetailedanalysisofaflattaxforCanada .

38 TheMinistryofFinanceinQuebecrecentlyevaluatedthebenefitstoQuebec’seconomyfromreducingdifferentprovincialtaxes(Quebec,MinistryofFinance,2005) .TheresultsoftheiranalysiscorroboratethefindingsofBaylorandBeauséjour .



Table 2: Estimates ($CDN) of the marginal efficiency cost (MEC) for selected US taxes

Capital income taxes (individual and corporate) $0 .92

Corporate income tax $0 .84

Individual income tax $0 .60

Payroll tax $0 .48

Sales tax $0 .26

Source: JorgensenandYun,1991 .

Table 3: Welfare gains from reductions in various taxes [a]

Capital Cost Allowance $1 .40[b]

Sales Tax on Capital Goods $1 .30

Personal Capital Income Tax $1 .30

Capital Tax $0 .90

Corporate Income Tax $0 .40

Average Personal Income Tax $0 .30

Wage Tax $0 .20

Consumption Tax $0 .10

[a]Revenuelossisassumedtoberecoveredthrough“lump-sum”taxation .Welfaregainsarecalculatedasthegainineconomicwell-beingperdollaroftaxreduction .[b]Theestimateforanincreaseincapitalcostallowances(CCA)isfornewcapitalonly .IncreasingCCAisnotataxreductionpersebutratheranincreaseinadeductionagainstcorporateincometaxes .Source: BaylorandBeauséjour,2004 .



4 Recommendation—eliminate capital gains taxes




andprovincialgovernmentrevenuein2005/06 .

Iflostrevenuesmustbereplaced,other,lesscostly,formsoftaxationshouldbeused .In

fact,theextenttowhichothertaxeswouldhavetoberaisedtoreplacethelostrevenuefrom

capitalgainstaxeswouldmostlikelybemuchsmallerthantheamountofrevenuelost .That

is,theeliminationofthetaxisexpectedtoincreaseeconomicefficiencyandleadtoincreased

revenuecollectedfromothertaxes .ArecentstudybyHarvardeconomistsGregoryMankiw

andMatthewWeinzierlfoundthat,“inalmostall,casestaxcutsarepartiallyself-financing .This

isespeciallytrueforcutsincapitalincometaxes”(2006:1431) .MankiwandWeinzierlsuggest

thatapproximately50%ofthelossofrevenuefromareductionincapitalincometaxwould

berecoveredthoughincreasedeconomicactivity .Whilecapitalgainstaxesarenotspecifically

modeled,MankiwandWeinzierldoprovidesomeevidencethattheeliminationofthetaxwould

bepartiallyself-financing .

Would eliminating capital gains taxes lead to “income shifting”?

Acommonobjectiontotheeliminationofcapitalgainstaxesisthatanincentivewouldbecre-

atedfortaxpayerstoshifttaxableincomeintonon-taxablecapitalgains,apracticeoftenreferred

toas“incomeshifting”or“surplusstripping .”Thatis,iftherewerenocapitalgainstaxes,busi-

nessownerswouldattempttoreducetheamounttheirbusinessesdistributeasdividendsand

insteadreinvestmoneyinthebusiness .Theownerscouldthenundertakelegalmanoeuvres

to“strip”thereinvestedfundsastax-freecapitalgains .Inaddition,anincentivewouldalsobe

createdforprofessionalsandotherswhooperatethroughawhollyownedcorporationtoshift

ordinarytaxableincomenormallypaidassalaryintonon-taxablecapitalgains .[39]

Grubel(2001)reviewedtheinternationalevidenceontheeffectsofhavingnocapital

gainstaxesandconcludesthatincomeshiftingwouldbelimitedbytwofactors:(1)methods

forincomeshiftingarecomplicatedandcostlyforsmallandwhollyownedbusinesses;and(2)

publiclytradedcompaniesfacestrictaccountingrulesandmarketdisciplinethatmakeitdifficult

toengageinsuchactivities .[40]Furthermore,severalcountriesdonothavecapitalgainstaxes

(figure2) .Forexample,HongKong,whichhasnocapitalgainstaxes,introducedlawsthatpro-

hibittaxavoidancethroughsurplusstrippingandestablishedaBoardofReviewtohearappeals

39 Seepages16–19inGrubel,2001fortwotheoreticalexamplesof“surplusstripping .”

40 Numerousparticipantsata1999FraserInstitutesymposiumoncapitalgainstaxeshadworkedinthefinan-cialsectorduringthe1960swhenCanadahadnocapitalgainstaxesandindicatedthatsurplusstrippingwasnotamajorproblematthattime(Grubel,2003) .



ofdisputeswiththetaxauthorities(HsuandYuen,2001) .WhileCanadaandHongKong’stax

systemsdiffergreatly,HongKong’sexperienceprovidesCanadawithanexampleofanti-avoid-

ancemeasuresthatcouldbeputintoplace .

The appropriate capital gains tax is zero

Awidebodyofacademicresearchhasrevealedthedamagingeconomiccostsofcapitalgains

taxes .Canadianswouldbemademuchbetteroffwithoutthistax .Eliminatingcapitalgainstaxes

wouldsubstantiallyincreaseprosperityinCanada .InthewordsofformerFederalReserveChair-

manAlanGreenspan,“[t]hemajorimpact[ofthecapitalgainstax]istoimpedeentrepreneurial

activityandcapitalformation .Whilealltaxesimpedeeconomicgrowthtooneextentoranother,

thecapitalgainstaxisatthefarendofthescale .Iarguedthattheappropriatecapitalgainstax

waszero”(Greenspan,1997) .



Conclusion


economiccosts .Unfortunately,thecostofcapitalgainstaxesisnotlimitedtotheamountof

taxcollected .Capitalgainstaxesimposeadditionalcostsontheeconomybecausetheyreduce

returnsoninvestmentand,thereby,causeindividualsandbusinessestoaltertheirbehaviour .

Asaresult,capitalgainstaxeshaveasubstantialimpactonthereallocationofcapital,thestock

ofcapital,andthelevelofentrepreneurshipinCanada .

Reallocation of capital


investmentstothosewithhigherratesofreturn .Numerousacademicstudieshavefoundthat

investorsdoindeedlockintheircapitalinthepresenceofcapitalgainstaxesandthatthe“lock-in

effect”significantlyimpedeseconomicgrowth .Withouttheefficientflowofcapital,thedevel-

opmentofnew,potentiallyprofitable,businessesislimited .Giventhatthesenewventuresare

theenginesofproductivity,employment,andwealth-creation,capitalgainstaxesreducethe

economicwell-beingofallCanadians .

Stock of capital

CapitalgainstaxeshaveasignificantimpactonthestockofcapitalinCanadabyincreasingthe

costofcapitaltoCanadianbusinesses .Capitalgainstaxesmakecapitalinvestmentsmoreexpen-

siveandthuslessinvestmenttakesplace .Areducedamountofcapitalhasanumberofnega-

tiveconsequencesincludingdecreasesintheproductivityofCanadianworkersand,ultimately,

lowerCanadianlivingstandards .

Entrepreneurship and risk-taking

Capitalgainstaxeshaveadetrimentalimpactonthenumberofentrepreneursandrisk-takersin

Canada .Entrepreneursandtheirfinanciersarecriticaltoasuccessfuleconomyinthattheychal-


increasewealth .Theseindividualstrade-offlowcurrentcompensationbecausetheyexpectto

generatesignificantfuturereturns .Capitalgainstaxesreducethereturnthatentrepreneurs,ven-

turecapitalists,andotherinvestorsreceivefromrisk-taking,innovation,andworkeffort .Lower

expectedreturnsdecreasesthenumberofentrepreneursandrisk-takersandultimatelyreduces

investment,technologicaladvances,employment,andoveralleconomicgrowth .



Compliance costs, administrative costs and tax evasion

Inadditiontothedamagingeconomiccostsofcapitalgainstaxesresultingfromchangesinthe

incentivesfacedbyindividualsandbusinesses,capitalgainstaxesalsoimposecomplianceand

administrativecosts .Compliancecostsareincurredbyindividualsandbusinesseswhentheful-

filltherecordingandfilingrequirementsassociatedwithpayingatax .Administrativecostsare

expensesincurredbygovernment—andultimatelypaidforbycitizens—tomanageandmain-

tainthetax-collectionsystem .Finally,therearealsocostsarisingfromtheevasionofcapitalgains

taxes:theresourcesspentinevadingthetaxcouldbeputtomoreproductiveuses .

Marginal efficiency cost (MEC) of capital gains taxes


thatpersonalcapitalincometaxes(dividends,capitalgains,andinterestincome)imposesub-


thata$1reductioninpersonalcapitalincometaxes(dividends,capitalgains,andinterestincome)

increasessociety’swell-beingby$1 .30 .Inaddition,thesetaxeswereshowntobemuchmore

costlythanothertypesoftaxessuchasconsumptionandpayrolltaxes .Asaresult,thereareeco-

nomicgainsavailabletoCanadiansfromshiftingawayfrompersonalcapitalincometaxes .

Recommendation—eliminate capital gains taxes




andprovincialgovernmentrevenuein2005/06 .Iflostrevenuesmustbereplaced,other,less

costly,formsoftaxationshouldbeused .

EliminatingcapitalgainstaxeswouldsubstantiallyincreaseprosperityinCanada .Inthe

wordsofformerFederalReserveChairmanAlanGreenspan,“[t]hemajorimpact[ofthecapital

gainstax]istoimpedeentrepreneurialactivityandcapitalformation .Whilealltaxesimpede

economicgrowthtooneextentoranother,thecapitalgainstaxisatthefarendofthescale .I

arguedthattheappropriatecapitalgainstaxwaszero .”



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About the authors

Jason ClemensistheDirectorofFiscalStudiesandtheDobsonCentreforEntrepreneur-

shipandMarketsatTheFraserInstitute .HehasanHonoursBachelorsdegreeofCommerce

andaMastersdegreeinBusinessAdministrationfromtheUniversityofWindsoraswellas

aPost-baccalaureatedegreeinEconomicsfromSimonFraserUniversity .Hehaspublished

studiesonawiderangeoftopics,includingtaxation,governmentspending,labour-market

regulation,banking,welfarereform,andeconomicprosperity .Hisarticleshaveappeared

insuchnewspapersastheWall Street Journal,Investors Business Daily,National Post,Globe

& Mail,Toronto Star,Vancouver Sun,Calgary Herald,Ottawa Citizen,Montreal Gazette,and

La Presse .MrClemenshasbeenaguestonnumerousradioprogramsacrossthecountry

andhasappearedontheCBC National News,CTV News,CBC Business Newsworld,CBC’s

CounterSpin,GlobalTV,BCTV,andReportonBusinessTVasaneconomiccommentator .

HehasappearedbeforecommitteesofboththeHouseofCommonsandtheSenateas

anexpertwitness .

Keith GodinisaPolicyAnalystintheDobsonCentreforEntrepreneurshipandMarketsat

TheFraserInstitute .HeholdsaBachelor’sdegreeineconomicsandaMastersdegreein

PublicPolicyfromSimonFraserUniversity .Histhesisfocusedonventurecapitalandentre-

preneurship .Hisrecentco-publicationsincludeMeasuring Labour Markets in Canada and

the United States,An Empirical Examination of Labour Relations Laws in Canada and the United

States,Union Disclosure in Canada and the United States,andCanadian Provincial Investment

Climate Report: 2007 Edition .SincejoiningTheFraserInstitute,Mr .Godinhaswrittenona

rangeofpolicyissuessuchastaxation,labourregulation,labour-marketperformance,and

fiscalpolicy .

Niels VeldhuisistheDirectoroftheCentreforTaxStudiesandAssociateDirectorofFiscal

StudiesatTheFraserInstitute .SincejoiningtheInstitutein2002,hehasbeentheauthoror

co-authorofthreebooksand21comprehensivestudiesonawiderangeoftopicsincluding

taxation,productivity,entrepreneurship,labourmarkets,andgovernmentfailure .MrVeld-

huishaswrittenover90articles,whichhaveappearedinover30newspapers,includingthe

National Post,Globe & Mail,andWall Street Journal .Heappearsregularlyonradioandtelevi-

sionprogramsacrossthecountryandhasappearedbeforecommitteesofboththeHouse

ofCommonsandtheSenateasanexpertwitness .MrVeldhuisholdsaBachelorsdegreein

BusinessAdministration,withjointmajorsinbusinessandeconomicsandaMastersDegree

inEconomicsfromSimonFraserUniversity .


The Economic Costs of Capital Gains Taxes / ��

Acknowledgments

WewouldliketoacknowledgeandthanktheJohnDobsonFoundationforitsfinancialsup-

portofthisprojectandtheCentreforEntrepreneurshipandMarkets .Wewouldalsolike

tothankProfessor(emeritus)JohnChantofSimonFraserUniversity,Dr .AlastairMurdoch,

Professor(emeritus)HerbertGrubelofSimonFraserUniversityandSeniorFellowatThe

FraserInstitute,andDavidPerryoftheCanadianTaxFoundationfortheirformalreviewof

thisstudy .Theircommentsandsuggestionswereinvaluableincompletingthisstudy .Any

remainingerrors,omissions,ormistakesremainthesoleresponsibilityoftheauthors .As

theauthorshaveworkedindependently,theviewsandanalysisexpressedinthisdocument

remainthoseoftheauthorsanddonotnecessarilyrepresentthoseofthesupporters,trust-

ees,orotherstaffattheFraserInstitute .

Documents

STUDIES IN ENTREPRENEURSHIP MARKETS · Entrepreneurship and risk-taking Capital gains taxes have a detrimental impact on the number of entrepreneurs and risk-takers in Canada . Entrepreneurs