Jack Mintz: The lock-in effect

Capital gains taxes make investors hold stocks too long

With the upcoming budget, the Conservatives have an opportunity to implement a 2006 campaign promise to let Canadians rebalance portfolios without triggering capital gains taxes, so long as they replace one asset for another. This measure would reduce significantly the “lock-in” effect that arises from the incentive to hold assets to avoid capital gains taxes on disposals.

Inertia in portfolio adjustments hurts economic growth by undermining stock-price signals, since investors are unwilling to sell off poorer-performing assets for better ones.

Tom Wilson at the University of Toronto and I recommended in 2006 a measure that could implement the Conservative proposal. We proposed a “capital gains deferral account” that would enable investors to roll over assets in the account on a tax-free basis. Only when withdrawals are made from the account would capital gains be subject to tax.

We thought this would be an eminently sensible approach to reduce the impact of the “lock-in” effect due to capital gains taxation. If a lifetime limit were provided equal to $150,000 invested in the deferral account, we estimated the revenue costs would be $425-million in federal and provincial personal taxes. Probably, this is an overestimate of the revenue impact since we assumed stock market values would rise annually by 6.3% based on the 1976-2006 experience, which is more than what would be reasonable to consider today. A larger limit is probably more affordable.

With tough fiscal times, a tax measure like this would be criticized as a sop to the rich. Yet, as most investors know (Warren Buffett excepted), capital gains reflect estimated changes in future corporate profits, net of corporate tax payments. Corporate taxes therefore reduce distributions and capital gains. The existing capital gains tax rate (applied to one-half of ordinary personal income) and the dividend tax rate (net of the dividend tax credit), is a second tax on income generated by business profits.

Typically, Canadian as well as most other governments generally keep dividend and capital gains taxes roughly aligned for high-income investors, to maintain the integrity of the tax system. Further, tax rates are set so that the combined corporate and personal tax on dividends and capital gains is roughly equal to other sources of income, such as interest, rents and salaries. This approach, which is a fundamental to our tax policy, imposes a similar burden on all forms of income earned by Canadians, which improves both efficiency and fairness of the tax system.

For example, if the capital gains tax rate is below the dividend tax rate, investors will prefer a corporation to repurchase shares rather than pay out dividends (limitations apply to corporate reorganizations). Canada began to tax capital gains in 1972 precisely to reduce the ability to convert income into tax-free capital gains.

With recent corporate tax rate cuts, federal and provincial governments have reduced the dividend tax credits so that dividends and other income bear a similar tax, taking account both corporate and personal taxes. However, a gap now exists between capital gains and dividend tax rates in many provinces. This especially applies to small business shares where the provinces have been aggressively reducing the small business tax rate, creating significant opportunities for tax avoidance.

To understand this argument, consider a large Ontario corporation that earns $1,000 in profits (Ontario is a good example, since its rates are close to the national average). With a federal-provincial corporate income tax rate of 26% by July 1 (assuming the Ontario Liberals carry out their legislated cuts), corporate profits available for distribution or reinvestment in the company will be $740.

If Ontario profits are paid out as dividends, the high-income investor will receive $521 after paying dividend taxes assessed at 29.54%. If profits are reinvested, the value of the company rises by $740, which results in a capital gain for investors. If shares are sold that year, high-income investors pay capital gains taxes at a rate of 23.21%, resulting in the investor getting net-of-tax capital gains equal to $568.

Capital gains such as on share repurchases are now tax-preferred compared with dividends.

Note if the corporation pays out interest or salaries, income net of Ontario taxes would be $535. The effective tax rate on other income in Ontario is somewhat below the combined corporate and personal tax rate on dividends but above the combined tax rate on capital gains.

If one were to roughly equalize tax rates on large corporate dividends and capital gains, the capital gains exclusion rate should be reduced from one-half to three-eighths, resulting in a capital gains tax rate of 29%, almost equal to the dividend tax rate.

A bigger gap between capital gains and dividend tax rates applies at the small business level, where the federal-provincial corporate tax rate on active income varies from 11% (Manitoba and Prince Edward Island) and 19% in Quebec (15.5% in Ontario). Dividends paid from low-taxed small business income are eligible for a smaller dividend tax credit (and therefore taxed more highly).

In Ontario, for example, the dividend tax rate on small business dividends is 32.57%, almost three points higher than the case of large corporate dividends. Thus, a capital gains tax rate of 23.21% is substantially lower than the dividend tax rate for small business income. For small business dividend and capital gains tax rates to be equalized, 70% of capital gains on small business shares should be taxable (rather than one-half).

Capital gains tax rates should be raised to the dividend tax rate to improve neutrality, resulting in some more tax revenue for federal and provincial governments. This would, however, impose other distortions, especially the lock-in effect that is a drag on the economy. With the additional revenues raised by the government, however, the Conservatives could afford to resurrect their sensible 2006 campaign proposal to broaden rollovers.

Financial Post
Jack M. Mintz is the Palmer chair of public policy at the School of Public Policy at the University of Calgary.

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