The Return of a Bad Idea: The Conservatives and the Capital Gains Tax Exemption

The Conservatives are at it again.

As reported in the Globe and Mail on October 31, federal Finance Minister Flaherty is reviving and polishing-up the Conservative Party’s ill-conceived election proposal to end taxation of individual capital gains if the proceeds are re-invested.

Light taxation of capital gains compared to wages is undoubtedly a gift to the rich. In the 2003 tax year, fully 41% of taxable capital gains income was declared by the small handful of individual taxpayers making more than $250,000. And another 24% was declared by those making between $100,000 and $250,000.

Only one-third of some $20 Billion in pre tax capital gains was declared by those making less than $100,000. This is hardly surprising given that very few ordinary working people save significant amounts outside tax sheltered pension plans and RRSPs.

Currently, thanks to Paul Martin’s actions as Minister of Finance, only 50% of capital gains income is subject to tax. The Department of Finance estimates the revenue loss from this special tax treatment of capital gains in the personal income tax system to be over $2 Billion, and it is now likely closer to $3 Billion.

What appears to have been forgotten by Conservatives and commentators alike is that the Mulroney government’s lifetime capital gains tax exemption proved to be one of the greatest public policy disasters in Canadian history.

Introduced in the 1985 Budget, $500,000 of lifetime capital gains was exempted from personal income tax. This was reduced to $100,000 in 1987, and the measure was eventually eliminated in Paul Martin’s 1995 Budget, except for small business owners and farmers.

Don’t take my word for the fact that this was a policy disaster. In 1994, a special symposium on the measure was convened by the Department of Finance and the Institute of Policy Analysis at the University of Toronto. Eleven academic research papers were presented to the symposium, and published in a November, 1995 Special Supplement to the journal, Canadian Public Policy.

The research found that federal tax revenues were reduced by between $4.5 Billion and $9 Billion by the special tax break over the course of its existence. This was, of course, a period of federal deficits, so the lost revenue was added to the public debt.

Distributionally, the measure was highly inequitable, with 57% of the benefit going to individuals making more than $100,000 a year (no mean sum in the early 1990s.)

Justified as a measure that would boost real investment via increased equity holding, the studies found that there was a negligible impact. In fact, one Jack Mintz (currently chief guru of the corporate tax cutters at the C.D. Howe Institute) concluded in his overview piece with Stephen R. Richardson that “the lifetime capital gains exemption failed to stimulate investment in a significant way.”

It is true that Minister Flaherty’s current proposal differs in terms of detail from the Mulroney era measure, and will have to be independently evaluated. But the fact remains that there is a very tenuous theoretical and empirical link from cuts in taxes on financial returns, to the kind of real investments which boost productivity and jobs.