A better capital gains plan

When the Conservatives first proposed, mid-campaign, to spare investors from paying tax on capital gains, so long as these were reinvested within six months, nobody quite knew what to make of it -- least of all, it seemed, the Tories. Ten weeks later, we’re no further ahead. How would it work? How much would it cost? What would it achieve? So it was no surprise when the Finance minister, Jim Flaherty, let it be known that the measure would not be taken up in his first budget. Good. There’s lots to recommend the Tory scheme, hazy as it is. But the good it would do can be achieved by other means, without the same drawbacks. It’s worth taking the time to get it right. First, the good. Because the capital gains tax only kicks in when gains are realized, investors are often loathe to sell stocks or other assets, even where it would make economic sense to do so -- what economists call the “lock-in effect.” The simplest way to fix this (well, simplest in theory) would be to tax capital gains as they accrue each year, rather than whacking investors over the head at realization. But if that’s not on, the six-month rollover idea is worth a look. So long as you kept reinvesting gains, rather than consuming them, you could put off the inevitable date with the taxman. So you could switch out of one asset and into another, undeterred by the tax implications. No more “lock-in effect.” Alas, it’s not as simple as that. The tax people say it’s fiendishly complicated to implement. Worse, even as it was eliminating one distortion, the Tory plan would introduce another. While investors could defer paying tax on capital gains in this way, the same would not apply to other types of investment income: dividends and interest. The effect of any such preference is to give investors an incentive to earn income, and companies the incentive to pay it, in the tax-preferred way. Firms and industries that structure their affairs in this way benefit at the expense of those that do not. Rather than focusing on the real economic returns of different assets, investors are distracted by the tax goodies attached to each. Fortunately, there’s an alternative. Indeed, by a happy coincidence, it’s one the Tories have already proposed -- not this election, but the one before. They’re called tax-prepaid savings plans, or in Tory campaign parlance, Registered Lifetime Savings Plans. As the name implies, they’re similar to Registered Retirement Savings Plans, only in reverse. With an RRSP, contributions are tax deductible, while withdrawals are taxed; contributions to an RLSP, on the other hand, come out of after-tax income. But from then on you pay no tax -- neither on the principal, nor on the returns. In both cases, the intent is the same: to ensure that, at whatever stage, savings are taxed just once, avoiding the “double-taxation of savings” that is the income tax’s worse defect. It’s easy to see that both also solve the “lock-in” problem, at least for investments within each plan. But they do so without imposing an arbitrary time limit on reinvestment, and without privileging one form of income over another. You might say: Why bother with a whole new savings plan? Why not just expand the limits on RRSPs? But for many savers, particularly those on low income, the RRSP is of little value, since they are likely to pay a higher effective rate of tax in retirement than now (especially if subject to the clawback on Guaranteed Income Supplement benefits). RLSPs also solve that problem. On top of which, they cost the treasury much less, at least in the short term. Working models of such a plan are already in place in Britain and the U.S. Much of the intellectual spadework for a Canadian version, moreover, has already been done, notably by Simon Fraser University economist Jon Kesselman and the C. D. Howe Institute’s Finn Poschmann. There’s an “out of the box” solution, in other words, to the “lock-in effect.” That it would also get the Tories out of the box they have put themselves in is a bonus.