Budget should fulfill capital gains vow

National Post

2008-02-26


Today's federal budget is Finance Minister Jim Flaherty's big opportunity to make a strong statement that can help stimulate our lagging economy and bolster sagging productivity while at the same time provide a real incentive for Canadians to better diversify their assets to help them invest in both their own and Canada's future.

In fact, all he needs to do is to keep a promise.

Albeit a promise that seems to have been so far ignored in the Conservatives' first two federal budgets, as well as in the most recent economic statement. While these documents contained billions of dollars of tax cuts, most notably the ill-advised, two-phased GST cut, along with a cornucopia of credits for everything from children's fitness to mass transit, the most fundamental promise many have been anticipating was the capital gains elimination proposal.

Canadians will recall that the Conservatives' pre-election platform promised to "eliminate the capital gains tax for individuals on the sale of assets when the proceeds are reinvested within six months. Canadians who invest, or inherit cottages or family heirlooms, should be able to sell those assets and plough their profits back into the economy without taking a tax hit. It is time government rewarded Canadians who reinvest their money and create jobs."

The theory behind this pre-election promise to "eliminate" (did the government really mean defer?) the capital gains tax when the proceeds of disposition are reinvested is sound.

Under current tax rules, there's a tax disincentive to sell an asset that has appreciated significantly in value, even if it may make sense to do so from an investment perspective, specifically if an alternate asset's future prospects look better than the current holding.

"But I don't want to pay the tax," is the common objection often heard by investors who are tempted to diversify out of a highly concentrated stock position or dispose of a long-held, significantly appreciated piece of real estate, but are reluctant to sell a sometimes overvalued asset for fear of having to pay the piper at the time of sale.

Clearly, this is a case of the tax tail wagging the investment dog. Behavioural finance types have even coined a term for this ailment: the "capital gains lock-in effect."

So, why the delay? I would suggest the reasons are twofold. Firstly, the prohibitive cost of such a measure, especially as originally proposed, and secondly, the practicality of how such a proposal could be implemented and the potential recordkeeping nightmare that could arise.

Fortunately, in the two years since the announcement, much analysis and thought has been devoted to how to best accomplish the government's noble policy objective with limited fiscal cost and in an administratively easy manner.

The C.D. Howe Institute was the first out of the gate in early 2006, when it proposed the introduction of a Capital Gains Deferral Account (CGDA), which would permit individuals to roll over securities within the account without incurring capital gains taxes until the securities are actually withdrawn from the account. Upon such a withdrawal, capital gains taxes would be due, calculated on a pro-rata basis.

This proposal was a good start, but concerns were raised by some in the financial services industry about the need to set up a new type of account to track all of this. And that's on top of a plethora of accounts already in use, from RRSPs, RRIFs, RESPs and even the new RDSPs (Registered Disability Savings Plans), which have yet to be offered, due, in part, to the administrative complexity of establishing them.

Similarly, Mr. Flaherty could look to the Tax Prepaid Savings Plan concept floated around by the previous Liberal government, which takes the CGDA proposal a step further by allowing individuals to withdraw funds from the account on a completely tax-free basis, similar to the Roth IRA in the United States. Again, this would also require establishing a new account type.

Perhaps a simpler solution to accomplish the capital gains deferral goal is to bring back the lifetime capital gains exemption for all property, which was eliminated back in 1994 (other than for small businesses, farms and fishermen). Even simpler? Further reduce the current 50% capital gains inclusion rate.

So, will Mr. Flaherty deliver in one form or another? We'll find out today at 4 p.m.