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Grand Bargains do not always come from the expected places. As the U.S. Administration and Congress struggle to find a solution before plunging over the "fiscal cliff," they might cast their eyes in a northerly direction. Part of a compromise solution could be crafted from the experience of Canadian tax policies for capital incomes.
One central part of the conflict between the Democratic administration and Congressional Republicans has been the top two income tax brackets – whether they should be hiked by 3 and 4.6 percentage points to restore the Clinton-era rates of 36 and 39.6 per cent or whether some other way can be found to generate the required revenues.
Surprisingly overlooked in discourse over how to surmount the "fiscal cliff" are the much more dramatic prospective hikes in tax rates on capital incomes. The top tax rate on long-term capital gains will rise from the current 15 per cent to 20 per cent – plus a new Medicare tax of 3.8 per cent, making the total hike more than half. The top tax rate on qualified dividends will soar from the current 15 per cent to the new top bracket rate of 39.6 per cent – plus the 3.8 per cent Medicare tax, for a near-trebling of the total tax rate.
These extreme tax increases on capital incomes will adversely affect incentives for savings and investment; they will also sharply impact investor portfolio strategies and corporate financial policies. Even now corporations are scrambling to pay out special dividends so that their shareholders will avoid prospective tax hikes in the new year.
While these changes are a modest part of the cliff's overall tax hikes, the favorably taxed types of incomes are heavily concentrated among high earners. Thus, relieving the prospective sharp tax increases on capital incomes would blunt the impact of higher rates on top-bracket taxpayers.
In 2010, the 87 per cent all tax returns with incomes below $100,000 reported nearly half of aggregate income but only 14 per cent of all qualified dividends and taxable net gains. In contrast the fewer than 2 per cent of filers with incomes above $250,000 had about a quarter of all income but nearly 75 per cent of income from those sources.
By moderating the tax rate increases targeted at capital incomes, the adverse economic effects could be relieved while also garnering Republican support. The Administration would not have to retreat on raising top-bracket tax rates, which are less distorting in their application to non-capital income sources.
This part of a Grand Bargain could be modeled on Canadian tax policies for capital gains, dividends, and estates. One component would be to follow Canada's practice of including just 50 per cent of realized capital gains in taxable income – a practice that the U.S. itself had used in earlier years.
With the Administration's proffered rate schedule for 2013, half inclusion of capital gains would yield effective tax rates (apart from the Medicare levy) of 19.8 and 18 per cent in the top two brackets, and 16.5, 14, 12.5, 7.5, and 5 per cent in the successively lower brackets. These figures contrast with "fiscal cliff" rates of 20 per cent in all brackets except for 10 per cent in the bottom bracket.
Unlike both the current and the "fiscal cliff" rate structures, the proposed scheme would restore progressivity to the taxation of capital gains. Half inclusion would also provide the largest relief for recipients of capital gains in the middle and lower brackets.
Other important elements in Canada's taxation of capital gains could add further attractions for a U.S. Grand Bargain:
- No distinction between short-term and long-term gains, with all net gains taxed at the half-inclusion rate; this greatly simplifies investment planning and tax compliance;
- No capital-loss offset against other income, but ability to carry back capital losses up to three years to offset previous capital gains and unlimited carry forward of losses;
- Computation of capital gains and losses based on average cost of each security type, as contrasted with complex U.S. multiple options including FIFO and tax-lot methods.
With reforms along these lines, investors would no longer have to concern themselves with holding periods, tax timing of securities trades, loss-offsetting of other income, or complex tax computations. Thus, all investors could focus on securing the best returns without such distractions, just like investors in tax-sheltered savings plans.
Canada also provides relief to taxpayers receiving domestic dividends via a tax credit scheme, which offsets the corporate tax already paid on those dividends. In a similar but simpler approach, the United States could apply a partial inclusion rate (such as 70 per cent) to qualified dividends. That would be much less severe for both investors and the economy than the prospective full taxation of dividends for higher earners.
Another aspect of Canada's tax provisions offers further guidance for the U.S. in surmounting the "fiscal cliff." When instituting capital gains tax in 1972, Canada imposed "deemed realization" of capital gains upon death of the taxpayer, with tax deferral of the tax allowed on bequests to a surviving spouse. The compensating part of this reform was abolition of the Canadian estate tax.
The U.S. in contrast provides a step-up in the cost basis of assets transferred at death – meaning that those gains forever escape tax – while imposing an estate tax. The fiscal cliff would sharply raise the estate tax by restoring its 2001/2002 parameters – dropping the current $5.1-million exemption to $1-million and hiking the current top rate of 35 per cent to 55 per cent.
While the U.S. is unlikely to abolish its estate tax even with deemed realization, that change could facilitate a political compromise. With added revenues from capital gains, the estate tax exemption could fall less and its rate rise by less than with the "fiscal cliff." Deemed realization would also eliminate the unfairness and inefficiency of rewarding individuals for holding appreciated assets until their death to avoid gains tax.
The proposed reforms offer attractions for both sides in confronting the "fiscal cliff." The Administration could secure its desired hikes to the top bracket rates, while Republicans would gain relief for both investors and the economy. A cliff need be not only a place of peril; it can also be a place for enhanced vision – even northerly vistas.
Jonathan Rhys Kesselman is a professor at the School of Public Policy, Simon Fraser University, Vancouver, and holds the Canada Research Chair in Public Finance. His proposals are detailedhere