Entrepreneurship, Demographics and Capital Gains Tax Reform in Canada

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Appeared in the Fredericton Daily Gleaner, April 23, 2015

A number of prominent Canadians, including Bank of Canada Governor Stephen Poloz, have raised concerns about the state of business start-ups and entrepreneurship in Canada. There is no question that entrepreneurship is critical to a well-functioning, prosperous economy. New firms are the lifeblood of innovation, creativity, and economic progress. While the decline in business start-ups is a worrying sign for future economic dynamism and progress, the concern has not been met with practical solutions. Capital gains tax reform is one practical possibility.

Consider first the worrying trend in Canada that the rate of business start-ups, a key measure of entrepreneurship, is declining. Since peaking in 2004, the rate of business start-ups, as a share of existing firms, has declined by 16.2 per cent. Specifically, in 2004 there were 17.9 business start-ups (all firm sizes) per 100 existing firms. The rate has since declined to 15.0 business start-ups per 100 existing firms.

The rate of decline in business start-ups is more pronounced for larger firms (measured by employment). For instance, the rate of decline in business start-ups between 2004 and 2012 for firms with 50 to 100 employees was -68.0 per cent.

Some of the explanation for this decline is not particular to Canada. That is, declines in business start-ups are also observed in other industrialized countries. For instance, over the last decade of available data (2003-2012), the United States has experienced a decline in the rate of business start-ups of 8.0 per cent.

One likely explanation for the decline, which has to-date been almost totally ignored, is the relationship between demographics and entrepreneurship. Younger people, for example, are less risk averse and more prone to question the status quo and experiment. Such characteristics are key to the entrepreneurial process. In older populations, not only are there proportionately less young workers with these characteristics but they are typically not in positions of influence within firms.

Canada, like all industrialized countries, is experiencing an aging of the population where a larger and larger share of the population is over the age of 65. Statistics Canada expects the portion of those over the age of 65 as a share of the population to increase by 74.1 per cent between 2008 and 2035.

Given the importance of entrepreneurship to the economy and the absence of any serious policy options available to governments with respect to demographics, it’s critical that governments enact policies supportive of entrepreneurship.

One such policy lever is capital gains tax reform. Capital gains taxes are applied to the sale of an asset when its sales price is nominally (not adjusted for inflation) above its original purchase price. The sale price is based on the present value expected by the purchaser from the future stream of income received by the asset. However, that stream of income is subject to annual taxes. The application of a capital gains tax after the sale is a type of double taxation and worse still, it creates disincentives for entrepreneurs and firms that finance entrepreneurs.

Currently, Canada has the 14th highest capital gains tax rate among the OECD countries despite two reductions in the tax rate implemented by the Chretien Liberals. A number of options for capital gains tax reform exist, but one that holds great policy and practical promise is the replication of a Clinton-era reform from the U.S. Specifically, the Clinton Administration created a rollover provision whereby the proceeds of a sale of an asset are exempt from capital gains if they are re-invested within a specific time period, perhaps six months. Such a reform frees up capital today that could boost entrepreneurship while deferring the eventual capital gains taxes.

Improving the incentives for, and the environment within which entrepreneurship occurs, can help mitigate the demographic headwinds currently impeding entrepreneurship, which has clear and serious implications for the economy as a whole. Capital gains tax relief offers an opportunity for Canada to super-charge entrepreneurship, and it’s worth considering.

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