A Canadian "Wealth Tax" Won't Work. Here's Why...

It has come to light that the Canadian Government is Considering a Temporary Wealth Tax on the Richest Canadians. This simple solution won't work. Here's Why...

?Introduction and Background

On January 24th, 2020, prominent medical journal, “The Lancet” published commentary titled: “A novel coronavirus outbreak of global health concern”[1] . This virus would become commonly known as COVID-19, which as of the date of this writing has infected more than 237,000,000 people globally and resulted in over 5,000,000 deaths[2] .

In response to this pandemic, many countries imposed long term stay-at-home orders and drastically restricted the economy by way of government mandated business closures in high-risk sectors, such as restaurants, theatres, and shopping malls. This economic shock had broad and immediate impact. Many of the most vulnerable members of the global workforce found themselves out of a job and many businesses were unable to satisfy their financial obligations. In response, governments around the world began spending[3] on relief, stimulus and support on a level not seen since the aftermath of the Second World War.

This article sets forth a brief analysis of the design challenges associated with the introduction of a tax on wealthy individuals as a mechanism to raise a large sum of revenue following the significant strain on public finances caused by the COVID-19 Pandemic.

Canada’s COVID 19 Response

As of April 2021, the Government of Canada projected COVID-19 related expenditures of $275.2 billion[4] in the form of wage and rent subsidies, enhanced employment benefits, wage replacement and tax relief. This spending contributed to a deficit of $354.2 billion[5] in 2020 and a projected deficit of $154.7 billion[6] in 2021. To place this in context, the Government of Canada’s total expenditures were 220%[7] of the Government’s revenue in 2020 and estimated to be 144%[8] of revenue in 2021. This significant deficit is the backdrop against which a new tax on net wealth is being considered.

Currently, the Canadian Federal Government’s total budgetary revenues of $334.1 billion[9] were generated from personal and corporate income taxes ($227.1 billion) [10] , Excise Taxes and Duties ($53.9 billion[11] ), Employment Insurance premiums ($22.2 billion[12] ) and other miscellaneous revenue ($28.3 billion[13] ). Canada does impose a tax on increases in capital in the form of a deemed inclusion of one half of a capital gain in the taxable income of the taxpayer in the year in which the capital asset is disposed of, or in the year of death in the case of a deceased individual, however this is the closest thing that the Canadian Federal Government has to a tax on net wealth.

Wealth Tax Defined

For the purposes of this analysis, we define a net wealth tax or ‘wealth tax’ as tax based on the open market value of an individual taxpayer’s assets as at a stipulated valuation date, net of associated liabilities. While taxes on specific assets such as real property taxes or generalized consumption taxes can be viewed as taxes on individual wealth, for this purpose our focus remains on the individual’s net worth.

Fairness and Equity

It can be persuasively argued that using wealth as the basis of taxation is far more equitable than primarily using income. This becomes obvious if one considers two taxpayers of identical income, one of whom has inherited a sizeable estate from a wealthy relative, has no student debt burden and another taxpayer who has accumulated significant student debt, and who has been forced to forgo saving and investment as she provides financial support to ailing parents. Under a system which uses income as the primary tax base, both taxpayers bear an equal burden[14] . By contrast, a wealth tax recognizes that the debt-free heiress has a far greater ability to pay by comparison. ?

Recognizing a taxpayer’s ability to pay, corresponds to the first of Adam Smith’s four canons of taxation[15] ?and also aligns with common conceptions of fairness and equity. The second of Smith’s canons of a desirable tax system, (that a tax should be certain and not arbitrary) would also be satisfied, as the tax base is an individual’s net wealth as at a set valuation date[16] . This is conceptually easier for taxpayers to understand than concepts such as taxable capital gains, which require not only a complex determination of ‘cost base’, but also a tracking of capital expenditures and depreciation. Adam Smith would also appreciate that a wealth tax is not arbitrary as there is a direct and rational connection between a taxpayer’s net wealth and their tax obligations.?

A wealth tax may prove more difficult when measured against Smith’s 3rd canon which is that a tax should be levied at the time or in the manner most convenient for the contributor to pay[17] . A tax on net wealth, unlike capital gains and income tax, does not arise from a transaction or a change in financial position. For example, income taxes arise on the receipt of new taxable income; similarly, a capital gains tax obligation generally arises from a disposition and associated cash liquidity. While there has been recent encouraging scholarship[18] on ways to address these challenges, a tax on all assets without regard to liquidity poses many difficulties.

Smith’s fourth canon is that the administrative costs of a tax should be as minimal as possible. While it is difficult to predict the administrative costs of a wealth tax, the valuation challenges suggest that vast amounts of wealth stored in illiquid and difficult to value assets may create a significant administrative burden.

Redistributive Virtues

To the extent that a wealth tax is viewed as a mechanism to achieve economic redistribution, it can be argued that it is superior to a progressive income tax in that global wealth inequality is far greater than income inequality. Progressive income taxes do not address concentrations of intergenerational wealth, except to the extent that income on wealth is taxed. Conversely, it has been argued that a tax on wealth is akin to taxing a fixed return on wealth, as the tax does not distinguish between different asset classes and return characteristics[19] . While this view is economically correct, it should also be noted that wealth taxes are generally discussed in a proposed environment where there would be a substantial exempt amount for each tax unit (whether family or individual). These large exempt amounts mean that the tax would be levied on investment or business assets as opposed to the typical family home or basic retirement savings. As such, the expected rate of return on these assets is largely within the control of the taxpayer based on their risk preferences. The ‘fairness’ criticism is less meaningful if the taxpayer has a high degree of control over the rate of return and if the tax is levied only on assets beyond the basic components of a middle-class family (a reasonably priced home, reasonable retirement savings, a vehicle, etc.).

The Need for International Consensus

Introducing a wealth tax as a near term response to the Canadian Government’s COVID spending will be difficult without consensus and support from other OECD member states. In the absence of a collaborative approach, there is a risk of capital flight to other jurisdictions. A one-time tax[20] with reference to a preceding ‘valuation date’ could mitigate the problem of capital flight and eliminate opportunities for taxpayers to rearrange their affairs prospectively. For this approach to be successful, taxpayers would need to believe that the tax truly was ‘one-time’[21] .

As of the date of this writing, the only OECD member states that have a wealth tax are Spain, Switzerland, and Norway. This is down from 12 countries as recently as 1990. The movement away from wealth taxes among OECD nations exacerbates the capital flight issue. As OECD countries move towards a heavier reliance on alternatives such as income and capital gains taxes, the introduction of a wealth tax appears even more out of sync with the international community. This is important as countries compete for an increasingly mobile capital base.

Behavioural Concerns

The behavioural responses to wealth taxes can be dramatic if the taxing authority prefers or exempts certain asset types[22] . Exemptions or preferences for private business assets, farmland and housing have been justified based on valuation difficulty, illiquidity, or general political concern, but these preferences result in capital accumulation in these assets[23] . This is an example of an undesired market impact given that the intent of the wealth tax in this case is not designed to incentivize investment in these asset classes.

Work completed by the Wealth Tax Commission[24] has indicated that capital migration did not appear as the primary response, however they acknowledge that the data is not necessarily applicable to the migratory response exhibited by the ultra-wealthy[25] who would be expected to have greater capital mobility.

The issue of income shifting between jurisdictions is a focus of the OECD and given that wealth taxes are far less prevalent than income taxes, an ultra-wealthy taxpayer would have a far greater number of options for tax migration (developed countries without a wealth tax) than exist with income tax avoidance migration.

The Wealth Tax Commission estimates based on work done in the UK, that a 1% tax introduced in that country would be expected to trigger between 7% and 17% behavioural base erosion. While this is not inconsistent with the 13%[26] estimate applicable to all self-reported income, the evidence of behavioural responses should be expected to be more pronounced among taxpayers with greater wealth and capital mobility.

Revenue Generating Efficacy

Determining the efficacy of a new wealth tax as a revenue generation mechanism requires that tax legislators know the size of the subject tax base and that there is a good approximation of the amount that will be sheltered or avoided. There has been work done on this issue in the context of the United States. Saez and Zucman [27] assume that the tax base would be the family tax unit (as opposed to an individual or marital tax unit) but providing for an exemption for those taxpayers in a super majority percentile (e.g., 99.9%). Those falling in the wealthy super-minority (e.g., 0.1%) would have an exemption for the base level of wealth required to fall into the super-minority with the excess being the tax base. In the US, they estimated that the tax base for the amounts in excess of that threshold amount is approximately $13.1 trillion[28] .?As such, a 2% tax rate on this base would result in potential revenue of $262 billion, before considering avoidance erosion.

Further study would be required to determine the precise applicability of these metrics to the Canadian economy, however given the relative size of the Canadian and US economies and the fact that US wealth is more concentrated by comparison, we can conservatively use a 1/10th multiplier to assume that a Canadian wealth tax of 2% on a comparable tax base would raise less than $26.2 billion per year prior to avoidance. Consequently, for any one-time wealth tax to meaningfully ‘shore up’ the $275.2 billion[29] of COVID relief spending in Canada, the wealth tax base would need to be much broader and the rate much higher than 2%. While a recurring wealth tax would have the benefit of generating larger revenue amounts over time, the behavioural challenges (capital migration, inter-family wealth transfer and clever planning) and implementation challenges (valuation, liquidity, administrative resources etc.) make it a difficult proposition.

Avoidance Challenges

Alvaredo and Saez [30] provide a striking example in Spain where tax authorities allowed an exemption for closely held corporate stock when the taxpayer is involved in management and holds 15% or more of the stock. In the year of introduction, 15% of the stock of privately held companies fell within this exemption, however 7 years later, 77% of the stock of private companies was subject to the exemption [31] . This is an example of the expected behavioural response to wealth tax preferred assets.?

The use of ‘offshore’ structures to avoid wealth taxes should also be expected. It is estimated that 75% of the wealth that is ‘hidden’ offshore is owned by the top 0.1%[32] . Evidence from Columbia shows correlation between reintroduction of wealth taxes and increased movement of capital offshore [33] .

We should distinguish between the ‘concealment’ of wealth offshore and the legitimate wealth migration that could be triggered by a significant wealth tax. The former can be addressed through proper enforcement; however, the latter requires alignment with other jurisdictions to reduce the benefit or increase the burden of capital migration. This would be difficult when the destination jurisdiction does not have a wealth tax.

The barriers to tax migration for Canadian taxpayers are lower given the test for tax nexus is one of ‘residency’ and does not require renunciation of citizenship as is required in the US. This may be of particular concern for Canada given the high population concentration around the Canada-US border which minimizes the disruption of a change in tax residency for the wealthy, many of whom already spend a considerable amount of time both recreationally and professionally in the United States.

Valuation Difficulties

Valuation of assets poses a challenge to tax authorities[34] . Tax regimes are far more comfortable with third party transaction values such as the sale price of an asset or the payment of a certain amount of income, than they are using a ‘moment in time’ assessment of the open market value of an asset in the absence of a price-setting transaction. In selecting an exact valuation date, or valuation date range, tax designers are faced with challenges. An agreed upon future valuation date, such as the end of a fiscal year, provides certainty (see Smith’s 3rd canon), however the use of a single date allows for opportunistic planning designed to minimize asset values on the valuation date. The use of a past date avoids this issue, however this only provides a solution in the event that the tax is levied as a ‘one-time’ tax without warning. Taxes which are levied without warning, and which are backward-looking generally have a negative impact on tax morale and if the tax is not legitimately viewed as being a one-time levy, the taxpayers are likely to respond with avoidance behaviors similar to those they would exhibit in the presence of an annual tax. If a date range is used, the valuation process becomes significantly more complex as determination of value ranges can be done a number of different ways with dramatically different results.

Once a valuation date or period is determined, wealth taxes have traditionally been levied on the ‘open market value’. This is difficult in the case of items of substantial but uncertain value, such as the shares of private companies and in the case of art, antiques, or any form of intellectual or intangible property. Consideration has been given to adopting a formulaic approach to valuation such as the book value of assets in the case of private companies, however this would distort the true value of many companies where the relationship between book values and true open market value is tenuous at best. There are certainly accepted methods to value all of these assets, however even among valuation professionals there is generally a wide range of opinions as to the price that a company will fetch on the open market in an arm’s length transaction.

Annual valuation would be a significant administrative burden that would need to be split between the tax authorities and the taxpayer. To the extent that the tax authority is responsible for the valuation, the costs of conducting meaningful valuation assessments are likely far beyond the authorities’ resources and capabilities, whereas to the extent that the taxpayer is responsible for the valuation exercise, there is likely to be great horizontal inequity between those of high integrity and those willing to underreport values[35] .?

Valuation difficulties are particular to certain classes of assets and in response other jurisdictions[36] have granted a preferred status to these assets. The administrative advantages of this approach unfortunately increase horizontal inequity and likely lead to behavioural disadvantages when taxpayers move assets and wealth into the preferred asset classes [37] .

Liquidity Difficulties

A wealth tax is generally not levied concurrently with a transaction or a payment (as in the case of capital gains or income taxes). To pay this obligation, the taxpayer must have the available cash resources or will be forced to encumber or dispose of assets. Assets such as the shares of private businesses (which are a significant source of private wealth) do not have any ready liquid market and pose a particular difficulty. Similarly, real property wealth is difficult to monetize if not sold unless it is used as collateral for debt and the debt proceeds are used to fund the obligations.

Glen Loutzenhiser and Elizabeth Mann[38] provide some of the leading scholarship on the liquidity challenges posed by wealth taxes.?Their work estimates the scale of the problem in the United Kingdom as well as proposing potential solutions.

Loutzenhiser and Mann confirm the intuitive correlation between the size of the revenue objective and the magnitude of the liquidity problem. They propose a high exemption threshold as a structural solution. While this may raise concerns about horizontal equity, the reduction in the number of taxpayers facing liquidity concerns and the allocation of the administrative cost of compliance to those ultra-wealthy individuals would be consistent with Smith’s cannon regarding the allocation of the tax burden to those with ability to pay.

The authors also point to income-based caps on the combined total of net wealth tax and personal income tax liability. In these instances, the cap ensures that the combined tax can be paid from that period’s income and reduce the requirement to sell assets or borrow. Loutzenhiser and Mann also highlight the possibility of an alternative minimum tax (AMT) which would allow the ultra-wealthy to simply pay an agreed upon levy and if paid, there would be no requirement to report the net wealth position. While administratively easier, an AMT wealth tax is prima facie regressive as those taxpayers above the threshold pay progressively less AMT per dollar of wealth as their wealth increases.

Other solutions such as withholding tax, sale of assets, borrowing, deferred payment plans or payment in specie offer viable solutions in many circumstances, but significant challenges remain in the case of farmers and business owners. While many other challenges remain, the work by Loutzenhiser and Mann clearly establishes that there are avenues of potential mitigation of the liquidity concerns if a wealth tax is desired.

Some Alternatives

A wealth tax as a revenue generation tool should be viewed alongside other potential ways in which additional revenue may be raised. Increase to capital gains taxes, inheritance taxes or income taxes should also be considered. Further the costs of successfully addressing the administrative challenges of a wealth tax should be measured against deploying similar resources in improving enforcement and minimizing avoidance in existing tax bases to ensure that the return on the administrative spend is appropriate.

Conclusion

Taxes based on net wealth have many equality-based and redistributive virtues, however in practice they would not be well suited to address a near-term revenue concern. A one-time tax is not likely to raise meaningful revenue unless it is implemented at an unreasonably high rate and across a very broad base with minimal asset exemptions. An annual wealth tax is likely to create undesirable behavioural responses in the form of strategic avoidance planning. Capital flight of the ultra-wealthy is a risk unless OECD nations can move together and bring wealth taxes back into vogue (the opposite of which is currently true). The valuation and liquidity concerns can certainly be addressed in the long term; however, this comes at significant administrative cost. In summary, Canada would be better served in the near term to look to existing tax units and tax bases and devote resources to enforcement and administration if a near term revenue increase is needed.

[1] Wang, Horby, Hayden and Gao A novel coronavirus outbreak of global health concern

The Lancet, Volume 395, Issue 10223, P470-473, February 15, 2020

[2] WHO Coronavirus (COVID-19) Dashboard (Accessed October 11, 2021) https://covid19.who.int/

[3] IMF Fiscal Affairs Department - International Monetary Fund, Database of Country Fiscal Measures in Response to the COVID-19 Pandemic (as of June 5th 2021) https://www.imf.org/en/Topics/imf-and-covid19/Fiscal-Policies-Database-in-Response-to-COVID-19

[4] Government of Canada COVID 19 – Planned Expenditures?https://www.canada.ca/en/treasury-board-secretariat/services/planned-government-spending/supplementary-estimates/supplementary-estimates-c-2020-21/covid-19-planned-expenditures.html

[5] Canada’s Budget 2021: A Recovery Plan for Jobs, Growth and Resilience, (Canada) p. 25 https://www.budget.gc.ca/2021/pdf/budget-2021-en.pdf

[6] P. 46?- A Recovery Plan for Jobs, Growth and Resilience, Budget 2021 (Canada) https://www.budget.gc.ca/2021/pdf/budget-2021-en.pdf

[7] Ibid [Table A15]??

[8] Ibid [Table A15]?

[9] Ibid [Table A15]??

[10] Ibid [Table A15]

[11] Ibid [Table A15]??

[12] Ibid [Table A15]??

[13] Ibid [Table A15]??

[14] Author’s Note: ?Ignoring the impact of tax deductions which may exist for dependant support or student debt payments

[15] Smith, Adam. 2012. Wealth of Nations. Wordsworth Classics of World Literature. Ware, England: Wordsworth Editions.

[16] Author’s Note: There is certainty as to the tax base and the tax rate. Valuation remains an administrative challenge as discussed later, but the challenges are not due to uncertainty of base or rate, but rather administrative burden.

[17] Smith (n 15)

[18] Daly, Hughson, Loutzenhiser Valuation for the purposes of a wealth tax (Fiscal Studies, Journal of Applied Public Economics, 2021)

[19] IMF Fiscal Affairs Department (n 3) p 37

[20] Advani, Chamberlain and Summers, Wealth Tax Commission Final Report, A Wealth Tax for the UK (Wealth Tax Commission) p. 106

[21] Ibid at p. 106

[22] Advani and Tarrant Behavioural responses to a wealth tax, Evidence Paper 5 Wealth Tax Commission Final Report, p. 511

[23] Ibid. p. 512

[24] Advani, Chamberlain and Summers (n 20)

[25] Advani and Tarrant (n22) p 512

[26] Ibid. p.510

[27] Saez, Zucman, Progressive Wealth Taxation - BPEA Conference Drafts, (Brookings Papers on Economic Activity, 2019) p. 14

[28] Ibid. p 14

[29] Government of Canada COVID 19 – Planned Expenditures?https://www.canada.ca/en/treasury-board-secretariat/services/planned-government-spending/supplementary-estimates/supplementary-estimates-c-2020-21/covid-19-planned-expenditures.html

[30] Alvaredo, Saez, Income and Wealth Concentration in Spain from a Historical and Fiscal Perspective (Journal of the European Economic Association September 2009) p.1150

[31] Ibid. p. 1151

[32] Alstads?ter, Johannesen, and Zucman Tax Evasion and Inequality (American Economic Review Vol. 109, No. 6)?

p. 2081

[33] Londono-Velez and Avila-Machecha Enforcing Wealth Taxes in the Developing World: Quasi-experimental Evidence from Colombia (American Economic Review Vol. 3, No. 2, 2021) p. 134

[34] Daly, Hughson, Loutzenhiser (n 18) ?

[35] Meade, The Structure and Reform of Direct Taxation (Allen and Unwin: 1978) p 356

[36] Alvaredo, Saez, (n 30)

[37] Ibid.

[38] Loutzenhiser & Mann Liquidity issues: Solutions for the asset rich, cash poor, Wealth Tax Commission Evidence Paper 10