Taxes are Prices and Prices are Messages
If a Dollar of Investment Income Doesn't Make Enough Cents, Then Investment Doesn't Make Sense.
The Canadian federal government has proposed a tax hike on capital gains. Previously, you were taxed at the ordinary income rates but on only half of the gain. They’re proposing increasing the inclusion rate to 2/3rds of the gain for earnings above $250k.
As you can imagine, many people are not happy. And as you can also imagine, many people aren’t terribly sympathetic to the 0.13% of high earners who will pay more taxes. After all, no one can whine like a bunch of rich people who will still be rich after “suffering” through what they are whining about.
Taxes are Prices
But stop thinking about this as a tax increase and start thinking about it as a price increase. Because that is what it is. Taxes, after all, are just a fee that you pay for working or for investing or for buying stuff:
You want to get a great job and earn lots of money? Well, it’s gonna cost ya. More and more the more you make, up to 53% of what you earn here in BC.
Want to buy a rental house, fix it up, and sell it six years later for double what you paid for it? That’s got a price too - which just went up.
Want to buy products or services? There’s the price of the item and then there’s the price of the transaction - the price of the sale. In BC, even used cars include the price of sales tax, so over enough sales, the price of the tax might be more than the price of the vehicle.
Heck, there’s even a price of owning your house which is separate and distinct from the total costs of owning and maintaining your house: property tax.
If you don’t believe taxes are prices, then try not paying the tax. You’ll be treated like you stole something. Like someone who bought work but didn’t pay for it.
Prices are Messages
So if taxes are prices, then what do prices do? Prices are incentives or disincentives. Prices are signals. Prices are messages that tell you what to do and not do with your time and with your money.
The message might be about the quality of the item (a Rolls Royce), its scarcity (a diamond ring), or about how much demand there is for it (seaside cottages in La Jolla). The messages prices send help us to make decisions between competing alternatives.
Part of the reason prices function as messages is that most of us don’t go through life calculating all the prices of everything in real time. We’re not quite sure whether we should go to McDonalds or Ruth’s Chris, but we’re darn sure we shouldn’t be ordering Kobe T-Bones at $75 per oz. We’re constantly making mistakes - making un-economic decisions - but over entire populations of us wacky creatures, these messages have an impact which affects our collective actions.
Governments don’t think about taxes as prices which convert to messages. Governments would rather believe that the prices they impose on activities and goods don’t affect their attractiveness or unattractiveness. They’d like to be able to send clear, definitive messages in the form of taxes (prices) and have people completely ignore those messages and go about their work or their business as if they didn’t hear or didn’t understand.
But people hear. And People understand. They can look at the price tag and figure out whether it’s a good deal or not. They get the message.
The Message of Increasing Gains Taxes
The problem with increasing taxes on capital gains is that you’re increasing the price of investment. Since an investment by its nature is risky and might not work out, the imposition of an increased price on the reward side of the spectrum moves every investment a little closer to the “not worth it” category.
Imagine a scrappy twenty-something who managed to buy a second home as an investment. She puts in a couple years of nights and weekends painting baseboards and remodelling bathrooms, and then decides to sell the home to repay herself for all her hard work and risk-taking. The capital gains tax she’ll pay on the sale is part of the price of her investment and if the price is too high, none of what she’s done makes any sense. She should have just waited tables or just enjoyed her free time - it would have been a better risk-adjusted return.
Or imagine my dad, who moved our growing family 12 times in my first 18 years, fixing up house after house with his own two hands while we lived in it, and then sold each house at a “capital gain.” He wouldn’t have triggered the $250k threshold, but that’s not the point. The point is that his willingness to take risks and invest was driven in part by the price of investment. His behavior was not independent of incentives and disincentives. He was listening to the messages which prices and taxes sent. He could read the tax brackets just like he could read the price of 2x4s at Lowes.
We may have a hard time empathizing with fat cat VCs and hedge fund managers, but their willingness to invest is affected by the price of investment too. If the price of investment is moved higher, then - at the margin - they will invest less or invest elsewhere.
Good riddance, you might say, but hold on. A bunch of poor upstart entrepreneurs like me (who grew up in 12 houses) or my business partner (who grew up with two parents and three siblings in a house with two bedrooms) would never have gotten off the ground were it not for VCs and rich investors who saw potential in our youthful energy and good ideas.
I’m the one considering investing in startups now among other ways to spend or save money. The tables have turned, but the equation is the same. When you’re considering an investment, you can’t ignore the price (the tax) any more than you can ignore the risks.
I’m no economist, but I think we want more investment not less. We want more investment because more investment creates economic growth. It helps to fix up broken down houses and launch new businesses which employ more people - and the cycle continues. It might strike some as unfortunate that low gains rates allow the rich to get richer, but I’m ok with that as long as the rich are still willing to invest money in poor young entrepreneurs.
I’m not opposed to taxes generally because I am in favor of national defense, clean streets, and the rule of law, and I’m not convinced by my more-libertarian friends that the private sector can deliver those collective goods. But setting the price of investment in Canada higher than it already is reduces the incentives and resources for pretty much the only activity which can create economic growth.
Increasing taxes on gains increases the price of investment, and this sends a clear message to investors of all stripes that the federal government of Canada wants you to stop investing quite so much.