Examining the Evidence
Prepared by the CAW Research Department
3. Public Subsidies for LSFs
Tax Subsidy #1: LSF Credit
The LSF industry would not exist without massive subsidies from the federal and provincial governments. These subsidies come in many forms. The first and most direct is the LSF credit itself. The federal government will cover 15% of the cost of any LSF investment, up to an annual individual maximum (which will be raised next year to $5000). Most provincial governments will match this subsidy, for a total credit of 30%. Before 1996, the two levels of government each paid 20% of an LSF investment (for a total subsidy of 40%), but this was reduced to 30% in the wake of widespread public concern about the economic value of LSFs. Individual investors have to keep their LSF shares for eight years, otherwise they have to pay back the subsidy. After eight years they can sell their shares, buy new ones (even in the same LSF), and claim the 30% credit all over again. Since 1992 the federal and provincial governments have spent a combined total of about $1.5 billion on the LSF credits alone. With the proposed expansion of the maximum subsidized investment, the LSF credit will cost both levels of government about $300 million per year.
Tax Subsidy #2: RRSP Deduction
The effective subsidy rate for LSF contributions is enhanced by virtue of the fact that they qualify for inclusion in an individuals RRSP account. For high-income earners, this translates into an additional subsidy of about 50% (depending on the specific high-income tax rates prevailing in each province). High income earners thus get a total of 80% back from government for their investments in an LSF: 30% from the LSF credit, and 50% from the RRSP. It is on this grounds that all the LSFs (including the "true" funds) market themselves: each dollar of investment in an LSF actually costs the investor just 20 cents. The rest is covered by the taxpayer.
Labour-sponsored funds made the list of top five tax
shelters for high-income taxpayers recently prepared by
Montreal-based chartered accountants Friedman &
- "Tax shelters still exist, but complex," by Matthew Elder, Financial Post, November 23, 1998.
Ironically, because of the regressive way in which the RRSP credit is designed, the effective subsidy rate for the typical Canadian worker contributing to a labour fund is actually lower than the subsidy paid to a high-income earner investing in exactly the same fund. For example, the average earnings of a Canadian worker in 1997 was just over $30,000. The marginal tax rate paid by this typical worker (including an average rate of provincial taxation) was about 25 percent. Thus the typical worker receives a total subsidy of 55 percent (30% for the LSF credit, and 25% for the RRSP deduction), compared to the 80 percent subsidy of a high-income earner. No wonder these "labour" funds are so popular with high-income individuals who have no connection to the labour movement. These wealthy investors are actually subsidized at a higher rate than the workers who supposedly run the funds! And it is worth noting that none of the LSFs (including the "true" funds) limit contributions to members of the participating unions; all of them welcome contributions from high-income investors with no labour movement connection, precisely because it is for these investors whom the public subsidy is most lucrative.
Tax Subsidy #3: Extra Foreign Investment
There is a lesser-known but incredible additional source of subsidy for the LSFs. LSF contributions qualify, for federal tax purposes, as a "small business" investment. Most Canadians are only allowed to invest up to 20 percent of their total RRSP accounts in foreign countries. The rationale for this restriction is obvious: since RRSPs receive a large subsidy from Canadian taxpayers, these funds should be invested in Canada. But investors who invest in "small businesses" (including LSFs) are allowed to put more of their total RRSP investment in foreign countries. The general rule is that an investor is allowed to invest three extra RRSP dollars abroad (above and beyond the normal 20 percent ceiling) for every RRSP dollar invested in a small business in Canada (including the LSFs).
What is this subsidy worth? The financial industry has been lobbying hard for the federal government to eliminate the 20 percent cap on foreign RRSP investments. They use studies showing that the typical foreign investment earns a higher rate of return than investments within Canada: an average of 0.75 percentage points of profit per year for each dollar invested abroad. By allowing an investor to attain extra foreign profit on three dollars of subsidized RRSP investments for each dollar contributed to an LSF, this translates into a subsidy of 2.25 percent per year (3 times 0.75 points), or a compounded total of about 19.5 percent over the eight-year period during which an LSF investor is required to keep their investment in the labour fund.
Incredibly, then, for a high-income investor, this third subsidy reduces the true cost of a LSF almost to zero: 30 percent for the LSF credit, 50 percent for the RRSP deduction, and 19.5 percent for the allowable extra foreign content. This equals a total subsidy rate of 99.5 percent. In other words, for each $100 contributed to an LSF, a high-income investor actually pays just 50 cents. [For the average Canadian worker, however, who receives a smaller RRSP subsidy, the true cost is higher: $25.50 in final net cost for each $100 contributed to the LSF.]
One financial journalist recently enthused about LSFs precisely because of their effectiveness in avoiding the 20 percent foreign content rule. He explained in detail how through LSFs and other loopholes, a high-income individual with a relatively large RRSP account could attain a total of 51 percent foreign content. Ironically, the article was titled: "Putting labour funds to work." This isnt quite the sort of "work" the policy-makers had in mind when they designed LSFs in as a supposedly job-creating tax incentive. The private investors who contribute to the funds, however, have a different notion of putting their money to worknamely, in foreign countries!
The foreign content rule creates some additional problems for advocates of the LSF concept. Tax-savvy investors are allowed to move three dollars of subsidized investments out of Canada, for each dollar they contribute to an LSF. The net impact on investment within Canada is minus two dollars! Can these investments then be seen as really contributing to business investment in Canada? Moreover, none of the LSFs (including the "true" labour funds) have publicly criticized this foreign content tax subsidy, nor encouraged their investors to voluntarily refrain from claiming it. In fact, some "true" LSFssuch as B.C.s Working Opportunities Fundhave placed special emphasis on this loophole in their public advertizing (despite their claim that the fundamental purpose of the fund is to help "keep your money in B.C.). The LSF managers are quite aware that the range of tax subsidies is crucial to the viability of their funds, and hence will not challenge these subsidies (no matter how perverse they may be to the Canadian economy).
The 20 percent foreign content limit on tax-subsidized pension funds (including RRSPs) has been the focus of a fierce debate in Canada. Understandably, the private financial industry is determined to have the limit removed, allowing investors in Canada unlimited freedom to use their publicly-subsidized funds to speculate on global markets. Progressives in Canada (including spokespersons for the CLC and the Alternative Federal Budget) have argued strongly in favour of retaining the rule. If these investments are subsidized by Canadian taxpayers, then they should be retained in Canada to create Canadian jobs. Retaining the rule (and even strengthening it by eliminating loopholes and reducing the allowed foreign content to 10 percent) would be one measure to help add stability and accountability to turbulent global financial markets. How ironic that these efforts by progressives are being undermined by the efforts by "labours money managers" to advertize the value of this loophole to well-off private investors. How much credibility will a labour leader carry in arguing for the retention of the 20 percent limit, when LSFs are aggressively promoting ways to get around the limit?
Tax Subsidy #4: Large Start-up Grants
In addition to these ongoing tax incentives, several LSFs (especially those with stronger ties to actual labour federations or coalitions of individual unions) have benefitted from generous start-up assistance from the federal and provincial governments. Quebecs Solidarity Fund received $20 million from the Quebec and federal governments in 1987. Ontarios First Ontario fund received a special $6 million interest-free loan from the Rae government in 1995; for some reason, other LSFs in Ontario did not receive the same assistance. Former federal Human Resources minister Doug Younga true friend of labour, who oversaw the dismantling of Canadas UI systemannounced $4.5 million in joint federal-provincial support for New Brunswicks Workers Investment Fund in 1996. Manitobas Crocus fund received a $2 million interest-free loan from the federal Western Diversification Project. B.C.s Working Opportunity Fund received $600,000 in start-up grants and a $2 million loan guarantee from the provincial government in 1992.
Subsidies: The Total Bill
The accumulated cost of all of the federal and provincial subsidies that have supported the LSF industry to date is well in excess of $3 billion. This represents about three-quarters of all of the assets held by Canadas LSFs. And it considerably exceeds the value of the total investments by LSFs in actual small and medium-sized businesses. (As discussed below, LSFs invest only about one-half of their funds in small businesses, with the rest being held in low-risk government bonds.) One recent study (by two authors who generally support LSFs as an investment model) estimated that it costs government $1.35 for each dollar that LSFs invest in actual businesses. Wouldnt it make more sense for government to simply invest that $1.35 directly in companies and other ventures that create jobs directly, instead of supporting a huge and expensive infrastructure of private money managers, accountants, and investment advisors?
Subsidy and Reality
For high-income individuals, the bottom-line effect of this range of subsidies is that an investment in an LSF is basically "free." For other investors, an LSF investment is not quite free, but it costs a small fraction of its face value. Not surprisingly, this tax treatment has been the main selling feature of the fundseven the "true" funds. Private financial consultants, business writers, and the funds own advertizing all trumpet the tax savings as the first and foremost advantage of this type of investment. For example, the promotional brochure of the Crocus Fund trumpets, in a banner headline that covers most of its front page: Save up to 80% in taxes on your RRSP investment. The First Ontario Fund starts its brochure with a similar headline: Raise your tax deductions. The Solidarity Fund at least ties the advertized tax savings into the nominal purpose of its existence: You help create jobs for people, so you deserve to save more income tax. A person also helps create jobs when they hire a maid, purchase a Cadillac, or have their living room redecorated. That hardly implies, however, that they should receive additional tax breaks for their troubles.
The problem with any investment strategy that operates primarily on the basis of tax subsidies offered to private individuals or companies is that all sorts of bizarre and unintended consequences are produced by the incredibly creative efforts of these same individuals and companies to avoid income taxes. This difficulty has been illustrated vividly by past failed Canadian investment policies that were similarly structured. For example, the huge subsidies offered to frontier oil exploration or Canadian TV and film production in the 1980s motivated the creation of entire industries whose existence was predicated solely on assisting individuals and companies mine these tax breaksquite apart from whether any oil was discovered or any film of cultural or economic value was actually produced. The lesson of these fiascos is that to be efficient, investment subsidies to private agents must be tied to concrete results: actual investments in real endeavours with real social benefits. Canadas LSF policy is repeating this same error: like the exploration grants of the National Energy Policy or the failed TV and movie subsidies, the appeal of the LSF industry has everything to do with tax breaks and little to do with real productivity and economic growth.
"That kind of heavy emphasis on the tax side I worry
about because history has proven there are many out there
who will buy investment products for reasons completely
unrelated to the merits of the product, simply because
theyd rather give their money to a promoter than to
Revenue Canada.... There have been a whole litany of tax
shelter deals, where people at the end of the day end up
with valueless securities because greed overcame common
- Edward Waitzer, then-chairman, Ontario Securities Commission, Globe and Mail, January 12, 1995.
Vivid evidence of this failing was provided by the steep downturn in LSF contributions that followed the reduction in LSF tax subsidies announced by the federal and provincial governments in 1996. The combined LSF credit was reduced to 30 percent from 40 percent. The maximum subsidized LSF investment was also reduced to $3500 per year (although the government now plans to bump that back up to $5000). Together with the RRSP deduction, this reduced the total subsidy (for high-income earners) to 80 percent from 90 percent. The value of the RRSP foreign content subsidy makes the total subsidy even sweeter. The bottom line actual cost of an LSF contribution to a private investor is still a tiny fraction of its face value; most of the LSFs cost is paid for by Canadian taxpayers.
But in the wake of even this modest reduction in the total tax subsidy, contributions to LSFs plunged dramatically. From a total of $1.2 billion in LSF contributions in Canada in 1995, new LSF contributions fell to just $500 million in the 1997 tax yeara decline of almost 60 percent. Little wonder that LSF managers launched a furious (and ultimately successful) campaign to reverse some of the 1996 tax changes; even a subsidy rate in excess of 80 percent could not guarantee the ongoing viability of their industry (and thus their own jobs). The decline in contributions was felt most severely in Ontario, home of both the "rent-a-union" industry and the home province of most of Canadas wealthy. The fact that fund contributions collapsed after 1995, despite a continuing and extremely generous public subsidy, is strong evidence that the inherent economic value of this investment vehicle is minimal.
The worst may be yet to come in terms of the liquidity and viability of the LSF industry, in the wake of even the modest 1996 reduction in the subsidy rate. Many funds in English Canada enjoyed a boom in contributions following their initial creation in the late 1980s and early 1990s, when the combined federal-provincial subsidy rate was still 40 percent. Starting in 1999 and 2000, many of those first investors will be allowed to begin withdrawing their funds from the LSFs without having to give back any of the subsidy they have already pocketed. In the face of the reduced subsidy and widespread questions about the efficiency of LSFs, many of those investors will take their money and run. [On the other hand, many may be willing to recycle their investmentseven back into the same LSFin order to claim the 30 percent subsidy all over again.] For example, the Working Ventures Fund (nominally sponsored by the Canadian Federation of Labour, and the largest LSF in English Canada) will face $500 million worth of eligible redemptions in 2000 and 2001. Note that the total assets of this fund have already been shrinking rapidly in recent years: from $860 million at end-1996 to just $700 million at present. The fund could very well face a liquidity crisis in coming years if redemptions pick up speed. On the other hand, since Working Ventures has been extremely slow to invest its assets in real businesses (more on this below), it has plenty of uncommitted cash in the form of subsidized investments in government bonds and other assets. Nevertheless, one financial analyst was reported as worrying that growing redemptions would hit many LSFs like "runs at the bank."
The concluding chapter to this ironic story could well be as follows: investors piled money into Working Ventures and other funds for the huge tax credit. Most of these funds were never invested in real businesses. After the required time limit, the investors pull the funds out again and go elsewherepocketing the initial 40 percent. What will this bizarre policy experiment have accomplished? The taxpayers of Canada will have simply subsidized billions of dollars in risk-free financial investments made by tax-savvy and mostly well-off individuals.