DeepDives is a bi-weekly essay series exploring key issues related to the economy. The goal of the series is to provide Hub readers with original analysis of the economic trends and ideas that are shaping this high-stakes moment for Canadian productivity, prosperity, and economic well-being. The series features the writing of leading academics, area experts, and policy practitioners. The DeepDives series is made possible thanks to the ongoing support of Centre for Civic Engagement.

One of the most consequential policy changes in this year’s federal budget was the increase to the capital gains tax rate. In particular, the government increased the tax rate on realized capital gains from the disposal of assets by including two-thirds instead of one-half of gains as part of income as of June 24, 2024. For individuals, the increase applies to realized capital gains net of losses in excess of $250,000. For corporations, the hike applies to all of their capital gains net of losses.

In a previous DeepDive, I analysed the reach of the tax change by estimating the number of tax filers who would be affected over their lifetime. The key finding was that it would affect far more Canadians than the government seemed to anticipate. On a lifetime basis, I estimated that 1.26 million Canadians (almost 5 percent of taxpayers) will be affected by the increase in the capital gain tax on individuals, half of whom earn less than $117,000 per year. My analysis at the time didn’t assess the macroeconomic effects, specifically for investment, employment, and economic output.

Yet a key assumption of the government is that the tax increase will have a limited effect on Canada’s economy. In particular, the budget stated: “Increasing the capital gains inclusion rate is not expected to hurt Canada’s business competitiveness.”

The International Monetary Fund reached a similar conclusion based on its focus on the capital taxes paid by individuals. It observed that “it [the tax change] is likely to have no significant impact on investment or productivity growth.”

These claims conflict with a large body of research on the economic costs of capital gains taxes. While studies often focus on capital gains taxes paid by individuals, they typically fail to account for the increase in the corporate capital gains tax rates that would undoubtedly affect many companies that rely on equity financing.

It is important to note that financial traders aren’t affected by the budget proposal since their capital gains are fully taxed as a source of business income. Banks and insurance companies also pay capital gains taxes on a mark-to-market basis (which is a tax on market value increase in their portfolio net of losses). These latter points were missed by a paper recently published by the Centre for Future Work that claimed financial intermediaries had declining employment despite their supposed capital gains preference. That conclusion was flawed since corporate capital gains earned by financial intermediaries are generally fully taxed and thereby unaffected by the budget proposal.

The purpose of this latest DeepDive therefore is to better understand the economic effects of the capital gains tax increase—with a focus on investment, jobs, and GDP. In particular, I estimate Canada’s capital stock will fall by $127 billion; employment would decline by 414,000; GDP will fall by almost $90 billion; and real per capita GDP will decline by 3 percent.

Capital gains taxes hurt business investment

Neither the Department of Finance nor the IMF produced estimates of the impact of the capital gains tax increase on the economy, specifically investment, employment, and GDP. So why did they claim it had no impact on business competitiveness?

There are two possible reasons for this. First, it’s typical to assume Canada is a small open economy in capital markets. Under this assumption, businesses borrow freely in international markets at a world interest rate and Canadian saving has no discernible impact on the international interest rate. Even if capital gains taxes discourage Canadian investors from buying corporate equities and bonds, it will have no impact on business investment since companies still borrow at the same international market interest rate.

Second, the typical investment modeling by Finance Canada (the marginal effective tax rate) includes the corporate income tax and provisions, sales tax on capital inputs, and asset-related taxes. However, corporate capital gains taxes are not included in the modeling (only the personal capital gains tax is included). So, obviously, an increase in the corporate capital gains tax rate will have no impact on investment in the model.

Neither of these assumptions holds up. While the Canadian capital market is only 2.5 percent of the world stock markets, Canadian companies depend very much on equity capital provided by domestic households, even the largest companies. As many studies have shown, Canadians invest 52 percent of their equity portfolio in Canadian markets even though a properly diversified portfolio would suggest only a small portion of assets would be invested at home.

There are many reasons for “home bias” in equity shares. Smaller companies don’t have easy access to international markets. Companies that are Canadian-controlled need a significant share of Canadian ownership beyond 2.5 percent. Also, Canadians have more information about domestic opportunities and risks than they have with respect to international assets. While Canada doesn’t have capital controls (except Investment Canada limitations on foreign direct investment), the dividend tax credit and certain other tax preferences apply to only Canadian resident companies, not foreign ones. Thus, under home bias, capital gains taxes have been shown to suppress equity values and raise the cost of equity-financed investment of Canadian companies.

Based on Statistics Canada data, I estimate that Canadian households own 35.5 percent of large company shares listed in Canada. If there were no home bias, Canadian household ownership of Canadian companies would be obviously much smaller and have little impact on the cost of investment for large companies.

As for corporate capital gains, they are paid when companies operate in Canada regardless of ownership. Corporate capital gains are earned when physical and financial assets are sold. Corporate capital gains taxes are also paid when corporate reorganizations take place such as in the case of mergers and acquisitions. Since the corporate tax applies to nominal capital gains, that capital gains tax increases the cost of investment even if there are no real capital gains.

From 2011 to 2021, taxable corporate capital gains are roughly 7 percent of corporate taxable income of non-financial corporations. Based on merger and acquisition data and the market value of the stock market, I estimate a fairly long holding period for corporate shares (35 years), not dissimilar for structures. Taking into account short holding periods for trading financial assets, I estimate that the annualized non-financial capital gains tax rate (the so-called accrual-equivalent capital gains tax rate) rose from 6.4 percent to 8.5 percent due to the budget’s capital gains tax hike.

Thus, the effect of the budget’s tax change is twofold. According to financial theory, the supply cost of equity increases as the personal tax on capital gains (and dividends) rises with income. Thus, the marginal investors providing equity finance to companies are higher-taxed investors such as those with gains of more than $250,000. Further, the corporate capital gains tax changes increased taxes on investment for large, medium, and small non-financial companies.

Impact on the economy

Overall, the capital gains tax hike has a significant impact on both the incentive to hold capital in Canada and employment. At least half of the impact is due to the increase in the corporate capital gains tax rate.

The budget’s capital gains tax hike increased the tax-inclusive cost of capital for large companies by 5 percent (according to estimates by Philip Bazel and me using our marginal effective tax rate model). Based on conventional assumptions that an increase in the tax-inclusive cost of capital by 10 percent causes the capital stock to fall by 7 percent, I estimate that Canada’s capital stock would fall by $127 billion. Employment would permanently decline by 414,000. To put this in terms of its impact on unemployment, the capital gains tax hike would increase unemployment from 1.5 to 1.9 million Canadian workers as of August 2024. GDP will fall by almost $90 billion and real per capita GDP by 3 percent.

While the impact of the capital gains tax hike is not catastrophic, it is meaningful. It’s another hit on Canada’s productivity and economic growth on top of other tax increases and more important, regulatory obstacles to investment.

What about neutrality?

It is not just tax rates that affect economic growth and productivity. Tax distortions that result in the misallocation of resources also undermine productivity when capital resources are misallocated in the economy. With capital gains taxation, however, the impact on distortions is rather complex.

The strongest argument made for increasing the capital gains tax from one-half to two-thirds of the ordinary personal income tax is neutrality in financial structures. As the federal-provincial corporate income tax rates have fallen from 43 percent to 26 percent today, the dividend tax credit was reduced. This resulted in dividend tax rates rising since 2000 while the capital gains tax rate remained unchanged at one-half of the personal income tax rate. When dividends are taxed more heavily than capital gains, it encourages companies to pass out income to investors in the form of capital gains rather than dividends. This is one distortion addressed by the budget, although limited to capital gains in excess of $250,000.

With the corporate capital gains tax, however, a different distortion arises in that corporate capital gains are taxed more heavily than inter-corporate dividends (the latter are exempt from taxation to avoid double taxation on profits distributed from one corporation to another). When corporate capital gains are more heavily taxed than dividends, companies are encouraged to structure inter-corporate payments as dividends rather than capital gains.

Thus, increasing the corporate capital gains tax rate widens the distortion between dividend payments and reinvested earnings at the corporate level. As shown in a recent European study, the corporate capital gains tax distorts the market for corporate control by discouraging acquisitions and mergers, resulting in a foregone deal loss of $1.1 billion in 2013 for Canada.

Further, the budget introduces a new distortion in the tax system. In the past, the capital gains tax at the corporate level was the same as that paid by individuals. The reason for this policy was to minimize the incentive to hold assets at the corporate or personal level to avoid capital gains taxes. For example, if there were no corporate capital gains tax, an investor could avoid capital gains taxes by selling real estate assets held by the corporation rather than selling them as an individual.

The 2024 budget introduces a lower tax rate on capital gains at the individual level (due to the $250,000 exemption) compared to the corporate level. This will encourage investors to hold equities directly rather than at the corporate level. While this might seem innocent, it can create distortions in the allocation of capital. For example, corporate assets are subject to limited liability and can be jointly held by many investors. By pushing assets to be held at the individual level, some of the benefits of incorporation can be lost.

Further, the increase in the capital gain tax rate encourages investors to hold on to assets longer rather than replace them with assets that provide superior returns to equity. Capital gains taxes also discourage risk-taking since the government taxes the nominal gains but does not provide a refund for potential losses.

Taking into account all these considerations, the 2024 budget reduces some but increases other tax distortions. Productivity is likely reduced simply by raising taxes on capital investment.

Key takeaways

Overall, the increase in the capital gains tax rate at both the corporate and personal level is expected to discourage business investment and employment, unlike that claimed in April’s federal budget or by the IMF. I find that the increase in the capital gains tax rate will reduce Canada’s GDP by $90 billion, real per capita GDP by 3 percent, its capital stock by $127 billion, and employment by 414,000. This is not a trivial loss to the Canadian economy.

DeepDives is a bi-weekly essay series exploring key issues related to the economy. The goal of the series is to provide Hub readers with original analysis of the economic trends and ideas that are shaping this high-stakes moment for Canadian productivity, prosperity, and economic well-being. The series features the writing of leading academics, area experts, and policy practitioners. The DeepDives series is made possible thanks to the ongoing support of Centre for Civic Engagement.

As the federal parliament returns from its summer break, there’s a lot of political speculation about an impending election, but less attention being paid to the myriad of public policy issues confronting parliamentarians.

We’re living in a moment of big economic, social, and geopolitical questions. Canadian policymakers must be cognizant of the opportunities and challenges facing the country and put forward policy proposals that are proportionate to them.

In order to situate the fall parliamentary sitting, we’ve compiled four short essays from leading experts on some of the policy issues that are likely to animate its deliberations.

These include: balancing the federal budget, fostering productivity growth, reforming temporary immigration programs, and responding to rising American protectionism.

Balance the budget, for the sake of Canadians

By Jake Fuss and Grady Munro, economists at the Fraser Institute

A key question for the Trudeau government and parliamentarians more generally concerns Ottawa’s deficit spending and debt accumulation. There’s now an urgent need to put forward a credible plan to balance the federal budget.

In 2024-25, it’s expected the Trudeau government will run its tenth consecutive budget deficit, primarily due to high levels of spending. Indeed, Prime Minister Trudeau has overseen the six highest years of program spending in Canadian history (2018-2023)—even after excluding COVID-related spending—on a per-person basis adjusted for inflation. And deficits and high spending are expected to continue for the foreseeable future.

Consequently, since 2015-16, federal gross debt has approximately doubled from $1.1 trillion to an expected $2.1 trillion by the end of 2024-25. While a growing debt burden ultimately means higher taxes on future generations, it also today means higher debt interest costs, which have similarly more than doubled since 2015-16. In fact, this year, more than $1 in every $10 the federal government collects in revenues will be used to service debt rather than provide services or tax relief for Canadians.

Given the risks associated with persistent spending-driven deficits, parliamentarians should focus on balancing the budget. The chart below shows how to achieve that goal.

Specifically, if the federal government limited growth in annual program spending (total spending minus debt interest) to 0.2 percent for two years (beginning in 2025-26), it could balance the budget by 2027-28. Once the budget is balanced, the government could resume increasing spending at a quicker pace and still run a surplus in 2028-29.

During the mid-1990s,  Prime Minister Jean Chrétien’s Liberal government employed a similar approach to balance the budget for the first time in three decades and avoid a fiscal crisis. The government reviewed all areas of federal spending with the twin objectives of eliminating the deficit and ensuring Canadians received value for their tax dollars. By balancing the budget through a shift towards smaller and smarter government spending, the Chrétien government’s reforms then helped create a decade of balanced budgets, tax relief, and overall economic success.

There are clear benefits to balancing the budget.

First, it will help slow the rate of federal debt accumulation. As noted in the chart, balancing the budget would allow the federal government to avoid accumulating $64.2 billion of additional debt. Second, a balanced budget will provide fiscal room to deliver tax relief for Canadians. Given the average Canadian family spends more on taxes than on basic necessities, tax relief would provide a meaningful boost for families struggling to pay the bills.

With the fall session getting underway, parliamentarians face political uncertainty and several important policy issues. In light of the sorry state of federal finances, balancing the budget should be a top priority.

The “productivity problem” is bigger than Canada

By Alicia Planincic, economist and manager of policy at the Business Council of Alberta

Canada’s standard of living is stagnating, and productivity—the only real way to fix it—is (rightfully) at the centre of the conversation. Conferences have been held, policy departments have been established, and, more recently, a new federal working group was announced—all in an effort to address this pressing problem.

For those following closely, it may seem like no stone is being left unturned. From the role of industry dynamics to interprovincial trade to the potential effects of immigration, and even why some productivity measures might look worse than others. This is all good; the more people, ideas, and thought behind it, the better.

But one point lost in the conversation is that this productivity slowdown isn’t unique to Canada; it’s global. To be sure, Canada’s recent record has been particularly bad. However, productivity growth has been weak across the G7 for decades. In fact, virtually every rich country in the world has seen slower productivity growth in recent decades, compared to the period from the 1920s to the 1970s.

So, while Canadians may feel bombarded by headlines about Canada’s productivity problem, a Google search of “Productivity Growth [insert country name]” shows we’re not alone. Much has been written on the issue from other perspectives, from “The UK Productivity Paralysis” to “The German Productivity Paradox” to “Why is Europe Losing the Productivity Race” and “Australia’s Woeful Productivity Sinks Living Standards,” just to name a few.

Oftentimes, these analyses compare productivity growth to that of the U.S., the one country that has managed to buck the trend at certain points in recent history (namely, in the late 1990s and early 2000s). But even the U.S. is failing to show the level of dynamism that it once did and, as they see it, they too have been experiencing a productivity slowdown for many years.

There are many reasons for the global decline. Certain factors that drove earlier improvements—like a more highly educated workforce—may have run their course. Likewise, services industries (where most employment now lies) haven’t been able to deliver the same productivity gains as the transition from agriculture to manufacturing did in the past. So far, the new technologies that could increase productivity ( for example 5G, big data, AI) have yet to yield the efficiencies for office workers that mass production techniques and electricity did for factory workers.

Of course there are exceptions. Some businesses are keeping pace with the productivity growth of the past. Interestingly, it’s not necessarily the ones that invest the most but rather the ones that use their resources (capital and labour) most efficiently. However, there is a growing divergence between the best and the rest, which fall substantially behind.

That said, just because other countries face a similar challenge doesn’t mean Canada doesn’t have a real problem. Canada’s productivity slowdown has been especially noticeable since the mid-2010s and has already had a very real effect on Canadians’ standard of living. But fixating on the gap in growth between Canada and the U.S., while real and concerning, may miss the bigger point: that strong productivity growth may be more difficult to capture than in the past, and we may need to challenge ourselves to think a little differently if we want to solve this problem.

It’s time for the federal government to get serious about immigration reform

By Mike Moffatt, senior director of the Smart Prosperity Institute

In the last three-and-a-half years, Canada’s population has grown by 3 million people, the level the country typically experiences in a decade, and slightly more than we experienced in the entire 1990s. This level of growth was only sustainable if infrastructure and housing construction experienced similar increases. They did not, leaving our healthcare system underfunded and growing Canada’s shortfall of homes at nearly one million units. Addressing this must be a top priority of the government this fall.

Nearly all of Canada’s net population growth comes from international migration. Increases in Canada’s permanent resident immigration targets, from 250,000 to 500,000 a year, played a role, but the larger driver was a massive increase in non-permanent residents, from temporary foreign workers and international students. As I told cabinet ministers just a few days ago, “Our immigration system has shifted away from adding to the skills and cultural vibrancy of Canada to creating an underclass of guest workers. It has become a tool to allow provinces to cut funding to higher education.”

The staggering growth in non-permanent residents is a net increase in that it’s the difference between the number of new incoming residents on time-expiring visas, subtracting out those who leave the country and those who gain permanent residency.

Canada’s opportunity to address this situation will come with this November’s release of the 2025-2027 immigration levels. I will judge the new plan as a success if it does the following three things:

1. In March, the federal government committed to decreasing Canada’s non-permanent resident population (which is currently 2.8 million)  down to 2.1 million over three years. The government should also commit to annual reductions in non-permanent residents by 250,000 each year, for the next seven years. By the end of 2031, Canada’s non-permanent resident population would therefore be one million persons, returning to the levels last seen in 2017.
2. The federal government should temporarily reduce the annual permanent resident target to around 300,000 persons per year. Coupled with the non-permanent resident population shrinking by 250,000 a year, Canada’s population growth would be effectively zero, giving the country time for infrastructure and housing to catch up to past population growth.
3. The plan should outline how the federal government, in conjunction with other levels of government, will address the current shortages in housing. The plan should give an estimate of the existing housing shortfall and provide annual targets for homebuilding. Once that shortfall is closed, immigration targets should be raised back up to 500,000, or potentially higher, if conditions allow.

While this may be characterized otherwise,  this is a pro-immigration approach. Despite recent population growth, the status quo is not pro-immigration. Shifting Canada’s immigration system towards a system of temporary guest workers with few rights, which the United Nations has characterized as “a breeding ground for contemporary forms of slavery” is not pro-immigration. It is not pro-immigration to invite newcomers to our country and not ensure they have access to the housing, healthcare, and education they need to succeed. Pro-immigration should never be pro-exploitation.

Federal policymakers have the opportunity to reform the immigration system to make it work better for both newcomers and Canadians. They need to take it.

Adjusting to the new Washington consensus on trade

By the Wilson Center’s Canada Institute’s Christopher Sands and Xavier Delgado

The 2024 U.S. elections will reinforce trends in U.S. trade policy that began in 2016 and then solidified with bipartisan support in 2020. The next U.S. administration, regardless of who wins, will seek to reshore jobs and production from China and prioritize the enforcement of existing trade commitments over negotiating new agreements. The big spending industrial policies shaped by recent Congresses will continue, though the industries receiving support may shift depending on the election outcome.

Canada has so far responded to these changes with piecemeal strategies, hoping for a return to pre-2016 norms. Since that is unlikely, and despite Canada’s significant reliance on trade with the U.S., Members of the 44th Parliament should prepare Canadians to adjust by engaging in an honest debate about the changes in U.S. thinking in five areas.

1. Buy American and Canadian content. Domestic content requirements have been used by both countries, notably by the United States for defence procurement and by Canada for the promotion of Canadian culture. The difference is that the United States typically applies set-asides (e.g., certain procurements being targeted at small businesses) as a condition of government financial support, whereas Canada is prone to establish content quotas (for example, music on Canadian radio) as a precondition for government licensing or permits. These patterns are engrained on both sides of the border and unlikely to change.
2. Industrial policy. The main critique of industrial policy, which argues it leads to inefficient resource allocation because it favours friends of the government, applies to both countries. However, the Biden administration’s novel industrial policy offers incentives to any private firm that qualifies by responding to a public sector priority, even foreign firms. For instance, the United States has financed Canadian-owned firms working in the U.S. and even invested directly in critical minerals projects in Canada.
3. Dispute resolution. When it comes to disputes, former U.S. ambassador to Canada Bruce Heyman observed that while Americans prefer litigation,  Canadians prefer negotiation. This difference often leads to a stalemate when the U.S. refuses to bargain and Canada drags its feet on a previous commitment. In implementing the United States-Mexico-Canada Agreement (USMCA), the U.S. has pushed Canada to fully open its dairy market as agreed, while disregarding the USMCA panel rejecting the U.S. interpretation of the formula for calculating the automotive rules of origin, daring Canada to sue.
4. Further trade liberalization. Congress last granted trade negotiating authority to an administration in 2015. It expired in 2021. Without new negotiating authority, the United States could not renegotiate the USMCA, only withdraw from it. That is unlikely: USMCA approval garnered bipartisan majorities in Congress and praise from Trump and Biden, even though as senator, Kamala Harris voted against it.
5. Security still trumps trade. Former U.S. Ambassador to Canada Paul Cellucci’s blunt expression of U.S. priorities still applies. Both Democrats and Republicans support efforts to develop critical minerals, increase defence spending, and impose sanctions on adversaries like China and Russia. Canada will benefit most from its integration into U.S. defence supply chains if it remains closely aligned with Washington in great power rivalries.

The new Washington consensus on trade combines economic nationalism with political pragmatism to overcome partisan polarization and get things done. Ahead of a Canadian federal election in 2025, MPs should be clear-eyed and creative in debating Canada’s economic future. An Ottawa consensus about relations with the United States eschewing partisanship and ideology would serve Canadian interests well.

Key Takeaways

While all eyes will be on politics upon Parliament’s return, parliamentarians shouldn’t lose sight of the policy challenges gripping the country. Almost two-thirds of Canadians think the country is headed in the wrong direction, and concerns about the rising cost of living, the economy, immigration, and Canada’s place in the world, are high.

Against this backdrop, we gathered a group of leading policy experts to discuss what parliamentarians should be thinking about heading into the fall sitting. Each part touches on key issues that matter to Canadians, including:

• Balancing the budget and righting Canada’s fiscal ship.
• Developing a set of made-in-Canada policies to address our productivity woes.
• Reforming temporary and permanent immigration to be more sustainable.
• Beginning to seriously think about Canada’s national interests and how those are best achieved amid rising U.S. protectionism.

Parliamentarians would do well to focus on these concerns and develop a substantive policy agenda that addresses the issues that matter most to Canadians.