The latest federal budget did little to address Canada’s mounting productivity challenge. Instead, the government focused on measures that, it argues, will increase “generational fairness.”

One such move sparked considerable debate: increasing capital gains taxes.

This is an important debate to be had, to be sure, but there are other tax changes coming that have been completely lost in the shuffle.

A significant increase in taxes on new business investment throughout the Canadian economy is most concerning of all.

It is likely the largest tax increase you’ve never heard of. And it will lower investment and productivity at a time when we need more of both.

So what is this tax change? And why does it matter?

It all comes down to how quickly companies can write off capital investments, and to the 2018 corporate tax changes that are now gradually being phased out.

The Trump tax cuts

In 2017, the U.S. implemented significant tax reform. Among many other changes, they lowered their corporate tax rate from 35 percent to 21 percent and allowed companies to immediately deduct the full cost of certain capital investments. A company spending $1 million on new equipment could “expense” the full amount immediately, lowering its taxable income and tax bill.

Before the change, the company would write off this investment over years. And since a dollar today is worth more than a dollar tomorrow, accelerating the write-offs is essentially a tax cut.

To understand the impact of these changes, consider one particularly useful measure: the “marginal effective tax rate” on investment, or METR for short. If a project delivers a 10 percent return before taxes but leaves only 5 percent for the investor after all taxes are paid, then the effective tax rate is 50 percent—taxes consume half of the investment’s returns.

Using this measure, the U.S. changes lowered their METR by roughly 11 percentage points—from 29.8 percent to 18.7 percent. That’s an enormous tax reduction.

Serious analysis suggests this could boost the U.S. economy by 1.7 percent, increase wages by 1.5 percent, and increase the total capital stock by 4.8 percent, mainly due to increased investment levels.

Canada’s (temporary) response

Fearing a loss of competitiveness, Canada followed in 2018 by also lowering taxes on new investments—not through tax rate reductions, but by allowing faster write-offs.

But here’s the catch: these changes were temporary.^{1Many of the U.S. tax changes were also temporary. But the negative effect of Canada increasing its tax on investment exists regardless of what the U.S. does.}

Starting in 2024, they are gradually being phased out and will be fully eliminated after 2027. The incentive to invest in Canada will consequently fall.

Overall, the effective tax rate placed on new investment in Canada is set to increase from 13.7 percent to nearly 17 percent.

Certain types of investment will see even larger increases. The tax on machinery and equipment investment—a critical source of labour productivity growth—will see an increase from 5.7 percent to 14.2 percent! And there are differences across sectors, as I illustrate below.

The effective tax rate in agriculture will increase from 8.1 percent to 11.6 percent, in construction from 20.8 percent to 22.5 percent, and in services from 17.2 percent to 20.7 percent. The largest increase of all is in manufacturing, which will see the tax on its investments nearly triple from 3.1 percent to 9 percent.

The consequence: smaller investment returns and, therefore, less investment and capital for Canadian workers and businesses.

It’s tough to say by how much, but the generic point is not controversial. By reducing the returns received by an investor, fewer investments will be made. There is considerable evidence for this. Some estimates suggest that, roughly speaking, a 1 percent increase in the METR may lower investment by as much as 1 percent or more.

Higher taxes on investment lowers productivity growth

This is crucial for productivity growth since capital accumulation has historically driven growth.

In a recently published paper for the Canadian Tax Journal and Finances of the Nation, researchers from the Centre for the Study of Living Standards, Andrew Sharpe and Tim Sargent, document that since 2000, approximately 90 percent of all labour productivity gains were from more capital available per worker. 

Any serious attempt to boost Canadian labour productivity must improve business investment incentives. Unfortunately, the coming federal tax changes will do precisely the opposite.

Rather than reversing the 2018 tax changes, governments could enlarge them.

Look back at the graph above. Even the lower tax rates on investment in construction and trade are over 20 percent, and services are nearly as high. 

We should adopt even more aggressive and expansive measures to lower those rates, as we’ve done for manufacturing. Provinces too can help, with changes to both corporate taxes (where provinces operate their own) and sales taxes. British Columbia and Saskatchewan, for example, levy sales taxes on firm input purchases, which also lowers returns on investment.

Given Canada’s dismal growth in living standards and real incomes recently, getting the tax system right is critical. The budget has led many to focus on capital gains. But we shouldn’t narrowly focus on just one tax change or another; the whole system of raising public funds in Canada needs a good, hard look.

The following is a French-language version of Derrick Hunter’s article, “Slower growth, fewer jobs, a worse economy—the consequences of the capital gains tax shouldn’t be shrugged off,” originally published at The Hub on April 19, 2024. The English-language version is included below.

Dans un article publié à la suite du budget 2024, Trevor Tombe a vigoureusement défendu la décision de Chrystia Freeland d’augmenter les taux d’inclusion des gains en capital pour les entreprises, les fiducies et les particuliers à revenu élevé. Le bon professeur explique avec des calculs mathématiques ce qui arrive lorsqu’une société réalise un gain en capital et transfère ensuite ce gain à ces actionnaires. Son exemple illustrait le concept d’« intégration », qui caractérise le système fiscal canadien depuis des décennies. L’intégration fait référence à l’idée selon laquelle les régimes d’imposition des entreprises et des particuliers ne devraient pas traiter différemment les investissements détenus dans une entreprise et ceux directement détenus par les contribuables. Le même principe s’applique aux dividendes et c’est d’ailleurs la raison d’être du crédit d’impôt pour dividendes. Sans intégration, certaines stratégies d’investissement seraient favorisées par rapport à d’autres. C’est pourquoi il est assez difficile de remettre le principe en question.

C’est lorsque Tombe pousse le principe un peu plus loin que la théorie abstraite entre en contradiction avec la prise d’une décision d’investissement dans le monde réel. Il poursuit son article en s’appuyant sur un vieux sophisme économique qui affirme qu’un « dollar est un dollar » et que l’économie n’est pas impactée différemment si ce dollar est perçu auprès d’un particulier ou d’une entreprise. Autrement dit, le dollar de revenu perçu auprès d’un employé devrait être imposé au même taux que le gain en capital réalisé par l’investisseur, et ce, dans le but de ne pas avantager certains contribuables par rapport à d’autres. Cette affirmation a été répétée à maintes reprises par des universitaires et des salariés dans la foulée du budget 2024.

Cette neutralité de l’imposition est peut-être réelle pour l’Agence du revenu du Canada, mais elle ne l’est certainement pas pour les entrepreneurs qui créent des entreprises ou pour les investisseurs qui les financent.

La firme que je dirige a été l’un des investisseurs en démarrage les plus actifs au cours de la dernière décennie au Canada. Il y a une semaine, nous avons réalisé notre centième investissement dans une entreprise en prédémarrage du secteur de la technologie, en grande majorité au Canada. Nous menons nos affaires avec sérieux et nous avons été récompensés pour nos efforts par de nombreux prix. Nous avons notamment reçu le titre d’investisseur providentiel canadien de l’année en 2019.

Il y a trois raisons principales pour lesquelles le dollar que nous gagnons grâce à nos activités d’investissement n’est pas comparable au dollar gagné par un employé typique. Ces raisons se résument au risque, à la liquidité et à la valeur temporelle de l’argent.

1. Le risque. Nous prenons nos décisions d’investissement en sachant que chaque entreprise dans cette classe d’actifs a 75 à 80 % de chances d’échouer. De très nombreuses études montrent que les investisseurs ne récupèrent pas le capital qu’ils ont investi dans la grande majorité des entreprises en démarrage du secteur de la technologie. Les investissements dans la minorité qui réussit doivent donc être suffisants pour compenser de multiples échecs. Un salarié gagnant un revenu régulier d’emploi ne court aucun risque comparable.
2. La liquidité. Lorsque nous investissons dans une entreprise naissante, nous prévoyons détenir cet investissement pendant sept à dix ans. Au cours de cette longue période, les possibilités de le convertir en liquidités sont très rares; les fonds sont véritablement bloqués jusqu’au moment où une sortie est réalisée, même si nous identifions de meilleures opportunités pour ces liquidités. Le contraste est saisissant avec l’employé dont les efforts seront récompensés par de l’argent liquide toutes les deux semaines.
3. Le temps. Sur une période de détention d’une dizaine d’années, il est très facile de voir comment l’inflation érode la valeur réelle d’un investissement, même lorsque les rendements nominaux peuvent sembler marginalement acceptables. Postulons que l’inflation grimpe en moyenne de 3 % par année pendant ces dix ans. La valeur d’un investissement devra augmenter de presque 75 % pour arriver à suivre le rythme de l’inflation pendant cette période de détention d’une décennie. Dans cet exemple, un investissement de 100 $ qui rapporte 175 $ n’a généré aucun rendement réel, mais l’impôt sur les gains en capital est prélevé sur le rendement nominal (c.-à-d. 75 $). L’investisseur devra alors payer 25 $ d’impôt sur un investissement qui n’a produit aucun rendement réel. En réalité, l’impôt transforme ce gain en perte. Encore une fois, un employé ne se retrouve jamais dans une telle situation, car il est payé toutes les deux semaines pour le travail effectué sans prise de risque.

Pour nous, investir dans des entreprises en démarrage est emballant et gratifiant, mais c’est la recherche pure et simple du profit qui nous motive. Bien qu’il ne s’agisse pas de dons de bienfaisance, les investissements que nous réalisons avec nos partenaires ont pour heureuse conséquence de créer des milliers d’emplois et des centaines de millions de dollars en activité économique tous les ans. La création d’opportunités économiques a toujours dépendu, avant tout, du nombre d’entrepreneurs innovants dans une société et de ceux qui investissent pour les soutenir. Nous devons tous les nouveaux emplois nets aux entreprises en démarrage. C’est la meilleure façon de développer l’économie que l’humanité a inventée, et 13 millions d’emplois du secteur privé au Canada doivent leur existence à ce type d’activité.

Mais demandez-vous pourquoi quelqu’un prendrait les risques associés à un investissement dans une entreprise naissante lorsque cet investisseur est soumis aux taux d’imposition marginaux canadiens les plus élevés, dépassant 50 % dans la plupart des provinces. Le gouvernement réclame la plus grande partie des fruits de vos efforts! Supposons que vous aviez le choix entre un CPG rapportant 5 % d’intérêt par an, sans risque de perdre votre capital, ou d’investir cet argent dans une entreprise en démarrage avec 80 % de chances d’échec. Sachant que l’investissement pourrait peut-être générer plusieurs fois ce capital dans dix ans, mais qu’il sera imposé ensuite au même taux qu’un rendement nominal, vous choisiriez probablement le CPG la plupart du temps. 

Un autre adage économique dit que « si vous voulez moins de quelque chose, taxez-le davantage ». C’est ce qu’ont fait Freeland et cie cette semaine. Le Canada connaît déjà une crise de productivité bien documentée, avec un PIB par habitant en baisse au cours des derniers trimestres. En réduisant la disponibilité des capitaux, le plus récent budget ne fera qu’accélérer cette très mauvaise tendance.

Derrick Hunter est le chef de la direction de Bluesky Equities Ltd. et est administrateur de la fondation Hunter qui finance le Hunter Prize for Public Policy décerné par The Hub.

Slower growth, fewer jobs, a worse economy—the consequences of the capital gains tax shouldn’t be shrugged off

We should be doing all we can to encourage entrepreneurship. This tax increase does the opposite

Trevor Tombe has laid out a vigorous defense of Chrystia Freeland’s Budget 2024 decision to hoist capital gain inclusion rates for corporations, trusts, and high-income individuals. In his essay, the good professor illustrated the mathematics involved when a corporation incurs a capital gain and then passes the proceeds on to its shareholders. The example depicted the concept of “integration,” which has been a hallmark of the Canadian tax system for decades. Integration refers to the idea that the corporate and individual tax systems should be indifferent to whether an investment is held in a corporation or directly by the taxpayer. The same concept applies to dividends; it is the reason why the dividend tax credit exists. Without integration, some investment strategies would be favored over others so conceptually, it is pretty difficult to argue with.

It is when he takes the concept one step further that academic theory collides with real-world investment decision-making. Tombe goes on in his piece to rely on the old economic canard that “a dollar is a dollar” and the economy is indifferent as to whether it is collected from an individual or a corporation. In other words, the income tax dollar collected from an employee should be taxed at the same rate as the capital gain earned by the investor in order to avoid advantaging certain taxpayers over others. This line has been repeated many times by academics and wage-earners in the wake of Budget 2024.

That indifference may well be true for the Canada Revenue Agency, but it is certainly not true for the entrepreneurs who start companies or the investors who finance them.

The company that I lead has been one of Canada’s most active early-stage investors over the past decade. Last week, we made our one-hundredth investment in a seed-stage technology company; the large majority of these are located in Canada. We treat this business seriously and for our efforts, we have been recognized with a number of awards including being named Canada’s Angel Investor of the Year for 2019.

There are three main reasons why the dollar that we earn from our investment activity is not the same as the dollar earned by a typical employee. These boil down to risk, liquidity, and the time value of money.

1. Risk. We make our investment decisions knowing that every individual company in the asset class has a 75 percent to 80 percent chance of failure. Loads of studies show that the large majority of early-stage tech companies fail to return their investment capital. Investments in the minority of companies that succeed have to be sufficient to carry the load of multiple failures. An employee earning regular income in a job bears no equivalent risk.
2. Liquidity. When we invest in a startup, we expect that the holding period will be between seven and ten years.  Over this long period of time, it is very rare to have the opportunity to swap our position for cash; we are truly locked in until the point where an exit is achieved even if we identify better opportunities for the cash.  This contrasts starkly with the employee who will see cash for his or her efforts within two weeks.
3. Time. With a holding period of a decade or so, it is very easy to see how inflation erodes the real value of an investment even when nominal returns may look marginally acceptable. Let’s say inflation averages 3 percent over the ten-year period. At the end of the ten-year holding period, the investment would have to increase in value by nearly 75 percent just to keep pace with inflation. In this illustration, a $100 investment that becomes worth $175 has produced no real return, yet the capital gain tax is levied on the nominal return (ie. $75). The investor owes $25 in tax on an investment that has produced no real return at all; indeed, the tax has actually put him into a loss position. Again, this does not happen to an employee, who is paid every two weeks for labour supplied and bears no such risk.

For us, investing in early-stage companies is exciting and rewarding, but it is purely profit-seeking. While this is not a charitable activity, the investments that we make along with our partners do have the delightful side effect of creating thousands of jobs and hundreds of millions of dollars of annual economic activity. The creation of economic opportunities has always depended first and foremost on the prevalence of creative entrepreneurs and those that invest to support them. All net new jobs come from startups. It’s the best recipe for economic development mankind has ever invented, and 13 million private sector jobs in Canada owe their existence to this sort of activity.

But ask yourself why anybody would ever take on the risks associated with early-stage investing if they were subject to the top marginal Canadian tax rates which exceed 50 percent in most provinces. The government has a larger claim on your efforts than you do! If your choice is between a GIC paying 5 percent per year with no chance of loss or a startup with an 80 percent chance of failure that might produce a multiple of that in ten years and then be subject to the same rate of tax on a nominal return, you probably would take the GIC most of the time. 

Another economic adage is that “if you want less of something, tax it more.” That is what Freeland and company have done this week. Canada is already experiencing a well-documented productivity crisis, with GDP per capita declining over the past several quarters. By reducing capital availability, this latest budget will only accelerate that ugly trend.