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DeepDive: What a pro-growth tax reform might look like


Conservative Leader Pierre Poilievre addresses his caucus in Ottawa, March 20, 2024. Sean Kilpatrick/The Canadian Press.

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.

Taxes shape our economy in countless ways. They influence everything from business investments to employment to our individual spending decisions. They also fund crucial public services, such as high-quality education and a reliable legal system, which in turn support economic growth.

This is why the United States Internal Revenue Service (their equivalent of the Canada Revenue Agency) inscribed above its main entrance Justice Oliver Holmes’ famous remark that “taxes are what we pay for a civilized society.”

But taxes—especially poorly designed ones—also come with costs. Some of which can be large, particularly in the face of Canada’s poor record on investment, productivity, and economic growth.

It’s critical to get the balance between the benefits and costs right. Raising revenues to fund public services, yes, but doing so in the most economically efficient way possible.

The recent federal budget, which increased capital gains taxes, sparked a renewed debate on tax policy in Canada. The discussion so far has focused on the narrow implications of the government’s decisions. Some, such as my own initial reaction, argue that there are technical reasons within the context of broader tax reform that one might adjust that component of the tax system. Others, such as this thoughtful counterargument by Derrick Hunter and Conservative Party leader Pierre Poilievre, point to potentially damaging economic effects.

It’s time for a broader debate about how to move Canada’s tax system forward.

It’s time for a growth-oriented tax reform to minimize economic distortions and maximize the potential for innovation and investment to support a thriving, dynamic economy.

In that vein, the Conservatives committed only a few weeks ago to establishing (if elected) a “tax reform task force” to design a “Bring It Home Tax Cut.” There is a lot that such a task force could explore. This DeepDive aims to inform such an exercise by presenting some pro-growth tax reform options to both Canada’s personal and corporate income tax regimes.

A growth-oriented tax reform

Currently, Canada’s tax system creates significant disincentives for both individual work and business investment. These issues go far beyond how we treat capital gains. The inefficiencies and distortions throughout the tax code lower employment, reduce hours worked, and shrink incomes for those who would otherwise prefer more of all three.

It also lowers capital investment in machinery, equipment, buildings, and other assets, leading to lower productivity and a smaller economy.

It doesn’t have to be this way.

There are numerous options to improve the situation. While any policy change involves trade-offs, the potential economic gains from tax reform in Canada almost surely outweigh the costs.

Let’s start with individuals.

High taxes on low- and middle-income families

Who faces the largest tax burden in Canada? You might be tempted to say higher-income individuals. But the reality is that lower- to middle-income working families face the largest hit anytime they earn additional income.

This is not because federal or provincial tax rates are highest for these earners. If you earn $60,000 in Ontario, for example, then the combined income tax rate you face on your next dollar is just under 30 percent. In Quebec, it’s 36 percent. The top rates that apply for the highest earners, meanwhile, are both over 53 percent.

The high effective tax rates for middle earners come from payroll taxes, such as for EI and CPP, and government transfer programs, like child benefits. Neither affects the tax rates that high-income earners face since payroll taxes drop off past certain income thresholds and most transfers phase out with income.

Let’s start with the simplest case. Below, I plot the current tax rates faced by a single individual without kids from Ontario whose only source of income is employment (see Figure 1). This jagged line shows how much of the next dollar earned is effectively taxed, either explicitly by income and payroll taxes or implicitly by the phase-out of transfers. Perhaps surprisingly, some lower- and middle-income levels face similar tax rates as higher-income ones.

Graphic credit: Janice Nelson.

This can discourage work. But the situation is even more striking for families.

When you have children, you are typically entitled to certain benefits that will be clawed back as your income increases. In effect, this is like an increase in the tax that you face when deciding whether to earn more or not.

So, let’s turn to the situation for a dual-income family with two young children (under six). There’s a lot going on under the hood here, and this illustration in Figure 2 is just an example, but the very high effective tax rate (over 70 percent for many!) is a common finding across a range of scenarios.

Graphic credit: Janice Nelson.

Indeed, in recent research, my University of Calgary School of Public Policy colleague Phil Basel finds clearly that families with modest incomes of between $30,000 and $60,000 face tax rates around 50 percent on the next dollar they earn, and as high as 57 percent in Quebec. That’s significantly higher than the tax on high-income families earning over $100,000, who face rates only slightly above 40 percent.

To oversimplify (but only a little), it is fair to say that there are families in poverty who face a higher tax rate on any extra income they earn than the highest-income families in Canada do.

Beyond affecting how much you might want to work, there are also large implications for whether one wants to enter the labour force at all or not. If a one-income family is considering whether it’s worth it for the second partner to enter the labour market, perhaps taking up a part-time opportunity to help make ends meet, they may face a situation where earning one more dollar leaves them only thirty cents better off. It may therefore make little sense for them to work at all.

A pro-growth tax reform would lower these high marginal rates for Canada’s working families. We could lower income tax rates, reform payroll taxes like the EI program, or change benefit programs like the Canada Child Benefit so they phase out more slowly.

We could also, as recent work by Alexandre Laurin and Nicholas Dahir recently recommended, introduce a “benefit shield” where child benefits, working income tax credits, and all the rest do not decline as income grows, at least in the first year. If decisions to work are based more on shorter-term financial payoffs than longer-term ones, then this could dampen the disincentive to work that our system currently creates.

One thing a pro-growth tax reform shouldn’t do is pay for tax cuts for lower- and middle-income families with tax hikes for higher-income ones.

The Laffer curve

There are limits to how high taxes can go—at least if your goal is to raise government revenue.

The “Laffer curve,” as it is frequently known, summarizes this straightforward idea (see Figure 3).

It’s not a political ideology but an empirical observation. A tax rate of 0 percent raises no revenue. A tax rate of 100 percent raises no revenue either (since why would anyone earn an additional dollar if all of it would be lost?). So, a revenue-maximizing tax rate must be somewhere in between.

Imagine an upside-down U-shaped curve with tax rates moving you from left to right along it, and the height of the curve represents revenues raised. Beyond the peak of the curve, revenues fall with higher tax rates because such increases increasingly discourage economic activity.

Graphic credit: Janice Nelson.

So where is the top of Canada’s curve?

While we can never know for sure, and it likely changes over time, some recent work by my University of Calgary colleague Bev Dahlby sheds light on this question. In simple terms, it comes down to how much the “tax base” (that is, the personal taxable incomes that we are taxing) shrinks in response to higher tax rates. In work with co-author Ergete Ferede, they found a one percentage point increase in the federal top income tax rate would shrink the amount of top taxable income by nearly two percent. That’s large.

These estimates suggest that the revenue-maximizing personal tax rate is somewhere around 50 percent. I’m abstracting from important interactions between different types of taxes, to be clear, but looking just at personal income tax revenues alone, Canada may have very limited, if any, scope to actually raise revenues by increasing top rates much further.

The same is true on the corporate income tax side of things. Dahlby and Ferede’s estimates suggest that the tax base is even more sensitive to taxes than personal income taxes are. Based on their estimates, the revenue-maximizing rates may be just under 30 percent. Again, that’s essentially where Canada already is, and the scope to raise more revenues by increasing rates may be highly constrained.

Where will top talent go?

Part of the reason why the tax base shrinks with higher rates is because some people—especially higher-income professionals—may move in response to changes in tax rates.

Top talent is, after all, mobile. And for many, the United States is a far more attractive destination. In many states, there is no income tax at all.

In California—the state with the highest top income tax—the top rate is lower than any Canadian province. But even there, you have to earn more than $1 million per year before that kicks in. In some provinces (I’m looking at you, P.E.I.), California-level income tax rates are reached once you earn $32,000.

Consider a high-income individual earning $300,000. I plot in Figure 4 the marginal income tax rates that they face below, including both province/state and federal taxes.

Graphic credit: Janice Nelson.

Canada’s lowest tax jurisdiction (Alberta) has a higher tax rate than the United States’ highest tax jurisdiction (California). No matter where top talent lives in Canada, they face a higher tax rate than they would in any U.S. state.

To better attract and retain highly skilled and in-demand workers and businesses, top-income tax rates could be reduced.

Corporate taxes and investment incentives

It’s not just human capital that is mobile. Investment capital is too.

A business or an entrepreneur with capital to invest must consider the alternative opportunities they could invest in. Say, some broadly diversified ETF. This determines a minimum rate of return (a “hurdle” rate) that the investor needs to receive. If a certain project is expected to yield more than this “hurdle” rate of return, then it will be funded. The more projects that have such returns, the faster Canada will grow its capital stock, increasing the amount of machinery and equipment workers have. This leads to higher labour productivity and, consequently, higher living standards.

But when a company makes such an investment, taxes reduce the returns it can keep. These can sometimes be considerable and are only growing larger in the coming years, as I wrote about recently for The Hub.

One approach to improving investment incentives is to lower corporate tax rates. But this affects not only new investments into Canada but the returns on all past investments as well. An alternative that targets just new investments is to allow firms to deduct from their taxes on any and all capital investments that they make today.

In effect, treat spending on capital the same as we treat spending on labour.

There are successful examples of this approach elsewhere.

Consider Estonia.

Their system is quite attractive. Estonia’s personal income tax rate is a flat 20 percent, with a basic exemption that lowers the burden on lower-income individuals. Its broad VAT rate (its equivalent to the GST/HST) is also set at 20 percent. And its corporate tax rate? You guessed it: 20 percent, which is much lower than Canada’s 23–31 percent, depending on the province.

Adopting a 20/20/20 tax system in Canada might not be feasible, at least in the short term, but there are features of the Estonian system worth considering for a pro-growth tax reform agenda in Canada.

The most innovative aspect of Estonia’s business tax system is that profits reinvested in the company’s operations are completely exempt from taxation. Taxes are only levied when profits are distributed to owners. Effectively, this treats capital spending the same as operational expenses. A dollar invested in new machinery and equipment would, in effect, be exempt from taxation.

This provides a significant incentive for investment and growth that Canada currently lacks. Adopting this approach to taxation—as another one of my University of Calgary colleagues, Jack Mintz, recently advocated—would be central to any pro-growth business tax reform.

A particularly important benefit of this approach is that it is broad-based, covering the entire economy and all forms of business investment. This is in sharp contrast to the current federal and provincial government approaches that aim to encourage investment through targeted tax measures and subsidies, which can distort market decisions and favour certain industries over others.

The Estonian approach provides a level playing field for all businesses. By allowing all firms to deduct their capital investments from their taxes, it removes the need for government intervention to pick winners and losers. This neutrality ensures that investment flows to the most productive uses, which creates an environment where businesses thrive based on their merits and contributions to the economy rather than their ability to secure subsidies or navigate complex tax incentives.

Radical reform: lower income taxes and raise consumption taxes

Lowering personal tax rates and modernizing business taxes could have real benefits for Canada’s economy. Modest pro-growth changes are possible even without needing to raise new sources of revenue. But to radically improve the situation, Canada should also consider increasing taxes on consumption to fund even more dramatic reductions in taxes on income.

This doesn’t mean we have to increase the GST. While there is a strong economic case to do so, there are political challenges. Luckily, there are options to make the income tax system look much more like a consumption tax without touching the GST.

This is easier to do than you might think. It involves expanding the scope to exempt savings and investment from income taxation. Consumption is, after all, what you are not saving out of your income.

A pro-growth tax reform could raise RRSP and TFSA contribution limits, for example, but also introduce new ways of saving for investment (rather than just saving for retirement). Allowing any dollar not consumed, but instead saved and invested, to be deducted from taxable income would be like increasing consumption taxes and decreasing income taxes without the same political challenges that a GST hike would have!

And while we’re on the subject of consumption taxes, it’s high time that British Columbia reconsidered their previous decision to scrap the HST. Research from Jack Mintz previously found that adopting the harmonized sales tax system in British Columbia reduced the effective tax rate on capital for large- and medium-sized entities from nearly 30 percent in 2009 to less than 22 percent in 2010. For small businesses, he found the size of the drop was even larger. This simple change was effectively a “giant leap” for B.C.’s tax competitiveness.

Compliance costs

Finally, there are the obvious costs of effort, time, and resources that we put into complying with existing taxes. Recent work by Francois Vaillancourt and Nathaniel Li surveys a large number of Canadians to learn about how much time and money is spent completing their annual filing. They find that compliance costs just for personal income taxation alone were roughly $4.2 billion in 2022, which doesn’t even include the much more significant costs imposed on businesses on the corporate side. Simplifying things would yield immense and immediate benefits.

This could involve automating more of our tax system, especially for those with simple returns. For those taxpayers, the CRA could simply send you a statement that you either accept or reject. If you accept, then you’re done, and no further actions are required. But this should also involve simplifying the tax code itself by eliminating most of the countless credits and deductions found throughout the system in exchange for lower rates across the board.

Key takeaways—A broad view by governments is needed

This list of issues goes on. And on.

But it should be clear that Canada is long overdue for a major and serious overhaul of its tax system. At the very least, it needs a good, hard look.

The above analysis presented several broad-based, pro-growth reforms that could improve the country’s economic climate, while also introducing more fairness and simplicity into the tax system, including:

  • Increasing fairness and reducing disincentives to work by lowering marginal tax rates on working families
  • Reducing top marginal tax rates and/or thresholds to help Canada attract and retain high-skilled workers
  • Use broad-based reforms to the corporate income tax system to incentivize new investments
  • Increasing taxes on consumption to fund even more dramatic reductions in economically costly taxes on income—not necessarily by increasing the GST, but by further incentivising savings that can be used as investment in Canada’s economy
  • Simplify the tax system to reduce compliance costs

Reform is difficult, of course. The system is a complex morass of overlapping and interacting components. Those who want one that increases investment, boosts labour force participation, enhances entrepreneurship and risk-taking, decreases compliance costs, and so on, must look at the entire picture.

The stakes are high. So whatever the outcome of the next election, the government shouldn’t shy away from bold, growth-oriented tax reforms that help reverse our current economic malaise.

DeepDive: The capital gains tax hike will hurt the middle class too


Chrystia Freeland in the media-lockup prior to tabling the Federal Budget in Ottawa on Tuesday, April 16, 2024. Sean Kilpatrick/The Canadian Press.

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.

The renowned philosopher and early economist, Adam Smith, made an important distinction between the incidence of taxes on land rents and on stocks: “Land is a subject which cannot be removed; whereas stock easily may…A tax which tended to drive away stock from any particular country would so far tend to dry up every source of revenues both to the sovereign and to the society.” Despite Smith writing these words in 1776, many experts today would agree with his understanding of tax incidence: taxes on immobile land fall on its owners while taxes on mobile capital have wider effects on society.

When the minister of finance, Chrystia Freeland, announced her recent hike to capital gains taxes she claimed in the 2024 federal budget: “We are making Canada’s tax system more fair by asking the wealthiest to pay their fair share.”

The purpose of this DeepDive is to test her claims about who will be affected by the budget’s capital gain tax proposal. The analysis shows that the effect of the capital gains tax affects not just the wealthy but many middle-class and even Canadians with modest incomes.

It will also hurt investment and, as Smith would say, “dry up revenue, both to the sovereign and to society.” In other words, the minister is badly misinformed. Much focus is on capital gains taxes paid by individuals, but the incidence of both the personal and corporate capital gains taxes goes beyond just taxing wealthy capital owners.

The budget capital gains proposal 

The budget presented on April 19, 2024, proposes to increase the capital gains inclusion rate from one-half to two-thirds on capital gains, and in the case of individuals, for those gains in excess of $250,000. (Capital gains below this threshold will still be subjected to the one-half inclusion rate.) Corporate and trust capital gains do not qualify for the exemption. The proposal will take effect until June 25, 2024, enabling investors an opportunity to sell assets prior to its enactment at a lower capital gain tax rate, losing the advantage of deferring gains to later years. Final legislation has not yet been released at the time of writing, which may result in some adjustments, creating uncertainty for many investors.

The budget states that 40,000 individual tax filers (0.13 percent of tax filers) and 307,000 corporations (12.7 percent of corporate tax filers) will be affected by the proposal. This has indeed been a major part of the government’s case in favour of tax change. The essential argument is that its design—including the $250,000 capital gains threshold—limits its incidence and in turn its economic costs.

The government predicts $19.4 billion in new revenues over five years, of which almost a third ($6.9 billion) would be raised in the first fiscal year (2024-25) as investors are expected to dispose assets before June 25th. Corporate capital gains taxes will yield the greatest share of new tax revenues: $4.9 billion in the first year (71 percent of the total) and $10.6 billion over five years (53 percent of the total).

The capital gain tax advantage more apparent than real

The strongest argument in favour of increasing the capital gains inclusion rate is linked to past corporate tax reform. Since 2000, the federal-provincial corporate income tax rate has been cut from 43 percent to roughly 26 percent by 2012, reducing taxes on distributed and reinvested profits. Individuals claim a dividend tax credit that avoids double taxation on distributed profits. This credit has declined along with the corporate income tax rate to keep the dividend tax rate aligned with the tax rate on other income. However, the capital gains inclusion rate, which was one-half since 2001 has not changed. As a result, dividends have become more highly taxed compared to the personal tax on capital gain realizations. Given the higher dividend tax rate, companies have an incentive to pay capital gains rather than dividends to investors.

In Ontario, for example, the top federal-provincial capital gain tax rate is one-half of the regular tax rate or 26.76 percent compared to the top personal dividend tax rate of 39.34 percent for eligible dividends and 47.74 percent on ineligible dividends (the higher rate on dividends reflecting the corporate tax rate on small business profits). By moving to a two-thirds inclusion rate, the capital gain tax rate in Ontario rises to 35.69 percent, which is closer but not equal to the top dividend rates.

While an increase in the personal capital gain tax rate reduces one distortion, it increases others. In the past, it was common to keep the corporate and personal capital gains tax rates aligned so that investors could not avoid capital gains taxes by leaving the asset in the corporation rather than directly owning it. Unlike corporate capital gains, inter-corporate dividends paid from one Canadian corporation to another are exempt to avoid double taxation since such dividends have already been taxed before being distributed. Thus, there is a tax disadvantage for a corporation to earn corporate capital gains taxes compared to dividends, which has been widened by the budget. Companies will try to avoid paying taxes on corporate capital gain realizations by structuring transactions to pay inter-corporate dividends instead.

Further, corporate capital gains will now be more highly taxed than personal capital gains below $250,000. This will encourage investors to hold equity directly rather than through a corporation, introducing a new distortion in the tax system.

This is not the end of the story. Capital gains taxes result in a higher tax on risky assets compared to non-risky investments since the government is more likely to share the gain but not investment losses. Also, the capital gains tax not only applies to gains from reinvested after-tax profits but also inflation—thus, the effective tax rate on real capital gains is higher than on nominal capital gains. Capital gains taxes on realizations encourage investors to hold assets for a longer period even though investors should rebalance their portfolio of investments to earn higher returns (the so-called “lock-in” effect). Overall, the capital gains tax advantage may be more ephemeral than real.

Capital gains and its lifetime incidence

Capital gains are “lumpy” since assets are not disposed on a regular basis. In many cases, a taxpayer may earn more than $250,000 in capital gains in one year but not realize it in other years. Investors could therefore be pushed into the highest income category but only on a temporary basis. On a lifetime basis, some taxpayers may only dispose significant amounts of assets once or twice throughout their lifetime. Examples of major asset disposal events include selling real estate, farmland, business assets or equity, secondary or vacation homes, and deemed realizations at death or departure from Canada.

In Table 1, the total number of tax filers with and without capital gains is provided including those with more than $250,000 in capital gains. Averaged over the years, the number of tax filers with capital gains in excess of $250,000 is 40,664 per year, almost identical to the number of filers for 2025  forecasted in the 2024 budget.

Graphic credit: Janice Nelson.

If the same tax filers repeatedly claimed more than $250,000 capital gains each year, one may conclude that only a small number of taxpayers are affected by the budget’s capital gains tax proposal. However, if large capital gains are realized only once or twice during a person’s lifetime or at death, many more Canadians, some with middle incomes, may be affected by the proposal on a lifetime basis. The extreme case would be tax filers who only appear once in their lifetime with capital gains of more than $250,000 in a particular year. In this instance, the total number of tax filers between 2011 and 2021 impacted by the proposal would be the sum of all filers in the third column of Table 1: 447,300.

With some longitudinal data, I estimate how many years in which tax filers among this group report capital gains in excess of $250,000 to see whether it is once or more frequently. Table 2 provides the number of years in which tax filers who in 2011 reported capital gains in excess of $250,000 report it in total between 2011 and 2021. Almost two-thirds report capital gains only once. Another 15.4 percent report capital gains in two of the years. Barely one percent report capital gains in seven or more years. In other words, most tax filers report capital gains quite infrequently.

Graphic credit: Janice Nelson.

Of the taxpayers who claim more than $250,000 capital gains in a year, many would otherwise have middle-class or modest income. In Table 3, I provide the distribution of those affected taxpayers according to their non-capital gain taxable income (based on 2018 data of those with more than $250,000 in capital gains).

Without capital gains of more than $250,000, the top 30 percent of all tax filers (P70, P80, and P90) had other taxable income in excess of $233,836. However, 50 percent had non-capital gain taxable income below $117,592 with 10 percent having only $18,131. Based on Table 2, roughly 80 percent have large capital gains only once or twice, suggesting a good number of taxpayers experiencing capital gains in one year would otherwise have middle or modest income in other years.

Graphic credit: Janice Nelson.

Using the distribution of reporting years, a typical investor claims capital gains in excess of $250,000 1.84 times over the 11 years. Since those claiming large capital gains in multiple years are so few, I can assume that in each year, 22,088 (44,664 divided by 1.84) unique tax filers claim large capital gains. Table 2 is only a snapshot of those reporting $250,000 or more in capital gains in one year (2011). It does not reflect the population of taxpayers (generally 25 years or over) who report capital gains of less than $250,000 in that year but could report capital gains in excess of $250,000 in other years of their lifetime. Based on 22,088 unique tax filers estimated above, the number of taxpayers with large capital gains sometime in their lifetime is estimated to be 1.26 million.

As a share of Canada’s tax filer population, those impacted by the new capital gains proposal on a lifetime basis is 1.26 million or 4.3 percent of tax filers compared to the budget estimate of 0.13 percent.

Canadian-controlled private corporations 

Many individuals hold savings in the form of a Canadian-controlled private corporation. As corporate capital gains will be subject to higher levels of taxation, the owners will be directly affected as they will receive lower dividends or realize lower prices for their shares when they choose to sell their equity held in the company. Once capital gains are realized in the private corporation, the deferral advantage for marginal taxpayers is eliminated with the refundable tax mechanism used for investment income. According to 2021 tax expenditure accounts, 1.112 million companies (98 percent of all corporations and 53 percent of corporate taxable income) are CCPCs. As in the case of individuals, corporate capital gains are infrequent as assets may be held for multi-years before they are disposed.

The 2024 budget estimates that 307,000 corporations in a year would have corporate capital gains but this includes public corporations. Taking 98 percent of this number, CCPCs affected by the change is equal to 300,860. Given multiple ownership of private corporations (such as family members or partners), the tax filers impacted by this provision will be much higher. On the other hand, some of the investors are already included in the number of affected individual investors on a lifetime basis.

Capital gain tax impact on the broad economy

Investors in both private and public corporations are affected by capital gains taxes to the extent that equity values are reduced, and investment is discouraged. Although the 2024 budget argued that capital gains taxes don’t affect business investment, that is only the case in which the valuation of large corporations is solely based on international equity markets of which Canadian savings have no discernible impact on the international cost of financing capital in Canada. That is clearly wrong in the case of corporate capital gains since a higher tax on such income will reduce the return to both domestic and foreign investors which would lower equity values.

From 2011 to 2021, corporate taxable capital gains were 6.98 percent of corporate taxable income. Increasing the inclusion rate from one-half to two-thirds increases the corporate capital gain tax rate from about 13 percent to 17.33. This is equivalent to increasing the aggregate corporate income tax rate by 0.3 percentage points, which would reduce corporate profits.

There is considerable evidence that capital gain tax increases affect the equity valuation of large corporations. Studies have shown that there is significant “home bias” with Canadians holding 52.2 percent of their portfolio in domestic assets even though Canada accounts for only 3.4 percent of global equity markets. Due to “home bias” and corporate capital gains taxes, several studies have shown that capital gain tax changes have had some impact on share prices of public corporations. In a Canadian paper by McKenzie and Thompson, personal dividend and capital gains taxes were found to be capitalized in Canadian equity prices, meaning that the assumption of a small open economy is not supported by the evidence.

Using these results, Milligan, Mintz, and Wilson examine the investment impact of reducing the capital inclusion rate for capital gains from two-thirds to one-half. They conclude:

“Even in a world with large tax-exempt entities (such as pension funds) and some degree of international capital mobility, taxes do appear to have an impact on the cost of capital for firms. We use the results of recent research to calculate that a reduction in the inclusion rate from 3/4 to 2/3 could increase investment by as much as 2%.”

Further, corporate capital gains taxes discourage acquisitions and mergers in markets, which protects management from takeovers. In a recent paper on mergers and acquisitions, corporate capital gains taxes were found to reduce acquisitions by $1.1 billion annually in Canada, resulting in an economic loss of annual synergy benefits equal to $300 million each year.

Capital gains taxes therefore have broad effects on the economy. Corporate capital gains taxes will suppress equity values impacting investors including pension funds and other saving deriving dividend and capital gains income from Canadian corporations. Both corporate and personal capital gains taxes will reduce business investment and therefore fall on capital owners or be shifted onto consumers through higher prices or workers as lower wages. Governments will lose other tax revenues as well.

Given capital gains taxes, especially corporate capital gains, can reduce equity values and business investment, many Canadian shareholders would be affected. In 2021, 4.74 million tax filers received taxable dividends from Canadian corporations, representing 15.8 percent of all filers. Adding equity valuation impacts on pension plans, registered saving plans, and real estate, an even larger number of taxpayers are affected.

Key takeaways

The 2024 budget claims that only 0.13 percent of tax filers are affected by the increase in the tax rate on capital gains in excess of $250,000 is badly off the mark. On a lifetime basis, many taxpayers are affected since they will pay capital gains taxes on infrequent asset disposals. Based on some longitudinal data, I estimate that 1.26 million individuals, or 4.3 percent of taxpayers, will be affected.

Even this estimate is an understatement. Capital gains taxes, especially at the corporate level, will impact equity values and reduce both dividends paid to shareholders as well as the capital gains on disposing equities held in private and public firms. Overall, 4.74 million individual investors in Canadian companies will be affected, representing 15.8 percent of all filers. Other Canadians will also be affected as equity held by pension plans, registered retirement plans and other non-registered saving in equity or real estate can be impacted too.

To the extent that capital gains taxes discourage investment, the broader economy is affected including worker incomes and government reliant on tax revenues generated by business activity. This was the point that Adam Smith made 250 years ago. The federal government should have paid attention to his arguments.