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.

Although successive Canadian governments have affirmed their support for greater competition in the telecommunications sector, their policy choices in the name of a so-called “fourth player” have come in the form of artificial competition or government-induced competition rather than a more sustainable, market-based approach.

The outcomes have been rather disappointing. While there are more players in the market than there were when the fourth-player policy was launched in 2008, it has required ongoing government intervention in order to sustain them. This has come with market distortions, opportunity costs, and other unseen consequences. Just consider for instance that the incumbent firms have had to spend more on acquiring spectrum ($29 billion) since 2020 than they’ve spent on their networks ($25 billion) over the same period.

The situation seems to be reaching a boiling point. Politicians are fighting with companies, the companies are in tension with one another, and government policy is becoming increasingly interventionist and anti-investment. One gets the sense that the status quo is unsustainable. Now is the time for a policy conversation about a better path forward.

This DeepDive offers an alternative conception of competition than the prevailing one in Canada based less on the number of market participants per se and instead focused on creating the conditions for greater market-based competition in the industry. In particular, it considers the case for liberalizing foreign ownership restrictions under the Telecommunications Act in order to enable more sustainable, market-based competition.

Static versus dynamic competition

When markets are competitive, consumers tend to benefit. Competitive markets and the competitive behaviour between firms that they engender produce a wide range of positive outcomes, including lower prices, higher quality goods and services, greater variety, more innovation, and even greater economic competitiveness on the whole. This is one of the basic insights of economics.

The telecommunications sector is no different. All things being equal, the evidence tells us that more competition in the sector generally produces better outcomes.

Yet it’s important to recognize that not all forms of competition are equal. One vision of competition, which focuses narrowly on the number of firms in a particular market, might be described as static. It assumes that more firms are always better for consumers and is prepared to use the levers of government policy to support and sustain new market entrants. As will be discussed below, this form of artificial or government-induced competition has largely been the source of policymaking for successive Canadian governments with regard to the telecommunications sector.

There is another vision of competition that’s less focused on the number of market participants per se and is instead concerned with how the dynamic process of technological change can create competitive forces between firms, even when there’s relative market concentration. As economist Neil Quigley explains:

Where technical change provides a credible threat to a network that is already in place, high levels of competition and substantial benefits to consumers do not, in fact, require that numerous competing providers operate in the market. Investment in new technologies and services that allow a firm to compete with existing technologies may provide greater benefits than competition among providers of the same technologies and services in the market…Consumers will benefit from this investment even if incumbent firms are not replaced by potential competitors.

The telecommunications sector is certainly one that experiences these dynamics of rapid technological change. Think about how quickly we’ve gone from the exclusive use of landlines to cell phones to broadband internet to fibre optics and now to satellite technologies. Even within wireless networks, the move from 3G to 5G evidences the consumer benefits from technological network upgrades. So long as the industry is free to attract investment capital (which it currently is not) and the pace of technological change keeps up, incumbent firms have strong incentives to compete with each other for the benefit of consumers and the Canadian economy.

Another way to understand the distinction here is as follows: a static conception of competition that prioritizes the number of market participants can lead to a policy of artificial or government-induced competition. If one’s primary concern is adding new entrants into the market, then the government can use different policy instruments to effectively induce and sustain them. The problem is that their activist origins make it challenging for these firms to transition into a position where they are supported by markets.

A more dynamic conception of competition, by contrast, lends itself to a more market-based policy framework. It essentially assumes that as long as there are not too many market distortions, the market will eventually reach a competitive equilibrium that accounts for its unique particularities, such as capital intensity, market size, technological change, and so on.

This is an important distinction because the case that Canada ought to have four telecommunications players—which is to say that our market equilibrium must be at least four—is inconsistent with trends in comparable jurisdictions and beyond.

Just consider the market structures of other countries. In the United States, for instance, three major firms dominate almost the entirety of the market. An OECD report on wireless market structures in advanced industrial countries found that the vast majority of these states had three to four national mobile network operators. Yet, despite these markets having similar structures to Canada, there’s plenty of evidence that Canada outperforms them in investment, network quality, and possibly even prices.

The key point here is that a narrow focus on the number of market participants may be misguided if the goal is to maximize consumer and economic benefits. A more dynamic model of competition would pay less attention to the number of participants per se and be more concerned with creating the conditions for firms to invest and innovate with technologies.

This is particularly relevant in a sector like telecommunications which is prone to what is known as the Bertrand Paradox. It’s an economic theory that describes cases where a duopolistic market structure provides the same result as that of perfectly competitive market conditions. In these instances, the most intense competition occurs if the market structure is duopolistic (e.g., Boeing versus Airbus or Coke versus Pepsi) because only in those markets winners can take all. That motivation keeps competition at its utmost level even if there are a relatively small number of market players.

Yet, as we will discuss next, this is not the path the Canadian government has taken. Instead, it has focused on artificially trying to bring a fourth player into the market, stemming from a vision of static competition. What has not been tried to date is a policy framework rooted in a dynamic model of competition whereby government frees up the ability of firms to attract capital from around the world in order to support greater investment, innovation, and technological change. This would be a more sustainable, market-based form of competition.

The fourth-player policy: a policy of artificial competition 

Understanding the current state of Ottawa’s telecommunications policy needs to start in 2006 with the road not taken. That year, the Telecommunications Policy Review Panel delivered its final report to the newly elected Conservative government under Stephen Harper, assessing how Canada should modernize the telecommunications regulatory landscape. The panel recognized that while Canada’s regulatory environment may have served the country well in the past, rapid technological change in information and communication technologies (ICT) necessitated a shift.

The goal of the panel was to ensure that Canada maintained its international economic competitiveness and that consumers had access to the latest technology at the lowest possible prices. The panel ultimately concluded, therefore, that it was “time for significant changes to Canada’s current policy and regulatory approaches, some of which date back to the early part of the last century.”

The report made several recommendations for how to modernize regulation and spur competition through a greater reliance on market forces. In particular, panel members recommended that the following guidelines be established to guide government policy and regulatory actions concerning the sector:

• Market forces should be relied upon to the maximum extent feasible as the means of achieving Canada’s telecommunications policy objectives.
• Regulatory and other government measures should be adopted only where market forces are unlikely to achieve a telecommunications policy objective within a reasonable time frame, and only where the costs of regulation do not outweigh the benefits.
• Regulatory and other government measures should be efficient and proportionate to their purpose and should only minimally interfere with the operation of market forces to meet the objectives.

In practice, these principles envisioned a significant deregulation for the sector, including “limiting economic regulation to markets where a service provider has significant market power.” The panel’s most notable recommendation, however, concerned the treatment of foreign investment and foreign ownership in the sector. In particular, it recommended the following:

[the] liberalization of the restrictions on foreign investment in Canadian telecommunications common carriers would increase the competitiveness of the telecommunications industry, improve the productivity of Canadian telecommunications markets, and be generally more consistent with Canada’s open trade and investment policies.

This meant, in practice, amending the Telecommunications Act to repeal the legislated foreign ownership restriction, which currently sets out that any firm with more than 10 percent market share of the telecommunications sector must be Canadian-owned, defined as having at least 80 percent of the board being Canadian and 80 percent of the voting shares being held by Canadians.

For all intents and purposes, the stage was set for a considerable overhaul of the Canadian regulatory environment. The panel’s recommendations were well received by Max Bernier, the minister of industry at the time. At a telecommunications industry event that year, Bernier told participants that “it is not the role of government to decide how this increasingly complex market should evolve. It is up to you—producers and consumers.”

Yet the Harper government ultimately chose the heavy hand of government and artificial competition over market-based competition. In what became known as the “Fourth Wireless Player” policy, the government sought to artificially spur competition in the telecommunications sector.

The essential idea was that the government needed to intervene in the market in order to support new market entrants who would place competitive pressures on the “big three” players (Bell, Rogers, and Telus). This thinking was predicated on the idea of static competition. It was taken for granted that Canada had an insufficient number of market participants, thus minimizing competition between firms and raising consumer prices.

To this end, the federal government launched an ongoing policy of market interventions in order to support and sustain new market entrants into the industry. It started with earmarked spectrum in a 2008 auction and has persisted to the present in the form of ongoing spectrum preferences, unequal access to foreign investment, and mandated tower sharing and wholesale access to the incumbents’ wireless networks.

By 2014, when the government was set to host another wireless spectrum auction, the problems with the fourth-player policy were already manifesting. Several of the new entrants were struggling for capital, limited to a small number of markets, and failing to make network investments. One of the new firms in the 2008 auction, Public Mobile, was later acquired by TELUS in 2013.

Others have since followed suit. These cases demonstrate that due to high capital costs and other unique characteristics, the telecommunications market is something of a natural oligopoly. Newcomers should come with a new way of providing services (e.g. Starlink) or through commercial partnerships. Market forces alone cannot accommodate a fourth identical competitor. This has been demonstrated in virtually every market in the world.

Yet, despite the cracks in the system, the Harper government decided to double down on the policy. In order to further support the nascent firms, the government provided them with asymmetric access to foreign investment. In particular, it amended the Telecommunications Act to eliminate foreign investment restrictions for telecommunications firms with less than 10 percent market share (this only applied to firms not also covered by the Broadcasting Act). This granted the new entrants disproportionate access to foreign capital that could then be used for auction bids.

Even with the preferential policy treatment, including in spectrum auctions held in 2014 and 2015 that transferred billions of dollars of indirect subsidies from taxpayers to non-incumbent firms, the new entrants never really came to own significant market share, with several later being acquired by incumbent firms when their sale restrictions expired.

Notwithstanding these disappointing results, the Trudeau government has continued with the fourth-player policy. Consider its most recent directive to the Canadian Radio-television and Telecommunications Commission (CRTC)—the industry’s regulator—in which the government stipulated that a key objective for the organization towards the goal of fostering competition and affordability was to “reduce barriers to entry into the market and to competition for telecommunications service providers that are new, regional or smaller than the incumbent national service providers.”

The sustainability challenges of the fourth-player policy were on display in the recent regulatory proceedings regarding Mobile Virtual Network Operators (MVNOs). In a spring 2021 decision, the CRTC granted regional telecommunications providers wholesale access to the incumbent’s cross-country networks in a move aimed at increasing the number of players in various markets. The regional players then became MVNOs outside their home networks, where they bought wholesale network access that they then resold to consumers.

While the initial decision to allow such access was made in 2021, challenges remain in realizing the competition envisioned by the CRTC. For example, in a 2024 arbitration decision regarding pricing for MVNO network access, the CRTC sided with TELUS over Quebecor, prompting the latter company to nix its planned expansion into Manitoba unless the government further intervenes. This part of the MVNO saga encapsulates the sustainability problem with the status quo. The artificial competition of the fourth player policy is built on a foundation of ever ratcheting up government intervention.

In the face of these types of heavy-handed policies, what incentives do firms have to incur the risk and costs of investment in new network infrastructure if the government can later unilaterally grant access to their competitors at rates determined by regulators? This move is arguably closer to government-backed expropriation than it is to any form of market-driven competition.

On the investment side, the Trudeau government has also continued to uphold foreign investment restrictions in the sector. Yet, as former Commissioner of Competition Calvin Goldman and his colleagues have written, these investment restrictions effectively protect the industry “from the entry of real and effective foreign-based competitors.” They add:

“These significant restrictions have very likely reduced the incentive of foreign-based telecom competitors (such as AT&T and Verizon) from entering Canada on any real scale. From our experience in many other cross-border transactions, acquirers investing substantial funds generally need to know they will have the opportunity to grow the investment over time. That may not necessitate majority ownership, but there needs to be a real voice in the direction of the operating entity in Canada beyond being a minority passive investor.”

A policy alternative: market-based competition 

Today, the record of the fourth-player policy is rather clear: successive government interventions have not only failed to establish a sustainable national competitor to the three incumbent firms but they’ve come at a cost to customers and taxpayers.

While this period of continuity between Conservative and Liberal governments with respect to artificial competition has largely failed, there’s an opportunity to shift to a more sustainable, market-based model within the sector, starting with eliminating foreign ownership restrictions altogether. If eliminated, theory and evidence from elsewhere tells us that markets would be able to function better and more competitively.

In practice, this might mean that Canadian firms, irrespective of their size, are able to draw on greater shares of foreign capital to finance their operations and network investments. It may also mean that foreign carriers could possibly enter the market themselves. Whatever happens, it will be driven by market-based decisions rather than regulatory ones.

To this end, a genuine market-driven policy alternative goes further than simply removing the foreign ownership restrictions in the Telecommunications Act. Instead, a market-based competition vision for the sector would also roll back auxiliary fourth-player policies, including preferential set-asides at spectrum auctions for smaller firms, ending the government’s wholesale policy, and the various other ways in which government policy has been focused on supporting and sustaining artificial competition.

This point is worth underscoring: amending the Telecommunications Act to repeal the foreign investment restrictions is a necessary yet insufficient policy to boost market-based competition. The government must be prepared to unwind the other policies that have come to comprise the fourth-player policy.

One long-standing objection to liberalizing the Telecommunications Act is that some of the incumbent firms are also subject to the Broadcasting Act and its own foreign investment restrictions. This is beyond the scope of this particular DeepDive, but one of us has previously written in favour of liberalizing both acts. Either way, this isn’t a compelling reason not to amend the Telecommunications Act. The whole premise of dynamic competition is that we shouldn’t assume that the market structure will remain the same forever. Amending the Telecommunications Act would have a dynamic effect that’s hard to fully predict. That’s the whole point. Markets will by and large determine the best approach and structure for the Canadian market. The only exception should be national security considerations rather than the conceptual preferences of policymakers.

Key takeaways: A competitive future for Canadian telecoms

While the above has largely focused on the problems inherent in government attempts to spur artificial competition, we should also say that we aren’t wholly against government intervention in the telecommunications market.

Given Canada’s unique economic geography, there may be a role for government policy to support investment in rural and remote areas such that Canadians, regardless of location, have access to reasonably similar levels of technology.

But in terms of big-picture policymaking, the evidence seems clear that the 2006 Telecommunications Policy Review Panel had it right when the panelists set out that government intervention “should be adopted only where market forces are unlikely to achieve a telecommunications policy objective within a reasonable time frame, and only where the costs of regulation do not outweigh the benefits.”

In the absence of such circumstances, the Canadian government should adopt a new competitive vision for the telecommunications sector, one which is dynamic and recognizes the importance of technological competition as a source of enhanced consumer welfare. The goal should be to create the conditions for investment, innovation, and technological development rather than micromanage the market to produce a particular number of market participants. The former is a model of sustainable, market-based competition. The latter is a version of the artificial or government-induced competition that’s underperformed over the past nearly two decades.

A key step in this direction is for Canada to take a step forward and liberalize foreign investment rules under the Telecommunications Act. In some instances, this may allow the incumbents to access foreign capital to further compete in network development. Liberalization may also allow a foreign player to enter the market and become a sustainable “fourth player.” Either way, these developments will be dictated by market forces rather than government intervention.

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.