The Taxation of Capital Income in Canada Part III: Bringing it all Together

Ken McKenzie

This is the final commentary in a three-part series examining possible reforms to Canada’s approach to taxing capital income. In this third commentary, I bring the material from the first two commentaries together and describe a tax reform package applied to the two sides of the capital market that would make Canada’s income tax system more attractive when viewed through the lens of the equity-efficiency trade-off. Key to the analysis is the decoupling of the supply and demand sides of the market in a small open economy like Canada.

In the first two commentaries in this three-part series I considered the taxation of the supply and demand sides of the capital market separately. In this final commentary I bring the two sides of the market together and discuss potential tax reforms in Canada.

To operationalize the two pillars of efficiency and equity in the analysis of tax reforms, and to focus the discussion regarding the “optimal” taxation of capital income, economists rely on three “sufficient statistics”. 

The first of these is the responsiveness of the tax base to taxation. This is captured by the elasticity of underlying tax base (in our case savings and investment) with respect to a change in the relevant tax rate. The more responsive (elastic) is the tax base, the more distortionary is the tax, and the higher are the efficiency costs of the tax due to losses in gains from trade.

The other two metrics relate to equity. The first of these concerns the degree of inequality in the distribution of capital income. The second relates to how society views the distribution of income, as represented by the impact of an incremental increase in income on “social welfare.” The social welfare impact is typically represented as the product of two terms: the increase in well-being, or utility, that an individual (or group) receives from an extra dollar of income, and the weight that society in turn places on the well-being of that individual. With respect to the first of these terms, it is typically presumed that the increase in well-being that an individual perceives from receiving an extra dollar of income declines with income: a higher-income individual places a lower value (in terms of the perceived impact on his/her well-being) on an extra dollar of income than does a lower-income individual. Economists call this the “declining marginal utility of income”.

The second term reflects the weight that society places on the well-being of various individuals (or groups). This entails a value judgement, as it requires weighing the well-being of individuals in different income groups against each other, so-called “interpersonal utility comparisons.” A common, but not universal, assumption is that this “social weight” declines in some way with income: society values an incremental increase in the well-being of lower income individuals more than the well-being of higher income individuals. Taken together these two ideas suggest that the decrease in “social welfare” associated with generating an extra dollar in tax revenue from higher income individuals is less than from lower income individuals.

As a general matter the optimal tax rate will be higher the less elastic is the tax base, the more unequal is the distribution of income, and the lower is the social welfare value at the margin placed on the group being taxed.

The difficulty, of course, is in quantifying these sufficient statistics in a concrete way. In principle we can estimate elasticities statistically, and therefore determine the efficiency costs of various taxes. As discussed in the previous two commentaries this can be difficult in practice, and indeed there is disagreement about the size of some of the relevant elasticities in the capital market.

With respect to the equity metrics, while the degree of inequality in the distribution of capital income is a relatively straightforward data exercise (see the first commentary in this series), the social welfare impact of increasing capital taxes can’t be meaningfully estimated in the traditional sense, as it reflects the preferences of individuals and a value judgement on the part of society. It is a useful notion nonetheless as it helps to focus the discussion squarely in terms of the equity-efficiency trade-off.

For example, it has been argued by some that combining the notion of the declining marginal utility of income with the assumption that social welfare weights also decline with income, suggests that society should place no value at the margin on the well-being of the very highest income earners. This is the approach taken by Diamond and Saez (and others) to support the argument for a progressive tax system that sets the top marginal tax rate on income so as to maximize government revenue collected from the top bracket.[1] Using U.S. data they argue, somewhat controversially, for a top marginal tax rate in excess of 70 percent.

Much of the early theoretical literature on optimal capital taxation actually argued for a zero tax rate on capital income. For example, the famous Chamley-Judd result concludes that capital should not be taxed at all in the long run.[2] This result dominated much of the discussion of capital taxation in the eighties and nineties. However, the result has since been questioned on several dimensions, and has been shown to hold in only a limited number of special circumstances.[3] 

A related literature has argued for a dual approach to taxing capital and labour income, which combines a progressive tax schedule for labor income with a lower flat tax rate on capital income at both the personal and corporate level.[4] This view is motivated in part by the presumption that capital income is more elastic with respect to taxes than is labour income.

More recent treatments have employed the equity-efficiency paradigm discussed above directly, and have argued to the contrary, that capital taxes should be progressive and indeed that the tax rate imposed at the top should be quite high, in large part because of the fact that capital income is skewed so strongly to the top.[5]

As has been discussed, corporate taxes are imposed on the demand side of the capital market, on the firms that employ the capital. Personal income taxes on dividends and capital gains are imposed on the supply side of the market, on the shareholders who finance the capital. In a closed economy both the distortionary (efficiency) and distributional (equity) implications of a tax on capital are independent of the side of the market the tax is imposed on; this is a so-called tax irrelevance result. Importantly, this is no longer the case in a small open economy like Canada, where domestic savings need not equal investment, the difference being made up by international capital flows. 

In this case there is a “disconnect” between the supply and demand sides of the domestic capital market. Because the required after-corporate tax return to capital is fixed in the small open economy by international financial markets, source-based demand side taxes like the CIT distort investment but have no impact on domestic savings on the supply side. Similarly, residence-based supply side taxes on the return to capital at the personal level, levied on capital gains and dividends, affect savings but have no impact on domestic investment on the demand side.[6] 

Before discussing the implications of this for capital tax policy in Canada, recall the key insights from the first two commentaries in this series:

  • Taxable income from dividends and capital gains is highly skewed toward the top, much more so than is labour income.
  • The empirical evidence is somewhat inconclusive but on balance points to aggregate savings being relatively unresponsive (less elastic) to PIT levied on dividends and capital gains.
  • The empirical evidence on the impact of the CIT on investment is more conclusive, and suggests that investment is relatively more responsive (more elastic) to taxes.
  • Some, and perhaps much, of the burden of the CIT as it is currently structured falls on labour. 

These insights, coupled with the “disconnect” which renders the tax irrelevance result inoperative in a small open economy, suggest the possibility of undertaking reforms to the two sides of the capital tax system that in my view would enhance the equity-efficiency trade-off in the Canadian tax system. 

The basic idea is to decrease demand side taxes levied on the (normal) income earned by corporations, while increasing supply side taxes levied on dividends and capital gains. 

The first step is to move to a rent-based approach to corporate taxation applied to the demand side of the capital market. This change would remove corporate taxes imposed on the normal return to capital, imposing the tax strictly on economic rents. As discussed in the second commentary, this would enhance economic efficiency by eliminating distortions to investment caused by the CIT. It would also enhance equity as the economic burden of a rent tax falls largely on the owners of capital, who benefit from economic rent, and not on labour through lower wages; this would increase the overall progressivity of the tax system. Because a tax base consisting of economic rent is smaller than the current CIT base, in order to generate the same revenue the statutory tax rate applied to economic rent would have to increase slightly.[7]

This reform to the taxation of corporations on the demand side of the capital market is in some ways consistent with the “zero capital tax” result discussed above, in the sense that it argues for a zero effective tax rate on the normal return to capital on the demand side, but, and importantly, a positive (and possibly higher) tax rate on economic rent.

With regard to the supply side of the market, the disconnect between the two sides of the market renders the economic rationale for integrating dividends for large corporations in a small open economy questionable. As discussed in the first commentary, there is little compelling evidence that taxes on dividends paid by large corporations have a substantial negative impact on either aggregate savings or investment in the economy. Moreover, the benefits of the enhanced DTC for dividends received from large Canadian corporations accrue in large part to high income earners, as taxable dividend income is significantly skewed to the top of the income distribution, and middle and low income earners are typically able to shelter dividend income completely by way of RRSP and TFSA accounts.

This suggests that the enhanced DTC acts as nothing more than a subsidy to higher income taxpayers to hold equity in Canadian corporations, while generating little in the way of efficiency gains on the supply side of the market. Moreover, by subsidizing dividends received from Canadian corporations, the enhanced DTC may distort the personal investment choices of taxpayers in favour of domestic corporations, exacerbating the well documented “home bias” in Canadian equity markets, and discouraging international portfolio diversification.[8]

This all suggests that eliminating the enhanced DTC for dividends received from large Canadian corporations – basically returning to the pre-2006 system – would be attractive from a distributional perspective without costing a great deal on the efficiency front. Indeed, and taking the argument to its logical conclusion, we could consider eliminating the DTC for the shares of large corporations altogether.

Maintaining full integration via the DTC for dividends received from small businesses, on the other hand, is sensible for two reasons. First, it seems clear that these corporations do not, as a rule, have access to international financial markets, but rather obtain financing locally; capital markets are at least partly segmented in Canada – the small open economy model does not apply to small businesses. Also, it is difficult to distinguish income from labour and income from capital for small businesses. This, coupled with the availability of tax planning opportunities for small corporations with regard to the decision to pay owner/managers by way of dividends vs wages, suggest that maintaining the same tax rate on wages and dividends at this level is sensible. 

What about capital gains? The partial inclusion of capital gains in income has been justified in part by similar withholding arguments to dividends and by the fact that capital gains are not indexed for inflation. As argued, the withholding argument for shares in large corporations in a small open economy is questionable. Moreover, if we want to account for inflation we should do it directly, by indexing capital gains along with all other income to inflation. 

As argued in the first commentary, while there is some disagreement, capital gains realizations do not appear to respond substantially to changes in the tax rate in the long run, which is consistent with the supply side of the capital market being relatively inelastic with respect to after-tax returns. This suggests that increasing the capital gains inclusion rate, perhaps back to 67 or 75 percent as has been the case in the past, would make our overall system more progressive without incurring significant efficiency losses. Maintaining the lifetime capital gains exemption for small businesses is sensible for the same reasons as maintaining full integration for dividends from CCPCs. 

These changes to the taxation of individuals on the supply side of the capital market are consistent with the insights of modern optimal tax theory. They follow from the highly skewed nature of capital income to the top of the distribution, the idea that the decrease in “social welfare” associated with generating a dollar in tax revenue from higher income individuals is less than from lower income individuals, and the presumption that the supply side of the capital market is relatively unresponsive to taxes on dividends and capital gains. All of this argues for higher tax rates on capital income earned by top earners. Indeed, if income from savings is exactly as responsive to taxation as is income from labour, optimal tax theory would call for a higher tax rate on the return to savings because capital income is much more unequally distributed.[9]

To sum up, in this series of three commentaries I have examined the taxation of capital income in Canada through the lens of the equity-efficiency trade-off. I have argued that the small open economy nature of the Canadian economy suggests that some reforms to the taxation of capital at the personal and corporate level have attractive features when viewed through this lens. In particular, eliminating taxes on the normal return to capital at the corporate level via the imposition of a rent tax (and possibly increasing the tax rate on that rent) coupled with increasing taxes on the return to capital at the personal level in the form of dividends and capital gains have potentially attractive features in this regard.


[1] Diamond and Saez (2011).

[2] Chamley (1986), Judd (1985).

[3] Straub and Werning (2020).

[4] Sorenson (2005).

[5] Piketty and Saez (2012), Saez and Stancheva (2019).

[6] See Boadway and Bruce (1992).

[7] Boadway (2015) calculates that corporate tax revenue would drop by about 20 percent if Canada moved to a rent-based tax without increasing the statutory tax rate.

[8] For example, Vanguard Canada estimates that the portion of Canadian portfolios made up by Canadian equities is 60%, which compares to Canada’s weight in the global equity market of just 4% (https://www.vanguardcanada.ca/documents/home-bias-inst-indv.pdf).

[9] See Saez and Stancheva (2018).