Thank you for the opportunity to be here.
For its part, the Montreal Economic Institute will focus on tax policy, an issue that is central to productivity. Canada has long trailed the United States in terms of wealth, largely as a result of lower productivity. One of the factors that contribute to this discrepancy is corporate taxation, which limits the ability to make productivity-boosting investments. While the government has very recently announced that it will reduce the rate for small business, which is welcome news, the basic rate that applies to larger businesses, which still remains at 15%, is the one that is the most significant in terms of productivity.
When thinking about corporate taxation and its effect on productivity, it is worth keeping in mind the current context in which U.S. President Donald Trump has just reiterated his intention to reduce the top federal corporate income tax from 35% to 20%. Such an abrupt reduction would have serious repercussions for the productivity of Canadian workers through a loss of fiscal competitiveness.
The consequences would be borne in large part by workers. This is because workers are less mobile than capital, a difference that has become even more significant in recent decades as the mobility of capital has increased. In terms of how easy it is to conduct business in Canada, Canada tends to fare poorly compared with the United States. However, it does outshine the United States in one of the key subcomponents of these indexes, and that is with regard to taxes. This advantage has been very important in attracting investments to Canada. The proposed U.S. reform, however, would make Canada much less competitive in terms of taxation.
A reduction in the corporate tax rate in the U.S. would attract more capital there in search of a higher relative return. This would mean two things for workers. The first is that, since capital is a complement to labour, there would be a reduction in the demand for labour in Canada, which in turn would depress wage growth. The second is that lower levels of investment reduce productivity growth, which would again restrict wage growth. As such, workers would bear a large share of the effect of Canada's relatively higher corporate taxes. It is worth keeping in mind that research shows that workers bear about 50% of the burden of the corporate tax. Canadian workers, through lost productivity, would therefore likely be the first to suffer the consequences of the American tax cuts, were Ottawa to leave the Canadian rates unchanged.
The maintenance of our current tax system in the event of an American reform would entail a loss of productivity when business investment crosses the border. The Government of Canada, therefore, has an interest in reforming its own corporate tax system without delay. It is our contention that introducing a proportional taxation based on the 10% rate that will apply to small business as of January 1, 2018—so that one single federal rate remains for all Canadian businesses—would counter the American reform.
By acting now, the Canadian government would be sending an unequivocal signal to companies that Canada is a good place to do business and will continue to be a good place to do business regardless of American reforms. This would maintain and possibly improve Canadian workers' productivity, in addition to being a great indirect help to them.
Another federal measure that would unambiguously improve Canadian productivity is to either substantially reduce the capital gains tax, or simply abolish it. Just as sin taxes reduce the behaviour that is being targeted, the capital gains tax hinders capital formation, which is one of the basic foundations of all economic growth. In fact, most government policies that intend to boost economic growth are geared towards increasing the supply of capital. This would also affect job creation and wages throughout the economy, as less capital can be matched with workers to make them more productive through technological and other improvements, which is a prerequisite for wage increases.
Taxing away capital is not the only detrimental effect of this tax. Capital gains taxation also encourages people to lock in their investments. Unlike most other types of income, realizing capital gains is largely a matter of choice, in the sense that you can simply choose not to sell and not to pay your capital gains tax. This makes it much more sensitive to taxation than other types of income. When rates are high, individuals who own assets become more reluctant to sell them, requiring greater benefits to outweigh the tax burden. For them, the capital gains tax thus reduces the probability that a given stock will be sold.
This hurts economic growth because it discourages the reallocation of assets to their most productive uses. Research pursued in the U.S. has suggested that for every 1% drop in the tax rate, capital gains realization increases by 1%. So we're on a 1:1 ratio.
The capital gains tax does not only reduce overall investment, it also affects which businesses venture capital invests in. Venture capital tends go to firms that offer unproven but potentially revolutionary technologies, services, or products. These are things that naturally boost productivity.
The capital gains tax, however, reduces the willingness of venture capitalists to finance these riskier business start-ups. As a result of the deterrent effect of this tax, they prefer less innovative forms of entrepreneurship. These effects of the capital gains tax represent one of the biggest fiscal burdens on economic performance and productivity in Canada. In a study of the macroeconomic effects of the different taxes that governments can use to raise revenues, the federal Department of Finance found that taxes that affect capital goods are the most detrimental to economic activity and productivity.
If governments were to reduce taxes on capital income by $1, the economic gains would be approximately $1.30. The elimination of this tax would bring about the most economic gains.
Moreover, the tax cannot be justified by the meagre revenue it generates for government. The reduction in federal government tax revenues would not be significant, approximately $4.3 billion or just 1.5% of its total revenues. Taxation of capital gains is particularly pernicious because it is the kind of income that is derived from the efforts of investors and entrepreneurs to grow the economic pie, which is the basis of our productivity and ultimately the prosperity of all Canadians.
Thank you.