Special tax treatment of dividend income costs a lot in terms of foregone government revenues, mainly benefits the very affluent, and thus merits serious re-consideration as part of the federal government's current review of tax expenditures.
In the 2015 election, the federal Liberals promised to “conduct a review of all tax expenditures to target loopholes that particularly benefit the top one percent.” The 2016 federal budget announced a review of personal income tax expenditures, and the Department of Finance has named a panel of economists to provide advice on how to make them “fair, efficient and fiscally responsible.” Action is expected in the upcoming federal budget.
The annual Department of Finance Report on Tax Expenditures estimates the cost of special breaks in the form of deductions and credits relative to a benchmark tax system. Special tax treatment of dividends is not considered to be a tax expenditure since it is intended to avoid “double taxation” through the corporate and personal income tax.
This is a somewhat selective principle in that double taxation in the overall system is quite common, as in the fact that most of us pay sales and property taxes out of after tax income.
In explaining taxation of dividends, it is stated that “recognition is given for taxes presumed to have been paid on a corporation's income when it is subsequently distributed and subject to tax at the individual level.”
The corporate and personal tax systems are roughly integrated by “grossing up” the amount of dividend income received by individual taxpayers by 38% to reflect pre tax corporate earnings, and then to apply a dividend tax credit of about 25% depending upon the province of residence to reflect tax deemed to have already paid by the corporation.
The net result is that individual taxpayers receiving dividends pay personal income tax on that income at a much lower effective rate than income from employment (about 36% compared to 50% for someone in the top tax bracket.) A smaller tax credit is given to owners of small private corporations to reflect the lower small business tax rate.
While the rationale for special tax treatment of dividends is clear, the growing consensus among economists is that the full incidence of the corporate income tax is not on shareholders, especially in increasingly open economies.
Leading, independent tax experts such as Robin Boadway at Queen's University and Kevin Milligan of the Vancouver School of Economics judge that as much as 40% of corporate income tax paid by companies is shifted forwards to consumers in the form of higher prices, or backwards to workers in the form of lower wages, rather than paid by shareholders.
It is increasingly argued by some experts that the corporate income tax should only be levied on surplus profits or rents, and that shareholders should have to pay the normal rate of income tax on dividend income. Others see the corporate income tax as a withholding tax which is essential to taxing non resident shareholders.
While this is part of a much larger discussion, it is clear that favourable taxation of dividends in the hands of individual investors almost certainly overcompensates them for corporate income tax paid. This is particularly the case for those receiving dividends from companies which paid below average rates of corporate tax in the first place.
This matters because it is costly. The Department of Finance estimates that the federal government will lose $4.6 billion in foregone personal income taxes taxes on dividends in 2017. Provinces will collectively lose about another $1.8 billion in lost revenues.
As with other cases of special treatment of investment income, including capital gains, the benefits of the dividend tax credit flow overwhelmingly to persons with very high incomes. This is because average and lower income persons earn dividends, if at all, in RRSP, pension and TFSA non taxable accounts or in very modest amounts.
According to a recent study by David Macdonald of the Canadian Centre for Policy Alternatives, almost all of the tax benefit of special tax treatment of dividends (91%) goes to the top one tenth of all tax filers. Brian Murphy of Statistics Canada and colleagues estimate in a study for the Canadian Tax Journal that almost one half of the benefit goes to the top 1% of individual tax filers, and one fifth to the top 0.1% (or one tax filer in every thousand.)
The reduced tax rate on dividends under the personal income tax is excessive, costly and regressive. It certainly deserves a review by Minister Morneau.
Andrew Jackson is an Adjunct Research Professor in the Institute of Political Economy at Carleton University, and senior policy adviser to the Broadbent Institute.