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A sensible proposal to change capital income taxation has to start with an understanding of the ideas behind tax integration.Melissa King

Kevin Milligan is Associate Professor of Economics at the University of British Columbia.

NDP leadership candidate Brian Topp's proposal to introduce a 35 per cent tax rate for those earning more than $250,000 grabbed many headlines in November. Less attention has been paid to the other key part of Mr. Topp's proposal: he wants to increase the tax on capital gains income. (I focus on Mr. Topp because he is the only candidate who has provided any detail on tax policy so far, to my knowledge.)

Does it make sense to introduce sharp changes in capital income taxation? To figure this out, let's begin with some basics about how different kinds of income are taxed in Canada. After that, we can work through what might happen if Mr. Topp or one of his NDP rivals succeeds in shaking things up.

To start, consider a high-earning British Columbian with various sources of income. Her earned income will be taxed as regular income, which in British Columbia generates personal taxes of $43.70 for an extra $100 of earnings in the top bracket. The same $100 of income through 'eligible' dividends ends up generating personal taxes of only $23.91. If the $100 came from capital gains, her personal tax bill would be $21.85.

On first glance, one might be tempted by the contention that Canadians receiving dividends or capital gains are getting a sweet deal. But, one glance is not enough.

The different tax rates are motivated by the recommendations of the 1960s Royal Commission on Taxation, also known as the 'Carter Commission'. The Carter Commission argued that 'a buck is a buck', and so all 'bucks' should be taxed the same. However, some 'bucks' get into your pocket in a simple way, while others pass through corporations before arriving in your pocket. Chapter 19 of the Carter Commission set out a system of personal-corporate tax integration to ensure that the total tax bill for income through any channel would be the same.

Take the example of a self-employed unincorporated cobbler who generates income by repairing a shoe and gets paid. This is taxed as regular income. However, if that same cobbler decides to incorporate his activities, the income his company earns will now face corporate tax. If the cobbler draws dividends, those funds come out of already-taxed money. Alternatively, the cobbler could leave the after-tax money in the corporation, and just sell his corporate shares for a capital gain. The principle of integration aims to ensure that a dollar passing through any of these routes will be taxed the same -- taking all taxes into account.

The benefit of corporate-personal tax integration is that our cobbler can choose to incorporate (or not) based on the merits of his business situation -- tax considerations should not impose themselves in the cobbler's decision. If tax integration fails, he may choose to incorporate as a tax dodge. Not only does that cost the treasury (that is, the rest of us taxpayers) lost revenue, but it also forces the cobbler into a corporate structure that might otherwise be bad for his business.

Precisely this problem led to the income trust fiasco of 2006. The taxation of income from one legal structure (income trusts) got too far out of line with the taxation of income from another legal structure (standard corporation). This led several large Canadian corporations to announce a switch to the income trust structure as a tax dodge. If one takes the time to read the Carter Commission report, putting similar tax dodge strategies out of business was the original motivation for tax integration.

It is quite difficult to integrate personal and corporate taxes perfectly. So, there is always room for tweaking to get the rates right. Moreover, some argue that integration isn't necessary because foreign investors make Canadian tax policy irrelevant for corporate behaviour. A principled proposal for changes to capital income taxation can always be made. However, a sensible proposal has to start with an understanding of the ideas behind tax integration.

Any proposal to tax dividends or capital gains without consideration of integration would open the door to the same kind of tax tricks we have seen in the past. Armies of tax lawyers and accountants are waiting in the wings to devise legal structures to exploit any newly created asymmetries. It might be surprising if the new NDP leader were the one who unleashed these armies.

Kevin Milligan's recent posts and Twitterfeed can be viewed here.

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