This paper explores the different types of tax preferences for investment income. The key question is whether they can be justified on the ground that they improve economic performance. This analysis finds that the current preferences generally fail to do so. In some instances, there may be problems that create an economic justification for special treatment of investment income, but the current preferences are poorly designed to deal with those problems.

One example is the taxation of capital gains, where half of the income is exempt from tax. It is variously justified on the grounds that it encourages entrepreneurial risk taking, or that it compensates for illusory capital gains that are due to inflation. It does not target either of these well. The aim of avoiding tax on inflationary gains would be better achieved by explicitly exempting the portion of a capital gain that is due to general inflation. To the extent that it does encourage risk taking, it is questionably targeted. It provides just as much of a tax break to Canadians who speculate on foreign stock markets as to those who create new businesses in Canada.

The dividend tax credit allows dividends from large Canadian corporations to be taxed at much lower rates than employment income. The claim is that it is needed to avoid double taxation, as the corporation has already paid taxes on its profits. In fact, many corporations have significant profits that are tax exempt. There is no attempt to verify that the corporation has actually paid tax before giving its shareholders the dividend tax credit. More generally, capital is internationally mobile. Economists believe that this enables large corporations to shift part of the burden of the corporate income tax to their employees or customers. This implies that the dividend tax credit often compensates shareholders where no compensation was needed.

The largest tax preference of all is for money put away for retirement, in Registered Pension Plans and Registered Retirement Savings Plans. At first blush, this might appear to be a justifiable reward to those who are financially prudent and save for the future. The problem is that a large proportion of Canadians does not participate in this type of saving. Therefore, this huge tax expenditure increases the tax burden of those who cannot participate in order to subsidize those who do. It is also likely that it fails in its goal of encouraging more saving. The subsidy to saving provided by the tax system means that those who have a target for future retirement income can achieve it more easily, without saving as much. Therefore, it is possible that these tax preferences have the perverse effect of actually reducing the national savings rate.

Another major tax preference is the lower business tax rate for small corporations. This benefit also flows disproportionately to higher-income people. It appears to encourage a proliferation of businesses that cannot achieve efficiencies of scale. It results in lower overall productivity in the economy.

Taken together, the story is not a pretty one. These tax preferences result in a large loss of tax revenue with little in the way of benefit for the Canadian economy. The loss in revenue forces overall tax rates to be much higher than they would otherwise need to be. That discourages economic activity and encourages tax avoidance and evasion. The tax system would be fairer and more efficient if these tax preferences were scaled back. Given the income tax rate cuts promised in the United States by the new administration, Canada will need to pay attention to tax rate competitiveness. Maximizing efficiency by eliminating unnecessary tax expenditures would help in that effort.

Each one of these topics could be a major paper on its own, and this paper is not intended to provide exhaustive coverage of all the possible variations. The point of this overview is to draw attention to the range of shortcomings of these schemes. In any broad review of tax expenditures, the major investment-related ones covered in this paper – which many consider either structural or sacrosanct – deserve particularly careful scrutiny.