Does the Dividend Tax Scheme in Canada make Sense

“Corporate businesses are flush with cash, which they still seem hesitant to deploy, presumably due to the uncertain economic outlook,” said David Madani, Canadian economist for the London-based research firm. “This obviously leaves scope for firms to increase dividends, which could boost personal income and consumption significantly.”

In a recent research note, Mr. Madani said Canada’s non-financial-sector corporate cash balances stood at $526-billion at the beginning of 2012 – up 42 per cent since the recession ended in mid-2009. Since the Canadian economy is roughly one-tenth the size of our U.S. neighbour, this Canadian cash pile, in relative terms, dwarfs the roughly $1.3-trillion (U.S.) in cash held by U.S. corporations.”

Who’s sitting on all the cash? Corporate Canada, By David Parkinson, The Globe and Mail, Published – Aug. 03 2012, 6:22 PM, Last updated – Aug. 03 2012, 8:44 PM

Trying to understand the history of Canadian Tax Policy is difficult at best. For example, the MacEachen Budgets transformed the way that the Canadian Government collected income taxes since it eliminated many tax credits and tax breaks. Insurance Policies, for example, that predate those budgets are still taxed much more favourably than policies which were issued under subsequent governments. In the 1990s’, Michael Wilson brought forth the GST. It allowed the Federal Govenrment to directly tax many goods and services. However, that change produced a new set of credits to offset the effects on various groups including the poor and businesses. So it is hard to go back in time and follow a variety of changes; for each tax changes leads to other modifications of the tax code and the collection regime.

Therefore, when we have a correction to the tax system, the best thing that we can do is to assess the existing system, as it is. In my opinion, our dividend tax regime is not working. Let me make the argument, for this opinion.

The Canadian Government, for a while now, has allowed dividends to be taxed at a lower rate -as compared to income taxes rates of debt revenue and/or employment revenue. One reason, for this system, was noted by John Heinzl of the The Globe and Mail. He argues “The gross-up and tax credit system is baffling to many investors, but there’s a good reason for it: It gives you ‘credit’ for the tax the corporation is presumed to have already paid.” (Getting a grip on the dividend gross-up, By John Heinzl, Published Tuesday, Mar. 22 2011, 6:29 PM EDT).

While, true there are a couple of other reasons why the Government of Canada has also allowed for the “tax-advantaging” of the dividends of Canadian Corporations. One of the simplest being Pensionners. Canadians who have retired; often live off the income provided by stocks. That income usually comes in the form of dividend payments.

Dividends can be thought of as a “return” of the profit of a company. They come on a regular frequency that is determined by the Board of Directors of the company in question. For most pensioners, the dividend cheques are convenient because the cheques does not come with a fee for selling a shares or other costs or consequencess. Most times, the cheque can just come to the owner of the share – in this case a Pensionner. Therefore, Canadian Banks and Insurance Companies fuel retirement. This is equally true of major Canadian Corporations like Rogers, Bell Canada, Telus, CPR and CNR. From a stock point of view, Dividends provide regular income, while also providing some capital growth. Therefore, it is a wonderful retirement tool.

Canadian Executives also love the tax advantaged nature of Canadian Dividends because it means Canadian Investors will be more inclined to invest in Canadian Corporations. Consequently, for a Canadian Corporation, there is an artifiicially large investment pool in Canada. This means it is easier for executives to find investors in Canada. A company just needs to list and go to market. Once the company is paying dividends, it will find itself with more Canadian Investors looking to take advantage of the tax system; so as to keep more of their profits.

Therefore, a number of stakeholders have reason to keep the system as it is. Given my past arguments – about the relationship of Liberalism and its need to care for the “Other” -, one might say that I am being contradictory or hypocritical. However, the truth of the matter is that the present system provides a disservice to other stakeholders. Therefore, there are reasons to change the system.

Take, for example, employees. At present, our dividend taxation system rewards investors who put money into established dividend paying companies. Just think about it. According to Taxtips.ca, Employment Income and Income from Canadian Debt Products is taxed twice as heavily as Dividend Income. If one looks at this point, in two ways, one will essentially see that our tax code essentially “subsidizes” the cost of capital for firms like Telus, Bell Canada, ManuLife Financial or CIBC.

Let us just look at the nature of dividends to show this. As we noted earlier, dividends are created by the accumulation of profit within a corporation. Or put differently, when a company has too much cash on hand, it finds ways of giving that profit to shareholders. One of those ways is by paying a small amount of money to each share. Shareholders with more shares, consequently, see more of profit. With this being said, one can see that larger companies can afford to part with more of their profit. This is especially true of profitable financial firms. Therefore, by reducing the tax burden of dividends, one does increase the chance of investors buying those shares.

This is not the true of Start-up or Venture Capital Companies. In most cases, there is very little profit in the early years. In fact, in the early years, there are often losses. This is why Venture Capitalist and Entreprenuers often use debt to fund their operations. From an investors point of view, the collaterialization of the Entrepeneurs’ property (i.e. taking possession of the Entrepeneurs’ Houses, investments and other assets) provides both an incentive for success and some financial compensation, if the operation turns sour. Accordingly, by providing a tax advantage for Dividends, the Government of Canada is managing to disincentize innovation and subsidize large cap companies.

For an employee the problem is simple: Large Companies often run more efficiently than small ones. Or put differently, Large Companies – like Apple, RIM, Ford, GM or Bombadier – will search the world to find the cheapest places to produce goods. For Canadian Workers, this is not necessarily a good thing. For, if a Saw Mill in BC or an Automotive Assembly Plant in Toronto is closed, they will lose their jobs. From a workers point of view, he wants to have another job he can jump into to. He or she wants to have a bunch of companies of different sizes – small, medium and big – who can jump to his aid when the worker needs a new employment opporunity. Accodringly, the worker wants an economic environment that is either neutral or provides incentives to smaller businesses.

This is especially true when one thinks of the risk that comes with developing a Venture Capital Company. Or put differently, for every one Google or Twitter, there has been at least ten disasters. By taxing dividends more favourably than debt or employment income, Canada has created a tax system that disincentizes the investment in smaller Canadian companies.

So what should be done? Firstly, I would argue that we need some principles. The first principle would be that our tax system should be “progressive”. Unlike the Fraser Institute, it will be argued here that this system is the most fair. (Flat Tax: Model for Personal & Business Tax Reform, By Jason Clemens and Joel Emes with Rodger Scott, A Fraser Institute Conference, October 11, 2001, Toronto, Ontario, Canada)

In fact, I will take an approached used by Alex Doulis. Mr. Doulis wrote a book called Take Your Money and Run!. The book is interesting because of what he argued. In his book, he described the possibility of retiring on ones’ own terms. This might mean retiring early or it might mean retiring in another country. To understand this theory, one needs what he thought government was for. In Mr Doulis’ mind, Governments are providers of services. There only purpose is to protect citizens and residents. They do so by maintaining militaries, police forces, paramilitary forces and intelligence agencies. Governments protect citizens by providing, or regulating, various markets including public and private health resources. Therefore, Governments, at their best, when they use regulations and laws to prolong peoples’ lives, protect property and elevate the countries’ prospects.

By this theory, the affluent would not send money to countries that do not have property rights. If one thinks about it, that theory has some validity. For example, wealthy and connected Russians often send their own money to Western Europe, while the Chinese Government buys US Treasury Bills. So, while Russia and China might be strong; their currencies – Russia’s Ruble and China’s Yen – are not considered reserve currencies because their respective Governments don’t protect their citizens right to accumulate capital. Furthermore, it explains why Western Europe, the US, Canada, Australia and parts of the Caribbean are places whether the worlds’ wealth is stored. For, those places have strong property rights and strong regulations. Barbados, Switerzland, Belgium and the Netherlands are just a couple of those countries that look like us.

So if Governments’ purpose is to protect wealth, those who are more wealthy receive the most benefit from Government. Unlike, weak states of the 18th and 19th century Europe or the Americans, the modern Canadian State provides Public Police Forces and Public Fire Fighters to protect both property and life. Furthermore, instead of hiring private security, the affluent largely depend on the Canadian State to secure their well being. In the 1920’s, Pinkerton Personnel were hired by the Canadian State to influtrate parts of the Canadian Social Fabric (Intelligent Control: Developments in Public Order Policing in Canada, By Willem De Lint, Alan Hall, University of Toronto Press, 2009). Today, Parliament has created various Professional Security Forces to do the same job. Accordingly, unlike in the Developing or Third World, the State in Canada ensures that individuals are able to hold onto those items that have been legal secured. So much so that Canadians are able to sue the Government if their property has been expropriated. For, this service, it will be argued here, that it is only fair that those with more wealth are charged a “market cost” for protecting those resources. Otherwise, those Canadians might have to do what the wealth do in other countries: spend more money on security and hire even more security guards.

With the establishment of the need for a progressive system, the question is how do we adjust it. It will be argued here that over the next five years, the Government of Canada should move to tax Dividends in the same way that we tax employment and debt income. Such a change would have some effect on Pensioners and Investment Managers but I think that it can be minimized.

For example, if the tax dividend rates are changed, so too should income tax rates. They most likely would have to be reduced. The first band ($10,822- $42,707) could be reduced from 15.00% to 11%. The second band (42,708 – $85,414) would be lowered from the present 22.00% to 19%. The third band ($85,415 -$132,406) and the fourth band ($132,407+) would be changed to 24.00% and 28%, respectively. Or put differently instead of the very wealth paying 26% and 29%, respectively, they would have a lower income tax rate. Given that I am not an economist, these number are likely not perfect. However, the idea is there. By taxing dividends, in the same way, we would take employment income and debt income, we would be able to lower tax rates for everyone. While, in my view, the wealth should pay more because of the cost of protecting their affluence, we all – on average – could have lower average tax rates.

Furthermore, more capital will be available for smaller, locally based businesses. Larger companies would be able to go to the TSX and other Capital Markets to find funds. In this new system, those funds would not have to be equity alone. Corporations might choose whether they want to issue debt, equity, warrants or other forms of security. Or put differently, they would look for the most productive way to grow their business. Changing the dividend taxation system might have the effect of moving increasing our economies productivity numbers. Given that the Canadian establishment has been complaining about productivity for years, this just gives us another reason to move along this new and intriguing path.

So buy looking at the dividend tax rates, we could create more local companies and increase the amount of jobs that our economy productes. By making this change in our tax could, Canadians could also begin to deal with our many persistent issues including our low productivity rates and the lose of our entrepreneurship class. While, not a silver bullet, reviewing our dividend tax credit has some advantages.

However, one question remains: how would it be administered? Or in other words, how can companies, investors and the general public ensure that dividends will not suffer from double or triple taxation issues. My argument is simple: allow companies to store some fixed amount of dividends in a trust account held by a Trust Company. The transfer of those monies would be treated as an expense on the balance sheet and, therefore, would decrease the corporations net income. This simple act would ensure that the dividends are not taxed.

This is something that we already do for indiviuduals. Just look at our retirement system as an example. If Corporations are allowed to transfer money into a registered account, they would be acting in similar way as employees do when they create and manage an RRSP. Corporations would like put away as much money as they could in any fiscal year. Like RRSPs, those limits could be set by statute or regulation. Furthermore, like the LIRA or LIF rules, Corporations would be required to pay out some of that non-taxed money to investors. Once in shareholders hands, that revenue stream – the dividends – could be taxed for the first and only time.

So as one can see there are a number of advantages to reviewing the present dividend taxation policy. By allowing for dividends to be taxed at the same rates as other forms of income, one might be able to deal with efficiency issues, overall taxation issues and decrease the main tax rate. Furthermore, more the people who benefit most from the Canadian State would pay the requisite amounts of tax. It would balance off the needs of lower income Canadians and taxpayers, while allowing those with ample amounts of money to have a fair way of protecting their wealth. The only question is does anyone else in our Party see the merit of this solution?

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