Can a Dividend Tax Credit Be Justified in a Small Open Economy?

Abstract

The stated purpose of Canada's Dividend Tax Credit (DTC) is to avoid double taxation of shareholders, given that corporate income tax has already been paid by their companies. I argue that the double tax viewpoint is a throwback to a closed economy world. The rate of return on equity net of corporate tax in Canada is set by the global market. Canadian shareholders are not the marginal suppliers of capital to major Canadian corporations and they do not actually bear much of the burden of the CIT. This implies that the taxation of dividends does not significantly affect capital investment in Canada.

The DTC is effectively a tax expenditure that subsidizes the ownership of shares in Canadian companies by Canadian residents. There is evidence that it has created a substantial degree of home bias on the part of taxable Canadian investors. However, the evidence is mixed on whether there is an economic benefit to having greater Canadian ownership of local corporations.

The clearest impact of the DTC is on income distribution. A disproportionate share of dividend income is received by people with incomes over $250,000. Therefore, the DTC reduces the progressivity of the tax system. It deserves a hard look in the context of concern about growing disparity in income distribution.

Keywords: taxation, dividends, dividend tax credit, Canada, income distribution

JEL Classification: H21, H24