Today, we sit down with Professor Kevin Milligan to unpack the recent capital gain changes and the complexities of the Canadian tax system. Kevin Milligan is a Professor of Economics at the Vancouver School of Economics, University of British Columbia. He holds positions as a Scholar-in-Residence at the C.D. Howe Institute and a Research Associate at the National Bureau of Economic Research. A two-time recipient of the Purvis Prize, Professor Milligan’s work is recognized for its significant contributions to Canadian economic policy. His research focuses on public and labour economics, particularly concerning the economics of children and the elderly, along with tax and labour market policy issues. In our conversation, we dive deep into capital gains tax, the progressivity of the tax system, and the distribution of tax burdens among different income groups. We explore the intricate details of who bears the burden of corporate taxes, the impact of recent capital gains changes, and the intriguing relationship between income and longevity in Canada. Professor Milligan also shares insights from his research on longevity and the implications of tax policies on economic behaviour. Join us and uncover the truths about Canada's tax system, capital gains changes, and their profound impacts on Canadians. Tune in now!
Key Points From This Episode:
(0:07:20) Background about Professor Milligan and an outline of today’s topic.
(0:10:10) Complexities behind tax policy and recent capital gains changes in Canada.
(0:14:22) Distribution of tax rates in Canada and how progressive the tax system is.
(0:20:12) Analysis of how the Canadian tax system is applied to the top 1% of earners.
(0:22:28) The theory behind capital income and how it relates to personal income tax.
(0:26:40) Explanation of tax integration and how income tax accounts for corporate taxes.
(0:29:53) Impact of the capital gains tax changes and Canada’s overall tax progressivity.
(0:40:55) How the new capital gains inclusion rate affects integration for incorporated business.
(0:46:32) The interplay between corporate investment, capital taxation, and productivity.
(0:54:11) Historical changes in tax rates and the shift of average tax rates over time.
(0:57:14) His perspective on the increase of the capital gains inclusion rate in Canada.
(0:58:35) Explore the correlation between income levels and longevity in Canada.
(1:03:30) Geographic longevity differences and policy implications for longevity.
(1:07:55) Implications of longevity trends on personal financial planning.
(1:13:24) Takeaways from a past episode, an update on Mark’s book, and more.
Read the Transcript
Ben Felix: This is the Rational Reminder Podcast, a weekly reality check on sensible investing and financial decision-making from three Canadians. We are hosted by me, Benjamin Felix, and Cameron Passmore, Portfolio Managers at PWL Capital. And Mark McGrath, Associate Portfolio Manager at PWL Capital.
Cameron Passmore: Welcome to episode 317. And once again, this week, Ben, you found a great guest. Very topical. Very interesting. Very thought-provoking. You really appreciate the complexity behind this. And we were just talking between the recordings. So I want to pass it over to you, Ben. And I know we're kind of tied on time. But this whole thing of tax policy and the recent capital gain changes in Canada, it is not easy.
Ben Felix: Did you just bring up the episode length, Cameron? My goodness.
Cameron Passmore: I didn't know about the length. I just said we're short on time.
Ben Felix: We brought on Kevin Milligan, who's an economist at the Vancouver School of Economics at UBC, in the University of British Columbia. And we talked to him about capital gains tax. Taxation in general. But to your point, Cameron, there's a lot of really interesting equilibrium thinking that goes on in terms of who actually bears the burden of corporate taxes and how that affects how you think about how progressive the Canadian income tax system is.
The whole conversation was fascinating. We had a whole discussion about the distribution of tax rates in Canada. How progressive is Canada's tax system? How progressive is Canada's tax system within the top earners, which is interesting? If you look at the Canadian tax system in aggregate, it is progressive. If you isolate to the 99th percentile of earners, it's actually regressive. The highest earners are paying less than the less highest earners, I guess. We'll let Kevin explain all that stuff. But super interesting.
We talked a lot about that. The income tax distribution. And then we talked about how capital gains relates to that. The theory behind capital gains. How capital mobility relates to how capital gains should be taxed in an economy. All just fascinating stuff. And then Kevin has this incredible research on longevity. Even though the focus was on capital gains, I couldn't leave out his longevity research. So we talked about that as well, which is also super interesting.
Cameron Passmore: We'll do his bio once we get into the main part of the episode. And then we will have the after show, of course, this week. Mark, I know you had a bit of a story to share here, I think?
Ben Felix: That was me.
Cameron Passmore: Your story, Ben? Sorry.
Ben Felix: I did a Twitter thread on why people hire financial advisers. A lot of people engaged with it, which was interesting. I never know how people are going to react when I say financial advisors are good. A lot of people get upset when you say that.
Cameron Passmore: Mark is smiling.
Mark McGrath: It's true.
Cameron Passmore: Little experience –
Mark McGrath: I've been there.
Ben Felix: The thesis of the Twitter thread was basically that people largely hire financial advisers for non-financial reasons. People listened to our episode on this recently. They'll be familiar with that. But I talked about a paper that we did not discuss in the episode. It was a 2020 study on a broad survey of 3,000 individuals. And in this study, they find evidence similar to what we've already talked about. But they find evidence that people hire financial advisors to satisfy needs, including peace of mind, accessing the opinions of an expert, and delegating financial decisions. It's not investment returns. Actually, they talk about that specifically.
They classify investor needs into five categories; knowledge, trust, personal improvement, delegation, and investment performance. And of those needs, they find that the most important need that investors want in a relationship is trust. Followed by personal improvement. The least important need is investment performance. I just thought that was interesting.
The peace of mind aspect is often missed when people are trying to figure out what the value of financial advice is. People want to think about what am I getting quantitatively for this relationship? But financial advice is a credence good is what you would call it. It's a good that's really hard to measure or impossible to measure the value of in objective terms even after you've received the service. But based on that survey data, peace of mind is a really important part of that.
I also wanted to mention as I was thinking about this, there's this financial advisor shaming that I see happen online where someone's like I want to have a financial advisor for like the reasons we just talked about, for peace of mind. For my spouse. For continuity of the relationship if I have some kind of cognitive incapacity or continuity of the financial plan. Those are all legitimate peace of mind reasons to have a financial advisor. But people online are so quick to jump in and say, "Never pay a financial advisor. You should just get a fee-only financial planner and then manage your own investments," which is a great solution for many people. Don't get me wrong. But I don't know. I just wanted to say that.
It's always interesting to see that this happened in the Rational Reminder Community. This is why I'm bringing it up. Someone came in and said, "I want to have a financial advisor so that we have continuity in a financial plan or something were to happen to me, for my spouse." But he also talked about how the spouse is not engaged at all. But is also extremely risk-averse and has most of their portion of the household savings in cash. I think a financial advisor might be able to help get her invested and increase her household's expected returns. But then people jump in and say, "Well, you just need a fee-only financial planner." The guy was asking for identifying the need for trust and peace of mind, which, based on the survey data, is what a lot of people looking for in a financial advice relationship.
I thought it was interesting that the Twitter thread – I posted on LinkedIn, too, and it got a ton of traction in both places in terms of like reach, and views, and engagement. I thought that was interesting. And then I saw that comment in the Rational Reminder Community and wanted to make my point about financial advisor shaming.
Mark McGrath: It seems to be the same types of people that I find that are engaging in that. And this is anecdotal, of course, but most of them don't really understand what good financial planning looks like. It's rare to me that somebody has really experienced proper ongoing financial planning from a third-party and then comes back and says, "Nobody needs to pay for ongoing advice." I find it's often those who don't understand what good financial planning is or why somebody might engage in that over the long run that have those opinions. And, rarely, somebody who's actually gone through it themselves.
Most of the time, a lot of these people come out and say, "You don't need a financial advisor because you can just buy index funds." I don't know how many times we have to talk about this. It's just like buying a financial product for your portfolio is a small component of financial planning. Just that alone identifies them as the type of person that I'm describing that doesn't actually understand what financial planning is. And I just ignore it now because I've just spent too many hours of my life, fighting people like that. I'm like, "Cool, man. Whatever. Two plus 2 equals 5. You're good. Have a good day."
Ben Felix: I don't want to keep going on this. This is supposed to be the introduction.
Mark McGrath: I do.
Ben Felix: But it's one of our longest in ages.
Mark McGrath: Let's vent.
Ben Felix: People that follow you and I on Twitter, Mark, or people that are in the Rational Reminder Community, they're probably great candidates to be do-it-yourself investors or at least –
Cameron Passmore: Right. You got selection bias going on.
Ben Felix: – better than the average person. But, yeah. There's huge selection bias. Anyway.
Mark McGrath: And fee-only planning is great. Advice-only planning, like you said, it's fantastic for the right person and for the right family. I don't know. Different people need different things. And it's just so obvious to me that there's not really much of an argument there.
Ben Felix: 100%. It's the shaming thing that I find annoying. Anyway, let's go introduce Kevin and talk about capital gains and longevity.
Cameron Passmore: All right. Let's go.
***
Cameron Passmore: Okay. Episode 317. Do you guys want to queue up Kevin's bio?
Ben Felix: We're joined in a moment here by Kevin Milligan. He's a Professor of Economics at the Vancouver School of Economics at University of British Columbia here in Canada. He is also a Scholar-in-Residence with the C.D. Howe Institute and a Research Associate of the National Bureau of Economic Research. Since 2011, he's served as Co-Editor of the Canadian Tax Journal. He studied at Queens University and the University of Toronto where he got his Ph.D. in 2001, and his thesis was awarded the 2002 National Tax Association Dissertation Award. And he's a two-time winner of the Purvis Prize, which is awarded annually to the authors of a highly significant written contribution to Canadian economic policy. Super cool.
His research spans fields of public and labour economics with a focus on the economics of children and the elderly. As well as other tax and labour market policy topics, which we got a taste of all of that throughout our conversation with Kevin.
Cameron Passmore: Any other backstory you want to share? Or you just want to go right to the conversation?
Ben Felix: The backstory is that the capital gains tax increase caused everyone to be an internet tax policy expert for a few weeks.
Cameron Passmore: So fun.
Ben Felix: As tends to happen whenever something happens. And I wanted to talk to Kevin earlier. He's been super busy with some other research projects. We weren't able to speak until now. But I reached out to him because I was like, "Man, there's so much misinformation, incorrect information, false beliefs going on about the proposed capital gains tax increase." I want to be clear. I'm not saying, "Yes, I'm so happy with the capital gains tax." That's going to affect me negatively personally. I don't know. That's all I have to say, I guess. But I have no political motivation to have this conversation with Kevin.
Cameron Passmore: It's more complicated than the throwaway comments you often hear.
Ben Felix: Yeah. I wanted an economics-focused discussion on tax policy from someone who is an expert specific to Canada so that we could hear good objective information about how taxes are supposed to work and how they do work. And what effect we should expect them to have? And I think we got all of that from Kevin.
I learned a lot talking to Kevin for this conversation, but also reading his research to prepare for it. I hope other people have the same experience and come away more knowledgeable about Canada's tax system taxation in general. I don't want people to be scared off by the Canada piece. But also the role of capital gains tax policy in all of that. Plus, there's like a bonus conversation at the end about longevity and the longevity distribution in Canada. That was really interesting as well.
Mark McGrath: The longevity bit was – yeah, like you said, super interesting.
Cameron Passmore: Okay. Let's go to our conversation with Kevin Milligan.
Ben Felix: Professor Kevin Milligan, welcome to the Rational Reminder podcast.
Kevin Milligan: Thanks for having me.
Ben Felix: Super excited to be talking to you. All right. To kick this off, why is the Buffett Rule important to consider for a taxation system?
Kevin Milligan: The origin of what's called the Buffett rule was, gosh, 10, 15 years ago now. During the Obama Administration, Warren Buffett, the famed investor, noted that the average tax rate he paid, so the total taxes divided by his total income, was lower than that of his secretary. And he thought this was not a good feature of the US tax system. And that ought to be something that is a focus for tax policy. He thought it was not a good feature because he thought it was unfair. This is purely a question of how progressive a tax system ought to be.
During the Obama Administration, they explicitly targeted this. They had press release saying here's what the Buffett Rule is. We think that's a good rule. We think Warren Buffett is smart. He's rich guy. We want to borrow his credibility to make the case so we ought to increase the taxes on high earners somewhat. I can't recall exactly which tax changes came out of that. But that was the origin of it.
More recently, analysis of the US tax system found that the Buffett Rule really failed in the US. In other words, higher earners were paying quite a bit less in terms of their average tax rate than middle earners. There's some analysis of that. That was one of my motivations for trying to do this for Canada.
Mark McGrath: What are the challenges with defining tax and income when measuring the distribution of personal tax rates in Canada?
Kevin Milligan: One of the main challenges, and this comes up in the US analysis too and is part of the source of the debate, is figuring out what we mean by taxes. Now, normally, people are just talking about the personal income taxes. Not talking about sales taxes and other things, which, of course, we pay. We're talking about progressivity of the personal income tax system is normally what people are talking about when they're talking about the Buffett Rule.
And the problem is there's several features, especially in the bottom half of the income distribution that are kind of harder to categorize. And just take it as an example, the Canada Child Benefit. The provision for that is in the Income Tax Act. So you can definitely argue it's part of the income tax system because it's right there. But it is not delivered through the tax forms. It's delivered as a monthly installment that goes direct deposit right into parents' bank accounts every month. Is that a negative tax? Does that reduce your tax burden? Or is that something that's outside the personal income tax system? Okay. Maybe we can have a debate about that.
But there's even a weirder one was something very similar to that, which is what used to be called the Canada Workers Benefit. It's changed a bit and evolved a bit now. But it was also a refundable tax credit. Very similar to the Canada Child Benefit. But for whatever reason, it was delivered right in the tax form. You finished your tax form. One of the last lines was like, "Oh, yeah. There's the Canada Workers Benefit. Here's how much you get. Subtract that from your taxes. Here's what you actually owe." There are other items that have been on and off the tax form. Refundable credit. Not refundable credit. It gets very murky what is income and what is a negative tax.
Now, importantly, this is something really matters if you're someone who gets Canada Child Benefit, GSC tax credit, Canada Workers Benefit, which tends to focus more at the bottom end of the income distribution. There, you can generate these average tax rates, which is taxes divided by income. You can generate very different tax rates depending on what you classify as your tax rate and what you classify as income.
To the second part of your question quickly, which was the income side of things, it gets murky there as well. Because there are various parts of income that can be exempted from the tax system. As an example, I'm at a university here, student scholarship income does not appear in your tax form at all. Now, people buy stuff with it. It's income from any conventional way of thinking about income. But it's not on the tax form.
Just as one example, there are other things like that. It's not a big part of the Canadian economy. But there are other examples of that where the income side can be a bit murky as well. In my work in this, I tried to be thoughtful about how I categorize what's taxes. What's income? Showed sensitivity to different definitions and tried to move forward on that.
Ben Felix: Can you talk about how the average tax rate in Canada varies across different income groups?
Kevin Milligan: As I mentioned, for the bottom, say, 25% of earners, it depends a lot on how you define these things. Are you going to put the Canada Workers Benefit in? Are you going to put the Canada Child Benefit in or not? It varies quite a bit. But when I think about overall, for people in the bottom 25, 50% of the income distribution, you're not actually paying a lot of income tax. At the margin, you might be. But in terms of your average tax burden, it's not huge. And why is that the case? Well, we all get a basic personal amount that's now getting close to $15,000 a year, 15,000 is going to be income tax exempt.
People have other credits for other things that can wipe out other parts of taxable income. For most people, get to mainly income tax until you're around 20 or $25,000. And so, then if you're like a median earner making 55 or 60, it's like only your last 25 or 30 of that is even subject to taxes. And that's going be at generally kind of a low rate. For the bottom half of the income distribution, we're looking at average tax rates during the range. At the median, it's only like 10% of your total income that you're paying in income tax. Again, your property taxes, sales taxes. There are other things going on there.
When you get to the top half though, that's where things start to stack up. You get the progressive tax system, where you have increasing tax brackets as you get higher. You have more income that's subject to tax because you're getting farther away from that part that's not taxed at the bottom. And so, you get tax rates are getting closer to – this is average tax rates. Again, 25% and even 30% for the top 1%. And at the very, very top, the top 1% of the top 1%, you're getting closer these days to 32 or 33%.
Listeners are going to say, "But wait. My marginal tax rate is 53.5%. What the hell are you talking about?" That's what you're paying on the last dollar of your income. I'm talking about your total tax burden. Why am I talking about your total tax burden is because I'm not talking about what's your decision marginally to invest a bit more here, work a bit more here. That's where your marginal tax rate matters. When I'm talking about how does our income tax system ask each of us to contribute and help out those who are in need and ask for bit more from those who are doing well? That's where you want to look at your total tax burden divided by your total income. That's why I'm talking about this average tax rate, which, like I said, these days is around 30 to 33% for those at the very top.
Ben Felix: That discussion in your paper of why you look at average tax rates instead of marginal rates was really insightful. How has that distribution of average tax rates changed over time?
Kevin Milligan: It's changed quite a bit and for a couple of reasons. As we went from the 80s into the 90s, we were in an era of fighting the deficit. The Mulroney government de-indexed the tax system. Partially de-indexed it. Such that all of the credit’s kind of frozen value, all the bracket thresholds frozen value. There was this – we called it back then bracket creep every year. That your income was going into more and more higher tax brackets as time went on.
In addition to that, there were these extra income taxes that hit middle earners, high earners. Every year, it seemed like everyone's income taxes were going up. People don't remember that. People complain now about high-income taxes. And it's like, "No, man. You should have been there in the 80s and 90s. Every single budget." This is under a progressive conservative government and under the Jean Chrétien government when Paul Martin was the Finance Minister. This was happening. And a lot of it happened under a progressive conservative government. That was a big increase in the 80s and 90s.
That kind of peaked out in 1997. That was the year that the deficit hit zero. And Paul Martin as Finance Minister put in place some tax cuts. He stopped the de-indexation of the tax system. Reindexed those tax brackets so they moved up every year as people's incomes moved up. Then we hit some tax cuts in 2000. The Harper government did a bit of income tax cutting. Not a lot. Their biggest focus was on the GST tax cut initially anyway.
And then we hit the mid-20-teens, the Trudeau government. You can see it in the data. There's bit of a tax cut in the middle. A bit of a tax increase at the top. But the net picture of this through time is, if you look at, say, someone in the middle of the income distribution, like in the mid-80s, mid-90s, they're paying about 15% of their income in income tax. By the time you hit the late 20-teens, it was like 10%. That's like a really substantial cut.
Similarly, for people at the very top, it takes the top 1% of the top 1%. Back in the mid-90s, you had surtaxes on top of surtaxes. And they all interacted with each other on tax brackets that weren't moving. We're talking 40% of your income on average. Not talking about the margin. On average, 40% of your income was going to income taxes. By the time you hit 2018, we're down to 32% for those high earners.
There was a substantial difference through time. People remember things through a bit of rose colour glasses. And no one likes to hear that, "Man, you had it way better back then into income taxes." Everyone likes to complain about taxes. But it's actually empirically true that the burden was higher 20 years ago than it is now.
Ben Felix: That's really interesting. It sounds like the whole distribution shifted down in terms of average tax rates. What are the shape of the distribution? Like the Buffett rule concept?
Mark McGrath: What happened there was it did come down fairly uniformly until the Trudeau government. When you started to see that at the very top, it started to kick back up a bit. Why was that is because they put in place this new tax bracket that kind of hit the top 1%. They explicitly targeted that in their election campaign in 2015. Voters made their choice. And that's what they wanted. That's what they got.
There's kind of a uniform shift down over time. A bit more frankly at the top even before 2015 because of those surtaxes that were in place in the 80s and 90s. As those came off, that kind of helped more at the top. And then a bit of a reversal of that over the last seven or eight years.
Mark McGrath: You kind of already answered this. But can you talk a little bit more about what the distribution of average tax rates looks like within the 99th percentile of earners?
Kevin Milligan: To dig into that, I use data that are really very fine that allow me to break up the top 1% into its various components. And what you find there is that the Buffett rule for Canada, as you get to higher income groups, the average tax rate is going up. That would make Warren Buffett happy except for those in the very top groups. This would be the top 1% of the top 1%. And even the top half of the top 1% of the top 1%, you get down to one in 20,000 Canadians there. There's not a lot of people there. Very high-income earners.
For them, their average tax is actually lower than their neighbors who are only in the top 1%. Warren Buffett would not be lower than his secretary in Canada. He would be lower than his neighbor is only a billionaire and not a multi-billionaire. What's interesting, and I think we're going to get there, is the reasons for that. It's not like there's a special billionaire’s tax bracket. It's not like there's a special billionaire tax credit. It's because of some certain features of the way we tax especially capital income.
Cameron Passmore: Well, that's my next question is very topical given the capital gains changes in Canada recently. How does the capital gains income affect tax rates at that top end of the income distribution?
Kevin Milligan: That's exactly why you see this dip down in average tax rates among the top 1% of the top 1%. It's because of the mix of their income. Like I said, there's no special billionaire tax cut out there. What there is, is special treatment of capital gains and dividends. And what those mean is if you happen to get a big share of your income through capital gains and dividends, then you're going to pay less tax. Because those forms of income are given special tax treatment.
You look at, again, the top 1% of the top 1%. They have over half of their income come in the form of capital gains and dividends. And so, they're getting these forms of income that have special tax treatment. And there are reasons why they get special tax treatment. And we can get into that. That's the mechanical reason why you see the average tax rate kind of top out and then go down to the top. It's a question of the income mix that those folks are getting.
Ben Felix: That is super interesting. I do want to come back to the rationale. But before we get there, I just want you to set up the theory. Can you talk about how the theory of capital income taxation in a small open economy like Canada relates to personal income taxes?
Kevin Milligan: Yeah. This actually gets right deep into economic theory. But it matters a lot for thinking about this. There's kind of two ways of thinking about this. If you have a closed economy and you're just funding your business operations at a domestic capital, then everyone who receives capital gains and dividends, that's coming out of business profit in some way.
And so, any changes to the corporate tax regime are going to feed through to your after-tax return on business profit. As money goes from the profit of the business to the pocket of the investor, we have to kind of trace through what's happening at the business level and the personal level.
The other polar case is one where all the capital is coming from abroad international investors. And the key thing about international investors is they do not pay Canadian personal income tax. They don't give a wit what we do about capital gains and dividends at the personal level in Canada. Is there a dividend tax credit or not? Is the inclusion rate 50, or 66, or 75? They don't care. Because like you're in Switzerland. You're in the Bahamas. You're wherever. You're international investor. You might care about the Canadian corporate tax rate if you have operations in Canada. You don't care about Canadian personal income taxes though.
If those investment dollars are coming from abroad, anything you do to personal taxes is not going back to the corporate sector at all. Those are the kind of the two polar cases where, if dollars are coming from abroad, personal taxes don't matter for the investment side of the economy. Whereas if we're kind of in a trapped economy with all money coming from domestic sources, then you do care about that. Because if I'm an investor, I'm like, "Well, if you tax corporations more, that's less in my pocket when I pull that money out of the corporation and put it in my pocket." And so, that's kind of the two polar cases. Which case we are in? Different economists have different views of things.
The way I tend to look at it is it really depends what sector you're in. If you're a big international company – my example here is too old. Last time I talked about this, when I talk in front of my classes about this, I talked about Bell Canada Enterprises, which I think it's still publicly traded. Went through a weird thing back 10 years ago. At that point, it was traded in the New York Stock Exchange. Or take any big Canadian company that might be traded in New York, traded in Toronto as well. They're cross-listed. This happens for the big companies.
Similarly, they float their own corporate bonds. Just think of the capital they have access to. They can walk into an investment bank in New York and like, "Yeah, we want to drop 100 million dollars of bonds, or a billion dollars of bonds,” or whatever the quantity might be. And they get an investment bank. Gets with some German credit union. It gets placed with some Japanese pension fund. Total international.
In contrast, you got a small construction startup. Guy wants to buy some equipment. Buy a frontend loader. Buy a new dump truck. Doing great work for the Canadian economy. Working hard. Getting up in the morning. We love this guy. But the thing about him is he can't go to New York and float bonds to fund his operation. What he's got to do is borrow from friends, borrow from the bank. That kind of thing. He's going to be faced with domestic capital system. He's going to care. He might be self-funding as well. He's going to care a lot. If the corporate tax rate goes up, he's going to care about that how that passes through to his individual taxes.
The big picture here is there's these different models. I think they affect different kind of firms differently. And this all feeds into that question we're talking. Why is it that the very high earners are paying a bit less tax than other earners in Canada? It's because they get a lot of dividends and capital gains. Well, why is it that we treat dividends and capital gains differently than other forms of income? The answer comes to, well, these forms of income have already been taxed at the corporate level. And should we care about that or not comes down to this question of this international economics and international capital flows.
It's a very deep dive there. But the reason why we have to do the deep dive is that is the reason why we think about the inclusion rate and the dividend tax credit as a special thing. And there's a lot of debate among economists about whether we should care about that and how much we care about that.
Mark McGrath: How does the concept of tax integration where personal income tax accounts for tax paid at the corporate level? How is that affected by capital mobility?
Kevin Milligan: This is kind of a part I skipped over a bit in talking about the international capital flows. But just think about what happens when a firm makes profit. A firm makes profit. It pays corporate taxes. Then goes into retained earnings after-tax profit account in the firm. What happens then? Well, two things can happen. Or three things. One is the firm reinvests that into the firm. That's great. We like when that happens. The second thing can happen is that they pay a dividend. The dividend then goes into shareholders' pockets. The third thing that can happen is they retain the earnings inside the firm maybe to pay future dividends, maybe to do something else. Whatever it might be. But when they do that, the value of the firm is going to go up.
And so, if future dividends are higher, the stock price might go up if it's a publicly traded company. That's going to then kind of transmit that value to the shareholder through a capital gain. Another thing they can do is take that retained earnings and do a share buyback program.
When I've mentioned this, I've had a lot of pushback from financial industry professionals saying, "Aha. If a firm does a share buyback program, that gets deemed as a dividend. And so, what you're talking about how that gets transmitted to shareholders through a capital gain is not true." Well, the answer is it is true. Depends on how you structure it as a firm. If a firm says, "Okay. Every 10 shares you have, I'm going to buy back one of them," then that's deemed as a dividend under a certain part of the Income Tax Act.
In contrast, the firm just says, “I got $100 million of retained earnings here. I'm just to go out to the market and put in orders and buy a bunch of shares on the open market." What happens then is that the price of the stock is bid up and then that benefits everyone who holds that stock to a capital gain. And that's a way to transmit that firm value to the shareholder through a capital gain.
I was very confused when I got angry emails. Like, "What are you talking about? How firms do share buybacks? That never happens." You just Google up share buyback Canada and you get dozens of firms saying the CFO makes an announcement in their quarterly earnings call, "Okay. We did well this quarter. We're going to institute a share buyback plan. Instead of reinvesting the firm, we're just going to buy back a bunch of shares." Why are they doing that? They explicitly say we want to juice the stock price. That's fair. I mean, there's nothing wrong with that per se. It's a way to transmit firm value into shareholder value.
What could be wrong with it though is if the tax system is favoring that way over, say, dividends or over, say, reinvesting in the firm. That gets into why we made the change to capital gains taxation. But generally, that's the big thing here. When we talk about the integration of the tax system, the personal and corporate tax system, it's about accounting for all the taxes that are paid in that journey from the corporate taxes through to the personal taxes.
I always like to say, “From the profit of the firm to the pocket of the shareholder.” Corporate tax, dividend tax credit, dividend taxes, capital gains taxes, all of that stuff, we think about is the integration of the personal and corporate tax systems.
Cameron Passmore: Wow. This is so interesting, Kevin. How does the new capital gains inclusion rate affect integration for incorporated business owners?
Kevin Milligan: What we've seen over the past, I'd say, 20 years is that there's been a change in how capital gains are taxed relative to dividends. Going back to that decision of profit to pocket, what I would like to see in the tax system is the tax system being neutral across those different things. If for a firm, for business reasons, it's the best thing to reinvest in the firm, that's what we wanted to do. If it's the best thing to pay out dividends, the best thing to do a share buyback program for internal company reasons, for good business reasons, that's what we want them to do.
What we don't want is the tax system to push firms one way or the other. And we've seen that through time when one of these channels gets tax favour over another. You have a CFO saying, "Well, we could invest in refurbishing our fleet of trucks. That's going to cost us a bunch of money. And the other competitors aren't doing that because capital gains are so cheap to transmit value to shareholders right now. We're just going to do a share buyback plan and flush the money out of the firm rather than investing in the firm.” That's the kind of thing that is good for existing shareholders perhaps right now. But it isn't good in the long run for the economy. We don't want firms to have an incentive to flush the money out of the firm instead of investing in the firm.
Similarly, with dividends versus capital gains, having a level playing field there is kind of the goal. That's how I entered this discussion of the capital gains inclusion rate. Over the last 20 years, the total tax rate from profit to pocket of capital gains versus dividends as a channel to transmit those firm profits to shareholders got out of line. And so, what that meant was if you graph over time, you saw a decline in dividends and a big increase in these share buyback programs.
To me, that was just an inefficiency that was going on. And we want to have those things made on business reasons not to try to gain the tax system. And so, to put those things back online, an increase in the capital gains inclusion rate was one way to do it. Of course, you could also say, "The other way to do is to lower the dividend tax rate," and that's a fair comment.
This government was also interested as – another thing that they viewed as a benefit of this was to try to shift that buffer curve up a bit and make high earners pay a bit more. That's why they made that choice. That's the question of who pays what in the tax system? Any government gets a choice of doing that and we all as voters get a choice of whether we like that or not. There's an efficiency argument for it, which is to say we want the integration to be level across all these different forums. And then there's the fairness argument of who should pay more? Who should pay less? Those are two different arguments. In this case, they both aligned to say we ought to increase the capital gains inclusion rate.
Ben Felix: You talked about how the two different models of who bears the cost of corporate taxes. How does that modeling decision affect how progressive taxes are at the personal level?
Kevin Milligan: It actually makes a huge difference. The reason is if you assume that capital gains and dividends are fully taxed at the corporate level and you account for those corporate taxes when you wash it through to the individual level. I get some dividends. I get a dividend tax credit. They're a bit light more lightly taxed. But the firm already paid profits on those taxes, if I take those corporate taxes and add it to the personal tax bill, that actually makes a pretty big difference. It makes our tax system look fairly progressive and that the high earners are paying more. Because, again, those high earners are getting this capital income. It was already taxed potentially at the corporate level.
Now in contrast, if what's happening is that those corporate taxes that are being paid at the corporate level, we don't want to account for those. If that's the other way you want to go, that you're not going to account for those, then all we see is what – we've been talking about is that, "Geez. Those high earners are getting capital income, which is lightly taxed. Therefore, they're not paying enough tax. They should pay more."
Whether you think the system is progressive or not depends on whether you think that those corporate taxes that are being paid by companies in Canada are being passed through to the shareholders or not. And some people think they are. Some people think they aren't. To me, it depends a bit what kind of firm we're talking about.
Just to put that in a nutshell again. If you think that those corporate taxes are being passed through to shareholders, then the system is already pretty progressive. Because those dividend tax credits and the inclusion rate are fair game. Because you want to account for the fact that corporate taxes are already been paid.
One of the points of my work on this is if you're worried about the progressivity of the tax system, you kind of have to take a stance on how much of those corporate taxes are going through to shareholders.
Ben Felix: That part of your paper was mind-blowing for me. If they're not being borne by shareholders – I know you already talked about this. So I just want to come back to it to make sure listeners and myself understand. If it's not being borne by the Canadian taxpayer, it's because it's being borne by international investors effectively?
Kevin Milligan: Well, yeah. That's the thing. The international investors have other options. If they're not going to invest in Canada, they can invest somewhere else. If corporate taxes go up, they're not going to pay any more for Canadian assets. What they're going to do though is they're going to pay less for Canadian assets. What happens under that model where it's International investors we worried about, when the Canadian corporate tax rate goes up, the stock market goes down.
Ben Felix: Oh, man. Wow. It's an equilibrium argument.
Kevin Milligan: Yeah. And so, that's where the burden is actually shared by not capital at all. It's actually shared by labour, by workers. Because in that model, whenever you put the corporate tax rate up, the value of the shares go down. The only way that the firm essentially can pay is by paying their workers less. That's perhaps a weird argument. It's a bit counterintuitive to people that corporate taxes up hurts workers. But there's a serious argument for it. Whether it holds empirically or not, again, there are different views. But in theory, if who holds Canadian shares is mostly international investors, they don't care about Canadian taxes. They need to be compensated if Canadian taxes go up. Or else they're not going to hold the stuff.
Ben Felix: Wow.
Mark McGrath: I actually made a similar argument on Twitter when this was first announced. And I was lambasted by quite a number of people. It's very validating to hear you elucidate that to our audience.
Kevin Milligan: It can often be the case that speaking a bit of truth on Twitter gets you lambasted.
Mark McGrath: Tell me about it.
Kevin Milligan: So you have, as I'm sure you have learned, to take that with a grain of salt.
Mark McGrath: Oh, absolutely. You touched on this already. I think you mentioned there's kind of two schools of thoughts around who bears the cost of corporate taxation. Can you elaborate a little bit on that? Is there a right way of thinking about that?
Kevin Milligan: I don't think there is a right way. But it, again, comes down to who you think the marginal investor is. If the marginal investor is a domestic taxpaying entity – I'm going take a diversion there. I said domestic taxpaying entity. Because you know who's the biggest shareholder in Canada? It's the Canada Pension Plan Investment Board.
You want to talk about the middle class, the Canada Pension Plan is paid into by all Canadians. And, really, middle class is a big beneficiary of it. When you tax companies a lot more and that diminishes the return to the Canada Pension Plan, that's a kind of channel you think about it hurting the middle class right there. The biggest shareholder in the country is not some rich family. It's the Canada Pension Plan Investment Board.
Just as a sidebar there. That's what I'm talking about taxable domestic entities. If you're a taxable domestic entity, that model says that if you increase corporate taxes, then I'm going to have to bear the burden of that when I pull the money out of the firm. I will have effectively paid that corporate tax. And then have to pay personal tax on top of that. If you don't allow some relief for the fact you already paid the corporate tax, that's going to lead to a very high tax burden. If your corporate tax rate is 30%, your personal tax rate is 53.5, that's an 83.5% tax rate. And that's not fair. That's not efficient. That's not good in any way that 83.5% tax rate. That's why you might give relief.
What we're going to do is we're going to lower the personal tax burden to account for the fact you've already paid 25 or 30% at the corporate level. That's one model. That's why you want to give this relief. The other model is that the money is coming from abroad. They're going to be paying that Canadian corporate tax. But they're not paying the Canadian personal tax. Their decision of what to do in Canada doesn't depend on personal taxes at all. If you give dividend tax relief, if you give capital gains tax relief, that does not change anything with respect to the firm's behavior. Because what the firm cares about is international investors. International investors aren't paying Canadian personal tax.
Cameron Passmore: Overall, how Progressive is Canada's personal income tax system?
Kevin Milligan: My answer to that is actually it's not bad. Even at these two polar extremes of how we think about capital income taxes as whether we ought to add in the corporate tax or whether we shouldn't, the curve still goes kind of up so that the Buffett Rule is pretty much satisfied. There is a bit of a dip down for the top half of the top 1% of the top 1%. The top one in 20,000 taxpayers. There's definitely some progressivity there.
What's interesting to me is a lot of the debate of what goes on in the middle versus the bottom. There, as I mentioned up front, depends a lot on how you think about those refundable tax credits like the Canada Child Benefit, the GST tax credit, whether those are Income, negative taxes, or whatever. But in general, there is a good degree of progressivity there. It's true for almost all Canadians that if you earn more, you're going to pay more. And that satisfies the rule of having a progressive tax system.
Whether it ought to be more progressive or not, especially at the top, to me depends a lot on how you want to think about that capital income taxation. That's really a core thing, which to me it's a difficult question. Because it depends a bit on your view of how international capital flows around.
The way I think about this question is something progressive enough. The questions of like what will be the impact on the economy? What will be the impact on efficiency, and investment, and growth? These are all good questions for an economist. And we have models and we have data on that.
When it comes down to like how much different people ought to pay, I get one vote out of 40 million Canadians. And so, I have my own views on that. And I just don't think I have anything special to say on that. We all have a view on how much more someone was making a bit more autopay. Whether we kind of hit the sweet spot on that. What I note is that there's been a lot of political mud-throwing about what's gone on over the past seven or eight years in terms of higher taxes at the top.
When you look at the last 30 years of progression on this, it's pushed it back a bit up. Nowhere near what it was in the 90s. You could argue, we shouldn't have gone up tried to reverse that at all. That's fine. You can argue that. Like I said, you have one vote. I have one vote. We all get to make our choices on election day. But what's empirically true is it was much worse for high earners in the 90s than it is now.
Mark McGrath: Going back to the capital gains taxes and specifically the increase in the inclusion rate around the capital gains taxes, what effect do you expect that to have on how progressive Canada's tax system is now?
Kevin Milligan: I think it will have some effect, especially at the top. As I mentioned, the people in the top 1% specifically, like the top half of the top 1% is where they start getting a lot more capital income in your income mix. It's going to have an increase in their taxes. That will increase the average tax rate for those folks. And that's going to increase the progressivity of the tax system a bit.
A couple of notes on that that have come up in thinking about this, one thing people have argued is that a lot of the realization of capital gains is very lumpy. You do it once in a life time. You work. You save through a firm. And then you sell off the firm. And there's like a one-time hit on capital gains. And that can be true.
The way that this capital gains increase was structured was it's only the first 250,000 in any year is exempt from the increase. The new capital gains tax only applies after you've already received 250,000 in one year. What I would say to a small business who might have a million or two million saved up through their firm through all their hard work through the life, first, I'd say thank you for working hard and doing well. That's great. We like people who do well.
But then I'd say if you were to realize all of that in one year, you should get a new accountant. Because there are ways that you could spread this out that would avoid it a bit for those people who are doing very well or did okay over their lifetime. If there's a target for this, it's the people who are in that 1 in 20,000 taxpayers who receive $4 or 5 million of income every year. Those are the folks who are going to be hit by it. And those are the folks who, if you want to increase the tax system, you're going to want to hit. That's one argument about who's going to be hit.
How this will impact progressivity is it's going to have an impact for people at the top who essentially can't avoid it very easily. There's going to be some people at the margin who have these once-in-a-while transactions selling off a firm or something where they can potentially avoid it. And that's okay. Because I'm not sure that someone who's making 70 or 80,000 a year as a small business person and then has a big payday at the end of their career is to sell off their firm. If they don't get hit by this, I don't think that's the worst thing in the world.
Mark McGrath: That's fair. And you mentioned the $250,000 threshold where the new inclusion rate applies. And that's for personal taxes.
Kevin Milligan: Yes, 250,000. That's right. At the corporate level, within corporate transactions, there's no threshold there. Companies will be paying capital gains immediately on their first dollar of capital gains at the higher inclusion rate.
Mark McGrath: I don't know how far you want to go into this. But to the degree that some small businesses do have retained capital and are potentially not the target of this new inclusion rate increase, the $250,000 threshold that applies to individuals seems to be reasonable. What are your thoughts on having or not having a similar threshold within a business?
Kevin Milligan: Generally, for businesses, this is a first principles tax policy thing. Having thresholds and brackets is more difficult. Because businesses, unlike people, can be cut into pieces. If you tend to have a threshold, 250,000 in this case, or whatever kind of tax you're talking about, there'd be an incentive to keep firms smaller, to break them into little pieces, so that each of those little pieces gets under the threshold and you stay in the bottom bracket. That's just a general principle. My suspicion is this is where the government was on this. We don't want to have an incentive or firms to stay small. We want firms to stay big.
But you have identified something here, which is a downside of this tax policy change. Where I have some concerns is exactly that small and medium. The smaller wants to become a medium-sized business. You have a firm who's doing well. Generating some cash flow. Has some retained earnings. They might want to start investing in other firms. Expand a bit. Whether it's taking over someone in a neighboring city. Whether it's expanding their operation. Going to a different industry a bit. A neighboring industry. Maybe vertically integrating in some way. Whatever it might be. You can have these cross-firm transactions that can get messed up because of this capital gains tax rate. Messed up in the sense that it'd be subject to higher taxes.
As a basic principle, we want business decisions to the extent possible made on business principles. Is this a good cash flow? Are revenues bigger than costs? These are things we want to matter. We don't want people to say, "Well, that would be a good investment. But the taxes are better if I make the investment over here. That's not what we want.
And the concern is these across business transactions might be affected by the fact that the capital gains inclusion rate is a bit higher. Now it's a bit higher. It's 16 points higher. From 50 to 67. It's not going to be the end of the world here. These are more rare transactions. I think there is some legitimate concern there.
Similarly, an entrepreneur who does well in one firm wants to roll that money into a new firm. They have a lifetime capital gains exemption. Once they exhaust that, they're going to be hit by the new one. And, again, rolling over into a new operation. That's the kind of thing we want to have, entrepreneurs successful. We want those people to do it again.
Here is where there's been some pushback. You could see in the budget announcement that the finance minister was concerned about this as well. There was an increase in lifetime capital gains exemption. There was some discussion of special rules for the tech sector on how they might be able to roll over this kind of money. The government is aware of these concerns. I think they're right to be aware of these concerns. But that comes down to these within corporate sector transactions could be hit by the higher inclusion rate. And there is some concern there that that might be at the margin diminishing a bit, the ability of firms to make good investment decisions.
Ben Felix: I want to keep going on that. What does the evidence say about the relationship between productivity and capital taxation?
Kevin Milligan: When you look at the big picture of productivity, like how much output we're getting per worker, the way the theory would go is that you change personal tax rates, which gives firms an incentive to invest more, which then allows them to invest more. And they buy more equipment. They expand. They invest in their workers. And the workers are more productive in their workplace. That's all potentially true. Each line in that logic has some sense to it. But it's kind of a bankshot to get there.
And what I mean by that is think of the first step of that is that an increase in the capital gains inclusion rate affects whether the firm wants to invest more or not. Well, that depends on whether the firm cares about personal taxes. Again, if the marginal investor is from New York, or Switzerland, or Bahamas, they don't care about the inclusion rate. The firm is not going to invest anymore. If you're in this world where you think that the marginal investor in the Canadian economy is international, this has zero impact in investment in Canada.
When you look across time, if you look over the past 30 years, we clearly have a productivity problem. I don't think that's up for debate. If you think that the best way to address that is by cutting the capital gains inclusion rate, I'd say that you're crazy. I don't see over the last 30 years we've had inclusion rates of 50, two-thirds, 75%. Through this whole time period, productivity has been getting worse.
I just don't see that there's any coherence in the time series for that. Internationally, there is some evidence that there may be some relationship between corporate investment and capital gains rates. It's going to depend on whether it's a firm or a sector that has access to international capital or not as we talked about before.
For me though, if your goal for increase in productivity was to try to increase corporate investment, which is one way you can get there, not the only way, but one way, I'd rather do it more directly, which is providing incentive for investment. And that's what we've done through the accelerated depreciation that we've had in place the past few years. So that when you invest, you get to write off those investments more quickly. That provides a firm big incentive to invest more quickly.
It's kind of boring stuff. Imagine your Rogers. You have a big fleet of vans that go out and fix people's internet where they're down. How often do you update those vans? Do you do it every five years or every six years? Well, I can tell you, the CFO at Rogers has like a spreadsheet that has a model of that. If the investment of that gets them a big accelerated depreciation credit, they might change that decision. Say, "You know what? We're going to do more vans every year." It's kind of very boring and methodical like that. But actually, that's really how this works. We're going to invest in upgrading our van fleet more often. We're going to invest in expanding our 5G network more quickly than otherwise would.
That's the kind of thing that can happen with accelerated depreciation. It's very tightly incoherence with investment. You invest more, you get a tax cut. Versus this bankshot of like, "Well, we'll give some rich guy a capital gains tax credit. And then maybe the firm will account for that when they do stuff." It seems like it's so far away that I don't prefer that. If I wanted to increase corporate investment, it's the accelerated depreciation where I'd go. The accelerated depreciation has expired. I really think that we ought to bring that back if that's the channel that we want to do to increase corporate investment.
A last point on this is increase in corporate investment is one part of that. Giving workers a better environment to work, better equipment, better tools to work with, that's one way. The other way to increase productivity is to make sure the workers are skilled up and tooled up and ready to go. One part of that is making sure our education system is doing well. But there's other more fundamental part which is making sure that people have a good core education when they're going through school.
When you think about the good functioning of the Canadian economy and where we want it to go, a large part of that you might think is elite higher education that people go on and be lawyers or MBAs or whatever. That’s fine. We can do better or worse at that, and maybe that's good for the Canadian economy. But all of that investment, the corporate investment in those better vans for Rogers or better computer equipment for whoever, there's a user sitting there, and they're not in the top one percent of the IQ distribution.
There's lots of middle-class regular workers there. We want those guys to be tooled up, so they can make best use of the equipment and tools and stuff they have. How do we do that? That's the education system that's making sure they feel secure, that they feel happy and able to work. It sounds far afield, but it's actually not. Things like parental leave and sick leave. This kind of stuff can make workers more productive and able to invest in their own careers. Child care can make women more able to invest in their own careers because they know they're going to be there in the workplace over the long run.
When I think about productivity, I do think about the corporate investment side. That's important. Also got to think about the workers and making sure they're doing a good job and that we have a good education system and good social support, so they can be on the job, invest in their own career.
Ben Felix: I just want to mention. You touched on earlier in our conversation about how tax rates have generally gone down over time, but productivity has also gone down. So to think that lowering taxes is going to fix productivity seems, at least in Canada, empirically false.
Kevin Milligan: That's kind of it, the idea that our productivity problem will be solved by cutting corporate or personal tax rates. We kind of done that over the past 20 years. Maybe it's pushed us a bit more and a bit more corporate investment, and that's a good thing. But it's not been enough to reverse this productivity slide. It just occurs to me.
A last point on this, think about AI stuff. We know that it involves big corporate investment and big server farms and fancy, fast computer chips, huge investment there. On the corporate side, imagine you wanted to have, for a productive economy, do stuff through a lot more AI rather than people slaving over spreadsheets or whatever, having some AI doing that all for us.
But what we also need is – so that's one side. That's the corporate investment part. The other part, and this is a lot of discussion of AI, is who's typing the instructions into the AI. We need workers who are able to exploit that, and that kind of really brings us into focus. If we're going to make best use of this new technology, the countries who are going to win are the ones perhaps who have access to the technology. But I think we're all going to have access to it. Countries are going to win economically out of this, so the ones that have the workers who are able to exploit this and make best use of that.
Again, I think this is so important. Think of plumbers as an example. Plumbing is a very hands-on profession. It's great profession. My kids ended up being a plumber. I'm going to tell them you're going to do well in life right now because maybe 30 years from now, there will be a robot that can dig down deep into stuff. I'm not sure. There's a lot of human judgment there. There's a lot of hands-on work that's needed and a lot of skill. I want my plumber doing this, not me.
Think about that, of where that can go with technology. You can imagine a plumber typing in like, “Okay, here's what I see. Okay, ChatGPT. What do you think the problem is?” “Oh, looks like there might be a blockage in the toilet pipe. You know where to go.” It saves a bunch of time of trying the kitchen pipe and everything else. That can really make that plumber more productive. But that plumber has to be comfortable with technology to access that, has to be literate, has to be numerate. These are things.
We think about elite education. When I think about education, it's like taking those people who are maybe not going to be an MBA or a lawyer but going to be a plumber. Making sure that they can read the instruction manual, and they can be comfortable with technology so that they can make most use of these new tools that are available. Those are the countries that are going to do well is the ones that have the workers that can complement the investments in IT and other kinds of investments.
Mark McGrath: Kevin, how much of an effect have taxes had on the long run trend of income concentration in Canada?
Kevin Milligan: Over the long run, I don't think the biggest impact on this has been taxes. What we see is bigger trends going on, the bigger trends being more of a winner-takes-all economy. For people at the very top, people get paid best. If you're the top stock broker or the top software engineer, there's a global market for your talents. You get paid an awful lot by the highest and best use of your talents around the world, 30 or 40 years ago, that might not have been the case so much.
That kind of winner-takes-all labour market leads to a concentration of labour market earnings. The concentration of labour market earnings perhaps happens in the US more than anywhere, but that has feedback effect, especially on Canada with NAFTA and CUSMA now where we have a lot of labour mobility for professionals. If you're in Toronto, you know very well that people who work, say, in the financial district in Toronto, the good ones are getting offers from New York. The Canadian banks have to stay competitive with that. Keep mark to market a bit their salaries.
That’s true in the tech sector in Waterloo. That's going to be true in the tech sector in Vancouver. That's true the software that's all produced here in Vancouver as well. They kind have to mark to market what's going on in the US and more broadly in the world, but mostly the US. People here in Vancouver are getting offers from Silicon Valley. We can't be out of line with that. Those kind of labour market things are to my mind what has driven inequality more than anything over the past 30 years.
What the tax system can do is push back against that a bit. How can it do that? It can increase those transfers to people in the bottom. That's the increase in things like the Canada child benefit that we've seen cut their income taxes a bit here and there. But also perhaps push back against that a bit at the top, which means that you're going to increase the taxes on higher earners a bit. That's kind of where the tax system comes in.
It’s really, really hard to use the tax system alone to try to reverse these big global trends. You can push back at it a bit here and there. We can debate how much you want to push back and how much is too much, how much is too little. To try to push back against those global trends would be very hard. Just think what would happen. If we were to impose a 65% tax bracket on high earners in Canada, think about the financial district in Toronto, the tech sector in KW or Ottawa or Vancouver. The firms would have to, again, mark to market against Silicon Valley, against other places, and pay really high pre-tax salaries to account for those higher taxes, which means they just wouldn't be here. Those firms would not locate their labour here. They would put it back in Silicon Valley to start with and not have their Vancouver operation going.
I just don't see those really, really big tax rates at the top to be feasible because of that kind of mechanism. For that reason, I think it's more fair to argue when to push back against it a bit. But those big global trends in labour markets are something that's harder for the tax system to completely undo.
Cameron Passmore: Before we jump to the next topic, I have to ask you about capital gains. In your view, is the increase in the capital gains inclusion rate a good thing for Canada?
Kevin Milligan: Overall, where I come down is I think it is good for two reasons. The one is that better alliance to the taxation of capital gains with dividends. The tax system is neutral across ways of getting firm profit to shareholder pocket. That's kind of the efficiency argument. On the fairness side, I get 1 vote out of 40 million on this, I kind of think that people who are doing well, ought to contribute more to the pot. This is one way to get them there. Other people have different views on that, and that's fine.
Sometimes, when people talk about having the rich pay a bit more, it's like, “Why do you hate the rich?” I don't. We have more people working hard and making a lot of money. That's great for Canada. I like that. That's good. But when you've been successful, I just think you have an obligation to pay back a bit to the rest of society who’s helped you in some ways get there. Whether it's the education system for you, your family, the society around you, I just think you got to throw some more back in the pot.
That's kind of where I am on that. I'm not someone who rages against rich people. I get paid a good salary here. I don't hate myself. I do think when I make more, I have an obligation to put a bit more back in the pot. Now, how much more you put back in the pot, people have different views. Some people think they put enough, and that's fine. We all get a vote on Election Day.
Ben Felix: We have a few more questions on some of your other research which was just too interesting not to ask you about. Can you talk about how longevity in Canada has evolved over the last 50 or so years?
Kevin Milligan: What we've seen across Western countries anyway is over the last century is that lifespan has been getting longer. People have been living longer, both men and women. Over the last half-century, what's unique about that is that most of this has been in the last half of your life. In the 50s, 60s, 70s, and 80s, you have more and more people surviving. Part of that is the first half of the 20th century, we kind of almost exhausted the gains. It's really good. The child mortality is down by a huge factor. People dying in their tens, their teens, 20s, 30s, 40s is way down. Where we’re making the gains recently is in the older end.
Thinking about longevity is an important part of thinking about overall mortality trends. What we've seen is people are living longer, and it's quite a bit. Just even over the past 50 years, we've gained like five years of life expectancy. That's really huge when you start thinking about it. Start thinking about your balance of how long you want to work, how much you have to save. If you have an extra five years or not, that can matter a lot.
What my research has done is look beyond. That's the number, the fact that life expectancy has been getting longer. You can get that. StatCan produces every year a life expectancy estimate, and that's good. But that's for the average Canadian. What I did in some work with Tammy Schirle from Wilfred Laurier Lauer is to look at the distribution of that and see how does that vary across different kinds of Canadians. We look specifically at high earners and low earners. What we found is there's quite a bit of difference in how long people live.
In fact, if you look at the top five percent of earners versus the bottom five percent, it's about eight years of life expectancy difference, which is almost like 10% of a lifetime. When you start thinking about that, we've all had loved ones who in the last year of their life and you want to spend more time with them. Every day seems precious when you're in that position. Imagine what you can do with an extra eight years, how many more birthdays you can attend. It gets you teary-eyed when you start thinking about Grandma or Grandpa, what you could do with an extra eight years.
High earners have eight more years on average of life expectancy than low earners. That's just, I think, a tremendous element to think about Canadian society and how our economy works just in terms of what we're doing here in life in the 21st century. I want to importantly say that's not a question necessarily of income. It's not like, “Oh, we tax the high guys more and give it to low guys. That's going to reverse it.” It could be other things going. It could be the healthcare you've received over your life. It could be where you live. It could be choices that you make about lifestyle. It could be lots of things that income might not change. So I'm not saying that income is the driving path. I'm just saying people who are in that bottom 10% for whatever reason tend to live a lot shorter than the people in the top 10%.
The other interesting fact on this is a strong contrast to the US. In the US, over the past 30 years, the way this has evolved, the top half of the income distribution has seen all the gains in longevity. The bottom half has stayed the same. They've not seen any gains at all. In contrast, in Canada, it's almost uniform, a uniform shift up for low earners and high earners. When I presented this research in the US, people immediately jump to health insurance as a big thing that matters for this. That's possible, but what's interesting is our public health insurance system didn't actually start until the 1960s. People who we're looking at, a lot of this happened while they all have public health insurance. These gains have happened. This uniform shift has been happening in the context of everyone having public health insurance.
Also, in the US, they have Medicare. They have Medicaid for – lower earners do have public health insurance in the US. People who are hurting more are the people in the working poor who don't qualify for the public health insurance but don't get health insurance through the workplace. That's where the gap is in the US. I'm less convinced it’s health insurance. I don't know what it is. There's lots of theories bouncing around. It might be different health behaviours. It might be different things going on. It might be crime and exposure to violent crime. I don't know what's going on. But it's really different in the United States and Canada in that the shift has been more uniform.
We were really happy to see that in results. It gives me a sense that even though there is this difference in life expectancy at least not getting worse over time that everyone's benefiting from the gains in society, that people are living a bit longer at the bottom. That’s, I think, a good thing. But why this was a new and interesting finding is that, again, we kind of knew the left expectancy overall was getting better. What we didn't know was how that varied across different kinds of Canadians. What we learned is there's a fairly big gradient. That eight-year difference between the top and bottom five percent I mentioned, in the US, that's 12 years. It's even bigger in the US, 12 years and getting bigger every year.
Ben Felix: Crazy.
Mark McGrath: You mentioned there's other things that impact longevity. It's not just income, and you've done some research into the relationship between geographic location in Canada and longevity. Can you talk a little bit about the relationship there?
Kevin Milligan: What we see is that the biggest difference when you look at a map. I map this out by the first three digits of your postal code. I'm sitting here in V6T in Vancouver, which actually is one of the highest longevity postal codes in Canada. Lots of rich people live outside UBC, in the neighbourhood there. The income is one part of it. I said, rich people. Income is certainly one part of it. You see that correlated within Vancouver. The poor neighbourhoods tend to have lower life expectancy. The rich neighbourhoods tend to have more. That's one factor you see.
You look at the city level. It’s the same in Toronto, same in Montreal. We look at a bigger map of the whole country. What really jumps out is rural areas have lower longevity. The urban areas have higher. There's a couple things going on. One is the income. Maybe you can afford a nicer house, better access to – for purchase parts of healthcare and a more stable life if you have more income. But my research shows that's not all that's going on because even if you take someone with the same income living in a poor neighbourhood in Vancouver. Imagine you're making 200,000. If you happen to live in a poor neighbourhood versus living in a rich neighbourhood, it cuts five years off your life expectancy to live in the poor neighbourhood.
It’s not just income that’s driving this. This is an emerging area we we're learning more about it. I was at a conference in Paris in June talking about this. Research from Sweden suggests that across different areas, it tends to be correlated with income. You have access to different quality of healthcare. Doctors in Canada, it's all part of a public system, but you get to choose where to locate, and you might have a different client base if you're located in a rich area versus a low area. Maybe you're someone who really has a passion for dealing with people with a whole host of social problems when they walk into your door. Maybe you don't want that. Maybe there's a difference in the kind of doctor who goes here and there, the availability. That's the quality of healthcare.
It can also matter for the access to healthcare. When I look at the rural-urban differences, that's the first thing that comes to mind there. If I'm living in a more rural area, I might have to drive three or four hours to go see a doctor, let alone a specialist. British Columbia has a really big geography. A lot of specialists live here in Vancouver, and so we have a lot of people who would come from Prince George or Fort St. John to come to Vancouver for cancer treatment or something like that. That's a thousand kilometres, man. That's only Prince George. Fort St. John is even farther. That's a real big burden on that. That's another piece of evidence.
There's evidence from the Netherlands that what really drives these differences is healthcare access specifically for chronic illnesses, things like cancer. It might be detected earlier. It might be this easier for you to get treatment if you live in an area that has better access to care. I think that's most likely one of the big things that's going on when we look at these longevity differences is access to quality healthcare is going to be a thing. Even within a public system, you're going to have these differences.
The other thing I'll mention that people think about a lot is the quality of the neighbourhood. People pay more to live in a nicer neighbourhood where nice might be defined as nice leafy trees, good parks, good schools, nice amenities around the neighbourhood. Some argue that those are things that can have a causal impact on your health and your longevity. Taking the same person and being around other neighbours can improve their longevity. People differ on how much they believe that. There are some mechanisms you can imagine. If you see everyone else jogging, then maybe you take up jogging. If you have bike paths and nice parks around you, you might go exercise more. Those are arguments that are possible. Those are plausible.
I'm a bit more skeptical than others that this stuff through osmosis affects me. Some people argue that it's about the stress in your life. That if you are at less stress, of being subject to violent crime, that can just improve the pleasantness of your life. The stress chemicals, cortisol is something. If you get shocks of cortisol every day, you're not going to live as long. These are things that really matter for your long-run longevity. Just live in a less stressful environment. Maybe that's something that helps you.
A lot of stuff in the mix there. Income is certainly going to play a role. My guess based on evidence from the Netherlands, from Sweden is that access to quality healthcare plays a role. Then there's these neighbourhood effects of being around other people who are doing good pro-health kind of things might matter for you.
Ben Felix: Super interesting. What do you think the implications of those findings are for personal financial planning decisions?
Kevin Milligan: I think they're really big. Think of the financial planning stuff. For pensions, it just makes a huge difference if you look at your life expectancy, and people know, “Oh, you know. It's around like 80 years or something, so I'm going to plan for 80.” If you're someone who's in the top 10% of earners, your life expectancy isn't 80 on average. It's going be closer to 90 than 80, and so it really does make a difference. I'm sure good financial planners have known this for a while.
I remember talking to Chief Actuary of the Ontario Teachers’ Pension Plan at one point. He was like, “Here's the thing about teachers. They live forever.” He knew this because he could see in the Ontario Teachers’ Pension Plan how long people were getting their benefits. He couldn't use the StatCan life tables to calculate how much the contributions are, how much the benefits are, whether the pension plan is imbalanced. He had to think about his clientele there at the Ontario Teachers’ Pension Plan.
The same thing for each of us here, we have to think about our own lives. We know there's a sex difference. Women live longer than men. We know that there's a difference in ethnic background that Asians tend to live a bit longer than others. Again, whether that's lifestyle thing, some cultural thing, I don't want to get into that. I don't know, and that gets into some more dangerous territory. But we know on average, that's the case for whatever reason it might be, and so you have to think about yourself.
One trick I've learned is the best way to figure out your own longevity is to look at your same-sex parents. For me, I'm a male. I look at my dad. For my wife, she looks at her mother, her mother's mother. That's the best guess, the best indicator of how long you're going to live is look at your same-sex parent and grandparent as an indicator of just of your genetic heritage of where things are going. Again, whether it's genetics lifestyle, mental attitude, I don't want to get into – I'm not a genetics-only kind of guy. I think a lot of things matter.
Anyway, that's kind of where that goes. It matters for financial planning because if you're retiring at, say, 65, if you are planning for a 10-year horizon versus a 30-year horizon, that makes a huge difference on your span rate and also whether you want to retire at age 65 because whether you can afford it. The other thing that matters for –that's for your own personal financial planning. From a policy point of view, this actually makes a really big difference to thinking about things like the Canada Pension Plan. It's actually moved my thinking about this a bit.
When you think about lower earners, paying in with the same contribution rate as everyone else, but the payback period is much less for them than a high earner. It makes me think about the Canada Pension Plan in a bit of a different way. I'm worried that rather than it being neutral about what kind of earner you are that it might actually pay off more to high earners than low earners. That's something that I don't think we ought to be doing with our public pension plans.
Now, it's not to say that CPP is a bad thing. There's disability insurance in there. It provides a pension for people who don't have one in their workplace. I'm a believer in the Canada Pension Plan as a social policy, but I think we do have to be attentive when we're thinking about the Canada Pension Plan to when we make a change to it to think about, well, what's the payoff period going to be for someone who's going to live to 90 versus someone who might only live to 65 or 70.
Ben Felix: I've thought about that. It feels kind of gross that it's kind of redistributive from lower income people to higher income people because of the distribution of life expectancies.
Kevin Milligan: That goes back to the more fundamental thing that those people are getting 10 more years of life or whatever it might be. Again, you think about the joy you get out of one year of life, and you do that times eight or times 10. The amount of joy you get out of that is just amazing to contemplate and the fact that there's that much difference. Frankly, in Canada, it is what it is at about eight years of bottom versus top. In the US, it’s 12. Man, that's just a huge difference in the quality of life taken over your whole lifespan.
Mark McGrath: That's really fascinating. I wonder, and you probably don't have an answer to this, but do people shift through that distribution over their lifetime? Specifically, with respect to CPP, you might be sort of lower income or living in a rural area for part of your life. But then maybe through promotions or you start a business, you become a high-income earner and move to, say, Vancouver downtown or what have you. I'm just curious if you've thought about, regarding CPP specifically, how you might even manage something like that.
Kevin Milligan: For a lot of thinking about CPP, assuming the average over your lifetime is going to matter for your benefit, and interesting question there is the payoff period for CPP of your longevity. If I move to – here I am in V6T, one of the longest longevity periods. I was joking. My daughter's actually a student here at UBC, and she's living just off campus but in the neighbourhood in an apartment here. I was joking like, “You're going to live to 90 now because you're spending a couple years in V6T.” It's kind of a joke.
But also thinking about the example you just gave, what if there's someone who's done well and retires to V6T? Are they going to benefit from the magic of V6T only living here for four or five years? What years of your life, how many years of your life do you have to live somewhere before you get that benefit of living in a nicer place? I don't know the answer to that, but it's really a deeper question that gets out a bit of this. Is it the income that allows you to buy stuff? Is it the neighbourhood that you're living in and you learn from your neighbours and you benefit from your neighbours? I don't know. One way to get at that is to see where you get this longevity boost of where you live when would help us to address that a bit.
Cameron Passmore: That is wild.
Mark McGrath: Interesting. Thanks.
Ben Felix: Super interesting. All right, Kevin. That's the end of our questions. We really appreciate you coming on. We started off talking about capital gains which was awesome. Your longevity stuff was just too good to pass up, so we appreciate you sticking around to discuss that as well.
Kevin Milligan: I really enjoyed the conversation, so thanks to you.
Cameron Passmore: It's amazing. Thanks, Kevin.
Mark McGrath: Thanks.
***
Cameron Passmore: All right, guys, after show. Awesome. Three others here.
Mark McGrath: It's still funny to me every time.
Ben Felix: It is always funny.
Mark McGrath: It’s fun.
Cameron Passmore: Before we get to – I know you got some community comments, Ben. But you doing okay out there, Mark, on your own?
Mark McGrath: Yes. My family's away. My wife took the kids to Mexico to see my in-laws, my wife's parents, and my son and daughter there, all their cousins and uncles and aunts and everything. They decided to make it a pretty long trip, so they're gone for still another three weeks from the date that we're recording. It’s been really good. I’m getting incredible amounts of sleep. I'm sleeping well. I'm waking up early. I'm eating healthy. I'm exercising every day. I am very productive at work, and it's been good.
But at the same time, the novelty sort of wears off after the first couple of weeks. We've done this before where they've taken a long trip, and so the novelty kind of wears off. You're like, “Okay. I miss you guys. Just come home now, right?” Looking forward to them coming back, for sure.
Cameron Passmore: You got the manuscript off to Dan Solin, right, for Wealthier?
Mark McGrath: I did. I got that off. He reviewed it. He sent some edits. I took his comments and applied them. We are now sending it off to some line editors and indexers. He's got a whole army of people lined up to go through the professional publication process. I know nothing about that, but it's in his hands, and it's moving forward.
Cameron Passmore: Target releases sometime this fall, hopefully.
Mark McGrath: Yes. I chatted with him the other day, and he's thinking probably October. We're originally targeting September, and then I had to do a couple rewrites but still on track for this whole as far as I can tell.
Cameron Passmore: Awesome. What's up in the community here, Ben?
Ben Felix: We had last week's episode with Andrew Chen which was awesome. Roughly a week before his episode came out, I posted about it in the Rational Reminder Community. I posted his papers that we talked about, and I just briefly explained what the discussion was about and just said like, “I think you guys are going to find this super interesting.” It turned into this massive threat in the community about his research and whether factor investing makes sense anymore based on his stuff. It was a really good discussion. Really, really good.
If anyone is nerdy enough, I highly recommend reading that thread. Been further great discussion, including some contributions from Andrew himself in the episode thread for his episode. Since people have actually listened to it now, really great discussion. His research suggests in very simple terms. I mean, you can listen to the episode for the less simple version if you haven't already. In very simple terms, it says that factor investing is probably not a great idea empirically and especially after costs. His research is great. It's a really high quality. He's presented at conferences with John Campbell, another past Rational Reminder guest as one of the discussants, so it's no joke.
Most of the stuff we talk about one unpublished paper. But most of it’s been published in the top journals, as we talked about in the episode. It's great research. I think it's important. I don't think it's a death blow to factor investing, though. People in our podcast community tend to get really excited about new research and want to change everything that they're doing immediately. I made the comment in one of those discussion threads that in the – whatever it is. How many years? Seven years we've been doing the podcast.
Cameron Passmore: Just over six. It's just over six years.
Ben Felix: PWL’s investment philosophy hasn't changed. Our portfolios have not changed in any material way. My personal portfolio has not changed any material way. Anyone that wants to change their portfolio after an episode should probably take a deep breath.
To come back for a second, Andrew's research suggests that factor premiums are roughly zero after costs. I do want to mention on that that that research is assuming the effective bid-ask spread, which Andrew explained to us in the episode, you can think of as assuming aggressive market orders for a small trader who does not have price impact.
Now, if we think about what the firms like Dimensional say that they do really well, one of those things is they're really good at managing transaction costs, which is what Andrew is talking about. Dimensional has research on their own trading costs showing that they're considerably lower than something called the SBBO benchmark. That is the immediately executable price, which is the prevailing bid price for a sell and offer price for a buy. Or sell at the bid and buy at the offer, SBBO.
Dimensional trade price advantage over the SBBO is pretty significant in smaller stocks. It's also pretty big in international stocks. It's really big in emerging market stocks. Those things can be combined, so like small-cap emerging market stocks. Their trade price advantage is substantial. But even in US large caps. There is an advantage that they have over that SBBO benchmark.
Andrew said this during the episode. If you want to pursue these premiums because they still exist a little bit before cost. Just after cost they're gone. If you want to pursue them, cost management is really, really important. I think that's something that Dimensional has always recognized. I don't know the details of a firm like Avantis. I don't know if they do have the same type of research that I was talking about for Dimensional, but presumably, they're doing similar cost management stuff.
The other point that I think is really important is that if Andrew were to reconduct, and I talked to him about this, if he were to reconduct his research using international data over the same period that he looked at, which is post-2005, it's likely that the expected premiums would be all positive after costs. I chatted about this with Andrew over email. There's a paper he referred to in the Journal of Financial Economics showing that premiums internationally have been substantial over the same period where premiums in the US have been small.
But Andrew did explain that could be caused by market frictions like investors having home country bias. If that is the case, you would not expect those non-US anomalies to persist. Andrew is still skeptical. But between real transaction cost from a firm like Dimensional that's focused on cost management and the fact that these premiums have still been pretty strong internationally.
The other interesting thing is that out of Andrew's sample, premiums have been, like in the US, all of a sudden, they've actually been kind of positive again in recent history. There's a lot of interesting questions like that, but I thought it was important to mention this because a lot of people heard the episode or saw my post about it and were like, “Oh, no. Factor investing.” Including you and I, Mark, after we talked to Andrew, when we first finished the conversation.
Mark McGrath: First thing I said was like, “Okay. Well, we're just going back to XEQT or VEQT or whatever.” I guess that just torpedoed.
Cameron Passmore: It's the end of all the years.
Mark McGrath: Ben's entire reason for existing was just blown up live so.
Ben Felix: Mike Green posted on Twitter. What did he say? Mike is pretty happy that we were willing to hear his perspective on something that we had disagreed with in the past. He posted that interview with Andrew Chen and said, “It's been a rough year for the Rational Reminder Podcast crew’s mental models.”
Mark McGrath: He blocked me. I can't see his post, but you'll have to send me a screenshot.
Ben Felix: Oh, Mike. You got to unblock Mark.
Cameron Passmore: Yes. Ask him to unblock him.
Mark McGrath: I don't think I ever interacted with him. I think I just probably harped up index funds enough times that he was just like, “Okay, this guy is deserving of a block.” Mike, if you're listening, I apologize. I don't think I ever talked to you, but please unblock me.
Cameron Passmore: Speaking of Twitter, on Twitter, we all have our Calendly links. I don't know about you guys, but I'm talking to probably three to four people a month, just reaching out for a bunch of different reasons. I got a nice email last week from someone that I spoke to in March, so check out this email.
“Dear, Cameron. I hope this message finds you well. I’m writing to express my sincere gratitude for the time you spent with me in March. Your current insights are incredibly valuable, and I'm thrilled to share some exciting news with you. I've been offered a graduate position with Dimensional, which I start in February, after finishing university at the end of this year. The program is a remarkable opportunity involving a year in portfolio management and a year in trading. I am honoured to have been chosen, especially considering DFA only selects one investment graduate each year.”
This is in Australia, by the way. “Your advice and the Rational Reminder podcast played a pivotal role in helping me decide that this was the area I wanted to pursue. The podcast episodes featuring Brad Steinman, David Booth, Gerard O'Reilly, and David Butler were particularly influential. I listened to them multiple times, taking detailed notes. Their insights significantly assisted me throughout the interview process. Once again, thanks for your invaluable advice and the contributions from the podcast. They have made a profound impact on my career path, and I'm deeply grateful. Best regards, a fellow Cameron.”
Mark McGrath: Awesome.
Ben Felix: Yes. That’s super cool. That is a pretty smart way to prepare for an interview with Dimensional.
Mark McGrath: True.
Cameron Passmore: True, man. Those episodes were all fantastic, so I thought that was really nice.
Ben Felix: No reviews this week.
Cameron Passmore: No reviews. The global treasure in the mids had no reviews this week.
Mark McGrath: Global treasure in the midst.
Ben Felix: If anyone's listening that has not left a review yet, we always appreciate them. They're fun to read.
Cameron Passmore: Especially when you're called a global treasure.
Ben Felix: Yes. In my limited understanding of how the algorithms work for the podcast platforms, the reviews do help people find the show. We always appreciate people leaving reviews.
Cameron Passmore: Any parting thoughts for the three people?
Ben Felix: I gave all my thoughts that I have, I think, for the day.
Mark McGrath: I'm good.
Cameron Passmore: All right. You want to sign off, Mark?
Mark McGrath: Yes. That's it. Thanks, everyone. See you next time.
Cameron Passmore: Talk to you next week.
Ben Felix: See you.
Is there an error in the transcript? Let us know! Email us at info@rationalreminder.ca.
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Participate in our Community Discussion about this Episode:
Papers From Today’s Episode:
‘How Progressive is the Canadian Personal Income Tax? A Buffett Curve Analysis’ — https://utpjournals.press/doi/10.3138/cpp.2021-087
‘The Evolution of Longevity: Evidence from Canada’ — https://onlinelibrary.wiley.com/doi/10.1111/caje.12497
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