This Selected Issues paper reviews empirical evidence on the main determinants of the real bilateral exchange rate between the Canadian and the U.S. dollars, with particular emphasis on the role played by cyclical and longer-term economic factors. The paper aims to identify the nature of the shocks that have contributed to the recent downward trend in the Canadian dollar. The analysis shows that fluctuations in the real bilateral exchange rate can be explained reasonably well by its long-term fundamentals. The paper also analyzes inflation and the natural rate of unemployment in Canada.


This Selected Issues paper reviews empirical evidence on the main determinants of the real bilateral exchange rate between the Canadian and the U.S. dollars, with particular emphasis on the role played by cyclical and longer-term economic factors. The paper aims to identify the nature of the shocks that have contributed to the recent downward trend in the Canadian dollar. The analysis shows that fluctuations in the real bilateral exchange rate can be explained reasonably well by its long-term fundamentals. The paper also analyzes inflation and the natural rate of unemployment in Canada.


1. On March 16, 1996, the Canadian government established a Technical Committee on Business Taxation to analyze taxes related to investment and business activity and to recommend changes. The Committee was asked to consider ways of improving, in a revenue-neutral way,2 the business tax system to promote: (i) job creation; (ii) economic growth; (iii) simplification and ease of compliance; and (iv) fairness. The Committee also was charged with examining the interaction between business taxes—including corporate income, capital, and payroll taxes—and taxes paid by individuals on investment income. The Technical Committee’s report was released to the public on April 6, 1998. This note briefly summarizes the state of business taxation in Canada and reviews the recommendations presented in the report.

A. Business Taxation in Canada3

2. The overall business tax environment includes corporate income taxes, payroll taxes, taxes on capital, and selected aspects of the personal income tax, particularly the taxation of dividends and capital gains. It also includes various tax preferences (credits and deductions) that tend to lower the effective corporate income tax rate relative to the statutory rate. In general, corporate income tax rates in Canada vary according to a firm’s size, its production activity, and its provincial location.

3. The federal corporate statutory income tax rate is 28 percent for general business income. However, a number of statutory tax preferences offer reductions from the general rate. Small domestically owned incorporated businesses, or Canadian-controlled private corporations (CCPCs), qualify for a rate reduction of 16 percentage points (to 12 percent) on the first $200,000 of taxable income. For income in excess of the small-business threshold, the general federal rate is reduced by 7 percentage points (to 21 percent) for income derived from manufacturing and processing. The provinces also frequently grant reductions in provincial corporate income tax rates for small businesses and in some cases for manufacturing and processing activities. When both federal and provincial rates are considered, there is significant variation in statutory tax rates on corporate income across Canada. Small business income earned in Newfoundland, for example, faces a 12 percent federal tax together with a 5 percent provincial tax, while general business income earned in New Brunswick faces a 28 percent federal tax along with a 17 percent provincial tax (see tabulation below). Federal and provincial governments also levy an annual tax of 0.225 percent on the paid-up capital of Canadian corporations.

4. Tax credits restrict the size of the corporate tax base by crediting certain corporate expenditures against the general corporate tax obligation. The current tax code grants tax credits, for example, for certain expenditures on research and development, for investment in eligible depreciable property used in Atlantic Canada, for certain exploration expenditures, and for certain contributions to registered political parties.4 Moreover, tax credits not used in the current tax year may be carried forward.

Federal and Provincial Corporate Income Tax Rates, 1998

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Source: Report of the Technical Committee on Business Taxation (1998).

In addition, a federal surtax is imposed raising the general business rate to 29.12, the manufacturing and processing rate to 22.12, and the general small business rate to 13.12.

5. A variety of income exemptions and deductions also reduce the size of the corporate tax base and increase complexity. These include an additional deduction from taxable income for certain exploration and development expenditures; deductions of corporate charitable giving; deductions of gifts to the Crown; and deductions of interest on loans for small business financing. The rules governing corporate income tax deferrals also affect the size of the tax base and potentially affect the amount and timing of capital expenditure decisions. Certain business investment losses may also be deducted from current income.

6. Payroll taxes in Canada include employment insurance premiums, Canada Pension Plan (CPP) contributions,5 workers’ compensation premiums, the provincial health/post-secondary education tax levied by some provinces, and general payroll taxes collected by some provinces.6 The structure and level of payroll taxes vary considerably across provinces and, with the exception of workers’ compensation, taxes paid across firms are hot closely linked to potential benefits received.

7. The individual income tax treatment of dividends and capital gains can affect the flow of financing for corporations and thus alter business investment decisions. Three-quarters of net capital gains, beyond a $500,000 lifetime exemption for farms and small corporations, are taxed as personal income. Gains realized from the sale of a principal residence are fully exempt, as are gains from the sale of certain personal property worth less than $1,000. Dividend income accruing to resident taxpayers from taxable Canadian corporations has been granted partial tax relief for several decades. This relief occurs through a gross-up and credit under the personal income tax. The gross-up and credit has been adjusted periodically with a view to maintaining rough parity in the tax treatment of small corporations and unincorporated businesses. Dividends are currently grossed-up by 25 percent and this grossed-up amount is taken into taxable income. The federal “basic tax” is then applied to personal income including grossed-up dividends, before the federal tax is reduced by a credit equal to 13.33 percent of the grossed-up dividend. When provincial taxes are taken into account, the net effect is to offset the double taxation of corporate source income accruing to individuals by roughly 50 percent for public companies and 100 percent for private corporations.

B. April 1998 Report of the Technical Committee on Business Taxation

8. The Committee reached a number of conclusions regarding the deficiencies of the current system of business taxes. First, combined federal-provincial corporate income tax rates, which average 43 percent, are higher than comparable rates in Canada’s major trading partners. High corporate tax rates on non-manufacturing activities, in particular, tend to discourage business operations in Canada. Second, the relatively high variation in corporate tax rates across provinces and across industries exacerbate economic inefficiencies and unfairness, and increase compliance costs. Third, Canada’s growing reliance on profit-insensitive business taxes (capital, property, payroll, sales, excise, and other non-profit business taxes) also exacerbate inequities and inefficiencies.

9. Broadly, the Committee recommends a number of steps to move closer to a neutral business tax system (one that does not alter investment or financing decisions), which would enhance efficiency, promote fairness, and improve competitiveness internationally. The Committee’s recommendations include: (i) lowering corporate income tax rates toward international norms while broadening the tax base; (ii) altering certain profit-insensitive taxes so that these fall more heavily on those deriving associated benefits (the user pays principle); (iii) reducing compliance costs and improving tax enforcement; and (iv) enhancing the coordination and disentanglement of federal-provincial corporate tax policies.

10. By lowering the corporate income tax rate and broadening the base, overall tax-based disincentives to business activity could be reduced while also mitigating tax-induced distortions in resource allocation. The Committee notes that lowering the average federal-provincial corporate income tax rate to 33 percent for large businesses would be expected to ensure the system’s international competitiveness. Thus, the Committee proposes that the general federal corporate income tax rate be reduced from 28 percent to 20 percent and that provincial corporate income taxes be reduced on average by 1 percentage point to 13 percent. Revenue neutrality would be maintained through the elimination of certain tax preferences, credits, and deductions. Preferences for small businesses would be retained, but with some modifications, including incentives for companies to increase employment.

11. The Committee also recommends that a closer correspondence be established between the level of certain profit-insensitive business taxes paid by firms and the economic benefits these firms receive from public goods or services, or the costs they impose on society (the user pays principle). Recommended measures include adopting experience-weighted employment insurance (EI) premiums for employers, under which employers with a history of fewer layoffs would pay lower EI premiums, and restructuring the federal fuel excise tax to include other pollutants in the tax base to ensure that the cost of environmentally damaging activities is borne, at least in part, by the responsible agent.

12. Measures recommended to enhance compliance and strengthen enforcement include: (i) harmonization of the structure and administration of certain federal and provincial business taxes—notably capital taxes; (ii) revised procedures for drafting tax legislation to enhance clarity; (iii) new mechanisms enabling Revenue Canada to apply sound commercial practices to settle disputes and collect assessed taxes; and (iv) provisions to expand civil penalties to include tax advisors and promoters of tax-related advice deemed to be grossly negligent.

13. In order to promote further tax cooperation and disentanglement between federal and provincial business tax policies, the Committee makes three principal recommendations. First, federal and provincial governments are encouraged to work toward using common, neutral corporate income and capital tax bases. Second, federal and provincial governments should extend the existing federal-provincial tax collection agreement to capital taxes, and to include all provinces. Finally, capital taxes should not be deductible from the corporate income tax base in order to eliminate an incentive for one level of government to expand its capital taxes. The provinces are also urged to enact an offsetting reduction in corporate income and capital taxes as base-broadening measures take affect.

List of References

  • Department of Finance, 1998, Government of Canada: Tax Expenditures, (Ottawa).

  • Cole, Jeffrey and Michael Leidy, Business Taxation in Canada,Canada—Selected Issues, International Monetary Fund, SM/97/3, January 15, 1997.

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  • Lin, Zhengxi, Garaett Picot and Charles Beach, 1996, “The Evolution of Payroll Taxes in Canada,Working Paper No. 90, Statistics Canada (February).

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  • Report of the Technical Committee on Business Taxation, (Ottawa) 1998.


Prepared by Michael Leidy.


“Revenue neutral” implies that the proposed changes would have no effect on overall revenues from all sources of business taxation.


This section draws on Cole and Leidy (1997). An overview of the corporate income tax system is presented in Department of Finance (1998, Chapter 5) and the Report of the Technical Committee (1998, Chapter 2).


Tax credits are discussed in detail in Department of Finance (1998), pp. 81–88.


The province of Québec has its own separate pension plan that is roughly comparable to the CPP. Residents of Québec have the option of participating in either the CPP or the Québec Pension Plan.


Lin, Picot, and Beach (1996) present a comprehensive review of developments in Canadian payroll taxes since 1961.