As economics professors, we cannot resist grading Finance Minister Bill Morneau on the package of corporate tax changes announced in this week’s fiscal update.
It’s a B-plus, which is not bad at all. But there’s room for improvement still. Here’s how.
First, the good. Canada had to act, following the big corporate tax rate cut and other changes in the United States earlier this year. Standing pat would have risked a loss of corporate investment and tax revenue to south of the border.
But Mr. Morneau was wise to resist matching the big U.S. tax rate cut, which some in the business community have been calling for. That would have been a mistake.
For one thing, it would be expensive. A rate reduction of 10 percentage points, which some have recently called for, would cost government as much as $15-billion to $20-billion in annual revenue. Replacing that lost revenue would be challenging – it’s the equivalent of a 2-percentage-point increase in the GST or more.
The evidence is clear. If rates were cut, much of the gains would go to shareholders in the form of new dividends and capital gains. And through a quirk of the U.S. tax reforms that we explained in a previous article, it would increase what U.S. companies pay in tax to Washington. None of that helps investment or job creation in Canada.
This reality is playing out in Washington now, where the federal deficit recently surpassed an astonishing US$100-billion a month – an unparalleled amount for an economic boom. That’s partly a result of the corporate tax cuts enacted there.
Our mothers often told us, “If Johnny jumped off a bridge, would you do it too?” The same holds for fiscal cliffs. Canada should avoid copying such irresponsible fiscal policy.
Mr. Morneau instead chose to target a temporary tax cut to firms making new investments. Manufacturing companies will be allowed to write off equipment purchases immediately, matching another feature of the recent U.S. reform.
Other industries and other assets will also receive tax breaks in the first year of acquisition, unlike in the United States, albeit to a lesser degree than manufacturers.
That is smart policy, because it targets job-creating investment at a lower overall fiscal cost. Based on our estimates, it will reduce the cost of investment for the average manufacturer by about 7.3 per cent, and the average of other companies by 4.3 per cent.
That will help investment throughout the economy. And based on the government’s estimates, the fiscal cost will be fairly modest – about $3-billion annually.
But it could be better. The new write-offs still favour “old economy” investments in manufacturing equipment more than the investments in computers, buildings and corporate acquisitions that tend to drive innovation in the new economy.
There’s no reason for that. A good tax policy treats all sectors and all investments equally, ensuring that capital goes to the more productive uses in the economy. Here too, there is no reason for Mr. Morneau to copy the bad policy choices of the U.S. government.
While helping business make new investment is good, Mr. Morneau has missed an opportunity to tackle another challenge of modern business taxation. Canada should do more to stop companies from shifting profits abroad to avoid paying taxes here.
Not all tax breaks are created equal. Our current system offers too many opportunities for corporate tax avoidance. The result is erosion of our tax base, loss of revenue and unfair advantages to multinational companies at the expense of smaller domestic firms.
For example, multinational companies can borrow from related companies located offshore. The interest payments are tax deductible in Canada. If the income is received by a company in a tax haven, then the underlying profit can escape taxation anywhere in the world.
Canada’s approach to dealing with this problem is outmoded. The OECD has called on countries to limit interest deductions. Countries in Europe have already moved to do so and that’s also part of the new U.S. tax system.
Canada has been slow to act, and that should change now. If businesses are to receive the same investment tax breaks as the United States is now offering, then they can accept some of the same restrictions on profit shifting, too. A limit on interest deductions is the right place to start.
Excessive borrowing is not just a problem with multinational companies. Because interest is fully deductible, but the cost of equity finance is not, all companies have an incentive to use debt to avoid tax. That increases systemic risk in our financial system.
Now that Canada will allow immediate write-offs for many investment costs, there’s no reason to allow firms to deduct the cost of borrowing for investment too. That’s a double dip that leads to inefficient subsidies to some investments through the tax system. Interest deductions should be limited for both foreign-controlled and domestic companies.
If Mr. Morneau is bold, he will go even further. The time is right for Canada to look at a more fundamental reform that would leapfrog the United States and restore our competitive advantage.
We should replace our corporate tax with a new system called “rent taxation” that would avoid taxing new investment decisions altogether, while maintaining high taxes on outsized earnings, and eliminating incentives to borrow excessively and shift profit abroad.
There is more than one way to achieve rent taxation. One straightforward approach is to eliminate interest deductions altogether, while giving full write-offs to all capital expenditures. This would give the maximum benefit to new investments at minimum cost in foregone tax revenues. Taxes would no longer impede business productivity, as they often do today.
U.S. corporate tax reform poses a challenge for Canada. But it is also an opportunity to make a bold but sensible change to how we tax business.
So, well done, Mr. Morneau. The proposed reforms are a step in the right direction – and you avoided the most important pitfalls. But we can see ways to improve in your next test, at budget time. Keep up the good work!
Ken McKenzie and Michael Smart are professors at the Universities of Calgary and Toronto, respectively. Ken McKenzie is also a Fellow-in-Residence at the C.D. Howe Institute. This article is based on a forthcoming Commentary to be published by the C.D. Howe Institute.