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Note to subscribers: The Tax & Spend newsletter will return on Aug. 16.

In the debate over income inequality, many have argued that it’s not that much – or at least not as much – of a problem in Canada.

A superficial glance at the top earners in Canada seemingly backs up that view. In 1998, the top 1 per cent of Canadians accounted for 10.2 per cent of total incomes. By 2018, the 1 per centers’ share of income actually edged down, to 10 per cent. By contrast, says University of Toronto economics professor Michael Smart, the top 1 per cent of U.S. earners saw their share of income jump to 19 per cent from 16 per cent in that same time.

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Leave it at that, and you might conclude that rising income inequality isn’t really a concern in Canada. But Prof. Smart argues in a new analysis on FinancesoftheNation.ca that there is something else at work that is obscuring a rise in the earnings of Canadian 1 per centers: a years-long surge in small business incorporation.

Prof. Smart notes that official statistics are based on the amounts that Canadians report on their income tax forms. But if a high-earning Canadian opts to set up a corporation and declares business income instead, that reduces their personal income. So, it might appear that the 1 per center in question had stagnant or declining income – but that would only be true because some of that income was sheltered out of view, inside a corporate structure.

This is a “sign of a growing problem with tax avoidance by high-income Canadians,” writes Prof. Smart. (And of course, tax avoidance is distinct from tax evasion, which is illegal.) According to his analysis, the number of Canadian-controlled private corporations nearly doubled between 2002 and 2018, rising to 2.6 million from 1.5 million. Similarly, 46 per cent of self-employed Canadians were incorporated in 2018, up from 36 per cent in 2002.

Driving this trend is the yawning differential in the rate of small business taxation, on average 12 per cent across Canada, and the top marginal personal rates, which can exceed 50 per cent. It pays to incorporate, and at least defer taxes.

“People are using their business as a massive open-ended RRSP,” Prof. Smart said in an interview.

But there are concerns that deferral of taxes may turn into permanent avoidance. Prof. Smart said that he’s concerned that the recently enacted Bill C-208 – the locus of much controversy this month – opens up opportunities for small business owners to pull out income from their corporate structures as capital gains, a practice known as surplus stripping. Billions of dollars in tax revenue are at risk, Prof. Smart said.

Policy makers face a clear choice: either close the loopholes in C-208 and other parts of the tax code, or close the gap in taxation rates of small businesses and the top marginal rates for individuals, he said. “If we can’t shut down the loopholes, it does call into question whether we can tolerate these low rates.”

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Taxing questions

Responding to a recent newsletter item about the Parliamentary Budget Officer’s fiscal outlook for the federal government and the provinces, Joe Polito of Toronto inquired about what labour-market assumptions underpinned the PBO analysis. “The projections suggest labour shortages which lead to increases in productivity. Am I missing something?”

Indeed, Mr. Polito is spot on with his observation. The PBO supplied its projections for its long-term fiscal outlook, stretching to 2095. Those figures show a gradual decline in both the participation rate (those employed or unemployed, as a percentage of the labour force population) and the employment rate (the proportion of the labour force that is working). Interestingly, the PBO forecast assumes that both measures have already peaked. The participation rate is forecast to have peaked in 2004, at 67.5 per cent, with the employment rate topping out at 63.2 per cent in 2007, just ahead of the financial crisis.

Over the next few decades, the PBO predicts continual declines in both measures. In 2045, the participation rate is forecast to hit 61.3 per cent, pushing it below the previous lowest level on record, in September, 1976. It will take decades longer – until 2085 – for the forecast employment rate to reach a historical low of 55.9 per cent, falling below the level of June, 1982. (Both of those date references disregard April and May 2020, when the pandemic violently but temporarily distorted labour markets.)

Then, the labour market keeps on shrinking, until 2095 when the participation rate hits 58.8 per cent and the employment rate declines to 55.6 per cent. Those trends, the PBO predicts, will be driven by the ageing of Canada’s society, primarily, reflecting a future where there are a growing number of retirees for each worker. The PBO says it assumes a long-term average unemployment rate of 5.4 per cent. One caveat: the PBO projections don’t take into account whatever lift a national child care system might provide to participation rates.

So, to Mr. Polito’s supposition about tight labour markets: The answer is a resounding yes. That should, over the long term, put steady upward pressure on wages, and create incentives for businesses to increase productivity, including by making capital investments that reduce the need for labour.

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Line Item

Take it or leave it: University of Waterloo economics professor Mikal Skuterud notes in a recent tweet that the clamour for provincially funded sick leave in Ontario hasn’t yet translated into demand for the actual program. The program, passed in late April, allows employers to claim reimbursement for up to $600 (up to $200 each for up to three days) for absences related to the coronavirus, including for vaccination, testing or illness. But according to the provincial government’s statistics, there have been relatively few claims to date: just $11.3-million claimed by employers for emergency leave paid to 39,887 employees. That averages out to 1.8 days per employee, and an average claim value of $154 a day.

Follow me on Twitter, @PatrickBrethour or ask your Taxing Question here.

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