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crowley and clemens

Kevin Van Paassen

Reducing corporate income tax to make Canada more internationally competitive and improve the internal incentives for investment, a policy introduced during the Chrétien-Martin era and extended by the Conservatives, is becoming a key issue in the election. The late U.S. senator Daniel Patrick Moynihan famously said that everyone is entitled to their own opinions but not their own facts. Given the importance of business taxes to the election and the country's future economic prospects, it's worth considering some facts.

First, economists of all stripes broadly agree that investment, the foundation for new firms and the expansion of existing firms, is key to job creation and thus lower unemployment.

Second, corporate income tax (CIT) affects investment, a well-established point that is surprisingly contentious in the current debate. According to both theory and the evidence, corporate taxes influence the rate of return that investors receive, and that affects their willingness to invest. Put simply, higher business taxes mean lower rates of return, leading investors to look for other uses for their savings.

Evidence from many sources supports this link between business taxes and investment. For instance, a 2008 Department of Finance paper examined industry-level investment in 43 manufacturing and services industries from 2001 to 2004, a period in which the general CIT rate was reduced from 28 per cent to 21 per cent. The study concluded that lower CIT rates led to higher investment - specifically, that a "10 per cent reduction in the tax component of the user cost of capital is associated with an increase in the capital stock in the 3 to 7 per cent range."

As well, Canadian economist Jack Mintz, the architect of the Liberal business tax reforms, estimates that reductions in CIT rates this year and next will increase Canada's stock of capital (investment) by more than $50-billion and employment by roughly 200,000.

International evidence bolsters these Canadian examples. Indeed, a chief proponent of business tax reduction is the Organization for Economic Co-operation and Development. Its many studies confirming the benefits of lower business taxes conclude that CIT is the highest cost way to raise government revenues because of its negative effects on economic growth and investment. The OECD studies also broadly find that reductions in CIT spur investment and productivity, and that lower rates lead to lower levels of unemployment through higher rates of job creation.

Moreover, increasing CIT rates will not yield the revenue bounty that advocates suggest, since businesses, like people, respond to tax changes by altering their behaviour.

Businesses react to increased CIT rates by using mechanisms such as transfer pricing and by shifting profits into lower-tax jurisdictions. For example, a multinational firm could borrow in Canada, thus increasing its financing costs here, and use the money to finance expansion elsewhere. The result is higher costs (that is, lower profits) in Canada and a shifting of tax liability to other countries.

Not only would an increase in CIT rates not result in the revenues expected, it would also send a signal to investors that Canada is moving away from its commitment to international competitiveness and openness to investment.

Finally, businesses' accumulation of cash reserves has been misinterpreted. Like people, businesses respond to credit crunches by holding as much cash as they can to meet their financial obligations. And it makes sense for firms to plan future business expansion out of such retained earnings, rather than, say, by borrowing. Bank of Canada Governor Mark Carney recently welcomed signs that firms in Canada are making increased machinery and equipment investment.

As citizens wade through the electoral options, it's important to consider the evidence, rather than just rhetoric. Making corporations pay more tax may sound an inviting, low-cost way to fund government spending, but the evidence shows it would have a markedly negative effect on investment and job creation.

If we want to attract more investment that creates jobs, then continuing on the path established by the Chrétien-Martin government, endorsed by the provinces and extended by the Conservatives, is smart policy.

Brian Lee Crowley is managing director of the Macdonald-Laurier Institute; Jason Clemens is a senior fellow.

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