Fred O'Riordan is national leader, tax policy, Ernst & Young LLP.
Last month, the United States enacted the most sweeping package of legislative changes to its tax code in more than 25 years. How these changes on balance will impact the U.S. is subject to debate. What is less debatable, however, is the impact they will have on Canada.
The most notable element of the new U.S. tax law is a reduction in both corporate and personal tax rates – the former on a permanent basis and the latter temporarily through 2025. Many expect the changes will have a stimulative effect on U.S. economic growth, inbound investment and job creation. Others express concern about their effect on federal deficits, the national debt and the after-tax distribution of personal income.
To the extent that the changes spur the U.S. economy, Canada will share some of the benefit through increased exports owing to the integrated nature of the two economies and access to the large U.S. market through the North American free-trade agreement. This access remains threatened by stalled NAFTA renegotiations. But elements of the U.S. tax reform may actually pose a more significant economic threat to Canada's tax competitiveness.
A company's decision to invest is very sensitive to the rate of return on capital. Other things equal, capital flows into jurisdictions where its rate of return is highest. Taxes imposed on businesses reduce the rate of return and affect both the amount and location of investment undertaken. Since 2000, Canadian federal and provincial governments have gradually reduced business taxes to attract investment, primarily by implementing staged reductions in corporate tax rates, eliminating taxes on capital and reducing taxes on business inputs. A measure of the effectiveness of this tax-policy strategy is that, in spite of the rate reductions, corporate-tax revenues continued to increase and the ratio of corporate taxable income to gross domestic product (GDP) remained stable. Canada is not unique in regard to this policy direction. It is consistent with a global trend among many Organization for Economic Co-operation and Development and G7 countries, the most notable exception being the United States. Until now, that is.
The U.S. federal corporate income tax rate has now fallen from 35 per cent to 21 per cent, compared with the Canadian federal rate of 15 per cent. More importantly, the average combined federal/state corporate rate in the United States has fallen from 39.1 per cent to 26 per cent and is now below the average combined Canadian federal/provincial rate of 26.7 per cent – completely eliminating Canada's competitive tax advantage.
A useful measure of this erosion in Canada's competitive position, more informative than a simple statutory-rate comparison, is a comparison of the marginal effective tax rate (METR) on new business investment between the countries.
The METR, which was developed by Phil Bazel and Jack Mintz of the University of Calgary's School of Public Policy, includes not only the corporate tax rate but also deductions and credits associated with purchasing capital goods and other taxes paid by the corporation. The METR measures the extra return on investment necessary to pay these taxes and maintain the same total return or, put differently, the share of the gross-of-tax rate of return on a marginal unit of capital needed to pay the business taxes on that capital.
Canada's METR has been lower than the United States' since 2006. This has been tremendously beneficial to Canada, influencing not only where businesses choose to locate but, for those multinational firms with significant cross-border operations and activity, where to place their highest-value functions and thereby report and pay the associated proportion of their corporate taxes in the lower tax jurisdiction.
U.S. tax reform has sharply reduced the country's METR from 34.6 per cent to only 18.8 per cent compared with Canada's 20.3 per cent. Disaggregated by industry, Canada's relative tax-competitive advantage has been completely reversed in favour of the United States in all but two sectors.
Although labour is less mobile than capital, the impact of U.S. personal tax reform is as threatening to Canada's competitiveness as corporate tax reform.
To illustrate, Ontario's top combined federal/provincial marginal tax rate of 53.53 per cent applies on employment income above $220,000. At the equivalent employment income level of $176,000 (U.S.), California's combined individual federal/state marginal rate for a single filer is only 41.3 per cent, making Ontario's rate almost 30 per cent higher. California's top combined marginal rate of 50.3 per cent is also lower than Ontario's and it only kicks in for income over $1-million (about $1.25-million Canadian). The comparison is even worse at the $100,000 (Canadian) income level, where Ontario's combined rate of 43.41 per cent is 12 percentage points or 38 per cent higher than California's combined individual rate of 31.3 per cent on a single filer.
Retaining and attracting the best and brightest talent is a top priority for Canadian companies to maintain their competitiveness. As part of its Economic and Innovation Strategy, the federal government launched a Global Skills Strategy in June, 2017, to streamline entry requirements and help Canadian firms source international talent in a more timely and efficient manner.
Whatever its merits, streamlined entry isn't likely to persuade top Silicon Valley talent to pull up stakes and move to Ontario, where the mercury dips below freezing much of the year and where the government takes more of your salary over $220,000 than you get to keep for yourself. The gravitational pull for this scarce talent is very much in the opposite direction. Furthermore, it is being pushed there in part by our tax policy running counter to the objectives of our immigration policy instead of being aligned with them.
As in the United States, it has been more than a quarter of a century since the last major tax review and overhaul took place here in Canada. The time has come for an appropriate policy rethink and response here to events there.