Reforming the Tax Cut Agenda

Transcription

1 Reforming the Tax Cut Agenda Jack M. Mintz* ABSTRACT The strategy to cut taxes should be accompanied by tax reform. There is a need to remove ineffective incentives and to make the tax system more efficient and fair. Tax bases should therefore be broadened and tax rates reduced. This is altogether more necessary given the rapid changes that the economy is now experiencing. Business inputs are more mobile today, and technological changes are constantly occurring. A tax system that interferes with entrepreneurial decision making imposes significant costs on the economy. This paper was written before the spring 2000 budgets of federal and provincial governments. Some of the recent changes adopted in those budgets lower personal and corporate income tax rates, lower capital gains tax rates, and a better treatment of stock options are outlined as proposals in this article. However, tax reform that would lead to a better tax structure still needs to be put on the political agenda. INTRODUCTION The opportunities for growth-enhancing public policies in Canada will soon have been squandered if federal and provincial fiscal planning continues along the lines that governments have pursued in the past few years. The current budget strategy spending fiscal surpluses, generated from taxes paid by Canadians, on new program expenditures or incremental tax cuts has a built-in bias of addressing problems in small steps rather than aggressively tackling the most critical problems in the fiscal system. Politicians are reluctant to cut back expenditures associated with existing inefficient programs or to eliminate ineffective tax incentives. This is most unfortunate. Instead of cutting taxes incrementally, there is a golden opportunity to undertake significant reform of the tax system, made politically acceptable by overall tax cuts. Tax reform should be on the agenda for governments today, and there is good reason to believe that it is urgent to deal with tax reform soon. The past decade was an important lesson for Canada. Economic growth was abysmal as per capita income scarcely grew in real terms. While most other * Of the C.D. Howe Institute and the Rotman School, the University of Toronto. 689

2 690 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE industrialized countries, including the United States, enjoyed much higher growth in incomes, Canada was burdened with high unemployment, high debt, and high taxes. To their credit, federal and provincial governments have virtually eliminated deficits. But this was the political price paid for fiscal mismanagement of previous years. As demonstrated by our turnaround in the late 1990s, good old-fashioned economic policies in the mid-1990s, particularly those related to fiscal and monetary discipline, can result in better times. We are now enjoying much lower interest rates, a lower burden of government debt, and better prospects for economic growth in the next decade. However, Canadians cannot sit back. We are witnessing a revolution in the business world resulting from the growth of information technology. The United States has embraced information technologies as part of business organization more quickly than we have. US per capita income has grown faster than ours in the past 10 years each person in Canada now has almost US $9,000 less in after-tax income compared to an American. For a family of four, that amounts to over US$35,000. As a result of its economic growth induced by information technology, the United States is drawing the very best talented individuals and businesses from all over the world. Being closest to the United States not just geographically but also culturally, Canadians especially are being attracted to work in this dynamic market. For Canada to enjoy sustained economic growth in future years, it must put into place policies that create opportunities for businesses to locate in Canada and for Canadians to work at home. Tax policies are important levers that can be used to maintain Canadian competitiveness and create opportunities for a rising standard of living for all Canadians. However, our tax system imposes major impediments that create significant disadvantages, rather than advantages for economic growth. We must address these issues head on in the near future if we wish to take advantage of economic opportunities available not just now but also down the road. Below, I will outline the most significant problems in Canadian tax policies that raise barriers to economic growth. I will then propose some major solutions to these problems, all of which entail substantial tax reform measures. I will conclude with comments on why the current policy process is woefully inadequate to achieve the best results available to Canadians. TAX IMPEDIMENTS TO GROWTH The most important role of government in the future economy will be to provide public goods and services needed to support economic growth and to enable Canadians to enjoy the opportunities offered by new technological development. Taxes are needed to pay for public programs and services, but the burden of taxes is minimized if governments spend efficiently on programs that are critical for carrying out their responsibilities. Further, economic growth is enhanced if the tax system is efficient and as simple as possible, so as to minimize administrative

3 REFORMING THE TAX CUT AGENDA 691 and compliance costs. Most important, growth in incomes for Canadians creates the political support necessary to make sure that the tax system is fair that tax burdens are similar for individuals in similar circumstances (horizontal equity) and tax burdens are less for those with fewer resources to pay taxes (vertical equity). Public programs and the progressive tax system provide a mechanism for all Canadians to share the gains arising from economic growth. This paper is not focused on public expenditures and the level of taxes imposed on Canadians to pay for these programs. Instead, it is directed at understanding how the current tax structure that is, the mix of taxes and the structure of individual taxes raised to provide a given level of revenue creates barriers to the realization of opportunities for economic growth. For countries to grow, four factors are important to improve productivity (defined here as the value of income derived from goods and services produced from the available resources): 1) The stock of capital machinery and structures, and capital inputs must grow if the economy is to produce more. 2) Growth in incomes is realized if people are willing to work and acquire the skills needed in businesses that offer high value-added jobs with good incomes. 3) Entrepreneurship and risk taking will improve opportunities for growth. 4) Finally, countries must be innovative and ready to adopt new technologies in today s increasingly integrated world economy. I will review the most serious tax impediments to economic growth in relation to these four factors. Investment in Capital Growth resulting from investment depends on savings provided by Canadians and foreigners. Gross private and public capital formation in Canada in 1996 was about the average of major OECD countries at 17.5 percent (see table 1). Canada s net national savings rate in 1997 was 5.2 percent of gross domestic product (GDP), sharply lower than that of many other OECD countries (as shown in table 1) and lower than that of the United States. 1 Canada s investment in machinery lags behind that of many other countries, and the business capital to labour ratio is also relatively low compared to that of most other countries (table 1). Taxes have a significant impact on investment and productivity. High corporate taxes on the return to capital will discourage investment. As shown by recent studies using panel data describing the investment patterns of individual businesses, a percentage point increase in the cost of capital induced by 1 Savings are typically measured as the difference between income and consumption. As GDP calculations do not include accrued capital gains in income, the savings:gdp ratio tends to be understated.

4 692 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE Table 1 Investment and Saving Rates of Selected Industrialized Countries, 1996/1997/1998 GDP per capita Gross capital Gross Business Net national (1998 PPP) formation machinery capital/ savings rate $00 as % of GDP investment labour ratio as % of GDP United States a b 7.0 Switzerland Denmark a Canada Japan a Netherlands Germany Ireland France Italy Sweden United Kingdom a a Figure taken from latest year available. b Available on net basis only. Sources: Organisation for Economic Co-operation and Development, OECD in Figures: Statistics on the Member Countries, 1998 Edition, and OECD in Figures: Statistics on the Member Countries, 1999 Edition, Supplements to The OECD Observer, various tables. taxes would reduce investment in the range of 0.05 to 1.7 percentage points. 2 Over time, the loss in capital stock and output could range from 0.25 percent to 17.0 percent. Thus, a major barrier to investment in Canada is the business tax system, which results in taxes on capital that are far too high relative to those in most other countries. As shown in figure 1, Canada s statutory corporate income tax rate is higher than that of other industrialized countries. Statutory corporate income tax rates in themselves do not, however, provide the whole picture with respect to taxes on capital. High statutory tax rates have two important effects. First, companies facing high statutory tax rates will invest less, all else being equal under the tax system. Second, companies in high-tax jurisdictions are more likely to shift income to low-tax jurisdictions, thereby reducing the amount 2 In a Canadian study, investment elasticities, defined with respect to the user cost of capital, varied by 0.05 to 1.7 depending on the industry. See Robert S. Chirinko and Andrew P. Meyer, The User Cost of Capital and Investment Spending: Implications for Canadian Firms, in Paul Halpern, ed., Financing Growth in Canada (Calgary: University of Calgary Press, 1997), See also Kenneth J. McKenzie and Aileen J. Thompson, Taxes, the Cost of Capital, and Investment: A Comparison of Canada and the United States, Working Paper 97-3 (Ottawa: Department of Finance, Technical Committee on Business Taxation, 1997). Using industrylevel data, McKenzie and Thompson found that higher taxes in Canada relative to those in the United States reduced Canada s investment rate relative to that of the United States.

5 REFORMING THE TAX CUT AGENDA 693 of corporate income tax collected by a government. 3 Income shifting does not require a company to move its operations. Probably the most mobile tax base in today s global economy is reported income of a corporation. The overall impact of the corporate tax system also depends on other statutory provisions, such as depreciation allowances and investment tax credits under the corporate income tax, capital taxes, and sales taxes on capital inputs. Taking into account the most important corporate tax provisions, among major OECD countries Canada imposes the highest effective tax rate on capital invested in service industries (figure 2) (including transportation, communications, utilities, trade, and business and other services). It also imposes one of the highest effective tax rates on capital in manufacturing (figure 3) 4 by comparison with other major OECD countries, many of which have recently undertaken significant business tax reforms. These high effective tax rates on capital affect the willingness of companies to invest in Canada rather than in foreign jurisdictions with comparable public services, political stability, and economic development. With less capital investment, businesses will hire fewer workers and pay less income. Thus, the corporate tax reduces not only capital investments but also the incomes of Canadian workers, especially with increasingly mobile capital. Without a doubt, federal and provincial corporate tax policies will create a significant barrier to economic growth in the future if they maintain their current focus and direction. The business tax system is one barrier to economic growth. Another is Canada s taxation of savings. The low Canadian savings rate contributes to a lower domestic ownership of assets and, to a certain extent, less capital investment when savings result in a higher cost of funds for businesses. 5 The tax system also discourages savings by imposing high personal tax rates on interest, dividends, and capital gains. The high marginal personal tax rates affect a wide range of incomes in Canada. Federal and provincial personal income taxes, 3 For example, a multinational company would shift income by placing debt in the high-tax jurisdiction to finance worldwide operations. See Vijay M. Jog and Jiamin Tang, Tax Reform, Debt Shifting and Tax Revenues: Multinational Corporations in Canada, International Tax and Public Finance (Kluwer Academic Publishers, forthcoming). 4 See also Jack M. Mintz, Why Canada Must Undertake Business Tax Reform Soon, Backgrounder (Toronto: C.D. Howe Institute, November 4, 1999). 5 Empirical studies show that, while Canada is certainly an open economy, it is not small. In a small open economy, investment does not depend on domestic savings rates since the cost of capital is largely determined by the availability of foreign savings from the international market. However, many financial studies suggest that the cost of equity finance will be somewhat influenced by Canadian domestic savings, and not solely dependent on international factors. See, for example, Usha R. Mittoo, Seasoned Equity Offerings and the Cost of Equity in the Canadian Market, in Halpern, supra footnote 2, ; and Kenneth J. McKenzie and Aileen J. Thompson, The Economic Effects of Dividend Taxation, Working Paper 96-7 (Ottawa: Department of Finance, Technical Committee on Business Taxation, 1996). The availability of savings clearly affects small business investment.

6 694 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE Figure 1 Statutory Corporate Income Tax Rate, Intention in Year Effective tax rate (%) Canada a US UK Germany France Italy Japan Sweden Ireland Australia Country a The rate shown for Canada excludes the manufacturing and processing tax credit. Source: Various issues of Tax Notes International. Effective tax rate (%) Figure Effective Tax Rate on Capital Investment in Service Sector, Intention in Year Canada US UK Germany France Italy Japan Sweden Ireland Country Source: Calculations by International Tax Program, Institute of International Relations, University of Toronto. clawbacks of child benefits, the goods and services tax (GST) credit, and other supplementary income and other provisions in the tax system result in very high marginal tax rates on interest income, sometimes well over 50 percent for levels of income above $25, Dividends and capital gains are subject to tax in 6 See Jack M. Mintz and Finn Poschmann, Tax Reform, Tax Reduction: The Missing Framework, Commentary no. 121 (Toronto: C.D. Howe Institute, February 1999).

7 REFORMING THE TAX CUT AGENDA 695 Figure 3 30 Effective Tax Rate on Capital Investment in Manufacturing Sector, Intention in Year 2000 Effective tax rate (%) Canada US UK Germany France Country Italy Japan Sweden Ireland Source: Calculations by International Tax Program, Institute of International Relations, University of Toronto. ranges that easily exceed 30 percent and are often over 50 percent for middle income earners. While certain retirement savings are exempt, 7 there are limits to the amount of income from savings that can be sheltered from tax. Thus, most marginal savings are subject to exceptionally high rates of tax. Further, the lack of adjustments for inflation imposes even higher effective tax rates on savings than those reported above. For example, even at a low inflation rate of 2 percent, for a bond that yields 5 percent interest, the inflationadjusted rate of return is only 3 percent. Since the tax falls on interest without adjustment for inflation, a marginal tax rate of 50 percent on the 5 percent yield turns into an unbelievably high marginal tax rate of 83 percent on the inflationadjusted interest yield of 3 percent. Canadian taxes on investment and savings are excessive, and they discourage capital formation and domestic ownership of businesses. They impede productivity and growth. They make it more difficult for the population to save for contingencies in the future, whether these are retirement, private medical expenditures, or education. We must address this urgent problem if we are to improve Canada s rate of economic growth. Labour-Force Participation and Acquisition of Skills Canada s employment statistics have recently improved, but they still lag behind those of the United States and a number of other OECD countries (table 2). 7 Income from the ownership of a principal residence is also exempt. However, individuals will not fully invest their assets in housing, which is illiquid.

8 696 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE Although Canada s unemployment rate is currently less than 8 percent, it remains almost twice as high as the US rate (4 percent). High unemployment is sometimes explained by an increase in the number of women entering the labour force, but we note that in 1997, over 67 percent of the eligible female Canadian population participated in the labour force compared to 71 percent in the United States. Over the period , Canada s civilian employment increased 12.2 percent compared to 15.2 percent in the United States. Part-time work and selfemployment, often resulting in lower incomes, are higher in Canada than in the United States. 8 The demand for employed workers depends on business profitability and competitiveness, as discussed in the previous section. The supply of workers to businesses depends on the willingness of individuals to work, including their willingness to migrate to or from Canada. Further, the quality of workers their skills depends on education and training. As discussed below, taxation affects both the supply of work effort and the acquisition of skills. The effect of taxes on work effort depends on the degree to which taxes reduce incomes available for the purchase of goods and services (the tax rate on income earned from additional hours worked). Taxes discourage individuals from offering to work longer hours (such as overtime) or from participating in the labour force altogether, since they have the alternatives of providing more services at home or obtaining government-funded assistance. On the other hand, the reduction in incomes from taxation induces workers to work harder to make up for lost income. Studies have generally shown that taxes have little effect on primary workers. However, the willingness of secondary workers to participate in the labour force is much more sensitive to taxes. 9 Further, unemployment benefits and other fixed employment costs, such as child-care expenses, are found to have a significant negative effect on the willingness of individuals to become employed. 10 As for migration of workers, studies have been less conclusive. The 8 Using OECD labour force statistics as shown in table 2, part-time employment as a portion of total employment in Canada for both sexes was 17.8 percent compared to 13.6 percent in the United States. Self-employment, according to the OECD, was 11.4 percent of total employment in Canada compared to 8.1 percent in the United States. The Canadian self-employment ratio including owner-workers of Canadian-controlled private corporations is estimated to be about 19 percent. See Canada, Report of the Technical Committee on Business Taxation (Ottawa: Department of Finance, April 1998) (herein referred to as the Mintz report ). 9 Male labour supply has been found to have a low or positive correlation with tax rates, taking into account both the willingness of individuals to substitute leisure for labour and their desire to work more in order to compensate for income lost through taxes. On the other hand, female labour supply effects are found to be quite large; sometimes the labour supply proportionately increases more than the proportionate increase in the after-tax wage rate. See Richard Blundell, Labour Supply and Taxation, in Michael P. Devereux, ed., The Economics of Tax Policy (Oxford: Oxford University Press, 1996), Ibid., at

9 REFORMING THE TAX CUT AGENDA 697 Table 2 Employment Statistics for Selected Industrialized Countries, Selected Years Female labour force Civilian Portion of 1997 Unemployment participation employment employment Selfrate rate a growth rate part time employment % Japan Switzerland United States Netherlands Denmark United Kingdom Sweden Canada Germany Ireland Italy France a Percentage of female population aged Sources: Organisation for Economic Co-operation and Development, OECD in Figures: Statistics on the Member Countries, 1998 Edition, and OECD in Figures: Statistics on the Member Countries, 1999 Edition, Supplements to The OECD Observer, various tables. willingness to migrate depends not only on the total amount of taxes paid but also on public services provided in a country. Migration into and out of Canada has not been found to be highly sensitive to taxes, in part because of legal restrictions and cultural barriers that discourage migration. Studies of migration within the United States or Canada, however, have shown that the labour force is sensitive to taxes and fiscal benefits provided by regional governments. 11 Marginal tax rates on incomes, as discussed above, are exceedingly high for some workers. Federal and provincial personal income marginal tax rates, clawbacks of tax credits, sales taxes, and excise taxes all contribute to less work being offered (see figure 3). This issue has been particularly important for individuals with incomes below $40,000 since marginal tax rates can be well in excess of 70 percent. With respect to the acquisition of skills, Canadian governments have traditionally absorbed a significant share of education and training costs in the primary, secondary, and post-secondary education systems. Of the total Canadian adult 11 A comprehensive review of Canadian studies is provided in Kathleen M. Day and Stanley L. Winer, Internal Migration and Public Policy: An Introduction to the Issues and a Review of Empirical Research on Canada, in Allen M. Maslove, ed., Issues in the Taxation of Individuals (Toronto: University of Toronto Press, 1994), 3-61.

10 698 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE population, 17.3 percent have university degrees and 76.4 percent have upper secondary or higher education levels. These figures are substantially higher than those in all OECD countries except the United States, where 25.8 percent and 85.7 percent of the population, respectively, have a university or upper secondary education. However, in recent years, Canada has surpassed even the United States in the number of students graduating from universities as a proportion of the available population. 12 In Canada, governments have recognized the increasing private cost of postsecondary education by providing credits for tuition fees, education costs, and interest on loans, as well as tax benefits under the registered education savings plan to encourage parents to save for the cost of their children s education. These tax benefits are partly offset by a progressive marginal tax rate schedule that provides a credit for education costs at a rate of about 25 percent, while the additional income generated by education can be taxed at a rate of about 50 percent when a person begins working. Overall, however, the transfer-tax system provides substantial support for education and the acquisition of skills in Canada. Entrepreneurship and Risk Taking While education and training are important to improve opportunities for economic growth, another critical factor is entrepreneurship and the willingness of Canadians to take risks. Data suggest that significant numbers of Canadians are engaged in self-employment relative to the United States (table 2). However, entrepreneurship depends also on traditional employment, since workers and managers contribute to entrepreneurship within the company as well. The tax system affects entrepreneurship and risk taking in two important ways. First, taxes on profits and capital gains earned by entrepreneurs reduce the incentive to take risks. Second, the inability to deduct non-capital or capital losses from other sources of income imposes higher effective tax rates on risky investments compared to less risky ones. As discussed above, Canadian corporate income tax rates are higher than those in most OECD countries. Personal income tax rates on the return to investments also are exceedingly high for most Canadians. Capital gains are now subject to a tax rate of close to 40 percent in many provinces, while many other OECD countries provide a more favourable tax regime by imposing lower rates of tax or special rollover provisions. 13 Further, given that operating losses 12 Recently, 46 percent of students completed tertiary education compared to 32 percent in the United States. See Organisation for Economic Co-operation and Development, OECD in Figures: Statistics on the Member Countries, 1997 Edition, Supplement to (1997), no. 206 The OECD Observer The US tax rate on long-term capital gains is 20 percent. The United Kingdom is lowering the tax rate on capital gains from 40 percent to 20 percent, bringing it closer to the personal tax rate on dividends.

11 REFORMING THE TAX CUT AGENDA 699 can be carried forward or back for only a limited number of years and capital losses can be used only to reduce capital gains for tax purposes, start-up investments in particular are discouraged. 14 In addition, existing tax incentives for small businesses tend to hinder their growth rather than promote it. As documented by the Technical Committee on Business Taxation, few small businesses grow substantially in terms of employment. 15 The current lifetime capital gains exemption provides relief for owners of Canadian-controlled private corporations (CCPCs); as a consequence, many public companies have been restructured to create private companies so that owners can qualify for the exemption. The small business deduction is lost if a company becomes public. In contrast, the United States provides capital gains tax relief for smaller companies that go public for the first time, thereby encouraging growth. Stock options and bonuses are also important for entrepreneurs since these incentive payments are rewards for good performance. The Canadian tax treatment of stock options for companies is less favourable than that for salary distributions paid to managers. Generally, Canada does not allow the cost of the option to be deducted from the employer s income. The employee, however, must pay tax on the capital gains arising from the exercise value of the stock option over and above the grant value. On the other hand, a salary payment is deductible from the employer s income and the income is fully taxed in the hands of the employee. For companies facing corporate income tax rates above 20 percent, 16 there is a tax advantage to the company in paying managers a salary rather than providing a stock option. In contrast, in the United States, the employer is able to deduct the stock option gain from taxable income and the employee is fully taxable on the option gain. Alternatively, in certain circumstances, US companies can provide an incentive stock option with no deduction for the employer and exemption from tax on the stock option gain for the employee. Both treatments for stock options in the United States are more favourable than the treatment in Canada. 14 See Kenneth J. McKenzie, The Implications of Risk and Irreversibility for the Measurement of Marginal Effective Tax Rates on Capital (1994), vol. 27, no. 3 Canadian Journal of Economics , for some illustrative calculations of the effective tax rates on capital for companies experiencing losses. Start-up companies are particularly affected since losses incurred in the initial years of an investment either are not written off or take a long time to be written off future earnings for tax purposes. 15 See chapter 5 of the Mintz report, supra footnote The integration measures under the Canadian tax system ensure that the effective corporate and personal tax rate on income earned by the employer is roughly equal to the tax rate on the employee when the corporate income tax rate is 20 percent. When the corporate income tax rate is above 20 percent, the employer s tax rate is generally more than the employee s. Thus, the tax cost resulting from the lack of deductibility of the stock option gain for the employer is substantially more than the tax on an employee s salary.

12 700 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE Canada s tax system therefore creates a disadvantage for entrepreneurship and risk taking. Personal and corporate income tax rates are too high and, in certain situations such as the tax treatment of stock options, the tax system discourages incentives to improve performance. Innovation The fourth significant factor influencing economic growth is innovation. Innovation comes from two sources. The first is research that results in new ideas that can be used by businesses to reduce costs or to develop new markets. The second is the adoption of ideas created by other firms including those in other countries that enhance the productivity of the business. Innovation therefore depends not only on the creation but also on the adoption of ideas by businesses. Most studies have measured the state of innovation in a country by calculating the ratio of research and development (R & D) expenditure by businesses and governments as a proportion of GDP and comparing this to data in other countries (table 3). By this measure, Canada s research performance is poor among major OECD countries, with gross domestic expenditure on R & D amounting to about 1.64 percent of GDP (1996). This ratio is surpassed by all G7 countries except Italy, and also substantially lower than that of many smaller countries such as Denmark, the Netherlands, Sweden, and Switzerland. Canada also has fewer researchers per 100,000 in the labour force compared to most countries with higher intensities of R & D. As well, it has fewer patent applications (resident and from abroad) per 100,000 in the total population. On the other hand, Canada is a net exporter of R & D in that technological receipts are larger than payments for technology. While R & D expenditure is critical for technological development, it is not necessarily a good indicator of the state of innovation in a country. Innovation includes the adoption of any ideas that improve production. The definition of R & D used by the OECD excludes many innovative practices in the areas of financing, marketing, and business management, for example. Further, even though a country may be spending less on R & D, it may be experiencing more successful hits in terms of discovery and application, which are a better measure of output. Finally, spillovers from R & D are substantial among countries, 17 so that expenditures on R & D may not be indicative of innovation to the extent that domestic businesses are adopting innovations created in other countries. Indeed, some countries have experienced quite rapid economic growth without high rates of R & D expenditure. Ireland, for example, increased employment 17 See David T. Coe and Elhanan Helpman, International R & D Spillovers (1995), vol. 39, no. 5 European Economic Review Coe and Helpman find that Canada is a significant beneficiary of research spillovers from other OECD countries.

13 REFORMING THE TAX CUT AGENDA 701 Table 3 Innovation Statistics by Related Industrialized Countries, 1996/ Patent % of 1996 % of Gross applications Researchers 1996 R & D business R & D per 100,000 Net exports financed R & D expenditure 100,000 labour technological by tax financed by as % of GDP population force payments subsidies government Sweden , Japan , Switzerland , United States a 20, France Germany , Netherlands Denmark United Kingdom Canada Ireland Italy a Underestimated. Sources: Organisation for Economic Co-operation and Development, OECD in Figures: Statistics on the Member Countries, 1998 Edition, Supplement to The OECD Observer, various tables; and (data in column 4) Canada, Report of the Technical Committee on Business Taxation (Ottawa: Department of Finance, April 1998). and GDP per capita faster than any other OECD country in the 1990s, but it has a relatively low ratio of R & D expenditure to GDP (1.39 percent in 1996). The tax system influences both the creation of ideas and their adoption. With respect to incentives to create ideas, Canada has the most generous tax treatment of R & D in the world. 18 Under the corporate income tax system, current and capital expenditures are expensed, a federal tax credit of 20 percent (for large companies) or 35 percent (for small CCPCs) is provided for R & D in Canada, and additional credits and allowances are provided for R & D in many provinces. Almost 30 percent of the cost of research is covered by tax incentives provided by federal and provincial governments. A further 7 percent of business expenditures are covered by direct government subsidies. As shown in table 3, this level of support is generally much higher than that in other major OECD countries. With respect to the adoption of new ideas, Canada s tax system has been far less encouraging compared to tax systems of other countries. High-tech industries aerospace manufacturing and communications tend to be subject to 18 See chapter 5 of the Mintz report, supra footnote 8.

14 702 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE higher effective tax rates on capital compared to similar industries in other countries. 19 Medium high-tech industries motor vehicles, professional goods, chemicals, electrical machinery, and transport also are generally taxed at rates higher than those in many other countries. Thus, the adoption of new ideas, whether created in Canada or abroad, is discouraged by the business tax system. An interesting paradox arises from Canada s tax policy in this area. The tax system strongly encourages the creation but discourages the adoption of new ideas in Canada. It is therefore not surprising that Canada is a net exporter of technology but has a low rate of R & D expenditure compared to that in many countries. The tax system encourages laboratories to locate here but does not support the complementary activities of businesses that result in the demand for and adoption of R & D. WHAT REFORMS ARE NEEDED? Given the above discussion, the direction for tax reform in Canada is clear. The aim should be to improve economic growth so that the next decade will not repeat the 1990s. Without tax reform, Canada s overall competitiveness will be harmed and, consequently, Canadians will be in a less advantageous position to enjoy the benefits of economic changes now occurring at the international level. Tax reform, at both the federal and provincial levels, should address four major areas of taxation: the business tax system, the personal income tax, payroll taxes, and indirect taxation. Each area is discussed below. The Business Tax System From the discussion above, it is clear that the business tax system needs to be substantially reformed, as discussed in the Report of the Technical Committee on Business Taxation. 20 At present, the combined federal and provincial corporate income tax rates are far too high, especially for non-manufacturing industries at 43 percent. Effective tax rates on capital for both the manufacturing and the service sectors also are far too high, compared to those in most major industrialized countries. Despite the generous tax support of R & D, Canada is not experiencing great success at adopting new technologies compared to many other countries. Both the federal and provincial governments should address concerns with the business tax system as quickly as possible. Corporate income tax rates should be reduced to levels well below the average of OECD countries about 34 percent in Taxes on capital should be replaced by more efficient business taxes that do not discourage investment. Italy, for example, has recently 19 See chapter 3 of the Mintz report, supra footnote Supra footnote 8.

15 REFORMING THE TAX CUT AGENDA 703 introduced a business value-added tax at the regional level to replace regional corporate income taxes. The advantage of this tax is that it results in a sharply lower corporate tax rate (4.25 percent instead of 16.0 percent) by broadening the tax base to include income paid to labour and capital. A similar change could be considered for business tax reform implemented by Canadian provinces. 21 While reducing both corporate income and capital tax rates, the federal and provincial governments should consider broadening the tax base to make it more efficient and simpler. Some of the changes could include tighter treatment of international income, modest reductions in the overly generous R & D tax credit, a scaling back of capital cost deductions and credits that are geared toward traditional investments, and replacement of incentives for small business that hinder their growth with new ones that encourage their development into medium-sized and large companies. The revenue gained from base broadening would help pay for significant reductions in corporate income and capital tax rates. Overall, the effective tax rates on capital can be reduced, and also can be made more even across different business activities. Current employer payroll taxes also could be improved. At present, the employment insurance (EI) system requires employers to pay the same premium rate regardless of the number of employees laid off by the employer. In the United States, experience rating has proven to be successful in reducing unemployment rates. While many provinces have incorporated experience rating into their workers compensation programs, a similar approach has not been adopted, even partially, for the EI program. As EI rates are being reduced at this time, we are missing an opportunity to introduce experience rating and thus make the EI program more efficient. Property taxes on non-residential businesses in most provinces also need serious reform. Property taxes for commercial property are much higher than for industrial property. Both are subject to higher taxes than residential property. Indeed, some provinces (such as New Brunswick) impose higher property taxes on rental properties compared to owner-occupied housing, even though the former type of housing tends to be used by people who are less well-off. Clearly, it is appropriate for businesses to pay property taxes to cover the cost of municipal services, but a better attempt should be made to match the services provided by municipalities with the tax payments related to those services. 21 See Richard Bird and Jack Mintz, Tax Assignment in Canada, working paper (Kingston, Ont.: Queen s University, Institute for Intergovernmental Relations, forthcoming).

16 704 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE Personal Income Tax Reform Personal income taxes need to be significantly reformed in order to improve opportunities for economic growth. The primary issues discussed above are the generally high marginal tax rates for most levels of income, high levels of tax on the working poor, and high taxes on capital income. To address all of the above issues, several changes are needed: Increasing the value of exemptions and credits. High marginal tax rates, well over 40 percent, apply to income at the $29,000 level and higher. As a result of the elimination of inflation adjustments for tax brackets since 1985, the incomes of many Canadians have crept up over time well above the lowest and middle bracket levels set for tax rates. Canada needs to substantially increase its tax brackets so that tax rates in excess of 40 percent apply to incomes that are truly those of the rich, such as $120,000 and higher twice the level of the current top bracket. The income threshold for other brackets also should be increased, to $50,000 for the middle bracket and $12,000 for the lowest bracket, compared with the current thresholds of approximately $30,000 and $8,000, respectively. Reducing marginal tax rates. The federal and provincial governments should lower personal tax rates to create better incentives for work, especially at the lower income ranges. Surtaxes should be eliminated at both the federal and provincial levels. At the provincial level, this can be accomplished by a move to tax on income (rather than tax on tax) so that provincial rates can simply vary by income. Governments should strive to lower tax rates so that the lowest combined federal and provincial tax rate should be no more than 20 percent, the middle rate 30 percent, and the top rate 40 percent. Alberta, with its move to tax on taxable income, will be reducing its top rate to almost 40 percent, combined with anticipated changes to the federal surtax. Improving clawbacks. Governments must recognize that tax measures aimed at providing relief to low-income taxpayers as virtuous as they seem result in substantial increases in marginal tax rates for low- and middle-income Canadians. The federal and provincial governments should harmonize their clawbacks, so that they are not stacked on each other. Some forms of targeted income relief child tax benefits, the GST credit, the guaranteed income supplement, provincial benefits should be aggregated and clawed back as a pool, in order to reduce the high marginal rates falling on many low- and middle-income Canadians. Improving the treatment of savings. With substantial reductions in effective marginal tax rates as proposed above (through adjusted brackets, rate reductions, and clawback rationalization), a more favourable environment for savings would be created. However, these changes would not be enough. There are three further reforms that are needed. First, tax-free treatment of savings for retirement, private medical expenses, and other contingencies should be broadened beyond the current registered pension plan and registered retirement savings plan (RRSP) regimes. Second, improved integration of corporate and personal income taxes would result

17 REFORMING THE TAX CUT AGENDA 705 in lower taxes on dividends and capital gains and a simpler corporate income tax system. 22 Third, incentives for venture capital and other risky investments could be improved by creating more tax-free savings plans for equity investments that would provide for an automatic rollover of assets within the plan on a tax-free basis. All in all, the taxation of savings could be improved by introducing more expenditure -based methods of treating savings to reduce taxes on capital income. These expenditure-based methods include RRSP-type regimes in which contributions to the savings plan are deductible, income within the plan is exempt, and withdrawals from the plan are fully taxable. Alternatively, treatment similar to equity held in owner-occupied principal residences (which is exempt from income taxation) could be provided: contributions to the plan would not be deductible, and neither the income within the plan nor withdrawals would be taxed. Base broadening. Although the current personal tax is fairly broad in application, several special preferences are provided which are of questionable effectiveness and fairness. These include the lifetime capital gains exemption, the labour-sponsored venture capital credit, the tax-free provision of employersponsored medical plans, the aged credit, flowthrough shares, and various provincial incentives such as stock savings plans. With the elimination of these various deductions and credits, the federal and provincial governments would be able to achieve greater reductions in marginal tax rates for all levels of income and a more efficient and fairer tax system. The list of changes provided above suggests that there is considerable scope for personal income tax reform, beyond merely cutting personal income tax rates. All these changes would increase incentives for work effort, savings, entrepreneurship, and risk taking, in contrast to the inhibiting effects of the existing personal income tax system. Payroll Taxes By comparison with most other industrialized countries, payroll taxes in Canada, especially at the employee level, are relatively small in relation to the total tax collected by all governments in Canada. However, most governments generally impose payroll taxes to fund social benefits: unemployment, medical, pension, and disability insurance. If the public programs were not provided, the payroll tax would not be assessed. This basis for payroll taxation is especially important 22 If the small business deduction were eliminated at the federal and provincial levels and corporate income tax rates were reduced to 25 percent or less, it would be possible to have a higher dividend tax credit, at the rate of 33 percent on taxable dividends and a capital gains exclusion of one-half. These changes would bring dividend and capital gains tax rates down to 20 percent at the personal level, assuming a 40 percent top personal tax rate. This type of reform would not only improve incentives for entrepreneurs but also accomplish considerable simplification in the corporate income tax system. See Jack M. Mintz and Thomas A. Wilson, Capitalizing on Cuts to Capital Gains Taxes, Commentary no. 137 (Toronto: C.D. Howe Institute, February 2000).

18 706 CANADIAN TAX JOURNAL / REVUE FISCALE CANADIENNE in continental Europe, where most of the above benefits are provided by governments and there is very little private involvement. Without the public program, employers and employees would need to pay for the benefits themselves, assuming that they became available on a private basis. Perhaps more thought should be given in Canada to the use of payroll taxes and other supplementary means to cover the cost of social insurance programs. As mentioned earlier, workers compensation programs at the provincial level are partly experience rated. EI benefits for individuals are related to layoff experience (although, as discussed above, employer contributions are not currently experience rated). It is quite possible to shift to payroll and similar taxes that would better relate the cost of the program to its use, especially in health care. The current system, in which general tax revenues are used to finance social insurance, provides no direct linkage between program benefits and contributions. For example, in health care, one could assess variable employer and employee payroll contributions based on health care benefits received by the employee. Limits could be imposed on the maximum charged per year, bonuses could be provided for use below a certain level of benefits, and allowances could be provided as relief for lower-income Canadians. The revenues would provide room for reductions in corporate and personal income taxes, as well as provincial payroll taxes that are currently unrelated to the expenditures made on programs. A further set of changes is needed with respect to the federal EI program. The current program operates at a surplus in that the contributions are greater than the benefits paid out. In light of the argument that the federal government should lower personal income taxes rather than payroll taxes, it may become an acceptable notion that the surplus EI payments are a good tax. They are not. As a general payroll tax, as opposed to a payment for social insurance, the EI contribution system is unfair in that it applies only to lower-income workers. It is also inefficient since it encourages businesses to use their existing employees for overtime work and discourages them from taking on part-time employees (when salaries exceed the maximum level of insurable earnings). If a general payroll tax is desirable, it should apply equally to all levels of income. It should also exempt the first tranche of income to offset the fixed costs of employing parttime workers and provide some relief for low-income workers. Perhaps it is time for both the federal and provincial governments to consider major reform of payroll taxes, including improving their use as part of the overall mix of taxes levied by governments. If payroll taxes are an efficient and fair means to finance public programs and to reduce Canada s reliance on taxes applied to savings, they can serve a useful purpose in making the tax system much more supportive of economic growth. Indirect Taxes Sales and excise taxes are important sources of revenue for governments to finance their expenditures in today s global economy. Canada has shifted toward