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 Special Reports LOOSENING THE TAX NOOSE ON BUSINESS INVESTMENT – MAKING PROGRESS March 20, 2008 Rarely do corporate tax issues receive extensive media attention. The surge in the Canadian dollar in recent years has re-cast attention on the critical need to improve the competitive playing field for business in Canada, and notably, in the area of taxation. That factor might explain how corporate taxation got onto the business pages of newspapers. The recent, bitter exchanges between the federal government and the Ontario government over Ontario’s corporate tax regime have taken the subject to the front section. But as often happens in the rhetoric of political debate, a lot of key facts are being missed. A conclusion may be drawn by many that little progress has been made on improving Canada’s corporate tax regime and the area is still fraught with problems. This simply isn’t the case. From actions already taken by the federal and provincial governments since 2000 we should consider corporate taxation policy a Canadian success story. The federal government has taken dramatic action to cut its corporate income tax (CIT) rates and has eliminated its capital tax. Most provinces have also taken bold steps. And we include Ontario in that category. Ontario is phasing out its capital tax, has substantially cut the education portion of business property taxes and introduced a number of measures to lighten the tax load on manufacturers. From changes already in the works, Canada will be transformed from the second highest business tax jurisdiction in the OECD to the lowest in the G-7 by 2010. Canada would still have a burden 3.4 percentage points above the OECD average (excluding Canada), but the advantage over the U.S. would surge to 9.1 percentage points by 2012. At a minimum we should conclude that Canada has turned corporate taxation from a distinct disadvantage to at least a neutral factor in supporting economic growth. Of course we should aspire to a corporate tax system that provides a Canadian advantage. To accomplish this further action will be required, mostly on the part of certain provinces. The pay-off will be there. By lightening their tax burden on business capital investment, Canada’s provincial economies will be better positioned to grow their productivity in the future, which will lead to expanding employment and wages for households over time. The evidence from a round of corporate income tax (CIT) cuts in Canada during the 2001-04 period has solidly supported the intuitive notion that investment is strongly and positively influenced by a reduction in the tax burden. We look to the 2008 round of provincial budgets to keep the momentum going on this front. A little more context Many individuals associate business tax competitiveness with the combined statutory federal-provincial general CIT rate. In fact, the taxes that businesses ultimately incur depend on additional characteristics of the tax system, including depreciation and inventory cost deductions, commercial and industrial property taxes, capital taxes and retail sales taxes on business inputs. All of these elements are included in a broader measure of the overall business tax structure called the marginal effective tax rate (METR) on new business investment. The accompanying chart provides some good news on this front. It shows that Canada’s overall METR on new business investment is slated to drop significantly by 2012 – from 33% prior to measures adopted in the 2006 federal budget to around 25%. Much of this decline is owing to federal initiatives. Notably, following on the heels of the former Liberal government, which reduced the general CIT rate from 28% to 21% between 2001 and 2004, the federal Conservatives have: In addition to cutting its own tax rates, the federal government has also taken a leadership role in encouraging the provinces to eliminate their taxes on capital and to lower CIT rates. Since provincial capital tax payments can be deducted against federal tax payable by corporations, the elimination of this provincial tax generates a federal windfall. In its 2007 budget, the federal government agreed to send these extra monies back to provincial governments that enact legislation to eliminate their capital tax before January 1, 2011. On average, this move offset about 15 cents per dollar of provincial revenue loss. As well, the federal Conservatives have urged the provinces to cut their CIT rates to 10% on average from their current level (weighted by nominal GDP share) of 12.4% by 2012. As we show in the chart on the left, if the provinces were to achieve this goal, Canada would have an estimated METR of 23.7%, further narrowing the gap with the rest of the OECD. Provinces stepping up, but more needs to be done Accordingly, the federal government has been turning the heat up on the provinces to follow suit in order to strengthen Canada’s business tax competitiveness. And, indeed, most of the remaining issues lie on the provinces’ doorstep. A number of provinces continue to levy high general marginal CIT rates and taxes on capital – especially on financial institutions – and charge retail sales tax on business inputs. And along with their municipal counterparts, several jurisdictions have high tax rates on non-residential properties. No doubt, these challenges have been complicated by the fact that a number of provinces have been facing a tighter fiscal squeeze compared to the federal treasury. On the plus side, the momentum has also been building at the provincial level to enhance their business tax competitiveness. Ontario and Québec have announced plans to fully eliminate their capital taxes by 2010, with the former jurisdiction eliminating the tax for corporations engaged in manufacturing and resources on January 1, 2008. We were particularly impressed with the decision the phase out the capital tax for all businesses, thus resisting the temptation of some other provinces to leave it on financial services. Not only did this decision give a growth impetus to a sector that looms large in these economies, but it puts pressure on other provinces if they want to attract or even retain financial services. In Ontario, this significant and positive move, together with a multi-year plan to reduce the education portion of business property taxes, will save businesses in the province more than $3 billion over the next three years. In its recent budget, British Columbia announced that it will phase out its capital tax on financial institutions by 2010 with a more palatable “minimum tax” that is deductible against corporate tax. Just as importantly, the province caught the attention of the nation by introducing a strategy that will lower the CIT rate from 12% to 10% as part of a larger plan to recycle savings from the implementation of a carbon tax to both businesses and households – a move that we applaud. It remains relatively early in the budget season, but we hope that other provinces will step up with additional reductions in CIT and capital taxes. In its 2008 budget, New Brunswick indicated that it generally supported the federal government’s principle of a 25% combined CIT rate. At the same time, it announced that it will table a green paper later this year likely containing substantial reforms to its overall tax structure to make the province more competitive. Manitoba, which, subject to a balanced budget requirement, last year announced a reduction in its CIT rate to 12% in 2009, could move the goal posts again in this year’s budget. The provincial distribution of estimated METRs in 2012 is shown in the table. Keep in mind that these exclude the financial sector, which explains why the capital tax burden is set to zero in all provinces. Nor are B.C.’s changes to its CIT rate factored in, since its budget was brought down only recently. A quick study of the three main components shows significant disparities across provinces: Keep the momentum running In light of the stronger currency and the the lightening speed at which business income and investment can cross provincial and national borders, it will become increasingly difficult for jurisdictions to sustain wide differentials in relative tax rates. While it’s difficult to pin down an exact number, in the case of the general CIT rate, this “breaking point” will probably be only a few percentage points – certainly much narrower than the current 6-point differential between the lowest- and highest-tax jurisdictions. This will present a challenge, especially for provinces that will continue to struggle with a more difficult fiscal predicament. Yet, even for those provinces, there are options available. One of the most appealing strategies is the “tax-shifting” approach adopted by British Columbia in its 2008 budget, which improved the efficiency of its overall tax system by cutting income taxes and boosting consumption levies. These impacts are estimated to be revenue neutral. The economic rewards from a competitive business investment tax regime have been found to be significant. Recent research by the Department of Finance Canada estimates that a 10% reduction in the tax component of the user cost of capital is associated with an increase of the capital stock of about 7%. Canada is well on its way to improving its tax treatment of business investment. Let’s not fumble the football so close to the end zone. Don Drummond Derek Burleton Pascal Gauthier, Economist For the full report in PDF format - including all charts and tables click here.
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