Radical tax reform is not just good policy: it’s the only kind likely to succeed

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Tax reform is one of those issues that confounds conventional political wisdom. The conventional wisdom, to which most politicians subscribe, is to move cautiously, incrementally, ploddingly – to do “nothing by halves/ Which can be done by quarters.”

But timid tax reform is not just bad policy. It’s bad politics. Tax reform is generally directed at a more neutral tax system: one in which decisions on what to consume, where to invest, whether to save or how much to work remain unaffected, to the greatest extent possible, by the tax laws. You want people to make these decisions based on the real economic costs and benefits of different options, not the tax goodies attached to each.

But moving to a more neutral system implies taking away the goodies from people who already have them. Whole professions are devoted to ensuring this does not happen. The proliferation of deductions, exemptions, and assorted other preferences that now clog our tax laws may be bad for the economy, but they have been very good to the industries, firms and investors to which they apply, who have every incentive to hire the finest lawyers, lobbyists and public-relations firms in their defence.

Picking out just one or two such preferences for elimination, as conventional political wisdom might dictate, does not mute their attacks: It amplifies them. Their beneficiaries are thus able to complain, not only at the hardship of being suddenly deprived of the advantageous tax arrangements on which they had come to rely, but even more at the injustice of being singled out for such harsh treatment.

This was the lesson of the Trudeau government’s attempts at tax reform. There was nothing wrong with the idea of closing the tax preference for small businesses that incorporate, or taxing employer health benefits, or taxing capital gains more like other income. But if that’s all you do then all you have created are, you should pardon the expression, losers: people who lose something from the reform. You haven’t created any winners.

Spread the misery more widely, on the other hand – take away everybody’s goodies, at one go – then not only is it harder for any one interest to make its complaints heard above the general din, but by broadening the tax base you raise the revenues with which to cut everybody’s tax rates. Some will still lose money on net, but enough (you hope) will be net winners to make the exercise politically saleable.

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Still, it’s tricky. Revenue-neutral tax reforms – which neither raise more nor less revenues for the government – are hard to make work politically: There usually aren’t enough winners to offset the losers, who tend to be more vocal. Revenue-negative tax reforms, on the other hand, are difficult to justify, given the state of public finances in this country.

So even the comprehensive tax reform economists and tax specialists have been calling for, with increasing fervour, for many years – broadening the base to slash rates – is probably not sufficient.

Certainly it’s necessary: because Canada’s economic growth is so chronically slow, and because Canada’s tax system is such a mess. The Tax Foundation’s 2025 International Tax Competitiveness Index ranked us 22nd out of 38 OECD countries for corporate taxes, 27th for personal taxes.

We tax personal income much more heavily than most other countries. On the corporate side, while the average marginal effective tax rate (METR) on investment is broadly competitive, it varies wildly depending on the industry, the investor and how the investment is financed. Manufacturing is taxed much less than services; forestry less than oil and gas; and so on.

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The recent move to extend immediate deductibility of investments to a much wider range of investments than before – two-thirds, versus 15 per cent – should improve this somewhat. But there is still much to do. The obvious starting point: Allow immediate expensing for all investments, across the board. Less obviously, immediate expensing implies eliminating the deduction for interest (otherwise firms face negative METRs on investment, i.e. a subsidy). If we really wanted to get serious, we would go all the way and tax corporate cash flow, or economic rents, rather than income.

But base broadening only gets us so far. If we want to achieve the kind of radical reductions in personal and corporate tax rates experts agree are required – especially now, given Donald Trump’s determined efforts to deindustrialize us – we will need to go beyond base-broadening. We will also need to cut spending. And yes, we will need to raise other taxes.

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Let’s take each of these in turn. Base-broadening first. As it happens, the Finance Department each year compiles a list of “tax expenditures” – preferences of various kinds that, so far as they deviate from tax neutrality, imply a cost in forgone revenues, which may be regarded as a kind of spending.

Strictly speaking, you can’t do what I’m about to do, and just add these costs together: If you eliminate one, you change the base on which the cost of all the others are calculated. But in broad-brush terms, it gives you an idea of the sorts of revenues that are available.

Top of the elimination list would be the preferential tax rate for small businesses, whose cost now runs to more than $6-billion annually, and whose chief economic effect is to deter small businesses from growing too large to be eligible for it. The Lifetime Capital Gains Exemption for small businesses, farmers and fishermen costs a further $2.9-billion annually.

Tax neutrality, not to say fairness, would also be enhanced by eliminating the deductions for employee stock options ($1.2-billion), as well as the Labour-sponsored Venture Capital Tax Credit ($205-million), the Atlantic Investment Tax Credit ($235-million) and the Film or Video Production Services Tax Credit ($455-million).

The Charitable Donation Tax Credit, together with the deductibility of charitable donations, at a combined cost of roughly $5.5-billion a year, might be thought relatively benign – until you have a look at what actually counts as a charity for tax purposes, a list that currently runs to more than 85,000, many of them of dubious purpose, necessity or even legality.

Virtue is supposed to be its own reward: Let people donate to their favourite charities with their own money, not force other taxpayers, via the credit, to do likewise.

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Employer health and dental benefits, mentioned earlier, are part of how companies pay their employees, just like wages – but unlike wages, aren’t taxed federally. Taxing them the same as income would raise another $5-billion a year. Capital gains on principal residences are also income, and also untaxed: one reason house prices are so inflated. Taxing them would raise $8.5-billion yearly. Tax incentives for first-time home buyers have the same price-boosting effect, at an annual cost of about $2-billion.

The Age Credit is another candidate for elimination: it seems unfair to give preferential treatment to older taxpayers over younger people on the same income. Cost: roughly $5-billion annually. Pension income-splitting is discriminatory in several different dimensions, favouring pension income over ordinary earnings, couples over singles, and (prior to age 65) workplace pensions over RRSPs. Scrapping it could save $2-billion. The Pension Income Credit ($1.4-billion) could be eliminated on analogous grounds, while the Canada Employment Credit ($3.2-billion) offers a benefit that for most people would be worth trading for lower tax rates.

Exempting basic groceries from GST (technically, it’s called “zero-rating”), at a cost of about $7-billion per annum, is another example of poorly targeted social policy: better to charge the tax on groceries, and bump up the low-income GST credit (now called, inexplicably, the Canada Groceries and Essentials Benefit) than give everyone the same tax break.

These are just the most egregious examples. But they suggest it should be possible to raise about $50-billion just from base-broadening alone.

On the spending side, we need not get too deeply into the weeds for present purposes. The politics of cutting transfers to individuals, whether for Old Age Security, the Canada Child Benefit, or employment insurance, are daunting, as they are for transfers to the provinces for health, education and equalization.

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But there is one expenditure item we should all be able to agree can be cut: subsidies to business. As with tax preferences, the effect of these is to divert capital and labour from competitive firms and industries, the kind that could compete without subsidy, into those that can’t.

Former Finance economist John Lester has calculated the federal government alone spends between $40-billion and $50-billion every year in handouts to business – equivalent to half of all federal revenues from the corporate income tax. He estimates about 80 per cent of these either have no economic justification, or do not provide benefits that exceed their costs.

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Some of these subsidies are delivered through the sorts of tax preferences we’ve already identified, but even if we just targeted the spending side, including battery plant subsidies and grants to Crown corporations, it ought to be possible to save at least $20-billion.

Finally, there are the revenues to be had from raising other taxes: taxes that, unlike taxes on income, do not deter people from earning more income, whether by working harder or saving more. That points to consumption taxes, which means the GST. Each percentage point on the GST is estimated to raise about $11-billion for the federal government.

Adding back the two points that Stephen Harper cut from it, after accounting for an offsetting increase in the GST credit (cost: roughly $2-billion), would therefore raise in the neighbourhood of $20-billion.

All told, that gives us about $90-billion to play with. How much could we cut tax rates with that kind of money? For this, we turn to the Parliamentary Budget Office’s “Ready Reckoner,” which calculates the revenue gained or lost by raising or lowering different taxes.

Cutting corporate tax rates remains an important objective. Immediate expensing does wonders for marginal tax rates, but average tax rates matter, too, when it comes to deciding where to locate a plant, or declare profits.

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We could cut the standard corporate tax rate from 15 per cent to 9 per cent – the same as the small business rate – at a cost, extrapolating from the Ready Reckoner’s estimates, of about $24-billion. That’s a better way to eliminate the small business preference than lifting the small biz rate up to the corporate rate, though it means we can no longer count on the revenues from doing so. (That cuts our overall envelope to $84-billion.)

Suppose, further, we collapsed the current five income tax brackets (14, 20.5, 26, 29 and 33 per cent) into three: 10, 15 and 20 per cent. Cutting the first bracket to 10 per cent, according to the Ready Reckoner, would cost about $24-billion. Cutting the second bracket to 15 per cent would cost another $20-billion; cutting the third, fourth and fifth brackets to 20 per cent, about $5.9-billion, $3.3-billion, and $5.9-billion, respectively.

All told, that’s about $59-billion in personal income tax cuts. Together with the $24-billion in cuts to corporate taxes, that adds up to about $83-billion in tax cuts – roughly the amount we started with.

Reasonable people can differ on specific proposals. This is meant just as an indication of what is possible, provided we are prepared to think big. The severity of our economic and geopolitical crisis demands that we put aside incrementalism, and embrace radical reform. But so does practical politics.