Economists have proposed a variety of alternatives to the corporate income tax.Chris Wattie/Reuters
So we’re agreed. The Canadian economy is in such a state of crisis that bold measures, previously unthinkable, are now in order. To quote the Prime Minister, we must do things we never imagined at speeds we never thought possible. Or is it we must do things we never thought possible at speeds we never imagined? Whatever. Things! Speed! Just do it!
Only … perhaps it might be best if we took a moment to consider what is the “it” we should just do? Yes, we need to cut our exposure to the United States, given its recent retrogression into so much political and economic krisenchaos. But much of the agenda that implies is not amenable to quick fixes.
We can talk all we like of trade diversification, but experience suggests it’s not going to happen to any appreciable degree for years, if not decades. We can spend however many tens of billions on the military, but the day when we no longer need to rely on the Americans for our defence – still less when we can defend ourselves against the Americans – remains far off.
But meanwhile there is a more proximate crisis, with more proximate solutions. It is one that long predates the advent of Donald Trump, but which his destructive, destabilizing policies have made more urgent. That crisis is growth.
We need more growth to generate rising living standards. We need it to keep up with rival nations. We need it to pay the crippling costs of population aging, notably for health care – and to fund the sudden, permanent surge in defence spending that now confronts us. And we need it to overcome the economic drag imposed by Trumponomics.
There isn’t any mystery where that growth will have to come from – not from rising commodity prices (they’re projected to fall) or faster population growth (desirable, but politically impossible for now); certainly not from accelerating a handful of large infrastructure projects.
It will have to come, rather, from increased productivity – not from lavishly funded, highly-targeted “moonshots” that may or may not pay off, but from continual incremental improvements across the economy, in businesses large and small.
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There isn’t a great deal more mystery about how to generate higher productivity. Broadly speaking, we need two things: more investment, and, at least as important, more efficient use of investment.
The answer to the second – again, broadly speaking, more competition and fewer subsidies – we can leave to another time. But how to generate an immediate, sizeable and permanent increase in the rate of investment?
We have to consider the possibility that Canada’s investment problems are so deep-seated (the rate of business fixed capital formation is so anemic it is barely enough to offset depreciation, meaning the amount of capital per worker, already low by international standards, has actually been falling) and so intractable that traditional measures – a cut in the corporate tax rate, say, or accelerated writeoffs for depreciation – are not enough.
That is to say, we need not just to improve incentives to invest in Canada, but to “shock the system”; not just to radically alter the cost-benefit calculus facing business decision-makers in favour of investing in Canada, but to send out an unmistakable signal that Canada is the place to invest – yes, even in the face of Trumpian tariffs. Let me suggest one such signal: abolishing the corporate income tax.
Hear me out. I’m not talking about abolishing corporate taxes altogether. I’m talking about changing the basis of corporate taxation: from income to something else.
Income, of course, is what corporate investors are interested in earning. The higher the rate of taxation on income, the less their after-tax return on investment – and the higher the pre-tax return will have to be to justify the same investment.
Suppose an investor needs to earn 10 per cent after tax to persuade them to invest, for a given amount of risk. At a marginal tax rate of 50 per cent, they’d need to earn 20 per cent before tax. Whereas at a rate of 33 per cent, the investment would have to pay just 15 per cent before tax. Cutting the marginal tax rate from 50 per cent to 33 per cent, therefore, means all those investments offering pretax returns of between between 15 and 20 per cent, previously uneconomic, suddenly become economic.
Of course, all of this assumes that shareholders bear the brunt of the corporate income tax. Certainly we know that corporations themselves don’t: They may collect the tax, but ultimately pass it on. To whom, though? Shareholders? That’s the assumption underlying much of Canadian corporate tax policy. It’s why shareholders are given a tax credit on the dividends they receive, or are taxed on only 50 per cent of capital gains – in recognition of the tax paid at the corporate level, and passed on to them.
Ah, but was it? Recent research suggests that most of the corporate income tax is paid, not by shareholders (capital is highly mobile, and will quickly shift to lower-tax investments and jurisdictions) or consumers (competition, at least in trade-exposed sectors, makes it equally hard to pass on the tax in the form of higher prices), but to a firm’s workers, in the form of lower wages.
Which is part of the reason why many economists argue for abolishing the corporate income tax altogether – and the dividend tax credit and the capital gains exclusion along with it – and simply taxing corporate income in the hands of shareholders as they receive it. So far as the corporate tax is not passed onto shareholders, that would obviously be fairer: well-to-do shareholders would pay more in tax, while workers (who, remember, pay most of the corporate income tax now) would pay less. And so far as it is, well, you’ve just reduced the corporate income tax rate to zero.
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Abolishing the corporate income tax would make the system more efficient in another way. Income is notoriously difficult to define. “Revenues” and “costs” are tricky enough. But much of what goes into measuring income – depreciation, capital gains, inflation – involves comparisons between the values of things in different tax years. The opportunities for tax gaming – and for inefficient, tax-motivated decisions – are huge.
What should replace it? Economists have proposed a variety of alternatives. The simplest is to tax corporations on their cash flow. All money received, from whatever source, during a given year is taxable; all money paid out is deductible. In particular, capital purchases would be fully deductible in the year they were made, rather than being deductible, as now, over many years, according to complicated schedules of amortization and depreciation.
The current system, moreover, is biased in favour of debt finance, since interest expenses are deductible, while dividends are not. So professors Robin Boadway and Jean-François Tremblay have made the case for a simple deduction for a “normal” return on equity, to reflect the cost of capital, whatever its source. Corporations would then be taxed only on “supernormal” returns, or what economists call “rents.”
Why does that make sense? Remember that bit about capital being highly mobile. Tax normal returns, and you risk encouraging capital to leave for tax-friendlier environments. But rents, sometimes called windfall profits – the kinds of short-term gains that accrue, for example, from spikes in resource prices – are basically gravy. Shareholders aren’t likely to earn that sort of return elsewhere. So you can tax it without scaring off investment.
The economist Jack Mintz, for his part, has argued for a distributed profits tax: Corporations would only be taxed on that part of their earnings they distributed to shareholders (including through share buybacks, designed to produce capital gains). Any profits reinvested in the company would be exempt.
Taxing cash flow, or rents, or distributed profits, rather than income, might once have been difficult to justify. The concern was that, in the absence of a corporate income tax, individuals would have a huge incentive to turn themselves into corporations, in order to shelter their income from tax.
But as Prof. Boadway and Dr. Tremblay point out, the proliferation of tax-free savings instruments in recent years – RRSPs, TFSAs, RESPs, and so on – mean that most people can already shelter as much income from tax as they want. That is, the personal tax system is close to being a tax on consumption. A cash-flow tax is the corporate-tax equivalent.
This is necessarily a pretty broad-brush treatment of some complicated issues. The point is that we need to get beyond penny-ante reductions in corporate tax rates, beyond even the usual tax reform proposals – broaden the base by eliminating distortionary tax preferences, using the revenue to cut rates – to what Dr. Mintz describes as “big bang corporate tax reform.”
Each of the proposals covered here has its pluses and minuses. But what is common to all, beyond the improvement they represent over the current system, is their value as signalling devices.
Not only would they lift us altogether out of the stale infighting between interest groups over this or that trivial deduction that has characterized previous tax reform debates, but they would tell the world, in unmistakable terms, that Canada is a country that is hungry for capital, and serious about courting investment – not by cutting special deals for favoured industries, but by treating investment generally as what it is: the indispensable ingredient in raising productivity, and with it the standard of living of our people.
It has been difficult to marshal a consensus in favour of radical tax reform in the past. But if we mean everything we’ve been telling ourselves about the crisis we are in – if we understand how grave our fiscal and economic situation is – then surely now is the time to have that discussion. If not now, when?