Queen’s Park, in Toronto.Eduardo Lima/The Canadian Press
In Ontario’s recent budget, Premier Doug Ford’s government boasted that its 30 per cent cut to the small-business tax rate would make Ontario even more competitive and productive. Unfortunately, the measure will likely have the opposite effect.
The pledge to drop the provincial tax rate for small businesses to 2.2 per cent, from 3.2 per cent, is part of Ontario’s multiyear “Tax Action Plan.” It’s part of a trend – in the past decade, the federal government, as well as many provinces and territories, have also cut small-business taxes. The cuts have obvious political appeal, given the large number of small businesses and the power of their lobby groups.
But the reality is that small-business rates are a costly subsidy that, even worse, act as a drag on growth.
Incorporated small businesses with less than $10-million in taxable capital get a lower income tax rate on the first $500,000 in income. (The income cutoff is higher in a handful of provinces.) Then they face a “tax wall” – a sharp increase in the tax rate as they pass the small-business limit and have to pay the regular corporate rate.
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Canada’s tax wall is steeper than in other G7 countries. In Ontario, for example, a small business using the new combined provincial and federal rate in 2027 would pay 11.2 per cent. On the other side of the tax wall, the rate jumps to 26.5 per cent. In many provinces and territories, the gap grew in recent years, with cuts to small-business rates outpacing cuts to general corporate rates.
The rates have a big impact on behaviour, with large numbers of businesses declaring income that lands right before the threshold. Much of the pattern is due to tax planning, with the declared taxable income changing quickly when thresholds have moved. However, research from the C.D. Howe Institute shows that in some cases, it’s because businesses have a reduced incentive to undertake investment that would generate income taxed at a higher rate. This brings down their productivity, as average production costs typically drop as firms grow.
The small-business rate ends up being a subsidy for less productive businesses. The lower rate doesn’t necessarily go to firms that are new and innovative – the majority have been around for at least 10 years. Rather than serve as engines of growth and employment, these firms tend to remain small, and they are less likely to adopt new technology. Overall, the policies subsidize less efficient businesses, acting as a drag on the economy, and they shift more of the tax burden to individuals and bigger businesses.
While the benefits of the lower rate are useful to a subset of companies with profits to reinvest, it doesn’t help companies facing losses, something that is common in the early years of a business. In Ontario’s case, the cut may not necessarily lead to entrepreneurs getting more after-tax money out of their companies, given a large corresponding decrease in the non-eligible dividend tax credit rate.
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The small-business deduction also greatly increases complexity in the tax system, with elaborate rules required to prevent companies from breaking into smaller units to multiply the benefits, says Schulich School of Business taxation professor Amin Mawani. This means the Canada Revenue Agency needs to play closer attention to the sector and it allows accountants and lawyers to charge higher fees.
Reducing perks for small businesses is a political minefield – something former federal finance minister Bill Morneau learned the hard way when he tried to tighten tax rules for private corporations in 2017. Even so, federal and provincial governments shouldn’t make the situation worse by continuing down the path of cutting small-business taxes. Instead, they should eliminate the small-business tax rate and put the savings towards lowering the general corporate rate.
Another measure in Ontario’s budget is a better bet: The acceleration of the income tax deduction for equipment and other assets, which mirrors a new federal change, will spur investment. However, the measure is still too narrow, and should be expanded and made permanent.
The provinces and the federal government are awash in red ink, claiming they need to run deficits to promote growth in the face of economic headwinds and global strife. But if that’s the case, this increased spending and tax cuts need to clearly lead to economic growth and boost Canada’s lagging productivity. Ontario’s small-business tax cut doesn’t make the cut.