Piecemeal tax changes won’t do. To get out of Canada’s productivity rut, we need radical reform

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Once again the Trudeau government has stepped on the hornet’s nest called tax reform, and once again it is getting stung. We have seen this happen before: for example, with the changes to the taxation of small private corporations in 2017, and with the “proposal” (if you can call it that: leaked to the press, it was more in the nature of a trial balloon) of the same year to tax employee health and dental benefits as income. Both encountered a storm of opposition, and were either amended or killed.

Now it is happening again, this time with regard to the taxation of capital gains. As with the previous attempted reforms, the proposal to increase the inclusion rate on capital gains from one-half to two-thirds (on gains over $250,000, for individuals; on all gains for corporations) is defensible on its own. It is right, on the face of it, to tax capital gains at the same rate as wages and dividends, which is the practical effect of increasing the inclusion rate.

Likewise, it was right, in 2017, to try to stem the enormous rise in wealthy individuals turning themselves into private corporations to take advantage of the preferential tax rate on small businesses – a wildly unfair opportunity for what is euphemistically called “tax planning” – as it would have been right to tax employee benefits as income, since that’s what they are.

The problem with all three reforms is their piecemeal nature. The tax system, it is well known, is riddled with dozens of similar anomalies and inequities: deductions, exemptions and other preferences that are either unfair or inefficient or both. To go after just one at any given time looks like selective justice. It opens the way for those affected, not just to persuade the public that they are being unfairly singled out, but much more importantly, to persuade themselves. There is no more lethal political movement than a special interest that is sincerely convinced it has been wronged.

Probably the government’s advisers thought a single-bullet reform was more manageable politically than one aimed at closing a number of tax breaks at one go. But it hasn’t tended to work out that way. With a broader reform, it is true, you antagonize many more taxpayers. But that in itself arguably makes it less toxic politically: if everyone’s ox is being gored at the same time, it’s harder for any one group to complain of ill treatment.

Moreover, with the revenue gains from a more substantial broadening of the tax base it becomes possible to cut tax rates, even quite significantly, without harm to the government’s fiscal position. Depending on how it was designed, this could result in an equal or greater number of “winners” from reform, to offset the “losers.” Whereas with a single-shot reform there are no winners, only losers.

That’s not just better politics. It’s also better policy. Raising the tax on capital gains to the same rate as other forms of income may eliminate one distortion in the system, but at the cost of increasing another: the distortion from taxing income generally. While it’s generally a good idea to close tax preferences – since they cause decision-makers to focus, not on the real economic costs or benefits of different choices, but on the tax advantages attached to each – it’s even better to close preferences and cut rates.

It’s particularly crucial at this particular moment. By now it is well understood that Canada is suffering from an acute crisis of growth, productivity and investment. That is to say, investment has sunk to such low levels – insufficient even to replace capital as it wears out or becomes obsolete, meaning the capital stock is actually declining – that productivity has not merely ceased to grow, but has of late been falling, as has per capita GDP.

This is not the sort of problem – a senior Bank of Canada official has referred to it as a productivity “emergency” – that can be turned around with piecemeal, incremental adjustments. It will take radical reform, on a wide range of fronts: from abolishing interprovincial trade barriers to ending business subsidies to opening up protected sectors of the economy to foreign competitors and investors.

But perhaps the most urgent imperative is sweeping reform to Canada’s tax system: the single largest barrier to investment and the biggest impediment to its efficient allocation. A good place to start is with the Finance Department’s annual report on the cost of federal “tax expenditures.” As the term implies, these are tax preferences that, by taxing certain taxpayers, activities and things at less than the statutory rate, cost the government money, the same as a spending program.

Not every tax expenditure should be considered a tax distortion, just because it loses the government revenue. The test is whether a given measure moves the system closer to or further away from neutrality. RRSPs, for example, which exempt savings from tax in the year they are saved – though they are taxed on withdrawal – ensure that savings are taxed only once, eliminating the bias against savings of a “pure” income tax.

The vast majority of such tax expenditures, however, serve no such legitimate purpose. Among the more obvious targets for elimination, on the personal income tax side:

• The non-taxation of capital gains on principal residences. High housing prices have many causes, but surely one of the most significant is that the gains on principal residences are entirely exempt from capital-gains tax: a tax break the Finance Department reckons costs the government roughly $6.5-billion annually. Is it any wonder that so much money has been plowed into housing, rather than more productive investments?
• The age tax credit. The tax system gives you a cookie for turning 65. It doesn’t matter whether you are rich or poor: everyone gets the same tax break, just for being old. The current cost to the treasury is $5.5-billion, up 50 per cent in the past seven years. As the numbers of the elderly swell, this can only grow.
• The Canada Employment Credit. Again, you get a tax goodie for being employed, no matter what your income. Why? Especially given the cost: $3.2-billion a year.
• The non-taxation of benefits from private health and dental plans. The failure to bring these into taxation costs the government another $4-billion annually.
• The charitable donation tax credit. Charity is a wonderful thing. But when you claim the charitable donation tax credit, you’re not just giving your money: you’re dragging everyone else into paying a part of it with you. What qualifies as a “charity” may have little to do with feeding the poor, and everything to do with political activism. Why should you have to pay for my pet causes? Cost: $3.8-billion.

There are lots more of these on the corporate income tax side. While many are inefficient and wasteful, most are fairly small beer, in terms of revenue forgone. The biggest exception: the preferential rate for small business.

We can see now what a distraction the 2017 controversy was. For all the political capital the government spent to somewhat limit the ability of a few wealthy taxpayers to have their income taxed at the small-business rate, it would have done far better to fix the problem at its source: by ending the preference for small business.

This isn’t just a matter of revenue loss. Baldly put, Canada has too many small businesses. Everyone loves a startup, but the real productivity gains come when a small business grows into a large business. Yet the tax system, perversely, encourages them to stay small. One dollar above $500,000 annual income, a corporation pays 15-per-cent federal tax. One dollar below, it pays only 9 per cent. This makes no earthly sense, and would make no sense even if didn’t cost the treasury $6.2-billion annually.

What sorts of tax cuts could be bought with these kinds of revenues? The Fraser Institute recently proposed reforms to the personal income tax system that would result in just two tax brackets: 15 per cent (under $235,675 in income, the same as the current top bracket threshold) and 29 per cent.

This would still leave Canada with relatively high marginal tax rates at the top end: at about 50 per cent, federal and provincial combined, Canada’s tax system would remain among the most steeply progressive in the developed world. But for most people below the top bracket it would mark a major improvement in tax competitiveness.

The institute put the cost of these cuts at about $38-billion. Just the handful of large preferences I have listed here would yield about $30-billion of that. It should not be hard to scrounge up the remaining few billion, whether by closing additional tax preferences or by – heaven forfend – cutting spending.

On the corporate side, the issue is less cutting rates – Canada’s corporate tax rates remain relatively competitive, though we are about to lose much of our edge, with the coming expiry of the Accelerated Investment Incentive – then it is more systemic pro-investment reforms, the kind that would really catch the attention of international investors.

For example, the economist Jack Mintz has proposed moving to a distributed profits tax: Profits would only be taxed on distribution to investors, exempting those reinvested in the company.

Professors Robin Boadway and Jean-François Tremblay, for their part, have suggested replacing the corporate income tax with a tax on corporate “rents.” Income is a slippery concept, depending as it does on measuring and comparing the values of things at different points in time, as we do when calculating inflation, capital gains, depreciation, amortization and so on.

The alternative is to tax corporations on their cash-flow each year: all cash in is taxable, all cash out is exempt. Capital purchases, in particular, could be expensed 100 per cent in the year they were made. But whereas corporations are currently biased in favour of debt finance – interest expenses are deductible, dividends are not – Mr. Boadway and Mr. Tremblay would allow a standard deduction for a “normal” return on equity.

The tax would therefore only fall on profits in excess of that normal return – what economists call “rents” – the kind that aren’t readily available elsewhere, and hence can be taxed without scaring off investors. Effectively, the marginal tax rate on investment would go to zero.

There are pros and cons to each approach (the Boadway/Tremblay proposal would also require, among other things, fully taxing dividends and capital gains at the personal level). The point is simply to say that incremental reforms (even supposing anyone were talking of those) are no longer sufficient.

It has taken decades for Canada to sink into its current state. Unless we want to spend the next several decades getting out of it, we will have to be prepared to think about radical, even revolutionary reforms, starting with our antiquated, overloaded, exception-riddled tax system.