Proposed tax changes targeting private corporations fall short of comprehensive reform

Yesterday the Trudeau government wrapped up consultations on its proposed tax changes targeting private corporations. The proposed changes are best described as a piecemeal approach that falls well short of the type of comprehensive tax reform Canada’s needs. Simply put, this is a lost opportunity.

Consider this. The standard approach to tax reform—as was the case with Canada’s major personal income reform in 1987—is to use the revenues from eliminating preferential tax measures to reduce marginal tax rates broadly. In doing so, the government would eliminate special preferences for certain groups while reducing tax rates for everyone, thus improving the economic environment for workers, businessowners, entrepreneurs and investors.

Instead, the Trudeau government plans to retain the new revenues. This is actually a trend, as this government has eliminated several tax credits and other special priveleges embedded in the tax system without using the resulting revenues to cut tax rates broadly by an equivalent value.

When it comes to the proposed tax changes targeting private corporations, it’s important to understand why anyone pursues tax-planning through such vehicles in the first place, since doing so comes at a cost. Business owners including professionals must spend significant amounts of money on accountants and lawyers in order to use these options in the tax code. These expenses make sense because the costs are less than the benefits gained by lowering their effective tax rates. Critically, the tax savings are a result of large gaps in tax rates between different levels and types of income.

For instance, if a professional can shift income from themselves to a spouse with lower earnings or perhaps a dependent child with no income, the gains from lower tax rates can be significant. Assume a doctor being taxed at the top federal tax rate of 33 per cent can shift income to their spouse who only works part-time and pays income taxes at the lowest federal rate of 15 per cent. That’s more than a 50 per cent reduction in the marginal tax rate from shifting income from one spouse to another. The gain is even larger if the income is shifted to a dependent child with no income.

These tax differences are the reason people pursue the strategies in question. If the government reduced the gaps between tax rates, it would reduce the incentives (that is, the benefits) of such tax planning in the first place. Instead, the current government has made this gap larger by increasing the top federal tax rate from 29 to 33 per cent. By making the tax gap larger, the federal government—along with several provinces—inadvertently increased the incentives for eligible professionals and business owners to use these strategies.

Introducing new rules to eliminate or mitigate the use of these strategies, as the Trudeau government proposes to do, alone will not solve the underlying problem. They will simply incentivize accountants and lawyers to figure out new ways to get around the new rules for their clients. The solution is to concurrently eliminate, or at least meaningfully reduce the tax rate differentials that exist in the system. Doing so will reduce the incentive for tax planning in the first place.

Indeed, absent from the debate around the proposed tax changes is the behavioural response by affected individuals or businesses. The federal government has implicitly assumed that affected Canadians will simply accept the higher taxes and continue to work the same, invest the same, and grow their businesses the same. The reality is that large-scale changes in behaviour can be expected from these higher taxes, as affected Canadians may work less in response, increase the fees they charge their customers, or seek new tax-planning methods to work around the new rules.
 
Moreover, a risk inherent in the government’s proposal is the potential to make the system more complicated without solving the fundamental problem. There will remain an incentive for Canadians to incur the costs of hiring accountants to help them tax plan but the administrative and compliance costs will increase as the Canada Revenue Agency plays a greater role in enforcing the proposed new rules.

A final concern relates to the negative signals the government is sending to entrepreneurs and investors in its public communications. During a recent nationally televised interview, Finance Minister Bill Morneau (pictured above right) used the phrase “going after” to describe his government’s approach to extracting more taxes from incorporated “professionals and wealthy people, ” when responding to a question about the government’s proposed changes to small business taxation. This language signals to the world that Canada is an unfriendly place to do business, which undermines our country’s ability to attract investment, a key ingredient for economic growth and innovation.

We’ve seen positive tax reform from past federal Liberal governments—whether that’s forging a Technical Committee on Business Taxation and implementing many of the committee’s recommendations, expanding RRSP contribution room, or lowering the inclusion rate for capital gains taxation. Pro-growth tax reform is a non-partisan issue and needed now more than ever.

Charles Lammam, director of Fiscal Studies at the Fraser Institute, presented a variation of this post before the House of Commons Standing Committee on Finance on September 28, 2017.