Tax reform may be prominent issue in U.S. election, with implications for Canada

In June, House Republicans led by Speaker Paul Ryan unveiled a tax proposal plan that might well become a major plank in the Republican Party platform in the upcoming presidential and congressional elections this November.

One major feature of the plan is the consolidation of the current seven tax brackets for individuals and joint filers to three brackets and a lowering of the top federal tax rate, currently 39.6 per cent, to 33 per cent.

A second major feature is the call to lower the top U.S. corporate tax rate from 35 per cent to 20 per cent and to shift the corporate tax structure to a “territorial” system whereby foreign earnings of U.S. companies would be exempt from U.S. taxation. Currently, U.S. companies must pay taxes in the United States when they repatriate profits earned abroad.

The Ryan tax plan would also result in a maximum tax rate for small business income of 25 per cent as opposed to subjecting that income to the top individual tax rate—33 per cent under the plan. There would also be a 50 per cent tax exclusion on capital gains, dividends and interest income, while the other 50 per cent would be taxed at the relevant marginal income tax rate. The net result is a substantial reduction in the tax rate on capital income.

For the highest income earner, the capital gains tax rate would drop to around 16.5 per cent. While some tax write-offs for businesses would be eliminated, the major tax deductions for individual filers, including those for mortgage interest, charitable giving and retirement savings, would continue.

Democratic opponents of Ryan’s plan were quick to criticize it as highly income regressive, that is, lowering rates proportionally more for higher income than for lower income taxpayers, particularly the provision to lower the effective tax rate on capital income. The presumptive Democratic candidate, Hillary Clinton, has argued on the campaign trail for modest tax reforms that would effectively raise the marginal tax rates of upper-income Americans. She has also called for a 15 per cent tax credit for companies that share profits with workers but would otherwise leave the corporate tax structure essentially unchanged. 

If anything resembling the current Ryan tax proposal does become a major part of the Republican Party’s presidential election platform, it will set out a clear choice for American voters between a move towards supply-side -oriented government fiscal policy and the continuation of the complex and opaque income redistribution-oriented tax code. Supply side fiscal policy emphasizes encouraging investment and entrepreneurship primarily by reducing marginal tax rates.

Any changes in the U.S. personal and corporate income tax codes along the lines of the Ryan plan could have significant implications for Canada. In particular, incentives for high income-earning Canadians to relocate to the U.S. would be strengthened.

By way of contrast to the Ryan-proposed tax rates, the combined statutory (federal plus provincial) 2016 marginal tax rate on income other than capital gains and dividends is 53.53 per cent for an Ontario resident earning over C$220,000. The capital gains rate is 26.76 per cent, while the tax rate for eligible Canadian dividends is 39.34 per cent. These are clearly substantially above comparable U.S. rates and would be even more so with the proposed Republican changes.

Canada’s corporate tax rate advantage would also disappear with the implementation of the Republican proposal. Specifically, the OECD estimates the combined (average) federal plus provincial government corporate tax rate in Canada to be around 26.7 per cent in 2016. A U.S. corporate tax rate substantially below this could tilt both domestic and foreign business investment towards the U.S. and away from Canada.

In any event, Canadian policymakers must be sensitive to any growing tax disparities between Canada and the U.S. if Canada is to remain competitive in the worldwide competition for corporate investment and for highly-skilled professional workers and entrepreneurs.