Trudeau government’s small business tax changes won’t help the middle class

The Trudeau Liberals were elected for, among other reasons, their commitment to a more prosperous economy, particularly one where the benefits flowed to the middle-class. Since coming to power in 2015, there’s almost nothing the federal government has done without first couching it in prosperity for the middle class.

To that end, the government recently embarked on a path to change the tax rules for small businesses with a focus on ending—or at least significantly curtailing—the ability of so-called “wealthy” Canadians to reduce their tax bill by incorporating. And the government is quite right—eligible professionals can markedly reduce their tax bill by re-organizing their affairs as a corporation rather than as an employee.

But the government is oblivious to “why” Canadians do this in the first place. The main reason to spend the time and money (often, significant time and money) to incorporate is to gain a tax advantage between the tax rates applied to individual employees and those available to small corporations. The gap between the two is what motivates people to pursue these mechanisms.

And the Liberal government’s hiking of the top personal income tax rate from 29 to 33 per cent made this gap larger. Indeed, the fed’s tax hike came on top of similar tax hikes in many provinces including Ontario, Alberta and New Brunswick. Put simply, these tax hikes increased incentives to incorporate because the tax gains available were made larger.

The political uproar that emerged across the country opposing Ottawa’s small business tax reforms has triggered more back-pedalling by the Trudeau government. A number of tweaks are being made to the proposed reforms to try to exempt most small businesses, in effect “targeting” only the very successful small businesses. In addition, the government recently announced it will re-introduce the Tories original plan to lower the small business tax rate from 10.5 to 9.0 per cent by 2019. This was bad policy when the Tories announced it, and even worse policy now given the larger spread between personal and business tax rates.

This is bad policy for two reasons.

One, it exacerbates the gap between tax rates for small businesses compared to employees, which as we explained above is the underlying reason people pursue these mechanisms in the first place. Put simply, the Liberals are encouraging the very behaviour they set out a few months ago to discourage. The real solution to the problem is to move to a lower, more uniform set of tax rates between both different types of income and different levels of income.

Perhaps more importantly though, the federal government’s changes to small business taxes will increase the incentives for firms to stay small. This is not a recipe for economic prosperity.

The cut in the small business tax rate means the tax wall small firms face as they grow and expand has increased. A number of research studies have noted how the enormous jump in taxes for businesses as they move from “small” to “general” is a disincentive for growth. The change in federal tax rates for businesses, given the announced rate reduction, increases by more than 50 per cent when a firm moves from a small business to a normal or general corporation. This is exacerbated by similar tax preferences imposed by the provinces.

Put simply, the tweaks announced recently to quell political and popular opposition to the Trudeau government’s small business tax reforms will discourage businesses from investing and growing, encourage more tax-planning through the use of corporations, and further complicate an already anachronistic and costly tax code. This isn’t the way to grow the economy for middle-income Canadians or any Canadians.