Morneau’s small business tax ‘fix’ won’t fix the problem

In response to widespread criticism of Finance Minister Bill Morneau’s plan to change the tax rules for small businesses, this week the federal government announced a series of “tweaks,” cutting the small business tax rate from 10.5 per cent to 9 per cent by 2019.

The problem, however, is that reducing the small business tax rate directly undermines Morneau’s stated goal and reinforces another problem with Canada’s tax system.

While Morneau’s aim is to end—or at least significantly curtail—the ability of some Canadians to reduce their tax bill by incorporating, the proposed changes do nothing to address why people pursue such tax strategies in the first place.

The main reason they spend 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 strategies.

Morneau actually contributed to the problem he wants to fix by hiking the top personal income tax rate from 29 to 33 per cent—making this gap larger. This federal tax hike came on top of similar tax hikes in many provinces including Ontario, Alberta and New Brunswick. These hikes increased the incentives to incorporate because the tax benefits available were made larger.

And now, instead of reducing the gap between individuals and the small business tax rate, Morneau will make the spread even larger by cutting the small business tax rate. Put simply, the Liberals are encouraging the very behaviour they want to discourage.

Making matters worse, the government’s changes will exacerbate the incentive for firms to stay small. Why? Because cutting the small business tax rate means the tax wall small firms face, as they grow and expand, has increased. Several research studies have shown how the enormous jump in taxes for businesses as they move from “small” to “general” discourages their growth. After Morneau’s changes, there will more than a 60 per cent increase in the tax rate 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.

Perversely, Morneau’s response to criticism will not only undermine his policy aims, it will also discourage businesses from investing and growing.