February 2001
Business Income Tax: Jumping from One Fire to Another
by Jason Clemens & Joel Emes
It seems that small businesses have attained near divine status in Canadian politics. Any initiative that appears to support small business is heralded as positive, regardless of its larger impact. This is reflected in the increasingly preferential treatment bestowed upon small business by the corporate income tax structure in Canada. However, the increasing differentiation between small business taxation and general corporate taxation raises serious questions.
Corporate tax reform
Canada is just now emerging from a period when we discriminated against businesses based on the sector in which they operated. Prior to the corporate income tax reforms announced in the February 2000 federal budget, manufacturers and processors faced a federal corporate income tax rate of 21 percent, while all other corporations were taxed at 28 percent.
In its 2000 budget, the federal government announced that it was phasing out the tax differential between manufacturing and processing industries and other corporations over a 5-year period by decreasing the general corporate income tax rate to 21 percent. It subsequently accelerated the reform to a 4-year phase- out in the so-called October mini-budget. The re-election of the Liberals ensures that the differential tax rates will be eliminated by 2004.
The fallacy of picking winners
Many years ago, the federal government decided to further industrial development and economic growth, and in so doing, picked a group of corporate winners.1 As The Fraser Institute has pointed out, governments don't pick winners very well. In this case, the federal government selected manufacturing and processing as the future cornerstones of industrial development—at the expense of other industries such as high-tech and finance.
That said, the federal and many provincial governments are not ready to get out of the winner-picking business just yet. Now, instead of endowing a specific sector with favoured status, governments (particularly the provincial governments) are frequently picking small business as the winners through increased preferential tax treatment. As the following analysis shows, almost every jurisdiction in Canada now has a preferential tax system tilted towards small business.
Small business income tax
As a result of special tax preferences, the applicable federal income tax rate for small business is 12 percent for the first $200,000 of net income. Therefore, at the federal taxation level, small businesses maintain a 9 percentage-point tax advantage over larger corporations in the same business.
|
Table 1: Summary of Provincial Business Income Tax Rates |
||||||||
|
Specific Tax |
BC |
AB* |
SK |
MB |
ON** |
QC |
NB |
NS |
|
Small Business |
4.75 |
3.00 |
8.00 |
7.00 |
4.00 |
9.04 |
4.50 |
5.00 |
|
Threshold§ |
200,000 |
400,000 |
200,000 |
200,000 |
400,000 |
N/A |
200,000 |
200,000 |
|
General Corporate Income Tax Rate |
16.50 |
8.00 |
17.00 |
17.00 |
8.00 |
9.04 |
17.00 |
16.00 |
|
M&P Income |
16.50 |
8.00 |
10.00- |
17.00 |
8.00 |
9.04 |
17.00 |
16.00 |
|
*Assumes full implementation; scheduled for 2004. The rates for 2000 were
6.0% for small business, 15.5% for general corporations and 14.5% for manufacturers
and processors. |
||||||||
Similarly, all provinces except Quebec maintain a preferential tax system for small business.2 In fact, the 2000 round of provincial budgets included a battle of one-upmanship regarding small business tax rates. First, British Columbia announced the lowest small business tax rate. Then BC was trumped by New Brunswick. Both were then trumped by Ontario. Then everyone was trumped by the Alberta Business Tax Review. By the end of it all, the range of preferential tax treatment for small business by all provinces except Quebec was between 5.0 percentage points (Alberta) and 12.5 percentage points (New Brunswick).
Bitter irony: hurting those we want to help
Should we care that nearly every province as well as the federal government is now increasingly favouring small businesses through the tax system? Yes.
The tax differential creates an artificial preference favouring smaller businesses at the expense of larger businesses. The goal of tax policy should be to raise sufficient tax revenue to finance government spending in the least distortionary manner.
Marginal tax
Economists are generally concerned with actions and decisions at the margin. One of the concerns that arises from the increasingly preferential treatment for small businesses are the high and increasing marginal tax rates that kick in when the firm gets larger, and begins to pay the general corporate tax rate. Assume you are a small business owner in British Columbia. Your business faces an income tax rate of 4.75 percent on net income up to $200,000. However, on an additional dollar of income after this threshold, your business' applicable income tax rate increases 347.4 percent, from 4.75 percent to 16.50 percent (see table 1). This is an enormous increase in the marginal tax for your firm. Such a large marginal tax can—and in all likelihood will—have a negative affect on the growth of small business.
Structural disincentives
Another potential problem is the possibility that firms will not restructure or merge because of the tax implications. Consider two firms of similar size but with different strengths. One has an excellent research and development team while the other has a large, reliable marketing and support team. These companies are interested in merging to take advantage of their respective strengths, but may not do so because of the merger's tax implications. Specifically, if both companies earn $200,000 (net income), all of their income is currently taxed at the small business rate. The merged company would pay the small business rate on only the first $200,000, and the general rate on the next $200,000. If the benefits of the merger do not at least match the increased tax burden, then the firms may choose not to merge.
No one benefits from this situation. Customers lose because the merged firm probably would be a better (i.e., a more efficient) supplier than are the two firms operating separately. Shareholders lose because the merged firm would likely have returned larger dividends and greater share value, excluding tax implications. Employees lose because of the foregone opportunities associated with growth and the stronger potential for wage increases in the merged firm. Governments lose because the growth prospects of the individual firms are likely lower than those of the merged firm.
Ironically, the tax-based preference may impede the very sector various governments are attempting to promote. A series of studies, primarily by Statistics Canada, suggests that Canadian firms are too small. Many firms face difficulties such as a lack of managerial skill and financing in part because they fail to grow. The irony of the recent bias in tax policy towards small business is that it creates a tax incentive to remain small.
Conclusion
The federal and some provincial governments were right to end the tax discrimination against non-manufacturing firms by reducing the rates faced by non-manufacturers to those faced by manufacturers. In other words, government dealt with the tax bias by reducing corporate income tax rates for non-manufacturers. A similar approach should be taken for small business income tax. Rather than simply increase rates for small business, governments should eliminate the various tax credit programs aimed at business while at the same time lowering corporate tax rates. This needs to be done anyway since many of our competitors have recently announced corporate income tax cuts. Lowering corporate tax rates would reduce the differential between the corporate and small business income tax rate. It would also reduce the marginality of moving from the small business tax rate to the corporate tax rate as firms grow. What we should be aiming for is an integrated tax system for both people and businesses based on a flat tax, but that's another story entirely.
Notes
1 The tax differential in Canada was introduced in response to a US government decision to create a tax preference for exporters.
2 Other types of preferential treatment also exist, such as tax holidays and generous tax credit programs. Quebec uses such programs to a greater extent than most other provinces.
References
Alberta Treasury, Alberta Business Tax Review: Report & Recommendations, Sept. 2000.
Baldwin, J. (1998). Failing concerns: business bankruptcy in Canada. Statistics Canada. Available on the Internet at www.statcan.ca/english/services/.
Baldwin, J., Hinchley, C. and Johnson, J. (1997). Successful entrants: creating the capacity for survival and growth. Statistics Canada. Available on the Internet at www.statcan.ca/english/services/.
Baldwin, J., Bian, L., Depuy, R. and Gellatly, G. (2000). Failure rates for new Canadian firms: new perspectives on entry and exit. Statistics Canada. Available on the Internet at www.statcan.ca/english/services/.
CIBC Economics Division, Small Business in Canada: Trends & Prospects. March 2000. Available on the Internet at www.cibc.com/english/business_services/economics/21_ANALYSIS/index.html.
Federal Department of Finance, The Budget Plan 2000: Better finances, better lives. February 2000. Available on the Internet at www.fin.gc.ca/fin-eng.html.
Federal Department of Finance, Economic Statement and Budget Update. October 2000. Available on the Internet at www.fin.gc.ca/fin-eng.html.
Ontario Ministry of Finance, Ontario Budget 2000, June 2000. Available on the Internet at www.gov.on.ca/FIN/english/enghome.htm.
Jason Clemens (jasonc@fraserinstitute.ca) is the Director of Fiscal Studies at the Fraser Institute and Joel Emes (joele@fraserinstitute.ca) is Senior Research Economist at The Fraser Institute. He has an M.A. in Economics from Simon Fraser University.
info@fraserinstitute.ca
4th Floor, 1770 Burrard Street, Vancouver, BC, Canada, V6J 3G7
Tel: (604) 688-0221 Fax: (604) 688-8539 Book Orders: 1-800-665-3558 ext. 580
You can contact us at the above email address for any comments or information requests. Please report any dead links or technical problems.