The Fraser Institute: Tax Reform in Canada:  Our Path to Greater Prosperity

A Fraser Institute Conference,
October 11, 2001, Toronto, Ontario, Canada

Business Taxes: An Evaluation

Thomas A. Wilson
Director, Policy and Economic Analysis Program,
Institute for Policy Analysis,
University of Toronto.

The author thanks his research associates, Duanjie Chen and Steve Murphy, who carried out the analysis underlying the tables in this report; and Erin Bell, who prepared the final version of the paper.

Paper prepared for "Tax Reform in Canada: Our Path to Greater Prosperity" Conference, to be held October 11, 2001, in Toronto, Ontario, Canada.

Introduction

Businesses in Canada are taxed in a variety of ways.  The most important tax on business is of course the corporate income tax (CIT), but a variety of other taxes are levied on businesses.  The personal income tax (PIT) levied on unincorporated businesses and the taxation of corporate dividends and business capital gains under the PIT also affect business decisions.  Federal and Provincial taxes on corporate capital represent another component of business taxation.   Municipal and Provincial property taxes on commercial and industrial property are also important.

The employer component of federal and provincial payroll taxes is the second most important set of taxes paid by businesses.  In 1995 revenues from business payroll taxes actually exceeded corporate income tax revenues.  In 2000 total corporate revenues were almost $46 billion, whereas total business payroll taxes were $28.6 billion.  Table 1 presents details on Corporate Income, Capital and Payroll Taxes.

In this paper I shall focus on the corporate income tax and the related issues of Personal/Corporate income tax integration.  For a discussion of the effects of business payroll taxes, see Mintz and Wilson (2001) and Dungan (1998).

In evaluating the corporate income tax and corporate/personal tax integration, I assume that the basic structure of the income tax system remains unchanged – i.e. no radical reforms such as a switch from an income base to a consumption base are contemplated.  This means that I evaluate the corporate income tax within an income-based tax system.

Table 1 Corporate Income, Capital and Payroll Taxes, 1971-2000.

Source: National Income Accounts and Author's Calculations

^a Federal corporate income tax includes the large corporation tax and capital taxes on financial institutions

^b Provincial corporate income tax includes taxes on mining and logging profits.

^c 58% of EI contributions, 100% of provincial payroll taxes and 50% of CPP/QPP contributions are paid by employers.  Following the Mintz Committee (Table 2.1) we assume that ¾ of employer payroll taxes are paid by businesses.

Reasons for a Separate Corporate Income Tax

Why tax corporate profits at all?  Since these profits are ultimately either distributed as dividends or generate capital gains, both of which are taxed under the personal income tax system, one could argue that a corporate income tax is redundant and involves an element of double taxation of corporate source income.

Whether there is in fact double taxation depends on the degree of integration of the PIT and the CIT.  A fully integrated CIT will eliminate double taxation.  I would argue that a separate (but integrated) corporate income tax is required in an income tax system for several reasons.  First, taxing corporate income at the corporate level protects the personal income tax base.  If there were no corporate income tax, the absence of taxation of undistributed profits would present extensive opportunities to defer personal income taxes (since capital gains are taxed on a realization basis).  Corporate level taxes mitigate or eliminate this problem.  Second, a corporate tax enables Canada to tax profits of foreign owned enterprises.  Without a corporate tax, profits of foreign owned enterprises would be fully taxed in the source country.  A Canadian corporate tax enables Canada to tax these profits first; eliminating this tax would effectively transfer most of the revenues to foreign treasuries.

Finally, a separate corporate income tax effectively taxes pure profits or 'rents' on an accrual basis.   As noted by Boadway and Kitchen (1980) this portion of the corporate tax would be non-distorting and hence highly efficient.¹

Existing Corporate Income Taxes in Canada

The federal and provincial governments in Canada tax corporate profits.  Seven of the provinces levy their tax on the federal base (and have the federal government collect tax on their behalf).  Three important provinces (Alberta, Ontario, and Quebec) have separate corporate taxes.

Statutory and effective rates of tax vary by industry, by size, by type of asset and by province.  Major features of the existing CIT system include:

A preferential rate for manufacturing.

Special allowances and deductions for certain resource industries.

A favourable rate for small Canadian controlled private companies (CCPCs).  The corporate taxation of these companies is approximately fully integrated with personal taxes.

Since dividends receive a credit (under a gross-up and credit mechanism) and capital gains are taxed at ½ the rate of ordinary income, there is partial integration of the CIT and PIT for large companies.

When compared with other countries, the current level of statutory corporate tax rates (except for small CCPCs) is higher than that of the US for non-manufacturing companies, and lower than that of the US for manufacturing companies.  Because of other features of the corporate tax (various deductions and credits) the marginal effective tax rate for manufacturing is about the same in Canada as in the US, but marginal effective tax rates for services are higher.  Several other countries (Sweden, the UK and Ireland) have lower rates of tax.

Fortunately Canada is in the process of lowering corporate tax rates.  The federal government reduced the general statutory rate by one percentage point on January 1, 2001 and is committed to reducing this rate by six more percentage points over the next three years.  Ontario reduced its general corporate tax rate by 1.5 percentage points in 2001, and is committed to a further six percentage point reduction over the next five years.  Alberta reduced its rate to 13.9% this year and is committed to reducing the rate to 8.0% over the next 5 years.  The recently elected government of British Columbia has announced a three precentage point reduction, effective on January 1, 2002.  When these federal and provincial rate reductions are fully implemented in 2006, the average statutory corporate rate for large corporations will be reduced to 32%.  This represents a decline of 11.3% for large non-manufacturing firms and a decline of 3.0% for large manufacturing firms.

These large statutory rate reductions generate significant reductions in marginal effective tax rates (METRs)  for most non-manufacturing firms.  With the exception of the Oil and Gas and Mining sectors, large non-manufacturing firms will experience declines in METRs of 3.6 to 7.2 percentage points.  The METR for large manufactures is projected decline by 2.5 percentage points.  At current rates of tax in the US, these planned rate reductions would put METRs in Canada 2½ to 3 percentage points below those in the US.  The statutory rate for large corporations would be about 7 percentage points below the US rate.  Even with these rate reductions, however, corporate taxes for large firms would be higher in Canada relative to the UK, Sweden and Ireland.

Principles for Efficient Taxation of Corporations

The existing corporate tax system was examined extensively by the Technical Committee on Business Taxation (The 'Mintz Committee').  Following other review of the corporate income tax the Mintz Committee argued that a basic general principle of business taxation should be neutrality, i.e. that the tax system should not distort business decisions by favouring particular industries, investments or activities.  The Mintz Committee also emphasized that the level of business taxation should also be internationally competitive, i.e. that rates of tax in Canada should not be higher than those of our major trading partners.

Neutral tax treatment would entail marginal effective rates of tax which would not vary across asset types or industries.  As the Committee found, however, these rates varied greatly across assets, across industries, and by size of corporation: the existing tax system was far from neutral.  There was substantial room for improvement of Canada's corporate tax structure.

Non-neutral treatment is appropriate where market imperfections affect investment decisions.  Two important cases where non-neutral treatment is desirable are investment in Research and Development (R&D) and investments by small businesses.  R&D investments can generate significant spillovers or externalities which are not captured by the investing firm.  This provides the justification for the various R&D tax incentives under the corporate income tax.  However, it may well be the case that Canada's tax treatment of R&D is too generous.  Currently investments in R&D capital enjoy large negative marginal effective tax rates (due to credits and deductions).

In the case of small businesses, the typical small corporation may be capital rationed i.e. the firm may have limited access to capital (or may force prohibitive capital costs).  Such capital rationing may be mitigated by a lower rate of tax on retained earnings of small businesses.  This is one justification for Canada's generous treatment of small CCPCs.  The other is personal/corporate tax integration, which is considered in the next section.

Corporate/Personal Tax Integration

Ultimately the corporate income tax, like other general taxes on business, is borne by individuals, whether in their capacity as shareholders/investors, as consumers or as employees.  Some business taxes (eg. payroll taxes) are eventually primarily shifted back to employees in the form of lower wages.  Others (eg. sales taxes) are shifted forward to consumers through higher product prices.  In the case of the corporate income tax the incidence of the tax is ambiguous.  The Technical Committee took an eclectic view, arguing that some portion of the CIT is borne by investors in Canada, and some by foreign treasuries.

To the extent that the corporate tax is borne by investors, there will be effects on savings and investment which adversely affect the rate of growth of future potential output, thereby reducing the average growth of real income of Canadians.  It is therefore most important to design an efficient corporate income tax which minimizes these negative effects.  As well as being neutral with respect to industries and assets, an efficient corporate tax should not favour one form of financial capital (eg. debt) over another (eg. equity).  Without integration and without a deduction for the 'normal' rate of return on equity capital, corporate income taxation encourages debt (since interest is deductible) over equity (since there is no deduction for the cost of equity capital).  Under a so called 'classical' CIT with zero integration, interest income is subject to tax only once, at the personal level, whereas income from equity investments are taxed twice: as corporate profits under the CIT and as dividends or capital gains under the PIT.  Full integration, which sets the combined CIT/PIT rate to the PIT rate applicable to other income, eliminates this distortion.

Furthermore, full integration eliminates another non-neutrality of a 'classical' corporate income tax: the distortion of incorporation decisions.  Without full integration, the combined taxation of corporate source income exceeds the taxation of comparable unincorporated businesses.²

Following the Tax Reforms of 1971, Canada's CIT was fully integrated for small CCPCs, but only partially integrated for larger firms.  The basic mechanism of integration is the gross-up and credit mechanism for dividends.  This was set to achieve full integration for dividend income for firms subject to the lower small business rate.  At the higher corporate tax rates faced by large taxpaying firms, however, the dividend credit was insufficient to fully compensate for corporate taxes paid.

Over the years the dividend credit has changed, along with changes in statutory corporate rates.  In some years there has been over-integration for small business, i.e., the dividend credit was generous enough to reduced the combined tax on dividend income below that on other income.  With the provinces levying differential rates of corporate tax on small business, and with federal and provincial surtaxes, the situation has become more complex.  With provinces having moved to a tax on income from a tax on tax PIT system, more complexity may follow.  At present there is over-integration in some provinces and under-integration in others. (However, the departures from full integration are not large.)

Recommendations of the Technical Committee on Business Taxation

The recommendations of the Technical Committee were constrained by the requirement that their overall package had to be 'revenue-neutral'.  Unless rate reductions were to be 'self-financing' (through stimulative effects to economic activity) rate reductions would have to be financed by base-broadening measures.  Furthermore, the cost of any transitional relief to be provided to industries adversely affected would be limited by the revenue neutral requirement.

Since the committee was established in 1996, at a time when deficit reduction dominated the fiscal policy agenda, this revenue neutral requirement was an understandable constraint.  Now that Canada is achieving fiscal surpluses, and the debate is about allocating the future fiscal dividend, this revenue neutral constraint is no longer binding.  There should be room to provide transitional relief to industries who would face increased tax burdens through base broadening reforms together with lower statutory rates (or general investment tax credit.

The key base broadening recommendations made by the Committee include:

Reduction of Capital Cost Allowance (CCA) rates for certain classes of investment.

Phase out of the 100% write-off of R&D Capital Assets, and reduction of R&D credits.

In consultation with the Provinces, restructuring the resource allowance to apply to resource revenues net of all deductions.

Reduction of the rate of write-off of development costs from 30 to 25%.

Following a 5 year notification, the immediate writeoff of development expenses in mining should be replaced by a 25% deduction on a declining balance basis.

Various limitations on the deductibility of interest expenses for investment in foreign affiliates (and other measures to tighten the taxation of international investment income).

Phase out of the Atlantic Investment Credit.

Harmonization of the capital tax bases of the federal and provincial governments, together with the elimination of the deductibility of provincial capital taxes.

The Committee's estimates of the revenues to be gained by these base broadening measures are summarized in table 2 below.

As is apparent, these recommended corporate tax measures would generate about 2 billion in revenue (as these estimates were based on 1997 estimates, the revenue impacts would be somewhat larger now).

The Mintz Committee also addressed the issue of integration and the taxation of capital gains.  While supporting the continuation of the gross-up and credit system for dividends, the Committee was concerned that the credit was too generous in cases where corporate income tax paid was less than the amount credited - e.g. where dividends were distributed from corporate income which has been sheltered by deductions and/or credits.  The Committee proposed a dividend distribution tax of 25%, payable by corporations.  As corporate and provincial corporate profits taxes would be fully creditable against this dividend distribution tax, it would mainly affect non-tax paying corporations, and to a lesser extent CCPCs in provinces where there is over-integration of dividend income.   The Committee estimated that this measure would generate a revenue increase of $525 million  -$350 million for the federal government and $175 million for the provinces.

Table 2 Revenue Impacts of Proposed Corporate Tax Measures

Source: Report of the Technical Committee, Table 1.1.

The taxation of capital gains represents another component of integration.  When capital gains are taxed at the same rate as dividends under the PIT, dividends and retained earnings are subject to the same degree of integration.  The Committee reviewed the argument for taxing capital gains at rates below the rate on other income and concluded that the ¾ inclusion rate then in effect for capital gains was appropriate.  I would question this conclusion, since the effective rate of tax on capital gains was higher than the effective rate on tax on dividends for top bracket taxpayers.  To bring these effective tax rates into line for top bracket taxpayers, the inclusion rate should be reduced to T. 

The Committee also recommended that the $500,000 lifetime capital gains exemption for farmers and owners of shares of CCPCs should be eliminated, to be replaced with enhanced RRSP contributions which would treat such capital gains as equivalent to earned income on a lifetime basis.  The Committee estimated that this measure would generate an additional $450 million of revenue, divided $275 million to the federal government and $175 million to the provinces.

When combined with the estimated revenue from the corporate tax changes, the implementation of the dividend distribution tax and the changed treatment of capital gains would altogether increase federal revenues by about two billion dollars and provincial revenues by about one billion.  These reforms were sufficient to finance the Committee's recommendation that the general federal corporate tax rate be reduced to 20% and the provincial rate to 13%.

Regarding payroll taxes, the Committee focussed on the only federal payroll tax: EI contributions.  As employers currently pay 1.4 times the employee contribution rate, they nominally pay 58 percent of this tax.  Governments and non-profit institutions contribute to EI; the Committee estimates that 75 percent of the employer payments are made by businesses.   While recognizing that, in the long run this type of tax is largely (but not completely) shifted back to workers, the Committee recognized that in the short run an increase in the employer contribution rate could raise labour costs with adverse effects on employment and economic growth.

The Committee's main concern was with the interindustry distribution of the costs and benefits of EI payments.  A small number of industries have very high benefit/contribution ratios, which means that these sectors are subsidized by payroll taxes paid by firms in other sectors.  The Committee recommended that an experience rating system for employers by gradually phased in.  Basically they recommended that, as the large surplus in the EI "Account" permits reductions in contribution rates, the reduction for employers be targetted to employers who have had superior layoff experience.

Because governments would be 'superior' employers under this system, the implementation of experience rating would reduce government payroll costs by almost $300 million.

The Committee also expressed the view that the federal government should reduce average EI premiums over time in order to bring revenues down to the long run cost of the program.  However, no explicit rate targets were recommended, and therefore no estimates of revenue impacts were provided.

What Has Happened Since the Report of the Technical Committee?

Key Federal Tax Measures Since 1997

The package of recommendations made by the Mintz Committee was revenue neutral.  They could therefore have been implemented during the period of fiscal restraints.  However, the federal government did not act immediately to implement any of the Committee's recommendations.  The federal budget of 1998 provided some personal income tax relief targetted to low to middle income taxpayers.  The basic employee contribution rate was reduced by 20¢ (and the employer contribution rate by 28¢).³  Otherwise, no significant changes to business taxes were introduced.

The 1999 budget broadened the PIT relief to include middle to higher income taxpayers.   Prior to the budget,  EI premia were again reduced - by 15¢ for employees and 21¢ for employers.  The budget did introduce a measure which reduced effective tax rates for electricity generation by extending the Manufacturing and Processing credit to these firms.  This measure was phased in over four years, and will reduce the statutory federal corporate rate by 7 percentage points when fully implemented in 2002.  While specific to the electrical generation industry, this measure can be viewed as a small initial step towards the more general corporate rate reductions recommended by the Technical Committee.

With Budget 2000, the federal government finally made a major commitment to reduce corporate income taxes.  The general corporate tax rate reductions proposed were a one percentage point cut in 2001 and six additional percentage point reduction within the five-year tax reduction plan.  These rate reductions, moreover, were targeted to those firms which were paying the highest statutory and effective rates.  The rate reductions do not apply to the manufacturing and processing, mining, and oil and gas sectors.  While there was no reduction in the rate for small businesses with profits below $200 thousand, but the budget reduced the statutory rate on profits between $200 and $300 thousand to 21 percent in 2001.⁴  Two months before the budget, EI premiums were again reduced  – by 15¢ for employees and 21¢ for employers.  Budget 2000 also reduced the capital gains inclusion rate from ¾ to T, effective on budget day (Feb 28, 2001).  This measure brought the top marginal rate applicable to these gains in line with the tope marginal rate applicable to dividends.⁵

Although the corporate rate reductions represented an important step towards improved international competitiveness and inter-industry rebalancing, there was a great deal of uncertainty about the timing of the tax cuts.  This uncertainty was substantially reduced by the Economic Statement and Budget Update, October 18, 2000 (hereafter "The October 2000 Statement").  This statement lays out a time-table of successive two percentage point corporate rate cuts, with the general federal corporate tax rate reduced to 21 percent⁶ by 2004.   The October 2000 Statement also accelerated and enhanced the PIT reductions laid out in Budget 2000.  The 'high income' surtax was eliminated, the low bracket rate was reduced to 16%, the middle bracket rate was reduced to 22%, and a new 'upper middle' bracket⁷ was created with a rate of 26%.

The October 2000 Statement also lowered the capital gains inclusion rate from T to ½ effective October 18, 2000.  With the top federal marginal rate on capital gains reduced to 14.5%, and with reduced  tax rates in many provinces, tax rates on capital gains in Canada are becoming competitive with tax rates on long term gains in the U.S.  Without changes to the dividend credit, however, the tax rate on capital gains is now below the tax rate on dividends for top bracket taxpayers.  This raises the prospect of 'surplus stripping' and administrative countermeasures which would increase tax complexity.  I address this issue in the section on recommendations below.

Key Provincial Tax Measures Since 1997

In 1998 several provinces (British Columbia, Alberta, Saskatchewan and Manitoba) introduced personal income tax reductions, while Ontario continued to implement its multi-year PIT tax reduction.  The corporate tax rate for small businesses was reduced to 8.5% in British Columbia and Ontario.  Several provinces introduced tax incentives for R&D and specified investments such as film production.⁸

  In 1999, several provinces announced reductions in personal income tax rates (or surtax rates).  The corporate rate for small business was reduced to 5.5% in British Columbia.  In Ontario, the phased reduction in corporate tax rates for small business continued, with the rate dropping to 8%.⁹ 

In the year 2000, 9 of the 10 provinces elected to switch to a "tax-on-income" PIT system (from the pre-existing "tax-on-tax" system).  This system will, of course, permit greater flexibility in the design of provincial personal income taxes.  Personal income taxes were reduced in several provinces.  Alberta adopted a single rate for its PIT, set originally at 11%, but subsequently reduced to 10.5%, combined with a large increase in personal exemptions.  Corporate tax rates were reduced in four provinces.  British Columbia reduced its corporate rate for small business to 4.75%.  Manitoba reduced its small business rate to 7%.  In Ontario, the phased reduction in taxes for small corporations continued, with the rate dropping to 6.5%.  More importantly, the 2000 Ontario budget reduced the corporate tax rates for large corporations – to 12% for manufacturers and to 14% for other firms.  Ontario also announced a number of incentives for specific activities involving film, publishing and other media.  New Brunswick reduced its corporate rate for small business to 4.5%¹⁰

In 2001 all provinces and territories adopted the 'tax-on-income system' for their Personal Income Taxes.  In British Columbia, the new government announced a major reduction in personal income taxes, retroactive to January 1, 2001.  Small reductions in these taxes were implemented in other provinces (partly through matching changes to federal brackets and indexing).  Corporate tax rates were reduced in six provinces.  The new British Columbia government  announced reductions in British Columbia's general corporate rate to 13.5%.  Alberta announced a four year plan to reduce all corporate tax rates.  By 2004 the rate for large corporations will be down to 8%, and the rate for small corporates to 3%.  Saskatchewan reduced its small business corporate rate to 6%.  Manitoba reduced its rate for small business to 5%, and announced a phased reduction in general corporate rates of 0.5% per year over four years.   Ontario announced a plan to reduce corporate taxes over four years.  When completed in 2005, the rate for large corporations will be 8%, and for small corporations 4%.  New Brunswick reduced its general corporate rate to 16%, and its small business rate to 4%.¹¹

Overview of Statutory Corporate Tax Rates

Tables 3 and 4 summarize the changes in general corporate income tax rates for large corporations and small businesses.  The data in table 3 make clear that one of the major recommendations of the Mintz Committee is being implemented.  Within five years combined federal/provincial statutory tax rates for large firms in Alberta and Ontario will be brought down to 30% and in Quebec to 31%.  Given the importance of these three provinces, the weighted average  combined statutory rate for Canada as a whole will be reduced to 32%.  This represents a decline of 11 percentage points relative to its level in 1997.  The weighted average level of the combined rate of tax for all provinces would be one percentage point lower than the 33% level recommended by the Technical Committee (although the Federal statutory rate would be about two percentage points higher).

For small businesses, the federal statutory rate does not change, but many provincial rates have been reduced by this year, and in Alberta, Ontario and Saskatchewan, further rate cuts are planned.  When fully implemented, the combined statutory rates for small business will be only 16.1% in Alberta, and 17.1% in Ontario.

Table 3 General^a Corporate Income Tax Rates

^aThese are rates applicable to large firms outside the manufacturing, mining and oil & gas sectors.

^bThe rate for B.C. for 2006 is from a B.C. Ministry of Finance New Release "Tax Relief, Sound Fiscal Management to Boost the Economy", July 30, 2001.

Table 4 Corporate Income Tax Rates for Small Business

Source for Tables 3 & 4:  Canadian Tax Foundation, Canadian Tax Highlights 9(5), May 2001.

I note that these low rates of corporate income tax for small businesses mean these will be over-integration of the corporate and personal taxes in all provinces and territories except for PEI and Quebec.¹²

Base Broadening and Other Recommended Measures

With the exception of certain measures designed to tighten the taxation of international investment income and of business profits of foreign owned corporations, the corporate base-broadening recommendations of the Technical Committee have so far been ignored.  This means that the federal corporate rate reductions have largely been financed from the 'fiscal dividend'.  The upside of this situation is that potential revenues from base broadening remain to finance other desirable tax changes.

  The recommendations of the Committee to implement a dividend distribution tax and to replace the $500,000 capital gains tax exemption have also so far been ignored.  Finally, the Committee's recommendation for the gradual implementation of experience rating for EI contributions of businesses has not been acted upon.  However, as noted above, EI contribution rates have been reduced each year.

At the provincial level we have witnessed the implementation of a variety of corporate tax measures which provide favourable tax treatment to designated activities.  By and large these represent deviations from the principle of tax neutrality endorsed by the Technical Committee.

An Evaluation of the Effects of Corporate Rate Reductions and Other Measures¹³

Most economic studies have suggested that the most distortionary revenue sources are related to business taxes, particularly the corporate income tax.  Effective tax rates on capital vary by industry, type of asset, size of firm and business organization.   The business tax system is not only distortionary but also quite complicated.  Some studies have suggested that each additional dollar of corporate income tax levied, causes the Canadian economy to lose near $1 in economic output.¹⁴  Therefore the total cost of raising one dollar of corporate income tax revenue can be about two dollars, once these distortionary effects of the tax are taken into account.

An ideal business tax system would be neutral with respect to different industries, asset types, and different degrees of risk.  Any non-neutralities in the system should be related to mitigation of the effects of market imperfections.  Examples of corrective non-neutralities in the tax system include favourable treatment of small business (to offset capital market rationing) and incentives for research and development (in recognition of the positive spillovers generated by an increase in knowledge or know-how).

In today's world, not only should business taxes be neutral but also they should be levied at rates that are competitive internationally.  This is especially important for the corporate income tax.  Given the relative ease with which corporations can shift income from high to low-taxed countries (without changing real economic activity), a country with a high corporate income tax rate could find its tax base eroded significantly.  Recent studies have shown that as corporate income tax rates are increased, the gain in revenues is anywhere from 8 to 20 per cent less than what would be expected if the tax base did not change.¹⁵

Four years ago, the Technical Committee on Business Taxation submitted its Report to the Minister of Finance.  This report recommended a more neutral business tax system with lower and more competitive tax rates.

High effective marginal corporate rates deter investment, and inter-industry and inter-asset variations in these effective rates distort the allocation of capital.  Consequently, a reduction in the level of marginal effective tax rates and a reduction in their variance are high priorities from the standpoints of growth and efficiency.

The Technical Committee recommended that the general federal corporate tax rate for large corporations be reduced by 9.1% points to 20% and average provincial rates by one point from 14% to 13%.  For manufacturing income, the reduction would be only 2.1% points, since the Committee also recommended that the manufacturing and processing deduction be eliminated.

This measure above would reduce corporate tax revenues by $2.2 billion.  However, the Committee also recommended a reduction in the average corporate tax rate for small business, and a variety of base-broadening measures such that their full set of measures would be approximately revenue neutral.

As the base broadening measures would tend to reduce the inter-market and inter-asset variance of effective marginal rates, the combined package recommended by the Committee  would improve efficiency.

Since the Committee's Report was released, developments abroad have made the case for a further lowering of effective corporate tax rates in Canada more important (Mintz, 2001).  Within the G7, Japan, Germany and Italy have all reduced effective marginal rates substantially.  The UK, which previously had the lowest effective marginal rate, also reduced their rate by two percentage points.  As a result, Canada has become an outlier, with the highest effective marginal rates of any of the G7 countries (except Japan).

Recent reforms in Scandinavia have resulted in companies being taxed at corporate income tax rates below 30% in Finland, Sweden and Norway, and 32% in Denmark.  However, the aggressive business tax policies of Ireland are the most important case in point, since Ireland is the fastest growing OECD country of the past decade, virtually doubling its per capita GDP in ten years.  While Ireland has reduced tax rates on manufacturing and financial service income to 10%,¹⁶ it also eliminated a number of special ineffective preferences for investments.  After pressure from the European Union, Ireland is implementing a corporate income tax rate of 12.5% by the year 2004 that will apply to all businesses.  As shown later, Ireland and Sweden have a far more favourable tax treatment of investments compared to Canada.

Effects of Budget 2000

With the 2000 budget and the October 2000 statement, the federal government committed itself to a one percentage point reduction in corporate income tax rates for the broad service sector¹⁷ in 2001, followed by four two percentage point cuts.  It indicated that it would reduce the corporate income tax rate from 28 points to 21 points by the year 2004-5 for active business income in non-resource, non-manufacturing sectors. It also increased capital cost writeoffs for railway assets, utility equipment and manufacturing equipment subject to obsolescence.  The government also introduced a few tightening provisions – tighter thin-capitalization rules for debt owed to related non-residents, the abolition of non-resident owned companies and adjustments for research and development expense deductions for provincial deductions in lieu of investment tax credit programs. 

The 2000 budget business tax changes took many observers by surprise.  The cut in corporate income tax rates, although small in the first year, are significant when fully implemented.  The rate cuts, moreover, would be focussed on the broad service sector, thereby reducing inter-industry distortions.  Tax rates on manufacturing and processing income as well as on resource profits would remain unchanged.

The impact of the 2000 budget changes and of planned provincial corporate rate reductions can be seen in Table 5.  The small changes introduced for the year 2001 have little impact on effective tax rates on capital.  Significant variation in effective tax rates would remain across all sectors.  When the proposed corporate rate reductions are fully in effect in 2004-5, they have a much more dramatic impact.  Most industries, except for mining, oil and gas, and manufacturing, would experience a sharp decline in the effective tax rate by over 4 percentage points.  Although this tax reform is in the right direction, it still leaves considerable variation in effective tax rates on capital across industries and, in some cases, rates remain far too high thereby discouraging investment.

Moreover, these changes will take five years to complete.  This is rather disappointing progress given the substantial reforms taking place around the world, as mentioned above.  In the near term the Canadian tax system will remain non-competitive as seen in Table 6 and, as discussed below.

Table 5:  Marginal Effective Tax Rates: Large-sized Tax-paying Firms Only

Table 6:   Effective Tax Rate for Domestic Firms in G-7 Countries, 1996, 2000 and 2001

In 1996, Canada's effective tax rate on capital invested in manufacturing was comparable to the United States and lower than that found in Germany, France, Italy, and Japan and higher than rates in the United Kingdom, Sweden and Ireland.  The broad service sector was more highly taxed in Canada compared especially to the United States and to most countries, except Germany, Italy and Japan.

In the current year and in 2001, Canada's competitive position will erode as a result of reforms in many countries.  In 2000, Canada's effective tax rate in manufacturing, while still comparable to the US, is below only Germany's.  However, in 2001, Germany's substantial reform of its system will put its effective tax rate well below Canada's.  For services, in the year 2001 Canada's effective tax rate is well above most countries.

With prospective reductions in federal and provincial statutory corporate tax rates, by 2006, Canada's effective tax rate on capital will be competitive with the US but still above those of the UK, Sweden and Ireland.  However, it is likely that many of these countries will undertake further changes to their corporate income tax systems.  It can be expected that in five years further reductions in corporate income tax rates will take place in many countries combined with initiatives to broaden their tax bases. 

The Need for Further Reforms

If all of the Technical Committee's recommendations were implemented, the dispersion of marginal effective rates of tax or capital across industries and assets would be reduced.  This should entail some efficiency gains by improving the allocation of capital.

However, these recommendations entail virtually no change in average effective marginal tax rates.  This is not surprising, given the revenue neutral constraint faced by the committee.  On the other hand, the 2000 Budget would cut effective tax rates but fails to move aggressively in reducing non-neutralities and rates.  Once the requirement of revenue neutrality is relaxed, it is feasible to design tax reductions to stimulate investment and make the tax system more efficient.  We accept the committee's view that R&D already receives extraordinarily favourable tax treatment in Canada.  Therefore, our focus should be on stimulating capital investment.

The Technical Committee report was partly criticized for eliminating a number of important special preferences for certain business activities in order to help cover the revenue loss arising from corporate income tax rate reductions.  While general reductions in corporate statutory rates are of benefit to all forms of capital investment, they may result in greater losses in revenue compared to investment tax credits.  Some investment tax credits are appropriate since they can encourage investments in specific activities without distorting the tax base used by federal and provincial governments for allocating corporate income to the provinces.  In our view, it may be appropriate to consider investment tax credits for certain activities that are insufficient due to market imperfections (undiversifiable risky investments or technology-related investments) and to smooth over transitional impacts of tax reform that eliminates special preferences for specific industrial activities (e.g. new mine assets).

Using the tax evaluation model maintained at the Institute for International Business, we have evaluated the impact of reduced statutory rates and investment tax credits on marginal effective rates on investments in new capital.

Table 7 presents effective marginal rates for 2000 (the "base case") and what effective marginal rates would be under four alternatives.  The first two incorporate reductions of statutory rates of 1 and 3 percentage points.  The third incorporates a 1% investment credit for machinery and equipment, and the fourth incorporates a 1% investment credit for all plant and equipment.

The results indicate that a 3% point reduction in the statutory rate would reduce effective marginal rates in the broadly defined service sector by about 2 percentage points.  Effective rates in manufacturing would drop by 1.7 percentage points.  Effective rates in the resource sector would actually increase, because of the interaction of statutory rates with various credits and allowances.

Investment tax credits (ITCs) would reduce marginal effective tax rate for all industries.  A general ITC of 1% has a stronger effect than a 3% rate cut for oil and gas, mining, and transportation and communications; has about the same effect for manufacturing and forestry; and has a weaker effect in the other service sectors and construction.  Looking at the inter-industry variability of METRs, it would appear that a 3% statutory rate cut would reduce these distortions, whereas an ITC would increase them somewhat.

Table 7: Impact of Corporate Tax Changes on Marginal

Effective Tax Rates: Large-sized Tax-paying Firms Only

International Comparisons and International Competitiveness

In an open economy, the business tax structure must be designed with an eye to the likely response of multi-national corporations (MNCs) as well as to its longer term effects on international competitiveness.

Attention should be paid to both statutory and effective marginal rates.  Statutory rate differentials may provide incentives for MNCs to shift expenses to and income away from high tax reductions, through transfer pricing and debt management practices.  Statutory rates differences may also influence location decisions. 

Current and projected corporate statutory rates for OECD countries are presented in table 8.  The corporate statutory rate for large manufacturers in Canada lies in the middle of this group of countries, but the statutory rate for large non-manufacturing firms is currently above all the other countries (except for Germany and Japan).  Projected rates for 2006 indicate that the Canadian corporate tax rate will be below the level of the US, Japan, Germany and France, but remain higher than many other countries.

Differences in effective marginal tax rates also provide incentives for MNC's to adjust their real capital stocks, increasing investment in countries with relatively low effective marginal rates relative to other countries.

In order to prevent substantial revenue erosion, statutory rates should not be higher than rates typically found in other industrialized countries where MNC investments take place.  In order to stimulate investment and provide economic growth, effective tax rates on capital should be lower than in other competing jurisdictions.

The implementation of the Technical Committee's recommendations regarding statutory rates would  establish Canada's rates at the OECD average and well below U.S. statutory rates, thereby eliminating the principal sources of revenue erosion via debt shifting and transfer pricing.   However, as noted above, the 2000 Budget would reduce effective marginal rates of tax on investment by 4 points for service sectors but have little impact on manufacturing and resource sectors.

A reduction in the combined general corporate income tax rate to 30% instead of 32%

Table 8: Statutory Corporate Income Tax Rates in Selected OECD Countries^a

Notes:

^a   The 1996 rates are based on the former Coopers & Lybrand, 1997 International Tax Summaries and the 1999 rates are adopted from the KPMG Corporate Tax Rates Survey, January 1999, unless otherwise specified.

^b   The rate is a combination of the federal CIT rate (22.1% and 29.1% respectively for manufacturing and others) and the average of provincial CIT rates that is weighted by the provincial GDP by industry.  The minor difference between the two years reflects some changes in provincial CIT rates.

^c This is a weighted average of all industries.  Note that the current general CIT rate of 43% will still be applicable to the resources sector, which also enjoys various preferential tax treatments unavailable to any non-resource sectors.

^d   The rate is a combination of the corporate income tax rate of 33 1/3% and the surtax of 10% and 20% respectively. The lower surtax is applied to smaller-scaled firms that are mainly owned by individuals. For year 2000 and future years, the lower rate will apply to all firms. (See Ernst & Young, 1999 Worldwide Corporate Tax Guide, for details.)

^e  Our estimate based on to Ernst & Young, 2000 Worldwide Corporate Tax Guide. It includes a corporate income tax rate of 40%, an average trade tax of 16.75% (ranged from 13% to 20.5%) which is deductible for CIT purpose, and a surcharge of 5.5% on CIT payable.

^f  Refer to Tax Notes International, Vol. 20, No. 4, 24 January 2000.

^g  The higher rate (41.3%) includes a general corporate income tax rate of 37 per cent and a regional tax of 4.25 per cent. The latter is levied on the Italian-source income from productive activities, which includes interest payments and labour cost. The general CIT rate may be reduced to 19 per cent for qualifying taxable income corresponding to the ordinary remuneration (currently 7 per cent) of the net equity increase.  However, the average corporate income tax rate for a company may not fall below 27 per cent, which, combined with the regional tax rate of 4.25 per cent, resulted in the lower aggregated income tax rate of 31.3 per cent.

^h  Effective as of April 1, 1999.

ⁱ  Our estimate based on an average state corporate income tax rate of 6.5% (ranged from 1 to 12%).

Accompanied by base-broadening would reduce typical marginal effective tax rates for non-resource firms by about 1 to 1½  points.  The lower statutory rate would also make Canada more attractive relative to other countries, providing added deterrence to debt shifting and transfer pricing by MNEs.

Because a reduction in corporate statutory rates would stimulate an increase in the tax base, the revenue costs are somewhat attenuated.  The Technical Committee estimates that the elasticity of the corporate tax base with respect to a reduction in tax rates is about 0.15.  Based on this elasticity,  in 1998 for example, a 2% point reduction in all corporate tax rates would involve a revenue loss of about $1.3 billion of federal corporate tax revenue (representing about 7% of federal corporate tax revenues)¹⁸.

In future years, moreover, this relative revenue loss would be further attenuated, as the lower corporate tax rates lead to higher investment, a higher capital stock, and hence increased labour productivity and real output.

9.  Summary

Recommendations for Corporate Taxes

Implement the 7 percentage point reduction in the general corporate rate in Budget 2000 on a timely basis, as is laid out in the October 2000 Statement.  The 1 percent point rate reduction scheduled for January 1, 2001 should be followed by three annual reductions of 2 percentage points over the following three years.

Implement the base broadening and other recommendations of the Report of the Technical Committee (including the elimination of the 4% corporate surtax).  This will permit additional reductions of federal and provincial statutory rates, bringing the combined rate close to 30%.

Provide selective investment credits which provide transitional relief for industries adversely affected by these reforms.

Recommendations for Corporate/Personal Income Tax Integration

As noted above, with growing concern about high tax rates affecting Canada's international competitive position, the federal government has recently moved to lower substantially taxes on capital gains, and plans to reduce corporate tax rates significantly over the next 4 years.  Some provinces have recently reduced these taxes, and others plan future reductions.

While these reductions in effective marginal rates on capital income are welcome, the reduction in capital gains taxes has created a differential between taxes on these gains and taxes on dividends, thereby providing an incentive for conversion of dividends into capital gains.  Resolving this issue is now more difficult, because all provinces have moved to a tax on income basis.  In this section I consider alternative ways of dealing with this problem.

There are several features of the existing income tax system which prevent the establishment of equal effective marginal tax rates on capital gains, dividends and other income.

There is not full integration of the corporate and personal income tax system.  While the system has been designed to approximately integrate corporate and personal taxes for small CCPCs, for all other corporations, integration is only partial.  Since the rate of corporate tax differs between small CCPCs and other corporations, a common dividend credit rate alone cannot achieve perfect integration for both types of firms.  Finally, the existence of the $500 K capital gains exemption for shares of qualifying CCPCs prevents equalization of taxes on the three categories of income derived from such companies. 

Since a major tax reform that equalized corporate rates, provides full integration and abolishes the special capital gains exemption is not in the cards what is the 'second best' solution?  As the differential treatment of small CCPCs lies at the heart of the problem, we first consider the appropriate taxes rates on dividends for these firms, and then consider the tax treatment of other companies.  For many small CCPCs the special capital gains exemption reduces the effective rate of tax on capital gains to zero.  The existence of this exemption has necessitated the implementation of many rules to determine how firms may qualify for the exemption.  These rules effectively prevent the generation of capital gains through either dividend strips or the accumulation of financial assets.

For small CCPCs, the most important issue is therefore the equalization of taxes on dividends and on other income paid by these firms (wages and salaries, bonuses, etc.)   This can be accomplished by setting federal and provincial net dividend credit rates so as to achieve perfect integration of taxes on dividend income for these firms.  One way of doing this is to implement dividend distribution taxes on dividends paid from income eligible for the small business deduction.

For other companies (public corporations, large CCPCs and other private corporations) the most important issue is the equalization of taxes on dividends and capital gains for top bracket tax payers.  If the rate of tax on dividends is higher than the rate of tax on capital gains, these firms would have an incentive to convert dividends into capital gains through share buybacks and other financial arrangements.

How do we implement these recommendations?  For all corporations except small CCPCs, I propose that the dividend gross-up and credit system be changed to equalize marginal rates on dividends and capital gains for individuals in the highest marginal rate bracket.  Specifically, I recommend that the dividend gross-up factor be increased to one third, and the federal dividend credit increased to set the top marginal federal tax rate on dividends at 14.5%, equal to the top marginal federal tax rate on realized capital gains.

I assume that participating provinces will accept the federal definition of taxable income, so that the 50% capital gains inclusion rate and the one third dividend gross-up enter the provincial income tax base.  Each province should then set its dividend credit so as to equalize its top marginal rate on dividends with its top marginal rate on capital gains.

At current corporate tax rates, this system will not provide complete integration for large corporations.  However, the degree of integration will increase as planned future corporate rate reductions are put into effect.

References

Boadway, Robin W., and Harry M. Kitchen (1980) Canadian Tax Policy, Toronto, Canadian Tax Foundation.

Canadian Tax Foundation (2001) Canadian Tax Highlights 9(5).

Coopers & Lybrand, 1997 International Tax Summaries.

Department of Finance Canada (1999) The Economic and Fiscal Update, November 2, 1999.

Department of Finance Canada (1999) The Budget Plan 1999, February 16, 1999.

Department of Finance Canada (2000) The Budget Plan 2000, February 28, 2000.

Department of Finance Canada (2000) Economic Statement and Budget Update, October 18, 2000.

Dungan, Peter, Steve Murphy, and Thomas A. Wilson (1997) "The Sensitivity of the Corporate Tax to the Statutory Rate" Working paper 97-1, Technical Committee on Business Taxation

Dungan, Peter (1998), The CPP Payroll Tax Hike: Macroeconomic Transition Costs and Alternatives, C.D. Howe Institute Commentary No. 116.

Ernst & Young, 1999 Worldwide Corporate Tax Guide.

Ernst & Young, 2000 Worldwide Corporate Tax Guide.

Jog, Vijay and Jianmin Tang (1997) "Tax Reforms, Debt Shifting and Tax Revenues: Multinational Corporations in Canada", Working Paper 97-14, Technical Committee on Business Taxation.

KPMG Corporate Tax Rates Survey, January 1999.

Mintz, Jack M. (2001) Most Favoured Nations: Building a Framework for Smart Economic Policy.  Toronto, C.D. Howe Institute (forthcoming, 2001).

Mintz, Jack and Thomas Wilson (2001) "Taxes, Efficiency and Economic Growth" in Pat Grady and Andrew Sharpe (eds) The State of Canadian Economics: A Festschift in Honor of David Slater, Queen's University-McGill University Press, forthcoming, 2001.

Ort, Deborah L., and David B. Perry (1999), "Provincial Budget Roundup, 1999", Canadian Tax Journal 47(5).

Ort, Deborah L., and David B. Perry (2000), "Provincial Budget Roundup, 2000", Canadian Tax Journal 48(3).

Ort, Deborah L., and David B. Perry (2001), "Provincial Budget Roundup, 2001", Canadian Tax Journal 49(3).

Perry, David B. (1998), "Provincial Budget Roundup, 1998", Canadian Tax Journal 46(3).

Tax Notes International, 20(4), 24 January 2000.

Technical Committee on Business Taxation (1997) Report of the Technical Committee on Business Taxation, Ottawa, Department of Finance Canada, 1997.

Whalley, John, "Efficiency Considerations of Business Tax Reform", Working Paper 97-8, Technical Committee on Business Taxation, Department of Finance, Ottawa, 1997.

Notes

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