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Article Excerpt
The Study in Brief
The 2006 Tax Competitiveness Report provides a window on how Canada's tax system ranks against the international competition. While the federal and provincial governments have made progress in reducing marginal income tax rates, the pace of tax reform has been slow, compared to some other developed countries, like Australia, Finland, Ireland and the Netherlands. Several Nordic countries have implemented significant reforms through "dual-income tax systems" that treat labour and investment income differently.
Meanwhile, Canada's productivity growth has been slow, and so has income growth. In the years to come, achieving better growth may pose stiff challenges, as population aging begins to pinch labour markets, making capital investment all the more important.
Canada will need to pay attention to its effective tax rate on investment. As this report shows, our marginal rate remains high, and stands at 8th highest among the 81 developed and developing economies we studied. This report therefore proposes a Pro-Growth Tax Reform plan that would improve how taxes treat people and their work effort, and how taxes treat savings and investment. Among other reforms, it proposes five immediate priorities:
* Lowering clawback rates for income-tested benefits to achieve lower marginal rates for low-income earners and seniors.
* Increasing the limits for contributions to pension and RRSP plans, most importantly raising the maximum age from 69 to 73 years and the earned income limit from 18 to 25 percent. Limits for deductions to RRSPs or a new Tax Pre-Paid Saving Plan would be increased from $22,000 to $32,000 by 2010.
* Increasing the tuition fee and education tax credit from about 23 to 40 percent and doubling the amounts transferred to a parent or eligible guardian.
* A further reduction in corporate income tax rates at federal level from 19 to 15 percent by 2010, as well as action to better match capital cost allowances and economic depreciation rates for assets.
* Removing the withholding tax on arm's length interest and, in the case of the US-Canada treaty, the withholding tax on non-arm's length interest.
Further, provincial governments should aim to lower their marginal tax rates on work, saving and investment, particularly capital taxes on businesses and sales taxes on business intermediate purchases and capital goods. Both federal and provincial governments should also pursue base-broadening measures, such as removing ineffective tax credits, helping offset the revenue cost of tax relief.
The 2006 Tax Competitiveness Report provides a snapshot of how Canada's tax system affects labour, investment and saving, which are all critical to prosperity in the future. While federal and provincial governments have made some progress in reducing high marginal tax rates on incomes, the pace of tax reform has been too slow over the years and far less dramatic than in some countries like Australia, Finland, Ireland and the Netherlands. Canadian federal and provincial governments are not sufficiently concerned about tax reform, even though economic restructuring is fundamentally altering the world's commerce. As business activity increases in Asia, industrial countries, including Canada, must cope with increased competition from abroad as well as with aging populations within. Tax reform is urgent.
Even the latest federal reforms, which have included introducing or expanding special preferences and reducing the GST rate from 7 to 6 percent, are out-of-step with the general drift to remove taxes on income in favour of consumption taxes. (1) Canadians, especially those with modest and low incomes, face very high marginal tax rates on employment income and saving. As documented below, Canada has the sixth highest effective tax rate on capital investment among 36 industrialized and leading developing countries, as well as the eighth highest effective tax rate on capital when a further 45 developing countries are included in the comparison.
The lack of tax competitiveness is a serious issue since it makes it difficult for Canada to achieve stellar economic growth in the face of labour shortages and low investment rates in many industries. For this reason, this report urges major structural changes in Canada's tax system through a Pro-Growth Tax Reform Plan that would improve both efficiency and fairness in the tax system. The plan would encompass cuts to high marginal tax rates and introduce a more neutral, simplified approach by removing the tax penalty on saving and eliminating preferences for specific activities. One approach to consider is the adoption of a version of the Nordic "dual income tax," with a sharp reduction in taxes on interest, dividends, capital gains and corporate income to a combined federal-provincial rate of 23 percent. While this is an attractive idea, the approach needs more careful study.
Although a number of recommendations are made for reforms, five fiscally responsible tax reforms could be easier priorities for now at the federal level. These include the following:
* The pooling of clawback rates for income-tested benefits to achieve lower marginal rates for low-income earners and seniors.
* Increasing the limits for contributions to pension and RRSP plans, most importantly raising the maximum age from 69 to 73 years and the earned income limitation from 18 to 25 percent. Limits for deductions to RRSPs or a new Tax Pre-Paid Saving Plan should be increased from $22,000 to $32,000 by 2010.
* Increasing the tuition fee and education tax credit from about 23 to 40 percent and doubling the amounts transferred to a parent or eligible guardian.
* A further reduction in corporate income tax rates at the federal level from 19 to 15 percent by 2010, as well as action to better match capital cost allowances and economic depreciation rates for assets.
* Removing the withholding tax on arm's length interest and, in the case of the US-Canada treaty, the withholding tax on non-arm's length interest.
Provincial governments should aim to lower their marginal tax rates on work, saving and investment, particularly with respect to capital taxes on businesses and sales taxes on business intermediate purchases and capital goods. Both federal and provincial governments should also consider several recommended base-broadening measures that would remove ineffective tax credits, thereby helping to cover the cost of tax cuts.
The Challenge of Economic Growth
Although employment has improved since 1997, increasing annually by 1.6 percent in terms of hours worked, growth in per capita output has been mediocre. Canada's labour productivity (output per worker) grew by a paltry 1.6 percent annual rate from 2000 to 2004, compared to 3.6 percent in the United States. There, Americans have experienced an overall decline in hours worked (Statistics Canada 2005). Low growth in output per worker translates into a poor performance in Canada's standard of living. Canada's growth in per capita GDP has been 24th best of 29 OECD countries (Poschmann 2006). Canadian GDP per capita remains almost US$6,500 per capita below that in the US, which for a family of four individuals implies a differential of $26,000 in income.
If anything, the challenge to achieve better economic growth will be even more difficult in the future. More Canadians will retire as the population ages, making labour shortages potentially greater (Bourgeois and Debus 2006). While Canada will continue to rely on immigration to help grow its labour force, it takes time and cost to integrate immigrants so that they can achieve their full earning potential. Businesses will continue to shift manufacturing and service production to Asia where wage costs are much lower, leaving industrialized countries like Canada the challenge of ensuring their place in worldwide supply chains. Security concerns and protectionism, as reflected in the failed Doha round for trade liberalization, make it more attractive for businesses to locate in large markets like China, the European Union and the United States, rather than in a smaller country like Canada, beset with border frictions arising from tariffs, quotas and immigration laws.
Fortunately, a mix of policies can generate higher economic growth through better use of labour and capital resources. Economic polices that encourage greater labour supply, better education and training, infrastructure, capital investment, and the adoption of new technologies can all contribute to better economic performance (Mintz 2001). Canada has had a relatively successful record in many respects, such as improving its quality of education and building good infrastructure, especially transportation and communication networks. However, one area of poor performance has been with respect to capital investment flows. In Canada, capital investment has been $3,200 and $1,400 per worker less this year than in the United States and the OECD, respectively (Robson and Goldfarb 2006). Without strong business investment, Canada's growth is restrained, making it more difficult to innovate, create better-paying jobs and provide the resources needed to support retirement and cover contingencies. The cuts in corporate taxes alone, implemented by federal and provincial governments in 2006, will boost capital investment by $45 billion in the next five years (Chen and Mintz 2006), increasing Canadian incomes by over $4.5 billion annually.
As discussed in more detail below, taxation reduces economic gains from work, investment, saving and risk-taking, thereby undermining a country's overall competitiveness. Non-neutral tax policies that are unevenly applied to various activities encourage Canadians to devote resources to less-taxed activities, rather than to those that generate the greatest economic returns. High marginal tax rates on those who choose to work or improve their skills discourage labour supply and training. Taxes on capital investment and saving reduce the ability of Canadians to create sufficient wealth to fund their future needs.
The Current Picture
Taxing People
Canadian federal and provincial governments levy substantial income, payroll, consumption and other taxes as well as pay out transfers that affect the amount of goods and services that Canadians can buy, either today or, through their savings, in the future. In 1975, the per capita personal income (prior to the payment of taxes and receipt of government transfers) was equal to about $6,000 and per capita disposable income (income net of taxes and including government transfers) was equal to $4,900, implying a net tax equal to $1,100 per person, or 18 percent of income. Thirty years later, the average personal income of a Canadian is about $31,500 and disposable income is equal to $24,100 (unadjusted for inflation). Taxes net of income transfers as a percentage of personal income are now 24 percent, one-third more than in 1975. This increase reflects the growth of government spending on goods and services during the period, despite the fact that many public programs such as Medicare and education were already in place by 1975. Given the rise of both tax levels and transfers, economic distortions associated with them are therefore even more important today than three decades ago.
The increase in disposable per capita incomes over the last 40 years has been due in part to inflation, which once removed, measures the growth of both real personal income per capita and real personal disposable income per capita over time (Figure 1). In 1975, disposable personal income was equal to $14,200 (in 1992 dollars), rising by almost a third to $18,900 (also in 1992 dollars) in 2005. During this period, government spending increased from 40 percent of GDP to over 50 percent by 1992, falling back to about 41 percent today. Total government tax and non-tax revenues grew from about 37 percent in 1975, peaking at 44 percent in 2001, and declining to about 41 percent today.
[FIGURE 1 OMITTED]
Even with better fiscal policies in place, as reflected in the slaying of the federal and most provincial deficits, growth in personal incomes and disposable incomes has been mediocre in the last five years. (2) In inflation-adjusted terms, both measures have risen by only $600 per capita from 2001 to 2005,...
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