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Article Excerpt
The Study in Brief
Recent research suggests that Canada's tax system acts as a drag on innovative activity. This study argues that the federal and provincial governments' preoccupation with tax credits targeted at research and development, and relative inattention to the competitiveness of the overall tax regime, is misguided. In effect, the Canadian approach has been to give with one hand, by providing generous tax credits targeted at R&D, and to take with the other, by imposing high taxes on the fruits of innovative activity and entrepreneurship.
Canada's tax treatment of business spending on R&D does appear to be internationally competitive. The cornerstone is a 20 percent federal tax credit--for small businesses it is 35 percent--which most provinces top up with a further R&D credit of 10 or 15 percent.
The result is "one of the most generous scientific research and experimental development tax incentive regimes in the world," according to the federal Department of Finance. And among industrialized countries, in terms of direct tax subsidies per dollar US$1 of R&D expenditures, Canada is indeed near the top.
Despite this support, Canada ranks low in aggregate R&D intensity--that is, R&D as a percentage of gross domestic product. On this measure, business R&D in Canada in 2004 was 1.07 percent--below the average of 1.53 percent for OECD member countries and well below that of the other Group of Seven major industrialized economies except Italy. Canada also compares poorly with Sweden, for example, which provides few direct subsidies for R&D (but has a very competitive production tax regime): business R&D as a percentage of GDP in Sweden is about double that in Canada.
What to do? Federal and provincial governments should work toward increasing the competitiveness of Canada's overall production tax regime. Such a policy could involve reductions in statutory tax rates and structural changes in the tax system. One possibility would be to move toward a business value tax at the provincial level, perhaps coupled with the introduction of tax prepaid savings plans for individuals.
Other changes would be to reconfigure the tax depreciation system to make it more in line with economic depreciation; introducing last-in, first-out inventory accounting for tax purposes would also reduce effective tax rates on investment. Taken together, these initiatives would lower the tax rate on production and free up domestic savings for investment in innovative activities, spurring investment, innovation, and entrepreneurship.
The competitiveness of Canada's tax regime has been the topic of some scrutiny of late, though perhaps not as much as it should be. The C.D. Howe Institute has played a leading role in this discussion, in particular through its Tax Competitiveness Program.
The inaugural Tax Competitiveness Report (Mintz et al. 2005) argued that there is scope for considerable improvement in Canada's tax competitiveness position, particularly with respect to the tax burden imposed on capital. Taking into account corporate income taxes and other capital-related taxes, Canada had the second-highest effective tax rate on capital among 36 industrial and leading developing countries in 2005. The report concluded that governments in Canada (both federal and provincial) "should develop multi-year tax plans to address the many existing problems in the tax system to achieve better economic growth and a higher standard of living for Canadians" (ibid., ii).
One area of tax policy where Canada already appears to be internationally competitive, however, is in the treatment of expenditures related to research and development (R&D). The cornerstone of the system is a 20 percent federal tax credit for R&D (for small businesses, the credit is 35 percent). Most provinces top this up with a further credit of 10 or 15 percent. As a result, the federal Department of Finance boasts that "Canada offers one of the most generous scientific research and experimental development tax incentive regimes in the world." (1) Despite this support, however, Canada ranks relatively low in terms of aggregate R&D intensity--that is, R&D as a percentage of gross domestic product (GDP). On this measure, business R&D in Canada in 2004 was 1.07 percent--below the average of 1.53 percent for member countries of the Organisation for Economic Cooperation and Development (OECD) and well below that of all other Group of Seven major industrialized economies except Italy (OECD 2006).
In a recent C.D. Howe Institute Commentary, Rick Harris of Simon Fraser University analyzed Canada's disappointing performance in R&D and suggested several policy responses (Harris 2005). In terms of tax policy, Harris argued that existing federal and provincial resources aimed at supporting business R&D need to be more focused than those provided by the existing R&D tax credit system, and that improving Canada's environment for innovation will require stronger incentives for business investment.
This Commentary picks up where Harris leaves off by examining in more detail the role of tax policy in promoting R&D and, indeed, economic activity in general. Recent empirical research supports the view that Canada's tax system, as it applies to the production of goods and services, not just to R&D, acts as a drag on innovative activity and entrepreneurial initiative in this country. I argue that the preoccupation of both the federal and provincial levels of government with tax credits targeted at R&D (and other activities), to the detriment of the competitiveness of the overall tax regime, may be misguided. In effect, the Canadian approach has been to give with one hand, by providing generous tax credits targeted at R&D, and to take with the other, by imposing high taxes on the fruits of innovative activity and entrepreneurship.
The Tax Treatment of R&D in Canada
At the federal level, R&D tax incentives are offered under the Scientific Research and Experimental Development (SR&ED) program, whereby all eligible current expenditures on R&D are immediately expensed for tax purposes. These include wages and salaries for workers engaged in R&D, as well as expenditures on materials and supplies. Immediate expensing is also extended to expenditures on eligible equipment used in R&D, which would ordinarily be depreciated over time as a part of the capital cost allowance system. Expenditures on buildings and other structures used in the process of conducting R&D do not receive special treatment, but are depreciated under the usual capital cost allowance system.
The most important aspect of the SR&ED program is the tax credit for eligible R&D expenditures, worth $1.7 billion in 2003 (Canada 2004). For small Canadian-controlled private corporations, the credit rate is 35 percent and is refundable; for other businesses, the rate is 20 percent and is non-refundable. Unlike in some other countries, the credit is non-incremental--that is, there is no minimum amount of R&D spending at which the credit kicks in--and it applies to a broad range of eligible R&D expenditures, including all current expenses as well as those on equipment (but not buildings).
In the United States, by way of contrast, the federal tax credit for R&D is much less generous and applies to a narrower range of expenditures than in Canada. The US credit rate is 20 percent of a corporation's qualified R&D expenditures in the current year, and is incremental in the sense that it applies only to R&D above a base amount. (2) The definition of the base amount has varied over time (see Watson 1994; Griffith and Klemm 2001); currently, it is...
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