Publication: C.D. Howe Institute Commentary
Publication Date: 01-FEB-07
Delivery: Immediate Online Access
Author: Cherniavsky, Ben ; Dachis, Benjamin
Company: Air Canada

Article Excerpt
Canadian air travelers had reason to be alarmed by the precedent. In July 2006, France introduced a "solidarity tax" on airline tickets to generate funds for social programs such as the fight against HIV/AIDs. Depending on the length of flight and the class of travel, this tax will cost passengers departing France up to $52, thus raising as much as $277 million annually. France has claimed that a further 18 countries will introduce similar taxes; (1) so far, four countries (Chile, Gabon, Ivory Coast and Mauritius) have followed France's lead and others may do the same.

Canada has not yet agreed to the idea. This is commendable on two counts. First, there is no economic reason to burden the airline industry with a targeted tax, even if aimed at noble causes. Perhaps when air travel was largely restricted to the rich, such a luxury tax could fly. In today's world, where low-cost carriers make the skies accessible to less well-off travelers, it would be a regressive tax, and could deter travel to developing countries, whose prosperity is increasingly dependent on global trade, commerce and tourism. Second, the fiscal burden on Canada's air transport sector is already heavy with taxes and fees.

A comparative assessment of this tax burden, which we undertake in this paper, reveals that the current tax treatment of airlines is inequitable and inefficient. We argue that the federal government should recognize these shortfalls and revamp its air transport policy. Among the recommended reforms: fuel taxes, currently applied unevenly and inequitably across jurisdictions, should ideally be scrapped altogether, unless earmarked for either air infrastructure or environmental investment; airport security charges, which far surpass government spending on airport security, should be reduced to the point where the program breaks even; the rent formula under which airport authorities pay rent to the federal government should be revised so that they pay no more than the imputed "rental" value of their land and assets.

The goal is to ensure that this sector of the economy is taxed on a level playing field with other transportation modes domestically and other airline sectors internationally. This would be a small step toward making our airlines more competitive internationally and less vulnerable to the cyclical downturns inherent in the business. And it will be an especially crucial change if we are to seek a more liberal market for air travel with other countries, particularly the US.

The Economic Role of Canada's Airline Industry

In 2005/06, the airline industry employed about 80,000 people in Canada and directly accounted for roughly 0.4 percent of GDP. While these numbers could be considered small on a relative basis, it would be wrong to assume that the government need not make airline tax reform a high priority or that constructive change would benefit only a narrow sector of the economy. First, a significant amount (38 percent) of the revenue that the government collects from this industry comes from taxes that are levied on ticket sales. Relief on this front would benefit the passengers--over 63 million of them in 2005--who take flights every year in Canada.

Second, the Canadian airline industry exerts an indirect influence over the Canadian economy. Airports, for example, employ thousands of people and generate millions of dollars of revenue for their commercial tenants. The same can be said of their impact on hotels, taxis, travel agents, and other businesses that service air travellers.

There are also positive economic and social benefits associated with the airline industry that are hard to quantify. These include the countless transactions that are facilitated by air travel to business meetings, or the intangible personal pleasures that are associated with air travel for vacation, and visiting friends and relatives.

Notwithstanding difficulties in measuring the sector's economic importance, Canadians and their governments see air transport as an activity with national significance--as exemplified by Air Canada's legacy as a Crown corporation. Policymakers have also treated airlines as too big or too important to fail--as shown by attempts to prop up Canadian Airlines. And the government continues to protect the industry through other means. For example, foreigners are limited to owning no more than 25 percent of an airline domiciled in Canada, based on the notion that control over an airline is too important an economic and strategic lever to let slip into nonresident hands. Yet air transport is nonetheless burdened with taxes and fees that are high (relative to other sectors and transport modes) and may threaten industry growth and firm survival.

Although we focus here on the need for tax policy reform, ownership regulations also require review. They arguably do the airlines more harm than good, by creating a fragmented industry that does not manage growth well or perform effectively through market downturns. With its enormous capital requirements, generally mature market, and global operations, it is difficult to imagine a business more suited for worldwide consolidation. Yet, despite the airlines' role in facilitating globalization, government policy has limited the sector's ability to fully participate in it.

While sectoral cyclicality will continue to challenge aviation, as any other sector, government policy should not contribute to its instability. Attention to aviation's tax burden and dropping existing ownership restrictions are sensible places to start. The federal government should also ensure that aviation is not hobbled by special rules and taxes not borne by other industries or modes of transportation.

Canada's Aviation Tax Burden

Last year, the federal, provincial and municipal governments collected roughly $1 billion in revenue from the air transportation industry in Canada. This money came from taxes and fees that are levied on airports, commercial carriers or passengers at various points in the value chain. Individually, each tax serves a defined purpose, and some--such as the $4.67 security surcharge for domestic travel--are relatively innocuous. Collectively, however, they add up to a very large number, especially when it is compared to the $282 million of combined profit that the industry's three dominant players, Air Canada, Jazz and WestJet, reported in 2005.

The following is a list of the different avenues through which the government and other agencies collect revenue from air transportation and a brief analysis of their respective rationales. This list excludes taxes of general application--such as payroll, corporate income taxes, capital taxes, etc.--that are levied on most industries in Canada. We also focus on taxes related to passenger transportation, leaving aside, for this report, the increasingly important air cargo sector (see Table 1).

Airports and Ground Rent

Canada's largest airports are operated by autonomous airport authorities that took over the operation and financing of various airports from Transport Canada during the 1990s, creating the National Airport System. All airport authorities are non-profit, non-share corporations. They pay what is called ground rent to the federal government for the right to operate airport facilities on federally owned land. The government gave these facilities, built by Transport Canada, to airport authorities at no upfront cost, with rent payments intended to compensate Ottawa for foregone revenue, investments and land costs. Airport land values have never been precisely assessed, casting doubt on the currently appropriate rent.

In May of 2005, then-minister-of-transport Jean Lapierre announced a ground rent formula for Canadian airports to replace the prior formula based on passenger throughput. The new rent formula is calculated using gross revenue and is graduated by the level of revenue. (2) Most large airports now pay an incremental rate of 8, 10 or 12 percent of total revenue to the government, with Toronto Pearson, Vancouver and Montreal in the 12 percent bracket.

The formula is problematic because of the vicious circle it creates for airports. If rent is calculated as a percent of revenue, then the price of every aeronautical service an airport provides must be marked up by at least the amount of rent charged. This, in turn, increases the airport's break-even point and raises the amount of revenue that must be generated. Suppose that the operating cost of maintaining parking facilities at an airport is $250 a day: the airport must charge parking fees that will generate daily revenues of at least that much in order to break even. However, if the airport must pay 10 percent of all its revenues in rent, then the airport's rent will equal $25 a day, which effectively raises the operation's costs and, in turn, increases its break-even point by $25 to $275 a day of revenue. If the airport generated $275 a day from parking services, its rent would increase to $27.50 and, again, its operating costs and break-even point would rise. (3)

Another flaw in the current rent formula is that it fails the test of economic efficiency: there is no connection between the amount of airport rent paid and the imputed rental value (opportunity cost) of the bequeathed government assets and land. Indeed, under the current formula, the highest amount of rent is charged against the airports that have expanded the most since facility ownership was transferred to them.

At most airports, federal ground rent as a percentage of airport expenses has been in general decline over the last few years. Average rents have declined from nearly 40 percent of operating and interest expenses in 1999 to less than 25 percent in 2005. This is not to say that airport rents have been declining in absolute terms.

In fact, the amount of rent paid has grown faster than passenger travel, which was the previous basis for calculating rent. Federal ground rent has declined as a share of airport costs owing to the rapid rise of airport operating and interest expenses, which grew 61 percent between 2002 and 2005 (or 141 percent from 1998 through 2005). Rent per passenger reached a new high in 2005, at $4.75 per passenger flight (see Table 2).

As the new rent formula is a tax on revenue, it affects airports' incentives to seek additional revenue sources, because the airport must charge higher rates to cover any rent due from a new source of revenue. It is easier for Canadian airports to increase rates for airlines and passengers, because airports have some locational monopoly power over landing slots, rather than on revenues from sales of goods and services available outside of airport precincts. The rent formula thus increases an airport's incentives to use its monopoly power over airlines relative to other airport tenants. Revenue sources other than landing or improvement fees make up 36 percent of total airport revenues for the median airport in Canada (see Figure 1), whereas they are more than 50 percent at airports in...



NOTE: All illustrations and photos have been removed from this article.



More articles from C.D. Howe Institute Commentary
Insuring Canada's exports: the case for reform at export development Canada, 01-DEC-07
Falling poverty rates, rising employment among poor, reflect social policy success: C. D. Howe Institute., 01-OCT-07
Reducing poverty: what has worked, and what should come next, 01-OCT-07

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