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Description
In this 2007 Tax Competitiveness Report, we highlight steady but slow progress made by Canada in improving its tax system, by shifting taxes away from productivity-enhancing investment and savings. However, as discussed in a previous report on federal and provincial 2007 budgets (Chen, Mintz and Tarasov 2007), many federal and provincial tax reductions were directed to targeted preferences, some only temporary, rather than broad-based tax cuts. Targeted tax reductions are not nearly as effective in achieving a better tax system, because they often result in a misallocation of resources from highly productive to politically favoured economic activities.
While governments should always keep an eye to fiscal prudence, so that taxes are only used to support smart spending, it is also important that governments choose the right tax structure that maximizes economic wealth without compromising equal opportunities for Canadians. Canada's tax system is far from optimal.
Comprehensive tax reform is needed in Canada to make the tax system more efficient and fair by reducing rates, broadening bases and relying on consumption and user-pay related taxes, including environmental taxes. Reductions in taxes on investment and savings will enhance Canada's economic growth and improve international competitiveness, in a world in which global linkages among multinational businesses are critical to achieving better incomes and jobs for Canadian workers. Relying on less mobile tax bases will reduce the economic cost of the tax system and the cost of providing government services to Canadians.
Canada continues to apply quite high marginal personal tax rates on labour income and savings, especially for individuals with modest incomes. Progress in alleviating many struggling Canadians from extraordinarily high effective marginal tax rates has been slow. With clawbacks under income-tested programs combined with payroll taxes, personal marginal tax rates on employment and savings (outside of pensions and RRSPs) are in excess of 70 percent, far higher than those faced by the richest Canadians. Major reform is needed to improve the situation, which to this point has only been tentatively addressed by incremental changes to tax policies.
We provide in this report our 80-country ranking of effective tax rates on capital for marginal investment projects, taking into account corporate income taxes, sales taxes on capital purchases and other capital-related taxes. Canada has made progress by moving from the 6th highest effective tax rate in 2006 (36.6 percent) to the 11th highest in 2007 (30.9 percent). However, much of the reduction has been in manufacturing's effective tax rates which, at 23.1 percent, are 28th highest in the world sample of 80 countries. Disappointingly, Canada's service sectors, including construction, transportation, communications, public utilities, trade, business and household services, remain the 6th highest taxed in the world, at 36.4 percent, or at least 4 percentage points above the global-weighted average.
Such high taxes on the service sectors are not going to make Canada's economy competitive. Many business services are traded internationally, and their costs influence the competitiveness of other industries. Such high taxes on investment discourage capital investment as well as the adoption of new technologies and ultimately adversely effect the income paid to workers. For this reason, Canadian governments should pay attention to broad-based reforms rather than focus on targeted tax relief limited to a few economic activities.
To their credit, federal and provincial governments are eliminating capital taxes (levied on a company's shareholders' equity and qualifying liabilities) by 2011 for non-financial businesses (although not for financial and insurance activities, which are globally traded). However, governments seem reluctant to reduce corporate income tax rates, which remain high. Canada's statutory federal-provincial corporate income tax rate in 2007 is 34.2 percent, the 12th highest in the world. Many countries levy corporate income taxes at rates well below 30 percent and several countries, including France, Germany and the United Kingdom, have indicated that they will be further reducing corporate income tax rates in the next several years. Even with future reductions of its own, Canada will continue to have one of the highest corporate income tax rates in the world.
Corporate income taxes continue to be a major source of inefficiency and unfairness in the Canadian tax system. They result in highly differential effective tax rates on industries and assets. They also discourage domestic investment, which is critical to long-run growth prospects.
Moreover, there is some published evidence--and we shall provide further analysis in this report--that Canada's corporate income tax rate is on the wrong side of the "Laffer curve," the relationship between government tax rates and tax revenue.
Canada's corporate income tax rate is 6 percentage points above the revenue-maximizing corporate income tax that we estimate. As a result, Canada could reduce corporate income tax rates, possibly increasing revenue or at worst losing little. Compared to any other business tax policy, this is a "win-win" proposition--both government and the private sector would be better off.
Reductions in the current corporate rate would increase corporate tax revenues because Canadian and foreign multinationals would shift fewer costs into Canada and fewer profits out of Canada. For example, Ireland's corporate income taxes comprised a 3.4 percent share of GDP in 2005, which is similar to the corporate tax collected in Canada as a share of GDP (3.5 percent), even though Canada has a statutory corporate income tax rate that is almost three times higher than the Irish rate. The US, with one of the highest corporate income tax rates in the world at 38.5 percent, collects only 2.9 percent of GDP in corporate tax revenue, less than in Canada where corporate income tax rates are lower.
Though Canada is reducing its corporate income tax rate to 30.5 percent by 2011, our evidence suggests that this rate is above the tax-revenue-maximizing rate of 28 percent. However, even if Canada were to reduce its corporate income tax rate to the revenue-maximization rate, the rate would still be far too high: the inter-asset and inter-industry distortions induced by corporate taxes suggest that the optimal corporate rate should be set below the revenue-maximizing rate when trading off revenues for economic efficiency and fairness. I suggest that all businesses should be taxed at a common rate that is applied to small businesses--roughly 20 percent--to reduce distortions as much as possible without requiring substantial change to the tax system. (1)
An incremental approach to tax reform is one alternative. Federal and provincial surpluses make it possible for further tax reductions, and Canada's efforts to reduce high marginal tax rates on effort, savings and investment could incrementally improve competitiveness. But rather than a slow-motion approach, governments could entertain major reforms if they were willing to "bite the bullet" and pursue two sequential strategies.
The first would be to substantially reduce personal and corporate income tax rates, with part of the fiscal costs offset by the tax revenues generated from a broader tax base. We will make a number of recommendations to bring down federal-provincial personal tax rates on savings and employment income earned by modest-income taxpayers, combined with proposals to eliminate some ineffective, targeted tax preferences.
The second strategy would be to shift taxes towards consumption. Clearly, one possibility is to increase sales-tax rates. A more intriguing possibility is to shift taxes on "goods"--investment and savings that most affect Canada's productivity--to "bads" by, for example, broadening the existing federal-provincial fuel-excise taxes to include other energy sources. Canada would have a low-rate, broad-based, consumption-based environmental tax to price the cost of environmental damage that affects Canadian lives. An environmental tax would be needed as part of an overall government strategy to deal with carbon and pollutants such as sulphur and nitrogen oxides. Hence, it would need to be coordinated with regulatory and other policies directed at pricing environmental costs. A key aspect of any environmental tax is that it should be broad-based, affecting consumers and businesses regardless of size or region, thereby enhancing the overall efficiency and fairness of the tax system.
Both strategies--sharp reductions in corporate and personal tax rates and a broad-based environmental tax--have been pursued by many OECD countries in recent years. Canada should consider a similar strategy. Overall, a major tax reform like this would sharply reduce taxes on investment, savings and employment, and would enhance Canada's competitiveness.
Our Current Taxing Problems
Governments take a significant share of the economy's resources--38.7 percent--through taxes and other revenues. On a consolidated basis, Canadian federal, provincial and local governments collect close to $560 billion in revenues, affecting each and every Canadian when they earn income, buy goods and services or purchase property. (2)
Of that amount, $246 billion, or 44 percent, is collected as income taxes comprised of personal income taxes ($181 billion), corporate income taxes ($58 billion) and non-resident withholding taxes ($7 billion). A further $107 billion, or 19.1 percent of revenues, is collected as consumption taxes, including general sales taxes ($69 billion), excise taxes on fuels, alcohol, tobacco and amusements ($22 billion) and custom duties ($3.6 billion). Contributions to social security programs add up to $34 billion (6.1 percent of revenues) and property tax payments are $44 billion (7.8 percent of revenues). Other revenues including natural resource taxes and royalties, user fees, licenses and earnings from investments account for $106 billion of government revenues.
The income tax is the largest and most obvious tax borne by Canadians, made especially clear when deducted from their employment paycheque. Income taxes also reduce the return on investments, because interest, dividends and capital gains are subject to personal tax. Corporate taxes reduce the profitability of investment projects, which ultimately affects employment income, consumer prices or investor incomes.
Given that most public corporations raise capital from international markets, much of the corporate income tax is ultimately borne by Canadian workers through lower wages and salaries or higher consumer prices. A recent UK study found that, in the short run, 54 percent of the corporate tax falls on workers by reducing labour income and, in... |
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