Morneau’s tax changes won’t just hurt the ‘rich,’ they will hurt growth.
Those old enough to remember know it’s hard to f orget Allan MacEachen’s disastrous deficit- fighting budget of 1981. As finance minister under then- prime minister Pierre Trudeau, MacEachen raised personal taxes to suck out more money from businesses, investors and entrepreneurs. The proposed tax changes to private corporations released yesterday by Finance Minister Bill Morneau brings back memories of the MacEachen experience, by hitting many small business owners with more income taxes. The redistributive policies that have been rolled out by this government since 2015 are piling up into a MacEachenlike approach, with higher taxes on growth- generating activities.
Even though MacEachen’s 1981 budget lowered personal income tax rates — for example, dropping the top federal income tax rate from 43 to 34 per cent — it adopted s o many basebroadening measures that it led to a multi- billion dollar increase in personal taxes right as the economy was headed for a recession. If the goal was an income tax system that treats every dollar of income the same, many of MacEachen’s proposals made good sense. However, many questioned that premise, noting that income taxes are highly unfavourable to business owners and investors who, unlike consumers, pay tax twice: once when they earn their income and a second time after they invest it and pay taxes on the returns. The proposals were met by considerable hostility, especially from small business owners, who got walloped with higher taxes.
Morneau’s proposal to attack the tax planning used by small businesses channels MacEachen, but with one important difference. Where MacEachen accompanied his base- broadening with lowered personal income tax, recent budgets from this Liberal government have steadily raised them ( except for a tiny 1.5- percentagepoint cut to the second tax bracket, worth about an average of $350 per taxpayer annually).
The federal top rate increased two years ago from 29 to 34 per cent on incomes in excess of $ 202,800 — a return, coincidentally, to the 1981 rate ( today the federalprovincial combined top rate is 51.6 per cent, higher than in the 1981 proposal of 50 per cent). Several tax preferences have been cut back such as education credits and TFSA limits. New CPP payroll, energy taxes and provincial levies also hit middle-class taxpayers hard.
Morneau’s base- broadening proposals on small businesses seem reasonable, even if imperfect, to establish more fairness among different types of taxpayers. They will make it more difficult to split income paid to family members owning shares in a small business, consistent with earlier Liberal moves to abolish the income splitting introduced by the previous Conservative government ( the Conservative policy did treat different family- types more fairly). They also target the preferential corporate income tax to support only business investment instead of passive investment, which could create some problems for companies using cash flow to support future investment or to improve their credit rating with lenders. The proposals also make it more difficult to convert more highly taxed dividends into lowertaxed capital gains.
These measures, which contrary to much of the news coverage, aren’t just targeted at the “rich” but will also hit middle- class business owners, are expected to increase federal taxes by $ 250 million, and provincial revenues by roughly another half of that. This is just one more way to discourage entrepreneurship, on top of all the tax increases in the past two years. If the Republicans’ plan for tax reform happens in the U. S., even more young entrepreneurs will be looking to head south instead of here.
Taxes on small businesses were already less than competitive, especially relative to the U. S. The discussion paper put out Tuesday by Finance Canada was particularly disingenuous in only comparing statutory corporate income tax rates for small businesses, leaving out the higher dividend and capital gains taxes Canadian business owners have been paying to make up for low corporate income taxes.
After taking into account corporate and personal income taxes on capital gains and dividends, the effective tax rates on new investment aggregated across industries tells a less favourable story. As the accompanying table shows ( it assumes debt finance at 40 per cent of capital), Canada’s tax system is competitive for very small businesses, at profit margins offering a “middleclass” owner $ 60,000 and $ 180,000 in income. But for high- income small business — typically the most important innovators — Canada has a relatively high effective tax rate, especially compared to the U. S., our biggest competitor.
Even more i mportant than the tax rate, Canadian entrepreneurial companies are heavily penalized on their growth compared to those in other countries. Recent studies have shown that many small businesses are created here, but few actually grow. We’ll help if you’re small, but we make it hard for businesses to become stars.
Overall, the business tax structure for small business is highly distortionary and complex. The new rules — adding even more complexity — do little to change the overall structure of small business incentives. Our low small- business rate adds considerable complexity to the personal tax system, for instance with different dividend tax credits for small and large business income. A single corporate income tax rate of 19 per cent, now prevailing on businesses of all sizes in the U. K., is a much simpler model. Our lower tax on capital gains versus dividends encourages not only complex tax planning but also distorts decisions around financing and organization. Morneau’s proposals won’t fix any of this.
If we really wanted to help businesses grow, there are better ways to do it. The U. K. provides a full writeoff for machinery expenditures (up to 200,000 pounds) that helps most small businesses. We could allow entrepreneurs to average the volatile income they earn from risky ventures for income-tax purposes, to lighten their load in face of rising personal tax rates ( averaging has not been available since 1987). In the U. S., a capital- gains tax incentive encourages smaller companies to go public, encouraging growth.
With higher t axes on entrepreneurs and l i ttle change to address the current failure of the small-business tax regime, Morneau’s tax-tightening proposals are just more redistribution at the expense of growth. If the government is trying to promote innovation and entrepreneurship, these proposals aren’t the way to do it.