UNFAIRNESS FEEDS THE BEAST.

Not everyone thinks small- business owners are right to complain that the Liberals’ proposal to target incorporated companies for more tax is unfair to entrepreneurs. But small- business owners have a point. Entrepreneurs face more income risk than do salaried workers, and the tax system fails to recognize this difference sufficiently.

My esteemed colleagues writing in these pages have rightly argued that the tax system should not be used to subsidize risk. What they miss is that income tax is neither neutral nor fair in its treatment of risky business activities, which typically bear a higher tax burden than jobs and investments offering more stable incomes. Thus, trying to impose the same tax rate on risky activities as non-risky ones will discourage risk-taking.

To understand this point, one must delve into the arcane world of tax policy. Under our system, governments are happy to tax away gains from success, while sharing little if any of the risk. This results from two fundamental imperfections in the system.

The first is the nature of the progressive income tax that results in much higher effective tax rates on income from success compared to income from bad outcomes.

Farmers, for example, know they will earn high incomes if market conditions are right, and earn little when crops fail. When their incomes fall short, farmers face real problems, like paying for next year’s fertilizer, not to mention the groceries and mortgage. Now, suppose the government levies two marginal income tax rates — 20 per cent on the first $ 50,000 in income and 50 per cent on income above $ 50,000. If the farmer earns $ 20,000 in one bad year, he pays $ 4,000 in tax. If he earns $80,000 the next year, he pays $10,000 in tax on the first $ 50,000 and $ 15,000 on the next $ 30,000, for a total of $ 25,000. Over those two years, the farmer pays $29,000 in tax on $100,000 of risky income earned, an effective rate of 29 per cent.

Now, suppose an employee earns $ 50,000 in salaried income each year, paying $ 10,000 in tax annually at the 20- per- cent rate. Over two years, the employee earns $ 100,000, exactly the same income as the farmer, but pays only $20,000 in tax — $9,000 less than the farmer.

So, risk bears a heavier tax burden compared to stable income under the progressive income tax. And that can discourage people from working in risky jobs or investing in risky assets. The problem could be alleviated by allowing taxpayers to average income over time, but the government stopped allowing averaging decades ago, due to its complexity.

The second burden on risk arises from government willing to take its share of gains but not of losses. Nine times out of 10, a venture capitalist loses money on her investments, earning only high rates of return from that one big success. If the government only taxes gains but provides no relief for losses, the venture capitalist might end up earning little or no after-tax income on a portfolio of investments.

Obviously, entrepreneurs face significant risks that require liquidity to meet payroll and other expenses when some investments go bust. Even their families bear risk if business income drops, since housing and other basic needs can be unaffordable in bad years. In practice, governments never fully refund the tax value of a loss since that can lead to evasion ( back in the 1980s, some taxpayers ran off to Costa Rica after receiving refunds of unused tax credits). And if Canada is too generous in allowing losses to be written off, it would encourage taxpayers to shift losses into Canada from their income earned abroad.

Self- employed individuals can set off business losses against other income (if they have it) or claim a refund if losses can be set off against profits in the previous three years or carried forward, at no rate of interest, against profits in the next 20 years. On the other hand, owners of a corporation generally cannot use corporate losses to reduce personal income for tax purposes. Instead, the corporation, not unlike the self- employed, can sometimes write off losses against past or future profits.

These observations make two clear points. Business income is more heavily taxed than employment income due to risk. And, business income in a corporation is more heavily taxed than self- employed income. So we clearly do not have tax neutrality when it comes to risk.

The federal tax- reform proposals are based on the principle of establishing neutrality between incorporated business income and self- employed or employment income. Even though this is appropriate, the proposals actually aggravate the unfair treatment of risky business income.

Obviously, Ottawa is all for establishing neutrality if it means more tax revenue to feed the government beast. Under the new proposals, income-splitting with a spouse and adult children through joint ownership of a corporation will only be possible when a family member contributes capital or work effort to the business ( even though the family already bears risk if the firm flops). The proposals also aim to tax corporate investments in “passive” assets to establish the same level of tax whether the portfolio is held in a corporation or by an individual investor. Yet, a corporation’s passive assets are also held to provide a cushion against risks, to improve credit terms or to be used for future investments.

The federal proposals provide no relief from unfair taxation of risk that would lower tax revenue. There are no provisions for better loss relief. No provisions for better averaging. No plan to reduce effective tax rates on risky incomes. Instead income and other taxes on business are hiked, crowding out private investment in risk. What the government is prioritizing is not fairness or an improved economic policy, but more tax revenues to pay for all sorts of public spending, some of which — such as subsidies for money- losing companies — will only harm the economy further.