Morneau admits we’re ‘Trumped’

Finance Minister Bill Morneau has finally admitted we’ve been “Trumped.” Morneau conceded in an interview over the weekend that Canada has a competitiveness problem and he plans to address it in the fall fiscal update. He said he wants to encourage business investment, which is no doubt a code word for selective tax credits or accelerated-depreciation allowances for new investments.

He’s not nearly as interested in lowering taxes, he said, which is the biggest policy issue of all. “People want to make sure that the next investment they’re going to be making is on an advantageous basis,” Morneau told Bloomberg News. “That’s a much more common refrain than someone coming in and saying, ‘You know, I really think you should really cut rates’.”

His government’s long-awaited shift to focusing on economic issues is certainly welcome. As noted recently by the Bank of Canada and just last week by the International Monetary Fund, Canada’s business investment is modest (or as the IMF puts it more strongly, “subdued”). Export growth has also stalled in 2018.

Canada is becoming the Austin Powers of economies — increasingly passé and rapidly losing its mojo. Tax and regulatory policies have continued to heap costs onto industries and job-creating entrepreneurs. A recent survey by EY of large Canadian businesses found that over 61 per cent of executives believe Canadian policies are having a negative impact on their businesses. Roughly the same number said that U.S. tax reform is having a strongly negative or somewhat negative impact on their operations in Canada.

We can’t do much about U.S. tax reform, but we can do something about our own business climate. Canada lost its corporate tax advantage in 2018. Recent federal and provincial policies have also resulted in much higher taxes on skilled labour, with Canada’s top personal tax rate averaging 52 per cent, about eight points higher than taxes on the top American bracket. And ours kicks in at income levels one-third below that of the top U.S. bracket.

Both the IMF and OECD have joined the chorus of businesspeople and investors calling for tax reforms in Canada. Reform is urgently required for both corporate and personal taxes for two reasons: improving the climate here for investment, work and innovation; and stopping the southward flight of investment, profits and skilled Canadians, and the tax revenue that goes with them.

U.S. tax reform, coupled with deregulation, has created a boom in American investment and GDP (with four-per-cent growth expected this quarter). The 14-point cut to the federal corporate tax rate and accelerated, 100-per-cent writeoffs for new equipment have been major factors. But so has Washington’s new, much-lower corporate tax rate for intangible activities (such as services, marketing and intellectual property). Also helping are lower small-business and personal taxes.

The IMF estimates American companies will cut capital investment in Canada by six per cent due to U.S. tax reform alone. Profit-shifting to the U.S. will result in a 15-per-cent drop in Canadian corporate tax revenues paid by U.S. multinationals, it projects. Likewise, the EY survey suggests half of Canadian companies now expect to shift investment and profits from Canada to the U.S. This after foreign investment here has already shrivelled.

The current thinking in the federal government, as Morneau’s hinting effectively confirms, is that Canada should match Washington’s 100-per-cent writeoff for new equipment. Trump-like expensing provisions will, the thinking goes, accelerate adoption of new technologies across Canada’s business sectors. More generous expense writeoffs could make sense if Ottawa then cancels the interest-expense deduction (otherwise, capital costs are written off twice). Losing interest deductions for faster machinery writeoffs might be the trade-off business owners could soon face.

However, focusing only on expensing is a mistake for three reasons.

First, expensing only benefits companies that pay income taxes; startups, for example, are provided little or no tax relief. Expensing also favours machinery-intensive business activities, distorting the allocation of capital in the economy.

Second, expensing provisions create an unstable tax system as businesses build up unused deductions over time. A stockpile of writeoffs results in complicated tax-planning structures to transfer losses to subsidiaries that can use them — and even more complicated tax laws to stop that behaviour. Since 1987, Canada has broadened tax bases, not narrowed them, in the interest of simplification and neutral tax treatment of businesses.

Third, expensing does little to counter the base erosion and tax-avoidance (by shifting activity to the U.S.) that is best mitigated by lowering corporate tax rates.

These reasons are why countries that respond effectively to U.S. competitiveness will do so by lowering corporate income tax rates, not just faster writeoffs. The IMF expects the reduction in corporate taxes among countries will be on the order of about four points. Already, France is reducing its tax rate from 33.33 to 25 per cent by 2022. Belgium is also lowering its rate from 34 to 25 per cent over a similar time frame. The Australian government has proposed reducing its rate from 30 to 25 per cent, although it currently lacks a Senate majority to push that through. Sweden is cutting its rate further from 22 to 20.6 per cent.

Canada, with a combined average federal-provincial corporate tax rate close to 27 per cent, now has one of the highest rates among 33 OECD countries (the highest is Japan’s, at nearly 31 per cent). If companies with U.S. operations plan to shift costs such as interest expense to other countries, and shift tangible and intangible profits to the United States, Canada is going to end up as one of the biggest victims of base erosion since our corporate tax rate is so high.

If federal and provincial governments fail to lower corporate and personal tax rates as well as broadening their tax bases, it will hurt Canada’s competitiveness and long-run growth prospects. Morneau’s focus on new investment breaks is not the answer Canada’s competitiveness requires. We need comprehensive tax reform.