Kevin Page

Policy - - In This Issue - Kevin Page

Cut­ting Taxes is Easy, Tax Re­form is Hard

Chang­ing tax pol­icy is al­ways po­lit­i­cal. In the ide­o­log­i­cal spec­trum that rep­re­sents Canada’s po­lit­i­cal land­scape, tax pol­icy is where the rhetor­i­cal rub­ber meets the gov­er­nance road. As the pub­lic de­bate over the Trudeau gov­ern­ment’s pro­posed changes to small busi­ness tax­a­tion has shown, the devil isn’t so much in the de­tails as in the di­a­logue. For­mer Par­lia­men­tary Bud­get Of­fi­cer Kevin Page lays out the lessons learned.

Yogi Berra, the late Hall of Fame baseball player, was fa­mous for his achieve­ments on the field and no­to­ri­ous for his mal­a­prop­isms. One of my favourites is: “When you come to the fork in the road, take it.” For Berra, the state­ment made sense be­cause it was re­lay­ing in­for­ma­tion to a visi­tor look­ing for his house that in­di­cated it did not mat­ter which way you pro­ceeded at the fork, you would get to the de­sired des­ti­na­tion.

Sadly, I fear this is not the case with the fed­eral gov­ern­ment’s in­ten­tion to re­form our tax sys­tem. The rough road ex­pe­ri­enced by the Lib­er­als on re­form­ing small busi­ness tax­a­tion likely

means the big­ger ef­fort to re­view other tax ex­pen­di­tures—the hun­dreds of ex­emp­tions, de­duc­tions, cred­its and pref­er­en­tial rates that are em­bed­ded in our tax sys­tem—is in jeop­ardy. The like­li­hood is that we will not get past the fork in the road. Po­lit­i­cal post-trau­matic stress is set­tling in, mak­ing it dif­fi­cult to be op­ti­mistic about tax re­form un­til after the next elec­tion. There is lots of blame to spread around.

The need for broad-based tax re­form in Canada has been build­ing for the past few decades. Bud­getary rev­enues rel­a­tive to the size of the econ­omy have fallen dra­mat­i­cally, re­duc­ing the ca­pac­ity of gov­ern­ments at all lev­els to pay for pro­grams and ser­vices in the face of ag­ing de­mo­graph­ics. Bud­getary deficits have re­turned. Debt is pil­ing up. The fed­eral fis­cal plan to man­age the debt in­crease is de­void of strong com­mit­ments—In 2015, the Lib­er­als cam­paigned on stim­u­la­tive deficits of $10 bil­lion a year over three years, with a re­turn to bal­ance in 2019. Deficit spend­ing con­tin­ues, with bal­ance nowhere in sight.

In­di­vid­u­als and cor­po­ra­tions have got­ten used to tax re­duc­tions of all types. A suc­ces­sion of gov­ern­ments has be­come ac­cus­tomed to de­liv­er­ing ben­e­fits to con­stituents through special pro­grams called tax ex­pen­di­tures (e.g., ac­cel­er­ated cap­i­tal cost al­lowances, char­i­ta­ble do­na­tions, tool cred­its, etc.). Ev­ery bud­get in re­cent years adds lay­ers of com­plex­ity for tax­pay­ers. Layer cakes are tasty and fun to look at. This is not the case with our tax code.

Sim­i­larly, con­cerns have been build­ing about Canada’s rel­a­tively low pro­duc­tiv­ity growth and its im­pli­ca­tions for our fu­ture stan­dard of liv­ing. It is a good ques­tion to ask if we can bet­ter use the tax sys­tem to support growth and job cre­ation. What if we re­duced in­come taxes and pay­roll taxes and in­creased con­sump­tion taxes? Could we raise labour force par­tic­i­pa­tion rates? Could we in­crease in­vest­ment? Sim­i­larly, coun­tries ev­ery­where are scratch­ing their heads try­ing to find ef­fec­tive tax­a­tion sys­tems for cor­po­ra­tions and in­di­vid­u­als in a world econ­omy seem­ingly with­out borders. How big is the tax gap? How do we re­duce tax avoid­ance?

The fed­eral elec­tion in 2015 raised the prom­ise of a tax re­form agenda be­yond tax cuts. Go­ing into the elec­tion, all the op­po­si­tion par­ties put forth pro­pos­als with sig­na­ture ini­tia­tives in­volv­ing some com­bi­na­tion of re­dis­tri­bu­tion mea­sures to strengthen lower and mid­dle classes, re­duc­ing tax eva­sion through bet­ter en­force­ment, and in­cen­tives to grow the econ­omy in a more sus­tain­able way, in­clud­ing through bet­ter en­vi­ron­men­tal and/or health pol­icy.

While it is prob­a­bly fair to say that none of the par­ties made tax re­form front-and- cen­tre in their agen­das, the vic­to­ri­ous Lib­er­als came close to promis­ing broad- based re­forms. In ad­di­tion to rais­ing taxes for wealthy peo­ple and re­duc­ing taxes for mid­dle class fam­i­lies, they promised to end “un­fair tax breaks”. This in­cluded the elim­i­na­tion of in­come-split­ting mea­sures brought in by the pre­vi­ous Con­ser­va­tive gov­ern­ment but also a re­view of tax ex­pen­di­tures. The lat­ter was wrapped in a cloak of fair­ness and the need to gen­er­ate rev­enues to pay for new pro­grams (e.g., child care, in­fra­struc­ture, In­dige­nous peo­ples, vet­er­ans, among oth­ers).

The lan­guage around the re­view and the pro­jec­tions for sav­ings from tax ex­pen­di­tures were quite spe­cific in the Lib­eral plat­form. The plat­form tar­geted sav­ings from the re­view of $1 bil­lion in 2017-18 ris­ing to $3 bil­lion in 2019-20. The re­view of small busi­ness tax­a­tion was high­lighted, sug­gest­ing that it was go­ing to be a rel­a­tively large con­trib­u­tor to the sav­ings:

“Con­duct­ing an over­due and wide-rang­ing re­view of the over$100 bil­lion in in­creas­ingly com­plex tax ex­pen­di­tures that now ex­ist, with the core ob­jec­tive be­ing to look for op­por­tu­ni­ties to re­duce tax ben­e­fits that un­fairly help those with in­di­vid­ual in­comes in ex­cess of $200,000 per year.”

“As we re­duce the small busi­ness tax rate to 9 per­cent from 11 per­cent, we will en­sure that Canadian Con­trolled Pri­vate Cor­po­ra­tion (CCPC) sta­tus is not used to re­duce per­sonal in­come tax obli­ga­tions for high-in­come earn­ers rather than sup­port­ing small busi­nesses. Michael Wolf­son from the Univer­sity of Ottawa es­ti­mates that ap­prox­i­mately $500 mil­lion per year is lost, par­tic­u­larly as high-in­come in­di­vid­u­als use CCPC sta­tus as an in­come split­ting tool.”

Win­ston Churchill said that “the first busi­ness of gov­ern­ment is to govern… which may at times call for the de­lib­er­ate en­durance of un­pop­u­lar­ity.” Some po­lit­i­cal sci­en­tists call this the “gov­ern­ing para­dox”— the need for politi­cians to gen­er­ate and sus­tain pop­u­lar support ver­sus the dif­fi­cult ex­pe­ri­ence of mak­ing un­pop­u­lar de­ci­sions that go against the wishes of some seg­ments of the elec­torate. Bu­reau­crats can ad­vise on the po­ten­tial eco­nomic, so­cial and fis­cal im­pacts of tax changes or risks to the in­tegrity of the tax sys­tem but only po­lit­i­cal lead­ers can make the choices and trade­offs re­gard­ing is­sues like fair­ness.

The rough road ex­pe­ri­enced by the Lib­er­als on re­form­ing small busi­ness tax­a­tion likely means the big­ger ef­fort to re­view other tax ex­pen­di­tures—the hun­dreds of ex­emp­tions, de­duc­tions, cred­its and pref­er­en­tial rates that are em­bed­ded in our tax sys­tem— is in jeop­ardy.

Po­lit­i­cal de­bates need pol­icy con­text. The Lib­er­als set the con­text in the 2015 elec­tion cam­paign. They moved quickly to bring about some big sig­na­ture tax changes that would see higher rates of tax on high-in­come peo­ple, a low­er­ing of the mid­dle rate complemented by a much-en­riched child care sub­sidy to help the mid­dle class. A small step was taken to lower the small busi­ness tax rate. In the wake of Bud­get 2016, they launched an expert panel of well-known pub­lic fi­nance economists in­clud­ing Robin Boad­way and Kevin Mil­li­gan to pro­vide ad­vice to the gov­ern­ment to tackle the re­view of tax ex­pen­di­tures.

This is text­book po­lit­i­cal strat­egy. If a gov­ern­ment is go­ing to do tough things over its man­date, it is bet­ter to do them in the first few years. Bet­ter to be reap­ing the po­lit­i­cal ben­e­fits in the lead up to the 2019 elec­tion by cut­ting rib­bons on new in­fra­struc­ture projects and have the squab­bles re­lated to clean­ing up tax ex­pen­di­tures well in the rear-view mir­ror.

The first “big” tar­get on the tax ex­pen­di­ture hit list was ad­dress­ing in­tegrity is­sues with small busi­ness tax­a­tion. There are more than 700,000 cor­po­ra­tions re­port­ing in­come taxed at the pref­er­en­tial fed­eral tax rate of 10.5 per cent com­pared to the gen­eral fed­eral cor­po­rate rate of 15 per cent. About half of all tax­able in­come of Canadian-con­trolled pri­vate cor­po­ra­tions get the pref­er­en­tial tax rate for small busi­ness.

The to­tal tax loss im­pact of the pref­er­en­tial tax rate for small busi­nesses is val­ued at $3.6 bil­lion in 2017 (note—chang­ing the pref­er­en­tial rate was never up for dis­cus­sion; only base-broad­en­ing mea­sures re­lated to in­come split­ting, pas­sive in­come and use of cap­i­tal gains). For com­par­i­son sake, this is about two times big­ger than the Sci­en­tific, Re­search and Ex­per­i­men­tal De­vel­op­ment In­vest­ment Tax Credit ($1.5 bil­lion); about a third big­ger than the non-tax­a­tion of ben­e­fits from pri­vate health and den­tal plans ($2.7 bil­lion); but about half the es­ti­mated size of the non-tax­a­tion of cap­i­tal gains for prin­ci­pal res­i­dences ($6.8 bil­lion). To­tal bud­getary rev­enues of the fed­eral gov­ern­ment are ex­pected to be a lit­tle more than $300 bil­lion in 2017-18.

Fi­nance pub­lished a tech­ni­cal con­sul­ta­tion pa­per in the sum­mer of 2017. The bu­reau­cratic case looks strong. The neu­tral­ity of the tax sys­tem as it re­lates to per­sonal ver­sus cor­po­rate taxes is mis­aligned. It would be hard to find in­de­pen­dent tax ex­perts to say oth­er­wise. Too many peo­ple were cre­at­ing small busi­nesses to take ad­van­tage of a tax regime that re­sulted in lower taxes through a pref­er­en­tial rate and some tax plan­ning tech­niques around in­come split­ting, pas­sive in­come and cap­i­tal gains. There was no talk of low­er­ing the pref­er­en­tial small busi­ness rate be­low 10.5 per­cent—it was deemed al­ready low, not­with­stand­ing a plat­form com­mit­ment to lower it to 9 per­cent over the man­date.

It fol­lows that the larger the pub­lic sec­tor, the more im­por­tant it is to have an ef­fi­cient, fair and ad­min­is­tra­ble tax sys­tem. The Lib­er­als were ex­pand­ing the fed­eral pub­lic sec­tor. They were not shy about in­creas­ing pro­gram spend­ing and plan­ning for bud­getary deficits over the medium term. They were also stick­ing to their com­mit­ment to con­sult. With Pow­erPoints and a con­sul­ta­tion pa­per in hand, they met with Cana­di­ans across the land. They went to Par­lia­ment. I give the gov­ern­ment full credit for con­sult­ing.

The con­sul­ta­tion pa­per was in­for­ma­tive but there were some cracks. A num­ber of ex­perts, like Jack Mintz, can le­git­i­mately ar­gue that the pa­per was short on dis­tri­bu­tional and fis­cal im­pacts. Clearly the base-broad­en­ing mea­sures were go­ing to hit pri­mar­ily high-in­come peo­ple but some mid­dle-in­come peo­ple as well. The pro­posed mea­sures were go­ing to add com­plex­ity to the tax sys­tem, not re­duce it. Also, the in­ter­na­tional tax com­par­isons of our small busi­ness sec­tor were spun in a very gen­er­ous light by not look­ing at the big­ger pic­ture in­clud­ing div­i­dend and capi- tal taxes. As the late Leonard Co­hen said: “There is a crack in ev­ery­thing. That’s how the light gets in”.

Tax the­o­rists typ­i­cally talk about two fair­ness con­cepts. One is ver­ti­cal equity, usu­ally taken to mean the more you earn, the more you pay. Two is hor­i­zon­tal equity, mean­ing those in sim­i­lar cir­cum­stances pay the same amount. The Lib­er­als were ef­fec­tively mak­ing the case that po­ten­tial base­broad­en­ing re­forms to small busi­ness tax­a­tion were ‘two birds with one stone’. Un­for­tu­nately, re­al­ity is al­ways more com­plex than the­ory.

The late Vic­tor Frankl said: “Don’t aim at suc­cess. The more you aim at it and make it a tar­get, the more you are go­ing to miss it.” Fair­ness in re­al­ity can be just as fickle as suc­cess or hap­pi­ness. As soon as the Lib­er­als opened up the de­bate on re­forms, small busi­ness own­ers in­clud­ing doc­tors, lawyers, farm­ers and many oth­ers ex­plained that they have come to de­pend on the cur­rent sys­tem to man­age their fi­nances. They used le­git­i­mate fair­ness ar­gu­ments to ex­plain why the po­ten­tial tax re­forms re­gard­ing in­come sprin­kling, pas­sive in­come and cap­i­tal gains were un­fair, even though the pref­er­en­tial low small busi­ness tax rate was go­ing to re­main in place. Doc­tors, for ex­am­ple, were able to talk about how th­ese tax ad­van­tages have off­set other gov­ern­ment ef­forts to re­strain grow­ing health care costs. Other small busi­ness own­ers have ar­gued that they need ad­di­tional ben­e­fits around pas­sive in­come at­tached to their cor­po­ra­tion to build up funds for fu­ture rein­vest­ments in the busi­ness.

The Lib­er­als came to Berra’s fork in the road on Oc­to­ber 16. After four months of swing­ing and miss­ing on tax re­form with small busi­ness own­ers, Lib­eral cau­cus and op­po­si­tion mem­bers of Par­lia­ment, they took the path of least re­sis­tance and com­mit­ted to re­duc­ing the pref­er­en­tial rate to 9 per cent in 2019 (an elec­tion year). Prom­ises were made to soften the ini­tially pro­posed im­pacts to in­come split­ting and pas­sive in­vest­ments. Pro­posed changes to cap­i­tal gains were dropped.

Cut­ting taxes is easy, even when it’s deficit fi­nanced. Tax re­form is hard. The odds are high that a full re­view of tax ex­pen­di­tures be­tween now and the next elec­tion is off the ta­ble. The po­lit­i­cal price is just too high.

What are the lessons learned?

One, we must be care­ful when we cre­ate new ways to use the tax sys­tem to in­cent be­hav­iours (whether it is to pro­mote small busi­ness cre­ation, re­search and de­vel­op­ment or use of pub­lic tran­sit). When we do so we are adding com­plex­ity to the tax sys­tem and cre­at­ing po­ten­tial fair­ness is­sues down the road. After ex­ten­sive anal­y­sis and con­sul­ta­tion, the UK, for ex­am­ple has cho­sen to go to one rel­a­tively low cor­po­rate rate for all busi­nesses and a broad-based mea­sure of in­come. Could this be a fu­ture path for Canada?

We need to go back to the draw­ing board and pre­pare a po­lit­i­cal and pub­lic process that sets up a tax sys­tem with less em­pha­sis on in­come and more on con­sump­tion; that is pro­gres­sive, sim­pler and eas­ier to ad­min­is­ter; and pro­motes sus­tain­able growth.

Two, it must be ac­knowl­edged that a piece­meal ap­proach to tax re­form (i.e., let’s ex­am­ine one tax ex­pen­di­ture at a time) is a type of (po­lit­i­cal)

lingchi— a form of tor­ture and ex­e­cu­tion where body parts are slowly re­moved over time re­sult­ing in fa­tal­ity. We need to go back to the draw­ing board and pre­pare a po­lit­i­cal and pub­lic process that sets up a tax sys­tem with less em­pha­sis on in­come and more on con­sump­tion; that is pro­gres­sive, sim­pler and eas- ier to ad­min­is­ter; and pro­motes sus­tain­able growth.

Three, we must ask our­selves if we have met the en­emy and it is us. We must not al­low our po­lit­i­cal sys­tem to be­come syn­ony­mous with fail­ure. We need our po­lit­i­cal lead­ers to tackle hard is­sues like tax re­form. If we fail now, we should learn from our mis­takes and try again. If the best we can set­tle for is some messy com­pro­mises then we must ap­pre­ci­ate that this is the price of democ­racy and gov­ern­ing through con­sen­sus. We must rec­og­nize that there is a cost to ex­panded pub­lic pro­grams and ser­vices. The deficits of to­day mean higher in­ter­est on the pub­lic debt for fu­ture gen­er­a­tions and less fi­nan­cial room to ma­neu­ver on pol­icy is­sues.

Kevin Page is found­ing Pres­i­dent and CEO of the In­sti­tute of Fis­cal Stud­ies and Democ­racy, Univer­sity of Ottawa, and for­mer Par­lia­men­tary Bud­get Of­fi­cer of Canada. kevin.page@ifsd.ca

Adam Scotti photo

Prime Min­is­ter Trudeau and Fi­nance Min­is­ter Bill Morneau an­nounce changes to the small busi­ness tax rate at Pastag­gio Ital­ian Eatery in Stouffville. Oc­to­ber 16, 2017.

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