A roadmap for ending the abuse
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Canada’s tax system is a
shambles of distortions, disincentives and neglect was amply demonstrated on the stock market yesterday. Shares of a dozen Canadian companies — TSX Group, CI Fund and BCE among others — dropped dramatically, wiping billions of dollars off total market capitalization. The only reason for the fall in values — nothing had happened to change the business outlooks of these companies — is a federal tax move that some see as Ottawa’s attempt to pull the plug on the creation of tax-driven income trusts.
The turmoil in income trusts, the product of a kind of tax loophole, is a perfect backdrop for the latest tax policy report from Jack Mintz and his colleagues at the C.D. Howe Institute. The report, optimistically subtitled Unleashing the Canadian Tiger, is a catalogue of federal and provincial abuse of taxpayers. It’s also a detailed roadmap on how to fix the warped network of tax measures that punish work, strip investors of their income, and distort business and economic behaviour.
Income trusts, in fact, are described as ‘‘ the most important example of financial distortions’’ caused by the tax system. The system discriminates against dividends and promotes the creation of trusts to dodge high dividend taxation. The Howe report offers a clean fix: Reform the tax system to stop the double-taxation of dividends and create a level playing field.
Above all, the report inadvertently helps answer another big question: Why have Canadian investors bought more than $100-billion in trust units in recent years? Because they are being screwed by the tax system, and income trusts offer a small way out, a chance to get some kind of real, after-tax cash back on their invested dollars. Income trusts, with their nominal returns of 8% or more, help offset a tax system that otherwise expropriates most investment income.
An investor who buys a bond that nominally yields 6% faces a tax rate of 40% and an inflation loss of more than 2%, effectively lowering the real rate of return down to 1.6%. On a 4% bond, which is closer to current market values, the real return drops to 0.4%. Retire on the income, they say. What income? With an 8% yield, the post- tax and post- inflation return on trusts would be 2.8%. Not great, but it’s more than Ottawa now leaves on the table on the average bond.
To fix the distortion and remove the artificial incentive to create income trusts, the Howe paper proposes a new tax regime that would lower the effective tax on dividends to 25% from its current level of about 46%. That would let Canadian investors hold on to 75% of their dividend income. At the same time, Ottawa should cut corporate income tax rates to 25%. That would end the tax game over income trusts.
The trouble with those proposals, as with most recommendations to fix the tax system, is that they must overcome an army of vested interests opposed to change. The C.D. Howe paper calls for a new tax system based on low rates, a broad base and a shift to a system that removes weird incentives and eliminates barriers to economic growth. Stop taxing savings and investment, and move toward greater reliance on consumption taxes.
Sensible enough. But each existing tax measure, no matter how bad or distortive, inevitably benefits someone who wants to maintain the status quo. The massed forces of Bay Street — lawyers, accountants, investment dealers, hedge funds, pension managers, advisors — are already scrambling to the defence of trusts.
Toronto lawyer Alfred Apps, of Fasken Martineau, told Dow Jones yesterday that income trusts are now a vital part of Canada’s financial system. They provide investors with yield-generating securities at a time with other sources are drying up. That yield opportunity, however, exists only because of the mess in the tax system that currently buries investors. The income trust boom is a rush for liberation by investors escaping an abusive system. The solution is to fix the system.
Resistance to change is even more deeply entrenched around other distortions identified by the Howe report. We have 70% effective marginal tax rates that make it uneconomic for people to work more, or increase their income; marginal corporate tax rates that effectively confiscate an average 39% of the return on capital invested; taxes that give preferences to some at the expense of others.
One set of industries — construction, communications, wholesale — pays more taxes while forest industries and manufacturers pay less. Small businesses pay even less, due to special preferences. Such uneven tax burdens on different business activities lowers productivity because they ‘‘ distort the allocation of investment,’’ as the report puts it. When taxes determine investment decisions, the best investment decisions don’t get made. This would mean cleaning out the special deductions and tax credits for films, small business, labour-sponsored venture funds. You can hear the howls of protest.
The biggest obstacles to change, however, are the politicians and their addiction to using the system to buy votes. But surely Canadians are not immovably chained to the rotting hull of a regime of taxes that is manifestly unfair, a system that prompts people to make decisions about employment, retirement, savings and investment that are not good for them or the economy.