Lighten the load

TA X C O M P E T I T I O N It’s time to unleash the Canadian tiger by reforming confiscatory tax policies that discourage saving and investment

In the past decade, many countries around the world awoke to the link between business investment and job and wage growth, and began to lighten the tax load on capital investment. Now Canada and most other G7 countries nest atop an unhappy pile of high-tax jurisdictions that need a dose of pro-growth tax reform to give themselves — and their trading partners — a healthy economic boost.

Smart Canadian policymakers should not simply react to changes in tax policy abroad. They should take the initiative and adopt measures to unleash the Canadian tiger by making this country, quite simply, the best in which to work and invest. And given the competitive and demographic challenges facing Canada, tax reform is increasingly urgent. Other countries are not standing still — as in the United States, where President George W. Bush’s reform initiative will soon spark a major debate on the advantages of reorienting the tax base from income toward consumption.

Federal and provincial governments have their work cut out for them. Heavy taxes on investment have discouraged businesses from buying the new- vintage capital and latest technologies that would improve labour productivity. In the absence of such modernization, production processes age, businesses fall behind and they have difficulty increasing their employees’ incomes. Annual business investment per worker has dropped in Canada by nearly a fifth in recent years and productivity and wage growth have languished for longer.

Canadian governments need to develop multi- year plans to make Canada friendlier to investment and to remove tax barriers to work and saving so that workers keep more of the fruits of their labour. Canada needs low rates, broad tax bases and a shift in the tax mix: We need to move toward greater reliance on taxes on consumption rather than on savings and investments.

Here is why. With an ageing population and savings rates at historical lows, the economy’s capacity to fund future public benefits at reasonable tax rates is threatened. But even if savings rates are unaffected by current taxes, as a few economists believe, Canadians are unable to build wealth for future needs when taxes take a confiscatory bite. Consider a five- year bond yielding 4%: A representative 40% statutory tax rate produces a 2.4% after- tax yield. With inflation running at 2%, the inflation-adjusted real rate of return is a thoroughly discouraging 0.4%. Hence, on an inflation- adjusted basis, the effective tax rate on savings in taxable bonds is more like 80% than the statutory 40%, and that needs fixing.

Taxes on saving should in principle be eliminated so that taxpayers pay the same tax regardless of whether they consume their earnings today or in the future. The shift can be smoothly accomplished by, for example, increasing allowable deductions for pension and registered retirement contributions and by relying more on sales, excise and user- pay fees.

Meanwhile, the current high marginal tax rates on employment earnings and investment income are especially damaging to people with modest incomes. Reductions in overall tax rates are needed, especially the clawback rates for income-tested programs and taxes on investment earnings. Federal and provincial governments should co- ordinate their income- testing policies to avoid the stacking of clawback rates and reevaluate how seniors are taxed.

Moreover, it is time for Tax-Prepaid Savings Plans. TPSPs would allow individuals to save after-tax earnings in registered accounts, and, as a mirror to RRSPs, accrued earnings and withdrawals would not face future taxation. This would allow Canadians to even out their tax base over time and provide choice for low-wealth seniors for whom RRSP saving would be financially backward.

Other savings changes would make sense: 10 years ago the maximum age for RRSP contributions was lowered from 71 years to 69. Recognizing that Canadians now live and work longer, the age limit (if there must be one), should be raised to 73. And if taxpayers withdraw their RRSP savings for contingencies, they should be able to increase their lifetime contribution room by the same amount.

Not all smart changes need be tax cuts. The current $ 500,000 lifetime capital gains exemption for owners of farm property and shares of Canadian-controlled private corporations should be replaced by a rollover provision that allows the proceeds of sales to be folded into an enhanced farmers’ and small business owners’ RRSP.

Now, the dividend tax credit: Dividends usually face heavier taxes than other forms of income, because the personal and corporation income taxes are imperfectly integrated. As recently noted by Finance Minister Ralph Goodale, this puts pressure on business to choose corporate forms that, while minimizing governments’ tax take, may not be well suited to an economy that needs continuing business reinvestment in productivityenhanced plants and processes. Fixing the dividend tax gross-up and credit system is the solution staring us in the face.

With lower taxes on saving and dividend income, other incentives to save would be less necessary. The federal and provincial labour-sponsored venture capital fund credits are dubious measures, as labour funds’ economic return to investors is typically low or negative: The median five- year return for labour funds in existence as of August, 2005, was –9.8% annually; Ottawa and other provinces should follow Ontario’s lead by ceasing to register new funds and by winding down the credit for investment in labour- sponsored funds.

Employment Insurance operates with a big and persistent surplus, even though its legislation says premiums and benefits should balance over the business cycle. That means premiums are too high and, given that contributions are limited to the first $39,000 in employment income, a heavier burden for low-income workers than high. Further, EI premiums are unfairly and inefficiently levied because they are unrelated to the layoff experience of a business. Employers who take advantage of the Employment Insurance program by routinely laying off workers are permitted to do so without facing higher premiums. As part of a premium reduction package, the federal government should adopt partial experience-rating at the business level so that employers who tend to lay off workers pay a higher premium, and establishments with good employment records pay lower rates.

On the corporate income tax side, the place to start is redressing the high taxes on business investment, with the aim of building labour productivity and offsetting some of the impact of work-force ageing. Policy initiatives for Canada to create a distinct advantage for itself include lowering the combined federal-provincial corporate income tax rate to 25%.

As things stand, Canada’s effective tax rates on investment are second-highest among the 36 developed and leading developing nations we surveyed, and that can be fixed. Further, a one- point reduction in the corporate income tax rate enlarges the tax base by 4% to 8%, as businesses shift income into lower- tax jurisdictions, and that suggests that additional taxes paid by large companies may offset some or all of the revenue impact of the rate cut.

There is much more to address, such as provincial capital taxes and withholding taxes that inhibit foreign investment in projects here. Canada’s federal and provincial governments have plenty of work to do, and Canadian workers can only benefit by unleashing our productive capacity. Finn Poschmann is associate director of

research at the C. D. Howe Institute.

“ The 2005 Tax Competitiveness Report”

is available at www. cdhowe. org.