Why tax revamp is getting pounded

It’s all about incorporation

A familiar mix of government incompetence and opposition shamelessness — together with a large dollop of special-interest shinola — have combined to turn a package of relatively modest tax changes into a government-shaking PR disaster.

There are lots of valid critiques of Finance Minister Bill Morneau’s proposals. But these have been lost in a cross-country meltdown among doctors and small business owners out of all proportion to any increase in tax they might suffer.

Indeed, among the early propaganda triumphs in the whole controversy is the notion that the measures in question are in fact aimed at these two groups.

Vast clouds of steamy rhetoric have been exhaled on impassioned tributes to their value to the economy, the hardships they endure, and so on, followed by righteous fury at the manifest injustice of requiring them to pay the same tax as others earning the same or less income.

But it isn’t about them: it’s about incorporation. The changes do not target small business, or doctors, as such: only those who turn themselves into corporations. It is only the small business owner or doctor who incorporates who benefits from the special lower tax rate that applies to small businesses, and it is only those small private corporations whose privileged tax status the government proposes to trim, to whatever small extent.

The anomaly in the current setup is not just that the owners of small private corporations pay so much less than mere wage earners. It is that they pay so much less in tax than other small businesses, and other doctors, of equivalent income: the ones who did not incorporate. The former pay less tax than the latter, not because they work harder, or take more risks, but solely because they are incorporated.

There are lots of good reasons why someone might wish to incorporate. There is no good reason why the tax system should, in effect, pay them to do so. And if there is evidence that lots of people are incorporating who otherwise wouldn’t, solely for the tax advantages attached, that’s a good reason on its own to detach those advantages.

In fact, this isn’t even about those small businesses who incorporate, but a still smaller subset: those with sufficient income to benefit from the practices the government seeks to limit. Most people, for example, can shelter from tax all the income they can possibly save within the limits of their personal RRSPs and TFSAs: very few have enough left over as to require further sheltering, as within a corporation.

“Income-sprinkling” — using a corporation to divide income among family members, rather than paying it all to the person who earned it — likewise only benefits those in a high enough tax bracket to take advantage of the lower rates paid on lower incomes. So it is no surprise that very few of those in the bottom 90 per cent of tax filers own a private corporation, while two-fifths of the top 1 per cent — and 75 per cent of the top one-hundredth of one per cent — do.

But even that overstates the numbers of those affected by the proposals. If you reinvest corporate income in the business — on a new computer, say — you’d pay the same low small business rate (less than 15 per cent, federal and provincial tax combined) as before. Likewise if you sock it away in so-called passive investments, like stocks and bonds: though the tax rate on these is much higher — 50 per cent-plus, the same as the top personal rate — it would not change under the government’s proposals. Only if you pay the income out to yourself would you pay more in tax than before — and then only to ensure you paid the same amount in tax as if you had not incorporated.

Ditto for income sprinkling: you can still pay your adult children out of the corporation, as before. You’d just have to show they were actually performing some sort of useful service in exchange. (As you do now, for non-adult children.) So we are a long way from the sweeping “attack on small business” or “death of the entrepreneur” of so much purple prose.

That’s not to say that the proposals are particularly well-considered: the government may have correctly identified the problem, but its proposed solutions are cumbersome, complex and intrusive. When Chamber of Commerce president Perrin Beatty thunders that small businesses “will need to prepare to be challenged by the government’s auditors for how they invest their profits, employ members of their family” and so on, he is not wrong.

Likewise for the government’s plan to achieve neutrality between corporate and non-corporate taxpayers in the treatment of passive investments. Right now both groups actually pay much the same marginal rate on this income: the advantage to corporate taxpayers lies in the larger amount of principal they can invest, since it comes out of income that was taxed at the lower small business rate. To offset that advantage, however, the government proposes to tax the return on that principal at a much higher rate, as much as 73 per cent. That’s obviously sub-optimal.

These and other pitfalls could have been avoided had the government addressed the root cause of the incorporation gold rush, rather than the symptoms: the vast disparity between the top personal rate and the small business rate. Were it simply to abolish the small business rate, as the United Kingdom has done, it would go a long way to reducing the tax advantages of incorporation, at very likely the same cost politically. What do they say: in for a penny, in for a pound?

PROPOSED SOLUTIONS ARE CUMBERSOME, COMPLEX AND INTRUSIVE.