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. firstname.lastname@example.org
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.