Why Tax Re­form is Po­lit­i­cally Per­ilous

Policy - - In This Issue - Geoff Norquay

Tax re­form in any democ­racy can­not be sep­a­rated from pol­i­tics any more than the broader budget process can be. Any gov­ern­ment’s fis­cal pri­or­i­ties are a re­flec­tion of prom­ises kept and in­vest­ments in fu­ture elec­toral suc­cess as much as they are a man­i­fes­ta­tion of eco­nomic stew­ard­ship and so­cioe­co­nomic alchemy. And, in any func­tion­ing democ­racy, there are lim­its to over-politi­ciza­tion.

Tax re­form is risky for any Cana­dian gov­ern­ment. When it tar­gets per­sonal or busi­ness in­come tax de­duc­tions, it can be­come po­lit­i­cally per­ilous.

The rea­son tax re­form is so hard is pretty sim­ple. Suc­ces­sive gov­ern­ments tinker with the tax sys­tem. Bit by bit, they add spe­cific de­duc­tions, write-offs, cred­its and de­fer­rals, mostly for jus­ti­fi­able pub­lic pol­icy rea­sons, in­clud­ing the in­cen­tiviza­tion of cer­tain eco­nomic ac­tiv­i­ties (in­vest­ing in R&D, sav­ing for re­tire­ment or for post-sec­ondary study, mak­ing char­i­ta­ble con­tri­bu­tions); the cost alle­vi­a­tion of cer­tain un­avoid­able re­al­i­ties of life, (par­ent­ing, ag­ing, liv­ing with dis­abil­ity); and more po­lit­i­cally ex­pe­di­ent tax ex­pen­di­tures that ben­e­fit cer­tain con­stituents (cap­i­tal gains tax ex­emp­tions, tax breaks for pri­vate jet own­ers).

Over time, as th­ese pro­vi­sions get “baked into” the sys­tem, broad classes of tax­pay­ers or­ga­nize and struc­ture their fi­nan­cial af­fairs around them to ac­cess the tax ben­e­fits. The peo­ple and com­pa­nies who use them do not see th­ese as “loop­holes” or “tax dodges,” but sim­ply as good busi­ness— mak­ing use of tax ben­e­fits “that were cre­ated by the gov­ern­ment for peo­ple like me.” Pre­dictably, strong and of­ten vo­cif­er­ous con­stituen­cies grow up in sup­port of th­ese ben­e­fits, re­main­ing cir­cum­spect un­til tax re­form time.

In the wake of the re­cent dif­fi­cul­ties en­coun­tered by the gov­ern­ment with its small busi­ness tax re­form pro­pos­als, C. Scott Clark, Peter T. Devries and Len Far­ber called for a full re­view of the tax­a­tion sys­tem in Canada. They noted that the In­come Tax Act now com­prises some 3,500 pages, is so com­plex that it presents a bar­rier to eco­nomic growth, and that its “key struc­tural ele­ments and core un­der­ly­ing as­sump­tions” have not been se­ri­ously looked at for years.

It’s a fa­mil­iar re­frain. Th­ese ar­gu­ments also echo the sug­ges­tions of many tax experts dur­ing the re­cent con­tro­versy, namely that in­stead of a piece­meal ap­proach to one as­pect of the sys­tem, the pro­posed changes should have been pre­ceded by a broader re­view of tax­a­tion.

All of this sounds ra­tio­nal, but Canada does not have a stel­lar his­tory of suc­cess when it comes to tax re­form.

The grand-daddy of Cana­dian tax re­forms was Ken­neth Carter’s Royal Com­mis­sion on Tax Re­form in the 1960s. Launched by John Diefen­baker in 1962, its re­port was re­ceived by Lester Pear­son in 1966, and re­sponded to by the Trudeau gov­ern­ment through a White Pa­per and then its 1971 Budget.

Carter took the com­pre­hen­sive ap­proach. His six ex­haus­tive vol­umes sug­gested sim­plic­ity, fair­ness and bal­ance as guid­ing prin­ci­ples, un­der­pinned by one key rec­om­men­da­tion: “a buck is a buck is a buck,” mean­ing that on both the per­sonal and cor­po­rate sides, the ba­sis of in­come tax should be all in­come, re­gard­less of its source.

Carter pro­posed an­other ba­sic rubric for ap­proach­ing tax re­form: “Broaden the base, lower the rate;” in other words, close de­duc­tions and write-offs that favour the few, in ex­change for lower rates over­all. Un­der Carter, de­duc­tions ben­e­fit­ting 10 per cent of tax­pay­ers would be rad­i­cally re­duced, while per­sonal tax rates would be low­ered by more than 15 per cent for 50 per cent of tax­pay­ers.

While Carter’s thought­ful rec­om­men­da­tions ul­ti­mately es­tab­lished the ba­sis for to­day’s in­te­grated ap­proach to per­sonal and cor­po­rate tax­a­tion, his more de­tailed pro­pos­als foundered. In 1971, af­ter years of study, fi­nance min­is­ter Edgar Ben­son largely aban­doned the re­duc­tion of tax ben­e­fits, due to vo­cif­er­ous op­po­si­tion and lob­by­ing from oil and

min­ing com­pa­nies and small busi­ness groups. The in­ter­ests of the 10 per cent con­quered the in­ter­ests of the 50 per cent.

Al­lan MacEachen’s 1981 budget took a dif­fer­ent ap­proach. In an un­char­ac­ter­is­tic de­par­ture from an other­wise stel­lar ca­reer, he launched a sneak at­tack with no ad­vance con­text or warn­ing, propos­ing to end or tighten no less than 163 “se­lec­tive (tax) write-offs, ex­emp­tions and de­fer­rals.” In fair­ness, he also of­fered a quid pro quo—lower over­all in­come tax rates for 5.8 mil­lion Cana­di­ans.

MacEachen’s budget pro­posed tak­ing down scores of tax pro­vi­sions around which mil­lions of Cana­di­ans had built their eco­nomic lives:

It treated as a tax­able ben­e­fit the em­ployer-pro­vided lunches of thou­sands of (largely women) who worked in the then re­tail gi­ants of Ea­ton’s, Simp­sons and The Bay across the coun­try. (Is there an echo in the room? This is what the Canada Rev­enue Agency was propos­ing in 2017— tax­ing em­ployee dis­counts— be­fore all hell broke loose.)

It hit em­ploy­ees’ sup­ple­men­tary health and dental plans.

It col­lapsed the jobs of many in the in­sur­ance in­dus­try by killing the ex­ten­sive re­tire­ment sav­ings schemes based on the tax sys­tem.

Pro­fes­sional hockey play­ers threat­ened to leave Canada be­cause of the end­ing of in­comeav­er­ag­ing an­nu­ity con­tracts.

• It even at­tacked the char­i­ta­ble con­tri­bu­tions com­mu­nity.

The Pro­gres­sive Con­ser­va­tive op­po­si­tion sent out a young On­tario MP named Per­rin Beatty to tap into the groundswell of anger. He held pub­lic meet­ings across the coun­try, and the re­sult was an out­pour­ing of rage. MacEachen did not help his case when he held a back­ground me­dia brief­ing over a lav­ish lunch at an up­scale Ot­tawa ho­tel. The me­dia ate his food and drank his wine, then went out and skew­ered him for it. Within a month of the budget, the gov­ern­ment caved and with­drew many of the pro­pos­als. MacEachen sur­vived to pro­duce one more budget and was then moved to Ex­ter­nal Af­fairs.

The third mod­ern ex­am­ple of tax re­form was the most suc­cess­ful. Prime Min­is­ter Brian Mul­roney and Fi­nance Min­is­ter Michael Wil­son de­parted from the Carter and MacEachen ap­proaches by lay­ing out ex­ten­sive ground­work for tax re­form in their ini­tial bud­gets and through spe­cific con­sul­ta­tions post-1984.

As a re­sult, the 86-page White Pa­per on Tax Re­form re­leased by Wil­son in June 1987 con­tained no sur­prises be­cause of the gov­ern­ment’s pre­vi­ous work on con­sen­sus-build­ing. It pro­posed changes based on four key prin­ci­ples: fair­ness and eq­uity, in­creased in­cen­tives to work and in­vest, the re­moval of ob­sta­cles to growth and job cre­ation and re­spon­si­ble fis­cal man­age­ment. In ad­dress­ing the in­equities that had arisen in the cor­po­rate tax sys­tem, the White Pa­per con­tained some eye­pop­ping sta­tis­tics about how cor­po­rate tax­a­tion had be­come skewed:

While com­pa­nies in whole­sale trade paid an aver­age of 24.5 per cent of their in­come in fed­eral cor­po­rate tax, the fi­nan­cial sec­tor (banks, in­sur­ance and real es­tate com­pa­nies) and the min­ing sec­tor were pay­ing an aver­age of 15 per cent and 14.5 per cent re­spec­tively.

• 51.3 per cent of the in­come of prof­itable com­pa­nies in the fi­nan­cial in­sti­tu­tions sec­tor and 50.2 per cent of the in­come of firms in the min­ing sec­tor was not be­ing taxed at all, while the aver­age of un­taxed in­come across all in­dus­tries was 27.6 per cent. Mean­while, only 1.1 per cent of the in­come of prof­itable com­pa­nies in the re­tail sec­tor was not sub­ject to tax.

In the min­ing sec­tor, the then­com­bined fed­eral and pro­vin­cial

tax rate on new in­vest­ment for large cor­po­ra­tions was ac­tu­ally -15 per cent, com­pared to an aver­age of +25 per cent across all sec­tors.

As the White Pa­per con­cluded, “the prob­lems with our tax sys­tem … are in­creas­ingly un­der­min­ing the foun­da­tion of eq­uity on which a well­func­tion­ing tax sys­tem must rest.”

As a re­sult, base broad­en­ing for both the cor­po­rate and per­sonal tax­a­tion sides was a ma­jor part of the Wil­son re­forms. On per­sonal tax­a­tion, the White Pa­per pro­posed the clo­sure or re­duc­tion of many tax de­duc­tions and the con­ver­sion of oth­ers into cred­its, but also would col­lapse the ex­ist­ing ten per­sonal brack­ets down to three, with re­duced rates for each of the new brack­ets.

The Mul­roney-Wil­son ap­proach worked. On the per­sonal side, the gov­ern­ment got the bal­ance right between low­er­ing or elim­i­nat­ing de­duc­tions or con­vert­ing them into tax cred­its, and con­sol­i­dat­ing brack­ets and low­er­ing tax rates across the board. On the cor­po­rate side, the gov­ern­ment took the time to do its re­search, mar­shal its ar­gu­ments and make the case for restor­ing greater hor­i­zon­tal eq­uity to the sys­tem. The changes pro­posed in the White Pa­per were largely im­ple­mented.

There are sev­eral lessons for cur­rent and fu­ture gov­ern­ments to be taken from th­ese three tax re­form ex­pe­ri­ences.

Carter took the tra­di­tional ap­proach, bring­ing huge ex­per­tise and ex­pe­ri­ence to the task. While his com­mis­sion re­sulted in an in­te­grated ap­proach to per­sonal and cor­po­rate tax sys­tems that was much-needed, his pro­posed clo­sure of per­sonal de­duc­tions as a trade-off for low­er­ing the rate were largely aban­doned. And the en­tire process was glacial, tak­ing nine years from start to fin­ish.

MacEachen’s at­tempt was an un­al­loyed dis­as­ter. By fail­ing to pre­pare the way for re­form through pre­vi­ous bud­gets, pro­pos­als for dis­cus­sion and con­sul­ta­tions, and spring­ing his pro­pos­als as a sneak at­tack with no con­text, he touched off a firestorm that could not be ig­nored or put out, and the gov­ern­ment was forced to re­treat.

The suc­cess of the Wil­son re­forms was clearly due to the care­ful and de­lib­er­ate prepara­tory work that pre­ceded it—Wil­son took the time to set it up and get it right. It’s also use­ful to note that in com­par­i­son to the two other failed at­tempts at tax re­form, Wil­son’s were prob­a­bly the most mod­est in scope.

There’s an­other im­por­tant les­son to note from th­ese three ex­pe­ri­ences: tax re­form win­ners are al­most al­ways silent, while losers can be counted on to howl and mo­bi­lize.

PMO photo

Fi­nance Min­is­ter Michael Wil­son, Prime Min­is­ter Brian Mul­roney and Deputy PM Don Mazankowski in 1986. Geoff Norquay writes that they got tax re­form right by tak­ing the time to do it right.

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