Taxing professionals no way to grow the economy

he Liberal Party ran on and won the 2015 federal election in large measure because of its promise to improve the economy. Unfortunately, in too many cases the actions of the now-governing Liberals run contrary to this important goal.

The latest example is the government’s proposal to eliminate certain loopholes for small businesses that are largely used by professionals such as doctors and dentists. These loopholes allow eligible professionals to reduce their comparative tax burden.

At first blush, getting rid of loopholes seems to be sound policy. The tax system shouldn’t provide advantages for otherwise similar households based on how income is earned.

However, it’s important to understand why anyone would use such loopholes, since doing so comes at a cost. Professionals spend money on accountants and lawyers to capitalize on these loopholes. These expenses make sense because the costs are less than the benefits gained by lowering their effective tax rates. The tax savings are a result of large gaps in tax rates between different levels and types of income.

For instance, if a professional can shift income from themselves to a spouse with lower earnings, or perhaps a dependent child with no income, the gains from lower tax rates can be significant. Assume a doctor being taxed at the top federal tax rate of 33 per cent can shift income to their spouse, who only works parttime and pays income taxes at the lowest rate of 15 per cent. That’s more than a 50 per cent tax reduction in the marginal rate from shifting income from one spouse to another. The gain is even larger if the income is shifted to a dependent child with no income.

These tax differences are the reason people pursue these loopholes. If the government reduced the gaps between tax rates, it would reduce the incentives of such tax planning in the first place. Instead, the Liberals made this gap larger when they increased the top federal tax rate from 29 to 33 per cent. By making the tax gap larger, Ottawa inadvertently increased the incentives for eligible professionals to use these loopholes.

Another problem with the government’s approach to these tax changes is how it plans to use the expected revenues from closing the loopholes, which is estimated at $250 million. The standard approach is to close loopholes and use the resulting revenues to reduce tax rates. In doing so, the government would eliminate special preferences for certain groups while reducing tax rates for everyone, thus improving the economic environment for workers, business owners, entrepreneurs and investors.

Instead, Ottawa plans to retain all the new revenues. This is a trend with the current federal government - it has eliminated a number of tax credits and other special privileges in the tax system without using the resulting revenues to cut tax rates broadly by an equivalent value.

Another worrying aspect of the government’s approach to this tax change is that it seems to have ignored any potential responses from those affected. Indeed, the operating assumption in its working paper is that none of the professionals affected will respond other than to passively pay more taxes. But the remaining large gap in tax rates means there’s a strong incentive for those affected to respond.

The responses could include raising their prices and passing on the higher tax rates to customers, offering less services, or paying even more for accountants and lawyers to find new ways to lower their tax rates. None of these responses improve the economy.

While the federal government is right to worry about tax fairness, its approach continues to be deeply flawed. Canadians would be far better served if the reforms were aimed at simplifying taxes (like removing special privileges) and lowering rates. Such reforms would actually improve our economy.