TAX me like a SWEDE
How Scandinavian- style ‘ dual- income tax’ could cure Canada’s competitive woes
We often think about the two sure things in life — death and taxes — but a third is the continuing refrain about Canada’s poor productivity or output produced by workers. When it comes to tax reform and its potential impact on productivity, Canada has not been complacent in the past two decades. These reforms have helped boost incomes since 2000 with better trade performance and lower unemployment.
We have adopted the GST and HST to replace uncompetitive federal and provincial sales taxes in most provinces that have encouraged trade and capital investment. Business taxes have been reduced with much lower corporate rates and the elimination of most capital taxes. Federal and provincial governments have also cut marginal personal tax rates, including the top rate from more than 53% in 1991 to 46% in 2012 ( except for the recent Ontario rate hike by 2013 to more than 49% from 46.4% for incomes more than $ 500,000).
Nonetheless, growth in output per worker has performed inadequately. A recent Statistics Canada report shows Canada’s growth in output per worker still lags the United States and has slowed down during the past decade. Have these past tax reforms failed?
In terms of capital spending, our improved tax system has helped. Tangible investment in machinery and structures grew more quickly in the 2000- 2008 period ( 5% per year) compared to the previous quarter century ( 3.8% per year). Intangible capital has also increased in part due to tax preferences for research, exploration and marketing. Canadian businesses spent $ 40- billion in 1990 on tax- favoured intangible capital, representing 8.6% of GDP. By 2008, these investments grew to $ 150- billion ( 13.2% of GDP) even though more growth took place in the IT- dominated decade of the 1990s.
Despite the growth, we continue to lag our U. S. counterparts, which ultimately means we must find new taxation measures to spur growth and entrepreneurship.
Our tax system is non- neutral, distorting investment decisions and organizational choices. It is typically geared to supporting businesses with poor economic performance while imposing much higher penalties on those that perform well. Entrepreneurs taking on risky, innovative investments see the hand of government taking almost a 50% share of profits but little share of potential losses. Further, Canada is laden with many small businesses that typically fail to grow in part because many would lose the many special tax concessions upon which they rely.
In recent years, many countries have moved to tax bases that reduce or eliminate personal and corporate taxes on capital income. One approach is to adopt expenditure bases for personal and corporate taxation by enabling investors and businesses to deduct investments from their income and fully tax the disposal of assets. Another is to shift broadbase sales taxes like the valueadded tax. Belgium and Italy have recently adopted “rent- based” corporate taxes that fully deduct investment costs from profits.
If Canada were to adopt a full-expenditure tax for personal and corporate taxes, it would remove limits for investments in RRSPS and TFSAS, as well as allow businesses to expense rather than depreciate capital expenditures. Interest expense incurred by individuals and businesses to finance capital expenditures would no longer be permitted.
In general, the expenditure approach to taxation would cost a lot of revenue. Governments would either need to cut spending or increase other taxes or user fees.
Another approach is a compromise. In recent years, Scandinavian and some other European economies have converted their corporate and personal taxes into a “dual- income tax” with low, flat tax rates on capital income ( dividends, interest, capital gains and corporate income) with a progressive rate on wages and salaries. Sweden, being the first, adopted the dual- income tax to encourage capital investments and growth after the 1990 recession, as well as reduce tax preferences for some types of investment, especially housing, since mortgage interest is deductible.
The Scandinavian dual- income tax could be an appealing approach for personal and corporate taxation for Canada. For example, if the federal- provincial capital income tax rate were about 15% on dividends, capital gains and interest, tax rates would sharply fall from existing average federalprovincial rates ( 23% for capital gains, roughly 30% on dividends and 46% on interest, ignoring Ontario’s recent surtax on the rich).
Small and large businesses would be taxed at the same rate, removing the taxation wall that impedes their growth. If governments also avoid their predilection to interfere with business decisions and remove tax preferences for certain business activities, the tax system should also help contribute to better productivity.
From the perspective of entrepreneurship, the dual- income tax would sharply reduce tax on capital income on investors. It would enable entrepreneurs to keep more of their gains from risky investments and encourage business growth. It would also enable Canadians to earn a higher net yield from their investments and help restore lost retirement wealth given the state of the stock market in recent years.
If expenditure or dual- income taxes do not provide better tax policy for productivity and growth, I don’t know what will.