The sources of government revenue in economies have shifted greatly over recent decades. Less now comes from taxing business, more is paid directly by people. The trend may vary in speed but will not disappear. Internationally, corporate income taxes are set to wither away, with Canada leading the way. By 2012, Canada’s corporate tax will be reduced to 15 percent, the lowest rate in the G7. One of the substantive debates to be joined in 2010 is between the Liberals, who would repeal the corporate tax cuts to enable program spending on social initiatives such as home care, and the Conservatives, with Finance Minister Jim Flaherty maintaining this would cost the economy as many as 400,000 jobs.
Lower corporate tax, I would argue, is a fact with which we must live, whether we like it or not. Corporate tax as we have known it is doomed to disappear because it does not fit with the globalized economy in which we now live. The consequences will be horrendous, however, if we accept the withering and continue either to endure prolonged deficits or merely to improvise occasional increases in other taxes or cuts in expenditures. The policy need is to plan a clean break, abolishing the corporation income tax as one item in a package of reforms. They could give us a smarter tax system, friendlier to both the productivity of our economy and the equity of our society.
All income tax, personal and corporate, weakens some of the incentives for work and enterprise. It is globalization, however, that has turned policy away from corporate more developed than from personal tax. Much of industry has become foot loose. An Adam Smith writing about “the wealth of nations” today would insist that corporate taxation, if levied at all, ought to be international. It should be at one uniform rate on business everywhere. Varying rates make markets inefficient and distort production. The world’s economy as a whole does less for the world’s people as a whole.
The theory is incontrovertible but irrelevant. A common international tax is a figment until, in some unforeseeable future, a world authority is empowered for its collection.
National tax rates are commonly qualified by concessions, in one form or another, for this industry or that, and for politically favoured projects. Such devices have long been partners, with tariffs and subsidies, in the armouries of both protectionism and export promotion. Increasingly, under the pressures of globalization, governments have moved on to competitive reductions in their standard rates of corporation tax. It is the new way to struggle, country against country, for gross national product and employment.
As always, there is one certainty about the outcome of such competition. It is the path to lower incomes. The losses of some nations outweigh the gains of others. Canada, with an economy heavily dependent on exports and a relatively small domestic market from which to bargain, is necessarily among the losers.
What has hurt us is not, as yet, a rapid race to the bottom. It may be further slowed for a time by the severity of the government deficits that currently need to be corrected. Politicians, however right-wing, will therefore be more aware of the public feeling that taxing corporations less must be followed by taxing people more. Familiarity, however, can soon breed acceptance. It is unlikely to be long before normal doses of spin doctoring are enough to weaken the resistance to further cuts in corporation tax.
Of course, all tax is paid at the expense of somebody’s spending or saving. A corporation is no more than an intermediary in the process. Simple removal of tax on its income would result in some combination of more spending or saving by its shareholders and more power for corporate managers to decide what they get and what is spent or invested otherwise. They naturally argue that the outcome would be more efficient production, with trickle-down benefits for the poorer as well as the richer of society. The productivity is dubious, and the trickling is indeed that, not of major account.
The first item in a reform package would be to abolish tax on all income that corporations pay out in dividends to shareholders with social insurance numbers — that is, who are liable for Canadian personal tax. It would be a simple measure if they were the only shareholders. In the real world, abolition of the corporate tax should be accompanied by a new tax that corporations would be required to deduct from dividends paid to external shareholders. Its appropriate level would be the same as the top rate (currently 29 percent) of federal personal tax. It must be clearly distinguished, however, as not a tax on income received but a deduction from the income to which a non-Canadian shareholder is entitled. The purpose is be in no way to penalize foreign investment but simply to secure a level playing field. It would make the revenue coming to the federal treasury the same whatever the shareholder’s nationality.
The deduction from the dividend that a foreigner receives from his share in an untaxed Canadian corporation would be equivalent to the personal tax paid to Ottawa by a Canadian shareholder.
What has hurt us is not, as yet, a rapid race to the bottom. It may be further slowed for a time by the severity of the government deficits that currently need to be corrected. Politicians, however right-wing, will therefore be more aware of the public feeling that taxing corporations less must be followed by taxing people more.
Cancelling corporate tax would be poor policy if the lost revenue had to be made up by increasing the present personal income tax. That is already too heavy for people living on low wages. Far from raising their tax, the second main item in the reform package should be to reduce it. The equitable way to do so is to increase, for everyone, the basic personal allowance before tax is charged. The minimum improvement, from its miserable present level, would be about 50 percent, to $15,000. To be fair to people on very low incomes, this should be available as a refundable tax credit, supplemented by further credits for dependants. Such credits could go a considerable way toward protecting people across the country against poverty, though of course the vast difference between city and rural living costs would continue to call for additional provincial or municipal measures.
In sum, for all Canadians, the first accompaniment to eliminating the corporate tax would be lower, not higher, rates of present income tax. The related reforms would have two quite different purposes. One would be to remove the many inconsistencies, inefficiencies and inequities that now disgrace personal tax, thereby fostering its widespread avoidance and facilitating major evasions.
The worst of the inconsistencies was thoroughly exposed long ago by the Carter Royal Commission. While we tax earnings and much interest income quite severely, other kinds of income are taxed much less or not at all. Removal of the corporate income tax ends the excuse for concessionary treatment of dividends. Realized capital gains are just as much investment income as is interest, and should be taxed the same. Share options are fully part of compensation. They should be taxed at the value of the shares when the option is given, with any capital gain or loss when they are sold taken into account at that time.
There is, it must be noted, a considerable political problem to treating capital gains from houses like those from financial assets. The practical compromise is probably to exempt one house per family, up to what could be judged a reasonable cost of housing for well-to-do people: perhaps $500,000 or, to take account of prosperous big cities, even a million dollars.
There is no reason why lottery winnings, for example, should be untaxed, as distinct from spread over some years for tax purposes. The worst of all the present inconsistencies, however, is the absence of a gift and inheritance tax. It would not, of course, apply to a spouse or other companion of at least a year’s standing. But the offspring of well-to-do parents start with great advantages during their years of dependency. A just society would not leave further benefits untaxed. Up to some quite high ceiling, gifts and inheritances should be taxed with other income of the recipient. Above the ceiling, a graduated surtax would be appropriate for massive bequests.
It must be emphasized that these proposals would in no way inhibit the accumulation of vast fortunes by creative innovators. As long as they keep their greatly appreciated shares, they would pay only normal income tax. They need pay nothing more if, when eventually realizing their capital gains, they devote the money to public causes or recognized charities. If some nevertheless insist on making bequests to individuals, at least there would be some incentive to spread the largesse, thanks to taxing the recipients rather than the donor.
The present system is shot through with devices designed to allow well-to-do people to pay less than the nominal rate of income tax. A cunning example is retirement savings. The program was introduced for the laudable purpose of enabling people on modest incomes to retire with modest pensions. It has morphed into a bonanza for people with incomes high enough for them to save up to $25,000 annually. Not only does that produce large cuts in current taxes; more importantly, the returns on their accumulated investment, its interest, dividends and capital gains, compound, year after year, tax free. They create a fortune on which tax is paid, as by less fortunate people, only when fractions of it are drawn out as pensions. The program has become an easy, risk-free road for people with good earnings to retire as millionaires.
This is one of many concessions designed to allow those who have to get more. If you can afford a clever accountant and lawyer, tax can be largely avoided without turning to the ultimate evasion. That, of course, is to shift money to tax havens, where billions of dollars rightfully belonging to the Canadian treasury now go annually.
Taxing capital gains equally with salaries and interest would itself make tax avoidance and evasion more difficult. There are many lesser changes, legal and administrative, by which a government capable of facing down greedy interests could reduce present inefficiencies and injustices. Those will not be eliminated, however, by improvements to income tax alone.
The package of reforms that would smarten our tax system has a further, major component. The way to make it more conducive both to productivity and to equity is to shift as much as is practicable from taxing earnings to taxing expenditure; that is, from the amount you put into the economy to the amount you take out of it.
The present system is shot through with devices designed to allow well-to-do people to pay less than the nominal rate of income tax. A cunning example is retirement savings. The program was introduced for the laudable purpose of enabling people on modest incomes to retire with modest pensions. It has morphed into a bonanza for people with incomes high enough for them to save up to $25,000 annually.
The familiar consumption tax — on goods and services at the retail level — is not only the most irritating of government contrivances. At the small-business level, it is costly to collect and exposed to much evasion. The GST and its ilk should be abolished quite as firmly as the corporate income tax.
Their simple replacement, a general expenditure tax, would be calculated annually like income tax and paid in instalments, monthly or quarterly. Its calculation would require a new item on our income tax returns: a valuation, on December 31 each year, of financial assets and liabilities and of residential property owned and not rented out. New valuations would be needed only on the December 31 when the tax began. Thereafter the amount recorded for each item would remain what it cost when the share or investment certificate or house was acquired. Its later value, when sold, would be relevant only as a new financial asset. The year’s expenditure would be simply calculated as after-tax income together with any change in assets (at acquisition cost) less liabilities. A decline in net assets would indicate expenditure above income; an increase would measure saving out of income.
While income tax is assessed for individuals, the family would be the better unit for expenditure tax. Consequently, the basic allowance, before tax begins, would be considerably larger. Beyond that, the initial rate, on expenditure up to a normal level from a moderate income, might well be lower than the first rate for income tax. But the appropriate graduation thereafter could be steeper and continue to a considerably higher peak for people who annually spend hundreds of thousands of dollars or more. It may be noted that, in contrast to what occurs with a sales tax, Canadian revenue would not be lost when people do their high spending in France or Florida or wherever.
A general expenditure tax would not replace specific excise taxes on items unfriendly to the environment, such as gasoline, or subject to unwise indulgence such as tobacco and alcohol. Specific taxes of a similar kind are applicable to some business expenditures. Hitherto the corporate income tax has been utilized as an excuse for the extent to which costs arising from some industrial operations are imposed on the public. With its abolition, there would be no shred of justification for sweetheart infrastructure arrangements or for environmental degradation that is costless to its perpetrators. There would be more room for adequate royalties on the extraction of nonrenewable resources. And it would become essential that corporations not be able to provide, as perquisites to their managements, services that on expenditure taxation should include the requirement that such benefits, from meals and club fees to travel by executive jet, should be fully costed and taxed to the corporation at rates comparable to those on similar spending by individuals.
With the abolition of corporate income tax, shareholders would have an increasing interest in questioning extravagance within their properties, including the payment of many millions of dollars a year to CEOs while they are on the job, plus millions more to go away when they have made a mess of it. Also, with full taxation of capital gains, shareholders would be less tolerant of corporations holding down dividends in favour of retaining profits to enhance the value of their shares. Managements, however, would remain strongly motivated to build their empires. Certainly a corporation should be able to set aside, as a business cost and therefore tax-free, enough of its profit to maintain a reserve fund to help it through business downturns. Beyond that, however, profit retained, instead of paid out to the company’s owners, should be subject to tax at rates scaled to the size of the business.
The present corporate tax system is tilted so far in favour of established businesses that it even subsidizes them, by tax relief, to buy out rivals and suppress the competition that is supposed to be the lifeblood of free enterprise. The proposed changes would powerfully reinforce the primary effect of shifting some personal tax to expenditure. Not only would there be the increased saving that the economy needs; it would accrue where it best belongs, in the hands of individual investors. It would then be more readily accessed by new and small enterprises, instead of propping up established interests.
In short, the proposed tax changes are strong encouragements to enterprise. Nevertheless, there would no doubt be some wealthy people so incensed by tax on personal and corporate expenditures that they would wish to flee to tax haven countries. The price of doing so could appropriately include liability to a deemed disposition tax on capital gains, comparable to the one now levied at death. More importantly, the fugitive’s Canadian passport should be invalidated. Any who nevertheless leave would no doubt be mourned, by some champions of the status quo, but for Canada the loss, if real at all, would count for nothing beside all the benefits of higher savings and encouraged enterprise.
There is, however, a more significant downside to the reforms that would have to be dealt with. Making our tax system less conducive to mergers and acquisitions would, other things being equal, create a new advantage for acquisitors from countries, including the United States, with different tax systems. The cure, however, is a measure that is highly desirable anyway. It is a simple prohibition on the sale of existing enterprises to non-Canadian interests. The motive is in no way to deter foreign investment. We have gained greatly in the past from its role in establishing new enterprises in Canada. For that we should be as warmly welcoming as ever. The objection is solely to the acquisitive lessening of competition, which weakens Canadian enterprise whether the acquisitor is domestic or foreign.
It is outside the scope of this article either to fill out all the details incidental to thorough tax reform, or to assess what rates of new taxation, notably on expenditures, would be necessary to replace the GST component of sales taxes along with the corporate income tax. That figuring would vary, of course, with economic and fiscal circumstances, but the range of the reforms means that in all circumstances the combination of income and expenditure taxes at the personal level would make moderate rates possible for both. The taxes which impinge on work and innovation would be lower than under the dysfunctional system to which we have drifted and which will become increasingly out of joint with a globalized economy.
The reforms suggested here would be extensive. They would offend many established interests. They would not be quick and easy even if our politics become far more conducive to decisive action than they now are. But whatever the stumbles, growing globalization will make drastic change of some kind unavoidable. Nothing will be gained by passivity in the meantime. The urgent need is for discussion and planning, so that the decision-makers are prepared, ready to seize opportunities for improvement when they come.
The main direction is clear. Smarter taxation will fall more on the spending, less on the making, of money. Its eventual detail might differ appreciably from the suggestions made here. What is important at this stage is to define the purpose, and to sketch the shape, of taxation that will better serve the future needs of Canadians.