Kevin Milligan

Professor, Vancouver School of Economics

FINA Testimony: Canada Workers Benefit

Notes prepared for House of Commons Standing Committee on Finance
April 30, 2018
Kevin Milligan
Professor of Economics
Vancouver School of Economics, University of British Columbia

Topic: Bill C-74. “An Act to implement certain provisions of the budget tabled in Parliament on February 27, 2018 and other measures.”

(PDF copy of these notes can be downloaded here.)

My name is Kevin Milligan and I am a Professor of Economics at UBC’s Vancouver School of Economics.  I’ve been asked to speak specifically about the new Canada Workers Benefit.

I’ve been studying the impact of tax benefits for modest income workers for 15 years, and the evidence from around the world is unusually strong and consistent. Benefits that are focused on providing an incentive for modest income workers to join the workforce have led to increased labour market attachment in the US, the UK, and Canada.

The existing Working Income Tax Benefit (or WITB) suffers from two major shortcomings.

First, it is too small. The maximum benefit for a single worker under the 2017 configuration was only $1,043, and that person would see no benefit if income is above $18,792. That means that a full-time full-year minimum wage worker in most provinces would see zero benefit from the WITB. In my view, this meant that the WITB was missing its proper target because it was too small.

Second, the WITB lacks salience. It is hidden away on the tax form, requiring the filing of a special supplemental schedule so people might not even be aware of it.  This has resulted in a substantial number of people who are eligible for the WITB not actually receiving it.

The proposed transition to the Canada Workers Benefit makes substantial and important progress in ameliorating both of these shortcomings.

The new CWB is larger.  The maximum benefit is 30% bigger for singles and 24% bigger for couples or those with children. As important, the income range now covered by the CWB is much larger—extending up to $24,112 for unattached singles and $36,483 for couples and those with children. This will mean a much larger proportion of modest-income workers will see the CWB increase the attractiveness of work compared to the old WITB.

The new CWB will also be easier to access. In a new and very important initiative, the Canada Revenue Agency will check tax forms that are filed to see if the taxfiler is eligible for the CWB. If the CWB schedule is not filled in, starting in 2019 the CRA will do so on behalf of the taxfiler automatically. Moreover, the government has committed to explore ways to pay out the CWB on a monthly basis rather than keeping it buried in the tax form.

Both of these measures—higher benefits and making benefits easier to access—are important advances. However, there is still more work to do. Here, briefly, are three ideas.

First, I think benefits still need to be larger, and extend up to $30,000 of income. Full time full year work is 2000 hours a year, and with the minimum wage heading to $15 an hour in some provinces, that’s $30,000 of annual earnings. In my view, the target should be to ensure a full-time full-year workers sees some benefit from the CWB so that we can help reward those who work.

Second, the government should continue efforts to make the benefit more salient. Economists spend a lot of time designing policies with good incentives to encourage positive responses from Canadian workers. But if those incentives are buried deep in complexity we can’t expect to realize the full positive response.  Separate notification and payment of the CWB outside the tax forms would be a step forward in furthering this needed salience.

Third, the government should undertake a study of the feasibility of “individualizing” the CWB as advocated by Professor Tammy Schirle of Wilfrid Laurier University. Individualizing means that the benefit is phased out based on individual income rather than couple income.  This would have an important impact on the work incentives for married women, which would give women a boost within the economy and our society.

 

Speaking Notes: Canada 2020 Event on Response to US Tax Cuts

Here are my notes prepared for today’s event on Canada’s response to the US tax cuts. It was hosted by Canada 2020 in Ottawa.

Should Canada Respond to the US Tax Cuts?
Kevin Milligan
Vancouver School of Economics
University of British Columbia

Notes prepared for Canada 2020 event

April 10, 2018
Ottawa, ON

The US Tax Cut became law at the beginning of the year. Canada’s response has been cautious, but the Finance Minister seems serious about looking at responses. Should Canada respond? If so, how?

What changed

To start, let’s review what happened with the US tax cut. I see four main elements relevant to the Canadian discussion.

  • The headline federal corporate tax rate was cut from 35% to 21%. When combined with state tax rates, this brings the US down to Canadian corporate tax levels. It depends what industry and state you look at, but they are within a point or two. This removed—but did not substantially reverse—Canada’s corporate tax advantage.
  • They created a so-called ‘pass through’ regime which gives a very strong tax incentive for many professionals to set up a special type of corporation to avoid taxes. Sounds familiar to us here in Canada, and we know how hard it is to reverse such tax avoidance structures.
  • Allowed some full expensing of corporate investment for the first five years of the reform period. Also cut back on allowable interest expense deduction. This is a move toward what economists call ‘cash flow’ taxation, which in its pure form completely removes interest deductibility and drawn-out CCA schedules.
  • Personal income tax cuts which lowered the top federal rate to 37% and capped some tax expenditures (such as state and local deductibility and the mortgage interest deduction)

Does it matter?

What will be the impact of the US tax reform on Canada? I see three areas to consider.

  • Corporate revenue: Between 2000 and 2015, Canada cut its main corporate tax rate nearly in half, but the tax revenue stayed constant as a share of GDP. This is remarkable. One factor contributing to this was shifting of corporate income into Canada from the United States—think of the corporate inversion that led to Burger King setting their headquarters in Mississauga a few years ago.. That’s been nice while it lasted, but that’s now over—there is no gain to shifting corporate income to Canada any more.
  • Corporate investment. With effective rates fairly close to those in the US, Canada no longer has a corporate tax advantage. Corporate investment decisions depend on a lot of things—workforce, resources, stable governments and legal systems. But investment also depends on taxes, so it’s reasonable to expect some measure of real investment shifting to the US—although I think some of the talk of a “tsunami” of corporate investment leaving Canada is overblown.
  • Personal mobility. The personal tax cuts now available in the US have led some to suggest that rich Canadians will move abroad. I’m sure some will. But taxes aren’t the only thing that matters for deciding where to live, and for every anecdote you hear about a rich Canadian who has decided he’s rather live in Trump’s America I can find you an anecdote of a young and talented immigrant who has chosen to move to Canada. We have seen this on the ground in our graduate students at the Vancouver School of Economics. On net, I don’t find this risk to be worth a policy response.

Overall, the potential loss of corporate tax revenue and investment is concerning. But whether action should be taken requires some more thought.

Is the US tax reform sustainable?

There is serious reason to doubt the sustainability of the US tax reform. There are two reasons for this.

  • It is not fiscally sustainable. The US deficit in 2019 is projected to be 5.6%. Even in a booming economy, this is an unsustainable fiscal situation. For Canada to match the US tax cuts, we’d have to plunge ourselves into deficit. Many people already seem concerned about our current tiny federal deficits, but I don’t think it would make our public finances better to do a deficit-financed corporate tax cut.
  • It is not politically sustainable. Unlike the Tax Reform Act of 1986, the 2017 tax bill was mostly a party-line vote in the US Congress—no Democrats voted for it in either House or Senate. If we see a Democratic White House and Congress in 2020, my political prediction is that the first place it would go to raise money to fund its new priorities would be to reverse the corporate tax cuts. That’s just my political guess; so yours may be different. But I think I’m on pretty solid ground to wonder what this all looks like after 2020.

If Canada acts what should we do?

If Canada decides to act, I think the priority should be to focus on realigning our corporate tax system to do one thing: encourage corporate investment. The reason we, as a society, have corporations is to facilitate long-run investment in our productive capacity. That’s why corporations exist, so that is a great place to start.

What’s the right way to refocus our corporate tax system on investment?

Some have argued we should cut the corporate tax rate in order to leapfrog over the United States. I think this is the wrong approach. It is wrong because it is scattershot and wastes our fiscal effort. Cutting corporate taxes does improve the return on future investment, but it also lowers taxes on past investments and monopoly profits. That’s a waste.

Instead, we should focus on rewarding new investment. We should do this by following the US lead on expensing investments. Right now, most investments in new plant or equipment are deducted from profit over time, according to a Capital Cost Allowance depreciation schedule that varies by the type of asset.

Instead, full expensing means that the tax effort is front loaded; the full investment amount is deductible in year 1. This rewards firms that make new investments without wasting resources by throwing money at sunk decisions that were made in the past.

There are many details that need to be worked out, but I think the case for moving toward full expensing of investment is strong because it resets our corporate tax system to do exactly what we want corporations to do—make productive investments in the future capacity of our economy.

Notes from address to Vancouver Rotary Club luncheon

Notes for talk to Rotary Business Luncheon
March 13, 2018
Kevin Milligan, UBC Vancouver School of Economics

With the big US tax reform now law, many are wondering what Canada should do in response. Minister Morneau has taken a cautious approach so far. I think that’s appropriate. But do think there is a strong case for action.  And I will soon tell you why I think that. But first, let’s review what has happened in the US and the likely impacts.

The “Tax Cuts and Jobs Act” does several things on several fronts: for personal taxes, corporate taxes, and overall fiscal stance.

  • On the personal tax side, some cuts to rates and limiting of deductions and exemptions.
  • On the corporate side, many initiatives:
    • Dramatic lowering of the federal statutory rate from 35% to 21%.
    • Opening of ‘pass-through’ special tax rates for partnerships and S-corps. 20% discount; top rate of 29.6%.
    • Introduction of immediate expensing of investment for some asset classes for 5 years; along with limits on interest deductibility.
  • Blows a hole in the budget. Projected 2019 deficit is 5.6% of GDP.

What are the impacts on Canada of each of these items?

On the personal tax side, high earners in the US will now pay less tax. Some have expressed concern that Canada will see an outflow of high earners. I’m dubious that the net outflow will be noticeable. Moving to another country involves not just your marginal tax rate, but the full social context of living in one country or another. For every high earner who moves to the US to save a few dollars in taxes I can find you a tech worker or a grad student choosing Canada because of our more internationally-open social environment.

For business taxes, Canada has enjoyed a substantial advantage in combined federal state/provincial tax rate for the last 20 years. The change in statutory rates means that Canada’s statutory tax advantage has been removed. It differs by a point or two, depending on what province/state you’re looking at, but it’s essentially tied. When you crunch through the effective tax rates on investment (see Philip Bazel and Jack Mintz from the University of Calgary) you’ll find that the US is a few points under Canada, but it varies by industry.

What impacts should we expect? Two fronts to consider: the statutory rates and the effective rates.

The statutory rate advantage over the last 20 years has meant that Canada has benefited by extra revenue from US corporations booking profit here and costs in the US, to the extent that accounting allows. As Canada dropped the corporate tax rate by nearly half, revenues as a share of GDP stayed constant. That was remarkable. But that era is now over.

The effective tax rate on investment is what matters more for the marginal investment decision. Here, the US now has a very slight advantage of a point or two. This is certainly going to push some more investment into the US, but I’m not one to panic over a difference of a point or two.

Two final notes assessing the US position.

First, the pass-through part of the reform is a large invitation to tax avoidance. We’ve just gone through some effort in Canada to tighten up tax avoidance among high earners. The US is going the opposite direction.

Second, it is highly doubtful the US reform is sustainable for more than a few years. Not just the deficit of 5.6% of GDP, but also the lack of bi-partisan support that characterized previous tax reform bills. Should the Democrats regain control of Congress in the future, recouping tax revenue through taxing corporations and high earners will be high on their agenda.

So, that’s where the US stands and how I see the impact on Canada.

What should Canada do in response? Minister Morneau has taken a cautious approach so far. I think that’s appropriate. But I do think there is a case for action.

Let’s start at the beginning. Why do we have corporations at all? The answer is that we have corporations to facilitate productive investment.  If society’s goal for corporations is investment, it makes sense to structure our fiscal system around investment.  We can do that by changing our tax system to focus on growing investment, rather than taxing profits.

Over the last forty years, economists have worked on alternatives to the corporate income tax to do just that—focus on growing investment rather than taxing profits. One of these alternatives is known to economists as a ‘cash flow’ tax. In a pure cash flow tax, the deductibility of interest is eliminated, but corporate investment is fully deductible in the year of investment—full expensing of investment. This tax system grows investment rather than taxing profits.

An investment-focused corporate tax eliminates three major problems with traditional income taxation.

The taxation of the normal return to investment is eliminated. For the breakeven investment project, the discounted flow of future returns exactly equals the cost of the investment—that’s the very definition of a breakeven project. So, by fully exempting investment you’re effectively fully exempting the future normal return to investment. Again, for the breakeven project the net present value of the flow of income exactly equals the cost outlay. Excess profits will still be taxed. But normal returns are not.

Second, CCA depreciation schedules are eliminated. This removes an investment distortion across types of assets, which improves the efficiency of investment.

Third, because there is no longer an interest deduction, both debt and equity are put on an equal footing. We don’t want the tax system pushing corporate finance decisions one way or the other, so this is good because it eliminates the debt-bias of the current system.

As a bonus, an investment-focused business tax can also can reduce the administrative burden by cutting back on CCA schedules, which is a step in the right direction for the simplicity of the system.

Of course—there are many details that need to be worked out. Among the most pressing:

  • How important is tax refundability for losses?
  • What to do about the SBD?
  • How should interest deductibility be restricted?
  • Which assets should move to full expensing?
  • What are the international tax implications?
  • How to make up revenue loss—should revenue neutrality be a goal?

So, there is lots of work to do. But I think now is the time to do this work. Building the policy case helps to build the political case for action.

That’s important because in my view the biggest barrier to corporate tax reform is the politics. Cutting corporate tax rates in today’s political environment is not going to be popular no matter how many charts and tables that we wonks print out. But, I think that an investment-focused corporate tax is different—I believe there is a much broader available constituency because the case is so strong.

Here’s the case. Our corporate tax system should be built around one thing: growing investment. That’s why society has corporations in the first place. That’s what our tax system should support.

Increasing investment is popular in union halls, in the tech sector, in corporate board rooms, and on Main St. Canada. Everyone likes investment! Since everyone likes investment, refocusing our discussion of corporate taxation directly and explicitly on investment can build broader support, from unions to the corporate sector, and everyone in between.

Another alternative is simply cutting corporate tax rates. The problem with rate cuts is that it rewards the return to past investments and to windfall profits. That’s a scattershot approach since rewarding past investments doesn’t grow future investment. In contrast, every milligram of fiscal effort put into an investment-focused business tax improves forward-looking investment. That’s what should be our goal. I think we need a business tax system that prioritizes investment, and full expensing is a great way to achieve that goal.

So, as Minister Morneau contemplates what Canada should do in response to the US tax reform, it is a fertile time to talk about Canadian corporate tax reform.

Thank you for inviting me to help spark that conversation here in Vancouver.

Notes from C.D. Howe: Investment-focused corporate taxation

Notes for talk to C.D. Howe Institute, National Council Meeting
March 7, 2018
Kevin Milligan, UBC Vancouver School of Economics

(Printable PDF version here.)

With the big US tax reform now law, many are wondering what Canada should do in response. Minister Morneau has taken a cautious approach so far. I think that’s appropriate. But do think there is a strong case for action.  Let me tell you why.

Let’s start at the beginning. Why do we have corporations at all? The answer is that we have corporations to facilitate productive investment.  If society’s goal for corporations is investment, it makes sense to structure our fiscal system around investment.  Let’s grow investment, rather than taxing profits.

The current corporate income tax has four problems, from an economist’s point of view.

First is that it imposes tax on the normal return to investment when there is equity financing, which discourages investment.

Second is the distortions of CCA depreciation schedules, which only work efficiently when they exactly match true economic depreciation—a very tough goal to achieve. Otherwise, they distort investment across asset classes.

Third, the current corporate income tax favours debt financing over other sources, which leads to inefficient capital structures and increases the risk of debt-induced bankruptcy.

Finally, today’s corporate income tax is complex, devouring too many resources in administration both in firms trying to comply with the rules, and with the CRA trying to administer them.

Over the last forty years, economists have worked on alternatives to the corporate income tax that can eliminate these problems. One of these alternatives is known to economists as a ‘cash flow’ tax. In a pure cash flow tax, the deductibility of interest is eliminated, but corporate investment is fully deductible in the year of investment—full expensing of investment. This tax system grows investment rather than taxing profits.

An investment-focused corporate tax eliminates three of the problems with income taxation, and cuts down on the fourth.

The taxation of the normal return to investment is eliminated. For the marginal breakeven investment project, the discounted flow of future returns exactly equals the cost of the investment—that’s the very definition of a breakeven project. So, by fully exempting investment you’re effectively fully exempting the future normal return to investment. Again, for the breakeven project the net present value of the flow of income exactly equals the cost outlay. That’s the magic. Excess profits will still be taxed. But normal returns are not.

CCA depreciation schedules are eliminated. This removes an investment distortion across types of assets.

Because there is no longer an interest deduction, both debt and equity are put on an equal footing. This eliminates the capital structure distortion.

So, an investment-focused business tax can solve three big problems with the current income tax approach. On the fourth problem—complexity—we can reduce the administrative burden of CCA schedules, which is a step in the right direction.

Of course—there are many details that need to be worked out. Among the most pressing:

  • How important is tax refundability for losses?
  • What to do about the SBD?
  • How should interest deductibility be restricted?
  • Which assets should move to full expensing?
  • What are the international tax implications?
  • How to make up revenue loss—should revenue neutrality be a goal?

So, there is lots of work to do.

Economists have been working on these questions for years. Why do I think that now is the right time for action?

Three reasons.

One reason is the US tax reform. The US reform included full expensing for many types of investment and restricts the deductibility of interest. Both of these are in line with the cash-flow tax model.

How sustainable are these changes—do we need to pay attention? Two reasons why I say “yes”. In my view, structural changes are harder to undo than rate cuts. Moreover, key Democratic economists support cash-flow taxation, so expensing has a good chance to survive for the long run, in my view.

The second reason is that it’s simply good policy for Canada. We want investment and the jobs that it brings, so a refocus of the tax system to one that centres on investment is the right thing to do no matter what is going on elsewhere.

Finally, in my view the biggest barrier to corporate tax reform is the politics. Cutting corporate tax rates in today’s political environment is not going to be popular no matter how many charts and tables that we wonks print out. But, I think that an investment-focused corporate tax is different—I believe there is a much broader available constituency because the case is so strong.

Here’s the case. Our corporate tax system should be built around one thing: growing investment. That’s why society has corporations in the first place. That’s what our tax system should support.

Increasing investment is popular in union halls, in the tech-sector, in corporate board rooms, and on Main St. Canada. Everyone likes investment! Since everyone likes investment, refocusing our discussion of corporate taxation directly and explicitly on investment can build broader support, from unions to the corporate sector, and everyone in between.

Another alternative is simply cutting corporate tax rates. The problem with rate cuts is that it rewards the return to past investments and to supernormal profits. That’s a scattershot approach since rewarding past investments doesn’t grow future investment. In contrast, every milligram of fiscal effort put into an investment-focused business tax improves forward-looking investment. That’s what should be our goal.

Over the next few months, I will be working on a new research project using Statscan company tax filing records to investigate how the structure and costing of a cash flow tax might work for Canada. I’m hoping to publish some of this work here with C.D. Howe, so I look forward to your guidance and feedback as this project progresses.

Thank you!

The Graham Lecture: Canada’s Fiscal Federation for the next 50 years

Canada’s Fiscal Federation: The Next 50 Years

Kevin Milligan
UBC Vancouver School of Economics

John F. Graham Memorial Lecture 2017
Dalhousie University
November 30, 2017
Draft Script

Slides can be found here.

A PDF of this script can be found here.

  1. Introduction

Slide 1: Title slide

Thank you for the introduction.

Slide 2: Pier 21: The Canada we Choose

My grandfather worked here back in the 50s and 60s in the Pathology lab over on University Avenue. One of his jobs was food safety testing for a local dairy. Sometimes, on a Friday, he would take a brick of ice cream home to his family across the ferry in Dartmouth. It’s one of my mother’s cherished memories of childhood. One question I always had about this family story though—were the ice cream bricks my grandfather got to take home the ones that passed the test, or the other ones?

My mother’s family arrived here in Halifax in January 1945 by plane and train from Bermuda.   So many other immigrant families arrived here down on the Harbour on Pier 21. All of them chose Canada; any many chose Nova Scotia.

Think back to what they saw 50 years ago.

Looking forward: a country of opportunity. A good place to settle and raise a family. They chose Canada; they chose Nova Scotia. What kind of place did they build over the next decades?

Now consider us, here in this room. What kind of country will we build over the next 50 years?

A society is composed of many parts, but what we do together as a society through government represents about 40 percent of our economic activity. I’m a public finance economist, so I’ll focus on that 40 percent this afternoon.

The namesake of this lecture, Professor John Graham, was a scholar of municipal and provincial public finance. Today, my lecture will take inspiration from Professor Graham’s legacy and consider how we organize our public finances across different orders of government.

I will start by pointing out what we’ve built over the last 50 years. I will argue that we have chosen to build a radical federation, and that we have done it well.

Next, I will focus on the great challenge our radical fiscal federation faces over the next 50 years, driven by provincial responsibility for healthcare spending.

I’ll then offer an economic framework for addressing this great challenge, and finally present my preferred policy solution.

2. A Radical Federation

Slide 3: Get Radical Canada!

We Canadians are radical. Over the last 50 years, we choose to create a radically-decentralized fiscal federation.

When my family arrived in 1945, provincial governments in Canada collected less than 10 percent of total government revenues, with the other 90 percent split between federal and municipal governments.

Slide 4: OECD subnational spending shares.

On this chart, you can see that by 2014, the spending share of subnational governments in Canada had risen to 78%. In the United States, it’s just 48%. The average across high-income OECD countries is 32%, and France is way down there at 21%.

This presents a mystery. How is it that we can maintain a modern welfare state mostly run by little provinces; some with only a few hundred thousand people? This looks terribly inefficient to people from any other country. How can we efficiently raise the taxes to do so? Why are we so different?  Let’s now dig into this mystery to see if we can figure out how Canada can ‘get away’ with such radical decentralization that no other OECD country seems able to do.

Some argue that it is our constitution. The division of powers in the original British North America Act gave responsibility for hospitals and schooling to provinces. So, it is true the constitution provides a starting place for understanding the shape of our fiscal federation.

But, in my view, the constitution is insufficient as a complete explanation. When economic forces pushed against the constitutional division of powers, we adjusted the constitution to allow it. We did this for Unemployment Insurance in 1940 after a previous federal unemployment relief program was struck down as unconstitutional.  Again in 1951 for Old Age Security, and one more time for the Canada Pension Plan in 1964.

In all of these cases, the economic argument overran the constitutional status quo. So, it can’t be just constitutional forces leading to our decentralization. Economic forces dominated constitutional ones at key points for large government spending programs in the past.

Is it our people that makes us so radical compared to any other OECD country? Do we lack a sufficiently strong sense of national economic purpose and national solidarity? I don’t know. But there are many other modern nation states on this chart cobbled together from historically independent and culturally diverse regions. Germany. Spain. Italy. Switzerland. Belgium. Are we really lacking in national solidarity compared to all of those places? One might argue that Belgium barely exists as a national cultural entity, yet their central government has a spending share twice Canada’s. So, it seems unlikely that what underlies our radical decentralization is a lack of national solidarity.

What other force shapes a federation? What about the structures of fiscal accountability? Some argue that democratic transparency and accountability demands taxes be raised at the level of government that spends them. But, in Canada, there are vast mismatches between what provincial governments spend and what they raise in taxes. PEI gets 38 percent of its total revenue from federal transfers. For Nova Scotia and New Brunswick it is 35 percent.. For BC it is 18 percent.  That’s a lot of other people’s money that is spent.

Have we developed some magical and secret formula of political accountability that allows us to get away with these vast fiscal mismatches when other OECD countries can’t? I don’t think that’s true. While concerns about accountability are important to keep in mind, it’s not evident this mismatch has cost us yet. Perhaps it’s enough that provincial governments still feel at present they have enough ‘skin in the game’ to control costs.

So, we have a radically decentralized federation unlike any other in the world. I’ve argued so far that it can’t be explained easily with arguments based on our constitution, our national solidarity, or structures of political accountability. What then explains our ability to ‘get away’ with our radical federation?

Slide 5: Efficient Decentralization

In my view, it is economic efficiency that underpins the radical decentralization of our fiscal federation. We can do what we do because we found a way to do it pretty efficiently.

There are two elements.

The first is our system of intergovernmental transfers. They have constitutional origins, and are certainly held aloft by national sentiments of solidarity—as strained as those sentiments might be from time to time. Both the constitutional and solidarity arguments are important, to be sure. But to me the strongest argument for our transfer system comes from the cold logic of economic efficiency.

Let’s consider the economic argument for our transfer system.

The scope and scale for efficient production of government-provided goods varies. For some goods, like education or parks, local or provincial governments can manage the spending efficiently.

We don’t want the federal government picking the right style of park bench to put in the Public Gardens. If you’ve been watching the news, the feds don’t appear to be great at skating rinks either. Those decisions seem best made locally.

Other goods seem well-suited to the provincial level. We don’t need every town developing its own education curriculum, but different provinces have different needs and may be best-positioned to deliver the mix of education that fits their provinces’ citizens.

Moreover, provincial control over education allows for a vital ‘laboratory’ of federalism. For example, in recent years, Quebec has introduced a new math curriculum that has met with some success. Other provinces have observed this, and should be learning from Quebec’s example. So, some goods seem properly situated in the provincial sphere.

For other kind of publicly-provided goods, like transportation or environment, a national or even global viewpoint is necessary to provide government services efficiently. Federal governments can best co-ordinate spending that has impact on the national economic space.

That’s how we might divvy up the responsibilities efficiently on the spending side. Different orders of government efficiently matched to the scope of each good.

What about the taxation side?

We can do a similar exploration on the tax side of the public ledger. Which order of government is best-suited to handle different kinds of taxation?

A key consideration here is the mobility of different tax bases.

Sales and consumption taxes can vary across local jurisdictions without much economic cost. It simply costs more for most people to drive across a border to make their weekly purchases than they save in sales taxes. Now, there are exceptions. Myself, I’ve been known to make a shopping run now and again to Seattle. And I bet the folks in Amherst know which things have lower taxes across the Tantramar Marsh in Sackville and vice versa. But for the large part of consumption spending, provinces have a lot of leeway to set their own consumption tax rates without upsetting economic efficiency too sharply.

At the other end of the tax spectrum, the corporate income tax base is much more mobile. By booking costs in places with high taxes and revenue in places with low taxes, a company active across different jurisdictions can try to shift profit to where it is taxed the least. With the modern tech economy, this is made even easier, as a big company like Google can park its intellectual property in a low-tax place like Ireland and then licence the use of that technology to the high-tax places, thus siphoning the taxable income to where it is taxed least.

Similar challenges affect provincial corporate taxation in Canada. There are apportionment rules that limit the ability of companies to shift profits around in Canada, but evidence suggests it still happens.

Let’s now put this together. Imagine if we assigned spending responsibilities on the principles of economic efficiency, and then did the same for taxes. What would that look like?

Economist Albert Breton noticed 50 years ago that it would be a great coincidence if efficient spending and tax assignment resulted in balanced budgets for each order of government. Professor Breton then argued that intergovernmental grants must be in place to maintain economic efficiency.

Applied to modern Canada, Breton’s insight tells us that if we did not have a strong system of intergovernmental grants, either spending or taxation in Canada would be set inefficiently. Our system of intergovernmental grants is not there to foil or frustrate efficiency. We have intergovernmental grants to maintain economic efficiency.

So, the efficiency of our system of intergovernmental grants is one big factor in explaining the mystery of our radically-decentralized fiscal federation.

The second main factor is our system of tax collection agreements. For GST; for corporate and for personal taxes, most provinces allow the federal government to collect taxes on their behalf. The provinces have scope to choose rates and some degree of exemptions, but it is the federal government that does the actual collecting and the administration. Provinces just have to cash the cheques they receive from Ottawa.

This arrangement allows decentralized decisions about the level and type of taxes. It aligns spending with taxes to the degree possible, which bolsters fiscal clarity and accountability. It saves private taxpayers money by creating a national economic space with comparable rules and administration, rather than a balkanized system that is hard to comply with. Finally, it saves money by avoiding the replication of a separate tax administration apparatus in every province and territory. Our system of central tax administration but provincial tax rate setting is efficient, and contributes to our ability to sustain a radical fiscal federation.

So, what is the resolution to the great mystery of Canada’s radically-decentralized fiscal federation?  I don’t think it is the constitution. Neither are we an outlier in national solidarity, nor in political structures for fiscal accountability.

I’ve argued here that we have been able to operate a radically-decentralized fiscal federation because we have found an economically efficient way to do so.

3. Trouble Ahead

This is the country that my grandparents and my parents’ generations have delivered to us as we sit here in 2017. There have certainly been some bumps and bruises along the way, but arguably we’ve been passed a working federation.

That’s where we are.

Where will our fiscal federation be 50 years from now, in our bicentennial year of 2067?

Slide 6: PBO projections

The Parliamentary Budget Officer produces an annual projection of fiscal sustainability for the federal and the provincial governments.

The chart shows the projected path of the debt to GDP ratio over the next fifty years. The federal government on its current trajectory will fully pay off its net debt by 2060. Federal government program spending and transfers to children, the unemployed, and the elderly aren’t projected to be a long-run problem. Old age pensions for the baby boom generation should hit its peak in 2031 and decline thereafter. The federal government is in a sustainable fiscal position.

The provinces, on the other hand, are not. The PBO projects debt to increase starting in the mid-2020s and the follow an explosive path. The reason is well-known: health spending.

As a caveat, there have been at least two decades of economists warning that health costs would “soon” rise substantially and some have noticed that dog hasn’t really yet barked. The Canadian Institute for Health Information reports that the annual real increase over the five years from 2010-2014 was negative 0.2%.

Provinces have been working hard at implementing innovations to the delivery and management of health services. In some places like British Columbia, there have been innovations on the structure of public-sector wage settlements. Other places like Ontario have experimented with the delivery of core services. I’m sure the government of Nova Scotia has made efforts as well.

Slide 7: Age 75+ across the country.

But, the problem is about to start accelerating. Health spending rises substantially at older ages—especially after age 75.  The average health spending on 40 year olds is $2,400 per year. For 75 year olds it is $11,600. Five times as much.

The 75+ population share starts to rise in the 2020s and by the 2040s will be double the current share nationally. In some places, it will almost triple. These are demographic realities fixed into our population structure and they are unlikely to vary much.

Slide 8: LucilleBall.gif

Again, provinces may be able to innovate their way through this. Economists have made bad projections before, and maybe we will be wrong this time too. But this time may really be different—the pace of demographic change is picking up and innovative health reforms will need to step up the pace substantially in order to keep up with the pace of demographic change.

To my mind, the most likely case is that provincial budgets will be strained over the next twenty years.

To take the example of Nova Scotia, the C.D. Howe Institute projects health spending will increase by four percentage points of GDP in the next 15 years. As a reference point, HST revenue in Nova Scotia is about 4.2% of GDP. So, you’d have to double the provincial part of the HST to raise enough revenue, taking the rate up to 25%. And that’s just the next 15 years. It gets worse after that.

Now, the Parliamentary Budget Office also does provincial projections, and their projections are milder than the C.D Howe ones. The PBO says Nova Scotia health spending will only rise 2 points of GDP in the next fifteen years. But that’s still a substantial challenge that can’t be ignored.

To summarize, the numbers look scary. This problem also looks unavoidable. Is there a solution?

4. An Economic Framework

Slide 9: A framework: Musgrave, Oates, Milligan & Smart

To figure out a way forward for our fiscal federation requires a framework. Let’s put together a framework starting with the work of Richard Musgrave.

In 1959, Harvard economist Richard Musgrave published a path-breaking textbook The Theory of Public Finance. This book transformed the field from what resembled more a branch of accounting featuring ad hoc principles and rules toward a field built systematically on the foundations of modern economic theory. One of his contributions was to consider the economic underpinnings of federations, and how we ought to assign taxes to different levels of government.

We’ve seen his argument earlier in the lecture, when we grappled with the mismatch between the efficient assignment of spending responsibilities and the efficient assignment of tax responsibilities across orders of government in a federation. |The thinking on efficient assignment of taxation is straight out of Professor Musgrave’s writings.

The key consideration for efficiency is the mobility of the tax base. I argued earlier that the sales tax base can be efficiently handled locally, while corporate taxes are more mobile and might best be handled centrally.

But we need to add to Musgrave’s analysis the framework of economist Wallace Oates, from his 1972 book Fiscal Federalism. Oates argues that central governments are good at things requiring co-ordination across subnational boundaries—when decisions in one place affect people in other places. But Oates also recognizes the advantages of subnational governments. Subnational governments can account for local circumstances much better than a far-away central government.

So, the Oates model rests on a tension between these two factors. Central governments are better at co-ordinating when decisions in one place affect people in other places, but subnational governments can account for local circumstances.

In a recent research paper I’ve written with Michael Smart, we combine the frameworks of Musgrave and Oates to reconsider tax assignment in a federation, with particular attention to personal income taxation.

We start with the Musgrave argument—that mobile factors are likely best taxed centrally. In previous work, we have examined the case of high income earners. We have shown that taxation of high-earners at the provincial level seems fairly inefficient, as taxpayers have some ability to respond to higher provincial taxation by shifting income to lower-taxed provinces through mechanisms like family trusts resident in a low-tax province.

But in our new research we add an Oatesian perspective. Provinces have vastly different situations. In some places, the income distribution is highly skewed with a large proportion of earnings going to the highest earners. In other places, the distribution of income is less skewed.  When considering high-income taxation, it seems efficient to have different taxation of high-income people in different provinces, depending on the shape of the income distribution in different places.

Our theoretical model grapples with this tradeoff. Central government income taxation can limit cross-province income shifting while provincial income taxation can address local situations. Our main result: the best way is to share responsibility for income taxation between the federal and provincial governments.

This economic framework delivers clear guidance on how we might assign taxation efficiently in our Canadian federation. Let’s now turn to some policy solutions.

5. Radical solutions

Slide 10:  Get radical Canada!

Let’s recap where we stand.

We have a radical federation. We are facing a large and daunting problem. I think we need some radical solutions. I think we’re up for it—our parents built this radical federation, it’s up to us to keep pushing it forward. We can do this.

Slide 11:  Solutions

I will consider three options, taking into account the arguments and framework developed in this lecture.

First is simply to continue the status quo. The status quo does involve the Canada Health Transfer and Equalization transfers, but on the current trajectory these federal transfer programs are not going to be sufficient to fund the large-scale increase in health spending brought about by population aging. So, the status quo means provinces will be left on their own to raise substantial new funds, starting a few short years from now.

The problem with this solution is the ability of provincial governments to raise new taxes. The provinces where the aging and health problems are most acute—places like Nova Scotia—already have the highest personal taxes, the highest corporate taxes, and the highest sales taxes. How can these provinces raise substantially more revenue—on the order of 3 or 4 percent of GDP just 15 years from now—in a federation with mobile factors? I think this is a poor solution.

The next option is to federalize the coming health costs. Using Musgrave’s logic on the mobility of tax bases, the federal government is best equipped to levy taxes on mobile factors that can balance the need for efficient tax sources with the desire for fairness in the tax system where high earners pay an appropriate share of the tax burden.

This option would certainly require a major rethinking and change of mindset about the level of federal taxes. By the late 2030s, we’d need something on the order of six more points on the GST or a 40% increase of federal personal income taxes.

But, the coming wave of health spending means we do need to rethink our fiscal federation, so we can’t be deterred by whether it is a hard thing to do. We do need to be radical. Instead, the right question is whether we can do better than this option.

I see two weaknesses with the approach of federalizing health spending.

First, is fiscal accountability. I argued earlier that Canada likely does not have any special advantage in fiscal accountability over other countries, but the efficient transfer system we have built has handled the federal-provincial fiscal mismatch adequately so far. That said, I do have concerns how far this can be pushed. If provincial health ministries are funded only by cashing cheques written in Ottawa, I begin to wonder whether attention to proper cost control will be maintained.

Second is the efficiency of the tax assignment mix. Yes, it is true that the Musgravian logic assigns taxation of mobile factors to the federal government. However, my work with Michael Smart points out that the local circumstances need to be considered for efficiency as well.

So, I think we can do better for efficiency than to further centralize the tax decisions in Ottawa while leaving spending decisions in provincial capitals.

Here’s my third option: we flip the table on the current assignment of taxes, guided by our efficient economic framework. Currently, provincial governments raise about $26 billion in corporate taxes. Corporate income is relatively mobile.

Why not hand over taxation of corporate income to the federal government? In exchange, the federal government could shrink the federal GST, handing over the GST tax room to the provinces. On an approximately revenue neutral basis, this swap would cost 4 out of the 5 current federal GST points.

Then, as funding needs grow in the decades to come, provinces can raise their HST rates as required by their provincial needs.

The final piece of this proposal is the maintenance of a robust and strong equalization grant, so that provinces without large resource revenues can maintain their relative position within the federation.

So, this is a three-part plan. One, provinces vacate corporate taxation. Two, the federal government vacates the GST space—but continues the efficient central collection through the CRA. Three, maintain a robust equalization grant.

Let me lay out five advantages of this plan, and then close by addressing some weaknesses.

The first advantage is efficient assignment based on the Musgrave principle of tax base mobility. The sales tax base is not mobile, and can stay provincial. The corporate tax base is mobile, and therefore should be taxed centrally.

The second advantage is the continued shared responsibility for the personal income tax. As my work with Michael Smart shows, allowing the personal income tax to reflect provincial circumstances can be efficient. Importantly, the provincial income tax is an important tool for fairness. It will be needed to adjust the overall sharing of the tax burden generated by higher GST rates in the provinces.

The third advantage is efficient administration. Canada’s system of tax collection agreements would continue, with the federal government setting the structure for the GST and personal income taxes while provinces set the rates.

The fourth advantage is ensuring adequate fiscal accountability. If a province doesn’t pay enough attention to continuous innovation in the efficient delivery of health services, voters in that province will notice that higher GST rates that would be required.

The fifth advantage is the volatility of incomes. Corporate income tax is a very volatile source whereas sales tax is much more stable. Health spending does not vary substantially through the business cycle, so it makes sense to match that spending with a stable financing source.

Of course, this reform would not be easy. While the revenue implications of swapping corporate taxes for GST might be made to balance overall, some provinces might gain and others lose in such a swap. On precedent, Quebec may refuse to participate in such a swap. Finally, provinces facing a particularly large increase in the elderly population share may still find it difficult to raise their HST rates substantially higher than other provinces.

I don’t argue this would be easy. But I do think it is necessary. Our radical federation needs a radical solution to meet the needs of Canada’s next 50 years. Funding for future health spending increases in Canada should come from provincially-set but federally-collected GST increases, tempered by continued sharing of the personal income tax base to adjust for local conditions and for tax fairness.

6, Conclusion

To wrap up, I began by showing that Canada’s fiscal federation is radically decentralized from an international perspective. I argued that there is a strong economic foundation for our radical federation, but that we may soon face a tremendous challenge because of provincial responsibility for health spending.

I proposed a radical reform of tax responsibility, with the federal government taking over all corporate taxation in exchange for provincial control over GST revenues. Future health costs can be covered through provincial sales tax increases, balanced by income tax adjustments and a robust equalization transfer.

We’ve inherited a strong Canada from those who’ve built it. It will take some work, but we can pass a stable and thriving federation on to the next generation.

Thank you.

Comments on Ontario PC Policy Platform

UPDATE March 12, 2018:

Because of the change in leadership of the Progressive Conservative Party of Ontario, my words below no longer represent my current views. I wish the voters of Ontario good luck with their choices. KM

—–

I am Kevin Milligan, Professor of Economics at the Vancouver School of Economics. My disclosure information is here.  Below are some comments about the recently-released Ontario Progressive Conservative platform. These are my words and my opinions, and I have received no compensation. See my FAQ #5 for why I’m making these comments.

I have comments on two aspects of the Ontario PC policy platform: the proposed Ontario Child Care Refund and cost management through a value for money audit.

Ontario Child Care Refund

The proposed childcare measure takes the existing deduction for childcare and replaces it with a credit that refunds up to 75 percent of the cost of childcare.  This proposal has two main advantages. First, it delivers the largest benefit to lower and middle income families who most need help with childcare expenses. Second, it supports flexibility for those families who need part-time care, shiftwork, or irregular care arrangements. The Ontario PC proposal is similar to what was proposed in this paper by Alexandre Laurin and me, based on the existing policy in Quebec. More background on the justification for a refundable childcare credit policy can be found here.

I was contacted a few months ago by members of the Ontario PC policy team who informed me of the childcare policy plans. They were interested in my views on how to properly assess the potential costs of their proposal. I have had several conversations with the Ontario PC policy team, and I have reviewed their final costing in detail. I think the quality of their costing analysis attains the standard I expect, and the cost estimates are reasonable.

To summarize, the Ontario PC childcare proposal offers improved, flexible benefits for all Ontario families. The costing analysis follows standard practice and gives reasonable estimates.

Value for Money and Cost Management

The Ontario PC policy platform proposes to find 2.8 billion in savings by 2021. Controlling costs for a provincial government in Canada depends mainly on the organization and compensation of public sector workers. In my view, a government with firm attention to cost management can achieve savings in the range proposed by the Ontario PC platform.

 

Canada’s Radical Fiscal Federation

Canada’s Radical Fiscal Federation
Kevin Milligan
UBC Vancouver School of Economics

Presentation at the conference “Canada at its Centennial and Sesquicentennial: transformative policy then and now” organized by UofT’s School of Public Policy and Governance, held in Toronto on November 17, 2017.

This is my draft script. The powerpoint slides can be downloaded here.

There will be a paper published in a book in 2018 based on this conference.

Introduction

We have created for ourselves a radically-decentralized fiscal federation. 78% of spending in Canada happens at subnational levels of government. In the US, it’s 48%. Across the OECD, the average is just 32%. We are a radical outlier.

How is it that we can maintain a modern welfare state mostly run by little provinces; some with only a few hundred thousand people? How can we raise the taxes to do so? Why are we so different? What forces shape our fiscal federation?

Is it our constitution? The constitution in 1867 gave much responsibility for unemployment relief, pensions, and schooling to provinces. That’s a starting place, but insufficient as an explanation. When economic forces demanded unemployment relief and pensions, we adjusted the constitution to allow it. The economic argument overran the constitutional status quo. So, it can’t be just constitutional forces leading to our decentralization.

Is it people? Is there a sense of national economic purpose sufficiently different in Canada that allows us to maintain this structure where other countries do not? A strong sense of national fairness and shared destiny could certainly contribute. You found some oil—share the gain. You lost your fish? Share the pain. Some Canadians feel this way. I’m sure not all do.  Whatever the answer, I am skeptical we are such an outlier on national sentiments among the population to explain why we’re so different from other OECD countries.

What about fiscal accountability? Some argue that democratic transparency and accountability demands taxes be raised at the level of government that spends them. But we somehow get away with vast mismatches between spending and taxes at different levels of government. This likely does matter, but we seem to have succeeded in spite of stretching this mismatch substantially.

Economic Roots of Radical Decentralization

We have a radically decentralized federation. Constitutions, a populace with  strong national purpose, and accountability are all important forces in a country. But in my view, it is economic efficiency—not fairness or constitutions—that underpins the radical decentralization of our fiscal federation. There are two elements.

The first is our system of intergovernmental transfers. They have constitutional origins, and are certainly held aloft by national sentiments. But to me the strongest argument for our transfer system is economic efficiency.

The scope and scale for efficient production of government-provided goods varies. For some goods, like education or parks, local or provincial governments can manage the spending efficiently. For others, like transportation or environment, a national or even global viewpoint is necessary to provide government services efficiently.

That’s the spending side. But the same is true as well for the efficiency of taxation, owing to the mobility or immobility of different tax bases. Sales and consumption taxes can vary across local jurisdictions without much economic cost, while at the other end, corporate and capital income is much more mobile and so might best be handled centrally.

Imagine if both taxes and spending are assigned to the optimal level of government. Economist Albert Breton noticed 50 years ago that it would be a great coincidence if optimal spending and tax assignment resulted in balanced budgets at each level of government. So, intergovernmental grants are required to maintain economic efficiency.

In other words, if we didn’t have a strong system of intergovernmental grants, either spending or taxation in Canada would be set inefficiently.

So, the efficiency of our system of intergovernmental grants is one big factor that allows us to have such a decentralized fiscal federation.

The second main factor is our system of tax collection agreements. For GST; for corporate and for personal taxes, most provinces allow the federal government to collect taxes on their behalf. The provinces have scope to choose rates and some degree of exemptions, but it is the federal government that does the actual collecting and the administration. Provinces just have to cash the cheques they receive from Ottawa.

This arrangement allows decentralized decisions about the level and type of taxes. It aligns spending with taxes to the degree possible, which bolsters fiscal clarity and accountability. It saves private taxpayers money by creating a national economic space with comparable rules and administration, rather than a balkanized system that is hard to comply with. Finally, it saves money by avoiding the replication of a separate tax administration apparatus in every province and territory.

So, my answer to why we have been able to radically decentralize the fiscal operations of our federation is that we have figured out economically efficient ways to do so. That’s where we are now, in the sesquicentennial year.

Trouble Ahead

Where will our fiscal federation be 50 years from now, in the bicentennial year? The Parliamentary Budget Officer produces an annual projection of fiscal sustainability for the federal and the provincial governments.

The chart shows the projected path of the debt/GDP ratio over the next fifty years. The federal government on its current trajectory will fully pay off its net debt by 2060. Program spending and transfers to children, the unemployed, and the elderly aren’t projected to be a long-run problem. Old age pensions for the boomers hit their peak in 2031 and decline thereafter. The feds are in a good position.

Debt to GDP Ratios

The provinces, on the other hand, are not. Debt is increasing starting in the mid-2020s and is on an explosive path. The reason is health spending.

There have been at least two decades of economists warning that health costs would rise substantially and some have noticed that dog hasn’t barked. The Canadian Institute for Health Information reports that the annual real increase over the five years from 2010-2014 was -0.2%.

Provinces have been innovating on the delivery of health services and working hard to limit health spending increases.

But, the problem is about to start accelerating. Health spending rises substantially at older ages—especially after age 75.  The 75+ population share starts to rise in the 2020s and by the 2040s will be double the current share. These are demographic realities fixed into our population structure and unlikely to vary much. Provinces may be able to innovate their way through this, but they will need to step up the pace substantially in order to keep up with the pace of demographic change.

Share of population age 75+

More likely, provincial budgets will be strained.

To get a sense of the magnitudes, take the case of British Columbia. The C.D. Howe Institute projects health spending will increase by 3 percentage points of GDP by 2030—just a few years from now. The kind of tax increase that would require is on the order of a doubling of either the provincial income tax or sales tax.

Radical solutions

But that’s the question: should provinces be left to handle this unprecedented increase in health spending on their own?

We could increase the existing Canada Health Transfer substantially to fund provincial health spending needs. This would require a sharp increase in federal taxation over the next two decades. The federal government, with its easier capacity to tax mobile personal and corporate income might be better placed to raise extra revenue fairly and efficiently. On the other hand, the transparency and accountability gap would grow as provinces spend more money they are not accountable for collecting.

A more radical solution is to “flip the table” on our current assignment of federal and provincial taxes. The federal government could relinquish four points of GST room to the provinces in exchange for provinces turning over all corporate income taxation to the federal government. This is approximately revenue neutral, but is arguably a more suitable assignment of taxing powers for several reasons.

  1. The sales tax base is not mobile, while the corporate tax base is the most mobile. The proposed move would therefore be more efficient.
  2. Central administration of the GST is efficient and nationally integrated.
  3. Personal taxes would continue to be split, allowing both the federal and provincial governments flexibility to adjust for fairness of the overall tax burden through the progressive income tax.
  4. Provinces would be raising their own revenue for their own spending needs, fulfilling demands for fiscal accountability.

The net result would give provinces primary control over a tax that can be used to fund future health needs that can be efficiently collected even when set differently across provinces.

Conclusion

Canada’s fiscal federation is radically decentralized from an international perspective. I argue here that the institutions that have evolved to facilitate this decentralization—intergovernmental transfers and centralized tax administration—are grounded in economic efficiency. The fiscal federation will face strong challenges in the next few decades as provincial health spending strains the existing arrangements, so radical solutions may need to be considered to maintain a stable decentralized federation.

Senate Finance Committee Testimony

Kevin Milligan
Professor of Economics
Vancouver School of Economics

Submission in support of testimony to the Senate Standing Committee on National Finance
November 6, 2017.

My disclosure is here. This text is available as a nicely-printable PDF here.

The Economic Impact of the Private Corporation Tax Proposals and Small Business Rate Cut

In October, Finance Minister Bill Morneau announced several changes to the proposals on the taxation of private corporations. In this note, I will briefly review my thoughts on the original proposals from July, and then examine the changes announced more recently, with particular attention on the small-business tax rate.

Taken together, I think the package moves the tax system forward by focusing business tax incentives where we want them—to facilitate productive business investment.

Comments on the original July proposals

The July consultation document proposed measures to restrict dividend payments to family members and to adjust the taxation of passive income inside private corporations, along with some other measures on capital gains which have now been deferred.  I will address each of two measures that are still under consideration in turn.

The first of the proposed measures aims to restrict the ability of businesses to “sprinkle” income to family members who have not materially contributed labour or capital to the business. Previous reforms restricted this practice for children under the age of 18; the current proposal extends the same “tax on split income” treatment to older children and other family members.

This measure makes sense for three reasons. First, income sprinkling offers a substantial tax advantage to those with private corporations that is unavailable to those of similar incomes without a private corporation. This is inefficient because it distorts the decision to incorporate—which should be based on business merits not tax advantages. Second, the use of income sprinkling is highly skewed up the income distribution, meaning that high earners can access a tax measure middle and low earners do not.[1] Third, it is an ineffective and wasteful incentive when looked at as a reward for entrepreneurship and investment, since it hands out benefits based on having a particular family structure rather than having good ideas, hiring workers, or making investments. Extending the “tax on split income rules” to other family members is good tax policy, and should be implemented.

The second measure in the package is the taxation of passive income. The right starting place to understand this tax measure is the concept of neutrality—that the tax system should treat similar activities in a neutral way. With respect to earnings retained within a corporation, the Royal Commission on Taxation in the 1960s summarized this by suggesting that “…the system would neither encourage nor discourage the retention of earnings by corporations.”[2] Currently, there is a strong deferral advantage for saving inside a corporation compared to saving outside the corporation. The goal of the proposed changes is to restore the balance, so that savings are treated the same whether held inside or outside a corporation. In my view, this reform makes substantial progress toward that ideal and should therefore be implemented.

The Small Business Tax Rate Now Focused on Active Investment

In the October announcements, Minister Morneau proposed a lowering of the small business tax rate from its current level of 10.5% to 10% in 2018 and 9% in 2019. Some have expressed concerns about this change because of increasing tax-rate gaps between large and small businesses, or gaps between business and personal rates in general. I think these concerns are overstated, and that these rate reductions—in the context of the other elements of the private corporation tax package—should bring about an increase in productive investments by small businesses. I will now explain why.

After profits are earned within a firm, three actions are possible. First is to flow the profits through to the owners, whether by dividends or by paying oneself a salary. Second is to retain the savings inside the firm and invest passively in assets not related to the business. Third is to reinvest the earnings back into the active business operations of the firm. Let’s examine how each of these three actions is taxed.

First, earnings can be flowed out of the firm immediately as earnings or dividends. Because of the dividend tax credit, there is currently little tax difference for a small business owner to choose one of these paths over the other; the current tax system is approximately neutral with respect to payments of salary or dividends.  This will continue to be true as the dividend tax credit changes to reflect the new lower small business tax rate. Moreover, with the addition of the proposed measures to restrict income sprinkling, it will be much more difficult for business owners to avoid paying taxes on distributions through payments to family members. So, a lower small business tax rate will have little impact on the taxation of earnings that are immediately flowed out of the firm and confer no extra advantage since the money will be taxed at the same personal rates whether the small business tax rate is high or low.

The second action that can be taken with earnings is to retain them within the firm and invest passively in assets not related to the active operations of the business. Under current tax law, there is a substantial deferral advantage for funds retained inside the firm. The proposed measures aim to correct this asymmetry and restore neutrality to the tax treatment of savings held inside or outside the firm. So, above the $50,000 per year passive income exemption proposed by the Minister, there would no longer be an advantage to retaining the funds inside the firm. This means that a lower small-business tax rate would not confer any advantage to those with savings in excess of the exempted amount.

The third option for profits is to re-invest inside the active operations of the business. The lower is the small business tax rate, the higher is the after-tax return on investments in the active operations of the business. In this way, the small business tax rate acts as a direct investment incentive for the business.

Taking these three points together, the impact of a lower small business tax rate is made clear. In the context of the package of reforms, there will no longer be advantages in distributing earnings to family members or to saving large portfolios inside the firm. The remaining incentive provided by the small business tax rate is for productive investment in the active operations of the firm.

Providing incentives for active investment was the original intent of the small business tax rate when it was first introduced in the 1971 budget speech by Finance Minister Edgar Benson.[3] The proposed reforms to business taxation maintain that spirit by providing stronger incentives to invest while closing off the other ways the tax-advantaged funds can be used.

Objections and Alternatives to the Small Business Deduction

In this final section, I address three objections to the changes to the small business tax rate and the current small business tax deduction system.

One objection to the lower small business tax rate arises from the gap between small and large corporate tax rates which acts as a barrier to growth. I think this criticism is right in spirit, but the magnitude of the impact is much exaggerated. There are very few firms operating near the $500,000 limit of the small business deduction, and evidence has not found much impact on firm growth.[4] Moreover, while the drop in the small business rate will make this gap larger, it is still at historically-small magnitudes. The small-large federal tax gap was over 20 percentage points in the 1970s and 1980s, and 16 points in the 1990s. This gap is now 4.5 points and will grow to 6 points by 2019.

The second objection focuses on the growing gap between personal and corporate tax rates in general. When corporate tax rates are lower than personal tax rates, the opportunity exists to lower one’s tax burden by retaining earnings inside the firm where savings are taxed more favourably. This is why traditional public finance tax policy advice has focused on keeping top corporate and top personal rates aligned. Over the past twenty years, however, almost all industrialized countries (with the current exception of the United States) have lowered corporate rates and introduced persistent and large gaps between corporate and personal rates. The goal has been to gain the benefit of higher corporate investment through lower corporate taxation while maintaining the ability to use the personal income tax to push back against growing income inequality.

This growing personal-corporate tax gap results from a choice; other choices are possible. Instead, we could choose to increase our corporate tax rate to match our top personal rate, but in doing so we would reduce the attractiveness of Canadian investments. Or, we could lower the top personal rate substantially to match the low corporate rates, but in doing so we would lose the ability to use a progressive income tax as part of our system of taxation. In my view, Canada has made the right choice by following the international trend in allowing this corporate-personal gap to open, and also to take measures to stem the tax avoidance opportunities that such a gap presents.

The third objection to the lower small business tax rate is the possibility of better ways to support new and growing businesses. We want to provide incentives for firms struggling to get started and to grow. It is less clear that merely being small is an aspect that needs to be supported. There are alternatives to the small business deduction that could be considered, such as allowing immediate expensing of active investments up to some annual limit. Immediate expensing front-loads the tax incentive for investing, rather than stringing out the depreciation expense over several years.[5]

In my view, a measure that focuses on new and growing businesses and provides direct incentives for active business investment is preferable to our existing small business tax regime. But, there is an all-party consensus in favour of maintaining the current small business tax regime. So, while I will continue to make the case that in the long run we ought to replace the small business deduction with a better measure, it is also necessary to offer advice in the current political context which offers near-unanimous political support to the small business deduction. In this political context, I think the cut to the small business rate should be supported because it improves the incentive to invest—which is what we want the small business tax system to do.

Concluding Thoughts

In closing, it is important to take the private corporation tax reform package as a whole and ask what it achieves. In my view, the changes rein in several avenues for tax avoidance which not only were inefficient but also were used primarily by very high-earning Canadians. Curtailing the ability to split income across family members who didn’t contribute to the firm is good policy. Restoring neutrality between the taxation of savings inside and outside the firm is good policy. Returning that extra tax revenue through tax cuts back to small businesses who invest in their active business operations is good policy.  While the final legislation must take into account concerns about administrative complexity, I think the economic thrust of the proposals is in the right direction and should be supported.


 

[1] At most 13 percent of small business families benefit from income sprinkling. The top five percent of business families receive about half the tax benefit. See David Macdonald “Splitting the Difference: Who really benefits from small business income splitting?” Canadian Centre for Policy Alternatives. https://www.policyalternatives.ca/publications/reports/splitting-difference

[2] I expand on the theoretical importance and practical implementation of this notion of neutrality in my comments presented to the Canadian Tax Foundation conference on September 25, 2017. http://blogs.ubc.ca/kevinmilligan/2017/09/24/integration-and-the-taxation-of-passive-income-an-economic-perspective/

[3] See the 1971 Budget Speech here: https://www.budget.gc.ca/pdfarch/1971-sd-eng.pdf

[4] See Benjamin Dachis and John Lester “Small Business Preferences as a Barrier to Growth: Not So Tall After All,” C.D. Howe Institute Commentary 426. https://www.cdhowe.org/public-policy-research/small-business-preferences-barrier-growth-not-so-tall-after-all Also, Ted Mallett, “Policy Forum: Mountains and Molehills—Effects of the Small Business Deduction,” Canadian Tax Journal, Vol. 63, No. 3, pp. 691-704, 2015.

[5] See Duanjie Chen and Jack Mintz “Small Business Taxation: Revamping Incentives to Encourage Growth,” University of Calgary School of Public Policy Research Papers, Volume 4, Issue 7, May 2011. https://www.policyschool.ca/wp-content/uploads/2016/03/mintzchen-small-business-tax-c_0.pdf

 

FINA Testimony, September 2017

Kevin Milligan
Professor of Economics
Vancouver School of Economics
University of British Columbia

Prepared Comments on Tax Planning for Private Corporations for Standing Committee on Finance
September 26, 2017
Ottawa, ON

I’d like to make two points this morning. First, I want to talk about the goals of this reform package. Second, I will discuss implementation.

A main goal of this reform is to push toward neutrality. A neutral tax system is one where people make the same business decisions in the presence of taxation as they would in a world without taxation. With a neutral tax system, the government has the lightest possible touch on the economy. Business decisions are made on business merits, and not pushed one way or the other by taxes.

The current system falls short of neutrality in many ways. One example is to consider a hard-working unincorporated person: someone with a truck, a hammer, some skills, and a passion for work. We want her to be able to start a business without the costs and hassle of incorporation. By loading tax benefits onto those who organize their businesses as corporations, we lean against people who want to work just as hard for their families, but in an unincorporated business. This has real costs to our economy.

Now, some words on implementation. Many tax practitioners have raised concerns about how some of the proposed tax measures may be implemented. As one example, when dividends are paid to family members, there are concerns about the accounting and keeping of records to support a claim for ‘reasonableness.’ There are many other examples.

In my view, some of these concerns hit the mark and they must be treated seriously. After the consultation period is complete, I think it is important for the Department of Finance and the Minister to provide a wide-ranging and thorough response to these concerns. I’m sure they are now working hard at this important job, and I look forward to hearing their responses.

But, we should not stand frozen from action because of concerns about transitions and implementation. Tax changes always require adjustments. To fret too much about adjustments simply resigns ourselves to the status quo, and Canadians deserve a tax system that works better than the one we have today.

Thank You.

Integration and the Taxation of Passive Income: An Economic Perspective

Notes prepared for the Canadian Tax Foundation conference “Tax Planning Using Private Corporations: Analysis and Discussion with Finance,” held in Ottawa on September 25, 2017.

Kevin Milligan
Vancouver School of Economics
kevin.milligan@ubc.ca

This presentation concerns the Department of Finance proposals on the tax planning by private corporations. The discussion document can be found here.

The spreadsheets on which the analysis here are based can be found here.

The Powerpoint slides can be found here.

Introduction

“The system would neither encourage nor discourage the retention of earnings by corporations”

This was the goal set out by the Carter Commission 50 years ago for the integration of the corporate and personal tax systems.

“…neither encourage nor discourage the retention of earnings by corporations”

The goal embodied in that quote is neutrality.  Neutrality is at the centre of the concept of economic efficiency. A neutral tax system means that people make the same decisions in the presence of taxes as they would in a world without taxes. Neutrality means that government has the lightest possible touch; business decisions are made on business merits, not pushed one direction or another by tax considerations.

Is neutrality a lofty idealistic academic goal? Of course. Along the road to any goal, we need to confront the concerns of on the ground reality. Concerns of administration. Of complexity. And of practical issues of tax law. These factors can and should determine how far down the road we go toward this goal.

But let us start first with deciding down which road to travel.  I think this benchmark—“neither encourage nor discourage”—set out by Carter is a good one. Over the next few minutes, I will explain why I think this is a good goal, then explore how good a job these proposed reforms do in achieving this goal.

What is integration?

Integration means that tax at the personal level should reflect tax already paid at the corporate level.

Put differently, all paths for a $ from “profit to pocket” should bear the same tax.

If integration holds, there should be no financial gain from readjusting the location of savings. Again, recall Carter:

“The system should neither encourage nor discourage the retention of savings by corporations.”

Why integration?

Integration supports neutrality: we want people making the same decisions as they would without taxation. This is a free-market goal and the literal economic definition of an efficient tax.

Firm owners decide to save inside the firm for a variety of reasons: retirement, maternity leaves, ‘buffer’ savings, saving for a future reinvestment. This is all fine, but the tax system should neither favour nor disfavor any of these choices. These decisions should be made on business merits, not pushed one way or the other by taxes.

It is useful to remember the reason we have the Small Business Deduction. The introduction of the SBD was explicitly meant to facilitate active investment. That’s the reason laid out in the 1971 budget speech by Edgar Benson.

If a corporation employs the tax savings that result from the low rate for non-business purposes, such as Portfolio investments, a special refundable tax will be imposed to recover the low-rate benefit.

We intend that the small business incentive be available only to Canadians and that it encourage Canadian ownership of our expanding businesses.

Ways Current Integration Falls Short

The current system of integration falls short of an academically pure neutrality in a variety of ways:

  • It’s notional; doesn’t reflect actual taxes paid.
  • One national gross-up rate.
  • Tax-exempts like RPP/RRSP can’t claim DTC.
  • Capital gains rate currently ‘too low’ compared to dividends/wages.
  • Firms claiming SBD have a ‘head start’ deferral advantage for saving.

The current proposals really only address the last of these. The aim here is not perfection, but to try to make an imperfect system a bit less imperfect. That’s a fine goal.

Do proposals improve integration?

I will present some analysis of the proposals on passive income. I focus on high-bracket investors for a few reasons:

  • High bracket investors are much more likely to have large passive portfolios.
  • Current system imposes a high flat tax on passive income, so low/mid bracket investors are already disadvantaged. Not clear it makes financial sense for them to save inside a corporation under the status quo.

But, it should be acknowledged that the proposals will make saving inside a CCPC even worse than the status quo for a low- or mid-bracket investor.

The current system is ‘over-integrated’, meaning that the credits given for tax paid inside the firm are too high. The proposed remedy is to remove the refundable dividend tax on hand (RDTOH) notional amount that is currently included when dividends are paid out.

Some have argued that the resulting tax rate on passive income inside the firm is excessive. But, any analysis needs to look at the whole flow of income from beginning to end. Inside the firm the taxation of the principal is very light to start, so the heavier taxation of the accruing income balances things out.

I will offer two pieces of evidence on integration under the current and proposed system.

First, I have independently redone the analysis appearing the Finance discussion document Table 7. My analysis can be found online here.

Replication of Finance Table 7

Replication of Finance Table 7

My analysis starts with $100 of pre-tax active business income and watches what happens when it is retained inside the firm or immediately distributed over a 10 year period.  Under the status quo, the individual is about 10% better off saving inside the firm as outside the firm. With the proposal, there is virtually no difference for saving inside and outside the firm.

This can vary a bit depending on time horizon and the mix of assets held. However, in my analysis the reform is fairly successful at removing the current deferral advantage of saving inside the firm.

The second piece of evidence is simple observation. If a system is properly integrated then, as per Carter, there should be neither advantage nor disadvantage from retaining earnings.

I observe the following. The financial planning industry in Canada makes a strong pitch to firm owners that there is a deferral advantage for saving in CCPCs. This pitch is not hard to find—a simple google search reveals dozens of examples.

http://lmgtfy.com/?q=doctors+canada+incorporation+deferral+advantage

If there is a deferral advantage, then the system is not currently properly integrated. If you claim there is no deferral advantage, then the ubiquitous pitch made by financial planners is wrong. I do not think this pitch made by financial planners is wrong. There is a current deferral advantage and that means the system today is not properly integrated.

How much do the proposals matter?

The last point I’d like to make is to emphasize the scale of the impact of the reform. I will do this in two ways—first with a simple example then a slightly more involved example.

First, the simple example. Imagine $100,000 in a passive portfolio paying 5% interest income. The change in tax for an Ontario high bracket tax payer can be calculated as:

  • There is $5,000 of passive income.
  • RDTOH on the $5,000 is 30.67%, or $1,534.
  • But, this is taxed as non-eligible dividend income. 45.3% effective rate for Ontario high bracket
  • So, RDTOH is worth $838 after tax if flowed through to the individual immediately.
  • This is <1% of the total value, but does eat up 17% of the return.
  • After 10 years, this can affect terminal value of the portfolio by 8-15%.

Is this large or small? That’s in the eye of the beholder, but I think it’s important to keep the scale in mind.

Now the slightly-more-involved example.

Imagine someone saving $33,333 per year for three years. This could be for the purposes of a reinvestment in the firm, a maternity leave, or for eventual consumption purposes outside the firm.

Imagine again that the savings earn interest income at 5% per year. This income is taxable each year as passive income. Here is what the account looks like at the end of three years.

The balance is $105,067. There is also a balance in the RDTOH account of $3,118. This has an after-tax value of $1,705.

Passive investment example

Passive investment example

Two points to make.

First, for money reinvested in the firm there is no change to cash flow. There is no less cash available for a maternity leave or a reinvestment. The RDTOH account is notional, so it only affects cash once there is a dividend paid eventually.

Second, because of the removal of RDTOH, the change in the after-tax  value of the portfolio because of the reform is $1,705, or 1.6%.

So, for those using a passive portfolio to save short-term within the firm, there is no change to cash flow and a fairly small change to the portfolio value.

Concluding thoughts

“The system would neither encourage nor discourage the retention of earnings by corporations”

My job here, as an economist, is to help us figure out what goals to set for the tax system. I think this goal, as laid out in the Carter Commission, is a sound one. At its core, integration and neutrality mean that business decisions can be based on business merits.

Of course, in deciding how far to go toward any goal, we need to weigh the costs and benefits. There are lots of important challenges that await.

  • Transition: how grandfathering will work.
  • Inter-company shareholdings and investments in startups.
  • I’m sure we will hear more today!

I’d like to emphasize that these concerns are serious. If there are problems, we need to see if Finance can fix them. If they can’t be fixed, certain elements of the package will then need to be reexamined. But, these issues are much more the purview of the lawyers and accountants among us than the economists. I have a suspicion you won’t need my encouragement to speak up on this as the day proceeds. I look forward to hearing what you have to say.

Thank you!

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