Kevin Milligan

Professor, Vancouver School of Economics

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!

The Efficiency and Fairness Case for Private Corporation Tax Reform

Background notes prepared for private corporation tax event: “Taxing Small Corporations: Increasing Fairness or Undermining Growth?”

University of Calgary School of Public Policy

September 14, 2017

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

PDF of these comments available here.


Introduction

Other speakers have covered the details of the proposed reform package in detail, so I will just summarize it briefly. The proposed package contains three measures.

  • Cutting back on the ability of business owners to “sprinkle” income to other family members.
  • Imposing heavier taxes on passive portfolio investments inside a corporation.
  • Changes to surplus-stripping rules.

The complete details are available from the Department of Finance.

In my time here, I’m going to make three substantive arguments about the goals of the tax reform, and assess this private corporation policy package as a whole.

The three substantive points are about efficiency, entrepreneurs, and equity.

Efficiency and Neutrality

The core aim of the reform is to restore neutrality to those conducting business inside vs outside a corporation. It’s worth spending some time to understand why this is important.

At the core of the economic model of taxation, we use as a benchmark the activities people would undertake if there were no government and no taxes. When we introduce taxes to the model, we compare what people do to what they would’ve done in the absence of taxes. The choices made without taxes are our ultimate benchmark.

The ideal for a tax system is neutrality. Neutrality means people choose the same activities with or without taxes. In other words, a neutral tax system is one where the government isn’t pushing economic activity one way or the other; a neutral tax system has the lightest possible touch of government on the economy. That’s the goal.

This concept of neutrality is central to the motivation for the current reform package. To apply this concept, we don’t want to give tax advantages to those who run their business as a corporation compared to those who run their business as unincorporated, or to those who save inside versus outside a corporation.

The reform aims to pull back on the tax advantage of incorporation. Incorporation is appropriate in many business circumstances, but the incorporation decision should be made on the business merits, not because of tax incentives. We as a society don’t have incorporation because we want people to give people tax advantages. We don’t have incorporation as a back-door way to give family-based taxation to a subset of Canadians. We don’t have incorporation to provide a parking place to put your retirement portfolio. You can argue that family taxation and retirement savings are good things, but that’s not what a corporation is for. The role of a corporation is to facilitate productive investment to grow the economy and produce better jobs.

Productive investment should be the focus, not loading tax savings into one particular way of organizing a business.

This is the basic efficiency case for a reform that moves toward neutrality.

Entrepreneurs

The future of our economy is built by investment decisions made today; our future prosperity is determined by the accumulated impact of each one of those investments. We want new ideas, new firms, and new jobs to be grown right here in Canada, and the job of policy is to make sure that happens.

Is there a case for helping small business? Ted Mallet, the economist for the Canadian Federation of Independent Business argues there is.[1] He provides some good examples:

  • Large firms have economies of scale in dealing with government regulations.
  • Internationally active firms can lower cost of capital through international tax arbitrage.

While I think Mallet makes a good economic case for helping out small business, it’s not clear to me the existing Small Business Deduction (SBD) is the right way to do this.[2] The SBD targets small firms; we want a system that targets new and growing firms.

If our goal is helping entrepreneurs, one attractive option put forward by Chen and Mintz introduces a system where every firm can immediately expense a certain amount annually, rather than deferring the depreciation deductions.[3] This gives an advantage to smaller firms, and the advantage is directly targeted where we want it: incentives to grow investment.

While it is useful to think about bigger potential reforms, we also must address the reform package currently on the table.

Do the three tax measures currently on the table spur entrepreneurship? Are these measures effective subsidies for what we want to achieve?

The ability to sprinkle income does not reward those with good ideas. Sprinkling is not a reward for innovation, investment, or job growth. Sprinkling rewards those with a certain family structure. As for passive portfolio income, by its literal and legal definition it is the opposite of active investment in firm activities. We want productive investment in firms; we want to encourage entrepreneurial activities. It is very hard to see the link between income sprinkling and passive portfolio taxation and innovation and entrepreneurship.

I think the government can and should do more to encourage entrepreneurship and growth through the levers of the tax system. We have much better ways to encourage entrepreneurs than income sprinkling and subsidizing passive investment.

Equity

A major consideration for the politics of taxation—and the economics of taxation—is to figure out who is affected by these tax measures.

These tax measures strongly and obviously impact high earners much more than anyone else. But before I get to the facts, let me start with three caveats.

  • The compliance burden of some measures may hit many regular small businesses. I hope to hear some creative ideas about how to lower the compliance burden of achieving the reform’s goals. But ultimately, the final package has to take into account whether any additional compliance burden is justifiable.
  • Poorly written draft legislation might rope in too many regular small businesses. I hope Finance is listening and offers fixes to problems that have been raised.
  • You can construct special cases showing someone as low as $70,000 per year might have a small impact. We should take note, but not generalize from these special cases.

In my view, these reforms have their largest impact on high earners.

First, take the case of income sprinkling. The gain to shifting income across taxpayers within a family is driven by the difference in tax rates. If the main operator of the business is in a middle tax bracket, the gain to splitting income is quite small. As the gap in the tax rate between the main operator and the other family members grows, the gain from sprinkling income grows.

The data on dividends provided by Michael Wolfson and Scott Legree makes this very clear.[4] If you put Canadians into ten decile bins and observe who is paying out dividends to family members, only about 6 percent is paid out from the bottom 5 deciles in total. In contrast, the top decile of income is the source for 46 percent of total dividends paid out to family members. Note that this is an understatement of the ultimate tax impact, since the actual tax dollars would be even more skewed than the income shown in this analysis. The tax dollars are more skewed because the tax gain to income splitting is much bigger for higher earners for a given dollar of income since the gap between their tax bracket and the dividend recipient’s bracket is on average larger.

Source: Wolfson and Legree (2015)

Second, let’s look at the taxation of passive portfolios. All working Canadians have access to the Registered Retirement Savings Plan / Registered Pension Plan / Tax-Free Savings Account system. If you’re a small business owner looking to save for retirement, in most circumstances you can do as well and likely better in an RRSP or TFSA than saving inside a private corporation.[5] So, the people for whom a private corporation starts to make sense are those who have more savings than can fit in the regular RRSP/RPP/TFSA system.

Of note, RRSP room for 2017 is $26,010 which covers earnings up to $144,500 if one contributes the maximum of 18 percent of earnings. Moreover, in 2015 23.1 million Canadians had a total of $909 billion in carried-forward RRSP contribution room, meaning they had RRSP space available.[6]

As a final consideration, the special tax rate that applies to passive income inside a corporation is a flat rate set to approximate the top tax bracket outside a corporation. For 2017 in Alberta this special rate is 50.67%. Since it is a flat rate, people in middle or lower tax brackets see an advantage for saving outside a corporation compared to high-bracket investors. This is the current situation.

So, while I am aware of no public data on the distribution of the $26 billion of passive investment income from CCPCs, it would be very surprising if many low or middle earners are currently making use of what is for them an expensive and tax-inefficient location for their savings.

To sum up, it is possible to construct a case that middle earners could bear some financial impact of these reforms. But the evidence and logic is quite clear that the impact of the proposed private corporation tax reform will fall most heavily on higher earners.

The path forward

To put a framework on this analysis, I propose separating policy advice into two piles.

The first pile is the “fantasy tax reform” pile. These are ideas that are outside the current political constraints.

Some examples:

  • We should have a big-bang tax reform (Carter 2.0).
  • We should just get rid of SBD.
  • We should lower top tax rates substantially.
  • We should have the family as the tax unit.

As academics and policy thinkers, it is our job to think outside current political constraints, so I welcome those offering and defending bold ideas of how we can do things differently. This is vital; that is why we sit in our “ivory towers”; to think things people in the hot house of every-day politics don’t dare to think in a particular moment.

The second pile of policy advice is to evaluate what’s on the table now. What is actually possible given current political constraints?

For this kind of policy advice, we need to compare any policy package not against the “fantasy reform” alternative, but against the status quo. Does a reform package improve us compared to doing nothing?

While offering “fantasy policy reform” advice is useful, we can’t hide from analyzing what is on the table now and comparing it not to an ideal, but the status quo.

So let me use this framework to analyze the current policy.

Does this reform meet my own personal fantasy tax reform checklist? Not really. I can see the benefit of a big “Carter 2.0” tax commission that plans our system on a rational basis for the 21st century. I think the existing small business deduction should be replaced with something better targeted at new and growing firms. The Finance package of reforms is clearly a patch on an imperfect and messy existing system.

But to the 2nd question, does this reform improve on the status quo? I think this reforms heads us in the right direction, on both efficiency and equity grounds. To merit full support, I think it is feasible and necessary to expect the Minister of Finance to address the following items when the final package is put together following the consultation period.

  • Administrative burden; e.g. easier accounting for ‘connectedness’ for Mom and Pop shops.
  • Problems with the draft legislation: Lots of examples have been floated that may lead to bad tax outcomes. Are these examples correct? Can they be fixed with better legislation?
  • Solid and feasible plan for transition: can the passive income reform legislation meet the goal without too much complexity?
  • Do more for entrepreneurs and startups. Turn the new revenue around within the small business envelope. If the Minister is serious about encouraging entrepreneurs, show it.

 

 


[1] Ted Mallet (2015), “Policy Forum: Mountains and Molehills—Effects of the Small Business Deduction,” Canadian Tax Journal, Vol. 63, No. 3, pp. 691-704. [link]

[2] The Mirrlees Review in the UK argued that there may be a case for using fiscal tools to help small business, but those tools should be targeted at the source of the market failure rather than a broad-based rate cut. See Claire Crawford and Judith Freedman (2010), “Small Business Taxation,” in Stuart Adam, Tim Besley, Richard Blundell, Stephen Bond, Robert Chote, Malcolm Gammie, Paul Johnson, Gareth Myles, and James M. Poterba (eds.) Dimensions of Tax Design. Oxford: Oxford University Press. [link] Also, the recommendations of the Mirrlees Review can be found in James Mirrlees, Stuart Adam, Tim Besley, Richard Blundell, Stephen Bond, Robert Chote, Malcolm Gammie, Paul Johnson, Gareth Myles, and James M. Poterba (2011), “Small Business Taxation,” Tax by Design. Oxford: Oxford University Press. [link]

[3] Duanjie Chen and Jack Mintz (2011), “Small Business Taxation: Revamping Incentives to Encourage Growth,” School of Public Policy Research Papers, Vol. 4, Issue 7. [link]

[4] Michael Wolfson and Scott Legree (2015), “Policy Forum: Private Companies, Professionals, and Income Splitting—Recent Canadian Experience,” Canadian Tax Journal, Vol. 63, No. 3, pp. 717-738. [link]

[5] I worked out a specific case in calculations available through my UBC blog here. Financial planning expert Jamie Golombek works through some more sophisticated cases here. Of course, individual circumstances vary so universal statements about the tax efficiency of different investment strategies are difficult.

[6] See CANSIM table 111-0040. There were 26.4 million taxfilers in 2015. Some of the 3.3 million (representing 12.4% of the total) without carryforward room were ineligible to contribute (for example someone over age 71), while others had used up all their available room.

Taxation of Private Corporations: An Explainer Compendium

This blog post assembles information I’ve provided to the public on the proposed changes to the taxation of private corporations. The discussion document from the Department of Finance is here. My disclosure is here.

The links below all work right now (Sept 2017), but some of them may go 404 as time passes.

Writing

Why Small Business Taxation Does Need Fixing,” Maclean’s, September 10, 2015.

Will Bill Morneau’s Crackdown on Tax Avoidance Work?” Maclean’s, July 18, 2017.

Taxation of Passive Income in a Private Corporation” Blogpost, Sept 4, 2017.

CCPC Tax Proposals: Some Examples,” Google spreadsheet, Sept 4, 2017.

The Efficiency and Fairness Case for Private Corporation Tax Reform,” Notes prepared for presentation at University of Calgary, Sept 14, 2017.

Radio/TV

Afternoons with Rob Breakenridge,” Calgary NewsTalk 770. Aug 31, 2017

The Early Edition” (At 2h10m40s) CBC Vancouver with Stephen Quinn, Sept 1, 2017.

On the Money with Peter Armstrong,” CBC News Network, Sept 5, 2017.

Twitter Essays

(Click on a link below, then scroll up to top to start reading.)

Impact of reforms on savings“, Sept 17, 2017.

Entrepreneurs and tax reform“, Sept 13, 2017.

The impetus for reform,” Sept 6, 2017.

Incentives for Entrepreneurs,” Sept 5, 2017.

Taxation of passive portfolios,”, Sept 4, 2017 (accompanies the google doc and blogpost)

Savings and the reasons we have corporations,” Aug 30, 2017.

Pensions and CCPCs,” Aug 24, 2017.

Taxation of risk, Domar-Musgrave, and Cream Soda“, Aug 23, 2017.

 

 

 

 

Taxation of Passive Income in a Private Corporation

I will be speaking at two academic conference in the next few weeks on the topic of the proposed changes to the taxation of Canadian-controlled private corporations (CCPCs). In preparation for these conference, I have prepared some spreadsheets to explore how the mechanics of the proposals should work. I have shared these with the public here, and I welcome feedback at kevin.milligan@ubc.ca. My disclosure documents can be found here.

The proposals can be found on the Finance website here:

In this blog post, I explore three scenarios for the taxation of passive portfolios. The reform also changes rules about ‘sprinkling’ income to family members, and converting income into capital gains. I don’t discuss those issues here in this blog post.

The aim of the reform to passive portfolios is to ensure people with portfolios of taxable assets face the same tax rates whether they choose to save inside or outside the firm. We economists call this ‘neutrality’. Neutrality is desirable because it allows people to make decisions based on the business merits, rather than having their decisions distorted by taxation. That’s both efficient and fair. Moreover, the reason societies have corporations is to facilitate productive investment, not to offer tax savings to those with large passive portfolios.

So, I defend as economically sound the aim of the reform to strive for neutrality. But will the reform actually achieve neutrality? One important question is whether the officials at the Department of Finance got the math right. It is this question I address with my spreadsheets and scenarios below. Another important question is whether the legislative/legal/accounting approach taken by Finance is the most effective. I leave that question to others.

Before getting to the scenarios, let me start with the bottom line:

In my view, Finance got the math right with their proposals on the taxation of passive portfolios.

Scenario 1: The (Incorrect) Immaculately-Conceived Principal

The spreadsheet is here.

This scenario compares the taxation of $100 of passive interest income in various tax locations:

  • Personal (taxable)
  • Personal (TFSA)
  • Inside a private corporation in the status quo
  • Inside a private corporation under the proposal

My view is this is the wrong way to approach the question. Why? Because it doesn’t account for how the principal that generated the investment income was taxed. For savings inside a CCPC, the initial principal is taxed very lightly, so those savings get a large ‘head start’ compared to savings outside the CCPC where the principal faces initial heavy taxation. This is apples-vs-oranges.

For this scenario, it’s as though the principal were ‘immaculately conceived’ and its taxation can be ignored. I think this is wrong. Why do I present an incorrect scenario here? Because I’ve seen many analyses from reputable financial planners that use this approach and I wanted to see that I can replicate it and understand it.

In the spreadsheet, I can replicate the claim being made that the effective tax rate on investment income is 73%. But, I contend that the basis for this calculation is wrong–they are assuming the principal is immaculately conceived.

Scenario 2: Start with the taxation of principal

The spreadsheet is here.

This is the correct way to approach the question. It starts with apples-vs-apples. $100 of pre-tax corporate active business income for all cases. I compare the same four cases as Scenario 1, using a high-bracket Ontario investor and a one-year time horizon. The main result is in Row 25. Savings on personal account yield $47.15, and in a TFSA yield $47.90. In the status quo, inside a CCPC the yield after one year is $47.63. Under the proposed reform, RDTOH is removed, so the one-year yield falls to $47.20.

There are several important points here:

  1. The aim of the reform is neutrality for savings inside and outside the firm. The success in meeting this goal can be learned by comparing D25 with J25. They are very close. They are not exactly the same because the dividend tax credits and gross-up rates lead to small discrepancies.
  2. The proposed change under the reform is to no longer allow the RDTOH refund. This leads to the differences between columns H and J. The one-year difference is 43 cents, or 0.43% of the initial $100 in earnings. this strikes me as quite small.
  3. Of note, the TFSA in this example does better than any other savings location. If you had dividends or capital gains income the advantage of the TFSA would shrink. This is important for the following reason: in most cases, it makes much more sense to invest through a TFSA or RRSP than inside a CCPC. Using a private corporation to house a passive portfolio really makes sense if you have exhausted TFSA/RRSP room. It is less clear why it would make sense to anyone with only a smaller amount of savings that could be housed in TFSA or RRSP. (But these scenarios do exist–for example Americans living in Canada face big tax issues with TFSA/RRSPs…..)

Scenario 3: Replication of Finance Table 7 

The spreadsheet is here.

In the Finance discussion document, the key table for the taxation of passive portfolios is Table 7. They go about the calculations in a different way than I did in Scenario 2. It is a very useful check on my calculations to see if I can replicate their Table 7 result, and to see if it matches my Scenario 2 result.

Of note, the Notes to Table 7 state they are based on:

“simplified tax rate assumptions, chosen to remove small discrepancies that can arise due to imperfect integration of federal-provincial tax rates and differences between the top personal income tax rate that applies in each province and current tax rates on corporate passive investment income.”

In English, this just says that the gross up rate (117%) and the tax rate on passive investments (38.67%) are one-size fits all. They adjusted their Table 7 tax rates so that the numbers work ‘perfectly’.

I take a slightly different approach. I just use Ontario. So, I expect that my numbers will differ a bit, but the patterns of where taxes on savings are heaviest should remain the same.

In Scenario 3, I start with a one-year horizon. Of note, I get the exact same results as I did in Scenario 2. This gives me strong confidence I’m getting it right–I got the same answer using two different approaches. The answer is that saving through a CCPC yields a 0.43% per year advantage over savings in an individual taxable account.

Underneath, I do a ten-year investment horizon like in Finance Table 7. I find that saving inside a CCPC currently gives you a 5.11% advantage over a ten-year horizon. Finance Table 7 finds a 4.89% advantage. Under the reform, this advantage drops to 0.53% over ten years. Finance finds a 0.00% difference over ten years. The differences between my numbers and Finance are driven by the fact I use ‘Ontario’ and they use ‘simplified’ tax rates. So, I am very confident I can replicate Finance Table 7.

The lessons here:

  1. I have independently replicated Finance Table 7.
  2. The status quo gives CCPC savers about a 0.43% per year advantage over people saving outside a CCPC.
  3. Over a ten-year horizon, the gain is 5.11% of the initial corporate earnings. Five buck on a hun.
  4. According to p. 12 of the Finance document, there was $26.2B of passive income in 2015, so it doesn’t take much of a rate change to create a sizeable change in tax revenue. BUT, remember that the Finance document says they intend to ‘grandfather’ in existing CCPC savings, so any new tax revenue would only start phasing in through time.

Conclusions

The point of my spreadsheets and this blog post is to present an exploration of the taxation of passive investment income inside CCPCs. I hope this can contribute to public debate. I am interested to hear feedback at kevin.milligan@ubc.ca.

I have confidence in my ability to check on Finance’s math. In my view, Finance got the math right here. I do not have the professional capacity to judge whether Finance has the draft legislation correct. I leave that question to others.

BC 2017 Election Outcomes

UDPATE May 12th: Elections BC has announced a revision to the preliminary count in Coquitlam-Burke Mountain which moves the margin from BC Liberal +170 to +268. This has a pretty big impact on the simulation results because it makes it much harder for the NDP to flip this riding. I’ve updated the text and charts below to reflect this change.

The preliminary counts from the BC election on Tuesday May 9th resulted in an apparent seat count of 43 BC Liberals, 41 NDP, and 3 BC Green MLAs. Because of the tight partisan balance, there is much interest in whether this result will hold up when all the votes are counted–around 10 percent of votes made through absentee ballots have not yet been counted. In this blog post, I first clarify how absentee and other special ballots matter. Following that, I present an analysis of the probability of a change in the outcome tallied on election night. The main finding:  there is a 1 in 4 chance that the 43L-41N-3G seat count from election night will change once all the ballots are counted.

Voting in BC

In BC in 2013, about 70 percent of voters place their vote in their designated voting station. Another 20 percent voted in advance. Both of these categories are counted on election night. However, there are six more categories of voters that provide another 10 percent of votes that are not counted with the preliminary count on election day. The BC Election Act lists all eight different categories of voting, which I produce below along with the 2013 proportions of each category and the relevant section of the Election Act.

  • Section 96 (69.9%): General Voting
  • Section 97 (20.3%): Advance Voting
  • Section 98 (0.8%): Voting at a special voting opportunity
  • Section 99 (4.3%): Voting on election day, but in a different voting area
  • Section 100 (1.81%): Voting on election day, but in a different electoral district
  • Section 101 (0.6%): Absentee in advance
  • Section 104 (2.0%) Voting in District Electoral Officer office
  • Section 106 (0.4%) Voting by mail

The bottom six categories are to be counted between May 22nd and May 24th–two weeks after election day. In 2013, these six categories totaled 9.8% of total votes. Only a small fraction of this is the mail-in ballots. Most of the 9.8% is just people who voted in a polling station different than the one printed on their voting card–perhaps somewhere located more convenient to work, school, or family obligations. For 2017, Elections BC announced that the absentee total is 176,104 ballots.

Impact of Final Vote Count

The preliminary vote count on May 9th led to several close results–four districts with a lead less than 300 votes. (See all results in a google document here.) In both the 2009 and 2013 elections, two results ‘flipped’ between the initial count and the final count. If some districts flip in 2017, the partisan balance of the legislature may change. For this reason, there is strong interest in the likelihood of different seat-count scenarios. Below, I present simulations that aim to inform the public about these likelihoods.

First, let me list the five closest districts, the current lead, and the party currently in first place.

  • Courtenay-Comox: 9 votes, NDP
  • Maple Ridge-Mission: 120 votes, NDP
  • Coquitlam-Burke Mountain: 268 votes, BC Liberal (revised from +170 in initial preliminary count)
  • Richmond-Queensborough: 263 votes, BC Liberal
  • Vancouver-False Creek: 560 votes, BC Liberal

When the final counts are announced, there will be extra votes for all the major parties. If the proportions of the absentee ballots differ from the proportions of the preliminary count, there will be a final count ‘bonus’ for one party or another. Some of the close races listed above will flip if these absentee ballot bonuses are large enough.

We cannot observe the absentee ballot bonuses for 2017 yet. To get a sense of whether the bonuses are likely to be large enough to flip any districts, I turn to the results of 2013. With the 2013 data, I calculate the absentee ballot bonus for each of the BC Liberal and BC NDP candidate for each district. These are measured as the gain in the percent vote share between the preliminary and final votes. So, if the BC Liberal candidate received 40.1% in the preliminary count and 40.4% in the final count, this scores as a +0.3% bonus.

For BC Liberals, here is what these absentee ballot bonuses looked like in the 85 districts in 2013.

  • Mean: -0.36%
  • 10th percentile:  -0.66%
  • 25th percentile: -0.48%
  • 50th percentile: -0.36%
  • 75th percentile:-0.12%
  • 90th percentile:+0.04%

For the BC NDP, here is the same information for the 85 districts in 2013:

  • Mean: +0.23%
  • 10th percentile:  -0.07%
  • 25th percentile: +0.05%
  • 50th percentile: +0.27%
  • 75th percentile:+0.38%
  • 90th percentile:+0.55%

So, there appears to be a systematic lean toward the NDP in the absentee ballot bonus. Why is that? It might result from a more energetic ‘get out the vote’ effort by the NDP. Or, it might result from a different selection of voters who make use of the absentee ballot opportunity. Either is a plausible explanation.

These kinds of absentee ballot bonuses matter. In 2013 for example, Coquitlam-Maillardville swung from +111 for the BC Liberals in the preliminary count to +41 for the NDP in the final count. This was a swing of 152 votes (or 0.70% of the final total vote count). So, the kind of swings necessary to move some 2017 districts are not impossible.

Here’s how I proceed to examine the sensitivity of the 2017 preliminary results to the absentee ballot bonuses.

  • For each close district in 2017, I take the BC Liberal and NDP vote share. No seats involving the BC Greens are close enough to matter.
  • I then assign an absentee ballot bonus to both of these parties in that 2017 district, drawn randomly from the set of 85 districts in 2013. Both the BC NDP and BC Liberal bonus is taken from the same 2013 district for each draw.
  • This is repeated across all 5 close districts for 2017.
  • I add the BC Liberal bonus to the BC Liberal initial vote share, and the same for the NDP.
  • I then see if the result flips and add up the final seat count for each party.
  • Repeat this 1 million times, record the results.

What can go wrong with this method?

  • The 2017 distribution of absentee ballot bonuses may be different than 2013.
  • The particular districts in play in 2017 may have idiosyncrasies not incorporated into the simulation. For example, Courtenay-Comox has a military base and the BC Liberal candidate served on that base. This kind of special situation is not incorporated into the simulation, since the simulation assigns a ‘generic’ absentee ballot bonus to each party.
  • The absentee ballot bonus may be correlated across districts. The simulation described above assumes that each 2017 district gets an independent draw from the 2013 distribution of bonuses. Instead, it is possible that there may be a province-wide swing in favour of one party or another. That is, a correlated bonus. I account for this by presenting an alternative simulation that draws one bonus from the 2013 distribution and applies that one bonus to all the 2017 districts. This can be considered a polar case of perfect correlation to be compared to the uncorrelated case presented first.

Here are the results. First, for the uncorrelated case in which each 2017 district gets an independent draw from the 2013 absentee ballot bonuses.

BC 2017 Election Simulations, Uncorrelated Case

Next, here is the correlated case, in which each 2017 district gets the same draw from the 2013 absentee ballot bonuses.

BC 2017 Election Simulations, Correlated Case

For the uncorrelated case, there is a 75.4% chance that the result remains unchanged at 43-41 for the BC Liberals over the NDP. About 97 percent of these are cases when no districts flipped; 3 percent are cases when the NDP gains canceled out the BC Liberal gains. So, by far the most likely outcome is no change.

However, there is still a 24.6% chance that something will change. in 11.6% of the cases, the new result is a BC Liberal majority with 44 seats.  About 85 percent of these are times when Courtenay-Comox flips; 15 percent are times when Maple-Ridge Mission flips. There is also a small chance that the BC Liberals can take both Courtenay-Comox and Maple-Ridge Mission to form a slightly-more solid majority at 45-39.

Given that the NDP lead in Courtenay-Comox is only 9 votes, why is it so rare that the BC Liberals flip it? The answer is that in 2013 it was quite rare for the BC Liberals to increase their vote share with their absentee ballot bonus. Only 11 of 85 seats in 2013 saw the BC Liberal vote share grow between the preliminary and final counts. So, a 9 vote lead may be small, but the BC Liberals rarely make any gains so it may just be too much to overcome.

On the NDP side, there is a 12.3% chance that they gain a seat. This would lead to a 42-42 tie with the BC Liberals.  The most likely candidate is Coquitlam-Burke Mountain, where the current deficit is now 268 votes. There is about a 9 percent chance this flips to the NDP. While it would be more of a stretch, there is still about a 6 percent chance the NDP could make up the 263 vote margin in Richmond-Queensborough. There is a very small chance that the NDP swings both seats to take a 43-41 lead.  In the uncorrelated case, this probability is 0.5%, but in the correlated case this probability rises to 5.9%. This bigger chance in the correlated case happens because if the NDP happens to get a lucky draw, that lucky draw swings all their ridings. In contrast, with the uncorrelated case they need two lucky draws at the same time to swing two seats at the same time.

It is very unlikely that the NDP can attain the 44 seats necessary to reach majority status. To do so, they’d need to flip Vancouver-False Creek where they face a 560 vote (2.6%) deficit. There is no precedent from 2013 for a swing this big for the NDP. However, it is not impossible–the NDP could conceivably generate a swing larger than any they enjoyed in 2013. While not impossible, I judge this very unlikely. So, the ceiling for the BC NDP is almost surely 43 seats.

Conclusion

This blog post aims to provide a sense of the potential volatility of the final results in the 2017 BC election. Because around 10 percent of ballots are yet to be counted, up to four electoral districts may flip from one party to another when the final count is announced between May 22nd and May 24th. While the most likely scenario is no change to the status quo 43-41-3 seat count, there is about a 25 percent chance that the seat count will change.

Whatever scenario is presented to us with the Final Count at the end of May, the new legislature will be volatile. See David Moscrop in Maclean’s or Jason Markusoff (also in Maclean’s) for informative discussions of the various scenarios and how they might work.

Prepared Comments for C.D. Howe Meeting, May 2017

Prepared Comments for C.D. Howe Panel on US Tax Reform

C.D. Howe Institute Fiscal and Tax Competitiveness Policy Council

May 3, 2017

Toronto, Ontario

Thanks for inviting me to speak.

I’m going to offer some brief comments on US tax reform in three parts: a Premise, a Model, and some Implications.

Premise

In my reading of the legislative situation in the US, the most likely scenario in the US is a temporary (3-5 year) CIT rate cut. I say temporary for 5 reasons:

  1. I don’t think permanent structural reform is likely.
  2. A deficit-financed tax cut won’t get 60 votes in the Senate, so will be capped at 10 years
  3. Rate cuts are easy to reverse; no big inter-industry lobbying and squabbling. It can just happen.
  4. Democrats may be in power again before we get too deep into 2020s.
  5. US federal long-run finances may force even the GOP to raise taxes in 2020s.

I don’t claim to have a legislative crystal ball, so if you think another scenario is more likely then you are free to do so. But for my comments here I will think through the implications of a temporary rate cut in the US.

The Model

The model I have in mind is one where firms make long-run investment decisions based on the long-run after-tax cost of capital. The temporary tax cut can be analyzed using the model of Jack Mintz (World Bank Economic Review 1990) on corporate tax holidays.

Mintz showed that when a firm receives a tax holiday, the impact on long-run investment depends critically on the timing of the realization of income and depreciation/interest deductions. Under a tax holiday, deductions are much more valuable later on when taxes go back up, while income is better when realized early during the holiday period.

Implications

I see 5 implications of the tax holiday model for the US temporary tax cut scenario.

  1. Impact on long-run investment depends on magnitude and expected duration of any tax cut. Small and short? Deep and extended?
  2. Less investment in assets with accelerated depreciation; more in ones with deferred depreciation. In the holiday model, firms want income now and deductions later. (IP? LBOs of firms in mature industries? Other examples?)
  3. Repatriation of accumulated US overseas retained earnings during holiday period–not quite a full tax amnesty, but will have an impact. Can mean temporary positive revenue effects for US Treasury.
  4. If US tax disadvantage shrinks, less investment in new income-shifting/BEPS transactions and infrastructure. But remember BEPS activity is to some extent a knife’s edge thing: existing tax infrastructure (eg Burger King HQ in Mississauga) would only reverse if US gets its rates below those in other countries.
  5. Canada’s concern in matching any US policy action should be proportional to the expected depth and duration of the tax holiday because of long-run investment, and our concern should rise disproportionately if the US gets its statutory combined (fed+prov/state) rate beneath Canada’s because of BEPS.

Assignment to Finance Canada

From September 1, 2016 to December 31, 2016 I will spend 80 percent of my time working for Finance Canada under an Interchange Agreement.  This is similar to a ‘secondment‘; Finance Canada is paying UBC an amount equal to 80 percent of my regular UBC salary for those four months.

My work during those four months will consist of some special research projects directed by Finance, regular consultations with Finance staff, and meetings of the full panel of experts advising the Finance review of federal tax expenditures.  This work will mostly take place in Vancouver, with some trips to Ottawa.

My UBC work during this time will consist of some continuing administrative duties, advising of graduate students, and other academic activities.

During the course of this agreement, I am contractually committed to refraining from making “through any public medium, either directly or through a third party, any statement critical of Finance Canada or government policies, programs, or officials, or on matters of current political controversy where the statements or actions might create a conflict with the duties of his position or Finance Canada’s and the Government of Canada’s programs and policies.” So, I will be limiting my contact with the public and the media (including my Twitter account) during this period.

I will return to full-time UBC work on January 1st, 2017.

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