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

by Kevin Milligan

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!