Kevin Milligan

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. https://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