Kevin Milligan

Notes for talk to Rotary Business Luncheon
March 13, 2018
Kevin Milligan, UBC Vancouver School of Economics
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With the big US tax reform now law, many are wondering what Canada should do in response. Minister Morneau has taken a cautious approach so far. I think that’s appropriate. But do think there is a strong case for action.  And I will soon tell you why I think that. But first, let’s review what has happened in the US and the likely impacts.

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

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

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

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

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

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

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

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

Two final notes assessing the US position.

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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

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