Kevin Milligan

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

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

Notes prepared for Canada 2020 event

April 10, 2018
Ottawa, ON

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

What changed

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

• The headline federal corporate tax rate was cut from 35% to 21%. When combined with state tax rates, this brings the US down to Canadian corporate tax levels. It depends what industry and state you look at, but they are within a point or two. This removed—but did not substantially reverse—Canada’s corporate tax advantage.

• They created a so-called ‘pass through’ regime which gives a very strong tax incentive for many professionals to set up a special type of corporation to avoid taxes. Sounds familiar to us here in Canada, and we know how hard it is to reverse such tax avoidance structures.

• Allowed some full expensing of corporate investment for the first five years of the reform period. Also cut back on allowable interest expense deduction. This is a move toward what economists call ‘cash flow’ taxation, which in its pure form completely removes interest deductibility and drawn-out CCA schedules.

• Personal income tax cuts which lowered the top federal rate to 37% and capped some tax expenditures (such as state and local deductibility and the mortgage interest deduction)

Does it matter?

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

• Corporate revenue: Between 2000 and 2015, Canada cut its main corporate tax rate nearly in half, but the tax revenue stayed constant as a share of GDP. This is remarkable. One factor contributing to this was shifting of corporate income into Canada from the United States—think of the corporate inversion that led to Burger King setting their headquarters in Mississauga a few years ago.. That’s been nice while it lasted, but that’s now over—there is no gain to shifting corporate income to Canada any more.

• Corporate investment. With effective rates fairly close to those in the US, Canada no longer has a corporate tax advantage. Corporate investment decisions depend on a lot of things—workforce, resources, stable governments and legal systems. But investment also depends on taxes, so it’s reasonable to expect some measure of real investment shifting to the US—although I think some of the talk of a “tsunami” of corporate investment leaving Canada is overblown.

• Personal mobility. The personal tax cuts now available in the US have led some to suggest that rich Canadians will move abroad. I’m sure some will. But taxes aren’t the only thing that matters for deciding where to live, and for every anecdote you hear about a rich Canadian who has decided he’s rather live in Trump’s America I can find you an anecdote of a young and talented immigrant who has chosen to move to Canada. We have seen this on the ground in our graduate students at the Vancouver School of Economics. On net, I don’t find this risk to be worth a policy response.

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

Is the US tax reform sustainable?

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

• It is not fiscally sustainable. The US deficit in 2019 is projected to be 5.6%. Even in a booming economy, this is an unsustainable fiscal situation. For Canada to match the US tax cuts, we’d have to plunge ourselves into deficit. Many people already seem concerned about our current tiny federal deficits, but I don’t think it would make our public finances better to do a deficit-financed corporate tax cut.

• It is not politically sustainable. Unlike the Tax Reform Act of 1986, the 2017 tax bill was mostly a party-line vote in the US Congress—no Democrats voted for it in either House or Senate. If we see a Democratic White House and Congress in 2020, my political prediction is that the first place it would go to raise money to fund its new priorities would be to reverse the corporate tax cuts. That’s just my political guess; so yours may be different. But I think I’m on pretty solid ground to wonder what this all looks like after 2020.

If Canada acts what should we do?

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

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

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

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

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

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