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How to stop the rich from dodging higher taxes

Federal Finance Minister Bill Morneau has the power to change the tax system to make it harder for high earners to avoid taxes, but it’s going to take political will


 
Minister of Finance Bill Morneau speaks to media as he delivers a fiscal update during a news conference in Ottawa, On Friday, Nov. 20, 2015. THE CANADIAN PRESS/Adrian Wyld

THE CANADIAN PRESS/Adrian Wyld

Finance Minister Bill Morneau will soon be implementing a new tax bracket that hits earners in the top one per cent with higher tax rates. Right now the highest federal rate is 29 per cent, but the Liberals promised to create a new bracket starting at $200,000 with a rate of 33 per cent, a boost of four points. Mr. Morneau faces a challenge with this tax policy. High earners have access to Canada’s best advice on how to avoid higher tax bills, and some might seek out such advice rather than just cut the CRA a bigger cheque.

How can high earners lower their tax bills? It’s likely not through working less—many in the top one per cent are high-earning executives driven more by peer competition than by finger-counting how many fewer hours they would work if their tax rate goes up a few points. Instead, most economists suspect that legal tax avoidance techniques shifting income off the personal tax form are the main vehicle of tax response to higher rates. This could be accomplished by shifting income to lightly taxed foreign locations, to a corporation, or to a lower-tax province. As one example, if you put some stocks and bonds in a trust, dividends and interest coming from those assets will be taxed wherever that trust is resident—which might not be the original taxpayer’s home jurisdiction.

A new estimate from Alexandre Laurin of the C.D. Howe Institute suggests that the high income tax bracket might bring in only $1 billion in revenue, instead of the $2.8 billion the Liberals were expecting in their platform. In part, Laurin’s calculations are built on estimates from a paper I wrote with Michael Smart, soon to be published in the Canadian Journal of Economics based on provincial tax changes from 1988 to 2011.

When applying those kinds of estimates to a federal tax change in 2016, you need to ask if anything is now different. I do think the circumstances are different, in three ways. First, federal tax changes will catch high earners in any province, so evidence based on interprovincial tax shifting will overstate the responsiveness of taxpayers to a federal change. In addition, recent court rulings on trust residency have made it harder to establish a trust outside your home jurisdiction. Finally, the federal government has already put some effort into closing some tax loopholes, with the 2015 budget providing more resources to fight aggressive tax avoidance.

Laurin’s calculations do provide a useful benchmark, but in my view we likely need to update the estimates of tax responsiveness downward to account for these factors. Issues like interprovincial shifting and changes in the interpretation of residency are substantial, and could reasonably cut the revenue leakage estimates in half. But, even then a large amount of revenue leakage will remain, potentially imperiling the success of the high-income tax rate.

Are there any steps Finance Minister Morneau can take to improve the odds that the high-income tax bracket will succeed?

Fortunately for Mr. Morneau, he can do something the number-crunching economists can’t—change the game. Economists have focused narrowly on the question of how high earners might respond in the context of our current tax system. Instead of fretting about these estimates, Mr. Morneau can start with a better question: how can we change the tax system to make it harder for high earners to avoid taxes in the first place?

Several options are available to diminish the ability of high earners to avoid higher taxes:

  • Executive compensation (such as stock options) should be changed so that all compensation is treated the same by the tax system.
  • The rules for small business corporations can be changed to limit the ability of high earners to use them as a tax shelter.
  • Further restrictions on the residency of trusts to limit interprovincial and international shifting.
  • Ensuring overseas income is properly reported on Canadian tax returns.
  • Adding additional resources for the Canada Revenue Agency to police the existing tax rules more effectively.
  • Study and remove tax expenditures that unduly favour high earners.

Action on some of these items is constrained by jurisdictional considerations—Canada can’t change trust law in the Cayman Islands or multilateral negotiations on tax havens. Other action is constrained by court rulings and interpretations that must be respected.

However, the largest constraint is simple political will. For example, changing how small business corporations are taxed will raise the ire of powerful lobby groups like the Canadian Federation for Independent Business, as well as influential constituencies like doctors and dentists. There are no legal or jurisdictional barriers there—just political will.

Without further action to tighten the tax system, large revenue shortfalls from the high-income tax bracket are possible. But, that fate can be avoided with a serious push both on the policy and political fronts. As this debate continues, I hope some of the focus can shift to suggestions of how tax avoidance opportunities can be curtailed rather than passively assuming that nothing can or should be done.


 

How to stop the rich from dodging higher taxes

  1. Before taking these kinds of steps, the first question that needs to be asked is “Should we be doing this?”, followed by another series of questions.
    Does the government really need more money? The correct answer is no. Pressure on government finances does not stem from demand from the “customer” side, but from internal demands for more money. In spite of the fact that virtually everything that the private sector supplies or does is actually cheaper now than in the past, costs of government keep going up simply because it’s easier to attack the taxpayer than to defend the taxpayer from uncontrolled increases in the costs of government.
    Can we guarantee that the new money will be spent wisely? No. Better access to money invariably leads to more opportunities for fraud, waste, and of course corruption. Plus, more money always- ALWAYS- leads to increased demands from the public workforce for more of that money to go home with them through either larger workforces or larger paycheques and usually both.
    If the new money doesn’t solve the fiscal problem that it is meant to address, will we take steps to address the uncontrolled growth in costs of government, including pay and job cuts? This is a trick question. If the answer is “No”, then the government should not be granted better access to money. If the answer is “Yes”, then the obvious step is to make the cuts now and see if that doesn’t address the problem without resorting to increased intrusion and confiscation of privately held resources.
    Who does that money belong to in the first place? It belongs to those who earn it, thus simply coveting that which belongs to others does not grant you the moral license to confiscate it from them. Demonizing the people who already pay the bulk of the taxes levied does not necessarily recuse from them the right to keep and use resources that they have earned as they see fit.
    Governments have too long assumed that their confiscatory powers grant them a great deal of social license, that the ability to simply take from others what they claim to “need” somehow removes from them the necessity to control their own confiscatory impulses or those same impulses within the halls of government.
    It’s also a failure of the schools of economics to grasp a fundamental fact that excuses and even drives this mentality. Any person with an average IQ and a basic understanding of the world can tell you that governments are the main driving forces of inflation. yet, economists routinely blather that the increased costs of government are often a product of inflation, thus underscoring the supposed need for tax rates to go up and for government budgets to grow at a rate that outstrips inflation and population growth. When we measure government revenues and spending as part of GDP, we are making a fallacy of supposedly learned study. Government is wholly parasitical in nature. All the governments in Canada, or anywhere, contribute zero to GDP, yet the inputs and outputs are measured and added into GDP figures. It’s full bore nonsense. It’s no different than measuring the power output of a gasoline engine, then measuring the maximum electrical output of the alternator and adding that number to the output as well. A university grad that can’t grasp this, should never have gone to university ion the first place, let alone been granted a degree in the pseudo-science of economics.
    Governments do not need more money, nor do they need to enact ever more draconian regulations meant to prevent the increased confiscation of resources that do not belong to them in the first place. What all levels of government need to do is begin the hard task of cutting expenditures. Government employees need to be given a choice, obviously. If pay cuts or job cuts are necessary in order to shrink governments down to levels that are affordable without the need to enact more rapacious tax legislation, then they should be given a choice- cuts to pay or cuts to jobs, and then move on. Those who choose to try and take job action will be given another choice, that of looking for a new job.

  2. [ ]
    “Executive compensation (such as stock options) should be changed so that all compensation is treated the same by the tax system.”

    This totally fails to take into account that employee stock options are routinely used by hi-tech startups to incentivize regular, non-executive employees (e.g., even the receptionist will typically get some options). This incentivization is needed because working at a hi-tech startup entails long hours with pretty much zero job security. Employees accept these conditions in the hope that there will be a big payoff at IPO time. If the rules are changed such that stock option gains are taxed as regular income, then in one fell swoop the value of options is cut in half (as the tax on their gain has doubled). This will have a negative effect on a startup’s ability to hire employees, and thus a negative effect on startups themselves. As such, any changes to how employee stock options are taxed should be limited to public companies so as to not affect the viability of startups.

    • Thanks for your comment. Actually, I don’t “totally” fail to take that into account. In fact, the opposite. I specifically targeted executive stock options in my suggestions. The reason I targeted executive stock options is precisely what you mention–there is a case (although perhaps not as strong as you might wish) for different treatment for non-executive stock options. Fortunately, there are ways to target high-earner use of stock options that don’t affect non top-earners.

  3. “There are no legal or jurisdictional barriers (to hiking the small business tax rate) —just political will.”

    Well, there’s also the “a buck is a buck” principle that would be tossed out the window if small business rates were hiked so that the combined corporate/personal rate exceeded the rate on income earned personally. Pretty easy to legally avoid that, such that you’d be lucky to realize even a modest increase in corporate tax revenues, but would still allow Trudeau a talking point about soaking the rich that will further endear him to those he holds enthrall.

    • Thanks for your comment. However, you have’t quoted me properly:

      “There are no legal or jurisdictional barriers (to hiking the small business tax rate) —just political will.”

      The part in the brackets is not something I wrote. I wrote “changing how small business corporations are taxed”. I don’t have in mind a change in the small business tax rate. There are other measures available that will make it harder for top earners to use small biz as a tax shield–without at all affecting actual small businesses. These measures don’t involve the rate.

      • I bracketed those words to ensure it was clear they weren’t yours. I did think it was implicit that what you meant by “changing how small business corporations are taxed” was hiking the small business rate. Frankly, I don’t know what other change could be made that would maintain the integrity of the tax system but still result in increase corporate tax from small business, other than to deny small business deductions that would still be available to everyone else.

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