A tale of two tax cuts

Stephen Gordon explains why it's pointless to talk about raising corporate income taxes

Stephen Harper’s government has implemented two major tax cuts: the reduction of the GST rate from 7 per cent to 5 per cent, and the reduction of the corporate income tax (CIT) rate from 21 per cent (plus surtax where applicable) to 15 per cent (with no surtax). The reduction in the CIT rate was the continuation of a trend that had begun under the Chrétien-Martin years.

I—and Macleans’ Paul  Wells (among others)—have pointed out several times that these tax cuts have reduced federal tax revenues as a share of GDP to levels lower than they’ve been in at least 50 years. So far, the only tax cut that anyone has talked about reversing is the one to the CIT. Both the NDP and the Liberals promised to increase corporate taxes in 2011, and it seems likely that the NDP will do so again in the next campaign. Neither party has showed much interest in reversing the GST cut.

The politics of talking about corporate taxes are obviously attractive—corporations don’t vote. But it turns out that there’s little reason to think that increasing corporate tax rates will generate significant new revenues. The raw correlation between CIT rates and CIT revenues as a share of GDP is essentially zero, if not slightly negative.

The chart to the right (click on the image for a larger version in a new window) traces the evolution of federal CIT rates (the horizontal axis) and CIT revenues as a share of GDP (the vertical axis) since 1981. Even though federal corporate tax rates are less than half what they were 30 years ago, there is no discernible downward trend in corporate tax revenues. (Data sources are the Fiscal Reference Tables and the OECD Tax Database.)

As I noted earlier, firms can and will react to higher corporate tax rates by reporting lower corporate incomes by shifting revenue to other jurisdictions or by simply cutting back on investment and output in Canada. I worked through the implications of a simple model based on estimates from this study by Bev Dahlby and Ergete Ferede in a recent WCI post. One of the cases considered was increasing the statutory CIT rate to 21 per cent, the level it had been when the Conservatives came to power:


Revenue changes: Increase federal CIT rate from 15% to 21%
Year Base case Weak response Strong response Static case
Fed Prov Fed Prov Fed Prov Fed Prov
1 $9.4b -$2.5b $10.4b -$1.9b $8.4b -$3.0b $14.0b 0
2 $6.8b -$3.8b $8.6b -$2.8b $4.9b -$4.8b $14.0b 0
3 $5.3b -$4.6b $7.7b -$3.3b $2.7b -$6.0b $14.0b 0
4 $4.4b -$5.1b $7.3b -$3.6b $1.2b -$6.8b $14.0b 0
4-year sum $25.9b -$15.9b $34.0b -$11.6b $17.1b -$20.6b $56.0b 0
Long term $3.2b -$5.7b $6.8b -$3.8b -$1.8b -$8.3b $14.0b 0


The base case scenario use the main Dahlby-Ferede estimates, which include dynamic effects: firms adjust over time to the new tax rates. Annual revenues in the long term are one-third of what they were in the first year, and less than a quarter of what static analysis (that is, assuming no behavioural response) predicts. As Kevin Milligan put it on Twitter:

Another thing to consider is the effect on provincial revenues: the federal and provincial CIT rates are applied to a common corporate income tax base. Even if provincial rates stay the same, an increase in the federal rate will shrink the tax base and reduce provincial CIT revenues. Four years after the increase, lost provincial revenues will more than offset any gains at the federal level.

If your goal is to increase revenues, hiking corporate taxes is probably the worst available choice (see also here): significant reductions in investment and wages in return for little in the way of new revenue. There are some efforts being made at the international level to coordinate efforts to make it harder for firms to shift income for tax purposes, and these are worth pursuing. But this is a long-term project, and not likely to bear fruit soon.

The GST cut is (so far) the Harper government’s signature legacy for future governments. Here is what happened to GST revenues during the Harper years (data source is the Fiscal Reference Tables):

[Vertical scale is the same as in the other chart]

There are many reasons why economists sing the praises of the GST, and one of them is that it generates a steady stream of revenues. As a share of GDP, GST revenues are now running about 0.65 per cent below what they were before the Conservatives took power in the neighbourhood of $12b per year.

A political party that wants to reverse the course that the Conservative government has established for the path of federal revenues won’t be able to do it by reversing the cuts to corporate income taxes. As long as the GST cut remains unchallenged, Harper’s fiscal legacy looks secure.