If you disliked the sight of your majority government bending the knee for the small-business lobby this autumn, you’d best start reading up on tax policy so you can offer better support in 2018, when the more consequential fight begins.
The Republican majority in Washington is on track to complete a tax overhaul that could one day result in financial ruin. That day won’t arrive before Christmas, however, so President Donald Trump at some point before then will throw himself a pseudo-event, at which he will add to his impressive collection of lies and exaggerations while boasting about his “historic” achievement. So be it; the Tax Cut and Jobs Act will be the first significant piece of legislation that Trump signs into law. Many will call it a victory, although I’m not sure that’s the right word for a policy that has the support of only a third of the population.
But as Andrew Coyne wrote over the weekend, there is little reason for a Canadian to get bogged down by any of this. What matters for Canada, for now, is whether the Republican tax cuts undermine Canada’s ability to compete for global investment and talent, both of which we desperately need if we are to offset the effects of weaker oil prices and an aging population. The short answer to that competitiveness question is, probably. A longer answer follows, but it can be summed up in this way: yes, but maybe not as much as Canadian advocates for tax changes are bound to say it will.
Cast your minds back to the start of this year, when it looked like Trump, Senate Majority Leader Mitch McConnell, and House Speaker Paul Ryan would undo Barack Obama’s legacy and pass a massive tax cut before the cherry trees bloomed in Washington. There was a feeling in Canada that the Republican agenda might help our economy by generating a spending spree that would create demand for exports. The Bank of Canada guessed a tax cut of the size Republicans were contemplating would provide a substantial boost to economic growth. But the governor, Stephen Poloz, warned against assuming Canada could only benefit. Lower taxes would encourage some spending, but they could also put Canada at a competitive disadvantage by causing executives to change their minds about where to invest, the central bank said at the time.
Assuming Republican unity holds for a few more days, the U.S. federal rate on corporate income will be 21 per cent in 2019, down from 35 per cent currently. That change isn’t as big as it looks on paper; very few American companies actually pay the highest rate on their income, because various credits, deductions and dodges allow the average American firm to keep its effective rate closer to 22 per cent, according to Kent Smetters, a tax expert at the University of Pennsylvania’s Wharton School who runs a highly regarded U.S. budget model.
So be wary of statements about Trump’s business tax cuts that rely on the big change in the statutory corporate rate. A proper competitiveness analysis must be done on an industry-by-industry basis, and then we need only concern ourselves with the areas where Canadians and Americans compete for business.
Consider Lear Corp., a big maker of automotive parts based in Michigan. Lear’s effective tax rate was about 25 per cent in the third quarter, not so different from that of Canadian parts makers such as Magna Corp. and Linamar Corp., which paid effective rates of about 24 per cent and 23 per cent, respectively, in the same period. The lower statutory rate in the U.S. probably isn’t enough on its own to cause a dramatic reordering of the North American economy as we know it today. For example, there is no obvious reason for Restaurant Brands International—the owner of Burger King, Tim Hortons and Popeyes Louisiana Kitchen—to leave Oakville, Ont., where it pays an effective tax rate of around 19 per cent, for the U.S., where it would have to deploy some aggressive accounting to do better than it is doing now. The U.S. is catching up to Canada in terms of corporate tax competitiveness, not overtaking it.
To be sure, if this summer’s brouhaha over taxes taught the Turbo-Tax filers anything, it’s the lengths to which a critical mass of entrepreneurs and richer professionals are willing to go to protect their wealth from the Canada Revenue Agency.
Entrepreneurs who lead smaller companies in Canada would have to get creative to do better south of the border. While supine this summer, Prime Minister Justin Trudeau and Finance Minister Bill Morneau said they would cut Canada’s already low small-business tax rate to 10 per cent next year, and then all the way down to nine per cent in 2019. The U.S. doesn’t have such a rate, per se; American business owners either incorporate, or they set up their enterprises in a such a way that their income is taxed at personal rates. The small-business lobby has pull in Washington, too, and the Republicans included a provision that will allow unincorporated owners to deduct 20 per cent of business income, which would work out to a top rate for owners of so-called “pass-through” companies of about 30 per cent, according to the Wall Street Journal.
But now that we are talking about personal rates, we must acknowledge that Canadian governments demand considerably bigger contributions to live on their turfs than do their American counterparts. An individual in the U.S. will pay the Internal Revenue Service 35 per cent on income above $200,000 per year, and 37 per cent on income above $500,000, compared with a federal rate of 33 per cent on income in excess of about $200,000 in Canada. Of course, provinces tend to tax more aggressively than U.S. states, and the top marginal rates in Nova Scotia, Ontario, and Quebec are above 50 per cent.
This is an issue, although it’s unclear modern workers decide where to live based solely on tax rates. Indeed, a Texas-based company that runs a web-based job-search platform, noticed a spike in searches for Canadian tech jobs around the time of the 2016 U.S. election and again around inauguration day, suggesting Trump and his policies could be a boon for non-American recruiters. Setting that aside, Canadian governments should be striving to lower individual tax rates to support an economy that is becoming increasingly reliant on consumption, preferably by reversing sops of the sort smaller companies got from Trudeau and Morneau this fall. Household spending represents about 58 per cent of Canada’s gross domestic product, the most on records dating back to 1961.
Let’s get back to business taxes. While the lower rates on business income are no big deal on their own, they do set up the U.S. as an attractive place to invest when combined with various other business incentives. The most important one is a new measure that will allow businesses to deduct all of an investment in machinery and equipment immediately, rather than over a number of years. The provision is scheduled to expire after 2022, but it could be enough to sway investment decisions at a moment when Canada needs just that sort of contribution to GDP to take the pressure off debt-burdened households. “The world is moving to reduce corporate taxation—Canada is moving in the other direction,” Jack Mintz, the Palmer Chair in Public Policy at the University of Calgary, wrote with a colleague in November when it was becoming clear that Trump would get his tax cuts. “Canada will lose investment as a result. Canadian policy makers need to prepare now for what could be a significant challenge to Canadian competitiveness. Money can move very easily across the U.S./Canadian border.”
Mintz is one of those fiscal-policy experts who has rarely seen a tax that he or she wouldn’t cut; he also ranks among the best in his field, and he is probably correct in this case. Trump may never approve another bill. His approach to governing has alienated so many Americans that the Democratic Party could take control of the House and the Senate in next year’s midterm elections, which would bring the sort of legislative paralysis that characterized most of Barack Obama’s presidency. But by then, Trump will have cemented conditions that will make bypassing the U.S. difficult for any company that wants to sell goods and services to American consumers. A system of carrots (competitive business taxes, deregulation) and sticks (punitive import tariffs and general confusion about the future of U.S. trade agreements) will give the U.S. a considerable economic advantage for at least the foreseeable few years.
Canada needn’t overreact to these circumstances, but it probably should respond with something to keep the playing field from tilting too much to the U.S.’s advantage. Avery Shenfeld, chief economist at CIBC Capital Markets, suggested last week that the Trudeau government and the provinces match the immediate deduction on business investment. That’s a good idea: if you want more of something, tax it less. If Trump prompts such a policy, or other good ideas like it, maybe his presidency won’t be a total disaster for Canada.
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