Corporate tax cuts have been central to the Harper government's economic agenda. The result has been a huge loss of public revenues for negligible economic gain, suggesting that we need a major policy rethink.
The general federal corporate income tax (CIT) rate has been cut by one third from 22.1% in 2006 to 15% today. According to the Parliamentary Budget Office, the annual cost is $12 billion of reduced tax revenues. The CIT now contributes just 13.4% of all federal revenues, down from 17.2% in 2007-08. Corporate tax cuts during a time of deficits have been paid for through cuts to public services and an increase in public debt.
The case for a much lower CIT rate was that higher after tax profits would boost business investment. But that has turned out to be a mirage.
Investment in machinery and equipment and in intellectual property combined is below the 2006 level in real dollar terms, and has fallen from 7.2% to 6.2% of GDP. Sluggish investment is recognized by the Bank of Canada, the IMF and the OECD to be one of Canada's key economic problems, but tax cuts have had little or no impact. The main reason for weak business investment despite generally strong corporate profits and healthy balance sheets lies on the demand side of the economy. Businesses will invest only if they see a healthy and growing market. Economic theory and evidence shows that cutting the CIT rate is a costly and not very effective way to stimulate new investment. At any given time, the corporate tax rate applies to profits from all previous rounds of investment, so rate cuts deliver windfall gains to businesses on their old investments. Further, a cut in the tax rate is irrelevant to companies earning so-called rents or above average profits. During the resource boom, companies would have invested in the tar sands and new mines even if the CIT rate had been higher. The financial sector is also highly profitable. Tax expert Robin Boadway, Professor Emeritus of economics at Queen's University, notes that, "to the extent that corporate taxable income constitutes rents, the need to maintain internationally competitive rates of return on capital is unaffected." And a lot of business investment would not leave for other countries simply due to a somewhat higher corporate tax rate. Canadian banks, utilities, airlines, railways, retailers and cultural industries among others all have to operate mainly in Canada to serve the Canadian market and could not just up and pull stakes to the US or elsewhere.
Another important factor is that Canada's combined federal-provincial corporate tax rate is now 26%, far lower than the 39% rate in the United States. CIT rates have been cut far more than was needed to give Canadian companies a competitive advantage over our closest trading partner. One result of corporate tax cuts has been a windfall gain for the US government since US companies operating in Canada get to deduct Canadian tax from their US taxes. Even former Bank of Canada governor David Dodge have questioned the wisdom of cutting corporate tax rates to well below US rates.
When it comes to a proposed new investment that could be undertaken in Canada or in a rival jurisdiction, a company will indeed take the tax rate into account. But other tools are available to attract that investment to Canada. It is already the case that manufacturers are taxed at less than the statutory CIT rate, there are generous tax credits available for scientific research and development, and accelerated two year write-offs are in place for investment in new machinery and equipment. These targeted tax incentives are a much more effective and cost efficient means of boosting new investment than across the board cuts to the CIT rate Department of Finance research shows that an increase in capital cost allowances for new investment boosts the economy by $1.35 per $1 spent, almost four times the $0.37 gain for a $1 reduction in the corporate tax rate.
A reasonable approach would be to modestly increase the corporate income tax rate, while redirecting a significant part of the new revenues to more targeted tax and spending measures which directly support new business investment. This approach is already being taken by British Columbia, Alberta and Ontario which have recently hiked or cancelled cuts to corporate tax rates. The key point is that across the board corporate tax cuts are a costly and inefficient way to boost business investment compared to the alternatives.
Andrew Jackson is Adjunct Research Professor in the Institute of Political Economy at Carleton University and senior policy advisor to the Broadbent Institute.
This column first appeared in the Globe and Mail's Economy Lab.