The Best and Worst Tax Measures of Budget 2015

The 2015 federal budget is intended to be "a balanced budget, low tax plan for jobs, growth and security."  

US experience shows that low taxes are no guarantee of jobs and growth. In fact, a recent study by the IMF found equality matters more for growth than low taxes. I quote: "lower net inequality is robustly correlated with faster and more durable growth."

There is nothing inherently good about low taxes. What's important is to have a well-designed tax system, which raises revenue equitably and efficiently - providing both income security, and the foundation for economic growth.

The question I wish to address is: which of the tax measures announced in the 2015 federal budget help build a good Canadian tax system, and which ones fail to promote economic efficiency and/or equity.

The table below the fold summarizes the major tax changes introduced in Part I of Bill C-59, this year's omnibus budget bill:

Two of the Budget measures are particularly praiseworthy.

The first is the measures taken to prevent the use of synthetic equity arrangements. The OECD, in its Base Erosion and Profit Shifting Action Plan, wrote, and I quote:

Fundamental changes are needed to effectively prevent ...cases of no or low taxation associated with practices that artificially segregate taxable income from the activities that generate it. 

Base erosion and profit shifting seriously threatens the ability of OECD countries to tax economic activity. It is good to see this Budget taking steps to forestall the erosion of Canada's tax base.

The second welcome change is the reduction to required RRIF withdrawals. Life expectancies have increased; rates of return on investment have fallen A change was needed. 

Unfortunately the budget also contains tax measures which have more limited potential to create jobs and growth.

The first is the reduction in the small business tax rate. Advocates of lower taxes on small business would have us imagine a future Bill Gates, building the basis of a world-class enterprise out of his garage.

Yet, as University of Calgary economist Jack Mintz and co-author Duanjie Chen have pointed out, reductions in the small business tax rate could actually discourage a future Bill Gates from growing his business, by creating, as they put it, a "'threshold effect that holds back small business from growing beyond the official definition of 'smallness."

Moreover, low small business tax rates create possibilities for tax avoidance - the well-paid self-employed professional who uses a corporate structure to reduce personal tax liabilities rather than grow a business.

The reductions in the small business tax rate are projected to cost 2.7 billion dollars over the next four years. There are far better uses for 2.7 billion dollars. For example, reforming the corporate tax base. Or raising the GST threshold so more small businesses would be exempt from the GST under the small suppliers rule. Or working with the provinces to reform provincial business taxes.

The other tax measure introduced in this budget that causes me grave concern is the doubling of the TFSA contribution limit. TFSAs were a welcome addition to Canada's savings system. They provide tax-sheltered savings opportunities for many who are not well served by RRSPs, such as students or low-income people.

However there is no case for an increase in the TFSA contribution limit to $10,000 per year. The long-term revenue cost is too great, there is too much potential for abuse of TFSAs.

Many economists advocate consumption taxation, on the grounds that taxing investment income discourages saving and has serious efficiency costs. If this government wishes to move towards consumption taxation - and there are good reasons for doing so - it be better served increasing RRSP contribution limits, or relying more on the GST to raise revenue, and less on income taxes. 

At the very least, there should be a lifetime limit on TFSA contributions. 

The Home Accessibility Tax Credit is one final tax measure worth commenting on. I am not convinced that this is the best way of helping the disabled, or helping seniors remain in their homes.

First, it is not refundable, so it will not provide help to those who need it most.

Second, I have concerns about the implementation of this credit. Which kind of home renovations count? Who decides whether or not any given bathroom or kitchen renovation improves accessibility? Furthermore, linking the home accessibility tax credit to eligibility for the disability tax credit is problematic. My own research suggests that the disability tax credit is not well targeted. Some people with disabilities fail to receive the credit; at the same time, there is some evidence that it may be abused.  

It would be more sensible to help seniors and the disabled through direct program expenditures: on housing, on community living programs, and on home supports.

Canada doesn't need a low tax plan for jobs, growth and security. It needs a good tax plan for jobs, growth and security.  

This is a draft of the remarks I plan to make at the House of Commons Finance Committee on May 28th. Comments welcome.

Comments

[Nick Rowe]

Frances: "Moreover, low small business tax rates create possibilities for tax avoidance - the well-paid self-employed professional who uses a corporate structure to reduce personal tax liabilities rather than grow a business."

Does it really create possibilities for tax avoidance, or just tax postponement (with the same present value of taxes)? (Genuine question.)

[Frances Woolley]

Nick, good point. One response: taxes deferred are taxes avoided. Second response: for self-employed professionals, it can be hard to distinguish personal consumption and business expenses. Given the way our tax system is set up, it's easy to err on the side of bumping up home office travel etc expenses, because the penalty associated with overclaiming is relatively small. But the second is really more evasion than avoidance.

[Frances Woolley]

Nick 0 Should expand on this - because there are still some taxes on investment income, allowing it's nice to take earnings, invest them tax free inside a corp for a while, and then withdraw them later. Basically a small business can be used just like an RRSP, unless it gets too big. Also small businesses offer opportunities for what someone you and I know calls "tax sprinkling" i.e. sprinkling income around the family to kids etc who are in a lower rate bracket. Plus I worry (because you know I worry) about earnings somehow changing its nature to capital income somewhere along the way and, given TFSAs etc, being taxed at a low level.

Say a dentist sits you in his chair, looks at your mouth, and charges you $100. How much of that $100 has he or she earned through his or her dental services? And how much of that is the profits that the chair generated, as a valuable capital asset? If the dentist can say "nope, not me, it was my chair that made the really valuable contribution" it's possible to treat part of that $100 as capital income, where it will attract a lower tax rate.

[Stephen Gordon]

And the tax can be avoided outright if the revenues are retained in the small business and passed on to their children. Here are Kevin Milligan's notes on the 'estate freeze'

[Frances Woolley]

Stephen - what I wish I knew for sure was precisely how TFSAs can be leveraged as part of this strategy. I think CRA has clamped down on this to some extent, but don't know the exact details.

[Majromax]

> I think CRA has clamped down on this to some extent, but don't know the exact details.

The regulations appear to be not exactly plain. In ordinary English, contributions are limited to "certain shares of small business corporations" without further elaboration. The full regulations are damn complicated and not obvious.

I think there is a regulatory attempt to limit TFSA ownership of small businesses in which one has an operating interest, but I can't say whether those regulations are effective. There may also be room for some maneuvering, for example where one spouse purchases an interest in the other's business.

[Nick Rowe]

Frances and Stephen: thanks. It's more complicated than I thought it was!

[RI]

Frances: "it was my chair that made the really valuable contribution" it's possible to treat part of that $100 as capital income, where it will attract a lower tax rate"

Bear in mind that it only attracts a lower tax rate if somehow the chair increased in value - if it is simply a return because of the chair's contribution, it is investment income which actually bears a higher tax rate than business income.

As far as increasing TFSA limits goes:
I recall shortly after Stephen Harper was elected PM he stated a goal of exempting all investment income from taxation to the extent that it was re-invested, and it appears that the TFSA is the mechanism for bearing the plan out. I recall when I was at Finance that we produced a (publicly available) document demonstrating that the TFSA was equivalent to RRSPs as far as taxation was concerned - unfortunately I can't find where it was available, but the math is not too difficult to re-create. If you think of the TFSA as equivalent to RRSPs, it becomes easier to see how the tax system is somewhat turning into one based on a progressive consumption tax (now, if all those income tax credits were turned into tax deductions, then it would truly be a progressive consumption tax system).

As far as the home accessibility tax credit is concerned, I think your comments would apply equally to all the boutique tax credits that we have seen with this government, ie. children's fitness tax credit - there are certainly better ways to target taxpayer at the margin than with a tax credit extended to everyone, and the tax credit doesn't support all the ways in which the policy objective is being achieved.

I want to throw in one final comment about holding shares of a small business corporation in your TFSA - I think the risk is more theoretical than actual. The problem at this time is finding a trustee to administer a TFSA account that would hold such investments. For example, private mortgages are eligible investments for both RRSPs and TFSAs, but there are very few financial institutions willing to act as trustee for the RRSP accounts, and I have yet to find a single one who will act for a TFSA.

[Frances Woolley]

RI: thanks for those comments. They're interesting

"I recall when I was at Finance that we produced a (publicly available) document demonstrating that the TFSA was equivalent to RRSPs as far as taxation was concerned"

That's a widely held view and, as you say, the math is not difficult. Issues are supernormal rates of return, and here TFSAs are more vulnerable than RRSPs, and timing of tax liabilities. A more general point that Michael Smart might make: some of the estimates of the efficiency gains from switching to consumption taxation stem from the fact that a consumption tax will tax the pre-existing capital stock. A TFSA system doesn't do that, so doesn't get you the gains that some estimates of the switch to consumption taxation suggest you might get. (I hope I've got that right)

On the dental chair: "it is investment income which actually bears a higher tax rate than business income."

The point I was trying to make is that the return to the chair could potentially be treated as investment income not earnings, and there the rate differential can favour investment.

"The problem at this time is finding a trustee to administer a TFSA account that would hold such investments." It might be easier when people have TFSAs worth hundreds of thousands. And, again, when we're talking about taxation of investment income, it's so important to remember that hardly anyone has any worth mentioning. So, yes, some of these things like trustees for RRSP accounts may be relatively rare, but people with non-trivial amounts of financial assets are relatively rare too. So it's hard to know which things are/aren't problems.

" I think your comments would apply equally to all the boutique tax credits that we have seen with this government"

Though one could make the case with the CFTC and the CATC that they're so widely claimed that they're basically not that different from an extension of the child amount tax credit, except that it's somewhat skewed to middle to upper-middle class households (and that the child amount tax credit is going). The closer something gets to a demogrant the less there's any need to worry about it. The disability tax credit is just really messy. You've been at finance? Do you remember the gluten intolerance disability tax credit case?

[Bob Smith]

Frances,

I'm not sure it's right to say that savings can be invested tax free inside a corp. Certainly, there's less tax at the first instance (by virtue of low corporate tax rate on business income), but investment income is subject to different refundable tax regimes so that it is effectively taxed at the same (or similar) rate at first instance). So, it's only a partial deferral on the initial income.

[Brad Fisher]

Frances,
I spent the greater part of last week doing our corporate tax return. Essentially this involves me yelling at the computer screen for 3 days. The problem is that we've had income taxes for around a century now. And in every one of those years politicians have felt the need to modify this, or tweak that, to satisfy some political constituency. This accumulates. So now a corporate tax return is an impenetrable thicket of sweetheart deals for the politically powerful. Personal tax returns aren't much better. Only political insiders and expensive tax accountants can take full advantage of all the wrinkles. I've heard plenty of Economists and Accountants argue that this is inefficient - and they are right. But is worse than that. It is corrupt (thus the screaming).

So if you are visiting our friends in the Finance department could you please ask them to just stop? Maybe do some pruning instead? If they want to encourage Canadian productivity then they want to have guys like me focussing on meeting our customers' needs at the lowest possible cost, and not mining the income tax act for income tax credits.

[Nick Rowe]

My taxes are a lot simpler than Brad Fisher's, but I can really sympathise. I just paid the accountant $800 to do my taxes. Add the cost to myself, my employer, and investment people, of keeping records, not losing stuff, and sending forms to each other, not to mention the Federal and Quebec tax authorities, and total compliance costs are probably a couple of percent of my income.

I recently spent $8k installing a heat pump and insulation in my home. The contractor said there's a 20% subsidy from the Quebec government. Will I actually go through all the hassle involved to try to collect that subsidy (which creates no wealth, but simply transfers $1.6k from Quebec to me)? Probably not. That says something about the deadweight costs of subsidies, as well as about their (lack of) incentive effects.

[anon]

> Second response: for self-employed professionals, it can be hard to distinguish personal consumption and business expenses.

Arguably, ambiguous expenses should be taxed as personal consumption, unless they're clearly in furtherance of work. Could one trade more stringent taxation of these expenses for lower overall taxes on businesses (esp. smaller ones)?

[Best Beta Trading]

The worst is either the lack of a carbon tax, or the income splitting. The income splitting isn't that bad; people live longer coupled but also waste more time, except a much superior alternative is tabled by another party: cancel income splitting and give the money for daycare. The latter improvement reduces childhood poverty and I'd guess incidence of mental illness (many ill-equipped parents yell about money matter a lot).

In SK 4 years ago the peat moss industry costed about 17.50/hr for a rural employee to harvest. This harvested around one cubic meter of peat an hour. The carbon content is about 2/3s a tonne ignoring that (post ice age) peat moss in Canada generally sequesters more carbon every year. To completely kill those jobs requires a carbon price in Canada only (after about 20000 years Sphagnum fuscum tends to stop growing probably because it rises too far above the water table and the USA didn't experience much glaciation). But even a partial carbon price would do good.

[Best Beta Trading]

...the other relevant carbon pricing points in the near-term relevant to setting a carbon price appear to me to be the technologies of utility grade batteries and Columbia U's fake plastic trees. The latter easily could've kept every job recently lost in AB/SK (probably a $10000 pay cut manufacturing plastics). But no one funded it and the idea awaited a Jr High school girl in NYC. So it is relvant to future America carbon price. Utility grade batteries are a decade away. Mining industry policy might be relevant but again, Germn, USA and Chinese chemical companies have most relevance. To me, a carbon price in Canada is dependant on the bulk price of peat moss in Canada. And set right, it should be able to create as many rural jobs as does agriculture now.

[Best Beta Trading]

I see now why there is a chromium subsidy. Chromium is not only used in the metal plating (aerospace) industry, it is used for petro refining. Both are good low dollar subsidies that would be better to be indexed to exchange rates, especially USD/CAD. Subsidizing animal hide tanning seems iffy but it might not be politically possible to just pick the above two applications.
I learned from a peat paper that used non-renewable catotelm and not the renewable acrotelm green top layer, that peat can be potentially used to filter chromium pollutants. There are better filter media, many of them cutting edge materials sciences Canada has the brainpower for...
I've noticed Gallium is useful for solar cells but is very toxic. There are Africans dying young trying to extract used computer metals. If there is to be a chromium subsidy, it ought to be accompanied by an environmental remediation industry subsidy. Canada has the same talent base as the USA here to generate such Superfund market players.