A Canada-U.S. tax gap means a Canada-U.S. tax transfer
TheGlobeandMail.com – news/commentary/opinion
Published Wednesday, Apr. 20, 2011. Munir Sheikh
Given Canada’s already substantially lower corporate tax rates compared to the United States, it’s important to analyze a range of important issues before starting on further rate cuts, to ensure such cuts would benefit Canada.
First, let’s look at the relevant statistics comparing the 1990s and 2000s. Over these periods, the profit share of GDP rose from 8.0 per cent to 12.4 per cent, and the corporate tax rate fell from 32.9 per cent to 25.7 per cent. Between the two decades, corporate profits rose 152 per cent and, as a result of corporate rate reductions, after-tax profits rose 173 per cent. In contrast, nominal investment rose 84 per cent, while constant dollar investment rose 59 per cent.
This evidence suggests there are factors constraining investment from growing in line with new resources. An understanding of these factors is key in shaping future tax policy.
The Canada-U.S. tax differential becomes increasingly important in this context, as our rates fall substantially below U.S. rates. According to the 2010 budget, the Canadian corporate tax rate at 16.2 per cent in 2012 would be half that of the U.S. at 34.2 per cent, with a still-to-come 1.5-point drop.
Under Article XXIV of the Canada-U.S. tax treaty, any U.S. citizen, resident or company earning income in Canada is subject to U.S. tax, with a credit for Canadian tax paid or accrued. This is critical.
Consider an example. A U.S. business, “USCO,” operates in Canada, with an income of $100-million and a U.S. tax liability of $35-million at a 35-per-cent rate. At a 25-per-cent Canadian tax rate, USCO pays $25-million Canadian tax and $10-million U.S. tax. At a 22-per-cent Canadian rate, USCO pays $22-million Canadian tax and $13-million U.S. tax; the $3-million increase in USCO’s U.S. tax is equal to the reduced Canadian tax. This money, provided to a business in Canada presumably to encourage investment, ironically reduces resources available to achieve that objective.
The potential to offset this tax transfer through increased USCO investment in Canada and increased placing of debt in the U.S. is limited because USCO is constrained and affected by an already large tax gap in Canada’s favour.
This tax transfer from Canada to the U.S. is potentially large. U.S. investment stock in Canada is $974-billion, consisting of $304-billion foreign direct investment, $459-billion portfolio investment and $211-billion other assets. Using rates of return in the 5-per-cent to 9-per-cent range from the 2000s yields annual pre-tax income in the $50-billion to $90-billion range. For comparison, the overall annual repatriation of investment income from Canada to the U.S. is about $50-billion, which translates into a pre-tax income of $67-billion assuming that retained earnings from this income and the ouflow of previously retained earnings roughly balance out.
The estimation of the overall actual tax transfer to the U.S. is, however, difficult because of the many complexities in the tax system. But it’s easier to get a feel for this transfer for changes in tax rates, in the presence of already large tax differentials, because the influence of factors related to the tax system’s complexity and tax planning are diminished.
The $50-billion low-end estimated income (not all income is taxed at the corporate rate, the dividing line is not always clear, and rates of return on capital are closer to 9 per cent) could result in a potential $500-million annual tax transfer from Canada to the U.S. for every point reduction in the Canadian tax rate.
As these calculations show, the issue deserves a more sophisticated analysis to determine the size of the actual tax transfer, and this, among other things, should be factored into any decision on future tax policy.
Finally, despite the U.S. corporate tax rate’s being double that of Canada, we are nowhere in sight of U.S. productivity growth. And it’s productivity that anchors living standards. So it’s essential to focus on the reasons for this weakness in productivity to strengthen Canada’s long-term economic performance.
Munir Sheikh, Canada’s former chief statistician, is a distinguished fellow at Queen’s University and a distinguished visiting scholar at Carleton University. He is a former associate deputy minister of finance and a former senior assistant deputy minister of the tax policy branch at finance.
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