Corporate tax brakes

Posted on August 30, 2015 in Policy Context –
August 28, 2015.   Jack M. Mintz

Governments will learn the hard way that raising corporate taxes doesn’t fill their coffers

Recently, a number of readers asked me to explain the reported impact of Alberta’s corporate tax increase on recent company earnings. It is not exactly the most exciting topic for around-the-cooler debate but it is an important one since it has meaningful implications for investors, the economy and government resources.

Even in this federal election, the corporate tax issue will be played up politically. The Conservatives and Liberals have pledged not to increase the federal corporate income tax rate. On the other hand, the NDP’s Tom Mulcair promises to raise the rate although we don’t know how much yet.

The effect of the Alberta corporate tax increase from 10 to 12 per cent on July 1 was quite substantial on corporate earnings. Looking over the quarterly financial reports of the 10 largest oil and gas firms, I estimate the impact to be $1.85 billion just for these companies alone. Unfortunately, for the Alberta government, little new cash this year will be received as profits have plummeted. Instead, the tax increase will come as so-called “deferred corporate tax liabilities” that will be paid some time in the future.

So what are deferred corporate taxes? These amounts arise from accelerated tax deductions for costs and other timing differences between accounting and taxable income. For example, suppose a manufacturing company buys a machine costing $1 million that is expected to be in use for 10 years. Under accounting rules, the company can charge $100,000 annually as a depreciation expense against its profit for 10 years. However, if the government allows the company to write off the machine in one year, the company takes an annual tax depreciation charge against its taxable income equal to $1 million for the first year and nothing thereafter. Deferred taxes are the future taxes to be paid on the difference between the accounting and tax expense still to be claimed after the current year. The amount paid depends on the prevailing corporate income tax rate when determining the future tax liability.

Companies also have “deferred tax assets” such as tax losses to be carried forward and written off against future profits. Deferred tax assets become more valuable when corporate tax rates are increased. Generally, deferred tax assets are much smaller than deferred tax liabilities.

With ghastly low oil prices, many Alberta oil and gas companies are now earning little income and therefore, paying little provincial corporate tax. However, with the higher corporate income tax rate, deferred tax liabilities have risen by 20 per cent to reflect the new rate. So investors see a major hit to earnings, companies will invest less and the government will be getting little new cash at least for some time. Not exactly the smartest policy to pursue during recessionary times.

Alberta shouldn’t run to the bank thinking it has raked in a pile of money. Moreover, companies will try to avoid paying higher Alberta tax in the future by shifting some or all of their profits to other jurisdictions in Canada or elsewhere to push their effective tax rates down. Alberta won’t get as much revenue as they would have thought even in the future.

Alberta has lost its tax advantage in Canada for mobile capital. Its corporate income tax rate is higher than British Columbia, Ontario and Quebec (the latter is reducing the rate from 11.9 to 11.5 per cent). With investment tax credits in the Atlantic provinces, only B.C., Saskatchewan and Manitoba have a heavier tax on capital investment than Alberta, given their provincial sales taxes on capital inputs. Since 2012, some provincial governments have been increasing taxes on capital investment, especially in British Columbia and New Brunswick. In both provinces, non-residential private investment has fallen in 2013 and 2014.

Ideological policies to raise business taxes are not the best way to grow the economy

At the federal level, an increase in the corporate tax rate will push Canada further up the international ladder in discouraging capital investment. Earnings can take a substantial hit especially if an elected NDP government increases the corporate income tax rate from 15 to 19 per cent, as some rumours have it. With close to $100 billion in corporate deferred tax liabilities, a four-point increase in the corporate tax rate at this time could potentially reduce corporate earnings by $13 billion as a one-time hit in addition to any new cash taxes to be paid by companies in the current year.

With a potential decline in world growth, higher interest rates in the United States and lower commodity prices, ideological policies to raise business taxes are not the best way to grow the economy. Most countries, even in the depth of the 2009 recession, avoided business tax hikes.

Virtually, every credible study I know of in the past 15 years has shown that higher business taxes reduce capital investment. Discouraging capital can lead to less income paid to workers since companies fail to purchase more advanced technologies to compete.

High corporate tax rates also don’t help governments much with revenues. With a higher rate as proposed by the NDP, Canada accumulates more debt, leasing and insurance costs rather than corporate profits. Rate hikes don’t generate much public revenues once businesses restructure their affairs.

Even in high-tax countries like the Scandinavian and Benelux countries, governments have figured out that smart policy is to avoid high taxes on capital investments. These countries tax capital less heavily than Canada today.

So voters beware. Balanced budgets based on corporate tax increases will be ephemeral as businesses avoid high taxes in Canada to earn profits elsewhere. Instead, Canada will be stuck with lower investment and higher deficits. Not a good trade off but I am glad both Stephen Harper and Justin Trudeau understand this.

Jack M. Mintz is the President’s Fellow, School of Public Policy, University of Calgary.

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