On small-business tax reform, Bill Morneau was more right than wrong

Posted on in Governance Debates

TheGlobeandMail.com – Opinion/Editorials –
December 19, 2017.   Globe Editorial

For the better part of six months, Finance Minister Bill Morneau has had to devote most of his calendar to the unpleasant duty of being publicly pilloried for his small-business tax reforms. In the face of criticism, he climbed down from his original proposals, but each step back only energized critics in business, among physicians, on the farm and on the opposition benches.

This week, in a final parting shot before Parliament went on vacation, the Senate Finance Committee recommended that Mr. Morneau make one last tweak to his watered-down small-business tax plans – by scrapping them entirely. The Senators told him to take Canada back to the day before he started talking about any of this.

But the issue the Finance Minister raised, and that his remaining tightening up of the rules still aims to at least partly address, is a real one. The fact that he never quite figured out how to sell Canadians on it doesn’t change that.

The mandarins at Finance identified a glaring inequity in the tax system, which allows some mostly upper-income Canadians to significantly lower their tax burdens, simply by incorporating an existing business. It isn’t fair. And it’s not something advocates of lower business taxes ever intended.

Cutting business-tax rates, a strategy pursued federally and provincially for more than a decade, was supposed to be about making the tax system smarter, while stimulating productive and entrepreneurial activities. There’s a lot of academic research that supports the move. But all medications, even correctly prescribed ones, have side effects.

Between 2001 and 2014, the number of incorporated small businesses – known as Canadian-controlled private corporations, or CCPCs – rose by 50 per cent, from 1.2 million to 1.8 million. CCPC income as a share of gross domestic product doubled. And passive-investment income earned by CCPCs tripled, to $26.8-billion. This is not because Canada suddenly turned into the global home of entrepreneurship.

The roughly 37-percentage-point gap between the top personal income-tax rates and the corporate-tax rates on small businesses created economic incentives – including the incentive for upper-income Canadians to hire lawyers and accountants, to incorporate, and to use the corporate structure to extend the tax benefits of incorporation to children and spouses.

Those moves by taxpayers were logical and legal, but also undesirable, since their effect was to shift some of the overall tax burden onto lower-income, unincorporated Canadians.

As a Finance study put it last summer, “low tax rates designed to encourage investment have increased the rewards associated with tax planning in a private corporation, and have been partly used to opt out of higher personal income tax rates.”

And yet as part of Mr. Morneau’s attempt to mollify critics, in the fall he announced a further lowering of the federal small-business tax rate. That’s bad in principle (why only reward businesses that stay small?), and it only enhances the incentive to incorporate.

The basic thrust of what Mr. Morneau was originally aiming at – tightening up the rules around income sprinkling, large passive investment portfolios held inside small business corporations, and conversion of dividends into capital gains – was sound. Critics were right that some of the details needed to be polished and tweaked, to avoid imposing confusion and big new compliance costs on taxpayers. But the gist of what the Finance Minister was trying to do, namely removing opportunities to abuse the system, made sense.

Take income sprinkling. Mr. Morneau opened with a tough proposal to rein in the practice; his current plan, though still aimed at reducing sprinkling, includes a long list of permissible exceptions. Critics say he hasn’t gone far enough in dismantling his original plan, but the truth is the opposite. A family member who truly works in a family business, like a family farm, should be able to share in the tax benefits of incorporation. But why should, say, the husband of an incorporated doctor, whose only relationship to the business involves being married to its proprietor, enjoy a tax benefit not available to most taxpayers?

The Senate committee was wrong to recommend that Mr. Morneau scrap his entire small-business tax reform.

But the Senators were right to also call for a big, independent study of the whole tax system, and not just one part of it, to consider major reforms for reducing complexity, enhancing competitiveness and increasing fairness. After the confusion of the last six months, it’s clear that such a review is badly needed, and long overdue.

https://www.theglobeandmail.com/opinion/editorials/globe-editorial-on-small-business-tax-reform-bill-morneau-was-more-right-than-wrong/article37380257/

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