Radical tax reform is in the wind — here’s how to make it efficient and fair

Posted on April 11, 2017 in Governance Policy Context

NationalPost.com – Full Comment
April 10, 2017.   ANDREW COYNE

One hundred years after the income tax was first introduced, and 30 years after the last major reform of Canadian taxes, radical tax reform is again in the wind.

The Mulroney-era reforms were driven, in part, by the Reagan tax reforms of the previous year; likewise, much of the present impetus for reform comes from Donald Trump’s vow to make deep cuts to Americans’ personal and corporate taxes. Whatever else he and Congressional Republicans disagree on, they agree on that, and with the Republicans in control of both houses of Congress, it seems likely they will bring in some sort of reform, even if it is less sweeping than advertised.

That has raised real questions of tax competitiveness for Canada, and so we are hearing talk of, for example, a major effort at pruning “tax expenditures” from the system — costly deductions and credits that distort decisions on consumption, savings and investment, in ways that are inefficient, unfair or both — with the revenues put to cutting marginal tax rates.

In addition, there are calls from some Conservative leadership candidates for even more radical reforms: from Maxime Bernier, to eliminate the capital gains tax altogether; from Rick Peterson, to scrap the corporate income tax. The latter is especially eye-opening: while the federal government collects a relatively modest amount of revenue from capital gains tax, roughly $3 billion annually, the corporate income tax contributes more than $44 billion to federal coffers. What makes these proposals questionable, however, isn’t so much the loss of revenues, but the harm they would do to basic principles of sound tax policy. While both seek to address real problems in the tax system — or might at least be charitably deemed to have such purpose — they do so in ways that would introduce their own distortions, certainly when compared to other possible reforms.

The bedrock principle of an efficient tax system is neutrality: the system should neither reward nor penalize any particular thing or activity, but should rather apply as evenly and as uniformly as possible: tax everything, and tax it at the same rate. Ideally it would make it impossible to do what thousands of tax lawyers and advisers are paid handsomely to do: arrange your affairs in a way that reduces your tax burden. If you paid the same tax no matter what you did, you’d ignore the tax, dump your advisers and get on with investing for the highest return.

There are lots of ways in which the system falls short of that ideal, of course, and one of the biggest is still the double-taxation of savings. Suppose you pay tax at a marginal rate of 40 per cent. And suppose you could earn a 10-per-cent return on investment. If you earn a dollar and spend it today, you get 6o cents worth of consumption. But if you save and invest it, you get, not the $1.10 you’d have if there were no taxes, and not even the 66 cents you might expect, but 63.6 cents, since the return on the 60 cents you had left after tax is also taxed. Effectively, the tax on future consumption is not 40 per cent but 42 per cent. So you can see how the income tax is viewed as a deterrent to investment. But that’s true no matter how the money is invested, or in what particular way the return on that investment is paid out. So it’s hard to see why Bernier wants to exempt only one particular form of return — capital gains — from tax, as opposed to dividends and interest. Far better to simply exempt all savings from tax, as we do under the current RRSP and Tax Free Savings Accounts. If Bernier wanted to make a radical proposal that was also sound tax policy, he’d suggest raising or even eliminating the limits on these, effectively turning the personal income tax into a tax on consumption.

Peterson’s corporate tax proposal might be seen as aiming at another form of double-taxation: the taxation of capital income in personal hands that has already been taxed at the corporate level. Right now that’s addressed by attempts to integrate the two tax systems, recognizing the tax that has already been paid via the tax credit on dividends and the partial inclusion of capital gains. But you could just as easily forego the corporate tax and collect the whole tax at the personal level, since in the end all taxes are paid by people anyway. (Among other benefits, that way you could ensure more of the tax was paid by those higher up the income scale, since the personal income tax is progressive in a way that the corporate tax is not.)

You could, that is, if you didn’t have to be concerned about people converting personal income into corporate income, for example by incorporating themselves. No doubt the corporate income tax adds needless complexity to the system, but that’s mostly because of what it taxes — income — rather than where it’s collected. Taxing income is insanely difficult, since so much of it involves comparisons of variables between years: not only capital gains, but inflation, and depreciation. So a better reform, since some form of corporate tax will always be necessary, is to convert the current tax on income into a tax on cash-flow: all cash in during a given year is taxable, all cash out is deductible.

A personal consumption tax, and a corporate cash-flow tax, are essentially mirror images of each other. Together they would make a fine pair of reforms, addressing critical weaknesses in the present system without adding their own.


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