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Is it time for major tax reform?

THE CANADIAN PRESS/Chris Donovan

On the same day that the Minister of Finance, Bill Morneau, clarified the federal government’s proposals to limit “income sprinkling” as a way for high income owners of private companies to reduce their taxes, the Senate Finance Committee released its report recommending that it all be scrapped.  Instead, the Senate Committee recommended that the government of Canada take on an independent and comprehensive review of the tax system with the purpose of “reducing complexity, ensuring economic competitiveness and enhancing overall fairness.”

The last time Canada had such a comprehensive review was the Carter Royal Commission which reported in 1966, with many but not all of its recommendations finally implemented in legislation in 1972.  This process took over a decade, from the start of the Royal Commission.  The Senate Committee’s proposal, if taken seriously, looks very much like the proverbial “kicking the can down the road” — a massive delaying tactic.

This is not to say that a more in-depth review of Canada’s income tax system would be wrong.  But it would be too much to accomplish if the objective were as extensive a review as that of Carter.  Instead, it would be more prudent to focus on one or two priority areas.

So what should be the focus of tax reform?  Let’s look at four possibilities.

First, the firestorm of protest that has dogged Minister Morneau over the proposed changes in the taxation of private companies raises the question of just how individual and corporate income taxes should relate to one another.  In tax jargon, the topic is corporate-personal income tax integration.

On the one hand, basic principles of income taxation require that incomes not be taxed twice: once when received by a corporation, and again, when the income is paid out as salary or a dividend to individual shareholders.

On the other hand, income flowed through a corporation should not be under-taxed, compared to the way this income would be treated if it were received directly by individuals in the first place — precisely the concern being addressed by the controversial proposals specified in the documents tabled by the Finance Minister.

A second possible focus for tax reform could be the tax treatment of retirement savings, an area where the Carter Royal Commission made extensive recommendations, specifically that there be comprehensive lifetime contribution limits.  The Commission’s objective was that it should make no difference whether the individual’s savings were through a workplace pension plan or an RRSP.  This proposal was never implemented in the 1972 reforms.

Shortly after I joined the Tax Policy Branch of the Department of Finance in 1977, I had the opportunity to talk with Bob Bryce, then retired and writing a history of the Department.  Mr. Bryce had been Deputy Minister of Finance during and after the Carter Royal Commission and oversaw the development of the 1972 tax reforms.  As a new tax policy analyst, I asked him what ever happened to the Carter proposal for comprehensive limits.  He replied that the department was too busy trying to implement other, higher priority recommendations, especially to include capital gains in income.  (Recall the famous phrase from the Carter Commission, “a buck is a buck is a buck.”)

Both the federal government Green Paper on pension reform in 1982, and the Special Parliamentary Committee on Pension Reform in 1983, recommended significant changes to the contribution limits for retirement savings that would essentially implement the Carter recommendations.  (I worked on both reports.)  The system we now have follows from those reports.

In the context of a major tax reform view today, I don’t think this second possible focus for income tax reform would merit nearly the priority for comprehensive review as the corporate-personal income tax integration just mentioned.

A third possible area for comprehensive review is the taxation of offshore income.  Publicity surrounding the scandals revealed by the “Paradise Papers” reinforces the fact that this should be a major priority.  In this case, though, it is an area that Canada cannot address on its own.  Major improvements in enforcement against tax evasion (which is illegal), and even in detecting serious tax avoidance strategies (which are legal, but may be highly abusive), will require substantial international collaboration.

The OECD has been leading work in the area of what’s known as “base erosion and profit shifting” (BEPs).  But so far, it is not delivering nearly as much as needed to tackle the major issues.

A fourth possibility is that “tax reform” (or in the words of the Senate Committee report, “ensuring economic competitiveness”) is actually code for simply cutting corporate income taxes.  The cliff-hanging tactics in the U.S. Congress are raising fears that a far lower corporate income tax rate there will place intolerable pressure on Canadian companies, inducing them to cut investment here.  But tax cuts themselves are not tax reform.

If cuts are not to increase the deficit, then taxes somewhere else would have to increase, or government spending would have to be cut.  And the pressures to use private companies to avoid taxes at the individual level, pressures being addressed (at least in part) by the Finance Minister’s current proposals on income sprinkling and passive income, would have to become even more severe, as the gap between corporate and top personal income tax rates widened.

With these four examples, it should be clear that the Senate Committee’s recommendation for a comprehensive review is likely little more than a delaying tactic and avoids a more thoughtful and probing identification of what should be the highest priority areas for review.

It is also fundamental for any such review to be based on solid evidence.

While little known, a major innovation of the Carter Royal commission was that it developed the first computer simulation model of the individual income tax (John Bossons of the University of Toronto led this effort).  This model was adopted by the Department of Finance and has been in regular use ever since.

In contrast, the recent proposals regarding income sprinkling, passive income and avoiding equitable capital gains tax on disposition of a private company, have been notable, at least for data nerds, for the weakness of the evidence base.  Even more important than another Royal Commission or comprehensive review would be for the government to provide itself with the high-quality data and analytical capacity to understand what’s really going on.

 

Michael Wolfson is an expert adviser with EvidenceNetwork.ca and a member of the Centre for Health Law, Policy and Ethics at the University of Ottawa. He was a Canada Research Chair at the University of Ottawa. He is a former assistant chief statistician at Statistics Canada.

December 2017

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