THE STANDING SENATE COMMITTEE ON NATIONAL FINANCE
EVIDENCE
OTTAWA, Tuesday, October 31, 2017
The Standing Senate Committee on National Finance met this day, at 9:30 a.m., to continue its study on the Minister of Finance’s proposed changes to the Income Tax Act respecting the taxation of private corporations and the tax planning strategies involved.
Senator Percy Mockler (Chair) in the chair.
[Translation]
The Chair: Honourable senators, welcome to this meeting of the Standing Senate Committee on National Finance.
[English]
My name is Percy Mockler, senator from New Brunswick, chair of the committee. I wish to welcome all those who are with us in the room and viewers across the country who may be watching on television or online. As a reminder to those watching, the committee hearings are open to the public and also available online on the Senate website at sencanada.ca.
I would like to ask the senators to introduce themselves, starting on my left, please.
Senator Jaffer: Mobina Jaffer, from British Columbia.
Senator Unger: Betty Unger, from Alberta.
[Translation]
Senator Pratte: André Pratte from Quebec.
[English]
Senator Black: Douglas Black from Alberta.
Senator Oh: Victor Oh, Ontario.
Senator Marshall: Elizabeth Marshall, Newfoundland and Labrador.
[Translation]
Senator Forest: Éric Forest, Gulf region, Quebec.
Senator Moncion: Lucie Moncion from Ontario.
[English]
Senator Cools: Anne Cools from Toronto. That's in Ontario.
The Chair: Thank you, senators.
[Translation]
I would also like to introduce the clerk of the committee, Gaëtane Lemay, as well as our two analysts, Sylvain Fleury and Alex Smith. I was in fact told, Mr. Paquet, that our analyst Sylvain Fleury had been your student. He does good work.
I would like to thank the witnesses for having accepted our invitation, and I will have the opportunity of introducing them formally in a few moments.
[English]
This morning, the committee continues its special study on the proposed changes to the Income Tax Act respecting the taxation of private corporations and the tax planning strategies involved, changes that the Minister of Finance proposed during the summer of 2017.
[Translation]
Today, we invited three independent experts whose opinions we requested on the impacts of the proposed changes. These experts are Mr. Éric Brassard, Partner, Brassard Goulet Yargeau, Integrated Financial Services; Mr. Jack Mintz, President’s Fellow at the School of Public Policy of the University of Calgary, as well as a colleague I have had the opportunity of meeting previously, Mr. Alain Paquet, former minister and now Full Professor at the Department of Economics, Management Sciences School, Université du Québec à Montréal.
[English]
Witnesses, we want to take this opportunity to thank you for accepting our invitation to share with us your comments, views and recommendations as per the order of reference from the Senate of Canada given to this committee.
We will begin with Mr. Brassard, then Mr. Mintz and completing with Mr. Paquet. We have limited you, witnesses, because questions will be coming forthwith from the senators.
[Translation]
You have the floor, Mr. Brassard.
Éric Brassard, Partner, Brassard Goulet Yargeau, Integrated Financial Services, as an individual: Good morning. I have been a CPA and CA for 35 years now. I taught accounting for 10 years at the university level and I am the co-founder of an integrated financial planning services firm that has offices in Quebec and Montreal. We work on a regular basis with the tax specialists of our clients on various tax issues, but we consider ourselves independent taxation and investment specialists. And that is in fact why we prepared a 50-page brief on the passive income aspect of Minister Morneau’s reform.
I would like to make a few general comments on the reform, which poses, as we know, a planning and organization problem. Tax experts were in agreement with several aspects of this reform, and they could have been put forward in a more orderly and less precipitous way, with a more reasonable time frame for a reform of this scope. Finally, it caused a considerable loss of time and energy, as we had to provide explanations to clients. Let’s just say that this could have been presented in a more coordinated and structured manner. If there had been consultation, the same objectives could probably have been achieved.
There are several aspects on which tax experts agreed, but with regard to passive income, we observed right from the beginning that the government was on the wrong track. It is important to understand that the government is the co-owner of all the investments taxpayers make in RRSPs and in businesses. And finally, the proposed reform will cause a loss of tax income instead of an increase. All the figures in our brief were taken from government consultation documents; we did not invent anything. For instance, if a taxpayer obtains an 8 per cent return on his RRSP, the government also obtains an 8 per cent return on the income tax it agrees to delay, and the calculations are very clear on that point.
The same principle applies to a company. If a taxpayer obtains a certain rate of return from a company, the government obtains the same rate. Consequently, it is false to claim that you are losing money. The proof is in the government consultation document, in Table 7, which gives the example of a $100,000 amount earned by a salaried worker who pays income tax, or by a taxpayer who earns that amount from a corporation, and who, after having paid a certain amount of tax, pays himself that amount as a dividend. If you take a sum of $100,000, invested at 3 per cent over 10 years, you will see that after 10 years, if the money that was earned in a company was distributed as dividends, the entrepreneur will have $4,800 more than the employee. But what the consultation document does not say is that that investment generated $6,700 more in tax revenue. So yes, the entrepreneur may have earned $4,800 more, but $6,700 in tax revenue has been generated for the community as a whole. So the government made a return.
We must of course take into account the value of money over time, because the money comes in at different points, but if you look at the rate of return for the government, it is higher than the cost of its debt. But we are talking here about a theoretical rate. If you look at the real rate, for instance in Quebec, the taxpayer would not receive $4,800, but $3,900, and the government would pocket $7,300 through the various tax rates. It is important to understand that.
In addition, regarding the additional sum of $11,500 which was generated — of which $4,800 would go to the entrepreneur, and $6,700 to the government — the government, rather than distributing it, wants to take all of it. The goal is to go and get that entire amount through a maximum, non-refundable tax imposed on the company. This is dangerous. The $11,500 will disappear. If the purpose of the measure is really to go and get all of the money rather than sharing it, people will simply stop incorporating, or they will take money out and that will generate a loss.
All the more so since with the non-refundable maximum tax rate, the implicit hypothesis is that the taxpayer, before even withdrawing the money from his business, is already at the maximum rate. The taxpayer already has $202,000 in income before having taking out any money. This will heavily penalize the small entrepreneur who is far from having $202,000 in income. And yet that is what is being implied.
We see that income tax rates explode at 150 per cent, 200 per cent and 250 per cent when the government wants to go and get all of these amounts through a non-refundable maximum rate. Unfortunately, this disqualifies the reform because it penalizes people, and the premise is unsound.
In addition, all of this has enormous economic impacts. However, this is not discussed anywhere in the document. We don’t know whether an impact study was done. You know this will mean that millions of dollars will be taken out of the economy. I don’t know if impact analyses were done, because they are not mentioned, but the famous amount of $11,500 that will disappear means there will be less funding, and that has a domino effect on the economy, a multiplier effect which means that sums will be withdrawn from the economy. That aspect is not mentioned anywhere. The government talks about fairness, and that is good, but we know that there already was fairness, because the entrepreneur pays a large part of his income in tax, and in addition, amounts are withdrawn. Rather than contributing $85,000 to the economy, there will be $50,000. That is 40 per cent less. And yet, no impact study was done to explain that.
We are accountants and we are used to dealing with complexity, but the new rules entail unprecedented complexity. There will be two series of measures, and the current measures are not necessarily simple either. In addition, a second series of measures will be added, because there will be transitional rules for the investments already made in the company. Consequently, there will be transitional rules entailing reconciliation complexity when we will have to decide which area we are dealing with. And honestly, it isn’t just complex; frankly, it will be unmanageable, as we will not be able to reconciliate both. This will all be extremely complex.
Changes were made recently to allow for an income threshold of $50,000, but this will not change the weaknesses of the reform, as I just explained, given the maximum rate and the money that will be taken out of the economy. It may simply add a level of complexity. We can discuss income of $50,000, which is a bit insulting. It adds complexity to the amounts, and once again, it does not remedy any of the weaknesses already identified.
Consequently, we believe that it would be preferable to maintain the status quo, because it provides more revenue to the government and stimulates the economy, unless we raise the matter of a sovereign fund, which would be the subject of another debate.
To conclude, the government proposed a tax reduction of 1.5 per cent for SMEs. In the short term, this may seem interesting, it may have some positive aspects, but you must understand that in the end it is a disguised income tax hike, because when you lower the income tax rate on active income, you have to increase the rate on dividends to maintain consistency. However, the rate for dividends is the same as the rate applied to passive income. And so by reducing the income tax rate for companies, you have just automatically increased the tax rate on passive income by 1 per cent. This means that even though the government is claiming that it will cost a certain amount to fund the income tax reduction, I am sorry, but that is false. On the contrary, this will generate more tax revenue, because the passive investments were just made subject to an automatic increase of 1 per cent.
I am now ready to answer your questions.
[English]
Jack Mintz, President’s Fellow, The School of Public Policy, University of Calgary, as an individual: Thank you very much. I appreciate my return invitation to the Senate Finance Committee to speak about the private corporation tax rules being proposed by the Minister of Finance. In the interests of time, I will keep my comments brief.
I do support a tax system that is simple, less distortive and fair. Evaluating taxation only in terms of fairness is inappropriate since public policy must balance competing objectives. Growth is also important. That is, in part, supported by a tax system that reduces distortions in the economy. I will come back to this later.
The October changes that rescinded many of the July 18 proposals still have two major problems associated with them. The most significant is with respect to the passive income rules. Actually, I like the words “passive income” as opposed to “retained earnings” because it’s really almost the same thing. Retained earnings, of course, are important, as I’ll get into.
With respect to the passive income rules that allow taxpayers to earn $50,000 annually, subject to a tax rate of 50 per cent as in the past, with excess potentially taxed at a 70 per cent rate, this rule is problematic for several reasons.
Cash flows that provide equity financing for smaller businesses are accumulated to reduce credit costs. A strong argument could be made to allow investors to accumulate retained earnings to finance investment or their future retirement needs. The excessive tax rate of 73 per cent on investment income will especially undermine corporate efficiency.
Canada’s taxation of entrepreneurial effort is currently not competitive with other countries except for France. The new passive income rules will encourage entrepreneurs to restructure their businesses as non-Canadian-controlled private corporations. That will result in some moving to other jurisdictions. With potential tax reform in the United States, Canada’s tax on entrepreneurial activity will become much more onerous compared to the United States.
This point I have made in a recent note published by Calgary’s School of Public Policy. I notice that it has been made available to you, but just to give you an idea: Currently, if a small business has $10 million in assets, when you include both personal and corporate tax rates — and one thing I don’t like about the Finance document is that they only talk about the corporate tax at the small-business level and forget talking about the personal tax. We have to remember that Canada has high personal taxes relative to the United States particularly. But the current Canada tax rate on small businesses of $10 million in asset size is 42.2 per cent, while for a U.S. subchapter corporation, where all the income is passed on to the investor and the corporation doesn’t pay tax but the investor pays full tax on the income, the tax rate is about the same, 42.1 per cent. When you get to $20 million in asset size, in other words, a bigger small business or a medium-sized business, the Canadian effective tax rate, including the personal tax side, is 47.3 per cent. For subchapter S, it’s 47 per cent. So we already tax more highly successful small businesses.
If U.S. tax reform goes ahead and we move to the 9 per cent small-business tax rate in Canada, the $10 million asset sized company effective tax rate will fall from 42.2 per cent to 41.3 per cent. That's not very much, actually. It’s a small reduction in the effective tax rate. For subchapter U.S. corporations — and we’ll find out more Wednesday what the house plan is going to be proposing in terms of exact tax rates — assuming that there is a 25 per cent tax rate and taking into account state level tax rates and personal income tax rates, the subchapter S corporation will have a tax rate of roughly 28 per cent, much lower than the Canadian one with the small business of $10 million in asset size.
For a small business double the size, and therefore subject to the higher corporate income tax rate, the Canadian rate will stay the same at 47.3 per cent, but for the subchapter U.S. corporation, the effective tax rate will fall from 47 per cent down to 34.9 per cent. That is a huge reduction in the effective tax rate in the United States, assuming tax reform goes ahead, and we’ll have to see what eventually happens.
The main point is that we have a system in Canada where we’re raising taxes on small businesses. The U.S. is looking at very substantial reductions in taxes in small businesses. You can imagine what that could do to competitiveness in Canada with respect to entrepreneurship.
The third point is that given that passive income is lumpy — such as capital gains and also losses may be incurred in some years — it is unclear as to how the rule will work fairly and without economic cost unless averaging is introduced. For example, somebody could have zero passive income for a few years on an equity investment, but then have a large capital gain, which then gets subject to tax at more than $50,000.
Fourth, a cap based on income unfairly treats entrepreneurs who are successful, earning high rates of return on assets. They will pay more average tax than those who do poorly. Averaging would help here to some degree, but not fully.
The main point is that the passive income rule, I think, has some very significant impacts, and the one that worries me the most is the impact on corporate efficiency and on competitiveness for Canada, especially for entrepreneurs that are in manufacturing, venture capital and other areas, which may be looking south after these proposals come through.
The other change is with respect to income splitting or, the word used in the finance document, income “sprinkling,” which is a rather new word being used. I guess they wanted to avoid using the words “income splitting.” While it is appropriate to limit advantages to adult children, it is another matter to apply income splitting with a spouse. A spouse bears the risk of an enterprise, including potential bankruptcy. As I am sure each of us know here, the management of working and personal affairs in a family situation requires splitting of time among partners in different ways. Both family and tax law often recognize the special relationship among spouses, including sharing of assets upon marriage and common-law breakups, transferability of income, assets and deductions under tax law and pension income splitting.
For these reasons, I believe the passive income rule should be abandoned and the income splitting proposals should be limited to adult children who are not involved in a business.
What I find most disappointing about the proposals is that we have missed an opportunity to improve the tax system by making it simpler, more efficient and fair. In other words, if we’re going to spend political capital in taxing small businesses differently, then I think we could at least achieve some better results compared to the package offered in July and what we’re ending up with in October.
I have argued in the past several years for three changes: the elimination of differential corporate income tax rates among businesses of different sizes, including eliminating the small business deduction; equal treatment of dividends and capital gains to minimize tax planning and distortions; and better incentives for small businesses more geared to growth compared to the small business deduction. With a single corporate income tax rate on business income, such as in the U.K., we can eliminate the distinction between eligible and ineligible dividends. Equal taxation of capital gains and dividends, the hallmark of 1972 tax reform, and a policy that the Department of Finance likes to follow over the years, reduces the scope for passing out the least taxed source of income to corporate owners.
This type of reform would have had much better balance, less complexity, fewer distortions and fairness while at the same time achieve growth objectives. I would be happy to explain some of these other incentives in discussion that one could consider and that would be better than the small business deduction. I am afraid, though, we have gone the wrong direction with the July 18 proposals and what we’re ending up with in October.
Thank you.
[Translation]
Alain Paquet, Full Professor, Department of Economics, Management Sciences School, Université du Québec à Montréal, as an individual: I thank the committee for this opportunity to discuss an important issue, because this matter affects entrepreneurs and Canadians as a whole in their daily lives. Taxation has important effects on the economy, and various objectives can be set. This may sometimes generate creative tensions, if you will. However, they do not always conflict, because of their different characteristics.
My experience is that of a research professor, on the one hand, and of a full professor at the Université du Québec à Montreal, in the Management Sciences School. I have also done consulting work with various governments on the management of the public debt, and I have practical experience in the development of economic policies within government as such, as from 2003 to 2012, I occupied various positions where I acted as economic advisor to the premier. I had various opportunities to discuss business transfers with the public servants of the Quebec Revenue Agency and the Department of Finance.
When you discuss taxation, it is important to examine it from different angles, from the angle of empirical economic experience as well as from the angle of its practical implications, that is to say the practical experience of tax specialists, lawyers and the experience of public servants, but you must also never forget the experience of those who pay income taxes. A corporation is ultimately owned by physical persons, and you must take all aspects of taxation into account in order to measure its impacts properly.
In the consultation document that was published by the Department of Finance in July, certain truly unfair situations were raised, and this illustrated possible cases of practices where the tax system is not neutral, and where, for example, current measures may mean that someone will be encouraged to incorporate to reduce taxes. A whole debate could be held on whether income tax is too high or too low. Or, we can determine the tax rates that are the least damaging to the economy by taking into account all of the objectives being sought. In any case, we must try to avoid having the tax system create indirect incentives to change people’s behaviour inadvertently, and without considering the global impact on the economy.
Despite these examples that bear mentioning, we have to conclude that the debate surrounding the Minister of Finance’s proposed changes got off on the wrong track. The unfairnesses may generate support in principle in favour of greater neutrality in the tax system where it is obviously lacking.
In fact, last month, at a meeting of the Standing Committee on Finance of the House of Commons, in an open letter I signed, I had the opportunity to discuss this principle. As is often the case, the devil is in the details. It’s important to look at them if we are to analyze their global impact on the economy. Some important points were missing from the consultation document, such as the amount of expected tax revenue, and an assessment of its economic impact.
A more specific definition of the ways in which the proposed changes are to be applied was needed, and remains necessary, if we are to avoid possibly arbitrary and uncertain interpretations by entrepreneurs and the Canada Revenue Agency, which can incur high administrative and economic costs.
This lack of precision has raised questions and concerns. At the same time, other positions that are difficult to justify were defended by the government, such as its decision not to tax Netflix, as opposed to other businesses in the same sector. Indirectly, these statements have a certain impact on how to conduct a major tax reform.
We have also heard some extreme positions expressed by the other side. Some people have said that if we do not have a tax system that is beneficial for physicians, a large number of incorporated physicians will leave. In Quebec, when I was a member of the National Assembly, the government I belonged to decided to allow physicians to incorporate. This did not increase the number of physicians. We could have taken other measures, but we would still have a shortage of physicians. We do not know whether, under a government-sponsored system, doctors who receive salaries and have a guaranteed clientele would not leave also. Such extreme positions got the debate off on the wrong track.
A certain number of essential elements are necessary to properly establish the efficiency and fairness of taxes and their economic impacts. These principles and elements must be rooted in theory as well as in economic practice. The last major tax reform goes back to 1971, and took place in the wake of the Carter report.
Some changes have been more extensive than others of course, including the creation of the GST/HST as part of the latest corrections in recent years, and the elimination of the capital tax, one of the worst taxes of the 1990s in Quebec and right across Canada. Other points made in Professor Mintz’s committee report of 1997 led to certain changes that served to reduce the tax non-neutrality of certain corporations. That was partly eliminated over time, which is why this all needs to be reviewed.
Piecemeal reform can be an opportunity, but in the end we should not avoid a general debate on tax reform. It is not easy because anyone who considers that they are not too badly off under the current system and even get certain benefits will defend the status quo or shy away from change. Everyone is happy to see their neighbour’s taxes being increased, while the expenditures that affect them are decreased. These are the debates surrounding tax reform.
There are international examples, such as the Meadows and Mirrlees report in Great Britain, which show that it is possible to have a debate that provides a good overview of the issues or that reconciles different taxation principles in seeking a tax system that is more effective or that maintains or increases vertical and horizontal equity.
There are problems with transparency and simplicity. All of these principles have to be combined to achieve effective tax reform. In this context, we have to examine what is being proposed from a broader and more measured perspective in order to discuss the various impacts. My predecessors have given some examples. I will not talk about them now, but we might come back to them in the discussion.
We have to bear in mind that not all taxes have the same economic effects. Some create more distortion and damage than others. Achieving the best tax system is not a question of plucking the goose so as to get the most feathers with the least hissing, as Colbert said, but rather of finding taxation methods that cause the least damage to the economy. All taxes cause damage. That does not mean there should be no taxes, because we need public programs. We could debate which programs should be given priority, but we have to choose the taxation methods that cause the least damage to the economy.
For example, one could argue that the capital gains tax is more damaging to the economy that the tax on employment income, or we could prevent people from converting their capital gains tax into employment income tax. That is in a way what the Department of Finance is proposing. Another approach would be to reduce the imbalance between the corporate rate and the personal rate, while preserving fairness.
There are established elements that need to be reviewed today in light of the changes facing the economy. The economy has more services and intangible physical capital. It is not just machinery, a piece of equipment or a building; in the case of information technology, it is intangible intellectual capital. So there are various issues that need to be considered to support this kind of reform.
As an economist, I can only hope that the current debate will highlight the need for broader reform of Canada’s taxation system, over and above partisan issues. I mentioned the example of Great Britain, as well as other examples. I wrote an article recently with a colleague from UQAM, Jean-Denis Garon. We concluded our article as follows, roughly translated:
Reforming the tax system is a huge task. Such reforms affect the daily lives of citizens and give rise to debates and opposition from certain groups and individuals. To increase the chances of success of such an undertaking, and its political feasibility in particular […] Tax reform proposals must be based on science and the best practices suggested by microeconomic and macroeconomic taxation theories, and on the lessons from empirical research. While no system is perfect, and bearing in mind imponderables and democratic requirements, a tax system can be more effective and fairer, as long as the government has vision, depth, transparency and commitment.
With your permission, I would like to table this document on corporate tax reform. We will have the opportunity to discuss it in relation to the transfer of family businesses.
The Chair: By all means. Thank you very much, Mr. Paquet.
[English]
We will now go to questions from the senators.
Senator Marshall: Thank you for being here this morning.
I wanted to talk about the passive income. I realize the income splitting is also an issue. Generally, the government is saying the objective is tax fairness, but, Mr. Brassard, I read your paper, and there was a chart that showed that the actual impact on entrepreneurs’ net worth, in some cases, could be 105 per cent. It sounds like taxes are going up. Mr. Mintz, you also mentioned the 73 per cent. It seems like it’s a revenue-generating exercise.
When the government came out with its proposal, they estimated the income splitting was going to raise $250 million, but they didn’t give an estimate for the passive income. Even with the revisions, they still haven’t given an estimate of what they think they will collect in additional revenues. I expect they will collect something. When they raised the personal income tax rate last year from 29 per cent to 33 per cent, I read somewhere that they didn’t actually get the income they thought they were going to get. Since they have not given an estimate, do you think they will really have a significant increase in their revenues?
Second, what can business people do now to avoid this extra income tax? I know we’re talking about the flight of companies to Mexico or the U.S., because there are more competitive rates, but will that really happen?
One last point I’d like to make is that when the doctors were here last week, we were talking about the fact that they always threaten they are going to move but they never do; they just pay their increased taxes and everything goes on as before. Are things just going to go on as before? Do you see they are going to increase revenues, and do you think business people will take action? Will there be flight risk and will they be doing something else?
Mr. Mintz: I might be the one most knowledgeable about the economic studies on this, but my colleagues might certainly add.
There have been a number of economic studies looking at what happens when you increase the tax rate on very high-income individuals, such as the 0.1 per-centers and the 1 per-centers. These, including a Department of Finance study that was relatively well done, find there was a much bigger reaction in terms of the loss in taxable income when you raise the rate and put it on very high-income individuals. The question is how they do it. There was no analysis to provide that. For example, do they move? Do they put more money into private corporations or whatever kind of tax avoidance strategy they might use?
We don’t really know, with respect to the passive income rules, to what extent it would affect people. We have to remember now that passive income in private corporations is taxed at a high rate of 50 per cent. Many entrepreneurs who don’t need the money in the corporation, especially if they have a marginal tax rate below 50 per cent — Alberta it's 48 and was at one time 39 — wouldn’t leave the passive income in the corporation in the first place, because of the very high tax rate on the returns. However, very high-income individuals would tend to leave passive income in the corporation for a number of reasons. Part of it is related to taxation, but there could be other reasons as well, including the intention to expand business and also reduce credit costs that the small business corporation faces.
I don’t know how much reaction there would be. Anecdotally for example, I already know that because of the July 18 proposals, one of our most important entrepreneurs in this country — and will become revealed later — has decided to move to the U.K., like Russian oligarchs, because they have an opportunity to earn foreign source income that is not taxable. We also know that one of our major entrepreneurs who took a strong leadership role in Alberta, Murray Edwards, moved because of the increases in the marginal tax rates.
We have to look at this in terms of more than just what revenue the government receives. To me, the issue becomes growth. If we lose some of our very best people, who create thousands of jobs for Canada, because they lose interest in Canada, that is a negative thing for the country in terms of our opportunities for growth in the future. That’s why tax policy has to be a balance of objectives. It is wrong to simply look at fairness as the only objective for tax policy.
[Translation]
Mr. Brassard: In the reference document, tax revenues under the first two headings are $250 million for income sprinkling. As to passive income, the amounts are not shown since there does not appear to be a study on the potential impact. For the average business owner, as the study shows, tax revenues will be lower for a certain period. In the short term, they might be a bit higher.
Let us say that someone decides not to incorporate. In the short term, they will pay more tax. In the long term, the smaller amount of money in the economy — and we demonstrated this in our analyses — will result in lower tax revenues. The rate of return that the government will have lost will be higher than its debt rate, for example, and more money will be withdrawn from the economy. That impact needs to be measured. That is not an easy task, but it is something that has to be analyzed. We are talking about the economic impact, but also the impact of tax revenues. In the short term, tax revenues will indeed increase somewhat. People will say they are paying the maximum rate, although they will not even be at the maximum rate if they leave that money in their company. They will then choose not to incorporate or to take money out. In the short term, this will increase tax revenues. In the medium term, however, this will all generate less money over time, less economic activity, and there will be a loss.
The calculations clearly show this. If we look at the table, we see that the business owner will be $4,800 richer. For someone with less expertise, it might be frustrating to see that they are $4,800 richer than the employee. That is forgetting the fact, however, that they will have generated $6,700 in taxes over time. You have to look at the updated values, but a lot of money will disappear. I do not think that people in the real estate sector will agree to work knowing that all the added value they generate will be paid back in taxes at a non-refundable minimum tax rate.
The impacts have not been measured, and that is a weakness. There have been no impact studies, but we know the impact could be serious. We are talking about taking billions of dollars out of the economy. There are a lot of passive assets and passive revenues. We are talking about $500 billion. If the economy slows down, what will the impact be? I would really like a group of economists to analyze this, because the impact could be sizeable, not to mention the drop in tax revenues for the government.
Mr. Paquet: I agree with what my colleagues just said. It is incredible that the Department of Finance did not conduct a study. It is incredible that there was not even an internal study. You will say that it is their right. This department has a lot of good economists and a good reputation — and I am not just saying that because some of my former students work there.
In one of the budgets a few years ago, we saw some elasticity in government revenues as a result of an increase in various types of taxes. This elasticity is all the more important. The revenues that the government collects by levying a tax are the product of two things: the taxation rate multiplied by a tax base that is defined in tax laws.
When the government increases the effective tax rate, directly or indirectly reducing certain credits or exemptions, those revenues will increase if the tax base does not change. Should people decide, however, to work less or invest less, the tax base will shrink over time.
Another way of reducing the tax base is to find different ways of declaring those revenues — and I mean legal ways. Unfortunately, tax evasion does occur at times. Even in terms of legal tax avoidance, unless the way that income is declared is changed — which is more or less what we see with the neutrality of the current system —, the result is that the government has less revenue than it could otherwise collect. I am referring strictly to budget balance now.
Moreover, there is no snapshot of the tax base. It changes over time. This decision therefore depends on the marginal tax rates and taxation as a whole, cumulatively.
In view of what is happening in the United States right now, where there is a lot of uncertainty, it is likely that certain factors will lead Americans to believe that their effective tax rates are too high for corporations, and they will decide to act accordingly. They might also react by decreasing the effective rate, which would result in a decrease in relative competitiveness. Like it or not, capital income is mobile. Since not all taxes are equivalent, we have to look at the whole picture.
These figures need to be updated and I will give you the following example. In 2003, using a general equilibrium model, the Quebec government analyzed the impact of a $1 increase in revenues collected by the government for various tax rates. I will use these numbers as an order of magnitude and not an exact number, just to give you an idea. If there had been an increase at that time in capital tax, capital stock at that time, the long-term impact would have been a real reduction of GDP by $1.37. GDP represents all production in the economy, revenues from both business owners and workers for the whole economy, and all the value added.
Typically, a tax on corporate profits reduces GDP by 89¢ in the long term. I will use this number as an order of magnitude and not an exact number. Tax on employment earnings reduces real GDP by 76¢ in the long term. A consumption tax reduces it by 28¢. We see therefore that taxes do not all have the same effect.
Even if the gap were not as wide, even if we could debate the exact value of the numbers, different types of taxes would have a different impact. So we have to look at taxation as a whole. Unfortunately, this approach is not evident in the current debate. In certain cases where it is true that the system is not neutral and certain things should be reviewed, the impact is that the effective tax rate on capital gains could increase enough, but it is hard to say by how much, except in certain specific examples. These might be realistic, but are they generalized? I could not say right now without a better analysis of the numbers and the impacts.
[English]
Senator Marshall: We may get more information in future hearings, but we know that the income splitting is $250 million, no assessment of the revenues for passive income, and there has been no economic impact of the changes.Thank you.
Senator Black: Gentlemen, thank you all very much for being here. The presentations have been extremely helpful to our deliberations. I also want to thank you for each of your commitment to good governance because that’s I think what we’re all driving at around this table.
I have what I believe is a very simple and straightforward questions. When I listened to your three excellent presentations, I’ve taken away two things. Can you confirm whether or not you agree with my takeaways? The first takeaway is the proposals that were tabled in October by Minister Morneau to tweak the tweaks to the tax system should be abandoned. Number two, I hear you all to suggest that it’s time for a comprehensive review of the taxation system in Canada to put an end to the piling on that has gone on, appropriately, likely, over the last 20 or 30 years. It’s time now for a complete refresh and review of the system. That’s what I hear you all to say. Would you agree or not?
[Translation]
Mr. Brassard: Yes, everything was done too quickly, and in the middle of the summer as well. There were just 75 days to react to certain provisions that were supposed to come into effect immediately, and to others that were to come into effect on January 1, 2018.
When other reforms were implemented, such as insurance reform, it took years. For a period of two or three years, we could see what was being planned, and there was time for a discussion in order to come up with something in 2016 that was ultimately the right thing.
In the present instance, everything went too fast, and there has been significant collateral damage. Provisions have been added without measuring the effects on one thing or another, such as the provision regarding death. In the end, they backed down on certain aspects in response to what they heard.
To be sure, broader reflection is needed. I said so in my introductory remarks: there are some aspects of this reform that most tax experts agree with. But they moved too quickly on this reform without allowing sufficient time for reflection; people died before, they will die after, and there are effects related to death. There are effects on transactions that took place right in the middle of the debate. This all has to be reviewed and a broader reform has to be carried out over a year or two. We have to take the time to consult people properly. In my opinion, that would be the right approach, instead of rushing it through with unexpected effects, and making proposals only to have to back down on them later on.
Even today, we do not know. Tomorrow is November 1; some provisions are supposed to take effect on January 1, 2018, and we still do not have the rules. We were told that it could take until the end of November; so that will give us two or three weeks to react. The impact is too great and it seems to be rushed.
Mr. Paquet: It is time for a complete overhaul and this could be the opportunity to examine matters comprehensively and consider the impacts.
As regards taxation and the impact on the economy, predictability is important. People have to know what to expect. The decisions that economic actors make regarding investments are not based solely on the past. We do of course inherit what happened in the past, but since we have to look to the future in deciding to invest in education, invest in or expand a business, or take risks, we have to consider the anticipated return.
No one can make perfect predictions, but we must be able to anticipate what the potential after-tax return will be, based on the risks incurred. If there is no predictability or if provisions are applied retroactively, the rules of the game change after the game has started. This has effects, and not only in the short term. For example, a decision might be made to tax accumulated past profits at 100 per cent since they are already accumulated and that has no impact on the future. Something similar was suggested in Great Britain in the past; fortunately, it was not implemented. That was to finance the war and not the debt, but by increasing taxes by nearly 100 per cent. That would be a capital levy.
Just as with political or business decisions, the problem with what is done in the short-term in personal life is that good decisions do not have an instantaneous effect but bad decisions have effects that last a long time. One effect of this, for example, is that, if investors and entrepreneurs believe that current changes are a signal that other similar changes will be happening in the future, thereby risking uncertainty, it will have an impact on economic growth, on employment, and on the incomes of people who are already employed, even if they do not lose their jobs. In that context, it seems that things are moving too quickly in some respects. There is still too much vagueness surrounding some of the measures that have been announced.
For example, when dealing with a spouse’s contribution in a company, why would an entrepreneur be able to distribute capital gains with people, even family members, who have not contributed to the company directly? After all, the tax system already recognizes the fact that, given the risks, the tax rate on corporations is, in practical terms, lower than the rates that apply to employment income.
One might actually say that it is not on, and see it as a way for someone to reduce their taxes. For example, as a consultant, I could earn income, incorporate myself and reduce the income from a consulting contract by making payments to my daughter who was in high school at the time. It would have been legal for me to do that. You can clearly see that a situation like that is not something that should be done. My example could lead us to think that things should be changed.
But, when we are talking about taxing a husband or a wife, and that husband or wife bears part of the risk in the company, there is a much broader issue that perhaps has to be looked at again. In the United States, for example, a taxpayer and a spouse can make a tax choice, to be taxed either individually or as a family. Would that not be an avenue to consider?
I would not like to take a strong position on that issue today, but it is the kind of questioning that one would like to have seen in the consultation document; it would clarify the debate and put the various issues into better perspective.
[English]
Mr. Mintz: Thank you very much, Senator Black, for your question. To answer it, perhaps right to the point, with respect to the proposals themselves, I think the only thing that might be appropriate, or at least certainly debatable but I think might be appropriate, is to extend the kiddie tax to adult children to maybe up to the age of 28 or 30 or something like that, which would be about the only thing I would leave in the proposals. Otherwise, everything else would be pretty well abandoned in the proposals.
I also do think that we need to look at our tax system. For example, in my view, you need to have some direction about where we want the tax system to go in the future. At the federal level, we have not had that kind of query since 1997, 20 years ago, when I chaired the business tax reform panel for the Honourable Paul Martin at that time. It did set the stage, at least for business taxation, about where we want to move the system, and in fact, a number of changes were made over the last 20 years, at least up to 2012, that were consistent with that report. A few things, I would argue, went backwards, like introducing accelerated depreciation for manufacturing, but generally we had followed the philosophy of that report, which I think provided the guide for governments, both federal and provincial, to follow through.
I do think that maybe we need a general review of the whole tax system, both personal tax and corporate tax, but also the GST. One of the things we did at the School of Public Policy, which has been published by the Canadian Tax Foundation as well as ourselves, is several papers that reviewed the GST. Do you know that our value-added tax collects roughly only one half of the consumption tax base because of all the exemptions in the system? It’s not a good value-added tax. I don’t know why we think it’s so great. In fact, if you’re arguing to raise the rate, I think we need to fix the system before we do that. I think there are a whole bunch of things in the tax system that need review, including changing the mix of taxes and what would be appropriate to consider. I think that would be a very important guide for governments.
I would also like to add on one other important factor that will be very apparent over the next few months, and that is U.S. tax reform. If the U.S. goes ahead with their major tax reform — I think you’ll find a lot of experts would argue that despite all the shenanigans that go on in the United States these days, there is a good chance there will be reform. We’ll certainly know in a few months’ time. Certainly corporate tax in the United States is really out of kilter. It needs to be fixed — both Democrats and Republicans understand that — and there’s a good chance there will be a significant reduction in corporate tax rates in the United States.
As we have modelled, if the U.S. went to a 20 per cent corporate income tax rate, which I am sure will be part of the house plan coming out this week, that would eliminate almost all of the business tax advantage we created in the past 20 years in Canada. We will no longer have a business tax advantage for large corporate capital. If the U.S. goes ahead with their very significant reduction for small businesses on business income, where you’re lowering the rate for the top personal rate down to 25 per cent at the federal level, that would also have a huge impact on competitiveness for Canada and we would have to worry about that.
In other words, we may be forced into tax reform because we need to sit back and ask where we are going in this country in terms of making sure that we have a tax system that is fair, but it’s not just fairness; it’s also one that is not going to be a major barrier to growth. That means relying more on less harmful taxes, fixing up some of the harms in the current taxes that are creating barriers to growth and keeping in mind the competitiveness issues that in today’s world you can’t avoid because of the mobility of capital and also talent around the world.
The Chair: Mr. Paquet, you had another comment.
[Translation]
Mr. Paquet: In Great Britain, there have been some major steps forward with the work of the Mirrlees committee. Economists have been saying for a long time that, all other things being equal, it is preferable to tax consumption differently, at a higher rate than other forms of taxation. Even the Godbout Report in Quebec, which was more limited in scope, was moving in that direction. Changes made over a number of years with the implementation of the GST and the HST, put Quebec a little further ahead than the other provinces that moved forward by abolishing the manufacturing tax, which was much narrower in scope. If fact, there is still work to be done in that regard.
In terms of taxing companies, taxing the capital income is often handled insensitively in the Mirrlees committee report, which emphasizes the benefits of a tax system that is neutral in two respects. Here is a passage from a document I prepared:
First, the tax system should not influence the point at which households decide on consumption over savings. In addition, it must not influence the type of assets selected, especially in terms of the risk taken.
Once again, there is the issue of neutrality.
A tax system that makes no distinction between capital income and other sources of income is not neutral in terms of the timing of decisions to save. Taxing “normal” performance penalizes households that wish to postpone consumption, including those that want to distribute it throughout their life cycle. The second kind of neutrality treats all savings vehicles in the same way, including capital gains or pension income. In that situation, taxing capital income becomes a redistributive policy, especially when it applies to what exceeds normal capital income. Taken together, all those elements justify a policy in which all capital income, independent of its source, could be taxed at the same rate as other income, but with an exemption for normal performance, which would need to be determined.
This is one of the important principles in the Mirrlees report as a whole and I feel that it deserves to be looked at in the light of the Canadian experience. To complete the answer to Senator Black’s question, this is a change that could be made in its entirety.
The final aspect is the matter of taxing investment income, that is, holding an asset or a resource that earns income that could be taxed differently. These are complex issues, but they need to be examined; the science and the practice of economics show that steps forward are possible. We see examples of them in Scandinavian countries with the tax on cash holdings, still considering that they tax capital income less than consumption or other sources of income. They are able to achieve a better balance.
Senator Forest: Thank you very much for your very instructive testimony. It will enhance the relevance of the consultations that the committee is going to hold during its Canadian tour. Mr. Brassard, in this whole issue of passive income, we all agree that the tax system of an entity like Canada must be fair and effective in order to be competitive. It must be fair, because it must also include families. It must also be effective so that SMEs are encouraged and motivated to set up and grow in Canada.
We have been told that 85 per cent of all passive income is held by 1.6 per cent of all companies. That is one of the major aspects of this reform. We have met with those representing young companies. I am still thinking about one witness last week who was very eloquent. He was a young, 30-year-old entrepreneur who said that he wanted to increase his capital. Given all the business transfers that will be happening in the coming years, he said that he wanted to have enough liquidity to be able to make acquisitions. The young man was pretty fired up, I found. Senator Pratte highlighted it very well in an article in La Presse on the weekend.
The figure of 1.6 per cent means that not a lot of companies are holding 85 per cent of the capital. We are talking about $255 billion. Would there be a way to remove from passive investments the parts of those amounts that are not used as a way to reduce income tax, but as a way to contribute to a company’s development? The capital could be used for replacing technology, for operating funds, and eventually for retirement. Everyone is telling us about the 1.6 per cent of the companies holding 85 per cent of this capital. How can we arrange to remove from that capital the amounts used for specific purposes?
Mr. Brassard: We could talk about the size of the figures.
Senator Forest: I am not so worried about the size of the figures we have been given.
Mr. Brassard: A lot of entrepreneurs are holding onto a lot of money. I would like to know the scale of the figures because, sometimes, a lot of things are called passive investments, like real estate, for example, that can also provide active income. However, in our brief, we are asking what the definition of passive income is. That is the real question you are raising. Passive investment is not always passive, as people who deal in real estate sometimes jokingly say. It may be passive income for some people, but, well —
Senator Forest: It’s active.
Mr. Brassard: People forget that, passive though the income is, a lot of real estate is generating very healthy returns. So is that really passive income? According to the law, it becomes active income when you have five employees and more, but, in reality, it’s open for discussion.
If you take away a lot of the stuff you are talking about, you raise the point about people who make private investments in the form of debt or in the form of capital in small businesses. Perhaps someone putting in some money is not active in the company, but they are making a private investment in that company. So if the gentleman you are talking about wants to use his capital to buy companies, that’s money that is working for the economy. Is it passive income? That is open for discussion.
The same goes for a small public company. Yes, it is a passive investment in the sense that it is a publicly traded stock. But it is still a small business. If you cut that financing and prevent people from incorporating and take 40 per cent of the money on the market to pay down the government debt or to spend more in some area or other, there are clearly risks.
Passive income has to be defined. At the moment, rental income may or may not be considered passive. Once you have taken away what is active, you have whatever is left, and, if you start playing with that, you are playing with a lot of money.
We have nothing against fairness, but if the result is that everyone is poorer, nothing has been gained. You have to measure competitiveness and the economic impact on growth. By wanting to solve one problem, you can create others. So you really have to define what a passive investment is. It has not been done; it has not been mentioned, and it deserves to be specified. A section in our brief specifies it, and it has to be done before we go any further. It is part of the overall thinking that should be done.
Senator Forest: A bit like its economic impact, really.
[English]
Mr. Mintz: Don’t be fooled by the 1.6 per cent number that people banter about. This sounds really small. We’re talking about 30,000 corporations in terms of 1.6 per cent. The question is: Who are these corporations?
As I mentioned, when you’re really small in terms of earning income, let’s say below $200,000, you’re likely not to leave any passive income in the corporation in the first place because there’s a very high tax on investment income. It’s really more the companies that get larger that end up having more passive income. In other words, of those 30,000 companies, are we talking about the growing companies? Are we talking about the ones that could become not only medium-sized businesses but, many years from now, large companies? There’s no data on this.
I don’t think we should minimize the importance of the passive-income rules in terms of its impact on economic growth.
[Translation]
Mr. Paquet: Ideally, if you had to define what passive income is, you would want to exclude money set aside for development. Once again, the devil is in the details, because what one person calls development, another person does not. So one of the problems of the minister’s current proposal is that we still don’t know how far into the details they will go, and we are only a few months away from it being applied. That is one of the issues.
When I mentioned just now that economists often say that is preferable to text consumption, while still considering the important issue of redistribution, I was not just thinking about the GST. Savings must not be taxed. Because savings is income earned in all its forms, by workers, by companies, and so on, minus consumption. In other words, not taxing savings is actually a measure of economic growth, because savings are not something you forget and bury in a hole in the ground. Savings are tomorrow’s consumption; they are Canadians’ future standard of living. So you have to consider the return you can accumulate. Hence the idea of RRSPs and TFSAs, although the mechanisms are different, and letting people accumulate a tax-free return on their existing funds.
The issue is in knowing how to treat the same objective and the same idea fairly, both for the returns accumulated inside a company and for a regular salaried employee, while considering the different risks assumed. Those are the issues that have to be dealt with.
A senator referred to the matter of transferring businesses. The Department of Finance’s consultation document started off by saying that it would be appropriate, in the consultations that will be taking place in the next weeks, to talk more about what could be done with business transfers. The aging population is an issue all over Canada, but particularly in Quebec. In many family-owned businesses, often small businesses in terms of their size, people are going to retire, they are going to try and find a buyer or, if not, they are going to shut up shop.
One of the issues at the moment, in Canada’s current tax system, started to arise in recent years in Quebec. If you own a company and you transfer your company to a third party with no family links or to an employee who is closer to the company, you then have a lifetime capital gains deduction that was $750,000 and, I believe, is now $800,000. The amount it indexed, so it means about $835,000. I can tell you that, between 2005 and 2012, when I was in government, I was involved in debates on the issue in Quebec. I debated it with officials from the ministère du Revenu at the time — it is now the Agence du revenu du Québec — and the ministère des Finances. They did not want to budge on the matter, and it was a pressing issue for young entrepreneurs in particular, but also for seasoned entrepreneurs who were planning on retiring. Companies were in danger of potentially being sold to people outside Canada. They have the right to do that; there is nothing illegal about it. But at the same time, we should not have a system that favours one kind of transfer over another that could directly threaten Canada’s economic growth. Despite the resistance from the ministère des Finances du Québec, and the ministère du Revenu, which I was able to see from the inside, resistance from very brilliant people, no less, changes were made.
Moreover, in the documents I took the liberty of submitting to you, there is one I wrote in 2013. But there are also updates, especially in our interpretation bulletin of February 2017, in the passage from Quebec’s economic plan, and in the additional Budget 2016-17 document. They describe the steps taken that show that, even if the federal government has not yet budged, in Québec, it is possible to transfer a company to a family member in a way that will not be treated unfairly or in a way that discourages a potential business transfer. I feel it would be good for the committee or the department to take a close look at this matter.
Senator Forest: I find it totally unfair and incomprehensible that these institutions of ours, which should be espousing these values of fairness, are showing such great resistance. It is simply beyond me.
In the short term, if Minister Morneau’s tax reform measures appear in the appropriation bill in December —
Senator Moncion: It was introduced yesterday.
Senator Forest: — or in the March budget, what I have noticed, in the very short term, is a broader acceptance of the reforms in the past few weeks. The key question, however, is how they will be implemented. It is crucial that the parameters be defined with precision. As I see it, whether in the medium or long term, against the backdrop of globalization and Canada’s new reality in the 21st century, we need to rethink our tax system on a much broader scale.
Senator Pratte: Building on the idea of a more comprehensive approach to tax reform or broader review of the tax system, I’d like you to tell me what such a review should focus on. A good many witnesses have shared their thoughts with us, but it would be helpful to hear what you think a commission or committee tasked with such a review should prioritize.
[English]
Professor Mintz, you were head of the last committee that studied at least part of the system. From you I’d like to know, besides the GST, what other things you think a committee should look at. I’d also be interested in what formula you think such a review should take. Should it be a technical committee such as the one you headed 20 years ago? Should it be a new Carter commission — which was an ambitious exercise — or a task force or what? Professor Mintz, maybe we could start with you.
Mr. Mintz: Let me say a few things about the panel in 1996 and 1997 and how that evolved before answering your question about process.
The panel, at that time, was struck with outside people from the Department of Finance. Particularly, it was not given personal income tax to review, in part because the department felt they could handle the personal income tax and that the real difficulty was around business taxes. At that time, globalization was taking place. The world was changing a lot. There was a real concern that Canada, because we actually had a corporate income tax of 43 per cent, which was one of the highest in the world and with a lot of distortions in the system, needed to do something with the business tax structure.
The panel was created. It was called a technical committee, and I have to admit I made the name up, partly to deflate some of the expectations around the committee, rather than calling it a commission or something like that. In the end, it really did act like a panel would, and a pretty substantive report came out of it. It was intended that the committee would not itself do consultations with everybody. We did some in terms of making sure that we got ideas or views of different business groups, but really the idea was that it would be a document that would become available for consultation by the minister afterward.
We do need a larger review of the system rather than just the business tax system. Part of that review would include two types of questions. One question is the mix of taxes: Should we change the mix of taxes? Should we rely more on, for example, the GST? Do we raise the GST rate and reduce income and corporate income taxes? This has happened in a number of countries around the world, and that could be considered.
I raise GST reform because we tend to ignore it, and I think that ought to be another question to ask about how we can improve it. New Zealand, for example, taxes almost 100 per cent of consumption under their GST, or their value-added tax, while we only collect 50 per cent. So we don’t do a very good job, and we need to ask some serious questions. In fact, we did a calculation that you could lower the federal GST rate from 5 to 3 per cent if you got rid of a lot of the exemptions and had something like the New Zealand system. That tells you something about the size of those exemptions. A lot of high-income people benefit from those exemptions as a result.
I also think that in the business tax system, we need to look at really two major issues. One is the tax treatment of small business. Do we have the right incentives in place? Is there something better than just simply lowering the rate, which is the system we’ve had for 45 years now, since 1972? Is there a better way to organize the taxation of small business, which would require a much bigger set of review or questions than what was being addressed in these proposals.
But we also need to look at the corporate system as well. There are a lot of new things that have been happening. We have flow-throughs now in terms of partnerships, trusts and things like that where some of our rules only apply to corporations and not to others.
The federal government doesn’t have a land transfer tax, but land transfer tax is a huge problem when you’re trying to tax commercial property. That would be more of a provincial concern, but when you start looking at the corporate sector, you have to remember there are all sorts of different types of organizations. How do you make sure you have a system that will equally apply without distorting the choice of organizations in businesses?
In terms of the corporate rate, we’ve gone to about the middle. In fact, we’re actually a little bit above the average OECD rate now; it’s close to 27 per cent, while the average OECD rate now is around 25 per cent. We have to remember that we really don’t have a lot of room there, unless we want to have a lot of profit-shifting from Canada to other countries if we try to raise the rate any further. But it doesn’t mean we can’t look at some of the incentives in the system. In fact, I did a calculation that we could get the corporate rate in Canada down to 23 per cent if we got rid of the small business deduction, a number of incentives and did some base-broadening that would actually get us even a lower rate if we want to do it on revenue-neutral terms.
The personal tax needs a good look.
In terms of retirement income, we have to ask the question: Do we have adequate incentives for retirement income in terms of the tax-free savings allowance limits and RRSP and pension limits? We’ve done a really good job integrating the systems in Canada, unlike the United States and other countries that may have different types of systems applying to different types of employees. We’ve handled that really well.
We also have to ask the question about the whole taxation of property income, investment income, capital gains taxation and things like that. Should the lifetime capital gains exemption still continue? Is there a better way of providing retirement saving incentives for small business, farmers, fishers, et cetera?
There’s a whole host of questions about reducing distortions in the corporate tax system and the individual tax system. It’s also a reminder to governments that some of the incentives they bring in don’t work, such as labour-sponsored venture-capital credits, which I was very disappointed to see brought in in a budget in 2015 after all the studies had shown how harmful they have been to venture capital markets. There are things where a study like this could become, in a sense, a Bible for governments to remember what things can work and what things don’t work.
[Translation]
Mr. Brassard: I agree with a number of those points. Among the reform’s central themes, questions have been raised about the impact on families. It is not just corporations using income splitting. Pension income can be shared as well. A public servant can share their income with their spouse, while other individuals do not have that option. If the arrangement exists at the company level, it is also possible in that context. That is one of the things that the reform seeks to manage. Tax experts generally agree that some guidelines are necessary to restrict the practice to some extent. Other countries have what is known as couples’ income. Perhaps we should follow their lead. It’s something worth considering. Further to what Mr. Mintz mentioned, I in fact talk about revisiting the corporate tax rate, as well as the GST. The Godbout report, in Quebec, put a lot of emphasis on reviewing every program one by one, in order to strengthen the impact of the consumption tax. A plethora of credits are used by very few people and, for the most part, have very little effect. That would involve a review of personal taxation as well.
Indeed, we need to take a good look at exemptions for corporations. Does it really make sense for a business owner to be able to share 16 tax exemptions and allocate them to his four-year-old great-niece who he saw for 10 minutes? That is not a joke; that is possible under the current system. Those are things that tax experts agreed on but subsequently abandoned, which is a bit odd. As far as the multiplication of the capital gains exemption is concerned, it makes sense within the family unit. I’m a taxpayer as well, and I see that option as an advantage.
We should take a broader look at a number of elements related to companies and family. All of the credits and incentives that do not have an impact need to be revisited. The GST and QST are certainly worth exploring too. In a nutshell, a broader review is needed, as opposed to this thrown-together package of tax reforms.
Mr. Paquet: I would like to add something about the consumption tax. Where the Godbout report falls a bit short is that it refers to the QST or GST as the consumption tax. Picking up on the definition laid out earlier, I would point out that consumption equals income minus savings. In other words, the difference between earned income and saved income would be income spent. Taxing income spent does not mean raising the consumption tax or GST. Border-related issues involve the goods we consume in Canada, the U.S. and elsewhere. Two options are possible to further tax consumption and eliminate the tax on savings, thereby encouraging economic growth. Neither the Godbout report nor any other examination in Canada has taken an in-depth, or even preliminary, look at that area.
That does not necessarily mean increasing the tax burden on individuals overall but, rather, reducing effective marginal tax rates. One of the problems when it comes to taxing individuals is that people think of the tax brackets in the official tax tables, now available on the Internet or attached to income tax forms. Consider the effective rate someone pays, for instance, using the tax credits available to individuals who earn $19,000 or $20,000 — we are not talking about wealthy people here. When their income goes up by $1,000, they no longer qualify for certain tax credits or redistribution measures, either federally or provincially. The effective marginal tax rate is much higher than the one in the official tables.
Quebec, for instance, implemented a tax shield, which partly resolves the problem at the provincial level. Although it doesn’t fix everything, it is a step in the right direction. To my knowledge, the issue has not been the subject of any recent in-depth analysis at the federal level. It certainly merits serious consideration: individuals whose income rose from $30,000 to $31,000 — so, an increase of $1,000 — would, as a result of the effective tax rate, end up with less money in their pockets because they would no longer be entitled to the tax credits that were previously accessible to them. It has nothing to do with people becoming lazy or engaging in something illegal. They are being penalized for wanting to earn a higher income or working harder. That has an impact on the economy, in terms of both efficiency and redistribution. What’s more, it is unfair. It is therefore an issue that is worth a much closer look.
The challenge is to review the indirect tax system and make it more consistent. As far as banks and other such financial intermediaries go, both the International Monetary Fund and the authors of the Mirrlees report favour the implementation of a cash flow tax on the economic rent of financial institutions, even before corporate tax is collected. A number of worthy options exist.
Environmental taxation is another important and well-intentioned consideration. Most of the time, governments propose taxes with commendable objectives in mind, but the overall impact is often disregarded.
Mr. Brassard: Obviously, we haven’t addressed the issue of tax havens, which need to be dealt with head-on. We are talking about billions of dollars. Rather than going after people, here, at home, we might do well to focus our energy on those using tax havens. The government is talking about it more and more, but we have yet to see any meaningful action.
All of these reform measures need to take complexity into account. We are talking about effective marginal tax rates, and the impact the proposed reform would have on passive income is unfathomably complex. Even for accountants, compliance could mean countless hours spent on record-keeping and communicating with CRA officials, not to mention, lost time and efficiency.
In this case, the so-called reasonable factor, a concept everyone seems to be bandying about, would mean never-ending litigation and discussions with public servants about what constitutes reasonable income. The government needs to pay particular attention to the complexity involved. Fundamentally, taxation is not straightforward, but that should be one of the objectives. Otherwise, it leads to a huge loss of energy.
Senator Moncion: I have two fairly different questions. In 2008, we experienced the asset-backed paper crisis, and, since then, the number of business loans granted by financial institutions has dropped. We have also observed a significant increase in passive investments at the company level and business incorporation rates that may have led to tax loopholes. Could you comment on that, please?
Mr. Brassard: I’ll speak to a point raised in a paper my colleague Paul Ryan wrote, on the topic of the level of incorporation. The issue has not been handled well; for the past decade, more businesses have indeed been incorporating because Quebec’s professions board, the Office des professions du Québec, allowed it. We have to answer an important question. Which situation is normal? The one we have today or the one that existed previously? Why could a law firm with 30 employees not incorporate 20 years ago? The previous situation is the abnormal one. Quebec began allowing professionals to incorporate. Nowadays, a professional is also an entrepreneur. That is important to bear in mind. Of course, then, we have seen an increase in the number of incorporations, stemming from the fact that the government now allows it. It hasn’t been that way for very long. In the past, it was perhaps not regarded as normal to not have so many companies and to discriminate on the basis that the business was an accounting or other such professional office. Why were they not treated the same as business owners? We could talk about doctors; that’s another debate.
The fact that we have more incorporated businesses today may simply be a return to normal. These people are entrepreneurs just the same as those in other professions that had the right to incorporate. Yes, then, we have more incorporations, but is that wrong? They should not be viewed as a nuisance.
Senator Moncion: That isn’t the case.
Mr. Brassard: It brings in more revenue. The money works harder. The entrepreneur may be getting richer, but they are handing over 50 per cent to 60 per cent of their income in taxes. The numbers speak for themselves.
The practice should not be seen as abusive. If a business owner has the right to hire employees and if the intention is to reduce taxes for those who do not hire employees, as Quebec did, by imposing the 5,500-hour requirement, tax policy comes into play and a person is deemed to qualify for a lower tax rate if they generate employment. Not allowing these businesses to incorporate and designating the practice as wrong would mean returning to an abnormal situation. They are entrepreneurs, just like everyone else.
[English]
Mr. Mintz: First, with respect to the question about post 2009, one of the most harmful concepts that ever developed was this dead money idea, which has been a complete misunderstanding of the role of cash flow and retained earnings in corporations.
Actually, one of the good things about Canada and some countries is that our corporations were not highly levered going into the 2008 financial crisis. As a result, we didn’t have the experience of bankruptcies and other things that did occur in Europe and the United States. There was still a downturn and it hurt us badly, but our corporations actually weathered it much better because they did have a cushion of cash flow to support them.
Being on boards, I can tell you, we’ve looked at the data. There was a growth in cash flow, but there were two reasons companies were doing that at that point. In fact, they weren’t necessarily buying back shares. They were actually keeping the money because they knew there were going to be good acquisitions or purchases of assets when the market started coming back and they wanted to have the flexibility to do that. The other thing is they really were very concerned about liquidity in case there was another significant downturn in the economy.
Things were not very good even after 2009 in terms of overall growth in the world economy. There were concerns regarding Europe, which was going through some very difficult tensions post 2010. The United States was still on a very slow growth recovery. People weren’t quite sure whether they would dip back into recession. In 2012 or 2013, we did have a slow down that didn’t lead to recession, but it was not a good growth year for the world economy. There was a lot of nervousness, and that’s one of the reasons for withholding cash flow.
When you look at economic studies on investment, it has been shown time and time again that cash flows can be an important source of equity finance for corporations and actually is their cheapest source of finance. This is one argument that I would give against the neutrality argument in the July 18 proposal. It was argued by some people that somehow it doesn’t matter whether the money is inside or outside the corporation. It does matter. When retained earnings are held in the corporation, it does give a cheap source of finance for investment expansion. In fact, many studies have shown that this is the case.
Much of financial theory talks about this because when companies have to go to the outside market by either borrowing money or getting new equity, people on the outside don’t know the company as well as people on the inside. Because of that asymmetric information, they tend to want a higher return on investments because of potential risks. One of reasons I have always been against new equity incentives is that it encourages bad firms coming into the market and hurts the good firms that are trying to raise capital. These models show that if you are going to have a problem of asymmetric information in the markets, you actually want to tax the signal, and the signal being that only the firms that don’t have good internal resources go to the outside market to raise money. If you start subsidizing that, you will encourage too many bad firms coming into the market.
Actually, I think this dead money argument is a harmful one, and I’ve been ashamed of people in important positions who have used this argument, especially people who understand investments by businesses and the issues around that.
One of reasons income trusts were such a bad vehicle for the corporate sector is that it starved companies of cash flow. As soon as a downturn occurred or a competitor came along and started grabbing market share, because the income trust kept passing out money to its investors, who had no cash flow, it found that it couldn’t raise money from the outside and got into serious trouble. In my view, one of the best things that happened was Halloween 2006. We’re celebrating the anniversary today, but on Halloween in 2006, we got rid of the income trust structure or at least took away the incentives for it. If we had gotten to 2008 or 2009 with many income trusts still operating in Canada, we would have gotten into very serious trouble in this country because many companies had starved their cash flow.
With respect to incorporation, we need to do a good study of this because I don’t think we understand why private incorporation has increased over the years. I can think of four reasons for this. First, there has been a change in labour markets where companies have been hiring fewer employees, partly because of all the expenses and regulations associated with it, and getting contract labour instead. If you are hiring contract labour, many self-employed people would incorporate, perhaps due to tax reasons but also due to limited liability and because they wanted to reduce the liability that they might face.
The second reason is that since 2009, many of the provinces allowed professionals — this included doctors, lawyers, accountants, chiropractors, veterinarians and social workers — to incorporate. They couldn’t extinguish their liability with respect to practice but, of course, it still gave some other positive aspects in terms of limited liability. For example, I saw my doctor the other day and he told me that at one time, he had his own practice and he said that he had nine people employed. He couldn’t draw anything out until everyone else got paid. His family wouldn’t get any food on the table unless he had enough money to pay out all his employees. So there is a certain amount of risk involved, but you do tend to minimize some of that risk in incorporation compared to liability that they face when it’s unincorporated.
Again, there may also have been tax reasons that would encourage incorporation, but given that the money is eventually fully taxed when it comes out of the corporation, it is mainly the deferral of tax within the corporation that is the benefit for individuals.
The third reason, which we often forget about, is that many public corporations delisted and became Canadian-controlled private corporations. That has happened since the early 2000s. With Sarbanes-Oxley and other changes brought in, it encouraged many companies to become private companies, and if they were directly or indirectly controlled by Canadians, they would be Canadian-controlled private corporations. I would like to see the data, in terms of new companies becoming Canadian-controlled private corporations, on how many of them were large, with a large amount of taxable income as a result.
The fourth reason is the disparity between corporate and personal tax rates, but we have to remember that back in 2000, the top personal rate at that time was around 46 per cent and the small business rate was a little less than 20 per cent. There was already a 26 per cent difference in tax rates at that time. Yes, they have opened up even more, but the question is, how much of that growth is due to that as opposed to some of the other factors? We need a study on that instead of trying to jump with policy conclusions when we really don’t know the facts yet.
[Translation]
Mr. Paquet: The example we just heard paints a good overall picture of the economy: it is becoming increasingly service-based in many respects and extremely diversified. It also draws attention to the whole issue of what really constitutes passive income, in terms of the type of service involved. A slew of factors have to be taken into account.
That is entirely in line with economists’ thinking when it comes to taxing income exceeding the normal rate of return. The issue could give rise to a whole debate. At the same time, or, at the end of the day, by feeding itself, on the one hand, the field of economics has moved in a certain direction, and, on the other, the actual economy has moved in another direction. That necessitates a broader debate.
[English]
Senator Moncion: You also mentioned that there will be U.S. tax reform coming this year. Are they starting the work or is it something they have been working on for a number of years and will be bringing forward? You were saying that once they do their reform, it could have a major impact on what is done here in Canada. I want to understand that.
Mr. Mintz: There was work done before the 2016 election by the Republicans and it was reflected in the house blueprint introduced last year. That was a brilliant document in which the corporate tax rate would be reduced at the federal level from 35 per cent to 20 per cent and there would be much lower tax on business income and lower personal tax rates. It would also include what was called the “border adjustment,” but when you get to the details, it was a sneaky way of bringing in a value-added tax to the United States without calling it that because it would never get in as a value-added tax in the United States.Of course, that has not happened. But over the past year, there has been a group of house Republicans, Senate Republicans and the administration working together — certain key senators and House of Representatives people from the Republican Party, as well as people from the White House — working on a tax reform.
We are finally going to see the results of this work over the past year on Wednesday, when the house is going to introduce a detailed plan for the first time. With the previous plans that have been introduced — it’s hard to call them plans, they were more intentions — to lower rates, to lower levels and to do certain kinds of changes, there was not much detail about how they were going to actually broaden the tax base.
What has been agreed upon is that they will accept — in the Senate but also the house — a $1.5 trillion loss in revenues over the next 10 years. That’s in the budget that has now been passed by both the house and the Senate. But right now, the loss of revenue associated with corporate rate reductions and personal tax rate reductions is over $5 trillion in 10 years. They have to close that gap.
There are a number of things being discussed, for example, a one-time tax on that huge pot of money sitting abroad, $2.5 trillion sitting abroad and held by U.S. multinationals. In fact, a 5 per cent tax would raise a fair amount of revenue on $2.5 trillion, or even the 10 per cent, which is what we’re talking about. They are talking about getting rid of a number of deductions and credits. They are potentially talking about lowering the personal tax rates but introducing a new top-rate category that could be over $1 million, where the personal tax rate will actually — at the federal level, instead of 39.6 per cent, it could be an even higher number, like in the 40s. That’s for over $1 million in taxable income. Just to remind you, in U.S. dollars, our top rate hits at around $160,000, so there is a big difference in that.
The house is just the first action, and because of the budget passing, the tax bill can be passed by the Senate with only 50 votes under the reconciliation rules they have. The house is planning to try to pass something by Thanksgiving. We’ll see how successful that will be. Then it goes to the Senate, the Senate will have its own package, and then they’ll have reconciliation between the house and the Senate. They are hoping to have this all done by January, which frankly I think is a very fast schedule for it to be done.
Senator Andreychuk: I thank you all for making a compelling case for the argument that trying to fix one problem creates so many more and that we’re due for looking at the whole system, not only for ourselves to make it fair but to be competitive across the country. I think that’s the main message I hear.
I want to go back to the public policy issue that started all of this. We heard that it was unfair that you can incorporate and pay a lesser tax than those who are employees. That’s really what I keep hearing from people, saying they think it’s unfair that I incorporated, and they were comparing an employee to an incorporated person. That discretion for some professionals was the nub of why they did this. Others have said it was perhaps to raise some tax, and you’ve given us some other reasons.
Here we have to determine whether the government’s actions have been helpful or unhelpful and make recommendations. What is the public policy issue that needs to be addressed more than anything else in assessing these changes?
Mr. Mintz: Well, I can tell you — and it goes back to an earlier point made — that when the top rate was raised from 29 to 33 per cent, not that much revenue was raised in 2016. There were good reasons that happened. In fact, a lot of people planned around the top rate going up, and they capitalized their companies or they got their capital gains in 2015 and paid the tax at that point at a much lower rate. They also had dividends paid out of their corporations and emptied their retained earnings to avoid the increase in the top rate. That was one the reasons that happened. I think certainly it was partly driven by revenue reasons. They were disappointed that in trying to put the screws to high-income people, they didn’t get enough revenue out of it, which is not entirely surprising.
It became a fairness question because they were trying to make the rich pay more. I have done a calculation. Individuals of more than $100,000, which is about 7.8 per cent of all taxpayers in Canada, pay more than half federal and provincial personal income taxes, so you can ask about fairness. No matter how you calculate it, we have a progressive tax system right now in Canada. It’s just a question of whether you want it more progressive or what.
Certainly fairness became important, but revenue was also an important part of it. What was forgotten, which goes back to my point, was growth. When you start hitting even the rich with more taxes, you can impact the economy, and I think that goes back to some of the comments that Alain made with respect to the marginal cost of taxation and the impact on the economy. In fact, many studies have shown — my colleague Bev Dahlby at the University of Calgary has shown this — you have very high economic costs of raising taxes, especially when you have very high marginal tax rates at the personal level because people avoid the tax, and that’s what the studies have shown.
My point is that we need to look at tax reform more generally and we have to remember there are several objectives for good tax policy, and it’s not just about fairness or raising revenue. In fact, usually the exercise is you say the government needs so much revenue to spend, because what determines how much revenue you need is spending. After that, you determine what the best tax structure is to give you that revenue, and that’s really the way you look at tax reform.
[Translation]
Mr. Brassard: Being fair does not mean being equal.
When you compare a business owner and an employee, it’s important not to hastily conclude that that has to happen. There are risks involved. We were talking about growth. With private companies, we are seeing that Canadian society is not being deprived of revenue. That is what we are trying to show. Tax revenue opportunities increase when people are allowed to engage in activities that generate growth. In an effort to make things equal, many people are being penalized, and, at the end of the day, that affects everyone.
[English]
Senator Jaffer: Thank you very much for your presentations. They have been very useful.
I have a lot of questions, but we’ve run out of time. One of the things that bothers me is the passive income. Professor Mintz, you have spoken about it. The way the minister and some have classified passive income is actually insulting, because if you are in business, often, as you said, you save the money to expand or for pensions or whatever. How would you define “passive income”? I have so many questions but I will just ask this one.
Mr. Mintz: Well, I’m not going to give —
Senator Jaffer: Let me tell you how I would define it, having grown up in a family of small business people. My father would save the money so he could expand because the banks would not take the risk on what he wanted to do. As a small business person, in my family, we would save the money so we could take the risk the bank would not support us on.
Mr. Mintz: Well, I think there is a certain propaganda value to using the term “passive income.” In fact, that’s why sometimes they use the term “investment income.” The tax system does make a distinction between active business income that comes from your work effort and your real investments and things like machinery and the course of doing business. Property income, investment income or passive income is kind of from your investments and portfolio, where you don’t necessarily have control of your business.
I actually like to remind people that what we’re talking about are retained earnings in a corporation. I think if you say we want to tax retained earnings more, that sounds a lot more problematic than saying we are taxing passive income, where it sounds like we’re saying, “You don’t really need that income. It has no purpose. It’s passive. It’s dead money.”
That’s why I like to remind people this is really a tax on retained earnings because we know that retained earnings in a corporation have all the positive aspects you were just mentioning. It allows for more expansion of the business and cheaper credit, provides a cushion against contingencies and things like. That’s why corporations have retained earnings, and that’s why retained earnings play a very important role.
I’ve looked at public corporations, and if you calculate their retained passive income or their retained earnings, the income they get from their retained earnings is roughly 11 or 12 per cent of their active business income. For small business, it’s 16 per cent. So it’s a bit higher in private corporations, but I wouldn’t say it’s exceptionally higher.
Senator Cools: I’d like to begin by thanking all of you for your clarity of mind and for your years of study on these issues.
I’m directing my question to Professor Mintz. Professor, you end your note to us by saying: “I am afraid we went the wrong direction with the July 18 proposals.” I think large numbers of people agree with you on that. Without resorting to a crystal ball, do you think there’s a reasonable probability that the government will abandon the course it’s on and set a new course?
Mr. Mintz: I can’t speak for the government or to the politics of it, but the passive income rule needs to be dropped. It’s just not workable, and it will create significant harm to the economy. It needs to be dropped.That really just leaves the income splitting proposal, and I still think it’s inappropriate to apply it to spouses. Once you take that away, you’re left with the kiddie tax being expanded to adult children.
Senator Cools: I was at a meeting last night with Senator Oh of relatively comfortable people, and the uneasiness and anxiety are profound. Right now, the Canadian population is bordering on moving into mistrust of the government. That’s never a good thing. Anyway, thank you so much for your opinions.
The Chair: Thank you, honourable senators. To the witnesses, thank you very much for sharing those enlightened recommendations and comments.
(The committee adjourned.)