Time for Tax Reform?

Following the release of the Department of Finance’s private corporation tax proposals on July 18, 2017, which was far more controversial than the government anticipated, over 21,000 letters containing comments, criticisms and suggestions were sent to Finance.  A common theme contained in many of the letters was that the tax proposals should be abandoned in favour of a comprehensive review of Canada’s tax system and broader tax reform.

Calls for tax reform raise their own questions. What is tax reform? Who would be responsible for this effort, and how would they do it? Why are so many people calling for tax reform now? We’ll try and answer those questions in this article.

What is tax reform?

Tax reform is time consuming and does not offer much upside for politicians, so it is unlikely that tax reform would be pursued until the current tax system is under obvious strain. Tax reform is a process that, based on historical experience, has three identifiable stages.  First, a body of experts will complete a back-to-basics review of foundational aspects of the Canadian tax system and make “big picture” recommendations. These experts include including legal and economic scholars, tax practitioners and government representatives.  Second, the Department of Finance will release its own report identifying which recommendations it accepts and how Finance believes those recommendations should be implemented.  Third, Parliament will pass legislation enacting the recommendations that Finance has adopted.

The most significant tax reform in Canadian history happened in the 1960s, when the Royal Commission on Taxation suggested that large-scale changes to Canada’s tax system were needed.  The Department of Finance subsequently released a White Paper endorsing most (but not all) of the proposed changes, and Parliament responded by repealing the existing, 1940s-era Income Tax Act and replacing it with the current Income Tax Act in 1972. A smaller tax reform project was undertaken in 1987, and advisory panels in the late 1990s and 2000s made recommendations that led to minor changes to the tax system.

Who would undertake tax reform, and how?

Tax reform is a process that, based on historical experience, has three identifiable stages.  First, a body of experts will complete a back-to-basics review of foundational aspects of the Canadian tax system and make “big picture” recommendations. These experts include including legal and economic scholars, tax practitioners and government representatives.  Second, the Department of Finance will release its own report identifying which recommendations it accepts and how Finance believes those recommendations should be implemented.  Third, Parliament will pass legislation enacting the recommendations that Finance has adopted.

In the past, both advocacy groups and other countries have complained that Canada’s international tax rules are too lax, as they permit Canadian taxpayers to avoid foreign taxes on business income while not having to pay Canadian tax. The most significant tax reform in Canadian history happened in the 1960s, when the Royal Commission on Taxation suggested that large-scale changes to Canada’s tax system were needed.  The Department of Finance subsequently released a White Paper endorsing most (but not all) of the proposed changes. Parliament responded by repealing the existing, 1940s-era Income Tax Act and replacing it with the current Income Tax Act in 1972. A smaller tax reform project was undertaken in 1987, and advisory panels in the late 1990s and 2000s made recommendations that led to minor changes to the tax system.

Why is tax reform a good idea?

Put simply, so much has changed in the last 50 years: more women are in the workforce and pursuing meaningful careers; Canada’s economy is shifting towards services and resource extraction; increased global competition and labour and capital mobility means that we are much more concerned with other countries’ tax systems. Because of these changes, many of the assumptions underlying the 1960s tax reform and our current tax system appear to be outdated.

Some tax professionals and academics don’t believe that the system can continue to be updated with technical tweaks while leaving the underlying assumptions unchallenged.  Instead, there are some big questions that need to be revisited:

• What is the right tax mix? Governments raise revenues not only from personal and income taxes, but also from sales taxes, excise taxes, customs duties, EI premiums, property taxes, resource taxes and regulatory charges. Nevertheless, personal and corporate income taxes continue to generate 63% of federal government revenues and around half of provincial government revenues.  Many experts believe that it would be economically efficient for governments to raise more revenues from GST/HST, carbon taxes and regulatory charges while reducing reliance on income taxes, but meaningful coordination with provincial governments would be required to realize these benefits.
• What is the income tax system supposed to do? The income tax system is used to raise revenue and deliver benefits and assistance through the CRA’s relatively efficient procedures. We also use the tax system to subsidize activities that we think create economic benefits (i.e. innovation by corporations) and to reward behaviour that we believe is virtuous (i.e. the school supplies tax credit, the small business deduction). Some of this signals the values supported by the government. Some of this is intended to hide the true cost of government expenditures since tax preferences are not accounted for as government spending. However, if benefits and assistance can be delivered by other means, the tax system could be streamlined and allow for a more honest discussion about the size of government.
• What is the right tax unit? A “tax unit” refers to the legal identity of the ultimate taxpayer.  For individuals, there are two types: the individual or the family. Canada currently uses the individual as its tax unit, meaning that spouses or common law partners file separate returns and (generally) calculate their income and tax owed without regard for anyone else’s income or tax payable, in the same way as single individuals. In contrast, the United States, Germany and France use the family as a tax unit, where a married couple or an entire household reports their combined income in a single return.

While we have rules that are intended to prevent income from being shifted to a lower-income spouse, those rules are relatively easy to circumvent using corporations.A family unit is superficially attractive, since it seems “fair” for families with a single earner as compared to a family with two earners and the same overall income, given our progressive rate structure. However, there are hidden complications: family taxation does not account for the value created for a family by a stay-at-home spouse, creates a disincentive for secondary earners (mostly women) to enter or re-enter the workforce, and alters the bargaining power between spouses.  These were some of the reasons that the Department of Finance chose to retain the individual tax unit in 1972.

Regardless of what tax unit you think is the correct choice, the current tax system is very inconsistent. While we have rules that are intended to prevent income from being shifted to a lower-income spouse, those rules are relatively easy to circumvent using corporations.  Equally troubling is that some useful tax incentives, like the working income tax benefit, are tied to household income, and therefore deviate from the individual tax unit in a way that eliminates some of the benefits of the individual tax unit.

• How do we tax corporations and their shareholders? In a global economy, taxing corporations at the same rate we tax individuals is unjustifiable. But many of the problems with Canada’s tax system stem from our corporate tax rates being too low relative to personal income tax rates, and from dividends on shares being taxed differently than capital gain realized on a disposition of a share. If raising corporate tax rates is problematic, then we need to think about how we set our personal income tax rates, how we integrate corporate-shareholder taxation, and how tax benefits for some corporations can be reduced in order to avoid some of these problems.

We also use the tax system to subsidize activities that we think create economic benefits (i.e. innovation by corporations) and to reward behaviour that we believe is virtuous (i.e. the school supplies tax credit, the small business deduction)Seemingly simple fixes within the current system like harmonizing dividend and capital gain tax rates would require cooperation by the provinces; the adoption of a single corporate tax rate (by eliminating the small business deduction) would require a government willing to expend significant political capital and face significant opposition.  Narrowing the gap between personal tax rates and corporate tax rates by either cutting personal tax rates or increasing corporate tax rates would have large impacts on government revenues or international competitiveness.

The July 18, 2017 legislative proposals were intended to address some of the symptoms of the corporate-shareholder tax problems, rather than tackling the underlying issues.  The public outcry and hasty retreat by the government under political pressure shows that these problems may not be solvable without returning to the drawing board.

• How do we tax foreign-source income? Canada, like almost all of its peer countries, does not tax foreign-source business income, but does tax foreign-source property income and employment income. This overall policy is unlikely to change, but how the policy is implemented may need to be reviewed. In the past, both advocacy groups and other countries have complained that Canada’s international tax rules are too lax, as they permit Canadian taxpayers to avoid foreign taxes on business income while not having to pay Canadian tax. Recent media attention to aggressive international tax planning has highlighted that our staggeringly complex tax rules for offshore activities may still contain some loopholes.

..personal and corporate income taxes continue to generate 63% of federal government revenues and around half of provincial government revenues.The common theme uniting all of these questions is that Canada’s tax regime is complicated, and is a part of an inter-related and global ecosystem. Piecemeal changes over the years to address specific issues have increased the complexity. It is very difficult to simplify the system or to change specific rules without addressing policy questions that impact the tax system as a whole.

When might tax reform happen?

Unfortunately for anyone who likes to think about or write about tax policy, the Department of Finance and the current government have indicated that they have no desire to initiate a tax reform process at this time. Tax reform is time consuming and does not offer much upside for politicians, so it is unlikely that tax reform would be pursued until the current tax system is under obvious strain. This is unfortunate, as a comprehensive study of Canada’s tax system might offer a chance to be proactive in addressing concerns about fairness, efficiency, and competitiveness.