Three ways Canada can respond to U.S. tax cuts and improve business competitiveness
August 1, 2018
The $1.5 trillion Tax Cuts and Jobs Act implemented this year by President Trump has put Canada’s business competitiveness at risk. Adding to this risk is the fact that many developed countries are also improving their tax competitiveness.
Federal Finance Minister, Bill Morneau, recently indicated that Canada will address these challenges during the government’s economic update this fall. We are outlining three recommendations the Federal Government should implement in response to U.S. tax cuts.
Background: Where Canada Stands Internationally
Canada is currently struggling to attract businesses investment, ranking 16th out of 17 comparable OECD countries in terms of business investment to GDP. One of the reasons for lagging investment is that we do not have a competitive tax environment. Twenty-one of 33 OECD countries have lower capital taxes than Canada.
Around the world developed countries are pushing through reforms that will make their tax systems more favourable for business. In 2017, the United Kingdom (UK), Norway, Italy, Israel, and Luxembourg all reduced their corporate taxes. Other countries are announcing reductions to their rates in upcoming years. The biggest threat to Canada’s tax competitiveness, however, may come from recent reforms from the United States. The U.S. has significantly reduced their corporate tax rate. This has resulted in capital investments now facing a lower tax rate in the U.S. than in Canada. Additionally, American businesses can now expense 100% of their investments in machinery and equipment for at least the next five years.
A recent International Monetary Fund report estimates that American companies will reduce capital investment in Canada by 6% due to U.S. tax reform alone.
Recommendation 1: Reduce the federal general corporate income tax rate
Making Canada’s corporate tax system more competitive will encourage private sector investment, reward entrepreneurship, maintain or increase government revenue by keeping corporate tax revenue in Canada. It will also increase the GDP of the country, which, in turn, will improve the standard of living of all Canadians.
Research suggests that corporate taxes impose the highest economic burden compared to all other taxes in Canada. Small reductions in the corporate income tax rate could help Canada’s lagging business investment. Evidence suggests reducing the rate by just one percentage point results in an increase in foreign direct investment by 2.5%.
In Canada it is relatively easy to start a business. We are ranked 2nd best out of 190 countries for ease of starting a business. However, less than 2% of Canadian companies become big businesses and its big business that generate significant increases in GDP. One of the best ways the Federal Government can encourage business growth is by reducing the costs. An example of this is to lower the general corporate income tax rate. This tax rate limits the funds available to reinvest in production, wage, and job growth.
Recommendation 2: Introduce full expensing for new investments in machinery and equipment
The Federal Government should also explore other measures being used around the world that reduce business tax burdens. For example, the Federal Government should match the U.S. reforms which allow 100% expensing of machinery and equipment. Currently, Canada only allows 50% depreciation for similar equipment. Due to this businesses are more likely to make these investments south of the border.
Evidence suggests that a generous expensing policy would have positive economic benefits. U.S. states that adopted full expensing in 2002 and 2008 saw increased investment by 17.5%. Five years after the full expensing window had been available, states that adopted the policy had 7.7% higher employment levels than comparable states that did not adopt it, and 10.5% higher output.
Experience in the United Kingdom echo the positive results among U.S. states. Access to more generous capital allowances increased investment by 11% for qualifying U.K. small and medium-sized businesses.
The small northern European country of Estonia has also realized great success through full expensing. In the four years after introducing the policy, along with other reforms to its corporate tax, investment growth was 39 percentage points higher there than in its Baltic neighbours. While Estonia is smaller than Canada, relevant lessons can still be drawn from the positive impact of Estonia’s expensing policy. The policy helped propel the country towards having the most competitive tax system in the developed world, as measured by the Tax Foundation.
The most effective way governments can encourage businesses to invest in more innovation and productivity enhancing technologies is to leave more money in their hands to make those investments. Adopting a U.S.-style full exemption would encourage long term capital investments to be made in Canada.
Recommendation 3: Address broad business issues including lagging productivity, regulatory inefficiency, and market access
As any business owner will tell you taxes are important. However, so are many other factors when deciding where to start and grow their enterprise. Canada’s plan to advance business competitiveness should start with taxes, but must also address regulatory reform and productivity. An OECD survey of global business leaders identified “inefficient government bureaucracy” as the single most problematic factor for doing business in Canada. Regulatory uncertainty and inefficiency have been a key factor deterring large capital investment, especially in Canada’s energy sector. The Federal and provincial governments are currently considering up to 50 policy and regulatory initiatives that could undermine investor confidence in Canada’s energy sector. These include carbon pricing, emissions limits and standards, and onerous permitting approval processes. To attract future investment, Canada needs a regulatory environment that offers stability, reliable timelines, minimizes duplication, and does not layer costs on business.
To reduce the regulatory burden across all sectors multiple steps need to be taken. First, to establish a business-government working group to identify areas where companies experience the greatest burdens and propose simplifications. After launching in 2012, a similar group was formed in Denmark reduced the annual regulatory burden for Danish businesses by an estimated $168 million.
While Canada has a highly skilled workforce, productivity challenges remain. In 2019 Canada is forecasted to be ranked 16th out of all OECD countries in terms of labour productivity growth since 2010. Productivity is a key determinant of standard of living over the long run. Improving labour productivity and ensuring businesses can acquire the right skills should be top of mind for governments.
With the rise of protectionism and global trade disputes, Canada has opportunity to make free trade our new competitive advantage. The Federal Government should continue to expand trading relationships around the globe. Simultaneously, they should work with the provinces to immediately reduce internal trade barriers that cost our economy billions of dollars.
Countries around the world are improving their tax competitiveness. This could put Canada’s ability to attract investment, new businesses, and skilled people at risk.
There is potential, however, for Canada to benefit from a more attractive U.S. and global business environment. Making our corporate tax system more business-friendly is step number one.
But to truly propel our business community forward, Canadian governments must address a broader suite of policy issues.
This means building a competitive business operating environment. We can do this by improving trade and access to markets, supporting innovation, reducing costs of government policy, and advancing workforce productivity.