Costs of the Corporate Income Tax Cut Under-Stated

The Economic Statement announced a cut in the federal corporate income tax rate from 21% today (22.1% including the corporate surtax, which is being phased out), to 19.5% in 2008, to just 15% by 2012-13. The new 15% rate is well below the already announced reduction to 18.5% by 2011-12.

The revenue cost in 2012-13 when the rate cut is completed, that is the annual revenue cost on full implementation, is put in the Statement at $6.1 Billion. (Table 2.1)

This estimate seems extraordinarily low.

The corporate income tax is estimated to raise $41.5 Billion this year (2007-08.) A cut to the general rate of almost one third could be expected to reduce future corporate income tax revenues by more like $12 Billion per year if revenues decline in the same proportion as the cut to the rate.

Moreover, the Statement estimates (Table 2.4) that, as a share of GDP, corporate income tax revenues will fall from 2.7% to 2.0% between now and 2012-13. That sounds like a small number but this decline – 0.7% of GDP – is equal to $10.7 Billion in terms of today’s GDP, and would be even greater in 2012-13 if we assume continued real growth in the economy.

The Statement’s revenue projections show that , notwithstanding the deep cut to the corporate income tax rate, federal corporate income tax revenues will slip only modestly in nominal dollar terms, from $41.5 Billion this year, to $38.3 Billion in 2012-13. This appears to be based on an assumption of continued growth in corporate profits from already near record-high levels as a share of GDP, and also on an increase in the effective tax rate on corporate profits as pools of unused losses and tax credits are exhausted.

Ironically, if corporate Canada were investing heavily, as we have been told they would do when given rate cuts, corporate tax collections would be much lower than they are today because deferred taxes would be accumulating. (Companies accumulate deferred taxes because the cost of new equipment is written off before profits are earned on the investments.)

The cost of cutting corpooate taxes is foregone public spending increases. This rate cut would be enough to launch a national pharmacare program, or a major child care program.

The Statement sets a goal of cutting Canada’s marginal effective tax rates at the lowest level in the G-7 in order to stimulate new investment, which is a sound objective. However, the link from the tax rate to real investment is questionable on several grounds.

First, corporate investment is driven first and foremost by profit expectations. Where profitability is high, new investments would be made even at current or even higher tax rates. Cutting the corporate income tax rate from 22% to 15% could deliver close to $1 Billion per year in windfall gains to the booming oil and gas and mining sectors of our economy, thus further fuelling the Alberta energy boom while under-cutting the role of the tax system as a mechanism for national sharing.

Based on today’s operating profit numbers, the booming resource sector will benefit almost as much as the entire manufacturing sector from the rate cut.  Manufacturing companies losing money will get no benefit at all. Manufacturers making investments in new plant and equipment would benefit much more from targeted investment incentives such as an investment tax credit.

The biggest beneficiaries of the rate cut will be the banks and insurance companies. With operating profits of $21 Billion per year, the finance sector will benefit by as much as $2 Billion per year.

Second, there is no indication that past corporate tax rate cuts – from 28% to 21% under the Liberals – have stimulated new corporate investment in a major way outside of the booming energy and mineral sectors. Real business investment has remained flat as a share of the economy even as corporate tax rates have been slashed. In the hard-hit manufacturing sector, tax cuts cannot possibly offset the huge negative impact of a hugely over-valued exchange rate.

Third, much of the benefit of this corporate rate cut will go to the US Treasury. US companies pay tax on their world-wide operations, and get to deduct corporate income tax paid in Canada. Higher after tax Canadian profits will result in higher taxes payable to the US government as Canadian corporate tax rates fall well below US rates.

One comment

  • Manufacturers making investments in new plant and equipment would benefit much more from targeted investment incentives such as an investment tax credit.

    Let’s not use euphamisms like “targeted investments” and “investment tax credits”. Let’s call them what they are: subsidies.

    As for corporate tax cuts in Canada benefiting the US treasury, this is far from certain. Lower cororate taxes here might just as easily encourage American-owned firms to reinvest more of their profit back into Canada to continue to take advantage of our lower rates. Will this overwhelm the eventual repatriation of profits to the US? Maybe, maybe not.

    Finally, while there is no evidence that previous corporate tax cuts have spurred investment, we really have no way of knowing do we? If we had kept the rates at 28%, we may well have experienced much lower rates of capital investment.

    The other factor is that the low dollar made many capital investments uneconomical by drastically lowering the cost of labour versus the cost of capital. It was simply a more profitable allocation of resources to hire more workers as opposed to investing in new capital. Now that dynamic has changed very suddenly, and manufacturers are hurting.

    Are manufacturers really being hurt by the “high” dollar, or are they finally paying for the extremely “low” dollar of 1995 to 2005? In 1998 when the C$ started testing new lows, some economists warned of exactly such a hangover effect. Seems like they were right. While I suspect the C$ is too high for our own good right now, I also suspect that the BoC was a tad irresponsible in the late 1990s when they avoided the necessary tough medicine (i.e. higher interest rates) and allowed the dollar to plunge as low as it did.

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