Marc’s Notes on the Economic and Fiscal Update
The surprise Economic and Fiscal Update delivered today demonstrates how politically clever the Harper government is, and at the same time, how out of touch they are. At a time when there are major challenges facing the country, this update, as predicted, squanders the opportunity. Tax cuts will not build any affordable housing, they will not reduce poverty, they will not make it easier to get to work in the morning, they will not improve the life chances for your child, they will not improve conditions on First Nations reserves, and they will do nothing to tackle climate change.
Let’s take a quick walk through the document. First up, the GST cut to 5%, which everyone knew was coming but has been accelerated to Jan. 1, 2008. Good politics for Harper, as he can claim credit for delivering on an election promise that seemed to be a tough one a year ago. Many economists will complain about GST cuts versus other “more efficient” tax cuts, and I will not get into that here.
Next, big corporate income tax cuts. Corporate income tax rates are already lower than in the US, and more tax cuts were already in the pipeline. The EFU accelerates the tax cuts and lowers the bar even further to a 15% rate in 2012 from a scheduled 18.5%. And the feds want the provinces to commit to a maximum combined corporate tax rate of 25%. For comparative purposes, note that back in the heyday of high investment and productivity growth in the 1960s, the federal rate alone was 40%.
Corporate tax cuts are justified on the grounds that they will increase investment in Canada. This is a dubious claim, as corporations invest for so many other reasons: access to resources (think oil patch), access to markets, availability of skilled labour, and energy costs are the main ones. If Canadian rates were way out of line, and all of these other factors were the same as comparator countries, there might be some justification for this move to cut corporate rates, but this is not the case. I have some sympathy for the argument that the Nordic countries tax capital relatively lightly and make up their revenues elsewhere, but I do not see evidence that our rates are that high in comparative terms.
Another related claim is that Canada’s rates on the margin for new investment were too high. This is the marginal effective tax rate claim, advanced by CD Howe and loved by the Finance bureaucrats. There are some questionable methodological issues in how these rates are calculated and how comparable they really are across countries (see this post). At heart, they are based on a neoclassical model that poorly correlates to the corporate sector and investment as we know it in the real world.
In the end, this is huge upper-income tax cut because the ownership of corporate Canada is pretty concentrated in the top decile of the distribution. A second impact is that by maintaining lower rates than the US, the subsidiaries of US-based corporations, who are taxed at home based on their global profits, will simply be paying that tax to the US treasury instead of the Canadian treasury. Why this is seen as good economic policy is rather baffling.
Politics is deeply embedded here, as the Dion Liberals had been talking about their own tax cut package with a big emphasis on corporate tax cuts. This thunder has now been stolen by the Tories, making it hard for the Liberals to vote against the package.
Ditto for the personal tax cuts. More political cleverness here as they restore the 15% bottom bracket rate that the Liberals had brought in just before the 2006 election, and that the Tories raised to 15.5% as part of paying for their first-round GST cut. This is what we get when both the government and the official opposition want tax cuts first and foremost.
Finally, there is an increase in the basic personal exemption, the threshold for paying income tax. This is deceptive, however, as the exemption has already been tied to inflation. The ways and means section has a table showing that the exemption is increased by about $671 in 2007, $298 in 2008, and $6 in 2009 above what would have otherwise been. That last number is not a typo, but $6 dollars (giving it a value in my pocket of $6 x .15 = $0.90).
While increasing the personal exemption is often popular on both left and right, I personally do not like it. It creates two classes of people: those who pay income tax and those who do not. I prefer a system where everyone pays and everyone benefits from the tax system. Even if the rate is very low at the bottom this gives the poor a rightful claim to the public goods and services we provide through taxes.
A final thought is around the possibility of an economic downturn. In the fiscal section, it is reported that a one percentage point drop in real GDP would lead to a negative change in the budget balance of $2.8 billion. Given that the $9.4 billion in tax cuts in 2008/09 leave a planning surplus of $4.4 billion, if real GDP came in at 1% growth for 2008 instead of the latest estimate of 2.4%, then all of the surplus would be eaten up. If growth dropped to zero or below, we would be back in deficit territory â€“ and that would mean spending cuts, I’m willing to bet, not a reconsideration of the tax cuts. This is a classic “starve the beast” strategy as pioneered by the Republicans in Washington.