Billions lost through tax loopholes and preferences

Finance Canada finally published its 2010 Tax Expenditure report this morning. 

This annual report provides new estimates for the revenues the federal government loses annually from different tax measures, deductions, credits, and other tax preferences.  These tax preferences also affect provincial revenues to the extent that they piggyback on the federal government’s tax base.  

The report includes estimates for the large and growing number of federal tax preferences, from the basic personal exemption to the “AgriInvest farm savings account” tax expenditure.  Unfortunately, under this government the number and cost of these tax expenditures has proliferated, with additions of tax credits for children’s fitness, first time home buyers, public transit, tax free savings accounts, etc — and that’s just a few on the personal side.  

While certain basic and progressive tax measures are certainly justified, in most cases these boutiquey tax preferences have been found to be an expensive and ineffective way of achieving social objectives.  In addition, they pepper the tax system with holes and make filling out your taxes much more complicated.

A number of the most expensive tax preferences and loopholes are also highly regressive and–I would argue–damaging for the economy.  The most egregious tax loophole of all appears to be the stock option deduction.  This allows executives who recieve much of their compensation in the form of “stock options” to pay tax at half the rate that tax is charged on wage income.   I’ve written about the problems with this loophole previously: not only is it highly regressive and costly, but it also seems to fuelled stock-buyback schemes by corporate execs, increasing the value of their own paypackets in an unethical way. 

This tax loophole cost the federal government an estimated $1 billion a year during the 2005 to 2007 period.  The 2010 tax expenditure report projects that the amount of revenue lost declined during the past few years, but it is starting to escalate again.  Their projection for 2010 is a loss of $590 million to the federal government, up 42% from the figure for 2009.

Another regressive and expensive tax measure of very dubious economic benefit is the tax preference that allows capital gains from investment income to be taxed at half the normal rate.   Half the value of this loophole goes to the top 1% highest income taxfilers.   The annual cost of this for the federal government reached $5.7 billion in 2007 on the personal side and $6 billion for corporate income taxes– close to $12 billion a year just for the federal government.   Following the financial crisis, the cost of these have declined, but they are still estimated to cost $2.8 billion on the personal side and $3.3 billion for corporate taxes.   These were supposedly introduced to spur real investment and economic growth, but there isn’t much evidence that they’ve actually achieved that.   Instead, they have likely helped fuel the asset booms and mergers and acquisitions that are destaabilizing our economy — as well as increasing income inequality.   Warren Buffet said it best when he criticized a tax system that allowed him and other wealthy people to pay a lower rate of tax than their receptionists or cleaning ladies. 

Some other countries have moved ahead with progressive changes to their tax systems, to increase tax revenues, reduce  inequalities and to reduce the economically harmful incentives that these  tax preferences create.   Now is the time to do this before they escalate even further in costs. 

Unfortunately, there’s no indication that the federal government intends to do that.   This year’s tax expenditure includes research reports with arguments which will no doubt be used to support its aim of keeping tax rates low on capital gains and on high income earners.   However, these arguments neglect important factors. 

For instance, Annex 2 (page 42) of the first research report suggests that both capital gains and total taxes paid are higher when capital gains are taxed on a realization basis than on an annual basis over 20 years.   It seems like magic, but only because it  neglects the opportunity benefit (or cost) of those taxes paid (or lost) for the government.    

The second research report provides estimates to demonstrate that Canadians, especially those with higher incomes, do respond to changes in tax rates.   This statement is of course true, however, it doesn’t always represents a change in real economic behaviour.   These can reflect changes in tax accounting, tax avoidance and shifting between forms of income to minimize taxes.  To its credit, the report accounts for a number of these factors.  At the same time it should be very evident from the tax expenditure part of the report that there are a myriad of opportunities for “tax planning” and tax avoidance that are especially beneficial for those with the highest incomes–and that a first priority should be to plug some of these regressive tax loopholes.