Corporate tax cut -- Yes: Reduce rate, fill public coffers

As federal and provincial governments struggle to keep public finances on an even keel, prominent Canadians, including a number of federal opposition party leaders, say we should halt, or even reverse, planned cuts in Canada's corporate income taxes.

They're on the wrong side of this argument. Canada must stay on the path established by Jean Chrétien in 2000 and followed by every government since.

The 2000 budget contained a five-year, $100-billion tax relief plan that covered most major taxes, including the general corporate income tax (CIT) which was cut to 21 per cent from 28 per cent by 2004.

In an effort to improve the business climate and attract investment, Ottawa and the provinces all agreed to a further plan to move Canada to a combined federal-provincial CIT of 25 per cent (15 per cent federal, 10 per cent provincial).

The planned cuts for 2011 are part of this signature tax policy, one that will see Canada's overall CIT set at slightly more than the average CIT rate for the OECD, the club of industrialized countries. They are also a key part of a thoughtful and necessary competitiveness strategy.

But there are other reasons to think staying the course is the wise move.

One important reason is that many people who think cutting corporate tax is a bad idea don't really get how taxes work.

When they talk about "raising" a tax they mean we should get more money from it, but governments have little control over whether that occurs.

They only control the "base," that is, what activities a given tax actually applies to (in the case of the CIT that's corporate profits), and the "rate", or what share of the base the government takes.

Intuitively, people believe an increase in the rate of tax on the base leads to more money. They forget, however, that changing the tax rates also leads to people changing their behaviour in ways that affect the size of the tax base (in this case the base, or the pool of corporate profits available to be taxed).

People respond to incentives, including the owners, managers and workers who make up businesses.

There are all sorts of ways companies can react to increases in CIT rates by revenue hungry governments. In a commentary just released by the Macdonald-Laurier Institute, institute fellow Jason Clemens argues large international companies can, for instance, shift more of their borrowing to higher-tax jurisdictions and write the interest cost off against their profits there. Smaller firms can also take steps like, say, financing more of their new investments through debt, which is tax deductible, rather than retained earnings or equity. And these are just short-run measures; over time firms can move operations or simply invest less.

As a result changing CIT rates does not produce a simple, linear rise or fall in revenues.

Instead, as Clemens notes, in Canada, the federal CIT "take" increased almost 18 per cent a year on average from 1994 to 2000 although the rate remained constant at 28 per cent. Revenues then grew almost 10 per cent a year, again on average, from 2001 to 2006 while the rate was being cut to 21 per cent.

Yes, you read that right; we cut the rate by a quarter, while revenues increased nearly 10 per cent annually.

Since reducing the rate improves the incentive to do productive things like work, save, innovate, and be entrepreneurial, it makes good policy sense.

And it is wrong to assume that the planned cuts will reduce CIT income, just as it is wrong to assume that raising them will increase CIT revenues in the medium term.

Remember, the key determinant of CIT revenues is not the "rate" but the "base," namely corporate profits. When companies do well, the base grows and the treasury does well. And since a key determinant of corporate profits is policy that encourages investment and growth, getting federal CIT rates down and keeping them there is the key not only to economic but to fiscal happiness, a proposition richly documented in a forthcoming paper by Harvard economist Andrei Shleifer and his colleagues.

Federal finance ministers from Paul Martin to Jim Flaherty and provincial finance ministers of every political stripe have endorsed the policy and seen good results.

At the very moment when we are relying on the private sector to pick up the slack from expiring stimulus packages, we need to resist calls to reverse course on the CIT. There is no good time for bad policy.

Brian Lee Crowley is the managing director of the Macdonald-Laurier Institute.

Republished from the Winnipeg Free Press print edition February 8, 2011 A11