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Russ E. Jackson Jr.'s Submission in Response to Finance Canada's Tax and Other Issues Related to Publicly Listed Flow-Through Entities (Income Trusts and Limited Partnerships) consultation:
Submission in response to the September 2005 Consultation Paper entitled "Tax and Other Issues Related to Publicly Listed Flow-Through Entities"
The tax system is deterring personal saving.
The personal savings rate continues its relentless decline, reaching minus 0.5% in the second quarter for the population as a whole, its lowest since the 1920s. Indeed, in the wealth generating 45-to-65 age group, the savings rate has dropped precipitously to 3.6% from 20% in the early 1980s.
The debt to personal disposable income ratio is now 117% up from 96% five years ago. There is no doubt that low interest rates, negative real after-tax returns to savers and the housing boom have contributed to the lowering of personal investment in financial assets and the assumption of greater debt.
The tax system is crushing savings. Using Exchange traded funds as a proxy for the market as a whole, iUnit Bond and iUnit 60 current after-tax yields at the top personal tax rate are 2.4% and 1.1%, respectively. In essence, returns are being totally eaten up by taxes and inflation.
High taxes on capital have contributed to unacceptably low levels of equity investment in Canada and greater current consumption to the detriment of improved productivity.
Growth in labour productivity in Canada has stalled.
According to Organization for Economic Co-operation and Development documents, Canada has lagged Australia, Ireland, France, Germany, Britain and the United States in this decade. Even more disturbing, the TD Bank Financial Group calculates that, over the past two years, Canada's productivity growth was lower than the gains in 21 of 23 nations that belong to the OECD.
Reference the U.S. Bureau of Labor Statistics productivity index for the manufacturing sector of the economy. The index uses 1990 as its base year, and starts the U.S. and Canada at 100. Fifteen years later, U.S. productivity has risen to 190 while Canada's productivity rests at 140.
Canada's productivity level was third among OECD nations in 1960, it is now 17th.
As the Conference Board of Canada observed this year, "Canada's relative size and status in the global economy is slipping".
Growth in labour productivity is the only route to growth in real incomes and a higher standard of living for individual Canadians. More needs to be done to foster equity investment in Canada – a key ingredient for the financing of new machinery and the adoption of new technologies and processes.
Having the tax system treat equity investment income in a no less favourable manner than passive interest or employment income would be a minimal first step in a prosperity agenda.
Growth in personal disposable incomes of Canadians is anaemic.
The real growth in personal disposable incomes of Canadians has dropped each decade from an average of 6% in the 1970's to 3.5% in the 1980's to 2% in the 1990's. Growth this decade has slipped further to approximately 1.5%.
As a result, Canadians' standard of living is about 80% of that of the U.S. – for what amounts to an annual income gap of about $9240 per individual. If this situation is not addressed, our relative standard of living will continue to deteriorate thus imperiling our ability to invest in health, education and infrastructure.
The tax system is deterring investment and strangling productivity.
As the C.D. Howe Institute has calculated, Canada has the second highest effective tax rate on investment among 36 industrialized and developing countries.
Canada's effective corporate tax rate for the job-critical manufacturing sector is 35%. This is prohibitively higher than the corporate tax rate in other competing jurisdictions: Britain, 22.7%; Belgium, 21.4%; Poland, 20.6%; Austria, 20.3%; Hungary, 18.8%; Mexico, 17.2%; Ireland, 14.1%; Sweden, 12.8%.
Canada's share of world foreign investment has fallen to 3 percent from almost 8 percent in 1980.
Aggregate investment in machinery and equipment per unit of labour in Canada is less than 60 percent of that in the U.S. The key to future productivity growth is the narrowing of this critical gap and investment in new efficient technologies.
Systemic discrimination is evident in the taxation of equity investment income.
Income derived from equity investments in public corporations is more highly taxed than other sources of income. The assumption of risk- the key to Canadian prosperity and higher living standards- is actively being penalized whereas strong incentives to investing should be the societal norm.
The effective tax rate when corporate operating profits are distributed as dividends to shareholders is 55.4% and 50.1% when harvested by shareholders as capital gains (i.e. derived from undistributed profits). These figures were calculated using the general corporate income tax rate of 35% and the top Ontario personal tax rate on dividends of 31.4% and 23.2% on capital gains. These rates would be even higher if one included federal and provincial capital taxes!
In contrast, other income such as interest and employment income is taxed at close to 46% on average across Canadian provinces at the top personal tax rates, despite the lower risks associated with this income.
This systemic discrimination against dividends is also evident at the lower tax rates facing the average investor (i.e. those not at the top personal tax rate). As shown in Table 2 on page 14 of the September 2005 Consultation Paper issued by Department of Finance, the combined tax rate on operating profits of public corporations distributed as dividends is 49.63%.
In contrast, all other income flowing to an average investor- be it from interest income, employment income, distributions from income trusts, unincorporated business or small CCPC's- face only a 37-38% tax burden.
Double taxation of dividends is unfair, distorts capital markets and hurts Canadian productivity.
Income trusts are a tax distortion developed largely in response to the tax system's discrimination against dividends compared to other sources of income.
Today, when a public corporation pays dividends to its shareholders, the taxman's take is as much as 55.4 cents because of the double taxation of dividends (the money is taxed twice, without full integration of taxes at the corporate and personal levels).
Unit holders in an income trust are not subject to double taxation. Their tax liability at the maximum personal tax rate would be approximately 46 cents out of every $1 distributed- note the near 20% higher level of taxes borne by the shareholders of a public corporation.
Similarly, shareholders in small Canadian controlled private corporations (CCPC), which are subject to the small business tax rate, are not subject to the double taxation of dividends.
In the absence of dividend and corporate tax reductions, more and more companies will convert to trusts as individuals rationally avoid the double taxation inherent in the current tax structure. This trend will seriously impair investment in research and development, adoption of new technologies, capital formation and consequently Canada's competitiveness.
As the CEO of CI Fund Management is reported saying: "Its nuts if you really think about it. There are two corporate structures a Canadian company can use, and one is
meaningfully more beneficial to the owners than the other....At some point, if they do not fix this inequity, we are going to be an income trust." In responding to the question;
"Other than playing the tax gap, is there any reason for a company like CI to take the trust plunge?" Mr. Holland replied: "No.".
Also, we have seen the tax distortion playing out with multi-national Canadian corporations divesting themselves of their international assets in order to convert their corporate structure to an income trust – an international, Canadian-based drilling company comes to mind, for example.
More favourable tax treatment of equity capital is critical to improving productivity and a higher standard of living in Canada.
As the C.D. Howe Institute has calculated, Canada has the second highest effective tax rate on investment among 36 industrialized and developing countries. As a reflection, Canada's productivity growth was lower than the gains in 21 of 23 nations that belong to the OECD. Canada's productivity level was third among OECD nations in 1960, when capital gains were not taxed and dividends treated more favourably. Canada is now 17th.
In 1987, Australia fully integrated the corporate and personal tax systems to eliminate double taxation of dividends. This action reduced the incentive for corporations in Australia to convert to the trust structure.
In 2003, the United States administration reduced the personal tax rates paid on dividends down to 15%. This contrasts to the 31.4% rate paid in Canada. Productivity growth in the U.S. has far outstripped the Canadian experience.
Tax policy is critical to reversing the wealth dampening reduction in personal savings rates and poor productivity performance of the Canadian economy.
Income trusts do not provide demonstrable economic efficiency gains. Indeed, given endemic low personal savings rates, the favoured tax status and structure of trusts will likely have a net negative impact on investment in research/development, machinery and equipment and new technologies.
Eliminate the double taxation of dividends received by the shareholders of public corporations. This measure would enable corporations to allocate their profits to retained earnings and share buybacks (capital gains) or dividends based on corporate strategic grounds rather than on the basis of tax efficiency considerations. It would also eliminate the tax distortion and systemic discrimination driving the conversions to the trust market. This would be but a meager first step in a prosperity agenda.
Do not discriminate against but move to strongly favour risk-taking, productivity enhancing equity capital. The ability to improve the standard of living of all Canadians is seriously compromised under a tax structure, which favours current consumption, low risk investing (ie.real estate), interest and employment income at the expense of equity capital.
Significantly reduce the corporate and personal tax rates on returns to equity capital, which is critical to the financing of productivity improvements, the generation of well-paying jobs and, in turn, Canada's future prosperity.
Russ E. Jackson Jr.,