Tax Expenditures and Evaluations 2003 : 5

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4. Results 

In this section, we present the tax expenditure projection for the reference scenario, based on the assumptions and methods outlined above. We also explore how the projection is sensitive to the economic parameters by making alternative assumptions regarding their values over time.

Reference Scenario

In the previous section, the TE for RPP/RRSP saving was estimated at 1.25% of GDP for 2001. Our reference scenario projection provided in Figure 8 suggests that the TE will decline as Canada’s population ages, but only modestly, reaching 1.11% of GDP by 2041.

In 2001 dollars, a TE decline of 0.14% of GDP amounts to about $1.5 billion, far smaller than the declines of over $30 billion in the projections cited earlier in this paper.

Figure 8 - Tax Expenditure Projection, Reference Scenario, 2001-2041

Figure 9 shows that, with contributions maintaining a roughly constant share of GDP, it is the fact that benefits rise more rapidly than investment income that produces the TE decline. On the other hand, as we saw in the more stylized aging baby boom model of Section 2, the drop in the TE is limited by the continuing growth of asset levels that accompanies the aging of the baby boom cohorts.

Figure 9 - Tax Expenditure Components in the Reference Scenario

Why does this projection not exhibit the same rapid decline in TE as seen in the aging baby boom model in Figure 4? One possible answer is that the Canadian pension system is less mature than the model of Section 2 in which age-specific contribution rates were assumed constant from 1961 on. Figures 10 and 11 provide some evidence of this.

Figure 10 - RPP/RRSP Contribution and Benefit Rates

Figure 10 shows how the RPP/RRSP contribution rate (total contributions as a percentage of GDP) has evolved since 1965. It also shows the increase in benefits over the latter part of the period. The contribution rate rose substantially in the 1970s and again in the 1990s. The modest decline in recent years has not been fully studied, but its sources could include: (1) a decline in public sector employment in the early and mid-1990s; (2) rapid employment growth after 1993 concentrated in sectors (small business, high technology) and demographic groups (youth) with relatively low pension coverage and savings rates; (3) a shift in saving from RRSPs to registered education savings plans with the introduction of the Canada Education Savings Grant in 1998; and (4) the reduction and/or freezing of the dollar limits on RPP benefits and RPP/RRSP contributions in 1996 and subsequent years.

This contribution rate history will overstate the change in contribution behaviour to the extent that it is affected by the movement of the baby boom cohorts into high-saving age groups. To correct for this factor, Figure 11 shows the age profile of contribution rates, expressed here as percentages of reported earnings, for the years 1969, 1979, 1989 and 2000. These years were chosen both to span the period and because they were all years of relatively good economic conditions. From the figure, it is evident that the contribution increases in the 1970s and the 1990s were not merely the result of the movement of the baby boom cohorts into high-saving age groups.

Figure 11 - RPP/RRSP Contribution Rates by Age Group; 1969, 1979, 1989 and 2000

An increase in the contribution rate up to the 1990s would delay the maturation of the pension system and raise TE levels in the projection period. However, it appears inadequate to fully explain the relatively slow decline in the TE between 2011 and 2031. Two other factors likely contributed. First, while in the stylized models of Section 2 the receipt of RPP/RRSP income is limited to the 65+ age group, the projection model recognizes that it is actually spread out over the life cycle with over 43% of benefits going to those under 65. Second, while the baby boom model of Section 2 assumes no demographic variation apart from the aging of those cohorts, there has been in fact a baby boom echo producing a small second peak in births around 1990 (as seen in Figure 3). Those echo cohorts will enter the labour force around 2010 and their high-saving years around 2030. Their effect is seen in a slight increase in the aggregate contribution rate, from 4.55% to 4.70% of GDP, over the projection period. Taken together, these three factors should account for the gradual pace of decline in the projected tax expenditure after 2010.

Sensitivity to Assumptions

Any long-run economic projection depends on the parameters assumed for factors such as real wage growth, inflation and the real return on investment. Our reference scenario employs plausible parameter values, which are quite similar (very similar real wage growth, somewhat lower inflation and a slightly lower real interest rate) to those used by the Chief Actuary in projecting CPP costs. However, other economic scenarios are quite possible so it is of interest to see how changes in key parameters would affect the TE projection. The parameter changes considered here include changes in the rate of real wage growth, the rate of inflation, and the real rate of return on investment. Also, in Appendix C, we examine the effect of departing from the definition used in the annual tax expenditure estimates by modifying the estimated marginal tax rates to take into account reductions in Guaranteed Income Supplement benefits due to the receipt of RPP/RRSP benefits or investment income on RPP/RRSP assets.

Figure 12 provides TE projections where, after a phase-in period, the rate of growth of real wages is assumed to be 2% or 0% per annum rather than the reference scenario value of 1% per annum. Over the phase-in period, the growth rate increases or decreases by 0.1 percentage point per year, reaching its final value by 2011.

The effects on the TE values are quite modest, with maximum changes of about 0.07% of GDP during the period. Another finding of interest is that the short- and medium-term effects of a real wage change are opposite to the long-term effects. Equation (4) of Section 2 showed that, in a steady state case, TE is positively related to the growth rate of earnings and GDP. Here, though, there is a 33-year transition before that result becomes evident. The reason is that, in the faster wage growth (2%) case, for example, the constant initial value of assets produces levels of investment income and benefits that are lower (as a percentage of GDP) than in the reference scenario, and the initial impact is significantly greater for investment income than for benefits. At 2021 the level of investment income is lower by 1.02% of GDP while the level of benefits is lower by 0.73%. For the lower wage growth case, the converse is true.

Figure 12 - Tax Expenditure With Different Rates of Real Wage Growth

Figure 13 shows the effect of alternative assumptions about the inflation rate-3% (as assumed by the Chief Actuary) and 1% per annum as compared to the reference scenario assumption of 2%. Again, the alternative rates are phased in over the period to 2011.

Figure 13 - Tax Expenditure With Different Rates of Inflation

Here the effects on the TE levels are simpler and stronger than for changes in real wage growth. The main reason for this is that higher inflation, for example, is reflected in a correspondingly higher nominal rate of return. This produces an immediate and proportional increase in the level of investment income, a positive component of TE. This direct effect on TE is essentially the only effect since additional inflation otherwise has the same proportional effect on the levels of earnings, GDP, contributions, assets and benefits.

The effect of an increase in the real rate of return on investment is shown in Figure 14, in which scenarios with real rates of return of 4.5% and 2.5% per annum, phased in by 2011, are compared with the reference scenario (3.5%). The results are similar to that of the inflation case in that a change in the real rate of return on investment directly affects the TE level through its investment income component. However, because the real return increase produces a more direct and immediate increase in asset levels than in benefit levels, it results in a further increase in the TE level that is reversed after a period of time as the asset increases are translated into faster benefit growth.

Figure 14 - Tax Expenditure With Different Real Rates of Return on Assets

A related scenario of interest involves a drop in the real rate of return during the projection period. General equilibrium, overlapping generations models predict such a result in response to a rise in the capital-labour ratio as the population ages and growth in the labour force slows. Simulating such a change as a rise in the real rate to 4.5% by 2011 and then a faster drop in the rate from 4.5% to 2.5% per annum by 2021 yields a time path of TE that is roughly approximated by a drop from the 4.5% track to the 2.5% one in Figure 15. By 2041, the TE value in the declining yield case is 0.83% of GDP, somewhat lower than the value of 0.90% in the 2.5% yield case.

Figure 15 - Tax Expenditure with a Decline in the Real Rate of Return on Assets

Finally, it is of interest to explore economic conditions that could result in a drop to quite low levels of TE as the population ages. Figure 16 combines the declining real rate of return scenario (4.5% in 2011 to 2.5% in 2021) with declines in inflation and real wage growth. In the first case, inflation declines from 2% to 1% by 2011, yielding nominal wage and GDP-per-worker growth of about 2%. In the second, both the inflation rate and the real wage growth rate decline to zero by 2011, producing zero growth in nominal wage levels and GDP per worker. Between 2011 and 2041, the federal TE drops from 1.25% of GDP to 0.51% in the 2% growth case and to 0.05% in the zero-growth case.

Figure 16 - Tax Expenditure With a Declining Return on Assets and Low Nominal Wage Growth

Even with considerable variation in economic parameters from those in the reference scenario, these projections do not exhibit declines in the tax expenditure to substantial negative values such as those projected in the studies cited in footnotes 2 and 3. What differences in methodology or assumptions could explain the differing results? A full accounting of the differences cannot be made here, but some points are worth mentioning. First, the projections in this section reflect the fact that individuals under age 65 receive about 43% of total RPP/RRSP benefits. This reduces the estimated effect of population aging on the aggregate level of benefits and thus on the TE value as compared to models in which seniors receive all benefits. Second, the projections here assume conservative long-run real rates of return on investment (3.5% in the reference scenario and up to 4.5% in alternative cases) while the cited studies appear to assume rates of 7% or higher at least in the early years of the projection period. High real rates of return tend to raise future benefits in relation to contributions and so produce a decline in TE values. Third, the current projections generally assume positive inflation while the cited studies ignore inflation. In addition, one of the studies assumes zero real wage growth. Again, these differences result in lower growth in the benefit-to-GDP ratio here than in the other studies. Finally, as noted earlier, one of the other projections is based on a modified definition of the tax expenditure that is lower and more sensitive to population aging than the conventionally-defined TE.

5. Conclusion

In the reference scenario, we estimate a decline in the federal tax expenditure on RPP/RRSP saving of 0.14% of GDP or $1.5 billion in 2001 dollars. A sharp and sustained decline in the real interest rate would increase this TE drop, especially if it were accompanied by a significant decline in real wage growth and inflation. On the other hand, increases in the rates of real wage growth, inflation and the return on investment over the period would tend to offset the projected TE decline. This range of scenarios demonstrates the high degree of uncertainty that must be attached to long-run projections. At the same time, they suggest that it would not be prudent for governments to count on receiving very large fiscal gains as a result of a decline in the tax expenditure on RPP/RRSP saving.

Finally, we would note that changes in the tax expenditure for retirement saving are only one aspect of the effect of population aging on income tax revenues-and probably not the dominant one. In particular, even though governments recoup deferred taxes as seniors withdraw funds from RPPs and RRSPs, the more important fact is that seniors generally have lower incomes than working-age taxpayers and so pay lower taxes. As a result, an increasing population share of seniors should tend to depress income tax revenues.

Appendices

A. Rate of Return on RPP/RRSP Saving

The value to savers of the tax preference on RRSP (and RPP) saving is sometimes not well understood. Some suggest that because RRSP proceeds are eventually taxed, the double taxation of savings inherent in an income tax system is reduced but not eliminated. Others conclude that the attractiveness of RRSP saving depends on whether the tax refund from the contribution deduction is saved or spent. These conclusions are based on a misunderstanding of what saving is and a failure to take the value of the contribution deduction fully into account.

Saving is the deferral of consumption from one period of time to another. The rate of return on saving is the rate at which consumption can be exchanged between periods. In the case of an RRSP contribution of $1,000 by an individual facing a marginal tax rate of 40%, for example, the net cost of the contribution and the net reduction in current consumption is $600. This is the amount of saving and thus the amount on which the rate of return calculation should be based. (Analysts sometimes calculate a rate of return based on a $1,000 RRSP contribution together with investment of the $400 tax refund outside an RRSP. By analyzing a mix of RRSP and non-RRSP saving, this procedure cannot correctly measure the return to RRSP saving.)

With a one-year investment and a pre-tax rate of return of 10%, the $1,000 RRSP contribution yields pre-tax proceeds of $1,100. After taxation at 40%, the net proceeds are $660, providing an after-tax rate of return of $60 or 10% on the net savings of $600. As the after-tax and pre-tax rates of return are the same, we can conclude that the RRSP has the same effect as the complete elimination of tax on the investment income earned on monies saved outside an RRSP.1 This result is demonstrated more formally below along with the effect of tax rates that vary between periods.

To obtain the after-tax rate of return on RRSP saving, we need to determine the rate at which current consumption can be exchanged for future consumption using an RRSP. Consider consumption levels in two periods, C0 a nd  CN, that depend on income levels, Y0 and YN, marginal tax rates, m0 and mN, tax parameters, K0 and KN, that account for tax credits and the taxation of part of income at tax rates less than m0 or mN, the level of the RRSP contribution, R0, and the pre-tax nominal rate of return, i, earned on the funds in the RRSP.

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The effects of an incremental change in the level of the RRSP contribution on C0 and CN are

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Consequently, the rate at which consumption can be exchanged between the periods by RRSP saving is

 

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To convert this to an annual rate of return on RRSP saving, we ignore the negative sign, take the Nth root of the expression and subtract 1.

 

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Where there are no income-averaging effects and the RPP/RRSP tax treatment provides a pure tax deferral, we have mN = m0 and RR = i.

Where mN is lower than m0, as will often be the case in saving for retirement, RR will exceed i. The importance of possible income-averaging effects on RR depends on the holding period, N, as well as the tax rates. Consider the case of an individual who faces a top-bracket (federal/provincial) tax rate of 45% before retirement and a lower rate of 30% after retirement. With a pre-tax rate of return of 7%, the after-tax rate of return is 9.6% with a 10-year holding period and 8.3% with a 20-year period, indicating that the income-averaging effects become relatively less important as the holding period increases.

B. Form of Benefit Payouts

In the projections, benefits received at each age up to 64 are assumed constant as a percentage of earnings while benefits received by those age 65+ are assumed to be paid out in the form of a term-certain annuity to age 84 with indexing at a rate of CPI growth less 1%. For each age cohort, the present value of post-age-64 benefits is equal to the sum of assets at age 64 and the present value of post-age-64 contributions. This appendix reviews the information about current benefit patterns on which these assumptions are based.

RPP/RRSP benefit payments are received not only by seniors and retirees. Taxation statistics for 2000 indicate that of $48.9 billion in total benefit payments, 12.2% went to individuals under age 55, 31.2% to those age 55-64 and 56.6% to those age 65+. Total payments to the 55-64 age group are composed of annuity income, mostly from RPPs but also from matured RRSPs, and discretionary withdrawals from RRSPs and RRIFs. Among both the 55-64 and 65+ age groups, annuity income accounts for 80% of the total. Pensioners age 55-64 have higher pensions on average than 65-69-year-olds. This reflects the payment of bridge benefits, which cease at age 65, as well as other factors.

RPP pensions usually begin at retirement but are not required to commence until age 69. RRSPs must be used to purchase annuities or converted to RRIFs by age 69, and RRIF payments must begin by age 70. In 2000, the percentage of tax filers reporting RPP/RRSP income rose from just over 50% at age 65 to over 68% at age 71, indicating that a considerable number of seniors are able to defer receipt of registered plan income for several years after age 65.

The time pattern of benefit payments may be expected to differ for annuity and non-annuity benefits. Annuities generally provide level or indexed payments. About one-half of RPP members belong to plans in which retirement benefits are fully or partially indexed to increases in the CPI. Those in most other defined benefit RPPs have benefits that are subject to ad hoc inflation adjustments. Annuity payments typically cease with the death of the annuitant or a surviving spouse but may also include payments of a guaranteed amount after death when it occurs within a limited period after pension commencement.

For withdrawals from RRSPs and RRIFs, the pattern of payments is likely to be less regular. RRIFs are subject to minimum withdrawal requirements and, where they include funds transferred from RPPs, withdrawal maximums as well. Within these constraints, withdrawals can vary from year to year at the annuitant’s discretion. Upon the death of the annuitant, the balance of funds must be withdrawn and included in the annuitant’s income unless it is transferred to the RRIF or RRSP of a spouse, minor child or dependent infirm child.

Direct evidence on the time pattern of benefits is presented in Figure B.1. It compares the level of RPP/RRSP benefits in 1999 and 2000 for tax filers reporting such benefits in both years.2 For each such filer, the ratio of benefits in 2000 to benefits in 1999 is calculated and the average of these ratios is shown, by age, in the figure.

Figure B.1 - Average Ratio of Benefits, 2000/1999, by Age of Recipient

On average, benefit levels tend to show large increases over the age range 65-70 and modest increases after that. The early increases, and the year-to-year jump at age 70 in particular, appear to result from additions to existing pension income coming from RRSP withdrawals and the required conversion of RRSPs to RRIFs. To provide a closer look at the time pattern of benefits, unaffected by RRSP-RRIF conversions, Table B.1 presents the size distribution of the average ratios, R, for the age group 72-80.

While there is considerable dispersion of ratios, we see that 40% of pensioners had level benefits (R = 1 exactly) or benefits that increased by up to 2%. The CPI increase in 1999, which typically would be the basis for inflation adjustments in 2000, was 1.7%. A further 12.5% had benefit increases between 2% and 5%, perhaps reflecting ad hoc adjustments of less than annual frequency. In view of this evidence, the projections assume that pension payments are indexed at a rate of CPI growth less 1%. For the reference scenario, with 2% inflation, this means an annual increase of 1%.

Table B.1 
Distribution of Ratios (R) 
Pension Income 2000/Pension Income 1999


Range of R

Average R

Frequency


   

(%)

< 0.75

0.460

6.3

0.75-1.00

0.949

22.5

1.00

1.000

15.2

1.00-1.02

1.012

24.7

1.02-1.05

1.030

12.5

1.05-1.25

1.115

10.2

> 1.25

3.009

8.6

Total

1.145

100.0


Regarding the duration of benefits, we noted above that about 80% of RPP/RRSP benefits received by seniors are paid in the form of annuities. (Given the growing importance of RRSPs compared to RPPs, this percentage may be expected to decline over time.) Among those who recently reached retirement age (the 65-69 age group), single males received 11% of RPP/RRSP benefits, single females 17% and couples 72%. Thus, the dominant form of payout at the present time is a life annuity with a survivor benefit continuing after the death of the annuitant.3

However, since annuities are subject to varying sets of survival probabilities (male, female, joint and survivor) and since a significant and growing portion of registered plan assets are paid out as RRSP or RRIF withdrawals, it seems appropriate to model the payout of benefits more simply as a term-certain annuity.

To choose the duration of a term-certain annuity, we looked for one that would embody a comparable degree of tax deferral, and TE cost, as the stream of expected payments under a representative life annuity with 1% indexing. By a representative annuity, we mean one for which the survival probabilities reflect an 11/17/72 mix of the survival probabilities for single males, single females and couples (given a pension with a 60% survivor benefit).

To compare TE costs of different patterns of benefit payout, a convenient measure is:

TE

fraction=1 -

PVTA

   
   

PVNTA

   

where PVTA is the present value of the stream of payments discounted at a pre-tax (i.e., tax-assisted) rate of return and PVNTA is the present value of the same payments discounted at an after-tax (non-tax-assisted) rate of return. Example: consider the case of a single payment in 10 years and assume i = 5.57% and tax rate m = 0.25 (in all years) so that the after-tax rate of return, (1-m)i = 4.1775%. Then the TE fraction
= 1 - (1.0557-10/1.041775-10) = 1 - (0.582/0.664) = 0.123. Table B.2 presents the TE fractions for several benefit payout forms. In each case the first payments begin at age 65. Except for the term-certain annuity cases, the payments are “expected” payments to age 110-i.e, the potential payment at each age multiplied by the survival probability for that age. In the RRIF cases, there is an expected payment assuming survival to each age plus an expected final payment of the fund balance assuming death at that age.

Table B.2 
TE
Fractions for Different Benefit Payout Forms


 

Fraction


RRIF, minimum withdrawals

0.132

23-year term-certain annuity, 1% indexing

0.129

Life annuity, 1% indexing

0.128

Life annuity, no indexing

0.121

RRIF, withdrawal rates: 7.5% age 65-70, minimum after

0.118

20-year term-certain annuity, 1% indexing

0.116


This analysis suggests that the TE for a representative life annuity with 1% indexing is equal to that of a term-certain annuity of close to 23 years.

To avoid overstating the tax expenditure and to allow for the presence of RRIFs with faster payout rates, though, we assume a 20-year term from age 65 to 84.

C. Projection With Modified Marginal Tax Rates

Figure C.1 provides a projection for a modified form of the cash flow tax expenditure that is reported on an annual basis. The TE is modified by adjusting the marginal tax rates on RPP/RRSP benefits and investment income to take into account the effect of additional income on the Guaranteed Income Supplement (and Allowance) benefits of lower-income individuals age 60 or older. The MTRs for 2001 are increased from 17.6% to 21.0% for benefits and 20.6% to 21.9% for investment income.4

These changes do not affect the flows into and out of RPPs and RRSPs but do affect the TE levels. By increasing the weight given to benefits in the TE formula, they reduce the TE level in all years and slightly increase its downward trend as the population ages over the projection period. The TE in this projection declines from 1.16% of GDP in 2001 to 0.91% in 2041.

Figure C.1 - Projected Tax Expenditure Reference Scenario and MTRs With GIS


Elimination of the Federal Capital Tax: Building on the Canadian Tax Advantage

1. Introduction

Enhancing the well-being of Canadians through higher living standards and a better quality of life lies at the heart of the Government’s economic and social policies. Achieving high and sustainable living standards and a better quality of life requires that economic and social progress advance together. By undertaking the right investments and creating favourable conditions for growth, the Government can help provide the foundation for such progress.

Beyond a stable fiscal and monetary climate, the key drivers of a stronger economy are those that allow Canada to improve its productivity performance. These include such factors as a tax system that encourages economic growth and job creation, and investments in new technologies and research.

An efficient tax structure can enhance incentives to work, save and invest. It can also support entrepreneurship and the emergence and growth of small businesses. A competitive tax system is also critical in encouraging investment in Canada, leading to greater economic growth and job creation.

In 2000 the Government set out a five-year $100-billion tax reduction plan that provided significant personal income tax reductions and strengthened the foundation for economic growth and job creation. The plan:

As a result, and taken together with cuts in provincial tax rates, in 2003 the average federal/provincial corporate tax rate (including capital taxes) is below the average U.S. rate.

The 2003 budget introduced measures to build on the Five-Year Tax Reduction Plan to further promote entrepreneurship and small business, and strengthen the Canadian advantage for investment. In particular, the 2003 budget announced the elimination of the federal capital tax over a period of five years. It also proposed to reduce the corporate tax rate of the resource sector to 21% over five years while improving the tax structure of this key sector.

This paper focuses on the elimination of the federal capital tax and how it is contributing to strengthening the Canadian tax advantage.

2. Background

The 7-percentage-point reduction in the general federal corporate income tax rate (from 28% to 21%) announced in the 2000 budget was an important step to make Canada’s corporate tax system more competitive internationally and more consistent across industries.

In 2000 Canada’s corporate tax rate (including federal and provincial capital taxes) was the highest of the Group of Seven (G-7) countries. While manufacturing (21%) and small business (12%) had competitive corporate income tax rates, the remaining sectors of the economy were facing a corporate income tax rate of 28%. A competitive tax system is critical in fostering a strong and productive economy by encouraging investment in Canada and in minimizing the incentive to shift income to other jurisdictions with lower corporate tax rates.

Chart 1
Corporate Tax Rates in G-7 Countries in 2000 and 2008

Chart 1 - Corporate Tax Rates in G-7 Countries in 2000 and 2008

Note: Corporate tax rates are average federal corporate income tax rates plus provincial/state corporate income tax rates and include the income tax rate equivalent of capital taxes.

Rates effective by 2008, based on changes announced to June 2003.

The elimination of the federal capital tax will strengthen the Canadian tax advantage. When the federal capital tax is eliminated in 2008, and taking into account announced changes to provincial tax rates, the average federal/provincial corporate tax rate in Canada, including the effect of capital taxes, will be more than 6 percentage points lower than in the U.S.

Chart 2
Corporate Tax Rates in Canada and the U.S.

Chart 2 - Corporate Tax Rates in Canada and the U.S.

Note: Rates are based on changes announced to June 2003. Rates are average federal corporate income tax plus provincial/state corporate income tax rates and include the income tax rate equivalent of capital taxes.

3. Capital Taxes

Federal Capital Taxes

The federal capital tax was introduced in the 1989 budget, at a time when the federal government was struggling with budgetary deficits. It applies at a rate of 0.225% to all corporations, including financial institutions, on taxable capital employed in Canada exceeding $10 million. A corporation’s taxable capital is generally described as the total of its shareholders’ equity, surpluses and reserves, as well as loans and advances to the corporation, less certain types of investments in other corporations. A corporation’s federal income surtax (1.12% of taxable income) is deductible against the corporation’s capital tax liability. Surtax credits in excess of a corporation’s capital tax liability can be carried back to reduce the federal capital tax paid in the three previous years or carried forward to reduce capital tax liability in the following seven years.

The revenue from the federal capital tax (after surtax offsets) was $1.3 billion in 2000, paid by approximately 18,500 corporations. Of that number, approximately two-thirds (about 12,000) had no taxable income (see Table 1).

Table 1
Tax Status of Corporations Subject to the 
Federal Capital Tax, 2000


 

Number of corporations

Capital tax paid

Average assets


($ million) ($ million)

No taxable income

11,998

(65%)

720

(54%)

112

Taxable income

6,463

(35%)

625

(46%)

295

Total

18,461

 

1,345

 

175


Source: Department of Finance Canada.

Budget 2003 announced the elimination of the federal capital tax, as follows: 

Table 2
Federal Capital Tax Rate Reduction Schedule


 

2003

2004

2005

2006

2007

2008


Rate (%)

0.225

0.200

0.175

0.125

0.0625

0


The federal government also levies a capital tax on large financial institutions that applies to banks, trust companies, mortgage loan companies and life insurers. It is levied at a rate of 1% of taxable capital employed in Canada in excess of $200 million and 1.25% on taxable capital in excess of $300 million. The amount of income tax paid by the corporation is deductible against this tax. In general, financial institutions should have long-term income tax levels in excess of the capital tax on large financial institutions. This tax ensures that all large financial institutions pay a minimum amount of tax to the federal government each year. No changes are proposed to the special capital tax on large financial institutions.

Provincial Capital Taxes

Quebec was the first province to introduce a capital tax in 1947 and other provinces followed suit in later years. Ontario introduced a capital tax in 1957, British Columbia in 1973, Manitoba in 1976 and Saskatchewan in 1980. Nova Scotia and New Brunswick introduced a general capital tax as part of the harmonized sales tax agreement in 1997.

Provincial capital taxes specific to financial institutions are more recent. Newfoundland was the first province to introduce such a tax in 1982, Nova Scotia followed in 1986, New Brunswick in 1987, Prince Edward Island in 1988 and Alberta in 1990.

Recently, several provinces have adopted measures to reduce the impact of capital taxes in Canada:

Currently nine provinces impose capital taxes on financial institutions, the exception being Alberta. Only six provinces impose capital taxes on general corporations: Nova Scotia, New Brunswick, Quebec, Ontario, Manitoba and Saskatchewan. These taxes are an important source of provincial government revenues. Provincial capital taxes are deductible from income for tax purposes both at the federal and provincial level. Unlike federal capital taxes, which can be reduced by the income or the income surtax paid, most provincial capital taxes have no offset mechanism. The Appendix provides more details on the structure of provincial capital taxes.

Chart 3
Provincial Capital Tax Revenues

Chart 3 - Provincial Capital Tax Revenues

Source: Statistics Canada, Public Institutions Division; 2008-2009 is a forecast from the Department of Finance Canada.

4. Economic Impacts of Eliminating the Federal Capital Tax

Like taxes on business income, taxes on business capital reduce investment by raising the required rate of return on incremental investment. A firm will only undertake investments that are expected to generate at least enough income (net of wages and other direct production costs and capital depreciation) to pay for the financial cost of capital and taxes. Taxes on business therefore mean less investment because they raise the required rate of return on investment. Unlike income taxes, however, capital taxes must be paid even if the investment is not profitable, which makes them more damaging to investment. For example, capital taxes add to the losses incurred by businesses during economic downturns and reduce the cash flow of start-ups and expanding firms. In other words, because they are profit-insensitive, capital taxes increase the risk of investing to business more than income taxes, which share risks between the firm and the government.

In order to quantify the economic impacts of removing the federal capital tax, simulations have been undertaken with a “general equilibrium” tax model developed by the Department of Finance Canada. This model embodies the essential features of the Canadian economy and tax system, along with standard economic principles-in particular, that taxes affect incentives to work, save and invest.5 The model is described as “general equilibrium” because it is assumed that capital and labour are fully employed at all times. As a result, general equilibrium models are used to assess how taxes (and economic policies in general) affect incentives to work, save and invest as well as to assess how efficiently, rather than how intensively, capital and labour are used. This is in contrast to macroeconomic forecasting models, which emphasize how government policies can help the economy return to or stay on a “full-employment” growth path.

The economic impacts of eliminating the federal capital tax are summarized in Table 3. Also shown are the impacts of a corporate income tax rate reduction that involves the same revenue loss as eliminating the federal capital tax. The simulations incorporate measures that offset the revenue loss from the tax cut, eliminating any direct effect on the government budget balance. The simulations thus abstract from changes in the Government’s fiscal position such that the model captures the pure efficiency gain of the tax reductions.6 Note, however, that the model cannot capture the risk-shifting aspect of the federal capital tax, so the benefits of eliminating the federal capital tax are understated.

Table 3
Impact of Revenue-Neutral Tax Reductions

1


 

Welfare

2 gain 
(in dollars) 
per dollar of 
lost government 
revenue

Consumer
spending

Output

Capital
stock


 

Present value

% change in steady state level

Elimination of the federal capital tax3

0.9

0.4

0.6

1.1

A revenue-equivalent reduction in the corporate statutory rate4

0.4

0.2

0.3

0.5


1 The revenue loss is recovered through lump-sum (non-distorting taxes.)
2 Includes the value of leisure as well as consumer spending.
3 Excludes impacts from profit insensitivity of the Federal capital tax.
4 Excludes impacts arising from changed incentives to shift income out of Canada.

The model indicates that the elimination of the federal capital tax will provide a significant boost to investment, which, in the long run, will raise the capital stock just over 1%. This is accompanied by a permanent increase in real output and consumer spending of about one-half of 1%. These benefits are easier to understand when expressed per dollar of tax revenue foregone. The first column of Table 3 shows that the present value of the welfare gain, which is defined as the sum of consumer spending and an imputed value of leisure, equals 90 cents for every dollar of revenue lost by eliminating the federal capital tax. As noted above, this is a pure efficiency gain since, for purposes of the simulation, the revenue lost by eliminating the federal capital tax is assumed to be recovered by raising other taxes that do not affect economic efficiency.

The economic benefits of eliminating the federal capital tax are roughly twice as large as the benefits from a revenue-equivalent reduction in statutory rates, even without considering the profit insensitivity aspect of capital taxes. A key source of the discrepancy is the interaction of tax rate reductions with capital cost allowances (CCAs) and adjustment costs. When CCA exceeds economic depreciation, as it does on average in Canada, firms receive a tax benefit on new investment that is valued at the corporate tax rate. Reducing the statutory rate therefore lowers the value of this CCA tax benefit. Since there is no interaction between CCA and capital taxes, eliminating the federal capital tax has a larger impact on the effective tax rate on new investment than a revenue-equivalent reduction in the income tax rate.

This effect is reinforced when the adjustments that firms must go through when they make new investments are taken into consideration. Adjustment costs, modelled in the form of temporarily lower production as firms invest, reduce taxable income, and an income tax rate reduction increases the after-tax cost of this “expense.” This also lowers the benefit of the income tax rate cut for new investment. There is no parallel effect with capital taxes.

While the simulation results show that statutory rate reductions are less potent than cuts in capital taxes, the benefits of lowering statutory rates are sensitive to the starting point. In 2000 Canada’s combined federal/provincial statutory rate was the highest in the G-7, giving multinational enterprises (MNEs) operating in Canada an incentive to shift taxable income to other jurisdictions. The rate reductions announced in Budget 2000, along with cuts at the provincial level, will make Canada a low-tax jurisdiction in the G-7. As a result, the income tax cuts initiated in 2000 will deliver two benefits: improved economic performance and potential additional revenue as Canadian-based MNEs have less of an incentive to shift taxable income out of Canada. In contrast, the hypothetical reduction considered in this analysis implicitly7 takes projected levels in 2005 as the starting point and assumes that the rate reduction has no impact on tax planning by MNEs.


Appendix: Main Features of Federal and Provincial Capital Taxes, 2003


 

GeneralRate 
(deduction)

Financial 
Institutions Rate 
(deduction)


Federal

0.225% ($10 million, $50 million after 2003)4

1/1.25% ($200 million)1, 6

Newfoundland and Labrador

None

4% ($5 million if taxable capital < $10 million; else none)

Prince Edward Island

None

3% ($2 million)

Nova Scotia7

If taxable capital < $10 million: 0.5% ($5 million); if taxable capital > $10 million: 0.25% (none)3

3% ($0.5 million; $10 million if trust/loan with head office in Nova Scotia)

New Brunswick

0.3% ($5 million)

3% ($10 million)

Quebec9

0.6% ($250,000)

1.2% ($250,000)8, 13

Ontario12

0.3% ($5 million)

0.6-0.9% ($5 million)5, 13

Manitoba7

0.3% on first $10 million of taxable capital; 0.5% on the excess ($5-million exemption, becoming a deduction on January 1, 2004)

3% ($5-million exemption, becoming a deduction on January 1, 2004)

Saskatchewan2

0.6% ($10 million to $15 million)10

If taxable capital < $400 million: 0.7%; else: 3.25% ($10 million to $15 million)10

Alberta

None

Repealed on April 1, 2001

British Columbia

Repealed on September 1, 2002

1% ($5 million);11 If taxable capital > $1 billion and head office outside B.C.: 3% ($5 million)


Source: M.G. Mallin, Preparing Your Corporate Tax Returns, Canada and Provinces, 23rd edition, 2003, CCH Canadian Limited.

1 1% on capital between $200 million and $300 million, 1.25% on the excess.

2 Large resource companies pay the greater of the general capital tax and a special gross resource revenue tax.

3 The Nova Scotia general capital tax is set to expire on March 31, 2006.

4 The general federal capital tax will be phased out over five years; 0.2% in 2004, 0.175% in 2005, 0.125% in 2006 and 0.0625% in 2007. Reduced by surtax on income.

5 0.6% on the first $400 million in capital, 0.72% on the excess for non-deposit-taking institutions, 0.9% on the excess for deposit-taking institutions. Credit unions are exempt.

6 Reduced by income tax.

7 Insurance corporations are treated as ordinary corporations.

8 A 1.6% surtax must be added after March 14, 2000, and before March 15, 2003. A compensatory tax is also added to financial institutions, consisting of 0.25% of capital plus 2% of wages paid in the year (2.5% of wages paid for credit unions).

9 Starting January 1, 2004, Quebec’s capital deduction will increase to $600,000. The proposed rate reduction to 0.3% (0.6% for financial institutions) is reported indefinitely.

10 Saskatchewan’s basic Corporation Capital Tax (CCT) exemption is $10 million. Corporations are entitled to an increased CCT exemption of $5 million ($7.5 million after 2003 and $10 million after 2004) to the extent of the company presence in Saskatchewan ($10 million + $5 million times percentage of wages/salaries paid in Saskatchewan).

11 Increased to $10 million for taxation year ending after March 31, 2003.

12 The 2003 Ontario budget proposes to reduce capital tax rates by 10% on January 1, 2004, with an intention to eliminate the capital tax by the time the federal government eliminates its capital tax. This rate reduction does not apply to the minimum capital tax on life insurers.

13 Quebec and Ontario impose a minimum capital tax on life insurers. It is levied at a rate of 1.25%, with a deduction of $10 million plus an amount that varies with the taxable capital employed in Canada. Income tax paid is deductible against this tax.


1 This is also the same result as would be obtained through saving in a tax pre-paid savings plan (TPSP). Contributions to a TPSP are not deductible, but investment income earned in the plan and benefits paid out of it are not subject to income tax. [Return]

2 For pension income and other income components, the T1 file contains data on both the current and previous tax years. [Return]

3 Federal and provincial pension benefits legislation generally requires that, except in the case of joint election by spouses, RPP members with spouses take their benefits in a form that includes a survivor benefit of 60% or more of the base pension. [Return]

4 Based on T1 data for 2000, about 22% of households headed by seniors receive both pension income and Guaranteed Income Supplement benefits. [Return]

5 A detailed description of the model is available. [Return]

6  These offsetting measures are included in the model by imposing “lump-sum” or per capita taxes that have no impact on the incentives to work, save or invest. The federal capital tax is of course being eliminated without any offsetting measures, so it will increase the level of demand in the economy. [Return]

7 The model used in this analysis does not capture tax base shifting by MNEs. [Return]

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