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Part 2
Tax Evaluations and Research Reports

Taxes on Business Investment: An International Comparison of Marginal Effective Tax Rates in the Manufacturing Sector

Introduction

The amount and quality of capital Canadians have to work with is a key determinant of their productivity, which is the ultimate determinant of the wages and hence the living standards that they can enjoy. The decision to invest is highly sensitive to the rate of return, and taxes have a direct and measurable effect on the rate of return. In order to assess the impact of taxes on capital spending, it is important to consider not only the statutory tax rate on corporate income but also all other elements of the tax system, which is often measured by what is known as the marginal effective tax rate (METR) on investment.

Last year’s edition of Tax Expenditures and Evaluations contained a report summarizing the METR methodology and presenting estimates for all jurisdictions in Canada and the United States. This report extends the earlier analysis of Canada’s tax competitiveness by comparing the tax treatment of investment by manufacturers in Canada and 35 other countries. The focus is on manufacturing because it represents a large share of Canada’s inbound foreign direct investment and because manufacturing investment is particularly sensitive to international differences in rates of return. Comparisons with the US are especially important given the close economic linkages between the two countries, but it is also revealing to make comparisons with other members of the Group of Seven (G7), with other smaller open economies and with emerging economies.

The main findings of the report are:

Marginal Effective Tax Rates—Methodology, Assumptions and Caveats

A marginal effective tax rate is a comprehensive indicator of the tax burden on new investment. It combines in a single measure the statutory tax rate that applies to corporate income, factors that affect the corporate tax base—capital cost allowances and interest deductibility—and profit-insensitive levies such as capital taxes, investment tax credits and sales taxes on investment goods.[1] A METR measures the extra return on an investment required to pay corporate-level taxes, expressed as a percentage of the total return to shareholders. For example, if the gross-of-tax return to shareholders is 6 per cent and if the corporate tax system reduces this return to 4 per cent, the METR would be 33 per cent.[2]

In addition to tax parameters, calculation of METRs requires assumptions about the financial structure of firms, the rate of return on debt and equity and the rate of inflation, all of which are used to calculate the financial cost of capital.[3] The estimates are also sensitive to the capital assets—machinery and equipment, buildings, inventories—used by firms and how quickly they depreciate.[4] In order to focus on differences in tax systems, the same "economic" assumptions are used for all countries included in the international comparison. As a result, the comparisons examine the impact of applying different tax regimes to a given investment in Canada.

An alternative approach would be to use country-specific tax and economic variables to calculate METRs. An international comparison would then show relative tax burdens on investment as they are affected by the tax system as well as by such factors as the rate of return on debt and equity, inflation and the mix of capital assets used in the investment. A case can be made that inflation is likely to be the single biggest source of variance in economic variables across countries, so some analysts present METR estimates based on common assumptions for all economic variables except inflation.[5] The impact on the estimates of making this change is shown in Annex 1.

The METRs presented in this document are applicable to a large taxable firm making an investment that is small relative to its ongoing operations. This assumption ensures that there is no delay in using the deductions and credits available on the investment. A delay would result in a higher effective tax rate.

Tax Competitiveness

While the METR is a comprehensive indicator of how the tax system is affecting the decision to invest, there are circumstances in which the statutory tax rate is a more relevant indicator of tax competitiveness.

It is therefore important to consider both the statutory rate and the marginal effective rate when assessing the competitiveness of the tax system.

Tax competitiveness is clearly not the only factor affecting foreign direct investment (FDI). Wage costs, the quality of labour, infrastructure, political risk, agglomeration effects (i.e. the presence of industrial clusters and a large market) and distance to export markets are some of the other factors affecting the decision to invest in a particular location. But investment decisions are highly sensitive to the rate of return, and taxes have a direct and measurable impact on the rate of return.

Tax competitiveness with the United States is particularly important since that country supplies two-thirds of Canada’s inbound FDI and is the destination for more than 40 per cent of outbound FDI by Canadians. Further, overseas countries often invest in Canada to serve the North American market and would therefore be comparing locations in Canada and the US. Changes proposed by the federal and provincial governments in 2006 will give Canada a substantial statutory tax rate advantage over the US in 2011, assuming no further changes in the US, on both general and manufacturing income (Table 1). Canada’s advantage as measured by the marginal effective tax rate on investment is, however, considerably smaller (Table 2).

Table 1
Statutory Tax Rates on Corporate Income in 2011—Canada and the US (Combined Federal/Provincial-State)


  Canada US Canada-US

  (%)
Pre-2006 measures      
General income 35.4 39.4 -4.0
Manufacturing 34.3 36.1 -1.8
Combined 35.0 37.9 -2.9
 
Post-2006 measures1      
General income 31.1 39.4 -8.3
Manufacturing 30.3 36.1 -5.8
Combined 30.8 37.9 -7.1

1 Includes measures announced in federal and provincial/state budgets as well as Canada’s Tax Fairness Plan and Saskatchewan retail sales tax reduction, both announced in October 2006.

Despite the dominant position of the US, Canada does compete against many other countries for investment. For example, Mexico is an alternative location for FDI by US and overseas firms if transport costs, duty-free entry or other factors necessitate a North American location.[6] In many cases, however, there is no compelling reason to locate in North America, so Canada is competing against a long list of countries for inbound FDI. Finally, Canadian multinational enterprises often have the choice of serving foreign markets through exports from Canada or by setting up production facilities abroad. More than half of Canada’s non-US outbound FDI goes to the European Union while the balance is spread over a large number of developed and emerging economies.

Table 2
METRs in 2011—Canada and the US 
(Combined Federal/Provincial-State)


  Canada US Canada-US

  (%)
Pre-2006 measures      
Manufacturing 30.7 30.0 0.7
All sectors 34.6 34.4 0.2
       
Post-2006 measures1      
Manufacturing 27.0 30.0 -3.0
All sectors 31.1 34.4 -3.3

1 Includes measures announced in federal and provincial state budgets as well as Canada’s Tax Fairness Plan and Saskatchewan retail sales tax reduction, both announced in October 2006.

International Comparison

In order to assess the competitiveness of Canada’s tax system, METRs for 36 countries have been prepared. All 30 members of the Organisation for Economic Co-operation and Development are included, along with four emerging economies, Hong Kong Special Administrative Region (SAR) and Singapore. The estimates include national and sub-national taxes,[7] except those applicable in selected regions of sub-national jurisdictions. This report is primarily concerned with how Canada’s business tax system affects FDI, so it focuses on METRs for the manufacturing sector,[8] which accounts for more than 40 per cent of Canada’s inbound FDI and the bulk of "footloose" FDI—i.e. FDI that supports production that is not tied to a specific location, making it particularly sensitive to tax differentials across countries. In contrast, most service sector industries are oriented to the domestic market, making FDI in these industries less sensitive to international 
tax differentials.[9]

Canada taxes business investment in the manufacturing sector at a high rate relative to the countries in the comparison group, occupying the ninth highest position for the METR, projected for 2011 (Chart 1). The impact on Canada’s tax competitiveness of corporate tax reductions proposed in 2006 is highlighted in Chart 1, which shows Canada with the sixth highest METR prior to these initiatives. The corporate tax reductions proposed by the federal government in 2006 will trim 3.2 percentage points from the Canadian manufacturing METR in 2011, while provincial measures will subtract a further 0.6 percentage points. These proposed changes are likely affecting investment decisions now, particularly for projects with long lead times, because investment is affected by expected after-tax returns.

In these 36 countries, statutory tax rates and manufacturing METRs are correlated, but in most countries the statutory rate overstates the overall tax burden on investment as deductions and credits reduce the effective tax rate (Table 3 and Chart 1). In addition, there is substantially less variance across countries in the statutory rate than in the METR.

The countries examined have been organized into three groups for comparison purposes: G7 countries, smaller developed countries and emerging and transition economies.[10] On average, the G7 countries impose the highest taxes on business investment, with both the statutory tax rate and the METR well above the corresponding averages for the other groups (Table 3). It is sometimes argued that large economies can sustain relatively high business tax rates because capital is more efficient due to agglomeration effects, so governments are able to capture some of the benefits through higher taxes.[11] Smaller economies, in contrast, may be using tax policy to offset locational disadvantages as well as the perception that investments in these countries are riskier due to exchange rate fluctuations and the potential for suffering reduced access to export markets. This pattern can be seen more clearly in a comparison of the typical country in each group, as measured by the 
median,[12] which shows successively lower METRs for G7 countries, smaller open economies and emerging economies.

Chart 1 - METR and Corporate Statutory Tax Rate (STR) by Country

Table 3
Summary Statistics—METR and Corporate Statutory Tax Rate (STR)


  METR (%) Corporate STR (%)  
 

 
  Median Mean Coefficient of variation Median Mean Coefficient of variation METR/STR correlation

All countries 21.1 21.1 49.4 27.8 27.1 25.7 0.74
G7 members 30.0 30.7 20.1 36.1 35.9 11.4 0.69
Smaller developed economies1 21.1 19.7 38.2 25.0 25.1 23.2 0.67
Emerging and 
transition economies
15.9 24.2 55.9 24.5 25.2 23.1 0.77
Canada   27.0      30.5     

1 Statistics exclude Singapore and Belgium. Their low METRs significantly alter the results, lowering the METR/STR correlation to 0.2 for smaller developed economies.

The ability to attract and retain internationally mobile capital is not, however, the only reason to be concerned about the competitiveness of Canada’s tax system. If Canada imposes a relatively high tax burden on business investment, the amount of capital per worker in firms operating in Canada, whether serving the domestic market or selling overseas, is likely to be lower than in other countries, which would put downward pressure on relative levels of productivity and wages in Canada. A comparison of economy-wide METRs on investment is more appropriate to address this issue.

METRs for the overall economy are generally higher than for the manufacturing sector, and the international rankings change slightly. Canada’s ranking deteriorates from ninth to seventh highest when METRs for the overall economy are compared. While only eight countries in the comparison group have explicit tax preferences for manufacturing, such as lower tax rates, most countries provide depreciation allowances for machinery and equipment that are generous relative to other assets. The manufacturing sector benefits disproportionately from this policy approach because it makes particularly intensive use of machinery and equipment (see Annex 2 for additional details).

Comparison With Other G7 Countries

Canada has the third lowest manufacturing METR among the G7 countries, although the gap with the US and France is not large. Italy has the least onerous business tax regime, undercutting the Canadian METR by 41⁄2 percentage points (Chart 2). The decomposition of the METR shown in Chart 2 reveals that a low statutory income tax rate is the main reason for Canada’s favourable ranking. Canada has the second lowest statutory rate in the G7, only half a percentage point higher than in the UK.

In contrast, the capital cost allowance (CCA) regime has only a small adverse impact on Canada’s tax competitiveness in the G7. CCA recognizes for tax purposes the annual expense resulting from the depreciation of a capital asset over its useful life. The positive values shown in Chart 2 for "economic depreciation less CCA" therefore indicate that in all G7 countries, CCA is not adequate to compensate for economic depreciation.[13] However, the impact on the METR of a given gap between economic depreciation and CCA rates is affected by the statutory rate of income tax: inadequate recognition of economic depreciation increases taxable income, so the impact on the METR rises along with the statutory rate. Removing the statutory rate from the calculation therefore isolates the relative impact of CCA regimes on METRs. This is shown in Panel B of Chart 2, which demonstrates that most G7 countries have similar CCA regimes. The exceptions are Italy, which comes closest to offering adequate recognition of economic depreciation of assets, and Japan, which has one of the least generous CCA provisions among the 36 countries examined.

In contrast to the CCA regime, inventory accounting methods slightly reduce Canada’s advantage relative to other G7 countries. In an inflationary environment, firms realize a gain on inventories because there is usually a lag between when goods are produced and when they are sold. Firms are required to bring this gain into taxable income under first-in first-out (FIFO) inventory accounting, but not under the last-in, first-out (LIFO) inventory accounting convention, which effectively values inventories in line with current production costs.[14] This difference in taxable income results in a higher METR under FIFO accounting than under LIFO. In the G7, Canada, the UK and France do not allow LIFO inventory accounting for tax purposes.

Germany and Italy impose restrictions on interest deductibility that put substantial upward pressure on their METRs. In Germany, sub-national governments allow only 50 per cent of interest expense to be deducted from taxable income, thereby raising the national METR more than 5 percentage points. Sub-national governments in Italy do not allow any deduction for interest on debt issued to finance capital investment, raising the national METR just over 3 percentage points. Japanese firms are not allowed to deduct interest payments on debt issued to finance the purchase of land, but this has a negligible impact on the METR given the small share of land in the capital structure of firms.

Chart 2 - METR Comparison - G7

Canada and the US are the only G7 countries that levy capital taxes.[15] By 2011, capital taxes will be levied in only four Canadian provinces—Ontario,[16] Quebec, Nova Scotia and Manitoba. These capital taxes increase the national METR by 11⁄2 percentage points. In the US, about a third of the states now levy capital taxes and no changes have been announced. Similarly, in the G7, only Canadian provinces and US states impose retail sales taxes that apply to capital goods. In Canada, the five provinces that levy retail sales taxes generally offer some exemptions for capital inputs, particularly for machinery and equipment used in manufacturing, that substantially reduce the effective sales tax rate on capital goods in the manufacturing sector. As a result, retail sales taxes raise the Canadian METR by approximately 21⁄2 percentage points, compared to the 9 percentage points that would prevail in the absence of any exemptions. In the absence of provincial taxes on both capital and retail sales, the Canadian manufacturing METR would be the second lowest in the G7, just half a percentage point higher than in Italy.

In the US, state governments also offer exemptions that reduce the impact of retail sales taxes on the price of capital goods. Many US states levying retail sales taxes provide investment tax credits (ITCs) that further attenuate the impact of retail sales taxes on the METR, as can be seen from the downward arrow in Chart 2.[17] While several of the smaller Canadian provinces offer ITCs, the largest effect comes from the federal credit for investment in the Atlantic provinces.

Comparison With Smaller Developed Economies

A comparison of the tax treatment of business investment in other smaller developed economies is of interest not only because some are direct competitors with Canada for FDI, but also because the comparison provides a perspective on alternative corporate tax strategies undertaken by countries that have some similarities with Canada.

Canada taxes manufacturing investment at the second highest rate among the 17 countries that are included in the comparison (Chart 3). All of the key elements of the tax system contribute to Canada’s relatively poor performance in this group, with the biggest impacts coming from the statutory tax rate, sales taxes on capital inputs and capital taxes. Canada’s statutory tax rate is the third highest in the group, behind Belgium and New Zealand.

Chart 3 - METR Comparison-Smaller Developed Economies

No countries in the comparison group impose sales taxes on capital inputs and only Luxembourg and Switzerland (at the canton level) levy capital taxes.[18] In the absence of provincial sales and capital taxes, Canada’s METR on investment in the manufacturing sector would be the sixth highest in the group of smaller developed economies. Canada’s CCA regime is less generous than the average (Chart 3, Panel B), largely due to a relatively low CCA rate for manufacturing plants (Chart A3-1 in Annex 3). Increasing the CCA rate on manufacturing plants to align it with economic depreciation would trim approximately 4 percentage points from the Canadian METR.

The CCA regimes add an unusually large amount to the METRs in Austria, Australia and Norway. Firms in Austria are able to specify the service life of assets for tax purposes but must use straight-line depreciation; this restriction severely reduces the value of deductions for depreciation compared to the declining-balance method, which allows greater deductions early in the life of the asset.[19] As a result, Austria has the third most restrictive CCA regime among the 36 countries examined. Firms in Australia are allowed to use their own service life estimates for machinery and equipment, but most choose those specified by the Commissioner of Taxation, which are reasonably well aligned with useful lives. The specification of CCA rates, however, leaves firms with a substantial undepreciated balance at the end of the useful life of an asset.

The CCA regimes in Singapore, Hong Kong (SAR) and Greece are more than adequate to cover economic depreciation, as indicated by the descending arrows in Chart 3. In Singapore, tax depreciation exceeds economic depreciation by such a large margin that the overall manufacturing METR is substantially negative—the tax system is providing a large subsidy to investment.

The METR is zero in Belgium, allowing, as of 2006, a deduction for a notional return on equity in order to provide similar tax treatment for debt and equity financing.[20] This new measure reduces the METR by almost 20 percentage points.

Comparison With Emerging and Transition Economies

The typical emerging economy[21] has the lowest METR and, by a small margin, the lowest statutory rate in the three comparison groups (Table 3). The Canadian METR is higher than in all countries in this group except China, Brazil and India (Chart 4, Panel A), while the Canadian statutory rate is the third highest, behind Brazil and India.

Chart 4 - METR Comparison-Emerging and Transition Economies

Among these emerging economies, only India imposes a capital tax[22] and only China imposes sales taxes on capital goods. Portugal is the only country in the comparison group that offers an investment tax credit. A 5 per cent investment tax credit is available on most investment in machinery and equipment exceeding the average investment of the previous two years, which reduces the METR by 1 percentage point, as indicated by the descending arrow in Panel A of CHART 4.

China has, by a substantial margin, the highest METR of all 36 countries, reflecting a restrictive CCA regime (Chart 4, Panel B) as well as the impact of sales taxes on capital goods. China has a value-added tax (VAT), but does not allow input tax credits for investment in machinery and equipment, which adds almost 21 percentage points to the METR.[23] Brazil’s tax system is characterized by a relatively high statutory tax rate and a relatively restrictive CCA regime, particularly for machinery and equipment. Straight-line depreciation must be used for all assets, and the useful lives for machinery and equipment are longer than in most other countries in the comparison group. India also has a relatively high statutory rate. Its CCA regime is also more restrictive than the average for the group of emerging economies, largely due to the 2005 budget, which scaled back the CCA rate for machinery and equipment, from 25 per cent straight-line to 15 per cent.

Mexico, which competes with Canada for inbound FDI, is the only country of the 36 to fully index its tax system for inflation.[24] Relatively high straight-line CCA rates are available for machinery and equipment, which, when combined with inflation adjustment, results in a CCA regime that comes close to compensating for economic depreciation. Turkey has the lowest METR in the group, due to a relatively low statutory tax rate and depreciation allowances that more than compensate for economic depreciation.

Conclusion

This paper compares manufacturing METRs in Canada, the US and 34 other countries in order to assess Canada’s ability to attract and retain the substantial volume of internationally mobile capital. The focus is on manufacturing because it represents a large share of Canada’s inbound foreign direct investment and because manufacturing investment is particularly sensitive to international differences in rates of return.

Federal business tax reductions announced in 2006, along with provincial initiatives, will give Canada an overall tax advantage in manufacturing over the US, which is the major source of inbound foreign direct investment and the most important destination for Canada’s outbound investment. Canada will also have an advantage over other G7 countries, except the UK and Italy. But Canada is competing against many other countries for internationally mobile capital, and even with the measures announced in 2006 the tax burden on investment in manufacturing is higher in Canada than in almost all other smaller developed economies. Provincial sales tax reform and elimination of capital taxes would substantially improve Canada’s tax competitiveness.

The ability to attract and retain internationally mobile capital is not, however, the only reason to be concerned about the competitiveness of Canada’s tax system. A relatively high tax burden on business investment will reduce the amount of capital per worker in firms operating in Canada, and this will put downward pressure on relative levels of productivity and wages in Canada. This issue is more appropriately addressed through an international comparison of economy-wide METRs, which also indicates that Canada places a greater tax burden on business investment than most other countries.

Annex 1

Impact of Country-Specific Inflation Rates


  2% Inflation Country-Specific Inflation
 

  METR (%) Rank Rate (%) METR (%) Rank Difference in rank

China 52.2 1 1.0 51.3 1 0
Japan 41.7 2 0.3 36.9 3 1
India 40.6 3 6.7 45.8 2 -1
Brazil 32.0 4 3.8 36.1 4 0
Germany 31.4 5 1.7 30.7 7 2
France 30.7 6 1.9 30.4 8 2
US 30.0 7 4.1 32.3 6 -1
Australia 29.5 8 4.0 33.0 5 -3
Canada 27.0 9 2.0 27.0 9 0
Norway 26.5 10 2.2 26.8 10 0
Austria 26.3 11 1.5 25.4 13 2
UK 24.7 13 2.4 25.5 12 -1
Luxembourg 24.7 12 2.9 25.4 14 2
Spain 23.6 14 4.0 25.7 11 -3
Denmark 23.1 15 2.0 23.1 18 3
Sweden 22.9 16 1.7 22.2 20 4
Italy 22.5 17 2.2 22.8 19 2
Korea, Rep. 22.3 18 2.9 23.2 17 -1
New Zealand 21.1 19 4.0 24.7 15 -4
Russian Federation 19.6 20 9.7 24.4 16 -4
Finland 19.5 21 1.9 19.3 21 0
Mexico 17.1 22 3.1 16.8 24 2
Switzerland 16.8 23 1.4 16.5 25 2
Netherlands 16.3 24 1.4 15.6 26 2
Iceland 15.0 25 8.6 17.9 22 -3
Portugal 14.6 26 2.3 14.4 28 2
Poland 14.2 27 1.1 13.6 29 2
Czech Rep. 14.1 28 2.9 15.3 27 -1
Slovak Rep. 13.5 29 5.0 17.2 23 -6
Ireland 10.8 30 4.2 12.9 30 0
Hungary 10.2 31 3.0 10.7 31 0
Greece 9.5 32 3.5 9.7 32 0
Turkey 6.6 33 10.3 9.5 33 0
Hong Kong (SAR) 1.9 34 2.3 1.8 34 0
Belgium 0.0 35 1.6 0.0 35 0
Singapore -59.8 36 1.1 -60.9 36 0

Annex 2

Comparison of Manufacturing and Economy-Wide METRs

The METR for manufacturing in most countries is lower than in other sectors (Table A2-1). This is occasionally the result of tax provisions targeting the manufacturing sector, but in most cases it is the result of preferential treatment of investment in machinery and equipment (M&E). The manufacturing sector benefits disproportionately from this policy approach because it makes particularly intensive use of M&E. The international rankings are not very sensitive to comparing economy-wide METRs instead of manufacturing METRs: only three countries experience a change in rank of four positions or more. Canada’s ranking deteriorates from ninth highest to seventh highest when economy-wide METRs are compared.

The US is the only country to have a special low tax rate for manufacturing income at the national level. A federal corporate income deduction for production activities of up to 9 per cent will be available by 2010, and so far 27 states have followed the federal government in granting the deduction. In Canada, there used to be a lower statutory tax rate for manufacturing but now the federal statutory rate is equal for all businesses. A number of provinces such as Ontario have retained a preferential rate on manufacturing income. In no other countries do sub-national governments vary income tax rates by sector.

In addition to special income tax rates, Canada and the United States provide investment tax credits and exemptions from retail sales taxes that target the manufacturing sector. For example, all service sector industries are excluded from the Atlantic investment tax credit. The only other country providing an investment tax credit is Portugal, which is available for incremental investment in M&E.

Eight countries vary capital cost allowance (CCA) rates for assets by industry of use, but only Hong Kong (SAR) targets the manufacturing sector. In recognition of higher economic depreciation, most countries have higher CCA rates for manufacturing plants than for other types of buildings. But only seven of these countries give preferential treatment to manufacturing plants as measured by the gap between economic depreciation and CCA rates for manufacturing plants compared to other buildings. In contrast, most countries give preferential treatment to M&E, wherever it is used, by aligning CCA rates more closely with useful lives for M&E than for structures. Countries adopting this approach have lower manufacturing METRs than in other sectors because M&E makes up over 60 per cent of depreciable capital assets in the manufacturing sector compared to about 40 per cent in other sectors. Italy allows firms to deduct two times the normal depreciation allowance for the first three years. This approach provides a bigger benefit to assets with a relatively short useful life. Since these assets are used disproportionately in the manufacturing sector, the METR is lower than in other sectors.

The METR for manufacturing is higher than the economy-wide METR in 10 of the 36 countries. However, the difference is significant only for the Slovak Republic, where the METR for manufacturing is 20 per cent higher than that for all sectors as a result of more generous CCA for commercial buildings and for some types of M&E used in the service sector, such as computers.

Table A2-1
International METRs in 2011: Manufacturing—All-Sector Comparison


  Manufacturing (%) Rank All sectors (%) Rank Difference (%-pts) Difference in rank

China 52.2 1 51.2 1 -1.0 0
Japan1 41.7 2 43.4 3 1.7 1
India3 40.6 3 43.9 2 3.3 -1
Brazil 32.0 4 31.9 6 -0.1 2
Germany1 31.4 5 32.7 5 1.3 0
France 30.7 6 29.6 8 -1.1 2
US1,2 30.0 7 34.4 4 4.4 -3
Australia1 29.5 8 29.0 10 -0.4 2
Canada2 27.0 9 31.1 7 4.1 -2
Norway 26.5 10 27.4 11 0.9 1
Austria 26.3 11 25.7 13 -0.6 2
Luxembourg 24.7 12 24.5 15 -0.2 3
UK3 24.7 13 29.3 9 4.6 -4
Spain 23.6 14 24.6 14 1.0 0
Denmark 23.1 15 22.1 19 -1.0 4
Sweden 22.9 16 23.6 16 0.7 0
Italy 22.5 17 26.5 12 4.0 -5
Korea, Rep.1 22.3 18 22.8 17 0.5 -1
New Zealand1,3 21.1 19 22.6 18 1.5 -1
Russian Federation 19.6 20 18.7 21 -0.9 1
Finland 19.5 21 20.3 20 0.8 -1
Mexico1 17.1 22 16.7 25 -0.4 3
Switzerland 16.8 23 17.9 24 1.1 1
Netherlands 16.3 24 18.7 22 2.5 -2
Iceland 15.0 25 16.3 27 1.3 2
Portugal3 14.6 26 18.7 23 4.1 -3
Poland 14.2 27 16.3 26 2.1 -1
Czech Rep. 14.1 28 14.7 28 0.5 0
Slovak Rep. 13.5 29 11.2 32 -2.3 3
Ireland3 10.8 30 12.6 29 1.8 -1
Hungary 10.2 31 11.2 31 1.0 0
Greece 9.5 32 12.0 30 2.5 -2
Turkey 6.6 33 8.0 33 1.3 0
Hong Kong (SAR)3,4 1.9 34 7.4 34 5.5 0
Belgium 0 35 0 35 0 0
Singapore3 -59.8 36 -23.6 36 36.2 0

1

CCA rates vary by industry of asset use, but manufacturing is not targeted.

2

Corporate income tax rate, retail sales taxes and investment tax credits vary by industry.

3

Higher CCA rates for manufacturing plants than for other buildings.

4

Accelerated CCA is available for all tangible assets used in manufacturing.

Annex 3

Capital Cost Allowances and Inflation

In most countries examined in this study, capital cost allowances (CCA) do not adequately recognize for tax purposes the expense resulting from the depreciation of a capital asset over its useful life. CCA rates are applied to the book value of assets with no adjustment for increases in prices. With inflation, CCA rates will therefore be inadequate even if they are set equal to economic depreciation rates, which will put upward pressure on the METR. Simply adjusting CCA for inflation would, however, leave intact another inflation-related bias that reduces the METR on fixed capital investment.

Firms finance capital acquisitions in part by issuing debt, and the interest paid is a tax-deductible expense. In an inflationary environment, the interest expense consists of a payment to compensate the lender for the declining real value of the principal amount (the "inflation premium") and a payment to compensate the lender for use of the principal. The inflation premium is effectively an early repayment of principal, which is not normally a deductible expense. Allowing a deduction for the inflation premium therefore puts downward pressure on the METR, cushioning the impact of inflation on the real value of CCA. The offset is incomplete since on average in Canada capital acquisitions are financed with 40 per cent debt and 60 per cent equity.

In a fully indexed tax system, the CCA system would be adjusted to reflect inflation, and only the real value of interest payments would be a deductible expense, along with a number of other adjustments.[25] This result could be approximated by setting CCA rates that compensate exactly for economic depreciation less the benefit from nominal interest deductibility.[26] This approach to calculating a neutral CCA rate is presented in Table A3-1.

Table A3-1
Calculation of a "Neutral" CCA Rate


  Economic depreciation rate   Penalty for nominal CCA   Inflation- adjusted CCA rate   Benefit from nominal interest deductibility    Neutral CCA rate

Manufacturing plants 10.0% + 5.4% = 15.4% - 2.2% = 13.2%
Automated manufacturing and processing equipment 21.0% + 10.0% = 31.0% - 4.8% = 26.2%

Note: Calculations assume a 2% inflation rate and 40% debt/asset ratio. Under 100% debt financing, the neutral CCA rate would be 3 percentage points lower for manufacturing plants and 6.5 percentage points lower for machinery and equipment.

As pointed out in the text, CCA rates in most countries are inadequate to compensate for depreciation expense measured in real terms. This shortfall is illustrated in Chart A3-1 for manufacturing plants, which shows that CCA rates in most countries, including Canada, are in fact below the economic depreciation rate. CCA rates are above the neutral rate in 11 countries.

CCA is substantially more generous for automated manufacturing and processing equipment, which accounts for about a third of machinery and equipment used in manufacturing, more than compensating for real depreciation in about a third of the countries studied. (Chart A3-2). In this case CCA exceeds the neutral rate in half of the countries, including Canada.

Chart A3-1 - CCA Rate for Manufacturing Plants

Chart A3-2 - CCA Rate for Automated Manufacturing and Processing Equipment


Notes:

1

A more detailed review of the methodology is presented in the 2005 edition of Tax Expenditures and Evaluations. [Return]

2

Calculated as (6-4)/6. The return to shareholders is net of all expenses including depreciation. [Return]

3

The financial cost of capital is a weighted average of the return on debt and equity paid by firms. The weights are determined by the economy-wide debt-asset ratio of 40 per cent. The returns on debt and equity are measured in real terms (i.e. observed returns are reduced by the inflation rate, assumed to be 2 per cent) and adjusted for risk. The adjustment for risk recognizes that suppliers of capital require a premium for investing in riskier assets, but in the long run expect to obtain the same real, risk-adjusted rate of return on all investments. [Return]

4

The economic depreciation rates used in this study are based on analytical work undertaken at Statistics Canada over the last several years. This analysis indicates that the official estimates now being used by Statistics Canada are too low, particularly for structures. See Gellatly, G., M. Tanguay, and Y. Beiling, "An Alternative Methodology for Estimating Economic Depreciation: New Results Using a Survival Model," Productivity Growth in Canada, Statistics Canada, Catalogue No. 15-204-XPE (2002); Baldwin, J., G. Gellatly, A. Patry, and M. Tanguay, "Estimating Depreciation Rates for the Productivity Accounts" Statistics Canada Working Paper, forthcoming; and Patry, A. "Economic Depreciation and Retirements of Canadian Assets: A Comprehensive Empirical Study," Statistics Canada Working Paper, forthcoming. [Return]

5

Mintz, J. M., D. Chen, Y. Guillemette and F. Poschmann, "The 2005 Tax Competitiveness Report: Unleashing the Canadian Tiger," C.D Howe Institute Commentary No. 216 (September 2005).  [Return]

6

The free trade agreements (FTAs) between Mexico and a large number of countries strengthen Mexico’s position as a competitor for overseas investment. Mexico has FTAs with the European Union, Japan, the European Free Trade Association, most Latin American countries, except the Mercosur, and Israel. Mexico is currently negotiating FTAs with the Mercosur and South Korea. [Return]

7

The estimates exclude property taxes and other business taxes imposed by municipal governments. The main reason for their exclusion is that part of local taxes represents a fee for service received, but data limitations preclude determination of the fee-for-service element. [Return]

8

METRs are available for 32 manufacturing industries. Research and development (R&D) assets are not included in the comparison. [Return]

9

Footloose industries in the service sector include call centres and a number of other business services, but these industries account for a very small share of both Canada’s inbound FDI and service sector output. [Return]

10

Countries are grouped according to per capita gross national income (GNI) in 2004 adjusted for purchasing power parity. Smaller developed countries have per capita GNI of at least $22,000 while emerging and transition economies have per capita GNI below this threshold. Source: The World Bank (2006). [Return]

11

See, for example, Haufler, A., and I. Wooton, "Country Size and Tax Competition for Foreign Direct Investment," Journal of Public Economics, vol. 71 (1999), pp. 121-139. [Return]

12

The median METR for emerging and transition economies is substantially lower than the mean or average METR because of a particularly high METR in China. [Return]

13

Inflation affects the adequacy of CCA. Economic depreciation is calculated using the replacement cost of the asset while CCA is calculated using the original purchase price of the asset. As a result, even if the CCA rate is equal to the economic depreciation rate, in the presence of inflation it will not fully recognize depreciation expense for tax purposes, which will put upward pressure on the METR. In Canada, the declining real value of CCA accounts for almost half of the impact shown in Panel A of Chart 2, adding about 4 percentage points to the METR. See Annex 3 for a more detailed discussion of capital cost allowances and inflation. [Return]

14

Note that inventory accounting methods put upward pressure on the METR even in those countries that allow LIFO accounting since many firms still choose to use FIFO inventory accounting. Countries allowing the use of LIFO accounting for tax purposes require businesses to adopt LIFO for financial reporting as well. Since LIFO accounting produces lower earnings and may result in higher bookkeeping costs, some firms prefer to use FIFO in both tax and financial accounts. US survey information suggests that the share of firms using LIFO accounting for some or all of their inventories is around 50 per cent. (Source: American Institute of Certified Public Accountants, Accounting Trends and Techniques, 58th edition (2004), p.177). In our METR calculations, this share is assumed to apply to all countries that allow LIFO except Mexico, where there are no restrictions on the use of LIFO. [Return]

15

Stamp taxes, which are one-time charges on additions to equity or debt by a firm, are levied on equity in Italy but have a negligible impact on the METR. [Return]

16

Ontario has tabled legislation to eliminate capital taxes by 2012, and will eliminate them by 2010 if the province’s fiscal situation permits. [Return]

17

A retail sales tax and an ITC set at the same rate have no net impact on the METR since the retail sales tax increases the price of a capital good while an ITC lowers it. [Return]

18

Stamp duties are levied in Switzerland, adding 3 percentage points to the METR; in Austria and Greece, raising the METR about 1½ percentage points; and in Spain, with a negligible impact on the METR. [Return]

19

Under the straight-line method, the annual depreciation expense is equal over the life of the asset. Under the declining-balance method, the annual deduction for depreciation is a constant fraction of the remaining value of the asset. As a result, the annual depreciation deduction is largest in the early years of the asset’s life under the declining-balance method. [Return]

20

The measure allows a deduction based on the risk-free return to equity determined by applying a risk-free interest rate to the book value of equity. Since the METR is developed assuming investments earn this minimum rate of return, in the absence of the capital taxes, stamp duties or sales taxes on investment goods, the deduction reduces the income tax METR to zero. Note that returns above this minimum rate are taxed at the statutory rate of incomes tax. [Return]

21

As measured by the median. [Return]

22

Stamp duties are levied in Portugal and Poland, raising the METR 3.1 and 1.6 percentage points respectively. [Return]

23

China has expressed interest in implementing a full VAT system, but has no specific plans to do so. The government has been experimenting with such a system in three northern provinces since 1999 where tax credits are offered to foreign enterprises, which account for less than 1 per cent of total investment. The government recently extended the VAT credit program to the central-western region but limited the measure to the purchase of domestically made machinery and equipment, which again accounts for a small share of total investment. [Return]

24

Portugal allows depreciation allowances to be revalued to account for inflation, but only 60 per cent of the revaluation is deductible. As explained in Annex 3, this restriction provides an offset to the effects of inflation on interest deductibility. [Return]

25

The most important of these other adjustments is to allow firms to use last-in, first-out inventory accounting, which prevents inflation-related gains on inventories from being included in taxable income. [Return]

26

For a more detailed explanation see Chen, Duanjie, and Jack Mintz, "Canadian Pipeline Contruction Cost Considerations For Capital Cost Allowances," (2005). [Return]

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