Archived - Tax Expenditures and Evaluations 2008 : 4
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Considerations in Setting Canada's Corporate Income Tax Rate
Introduction and Summary
The Government of Canada is committed to achieving the lowest overall tax rate on new business investment in the Group of Seven (G7). In order to achieve this objective, the Government announced in its October 2007 Economic Statement that the federal statutory tax rate on corporate income earned by large firms would be reduced from 22.12% (including the corporate surtax) in 2007 to 15% by 2012. This reduction has now been enacted through legislation. It builds on other actions that have made the tax system more neutral with respect to investment in specific assets and sectors, as well as the choice of business structure. These initiatives help ensure that investment is made on the basis of economic rather than tax considerations while also contributing to a lower tax burden on investment. The federal government is also encouraging the provinces to reduce their statutory rates to 10% by 2012, in order to achieve a combined federal/provincial rate of 25%. This paper discusses some of the considerations that are relevant in setting Canada's corporate income tax rate, particularly as they relate to international competitiveness.
Lower corporate income taxes result in more business investment by both domestic and foreign firms operating in Canada, which leads to new and better jobs and increased living standards for Canadians. The large volume of global capital that can be invested in a variety of locations makes foreign direct investment (FDI) highly sensitive to tax rate differentials. Tax reductions also help protect the tax base, which mitigates the revenue loss associated with lower tax rates. An important, but by no means the only, consideration in setting Canada's corporate income tax rate is therefore international competitiveness.
A complicating factor in setting a competitive tax rate in this context is that some of Canada's key competitors have international tax regimes designed to make their multinational enterprises (MNEs) indifferent between investing at home and abroad despite lower tax rates in foreign countries. This raises the prospect that tax reductions might reduce tax revenues without having a large impact on investment. An examination of this "treasury transfer" effect indicates, however, that it is not likely to be a large concern in Canada's case.
This paper considers the cost-effectiveness of tax reductions—defined as the additional investment per dollar of tax revenue forgone—when assessing how Canada should position itself on corporate income taxation. The adverse effects of taxes on domestic investment, FDI and the tax base all increase as tax rates rise, which results in smaller revenue gains from successive rate increases along with growing negative impacts on investment. Tax reductions reverse this process: cuts are highly cost-effective over a certain range of rates but become less so with successive rate reductions. Declining cost-effectiveness does not mean that the benefits of lower tax rates disappear as rates are brought down; but it does mean that benefits per dollar of revenue forgone diminish.
The evidence reviewed in this paper suggests that with a 25% statutory rate of corporate income tax, Canada would be well placed to encourage domestic investment, attract FDI and protect its tax base. Analysis is required on an ongoing basis, however, since the appropriate position for Canada at any given time must take into account corporate income tax rates in other countries, which are subject to frequent change, as well as evolving trade and investment patterns. In addition to competitiveness, corporate income tax policy is affected by more general considerations such as fairness, simplicity and its impact on economic efficiency.
The outline of this paper is as follows: First, it discusses how taxes affect business investment and the allocation of profits across countries. Second, it sets out a framework for assessing the cost-effectiveness of corporate tax reductions. Third, it reviews the role of international competitiveness in determining how Canada should position itself on corporate tax rates. Fourth, it assesses the potential for a treasury transfer effect as the statutory rate is reduced. Finally, it discusses the benefits of provincial participation in reducing corporate taxes.
Lower Taxes Increase Business Investment and Protect the Tax Base
The decision to invest is sensitive to the expected rate of return on the investment. Taxes clearly affect the rate of return on investment, so there is a theoretical expectation that tax reductions will raise business investment. Recent empirical work confirms this expectation. For example, a recent Department of Finance study examined the impact of the federal corporate income tax rate reductions implemented over the 2001 to 2004 period and found a strong relationship between taxation and investment: a 1% reduction in the cost of capital arising from lower taxes raised investment by 0.7%. This finding is consistent with a number of other studies that have examined the impact of taxes on investment.
Tax rates impact investment decisions by both domestic and foreign firms. As production facilities can be located in a variety of countries, inbound FDI is highly sensitive to tax rate differentials. There are a large number of studies[5 ] demonstrating that FDI responds to both the statutory rate of corporate income tax and the overall tax burden on a new investment—the marginal effective tax rate or METR. A key assumption underlying the calculation of the METR is that the investment being considered has an expected rate of return, adjusted for risk and inflation, equal to the minimum return required by the suppliers of financial capital. That is, the METR applies to the "normal" rate of return on the investment while above-normal returns are taxed at the statutory rate, so both can affect investment decisions.
Canada, like other countries, obtains substantial benefits from attracting (and retaining) investment by MNEs: the corporate tax base expands and the use of innovative technology and management techniques can spill over to domestic firms. For example, researchers at Statistics Canada "find robust evidence for productivity spillovers from foreign-controlled plants to domestic-controlled plants."
In addition to affecting the global distribution of FDI, statutory rates affect the global distribution of profits. MNEs have an incentive to arrange their financial activities in a tax-efficient manner across countries in order to minimize their worldwide tax liabilities. As a result, lower statutory tax rates will help protect the tax base by better aligning Canada's share of global taxable income with its share of global investment. Studies examining profit allocation strategies used by MNEs typically find a substantial impact from differences in statutory tax rates.
Cost-Effectiveness of Tax Reductions
Taxes have an unavoidable impact on economic efficiency by affecting decisions to invest, save and work. These negative impacts become stronger as tax rates rise, which shows up in lower revenue gains in response to successive tax rate increases. Further, beyond a certain point, higher tax rates are likely to be counterproductive: the disincentives created could cause the tax base to shrink by enough to offset the direct impact of the rate increase and total revenues could actually decline. This is commonly referred to as the "Laffer Curve" effect. At a low tax rate, total revenue rises rapidly as the tax rate increases, but at higher levels, successive rate increases generate less additional revenue as rising rates create more disincentives and may ultimately cause revenues to fall.
This relationship indicates that the cost-effectiveness of tax reductions, defined as the additional investment per dollar of tax revenue forgone, varies with the level of tax rates. At relatively high rates, the sensitivity of revenues to tax rate changes is low, but the adverse effect on investment is relatively high, implying a particularly high cost-effectiveness of tax reductions. At lower rates, investment continues to increase but at a slower pace, while the loss in revenue grows larger, indicating a declining cost-effectiveness of tax reductions.
A number of researchers have developed empirical estimates of the Laffer Curve. The methodology may not, however, be robust enough to allow identification of either the peak of the Laffer Curve, where further tax increases result in less revenue, or the range in which rate reductions become less cost-effective. The available empirical estimates are far from definitive due to a number of factors, including the following:
- There is insufficient information to control for the possibility that the observed association of lower rates with higher revenues arises because low rates are accompanied by measures to broaden the tax base.
- Empirical work does not take into account administrative and institutional factors that may affect the incentive for MNEs to allocate taxable income to a particular country, which would make it more difficult to estimate precisely the impact of statutory rates on revenues.
These considerations suggest that while the Laffer Curve provides a useful analytical framework, it does not provide explicit guidance on the appropriate level for the corporate income tax rate. Further analysis is required in order to determine the cost-effectiveness of rate reductions, including consideration of Canada's competitors for mobile capital. This is addressed in the next section.
International Competitiveness Considerations
International competitiveness has two aspects: attracting and retaining FDI and protecting the tax base to ensure that a country's share of global profits is broadly aligned with its share of global investment.
With respect to attracting and retaining FDI, one method of determining precisely who are Canada's competitors for FDI would be to assume that globalization has progressed to such an extent that MNEs "compete with everyone from everywhere for everything." While this may be a reasonable assessment for some firms, taking it literally would imply reducing the corporate tax rate below that of any conceivable competitor. Adopting such a tax rate is unlikely to be cost-effective—the benefits of tax reductions would decline substantially as tax rates are lowered below rates in countries that are not realistic alternatives to investment in Canada, or that account for a small share of world FDI.
Another approach to determining competitors would be to identify which countries are the significant sources of inbound FDI (by foreign firms investing in Canada) and destinations for outbound FDI (by Canadian firms investing abroad). These flows are dominated by transactions with the United States and a small number of other countries (see annex). This approach may be too restrictive, however, since it does not recognize that countries supplying FDI to Canada would not necessarily only be comparing after-tax rates of return in Canada and the home country. In many cases, suppliers of FDI would be comparing after-tax rates of return in many countries. For example, a US MNE considering an investment abroad could be comparing Canada with Mexico, which is not an important source or destination of Canada's FDI. On the other hand, a number of the important destinations for Canada's outbound FDI are small countries without a substantial economic base, suggesting that they are not the ultimate destination of the FDI outflow and therefore that they are not competing with Canada for real investment.
A third method would be to examine Canada's trading partners, since a substantial proportion of FDI is made in support of trade flows. For example, MNEs may decide to serve a foreign market from a facility in or near that market as well as from their home country. Such firms exporting to Canada would be comparing competitiveness in Canada and at home, while Canadian exporters would be undertaking a parallel calculation. In addition, Canadian firms "outsourcing" the production of goods or the supply of services may also invest in the source country to enhance security of supply and to protect intellectual property. Canada's trade flows are dominated by the US and several of the other countries that are important suppliers of or destinations for Canada's FDI. The analysis confirms that Mexico should be included and suggests that China be added to the list of potential competitors for mobile capital (see annex).
The final approach considered here is to examine global FDI inflows by destination country, which recognizes that suppliers of capital compare after-tax returns in a number of countries. Almost 70% of the world's inbound FDI is directed to the 30 industrialized countries that are members of the Organisation for Economic Co-operation and Development (OECD); two other developed economies (Hong Kong Special Administrative Region, or SAR, and Singapore) account for a further 5% (Chart 1). This exercise also highlights the importance of the large and rapidly growing emerging economies of Brazil, Russia, India and China (BRIC), which are the destination for approximately 10% of global inbound FDI. This approach suggests that 35 countries are potentially important competitors for FDI. Note that this approach captures all of the countries that are important final destinations for Canada's outbound FDI.
Further analysis of FDI flows to these countries suggests, however, that they may not always be the ultimate destination for the inflows. Some of these countries receive a share of world FDI that is highly disproportionate to their share of world output (Chart 2). Defining what is highly disproportionate requires some judgement, but Singapore, Hong Kong SAR, Belgium and Luxembourg are exceptional cases—it is highly likely that a substantial portion of their inflows are reinvested in other countries, a situation that has led some observers to describe such countries as "conduits" because they have large flows of both inbound and outbound FDI. Iceland, the Netherlands and Switzerland are also characterized by FDI inflows and outflows that are large relative to their output. In most cases, these large two-way flows increase the tax base without a commensurate rise in real investment. For example, some of these countries have special provisions unrelated to statutory rates that make them attractive locations for managing intra-group financial activities. As a result, attempting to compete with these seven countries on the basis of statutory tax rates is not likely to result in either substantial additional inflows of FDI or provide additional protection to Canada's tax base, leaving 28 countries as important competitors.
With respect to protecting the tax base, or ensuring rough alignment of global shares of taxable income and investment, the list of potential competitors is much longer. Considering only those countries with a substantial economic base, however, eliminates countries that use extremely low tax rates to attract global taxable income but not real investment. With this limitation, protecting the tax base involves considering competitiveness with virtually the same 28 countries identified above.
In 2008, only five countries—Japan, the United States, India, Brazil and France—in this group of 28 potential competitors have a higher tax rate than Canada's average federal/provincial statutory tax rate of 31.7%. Based on tax rates in place or announced as of November 2008, the Canadian average rate will be 27.2% in 2012. This rate will be competitive with those of half of the countries identified as key competitors (Chart 3) accounting for almost 60% of adjusted global FDI flows. A rate of 25% would make Canada competitive with an additional eight countries (from Portugal to the Russian Federation in Chart 3) accounting for about 13% of global FDI inflows, bringing total "coverage" to almost three-quarters of both global FDI and global gross domestic product (GDP). The next five countries, with statutory rates ranging from 20% to 19%, account for about 3% of FDI inflows and global GDP, suggesting a decline in cost-effectiveness from reducing Canada's statutory rate below rates in these countries. The last remaining country, Ireland, has a 12.5% statutory tax rate.
While the "headline" statutory rate is an important signal about competitiveness, the marginal effective tax rate (METR), which takes into account other features of the tax system that affect the burden of taxation, is also an important indicator of competitiveness, as measured by the ability to attract and retain FDI. Assuming no further tax rate changes in other countries, a 25% statutory rate would give Canada a METR that is competitive with 14 of the 28 countries in the comparison group, ranging from China to Sweden in Chart 4. These 14 countries include all of the other G7 countries, all of the BRIC countries except Russia, Australia and four smaller European nations, which account for about two-thirds of global FDI inflows and global GDP.
Many of the remaining 14 countries have substantially lower per capita incomes than Canada and other countries in the comparison group, which may make them less important competitors for world FDI flows. Even without considering this possibility, however, further rate reductions would be subject to declines in cost-effectiveness. For example, cutting the target statutory rate in half would lower the METR sufficiently to compete with an additional nine countries that account for only about 9% of world FDI. Nevertheless, reducing the METR below 22% would still provide a net benefit to Canada by increasing domestic investment and drawing in some additional FDI.
In summary, based on current international tax rates as well as trade and investment flows, statutory rate reductions below 25% are likely to result in smaller gains in competitiveness, as measured by the additional FDI that could be redirected to Canada and lower potential revenue gains from protecting Canada's tax base. This type of evidence, however, needs to be reassessed from time to time in order to take into account changing tax parameters in various countries, as well as the evolution of trade and investment patterns. Considerable judgement is required to determine Canada's competitors for mobile capital.
The Treasury Transfer Effect
Taxpayers in certain countries, in particular the United States and the United Kingdom, are taxed by their home jurisdiction on their worldwide income, with a credit for foreign taxes paid. For MNEs based in these countries, income earned from investments in another country is taxed, in principle, at the higher rate of either the host or the home country, although in practice other tax rules can affect this result. In the case of FDI in Canada by MNEs based in these countries, it is therefore possible that lower taxes in Canada would not reduce the overall tax liability of the MNE. Under the "treasury transfer effect," the revenue forgone by Canada could simply reduce the amount that the home country allows as a credit for foreign (i.e. Canadian) taxes, thereby increasing taxes payable in the home country. Such an outcome would result in a revenue loss for Canada without any favourable impact on investment.
This is a potentially important concern with respect to the US, since it supplies about half of Canada's inbound FDI. The UK, which accounts for 13% of Canada's inbound FDI, announced in late November its intention to introduce legislation in 2009 to exempt foreign dividends from UK tax. The tax treatment of foreign source income is also under review in the US.
Given current institutional arrangements, however, the transfer of tax revenue to the US treasury should not now be considered a serious constraint on Canada's choice of statutory rate:
- Many analysts hold the view that the US credit system does not affect investments financed by retained earnings, which account for about one-third of Canada's FDI from the US. According to this view, since a US firm with a subsidiary in Canada has to pay an additional tax on repatriation either up front (by distributing the earnings immediately to the US parent) or at the end of the investment period, the repatriation tax will not affect the decision of where to invest retained earnings. Retained earnings will be allocated to the country that has the higher after-tax rate of return.
- US MNEs are also able to use tax-planning techniques to indirectly repatriate income from low-tax jurisdictions without incurring additional US tax.
- US MNEs are able to pool incomes from high- and low-tax jurisdictions when calculating additional US taxes payable upon repatriation of dividends, so a low rate in Canada would not necessarily result in a treasury transfer.
In addition, in 2004, US MNEs were allowed a one-time, 85% tax-free repatriation of dividends from controlled foreign corporations, provided that the funds were reinvested in the US. As a result, firms may be adjusting the expected value of the repatriation tax for the probability that such an event will occur again.
Finally, the maximum foreign tax credit allowed under US tax law is substantially less than foreign taxes actually paid due to the allocation of expenses incurred by the US parent to foreign subsidiaries in calculating the credit and different definitions of taxable income under Canadian and US tax rules. As a result, it appears that Canada could reduce its statutory rate of corporate income tax substantially below the US rate without creating potential additional US tax liabilities on repatriated dividends. This "threshold" rate is further reduced by the existence of withholding taxes on dividend payments.
The Benefits of Lower Provincial Business Taxes
At 15%, the federal statutory corporate income tax rate in 2012 will be 14 percentage points lower (including the elimination of the corporate surtax) than in 2000. In contrast, based on changes now legislated, the weighted average provincial statutory tax rate in 2012 will be only slightly more than 1 percentage point lower than in 2000. Reaching the 25% target would require all provinces, except Alberta and British Columbia, to reduce their general corporate tax rate to 10% (Chart 5).
A uniform 10% provincial corporate income tax rate would lower the weighted average rate by 2.2 percentage points. This decline would reduce the METR by 1.5 percentage points, which would stimulate additional investment by domestic and foreign firms. In addition, provinces lowering their tax rates would help protect their tax bases from international competition.
Provincial tax rates projected for 2012 range from 10% to 16% (Chart 6). Uniform provincial tax rates would help ensure that investment decisions within Canada are made on the basis of economic rather than tax considerations, which would improve economic efficiency in Canada overall and in the provinces reducing taxes. By reducing incentives for interprovincial tax planning, a uniform provincial corporate income tax rate would also help protect the tax bases of the provinces and simplify tax compliance for corporations.
5 See de Mooij and Ederveen (2003) for a review of studies based on data up to the early 1990s. More recent studies include Altshuler and Grubert (2004) and de Mooij and Ederveen (forthcoming). These studies examine the impacts of both statutory rates and marginal effective tax rates on FDI flows. [Return]
16 This view was first articulated by Hartman (1985). See also Sinn (1993) for a discussion of how the repatriation tax could affect the size of the initial investment abroad by a US MNE. As discussed in footnote 17, less definitive results are obtained if subsidiaries are assumed to be able to invest in other affiliated corporations in addition to reinvesting or repatriating their earnings (Altshuler and Grubert ). [Return]
17 As described in Altshuler and Grubert (2003), one way to achieve this outcome is to have a subsidiary in a low-tax jurisdiction invest in an affiliated firm in a high-tax jurisdiction. This equity injection is used to fund the operations of the high-tax affiliate. If all of the earnings in the high-tax affiliate are paid out in dividends to the low-tax affiliate, the equity investment of the parent can be returned without US tax consequences. Dividends paid by the high-tax affiliate to the low-tax affiliate will not incur any taxes (they will be either exempt or sheltered by tax credits), and when these dividends are eventually repatriated the taxes paid in the high-tax jurisdiction will be creditable against US taxes. The end result is repatriation of earnings from a low-tax jurisdiction with no additional US taxes payable, although there is an additional cost in the form of higher taxes on the earnings of the low-tax affiliate that are invested in the high-tax affiliate. [Return]
18 There is a 5% withholding tax on dividends arising from direct investment repatriated to the US. This withholding tax increases the effective tax rate on repatriated earnings, and hence reduces the threshold rate by 3.75 percentage points, assuming a 25% combined federal-provincial tax rate. This estimate is obtained by multiplying one minus the statutory rate (i.e. after-tax income on $1 of profits) by the withholding tax rate. [Return]