Dear Buddy,

You know who you are. We were great friends in Jr. High and High School but drifted apart over the years. And now you are running for the NDP. I know my die-hard socialist mother would be so proud to have had you as her son right now, rather than not-so-socialist me, at this particular moment.

Anyone who has read my blawgs knows I really hate the Harper conservatives. Unfortunately, I am not able to get behind any of the other parties either, because while there are a few things in their tax policies that are OK, for the most part I do not think they really understand how the economy/tax thing really works…

The sad thing is that although the economy has been the number one issue for most Canadians, what little debate there has been on “tax policy” has been superficial to say the least. This is mostly because taxes are boring and not sexy. But the tax system is the fundamental building block of economic policy because taxes are the only real policy tool the government has to influence the economy.

Despite what Mr. Mulclair said in the one debate to date, politicians can’t actually control the economy; the recessions on his watch are not Harper’s fault, and neither would any recovery happen because of what anything any politician can do. However, governments they can decide what they are going to punish and reward in the economy. If you tax it, you are punishing it, if you cut taxes on something, even relatively, you are trying to reward or incentivize that something. That is why we tax cigarettes and alcohol, right? We tax in order to discourage bad behavior, but we also tax consumption, work and investment… all of which would seem to be good things. The issue is that we have to tax something to have the money to fund the basics of a society, so we have to determine what we are going to tax or not, and what are we going to tax relatively more or less than others. It is that relative mix of tax that has a long-term impact on the growth and direction of the economy. It is kind of like steering a supertanker with a canoe paddle; it actually does makes a difference eventually….

First of all, I commend the NDP (and all the other parties except the Grits) on their promise to lower the “small business tax rate” from 11% to 9%. This is the rate on which the first $500k of profits of a Canadian Controlled Private Corporation (“CCPC”) are taxed. Larger CCPCs, foreign companies and publicly owned companies to pay corporate income tax at the current rate of 15%. Lowering the Small Business tax rate would be a good thing, as it will make owning a business more profitable Everyone agrees on this except the Grits. Because they say that it could help the rich. Which it will. But that is the point. It will make owning a business more profitable, which makes starting a business more attractive. Which is a good thing because small businesses have historically driven job creation in Canada.[i] This is not right-wing dogma, but a fact backed up by evidence.[ii]

Turning to larger corporations/listed entities and foreign owned companies; the NDP position seems to be a little weak on this topic. They seem to be implying that they will raise the tax rate corporate profits in excess of CAD$500k for CCPCs and on all profits from non-CCPCs. However the NDP has been a little sketchy on the details. Which is good politics, because if they promised to crank corporate tax rates up then the Conservatives and Liberals would pounce on them as being anti-business. Which would be true. But the bigger issue here is that NDP policy is fuzzy and unclear because I think they have a hard time knowing what to do on this.

The reality is that the NDP has always historically been pro-union and pro-worker and anti-business/capital. Although the NDP’s die-hard activists want the party to have a more anti-corporate/capital agenda, the general public is starting to understand that corporations and capital in Canada are not owned by top-hat-spats-&-monocle wearing Capitalists who twist their mustaches ominously while contemplating which natural park to rape next for fun and profit. The reality is that most of Canada’s capital comes from pension funds, including the Canada Pension Plan (CPP), the pension funds of the teacher’s unions, provincial and municipal workers unions, and ordinary people’s retirement savings (corporate pensions, and mutual funds and other investments in RRSPs and TSFAs). So “taxing the big bad corporations” actually just means “taking value from ordinary people’s pensions and retirement funds”.

However, the issue is even more complicated and difficult for the NDP. The pension plans and other institutional asset managers have historically been quite passive in their view towards corporate governance. However, most of those plans are, or are rapidly heading towards, becoming demographically inverted. Meaning that whereas they used to be structured like a Ponzi scheme (lots of people paying in who just joined and few people who have been involved for a long time being paid out), the pensions are increasingly seem less money coming in than they have going out, and they therefore have to “make money” on their investments. Indeed, they have to make a lot of money if they want to remain solvent. CPP is relatively OK based just on size, but a lot of other pensions are facing a financial Rubicon.

So that means that the pensions increasingly will not tolerate corporate leadership that does not make them money. What does this have to do with corporate tax rates? If corporate tax rates go up, then the corporations will have less money to pay in dividends or invest in growth opportunities. Therefore value of the pensions’ assets and cash-flows from investments will fall, all other things being equal. Which they are not, because the pensions/fund managers will not put up with that, so cuts will be made inside the corporation to make up what would otherwise be lower after-tax returns to investors.

And this is the really hard part to get people to understand about how corporate tax rates affect the economy. A corporation generally has a certain amount of anticipated income each year or quarter, and from that it has to pay its expenses (inputs, overheads, labour etc.) and pay taxes and give a return to investors. As we note, the investors will not tolerate their share of the profits going down, so if taxes go up, that means cuts to expenses. And the easiest place to cut is on labour. Especially highly-paid, high-benefit labour in wealthy countries…. Empirically, the evidence from around the world shows increasing corporate taxes, reduces economic growth, largely through a reduction in corporate expenditures on labour. So although there is some debate as to whether corporate tax cuts necessarily “create jobs”, the evidence is clear that corporate tax hikes do hurt the economy and kill good jobs.[iii]. And again, that is not some BS-right-wing-ideology talking, this is a fact backed up by empirical evidence.

So raising corporate tax rates, particularly in a recession, is a really, really bad idea. OK?

Conversely, there is one way that the NDP could offset their corporate tax increase promises, not hurt the economy and at the same time really stick it to “The Man”. Although most of Canada’s economy is owned by pension funds/mutual funds there are some very wealthy families in Canada that do dominate in a lot of sectors/regions still – and they are almost all brand names: the McCains & the Irvings for example, and a few self-made moguls like Stronach at Magna. These families do control a large number of publicly listed corporations on the Toronto Stock Exchange (TSE). Canadian pension funds and asset managers are required to hold shares in these corporations pretty much whether they want to or not because they make up such a large portion of the TSE Index.

However, generally speaking, Canadian companies do not pay out large dividends, and family dominated companies also tend to be less generous to their general shareholders. However, during the period when “Income Trusts” were all the rage before the “Halloween Massacre” when former Finance Minister Jim Flaherty banned them outright, the income trusts were putting huge pressure on the CEOs and CFOs of Canada’s largest corporations to provide more returns to investors in the form of cash flow.

Income trusts were loved by pension funds, pensioners and anyone wanting to retire well because they provided tax-advantaged strong and steady cash flow to the unit holders. The structure was surprisingly simple; a corporation (or a part thereof that was being spun out into an income trust) arranged its affairs so that it would borrow a ton of money from a trust, then buy out the vast majority of its shareholders. Then rather than make a profit and pay tax, the company (which was usually a cash-cow type of business, say a collection of existing oil wells, a real estate property or a pipeline; i.e. a set of assets requiring only a modicum of management to provide consistent returns) would have to spend most of its operating profit to pay its debt to the trust. The trust paid its debt to the banks, which initially funded the structure, by selling units. The trust would then pay the unit-holders a combination of interest flowed through and capital, which is tax-free. The net result was a relatively tax-efficient, high return, low risk investment for the unit holders.

Regardless of what anyone says, income trusts were good for the economy, the stock market and for business in general because they attracted a lot of investment by giving investors what they wanted. The problem is that the structure cuts corporate tax revenues. Which is why the government killed it, because the Bloc Quebecois told the government that unless they dumped it, they would bring the Tory minority government down because some major Quebec cash-cow businesses were thinking about it, and it would have adversely affected the Quebec provincial government’s capacity to fund a parallel independent state. The income trust structure also put pressure on Canada’s big family-owned publically listed businesses to “up their game”, and distribute more cash to shareholders or see their share price tank. The combination of the BQ and major Tory party fundraising targets complaining about it was what did the income trusts in, not anything bad for the economy.

Please note that if someone receives funds as a pension or RRSP payout, the income is taxed at the ordinary rate of income. The Canadian tax system is set up so that effectively, the corporate tax rate, plus the rate of tax on dividends in the hands of the shareholder, broadly match the rate on ordinary income. So the net tax haul, at the end of the day, from the income trust (taxing only the income at the individual level at ordinary rates as pension income) is theoretically identical to taxing it twice, once at the corporate level and again at the dividend rate at the level of the shareholder. There is some tax leakage with the income trust structure, but not as much as the Tories would have you believe.

So my suggestion to the NDP is that if they feel they have to raise corporate tax rates, they should also propose to bring back the income trust. However, I would put on one rider – the thin-capitalization rule needs to apply. If a foreign entity wants to carry on business in Canada, they can fund their operations in Canada with “related party debt” (i.e. loaning their subsidiary money) only up to the ratio of two parts debt to one part equity. This rule prevents foreign investors from avoiding Canadian corporate tax by loading up their subsides with debt similar to the way an income trust works. So right now, domestic Canadian businesses are at a financial disadvantage to foreign entities, because foreign entities have more financing and structuring options.

Bringing back income trusts, but only allowing the structure to work up to the “thin-cap rule”, is therefore a middle-of-the-road solution that would allow the NDP to raise corporate tax rates modestly to satisfy their more left-wing base, while still allowing the pension funds and retirees to get their money’s worth out of their investments and stick it to the C-suite of Canada’s corporate oligarchy… all at the same time. Overall, everyone I care about wins!

And yes, Buddy, I do hope you win your riding too!

By Jonathan N. Garbutt, Barrister & Solicitor (Ont. & Ab.), Counsellor and Attorney-at-law (NY).

This Blawg is not intended as and should not be perceived as tax or legal advice. All opinions contained herein are my own.

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[i] See specifically Industry Canada’s summary of Statistics Canada’s jobs data at https://www.ic.gc.ca/eic/site/061.nsf/eng/02806.html

[ii] Specifically the OECD has researched entrepreneurship and found numerous links between taxation and the level of entrepreneurship. Specifically, “ Tax Policy Reform and Economic Growth” OECD Tax Policy Studies, November 02, 2010.

[iii] See A. Ljungqvist & M. Smolyansky “To Cut or Not to Cut? On the Impact of Corporate Taxes on Employment and Income” NBER Working Paper No. 20753 December 2014, also see “The Economic Impact of Corporate Tax Rate Reductions” Canadian Manufacturer’s and Exporters Association, January 2011, at http://www.cme-mec.ca/download.php?file=giubgju9.pdf. See also J.G. Gravelle and D.J. Marples, “Tax Rates and Economic Growth” US Congressional Budget Office, January 2014. This report basically says that tax cuts, at the corporate or personal level do little to impact growth. However, see also W. McBride “What Is the Evidence on Taxes and Growth?” December 18, 2012at http://taxfoundation.org/article/what-evidence-taxes-and-growth, which basically says that a broad survey of economics papers (all listed) shows that raising corporate taxes is bad for growth. See also Kevin Milligan, “There are two big problems with the Alberta NDP tax plan” , May 19, 2015 at http://www.macleans.ca/economy/economicanalysis/there-are-two-big-problems-with-the-alberta-ndp-tax-plan/ for a Canadian analysis of what happens when you increase corporate tax rates. See also, E. Ferede & B. Dahlby, “The Impact of Tax Cuts on Economic Growth: Evidence from the Canadian Provinces“, 65 National Tax Journal 563-594 (2012).