This is an abridged version of a longer article recently published by the Canadian Tax Foundation in (2020) 1:2 Perspectives on Tax Law & Policy. The full article can be accessed here.
Canada’s corporate tax system is not designed to address income inequality through redistribution, or to further any political visions of vertical equity. Such “fairness” objectives are explicit goals of our progressive income tax system for individuals, but they have little relevance when it comes to evaluating corporate taxation. Canada’s corporate tax system is intended to raise revenue from business activity carried on through corporations, and to do so in a manner that least impairs the competitiveness and efficiency of the Canadian economy while promoting its adaptation to the ever-changing conditions for highly mobile global business investment.
Canada has multiple corporate tax rates: the general rate applicable to most corporations, including public corporations and their subsidiaries; a preferential rate for small Canadian businesses; higher rates for investment income and dividends earned by certain private corporations; and a punitive rate for incorporated employees. The focus here is on the much debated issue whether Canada’s general rate of corporate tax is too high, too low, or just right.
There is no “natural” or “correct” general rate of corporate tax; the optimal rate all depends on the context and (especially for a medium-sized open economy like Canada) the prevailing international tax rates in countries with which we compete for business investment. And that international context may soon be upended by the covid-19 pandemic.
Nonetheless, if we take as a benchmark the pre-pandemic CIT rates in other OECD countries and use the “competitiveness” criteria based on the incentives in our current system that affect taxpayer behaviour, I would argue that Canada’s general corporate rate is somewhat too high.
Why Do We Tax Corporations?
The taxation of corporations is not inevitable. The 1966 Carter commission would have abolished corporate income tax and, instead, assessed shareholders on corporate distributions, gains from share dispositions, and accrued gains on shareholdings measured on an annual mark-to-market basis. But the commission recognized the difficulty of taxing accrued share gains, and it reluctantly concluded that corporate taxes are a practical necessity as a backstop to the personal income tax system.
Thus, we tax corporations primarily to limit the deferral of tax that would otherwise be enjoyed by individuals who earn income indirectly through corporations, and also to capture tax revenue from corporate income that is ultimately distributed to (1) shareholders that are not subject to immediate Canadian tax (such as tax-exempt pension funds, RRSPs, RRIFs and TFSAs) and (2) non-residents, as a supplement to part XIII withholding taxes.
If Canada were a closed economy, indifferent to cross-border flows of business investment, we could eliminate deferral by taxing corporations at a rate approximating top personal marginal rates. The Carter commission recommended this congruence of corporate and personal rates, and the two rates were nearly aligned at the time of the commission, but since then the gap between the two has exploded.
Of course, Canada is not an insular nation that can disregard economic conditions in other countries. Canada (like most countries) is constrained in how high its CIT rates can go: if Canadian rates exceed prevailing international norms, business investment will increasingly avoid Canada and seek higher after-tax returns in countries that have more competitive tax systems. Canadian CIT rates that are high relative to other countries’ rates will discourage inbound investment into Canada from foreign sources, and they will encourage more outbound investment because domestic companies will expand not into Canada but into foreign jurisdictions, unimpeded by our foreign affiliate rules which are, by design, not “capital export neutral.”
In our globalized economy, these competitive constraints have led to de facto rate harmonization whereby most OECD countries impose CITs within a relatively narrow range of rates (the OECD average is about 23 percent), with few outliers (according to OECD statutory rate tables). Moreover, nearly all OECD countries tax foreign-source business income in a similar manner, using some variation of a territorial system that cedes taxing jurisdiction to the source country.
In this context, it is difficult for a country like Canada to deviate significantly. CIT rates that are too high relative to other countries’ rates impair our competitiveness with respect to mobile business investment. On the other hand, dramatically reducing our rates or eliminating CIT altogether would mean relinquishing much needed tax revenue—over $81 billion of federal-provincial revenue in 2018 (see row 1200 of the OECD tables referred to above)—and would result in the undertaxation of Canadian-source corporate income.
Further, the harmonized corporate tax rates of OECD members have trended downward over the last two decades, with the OECD average rate dropping from 32.2 percent in 2000 to 23 percent today. Canada has contributed to this trend, with an even more pronounced drop—from 42.4 percent to 26.5 percent—in its average combined federal-provincial corporate tax rate over the same period. Some describe this synchronized reduction of CIT rates as a “race to the bottom,” but, as noted above, reductions in CIT rates are constrained in most countries, including Canada, by the significant practical reliance on CIT revenue. Realistically, the bottom for the Canadian corporate tax rate may be lower than the current rate, but it is nowhere close to nil.
Keep Canada’s General Corporate Tax Rate Below the OECD Average
Canada’s statutory CIT rate is established in a somewhat convoluted manner, owing to several factors: provincial corporate taxation; downward adjustments to the federal CIT rate phased in through 2011 for a short-lived Canadian tax advantage; and special treatment for Canadian-controlled private corporations (CCPCs). The resulting combined federal-provincial CIT rate is 26.5 percent in both Ontario and Quebec, and higher in all other provinces except Alberta.
As noted above, our average 26.5 percent rate compares unfavourably with the OECD average of 23 percent. If we narrow the field of comparison to G7 countries, the average statutory rate is about 27 percent, and Canada’s position improves.
However, the most relevant comparison for Canada is the United States. US tax reform lowered that country’s statutory federal corporate tax rate from 35 percent to 21 percent in 2018; when average state-level corporate taxes are factored in, the combined US corporate tax rate is 25.8 percent (by the OECD measure). The Trump tax cuts marked a sea change in the competitive landscape and eliminated Canada’s advantage over the United States in attracting capital for business investment. Canada’s response in 2018 was to permit some accelerated capital cost allowance deductions for new investments, but, so far, we have not reduced our statutory corporate tax rate, which now exceeds the rate in most US states.
It is not good enough for Canada’s statutory corporate tax rate to be merely middle of the pack, higher than both the OECD average and, in particular, the US average rate. Although national variances in tax base components give rise to customized marginal effective tax rates (METRs) in particular circumstances, it is the headline statutory CIT rate, generally speaking, that signals to executives whether, from a tax perspective, Canada is a jurisdiction to which they should direct investment capital. To offset the negative impact of certain non-tax factors (including our regulatory burden) on Canada’s appeal as a business-friendly jurisdiction, our statutory CIT rate should be demonstrably lower (as it was for many years before 2018) than that of our chief competitor for business investment.
Keeping Canada’s general CIT rate in sync with, but somewhat below, the rates of other developed nations would provide other benefits. It would reverse incentives for international tax-planning structures that erode the Canadian tax base by shifting deductions into Canada and income to lower-tax jurisdictions. We might even see income deliberately shifted into Canada, and our tax base expanded, if we taxed that income more lightly than other OECD countries do.
Looking ahead, the synchronized downward trend in worldwide corporate tax rates, with rates harmonized in the mid-20 percent range in most OECD countries, may have run its course. The extraordinary fiscal responses to the covid-19 pandemic will lead to increased government debt and, inevitably, higher tax burdens throughout the world, including Canada. If other countries choose to raise needed revenues by raising their CIT rates, it is possible that Canada could enhance the international competitiveness of its general corporate tax rate merely by leaving its rate structure unchanged.
In any event, we should continually benchmark our Canadian corporate tax rate against those of the US and other OECD countries as they evolve. Our statutory rate should always remain compellingly competitive so as to retain and attract maximum business investment, and thereby drive productivity, job creation and Canadian living standards.