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Go Big or Go Home: Lessons from the federal government’s botched tax reform attempt

October 24, 2017

5-minute read

Now that the dust has begun to settle on the federal government’s train wreck of a tax reform initiative that would have limited the ability of wealthy Canadians to use special provisions for small business to reduce their taxes, it is worth sifting through the ashes for clues as to why it crashed and burned.

From a communications perspective, the government lost control of the narrative and didn’t seem to have much appetite to fight for a fairer tax system.

Much of what happened immediately after the introduction of its proposed changes was perfectly predictable: any effort to change the tax system to improve its fairness faces a political challenge right out of the gate.

Any tax reform that isn’t just a give away creates winners and losers. If the goal is to make the tax system fairer, the majority of Canadians win—especially if the result in increased capacity to pay for public services. But, almost inevitably, the gains look pretty small and remote to most individual Canadians because they are spread out amongst so many of us.

The losers, on the other hand, are inevitably a concentrated group who know exactly who they are, who know exactly what they have at stake, and have the resources to fight back. That is, the rich and the powerful.

The opposition to the federal government’s proposed tax changes had a “usual suspects” ring to them. Deprived of the widows and orphans stories that normally front for campaigns against changes in the taxation of income from capital, the opposition was reduced to generalized complaints about tax grabs and self-serving complaints from the tax avoidance industry itself.

The first attempt at finding a sympathetic poster child—incorporated physicians—was a complete bust. Canadians had a lot of trouble mustering up sympathy for people with significant six-figure incomes who are paid from the public purse using a wrinkle in the tax system to reduce their tax rates far below those paid by the majority of Canadians.

The fact that a lot of the push back to the Canadian Medical Association’s position came from within the profession didn’t help.

But then the lobby on behalf of one of Canada’s most powerful political sacred cows—small business—shifted into high gear. What started as a measure to prevent wealthy individuals from avoiding taxes by funnelling income through shell corporations became a “small business tax increase.”

And when the phrase “small business tax increase” moved from Canadian Federation of Independent Business quotations buried in the story onto the headlines, the battle was lost.

The government’s capitulation, a promise to reduce general small business taxes, will only make Canada’s tax system more unfair.

The retreat was so complete that the government didn’t even have the courage to point out the holes in the counterarguments. For example, the $50,000 a year in passive income that would be protected from taxation because it would be treated as “retirement savings” would have amounted to twice the maximum contribution Canadians are permitted to make to their RRSPs.

To be sure, the opposition was emboldened by the government’s earlier about-face on the taxation of income in the form of stock options, a collapse applauded by the excessively well-paid corporate executives who were its primary beneficiaries. As the debate became more one-sided, it began to look for all the world as if the government was just going through the motions to mark a tick beside a “seemed like a good idea at the time” campaign promise.

The real lesson here is not that the government tried to do too much, but that it tried to do too little.

The two touchstones of Canada’s tax system—that the amount of tax you pay should not depend on the sources of your income and that the income taxes that people pay should be related to their ability to pay—have been undermined by tax-cutting governments ever since they were first clearly articulated in the 1960s in the Carter report.

The tax system has been swamped with special deductions and preferential treatment that is heavily dependent on the form in which you receive your income and what you spend it on.

Nowhere is that inherent fairness failure more apparent than in the taxation of income from capital as compared with the taxation of employment income.

Capital gains income is taxed at half the rate of ordinary income. That’s supposedly intended to offset the impact of inflation on asset values. But with the rate of inflation one quarter of what it was when the tax preference was introduced, the tax benefit is now twice as big.

Dividend income is subject to reduced taxation on the dubious theory that taxes paid at the corporate level are actually paid by the owners of the company’s share and therefore should be credited against personal income taxes. To underline the inherent unfairness of this provision, this benefit is not available to people whose investment assets are in RRSPs or pension plans.

The most egregious of these preferential tax breaks, however, is the special tax treatment given to income earned in what is deemed to be a small business.

Let’s set aside the question of whether or not the claim that small business, as defined in income tax laws, is the economic engine of job creation its advocates, though there little evidence to support the claim. If the rationale for preferential tax treatment of small businesses is job creation, it is poorly targeted.

The preferential treatment of small business was clearly unjustified when it was introduced. Since then, it has only gotten worse as the gap between the small business rate and the general corporate tax rate has widened and the definition of what defines a small business has expanded.

The outcry about the federal government’s proposed tax changes highlights another growing problem. The examples of professionals and senior executives routing their incomes through corporations demonstrate that the small business tax regime has become a convenient way to park investment income at a low tax rate, to convert higher tax employment income into lower tax investment income, and to convert ordinary income into lower-tax capital gain.

These are not simple problems to address. They go to the core of the design of Canada’s tax system and they merit careful study, like the study conducted by the Carter Commission three generations ago.

Any serious attempt to shift the course of the system towards fairness will generate ferocious opposition from vested interests. The corporate lobby’s wildly disproportionate response to what amounts to tinkering with the small business tax system at the margins should teach us that the opposition is never calibrated to the ambitiousness of the initiative.

If anything we do is going to generate hysteria from the concentrated few with vested interests, why not do something meaningful and take the debate head on with real energy and with stakes that are actually meaningful to the vast majority of Canadians who stand to benefit from a fairer tax system.

The risk in this debate is that the lesson learned is don’t mess with small business. The lesson should be go big or go home. If tax fairness for the majority is what you want, be prepared to fight for it.

Hugh Mackenzie is a research associate with the Canadian Centre for Policy Alternatives. In the early 1990s, he was executive director of Ontario’s Fair Tax Commission. His first published article was a defence of the Carter Commission’s “a buck is a buck is a buck” guiding principle for tax reform in 1969 when he was an undergraduate student in economics at what was then the University of Western Ontario.

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