Worst Idea at NDP Convention 2009

Strangely, neither of the two most hyped issues at last weekend’s federal NDP convention reached the floor for debate. I have nothing to add to the discussion about changing the party’s name.

However, the proposal to not tax small-business profits compels me to elaborate the case I made when Nova Scotia Liberals promised to slash the provincial small-business tax to 1%. Eliminating the federal small-business tax would immediately reduce corporate tax revenues and probably also reduce personal tax revenues by facilitating avoidance.

The Resolution

On the first day of the convention, The Globe and Mail cited Jack Layton as supporting “a proposal to phase out small-business income tax.” This motion was not debated in plenary, let alone passed. Nevertheless, Layton’s closing speech and post-convention press release stated, “We want to cut taxes and red tape for small business.” (There was no sense of which regulations might be removed to reduce “red tape.”)

The resolution submitted to convention (PDF) was muddled:

BE IT RESOLVED THAT the following clause be added to section 1.4 of the policy book:

g. A gradual reduction in the small business tax rate to zero on gross annual income of up to one million dollars.

Of course, businesses do not pay tax on their gross income (revenue). Corporate tax applies to net income (profit).

Specifically, the 2009 federal tax rate for most corporate profits is 19%. The first $500,000 of profit collected by any Canadian-controlled private corporation (with up to $10 million of assets) enjoys a federal tax rate of only 11%. The resolution’s intent is presumably to double the threshold to $1,000,000 and slash the rate to 0%.

The Cost

When Finance Canada released its last Tax Expenditures and Evaluations, only the first $400,000 of profit was eligible for the small-business rate. It estimated that the 8% tax discount (19% minus 11%) cost about $4 billion annually in lost corporate tax revenue. In other words, each percentage point of “small business” tax was worth about half a billion dollars.

Therefore, eliminating the remaining 11% tax would cost at least a further $5.5 billion annually. Given the current threshold of $500,000, this cost would now be somewhat higher. Raising the threshold again would raise the cost even more.

Similarly, Gloria Galloway reported on The Globe and Mail blog, “Eliminating the federal [small business] tax will cost $5.7-billion.” (Unfortunately, this figure did not make the print edition.)

To put this amount in perspective, the single most expensive item in the last federal NDP platform – a substantial new Child Benefit – would have cost $4.4 billion annually, when fully phased-in. Are further tax breaks for business a higher social democratic priority than ending child poverty?

Personal Taxes

Some proponents of the resolution argue that corporate tax on small business is unfair because small-business owners ultimately also pay personal tax on their income. Their implicit claim is that the proprietors of small corporations are currently taxed more heavily than employees or proprietors of unincorporated businesses.

The fact that owners voluntarily choose to incorporate their small businesses suggests that this claim is incorrect. Indeed, examining the relationship between corporate and personal taxes in detail confirms that small-business owners already enjoy preferential treatment.

Since the proposal covers hundreds of thousands of dollars in annual income, we should consider a small-business owner in the highest personal tax bracket: 29% at the federal level. (A lower tax bracket would make all the numbers smaller. Including provincial taxes would make all the numbers larger. Neither change would alter the comparative conclusion.)

For the sake of simplicity, imagine $100 of business proceeds. If the owner added it to his salary, he would owe an extra $29 of personal income tax. Since this salary would be deducted from profit as a business expense, it would incur no corporate tax. This option ensures that proprietors can obtain exactly the same tax treatment as employees.

However, they can obtain preferential tax treatment by collecting the proceeds as profit. On $100 of profit, a small business would pay $11 of corporate tax. If the owner paid the remaining $89 to himself in dividends, he would owe another $26 of personal income tax.

But the corresponding dividend tax credit would reduce his personal tax liability by $15 (i.e. $89 * 1.25 * 13.3%). The combined corporate and personal tax payment is $22 (i.e. $11 + $26 – $15), significantly less than the $29 paid on the same amount of employment income.

Another option would be to capitalize the $89 in the corporation, which would add to the owner’s capital gain when he sells his shares. The first $750,000 of such capital gains would be completely exempt from personal tax. Half of any capital gains beyond this lifetime exemption would be taxed. If so, the owner would owe $13 of personal income tax, for a combined corporate and personal tax payment of $24 (i.e. $11 + $13).

Despite paying a combination of corporate and personal tax, proprietors of small corporations pay less tax (in total) than employees on a given amount of income. Eliminating corporate tax on small-business profits would aggravate this inequity. Indeed, small-business owners would pay only about half the tax rate faced by workers.

To tax profits from small corporations as much as employment income (or profits from unincorporated businesses), one would need to raise the small-business corporate tax rate to 18%. The following table summarizes these scenarios.

Combined Corporate and Top Personal Federal Tax Payments on $100 at Various “Small Business” Tax Rates

Â	 18%	 11%	 0%
Employment Income	 $29	 $29	 $29
Dividend Income	 $28	 $22	 $12
Taxable Capital Gain	 $30	 $24	 $15
Exempt Capital Gain	 $18	 $11	 $0

 

Tax Avoidance

A fundamental reason for having corporate taxes is to prevent individuals from avoiding personal taxes by sheltering their income in corporate structures. This concern is even more important for small corporations, which can be controlled by a single shareholder/taxpayer, than for large corporations, which are not directly controlled by shareholders.

 As explained above, the existing low tax rate for small business already encourages owners to collect business proceeds as dividends or capital gains rather than as salary. Indeed, there is currently a tax incentive to flow as much of one’s income as possible through small corporations.

Eliminating corporate tax on small-business profits would worsen this problem. Affluent Canadians could halve their tax rate simply by setting up small corporations through which to conduct their income-generating activities.

Given a 0% tax rate on small-business profits, such strategies would decrease personal taxes without any offsetting increase in corporate taxes. This loss of personal tax revenue would add to the annual loss of more than $5.5 billion in corporate tax revenue.

Progressive Reforms

The existing inequities outlined above can and should be corrected through personal-tax reforms. The dividend tax credit for small-business dividends should be reduced to match the low corporate tax rate on small-business profits. The government should tax more of the value of capital gains, particularly by abolishing the Lifetime Capital Gains Exemption for business shares.

In theory, we could maintain some semblance of tax fairness without applying corporate tax to small business by taking these personal-tax reforms even further. If the government does not tax small-business profits, it should provide no dividend tax credit for small-business dividends. It should also tax the full (inflation-adjusted) value of capital gains.

However, even if accompanied by such progressive policies, eliminating corporate tax on small-business profits would still delay tax payments from when profit is generated until when it is paid out of the corporation. Given positive interest rates, money is worth more now than in the future. Deferring tax payments for years, or even decades, would constitute a significant drain on public finances.

Beyond fiscal costs, there is another important reason not to cut the small-business tax rate. Giving small corporations an even wider tax advantage over large corporations encourages the latter to contract out more functions to the former, generally to the detriment of employee wages and benefits.

Canada-US Comparison

In opposing further reductions in Canada’s general corporate tax rate, the NDP accurately notes that this rate is already much lower in Canada than in the US. The same is true of corporate tax for small business.

The lowest American federal corporate tax rate is 15% on the first $50,000 of profit. The rate is 34% (only 1% less than the general rate) for profits between $75,000 and $100,000. A higher rate of 39% applies to profits between $100,000 and $335,000, clawing back the gain from lower rates on lesser amounts of profit.

Alternative Policies

There are other policy options that would help small business at far less cost and without creating massive opportunities for tax avoidance.

If the objective is to provide a tax break to Canadians who eke out modest incomes running small personal or family businesses, then the US corporate tax system provides a reasonable model. Reduced corporate tax rates should be available for no more than first $100,000 of profit. The principle of progressive taxation does not justify giving tax breaks to proprietors making hundreds of thousands of dollars annually, based on ownership of millions of dollars of assets.

Before the 2003 federal budget, Canada’s corporate tax threshold for the small-business rate was $200,000 of profit. The NDP rightly criticized recent elevations of this threshold. It should now advocate reducing this threshold to a sensible level, rather than doubling it.

Another worthy goal is to promote investment and employment. If so, the appropriate mechanism is targeted tax measures tied to investment and employment rather than across-the-board tax cuts on profit. The NDP has correctly put forward this logic regarding large corporations. Targeted tax measures could be made even more generous for small corporations.