Mintz is Right on “Small” Business Tax

One of my main undertakings on this blog has been to debunk Jack Mintz’s relentless advocacy of tax cuts for large corporations. However, I also give him credit when he proposes good policy, such as raising potash royalties and the small-business corporate tax rate. This past week, he was out with a paper on the latter subject.

The small-business deduction provides a federal corporate tax rate of 11%, compared to a general rate of 15% by next year. All provinces and territories except Quebec have small-business rates of 5% or less, compared to general rates of 10% or more.

These small-business rates apply to the first $500,000 of annual profit collected by any Canadian-controlled private company with assets under $10 million. For provincial taxes in Nova Scotia and Manitoba, the profit threshold is $400,000. The small-business deduction is phased out between $10 million and $15 million of assets.

Problems

The Tax Expenditures and Evaluations projected that the lower rate for small business reduced federal corporate tax revenues by $4 billion in 2010, when it was 7% below the general rate (i.e. 18% versus 11%). Since the difference will be only 4% next year, the cost should be closer to $2 billion. Provincial governments also lose about that amount.

Beyond this significant loss of corporate tax revenue, Mintz and co-author Duanjie Chen identify the following problems with the small-business deduction:

First, it could result in the breakup of companies into smaller, less efficient-sized units in order to take advantage of tax benefits even if there are economic gains to growing in size. Second, it could encourage individuals to create small corporations in order to reduce their personal tax liabilities rather than grow companies. And third, it could lead to a “threshold effect” that holds back small business from growing beyond the official definition of “smallness” . . .

I have written before about the second point. Although the paper does not elaborate on it, Mintz deployed this point against the NDP during the federal election.

However, it is important to put the NDP platform in perspective. It proposed to raise the general corporate tax rate to 19.5%, increasing annual revenue by $9 billion.

It also proposed to lower the small-business rate to 9%, which would reduce annual corporate tax revenue by $1 billion and might also allow high-income professionals to avoid slightly more personal tax. Still, the NDP platform constitutes a huge improvement over the status quo for those of us concerned about fiscal capacity to fund public services.

The paper mostly focuses on a “taxation wall” deterring business growth beyond tax thresholds, a concern that may be overstated. But tax preferences for small businesses do create an artificial incentive for large enterprises to contract out functions to smaller firms and for investors to create new firms rather than expanding ones that already have $500,000 of profits and/or $10 million of assets.

Mintz and Chen reasonably object that this incentive reduces efficiency and productivity. I would add that, on average, smaller employers pay lower wages, provide fewer benefits and are harder to unionize.

Solutions

I support the paper’s calls for “eliminating the small-business deduction” and “abolition of the lifetime capital gains exemption.”

I am less keen on its proposed substitutes: expensing the first $70,000 of annual capital spending by all corporations, lower capital gains tax on shares issued when a small business goes public, and deferral of tax on capital gains from small business shares reinvested in other assets. Mintz and Chen offer no cost estimates for these recommendations.

Expensing $70,000 of capital spending would encourage investment by very small corporations and would not cost much for larger ones that invest far more anyway. Reducing capital-gains tax on initial public offerings does not seem useful, but could at least be fairly inexpensive.

The third proposal is clearly the thin edge of the wedge toward unlimited deferral of capital-gains tax, which would be quite costly and regressive. As the paper notes, “While we would suggest developing the capital gains deferral account to apply widely to all investors, it could be limited to owners of smaller public and private corporations on a limited basis to reduce the fiscal cost of the incentive.”

It’s worth recognizing that there is a strong political consensus across all parties in favour of the small-business deduction. This consensus is motivated by a desire to help genuinely small, local businesses.

However, as currently structured, the small-business deduction provides tax breaks to privately-held companies with assets up to $15 million on profits up to $500,000 per year. This profit threshold used to be a more reasonable $200,000. Mintz and Chen argue that raising it was “unjustified,” but do not explicitly propose to cut it back.

But if we cannot eliminate the small-business deduction, we should at least limit its fiscal cost and focus it on truly small businesses by reducing the profit and/or asset thresholds below which it applies. The federal NDP would be well-positioned to advance such a proposal given that the NDP provincial governments are the only two that did not go along with Ottawa’s latest boosting of the profit threshold from $400,000 to $500,000.