The High Cost of Low Corporate Taxes

Monday’s federal budget will certainly reaffirm the corporate-tax reductions already scheduled through 2011 and may announce further reductions. Between 2001 and 2004, the federal government reduced its corporate-income-tax rate from 28% to 21% and began phasing out its corporate-capital tax.  It has committed to eliminate the corporate surtax and reduce the corporate-income-tax rate to 18.5% between 2008 and 2011.

These latter reductions were proposed by the Liberals in Budget 2005, but removed by the NDP. The Liberals revived them in the 2005 Economic and Fiscal Update, and the Conservatives confirmed them in Budget 2006.

The following table shows federal corporate-tax revenues as proportions of all federal revenue, Gross Domestic Product (GDP), and corporate profits.  The fact that corporate taxes have bounced back a bit relative to other revenues and GDP reflects the recent, record-high level of pre-tax profit as a share of GDP.  The most telling statistic is federal corporate taxes as a share of these profits, which has remained around 17%.

The table estimates the cost of corporate-tax cuts as the additional amount that would have been collected if corporate taxes had remained constant as a share of pre-tax profits through 2006. In the absence of future profit projections, my post-2006 “forgone revenue” estimates are based on corporate taxes as a constant share of GDP.

The $10 billion forgone in each of the last three years (2004, 2005, and 2006) could be compared to the “big ticket” spending programs announced by Paul Martin, which always seemed to cost $5 billion over five years.

Federal Corporate Tax Revenues, 2000 – 2010 ($ Billions)

The corporate-tax system is somewhat “progressive”, in the sense that the effective tax rate rises with profits: the small-business rate is far lower than the general rate and most corporations can shelter some initial increment of profits from tax. Therefore, it is likely that the post-2000 decline in corporate profits explains part of the drop in taxes as a share of profits through 2002. In other words, not all of the $7.4 billion in forgone revenue for 2002 is attributable to corporate-tax cuts.

However, since 2004, pre-tax profits have been a higher share of GDP than in 2000. The fact that taxes as a share of profits remained so low is clearly attributable to corporate-tax cuts. By 2004, statutory corporate-tax rates were down by about one-quarter (28% to 21%). The above table confirms that corporate-tax revenues were down by the same magnitude ($10 billion out of a potential $40 billion). By 2010, statutory rates will be down by more than one-third (28% to 19% and no surtax) and the above table suggests a proportional loss of revenue ($20 billion out of a potential $55 billion). In other words, the “forgone revenue” figures seem quite plausible as estimates of the cost of corporate-tax cuts from 2004 onward.

Some economists would presumably argue that pre–tax corporate profits, and hence potential revenues, would not have grown so much without the corporate tax cuts. Theoretically, there are two ways in which tax cuts could increase Canadian pre-tax profits: by inducing corporations to make greater investments that generate greater profits and/or by inducing multinationals to report more of their profits in Canada. As Jim Stanford and TD Bank have shown, corporate tax cuts have not induced greater investment in Canada. The issue of reported profits should be addressed through tougher compliance measures in any case. Therefore, it seems reasonable to treat actual corporate profits as the potential tax base.

In conclusion, corporate-tax cuts now cost the federal government $10 billion annually and could soon cost it up to $20 billion annually, even if Budget 2007 announces no further reductions.  There is little evidence that these cuts have contributed, or will contribute, to increased business investment in the Canadian economy.