We must stop punishing capital

In 2004, Quebec’s level of capital investment per worker was 38% below the North American average. This deplorable performance was caused by a number of factors, the capital tax among them.

Canada is one of the few countries in the world to employ a corporate capital tax. At the federal level, it hits all large companies, with big financial institutions paying higher rates. All provincial governments, with the exception of Alberta, levy a tax on the capital of financial institutions, and six of them also tax the capital of other medium-to-large companies.

The capital tax discourages investment by raising the cost of capital, thereby reducing the amounts invested. It differs from income tax in that it strikes at capital even when the yield on this capital is nil or negative; in other words, even when a company is losing money. The reduced investment means less innovation, less economic growth, and lower income and consumption.

This tax also harms Canada’s international competitiveness and its ability to attract investment in a context of globalization and business relocation. Its effects are all the more serious since Canada heavily taxes income from capital.

A recent study by the C.D. Howe Institute shows that, even though Canada has lower statutory corporate income tax rates than the United States, Canada’s effective rate of capital taxation is higher. In 2004, the effective rate was 31.3% in Canada compared with 23% in the United States, despite a combined statutory rate on corporate income of 34.9% in Canada and 39.5% in the United States. Canada, in fact, has the third-highest effective tax rate on capital among a group of 20 industrialized countries.

Even if it applies in theory to companies, this tax, like any other, ends up being paid by individuals, whether as shareholders (in lower returns on capital), as consumers (in higher prices) or as employees (in lower wages).

Studies on this topic suggest that, in a small, open economy, taxes formally levied on companies fall at least in part on workers since labour is the least mobile factor of production. Investors, who have access to international capital markets, will not be satisfied with a less-attractive return on capital within the country and would choose instead to invest elsewhere. With labour kept relatively less productive by this smaller capital contribution (in machines, technology, etc.), wages are lower than they would be otherwise.

The economic benefits of abolishing this tax are so obvious that the federal government has been lowering it gradually over the last several years and plans to eliminate it completely in 2008.

For Quebec, an estimate done for the Montreal Economic Institute shows that eliminating the provincial capital tax would lead to a rise in capital stock of at least $7-billion following a readjustment in investment decisions (3% of the $215-billion recorded in 2003). This would create a proportionate rise in production, employment and income-generation possibilities.

In 2001, Pauline Marois, then the Quebec finance minister, unveiled a plan to lower the province’s capital tax, cutting the general rate in half by 2007. In March 2003, a document from the Quebec Liberal party went further, proposing to eliminate the tax on the capital of small and medium enterprises (SMEs) during its first term in office.

In its first budget in June, 2003, however, the new Liberal government decided to postpone the planned rate reduction, although it did raise the basic exemption to $600,000 in 2004 and to $1-million in 2005 to fulfill its promise to exempt SMEs. But this threshold is so low that many SMEs are still subject to the tax.

In an interview with the weekly business newspaper Les Affaires in January, shortly before emerging from the recent Quebec Cabinet shuffle as Minister of Finance, Michel Audet said he would like to see elimination of the tax speeded up and abolished for all companies by 2008. If this were to be announced in his next budget, it would unquestionably be excellent news for the Quebec economy.

Norma Kozhaya is Economist at the Montreal Economic Institute and author of the Economic Note The economic costs of the capital tax.