The Recent Corporate Income Tax Reform Proposals in Canada and the United States

Grady, Patrick (1986): The Recent Corporate Income Tax Reform Proposals in Canada and the United States. Published in: Canadian Tax Journal , Vol. 34, No. 1 (1 January 1986): pp. 111-128.

Abstract

In May 1985, Canada's Minister of Finance and the President of the United States each put forward a proposal for reforming his country's corporate income tax system. Both proposals called for a broadening of the tax base and the elimination of investment tax credits. The U. S. proposal also included indexation of depreciation allowances and inventory cost. The study reported in this article examines these two proposals, focussing on their significance for Canada. The study uses the concept of the marginal real effective tax rate on investment to analyze some of the possible effects of the proposals on the burden and the distribution of the corporate tax; it then compares the effects of the proposals on real effective tax rates in Canada and the United States. The analysis is carried out under several different assumptions about the rate of inflation and the extent to which the investment is debt financed.

The Canadian proposal calls for a reduction in the standard combined federal and provincial corporate tax rate from 46 to 39 per cent, in the small business rate from 25 to 21 per cent, in the rate for manufacturing and processing from 40 to 33 per cent, and in the rate for small manufacturing corporations from 20 to 16 per cent. A reduction in accelerated capital cost allowances and an elimination of the investment tax credit (except for scientific research expenditures) would offset the resulting reduction in federal revenues. The proposal would reduce the three-year write-off for manufacturing and processing assets in class 29 to 25 per cent on a declining-balance basis. The reduction to 25 per cent would also apply to write-offs for energy-saving and pollution control assets in classes 24,27, and 34; for resource extraction equipment, automobiles, and other assets in classes 10 and 28; and for heavy construction equipment in class 22. In addition, the proposal would eliminate the 3 per cent inventory allowance, which was introduced to compensate partially for the tax levied on inflationinduced capital gains on inventory holdings.

The budget paper sets out some of the advantages of the proposal. It would reduce tax-induced distortions in investment decisionmaking by distributing the tax burden more evenly among industries and different types of investment assets. The reduction in the corporate tax rate would make equity financing more attractive than it is at present relative to debt financing; this change would help to improve the balance sheets of corporations. Finally, the elimination of tax credits would stem the substantial build-up of unused tax deductions and credits on corporate books.

The key analysis contained in the study is a comparison of the effects of the two sets of proposals on marginal real effective tax rates applicable to large manufacturing corporations in Canada and the United States. The analysis usesthe manufacturing sector because it is the sector in which competition between companies in the two countries is most intense and in which the corporate tax rate probably has its greatest potential impact on the location of investment and employment.

Under the current systems, the real effective tax rate on investment in machinery and equipment in manufacturing is several percentage points lower in Canadathan it is in the United States if the investment is equity financed or only 25 per cent debt financed. For investment that is 50 per cent debt financed, the difference is only marginally in favour of Canada.

If both of the proposed systems were implemented, the Canadian real effective tax rate on equity-financed investment in machinery and equipment would be substantially (more than 10 percentage points) higher than the U.S. rate. The advantage would increase with the degree of debt financing. At the current 4 per cent rate of inflation, this advantage would exceed 20 percentage points for investment in machinery and equipment that was 50 per cent debt financed. Given 10 per cent inflation, the U.S. advantage would be 30 percentage points.

Implementation of the two proposals would increasethe real effective tax rate on equity-financed investment in nonresidential construction in both countries, but the increase in Canadian rates would be smaller than the increase in U.S. rates. Implementation of both proposals would therefore reduce the current U.S. advantage in real effective tax rates on investment of this kind. The lower the rate of inflation and the greater the degree of debt financing, the greater the reduction would be. This reduction, however, would have less effect on the competitiveness of Canada's manufacturing sector than the relative increase in the real effective tax rate on investment in machinery and equipment.

The analysis raises three neglected issues that should be taken into account in discussions of the proposed Canadian corporate tax changes: (1) the prudence of raising real effective tax rates on manufacturing investment in machinery and equipment above rates in the United States; (2) the implications for the relative tax burdens in Canada and the United States of the proposed indexation of the U.S. corporate tax system; and (3) the implications for regional development policy of eliminating special tax incentives for investment in less developed regions of Canada.

• Item Type: MPRA Paper
• Language: English
• Keywords: Corporate tax reform in Canada and the United States, Comparison of Marginal Effective Tax Rates on Investment
• Subjects: H - Public Economics > H2 - Taxation, Subsidies, and Revenue > H25 - Business Taxes and Subsidies

References

Canada, Department of Finance, Budget Papers, The Corporate Loss Transfer System: A Direction for Change, May 1985.

Grady,Patrick, Indexation and the Taxation of Business and Investment Income, Discussion Paper no. 283 (Ottawa: Economic Council of Canada, December 1984).

Kenward,Lloyd, "Business Investment and Output: Sector 3," in Sectoral Analysis of RDX2 Estimated to 4Q72, Technical Report 6 (Ottawa: Bank of Canada, 1977), 52-54.

United States, The President's Tax Proposals to the Congress for Fairness, Growth and Simplicity (Washington, D.C.: U.S. Government Printing Office, May 1985).

United States, Treasury Department Report to the President, Tax Reform for Fairness, Simplicity, and Economic Growth (Washington, D.e.: Department of the Treasury, November 1984).