Canada: Economic Developments and Policies

This paper examines economic developments and policies in Canada during 1990–95. Spurred by the robust growth in the United States and the easing of monetary conditions between 1991 and 1993, economic growth in Canada continued to strengthen during 1994. Real GDP grew by 4.5 percent in 1994 after growing by 2.2 percent in 1993 and 0.6 percent in 1992. Economic growth in 1994 was led by exports and investment in machinery and equipment. However, growth was more broadly based in 1994; private consumption strengthened, and there was a rebound in residential and nonresidential construction.

Abstract

This paper examines economic developments and policies in Canada during 1990–95. Spurred by the robust growth in the United States and the easing of monetary conditions between 1991 and 1993, economic growth in Canada continued to strengthen during 1994. Real GDP grew by 4.5 percent in 1994 after growing by 2.2 percent in 1993 and 0.6 percent in 1992. Economic growth in 1994 was led by exports and investment in machinery and equipment. However, growth was more broadly based in 1994; private consumption strengthened, and there was a rebound in residential and nonresidential construction.

XIII. Federal Tax Expenditures 1/

The Canadian Government signaled recently that the size of the Canadian fiscal problem will require consideration of tax initiatives that would enhance economic efficiency, fairness, and a broadening of the tax base. 2/ At the same time the Government stressed that tax rates were relatively high in Canada compared to the United States. In this light, the fiscal consolidation effort would need to center on reducing tax incentives rather than increasing tax rates. 3/

The 1995/96 budget that was presented to Parliament on February 27, 1995 reduced or eliminated a number of tax incentives. In particular, tax assistance for retirement saving, the tax deferral advantage for income earned through private corporations, and tax incentives for research and development were reduced. However, the estimated yield from these measures was relatively small, and in view of the substantial structural fiscal deficit that remains further tax measures may be required in the future. This note briefly reviews some of the major federal tax expenditures, and describes some of the implications of their possible reduction or elimination. 4/

1. Personal income tax expenditures

Tax assistance for retirement saving represents one of the largest personal tax incentives (roughly $14 billion in 1991). 5/ The Canadian income tax system provides for tax deferral (until retirement) for contributions to defined-benefit pension plans (Registered Pension Plans or RPPs) and on contributions to defined-contribution pension plans (Registered Retirement Saving Plans or RRSPs). 1/ In addition to the tax deferral granted on such contributions, the income earned by RPPs and RRSPs is not taxed until distribution. Under the current system, which was adopted in 1991, RRSPs and RPPs are treated symmetrically; contributions to either type of saving plan are limited to no more than 18 percent of income, up to a maximum of $13,500 in 1994. 2/

While the size of this tax incentive is large, a number of factors would need to be considered before implementing a reduction. First, reducing incentives to save for retirement could mean that any gain in public saving could be partially offset by a fall in private saving. Evidence on the effects of similar schemes in the United States seems to suggest that savings incentives have not had a large effect on the amount of private saving. 3/ However, a recent study of the RRSP/RPP system in Canada by Venti and Wise (1994) indicates that the tax deferral may have stimulated private saving. 4/

Second, reducing tax assistance for saving could affect the equity of the tax system. For example, if the tax incentives were reduced by lowering RRSP contribution limits, this would mean that participants in RPPs (typically those working for larger companies) would be at an advantage compared to those relying more heavily on RRSPs (i.e., the self-employed). Thus, care would need to be taken to ensure a symmetric treatment of RRSPs and RPPs in line with objective of the 1991 pension reform.

An alternative that is sometimes suggested (Courchene (1994)) would be to convert the RRSP/RPP deduction to a tax credit at a standard 17 percent rate. This approach would reduce the tax benefit to higher income individuals (i.e., those for whom the marginal tax rate exceeds 17 percent) and it would promote vertical equity. However, a drawback to this approach would be that it would create an incentive for higher income participants in RPPs to increase their employers’ share of contributions (and reduce their taxable income) in order to reduce their overall tax burden. In theory this problem of tax avoidance could be overcome by requiring that employer contributions to RPPs be included as part of taxable income, but the additional administrative costs involved could be large.

In addition, the RRSP/RPP deduction mainly represents a deferral of tax receipts (until retirement) rather than a permanent loss of tax revenue. For example, suppose that individuals intended to save an amount S at an interest rate r, and their tax rate is τ. Then, after two periods, the value of saving with and without the deduction would be:

With deduction: S(1+τ)(1+τ)(1-τ)

Without deduction: S(1-τ)(1+τ(1-τ))(1+τ(1-τ))

i.e., the difference is simply the ability to invest one’s savings at a pretax rate of interest rather than a post-tax rate. Reducing the generosity of the tax deduction, therefore would not have a large effect on the present value of tax receipts. 1/ Indeed, if interest rates rose in response to a fall in the tax deduction, the fiscal saving would be reduced further.

Age and pension tax credits also are provided for the elderly (costing about $1.7 billion in 1992). Taxpayers aged 65 and over are allowed a tax credit of 17 percent of $3,482 (this credit was means-tested beginning in 1994 and is reduced gradually for incomes above $25,921). In addition, taxpayers can claim a tax credit, equal to 17 percent of the first $1,000 of private pension income, regardless of age. Further intensifying the means-testing of these benefits could be considered, but would have the drawback of increasing marginal tax rates. An alternative would be to withdraw the credits completely, and deliver income assistance as needed through the Guaranteed Income Assistance program.

Another large personal income tax incentive is the tax exemption of lottery and gambling winning of ($0.9 billion in 1992). While there seems no obvious reason for the continuation of this exemption, a number of factors would make its withdrawal difficult. First, the Federal Government agreed with the provinces several years ago to eliminate its federal lottery in exchange for compensation from the provinces. Thus, imposition of federal income tax on lottery winnings might be viewed as an abrogation of this agreement. Second, if gambling winnings are viewed as income, there is a question whether wagers should be viewed as a deductible cost of “investment.” Finally, it could be argued that many gambling enterprises (i.e., lotteries and bingos) help finance charities or public services and that they should continue to receive special treatment. However, as they represent a relatively regressive form of taxation, and may also encourage socially undesirable behavior, other means of supporting such activities could be considered.

Support for post-secondary education is provided through the personal tax system in the form of a 17 percent tax credit for tuition fees as well as a tax credit for school attendance ($0.4 billion in 1992). These tax credits may be transferred (up to $4,000) to a supporting spouse, parent, or grandparent. While there are economic arguments in favor of subsidizing education, the fact that access to post-secondary schooling is greatest among higher income families suggests that the incidence of the subsidy may be regressive. Moreover, it is often argued that the social rate of return on public investment in education is greater for primary and secondary schooling, so that reallocating public funding away from tertiary education might yield efficiency gains.

Substantial tax preferences for capital gains are provided through the personal tax system. These include the exclusion of one quarter of all capital gains from taxable income ($0.7 billion in 1992), a $500,000 lifetime capital gains exemption for farm property ($0.2 billion in 1992), a $500,000 lifetime capital gains exemption for small business shares ($0.8 billion in 1992), and the exclusion of capital gains on principal residences ($5.2 billion in 1992). 1/ These exemptions (particularly the 25 percent exclusion of capital gains) are sometimes argued to offset the fact that the income tax system does not properly distinguish between inflation-related and other capital gains. 2/

Social assistance payments (including worker’s compensation) are nontaxable ($1.3 billion in 1992). These benefits are income-tested (or income-related in the case of worker’s compensation), and their deductibility enables the provincial government agencies involved to provide a lower level of benefits than would otherwise be required. However, they also lower the effective tax rate on other income and provide an implicit subsidy from the Federal Government to provincial governments.

2. Corporate income tax incentives

One of the largest corporate income tax incentives is the low tax rate for small businesses ($2.0 billion in 1991). In particular, a 16 percentage point tax rate reduction is allowed on the first $200,000 earned by a Canadian-controlled private corporation, reducing the effective tax rate from 28 percent to 12 percent. While this deduction is designed notionally to promote small business, it is available regardless of a firms’ size or income. In addition, a preferential tax rate (21 percent as compared to 28 percent) is provided for manufacturing and processing enterprises ($0.4 billion in 1991). Substantial tax incentives for research development (R&D) also are provided ($0.6 billion in 1991). The Scientific Research and Experimental Development Investment tax credit provides a 20 percent tax credit for R&D expenditures; a 35 percent rate also applies to Canadian companies whose income in the previous year did not exceed $200,000. 1/

Tax preferences also are provided for exploration and development in the mining and oil and gas sectors, in the form of accelerated write-offs ($0.5 billion in 1991). Development expenditure may be written off at a 30 percent rate on a declining balance basis, while exploration expenses can be deducted at a rate of up to 100 percent. Unused write-offs can be carried forward indefinitely. While regional tax preferences have been reduced in recent years, a 10 percent tax credit is still provided for purchases of qualified capital goods in the Atlantic provinces and the Gaspe region. A substantial regional tax preference is still delivered through the income tax system, though. The northern residents deduction ($0.2 billion in 1992) permits individuals living in prescribed areas to deduct up to $15 a day from taxable income.

These preferences are relatively generous and their effectiveness in promoting investment does not appear to have been large. For example, the threshold for the small business tax rate is considered to be high by international standards (a preferential rate is provided on corporate income up to US$75,000 in the United States). Similarly, Canada’s system of tax incentives for R&D has been described as one of the most favorable among industrial countries. 2/

An issue to be resolved before withdrawing these preferences would be the effect on the corporate income tax burden in Canada relative to the United States, since large divergences between the U.S. and Canadian rates could encourage companies to relocate. For example, although corporate tax preferences seem relatively generous, Canadian statutory corporate income tax rates, taking provincial taxes into account, are somewhat higher than those in the United States. Nonetheless, corporate income tax payments are a somewhat lower share of GDP in Canada suggesting that there may be scope for reducing tax preferences.

3. Goods and Services Tax (GST)

The Goods and Services Tax (GST)--a value-added tax--replaced the federal sales tax in 1991. 3/ While relatively broad based, the GST does include a number of exemptions and zero ratings that could be considered tax expenditures, many of which were adopted in order to reduce the administrative burden or the regressivity of the system. 4/

A broad range of goods and services are zero-rated, including basic groceries ($2.5 billion in 1992), prescription drugs, medical devices, most agricultural and fish products for food production, certain major purchases by farmers and fishermen, and exported goods and services. Tax exemptions include those for health and dental care ($0.3 billion in 1992), most educational services ($0.3 billion in 1992), most financial services (especially those that are difficult to measure), long-term residential rent exceeding 30 days ($1.0 billion in 1992), sales of used housing, and most goods and services supplied by charities and nonprofit organizations. The housing sector also receives special treatment; GST is assessed at a 4 1/2 percent rate for homes costing up to $350,000, as compared to the 7 percent standard rate. 1/ Businesses with sales of less than $30,000 and charities are exempt from GST.

described above are substantial, especially those for groceries. However, reducing or withdrawing this or other preferences would require consideration of a number of factors. First, an important concern with the GST since its inception has been the added administrative burden that it has imposed on the private sector, as well as the apparent increase in tax evasion it has engendered. Withdrawing tax preferences for small businesses could add to the GST’s administrative complexity. Second, a reduction in tax preferences would likely be regressive, especially in the case of basic groceries. While scope exists for expanding tax credits through the income tax system to offset adverse effects on low-income households, these also have the effect of increasing marginal income tax rates and possibly reducing work incentives. 2/

References

  • Bird, Richard M., David B. Perry, and Thomas A. Wilson, “Tax Reform in Canada: A Decade of Change and Future Prospects”, University of Toronto, International Centre for Tax Studies, Discussion Paper No. 1 (November 1994).

    • Search Google Scholar
    • Export Citation
  • Courchene, T. J., Social Canada in the Millennium: Reform Imperatives and Restructuring Principles (Toronto: C.D. Howe Institute, 1994).

    • Search Google Scholar
    • Export Citation
  • Department of Finance, Goods and Services Tax (Ottawa 1990).

  • Department of Finance, Personal and corporate income tax expenditures: December 1993 (Ottawa: Supply and Services Canada, 1993).

  • Department of Finance, Tax Expenditures: December 1994 (Ottawa: Supply and Services Canada, 1994).

  • Department of Finance, Creating a Healthy Fiscal Climate: The Economic and Fiscal Update (Ottawa: Supply and Services Canada, 1994).

  • Engen, Eric M., William G. Gale, and John Karl Scholz, “Do Saving Incentives Work?” in Brookings Papers on Economic Activity, 1:1994 (1994), pp. 85-180.

    • Search Google Scholar
    • Export Citation
  • Price Waterhouse, Doing Business in Canada (Price Waterhouse, 1994).

  • Venti, Steven and David Wise, “RRSPs and Saving in Canada”, (mimeographed, National Bureau of Economic Research, Inc., May 19, 1994).

    • Search Google Scholar
    • Export Citation
1/

Prepared by Christopher Towe.

3/

The term “tax expenditure” refers to special tax rates, deductions, credits, etc. usually intended to promote social or economic objectives. They can be considered “expenditures” since in many respects they are equivalent to government transfers and subsidies.

4/

The principal source of the data described below is the Department of Finance (1993 and 1994).

5/

The estimate of the tax incentive is a net figure and includes the tax revenue on withdrawals from retirement saving plans. It also includes the effect of the tax incentive on provincial revenues--as the provinces (with the exception of Quebec) levy personal income taxes as a percentage of federal tax the size of the general government tax incentive would be considerably higher.

1/

A defined-benefit pension plan provides a level of retirement income that is defined on the basis of pre-retirement contributions and does not vary with the rate of return earned on contributions. Retirement income from a defined-contribution plan is determined on the basis of the return on pre-retirement contributions. RPPs generally are defined-benefit retirement plans, which are operated by the employer; RRSPs generally are saving vehicles that are managed by financial institutions on behalf of individual depositors, and thus are similar to defined-contribution plans.

2/

The maximum amount was scheduled to rise to $15,500 by 1996, and to increase by the rate of inflation thereafter. RPP limits were set already at $15,500.

3/

For a recent example, see Engen, Gale, and Scholz (1994).

4/

See also Bird, et al (1994) for a discussion.

1/

The fiscal effect of changing the RRSP/RPP deduction would also depend on the difference between the marginal tax rates of retirees and workers.

1/

A general $100,000 lifetime capital gains exclusion was withdrawn as part of the February 1994 budget.

2/

Also, mortgage interest and deductibility is not provided for principal residences.

1/

This tax credit is in addition to the deductibility of current and capital R&D spending.

2/

Price Waterhouse (1994), p. 156.

3/

See Chapter XII for a further discussion of the GST.

4/

Goods and services are zero-rated or exempt from value-added tax when tax does have to be paid on the value of their sale. In the case of zero rating, however, the amount of tax paid on inputs used in their production can be claimed as a credit.

1/

The rate rises gradually to the full 7 percent for houses costing $450,000 or more.

2/

For example, Bird et al. (1994) estimates that the effect of existing tax credits is to raise the marginal tax rate by 10 percentage points.