Canada: Selected Issues
Author:
International Monetary Fund
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Publication Date:
24 Mar 2000
eISBN:
9781451806922
Language:
English
Keywords:
ISCR; CR; Canada; rate; employer; tax rate; labour market; personal income income tax; rates in Canada; middle PIT rate; income threshold; system to inflation; Personal income tax; Personal income; Marginal effective tax rate; income tax tax burden
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The issue of productivity growth in Canada has received considerable attention reflecting its marked slowdown since the early 1970s and concerns about its implications for Canadian competitiveness. To better understand productivity developments in Canada, it is useful to decompose total factor productivity (TFP) into investment-specific productivity change (ISP) and technologically neutral productivity change (TNP). The gap in manufacturing productivity growth between Canada and the United States originates mostly in the strong performance of specific industries, such as electrical products and commercial and industrial machinery.

Abstract

The issue of productivity growth in Canada has received considerable attention reflecting its marked slowdown since the early 1970s and concerns about its implications for Canadian competitiveness. To better understand productivity developments in Canada, it is useful to decompose total factor productivity (TFP) into investment-specific productivity change (ISP) and technologically neutral productivity change (TNP). The gap in manufacturing productivity growth between Canada and the United States originates mostly in the strong performance of specific industries, such as electrical products and commercial and industrial machinery.

IV. Options for Income tax Reform in Canada1

1. The relatively high marginal and average personal income tax rates in Canada (federal and provincial combined) create disincentives to work and save. At the same time, the combined federal and provincial corporate income tax rate on general business income is generally higher than comparable rates in Canada’s major trading partners. In addition, there is relatively high variation in corporate tax rates across provinces and across industries, creating economic inefficiencies and increased compliance costs. This paper briefly reviews the current personal and corporate income tax systems in Canada, identifies priorities for reform, and presents estimates of the fiscal costs of illustrative reform packages that are feasible given prospective fiscal resources.

A. An Overview of Income Taxes in Canada

Personal income taxes

2. Personal income is taxed at both the federal and provincial levels. The federal income tax system comprises three progressive marginal rates (17, 26, and 29 percent), a set of refundable tax credits, including the GST tax credit and the National Child Benefit (NCB), 2 and a high-income surtax.3 Since 1986, the system has been indexed to inflation only for that amount exceeding 3 percent, implying a de facto absence of any indexing since the early 1990s. With the exception of Quebec, provincial income taxes are calculated as a percentage of the federal tax obligation plus any applicable surtaxes.

3. While the ratio of total tax revenue to GDP in Canada is broadly in line with other G-7 countries, the ratio of personal income tax to GDP is relatively high (Figure 1). In part, this reflects the greater reliance of the tax system in Canada on personal income taxes relative to other taxes (Table 1). The high ratio also reflects the steep progressivity of personal income taxation in Canada. In comparison to the United States, which also relies substantially on personal income taxes, the statutory marginal tax rates in Canada (federal and provincial combined) are significantly higher and apply at far lower income levels (tabulation below). In comparison with other G-7 countries as well, the top statutory rate in Canada starts to apply at a relatively low-income threshold, both in absolute terms and in relation to average income (Table 2).

Figure 1.
Figure 1.

Selected Countries: Tax Revenues

Citation: IMF Staff Country Reports 2000, 034; 10.5089/9781451806922.002.A004

Sources: IMF Government Financial Statistics; and OECD Revenue Statistics.
Table 1.

Canada: International Comparisons of the Tax Structure 1/

(Shares in total tax revenue, in percent)

article image
Sources: IMF; and OECD data.

Average 1994–96.

Table 2.

Selected Countries: Personal Income Tax, 1985-97

article image
Source: Coopers and Lybrand (1998), Messere (1998), staff calculations.

Converted to U.S. dollars at average 1997 exchange rate.

Fully indexed before 1986. Subsequently, partial indexation: for the excess of inflation over 3 percent.

Germany’s tax schedule is based on a formula and does not have brackets, individuals pay taxes according to an arithmetic progression at rates between 26 percent and 53 percent.

Subject to Parliamentary approval each year.

Rate schedule indexed during 1990-92.

Statutory Marginal Tax Rates

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Source: Tax Policy Branch, Department of Finance Canada.

Includes average provincial income tax rates.

Includes average state income tax rates.

4. The income tax burden is especially high on middle-income taxpayers, with the middle federal statutory tax rate (26 percent) starting to apply at a relatively low income threshold ($29,590). In addition, the jump in the federal and provincial marginal income tax rate between the low and middle brackets (14.5 percentage points)4 is the largest among G-7 countries. Taking into account the clawback of the GST tax credit and the NCB as family incomes increase, the effective marginal tax rates facing low-and middle-income households are significantly higher than the statutory rates. For a single taxpayer with two children residing in Ontario, for example, the effective marginal income tax rate (based on all income-related taxes, including federal and provincial income taxes combined, the Employment Insurance premium, the Canada Pension Plan premium, and all refundable tax credits) is estimated to rise to about 60 percent for incomes around $30,000, before falling back to about 40 percent for incomes around $40,000 (Mintz and Poschmann, 1999).

5. The partial, rather than full, indexation of the income tax system to inflation has resulted in a steady decline in the real-income thresholds at which successive statutory marginal tax rates apply (“bracket creep”) and in the real value of the basic personal credit.5 During the period since 1988, partial indexation has resulted in a cumulative 7½ percent increase in nominal tax parameters, compared with a 36 percent increase that would have occurred if instead the system were fully indexed. The Government adopted measures in 1997–99 to partially offset the rising tax burden owing to partial indexation. Nevertheless, the tax thresholds remain significantly out of line with what they would have been under full indexation (tabulation below).6 As a result, many individuals (28 percent of the estimated 15½ million Canadians who will have tax obligations in 2000) either have become taxable or have moved into a higher tax bracket because of less-than-full indexation (Table 3), including 1½ million individuals in the 17 percent marginal tax bracket who would have had a zero marginal tax rate under full indexation.

Table 3.

Canada: Effect of Partial Indexation From 1988–2000 on the Distribution of Tax Filers by Tax Bracket

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Source: Tax Policy Branch, Department of Finance Canada.

Impact of Partial Indexation on Federal Personal Income Tax Rate Thresholds 1988–2000

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Source: Tax Policy Branch, Department of Finance Canada.

Corporate income taxes

6. Corporate income tax rates in Canada vary depending on a firm’s size, activity, and its provincial location 7 The federal corporate statutory income tax rate is set at 28 percent for general business income, and a reduction from the general rate is provided to manufacturing and processing operations (21 percent) and to small businesses (12 percent).8 The provinces also frequently grant reductions in provincial corporate income tax rates for small businesses and, in some cases, for manufacturing and processing activities. This leaves the services sectors facing the highest corporate income tax rates. When both federal and provincial rates are considered, there is significant variation in the tax rates on corporate income across Canada (Table 4).

Table 4.

Canada: Federal and Provincial Corporate Income Tax Rates, 1998

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Source: Report of the Technical Committee on Business Taxation (1998).

Includes the federal surtax of 1.12 percent.

7. Canada’s average combined (federal and provincial) statutory tax rate for general business income (43 percent) is high relative to that in the United States (39 percent), the United Kingdom (31 percent), and Mexico (34 percent), for example, but is lower than in Germany, Italy, and Japan, where rates exceed 50 percent.9 Although the overall corporate income tax burden is close to the OECD average as a share of GDP (Figure 2), rates on nonmanufacturing, nonprocessing activities are relatively high, and raise the concern that these tend to discourage business operations and new investments in Canada’s service sectors. Moreover, the relatively high variation in corporate tax rates across provinces and across industries tends to exacerbate economic inefficiencies (by distorting investment decisions) and increase compliance costs (by adding complexity).

Figure 2.
Figure 2.

Selected Countries: Corporate Income Tax

(Percent of GDP, 1998 or most recent year available)

Citation: IMF Staff Country Reports 2000, 034; 10.5089/9781451806922.002.A004

Sources: IMF Government Financial Statistics; and OECD Revenue Statistics.1 1996.

B. Priorities for Income Tax Reform

8. The principal distortion in the personal income tax system is attributable to the high effective marginal tax rates, particularly on middle-income taxpayers. Reform of the personal income tax system should focus on correcting this problem by increasing the income thresholds at which progressive statutory marginal tax rates apply, cutting the high effective marginal tax rates applied at middle-income levels (through cuts in statutory rates and by reducing the rate of clawback of tax credits as incomes rise), and by indexing the system fully to inflation. The first two of these approaches would directly reduce the marginal tax rates facing middle-income taxpayers, while full indexation would stabilize the real parameters of the system to prevent inflation from eroding the real value of successive tax thresholds (bracket creep), tax credits, and the personal exemption.

9. In dealing with the erosion of the real value of tax parameters, there are two polar options: (i) formally index the system fully in legislation so that tax-parameter adjustments are automatic; or (ii) adopt discretionary measures periodically to correct (fully or partially) for the effects of inflation. International experience suggests a range of practices—featuring full, partial, and no indexation—and suggests that political and other noneconomic considerations play a large role in determining whether governments choose formal indexation, or choose to leave tax-parameter adjustments open to discretionary actions.10 A factor sometimes weighing against formal indexation is that a nonindexed system can provide a politically convenient way of raising revenue. Some countries, including the United States and the United Kingdom in the 1980s, introduced indexation as part of a general move toward lower taxes. Others, including Germany, Spain, and, until recently, Italy and Sweden, chose not to adopt indexation. In addition to foregone revenues, it was argued that indexation may make for easier public acceptance of inflation and lead to higher inflationary expectations. In a few countries, indexation has been used to meet distributional objectives. In France, for example, frequently only the top tax bracket has been indexed. Overall, experience among OECD countries in the late 1970s (when inflation was relatively high) suggests that the amount by which fiscal drag was offset in countries with formal indexation was roughly the same as in countries that relied on periodic discretionary measures (OECD, 1986).

10. Nevertheless, formal ex ante indexation has the virtue of being automatic and transparent, thereby reducing uncertainty and facilitating better longer-term planning. The ad hoc approach, on the other hand, could be more susceptible to ongoing political influence. The restoration of full indexation would ensure that, once measures to improve the efficiency of the income tax system were adopted, maintaining these improvements would not require legislative action.

11. With regard to the corporate income tax, the priorities should be on reducing the statutory tax rate on general business income in order to move closer to the average U.S. rate and to narrow the preferences for manufacturing/processing and small businesses. This would help to level the playing field for Canadian firms that compete internationally while also reducing the distortions associated with existing preferential tax rates. After sufficient time to provide a reasonable interval for business planning, there also is scope for broadening the tax base along the lines of the measures recommended in the 1998 Report of the Technical Committee on Business Taxation. These might include, for example, the elimination or reduction of certain preferences (e.g., reductions in the research and development tax incentives, which the Technical Committee judged to be among the most generous in the world), credits (e.g., replacing the Atlantic Investment Tax Credit with a more cost-effective and broad-based nontax program), and deductions (e.g., a general review of capital cost allowances to ensure that rates are closer to economic depreciation). The Committee also made a number of recommendations for reducing compliance costs and improving tax enforcement including harmonizing federal and provincial taxes on capital, establishing new mechanisms to settle disputes and collect assessed taxes, and adopting provisions to expand civil penalties on tax advisors whose advice is deemed to be grossly negligent.

C. The Fiscal Cost of Alternative Income Tax Measures

12. The fiscal costs of several illustrative tax packages are presented in Table 5. Package 1 includes full inflation indexation, a 1 percentage point cut in the 26 percent statutory marginal rate, an increase in the income threshold at which the middle marginal rate applies of $1,000, a reduction in the phase-out rate for the National Child Benefit as incomes rise, and a cut in the basic tax rate on corporate income of 1 percentage point. Package 2 is somewhat more ambitious than package 1, in that it cuts the middle marginal tax rate by 2 percentage points over two years, raises the income threshold for the middle tax rate by $2,000, increases the threshold for the top tax rate by $2,000, and cuts the basic corporate income tax by 2 percentage points over two years, in addition to the other measures in package 1. Package 3 includes the measures in package 2 as well as an additional 1 percentage point cut in the middle personal income tax rate (to 23 percent) in year three.

Table 5.

Canada: Fiscal Costs of Alternative Tax Reform Packages

(Millions of dollars)

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Source: Staff calculations based on data provided by the Department of Finance.

This is the ex ante fiscal surplus under current policies less the contingency reserve and the economic prodence.

Assumes 1.5 percent inflation.

The base benefit of the Canada Child Tax Benefit is currently phased out for family net incomes over $29,590 at a rate of 2.5 percent for a one-child family and 5 percent for families with two or more children.

assumes the additional $1,000 increase costs the same as the first $1,000.

13. The fiscal costs of all three packages over the five-year period through 2004/05 would be less than the annual planning surpluses over this period presented in the Fall 1999 Economic and Fiscal Update. Adoption of any of these packages would still provide sufficient resources to continue to bring down the debt-to-GDP ratio and to increase spending in priority areas such as health care and education.

List of References

  • Bird, Richard, David Perry, and Thomas Wilson, 1998, “Canada,” in The Tax System in Industrialized Countries, edited by Ken Messere, (New York: Oxford University Press).

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  • Cole, Jeffrey and Michael Leidy, 1997, “Business Taxation in Canada,” Canada–Selected Issues, IMF Staff Country Reports No. 97/20.

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  • Coopers and Lybrand Global Tax Network, 1998 International Tax Summaries: A Guide for Planning and Decisions, (New York: John Wiley and Sons).

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  • Duclos, Jean–Yves and Julie Gingras, 1999, “Mixing It Up: Directions for Federal Tax Reform,” (Toronto: C.D. Howe Institute).

  • Department of Finance, Canada, 1999, The Economic and Fiscal Update.

  • Messere, Ken (editor), 1998, The Tax System in Industrialized Countries, (New York: Oxford University Press).

  • Mintz, Jack and Finn Poschmann, 1999, “Tax Reform, Tax Reduction: The Missing Framework,” (Toronto: C.D. Howe Institute).

  • Organisation for Economic Co-operation and Development, 1999, 1998–1999 Annual Review: Canada (draft), (Paris: OECD).

  • Organisation for Economic Co-operation and Development, 1999, Revenue Statistics, 1965–98, (Paris: OECD).

  • Organisation for Economic Co-operation and Development, 1993, Taxation in OECD Countries, (Paris: OECD).

  • Organisation for Economic Co-operation and Development, 1986, Personal Income Tax Systems under Changing Economic Conditions, (Paris: OECD).

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1

Prepared by Vivek Arora and Michael Leidy.

2

The GST credit was introduced in 1991 to ease the burden of the newly introduced goods and services tax on low-income Canadians. The GST credit is gradually reduced until it is eliminated once family incomes reach $50,000. The NCB is a joint initiative of the federal and provincial governments that includes the Canada Child Tax Benefit (CCTB) and the National Child Benefit Supplement (NCBS). The CCTB is a tax-free monthly payment to eligible families with children. The NCBS is a monthly benefit to low-income families with children. The CCTB basic benefit begins being withdrawn if family net income exceeds $29,590 (raised from $25,921 in the 1999/00 Budget) and is fully withdrawn when family income exceeds $70,000 for the first child. The NCBS begins being withdrawn when net family income exceeds $20,921.

3

Individuals who owe basic federal tax of $12,500 or more (roughly corresponding to incomes of $65,000 or more) are subject to a 5 percent surtax. A 3 percent surtax, which previously applied to all taxpayers, was reduced in coverage in July 1998 and eliminated in July 1999.

4

This is the difference between the marginal tax rates applicable at 66 percent and 100 percent of the average production wage.

5

Following the move from full to partial indexation in 1986, a major tax reform reduced the number of tax brackets from ten to three and cut the top federal marginal tax rate from 34 percent to 29 percent.

6

The 1998 and 1999 Budgets, for example, raised the personal exemption by $675 so that the tax-free amount in 2000 will be $7,131. But this is still insufficient to offset the effects of inflation on the personal exemption since 1988 (tabulation).

7

Cole and Leidy (1997) present an analytical overview of Canada’s business tax system.

8

In addition, a federal surtax is imposed raising the general business rate to 29.12 percent the manufacturing and processing rate to 22.12 percent, and the general small business rate to 13.12 percent.

9

Report of the Technical Committee on Business Taxation (1998).

10

See Messere (1998), Chapter 1, for a summary of international practice.

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Cover IMF Staff Country Reports
Canada: Selected Issues
Author:
International Monetary Fund
Volume/Issue:
Volume 2000: Issue 034
Publisher:
International Monetary Fund
ISBN:
9781451806922
ISSN:
1934-7685
Pages:
60
DOI:
https://doi.org/10.5089/9781451806922.002
  • Figure 1.
    View in gallery
    Figure 1.

    Selected Countries: Tax Revenues

  • Figure 2.
    View in gallery
    Figure 2.

    Selected Countries: Corporate Income Tax

    (Percent of GDP, 1998 or most recent year available)

Figure 1.

Selected Countries: Tax Revenues
Figure 2.

Selected Countries: Corporate Income Tax

(Percent of GDP, 1998 or most recent year available)