Tax Policy Next to the Elephant: Business Tax Reform in the Wake of the US Tax Cuts and Jobs Act

While there is considerable uncertainty regarding the US Tax Cut and Jobs Act’s (TCJA) economic and fiscal impacts, one thing is certain – the significant corporate tax competitiveness advantage that Canada enjoyed over the US for years has disappeared. This Commentary explores some major TCJA measures as they relate to corporations, examines their implications for Canadian business, evaluates Ottawa’s response in the Fall Economic Statement and discusses what is required going forward. The TCJA impact on real domestic investment in Canada is complicated, with competing effects. The TJCA will likely have a net negative effect on domestic and US foreign investment in Canada, moderated in the long-run by the international nature of capital markets. Still, concerns remain about income shifting due to the statutory rate reductions in the US. Our review of the academic literature suggests the US tax-rate cut will result in Canadian affiliates of US companies shifting homeward 8 percent to 28 percent of their profits – a back-of-the-envelope calculation for sure, but nonetheless suggesting a potential significant impact on Canadian corporate tax revenues. The TCJA represents a long overdue sea change in US corporate taxation and, on balance, will have a positive impact on investment and productivity in that country. However, the reform is not anchored in sound tax principles and introduces undesirable distortions. Ottawa, in its 2018 Fall Economic Statement, duplicated in part some aspects of the US reforms in accelerated depreciation for new capital expenditures. While we think that this short-run response is reasonable in light of the fiscal constraints facing the government and the uncertainty regarding the impact of the TCJA, we do not think that the work is done. The US reform provides an opportunity to make a bold move toward a corporate tax system in Canada that is grounded in sound tax policy principles, is less distortionary, promotes economic growth and prosperity, and restores Canada’s tax competitiveness on a worldwide basis. A structured, principled approach to tax reform in Canada is preferable than an ad hoc response to US developments, which may turn out to be fragile in light of the American political climate and the point in the business cycle. We advocate for a corporate tax system based on the taxation of economic “rents.” A simple example of such a regime is a cash-flow tax, which would involve the immediate write-off of all capital expenditures coupled with the elimination of the debt-interest deduction. The basic idea is to replace the corporate income tax with a rent tax that taxes only the above-normal return on investment and is, therefore, neutral with respect to business investment and financing decisions. A cash-flow tax would reduce the business cost of capital investment by roughly 20 percent – offering a much greater boost to capital investment than alternative and fractional reforms such as temporary accelerated depreciation or statutory tax rate cuts.