Canada's Corporate Taxes Hindering Investment, Says OECD

by Mike Godfrey, Tax-News.com, Washington

29 June 2006

Canada's complex system of federal and provincial corporate taxation acts as a disincentive to investment and distorts business and investment decisions, according to a report by the Organisation for Economic Cooperation and Development (OECD).

In its survey of the Canadian economy, the OECD said that firms in Canada faced one of the highest average marginal effective tax rates (METRs) on investment in the OECD in 2005, meaning that an investment project that appears worthwhile before tax is less likely to be profitable after tax in Canada than elsewhere.

Noting that both federal and provincial/territorial governments tax businesses in a range of ways, the report stated that firms face considerable variations in the METRs, although the OECD highlighted two elements of provincial taxation that have "an especially pernicious effect".

First, provincial capital taxes are levied on debt and shareholders' equity beyond a threshold in six provinces, including Ontario and Quebec. These taxes directly raise the cost of financing business investment for larger firms.

"Abolishing capital taxes as rapidly as possible would significantly improve the business environment in those provinces," the report noted.

Second, provincial sales taxes are not generally refunded on capital goods purchased by firms. This directly raises the cost of purchased machinery and equipment, discouraging investment.

A shift by the five provinces that still have retail sales tax regimes to provincial value added taxes would create a more favourable investment climate, the OECD said.

Furthermore, the report suggested that Canada should seek to reduce the complexity of its federal and provincial corporate tax system, which tends to tax smaller companies at much lower rates than larger firms. There is also a myriad of special tax breaks at both federal and provincial level, ranging from the Atlantic Investment Tax Credit through to sectoral tax credits, while provinces offer additional targeted measures.

"All these factors combine to distort business decision-making by favouring manufacturing and primary production at the expense of services and penalising firms when, according to the tax rules, they grow from 'small' to 'large'. They may also lead managers to modify their business strategies to optimise tax rules and steer the economy away from the most efficient use of resources," the report observed.

While the government's commitment to additional cuts in corporate tax is seen as a positive step by the OECD, the organisation argued that the business environment would benefit more from comprehensive reform, which would treat all companies equally and broaden the tax base.

Moreover, the OECD suggested that the Canadian government has got its tax priorities wrong with its decision to lower GST from 7% to 5%. This is because Canadian governments raise a higher share of government revenues by taxing businesses than do most countries and a lower share than most through value added taxes, such as the GST.

Therefore, the organisation recommended that Canada concentrate on lowering its corporate tax burden, while relying more on GST for revenue collection. According to the OECD, value added taxation raises revenue more efficiently than either personal or corporate income tax because it generally has a broader base and does less to discourage work, saving and investment.

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