CANADIAN TAX REFORM: ECONOMIC AND POLITICAL IMPLICATIONS

• Document Type: CREST
• Collection: General CIA Records
• Document Number (FOIA) /ESDN (CREST): CIA-RDP89T00295R000600680003-8
• Release Decision: RIPPUB
• Original Classification: C
• Document Page Count: 19
• Document Creation Date: December 22, 2016
• Document Release Date: January 20, 2012
• Sequence Number: 3
• Publication Date: December 1, 1987
• Content Type: REPORT

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Directorate of Confidential
? Canadian Tax Reform:-
Economic and Political
Implications
An Intelligence Assessment
Confidential
EUR 87-10030
? / ?December 1987
Copy 3 0 1
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11 Intelligence ? rx i
Directorate of Confidential
Canadian Tax Reform:
Economic and Political
Implications
An Intelligence Assessment
Office of European Analysis. Comments and queries
are welcome and may be directed to the Chief,
Western Europe Division, EURA
This paper was prepared by
Confidential
EUR 87-10030
December 1987
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Canadian Tax Reform:
Economic and Political
Implications
Key Judgments The Canadian Government has decided to push ahead with a US-style tax
Information available reform that probably will improve its tax system but also may increase
as of 30 October 1987 frictions with the United States and pose political dangers for the
was used in this report. g
Mulroney government. For political reasons, Ottawa will implement the
reform in two stages-one before and the other after the next election,
which must be held by late 1989. The first stage-taking effect in early
1988-will lower income tax rates and broaden the tax base in a Tory ef-
fort to win support before the election. The immediate economic result is
likely to be a contraction in growth; if not accompanied by the second
stage, tax reform is unlikely to improve the tax system enough to provide
more than a modest boost to growth over the longer run.
More substantial economic benefits probably will result from the second
stage-replacing the present manufacturers' tax with a new sales tax. This
controversial new tax may never be enacted, however, because of the
uncertainty of a Conservative victory in the next election. The Tories trail
badly in the polls, and neither opposition party is likely to follow through
The Tories will benefit politically from reform only if they can focus the
voters' attention on the immediate benefits of the personal income tax cuts
and convince them that the reform will significantly improve the economy.
We believe the Tories are underestimating the public's opposition to the
sales tax proposal, and we doubt Prime Minister Mulroney-who has an
unprecedentedly low credibility rating-can convince most voters that
reform will result in a fairer tax system or a smaller tax burden. The
opposition parties probably can capitalize on the Tories' reputation for
raising taxes and skewing the tax system to favor the wealthy. 25X1
Other economic results of the reform are likely to be mixed. By slowing the
rate of revenue increases, the first-stage reforms will hinder Ottawa's
efforts to cut its budget deficit over the next four years. Moreover,
uncertainty over the implementation of the revenue-generating new sales
tax puts longer range deficit reduction efforts in jeopardy. If the sales tax is
not implemented, a continuing high deficit, in turn, will reduce Ottawa's
ability to use fiscal policy to stimulate the economy when necessary and
probably will undermine investor confidence in the government's ability to
sustain economic growth. Stalled progress on deficit reduction also is likely
to cause interest rates to remain high, curtailing investment, and probably
renewing downward pressure on the Canadian dolls 25X6
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EUR 87-10030
December 1987
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Ottawa is selling its tax reform proposal as a means of encouraging growth,
but the package as it is likely to be implemented probably will give only a
small boost to the economy. In the short term, the first stage of reform will
almost certainly discourage business investment more than it stimulates
consumption. Over the longer term, the first stage of reforms is likely to
lead to more rational investment decisions, which will improve the quality
of the capital stock and increase economic efficiency. The later introduc-
tion of a broadly based sales tax would remove distortions present in the
current system and probably would create a small upturn in real economic
activity by encouraging resource allocation based on economic rather than
tax considerations.
Tax reform will increase the potential for friction between the United
States and Canada, particularly if Ottawa applies the stricter tax-
avoidance regulations it has in mind to US corporations doing business in
Canada. And the likely weakening of the Canadian dollar would allow
Canadian exporters to make further inroads into the US market. The
constraints of the deficit on the government's ability to stimulate the
economy through fiscal policy would also aggravate bilateral tensions if
Ottawa, as is likely, follows its past practice of blaming US dominance of
the Canadian economy for the government's shortcomings. Finally, feder-
al-provincial negotiations on the details of a new sales tax regime may
become heated and spill over into US-Canadian relations by making the
provinces less willing to cooperate in implementing the recently signed free
trade agreement.
Confidential iv
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Contents
Key Judgments
The Tax Reform Proposal
Prospects for the Reform Package
Impact on the Tax System
Negative Impact on Deficit Reduction
Meager Economic Benefits
Political Impact
Implications for the United States
Canada's Winners and Losers: Impact of Tax Reform on
Various Sectors of the Economy
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Canadian Tax Reform:
Economic and Political
Implications
Introduction
After several years of internal party debate, Prime
Minister Mulroney's government announced a two-
tiered tax reform proposal in June designed to correct
many distortions and inefficiencies in the old tax
system. In the first stage of reform, effective in 1988,
the Tories plan to improve the effectiveness of the
Canadian income tax system by lowering income tax
rates and broadening the income tax base. Ottawa
plans to follow this step by replacing the exemption-
riddled federal sales tax on manufactured goods with
a more broadly based value-added sales tax in the
early 1990s. The Mulroney government believes that
a simpler, more equitable tax structure will improve
Canada's competitiveness and encourage economic
growth by removing barriers to efficiency.
This paper provides an overview of the proposed
changes to the Canadian tax system, along with an
analysis of why Ottawa has undertaken reform at this
time. It outlines the uncertainties involved in imple-
menting both stages of the reform and assesses the
shape of Mulroney's ultimate tax package. The paper
examines the impact of the tax changes on economic
growth, investment, and Ottawa's effort to control its
budget deficit, as well as their political impact. Final-
ly, it outlines some potential irritants to US-Canadian
relations arising from tax reform.
Why Tax Reform is Needed
The need to replace the present Canadian tax system
with a simpler and fairer program has been debated
for two decades. Years of tinkering with the income
tax structure to encourage investment and regional
development have created a complex and biased sys-
tem that hinders economic growth. The present tax
system's high marginal income tax rates, for example,
discourage labor productivity and investment. Be-
cause of the many deductions and exemptions offered,
both individuals and corporations often base their
investment decisions more on tax considerations than
on economic factors, thereby impairing efficiency.
The current manufacturers' sales tax creates even
more distortions. Half of the revenue from the manu-
facturers' tax is derived from levies on goods used by
businesses, which creates a cascading effect where
taxes paid at several levels of production are included
in the taxable value of a good. This cascading tax
greatly increases investment costs and erodes Cana-
da's export competitiveness. Moreover, because the
manufacturers' tax is applied at varying rates-and to
only one-third of consumption-similar products are
subject to widely varying taxes, a situation which
distorts consumption decisions. Finally, the system is
biased against. Canadian-made goods since no tax is
levied on imports.
The frequent granting of exemptions from both in-
come taxes and the manufacturers' sales tax over the
last decade has eroded the federal government's abili-
ty to raise revenue and has undermined economic
efficiency. Increases in tax rates over the years have
also encouraged tax evasion and delinquency of pay-
ments. Today, tax revenue as a share of GNP is about
17 percent-only marginally higher than when the
Tories took office in 1984-despite efforts to broaden
the tax base and raise revenues through a minimum
income tax, surtaxes, partial deindexation of tax
brackets, and three hikes in the manufacturers' sales
tax. Finally, Ottawa's estimates of its tax revenues are
often overstated, partly because of the tax evasion
problem, and partly because unused corporate tax
credits can be carried over from year to year
Finance Minister Wilson has advocated measures to
amend the tax system since 1985, but the problem-
plagued Tory Cabinet has been reluctant to take the
political risks involved in widespread reform. Wilson
has pressed for lower tax rates, limited deductions,
and a more progressive tax system: one that would
shift the tax burden away from savings toward con-
sumption. He has insisted, however, that tax reform
must not undermine other economic objectives of the
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Canadian Government such as continued funding of
generous social programs, encouragement of regional
economic parity, and maintenance of a high savings
rate-to cover the high costs of capital in Canada.
What finally helped Wilson convince his colleagues to
push ahead with reform this year was the lowering of
tax rates in the United States. Wilson argued that
failure to narrow the gap between US and Canadian
rates would drive both people and investment from
Canada. He estimated, for example, that Ottawa
would lose several million dollars in tax revenues
annually from corporations shifting investments to the
United States to take advantage of lower tax rates.
This lost investment, he believed, would slow econom-
ic activity and job creation. On the political side, the
Tories decided that further delaying tax reform would
threaten their credibility. Moreover, they hope to use
lower tax rates to enhance their chances in the next
election, which must be held by the fall of 1989. They
have designed the package to maximize its political
benefits.
The Tax Reform Proposal
The first stage of the two-tiered reform package that
Wilson introduced last June addresses shortcomings
in the personal and corporate income tax structure.
Effective in early 1988, the first stage will lower
personal and corporate income tax rates, eliminate
many deductions to simplify the system, and change
others to tax credits to make the system more progres-
sive (see inset). Removing deductions will also broaden
the tax base-a necessary step to recoup some of the
income lost through lower tax rates. Moreover, several
of the proposed changes will force financial institu-
tions, insurance companies, and real estate firms to
bear their fair share of the tax burden; under the
present system these companies pay no tax on invest-
ment income.
Ottawa, however, retained several tax incentives that
encourage research and regional development, help
maintain Canada's high savings rate, or aid key
industries. The Tories plan, for example, to keep
several deductions that lower the effective tax rate on
savings and investment, hoping thereby to shift the
burden of the personal tax system away from savings
toward consumption. In addition, preferential treat-
ment for investment in the mining and petroleum
industries will be continued, albeit on a smaller scale,
and tax credits to companies investing in Atlantic
Canada will be retained.
In an effort to keep the first stage of changes revenue
neutral, the government will resort to temporary
changes in the manufacturers' sales tax and will
accelerate tax collection measures to recoup revenue
lost by lowering tax rates. Ottawa will abandon these
measures if and when the new sales tax is in place.
Wilson also anticipates additional revenues from a
strengthening of antiavoidance rules, although court
challenges to the proposed legislation probably will
gradually erode Ottawa's ability to raise revenues
through these means. The proposed measures grant
Revenue Canada-Ottawa's tax collection agency-
broad power to examine company transactions and
disallow those undertaken solely to reduce taxes.
Because the second stage of reform-the new sales
tax-is likely to be unpopular, its introduction will
almost certainly be delayed until 1990 or 1991.
Although Wilson initially implied that substitution of
a new sales tax for the manufacturers' sales tax would
occur soon so as to maintain revenue necessary for
budget reduction, he has since declared that the sales
tax legislation would not be introduced before the
next election. He apparently was overruled by Cabi-
net colleagues who did not want to defend a contro-
versial new tax on the hustings.
The Tories have purposely left their proposals for the
new sales tax vague. Wilson outlined three sales tax
options in his June speech-a national sales tax, a
European-style value-added tax (VAT), and a goods
and services tax-and has said he will choose one
after discussions with the provinces this winter (see
inset). Replacing the separate federal and provincial
tax systems with a single national tax appears to have
the most support at present, but the provinces' reluc-
tance to cede some of their tax autonomy to a central
system could force Ottawa to choose one of the
federal-only options. Whatever the form, Wilson will
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Highlights of the Tax Reform Package
Personal Income Taxes
Tax Rates. Effective January 1988, the number of
brackets is reduced from 10 to three; new tax rates
ranging from 17 percent for incomes below $20,625 to
29 percent for incomes above $41,250 replace old
rates of between 6 percent and 34 percent; rates to
drop further when new sales tax implemented.
Exemptions/Deductions. Interest and employment
deductions eliminated; all exemptions personal,
marital, child, old age/disabled-replaced with tax
credits; deductions for medical expenses, tuition fees,
unemployment insurance premiums, contributions to
Canada and Quebec Pension Plans changed to tax
credits worth 17 percent of expenses/contributions.
Capital Gains. Lifetime capital gains exemption re-
duced from $375,000 to $75,000 for all Canadians
except farmers and small businessmen; tax rate on
taxable portion of capital gains rises in 1988 from
50 percent to 66.6 percent, and to 75 percent by 1990.
Sales Tax Credit. Credit rises from $37.50 to $52.50
for adults, $18.75 to $26.25 for children.
Corporate Income Taxes
Tax Rates. Reduced from 36 percent to 28 percent on
1 July 1988; rate for manufacturers drops from 30
percent to 26 percent next year and to 23 percent by
press for a tax covering almost all goods and services,
including politically sensitive goods like food, partly
because such a measure can be implemented at a
much lower rate than the present manufacturers' tax.
Ottawa estimates that every percentage point of a
more broadly based tax would raise $1.5-2.3 billion
annually for the government; therefore, a 5- to
7-percent tax would yield the $11 billion the present
12-percent tax raises. Wilson also promises that
1991; rate for small businesses declines from 15
percent to 12 percent; 3 -percent surcharge to be
dropped when new sales tax is introduced.
Capital Cost Allowances. Reduced to 25 percent of
declining balance for manufacturers; by 1990 capital
cost allowance only claimable in year asset put into
use; earned depletion allowances for natural re-
sources phased out by 1990.
Financial Services. Funds transferred to reserves
made taxable; claims discounted to present value; tax
on investment income accruing to fund insurance
liabilities of life insurance companies.
Capital Gains. Same as for personal income.
Other Measures
Manufacturers Tax. Levied 10 percent tax on tele-
communications services; raised from 8 percent to 12
percent tax on paint, varnish, and wallpaper; switched
tax on selected goods from the manufacturers' to the
wholesale level; temporary until new sales tax
implemented.
Cash Flow Manipulation. Starting April 1988, large
corporations to pay sales and excise taxes every two
weeks rather than monthly; in 1990 remittances for
source deductions accelerated to four times a month.
broadening the tax base will enable him to provide a
refundable, prepaid tax credit to low-income Canadi-
ans to offset the regressivity of the tax.
Prospects for the Reform Package
The Mulroney government will find it easier to im-
pose the initial reforms than the proposed sales tax.
Although there has been widespread criticism of the
first-stage tax measures, it has generally been muted.
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The Sales Tax Options
The three options are all variations of a multistage
value-added tax (VAT). Since all three probably
would introduce a common tax rate applied to virtu-
ally all goods and services, any of the alternatives
would benefit the economy by minimizing distortions
of consumption preferences. The differences among
the three options lie mainly with the methods of
calculating the tax and the costs of its administra-
tion.
The national sales tax appears to be the favorite with
the Tory Cabinet because it replaces both the federal
and provincial sales taxes with one system. According
to Wilson, however, the tax-applied at a common
federal rate and individual provincial rates-would
be flexible enough to allow provinces to opt out of
their portion of the tax. A national tax would
complicate a businessman's paperwork because sales
invoices would be needed for every transaction, but
this added burden would be partially offset by the
integration of the existing federal and provincial tax
systems.
A goods and services tax-formerly called a business
transfer tax-is a subtraction-style VAT where the
tax base is determined by subtracting the cost of
purchases of goods and services, including invest-
ment, to which the tax is already applied, from the
The business sector is unhappy with the raising of
effective corporate tax rates, but is also relieved that
the reforms are not as extensive as many had privately
feared. After several months of public hearings, the
House of Commons Finance Committee approved the
general thrust of Wilson's reform measures in mid-
November, and released many recommendations to
smooth out the package's rough edges. While most of
the recommendations are technical fixes, two major
criticisms emerged: that the tax burden falls too
heavily on middle-income families, and that financial
institutions still escape from contributing a fair share
to government revenues. We expect Wilson will make
some minor changes to the tax legislation so as to
value of the goods and services sold. The tax would
be administered at the federal level, and would not in
itself affect provincial tax rates. To make the effec-
tive tax rate on exports zero, their value would be
subtracted from the value of a company's sales. The
main advantage of this option is that it is simpler for
businesses to administer because it uses sales and
cost figures from a company's books rather than
separate invoices to calculate tax owed.
A European-style, credit-invoice VAT probably is the
least likely to be selected because its reliance on
invoices to determine the taxes owed adds to the
complexity and administration costs of such a sys-
tem. Under this option, the tax is calculated on the
value shown on the invoices of a business's sales of
goods and services. To avoid double taxation of
inputs included in the final value of the good or
service being taxed, a credit is given for the tax shown
on invoices that the company already has paid. For
exports, a tax rate of zero would be applied and the
taxes paid and recorded on invoices would be fully
deducted. This option is more flexible than the others
in that it allows selected goods to be exempted from
the tax or different tax rates to be set for various
goods and services.
appear receptive to public concerns, but he is likely to
reject major revisions such as the Committee's recom-
mendation of a minimum tax on financial institutions.
The Tories want to present the tax package to Parlia-
ment in December-using their large parliamentary
majority to pass the legislation quickly-and the tight
time frame precludes major changes.
Implementation of the second stage of tax reform is
far less certain. Ottawa would have liked to push
ahead quickly with the national sales tax option, but
the need to negotiate with the provinces-because it
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cannot unilaterally replace the provincial tax sys-
tems-and the unpopularity of a tax on food have
forced the government to move more cautiously.
Negotiations with the provinces promise to be compli-
cated as the various governments try to merge provin-
cial tax rates ranging from 0 to 12 percent into a more
uniform system. ' In mid-July, federal and provincial
officials agreed on a list of issues that had to be
discussed before a national sales tax could be imple-
mented. One thorny problem will be agreement on a
uniform list of taxable goods. Each province has
certain goods that it would like exempted-most
would hesitate to tax food, for example-and several,
particularly Quebec, have reservations about losing
their provincial tax autonomy. 2 Another potential
roadblock is the sharing of revenues from taxes
collected on financial services and interprovincial
transportation where it is not clear in which province
the service is sold. In order to succeed, Ottawa must
prevent negotiations over these tax revenues from
degenerating into a battle between the well-endowed
central provinces and economically depressed Atlantic
and Western Canada. On balance, we believe
Mulroney can win provincial support for the national
After winning the support of the provincial leaders,
Ottawa will face an even more difficult challenge in
convincing voters of the benefits of the new sales tax.
Mulroney knew the tax would be tough to sell; a poll
commissioned by the Tories last March showed only
7 percent of the public favored a new sales tax,
particularly one that taxed food. Negative public
sentiment has already forced Ottawa to postpone
introducing the new tax until after the next election,
the tax until after the next election endangers its
implementation because neither of the two opposition
parties-which are currently thrashing the Tories in
the polls-is inclined to implement such a tax if-as
seems likely-the Tories are ousted from power.
We suspect that even a reelected Mulroney govern-
ment would bow to public pressure and decide against
including food in the new sales tax. The Tories'
reputation as the party of the rich will undermine
their argument that the promised refundable sales tax
credit for low-income families will correct the regres-
sivity of the system. Many Canadians also fear that
sales tax reform is just a grab for more revenues since
a relatively small increase in the new tax would
generate a great increase in income for the govern-
ment. Therefore, to minimize the public outcry, we
believe Ottawa will be careful to start with a relative-
ly low sales tax rate.
Impact on the Tax System
Many Canadian economists and financial analysts
have applauded the reform package for taking steps to
lessen the distortionary effect of the tax system on
consumption and investment decisionmaking, but they
lament that the reform package is not as bold as is
needed to correct all the problems with the system.
Lower personal and corporate tax rates, for example,
probably will restore Canada's tax competitiveness
with the United States and enhance Ottawa's ability
to accurately estimate tax revenues by making tax
evasion less attractive. Tax reform will be less effec-
tive, however, in shifting the tax burden onto corpora-
tions, in simplifying the tax code, or in making the
personal income tax system more equitable.
and the two opposition parties undoubtedly will add to ' Analysis of the impact of the reform package on the tax system
the pressure on the government by reminding the and on the economy is difficult as a result of its two-stage
implementation and the uncertain form and timing of the new sales
public of past Tory tax hikes. Moreover, postponing tax. For purposes of this paper we assume that the first stage
reform proposals are accepted and implemented as scheduled. In
Alberta, which levies no retail sales tax, has rejected the national addition, we assume that the Tories will pass a new broadly based
sales tax option, but Ottawa believes a national tax can be flexible national sales tax of about 9 percent-exempting food for political
enough to allow some of the provinces to opt out if necessary. reasons-in late 1990 or early 1991.
' Under a national sales tax, a province could not unilaterally add or
exempt goods from the tax, although one could alter its portion of
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Making the System Fairer. Although low-income
taxpayers will face a lighter tax burden, lowering
marginal tax rates across the board gives a propor-
tionally larger benefit to high-income earners. The
parliamentary Finance Committee's major criticism
of the tax package is that it places an unfair burden
on middle-income families. Moreover, we believe the
greater progressivity introduced into the personal
income tax system by the switch from deductions to
tax credits will be offset if the regressive sales tax is
introduced in the second stage of reform. Implemen-
tation of the sales tax would hit low-income Canadi-
ans hardest even if-as is likely-it exempts food. In
fact, without a tax on food, we would expect Ottawa
to greatly reduce the planned refundable sales tax
credit, arguing that there is less need for one and less
revenue available to fund it. Moreover, exempting
food is likely to force the government to adopt a
higher tax rate, further increasing the regressiveness
of the sales tax.
We believe, however, that the changes to corporate
income taxes will make the system more equitable by
reducing the variability of corporate tax burdens
across industries and capital assets. At present, the
effective tax rate applied to business income ranges
from 15 percent in mining to 24.5 percent for the
wholesale sector. By eliminating many deductions, the
reform package will reduce the variation in effective
tax rates to between 15.5 percent and 22.6 percent.
The reform package will also reduce the disparity
among the various sectors in the percent of income
that is taxable. Finally, tax reform will smooth out tax
treatment of different capital investments strategies.
Shifting the Tax Burden. Our analysis of the tax bill
suggests that Wilson is wrong in claiming that he is
shifting a significant portion of the tax burden to
corporations. Under the first stage of reform, the
personal income tax share of total tax revenue drops
from 65 to 63 percent by 1991, while the corporate
income tax share increases just 1.6 percentage points
to 17.2 percent. The personal income tax burden
would drop further if, as Wilson argues, the new sales
tax allows future reductions in tax rates. In our
opinion, however, the likelihood that the new sales tax
will exempt food and the need to reduce the budget
deficit will prevent another cut in income tax rates.
Wilson is likely to find it politically expedient to
reduce the deficit by maintaining tax rates rather
than by other possible measures such as cutting
expenditures for popular social programs or by reduc-
ing aid to farmers.
Restoring Tax Rate Competitiveness. The new tax
system, in our view, will bring personal tax rates close
enough to US levels to prevent an exodus of people
and investment from Canada. Although the top com-
bined federal/provincial personal income tax rate will
be about 3 percentage points higher than in even the
more heavily taxed US states, this will be partially
offset by the fact that many of the deductions elimi-
nated by the United States were kept as tax credits by
Ottawa. Moreover, Canadians historically have ac-
cepted higher rates to support more generous social
programs.
We believe that corporate rates also will be low
enough to stem any outflow of capital caused by US
tax reform. Under the new system, Canada's federal
corporate tax rate will fall below the federal tax rate
in the United States, but the combined federal/
provincial tax rate will remain at least 2 percentage
points higher than the combined federal/state rate in
the bordering US states. Wilson is putting pressure on
the provinces to join Ottawa in lowering tax rates, and
we believe the two most heavily industrialized prov-
inces, Ontario and Quebec, will comply. With lower
provincial rates and the slightly more generous deduc-
tions maintained by Ottawa, Canadian companies
probably will enjoy a slight advantage over those in
the United States. The preferential tax rates granted
to small businesses and manufacturers will allow
these companies a substantial tax advantage over
their US competitors.
Improving Revenue Estimates. The new tax package
will enhance the government's ability to accurately
estimate tax revenues. Lower rates will discourage tax
evasion and delinquent payments, while fewer deduc-
tions and stronger antiavoidance measures will broad-
en the tax base and reduce the variability in tax
collections. The sales tax, after it comes into effect,
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Table 1
Budget Deficits Under the Tory Government
Deficit (billion US $) 28.7 25.8
Deficit (percent of GDP)
a Estimate.
b Projections included in tax reform white paper.
86/87
87/88 a
88/89 b
89/90 b
90/91 b
91/92 b
23.3
22.0
21.7
21.5
19.6
17.6
6.1
5.4
5.0
4.7
4.0
3.4
also will provide Ottawa with greater potential to
raise revenues. Although Wilson insists the initial
reform package will be revenue neutral, the govern-
ment could raise much revenue with only small hikes
in the sales tax, and it may be difficult for future
governments to resist this lucrative source of funds as
they struggle to reduce the budget deficit.
Negative Impact on Deficit Reduction
We believe the prospects for continued deficit reduc-
tion will worsen as the government moves to change
the tax system. The Mulroney government has
reduced the federal deficit by an average $2.7 billion
per year since taking office in 1984, but Wilson
himself estimates that the average annual decrease in
the budget deficit will slow to $1.1 billion after the
reform is implemented (see table 1). We believe,
moreover, that much of this improvement will be
illusory. Wilson manages to keep next year's target at
$22.0 billion only through extensive cash flow maneu-
vering, such as accelerating the collection of some
taxes from corporations. In addition, although lower
personal income tax rates take effect in January, the
government will continue withholding taxes at the
higher, old rate until July, thus taking in $1.4 billion
in additional revenues in 1987/88. These withheld
revenues must then be refunded to the taxpayer the
following spring, thereby preventing any large decline
in the deficit in 1988/89. The key to further deficit
reduction, therefore, is the new sales tax, but delays in
its introduction and the likely exemption of food will
almost certainly erode the ability of the government to
meet its deficit targets in the next decade.
Although the Tories have won credit for their past
fiscal performance, the likelihood that Ottawa will
further delay or back away from the sales tax threat-
ens to undermine this hard-won reputation for fiscal
responsibility. Important representatives of the busi-
ness community have expressed concern, for example,
that the pace of deficit reduction is too slow and that
Ottawa is making overly optimistic assumptions about
growth, interest rates, and inflation in forecasting its
deficit targets. Slower deficit reduction, in our view,
will discourage private-sector investment by eroding
investor confidence in Ottawa's management of the
economy. A high deficit-and more particularly the
need to finance the growing public debt-also reduces
the government's ability to shift spending priorities in
response to changing economic conditions. Further-
more, the Canadian dollar's strength earlier this year
derived largely from the fact that Canada reduced its
budget deficit as a proportion of GDP more than the
United States. Less fiscal restraint would renew
downward pressure on the Canadian dollar.
Meager Economic Benefits
Ottawa is selling its tax reform proposal as a means of
enhancing growth, but the overall package as it is
likely to be implemented probably is not far reaching
enough to give more than a modest boost to the
economy. The effects will almost certainly be mixed.
Initial changes to the income tax system-particular-
ly the reduced investment incentives-are likely to
slow slightly the real level of economic activity. The
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boost to growth from the first stage of reforms will
come through the less tangible mechanisms of labor
supply responses and the increase in the quality of the
capital stock. The later replacement of the manufac-
turers' sales tax with a more broadly based national
sales tax, however, probably will create a small upturn
by removing many distortions that now influence
consumer and corporate decisionmaking.
Growth Prospects. The initial changes in the personal
and corporate income tax systems will have some
positive implications for growth. For example, lower
personal tax rates will increase net take-home pay,
putting $8.3 billion back in consumers' pockets over
the next five years; this in turn is expected to increase
both consumer spending and savings. Moreover, con-
sumer spending should increase further in 1989 when
tax payers receive large refunds as a result of
Ottawa's budgetary cash flow manipulations. Im-
provement in economic efficiency resulting from re-
moving distortions from the corporate tax system will
also enhance growth, especially over the longer term.
In particular, the variability of tax burdens across
industries and capital assets will be reduced (see
appendix). After reform, we believe businesses will
gradually base their decisions more on economic
fundamentals and less on tax considerations, thus
improving the quality of capital stock.
The prognosis for growth will improve somewhat if
the new sales tax is implemented, because consumer
and corporate choices will be much more efficient.
The present manufacturers' sales tax, applied at
varying rates to a limited number of goods, is riddled
with illogical exemptions that distort relative prices.
By removing these distortions, the new sales tax would
reduce the costs of capital investment, strengthen
Canada's competitive position, and provide additional
flexibility to fight the budget deficit.
Employment. We believe the expected increase in
consumer spending resulting after the implementation
of the first stage of the tax package will boost demand
and encourage companies to hire more workers, lead-
ing to an additional drop in the unemployment rate of
between 0.1 and 0.2 percent by 1991. Much of the
expansion will come because labor-intensive industries
will benefit most from tax reform; Wilson plans to
eliminate several tax exemptions that bias the system
in favor of capital investment. In addition, the
Mulroney government hopes that higher take-home
pay will be an added incentive to work. In our
judgment, however, the higher pay is unlikely to make
much difference to many of Canada's unemployed-
now about 9 percent of the population-many of
whom live in outlying regions with structural employ-
ment problems and who also enjoy substantial unem-
ployment benefits.
We believe, however, that other aspects of the first-
stage reforms will negate these potential benefits, and Ejects on Trade. The first stage of tax reform is
the tax package will cause a slight decline in the real likely to cause a moderate deterioration in Canada's
level of activity over the next few years. Although trade balance. Increased consumer spending is likely
corporate tax rates will be lower, the average Canadi- to boost imports, although this will be partially offset
an company probably will pay more tax because of the by a decline in demand for investment-related im-
reduction in writeoffs. In addition, the higher tax bill ports. We expect a modest decline in Canada's export
is likely to have a dampening effect on business competitiveness. Canada already suffers from low
investment largely because we expect that by 1991 the labor productivity compared to many of its major
tax reform measures will chop $2.5 billion annually trading partners, and faces higher capital costs, both
from corporate profits. Moreover, higher interest rates of which are likely to be exacerbated by the reduction
resulting from a slowdown in deficit reduction would of depreciation allowances and removal of investment
further discourage investment activity. Businesses un- deductions in the tax reform package.
doubtedly will try to shift some of their higher tax
burden to consumers through higher prices, which We believe the eventual implementation of the new
would reduce the overall benefits of the anticipated sales tax would more than counteract this negative
increase in take-home pay. The temporary hikes in the effect on the trade balance. Countries that rely heavi-
present manufacturers' tax also cancel out much of ly on indirect taxes such as a sales tax enjoy a trading
the increase in take-home pay. advantage because the GATT allows indirect taxes to
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be deducted from an exported good's value, while
disallowing a similar adjustment for direct taxes.
More important, when the sales tax is introduced, an
existing bias against domestically produced goods will
be eliminated. The manufacturers' sales tax currently
taxes Canadian-made goods at a rate one-third higher
than imports. The temporary changes to the manufac-
turers' tax that switch the collection point of the tax
from the manufacturer to the wholesaler will help
reduce this discrepancy somewhat, but the full bene-
fits will not be felt until the VAT is adopted and
businesses are no longer taxed on their inputs to
production. Canada's international competitiveness
will be improved by the removal of the cascading
effects of the present tax system.
Inflation Prospects. Despite these advantages, howev-
er, we believe that the reform package will increase
the price level. The interim increase in the manufac-
turers' tax and attempts by business to shift their
higher tax burden to the consumer through higher
prices will cause a one-time rise in the consumer price
index of about 0.5 percentage points in 1988. An even
greater rise will result from the new sales tax. In our
view, the resulting expansion of the tax base will
greatly outweigh the lowering of the overall sales tax
rate, and this will create a strong upward pressure on
prices. Technical factors also will reinforce this trend;
the Consumer Price Index, as calculated in Canada, is
weighted toward services, which will be taxed much
more heavily. Overall, we expect that the rise in
consumer prices will be between 1.5 and 2.0 percent-
large enough to boost wage demands despite the
higher take-home pay provided by the cut in income
tax rates, and this will add further to inflationary
Political Impact
The Tories hope to use tax reform-along with the
new constitutional accord and the free trade agree-
ment-to increase their standings in the polls. The tax
package is clearly designed to boost Tory support in
the next election, but it falls far short of the sweeping
reforms that a more politically popular and less
fumbling government might have implemented. The
government's political design can be seen in the
benefits it provides for key interest groups, particular-
ly the lower taxes for most Canadians and postpone-
ment of new taxes until after the election. Lowering
income tax rates in January, but postponing the
reduced withholding taxes until July, also gives the
Tories more options in timing the election. An election
could be held in the fall of 1988, after paychecks
begin to show the benefits of lower taxes, or in the late
spring of 1989 after most voters have received their
large refunds. In our opinion, however, voters' memo-
ries probably will not be so short, nor their outlook so
shortsighted, as to completely dismiss the prospect of
higher sales taxes after an election.
Mulroney's efforts to revive his diminished political
support will backfire if tax reform is not handled
carefully. Tax reform is a very touchy issue in Cana-
da; in the 1960s and again in 1981 Ottawa was forced
to back away from proposed reforms because of public
dissatisfaction. We believe the government will perse-
vere with the bulk of this package, although it will
accept some of the Finance Committee's recommen-
dations to demonstrate some flexibility to the public.
Lower income tax rates, however, probably will not
alter the perception of many voters that the Tories
tend to favor the rich. Although Wilson is one of the
few well-respected Conservative Cabinet ministers, he
will probably be undermined by the fact that hefty tax
hikes in previous budgets have largely hit the lower
and middle classes. Memory of this has made voters
skeptical of promises that most Canadians will pay
less tax once both stages of the reform are complete.
The opposition parties will almost certainly try to
focus the debate on the Tories' overall tax record,
arguing that the tax reform package does not negate
past Tory tax hikes and that the average Canadian is
not as well off as when the Conservatives took office
in 1984. In the face of such arguments, we doubt that
the Tories will achieve enough of a popular success to
alter significantly their reelection prospects, and any
political benefits from tax reform probably would be
overshadowed by the contentious debate over the
recently signed free trade agreement with the United
Implications for the United States
Although the Canadian tax package is similar to US
reforms introduced last year, some aspects of the
proposal have the potential to increase friction be-
tween the two countries. Wilson probably has suffi-
ciently narrowed the gap between US and Canadian
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tax rates to stem any outflow of investment set off by
US reform last year, but some multinational firms are
likely to continue to adjust their investments as a
result of changes in the tax code. Bilateral disputes
would probably arise if Ottawa applied the stricter
antiavoidance measures included in the tax package
to US firms that it believed had chosen particular
investment plans solely to avoid taxes. In particular,
the new measures greatly enhance the federal govern-
ment's ability to declare business activities-includ-
ing cross-border activities such as transfer pricing-to
be tax avoidance.
The likelihood of a continued high Canadian budget
deficit resulting from the tax changes would also
increase bilateral tensions in several ways:
? It would lead to higher interest rates and raise
questions about Canada's economic soundness,
which, in turn, probably would create downward
pressure on the Canadian dollar.
? It would inhibit the government's ability to use
fiscal policy to stimulate economic growth or en-
courage development of key sectors. In such circum-
stances in the past, Ottawa has often lashed out at
the United States, blaming the dominating economy
of its southern neighbor for Canada's economic ills
and taking out its frustrations by becoming more
nationalistic in trade and investment dealings.
? It would call into question Ottawa's ability to fund
planned increases in defense, spending.
the new sales tax.
Another potential irritant might arise from Ottawa's
discussions with the provinces on the national sales
tax this fall. Although it is unlikely that the provinces
would hold a free trade agreement with the US
hostage to concessions from Ottawa on the sales tax,
heightened federal-provincial bickering over the form
of the new sales tax could create resentments that
would undermine federal-provincial cooperation on
the implementing legislation needed for the free trade
agreement. Regional tensions are already rising be-
cause of the trade accord, and Ottawa will have to
tread lightly so as not to exacerbate the problem with
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Appendix
Canada's Winners and Losers:
Impact of Tax Reform on
Various Sectors of the Economy
Table A-1
Average Effective Tax Rates
Average Tax
Rate
Percent of
Income
Taxed
Average Tax
Rate
Percent of
Income
Taxed
Construction
20.1
96.1
18.8
102.4
Wholesale trade
24.5
94.7
22.6
101.0
Retail trade
21.2
98.9
19.5
103.8
Financial institutions, insurance, real estate
14.5
48.7
21.3
74.0
This table, based on information released with
Wilson's tax proposals, provides data on the average
effective tax rates applied to various sectors of the
economy both before and after the proposed changes
to the corporate income tax system. This data illus-
trates how the proposed changes will narrow the
disparity among effective tax rates in the different
sectors. The data also allows us to assess the impact of
tax reform on different industries to determine which
will benefit from the reform proposals and which are
subject to less favorable tax treatment after reform.
Ottawa proposes to reduce the variability of tax rates
among sectors of the economy by removing deduc-
tions, exemptions, and incentives that caused the
widely varying rates. Under reform, the average
effective federal corporate tax rate will rise by about
1 percentage point to 19.6 percent, but several sectors
that have escaped taxation in the past will see their
effective rates rise by much more than the average.
There undoubtedly will be shifts in investment result-
ing from the new tax rules, but we do not anticipate
massive disinvestments from those industries hardest
hit. The service sector, for example, anticipated mea-
sures requiring it to bear more of the tax burden, and
reportedly is relieved that the reform package is not as
Winners under reform will be mainly those sectors
that presently cannot take advantage of exemptions. 25X1
They range from the agriculture, forestry, and fisher-
ies sectors, who already enjoy the lowest effective tax
rates, and retail and wholesale traders, who are
among the most highly taxed. Because most of the
income of these industries is already taxable, they
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benefit most from the lower overall rates. Other
winners are industries where deductions and incen-
tives have been retained. Although the oil and gas
industry loses some of its preferential treatment for
flow-through shares, it retains resource allowances
and deductions for exploration, research, and develop-
ment. Since the cut in tax rates more than makes up
for the loss of deductions, the effective tax rate for the
industry will drop slightly. The tax package also
favors labor-intensive industries.
The biggest losers are companies in the financial
services sector, which currently are subject to the
lowest effective tax rates. Most of the deductions
eliminated under the reform applied to financial
services. The reform package clamps down, for exam-
ple, on tax-free dividends on preferred shares and the
way banks treat loan-loss expenses, thus greatly in-
creasing the taxable income of financial institutions.
Insurance and real estate companies also face sharply
reduced deductions. Although the mining industry
retains much of its preferential treatment, this will be
offset by cutting the earned depletion allowance to
100 percent rather than 130 percent of the amount
actually spent on exploration and development. The
average tax rate on manufacturing probably will rise
slightly because of the proposed limitations on depre-
ciation allowances. Nonetheless, manufacturers will
still enjoy a preferential tax rate, and will benefit
more when the sales tax is expanded to other sectors
of the economy: not only will their goods be taxed at a
lower rate, but they will also no longer be the only
industry subject to the tax.
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