FINA Committee Report

CHAPTER FOUR — THE PRIORITY OF TAX CHANGES

To encourage business and individuals to invest in building a globally competitive nation, the federal government must eliminate the disincentives created by inefficient and excessive taxes. The better than expected economic outlook should provide the government with the fiscal stimulus and capacity to respond effectively. (Mining Association of Canada, 9 September 2002)

Taxation is primarily a means for governments to raise revenue that can then be used to provide a variety of public goods and services. Taxation is also, however, an important public policy tool in its own right. For example, the design of the tax system can help to bring about a more egalitarian society by taxing individuals according to their ability to pay, so that those who have more pay more. In Canada, the personal income tax system embodies this principle through four different tax brackets with progressively higher marginal tax rates, which are also indexed to inflation. For 2002, the personal income tax rates are:

As well, a taxation system can be structured to encourage or discourage behaviour. Consider, for example, governments’ taxation of so-called “sin products” such as tobacco and alcohol. Earlier this year, the taxation of tobacco products increased by $2 a carton in Quebec, $1.60 in Ontario and $1.50 in the rest of the country, with the tax increase defended by a suggestion that it would curb tobacco consumption while raising an additional $440 million annually in revenue.³⁴ In the course of legislative hearings, the Department of Finance told the Committee that a 1% increase in tobacco costs can be expected to reduce consumption by between 0.4% and 0.7% for the population as a whole and by 1.4% for youth.³⁵

Groups and individuals presented the Committee with numerous proposals for changes to the Income Tax Act, each of which individually appeared to satisfy the Committee’s objectives of improving economic prosperity and/or improving Canadians’ quality of life. While we appreciate the efforts taken to develop policy proposals that meet our stated objectives, we must also be wary of increasing the complexity of an already complex tax code. As the C.D. Howe Institute indicated to the Committee,

Canadians … , after filling out their difficult-to-comprehend income tax forms this past week, know that the government continues to absorb a large share of their paycheques. Our bloated tax system, with high rates and targeted preferences, continues to be an impenetrable obstacle in improving Canada’s standard of living. Further tax reform is needed if Canada is going to reverse the slide in our standard of living relative to other growing economies, including the United States.

In trying to decide whether to recommend a particular tax policy change, the Committee must also consider the proposal’s potential revenue impact. While many witnesses presented evidence that their proposals would have little or no impact on government revenue in the long run,³⁶ we are also mindful of our long-standing recommendation — and the desire expressed by many groups and individuals — that the government avoid deficits, reduce the national debt and ensure the integrity of our social programs.

As indicated earlier in the report, incurring a budget deficit today in order to implement a tax cut that may generate additional revenues — or generate revenues of an unknown amount — tomorrow is not an option. The Committee is also concerned that the impact analyses of some of the proposals presented to us were “static” in nature: while a small tax change in part of the Income Tax Act might, by itself, have a relatively small effect on revenue, there is a risk that this same tax change — when combined with other proposals — could have a much greater effect and unintended consequences.

Consequently, the Committee must choose judiciously when considering tax policy changes, and recommend those that not only provide the biggest benefit in terms of economic prosperity but that are also consistent with the commitment to, at a minimum, a balanced budget. All proposals presented to us by witnesses were considered, even though they may not have been adopted as recommendations. In the end, our recommendations reflect the advice of the C.D. Howe Institute, which told us that while major reforms to the tax code may be needed, we should begin by concentrating on the reduction of corporate taxes and on recommending policies that encourage citizens to save for their retirement.

Personal Income Taxes

Our marginal tax rates on mobile factors — physical, financial, and human — must be competitive with those south of the border. In the 2000 budget and in the 2000 economic statement, we made important progress, but it’s still the case that the top combined, federal plus provincial, marginal tax rates for personal income taxation are too high vis-à-vis the U.S. rates. High marginal tax rates are one of the factors that can fuel the brain drain. (Dr. Thomas J. Courchene, 30 April 2002)

While the Goods and Services Tax accounts for an ever-increasing portion of government revenue (14% in 2001-02), personal income tax still generates almost one-half of federal revenues (48.3% in 2001-02). The Committee heard from a number of groups and individuals that lowering the income tax rates might help Canada to retain — and lure back — some of its most skilled workers, thereby enhancing the country’s productivity and economic prosperity.

There was a general sense that Canada cannot afford to allow its income tax rates to diverge too much from those of the United States. The Toronto Board of Trade, for example, told the Committee that “we don’t have to be first in the race for competitive taxes, but we need to be in the race, and we need to be competitive. The package that attracts investment here is not necessarily just one regime or the other.”

Le Conseil du patronat du Québec told the Committee that Canada should strive to gradually lower its personal income tax rates to the G-7 average, paying particular attention to the highest marginal tax rate, which affects the most skilled and most mobile workers. The Committee feels that the federal government should pay particular attention to its tax competitiveness with the United States, where the top marginal rate begins at US$307,050 for married individuals filing joint returns and for unmarried individuals, and at US$153,525 for married individuals filing separate returns. The Canadian Professional Sales Association recommended that the federal government reduce its top marginal rate to 27% from 29%. Finally, Canadian Federation of Independent Business surveys of its members consistently place personal income tax reductions at the top of their list of federal tax priorities.³⁷

That being said, when asked to choose their most desired tax policy change, most witnesses identified other priorities. Some felt that while Canada may be unable to match the United States in terms of personal income taxes, it could be more competitive in its corporate taxation and in its payroll tax system. A number of witnesses expressed the sentiment that higher marginal tax rates, relative to the United States, may be the price that Canadians have to pay in order to both maintain their social programs and be competitive in terms of corporate taxes.

The Committee believes that the federal government must continue to implement planned changes to the tax system, which should be fully phased in by 2004-05. Moreover, we feel that tax reductions generally serve as an economic stimulus, since Canadians will have greater disposable income that can then be spent on more goods and services. Nevertheless, as indicated earlier, we are also of the view that the budget must, at a minimum, be balanced, although surpluses are preferred and should be used to reduce market debt and thereby generate savings in debt-interest costs.

That being the case, the Committee hesitates, at this time, to recommend additional reductions to personal income tax rates. As our fiscal situation improves, however, and as the need for spending on lifelong learning and skills development, research and development, health care, infrastructure, the environment, vulnerable Canadians and other issues of importance to Canadians are met, the government should revisit the issue of reductions in personal income tax rates. Such a review should also occur if the difference between rates in Canada and those in the United States grow, since this divergence could present problems for Canadian employers wishing to recruit and retain workers. It is from this perspective that the Committee recommends that:

RECOMMENDATION 3

The federal government consider further personal income tax rate reductions as a source of economic stimulus and for reasons of competitiveness, as resources permit.

Corporate Taxes

Governments must recognize that their approach to business taxation can attract and maintain businesses just as easily as it can sweep away business investment, job creation and economic growth. (Canadian Bankers Association, 9 September 2002)

Within Canada, the general (federal) corporate tax rate will fall to 21% by 2004 for sectors such as services, but not for sectors such as manufacturing and processing, which are already taxed at the lower 21% rate. The resource sector continues to face a 28% corporate tax rate because, according to the Department of Finance, it “benefits from a number of sector-specific tax measures.”³⁸

Without further changes, Canadian corporate tax rates — including the capital tax — will fall below those of the U.S. by 2003 and will be five percentage points less by 2005, as shown in Figure 14.

Figure 14

               Source: Department of Finance, Budget 2001, p. 173.

While many witnesses expressed support for the federal government’s actions in this regard, they also urged the government to push Canada’s advantage even further, particularly in light of the widespread expectation that Republican Party control in both the U.S. Senate and the House of Representatives will ease passage of President George W. Bush’s tax-cutting agenda and thereby erode Canada’s potential tax advantage.

Data from the National Tax Program at the University of Toronto suggest that a more comprehensive analysis of corporate taxes — including an examination of depreciation rates, the treatment of inventories and other elements of the corporate tax system — shows that Canadian corporate tax rates will actually be much closer to those of the U.S. by 2004 than what has been suggested by the Department of Finance, with less than one percentage point difference.³⁹

A number of witnesses from the resource sector, including the Canadian Association of Petroleum Producers and the Canadian Fertilizer Institute, argued that they should be taxed at the same marginal rate as the rest of the corporate sector for both competitive and equity reasons. This position was supported by the Tax Executives Institute, Inc. Adoption of this recommendation would lower the sector’s tax rate to 23% in 2003-04 and to 21% in 2004-05. It rejects the Department of Finance’s arguments that the sector benefits from special considerations that effectively reduce its corporate tax revenue.⁴⁰ These include the Canadian Exploration Expense (CEE), which allows firms to deduct 100% of their exploration costs, the Canadian Development Expense (CDE), which allows firms to deduct 30% of their exploration costs, and a resource allowance to partially compensate for provincial royalties, which are not deductible.⁴¹

Whatever the merits of these arguments, the potash industry told the Committee that it deserves special treatment because, unlike other firms in the resource sector, it does not benefit from the CDE or the CEE because it has little need for exploration or development of potash sources. In fact, the industry benefits from one of the richest ore bodies in the world, with proven reserves in excess of 100 years. It asked the Committee to recommend both full deductibility of provincial royalties for the potash sector and a reduction in the marginal corporate tax rate in line with other non-resource industries.

Other groups argued that the federal government should accelerate its tax cuts and reduce rates to 21% next year rather than wait until 2004-05. They also recommended that the federal government gradually reduce the general corporate tax rate to 17%, as the fiscal situation permits.

Recommendations were also presented to the Committee about the threshold on small business taxation. Currently, the federal government imposes a 12% marginal rate on the first $200,000 worth of income of Canadian-controlled private corporations, followed by a 21% rate on income between $200,000 and $300,000 and 25% — the general corporate tax rate for 2002 — on income above this amount. The Canadian Hardware and Housewares Manufacturing Association, the Canadian Retail Building Supply Council, the Canadian Retail Hardware Association, the Canadian Automobile Dealers Association and the Canadian Construction Association have proposed increasing the 12% threshold to between $300,000 and $500,000.

The Committee believes that some of the arguments presented by witnesses on the issue of corporate taxation are compelling. In particular, we believe that the Department of Finance must be vigilant in order to ensure that Canadian corporate taxation rates are at least competitive with — if not continuously lower than — those in the United States. This is particularly important in light of the result of the 2002 mid-term elections in the United States. Moreover, we must ensure that business continues to be attracted to, and invest in, Canada. Corporate tax rates are one decision factor in this regard.

The Committee is also sympathetic to the resource sector’s concerns, and especially those of the potash industry, that it is being unfairly taxed. It must, however, balance these concerns with those of environmentalists, who have long argued that prices via taxes should reflect the externalities of the resource sector and, in the case of the potash industry, the need for minimizing the complexity of the Income Tax Act. That being said, we believe that a major review of the tax code should occur, and that the review should address these, and other, concerns. From this perspective, the Committee recommends that:

RECOMMENDATION 4

The Department of Finance report to Parliament annually on the extent to which corporate rates of taxation in Canada are competitive with rates in the G-7 nations, especially the United States.

Capital Taxes

Capital taxes are damaging Canada’s economy. They discourage investment in plant and equipment and technology, which are essential for long-term growth and job creation. … There is no dispute amongst academics, the business community and governments themselves that capital taxes are a bad form of tax. (Association for the Abolition of Capital Taxes, 5 November 2002)

The Committee received testimony from at least 20 groups and individuals, including the Forest Products Association of Canada, the Fraser Institute, Dr. Herbert Grubel, the Canadian Taxpayers Federation, the Canadian Institute of Public and Private Real Estate Companies and the Credit Union Central of Canada, calling for the elimination of, or a reduction in, the capital tax. These groups pointed out that no other major industrial country has a capital tax, and noted the relatively small amount of revenue collected. In 1999, the latest year for which data are available, capital taxes generated about $1.5 billion for the federal government, as shown in Figure 15, and about $3.9 billion for the provinces.⁴² Seven provinces⁴³ levy a general capital tax on corporations, and every province levies a capital tax on financial institutions. The bases for provincial capital taxes differ from the federal base, and the provincial bases differ from one another.

The federal government collects two capital taxes, the Large Corporations Tax (LCT) — which applies to all corporations with capital employed in Canada in excess of $10 million — and the Part VI capital tax on financial institutions. The main difference between the two taxes is that the LCT base includes balance-sheet entries such as equity, reserves and debt plus the net book value of fixed assets (all fixed assets and land used in Canada). Both taxes are reduced by the amount of corporate surtax paid. Life insurers must pay an additional surtax. These taxes act as a minimum tax — rather than an additional tax — that is paid in good times and bad. Surtax incurred in any of the previous three, or subsequent seven, years may also be applied against current year capital tax liabilities.

Recommendations to eliminate the capital tax may have a particular urgency in light of the uncertain economic outlook in the United States, with its possible ramifications for Canada. As many witnesses noted, the capital tax is largely profit insensitive.⁴⁴ In the event of an economic slowdown, some companies could be required to borrow cash to meet their tax obligations, even if they are losing money.

The Committee was presented with studies by Ernst & Young showing that the capital tax disproportionately affects three of Canada’s most important industries: mining and oil and gas, manufacturing, and financial services.⁴⁵ The data indicate that the mining and oil and gas industry contributed about 4.5% of total GDP in 1998 but paid 12.2% of the LCT, while the manufacturing industry accounted for about 18.7% of GDP but contributed 26.5% of the LCT. The disparity was most severe in the financial services industry, which accounted for 5.5% of GDP but paid 21.3% of the LCT in 1998. These three industries also rank amongst the most productive in Canada. The correlation between productivity and the capital tax burden is not surprising, since the capital tax is, by design, meant to target the most capital-intensive industries that also tend to have the highest productivity.

The Saskatchewan Chamber of Commerce recommended that the Committee “eliminate the capital tax, since it was introduced as a deficit-elimination measure, and the deficit is now gone. Capital taxes also are not linked to ability to pay; their elimination will lead to increased investment in capital-intensive operations, enhance productivity and lead to increased economic activity.” The Canadian Council of Chief Executives told us that a “commitment to eliminating the federal capital tax on a phased basis over the next three years would be not only affordable within the current fiscal context but also the single most powerful move this government could make in driving innovation, productivity and economic growth.”

The Committee supports the elimination of the capital tax. As noted earlier, many witnesses told us that the elimination of the capital tax is the single most important tax change that we could recommend that would respect the government’s commitment to debt reduction, balanced budgets and effective social programs. While some suggested that the tax be phased out over a number of years, we believe that more rapid change is needed. Consequently, the Committee recommends that:

RECOMMENDATION 5

The federal government eliminate the capital tax in the next federal budget.

Tax-assisted Savings Plans

Registered Retirement Saving Plans (RRSPs) are not a “program for the rich.” A variety of middle-income salaried employees are adversely affected, such as nurses, plumbers, police officers, sales managers and school administrators. Moreover, RRSPs play a vital role for over 2.4 million self-employed Canadians who must plan their own retirement without the luxury of a company-assisted pension plan. (Canadian Real Estate Association, 9 September 2002)

Source: National Accounts.

As shown in Figure 16, in 2001 Canadians saved, on average, 4.6% of their disposable income, down from 9.2% in 1995, suggesting that Canadians may not be as actively saving for their future as might be hoped. Low savings rates also have consequences for interest rates and investment: generally speaking, increased savings are believed to lead to lower interest rates which, in turn, can lead firms to increase their investments.

In 2000, the federal government took steps to encourage saving behaviour among Canadians by reducing the capital gains inclusion rate — the portion of capital gains that is taxable — to 50% from 75%. At that time, the government also committed to increasing Registered Pension Plan (RPP) limits to $14,500 in 2003 and Registered Retirement Savings Plan (RRSP) limits to a similar amount in 2004. Thereafter, the limit will rise to $15,500 for RPPs in 2004 and $15,500 for RRSPs in 2005, after which limits will rise with inflation. The current limit of $13,500 or 18% of income, whichever is less, has been unchanged since 1996, when it was lowered from $14,500 as part of the government’s effort to eliminate the deficit.⁴⁶

For most witnesses who commented on this issue — including the Association of Canadian Pension Management, the Canadian Teachers Federation, the Direct Sellers Association of Canada, the Investment Dealers Association of Canada, the Investment Funds Institute of Canada and the Retirement Income Coalition — the planned contribution limit increases are not sufficient. In their view, contribution limits have been frozen for too long and must be increased more quickly to compensate for inflationary increases and to remain competitive with the United States. Higher contribution limits are especially important for self-employed individuals and small businesses. In the former case, they are both the employer and employee in some sense, and do not benefit from employer-sponsored pension plans. In the latter situation, few small businesses offer Registered Pension Plans. Ultimately, providing incentives for individuals to save for their own retirement should relieve part of the burden on government support programs.

Increasing individual incentives to save for retirement would not necessarily entail a large long-term fiscal cost for the federal government: the monies saved today will be taxed tomorrow when citizens begin to retire and withdraw funds from their tax-sheltered investments. Government tax revenues should, therefore, rise as the baby-boomer population reaches retirement and withdraws funds from its retirement plans. These increased tax revenues will be collected at the same time as this population increases its requirements of the healthcare system.

As the Canadian Life and Health Insurance Association Inc. noted in its appearance before the Committee, “not only do low RRSP and RPP contribution limits make employment in Canada less attractive, but they ultimately reduce the tax revenue available to federal and provincial governments when such plans enter their payout stage. Given that health care costs rise dramatically throughout our retirement years, that is precisely when governments will need to maximize their tax base. Income withdrawn from enhanced private retirement savings vehicles …  would provide critical tax revenue at that time to match the anticipated tax expenditures necessary to provide the quality of life that Canadians expect.”

The Committee heard a wide range of recommendations on how to change tax incentives for savings, although their essence was an increase in the annual contribution amount. Several organizations recommended that the 18% contribution rate apply to the highest tax bracket — that is, $103,000 in 2002 — which would mean a maximum contribution of $18,540. Witnesses such as Wayne Burroughs recommended that the federal government increase the contribution limit to $15,500 immediately to better reflect the “implicit limit” for employer-sponsored pension plans.⁴⁷ Several groups requested immediate indexation of the contribution limit to inflation, rather than waiting until 2005, while Kebrom Haimanot discussed the foreign content limit.

The Committee believes that Canadians should be given appropriate incentives to save for their retirement. While these incentives would involve a short-term cost to the federal government, there would be long-term benefits in terms of a more limited burden on federal retirement programs. Moreover, revenues will be gained when the retirement funds are taxed as they are withdrawn. We also note that increasing the contribution limit could also help Canada attract and retain workers. As the Investment Fund Institute of Canada observed in its appearance before us, “raising the RRSP limits would accomplish two objectives: First, it would provide Canadian workers, at all income levels, with more flexibility in planning for their retirement. … Second, it would bring Canada in line with other countries that are competing with us for skilled talent. For example, in the U.K. the contribution limit to their savings plan amounts to the equivalent of $45,000 annually.” The Committee feels that an increase in RPP and RRSP contribution limits is overdue and, therefore, recommends that:

RECOMMENDATION 6

The federal government, in the next budget, raise Registered Retirement Savings Plan and Registered Pension Plan contribution limits to $19,000 in order to allow those in the top income tax bracket to shelter 18% of earnings. Moreover, contribution limits should be raised in accordance with the inflation rate beginning immediately.

Another important aspect of the federal government’s efforts to encourage savings is the Registered Education Savings Plan (RESP), which allows parents to invest up to $4,000 per year for their children’s post-secondary education up to a lifetime maximum of $42,000. In 1998, the government introduced the Canada Education Savings Grant, which contributes 20% of the first $2,000 invested — that is, $400 annually — in an RESP.

While the Committee heard unanimous support for both programs, some witnesses shared concerns that they do not provide enough assistance to low- and middle-income families. The Canadian Association of Not-for-Profit RESP dealers shared with us its three-pronged proposal to address this concern:

The Committee believes that the proposal of the Canadian Association of Not-for-Profit RESP dealers has merit, and would contribute to the goal of ensuring equal access to higher education. It is from this perspective that the Committee recommends that:

RECOMMENDATION 7

The federal government increase the Canada Education Savings Grant contribution for low- and middle-income families to 30% of the first $1,000 contributed annually to a Registered Education Savings Plan. Moreover, the Income Tax Act should be amended to permit the provinces and territories to set up contribution programs similar to the Canada Education Savings Grant. Finally, the government should amend the Bankruptcy Act to provide protection for Registered Education Savings Plan funds.

Employment Insurance Issues

EI should not run a surplus “well in excess of any reasonable reserve.” The current employee premium should therefore be reduced to $2.00 per $100. (Canadian Construction Association, 6 June 2002)

A number of the Committee’s witnesses presented proposals to reduce employment insurance (EI) premiums from the current rate of $2.20 per $100 of insurable earnings. This rate is down from a peak of $3.07 in 1994. The portion paid by employers is 1.4 times the employee rate. Even at this relatively low rate, the federal government recorded an EI account surplus of $3.9 billion in 2001-02 and expects a surplus of $2.3 billion in 2002-03. While revenue from employment insurance premiums are part of general government revenue — a change recommended by the Auditor General of Canada and in effect since 1986 — the notional employment insurance “surplus” in 2002-03 is expected to total $42.3 billion by the end of 2002-03. Figure 17 provides details of premium rate changes and the size of the cumulative surplus over the 1987-2001 period.

Source: Human Resources Development Canada.

Although the federal government has not explicitly committed to a further reduction in the EI premium rate, the budget estimates in the Economic and Fiscal Update 2002 assume that rates will fall to $2.00 by 2004.⁴⁸ Moreover, Human Resources Development Canada notes, in Part III of its Report on Plans and Priorities, that “for planning purposes, a premium rate at 2.1% (i.e., $2.10) is used to forecast premiums for the first three months of 2003.”

The Committee is sympathetic to the view of many witnesses that EI premium rates should not generate surpluses of the magnitude currently being realized, and that EI premium payments can limit employment growth, and hence economic prosperity, by raising the cost of hiring new workers. Moreover, we feel that the public consultation process on the setting of the EI premium rate — which is to be led by the Department of Finance — should begin immediately, since there has been an expectation for more than 18 months that a discussion paper would be forthcoming and that consultations would then occur. As well, we are mindful of the Department of Finance budget estimates that include a reduced premium rate. It is for these reasons that the Committee recommends that:

RECOMMENDATION 8

The federal government reduce the Employment Insurance premium rate. Moreover, the government should immediately commence a public consultation process regarding the setting of the premium rate, with additional rate reductions considered in accordance with the new premium rate-setting process following the consultation process. The rate should be set to ensure, to the extent possible, sufficient revenues to cover program costs and fund an appropriate reserve that would enable relative stability in the rate over the business cycle.

The Committee heard several other proposals designed to reduce the gap between EI revenues and expenditures. The Canadian Labour Congress, for example, recommended to the Committee that the federal government “[b]uild into the EI program a training relief component, whereby contributors could accumulate five weeks worth of training leave for each year of contribution to the system, up to a maximum of 50 weeks. Such a program would have the merit of portability and of creating an incentive for workers to get retrained.”

Other labour groups — such as the Canadian Office of the Building and Construction Trades Department — recommended instead that EI benefits be made more generous. The Confédération des syndicats nationaux (CSN) recommended “increases in the coverage rate, the replacement rate and the benefit period” for EI. In its view, “the employment insurance system constitutes an important strand in the social safety net that protects Canadians from poverty or economic insecurity. That is why, in the CSN’s opinion, Canadians want a progressive return to a balance between the employment insurance plan’s revenues and its expenditures by raising expenditures to reflect the plan’s current revenues rather than the other way around, as suggested by the five-year debt-reduction plan.”

Many employers had a somewhat different view. The Canadian Construction Association, for example, recommended that employers pay the same premium as employees, a position supported by the Tourism Industry Association of Canada and the Vancouver Board of Trade.

Another proposal focussed on the creation of a yearly basic exemption (YBE) for EI, similar to that which exists in the Canada and Quebec Pension Plans. A YBE would exempt employers and employees from paying EI premiums on part of an employee’s income, and would primarily benefit labour-intensive sectors of the economy that employ immigrants, students and part-time workers. The Canadian Restaurant and Food Services Association has been a main proponent of this view, believing that such a change would increase both the disposable income of Canadians with the greatest propensity to spend, and the ability of labour-intensive business to retain staff. It has proposed to the Committee that a YBE of $3,000 be established. At current premium rates of $2.20 per $100 of insurable earnings, the Association has estimated that the cost would be about $2.2 billion annually, slightly less than the expected surplus for 2002-03.

The Committee realizes that the concept of a YBE for the employment insurance program is not new. The House of Commons Standing Committee on Human Resources Development and the Status of Persons with Disabilities supported a $2,000 YBE in its May 2001 report, Beyond Bill C-2: A Review of Other Proposals to Reform Employment Insurance. The report noted that a YBE would “reduce administrative complexity and … ensure that all individuals, not just those who apply for a premium refund by filing an income tax return, are treated equally... . This approach is not only fairer to workers with low earnings, but also to employers who are currently required to pay premiums on behalf of workers who receive a premium refund.”⁴⁹

Selected individuals also support the initiative. For example, Joseph Polito shared with the Committee his view that “[t]he exemption will provide a financial incentive for employers to create a bias to full employment. Employers will save money by reducing hours, not employees, during recessions, and save money by hiring rather than relying on overtime in good times.”

The Committee believes that the idea of a YBE in the context of the EI program has merit. In our view, it would stimulate both consumer spending and employment creation. It is from this perspective that the Committee recommends that:

RECOMMENDATION 9

The federal government amend the Employment Insurance Act to create a yearly basic exemption. The amount of the exemption should be determined following consultation with stakeholders. This change should occur concurrently with a reduction in Employment Insurance premium rates.

Sectoral Issues

The government’s success in setting a strong macroeconomic environment for Canadian business has yielded impressive results. The focus now must be on improving the microeconomic climate and helping our small and medium size enterprises grow and flourish into large, world-leading enterprises. (Certified Management Accountants of Canada, 1 October 2002)

As noted earlier in the report, many witnesses made recommendations for tax policy changes that were specific to their industry or sector. The Committee has considered the full range of representations made to us, and we make recommendations about a number of them.

Capital Cost Allowance Rates

Accelerated capital cost allowances could also be geared towards particular investment activities and could be used to encourage investment in innovation. The accelerated capital cost allowance would also allow companies to defer taxes payable, which would also serve to improve Canada’s comparative tax advantage. (Canadian Vehicle Manufacturers’ Association, 9 September 2002)

The existing schedule of capital cost allowance rates (CCA) — the rate at which a firm can write-down the value of its investment in a piece of machinery or real estate — often does not appear to reflect the actual economic life of the underlying equipment. This result is due largely to rapid technological change, which renders the existing stock of machines and equipment economically obsolete more quickly than in the past. Accelerating CCA rates would have productivity and environmental benefits, since new equipment is generally more productive and more energy efficient.

To remain competitive, companies must constantly re-invest in new computer-based hardware and software, and other capital equipment, since technology becomes obsolete very rapidly. The Canadian Printing Industries Association told the Committee that “according to a recent survey, printers are disposing of computers and peripheral equipment within 24 to 36 months. At [the] present time, it may take more than seven years before a piece of computer equipment is substantially depreciated for tax purposes and even longer for expensive technology devices.” The Certified Management Accountants of Canada emphasized that small businesses, in particular, have fewer resources to replace aging equipment or to invest in new machinery.

The Canadian Association of Railway Suppliers also told the Committee that changing the structure of CCA rates is important for Canadian competitiveness. It said that U.S. railcar and locomotive leasing firms have an important advantage over their Canadian competitors because they can fully write off a railcar in seven years, equivalent to a CCA rate of 30%. The CCA rate for Canadian railcar leasing firms is 13%. Even after 20 years, Canadian rail assets are not fully written off. Given the integrated rail business within North America, this presents a serious competitive disadvantage to Canadian firms. Moreover, we were told by the Railway Association of Canada that “[t]he recent U.S. stimulus package provides a bonus first-year depreciation of 30% for rail assets — this has the effect of widening the gap between Canada and the United States.”

The electricity-generating sector faces similar North American competitive issues, especially with deregulation in Alberta and Ontario as well as a growing gap between demand and supply that has led to sharp price increases. These, in turn, have prompted the use of either price caps or consumer rebates to cushion the blow to consumers. In its presentation to the Committee, the Canadian Electricity Association said that “[h]igher CCA rates are needed to attract the investment capital to upgrade and build new generation and infrastructure capacity. … [T]hese would allow the industry to improve environmental performance, … enhance security and reliability of the overall electricity system, [and] safeguard our competitive advantage in electricity.”

The Committee understands that capital cost allowance rates have the potential to either assist or hinder the global competitiveness of a number of sectors. In a dynamic business environment, we believe that the federal government must do what it can to assist our businesses in maximizing their competitive potential. For this reason, the Committee recommends that:

RECOMMENDATION 10

The federal government, as a priority, undertake a comprehensive review of capital cost allowance rates to ensure that they accurately reflect the pace of technological change, the ever-shortening economic life of many pieces of modern machinery and competitiveness concerns.

Microbreweries

Regional breweries of Europe and [the] U.S.A. have long enjoyed a tax privilege, not allowed in Canada, rendering them more competitive domestically and internationally. Conversely, this privilege is making it hardly possible for Canadian regional breweries to compete outside our country. The financial well-being and required growth of our young industry are seriously threatened as evidenced by the very limited number of regional breweries still doing business in Canada. (Canadian Council of Regional Brewers, 1 November 2002)

Representatives of the microbrewing sector, including the Brewers Association of Canada, told the Committee that excise duties are having an adverse effect on their economic viability, and are contributing to the loss of small regional brewers. Excise taxes represent the single-highest federal tax paid by the industry. We were informed that small Canadian breweries — those with an annual volume of production less 300,000 hectolitres (30 million litres) — require parity with American breweries, which would be achieved through a 60% reduction in the federal $0.28 per litre rate to $0.12 per litre.

The Committee believes that the current excise duties applied to small breweries are limiting their competitiveness, with negative effects on them and the Canadian economy. From this perspective, the Committee recommends that:

RECOMMENDATION 11

The federal government lower the federal excise tax rate applicable to small breweries to achieve parity with rates in the United States.

Air Travellers Security Charge

The Air Travellers Security Charge … is an impediment to the mobility of Canadians and an encumbrance on many businesses that depend on Canadians’ readiness to travel. (Tourism Industry Association of Canada, 7 November 2002)

The Air Travellers Security Charge (ATSC) was introduced in the 2001 budget as part of the federal government’s broader security initiative. The charge, which came into effect on 1 April 2002, is $12 for a one-way trip and $24 for a round trip within Canada. The Department of Finance originally estimated that the charge would generate $430 million in 2002-03 and $445 million per year through to 2006-07, and would be “roughly equivalent to the new air security expenditures.”⁵⁰ Former Minister of Finance Paul Martin promised that the charge would be reviewed in fall 2002, and said that “if revenue from the charge exceeds the cost of enhanced air security, the charge will be lowered.”⁵¹

In November 2002, interested parties were asked to provide the Department of Finance with their views on the Air Travellers Security Charge. In launching the consultation process, the Department noted that “under the Government’s current five-year forecast, which is based on ATSC collections and air traffic data observed to date, revenue from the charge is not expected to exceed the cost of enhanced air security as set out in Budget 2001. As such, there is little scope for reducing the charge at the present time. However, the Government’s change to accrual accounting — possibly as early as Budget 2003 — could provide an opportunity for reducing the charge. Under accrual accounting, the costs to be recovered from the charge through 2006-07 may be lower than those set out in Budget 2001.”⁵² The public consultation process will continue until 31 December 2002.

While the Committee welcomes the consultation process, we must indicate that many witnesses appearing before us rejected the Department of Finance’s criteria for setting the charge, arguing in part that air security affects everyone, as demonstrated by the events of 11 September 2001. They shared the view expressed by Air Canada, the Air Transport Association of Canada, the Association of Canadian Travel Agencies and the Air Line Pilots Association (International), that the costs of enhanced airport security should be financed out of general revenue, rather than by a dedicated tax. Witnesses also argued that the charge is regressive, since its flat-rate structure disproportionately affects low-cost and short-haul carriers and budget travellers.

The Committee was told that some low-cost carriers have reduced their flight schedules. WestJet, for example, indicated that it has cut back on flights between Edmonton and Calgary as well as between Kelowna and Vancouver. It told us that “[i]f this trend continues as we expect it will, more capacity will be taken off our short-haul routes like Calgary-Edmonton, Hamilton-Ottawa, and Kelowna-Vancouver. … A move away from short-haul markets will aid us in operating a financially successful business, but it will cause considerable damage to the communities of the markets that now enjoy short-haul service.” Pacific Coastal Airlines, which operates a charter service for communities on Vancouver Island and the British Columbia coast, informed us that it has had “customers tell us they will no longer be flying between Vancouver and outlying communities with their families because the round-trip charges for security fees exceed the cost of ferry rides, plus fuel for their car.” It also said that no security improvements have been made at the main airports out of which it operates.

Notwithstanding the consultation process that is now underway, the Committee believes that there is a critical need to reconsider the manner in which the Air Travellers Security Charge is applied. During legislative hearings in spring 2002 and again during our pre-budget discussions and consultations, we heard from air carriers and others about the negative effects of the charge on short-haul and low-cost carriers. As well, we feel that it is inequitable that some travellers are charged a fee without receiving any increase in air security. In our view, the charge should be applied in a manner that is neither regressive for passengers nor detrimental for low-cost and short-haul carriers. It is for this reason that the Committee recommends that:

RECOMMENDATION 12

The federal government, in the next budget, consider changes to the size and manner of calculation of the Air Travellers Security Charge. The government should have regard for the consensus reached in the public consultation process and the actual costs of providing air security. Moreover, a mechanism should be established for ongoing review of the manner of calculation and amount of the charge in order to ensure that revenues collected are just sufficient to cover the reasonable costs of air security.

Other Tax Measures

Tax levels are obviously not the only factors that drive decisions on the location of investment but they are important considerations. Canada remains at a disadvantage in attracting and keeping investment because, notwithstanding recent progress, our tax levels remain too high. That means Canada also loses the substantial jobs and other economic benefits that increased foreign investment would provide, together with the multiplier effects those investments would trigger. (CanWest Global Communications Corporation, 9 September 2002)

The Income Tax Act is complex. With the associated regulations, tax treaties and explanatory notes, it exceeds 2,800 pages in length.⁵³ Given its complexity and size, it is not surprising that the Committee heard numerous other narrowly targeted proposals for change to the Act, including those discussed below.

These proposals were generally advocated by a very limited number of groups or individuals. Consequently, while the Committee has elected not to make specific recommendations in these areas, we urge the federal government to consider the following issues, with a view to their implementation where feasible.

One matter concerns Employee Stock Ownership Plans (ESOPs) or, alternatively, Employee Stock Purchase Plans (ESPPs). ESOPs are benefit plans that help employees to acquire shares in the company for which they work, usually with little or no initial expenditure, no salary deduction, no commitment of the employee’s pension funds and no personal liability. The shares are purchased with loans assumed by the company on the employee’s behalf and repaid out of the company’s own contributions.

The ESOP Association of Canada told the Committee that, by giving employees a stake in their own company, share-ownership plans encourage employees to think more like owners, leading to the development of cost-saving and revenue-generating ideas that result in productivity gains. In its view, “ESOPs are win-win, equity-incentive plans geared to helping employees of small and medium Canadian private companies increase their wealth and plan for their futures; and to helping employers attract and retain staff, increase productivity and competitiveness and create succession plans.” We urge the federal government to consider the creation of a 15% tax credit to promote the use of ESOPs. This would match the tax incentive already in place for investments in labour-sponsored venture capital funds.

A second issue, that of duty-free shops, is also familiar to the Committee as a result of prior legislative work. The Association of Canadian Airport Duty-Free Operators urged the Committee to recommend that the federal government “restore the principle of keeping duty-free truly duty free since it first imposed taxes on duty-free shopping (tobacco) on 5 April 2001. This immediately began eroding consumer perceptions of what duty-free is.” The argument was also made that elimination of the tobacco tax would not jeopardize the government’s efforts to reduce tobacco consumption or lead to increased tobacco smuggling because, even prior to the application of the tax, customers could only purchase one carton for convenience purposes. Any purchases above this amount were subject to all duties and taxes. In its view, “[d]uty-free has never been a vehicle for purchasing quantities of tobacco that could be a factor in smuggling.”

The Information Technology Association of Canada asked the Committee to recommend a measure that would help it spread out the revenue from maintenance contracts over a number of years. Currently, firms can claim reserves that spread the revenue from payments for future delivery of goods and services if they can show that it is reasonable to expect that the goods and services will be provided after the year-end. The Association noted that most software maintenance agreements do not provide for scheduled releases of upgrades, updates or code fixes. That being said, it informed us that most maintenance agreements specify regular preventive maintenance and “therefore there is no question as to whether or not services will be provided.” Therefore, it recommended that the government create “a provision that will allow [information and communications technologies] vendors to recognize revenue from maintenance contracts over time as the maintenance service is provided, rather than when the payment is received. … It should be done by prorating the fees collected and including only income for the portion of the fees that relates to the percentage of the contract period for the current taxation year.”

The Horse Racing Tax Alliance of Canada told the Committee that section 31 of the Income Tax Act is harming the Canadian horse racing industry, weakening its position with respect to other Canadian sport and entertainment industries, as well as its U.S. counterpart. For most businesses, losses are fully deductible against other income if it can be shown that there is a reasonable expectation that the business will generate a profit. Part-time farmers — including most race horse operators — however, can deduct a maximum loss of $8,750 against other income, regardless of the size of their investment in the business. It is seeking a repeal of section 31 and an Interpretation Bulletin from the Department of Finance and the Canada Customs and Revenue Agency providing guidance on the requirements for meeting the “reasonable expectation of profit” test in the context of the horse racing industry.

Finally, the Canadian Factors Association told the Committee of its concern that the Department of Finance could soon introduce proposed legislation that would make the factoring industry liable for Goods and Services Taxes (GST) owed by a debtor. Factoring firms buy the “accounts receivables” of small and medium-sized firms (for the sake of clarity, consider these latter firms to be manufacturing firms) at a discount to the nominal value of the accounts receivable. As a result, manufacturing firms are provided with immediate cash flow and the factoring industry receives a profitable asset. This “intermediation role” is similar to the rediscounting historically done by banks and central banks.

Recently, the Supreme Court of Canada found that factoring firms are not liable for GST owed by manufacturing firms that found themselves in financial distress (i.e., the firms that sell their accounts receivables to the factoring industry). The factoring industry asked the Committee to recommend that the government make a public statement saying that it will abide by the Supreme Court decision. It also asked that we recommend the creation of a “public record for consultation” that would identify financially troubled manufacturers that owe the government GST remittances.