The Recent Corporate Income Tax Reform Proposals in Canada and the United States

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Munich Personal RePEc Archive

The Recent Corporate Income Tax Reform Proposals in Canada and the United States

Grady, Patrick

1 January 1986

Online at https://mpra.ub.uni-muenchen.de/18749/

MPRA Paper No. 18749, posted 20 Nov 2009 00:30 UTC

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The Recent Corporate Income Tax Reform Proposals in Canada

and the United States rqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA

Patrick Grady*

PRECIS

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E n m a i 1 9 8 5 , le M in is t r e d e s F in a n c e s d u C a n a d a e t le P r e s id e n t d e s E t a t s - U n is o n t t o u s d e u x p r o p o s e la r e f o r r n e d u r e g im e d e s ir n p o t s s u r le s b e n e f ic e s d e s s o c ie t e s d e le u r s p a y s r e s p e c t if s . L e s d e u x p r o p o s i- t io n s p o r t a ie n t s u r l'e la r q is s e r n e n t d e I 'a s s ie t t e f is c a le e t l'e lim in a t io n d e c r e d it s d 'ir n p o t

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I 'in v e s t is s e m e n t . L a p r o p o s it io n a r n e r ic a in e c o r n - p r e n a it a u s s i I 'in d e x a t io n d e s a llo c a t io n s d 'a m o r t is s e m e n t e t d u c o a t d e s in v e n t a ir e s r e la t if s a u x s t o c k s . C e s d e u x p r o p o s it io n s s o n t e x a - m in e e s d a n s l'e t u d e r e s u m e s d a n s c e t a r t ic le , e n f a is a n t r e s s o r t ir le u r p o r t e e p o u r le C a n a d a . L a n o t io n d u t a u x m a r g in a l e f f e c t if d 'im p o s i- t io n d e s in v e s t is s e m e n t s e s t u t ilis e e p o u r a n a ly s e r le s c o n s e q u e n c e s p o s s ib le s d e s m e s u r e s p r o p o s e e s q u a n t

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la r e p a r t it io n d e l'ir n p o t d ir e c t d e s

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L 'a r t ic le c o m p a r e e n s u it e I 'e f f e t d e s p r o p o s it io n s s u r le s t a u x r e e ls d 'im p o s it io n e f f e c t if s a u C a n a d a e t a u x E t a t s - U n is . L 'a n a ly s e e s t

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s e lo n p lu s ie u r s h y p o t h e s e s d if - f e r e n t e s q u a n t a u t a u x d 'in f la t io n e t a u n iv e a u d u f in a n c e m e n t d e s in - v e s t is s e m e n t s p a r e m p r u n t .

S e lo n la p r o p o s it io n c a n a d ie n n e , le t a u x d 'im p o s it io n d e b a s e d u r e v e n u d e s s o c ie t e s d im in u e r a it , p a s s a n t d e 4 6

a

3 9 p o u r c e n t ( t a u x c o m b in e d e s ir n p o t s f e d e r a u x e t p r o v in c ia u x ) : p o u r le s p e t it e s e n t r e - p r is e s il p a s s e r a it d e 2 5

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2 1 p o u r c e n t , p o u r la f a b r ic a t io n e t la t r a n s - f o r m a t io n d e 4 0

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3 3 p o u r c e n t e t p o u r le s p e t it e s s o c ie t e s d e f a b r ic a - t io n d e 2 0

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1 6 p o u r c e n t . L a d im in u t io n d e I 'a m o r t is s e m e n t f is c a l a c c e le r e e t I 'e lim in a t io n d u c r e d it d 'ir n p o t

a

I 'in v e s t is s e m e n t ( s a u f p o u r le s f r a is d e r e c h e r c h e s c ie n t if iq u e ) c o m p e n s e r a ie n t la r e d u c t io n d e s r e c e t t e s f e d e r a le s c a u s e s p a r la d im in u t io n d e s t a u x d 'im p o s it io n . L a r a d ia t io n s u r t r o is a n s d e s b ie n s d e la c a t e q o r ie 2 9 u t ilis e s p o u r la f a b r ic a t io n e t la t r a n s f o r m a t io n s e r a it

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p a r a m o r t is s e m e n t d e q r e s s if e t r a r n e n e e

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2 5 p o u r c e n t . C e t t e r e d u c t io n

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2 5 p o u r c e n t s 'a p p liq u e r a it a u s s i

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I 'a m o r t is s e m e n t d e s b ie n s d e s c a t e g o r ie s 2 4 , 2 7 e t 3 4 s e r v a n t

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la lu t t e c o n t r e la p o llu t io n e t

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la c o n s e r v a t io n d e l'e n e r q ie ,

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I 'a m o r t is s e m e n t d u r n a t e r ie l d 'e x t r a c t io n d e r e s s o u r c e s , d e s a u t o m o b ile s e t d 'a u t r e s b ie n s d e s c a t e g o r ie s 1 0 e t 2 8 , e t

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*Of Grady Economics Associates Ltd., Ottawa.

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J a n u a r y - F e b r u a r y 1986 III

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tis s e m e n t d u r n a te r ie l d e c o n s tr u c tio n lo u r d c o m p r is d a n s la c a te q o r ie 2 2 . E n c e q u i c o n c e r n e le s a llo c a tio n s d 'in v e n ta ir e , il e s t p r o p o s e d 'e lir n in e r I'a b a tte m e n t d e 3 p o u r c e n t q u i a v a it e te in s titu e p o u r c o n - tr e b a la n c e r p a r tie lle m e n t l'im p 6 t s u r le s g a in s e n c a p ita l r e s u lta n t d e I'in fla tio n .

C e r ta in s a v a n ta g e s d e la p r o p o s itio n s o n t e n u r n e r e s d a n s le s d o c u m e n ts b u d q e ta ir e s , D 'a b o r d , le fa c te u r fis c a l in flu e r a it m o in s s u r le s d e c is io n s r e la tiv e s

a

I'in v e s tis s e m e n t, c a r le fa r d e a u fis c a l s e r a it r e p a r ti p lu s u n ifo r r n e m e n t e n tr e le s s e c te u r s in d u s tr ie ls a in s i q u 'e n tr e le s d iffe r e n te s c a te g o r ie s d e b ie n s d 'in v e s tis s e m e n t. E n s u ite , e n d im i- n u a n t le ta u x d 'im p o s itio n d e s s o c ie te s , le fin a n c e m e n t p a r a c tio n s d e - v ie n d r a it p lu s a v a n ta g e u x q u 'a c tu e lle m e n t p a r r a p p o r t a u fin a n c e m e n t p a r e m p r u n t. C e tte m o d ific a tio n c o n tr ib u e r a it

a

I' a m e lio r a tio n d e s b ila n s d e s s o c ie te s . E n fin , l'e lim in a tio n d e c r e d its d 'im p 6 t e n d ig u e r a it le c u m u l c o n s id e r a b le d e d e d u c tio n s e t d e c r e d its fis c a u x in u tilis e s fig u r a n t d a n s le s c o m p te s d e s s o c ie ta s .

L a p r in c ip a le a n a ly s e d e I' e tu d e e s t la c o m p a r a is o n d e s e ffe ts d e s d e u x s e r ie s d e m e s u r e s p r o p o s e e s s u r le ta u x m a r g in a l e ffe c tif d 'im - p o s itio n q u i s 'a p p liq u e a u x g r a n d e s s o c ie te s c a n a d ie n n e s e t a r n e r i- c a in e s d e fa b r ic a tio n . L e s e c te u r d e la fa b r ic a tio n a e te a n a ly s e p a r c e q u e c 'e s t d a n s c e s e c te u r q u e la c o n c u r r e n c e e n tr e le s e n tr e p r is e s e s t la p lu s v iv e d a n s le s d e u x p a y s . C 'e s t e n o u tr e p r o b a b le m e n t d a n s c e m e m e s e c te u r q u e I'in flu e n c e d u ta u x d 'im p o s itio n d e s s o c ie te s q u a n t

a

I' e m p la c e m e n t d e I'in v e s tis s e m e n t e t d e s p o s s ib ilite s d ' e m p lo i e s t la p lu s g r a n d e .

E n v e r tu d e s r e g im e s a c tu e ls , a u C a n a d a le ta u x e ffe c tif r e e l d 'im - p o s itio n d e I'in v e s tis s e m e n t d a n s le r n a te r ie l e t I' o u tilla g e d e fa b r ic a - tio n e s t in fe r ie u r d e p lu s ie u r s p o in ts d e p o u r c e n ta g e a u ta u x a r n e r ic a in s 'il e s t fin a n c e p a r a c tio n s o u n 'e s t fin a n c e q u 'a 2 5 p o u r c e n t a u m o y e n d 'e m p r u n ts . D a n s le c a s d 'u n fin a n c e m e n t p a r e m p r u n t d e 5 0 p o u r c e n t la d iffe r e n c e n ' e s t q u e tr e s le g e r e m e n t

a

I' a v a n ta g e d u C a n a d a .

S i le s d e u x r e g im e s p r o p o s e s e ta ie n t in s ta u r e s . le ta u x e ffe c tif r e e l d 'im p o s itio n a u C a n a d a d e I'in v e s tis s e m e n t d a n s le m a te r ie l e t l'o u tilla g e fin a n c e p a r a c tio n s s e r a it b e a u c o u p p lu s e le v e ( p lu s d e 1 0 p o in ts d e p o u r c e n ta g e ) q u 'a u x E ta ts - U n is , C e t a v a n ta g e ir a it c r o is s a n t a v e c la p r o p o r tio n d u fin a n c e m e n t p a r e m p r u n t. A u ta u x d 'in fla tio n a c tu e l d e 4 p o u r c e n t, c e t a v a n ta g e d e p a s s e r a it 2 0 p o in ts d e p o u r c e n ta g e d a n s le c a s d e I'in v e s tis s e m e n t d a n s le r n a te r ie l e t I' o u tilla g e fin a n c e

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5 0 p o u r c e n t a u m o y e n d 'e m p r u n ts . D a n s le c a s d 'u n ta u x d 'in fla tio n d e 1 0 p o u r c e n t, I'a v a n ta g e d e s E ta ts - U n is s e r a it d e 3 0 p o in ts d e p o u r - c e n ta g e .

L a m is e e n o e u v r e d e s d e u x p r o p o s itio n s fe r a it a u g m e n te r d a n s le s d e u x p a y s le ta u x e ffe c tif r e e l d 'im p o s itio n d e I'in v e s tis s e m e n t fin a n c e p a r a c tio n s d a n s la c o n s tr u c tio n n o n r e s id e n tie lle . C e p e n d a n t la h a u s s e d e s ta u x c a n a d ie n s s e r a it m o in d r e q u e c e lle d e s ta u x a r n e r i- Vol.34,^{No. 1}

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C O R P O R A T E I N C O M E T A X R E F O R M P R O P O S A L S

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c a in s , d im in u a n t d o n c I'a v a n ta g e a c tu e l d e s E ta ts - U n is a u n iv e a u d u ta u x r e e l d 'im p o s itio n d e c e ty p e d 'in v e s tis s e m e n t. L a d im in u tio n d u ta u x d 'in fla tio n e t I'a u g m e n ta tio n d u n iv e a u d u fin a n c e m e n t p a r e m - p r u n t a u r a ie n t p o u r e ffe t d 'a c c r o ttr e c e tte d im in u tio n . P a r c e n tr e . c e tte r e d u c tio n d e I'a v a n ta g e a r n e r ic a in a u r a it m o in s d 'e ffe t e n te r m e s d e c o n c u r r e n c e s u r le s e c te u r c a n a d ie n d e la fa b r ic a tio n q u e I' a u g - m e n ta tio n r e la tiv e d u ta u x r e e l d 'im p o s itio n d e I'in v e s tis s e m e n t e n m a te r ia l e t e n o u tilla g e .

L 'a n a ly s e fa it r e s s o r tir tr o is c o n s id e r a tio n s d o n t il fa u d r a it te n ir c o m p te lo r s d e la d is c u s s io n d e s c h a n g e m e n ts p r o p o s e s p o u r le r e - g im e d e s im p o ts s u r le s b e n e fic e s d e s o c ie te s a u C a n a d a : ( 1 ) le r is q u e d e p o r te r a u - d e la d e s ta u x e ffe c tifs a r n e r ic a in s le s ta u x r e e ls d 'im p o s i- tio n d e l'in v e s tis s e m e n t d a n s le r n a te r ie l e t I'o u tilla g e d e s tin e s

a

la fa - b r ic a tio n ; ( 2 ) la p o r te e a u n iv e a u d u fa r d e a u fis c a l r e la tif, a u C a n a d a e t a u x E ta ts - U n is , d e I'in d e x a tio n d u r e g im e d e s ir n p o ts s u r le s b e n e fic e s d e s s o c ie te s te lle q u 'e lle a e te p r o p o s e e a u x E ta ts - U n is , e t ( 3 ) I'e ffe t d e l'e lim in a tio n d e s s tim u la n ts fis c a u x s p e c ia u x p o u r le s in v e s tis s e m e n ts d a n s le s r e g io n s m o in s d e v e lo p p e e s d u C a n a d a e n te r m e s d e p o litiq u e d ' e x p a n s io n r e q io n a le .

ABSTRACT

In M a y 1 9 8 5 , C a n a d a 's M in is te r o f F in a n c e a n d th e P r e s id e n t o f th e U n ite d S ta te s e a c h p u t fo r w a r d a p r o p o s a l fo r r e fo r m in g h is c o u n tr y 's c o r p o r a te in c o m e ta x s y s te m . B o th p r o p o s a ls c a lle d fo r a b r o a d e n in g o f th e ta x b a s e a n d th e e lim in a tio n o f in v e s tm e n t ta x c r e d its . T h e U . S . p r o p o s a l a ls o in c lu d e d in d e x a tio n o f d e p r e c ia tio n a llo w a n c e s a n d in - v e n to r y c o s t. T h e s tu d y r e p o r te d in th is a r tic le e x a m in e s th e s e tw o p r o p o s a ls , fo c u s s in g o n th e ir s ig n ific a n c e fo r C a n a d a . T h e s tu d y u s e s th e c o n c e p t o f th e m a r g in a l r e a l e ffe c tiv e ta x r a te o n in v e s tm e n t to a n a ly z e s o m e o f th e p o s s ib le e ffe c ts o f th e p r o p o s a ls o n th e b u r d e n a n d th e d is tr ib u tio n o f th e c o r p o r a te ta x ; it th e n c o m p a r e s th e e ffe c ts o f th e p r o p o s a ls o n r e a l e ffe c tiv e ta x r a te s in C a n a d a a n d th e U n ite d S ta te s . T h e a n a ly s is is c a r r ie d o u t u n d e r s e v e r a l d iffe r e n t a s s u m p tio n s a b o u t th e r a te o f in fla tio n a n d th e e x te n t to w h ic h th e in v e s tm e n t is d e b t fin a n c e d .

T h e C a n a d ia n p r o p o s a l c a lls fo r a r e d u c tio n in th e s ta n d a r d c o m - b in e d fe d e r a l a n d p r o v in c ia l c o r p o r a te ta x r a te fr o m 4 6 to 3 9 p e r c e n t, in th e s m a ll b u s in e s s r a te fr o m 2 5 to 2 1 p e r c e n t, in th e r a te fo r m a n u - fa c tu r in g a n d p r o c e s s in g fr o m 4 0 to 3 3 p e r c e n t, a n d in th e r a te fo r s m a ll m a n u fa c tu r in g c o r p o r a tio n s fr o m 2 0 to 1 6 p e r c e n t. A r e d u c tio n in a c c e le r a te d c a p ita l c o s t a llo w a n c e s a n d a n e lim in a tio n o f th e in v e s t- m e n t ta x c r e d it ( e x c e p t fo r s c ie n tific r e s e a r c h e x p e n d itu r e s ) w o u ld o ffs e t th e r e s u ltin g r e d u c tio n in fe d e r a l r e v e n u e s . T h e p r o p o s a l w o u ld r e d u c e th e th r e e - y e a r w r ite - o ff fo r m a n u fa c tu r in g a n d p r o c e s s in g a s s e ts in c la s s 2 9 to 2 5 p e r c e n t o n a d e c lin in g - b a la n c e b a s is . T h e r e - d u c tio n to 2 5 p e r c e n t w o u ld a ls o a p p ly to w r ite - o ffs fo r e n e r g y - s a v in g a n d p o llu tio n c o n tr o l a s s e ts in c la s s e s 2 4 ,2 7 , a n d 3 4 ; fo r r e s o u r c e e x -

J a n u a r y - F e b r u a r y 1 9 8 6

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t r a c t io n e q u ip m e n t , a u t o m o b ile s , a n d o t h e r a s s e t s in c la s s e s 1 0 a n d 2 8 ; a n d f o r h e a v y c o n s t r u c t io n e q u ip m e n t in c la s s 2 2 . I n a d d it io n , t h e p r o p o s a l w o u ld e lim in a t e t h e 3 p e r c e n t in v e n t o r y a llo w a n c e , w h ic h w a s in t r o d u c e d t o c o m p e n s a t e p a r t ia lly f o r t h e t a x le v ie d o n in f la t io n - in d u c e d c a p it a l g a in s o n in v e n t o r y h o ld in g s .

T h e b u d g e t p a p e r s e t s o u t s o m e o f t h e a d v a n t a g e s o f t h e p r o p o s a l.

I t w o u ld r e d u c e t a x - in d u c e d d is t o r t io n s in in v e s t m e n t d e c is io n - m a k in g b y d is t r ib u t in g t h e t a x b u r d e n m o r e e v e n ly a m o n g in d u s t r ie s a n d d if f e r e n t t y p e s o f in v e s t m e n t a s s e t s . T h e r e d u c t io n in t h e c o r p o - r a t e t a x r a t e w o u ld m a k e e q u it y f in a n c in g m o r e a t t r a c t iv e t h a n it is a t p r e s e n t r e la t iv e t o d e b t f in a n c in g ; t h is c h a n g e w o u ld h e lp t o im p r o v e t h e b a la n c e s h e e t s o f c o r p o r a t io n s . F in a lly , t h e e lim in a t io n o f t a x c r e d it s w o u ld s t e m t h e s u b s t a n t ia l b u ild - u p o f u n u s e d t a x d e d u c t io n s a n d c r e d it s o n c o r p o r a t e b o o k s .

T h e k e y a n a ly s is c o n t a in e d in t h e s t u d y is a c o m p a r is o n o f t h e e f f e c t s o f t h e t w o s e t s o f p r o p o s a ls o n m a r g in a l r e a l e f f e c t iv e t a x r a t e s a p p lic a b le t o la r g e m a n u f a c t u r in g c o r p o r a t io n s in C a n a d a a n d t h e U n it e d S t a t e s . T h e a n a ly s is u s e s t h e m a n u f a c t u r in g s e c t o r b e c a u s e it is t h e s e c t o r in w h ic h c o m p e t it io n b e t w e e n c o m p a n ie s in t h e t w o c o u n t r ie s is m o s t in t e n s e a n d in w h ic h t h e c o r p o r a t e t a x r a t e p r o b a b ly h a s it s g r e a t e s t p o t e n t ia l im p a c t o n t h e lo c a t io n o f in v e s t m e n t a n d e m p lo y m e n t .

U n d e r t h e c u r r e n t s y s t e m s , t h e r e a l e f f e c t iv e t a x r a t e o n in v e s t m e n t in m a c h in e r y a n d e q u ip m e n t in m a n u f a c t u r in g is s e v e r a l p e r c e n t a g e p o in t s lo w e r in C a n a d a t h a n it is in t h e U n it e d S t a t e s if t h e in v e s t m e n t is e q u it y f in a n c e d o r o n ly 2 5 p e r c e n t d e b t f in a n c e d . F o r in v e s t m e n t t h a t is 5 0 p e r c e n t d e b t f in a n c e d , t h e d if f e r e n c e is o n ly m a r g in a lly in f a v o u r o f C a n a d a .

. I f b o t h o f t h e p r o p o s e d s y s t e m s w e r e im p le m e n t e d , t h e C a n a d ia n r e a l e f f e c t iv e t a x r a t e o n e q u it y - f in a n c e d in v e s t m e n t in m a c h in e r y a n d e q u ip m e n t w o u ld b e s u b s t a n t ia lly ( m o r e t h a n 1 0 p e r c e n t a g e p o in t s ) h ig h e r t h a n t h e U . S . r a t e . T h e a d v a n t a g e w o u ld in c r e a s e w it h t h e d e g r e e o f d e b t f in a n c in g . A t t h e c u r r e n t 4 p e r c e n t r a t e o f in f la t io n , t h is a d v a n t a g e w o u ld e x c e e d 2 0 p e r c e n t a g e p o in t s f o r in v e s t m e n t in m a c h in e r y a n d e q u ip m e n t t h a t w a s 5 0 p e r c e n t d e b t f in a n c e d . G iv e n 1 0 p e r c e n t in f la t io n , t h e U . S . a d v a n t a g e w o u ld b e 3 0 p e r c e n t a g e p o in t s .

I m p le m e n t a t io n o f t h e t w o p r o p o s a ls w o u ld in c r e a s e t h e r e a l e f f e c - t iv e t a x r a t e o n e q u it y - f in a n c e d in v e s t m e n t in n o n r e s id e n t ia l c o n s t r u c - t io n in b o t h c o u n t r ie s , b u t t h e in c r e a s e in C a n a d ia n r a t e s w o u ld b e s m a lle r t h a n t h e in c r e a s e in U . S . r a t e s . I m p le m e n t a t io n o f b o t h p r o - p o s a ls w o u ld t h e r e f o r e r e d u c e t h e c u r r e n t U . S . a d v a n t a g e in r e a l e f f e c t iv e t a x r a t e s o n in v e s t m e n t o f t h is k in d . T h e lo w e r t h e r a t e o f in - f la t io n a n d t h e g r e a t e r t h e d e g r e e o f d e b t f in a n c in g , t h e g r e a t e r t h e r e d u c t io n w o u ld b e . T h is r e d u c t io n , h o w e v e r , w o u ld h a v e le s s e f f e c t o n t h e c o m p e t it iv e n e s s o f C a n a d a 's m a n u f a c t u r in g s e c t o r t h a n t h e

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ZYXWVUTSRQPONMLKJIHGFEDCBA

r e la t iv e in c r e a s e in t h e r e a l e f f e c t iv e t a x r a t e o n in v e s t m e n t in m a c h in e r y a n d e q u ip m e n t .

T h e a n a ly s is r a is e s t h r e e n e g le c t e d is s u e s t h a t s h o u ld b e t a k e n in t o a c c o u n t in d is c u s s io n s o f t h e p r o p o s e d C a n a d ia n c o r p o r a t e t a x c h a n g e s : ( 1 ) t h e p r u d e n c e o f r a is in g r e a l e f f e c t iv e t a x r a t e s o n m a n u - f a c t u r in g in v e s t m e n t in m a c h in e r y a n d e q u ip m e n t a b o v e r a t e s in t h e U n it e d S t a t e s ; ( 2 ) t h e im p lic a t io n s f o r t h e r e la t iv e t a x b u r d e n s in C a n - a d a a n d t h e U n it e d S t a t e s o f t h e p r o p o s e d in d e x a t io n o f t h e U . S . c o r - p o r a t e t a x s y s t e m ; a n d ( 3 ) t h e im p lic a t io n s f o r r e g io n a l d e v e lo p m e n t p o lic y o f e lim in a t in g s p e c ia l t a x in c e n t iv e s f o r in v e s t m e n t in le s s d e -

v e lo p e d r e g io n s o f C a n a d a .

rqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA

INTRODUCTION

In May 1985, Canada's Minister of Finance and the President of the United States each put forward a proposal for reforming his country's corporate income tax system. Both proposals called for a broadening of the tax base, the elimination of tax credits, and a reduction in tax rates. The U.S. pro- posal also included indexation of depreciation allowances and inventories.

The process of corporate tax reform is at a more advanced stage in the United States than it is in Canada. When President Reagan submitted his proposal to the Congress, with a request for prompt enactment,

¹

the Con- gress and the administration had already extensively discussed a preliminary proposal presented by the Treasury Department in November 1984.

²

The Canadian proposal, set out in one of the many discussion papers issued with the May 23, 1985 budget.! was intended to be illustrative rather than defini- tive. Its purpose was to serve as a basis for discussion and to suggest some ways in which the operation and the impact of the corporate tax system could be improved.

The study reported in this article examines the two proposals, focussing on their significance for Canada. The study uses the concept of the marginal real effective tax rate on investment to analyze some of the possible effects of each proposal on the burden and the distribution of the corporate tax; it then compares the effects of the proposals on real effective tax rates in Canada and the United States. The analysis is carried out under several dif-

1United States, T h e P r e s i d e n t 's T a x P r o p o s a l s t o t h e C o n g r e s s f o r F a i r n e s s , G r o w t h a n d S i m p l i c i t y (Washington, D.C.: U.S. Government Printing Office, May 1985). The corporate tax reform proposal contained in this document is only part of a broader package of tax reforms encompassing all aspects of the income tax. Note that the analysis in this study deals with the President's proposals, which are currently under consideration by the Congress. Any reforms that eventually emerge from the legislative process may differ significantly from the original proposals.

2United States, Treasury Department Report to the President, T a x R e f o r m f o r F a i r n e s s , S i m p l i c i t y , a n d E c o n o m i c G r o w t h (Washington, D.e.: Department of the Treasury, Novem- ber 1984).

3Canada, Department of Finance, B u d g e t P a p e r s ,The Corporate Loss Transfer System: A Direction for Change, May 1985.

J a n u a r y - F e b r u a r y 1986

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1 1 6 C A N A D I A N T A X J O U R N A L

rqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA ferent assumptions about the rate of inflation and the extent to which the

investment is debt financed.

The analysis of real effective tax rates and the examination of the U .S.

proposal raises a number of issues that should be considered in discussions of the Canadian proposal. These issues are reviewed in the concluding sec- tion of the article.

THE CANADIAN CORPORATE TAX PROPOSAL AND REAL EFFECTIVE TAX RATES

The illustrative proposal presented in the budget discussion paper calls for a reduction in the standard combined federal and provincial corporate tax rate from 46 to 39 per cent, in the small business rate from 25 to 21 per cent, in the rate for manufacturing and processing from 40 to 33 per cent, and in the rate for small manufacturing corporations from 20 to 16 per cent. A re- duction in accelerated capital cost allowances and elimination of the invest- ment tax credit (except for scientific research expenditures) would offset the resulting reduction in federal revenues. The proposal would reduce the three-year write-off for manufacturing and processing assets in class 29 to 25 per cent on a declining-balance basis. The reduction to 25 per cent would also apply to write-offs for energy-saving and pollution control assets in classes 24,27, and 34; for resource extraction equipment, automobiles, and other· assets in classes 10 and 28; and for heavy construction equipment in class 22. In addition, the proposal would eliminate the 3 per cent inventory allowance, which was introduced to compensate partially for the tax levied on inflation-induced capital gains on inventory holdings.

Table 1 summarizes the current and the proposed corporate tax rates, in- vestment tax credit rates, and capital cost allowance rates for representative industry groups and broad categories of investment. These rates provide the basis for the calculations of real effective tax rates presented below.

The budget paper sets out some of the advantages of the proposed reforms. Because the proposal offers broader tax incentives than does the existing corporate tax scheme, it would reduce the degree of tax-induced distortion in investment decision-making. This change could lead to in- creased economic growth and employment by redirecting investment to the areas of greatest return. For example, the proposal would end the current emphasis on inducements to investment in the manufacturing sector and thus encourage increased investment in sectors such as utilities, construc- tion, transport, wholesale trade, retail trade, and services. This reallocation of investment would increase employment, since the nonmanufacturing in- dustries tend to be more labour intensive than the manufacturing industries.

One important way in which the proposal would encourage a reallocation of investment is by equalizing the marginal tax rates on investments in build- ings, land, and machinery: the shift in the pattern of incentives away from machinery and toward structures would increase demand in the construc- tion-related industries.

The proposal has other advantages. The reduction in the corporate tax rate would make equity financing more attractive than it is at present rela-

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117

Table 1 Tax Parameters Used in Calculating the Real Effective Tax Rate for Various Industry Groups and Categories of Investment Under the

Current and Proposed Tax Regimes in Canada

Current Proposed

Corporate Investment Capital Corporate Investment Capital

ZYXWVUTSRQPONMLKJIHGFEDCBA

ta x tax cost tax tax cost

rate credit allowance rate credit allowance

p e r c e n t L a r g e , n o n - A t l a n t i c r e g i o n

Nonmanufacturing

Machinery and equipment .... 46 7 20 39 ₀ ₂₀

Nonresidential construction 46 7 5 39 0 5

L a r g e , A t l a n t i c r e g i o n

Nonmanufacturing

Machinery and equipment .... 46 20 20 39 ₀ ₂₀

Nonresidential construction 46 20 5 39 ₀ ₅

L a r g e , n o n - A t l a n t i c r e g i o n

Manufacturing

Machinery and equipment .... 40 7 50 33 ₀ 25

Manufacturing

Machinery and equipment .... 40 20 50 33 0 25

S m a l l , n o n - A t l a n t i c r e g i o n

Nonmanufacturing

S m a l l , n o n - A t t a n t i c r e g i o n

Manufacturing

Nonresidential construction .. 20 7 5 16 0 5

Note: Only one-half of the indicated capital cost allowance can be claimed in the first year.

tive to debt financing; this change would help to improve the balance sheets of corporations. The elimination of tax credits would stem the substantial build-up of unused tax deductions and credits on corporate books-a source of much complication for tax administrators when corporations seek to transfer the unused write-offs.

4

The budget paper presents much useful analysis of the impact of the pro- posal. The purpose of the present study is not to criticize this analysis but to supplement it. The concept used in this study to shed light on the impact of the proposal is the marginal real effective tax rate on illustrative investment projects. This concept has the virtue that it captures in one number the com-

+Another discussion paper issued with the May 1985 budget proposes a system that would allow the transfer of losses between commonly owned firms. See Canada, Department of Finance, B u d g e t P a p e r s , A Corporate Loss Transfer System for Canada, May 1985.

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ZYXWVUTSRQPONMLKJIHGFEDCBA

bined tax effect on new investment of changes in corporate tax rates, capital cost allowances, and investment tax credits.

The analysis calculates the real effective tax rate by dividing the present value of real (inflation-adjusted) tax payments by real income. It computes real income by deflating by the price level the income from the investment less indexed capital consumption allowances and real interest payments on any debt incurred to fmance the investment. The analysis uses real rather than nominal taxes and income because in the absence of money illusion, it is real rather than nominal magnitudes that influence business decisions.

The real discount rate used in the calculations is 10 per cent. This rate is the same as the assumed before-tax rate of return and cost of debt financing.

The calculations assume economic depreciation of 7.89 per cent for machinery and equipment and 3.45 per cent for nonresidential construe- tion.> A more detailed discussion of the calculation of the real effective tax rate appears in the appendix.

The calculations of real effective tax rates used in this article have several limitations as indicators of the effect of corporate tax changes. First, the calculations obviously do not capture all aspects of the corporate tax system. Second, they do not measure the overall impact of corporate taxa- tion on corporations but only its impact on illustrative new investment proj- ects. Third, the calculations assume that the corporations subject to tax are able to take full advantage of all write-offs and credits-an assumption that does not strictly apply to the roughly two companies in three that are only sometimes taxable. Since losses can be carried backward three years and forward seven years, the tax benefits flowing from write-offs and credits are not necessarily lost altogether by firms in a non-tax-paying position, but they may be substantially reduced in value. These limitations must be borne in mind in interpreting the analysis of real effective tax rates.

Table 2 shows the calculated real effective tax rates by industry groups and by type of investment, assuming a continuation of inflation at its recent level of 4 per cent, under both the current and the proposed corporate tax regimes. Under the current system, real effective tax rates are in all cases substantially lower than the statutory rates. For machinery and equipment, the real effective tax rates are actually negative for large Atlantic region manufacturing corporations and small non-Atlantic-region manufacturing corporations. This circumstance reflects the generosity of the three-year write-off for manufacturing and processing and the high value of the invest- ment tax credit, particularly in the Atlantic region.

6

Under the proposed tax regime, real effective tax rates would be brought more in line with statutory

5These depreciation rates are those estimated by Lloyd Kenward for use in RDX2, the Bank of Canada's econometric model. They are based on data from Statistics Canada's annual esti- mates of fixed capital flows and stocks. The methodology is described in Lloyd Kenward,

"Business Investment and Output: Sector 3," in S e c t o r a l A n a l y s i s o f R D X 2 E s t i m a t e d t o

4 Q 7 2 , Technical Report 6 (Ottawa: Bank of Canada, 1977), 52-54.

6The tax credit rate in the Atlantic region is 20 per cent; in the rest of the country, it is 7 per cent.

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C O R P O R A T E I N C O M E T A X R E F O R M P R O P O S A L S 1 1 9

Table 2 The Real Effective Tax Rate on Investment by Industry Group in Canada Under the Current and the Proposed Tax Regimes,

Assuming 4 Per Cent Inflation rqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA

Current Proposed

L a r g e , n o n - A t / a n t i c r e g i o n

Nonmanufacturing

Machinery and equipment .

Nonresidential construction .

Nonmanufacturing

L a r g e , n o n - A t l a n t i c r e g i o n

Manufacturing

Nonresideritial construction .

S m a l l , n o n - A t l a n t i c r e g i o n

Nonrnanufacturing

S m a l l , n o n - A t l a n t i c r e g i o n

Manufacturing

p e r c e n t

34.6 39.5

36.7 39.9

18.4 25.5

36.7 39.9

6.7 33.2

29.8 33.7

-7.0 19.0

29.8 33.7

13.6 17.6

19.8 21.5

-2.3 12.3

14.5 16.4

rates, an outcome that would result in significantly higher effective tax rates in the manufacturing sector and in the Atlantic region.

Since neither the current nor the proposed corporate tax regime is in- dexed, the real effective tax rate under both regimes is influenced by the rate of inflation. Inflation affects the real effective tax rate in two ways. First, it erodes the real value of capital cost allowances and thus tends to raise the real effective tax rate. Second, it increases the inflation premium in the nominal interest rate and hence the value of nominal interest payments;

because these payments are deductible, the increase in their nominal value tends to lower the real effective tax rate. ZYXWVUTSRQPONMLKJIHGFEDCBA

⁷

Table 3 shows the combined impacts of inflation and debt financing on the real effective tax rate for large non-Atlantic-region corporations under

7A paper prepared by the author for the Economic Council of Canada's Study on Taxation provides a detailed discussion of the issues involved in indexation and the impact of inflation on the taxation of business and investment income. See Patrick Grady, I n d e x a t i o n a n d t h e T a x a t i o n o f B u s i n e s s a n d I n v e s t m e n t I n c o m e , Discussion Paper no. 283 (Ottawa: Economic Council of Canada, December 1984).

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rqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA

both the current and the proposed tax regimes. 8The table clearly reveals the tendency of inflation to raise real effective tax rates in the absence of debt financing. This tendency is slightly more pronounced under the current system than it is under the proposed system, except in the case of manufac- turing investment in machinery and equipment. The proposed lowering of tax rates would reduce the erosion by inflation of the real value of capital cost allowances. In the case of manufacturing machinery and equipment, however, the proposed lengthening of the write-off period would more than offset the impact of lower tax rates, making the increase in the effective tax rate greater under the proposed system than it is under the current system.

If investment involves debt financing, inflation will reduce real effective tax rates. The greater is the reliance on debt financing, the larger is the re- duction. The reduction arising from the interaction of inflation and debt financing, however, would be much less under the proposed system than it is under the current system. Under the current system, given 10 per cent inflation, the effective tax rate is translated into significant subsidies at the margin for both manufacturing and nonmanufacturing investment in both machinery and equipment and nonresidential construction. Under the pro- posed system, a subsidy results only for manufacturing investment in machinery and equipment. Thus the proposed changes would mitigate the adverse impact of inflation on the dispersion in effective marginal corporate tax rates. This mitigation, however, would stop far short of the relief that would result from a comprehensive indexation of the corporate income tax.

THE

U.S.

CORPORATE TAX PROPOSAL AND REAL EFFECTIVE TAX RATES

The current corporate tax system in the United States imposes a tax rate of 46 per cent on all income in excess of $100,000. The rates on income under

$100,000 are

.• 15 per cent on taxable income up to $25,000,

• 18 per cent on taxable income between $25,000 and $50,000,

• 30 per cent on taxable income between $50,000 and $75,000, and

• 40 per cent on taxable income between $75,000 and $100,000.

The graduated tax rates are phased out for corporations with taxable in- comes over $1,000,000; corporations earning more than $1,405,000 pay a flat rate of 46 per cent.

Under the proposed tax system, the tax rate would be 33 per cent on all income above $75,000. The following rates would apply to income under

$75,000:

• 15 per cent on taxable income up to $25,000,

8The table shows the real effective tax rates for illustrative cases where the proportion of the investment assumed to be financed by debt is zero per cent, 25 per cent, and 50 per cent. On average, about one-third of all investment is debt financed.

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C O R P O R A T E I N C O M E T A X R E F O R M P R O P O S A L S 1 2 1

rqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA

Table 3 The Impact of Inflation and Debt Financing on the Real Effective Tax Rate in Canada Under the Current and the Proposed Tax Regimes

Current, Proposed,

% debt financed 0/0 debt financed

Large, non-Atlantic region 0 25 50 0 25 50

p e r c e n t N o n m a n u f a c t u r i n g

Machinery and equipment

4% inflation ... 34.6 24.0 2.9 36.7 30.2 17.3

100/0 inflation ... 39.3 20.2 -18.0 41.0 27.4 0.1

Nonresidential construction

4% inflation ... 39.5 30.6 12.8 39.9 34.4 23.6

10% inflation ... 42.7 24.7 -11.2 42.8 29.7 3.6

M a n u f a c t u r i n g

Machinery and equipment

4% inflation ... 6.7 -10.2 -44.1 29.8 23.9 12.2

10% inflation ... 9.4 -15.4 -65.2 33.1 21.0 -3.2

Nonresidential construction

4 % inflation ... 33.2 25.1 8.9 33.7 29.1 20.0

10% inflation ... 36.0 20.0 -12.0 36.2 25.1 3.1

• 18 percent on taxable income between $25,000 and $50,000, and

• 25 per cent on taxable income between $50,000 and $75,000.

The graduated rates would be phased out on taxable incomes over $140,000, and corporations with incomes over $360,000 would pay a flat tax of 33 per cent.

The proposed system would eliminate the investment tax credit. Under the current system, the investment tax credit rate is generally 10 per cent ex- cept in the case of three-year property, for which the applicable rate is gen- erally 6 per cent. The investment tax credit reduces the basis of depreciable property by 50 per cent of the credit. A taxpayer may elect a 2 per cent reduction in the value of the credit instead of the basis reduction.

The current system of depreciation allowances in the United States, which is called the accelerated cost recovery system

(ACRS),

is not based on the useful economic lives of assets and provides greatly accelerated depre- ciation schedules. In brief, the

ACRS

classifies all personal property (except public utility property) as three-year or five-year property. The main three- year properties are cars, light trucks, and research and experimentation property. Most other personal property, including machinery and equip- ment, may be written off over five years. Real property, except low income housing, is classified as 18-year property.

Under the proposed regime, a new capital cost recovery system

(CCRS)

would replace the

ACRS.

The

CCRS

would index depreciation allowances and would thus allow the cost recovery of the real (inflation-adjusted) cost of depreciable assets, rather than just the original, nominal cost. Also, depre- ciation allowances would be based more closely than they are at present on

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122

ZYXWVUTSRQPONMLKJIHGFEDCBA

economic depreciation, an arrangement that would establish a more neutral system of investment incentives. Under the

CCRS,

all investment assets would be assigned to one or another of six classes, where they would qualify for declining-balance rates of depreciation ranging from 55 per cent to 4 per cent for specified recovery periods ranging from 4 to 28 years.

Table 4 compares the depreciation allowances under the

ACRS

and the

CCRS

for three classes of assets, assuming zero inflation. The two classes that are of most interest are class 4, which includes most machinery and equipment and has a 22 per cent rate, and class 6, which covers most non- residential construction and has a 4 per cent rate. The table shows clearly the extent to which the

^CCRS

system would temper the front-end-loaded nature of accelerated depreciation allowances. The table does not reveal the

Table 4 Depreciation Allowances Under Current and Proposed Depreciation Methods in the United States

Class 1 asset Class 4 asset Class 6 asset

ACRS, CCRS, ACRS, CCRS, ACRS, CCRS,

Year 3 years 55070 5 years 22% 18 years 4%

p e r c e n t

1

ZYXWVUTSRQPONMLKJIHGFEDCBA

. . . 25.0 27.5 15.0 11.0 5.0 2.0

2 . . . 38.0 39.9 22.0 19.6 9.0 3.9

3 . . . 37.0 17.9 21.0 15.3 8.0 3.8

4 . . . 0.0 8.1 21.0 12.0 8.0 3.6

5 . . . 0.0 6.6 21.0 12.0 7.0 3.5

6 . . . 0.0 0.0 0.0 12.0 6.0 3.5

7 . . . ,_. 0.0 0.0 0.0 12.0 6.0 3.5

8 . . . 0.0 0.0 0.0 6.0 5.0 3.5

9 . . . 0.0 0.0 0.0 0.0 5.0 3.5

10 . . . 0.0 0.0 0.0 0.0 5.0 3.5

11 '.. . . 0.0 0.0 0.0 0.0 5.0 3.5

12 . . . 0.0 0.0 0.0 0.0 5.0 3.5

13 . . . 0.0 0.0 0.0 0.0 4.0 3.5

14 . . . 0.0 0.0 0.0 0.0 4.0 3.5

15 ^{. ,} . . . 0.0 0.0 0.0 0.0 4.0 3.5

16 . . . 0.0 0.0 0.0 0.0 4.0 3.5

17 . . . 0.0 0.0 0.0 0.0 4.0 3.5

18 . . . 0.0 0.0 0.0 0.0 4.0 3.5

19 . . . 0.0 0.0 0.0 0.0 2.0 3.5

20 . . . 0.0 0.0 0.0 0.0 0.0 3.5

21 · . . . ^0.0 ^0.0 ^0.0 ^0.0 ^0.0 ^3.5

22 . . . .

-

. . 0.0 0.0 0.0 0.0 0.0 3.5

23 . . . 0.0 0.0 0.0 0.0 0.0 3.5

24 . . . 0.0 0.0 0.0 0.0 0.0 3.5

25 . . . 0.0 0.0 0.0 0.0 0.0 3.5

26 . . . 0.0 0.0 0.0 0.0 0.0 3.5

27 . . . . 0.0 0.0 0.0 0.0 0.0 3.5

28 · . . . ^0.0 ^0.0 ^0.0 ^0.0 ^0.0 ^3.5

29 · . . . 0.0 0.0 0.0 0.0 0.0 2.7

30 · . . . 0.0 0.0 0.0 0.0 0.0 0.0

Note: Depreciation is computed on an asset placed in service by a calendar-year taxpayer on July 1 of year 1.

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rqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA

¹²³

degree to which inflation would cause depreciation allowances to rise over

time under the indexed

CCRS

system.

Another aspect of the proposed corporate tax system that is designed to offset inflation is a proposal to allow taxpayers the use of an indexed first in, first out

(FIFa)

method of inventory accounting in addition to the cur- rent last in, first out

(LIFO)

and

FIFa

methods. Indexing would be based on the increase in a general price index such as the consumer price index, and it would be allowed only for inflation that occurred after the proposal was im- plemented. A related proposal calls for dropping the requirement that those who use the

LIFO

method for tax purposes also use it in financial statements.

The proposed corporate tax reforms in Canada and the United States dif- fer strikingly in their approaches to indexation. The U.S. administration is proposing to enact an almost comprehensive indexation of the corporate in- come tax (it would cover depreciation allowances and inventories but exclude interest income and expense). The Canadian government, for its part, is tentatively proposing the elimination of the 3 per cent inventory allowance on the ground that the decline in inflation makes the allowance unnecessary.

Table 5 shows the marginal real corporate effective tax rates on most new investment in machinery and equipment and nonresidential construction under both the current and the proposed U.S. systems, given 4 per cent in- flation; these rates were calculated in the same manner as the Canadian tax rates discussed earlier. The real effective tax rates are higher under the pro- posed system than they are under the current system-a result that is only to be expected from a reform designed to tip the tax regime away from acceler- ated write-offs and investment tax credits and toward a lower general tax rate. The reform would not, however, significantly alter the existing bias in favour of shorter-lived assets. The effective rate on new investment in machinery and equipment would remain substantially below the rate on in- vestment in structures.

Table 6 shows the combined impact of inflation and debt financing under both the current and the proposed corporate tax systems in the United States. The indexation of depreciation allowances under the pro- posed system would stop inflation from raising effective tax rates for equity-financed investments, as it does under the present system. On the other hand, the proposed reforms would curtail the inflation-induced reduction in real tax rates associated with debt financing. The tendency of

Table 5 The Real Effective Tax Rate on Investment by Asset Class in the United States Under the Current and the Proposed Tax Regimes,

Assuming 4 Per Cent Inflation

Current Proposed

p e r c e n t

Class 4 asset (machinery and equipment) . . . 11.3 Class 6 asset (nonresidential construction) . . . 25.4

18.0 30.2

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124

ZYXWVUTSRQPONMLKJIHGFEDCBA

C A N A D I A N T A X J O U R N A L

Table 6 The Impact of Inflation and Debt Financing on the Real Effective Tax Rate in the United States Under the Current and the

Proposed Tax Regimes

Current, Proposed,

0/0debt financed % debt financed

0 25 50 0 25 50

p e r c e n t C l a s s 4 a s s e t

4% inflation ... 11.3 -7.0 -43.7 18.0 8.2 -11.5

10070inflation ... 16.5 -10.1 -63.5 18.0 0.9 -33.2

C l a s s 6a s s e t

4070inflation ... 25.4 11.8 -15.5 30.2 24.4 12.8

10070inflation ... 30.3 8.2 -36.0 30.2 17.1 -8.9

the indexation of depreciation allowances to reinforce the reduction in real effective tax rates as the degree of debt financing increased would be more than offset by the dampening effect of the decrease in the statutory general tax rate. ZYXWVUTSRQPONMLKJIHGFEDCBA

A COMPARISON OF EFFECTIVE TAX RATES IN CANADA AND THE UNITED STATES UNDER THE CURRENT AND

PROPOSED TAX SYSTEMS

This section compares the marginal real effective tax rates applicable to large corporations in the manufacturing sector in both Canada and the United States." The analysis uses the manufacturing sector because it is the sector in which competition between companies in the two countries is most intense and in which the corporate tax rate probably has its greatest poten- tial impact on the location of investment and employment. Table 7 com- pares real effective tax rates in the two countries under both the current and the proposed systems.

Under the current systems, the real effective tax rate on investment in machinery and equipment in manufacturing is several percentage points lower in Canada than it is the United States if the investment is equity financed or only 25 per cent debt financed. For investment that is 50 per cent debt financed, the difference is only marginally in favour of Canada.

If both of the proposed systems were implemented, the Canadian real effective tax rate on equity-financed investment in machinery and equip- ment would be substantially (more than 10 percentage points) higher than the U .S. rate. The U .S. advantage would increase with the degree of debt financing. At the current 4 per cent rate of inflation, this advantage would

9The results described in this section exclude Canada's Atlantic region. Only a very small part of the Canadian share of the manufacturing sector qualifies for the higher investment tax credit rate allowed to firms in the Atlantic region; consequently, exclusion from the calculations of manufacturing investment in the Atlantic region does not significantly distort the comparison.

V o l .34, N o . I

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C O R P O R A T E I N C O M E T A X R E F O R M P R O P O S A L S

rqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA

¹²⁵

Table 7 Comparison of the Real Effective Tax Rates, at Different Levels of Inflation and Debt Financing, for Investment in Manufacturing in Canada

and the United States Under the Current and the Proposed Tax Regimes

Current, Proposed,

0,10

debt financed

0,10

debt financed

0 25 50 0 25 50

p e r c e n t M a c h i n e r y a n d e q u i p m e n t

4 0 ,1 0

inflation

Canada ...

6.7 -10.2 -44.1 29.8 23.9 12.2

United States ...

^11.3 -7.0 -43.7 18.0 8.2 -11.5

Difference ZYXWVUTSRQPONMLKJIHGFEDCBA

. . . -4.6 -3.2 -0.4 11.8 15.7 23.7 100,10

inflation

Canada ...

^9.4 -15.4 -65.2 33.1 21.0 -3.2

United States ...

16.5 -10.1 -63.5 18.0 0.9 -33.2

Difference

. . . . -7.1 -5.3 -1.7 15.1 20.1 30.0

N o n r e s i d e n t i a l c o n s t r u c t i o n

4 0 ,1 0

inflation

Canada

. . . 33.2 25.1 8.9 33.7 29.1 20.0

United States ...

^25.4 11.7 -15.5 30.2 24.4 12.8

Difference

. . . 7.8 13.4 24.4 3.5 4.7 7.2 100,10

inflation

Canada

. . . 36.0 20.0 -12.0 36.2 25.1 3.1

United States ...

30.3 8.2 -36.0 30.2 17.1 -8.9

Difference

. . . , . 5.7 11.8 24.0 6.0 8.0 12.0

exceed 20 percentage points for investment in machinery and equipment that was 50 per cent debt financed. Given 10 per cent inflation, the U .S.

advantage would be 30 percentage points.

Implementation of the two proposals would increase the real effective tax rates on investment in nonresidential construction in both countries, but the increase in Canadian rates would be smaller than the increase in U .S.

rates. Implementing both proposals would therefore reduce the current U.S. advantage in real effective tax rates on investment of this kind. The lower was the rate of inflation and the greater was the degree of debt financ- ing, the greater the reduction would be. This reduction, however, would have less of an effect on the competitiveness of Canada's manufacturing sector than the relative increase in the real effective tax rate on investment in machinery and equipment.

It is important to understand the reasons why the implementation of the two sets of tax proposals would cause the real effective tax rates on manu- facturing investment in machinery and equipment to be so much higher in Canada than in the United States, even though the applicable statutory rate would be 33 per cent in both countries and both countries would eliminate their investment tax credits. One reason is that the Canadian proposal to substitute a 25 per cent capital cost allowance rate for the three-year write- off for manufacturing investment in machinery and equipment would have a much greater effect than the V.S. proposal to replace the ACRS's five-year write-offs with the applicable write-offs in the CCRS's class 4.

A

second

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1 2 6 C A N A D I A N T A X J O U R N A L

rqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA reason is that the indexation of depreciation allowances called for in the

U .S. proposal would prevent the allowances from being eroded by infla- tion. Indexation would have a significant effect even at 4 per cent inflation.

Table 8 shows some present values of the depreciation allowances under the current and the proposed systems in both Canada and the United States, given various rates of inflation. Under the current systems, the present value of capital consumption allowances is greater in Canada than it is in the United States for manufacturing machinery and equipment and less in Canada for manufacturing nonresidential construction. Under the pro- posed systems, the present value of capital consumption allowances for manufacturing machinery and equipment would be substantially less in Canada than in the United States. Moreover, since the proposed U.S.

system would be indexed, the gap between the present values of the capital consumption allowances in the two countries would increase with the rate of inflation. For nonresidential construction, on the other hand, the gap be- tween the present values of the capital consumption allowances in the two countries would be narrower under the proposed systems than it is under the existing systems, and the narrowness would be more pronounced the lower was the rate of inflation.

CONCLUSIONS

The preceding examination of the proposed corporate tax changes in Can- ada and the United States and analysis of their implications for real effec- tive tax rates raises several neglected issues that should be taken into account in discussions of the Canadian proposal.

The analysis has shown that the Canadian proposal would raise the real effective tax rate on manufacturing investment in machinery and equip- ment. The first issue may be expressed by a question-would it be prudent to raise the tax burden on Candian manufacturing now, when Canada is embarking on negotiations for freer trade with the United States and when the manufacturing sector may be called on to bear the brunt of any required industrial restructuring? This question arises whether or not the United

Table 8 Comparison of the Present Values, at Different Rates of Inflation, of Capital Cost Allowances for Manufacturing in Canada and the United States

Under the Current and the Proposed Tax Regimes

Current,

rate of inflation

Proposed, rate of inflation

0070 4070 10070 0070 4070 10070

c e n t s p e r d o l l a r o f i n v e s t m e n t M a c h i n e r y a n d e q u i p m e n t

Canada

ZYXWVUTSRQPONMLKJIHGFEDCBA

. . . 84.7 81.7 77.6 59.4 54.1 48.2 United States . . . 82.5 76.6 69.2 76.0 76.0 76.0

N o n r e s i d e n t i a l c o n s t r u c t i o n

Canada . . . 3l.0 _24.5 18.9 30.9 26.4 20.3 United States . . . 54.9 45.4 36.2 35.2 35.2 35.2

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rqponmlkjihgfedcbaZYXWVUTSRQPONMLKJIHGFEDCBA

127

States implements its proposal. Indeed, if the Canadian proposal was enacted but the U.S. proposal was not, the increase in the relative corporate tax burden on new investment in Canada would be even greater.

A second issue is indexation. The United States is definitely proposing to move toward a comprehensive indexation of the corporation tax system (ex- cept for treatment of interest expense and interest income). Although the proposed reforms would reduce the distortions in effective tax rates that result from inflation, distortions would still exist because of the tax treat- ment of the inflation premium in interest income and interest expense.

Nevertheless, certain advantages would accrue to U.S. industry from this incomplete indexation even if inflation remained around the current level of 4 per cent. If inflation returned to double-digit levels, the advantages would be more telling. For Canada, the key question is whether to follow the U.S.

lead on indexation. There would be advantages in the form of improved re- source allocation and increased tax harmonization. The disadvantage would be the increase in the complexity of the tax system that indexation would en- tail. This increase would be minimized if, following the U.S. example,

Canada did not extend indexation to interest income and expense. ZYXWVUTSRQPONMLKJIHGFEDCBA

^{1 0}

A third. issue raised by the proposed changes is whether a withdrawal of

the tax incentive for investment in the less developed regions of Canada should be. part of any general reform of the corporate tax system. Unfor- tunately, discussion of this issue is hampered by a lack of evidence about the effectiveness of the incentives in promoting regional development.

These three issues deserve consideration before we draw any final con- clusions about the merits of the proposed corporate tax changes and the de- sirability of their implementation.

ApPENDIX: THE CALCULATION OF EFFECTIVE CORPORATE TAX RATES

The effective tax rates shown in Tables 2, 3, 5, 6, and 7 were calculated by computing the ratio of the present value of taxes to the present value of real income expressed in current dollars. The calculation of present values used a discount factor equal to the product of 1 plus the real interest rate (as- sumed to be 10 per cent) and 1 plus the rate of inflation.

Real income expressed in current dollars was calculated as the return on the investment minus real interest and indexed depreciation. Return on in- vestment in year N was calculated as follows:

RETURN[N]

=

100*[(1 + PDOTf (N - 1)]*[(1 - DEPnN - 1)]*(R + DEP),

where

RETURN

is return on investment; N is the year; 100 is the initial invest- ment;

PDOT

is the rate of inflation; R is the real rate of return (assumed to be 10 per cent); and

DEP

is the depreciation rate (set equal to 7.89 per cent for machinery and equipment and 3.45 per cent for nonresidential construc- tion).

IOFor a fuller discussion of these issues, see Grady, supra footnote 7.

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128

ZYXWVUTSRQPONMLKJIHGFEDCBA

Taxes were calculated as follows:

TAXES

ZYXWVUTSRQPONMLKJIHGFEDCBA

⁼ (T*RETURN) - [(T*INTDEDUCfION) + (T*CCA) + (ITc*lOO)],

where T is the corporate tax rate;

INTDEDUCfION

is nominal interest pay- ments, calculated as the nominal interest rate times the stock of bonds issued to finance the investment;

CCA

is the capital consumption allowance on the initial investment of 100, either indexed or unindexed as applicable;

and

ITC

is the investment tax credit.

Table 1 shows the values of the parameters used for the tax rate, T, and the capital cost allowance rate and investment tax credit rate for Canada.

Table 4 shows the depreciation allowance rates for the United States. The text provides the values of T and the investment tax credit rate.

An alternative methodology for calculating effective tax rates, based on a comparison of before-tax and after-tax internal rates of return, was tried but rejected because of the extreme sensitivity of the results to what were considered to be unreasonably high internal rates of return.

V o / .34, N o . ]