The case for corporate tax cuts is that they supposedly prompt businesses to invest more in Canada. Critics have countered that an unconditional gift to those corporations which are already profitable will not necessarily increase investment. A third possibility that has received little attention helps explain why corporate tax cuts are so ineffective.
Much of the revenue forgone by Canadian governments will flow not to enterprises operating in Canada but to foreign governments. In particular, the U.S. government taxes its corporations on a worldwide basis and President Obama has proposed tougher enforcement of this policy. American corporations account for nearly one-third of all profits subject to Canada’s general corporate tax rate.
When an American company repatriates profits from Canada to the U.S., it pays the 35% American federal corporate tax rate minus a credit for taxes already paid in Canada. If our federal plus provincial rate is at least 35%, these corporations do not owe American tax on their Canadian profits.
Emphasis added, because it is that particular word that betrays a misunderstanding of the case for lower corporate tax rates.
If the only way that foreign savings could transform themselves into Canadian productive capacity was by way of foreign-registered corporations, then this would be a powerful point. As far as foreign investors are concerned, the relevant corporate tax rate would be that which prevails in their home country. Canadian investors might see the benefits from lower Canadian corporate tax rates, but international investors wouldn't. The gains from such a policy would be somewhat problematic.
Happily, that is not the case. Foreign investors are not obliged to invest in companies registered in their own countries. They are free to invest in Canadian corporations directly and to take advantage of the higher returns generated by lower Canadian corporate income taxes.
The case for lower corporate income taxes is not based on providing opportunities for foreign businesses to invest in Canada, it is based on providing incentives for foreign lenders invest in Canada. The former are bound by their domestic corporate income tax rates; the latter are not.
Worthwhile Canadian Initiative 
There’s another powerful argument for foreign investors to invest directly in Canadian registered businesses – Canadian funders, customers, and suppliers prefer dealing with companies that are under Canadian jurisdiction.
The case for lower corporate income taxes is not based on providing opportunities for foreign businesses to invest in Canada, it is based on providing incentives for foreign lenders [to] invest in Canada.
I would have thought it was BOTH – providing incentives to both Canadian and foreign lenders. No?
And as far as foreign investors picking a Canadian based firm instead of an American one. If as your earlier post indicated, foreign owned firms are more innovative and productive than their Canadian counterparts, does it necessarily follow that the foreign money would flow into Canadian vs American owned firms?
Thanks for this post, Stephen. I had heard that argument on The Agenda on TVO and I wasn’t sure what to make of it. This help to clarify my thinking. Appreciated.
While it is certainly true that differential rates of corporate income taxes are reflected in the competitiveness of firms, no matter where located, the very existence of the corporate income tax will reduce the standard of living through its negative impacts on customers, workers and investors, which are the only effective targets that a corporate tax can hit. Rather than penalize profitable firms producing what consumers want, as well as jobs and investments, it might make more sense to penalize the non-profitable firms that waste otherwise valuable resource inputs. This is not a serious suggestion, but just a further demonstration of just how silly a corporate income tax really is. Only people can really pay taxes.
Regards, Don
Foreign multinationals will invest in local subsidiaries with reasonable levels of corporate taxation for certain types of industries (financial services, resources, construction, real estate, retail) which are inherently local in nature. Other types of income, such as licensing fees, and interest income are far more rate sensitive, so you will see foreign multinationals setting up licensing and financing subsidiaries in tax favourable jurisdictions in other parts of the world, irrespective of the Canadian corporate tax rate.
For “local” industries, foreign multinationals are more concerned with sustainable profitability than with Canadian income tax rates. The target Canadian corporate income tax rate of 25% (plus withholding tax on dividends) is reasonable for an industrialized country, and I do not expect that lowering it any further would attract significant additional foreign investment. Foreign investors are more interested in investing in particular profitable industries, than they are in lower Canadian corporate tax rates.
Setting a target corporate tax rate is a balancing act of raising a reasonable level of corporate tax revenue; at some point excessively low tax rates leave money on the table since profitable “local” business activities will be carried out in any case, whereas excessively high rates will curtail less profitable activities and drive some portion of the economy underground).
@Robert Ireland’s corporate tax rate of 12.5% spurred massive investment over the course of 20 years, though it also used to have a cheap and educated workforce. Now it just just has an educated one.
Don writes: the very existence of the corporate income tax will reduce the standard of living through its negative impacts on customers, workers and investors,
How would you propose to finance say the twinning of Highway 63 to Fort McMurray? Toll road?
The highway sees an increasingly high volume of traffic due to the booming oilsands industry in Wood Buffalo, causing potentially serious transportation-related problems. Trucks carrying large equipment can delay the traffic greatly, since they can be large enough to occupy two traffic lanes.
…
There were more than 1,000 crashes on the highway between 2001 and 2005, killing 25 people and injuring 257 others. [3] The highway has been referred to as Suicide 63.
http://en.wikipedia.org/wiki/Alberta_Highway_63
Withholding taxes?
JV: how about oil royalties? A road toll sounds good, too. Perhaps a fee for transporting wide loads as well (I’m sure there already is one).
Chris:
“Ireland’s corporate tax rate of 12.5% spurred massive investment over the course of 20 years, though it also used to have a cheap and educated workforce. Now it just just has an educated one.”
Nicely put.
As Stephen points out, the problem with the argument is that it ignores the reality that reducing corporate taxes make it easier for Canadian corporations (i.e., businesses that are not just wholly owned subisidiaries of foreign companies) to raise capital, either by borrowing or by direct investment by foreign portfolio investor. It also matters for foreign private equity funds, which are typically structured as partnerships. At least in the US, the funds themselves aren’t taxed, but their investors are, who typically cannot claim the foreign tax credit for the underlying tax paid by the Canada company)and for non-taxable entities (pension funds, 401ks, charitable endowments, etc.) which may invest in Canadian companies.
Why stop at 12.5%? Why not go to 0%? Or even negative?
@Just visiting from macleans – Because the government still wanted to raise revenue directly from corporations. And if you went “negative” then you’d only be dragging the economy to pay companies who setup shop there just for the money, like all other subsidies. But it is also true that the more you cut taxes, the less effect each cut has. Going from 25% to 12.5% will be a big deal. But going from 12% to 7% won’t have the same effect, though it may still be beneficial and worth doing.
Can’t say about 0%, but I expect than negative tax rates on corporate profits would change the incentives: you’d need to audit to ensure stated profits are real (corporations could lie/cheat/steal to show false profits, then fold).
One thing the NDP never points out is that increasingly American based companies do business in Canada through local subsidiaries incorporated as Nova Scotia unlimited liability companies or ULC’s which help US based companies shelter their Canadian profits in an extremely complex way from the IRS in the US.
The writer of the counterpoint article conveniently ignores the fact that corporations can migrate from jurisdiction to jurisdiction, or reorganize to shift revenue generating operations to lower tax locales. In fact, this type of reorganization is very common. Moreover, the system of tax treaties can restrain the ability of governments, with taxes on worldwide income, to claim the full amount to which they think they are entitled.
I would agree though that low corporate taxes are not necessarily the best incentive for corporations to locate value-generating investments in one’s country. I would argue that a well-trained workforce, a fair and efficient justice system, good transportation and communication infrastructure, and access to a large market of consumers are much bigger draws for corporations than low taxes.
@Ross Canada doesn’t have a large market of Consumers. Should RIM pack up and leave Canada?
Those other points are all important, but a companies don’t necessarily need all of them. Good transportation is irrelevant if you’re going to have your stuff built in China, where there’s not a well trained workforce and a dubious justice system. Companies still have presences there. They wouldn’t necessarily if the tax rates were so high to not make it worth it.
Should RIM pack up and leave Canada?
If it did, it would lose any competitive advantage it had through its close affiliation with U of Waterloo, and the supply of its high quality technical graduates (traditionally a big supplier to Microsoft and other Silicon Valley high-techs), one of its Key Success Factors.
How about this?
http://economistsview.typepad.com/economistsview/2010/03/recovery-depends-on-main-street.html
“Can the American economy recover if only its big global companies, Wall Street and high-income Americans are doing better, but its small businesses and middle and lower-income Americans are not? The short answer is no. …
US companies have lots of cash… But this cash is not going into new investment. … None of this is stopping supply-side fanatics from arguing government needs to cut taxes on big corporations to spur the recovery. Their argument is absurd. Big companies do not know what to do with all the cash they have as it is. They are not investing it in new plant or jobs. So why should the government cut their taxes and enlarge their cash hoards even more?
The picture on Main Street is the opposite. Small businesses are not selling much as they have to rely on American consumers and Americans still are not buying much.”
Some observations regarding various points raised in the comments from today:
1) China is not a low tax jurisdiction. Subject to some grandfathering for low rates applicable to foreign owned enterprises carrying on business prior to the 2009 tax reform, China now has a 25% corporate tax rate applicable to domestic and foreign owned enterprises.
2) While Ireland had positioned itself well over the past two decades, it is has lost some of its lustre over the past few years. Companies which exploit IP and earn significant royalty income are looking to Luxembourg or the Netherlands to hold the IP since those two countries subject royalty income to very low effective tax rates, and they have good treaty networks (to minimize foreign withholding on the royalties). I expect that its manufacturing sector is under the same pressures that manufacturing is facing in North America, irrespective of the Irish tax rate. Its financial sector is facing its own difficulties.
3) The discussion of US taxes in the post itself assumes that foreign earnings will be repatriated to the US (in which case the US indirect foreign tax credit system is relevant). Many US multinationals do not repatriate earnings to the US. If a US company can demonstrate that its foreign subsidiary intends to “permanently reinvest” its earnings offshore, then the US parent does not have to take the high US tax rate into account for financial reporting purposes. A US company which sets up an effective offshore structure can consolidate the results of a profitable foreign subsidiary, and include only the local tax expense in the consolidated tax expense.
In view of the main sources of corporate profits in Canada (financial services, resources, construction, real estate, retail), the effect of foregone corporate tax revenues (of any further corporate tax rate decreases below the target of 25%) should not be taken lightly.
I wish people would distinguish between the anti-social negative-sum behaviour of attracting mobile entities like corporations by undercutting the tax rates of other countries, and the question of what, leaving aside the question of migration, the optimal level of corporate tax should be.
If we could settle the second question, then we could impose the same rate globally and render the first issue moot. Unrealistic, maybe, but faced with a similar global prisoner’s dilemma, all the countries in the world signed up to global bank capital rules, and there is some momentum in this direction on tax shelters as well.
If we ignore corporations and assume that it is all about individual “lenders” (as Stephen suggests), then the US taxing its corporations on a worldwide basis does not affect Canada.
However, if the goal is to actually influence the investment decisions of corporations, then these institutional realities are rather important.
By the way, how do you reconcile the fact that the corporate sector itself became a net lender with your view of corporations as mere intermediaries to which individuals lend?