Dan Herman Research

Seeing the forest through the trees March 5, 2011

Why continued corporate tax cuts miss the point.

Much ink has been spilt debating the merits of continued corporate tax cuts in Canada. But it’s fair to say that much of this debate misses the point. For corporate tax cuts are only one element, amongst many, of an economic strategy that will facilitate the development of a highly skilled, flexible workforce that will provide the foundation for a competitive Canadian economy well into the 21^st century.

In isolation, corporate tax cuts are proving to have very little impact on either job growth or foreign direct investment. For example, the federal corporate tax rate in 2009 was 18%, down from 29% a decade ago. Similar cuts in Ontario have made this province tax regime one of the most competitive in the developed world, ahead of both the US and EU averages. But instead of leading to more investment in employment-creating or productivity enhancing projects, all they’ve done is pad corporate profits and savings rates – while business investment and private sector R&D development inputs have actually decreased, as shares of GDP, across Canada.

The impact on foreign direct investment was similarly muted. Even the Canadian Association of Manufacturers and Exporters (an invariably staunch supporter of corporate tax cuts), have admitted that “over the past decade, reductions in Canada’s effective and average combined statutory corporate tax rates have had little observable impact on net flows of foreign direct investment into the country.”

So why, in the face of Canada’s so far ambiguous (and perhaps that’s being generous) record with corporate tax cuts, are policy makers and economists still battling over their implementation – and why are we now looking to reduce them further (target of 15% in 2012)?

Jack Mintz from the University of Calgary is often pointed to as a primary source of support for the cuts in corporate taxes. His work, as well as research by the OECD, highlights a large body of empirical evidence that shows that higher corporate taxes have a negative relationship with economic growth, therefore cutting taxes should expand the economy.

That this theory has not played out in the real economy should make us leery. But the bigger issue is that much of the empirical basis of this work is on the effects of cutting corporate tax cuts in high tax economies – not what should be done once corporate tax levels have been made competitive. This is an important distinction, because otherwise the theory would point to 0% tax rates across the board.

So further tax cuts have neither a strong theoretical foundation, nor any recent evidence of real impact on job creation and productivity. Further, they could be counterproductive. As Jim Stanford of the Canadian Auto Workers notes, by choosing to allocate tax revenue back to corporations and consumers rather than to productive investments in infrastructure, we actually cost ourselves the opportunity to create 50,000 new jobs.

Hence the focus on corporate tax cuts fails to address the most important issues related to the future of our Canadian economy. Our key issue is not corporate profitability, or even driving economic growth. Rather, it is productivity. Canadian labour productivity lags behind our American counterparts by 25 per cent, and over the last decade ranks second last amongst G7 countries and far behind most comparable EU countries. A decade of large corporate tax cuts has not improved this; it’s unlikely another decade of them will either.

So perhaps some tweaks to the tax code, such as targeted subsidies and tax incentives for productivity-enhancing investments in new technologies, research and development and job creation activities, and maybe even tax cuts aimed directly at  small and medium sized businesses, could be beneficial. However, implementing blanket tax cuts for large corporations, when we already have a competitive tax regime, is not the answer.

What will attract both domestic and foreign investors in the future is a productive and highly skilled workforce, and further incentives for long-term investments that boost productivity and our ability to compete. This means that ongoing investments into education, retraining and infrastructure (both digital and physical), are the keys to building a Canadian economy able to withstand the pressures and uncertainties of a hyper-competitive global marketplace – rather than continually lowering tax rates to pad corporate profits. If we’re serious about competing with the world then Canadians need to look beyond political and economic rhetoric and focus on the real issues and actions that can help facilitate the ongoing development of a highly-skilled, flexible workforce that positions Canada as a place to invest.

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Dan Herman is a PhD student at the Balsillie School of International Affairs and a Senior Associate at the Ottawa-based Institute on Governance. You can follow him on Twitter @danherman