As finance ministers across Canada start putting the finishing touches on their 2018 budgets, they are sure to be casting a nervous glance to the south. In late December, the U.S. Congress approved – and President Donald Trump signed – a package of tax reforms and rate reductions that amounts to the biggest overhaul of America’s tax system in four decades. The changes are numerous and complex. For policy-makers and business leaders in Canada, the new reality of U.S. taxation heralds a significant shift in the competitive landscape.
The most important modifications to the U.S. tax regime apply to the business sector. They include:
•A dramatic reduction in the federal corporate income tax rate: to 21% from 35%, effective in 2018, along with elimination of the “alternative minimum tax.”
•A shift from “worldwide” to “territorial” taxation of business income, which brings the U.S. closer into line with other advanced economies.
•A provision allowing 100% immediate expensing for business capital spending on machinery, equipment, intellectual property, digital assets and certain other forms of property. This measure will remain in place for five years and be phased out gradually starting in 2022. Over the medium term, it provides a powerful incentive for companies operating in the U.S. to boost domestic investment.
•Restrictions on interest deductibility and on companies’ ability to use net business operating losses to shield income from tax.
•New tax rules for income generated by intangible products/assets owned by U.S.-controlled foreign corporations. These changes are designed to encourage American multinationals to repatriate intellectual property by making it less attractive for them to hold IP assets abroad.
The U.S. tax reforms also touch on individuals and families. There are modest reductions in personal income tax rates, a doubling of the estate tax exemption and new limits on the use of certain “itemized deductions” – including interest on mortgages taken out to buy expensive homes, and taxes paid to state and local governments. The top federal individual tax rate – on earnings above $500,000 – drops by more than two percentage points to 37%.
The U.S. tax changes add up to an estimated $1.5 trillion tax cut spread over 10 years. Taken together, these measures will deepen America’s already substantial fiscal hole. Despite a multi-year economic expansion, the federal deficit is still hovering near $700 billion. Since 2007, the accumulated government debt has roughly doubled as a share of GDP. This set of tax reforms is expected to push the debt higher – and at an accelerating pace.
What does it all mean for Canada?
In the near term, lower taxes should lead to a modest pickup in U.S. economic growth – a positive outcome for Canada’s export industries, notwithstanding the protectionist inclinations of the Trump administration.
But looking further ahead, the picture gets murkier. For one thing, a dose of unneeded fiscal stimulus when the U.S. economy is running at full tilt suggests a faster rise in interest rates – a trend that could spill over the border and put upward pressure on borrowing costs here in Canada.
More importantly, the new U.S. tax provisions applying to business instantly erase any tax advantages from investing in Canada across a swath of industry sectors. For 15 years, Canada has had significantly lower corporate income tax rates than the United States. In many industries, effective business tax rates – which account for the impact of depreciation, tax credits and other provisions in the tax code – have also been lower here. These advantages have disappeared. In addition, the new U.S. rules permitting immediate expensing of business investment mean many companies will soon find that it makes economic sense to deploy incremental capital to the U.S. rather than Canada.
Overall, it’s clear that any tax-related reasons for businesses to invest in Canada versus the United States have suddenly become much weaker. A lower individual tax burden on entrepreneurs and highly skilled personnel under the U.S. tax plan may also influence the future locational decisions of companies, managers and top professional talent.
Canada faces a changed competitive environment occasioned by the implementation of far-reaching American tax reforms. While there is no need to panic, policy-makers in Ottawa and Victoria cannot afford to stand still. Put simply, the United States is engaged in an aggressive, multi-faceted effort to repatriate corporate investment, head offices, intellectual property, employment and business activity generally. How will governments in Canada respond? •
Jock Finlayson is the Business Council of British Columbia’s executive vice-president and chief policy officer; Ken Peacock is the council’s chief economist.