Doug Porter, chief economist at BMO Financial Group weighed in on Canada’s investment woes. “The bottom line is there really is a need for more urgency on the competitiveness front,” he said. “We’ve got a sluggish picture for business investment in 2018 and now a report showing record net outflow of FDI. It all suggests that even before we had the U.S. tax changes, there was a challenge facing Canadian business investment.”
Porter continued by suggesting that something else might be in play. “Usually late in the cycle when the global economy is doing well, you tend to get large inflows into Canada not the opposite. That’s why this number is disappointing. There is a problem here. Some of it does reflect ongoing concerns in the energy sector but I think there’s something else at play here as well,” Porter said.
And he might just be right.
Canada’s investment woes did not just appear all of the sudden. Canada has seen a considerable drop in foreign investment since 2014. Fraser Institute President Niels Veldhuis and Vice President Jason Clemens provide a sobering analysis of Canada’s troubling investment climate:
“And unfortunately investment data bears out these anecdotes. Since peaking in the fourth quarter of 2014, total business investment –excluding residential housing and adjusted for inflation – is down almost 17 percent. Private-sector investment in factories and other structures is down 23.3 percent. And investment in intellectual property is down 13.3 percent. Investment by foreigners has collapsed. Foreign direct investment (FDI) in Canada was $31.5 billion in 2017, down 56.0 per cent since 2013 when it totaled $71.5 billion.”
For years, Canada has been a solid competitor to its southern neighbor in the United States, but now it is seeing its economic fortunes reverse.
What exactly gives?
Ever since President Donald Trump signed tax reform into law, the once notable tax advantages that Canada held are no longer present. Now that the United States has the edge on Canada in various aspects of tax policy, Canadian policymakers have tough choices to make.
One thing is clear: To remain economically competitive with its neighbor, Canada must consider reform.
The nature of U.S tax reform
To understand why Canada’s trend of declining investment may become even more pronounced, we must first look at what the Trump administration’s latest tax reforms have accomplished.
Kicking off 2018 with a bang, the United States government undertook a series of tax reforms that saw certain taxes rates brought down.
While not far-reaching from a free market standpoint, these reforms have still made the United States considerably more competitive on the international stage, especially against its rival and long-time trading partner Canada.
President Trump’s latest tax reforms notably dealt with reductions in corporate taxes from 35 percent to 21 percent top individual income tax rates were slashed from 39.6 percent to 37 percent.
For years, Canada has enjoyed a considerable corporate tax advantage. In 2017, the United States marginal corporate income tax rate stood at 35 percent, whereas the Canadian rates were at 21 percent. The most high-profile case where Canada exploited this advantage was when Burger King merged with Tim Hortons and moved its headquarters to Canada as a means of reducing its corporate tax burden.
On the other hand, Canada’s top income tax rates were already considerably higher before the American tax reform, with the top federal-provincial rates at approximately 54 percent, while the United States topped out at 46 percent. It should also be noted that Canada’s top rate covers a considerably lower income level.
A Fraser Institute report provides a sobering picture of how the Canadian government, both at the federal and provincial level, is making the country less competitive:
“Ottawa and several provinces have undermined Canadian competitiveness with an assortment of policies that discourage investment. This includes higher tax rates on personal income, corporate income and payroll; persistent budget deficits, which risk future tax increases; new regulations on carbon, resource projects and labour; and higher costs of doing business through minimum wage and energy price hikes. And now, as we’re seeing with the Kinder Morgan Trans Mountain pipeline expansion, increased uncertainty about the rules and policies affecting economic and resource development. The cumulative effect of such policies, along with strong anti-business rhetoric from many governments, has struck a harsh blow to Canada’s investment climate. U.S. tax reform, plus uncertainty surrounding NAFTA renegotiations and access to the U.S. market, only rubs salt in Canada’s self-inflicted policy wounds.”
Although the effects of investment will take time to manifest themselves in the United States, Canada will now be operating in an environment where it no longer has a leg up on the United States in tax policy.
The effects could be harmful for Canada, as companies will opt to the more business-friendly United States.
Canada’s anti-middle class tax policy
Canada must now come to grips with the new reality of a more tax-competitive United States If Canada maintains it high-tax status quo, it will continue to remain unattractive to foreign investors.
To keep pace with the United States, should Canada consider its own tax reform program?
Tax-wise, Canada has embarked on the wrong path to tax policy since Prime Minister Justin Trudeau arrived in office in 2015. Ostensibly campaigning under the banner of cutting taxes for the middle class, the Liberal Party’s tax reforms have done the exact opposite.
A paper by Charles Lammam, Milagros Palacios, and Hugh MacIntyre exposes the unsavory truth behind this tax plan. For starters, this report initially found the following: “[I]ncome tax changes have resulted in 60 percent of the 3.88 million families with children covered in this paper (representing 13.9 million individuals), paying more in taxes. The average tax increase amounts to $1,151 each year.”
But it gets even juicier: “Among middle income families – the group of families the federal government claims to want to help – 81 percent are paying more in taxes as a result of the federal income tax changes. The average income tax increase for this group of middle income families is $840.”
And to top it all off: “For the subset of middle income families consisting of couples with children, an even greater share (89 percent) pays higher income taxes ($919 on average).”
No matter how much the Liberal Party claims to be pro-middle class, the tax reforms they have recently spearheaded do not bode well for their constituents. In many regards they have violated their trust by doing the exact opposite they campaigned on.
Time will tell if the Canadian middle class will eventually come to their senses and push back against any more tax hikes.
Mandatory pension contributions: A domestic investment bottleneck
Foreign investment is not the only form of investment in potential trouble.
In an article for the Financial Post, the Fraser Institute warns how increased contributions to the Canada Pension Plan (CPP), which is slated to go into effect in 2019, could stymie domestic investment. Simply put, mandatory increases in contributions are a non-starter for a country that is already going through a questionable investment climate.
The Fraser Institute recognizes how vital investment is for economic growth: “A decline in investment within Canada will have negative effects on the Canadian economy, as investment is critical to making workers more productive, increasing wages and improving living standards,” the report said.
It continued: “The decline in investment will also come at a time when business investment in Canada is already decreasing and lagging behind other industrialized countries.”
Starting in 2019, money that would otherwise be allocated to productive activities like domestic investment will then be siphoned into a government-run pension scheme notorious for its costs and inefficiencies.
In the end, Canadians get a raw deal. Every dollar that Canadians can pocket makes all the difference in the quest to grow Canada’s wealth. When the government continues to embark on a confiscatory route of taxation or forced contributions, economic stagnation will follow.
It’s all about jurisdictional competition
Economic growth remains king in discussions about reducing poverty.
The most proven method to attracting the investment necessary to boost economic activity is having low fiscal and regulatory barriers. High taxes and out of control spending generate economic uncertainty and makes investors and businesses think twice about setting up shop in countries like Canada.
This will be especially pronounced now that the United States is at least beginning to embrace certain tax reforms, as is the nature of tax competition between different jurisdictions.
When pushed against the wall, countries will seek whatever competitive edge they can get – be it lower taxes, lower regulations, or easier steps to start up a business. As fierce as this competition maybe, it yields positive results for workers worldwide.
Historically speaking, citizens around the world were bound to their birthplace and had to serve some type of overlord. Thanks to tax competition, citizens worldwide now have the ability to take their skills to jurisdictions that are in line with their financial and political values.
Both countries and skilled laborers win out in this arrangement.
Now Canadians policy makers must consider fiscal policies that make Canada attractive to businesses and investors alike.
They can start by cutting income taxes and considering a move to privatized pension scheme in the mold of Chile, where voluntary contributions are emphasized and the state’s role in the process is reduced.
A tax-competitive North America is a win-win for both American and Canadian workers.