canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2, 392 - 468

392

Policy Forum: Corporate Income Taxation in Canada

George R. Zodrow*

A b s t r A c t

The author examines Canadian corporate income tax policy, focusing on the implications of international capital mobility, international tax competition—including the need for a corporate tax structure that is competitive with respect to the United States and other competing economies—and international tax avoidance. He begins by considering the arguments for tax exemption or even subsidization of capital income, and then examines the many qualifications to these arguments. His analysis pays particular attention to the implications of the existence of firm-specific and location-specific economic rents and the issues raised by new techniques for international tax avoidance. In all cases, the discussion of theoretical arguments is followed by an examination of the empirical evidence, including studies specific to Canada as they are available. The author then traces the implications of the analysis for corporate income tax policy in Canada, including the recently enacted corporate income tax rate reductions and other potential reforms.

Keywords: Canadian n Corporate inCome taxes n business taxes n tax reform n

international taxation n international tax avoidanCe n Capital movement

c o n t e n t s

Introduction and Background 393The Case for Tax Exemption or Subsidization of Capital Income 404

The Basic Argument for a Zero Tax Rate 404Extending the Zero Tax Argument to Statutory Tax Rates 407

The Taxation of Firm-Specific Rents 407The Role of Income Shifting in Limiting Statutory Tax Rates 409

A Case for Subsidization 415The Role of Imperfect Competition 415The Role of Imperfect Information 416

* ProfessorofEconomicsandRiceScholar,TaxandExpenditurePolicyProgram,JamesA.BakerIIIInstituteforPublicPolicy,RiceUniversity,Houston,Texas;andinternationalresearchfellow,CentreforBusinessTaxation,OxfordUniversity.IwouldliketothankAshleyRussellforresearchassistanceinthepreparationofthisarticle.

corporate income taxation in canada n 393

Qualifications 417Openness of the Economy and Perfect Substitutability of Imports 417The Personal Income Tax Backstop Argument 424The Implications of Tax-Avoidance Activities 427The Treasury Transfer Argument 430

Territorial Countries 430Firms in Excess FTC Positions 431Deferral of Credits Until Repatriation 437The Treasury Transfer Effect: Empirical Evidence 439

The Benefits of Taxing Location-Specific Economic Rents 440Political Realities 441

Implications for Corporate Income Taxation in Canada 442Weighing the Arguments: A General Discussion 444

Taxing Economic Rents 445The Treasury Transfer Argument 446The Role of Tax Avoidance 449The Backstop Argument 449Political Arguments 450The Gravelle-Smetters Arguments 450Summary 451

The Recent Rate-Reducing Corporate Income Tax Reform 451Additional Issues 457

Rate Preferences for the Manufacturing Sector 457The Dual Income Tax Option 458Windfall Gains to Old Capital 462Interprovincial Tax Competition 465Withholding Taxes 466

Conclusion 467

Intro duc tIo n A nd b AcKgro und

Asinmanycountries,taxreformisaperennialtopicinCanada.Inrecentyears,oneofthemainfactorspromptinginterestintaxreformhasbeenconcernaboutCan­ada’srelativeeconomicperformanceintheglobaleconomy.Forexample,Mintz1observes that (1)over the period 2000­2004, the growth rate of gross domesticproduct(gdP)percapitainCanadaranked24thamong29countriesintheOrgan­isationforEconomicCo­operationanddevelopment(OECd);(2)Canadianlabourproductivitygrewbyonly1.6percentover thesameperiod,ascomparedwitha3.6percentrateofgrowthintheUnitedStates;and(3)in2006,capitalinvestmentperworkerlaggedotherOECdcountriesbyanaverageofCdn$1,400andlagged

1 JackMintz,The 2006 Tax Competitiveness Report: Proposals for Pro-Growth Tax Reform,C.d.HoweInstituteCommentaryno.239(Toronto:C.d.HoweInstitute,2006).

394 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

theUnitedStatesbyCdn$3,200.Similarly,MintzandTarasov2arguethatCanadaislagginginattractingforeigndirectinvestment(FdI)fromtheworld’smultinationalenterprises(MnEs),ranking25thinnetFdIamongagroupof73industrializedanddevelopingcountries,and46thinnetinflowsofFdIasapercentageofgdP.

Althoughtheseshortfallscouldpotentiallyberelatedtoawidevarietyoffactors,oneplausibleexplanation is that relativelyhighcombined federal andprovincialtaxesappliedtocapitalincomehavehadanegativeimpactonthelevelofcapitalinvestment,leadingtolowerratesofgrowthinlabourproductivityandoutput.Thisconcernismagnifiedbyasensethatincreasingglobalizationandinternationalcap­italmobilityaregivingrisetogreaterinternationaltaxcompetition,especiallyfromsmaller developed economies and countries emerging from socialism, many ofwhichhaverecentlyenactedtaxsystemsthatareveryfavourabletoFdI.Indeed,therecentdramaticsuccessofseveralcountrieswithstrikinglylowcorporateincometax rates in attracting FdI and stimulatingeconomicgrowth—particularly in thecaseofIreland,withitscorporaterateof12.5percentanddramaticgrowthexperi­ence,muchofwhichisattributabletoFdIinbusinessesthatservetheEUmarket3—havenaturallyraisedthequestionofwhethersuchanexperiencecouldbereplicatedinCanada,givenitsproximitytothelargeUSmarket.

TheseconcernshavepromptedtaxchangesinCanadainrecentyears,especiallywithrespecttothetaxationofcapitalincome.Indeed,undercurrentlyscheduledreformsannouncedinthe2006budget,thetaxfairnessplan,andthe2007economicstatement,4thefederalstatutorycorporateincometaxratewillfallfrom22.12per­centin2006(includinga1.12percentagepointsurtax)to15percentin2012.Witha smallnet increase inprovincialcorporate incometaxes, thecombined federal­provincialstatutorycorporateincometaxratewillfalltoapproximately27.6per­cent in2012, relative to34.3percent in2006and42.9percent in2000.5Otherrecentandscheduledfuturereformsincludetheeliminationofthefederalcapitaltaxin2006;theeliminationofallprovincialgeneralcapitaltaxes(by2012,onlyoneprovincewillhaveageneralcapitaltax);andincreasesintaxdepreciationratesforanumberofassets,notablybuildingsandcomputers.Inaddition,federalandprov­incialdividendtaxcreditmechanismshavebeenadjustedsothatthecorporateand

2 JackM.MintzandAndreyTarasov,“CanadaIsMissingOutonglobalCapitalMarketIntegration”e­brief(C.d.HoweInstitute,August21,2007)(online:http://www.cdhowe.org/pdf/ebrief_48.pdf ).

3 BrendanWalsh,“TaxationandForeigndirectInvestmentinIreland,”inHerbertg.grubel,ed.,Tax Reform in Canada: Our Path to Greater Prosperity(Vancouver:FraserInstitute,2003),221­45.

4 Canada,departmentofFinance,2006Budget,May2,2006;“Canada’snewgovernmentAnnouncesTaxFairnessPlan,”Releaseno.2006­061,October31,2006;andCanada,departmentofFinance,EconomicStatement,October30,2007.

5 SeeEconomicStatement,supranote4.notethatprovincialincometaxesarenotdeductibleagainstfederalincometaxliability(althoughprovincialcapitaltaxesandpropertytaxesaredeductible).

corporate income taxation in canada n 395

individualincometaxsystemswillbealmostfullyintegratedforlargecorporations,thuseliminatingvirtuallyalldoubletaxationofdividendincome.6Capitalgainsaresubjecttoa50percentexclusion,whichactstooffsettheeffectsofcorporate­leveltaxationoftheearningsthatgiverisetothegains,aswellasthetaxationofpurelyinflationary gains.7 Finally, personal income is subject to tax at a top rate of29.0percentatthefederallevelandaweighted(bywages)averageof16.5percentattheprovinciallevel,resultinginacombinedmaximumtaxrateonlabourincomeof45.5percent.

Whetherthesenewstatutorycorporateincometaxratesarecompetitiveorhighrelativetoothercountriesdependsonthecomparisongroup.TaxcompetitivenesswiththeUnitedStatesisacriticalminimalrequirement.TheUnitedStatessuppliesabouthalfofCanada’sinboundFdIandisthedestinationofabout30percentofCanada’soutboundFdI.8Moreover,itiscriticalthatCanadabeanattractiveinvest­mentlocationforMnEsfromothercountriesthatwishtoservetheUSand,moregenerally,thenorthAmericanmarkets.9Accordingtothismetric,andassumingthattheUnitedStatesdoesnotreduceitscorporateincometaxrateoverthenextfouryearsorso(whichmaybeafaultyassumption,especiallyinlightofrecentpro­posalsforsignificantcorporateincometaxratereductions),theCanadiancombinedfederalandprovincialstatutorycorporateincometaxrateof27.6percentlegislatedfor2012comparesquitefavourably:theCanadiandepartmentofFinanceestimatesthatthecomparablecombinedUSfederalandstatecorporatestatutoryincometaxrate(includingthespeciallowereffectivetaxrateon“manufacturing”income)in2012willbe37.9percent,yieldingastatutoryratedifferentialof10.3percentagepoints in Canada’s favour.10 Canada’s projected combined statutory corporateincometaxrateof27.6percentisalsothelowestamongthegroupofSeven(g7)

6 dividendsreceivedwillbegrossedupbyafactorof1.38andthentaxedatthepersonallevel,atatoprateof29.0percentunderthefederalpersonalincometaxandatanaveragetoprateof16.5percentundertheprovincialpersonalincometax(implyingatopmarginaltaxrateof45.5percent).Individualswillreceivedividendtaxcreditsof15.0percentatthefederallevelandanaverageof10.8percentattheprovinciallevel,ortotalcreditsof25.8percent,whichisclosetotheaveragecombinedfederalandprovincialcorporateincometaxrateof27.6percent.Thus,thereformswillachievenearlycompleteintegration.

7 Itisestimatedthatacapitalgainsexclusionrateoftwo­thirdswouldberequiredtofullyintegratethepersonalandcorporatetaxsystemsfornon­distributedearnings:seeThomasA.Wilson,“AnEvaluationofBusinessTaxesinCanada,”inTax Reform in Canada,supranote3,at111­40.

8 ThesefiguresarebasedonaverageFdIflowsover2001­2006.

9 AsstressedbyMintz,supranote1,increasingsecurityconcernsandthespreadofprotectionismreducethelikelihoodthatfirmswilllocateinCanadatoserveothernorthAmericanmarkets,andthusincreasetheneedforataxsystemthattreatsforeigninvestmentfavourably.

10 Canada,departmentofFinance,“TaxesonBusinessInvestment:AnInternationalComparisonofMarginalEffectiveTaxRatesintheManufacturingSector,”inTax Expenditures and Evaluations 2006(Ottawa:departmentofFinance,2006),37­58.

396 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

membercountries,whichtogetherhaveamedianstatutorycorporateincometaxrateof31.4percent.11

Although comparisons with the other g7 countries are certainly relevant forCanada, the modern integrated world economy is characterized by ever greatermobilityofcapital,goods,andtoanincreasingextentservicesandskilledlabour,aswellassignificantlylowertransportcosts,especiallyforproductsthatcanbepartiallyorfullydigitized.Accordingly,internationaltaxcompetitionoftenextendsbeyondtheheavilyindustrializedg7nationstoincludesmallerdevelopedeconomiesandemergingandtransitionaleconomies,includingbothLatinAmericancountriesincloseproximitytoUSmarkets,forgoods(forexample,thosewithrelativelyhightransportcosts)whereanorthAmericanlocationiscriticaland,moregenerally,virtuallyallsuchnationsforgoodswhereproximitytotheUSmarketisrelativelyunimportant.At some level, all suchcountries represent apotential location forinvestmentbytheMnEsofothercountries(increasinglyincludingthosewishingtogainaccesstotheUSmarketastransportationcostsdeclineandmoregoodsandservicesbecomedigitized),aswellasbyMnEsbasedinCanada.However,existingandlikelyfuturetradeandinvestmentpatternsprovideinformationthatinpracticeishighlyrelevantindeterminingacountry’scompetitorsforinternationallymobilecapital.Atpresent,Canada’skeynon­USsuppliersofinboundFdIaretheUnitedKingdom,thenetherlands,Brazil,Switzerland,andgermany.12WhilesomeofthisinboundFdIisasubstituteforimports,muchofitisinsupportofexportstotheUnitedStates.Potentialalternativelocationsforthisinvestment,inadditiontothelistedcountriesandtheUnitedStates,areothercountriesinnorthandSouthAmerica,particularlyMexicoandBrazil.AconsiderationofCanada’soutboundFdIaddsonlyoneothercurrentmajorcompetitor,France.Itisprudent,nevertheless,to also consider large, rapidlygrowingeconomies suchasChina, India, and theRussianFederationwhenassessingfuturegrowthinCanada’sexportsandFdI.

TherecentratereductionsimplythatCanadawouldbecompetitivewithallofthese nations with a combined federal­provincial statutory rate of 25percent—Canadawouldbewithin1percentagepointofthelowestrateinthegroup(24per­cent, inRussia).Moreover,reducingtaxratesfurthertocompetewithextremelysmalllow­taxjurisdictionsislikelytoresultinsignificantrevenuelosseswithlittleadditionalFdI.Similarly,competingwiththerelativelysmallcountries thathavespeciallow­taxregimesforhighlymobilefinancialcapitalisunlikelytobeacost­effectivepolicy.

Althoughrelativestatutorytaxratesareimportantinattractinginvestmentanddeterminingincentivesfortaxavoidance(aswillbediscussedatlengthbelow),itis

11 BycomparisonwiththeprojectedCanadianandUSrates,in2012thecombinedstatutorycorporateincometaxratesfortheotherfiveg7countrieswillbe41.9percentinJapan,31.4percentinItaly,33.3percentinFrance,29.8percentingermany,and28percentintheUnitedKingdom.SeeEconomicStatement,supranote4,updatedforrecenttaxchangesinItaly.

12 Onaverage,from2001to2006,theUnitedStatesaccountedforalmosthalfofCanada’sinboundFdI,whiletheotherlistedcountriesaccountedforalmost40percent.

corporate income taxation in canada n 397

wellknownthatstatutorytaxratesareonlyonecomponentofthetotaleffectofataxsystemoninvestmentincentives.Otherfactorsincludedepreciationorcapitalcostallowances(CCAs),investmenttaxcreditsandotherinvestmentallowances,themethodoffinancecoupledwiththetaxtreatmentofinterestdeductionsanddivi­dendspaid,andthetaxtreatmentofinflation.Inaddition,theeffectsoftaxesotherthancorporateincometaxmustbeconsidered,includingtaxesonwealthorcapitalandindirecttaxes,suchasprovincialsalestaxes,thatareassessedonbusinesspur­chases.Thestandardtoolusedtoanalyzethecombinedeffectsofalltheseprovi­sions is the marginal effective tax rate (METR), which measures the differencebetweengrossandnetreturns,relativetothegrossreturn,imposedbyataxsystemonamarginalorbreak­eveninvestment,takingintoaccountallthefactorsnotedabove.

AcomparisonofMETRsinCanadawiththekeycompetitorsforFdIidentifiedaboveisslightlylessfavourablethanacomparisonofstatutoryrates.13Assuminga25percentstatutoryrate,Canada’sprojectedMETRin2012is23.7percent,14thefourthlowestinthecomparisongroup.Thenetherlands,Mexico,andSwitzerlandwill have lower METRs, ranging from 7 to 11percentage points lower than theMETRprojectedforCanada.giventhecurrentleveloftradeandinvestmentlinks,however,itisunlikelythatitwouldbecost­effectivetoreduceratesbyenoughtobecompetitivewiththesethreecountries.

In summary, once the recent changes in tax structure are fully implemented,CanadiantaxationofcapitalincomeasmeasuredbybothstatutoryratesandMETRswillcomparequitefavourablytothatintheUnitedStatesandCanada’sotherkeycurrentandfuturecompetitorsforFdI.Inthiscontext,therecentreductiontoatargetedcombinedfederalandprovincialcorporateincometaxrateof25percentseemseminentlyreasonable.

note,however,thatalthoughthedatapresentedtakeintoaccountlegislatedtaxreductionsinCanadaandothercountriescomingintoeffectby2012,theydonotconsiderotherpotentialtaxreductionsbyothercountries.Thisisalmostcertainlyahighlyoptimisticassumption,asitseemslikelythatinternationaltaxcompetitionwillcontinuetoputdownwardpressureonbothstatutoryandmarginaleffectivecorporatetaxratesaroundtheworld,includingintheUnitedStates,wherepropos­alstosignificantlyreducethecorporateincometaxratearecurrentlyunderdiscus­sion. In particular, interest in the schedular nordic dual income tax (which isdiscussedfurtherbelow),underwhichcapitalincomeistaxedatalowerratethanthatappliedtolabourincome,seemstobespreading:variantsofsuchtaxes(includ­ingprovisionsfortaxingonlyinterestincomeatrelativelylowrates)haverecentlybeenenactedinAustria,France,Iceland,greece,Italy,Japan,andPortugal,andare

13 ForestimatesofMETRsfor80countries,seeJackMintz,The 2007 Tax Competitiveness Report: A Call for Comprehensive Tax Reform,C.d.HoweInstituteCommentaryno.254(Toronto:C.d.HoweInstitute,2007).

14 SeeCanada,departmentofFinance,2008BudgetPlan,February26,2008.

398 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

under consideration ingermany andSwitzerland.15 In addition,other countriesmayfollowtheexampleofBelgium,whichrecentlyadoptedan“allowanceforcor­porateequity”(ACE)tax;underthisapproach,businessesreceiveaspecialdeductionforequity­financedinvestment,equaltotheproductoftheirequitycapitalandamarket­determinedinterestrate,whichequalizesthetaxtreatmentofdebt­financedandequity­financedinvestmentandcreatesaconsumption­basedbusinesstaxsys­temcharacterizedbyaMETRofzero.16giventhesedevelopmentsandthewide­spreadconcernaboutincreasingglobalizationandinternationalcapitalmobility,itseemslikelythatCanada’sinternationalcompetitivenesswillcontinuebeanissue,althoughthecorporatetaxratereductionsthathaveoccurredorarescheduledtooccurhavesignificantlyimproveditscurrentrelativestanding.

InlightoftherecentreductionsinthetaxburdenoncapitalincomeinCanada,anaturalquestioniswhethersuchtaxreductionsarelikelytoaffecttheoveralllevelof investment in Canada, and more specifically whether FdI will be favourablyaffected.Althoughtheearlyempiricalevidenceontheissueofthetaxsensitivityofinvestmentwasmixed,themorerecentevidence,whichaccountsforthecostsofadjustingthecapitalstockinresponsetochangesintaxesandusesimprovedecono­metrictechniques,isconsistentwithsignificanteffectsoftaxesoninvestment,ascaptured by tax­induced changes in the cost of capital.17 More specifically, thedepartment of Finance estimates that the corporate income tax rate reductionsimplementedovertheperiod2001­2004hadasignificantpositiveeffectoninvest­ment,withapreferredestimatethatindicatesanelasticityof0.7(inabsolutevalue)ofnet investmentwithrespecttotax­inducedchangesinthecostofcapital.18Inaddition,Iorwerthanddanforthestimatethata10percentreductioninthecostsof capital increases investment in machinery and equipment by approximately10percent,implyingaroughlyunitaryoverall(domesticandforeign)investmentelasticity.19

15 PeterBirchSørensen,“neutralTaxationofShareholderIncome”(2005)vol.12,no.6International Tax and Public Finance777­801;andBerndgenserandAndreasReutter,“MovingTowardsdualIncomeTaxationinEurope”(2007)vol.63,no.3FinanzArchiv: Public Finance Analysis436­56.

16 BrazilhasavariantoftheACEtax,underwhichthedeductionforequityisallowedonlyfordividendspaid.SeeAlexanderKlemm,Allowances for Corporate Equity in Practice,IMFWorkingPaperno.06/259(Washington,dC:InternationalMonetaryFund,2006).

17 KevinA.HassettandKathrynnewmark,“TaxationandBusinessBehavior:AReviewoftheRecentLiterature,”inJohnW.diamondandgeorgeR.Zodrow,eds.,Fundamental Tax Reform: Issues, Choices, and Implications(Cambridge,MA:MITPress,2008),191­214.

18 Canada,departmentofFinance,“CorporateIncomeTaxesandInvestment:Evidencefromthe2001­2004RateReductions,”inTax Expenditures and Evaluations, 2007(Ottawa:Queen’sPrinter,2008).

19 AledabIorwerthandJeffdanforth,Is Investment Not Sensitive to Its User Cost? The Macro Evidence Revisited,departmentofFinanceCanadaWorkingPaperno.2004­05(Ottawa:departmentofFinance,2004).

corporate income taxation in canada n 399

TheempiricalevidencealsodemonstratesthatFdIissensitivetotaxfactors,andsuggeststhatthissensitivityisincreasingovertime—althoughsomeoftheincreaseinthemeasuredsensitivityofFdImaysimplyreflectimprovedmeasurementtech­niques.20Forexample,Hines21concludesthatthe“econometricworkofthelast15yearsprovidesampleevidenceofthesensitivityofthelevelandlocationofFdItoitstaxtreatment.”AsimilarconclusionisreachedbydeMooijandEderveen,22whoperforma“metaanalysis”oftheliterature,inwhichtheycorrelatetheresultsof25studiesoftheeffectsoftaxesonFdI(measuredaselasticitiesofFdIwithrespecttovarioushome­countrytaxvariables)tothecharacteristicsoftheunderlyingstudies.BothsurveyssuggestthatFdIisresponsivetoeffectivetaxrates,withelasticitiesintheneighborhoodorinexcessof1.Perhapsmoreimportant,themostrecentandmost careful studies—especially Altshuler, grubert, and newlon;23 grubert andMutti;24anddeMooijandEderveen25—tendtoobtainthelargestestimates.Forexample,Altshuler,grubert,andnewlonestimatethattheelasticityofinvestmentwithrespecttoafter­taxhost­countryratesofreturnforUSMnEsincreasedfrom1.5in1984to2.8in1992.grubertandMuttiestimateaninvestmentelasticityofroughly3forcountrieswithrelativelyopentraderegimes.Finally,forthesampleofstudiestheyanalyze,deMooijandEderveencalculateamedianestimateoftheinvestment elasticity of 3.3; they also note that the more recent studies tend toobtainthelargestelasticities.Thesestudiesarelimitedtodatafromtheearly1990s.Asdiscussedimmediatelybelow,theincreasingtax­avoidanceactivityonthepartofUSMnEssuggeststhatFdIshouldbecomelesssensitivetotaxes,sincetheburdenofhighhost­countryratescanbemoreeasilyavoided.nevertheless,morerecentresearchsuggeststhatatleastthrough2000,thetaxsensitivityofFdIisnotdeclining

20 notethatthesestudiesattempttoisolatetheeffectsoftaxesoninvestmentanddonotimplythatotherfactors(suchasaccesstomarkets,theavailabilityofrelativelylow­costproductivelabour,andastableandtransparentlegalandpoliticalenvironment)arenotalsocriticaltoinvestmentdecisions.notealsothattherearedifficultiesinestimatingtaxeffectsoninvestment,includingvariouseconometricissuesandmeasurementproblems(forexample,mostmeasuresofFdIincludemergerandacquisitionactivity,andeffectivetaxratesaredifficulttomeasure):seeRogerH.gordonandJamesR.HinesJr.,“InternationalTaxation,”inAlanJ.AuerbachandMartinFeldstein,eds.,Handbook of Public Economics,vol.4(Amsterdam:northHolland/Elsevier,2002),1935­95.

21 JamesR.HinesJr.,“LessonsfromBehavioralResponsestoInternationalTaxation”(1999)vol.52,no.1National Tax Journal305­22,at312.

22 RuudA.deMooijandSjefEderveen,“TaxationandForeigndirectInvestment:ASynthesisofEmpiricalResearch”(2003)vol.10,no.6International Tax and Public Finance673­93.

23 RosanneAltshuler,Harrygrubert,andT.Scottnewlon,“HasU.S.InvestmentAbroadBecomeMoreSensitivetoTaxRates?”inJamesR.HinesJr.,ed.,International Taxation and Multinational Activity(Chicago:UniversityofChicagoPress,2001),9­32.

24 HarrygrubertandJohnMutti,Taxing International Business Income: Dividend Exemption Versus the Current System(Washington,dC:AEIPress,2001).

25 deMooijandEderveen,supranote22.

400 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

andmayevenbeincreasing.Forexample,Altshulerandgrubert26examinedatafor1992,1998,and2000,andfindthattheirestimatedinvestmenttaxelasticitiesareincreasingovertheperiod(withsomeestimatesintherangeof−4),althoughthedifferencesintheelasticitiesovertimearenotstatisticallysignificant.27Thus,theempiricalliteratureasawholesuggeststhatinternationalcapitalisquitemobileandsignificantlyaffectedbytaxfactors—evenifthedegreeofresponsivenessisnotaslargeaswouldbeimpliedbyaperfectlyelasticsupplyofinternationallymobilecap­ital—andthepossibilitythatthetaxsensitivityofFdIwilldeclineastax­avoidanceactivitycontinuestogrowhasnotyetappearedinthedata.

Because various financial accounting manipulations (described below) can beutilizedtoloweranMnE’staxburden(andthereisampleevidencethatatleastsomefirmsaretakingadvantageoftheseoptions),onewouldexpectadeclineinthesen­sitivityofFdItolegislatedstatutorytaxratesoreffectivetaxratescalculatedwithouttakingintoaccountthepotentialfortax­avoidanceactivity.Altshulerandgrubert,28amongothers,havearguedthatMnEs,especiallythosebasedintheUnitedStates,havebecomemoreaggressiveinrecentyearsintheirtax­avoidanceactivity.AltshulerandgrubertnotethatinthecaseofUSfirms,thishasbeenespeciallysosincethepassageofthecheck­the­boxregulationsin1997,whichsignificantlyfacilitatedtax­avoidanceactivitybyallowingUSMnEstospecifythetaxtreatmentofarelatedentityasaseparatecorporatesubsidiaryoranintegratedbranch(thatis,apassthroughordisregardedentity)simplybycheckingtheappropriateboxonthefirm’staxreturn.Thus,thereissomereasontobelievethatthetaxsensitivityofFdImaybedeclining,sincemuchofthistax­avoidanceactivityincreasescross­borderfinancialflowswith­outaffectingrealinvestment.However,thispointhasyettobeconfirmedempirically,and,ifanything,thetaxsensitivityofFdImayhaveincreasedinrecentyears.

Tosumup,empiricalevidencesuggeststhatwhilecapitalmaynotbeperfectlymobile,FdIisquitesensitivetotaxfactors.Moreover,thereissomeevidencethatthissensitivityis increasingovertimeasglobalizationincreases,especiallyintheformofinternationalcompetitionforhighlymobilecapital.However,otherresearchsuggeststhattheincreaseinthetaxsensitivityofinvestmentmaybetemperedbytheincreasedavailabilityoftax­avoidancedevicesthatreducetheneedtoreallocaterealinvestmentinordertoreducetaxliabilityinrelativelyhigh­taxcountries.

Asafinalbackgroundpoint,itisusefultoexaminetheextentofinternationaltaxcompetitioninrecentyears.It isclearthatstatutorycorporatetaxrateshave

26 RosanneAltshulerandHarrygrubert,“TaxpayerResponsestoCompetitiveTaxPoliciesandTaxPolicyResponsestoCompetitiveTaxpayers:RecentEvidence”(2004)vol.34,no.13Tax Notes International1349­62.

27 SimilarresultsarereportedbydeMooijandEderveeninanupdateoftheir2003study:RuuddeMooijandSjefEderveen,Explaining the Variation in Empirical Estimates of Tax Elasticities of Foreign Investment,TinbergenInstitutediscussionPaperno.2005­108/3(Rotterdam:TinbergenInstitute,2005).

28 RosanneAltshulerandHarrygrubert,“governmentsandMultinationalCorporationsintheRacetotheBottom”(2006)vol.110,no.8Tax Notes459­74.

corporate income taxation in canada n 401

declined significantly. For example, devereux, griffith, and Klemm29 note thataveragestatutorycorporateincometaxratesintheEuropeanUnionandtheUnitedStatesfelldramaticallyfrom48percentin1982to35percentin2001.Similarly,devereux30 shows that the average statutory tax rate in the OECdcountrieswasroughly40percentovertheperiodfrom1965totheearly1990s,butdroppedfrom41percent in1988to33percent in1993,andwasroughlyconstantatthat levelthrough 2004 (when it was 32percent). At the same time, however, those ratereductionshavebeenaccompaniedbybase­broadeningefforts,sothatoverallcor­porate tax revenues as well as average effective tax rates (AETRs) and especiallyMETRshavedeclinedconsiderablyless;31indeed,corporatetaxrevenuesasashareoftotalrevenueshaverisenoverthepasttwodecadesinboththeUnitedStatesandCanada.32Similarly,corporatetaxrevenuesasafractionofgdPhavebeenroughlyconstantoverthepast40years,andindeedhaveincreasedinrecentyears.33Thisevidenceissuggestiveoftaxcompetitioninstatutoryrates,butitalsoimpliesthattaxcompetitionhasnotyethadassignificantanimpactinthesecountriesontheMETRsthataretherelevantconceptinmosttheoreticaltax­competitionmodels.34

Moregenerally,althoughthedataarenowsomewhatdated,grubert35examinesasampleof60countriesandshowsthatAETRs,definedasforeigntaxespaidrelative

29 MichaelP.devereux,Rachelgriffith,andAlexanderKlemm,“CorporateIncomeTaxReformsandInternationalTaxCompetition”(2002)vol.17,no.35Economic Policy451­95.

30 MichaelP.devereux,Developments in the Taxation of Corporate Profit in the OECD Since 1965: Rates, Bases and Revenues,OxfordUniversityCentreforBusinessTaxationWorkingPaperno.07/04(Oxford:OxfordUniversityCentreforBusinessTaxation,2007).

31 devereux,griffith,andKlemm,supranote29;JoerigorterandRuuddeMooij,Capital Income Taxation in Europe: Trends and Trade-Offs,CPBSpecialPublicationsno.30(TheHague:CPBnetherlandsBureauforEconomicPolicyAnalysis,2001);andJohannesBeckerandClemensFuest,Optimal Tax Policy When Firms Are Internationally Mobile,CESifoWorkingPaperno.1592(Munich:CenterforEconomicStudiesandIfoInstituteforEconomicResearch,2005).

32 AlanJ.Auerbach,The Future of Capital Income Taxation,BerkeleyPrograminLawandEconomicsWorkingPaperno.217(Berkeley,CA:BerkeleyPrograminLawandEconomics,2006).

33 devereux,supranote30.

34 Seedevereux,ibid.,foradiscussionofadditionalpossibleexplanationsfortherelativestabilityofcorporaterevenuesinlightofreductionsinstatutoryrates,includingincreasedinwardprofitshiftingasstatutoryratesdecline,increasedshiftingofincometothecorporatebasefromtheindividualbase,increasedrelativefirmprofitability,andincreasedinvestmentinresponsetotaxreductions.Inaddition,Auerbacharguesthatcorporatetaxrevenueshaveincreasedowingtoincreasingdispersionofcorporateprofitability,coupledwiththefactthatprofitsaretaxedwhilelossesarenotfullydeductible,resultinginahigheraveragetaxrateonpositiveincomenetoflosses:AlanJ.Auerbach,Why Have Corporate Tax Revenues Declined? Another Look,nBERWorkingPaperno.12463(Cambridge,MA:nationalBureauofEconomicResearch,2006).

35 Harrygrubert,“TaxPlanningbyCompaniesandTaxCompetitionbygovernments:IsThereEvidenceofChangesinBehavior?”inInternational Taxation and Multinational Activity,supranote23,113­39.

402 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

tonetincomeasreportedbyUSMnEstotheInternalRevenueService(IRS),fellbyalmost10percentagepointsbetween1984and1992,36withstatutoryratesfallingbyasomewhatsmalleramount (andrates in theEuropeanUnionfallingby lessthanthisaverage).Thisresultismoreconsistentwiththeexistenceoftaxcompeti­tionineffectivetaxrates,asisgrubert’sfindingthatAETRsfellmuchmoreinthesmall,open,andrelativelypoorcountriesthataremostsusceptibletotheeffectsoftaxcompetition.37Altshulerandgrubert38findthat therateofdecline inAETRscontinuedbutmoderatedoverthe1992­2000period,andthatalthoughthedeclinesweremorepronouncedinsmallercountriesthrough1997,thisresultvanishesfortheperiod1998­2000—aresultthattheyattributetotheincreasedimportanceoftaxplanningandtax­avoidanceactivitiesratherthantoreducedcompetitionintaxrates.Similarly,Slemrod39finds that statutory tax rates arenegatively associatedwithmeasuresofopenness(althoughhedoesnotfindevidenceofsuchalinkforrevenuesasafractionofgdP).devereux,Lockwood,andRedoano40presentempir­icalevidenceconsistentwithanexpandedstructuralmodeloftaxcompetitioninwhich countries engage both in tax competition in statutory tax rates to attractmobileprofitsandinvestmentsthatearnabove­normalreturns(aswillbediscussedfurtherbelow),andintaxcompetitioninMETRs.

garretsenandPeeters41examinetheimpactofincreasingcapitalmobility(meas­uredeitherasincreasesinFdIflowsrelativetogrosscapitalformation,orbyusinganindexoftheextentofthelegalrestrictionplacedoninternationalcapitalmobil­ity)oncorporatetaxratesforasampleof19OECdcountries.Theybasetheirmodelonthe theoryof taxcompetitionwithagglomerationeconomies,whichsuggeststhattaxcompetitionshouldbelessintenseamong“corecountries”thatarecharac­terizedbysignificanteconomiesofagglomeration,relativetosmaller,lessdeveloped

36 ThisevidenceisdifficulttointerpretbecausecorporateAETRsmayfallformanyreasonsotherthanchangesinthecorporatetaxstructure,includingvariationsinprofitrates,cyclicalfactors,interactionsbetweenthecorporateandindividualtaxsystemswhenindividualrateschange,changesininflationrates,andchangesintheextenttowhichmultinationalsengageinincome­shiftingactivities.SeeJackM.MintzandduanjieChen,“WilltheCorporateIncomeTaxWither?”inReport of Proceedings of the First World Tax Conference: Taxes Without Borders(Toronto:CanadianTaxFoundation,2000),45:1­16.

37 grubertnotesthatratesintheEuropeanUnionhavenotconvergedoverthisperiodandarguesthatthissuggestsanabsenceoftaxcompetition:supranote35.However,thisinterpretationisopentoquestion:ifthelong­runimplicationofincreasedtaxcompetitionisthatcorporateincometaxrateswillconvergetozero,itisnotclearthatconvergenceaboutintermediateratesduringthetransitiontothisequilibriumshouldnecessarilybeexpected.

38 Altshulerandgrubert,supranote28.

39 JoelSlemrod,“AreCorporateTaxRates,orCountries,Converging?”(2004)vol.88,no.6Journal of Public Economics1169­86.

40 MichaelP.devereux,BenLockwood,andMichelaRedoano,“doCountriesCompeteoverCorporateTaxRates?”(manuscript,UniversityofWarwick,2005).

41 HarrygarretsenandJolandaPeeters,Capital Mobility, Agglomeration and Corporate Tax Rates: Is the Race to the Bottom for Real?denederlandscheBankWorkingPaperno.113(September2006).

corporate income taxation in canada n 403

“peripheral”countries.42Theyfindthatincreasedcapitalmobilitydoesleadtotaxcompetitionintheformoflowercorporatetaxrates,butthatthiseffectisconsider­ablylesspronouncedforcountrieswithsignificantagglomerationeconomies(esti­matedusingseveralmeasuresofmarketpotential);theyconcludethat“[i]fthereisaracetothebottom,itseemsthatitismorerealforsomecountriesthanothers.”43TheirresultssuggestthatinternationaltaxcompetitionformobilecapitalfallsinthelowtomoderaterangeforCanada,whichranksbetweenthirdandninthamongthe19countriesintheirsampleinthelevelofagglomerationeconomiesaccordingtotheirvariousmeasures;Canada’srelativelyhighrankingisexplainedprimarilybyitsproximitytotheUSmarket.44

A further complicating factor in measuring the extent of tax competition,stressedbyAltshulerandgrubert,45isthatitmayincreasinglybetakingtheformofallowingandevenfacilitatingtaxavoidancebyMnEs.Ifthisisso,theAETRsonMnEs in host countries may be relatively low once tax avoidance is taken intoaccount,whileeffectivetaxratesmaybehigherfordomesticfirmsthatcannottakeadvantageoftheseopportunities.ThesetechniquesmaybefacilitatedbythehomecountryoftheMnEintheinterestofinternationalcompetitiveness.Altshulerandgrubertestimatethatmoreaggressiveuseoftax­planningtechniques,facilitatedbybothhostandhomecountries,reducedthetaxburdensofMnEsby15percentin2002.

Yetanothercomplicating factor in interpreting theempirical evidenceon taxcompetition,especiallyduringthelate1980sandearly1990s,isthatmuchofthestatutorytaxratereductionthathasoccurredworldwideoverthepast30yearsmaybeattributablenottointernationaltaxcompetitionbuttoawidespreadperception,supportedbymanyeconomists,thatamovementtowardbroaderbasesandlowerrates is an inherently desirable tax policy, especially following the large­scalereformsinthemid­1980sintheUnitedStatesandtheUnitedKingdomthatwerebased on this longstanding principle.46 In addition, to the extent that capital­importingcountrieswereatleastpartiallysettingtheircorporateratestomaximizethetreasurytransfereffectfromtheUnitedStatesandtheUnitedKingdom(dis­cussed further below), reductions in their corporate tax rates would have been

42 RichardE.BaldwinandPaulKrugman,“Agglomeration,IntegrationandTaxHarmonisation”(2004)vol.48,no.1European Economic Review1­23.

43 garretsenandPeeters,supranote41,at1(abstract).

44 ThecountriesinthestudysampleareAustralia,Austria,Belgium,Canada,Finland,France,germany,greece,Ireland,Italy,Japan,thenetherlands,norway,Portugal,Spain,Sweden,Switzerland,theUnitedKingdom,andtheUnitedStates.

45 Altshulerandgrubert,supranote28.

46 CnossenandMesseredescribetheworldwidereformsthatfollowedtheUSandUKreforms:SijbrenCnossenandKenMessere,“PersonalIncomeTaxReformsinOECdMemberCountries,”inSijbrenCnossenandRichardM.Bird,eds.,The Personal Income Tax: Phoenix from the Ashes?(Amsterdam:north­Holland,1990),17­60.

404 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

expected after the 1980s reforms. Indeed, grubert, Randolph, and Rousslang47demonstrate that theamountof foreign­source income for US MnEs thatwouldhavebeenattributabletofirmsinanexcessforeigntaxcredit(FTC)positionwouldhavesoaredhadsuchratereductionsnotoccurred.Thus,althoughthereisconsid­erableevidencewhichsuggeststhatthestatutorytaxrateandMETRreductionspre­dictedbysometheoriesoftaxcompetitionareoccurring,thatevidenceisnotyetentirelyconclusive.Moreover,taxcompetitionismorelikelytoaffectsmaller,lessdevelopedcountries thancountrieswithsignificanteconomiesofagglomeration,withCanadacharacterizedbyarelativelyhighlevelofsucheconomies,andsomeoftherecentdeclinesinAETRsappeartobeduetotheincreaseduseoftaxplanningandtax­avoidanceactivitiesratherthantoincreasingcompetitionintaxrates.

ThepurposeofthisarticleistoexamineCanadiancorporateincometaxpolicywithin this context, following and extending the analytical framework initiallypresented inZodrow48 and focusingon income tax reformwhile ignoringmoresweepingoptionsinvolvingconsumption­baseddirecttaxes.Theremainderofthestudyproceedsasfollows.Thefollowingsectionconsiderstheargumentsfortaxexemptionorevensubsidizationofcapitalincome;thesubsequentsectionconsidersqualificationstothosearguments.Inbothcases,thediscussionoftheoreticalargu­mentsisfollowedbyanexaminationoftheempiricalevidence,includingstudiesspecifictoCanadaasapplicableandavailable.Thefourthsectionsetsouttheimpli­cationsoftheanalysisforcorporateincometaxpolicyinCanada.

the c A se fo r tA x e x emp tIo n o r subsIdIz AtIo n o f c A pItA l Income

The Basic Argument for a Zero Tax Rate

Thestandardargumentagainstsource­basedtaxationofcapitalincomebyasmallopeneconomy—definedasonethatistoosmalltoaffectthereturntointernation­allymobilecapitalorthepricesofinternationallytradedgoods—isthatsuchtaxa­tion is inherently counterproductive because mobile international capital willmigratefromthetaxingcountryuntilitsbefore­taxrateofreturnrisesenoughtoentirelyoffsetthetax.49Thisemigrationofcapitallowerstheproductivityofthe

47 Harrygrubert,WilliamRandolph,anddonaldRousslang,“CountryandMultinationalCompanyResponsestotheTaxReformActof1986”(1996)vol.49,no.3National Tax Journal341­58.

48 georgeR.Zodrow,“CapitalMobilityandSource­BasedTaxationofCapitalIncomeinSmallOpenEconomies”(2006)vol.13,no.2International Tax and Public Finance269­94.

49 georgeR.ZodrowandPeterMieszkowski,“TheIncidenceofthePropertyTax:TheBenefitViewvs.thenewView,”ingeorgeR.Zodrow,ed.,Local Provision of Public Services: The Tiebout Model After Twenty-Five Years(newYork:AcademicPress,1983),109­29;RogerH.gordon,“TaxationofInvestmentandSavingsinaWorldEconomy”(1986)vol.76,no.5The American Economic Review1086­1102;andAssafRazinandEfraimSadka,“InternationalTaxCompetitionandgainsfromTaxHarmonization”(1991)vol.37,no.1Economics Letters69­76.ThisargumentignoresanyFTCsforhost­countrytaxesthatmightbegrantedinthehome

corporate income taxation in canada n 405

fixedfactorsinthetaxingcountry—landandlabour(oratleastrelativelyimmobilelabour)—sothatlocalfactorsofproductionultimatelybeartheentireburdenofthecapitalincometax,includingtherevenueraisedandtheefficiencycostsofthetax.Theefficiencycostsarisefornumerousreasons.Mostobviously,thetaxinducesaninefficiently low overall capital intensity of production and a tax bias favouringlabour­intensivegoods.50Inaddition,asstressedinthetax­competitionliterature,theuseofcapitalincometaxationcreatesdownwardpressureoncapitalincometaxratesduetointerjurisdictionalcompetitionformobilecapital,whichinturncreatesa tendency for inefficiently low expenditures on public services.51 Finally,Harberger52arguesthatinasmallopeneconomy,immobilelabourandlandwilltypicallybearmorethan100percentofataxoncapitalincome,oncegeneralequi­libriumeffectsacrossbusinesssectorsareconsidered.Specifically,Harbergerana­lyzestheeffectsofacorporateincometaxinthecontextofageneralequilibrium

country,anissuethatisdiscussedbelow.Inaddition,itisimportanttonotethatthisargumentdoesnotextendtobenefittaxesthatreflectthevaluetobusinessesofpublicservices,includingpublicinfrastructure(seeRichardM.BirdandThomasTsiopoulos,“UserChargesforPublicServices:PotentialsandProblems”(1997)vol.45,no.1Canadian Tax Journal25­86;anddavidg.duff,“BenefitTaxesandUserFeesinTheoryandPractice”(2004)vol.54,no.4University of Toronto Law Journal391­447),ortotaxesonnegativeexternalitiessuchaspollutiontaxes;bothoftheseformsoftaxationarehighlydesirablesourcesofrevenueifstructuredappropriately.

50 gordonandHines,supranote20.

51 georgeR.ZodrowandPeterMieszkowski,“Pigou,Tiebout,PropertyTaxation,andtheUnder­ProvisionofLocalPublicgoods”(1986)vol.19,no.3Journal of Urban Economics356­70;Johnd.Wilson,“ATheoryofInterregionalTaxCompetition”(1986)vol.19,no.3Journal of Urban Economics296­315;andHans­WernerSinn,“TaxHarmonizationandTaxCompetitioninEurope”(1990)vol.34,no.2­3European Economic Review489­504.Taxcompetitionmodelsoftensuggesta“racetothebottom”astaxcompetitioneliminatescapitalincometaxes,althoughthiscouldjustaseasilybelabelleda“racetothetop”ascountriesareforcedtouseefficientbenefittaxestofinancetheirpublicservicesratherthaninefficientnon­benefittaxesonmobilecapital:seeCharlesE.McLure,“TaxCompetition:IsWhat’sgoodforthePrivategooseAlsogoodforthePublicgander?”(1986)vol.39,no.3National Tax Journal341­48.Forrecentreviewsofthevoluminousliteratureonbothnegativeandpositiveaspectsoftaxcompetition,seeJohnd.Wilson,“TheoriesofTaxCompetition”(1999)vol.52,no.2National Tax Journal269­304;MintzandChen,supranote35;WallaceOates,“FiscalCompetitionandEuropeanUnion:ContrastingPerspectives”(2001)vol.31,no.2­3Regional Science and Urban Economics133­45;georgeR.Zodrow,“TaxCompetitionandTaxCoordinationintheEuropeanUnion”(2003)vol.10,no.6International Tax and Public Finance651­71;ClemensFuest,BerndHuber,andJackMintz,“CapitalMobilityandTaxCompetition:ASurvey”(2005)vol.1,no.1Foundations and Trends in Microeconomics1­62;anddavidE.WildasinandJohnd.Wilson,“CapitalTaxCompetition:BaneorBoon?”(2004)vol.88,no.6Journal of Public Economics1065­91.

52 ArnoldC.Harberger,“TheABCsofCorporateTaxIncidence:InsightsintotheOpen­EconomyCase,”inAmericanCouncilforCapitalFormation,ed.,Tax Policy and Economic Growth(Washington,dC:ACCFCenterforPolicyResearch,1995),51­71;andArnoldC.Harberger,“CorporateTaxIncidence:ReflectionsonWhatIsKnown,Unknown,andUnknowable,”inFundamental Tax Reform,supranote17,283­308.

406 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

modelwithfoursectors(corporateandnon­corporatetradablegoodsandcorporateandnon­corporatenon­tradablegoods).Hearguesthatwhenacorporateincometaxisimposedinanopeneconomy,itseconomiceffectsaredeterminedprimarilyinthecorporatetradablegoodssector,sinceboththepriceoftradablegoodsandtheafter­taxreturntocapitalarefixed.Asaresult,labourmustbearallofthetaxburdeninthissector.However,becauselabourismobile,itspricefallsacrossallsectors,whichcreatesatendencyforlabourtobearmorethan100percentofthetax—aresultthatHarbergerarguesobtainsformostofhisanalyses;forexample,inthecentralcasethatheconsiders,53labourbears130percentoftheburdenofthecorporateincometax.

Theclearimplicationofalltheseanalysesisthat,solelyfromtheviewpointoftheresidentsofthetaxingcountry,itispreferablesimplytotaxlocalfactors(landandrelativelyimmobilelabour)directly,andthusavoidatleasttheefficiencycostsof the tax on capital income. Furthermore, this argument implies that concernsabouttheequityimplicationsofreducingsource­basedtaxesoncapitalincomeinanopeneconomyaremisplaced:theincidenceofsuchataxwillnotfallonrelativelywealthycapitalowners,butinsteadwillbebornebylabouraslowerwagesorbyconsumersashigherprices.Thislogicyieldsthenowstandardzerotaxresult—inasmallopeneconomy,theoptimalsource­basedtaxrateoncapitalincomeiszero.54

Itisimportanttonotethattheseresultsaretypicallyderivedwithinthecontextofmodelsthatassumeaperfectlycompetitiveenvironment,andthusimplythatitistheMETR,ortheeffectivesource­basedtaxrateappliedtoabreak­eveninvest­mentthatjustearnsnormalprofits,thatshouldbezero.Thisdoesnotimply,how­ever,thatthestatutorybusinesstaxratemustnecessarilybezero.Forexample,the

53 Harberger,“CorporateTaxIncidence,”supranote52.

54 Thesearguments,ofcourse,supplementthetraditionalcaseagainstthemostcommonformofsource­basedcapitalincometaxation,thecorporateincometax.Manyobservershavearguedthatthecorporatetax,especiallywhenappliedtoMnEs,isasingularlycomplexandinefficienttaxinstrument,significantlydistortingawidevarietyofdecisions,includingthoseregardingassetmix,methodoffinance,organizationalform,andthemixofretentions,dividendspaid,andsharerepurchases:seeJaneg.gravelle,The Economic Effects of Taxing Capital Income(Cambridge,MA:MITPress,1994);andSijbrenCnossen,“CompanyTaxesintheEuropeanUnion:CriteriaandOptionsforReform”(1996)vol.17,no.4Fiscal Studies67­97.Moreover,taxationofcapitalincomereducesthelevelofinvestment,whichinturnreduceslabourproductivityandwagegrowth.Indeed,althoughitisstillacontentiousissue,manytaxexpertsarguethat—independentofinternationalconsiderations—taxationonthebasisofconsumptionis,fortheseandotherreasons,preferabletoincometaxation;thatis,aMETRofzeroonthereturntosavingandinvestment,includingtaxesonapersonallevel,isdesirable.Forrecentreviewsofthesearguments,seeAuerbach,supranote32;AlanJ.Auerbach,“TaxReforminthe21stCentury,”inFundamental Tax Reform,supranote17;PeterBirchSorensen,Can Capital Income Taxes Survive? And Should They?CESifoWorkingPaperno.1793(Munich:CenterforEconomicStudiesandIfoInstituteforEconomicResearch,2006);andgeorgeR.Zodrow,“ShouldCapitalIncomeBeSubjecttoConsumption­BasedTaxation?”inHenryJ.Aaron,LeonardE.Burman,andC.EugeneSteuerle,eds.,Taxing Capital Income(Washington,dC:UrbanInstitute,2007).

corporate income taxation in canada n 407

standardzerotaxprescriptionisconsistentwithabusinesscashflowtaxthatallowsimmediateexpensing(ratherthandeductionsfordepreciation),andthusischarac­terizedbyaMETRofzero,whileabove­normalreturnsoreconomicrentsaresimul­taneouslytaxedatthestatutorytaxrate.Themorerecentliterature,however,hasarguedthatamorebroadlydefinedconceptoftaxcompetitionappliestostatutorytaxratesaswell.

Extending the Zero Tax Argument to Statutory Tax Rates

Althoughthediscussionthusfarhasfocusedontheeffectsoftaxationonmarginalinvestments,twoadditionalstrandsoftheliteraturehaveemphasizedtheimportantroleplayedbystatutorytaxrates.Specifically,muchrecentresearchfocusesontheeffects of statutory tax rateson thedecisionsof MnEs regarding the locationofinvestments thatgeneratefirm­specificeconomic rents55 andon incomeshiftingacrosscountriesbytheMnEs.

The Taxation of Firm-Specific RentsTheacceleratingpaceofglobalizationimpliesthatakeyelementintheevaluationofanysystemofcapitalincometaxationisitseffectsoninvestmentbylargeMnEs.METRanalysisisrelevantforinvestmentbyanMnE,becauseitslevelofinvestment,givenitsdecisiontoinvestinacountry,willbeaffectedbytheMETRsassociatedwiththetaxsysteminthatcountry.However,asstressedbydevereuxandgriffith56anddevereuxandHubbard,57theeconomictheoriesunderlyingtheformationofMnEsandtheirdecisionstoinvestabroadfocusontheirpotentialtoearnsignificanteco­nomicrents,especiallythoseattributabletoownership,locational,orinternalizationadvantages.58Muchoftheserentsarefirm­specific—thatis,theyareattributableto

55 Thezerotaxargumentdoesnot,however,applytolocation­specificrents,discussedbelow.Itshouldbenotedthatdistinguishingbetweenfirm­specificandlocation­specificrentsisfarfromstraightforward.SeeJamesR.Markusen,“TheBoundariesofMultinationalEnterprisesandtheTheoryofInternationalTrade”(1995)vol.9,no.2Journal of Economic Perspectives169­89,forarecentreviewofthetheoryofmultinationalenterprises,includingadiscussionofthecharacteristicsofmultinationalinvestmentsthatmaygeneratelocation­specificandfirm­specificeconomicrents.

56 MichaelP.devereuxandRachelgriffith,“TaxesandtheLocationofProduction:EvidencefromaPanelofU.S.Multinationals”(1998)vol.68,no.3Journal of Public Economics335­67;andMichaelP.devereuxandRachelgriffith,“TheImpactofCorporateTaxationontheLocationofCapital:AReview”(2003)vol.33,no.2Economic Analysis and Policy275­92.

57 MichaelP.devereuxandR.glennHubbard,“TaxingMultinationals”(2003)vol.10,no.4International Tax and Public Finance469­87.

58 J.H.dunning,“Trade,LocationofEconomicActivity,andtheMultinationalEnterprise:ASearchforanEclecticApproach,”inB.Ohlin,P.O.Hesselborn,andP.M.Wijkman,eds.,The International Allocation of Economic Activity(London:Macmillan,1977),395­418;andJ.H.dunning,International Production and the Multinational Enterprise(London:AllenandUnwin,1981).Rathersurprisingly,empiricalevidenceontheextenttowhichMnEsactuallyearnabove­normalrents,atleastoutsidetheresourcesector,islimited,andtheavailableresultsare

408 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

factorssuchasuniquetechnologicalknowledge,superiormanagerialskillsorpro­ductiontechniques,orvaluablebrands,trademarks,reputations,andotherintangi­ble assets. Moreover, recent empirical evidence indicates that the dispersion ofrelativeprofitabilityintheUnitedStateshasincreasedsignificantlyinrecentyears,suggesting an increase in the relative importance of investments that generateabove­normalreturns.59Suchinvestmentsarealsoamongthosemosthighlyprizedbynationalgovernments,becausetheyaremostlikelytobeassociatedwithhighlevelsoftechnologytransferandthegenerationofotherexternalbenefits.Inaddi­tion,thisliteraturestressesthatmultinationaldecisionsregardingthelocationofsuchinvestmentsaretypicallymadeamongnumerousmutuallyexclusivediscretechoices;forexample,afirmmaywanttotakeadvantageofsignificanteconomiesofscaleduetolargefixedcostsbychoosingasinglelocationtoservemultiplenationalmarkets.

Inthesecircumstances,thekeytaxfactoraffectinginvestmentdecisionsistheAETR,definedbydevereuxandgriffith60asaweightedaverageofthestatutoryrateand the METR,with theweights equal to theabove­normal andnormal ratesofreturn available on investments. This reasoning has important implications forinternational taxcompetition.Specifically,becausethe investmentsthatgeneratefirm­specificeconomicrentsarealsohighlymobile,countriesfaceanincentivetoundercuttheircompetitorsinanattempttogainthebenefitsofsuchinvestmentfortheirresidents,resultinginanequilibriuminwhichthereisagainatendencyforcapitalincometaxratestobecompeteddowntozero.61Thus,becausetheseinvest­mentsarediscreteandgenerateeconomicrents,thestatutoryrateisascriticalasthemarginaleffectiverate—andthestandardtaxcompetitionmodels implythatbothratesshouldbezeroforasmallopeneconomy.

RecentempiricalevidencesupportstheimportanceofAETRs,andthusstatutorytax rates, in determining investment levels. The study most often cited is bydevereuxandgriffith,62whoinvestigatetheeffectsofAETRsandMETRsontheproductionlocationdecisionsofasampleofUSMnEs.devereuxandgriffithcon­struct a model in which the level of investment is determined primarily by theMETR,whilethechoiceofinvestmentlocationamongseveralalternativeoptionsisdeterminedprimarilybytheAETR.Theirempiricalresultsindicatethata1percent­agepointincreaseintheAETRinacountryreducestheprobabilitiesofaUSfirm

largelyinconclusive:see,forexample,Johndoukasandnickolaosg.Travlos,“TheEffectofCorporateMultinationalismonShareholders’Wealth:EvidencefromInternationalAcquisitions”(1988)vol.43,no.5Journal of Finance1161­75.

59 Auerbach,supranote32.

60 devereuxandgriffith,“TheImpactofCorporateTaxationontheLocationofCapital,”supranote56.

61 gordonandHines,supranote20.

62 devereuxandgriffith,“TaxesandtheLocationofProduction,”supranote56.

corporate income taxation in canada n 409

choosingtoproducetherebybetween0.5and1.3percentagepoints.63SeveralotherstudieshavelinkedFdIandAETRs;forexample,Altshuler,grubert,andnewlon,64usinganAETRmeasure,estimateanelasticityofFdIwithrespecttothecostofcap­italof2.7.

devereux,Lockwood,andRedoano65explicitlyexaminetheissueoftheextentofinternationaltaxcompetitionoverMETRsandstatutorytaxrates.Followingtheliteraturecitedabove,theyconstructamodelinwhichMnEschoosetheirinvest­mentlocationsinresponsetodifferencesinstatutorytaxratesandchoosetheirlevelof investment,given the locations, in response to theMETR. Inaddition,asdis­cussedbelow,firmsareassumedtohavetheabilitytoshiftprofitsacrossjurisdic­tions in response to differences in statutory tax rates. governments potentiallycompeteinbothMETRsandstatutorytaxrates.devereux,Lockwood,andRedoanoanalyzemultinationalinvestmentdecisionsinasampleof21OECdcountriesovertheperiod1982­1999.Theyfindstrongevidenceofinternationaltaxcompetitionover statutory corporate tax rates; specifically, they estimate that a 1percentagepointreductionintheweightedaveragestatutorytaxrateinothercountriesresultsina0.7percentagepointreductioninthehome­countrytaxrate.Theyalsofindevidence of competition in METRs, but the magnitudes of the effects are muchsmaller,suggestingthatcompetitionoverstatutorytaxratesisthedominantformofinternationaltaxcompetition.66Finally,theynotethattheirestimatedgovern­menttaxreactionfunctionssuggestthatequilibriumstatutorytaxratesshouldhavefallensubstantiallyoverthetimeperiodconsidered,consistentwiththeobservedbehaviourdescribedabove.

The Role of Income Shifting in Limiting Statutory Tax RatesTheargumentforlowstatutorytaxratesowingtotaxcompetitionforfirm­specificeconomic rents is buttressed by the pervasive phenomenon of income shifting.ModernMnEshaveconsiderablediscretioninallocatingprofitsamongthevariouscountriesinwhichtheyoperate.Inparticular,becauseitisexceedinglydifficultfortaxauthoritiestoallocateamultitudeofoverheadexpenses,determineappropriate“transferprices”fortransactionsbetweenrelatedentities,andallocatedeductionsfor

63 Thisresult,however,issensitivetothechoiceoftheAETRvariable;inparticular,theeffectoftheAETRontheprobabilitythataUSfirmwillinvestinaparticularcountrydisappearsifanaccountingmeasureoftheAETRisutilized.

64 Altshuler,grubert,andnewlon,supranote23.

65 devereux,Lockwood,andRedoano,supranote40.

66 devereux,Lockwood,andRedoanonotethatthestrategictaxinteractionsbetweencountriesthattheyobserveoccuronlybetweenrelativelyopeneconomies,andarguethatthisimpliesthattheseinteractionscannotbeexplainedbyeitheroftwoalternativetheories—”yardstickcompetition”(underwhichvotersevaluatetheirpoliticalrepresentativesrelativetothoseinneighbouringjurisdictions)orcommonintellectualtrends,suchasamovetowardbroadertaxbasesandlowerrates.

410 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

interestexpense,MnEshaveconsiderablefreedominallocatingrevenuestolow­taxcountriesanddeductionstohigh­taxcountries—inadditiontothetaxadvantagesofferedbydeferringrepatriationofincomeheldinlow­taxjurisdictions,includingtaxhavens.Althoughgovernmentshaveattemptedtominimizetheirrevenuelossesfrom thesemanipulationsbyusingvarious tools (suchas advancepricingagree­ments,thincapitalizationrules,interestallocationrules,andspecialtreatmentofpassiveinvestmentincome),revenuelossesduetoincomeshiftingstillposeaseri­ousproblemformostcountries.Thisinturnputsdownwardpressureonstatutorycorporateincometaxrates—theratesthatarerelevantforincomeshiftingbecausethey determine the value of deductions and the tax cost of revenues—since anycountrywitharelativelyhightaxratewillreceiveadisproportionatelylargeshareofworldwidedeductionsorloseitsfairshareofworldwiderevenues.Alternatively,fromtheperspectiveofthetaxingcountry,alowercorporateincometaxrateisadvantageous(beyondtheconventionaleffectofattractinginvestmentthroughalowercostofcapital)becauseitmayincreasetaxrevenuesbyencouragingfirmstoengageinmanipulationsthatallocaterevenuetothetaxingcountryandexpenseselsewhere.Similarly,alowertaxratemayhaveanindependenteffectinattractingFdItoacountry,sincehavinginvestmentsinlow­taxcountriesfacilitatessuchtax­avoidancemanipulations.67Yetathirdargumentforalowstatutorycorporateincometaxrateisthe“headlinetaxrate”argument.Specifically,MnEsmay,atleastintheinitial stagesof choosing among competing locations, focuson a comparisonofstatutorytaxratesacrossthelocations,independentofspecialprovisionsthatmightlowertheMETR,suchasacceleratedCCAs,investmenttaxcreditsorotherinvestmentallowances,andotherinvestmenttaxpreferences,whichareconsideredonlyinasubsequentevaluationofcountriesthatmaketheshortlistofpotentialinvestmentlocations.Allofthesefactorssuggestthattherevenuecostsassociatedwithareduc­tioninthecorporatetaxratewillbelessthanimpliedbyananalysisthatassumesaconstanttaxbase,andindeedtheyraisethepossibilitythatatasufficientlyhightaxrate,aratereductionwillactuallyincreaserevenues.

Severalrecentpapershaveidentifiedconditionsunderwhichstatutorytaxratereductions are desirable, even if they must be accompanied by base­broadeningmeasuresthatincreaseMETRs.Forexample,HauflerandSchjelderup68considerthecaseinwhichMnEsearnabove­normalprofitsandcanusetransferpricingtoshiftthoseprofitstolow­taxcountries;theyassumethatforpoliticalorotherreasonsthegovernmentmustraiseafixedamountofrevenuefromthecorporateincometax.HauflerandSchjelderupshowthattheoptimalcorporateincometaxpolicyinthese

67 JoelSlemrod,“TheTaxationofForeigndirectInvestment:OperationalandPolicyPerspectives,”inJamesM.Poterba,ed.,Borderline Case: International Tax Policy, Corporate Research and Development, and Investment(Washington,dC:nationalAcademyPress,1997),11­38.

68 AndreasHauflerandguttormSchjelderup,“CorporateTaxSystemsandCrossCountryProfitShifting”(2000)vol.52,no.2Oxford Economic Papers306­25.

corporate income taxation in canada n 411

circumstancescanbetolowerstatutoryratesandbroadenthecorporatetaxbase,evenatthecostofraisingtheMETRonnewinvestment.69FuestandHemmelgarn70obtainasimilarresultinamodelinwhichfirmsearnonlynormalprofits,astheydemonstratethatarate­lowering,base­broadeningpolicymaybeoptimaliffirmscanreallocatedebttominimizetheirtaxliability.BeckerandFuest71showthatinthe presence of differentially mobile firms, corresponding loosely to relativelymobile MnEs and relatively immobile domestic firms, a rate­lowering, base­broadening reform will be desirable if the marginal highly mobile firm is moreprofitablethantheaveragefirminthecountry.Inthiscase,alowerstatutorytaxrateinducesthehigh­profitabilitymobilefirmstoremaininthecountry,sincetheirprofitsaretaxedrelativelylightly,whilethebroadertaxbaseimpliesthatmorerev­enues are collected from the low­profitability immobile firms. In the Canadiancontext,Mintz72estimatesthattherevenue­maximizingcorporateincometaxrateisintheneighbourhoodof28percent.

EmpiricalresearchconfirmsconclusivelythatMnEsengageinthetax­avoidancemanipulationsdescribedabove, including shifting revenues to low­tax countries,shiftingdeductions(includinginterestexpense)tohigh­taxcountries,andarrangingtodeferrepatriationssubjecttotax.Forexample,manytestsoftheextentoftax­motivatedtransferpricingexaminedifferencesinprofitabilityacrosshostcountrieswithvaryingtaxrates;Hines73providesareviewofthisliterature.normally,onewouldexpectbefore­taxprofitstoberelativelylowinlow­taxhostcountries,sincethe host­country tax burden is relatively low. However, numerous studies havefoundthatafter­taxprofitabilitytendstobehighinlow­taxcountries,suggestingthatfirmsareshiftingprofitstosuchcountries,especiallytaxhavens.74Forexample,

69 Basebroadeningismodelledasreducingdepreciationallowances.Intheabsenceofopportunitiesfortransferpricing,theoptimalpolicyistoallowexpensing(aconsumption­basedbusinesstax),inwhichcasenormalreturnsareuntaxedwhileabove­normalreturnsaretaxedatthestatutoryrate.

70 ClemensFuestandThomasHemmelgarn,“CorporateTaxPolicy,ForeignFirmOwnershipandThinCapitalization”(2005)vol.35,no.5Regional Science and Urban Economics508­26.

71 BeckerandFuest,supranote31.

72 Mintz,supranote13.

73 Hines,supranote21.

74 HarrygrubertandJackMutti,“Taxes,TariffsandTransferPricinginMultinationalCorporatedecisionMaking”(1991)vol.73,no.2Review of Economics and Statistics285­93;davidHarris,RandallMorck,JoelSlemrod,andBernardYeung,“IncomeShiftinginU.S.MultinationalCorporations,”inAlbertogiovannini,R.glennHubbard,andJoelSlemrod,eds.,Studies in International Taxation(Chicago:UniversityofChicagoPress,1993),277­302;JamesR.HinesJr.andEricM.Rice,“FiscalParadise:ForeignTaxHavensandAmericanBusiness”(1994)vol.109,no.1Quarterly Journal of Economics149­82;andJulieCollins,greggeisler,anddouglasShackelford,“TheEffectsofTaxes,RegulatoryCapital,Earnings,andOrganizationalFormonLifeInsurers’InvestmentPortfolioRealizations”(1998)vol.24,no.3Journal of Accounting and Economics337­61.

412 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

HinesandRice75findthatataxratedifferentialof1percentagepointisassociatedwitha2.3percentdifferentialinbefore­taxprofitability.Morerecently,grubert76showsthattax­minimizingchoicesregardingthelocationofintangibleincomeandthe allocation of debt explain all the observed differences in profitability acrosscountries with high and low statutory tax rates. Moreover, increasing economicintegration, especially the greater intra­firm trade that now accounts for nearly40percentofallUSinternationaltrade,77suggeststhatsuchtax­motivatedincomeshiftingislikelytobecomemoreprevalentovertime.Thisconjectureissupportedbyempiricalevidencepresentedingrubert78andAltshulerandgrubert,79whofinddramatic increases in income shifting over time; indeed, the Altshuler­grubertestimatesimplythatonaveragein2000theratioofprofitstopre­taxearningsinacountrywitha10percentcorporatetaxrateisalmosttwicethatinacountrywitha40percenttaxrate.

Themoststrikingresultsareobtainedintworecentstudiesthatexamineincomeshiftingdirectly.BartelsmanandBeetsma80estimatetheextentofincomeshiftingduetochangesintransferpricesonintra­firmtransactionsinthemanufacturingsectorinresponsetonationaltaxdifferentialsforasampleofindustrialsectorsinagroupofOECdcountries.Theyfindevidenceofsignificantincomeshifting:a1per­centincreaseinacountry’staxrateleadstoadeclineinreportedbefore­taxincomeof2.7percent.Theirestimatessuggestthattherevenueincreasefromaunilateraltaxincreaseisreducedbymorethan65percentbecauseofincomeshiftingsolelyintheformoftransferpricing(thatis,theirestimateofthedegreeofincomeshiftingdoes not include reallocation of debt in response to the tax increase). Similarly,Clausing81findsthatpricesforintra­firmimportsandexportsarestronglyaffectedbyinternationaltaxdifferentials.Herestimatesindicatethatrelativetogoodsthatarenottradedwithinthefirm,areductioninacountry’sstatutorytaxrateof1per­centagepointresultsinchangesinthepricesofintra­firmtradedgoodsofroughly2percentinthedirectionspredictedbyatax­minimizationstrategy.

Inaddition,severalstudiesfindthatdeductibleinterestpayments(andinsomecases rents and royalties) tend to be made by subsidiaries in high­tax countries,whilenon­deductibledividendpaymentstendtobemadeinlow­taxcountries.For

75 HinesandRice,supranote74.

76 Harrygrubert,“IntangibleIncome,IntercompanyTransactions,IncomeShifting,andtheChoiceofLocation”(2003)vol.56,no.1,Part2National Tax Journal221­42.

77 KimberlyA.Clausing,“Tax­MotivatedTransferPricingandU.S.IntrafirmTradePrices”(2003)vol.87,no.9Journal of Public Economics2207­23.

78 grubert,supranote35.

79 Altshulerandgrubert,supranote28.

80 EricJ.BartelsmanandRoelM.W.J.Beetsma,“WhyPayMore?CorporateTaxAvoidanceThroughTransferPricinginOECdCountries”(2003)vol.87,no.9­10Journal of Public Economics2225­52.

81 Clausing,supranote77.

corporate income taxation in canada n 413

example,Altshulerandgrubert82showthatthefinancialstructureofUS­controlledforeigncorporationsisahighlynegativefunctionoflocalstatutorytaxrates;similarresults are obtained by Hines and Hubbard83 and grubert.84 Most recently,Huizinga,Laeven,andnicodème85constructamodelinwhichanMnEchoosesitsallocationofdebtacrosstheparentfirminitshomecountryanditssubsidiariesinalltheothercountriesinwhichitoperatestooptimizeitscapitalstructure,takingintoaccounttherelativetaxadvantagesinallcountriesaswellasnon­taxfactors,suchaslimitingthelikelihoodofbankruptcyandconstrainingtendenciesforover­investmentbyempire­buildingfirmmanagers.TheirmodelindicatesthatanMnE’sindebtednessinaparticularcountryisafunctionnotonlyoftheown­countrytaxratebutalsoof thedifferencebetweentheown­country taxrateandforeigntaxrates.TheytesttheirmodelusingasampleofMnEswithinvestmentsin33Euro­peancountriesandfindthatthelevelofindebtednessinacountryisfairlysensi­tivetotax­ratedifferentials.Forexample,foranMnEwithtwoestablishmentsofthesamesizeintwoseparatecountries,a10percenttaxincreaseinonecountryincreases the leverage ratio by 2.44percent.86 Finally, Buettner and Wamser87examinetheuseof intercompany loansbya largesetofgermanMnEsovertheperiod1996­2004.Theyfindstrongevidenceoftheuseofintercompanyloanstolowertaxliability;however,therevenueeffectsoftheassociatedprofitshiftingarerelativelysmall,suggestingthatthecostsofadjustingcapitalstructureinordertoshiftprofitsmaybesubstantial.

Similarly,thereisevidencethatMnEsreducetheircombinedtaxliabilitiesbysubstitutingdeductibleroyaltiesfornon­deductibledividendsinhostcountrieswith

82 RosanneAltshulerandHarrygrubert,“RepatriationTaxes,RepatriationStrategies,andMultinationalFinancialPolicy”(2002)vol.87,no.1Journal of Public Economics73­107.

83 JamesR.HinesJr.andR.glennHubbard,“ComingHometoAmerica:dividendRepatriationsbyU.S.Multinationals,”inAssafRazinandJoelSlemrod,eds.,Taxation in the Global Economy(Chicago:UniversityofChicagoPress,1990),161­200.

84 Harrygrubert,“TaxesandthedivisionofForeignOperatingIncomeAmongRoyalties,Interest,dividendsandRetainedEarnings”(1998)vol.68,no.2Journal of Public Economics269­90.

85 HarryHuizinga,LucLaeven,andgaëtannicodème,Capital Structure and International Debt Shifting,EuropeanEconomyEconomicPaperno.263(Brussels:EuropeanCommission,2006).

86 Huizinga,Laeven,andnicodème,ibid.,alsofindthattherelevanttaxratesarethesource­countrytaxrates,ratherthanresidence­basedtaxratesonworldwideincome.Theysuggestthatthisislargelybecausethehome­countrytaxcanbedeferredindefinitely(consistentwiththe“newview”oftheeffectsofdividendtaxation,discussedbelow).Inaddition,theyfindthatwithholdingtaxesarelargelyirrelevanttodeterminingdebtpolicy,becauseMnEscangenerallyavoidsuchtaxes—forexample,byroutingdividendpaymentsthroughaconduitcompanyinathirdcountry.

87 ThiessBuettnerandgeorgWamser,Intercompany Loans and Profit Shifting—Evidence from Company-Level Data,CESifoWorkingPaperno.1959(Munich:CenterforEconomicStudiesandIfoInstituteforEconomicResearch,2007).

414 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

hightaxrates.88HinesandHubbard89anddesai,Foley,andHines90findthatUSMnEs are more likely to defer repatriation if its tax costs are relatively high.Researchanddevelopment(R&d)expensesandotherintangibleinputsalsocreateopportunitiesforincomeshifting.Forexample,Hines91estimatesthattheallocationofR&dexpendituresishighlysensitivetointernationaltaxdifferentials;Altshulerand grubert92 find that low­tax countries are becoming much more importantdestinationsforintangiblesinitiallyproducedintheUnitedStates;andMuttiandgrubert93estimatethatlessthanhalfofthecontributionofparentR&dexpendi­tures to subsidiary income is reflected as royalties.Taken together, these resultsstronglysupportthewidelyheldperceptionthatmanyMnEsaggressivelyengageinvariousformsofinternationaltax­avoidanceactivity.

SeveralstudiesexaminethebehaviourofCanadianfirmsspecifically,andtheirresultsarealsoconsistentwithsignificantprofitshifting.MintzandSmart94exam­ineincomeshiftinginCanadainresponsetodifferencesinprovincialcorporatetaxrates.Theyestimatethattheelasticityoftaxableincomewithrespecttostatutorytaxratesforgroupsofaffiliatedcorporatefirmsthatarenotallowedtoconsolidateincomefortaxpurposesandthuscanengageinincomeshiftingismorethantwiceas largeas theelasticity forfirmswith limitedopportunities for incomeshiftingbecausetheyaresubjecttoformulaapportionment(4.9versus2.3).95Thisestimate,however,maynotbedirectlyapplicable to internationalprofit shifting,which ispresumablysomewhatmoredifficultthanprofitshiftingwithinacountry.JogandTang96examineincomeshiftingintheformofdebtreallocationinthecontextofthetaxchangesthatoccurredintheUnitedStatesandCanadainthemid­1980s,aperiodduringwhich(amongmanyotherchanges)statutoryratesinbothcountries

88 grubert,Randolph,andRousslang,supranote47;andgrubert,supranote84.

89 HinesandHubbard,supranote83.

90 MihirA.desai,C.FritzFoley,andJamesR.HinesJr.,“RepatriationTaxesanddividenddistortions”(2001)vol.54,no.4National Tax Journal829­51.

91 JamesR.Hines,“Taxes,TechnologyTransfer,andtheR&dActivitiesofMultinationalFirms,”inMartinFeldstein,JamesR.Hines,andR.glennHubbard(eds.),The Effects of Taxation on Multinational Corporations(Chicago:UniversityofChicagoPress,1995),225­52.

92 Altshulerandgrubert,supranote26.

93 JohnMuttiandHarrygrubert,“newdevelopmentsintheEffectofTaxesonRoyaltiesandtheMigrationofIntangibleAssetsAbroad,”paperpresentedatthenBER­CRIWConferenceonInternationalServicesFlow(nationalBureauofEconomicResearch—ConferenceonResearchinIncomeandWealth),Bethesda,Maryland,April28­29,2006.

94 JackMintzandMichaelSmart,“IncomeShifting,Investment,andTaxCompetition:TheoryandEvidencefromProvincialTaxationinCanada”(2004)vol.88,no.6Journal of Public Economics1149­68.

95 MintzandSmartalsonotethatfirmsreducetheeffectiveburdenofrelativelyhightaxratesthroughincomeshifting,thusdampeningtheirnegativeeffectsonrealinvestment.

96 VijayJogandJianminTang,“TaxReforms,debtShiftingandTaxRevenues:MultinationalCorporationsinCanada”(2001)vol.8,no.1International Tax and Public Finance5­25.

corporate income taxation in canada n 415

declined,butbysufficientlylessinCanadathatitchangedfrombeingtherelativelylow­taxjurisdictiontotherelativelyhigh­taxjurisdiction.TheyestimatethatCan­adiantaxrevenuesfromforeign­controlledcorporationswouldhavebeensignifi­cantlylargerhadnottheirdebt­to­assetratiosincreasedinresponsetothereformbybetween45and120percent.TheycautionthatrelativelyhighCanadiancorporateincometaxratesgiverisetoreallocationsofdebtthatputpressureontheCanadiancorporatetaxbase.

A Case for Subsidization

The Role of Imperfect CompetitionJudd97extendsthestandardcaseforzerosource­basedtaxationofcapitalincometoarguethattheoptimaltaxrateforcapitalincomeisnegative—thatis,capitalincomeshouldbesubsidized.TheessenceofJudd’sargumentisthatasignificantnumberofmarketsinamoderneconomyarenotperfectlycompetitive,asassumedinthestandardmodel,butratherarecharacterizedbymarketpowerandthusbypricesthat exceedmarginal costs.This includes themarket for capital goods if capitalincome is taxed, since such taxation effectively raises the price of capital goodsabovemarginalcost,orif,asisthecaseinsomeCanadianprovinces,indirecttaxesareappliedtocapitalgoods.Inprinciple,thedistortionsattributabletoimperfectcompetitionarebest addressed throughanti­trustpolicies focusedon increasingcompetition. In the absence of such policies, however, a capital subsidy may bedesirable to offset the monopolistic price distortion. Moreover, the well­knownproductionefficiencytheoremofdiamondandMirrlees98impliesthatintermediateinputs,suchascapitalgoods,shouldnotbetaxed.99Juddshowsthatthisgenerallyimplies that capital income taxes are especially distortionary and capital incomeshouldbesubsidizedeveniftherevenuestofinancethesubsidymustberaisedfromdistortionarytaxesonconsumptionorlaboursupply.

Inordertoobtainasenseofthemagnitudesinvolved,Juddsimulatestheoptimalcapitalincomesubsidyinhismodelforavarietyofvaluesofthemonopolymarkup,

97 KennethL.Judd,The Optimal Tax Rate for Capital Income Is Negative,nBERWorkingPaperno.6004(Cambridge,MA:nationalBureauofEconomicResearch,1997);andKennethL.Judd,“TheImpactofTaxReforminModerndynamicEconomies,”inKevinA.HassettandR.glennHubbard,eds.,Transition Costs of Fundamental Tax Reform(Washington,dC:AEIPress,2001),5­23.

98 PeterA.diamondandJamesA.Mirrlees,“OptimalTaxationandPublicProductionI:ProductionEfficiency”(1971)vol.61,no.1The American Economic Review8­27,and“...II:TaxRules”(1971)vol.61,no.2The American Economic Review261­78.

99 Thatis,diamondandMirrleesarguethatconsumptiondistortionsarealwayspreferabletoproductiondistortions.Itisimportanttonote,however,thatthisresultobtainsonlyifanoptimalsetofcommoditytaxesisavailableandutilizedefficiently,andeconomicprofitsaretaxedata100percenttaxrate;iftheseconditionsarenotmet,thencapitalincometaxationmaybedesirabletoindirectlytaxcommoditiesthatarenottaxedoptimallyortoindirectlytaxeconomicprofits.Theissueoftaxationofeconomicrentsisdiscussedfurtherbelow.

416 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

thedistortionarycostsofalternativetaxesonconsumptionorlaboursupply,andtheextent of profit taxation. His optimal subsidies range from 10 percent to nearly70percent,withthelargestsubsidiescorrespondingtocasesinwhichthemarkupislarge,thedistortionarycostsofalternativetaxesarelow,andprofitsaretaxedatarelativelyhighrate.Oneimportantresultisthattheoptimalpolicyisalmostalwaysasubsidy,evenifthedistortionarycostsofalternativetaxesarerelativelyhigh.JuddalsoarguesthattheempiricalevidenceintheUnitedStatesisconsistentwithlargerdifferencesbetweenpriceandmarginalcostinequipmentindustriesthaninstruc­tures.Thisimpliesthattaxpreferencesfavouringinvestmentinequipment,suchasaninvestmenttaxcreditavailableonlyforequipment,aredesirableonefficiencygrounds.

The relevance of this argument for Canada clearly depends on the extent ofmonopolisticpricinginimperfectlycompetitivemarketsandthesizeoftheresult­ingdistortionsintheformofexcessesofpriceovermarginalcostandeconomicrents.Asdiscussedabove,somemarketsarelikelytobecharacterizedbyMnEsthatearnfirm­specificrents,andrelativelyeasyaccesstotheUSdomesticmarketandalonghistoryofmutuallybeneficialtradesuggeststhepotentialforlocation­specificeconomicrents.At thesametime,however,becauseCanada isarelativelysmallopeneconomy, internationalcompetitionis likelyto limiteconomicrents inthemarketsformanytradablegoods.Thus,theimportanceofthisargumentcanberesolved only with empirical evidence on the importance of economic rents—sustainedabove­normalreturnsotherthanthoseattributabletodynamicinnova­tion—inthekeysectorsoftheCanadianeconomywithasignificantmultinationalpresence. In addition, although the capital subsidies implied in Judd’s relativelysimpleanalysisarerelativelylarge,itisnotclearwhethersimilarresultswouldbeobtainedinamorerealisticfullydevelopedgeneralequilibriummodel.

The Role of Imperfect Informationgordon and Bovenberg100 argue that information asymmetries provide an addi­tional rationale for the subsidizationofcapital income.Specifically, theysuggestthatforeigninvestorsarepoorlyinformed,relativetodomesticinvestors,regardingprospectiveinvestmentreturns,becausetheyfaceaninformationdisadvantagenotonlyinpredictingmarketoutcomesbutalsoinotherareassuchasunderstandingthe nuances of the legal system and local customs, especially those concerninglabour relations. As a result, they require a premium on the returns earned byinvestmentsinforeigncountries.Inthesecircumstances,gordonandBovenbergarguethatcountriesattemptingtoattractsuchinvestmentscaneffectivelycreatesuchapremiumwithacapitalincomesubsidy.Ifsetcorrectly,thissubsidywilloff­settheeffectsoftheinformationaldisadvantagefacedbyforeigninvestors.

100 RogerH.gordonandA.LansBovenberg,“WhyIsCapitalSoImmobileInternationally?PossibleExplanationsandImplicationsforCapitalIncomeTaxation”(1996)vol.86,no.5The American Economic Review1057­75.

corporate income taxation in canada n 417

Thegordon­Bovenbergargument,however,appears toberelevantprimarilyforcountrieswithoutwell­developedaccountingandlegalsystems.ItsrelevanceforCanadaseemstobelimited,especiallyforinvestmentsbyUSMnEs,wherealongtraditionofcross­borderinvestmentexistsandinformationaldisadvantagesseemtobeminimal.Accordingly,thecaseforsubsidizingcapitalincomeinCanadatooffsetinformationaldisadvantageswillnotbeconsideredfurtherinthisarticle.

QuA lIfIc AtIo ns

Ofcourse,notwithstandingtheargumentsdetailedintheprevioussection,thecor­porateincometaxisstillanimportantsourceofrevenuesinmostdevelopedanddevelopingcountries.Avarietyofargumentshavebeenoffered insupportof itscontinued use,101 all of which qualify the argument that a small open economyshouldeitherexemptorsubsidizecapitalincome.Sinceallofthesequalificationshaveatleastsomevalidity,theypotentiallyprovidesupportforthetaxationofcap­ital income—although it is exceedingly difficult to determine their quantitativeimportance relative to the case for capital income exemption or subsidization.nevertheless,thepervasivenessofsuchtaxationsuggeststhatthesequalificationshavebeentakenseriouslyinvirtuallyallcountries.Thefollowingdiscussionexam­ines thesequalifications,reviewstheempiricaldataontheirrelative importance,andattemptstogaugetheirimportanceintheCanadiancontext.

Openness of the Economy and Perfect Substitutability of Imports

Theargumentfortaxexemptionorsubsidizationofcapitalincomeassumesthattheeconomy is sufficiently small that it faces aperfectly elastic supplyof capital—afixed,internationallydeterminedrateofreturn—whichimpliesthatdomesticresi­dents,primarily labour,ultimatelybear theburdenof thecapital income tax. Inaddition, the standard analysis assumes that in the markets for tradable goods,domesticallyproducedgoodsandcompetingimportsareperfectsubstitutes.

ThesetwoassumptionshavebeenchallengedbygravelleandSmetters,102whoarguethat,atleastintheUScontext,somemarketpowerintheinternationalcapitalmarket and/or imperfect substitutability between domestically produced tradedgoodsandimportsimpliesthatmuchoftheburdenofasource­basedtaxoncapital

101 JackMintz,“TheCorporationTax:ASurvey”(1995)vol.16,no.4Fiscal Studies23­68;PeterBirchSørensen,“ChangingViewsoftheCorporateIncomeTax”(1995)vol.48,no.2National Tax Journal279­94;RichardM.Bird,Why Tax Corporations?departmentofFinance,TechnicalCommitteeonBusinessTaxation,WorkingPaperno.96­2(Ottawa:departmentofFinance,1996);AlfonsWeichenrieder,Why Do We Need Corporate Taxation?CESifoWorkingPaperno.1495(Munich:CenterforEconomicStudiesandIfoInstituteforEconomicResearch,2005);Auerbach,supranote32;Sorensen,supranote54;andZodrow,supranote48.

102 Janeg.gravelleandKentA.Smetters,“doestheOpenEconomyAssumptionReallyMeanThatLaborBearstheBurdenofaCapitalIncomeTax?”(2006)vol.6,no.1Advances in Economic Analysis and Policy1­42.

418 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

incomeisbornebycapitalratherthanlabour.Moreover,evenwhencapitaldoesnotbeartheburdenofsuchatax,muchoftheburdenisexportedtoforeigncapitalown­ersratherthanbornebyimperfectlymobiledomesticlabour.Thegravelle­Smettersargumentthuspresentsafundamentalchallengetothestandardtaxexemptionorsubsidizationresult,becauseasource­basedtaxationofcapitalincomeisnolongernecessarilycounterproductivefortherelativelyimmobileresidentsofacountry.

Thegravelle­Smettersargumenthastwocomponents.Thefirstisfairlystan­dard:iftheeconomyisnotsmallinthesensethatitcanaffecttherateofreturntocapitalearnedininternationalmarkets,thensomesource­basedtaxationofcapitalincomemaybedesirable.Specifically,ifthecountryisacapitalimporter,taxationofcapitalincomewillreducethedemandforcapitalimportsandimprovedomesticwelfarebydrivingdowntheequilibriumrateofreturntocapital—thatis,thecostofimportedcapital.Insuchasituation,theshareofthetaxburdenbornebydomes­tic capital is approximately equal to the share of world output produced by thedomesticeconomy(withtherestofthetaxburdenbornebydomesticlabour),andtheoptimaltaxrateoncapitalincomeisafunctionoftheinverseoftheelasticityofsupplyofinternationalcapitaltothedomesticeconomy.103

Thesecondelementoftheargument—andthepointstressedbygravelleandSmetters—is that whether or not the country faces a perfectly elastic supply ofinternational capital, source­based capital income taxation may be desirable if

103 Variationsofthisargumentarethatacountrythatpresentsuniqueinvestmentopportunitiesmayimposeasource­basedcapitalincometaxasameansof“charging”fortherisk­spreadingservicesitprovidestomultinationals(seeRogerH.gordonandHalVarian,“TaxationofAssetIncomeinthePresenceofaWorldSecuritiesMarket”(1989)vol.26,no.314Journal of International Economics205­26),andthatacountrywithmarketpowerinitsexportmarketsmayutilizeasource­basedcapitalincometaxasanindirectmeansofdrivinguptheworldpriceofitsexports(seedavidF.Burgess,“OntheRelevanceofExportdemandConditionsforCapitalIncomeTaxationinOpenEconomies”(1988)vol.21,no.2Canadian Journal of Economics285­311).ItseemsunlikelythattheseargumentswouldbeofquantitativesignificanceforCanada.Bird(supranote101)offersthreeotherpotentialbutlesscompellingeconomicjustificationsforacorporateincometax.First,acorporatetaxmightbeusedtooffsetotherproductioninefficiencies(seedavidg.Hartman,On the Optimal Taxation of Income in the Open Economy,nBERWorkingPaperno.1550(Cambridge,MA:nationalBureauofEconomicResearch,1986);andChristopherFindlay,“OptimalTaxationofInternationalIncomeFlows”(1986)vol.62,no.177Economic Record208­14);inpractice,however,itwouldbedifficulttostructurethetaxtodosoeffectively.Second,giventheresultspresentedaboveontheincidenceofasource­basedtaxoncapitalincomeinasmallopeneconomy,suchataxmaybeameansofincreasingtaxesonimmobilelocalfactorsbeyondthelevelpoliticallypossiblethroughthedirectindividualtaxsystem(Sørensen,supranote101)ifsuchincreasesaredeemeddesirableandcannotbeimplementedthroughalternativemeans.Third,acorporatetaxfacilitatesgovernmentinterventionintheeconomyintheformofcorporatetaxpreferencesforvarioustypesofactivities,which,ifimplementedforeconomicallyjustifiablereasons(suchasdemonstrableexternalbenefitstoadditionalresearchanddevelopmentactivity)ratherthanforpurelypoliticallyadvantage,maybesociallydesirable;however,directgovernmentexpenditurescanachievethesamegoalinamoretransparentfashionandwithoutincurringthedistortionsofthecorporatetax.

corporate income taxation in canada n 419

importedproductsarelessthanperfectlysubstitutablefordomesticallyproducedgoods. If traded goods are imperfect substitutes, then some of the burden of asource­basedtaxoncapitalincomecanbeshiftedforwardtodomesticconsumers,includingtheownersofdomesticcapital,whoexperienceareductioninpurchasingpowerandthusbearsomeoftheburdenofthetax.

gravelleandSmettersexaminetheincidenceofataxoncapitalincomewithinthecontextofafour­sector(corporateandnon­corporatetradablegoodsandcor­porate and non­corporate non­tradable goods) general equilibrium simulationmodeloftheUSeconomysimilartothatdescribedbyHarberger.104Withperfectsubstitutabilitybetweendomesticgoodsandimports,theshareofthetaxburdenbornebydomesticlabourisapproximatelyequalto1minusthedomesticshareofworldoutput(whichimpliesadomesticlabourtaxburdenshareofabout70percentinthecaseoftheUnitedStates,butover97percentinthecaseofCanada).More­over, the labour share falls dramatically as the substitutabilitybetweendomesticgoodsandimportsfalls.Forexample,iftheelasticityofsubstitutioninconsumptionbetweentradedcorporatedomesticgoodsandimportsisreducedto3.0,theshareofthetaxburdenondomesticlabourfallsto38percent.Inaddition,gravelleandSmettersarguethattheirresultisreinforcedifcapitalisimperfectlymobile,whichalsotendstodecreasetheshareofthetaxburdenbornebydomesticlabour.Forexample,ifdomesticandimportedgoodsareperfectsubstitutesbuttheelasticityofportfoliosubstitutionbetweendomesticandforeigncapitalwithrespecttotheratioofdomesticandforeignratesofreturnis3.0(ratherthaninfinite,asinthecaseofaperfectlyelasticsupplyofforeigncapital),theshareofthetaxburdenondomesticlabourfallsto28percent.Ifboththeportfoliosubstitutionelasticityandtheprod­uctelasticityequal3.0,thedomesticlabourshareofthetaxburdenfallsto18per­cent.gravelleandSmettersarguethatempiricalestimatessuggestthatthevaluesofbothelasticitiesare3.0orless.Theystress,however,thatevenifcapitalisper­fectlymobile,areasonabledegreeofimperfectsubstitutabilitybetweendomesticgoodsandimportsleadstoasignificantshare(typicallyexceeding50percent)oftheburdenofthetaxbeingbornebycapitalratherthanlabour.

Thegravelle­Smettersargumentthuspotentiallyunderminesthestandardsmallopen economy argument for tax exemption or subsidization of capital income,becauseitimpliesthatdomesticlabourdoesnotnecessarilybearthefullburdenofasource­basedtaxoncapitalincome.105However,therelevanceandimportanceofthisargumentfortheCanadiancasearefarfromclearforseveralreasons.

104 Harberger,“TheABCsofCorporateTaxIncidence”and“CorporateTaxIncidence,”supranote52.

105 Ofcourse,taxationofcapitalincomemaynotbedesirableevenifdomesticcapitalownersbearmuchoftheburdenofthetax.Althoughtheissueisstillcontentious,muchoftheacademicliteraturesuggeststhatthenormalreturnstocapitalshouldbeexemptfromtaxinordertoavoidextremelycostlydistortionsofpresent­futureconsumptiondecisions:seeZodrow,supranote54.Areviewoftheseargumentsisbeyondthescopeofthisarticle,sinceitisassumedherethatthebasicstructureofincometaxationisretained.

420 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

Mostobviously,thegravelle­SmettersresultsarefortheUSeconomy,anditisclearthat,allelseconstant,thelabourshareoftheburdenofasource­basedtaxoncapitalincomeinCanadaissignificantlylargerbecauseoftherelativelysmallersizeoftheCanadianeconomy,whosegdPisapproximatelyone­tenththatoftheUnitedStatesandaccountsforroughly2.5percentofworldoutput.106TheimportanceforCanadaofthegravelle­SmettersargumentcanthusbedeterminedonlywithanexplicitgeneralequilibriumanalysisoftheCanadianeconomy,butitisreasonabletoassumethatitsimpactisfarsmallerthaninthecaseoftheUnitedStates.

Asecond issue is thatalthoughcapital isnotperfectlymobile internationally,increasingglobalizationandtheaccompanyingincreaseincapitalmobilityingen­eral107suggestthattaxpolicyinCanadashouldbebasedontheassumptionofarelativelyhighlyelasticsupplyofinternationalcapital,especiallyinlightofthehighdegreeofmobilityofcapitalbetweentheUnitedStatesandCanada.Forexample,Cummins108andAltshulerandCummins109estimatethatforCanadianfirmsinvest­ingintheUnitedStates,theelasticityofsubstitutionbetweendomesticandforeigncapitalintheUnitedStatesexceeds1.Cummins110concludesthat“U.S.andCanad­ianfixedcapitalarerelativelyeasysubstitutesatthefirmlevel.”Similarly,Mintz111stressesthatCanadiancapitalmarketsarebecomingincreasingly integratedwithinternationalmarkets.Forexample,henotesthatafter­taxratesofreturnonequityforfirmslistedontheTorontoStockExchangearenotcorrelatedwitheithercur­rentorfive­year­averageCanadiancorporateincometaxrates,suggestingthattheCanadiancorporateincometaxisnotbornebycapitalownersforsuchfirms.112

SomeindirectevidenceregardingtheelasticityofsupplyofcapitaltoCanadaisprovidedbytheassumptionsthatvariousresearchershavemadeinconstruct­ingcomputationalgeneralequilibriummodels(CgE)oftheCanadianandworld

106 WorldBank,World Development Indicators 2006(Washington,dC:WorldBank,2006).

107 CharlesL.Ballard,“InternationalAspectsofFundamentalTaxReform,”ingeorgeR.ZodrowandPeterMieszkowski,eds.,United States Tax Reform in the 21st Century(Cambridge,UK:CambridgeUniversityPress,2002),109­39;andHarberger,“CorporateTaxIncidence,”supranote52.

108 Jasong.Cummins,The Effects of Taxation on U.S. Multinationals and Their Canadian Affiliates,WorkingPaperno.96­4(Ottawa:departmentofFinance,TechnicalCommitteeonBusinessTaxation,1997).

109 RosanneAltshulerandJasonCummins,Tax Policy and the Dynamic Demand for Domestic and Foreign Capital by Multinational Corporations,WorkingPaperno.97­31(newYork:C.V.StarrCenterforAppliedEconomics,1997).

110 Cummins,supranote108,quotedfromabstract.

111 Mintz,supranote1.

112 MintzalsonotessomeempiricalresultsthatindicatethatCanadianstockprices,especiallythoseofsmallerfirmsthatdonotborrowoninternationalmarkets,arepartlydependentonCanadiansavingsbehaviour.Thissuggeststhatsomemarketsegmentationstillexists,butthatlargerfirms,especiallyMnEs,arelikelytobequitemobile.

corporate income taxation in canada n 421

economies.TheCgEtaxmodelusedbyCanada’sdepartmentofFinancetypicallyassumesanelasticityofforeign­ownedcapitalwithrespecttorelativeinterestratesinCanadaandabroadof1.0,althoughmorerecently ithasbeenarguedthatanelasticityintherangeof1.3to2.5wouldbemoreappropriate.113AmongCgEstud­ies thathave analyzed the effectsof recent trade agreements innorthAmerica,Roland­Holst,Reinert,andShiells114assumecapitalsupplyelasticitiesthatrangefrom0.3to1.1,whileCoxandHarris115andCox116assumethatcapitalisperfectlymobilebetweenCanadaandtherestoftheworldeconomy.117

Finally,notethatevenifthesupplyofforeigncapitalisnothighlyelastic,itisnotclearthathighcorporatetaxratesaredesirable,sincetheywoulddiscouragedomesticsavingandinvestment,includingbythesmallerentrepreneurialfirmsthatareoftenamongthemostdynamicelementsofaneconomy.Beyondthetraditionalargumentsfavouringloworzerotaxratesonsaving,independentofinternationalconsiderations (reviewedbyZodrow),118gordon119notes that the importanceofentrepreneurialactivityinpromotinginnovationandsparkingproductivitygrowthmayjustifyataxpreferenceforsuchactivitiesonthegroundsthattheygeneratepositiveexternalitiesandshouldbeencouragedbythetaxsystem.Inpractice,thisencouragementcouldtaketheformofimplicitlyprovidingentrepreneurswiththeopportunitytoconvertlabourincomeintobusinessincomeandthentaxingthelatteratrelativelylowrates.(Ofcourse,suchapolicywouldbeperceivedasinequitableandwouldencouragetaxavoidancenotrelatedtoproductiveentrepreneurialactivity.)Moreover,somerecentempiricalevidencesuggeststhathightaxes,especiallyhighstatutorytaxratesthatimposeasignificantburdenonabove­normalreturnstosuc­cessfulentrepreneurialventures,actasanimportantdeterrenttoentrepreneurial

113 ThisinformationwasprovidedbyJohnLesterofthedepartmentofFinance.

114 davidW.Roland­Holst,KennethA.Reinert,andClintonR.Shiells,“AgeneralEquilibriumAnalysisofnorthAmericanEconomicIntegration,”inJosephF.FrancoisandClintonR.Shiells,eds.,Modeling Trade Policy: Applied General Equilibrium Assessments of North American Free Trade(Cambridge,UK:CambridgeUniversityPress,1994),47­82.

115 davidCoxandRichardHarris,“TradeLiberalizationandIndustrialOrganization:SomeEstimatesforCanada”(1985)vol.93,no.1Journal of Political Economy115­45;anddavidJ.CoxandRichardg.Harris,“northAmericanFreeTradeandItsImplicationsforCanada:ResultsfromaCgEModelofnorthAmericanTrade”(1992)vol.15,no.1The World Economy31­44.

116 davidJ.Cox,“SomeAppliedgeneralEquilibriumEstimatesoftheImpactofanorthAmericanFreeTradeAgreementonCanada,”inModeling Trade Policy,supranote114,100­23.

117 H.E.Sobarzo,“AgeneralEquilibriumAnalysisofthegainsfromTradefortheMexicanEconomyofanorthAmericanFreeTradeAgreement”(1992)vol.15,no.1The World Economy83­100,alsoassumesperfectlymobilecapital.

118 Zodrow,supranote54.

119 RogerH.gordon,“CanHighPersonalTaxRatesEncourageEntrepreneurship?”(1998)vol.45,no.1IMF Staff Papers49­60.

422 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

activity,120althoughthisroleistemperedbytheadditionalrisksharingthatsuchratesprovide.121

Third,theimportanceoftheelasticityofsubstitutioninconsumptionbetweendomesticandimportedgoodsindeterminingtheextenttowhichlocalfactorsofproductionavoidthecorporatetax isunclear.Randolph122extendsthegravelle­Smettersmodel toallowadomesticcorporatesector thatproduces twotypesoftraded goods—some that are perfect substitutes for imports and others that areimperfectlysubstitutable.Heshowsthatthisplausibleextensionofthemodeldra­maticallyaffectsitsresults.Forexample,ifthecapitalintensitiesinthetwocorpor­atetradablegoodssectorsareidentical,theincidenceofthecorporateincometaxisindependentofthedegreeof importsubstitutabilityinthesecondsector;and, ifcapitalisperfectlymobile,domesticlabourbearsslightlymorethan70percentofthecorporatetaxburdenintheUnitedStates.Ifthetradablegoodscorporatesectorwithperfectimportsubstitutabilityismorecapital­intensivethantheothertradablegoodscorporatesector,theshareoftaxburdenbornebydomesticlabourincreasesmoderately,asitdoesifcapitalisperfectlymobile.Inaddition,andmostrelevantinthe Canadian context, Randolph shows that the labour share of the tax burdendependssignificantlyonthesizeofthedomesticeconomy;inatypicalsimulation,domesticlabourbearsmorethan100percentoftheburdenoftaxifthedomesticeconomyproduceslessthan5percentofworldoutput.

In any case, the appropriate value for the elasticity of substitution betweendomesticgoodsandimportsisfarfromclear.gravelleandSmettersarguethatfortheUnitedStates,mostempiricalestimatessuggestarelativelylowelasticityrang­ingfrom0.5to3.0;theyarguethatanelasticityof1isareasonablebenchmark.Forexample,oneoften­citedstudyisReinertandRoland­Holst,123whoreportelasti­citiesthatrangefrom0.04to3.0.Morerecently,gallaway,Mcdaniel,andRivera124estimateanaveragelong­runimportsubstitutionelasticityintheUnitedStatesof1.55,witharangeof0.52to4.83.InCanada,ShiellsandReinert125reporteven

120 WilliamM.gentryandR.glennHubbard,“TaxPolicyandEntrepreneurialEntry”(2000)vol.90,no.2The American Economic Review283­87.

121 JulieB.CullenandRogerH.gordon,Taxes and Entrepreneurial Activity: Theory and Evidence for the U.S.,nBERWorkingPaperno.9015(Cambridge,MA:nationalBureauofEconomicResearch,2002.)

122 WilliamC.Randolph,International Burdens of the Corporate Income Tax,CBOWorkingPaper(Washington,dC:CongressionalBudgetOffice,2006).

123 KennethA.ReinertanddavidW.Roland­Holst,“ArmingtonElasticitiesforUnitedStatesManufacturingSectors”(1992)vol.14,no.5Journal of Policy Modeling631­39.

124 MichaelP.gallaway,ChristineA.Mcdaniel,andSandraA.Rivera,“Short­RunandLong­RunIndustry­LevelEstimatesofU.S.ArmingtonElasticities”(2003)vol.14,no.1North American Journal of Economics and Finance49­68.

125 ClintonR.ShiellsandKennethA.Reinert,“ArmingtonModelsandTerms­of­TradeEffects:SomeEconometricEstimatesfornorthAmerica”(1993)vol.26,no.2Canadian Journal of Economics299­316.

corporate income taxation in canada n 423

lowerelasticities,rangingfrom0.1to1.5.126TurningtoCgEmodelsofCanadaandtheworldeconomy,Roland­Holst,Reinert,andShiells127assumeanimportsubsti­tution elasticity that varies from 0.1 to 1.5, while Cox and Harris128 and Cox129assumeimportsubstitutionelasticitiesthatvaryfrom1.0to4.8.130

However,McdanielandBalistreri131notethatmanytradeeconomistsareskep­ticaloftheserelativelylowestimatesofimportsubstitutionelasticitiesandbelievethatimportsanddomesticgoodsaremuchmoresubstitutablethantheseestimatesimply.Similarly,Harberger132arguespersuasivelythatsuchrelativelylowelasticitiesofsubstitutionbetweendomesticandimportedproductsimplyanimplausiblylargedegreeofmarketpowerfordomesticproducers,whoinmanycasesappearinfacttohaverelativelylittlemarketpower.133ThisobservationappearstoberelevantinthecaseofCanadatotheextentthatdomesticandinternationalcompetitionissuf­ficientlygreattolimitthemarketpowerofdomesticfirms.

Moreover,severalrecentstudieshaveobtainedsignificantlyhigherelasticitiesonaverage,aswellasawiderangeofelasticities,thusprovidingsomejustificationforthestructureoftheRandolphmodel,whichhastwocorporatetradablegoodssectorswithdifferentimportsubstitutionelasticities.Forexample,Erkel­RousseandMirza134estimateanoverallimportsubstitutionelasticityof3.8,withmanyindustrieschar­acterizedbyelasticitiesbetween6.5and7.0andsomeashighas13.0.Herteletal.135focuson the import substitutionelasticity in their studyofCgEanalysesof freetrade agreements. They argue that earlier estimates tend to understate the true

126 Inaddition,Wirjantoestimatesdemandelasticitiesforimportedgoodsthatvaryfrom1.1to1.9:TonyS.Wirjanto,“EstimationofImportandExportElasticities,”reportpreparedfortheEconomicandFiscalPolicyBranchatthedepartmentofFinance(UniversityofWaterloo:departmentofEconomics,1999).

127 Roland­Holst,Reinert,andShiells,supranote114.

128 CoxandHarris,“northAmericanFreeTradeandItsImplicationsforCanada,”supranote115.

129 Cox,supranote116.

130 Sobarzo,supranote117,assumesimportsubstitutionelasticitiesthatvaryfrom0.375to3.0.

131 ChristineA.McdanielandEdwardJ.Balistreri,A Discussion on Armington Trade Substitution Elasticities,U.S.InternationalTradeCommissionOfficeofEconomicsWorkingPaperno.2002­01­A(Washington,dC:InternationalTradeAdministration,2002).

132 Harberger,“CorporateTaxIncidence,”supranote52.

133 Inaddition,Randolph,supranote122,notesthatmostempiricalestimatesoftheimportsubstitutionelasticityarerelativelyshort­run,andwouldpresumablybelarger,perhapssignificantlyso,inthelongrun(asconfirmedinthereviewofthisliteraturebyMcdanielandBalistreri,supranote131).

134 HélèneErkel­RousseanddanielMirza,“ImportPriceElasticities:ReconsideringtheEvidence”(2002)vol.35,no.2Canadian Journal of Economics282­306.

135 ThomasHertel,davidHummels,MarosIvanic,andRomanKeeney,How Confident Can We Be in CGE-Based Assessments of Free Trade Agreements?CenterforglobalTradeAnalysisWorkingPaperno.26(WestLafayette,In:PurdueUniversity,2004).

424 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

elasticitybecausetheydonotproperlyaccountforqualityvariationamongimportsanddomesticgoodsandinappropriatelyusefixed­weightimportpriceseriesdata,whichoverweightrelativelyhighforeignpricesandunderweightrelativelylowfor­eignprices.Theiraverageestimatedimportsubstitutionelasticityfor40differentproductsis7.0,withestimatesthatexceed10insomecases.Intworecentexamina­tionsofUS­Canadatrade,HeadandRies136estimateimportsubstitutionelasticitiesthatrangefrom7.9to11.4,whileClausing’sestimates137areslightlyunder10.

Theseresultssuggestthattheresultsofthegravelle­SmettersstudyshouldbeinterpretedcautiouslyintheCanadiancontext.Althoughitisclearthatneitherthesupplyelasticityofcapitalnortheimportsubstitutionelasticityareinfinite,boththestructuralmodelofRandolph138andseveralrecenteconometricestimatessuggestthatoneshouldexercisegreatcautionbeforeassumingthattherelativelyhighcor­porateincometaxratesinCanadaarenotlargelybornebylocalfactors.Moreover,evenifdomesticcapitalbearsasignificantportionoftheburdenofthecorporateincometax,itisfarfromclearthatsuchataxisdesirable,givenitsefficiencycostsandnegativeeffectsonsavingandinvestment,entrepreneurialactivity,productivity,andgrowth.

The Personal Income Tax Backstop Argument

Fromadomesticstandpoint,thetraditionalrationaleforacorporateincometaxisthatit isessentialtoprotecttherevenuebaseofthepersonalincometax.Atthemostbasiclevel,thebackstopargumentsimplyreflectstheadministrativeadvan­tagesofwithholdingtaxatsource,especiallyforthepurposeofensuringthatthecapitalincomeofwealthyindividualsissubjecttotax.Forexample,gordonandLi139arguethattherelianceofdevelopingcountriesoncorporateincometaxation,especiallyonfirmsthatmakeuseofthefinancialsector,simplyreflectstheinabilityofthosecountriestoeffectivelycollectpersonalincometaxes.TherelevanceofthisargumentforCanadaappearstobelimited.

Moreimportant,however,intheabsenceofacorporatetax—andespeciallyifcapitalgainsareuntaxedortaxedpreferentially—individualscouldincorporateanddeferpersonalincometaxonlabourincomebyretainingtheearningsincorporateform.Indeed,theycanavoidtaxaltogetherifthecapitalgainstaxatdeathcanalsobeavoidedowingtoasufficientlylargeexclusion,suchasthe$750,000exclusion

136 KeithHeadandJohnRies,“IncreasingReturnsVersusnationalProductdifferentiationasanExplanationforthePatternofU.S.­CanadaTrade”(2001)vol.91,no.4The American Economic Review858­76.

137 KimberlyA.Clausing,“TheImpactofTransferPricingonIntrafirmTrade,”inInternational Taxation and Multinational Activity,supranote23,173­94.

138 Randolph,supranote122.

139 RogerH.gordonandWeiLi,Tax Structure in Developing Countries: Many Puzzles and a Possible Explanation,nBERWorkingPaperno.11267(Cambridge,MA:nationalBureauofEconomicResearch,2005).

corporate income taxation in canada n 425

availableunderCanadianlawforcapitalgainsonsmallbusinessshares.140Alterna­tively,capitalgainsinexcessoftheexclusionmaybetaxedatpreferentialrates,oronlypartiallyincludedinincome,asisthecaseinCanada,whereonly50percentofgainsareincludedinthetaxbase.Asfundsaccumulateintheuntaxedcorporation,personal consumption can be financed by personal loans from the corporation.notethatthisargumentdoesnotimplythatonlydomesticcorporationsmustbetaxed.Ifforeigncorporationsdonotfacethesamecorporateincometaxasdomes­ticfirms,individualsandfirmscanestablishcorporationsthatarenominallyforeign(forexample,inataxhaven)andagainavoiddomesticliabilityontheircorporateincome.141Shiftingbetweenthebusinessandindividualtaxbasesisalsopossibleifonechangesthelevelofdebtfinanceinacloselyheldcorporation(sinceinterestincomeisdeductibletothefirmandtaxedattheindividuallevel),orifonechangesthemixofcompensationbetweensalariesandstockoptions.

note,however,thattheoverallimportanceofthisbackstopfunctionofthecor­porateincometaxshouldnotbeoverstated,sinceitappliesonlytoself­employedindividuals and theownersof closelyheldcorporations.Moreover, such income(reportedascorporateincomeorasbusinessincomeonanindividualreturn)istyp­icallyunderreportedtoasignificantextentinanycase,limitingtheeffectivenessofthecorporate tax as abackstop to thepersonal income tax.Forexample, recentestimatesofthedegreeofunderreportingofself­employmentincomeinCanadarangefrom11to24percent.142

Anadditionalissueistheextenttowhichanyincomeshiftingattributabletoataxratedifferentialbetweenthecorporateandindividualincometaxesrepresentsapermanentlossofrevenueorsimplydeferraloftax,sincetherevenueandequityproblemsinthelattercaseareconsiderablysmaller.Inparticular,equityproblemsare lessseverebecausetheCanadianIncomeTaxAct143currentlyprovidesmany

140 ThereisnoestatetaxinCanada,althoughaccruedcapitalgainsaretaxableupondeath.Inaddition,Canadataxesinvestmentincomeearnedbyaprivatecorporationonacurrentbasis,witharefundwhentaxabledividendsaredistributed.

141 RogerH.gordonandJeffreyK.MacKie­Mason,“WhyIsThereCorporateTaxationinaSmallOpenEconomy?TheRoleofTransferPricingandIncomeShifting,”inMartinFeldstein,JamesR.HinesJr.,andR.glennHubbard,eds.,The Effects of Taxation on Multinational Corporations(Chicago:UniversityofChicagoPress,1995),67­91;andRogerH.gordonandJoelSlemrod,“Are‘Real’ResponsestoTaxesSimplyIncomeShiftingBetweenCorporateandPersonalTaxBases?”inJoelSlemrod,ed.,Does Atlas Shrug? The Economic Consequences of Taxing the Rich(newYorkandCambridge,MA:RussellSageFoundationandHarvardUniversityPress,2000),240­80.

142 RolfMirus,RogerS.Smith,andVladimirKaroleff,“Canada’sUndergroundEconomyRevisited:UpdateandCritique”(1994)vol.20,no.3Canadian Public Policy235­52;HerbJ.Schuetze,“ProfilesofTaxnon­ComplianceAmongtheSelf­EmployedinCanada:1969to1992”(2002)vol.28,no.2Canadian Public Policy219­38;andLindsayM.Tedds,“nonparametricExpenditure­BasedEstimationofIncomeUnder­ReportingandtheUndergroundEconomy”(manuscript,UniversityofManitoba,2006).

143 RSC1985,c.1(5thSupp.),asamended.

426 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

other options for deferral. given the $750,000 lifetime capital gains exemptionavailable tobusinessowners, tax exemption ispresumably theoutcome inmanycases.nevertheless,deferralmayalsobetherelevantresultinasignificantnumberofcases;somefundswithincloselyheldcorporationsareeventuallypaidoutastax­abledividendsandinterest(orasfuturewages),orastaxablecapitalgains,especiallyifitisrelativelydifficulttoborrowagainstcorporateassetsoriftheinterestratesonsuch loans are typically relatively high. The Canadian corporate and personalincometaxsystemsareverynearlyfullyintegrated,whichimpliesthatlabourin­comewithinacloselyheldcorporationwilleventuallybetaxedatpersonalincometaxrates.Indeed,totheextentthatearningsretainedwithinacloselyheldcorpora­tiongrowattheaveragerateofreturnoninvestment,thepresentvalueofgovern­mentrevenueswillnotbeaffectedbydeferral,excepttotheextentthatthetaxratesthatapplytodividendsandcapitalgainsarelowerthanthosethatapplytolabourincome.144Inaddition,someincomeshifting,especially ifthegainisprimarilyadeferral, may be deemed acceptable as a means of encouraging entrepreneurialactivity,althoughthiswillbeperceivedasproblematicalonequitygrounds.Thebackstopfunctionof thecorporate incometax is thusastrongargumentagainstcreatingahugedifferentialbetweencorporateandindividualtaxrates,althoughthemagnitudeofanacceptabledifferentialisdifficulttoascertain.

nevertheless,intheabsenceofabusiness­leveltaxinCanada(orifbusinessratesweresignificantlybelowpersonalrates),thepotentialfortaxavoidanceandevasioncouldbesignificant,implyingseriousequityandperceptionproblems.Thisisespe­ciallysobecauserecentempiricalworkbygordonandSlemrod145suggeststhatthedegreeofincomeshiftingbetweenthecorporateandindividualtaxbases,atleastintheUnitedStates,couldbelarge;indeed,theyestimatethata1percentagepointreduction in the difference between individual and corporate tax rates increasesreportedlabourincomeby3.4percent.146ItisofcoursenotobviousthatthisresulttranslatestotheCanadiancontext,especiallygiventhemuchhigherlevelofinte­grationofthepersonalandcorporateincometaxsystemsrelativetotheUStaxsystem.AlthoughnostudiesofsuchincomeshiftinginCanadaareavailable,theestimatesoftheelasticityoftaxableincomewithrespecttochangesinmarginalincometaxrates—whichincludesincomeshiftingbetweenindividualandcorporatetaxbases,

144 Owingtoawidevarietyoftaxpreferences,includingveryfavourabletaxtreatmentofretirementsavingsvehiclessuchaspensionplansandregisteredretirementsavingsplans(taxpostpaidplanssubjecttocontributionlimits),theaveragetaxrateappliedtocapitalincomeattheindividuallevelislikelytobequitelowinCanada.Ontheotherhand,sincethepersonalincometaxisnotindexed(beyondtheindexationofincomebrackets),theeffectivetaxratesappliedtocapitalincomethatissubjecttotaxcanbequitehigh,especiallyforinterestincomethatreflectsarelativelylowrealrateofreturn.

145 gordonandSlemrod,supranote141.

146 Somewhatsurprisingly,gordonandSlemrodfindthatthetop1percentofthepopulationisonlyslightlymoreresponsivetothedifferenceinpersonalandcorporatetaxrates(aresponseof3.64percent)thantherestofthepopulation(3.27percent).

corporate income taxation in canada n 427

butmanyotherfactorsaswell—obtainedbySillamaaandVeall,147whicharearound0.25,aresignificantlysmallerthanthoseobtainedinmoststudiesofUSbehaviour,whichtendtoclusteraround0.4orhigher.148However,SillamaaandVeallalsore­portthatthetaxableincomeelasticityofself­employmentincomeexceeds1,raisingthepossibilitythatsomeofthissizableresponseisduetoincomeshifting.

Therelativesizeofthesmallbusinesssectorisalsoimportantbecauseitisapri­marydeterminantof the extent towhich labour income shifting is potentially aproblem.ThesmallbusinesssectorisfairlysizableintheCanadianeconomy.Forexample, in 2004­2005, small Canadian­controlled private corporations (CCPCs)accountedfor18.5percentofnetrevenuesunderthecorporateincometax.Finally,althoughthebackstopargumentprovidesarationaleforsomebusiness­leveltax,itdoesnotnecessarilyrequireacorporateincometax.Inparticular,mostoftheanti­avoidance, anti­evasion backstop characteristics of the corporate tax could beachievedwithacorporatecashflowtaxassessedatthetopindividualrate,whichwouldremovetheincentivesforconversionoflabourincomeintocorporateincomewhiletaxingeconomicrentsandexemptingordinaryreturnstocapital.149

The Implications of Tax-Avoidance Activities

Asdiscussedabove,thepotentialfortaxavoidanceandincomeshiftingingeneralprovidesanotherargumentforloweringcorporateincometaxrates—tominimizetheextenttowhichrelativelyhighstatutoryratescreateanincentiveforMnEstoshiftrevenuesoutof,anddeductionsinto,acountry.However,possibilitiesfortaxavoidancebyMnEsalsosuggestthatthenegativeimpactofrelativelyhighstatutoryandeffectivetaxratesonFdImaybesignificantlymutedifMnEsareeasilyabletomitigatetheireffectsonthecostofcapitalwithtaxplanning.Indeed,theavailabilityofstrategiesfortaxplanningthatareavailableonlytoMnEssuggestsaninteresting“optimalcapitalincometax”strategythatmightbepursuedbycountriesattempt­ingtoattractFdIatminimalrevenuecost.Specifically,totheextentthatMnEsaremore mobile than domestic firms (and neglecting the higher administrative andcompliancecostsofdifferentialtaxation),optimaltaxtheorysuggeststhatthefor­mershouldbetaxedatrelativelylowerrates—indeed,asdescribedabove,atazerorateiftheyareperfectlymobile.150Inpractice,politicalconsiderationsprecludethe

147 Mary­AnneSillamaaandMichaelR.Veall,“TheEffectofMarginalTaxRatesonTaxableIncome:APanelStudyofthe1988TaxFlatteninginCanada”(2001)vol.80,no.3Journal of Public Economics341­56.

148 SethH.giertz,Recent Literature on Taxable Income Elasticities,CongressionalBudgetOfficeTechnicalPaperno.2004­16(Washington,dC:CongressionalBudgetOffice,2004).

149 R.glennHubbard,“CapitalIncomeTaxationinTaxReform:ImplicationsforAnalysisofdistributionandEfficiency,”inUnited States Tax Reform in the 21st Century,supranote107,89­108;georgeR.ZodrowandCharlesE.McLureJr.,“ImplementingdirectConsumptionTaxesindevelopingCountries”(1991)vol.46,no.4Tax Law Review405­87;andZodrow,supranote48.

150 ElisabethguglandgeorgeR.Zodrow,“InternationalTaxCompetitionandTaxIncentivesfordevelopingCountries,”inJamesAlm,JorgeMartinez­Vasquez,andMarkRider,eds.,The Challenges of Tax Reform in a Global Economy(newYork:Springer,2006),167­91.

428 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

taxationofforeignfirmsatrateslowerthanthoseappliedtodomesticfirms.How­ever,thesameresultcanbeachievedifhostcountriesallowMnEstohaveaccesstotax­avoidancedevices(forexample,throughexplicitregulationsorlaxenforcement)thatarenotavailabletodomesticfirms.Indeed,HongandSmart151arguethattaxhavensshouldbe“praised”forallowingthisflexibility;theyalsonote,asdiscussedabove,thattheexistenceoftaxhavensimpliesthatrealFdIwillbelesssensitivetotaxratedifferentials,thusallowinghighercorporatetaxratesinhostcountriestobewelfare­increasingfortheircitizens.152

Altshuler and grubert153 argue that this phenomenon provides an importantexplanationofthebehaviourofhostcountriesinrecentyears,astaxcompetitionamongcountriesincreasinglytakestheformofallowingtaxavoidance,mostcom­monlyintheformofallowingincomeshiftingtolow­ratetaxhavens,ratherthantheexplicitreductionsinstatutoryoreffectivetaxratesstressedinthetraditionaltaxcompetitionliterature.154Furthermore,theyarguethathomecountries,includ­ingtheUnitedStates,faceanincentivetoalloworevenfacilitatetaxavoidancebyMnEsiftheybelievethatthegainsfromincreasedcompetitivenessoftheirMnEsoutweightheassociatedrevenuelosses.TheprimeexampleofsuchbehaviouristheadoptionoftheUScheck­the­boxregulationsin1997,whichallowedaffiliatedfirmstochoosetheirtaxstatusasasubsidiarysubjecttoseparatetaxation,orasabranchtaxedonapassthroughbasistotheparentfirm,andgreatlyfacilitatedvarioustax­avoidanceschemes.

Altshulerandgrubertprovideseveralexamplesoftax­avoidanceactivitymadeeasierbythecheck­the­boxrules.Ingeneral,thesestrategiesinvolvecircumventionofthecontrolledforeigncorporation(CFC)rulesthatrequirecurrenttaxationoffundstransferredtotaxhavens.Forexample,thenewrulesforthefirsttimepermitUSfirmstoutilizetaxhavenfinancesubsidiaries,whichallowstheinjectionbytheUSparentofequityfundstoanaffiliatedcompanyinalow­ratetaxhaventhatinturnloansthefundstoanotheraffiliatedcompanyinahigh­taxcountry.Underthefor­merregulations,thepaymentof interesttothecompanyinthetaxhavenwouldhavebeentaxablecurrentlyundertheCFCrules.Withthenewregulations,how­ever,thecompanyinthehigh­taxhostcountrycanbeahybridentity—onethatis

151 QingHongandMichaelSmart,In Praise of Tax Havens: International Tax Planning and Foreign Direct Investment,CESifoWorkingPaperno.1942(Munich:CenterforEconomicStudiesandIfoInstituteforEconomicResearch,March2007).

152 Similarly,grubertandMutti,supranote24,arguethatbecausetaxesdueonrepatriationcanbeeasilyavoided(forexample,througharbitragetransactionsinvolvingaconduitcompanyinathirdcountry),thedistortionary(andrevenue)impactsofsuchtaxesarerelativelysmall(althoughtheresourcesdevotedtoavoidingthemareclearlywasted).However,Altshulerandgrubert,supranote28,acknowledgethatthesixfoldincreaseininflowsofrepatriatedfundsintotheUnitedStatesinresponsetotherecentlyenactedtemporaryratereductionforrepatriatedfundscallsthisviewintoquestion.

153 Altshulerandgrubert,supranote28.

154 ZodrowandMieszkowski,supranote51;andWilson,“ATheoryofInterregionalTaxCompetition,”ibid.

corporate income taxation in canada n 429

treatedasacorporationinthehostcountrybutasanunincorporatedbranchofthecompanyinthetaxhavenbytheUnitedStates—sothattransfersbetweenthemareintercompanytransfersandthusnotsubjecttotheCFCrules.Asaresult,thecom­panyinthehigh­taxcountrygetsadeductionforinterestatarelativelyhighrate,buttheassociatedinterestincomeiseithertax­exemptortaxedataverylowrateinthetaxhaven,withUStaxdeferred,perhapsindefinitely.

Hybridentitiesmadepossiblethroughthecheck­the­boxrulescanalsobeusedtoshiftdividendstoholdingcompaniesincountrieswithlowornowithholdingtaxes coupled with extensive treaty networks that ensure low dividend taxes onrepatriationswithoutinvokingCFCrulestaxingintercompanydividends.Similarly,ahybridentityinataxhavencanreceiveroyaltypaymentsfrompatentsandotherintellectualpropertyutilizedinhigh­taxcountrieswithoutbeingsubjecttotheCFCrules.Ifthecostshareofthetaxhavencompanyindevelopingtheintellectualprop­ertyisunderstatedanditsroyaltiesareoverstated,muchoftheincomeattributabletotheintellectualpropertycanbeshiftedtothetaxhavencountry.155

Altshulerandgrubert,examiningvariousphenomenabeforeandafterthe1997taxchange,provideseveralpiecesofempiricalevidencetosupporttheirviewthatinternationaltaxcompetitionincreasinglytakestheformofallowingtaxavoidance.First,theyexaminechangesinAETRs,whichcontinuedtodeclineovertheperiod1992­2002,althoughataslowerratethanthedeclinedocumentedinthestudiescited above. They conclude that after 1998, tax­avoidance behaviour was muchmoreimportantinexplainingthesedeclinesinhost­countryeffectivetaxratesthanthedeclinesinstatutorytaxratesthatoccurredoverthesameperiod,asthecorrela­tion between effective and statutory tax rates declined significantly. Second, theextent to which the reported profitability of subsidiaries in low­tax countriesexceeded that in high­tax countries grew considerably after 1997, as would beexpectedifprofitswereincreasinglybeingshiftedtolow­taxjurisdictions.Third,Altshulerandgrubertshowthatintercompanytaxpaymentsandholdingcompanyincomegrewconsiderablyafter1997,aswouldoccurwith thevarious strategiesdescribedabovethataredesignedtoshiftincometolower­taxcountries.Theyesti­matethatin2002,USMnEssaved$7billionperyear,or15percentoftheirtotalforeigntaxburden,byusingthesetechniques.

Tosumup,althoughincreasingtaxavoidanceprovidesarationaleforalowercorporatetaxrateinordertoreduceincentivesforincomeshifting,italsoimpliesthatthedeleteriouseffectsofrelativelyhighcorporatetaxratesmaybemitigated,especiallyiftheavoidanceisfacilitatedbythehomecountry,asoccurredwiththecheck­the­boxrules intheUnitedStates.This inturnprovidesanargumentforkeepingcorporateincometaxrateshighinordertotaxrelativelyimmobiledomes­ticfirms,especiallythoseearningeconomicrentsatsuchrates,whiletaxingrela­tivelymobileMnEsatalowerratebyallowingorevenfacilitatingtaxavoidance.

155 Inaddition,similareffectscanbeobtainedthroughtheuseofhybridsecurities—instrumentsthatareconsideredtobedebtbythehostcountrybutaretreatedasequitybyataxhavencountryoracountrythatexemptsdividendsandthroughwhichdividendsarerouted.

430 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

The Treasury Transfer Argument

Perhapsthemostprominentrationaleforacorporate incometax,at least intheinternationalcontextforcapital­importingcountries,istheso­calledtreasurytrans­fer argument. The United States, as well as several important capital­exportingcountries,includingtheUnitedKingdomandJapan,taxtheirMnEsonaresidencebasisbutallowFTCsfortaxespaidabroad,uptotheamountofthedomestictaxthatwouldbeassessedonsuchincome.Incertaincircumstances,theexistenceofFTCscreatesastrongincentivefortheimpositionofacorporateincometaxbycountriesthatimportsignificantamountsofcapitalfromcredit­grantingcountries,sinceahost­countrytaxrateincrease(toanyratebeloworequaltothehome­countryrate)costlesslytransfersrevenuesfromthehometothehostcountrywithoutcreatinganydisincentivesforinvestmentinthehostcountry.Inmarkedcontrasttothezerotaxargumentpresentedabove,thisrationalesuggeststhatthegovernmentofacap­italimportershouldinstituteacorporateincometaxwitharateequaltothatofitsmainsourceofcapitalimports,adjustedforthespecialrulesusedtocomputetheamountoftaxcreditable,orperhapssomeweightedaverageofthetaxratesofitsprimarysourcesofcapitalimports.

Thetreasurytransferrationaleforhighercorporateincometaxeshasconsider­ableappeal,aswouldany“free”sourceoftaxrevenues.nevertheless,itisoflimitedrelevanceincertaincircumstancesthatareapplicableinCanadatovaryingdegrees,makinganevaluationoftheimportanceofthisargumentdifficult.Eachoftheseargumentsisdiscussedinthefollowingsubsections.Inaddition,somegeneralsup­portforthepositionthattheimportanceofthetreasurytransfereffectisrelativelymoderateisprovidedbyempiricalevidencethatlargely,thoughnotentirely,sup­portstheideathathome­countrytaxratesarerelativelyunimportantindeterminingthelevelsofFdIinhostcountries.

Territorial CountriesFirst,thetreasurytransferargumentclearlydoesnotapplytoMnEsbasedinterri­torialcountries,includingAustralia,France,germany,andthenetherlands,thatexemptforeign­sourceincomefromhome­countrytaxation.156However,theUnitedStates,whichisaresidence­basedFTCcountry,accountsforasignificantfractionofFdIinCanada.Forexample,in2005,FdIfromtheUnitedStatesof$266.5billion

156 Moreover,forsomehostcountries,theargumentmaynotapplytohomecountriessuchasJapanandtheUnitedKingdom,whichgrantFTCsbutalsohavetax­sparingprovisionsthatinsomecasesallowtheirMnEstobenefitfromhost­countrytaxincentives(seeJamesR.HinesJr.,“‘TaxSparing’anddirectInvestmentindevelopingCountries,”inInternational Taxation and Multinational Activity,supranote23,39­66);however,thesecountrieshavenotax­sparingagreementswithCanada.notethatinsomecasesspecialtreatmentprovidedtocertaincountriesundertaxtreatiesblursthedistinctionbetweenresidence­basedcountriesthatofferFTCsandterritorialcountriesthatexemptforeignearnings.Forexample,germanyextendstaxexemptiononlythroughtreaties.

corporate income taxation in canada n 431

represented64percentofthetotalstockofFdIinCanadaof$415.6billion.Inaddi­tion,theUnitedKingdomandJapan,whicharealsoFTCcountries,arealsoimportantinvestorsinCanada:FdIfromtheUnitedStates,theUnitedKingdom,andJapanaccountedfor74percentoftotalFdI.Moreover,theshareoftheUnitedStates,theUnitedKingdom,andJapaninFdIintherelatively“footloose”orhighlymobilemanufacturingsectorwasevenhigher,at82percent.157Thus,givencurrenttradingpatterns,theargumentthatFTCsareirrelevanttoMnEsfromterritorialcountriesisapplicableonlyforaverymodestfractionoftotalFdIinCanada.

Firms in Excess FTC PositionsSecond,MnEsfromFTC­grantingcountriescanbeinanexcessFTCposition—thatis,theyalreadyhavemoreFTCsthantheycanusecurrently.ProvidedthatsuchafirmremainsinanexcessFTCposition,itwill—inmarkedcontrasttothetreasurytransfer argument—be negatively affected by a tax increase in the host country,sincethefirmwillaccumulatemoreexcessFTCsratherthanbenefitfromanoffset­ting reduction indomestic tax liability.Alternatively, a tax reduction in thehostcountry will confer a benefit on the US MnE in an excess FTC position, since itallowsthecompanytousesomeof itsexcessFTCsandthusavoidanyoffsettingdomestictaxincrease.

Ingeneral,USMnEsaremorelikelytobeinanexcessFTCpositioniftheytendtoinvestheavilyinrelativelyhigh­tax­ratecountries.However,twoadditionalfac­tors—tax­avoidancetechniquesandthecurrentUSrulesonexpenseallocations—haverecentlyincreasedtheprevalenceoffirmsinanexcessFTCpositionandthusmitigated the importance of the treasury transfer effect as a factor encouraginghighercorporateincometaxesinhostcountries.

tax-avoidance techniques

First,USMnEshavesuccessfullydevisedtechniquesthateffectivelyseparateforeigntaxes paid, which can be credited currently, from the associated foreign­sourceincome,whichcanthenbedeferred—perhapsindefinitely,providedthattheMnEdoesnotneedtorepatriatethefundstotheUnitedStates—fromUStaxliability.Asaresult,itispossiblethatFTCscaneffectivelybemanufacturedinsufficientquanti­tiestoshieldfromUStaxanyincomethatisrepatriatedtoaUSparent.Inthiscase,thetreasurytransfereffectisinoperative,sincelowerhost­countrytaxesaresimplyreflectedinmoretax­avoidanceactivitybytheUSMnEratherthanhigherdomestictaxliabilities.Inthesecircumstances,thesource­countrycorporateincometaxisonce again the primary tax liability assessed on the income from foreign directinvestmentbyUSMnEs.

Thisseparationofforeigntaxespaidfromtheassociatedincomewasalsofacili­tatedbythe1997check­the­boxregulations,describedabove,whichallowUSMnEs

157 StatisticsCanadaCAnSIMTable376­0051.

432 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

todesignatetheiraffiliateseitherasseparatecorporateentities(subsidiaries)oraspassthroughordisregardedentities(branches)simplybycheckingtheappropriateboxontheirtaxforms.Thismeasuremakesitsimpletocreateahybridentity(acompanythatistreatedasapassthroughentityforUStaxpurposesbutasacorpor­ationforforeigntaxpurposes)andareversehybridentity(acompanythatistreatedasacorporationforUStaxpurposesbutistreatedasapassthroughentityforforeigntax purposes). A typical arrangement for separating foreign taxes from foreignincomeusingsuchentitiesmightbestructuredasfollows.

AUSparent(USP)ownsaforeignholdingcompany(FHC),whichinturnownsaforeignoperatingcompany(FOC).FHCisstructuredasahybridentity(aforeigncorporationbutaUSpassthroughentity),whileFOCisstructuredasareversehybridentity(aforeignpassthroughentitybutaUScorporation).Thetwoentitiesarelo­catedinaforeigncountryinwhichthetaxlawsspecifythatthetaxliabilityofFOCislegallyconsideredtobethetaxliabilityofFHC,sothattheIRSdeemsFHCtobethetaxpayerbecauseitmeetstherequirementsofthe“technicaltaxpayerrule”intheUnitedStates,eventhoughtheassociatedincomewasearnedbyFOC.Asare­sult,becauseFHCisapassthroughentityforUStaxpurposes,all thetax liabilityflowsthroughtoUSP.However,becauseFOCisaseparatecorporateentityforUStaxpurposes,theassociatedincomeisdeferreduntilitisrepatriatedtoUSP,achiev­ingthedesiredresultofcurrentFTCscoupledwithdeferral,perhapsindefinitely,oftheassociatedincome.158

Ofcourse,suchopportunitiestogenerateFTCsforseparatingforeigntaxesfromtheassociatedincomemaynotlastforever.Indeed,regulationsproposedbytheUSTreasurydepartmentandthe IRSwouldshutdownthereversehybrid techniquedescribedabovebyrequiringthatthereversehybridbeassumedtohaveliabilityforforeigntaxesinproportiontoitsshareoftheassociatedincome—althoughitshouldbenotedthattheseregulationsfollowaninitialsetofregulationsthatprovedinef­fective.159However,untilsuchprovisionsareenactedandexperienceprovesthattheycanbeenforcedeffectively(andifalternativetechniquesthatachievethesameresultsarenotdevised),theuseofsuchtax­avoidancetechniquessignificantlyreducestheextenttowhichthetreasurytransfereffectprovidesaneffectivecounterargument

158 Asimilarresultcanbeobtainedwithaforeignconsolidatedgroupifthetaxregimeintheforeigncountrytreatsthetaxliabilityofthegroupasthesoleresponsibilityoftheparent,asisthecase,forexample,inLuxembourg.AcourtrulinginthecaseGuardian Industries v. United States,65Fed.Cl.50(2005),specifiedthataUScorporationthatownedaparentholdingcompanyinLuxembourg(apassthroughentityforUStaxpurposes)couldclaimthefullFTCsoftheconsolidatedgroup,eventhoughtheassociatedincomeearnedbythecorporatesubsidiariesoftheLuxembourgholdingcompanywasnotsubjecttocurrentincometaxationintheUnitedStates.SeeJosephM.CaliannoandJ.MichaelCornett,“guardianRevisited:ProposedRegsAttackguardianandReverseHybrids”(2006)vol.44,no.4Tax Notes International305­16;andJeffreyL.Rubinger,“Proposed‘TechnicalTaxpayer’RegulationsShutdownguardianandReverseHybridStructures”(2007)vol.81,no.2Florida Bar Journal44­48.

159 CaliannoandCornett,supranote158;andRubinger,ibid.

corporate income taxation in canada n 433

totheuseoflowercorporateincometaxratesbyhostcountriesattemptingtoat­tractFdIfromUSMnEs.

expense allocation rules

AsecondfactorthathasincreasedtheprevalenceoffirmsinanexcessFTCpositionistherulescurrentlyusedbytheUnitedStatestoallocateexpensestoforeign­sourceincome. These include R&d expenditures, general and administrative expenses,and,mostimportant,interestexpense,whichwillbethefocusofthisdiscussion.Asnotedabove,theamountofFTCavailabletoaUSMnEonforeign­sourceincomeislimitedtotheamountoftaxthatwouldbepaidintheUnitedStatesonthatincome,calculatedusingrulesspecifiedbytheUnitedStates.Inparticular,sincethe1970s(withasignificantreformenactedintheTaxReformActof1986),160somedomesticexpensesofUSMnEs,includinginterestexpense,havebeenallocatedtoforeign­sourceincome.Theeffectofthisprovisionistoreducetheamountofforeign­sourceincomeasdefinedforUStaxpurposesandthusreducetheamountofFTCallowedforanygivenlevelofforeigntaxpaid,increasingthelikelihoodthatexcessFTCswillbegenerated.Asaresult,evenifthetreasurytransfereffectwerefullyoperative,thestatutorytaxrateinthehostcountrywouldhavetobelowerthanthestatutorytaxrateintheUnitedStatesifexcessFTCsandthusthepotentialfordoubletaxationaretobeavoided.

Ingeneral,theinterestallocationrulesoperateasfollows.161Therulesrecognizethefungibilityofmoneyandallocatedomesticinterestexpenseproportionatelytoallassetsbasedonassetvalue(asdeterminedfortaxpurposes)ratherthantopar­ticularassets—evenifaspecificdebtwasincurredtopurchaseaspecificassetandthatasset isbeingusedascollateral forthedebt.Althoughthegeneralprincipleunderlyingsuchanallocationiseminentlyreasonablegiventhefungibilityofmon­ey,itsapplicationundercurrentlawtoforeign­sourceincomeiswidelyperceivedtobe inappropriate (andhas recentlybeen changed, effective in2009, asdiscussedbelow). Current regulations use a water’s­edge apportionment approach, whichtreatsasfungibletheinterestexpenseofaffiliateddomesticcorporations,butdoesnotincludetheinterestexpenseofforeigncorporationsthataremembersofthesamegroup.Thatis,whiletheinterestexpenseofdomesticaffiliatesisapportionedbetweenUS­sourceandforeign­sourceincomebasedonassetvaluesascalculatedforbookpurposes(thetaxbasisofeachasset),theinterestexpenseofforeignaffiliatesisignoredinthiscalculation.162Thus,100percentofforeigninterestiseffectively

160 Pub.L.no.99­514,enactedonOctober22,1986.

161 Forfurtherdetails,seeKevinM.Cunningham,“TheU.S.WorldwideInterestApportionmentRules:Ready,Set,Wait”(2006)vol.42,no.8Tax Notes International719­29;andStevenP.HannesandJamesA.Riedy,“WorldwideApportionmentofInterestRevisited”(2003)vol.100,no.1Tax Notes73­84.

162 Tofurthercomplicatematters,taxpayersmayelecttoapportioninterestonthebasisofthefairmarketvaluesofdomesticandforeignassets.

434 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

allocated to foreign­source income, inaddition toanydomestic interestexpensethatisallocatedtothesameincomeonthebasisoftheassets’bookvalueasde­scribedabove.Aslongasanyinterestexpenseisincurredabroad,thisapproachwillresultinoverallocationofinterestexpensetoforeign­sourceincome(relativetoaworldwideallocationofallthefirm’sdomesticandforeigninterestexpense),lowercalculatedforeign­sourceincomeforUStaxpurposes,andthusalowerlevelofal­lowableFTCs(thatis,alowerFTClimitation).TheinappropriatelysmallFTCsthatresultfromthiscalculationinturnmayimplydoubletaxationofforeign­sourcein­come,raisingtheeffectivetaxrateonsuchincome.163Forthesamereason,ifthetaxratesintheUnitedStatesandthehostcountryarethesame,theMnEwillaccumulateexcessFTCs,giventheartificiallylowFTClimitation.Toavoidthisresult,thehostcountrycouldreduce its statutoryrate,with thesizeof thereduction increasingwiththeamountofdebtassumedbytheMnEinthehostcountry.

Thediscussionthus farhas implicitlyassumedthatall foreign­source incomeearnedbyaforeignsubsidiaryisrepatriatedtothedomesticparentintheUnitedStates.Iftheforeignsubsidiaryretainstheearnings,therecanbenocurrentdoubletaxationofforeign­sourceearnings.However,currentregulationsrequirethattheamountofretainedearningsbeaddedtothebasisoftheassetsoftheforeignsub­sidiaryforthepurposesofcalculatingtheallocationofdomesticinterestinfutureyears, so that the basis of foreign assets grows and the allocation of interest toforeign­sourceincomeincreases—untiltheforeignsubsidiaryeventuallyrepatriatestheearnings,whichwillthenbesubjecttodoubletaxation.

giventheresultingharshtreatmentofforeign­sourceincome,theinterestallo­cationruleshavebeentheobjectofsevereandjustifiablecriticismintheUnitedStates.Forexample,HannesandRiedy164concludethat“thecurrentwater’sedgesystem of interest apportionment... unfairly and adversely affects companiesthroughtheforeigntaxcreditinwaysthatappearcontrarytoU.S.taxpoliciesaswellasthebestinterestsoftheU.S.economy.”Theyarguethatthecurrentsystemisdistortionary,thatitisarbitraryinitsapplicationoftheprincipleoffungibilitybecauseforeigninterestisignored,thatitcreatescompetitivenessproblemsforUSfirmsowingtodoubletaxation,andthatitwasadoptedsolelytoraiserevenueratherthantobeconsistentwithsoundtaxpolicy.

Althoughtheinterestallocationrulespotentiallyhaveasignificantimpact,theiroverallimplicationsforcorporateincometaxpolicyarenotclearforatleastthree

163 AspointedoutbyRosanneAltshulerandJackM.Mintz,“U.S.Interest­AllocationRules:EffectsandPolicy”(1995)vol.2,no.1International Tax and Public Finance7­35,theeffectontheUSMnEdependsonwhetheritisinanexcessFTCoranexcesslimitposition.Ifthefirmisinanexcesslimitposition(witharesidualUStaxonitsforeign­sourceincome),thelowertaxonitsforeign­sourceincomeresultingfromtheinterestallocationtosuchincomewillbeoffsetbythehighertaxonitsdomestic­sourceincome.However,ifthefirmisinanexcesscreditposition(wherenoadditionalUStaxisdueonitsforeign­sourceincome),theallocationofinteresttoforeign­sourceincomeonlywillincreaseitsexcessFTCswhilesimultaneouslyincreasingitstaxliabilityondomesticincome.

164 HannesandRiedy,supranote161,at73.

corporate income taxation in canada n 435

reasons.First,asdescribedabove,MnEs increasinglyhaveaccess to,andpursue,tax­planningstrategiesthatmitigatethedeleteriouseffectoninvestmentincentivesthattheinterestallocationruleswouldotherwisehave.Atsomelevel,theinterestallocationrulescanbeviewedasarevenue­raisingoffsettotherevenuelossesthattheUnitedStatesisexperiencingowingtoasurgeinaggressivetaxplanning.

Second,tosomeextent,theimpactoftheinterestallocationrulescanbeelimin­atedwithoutresortingtomoreaggressivetax­planningstrategies—ortothemoredrasticstrategiesofconvertingsubsidiariestobranches(inwhichcaseforeigninter­est is includedinthecalculationoftheinterestexpensecalculation)orfinancingforeignventuresentirelywithequity.Instead,asoutlinedbyCunningham,165theeffectsoftheinterestallocationrulescanbenegatedwitharelativelysimpletech­nique:anintercompanyloanfromthesubsidiarytotheparent(assumingthatsuchaloandoesnotrunafoulofforeignthincapitalizationrulesorotherlimitationsonborrowing).Specifically,ifsuchaloanisonthesametermsasthethird­partyfor­eignloan,theinterestincomeontheintercompanyloancanbeusedbythesubsidi­arytopaytheinterestexpenseontheforeignloan,resultinginnetinterestofzero,andtheinterestexpenseoftheUSparentwillbeusedintheallocationofinteresttoforeign­source income. This technique effectively converts foreign interest todomestic interest, thus avoiding the problems with the interest allocation rulesdescribedabove.AlthoughtheUSTreasuryissuedproposedregulationsthatwouldhaveeliminatedthebenefitsoftheintercompanyloanstrategyoutlinedabove,theymetwithseverecriticismandwereneveradopted.Thus,undercurrentregulationsintercompanyloanscanachievetheresultsoutlinedaboveunlesstheyaredeemedtobe“abusive”(thatis,thedebt­equityratiosofboththeUSparentandtheforeignsubsidiaryhaveincreasedrelativetohistoricalaverages).166

Finally,andmostimportant,thevociferousandsustainedcriticismsofthecur­rentinterestallocationrulesintheUnitedStateshaverecentlyresultedinlegisla­tiveaction.TheAmericanJobsCreationActof2004167allowstaxpayers,effectivein2009,tomakeaone­timeirrevocableelectiontouseworldwideapportionmentofinterestratherthanthecurrentwater’s­edgeapportionmentapproach.Althoughallofthedetailsoftheregulationssupportingthislegislationarenotyetclear,thebasic worldwide apportionment approach requires that all worldwide interestexpense (rather than just domestic interest expense, as under the water’s­edgeapproach)beallocatedaccordingtothebookvaluesoftheassetsheldbytheUSparentanditssubsidiaries.

Morespecifically,Cunningham168describestheallocationcalculationasafive­stepprocess.(1)TheworldwidegroupconsistingoftheUSparentanditsforeignsubsidiariesdeterminestheratioofitsforeignassetstoitstotalassets,usingbook

165 Cunningham,supranote161.

166 Ibid.

167 Pub.L.no.108­357,enactedonOctober22,2004.

168 Cunningham,supranote161.

436 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

values.(2)Thegroupcalculatesitscombinedinterestexpense.(3)ThecombinedinterestexpenseistentativelyapportionedbetweenUS­sourceandforeign­sourceincome,usingtheassetratiosdeterminedinthefirststep.(4)Theinterestexpenseof the foreign members is then allocated among foreign­source and US­sourceincomebasedonassetbookvalues;inmostcases,theforeignsubsidiarieswillhavenoUSincomeorassets,sothatalltheirinterestwillbeforeign­source.(5)Thenetamountofinterestexpensetobeallocatedtoforeign­sourceincomeiscalculatedasthedifferencebetweentheamounttentativelyapportionedinstep3andtheactualforeign­sourceinterestexpensedeterminedinstep4.

ThenetresultisthataslongastheassetsoftheforeignmembersofaworldwidegroupareleveragedtothesameextentastheUSparent,nointerestallocationwilloccur.Incontrast,iftheassetsoftheforeignmembersareunderleveraged,interestallocationwill occur to thepoint thatworldwide fungibilitywill be attained (alldomesticandforeigninterestisallocatedtoalldomesticandforeign­sourceincomeon the basis of asset book values). However, total worldwide fungibility is notachieved,sincenointerestallocationoccursiftheassetsoftheforeignmembersofthegroupareoverleveragedrelativetotheUSparent.Thatis,theUnitedStateswillnotreallocateinterestexpensetotheUSparentevenifsuchareallocationwouldbecalledforunderfullworldwidefungibility.nevertheless,theworldwideinterestal­locationrepresentsasignificantimprovementoverthecurrentwater’s­edgeinterestallocationapproach,anditshouldinmostcasesattainorapproximateworldwidefungibility.

Thus, when the new rules apply, their implications for the treasury transfereffect,atleastforinterestexpense,willbemuchlessthanthecurrentwater’s­edgeapproach.AninterestallocationwillstilloccuriftheassetsoftheforeignsubsidiaryareunderleveragedrelativetotheUSparent.Buttheextentofinterestallocation,andtheassociatedreductionsinforeign­sourceincomeandtheFTClimitationwillbesmaller,aswillthereductioninthestatutorycorporateincometaxrateinthehostcountryrequiredtoavoidgeneratingexcessFTCs.IftheassetsoftheforeignsubsidiaryareoverleveragedrelativetotheUSparent,theonlyexpenseallocationthatwilloccurwillbeduetotheallocationofnon­interestexpenses,suchasR&dexpendituresandadministrativeandgeneralexpenses.

Tosumup,thecurrentUSexpenseallocationrulesreducetheamountofforeign­sourceincomeforUStaxpurposesandthusreducetheamountofFTCavailable,increasingthelikelihoodthatexcessFTCswillbegenerated.Asaresult,evenifthetreasurytransfereffectwerefullyoperative,thestatutorytaxrateinthehostcoun­trywouldhavetobelowerthanthestatutorytaxrateintheUnitedStatesifexcessFTCsandthusthepotential fordoubletaxationaretobeavoided.However, thelevelofthisthresholdrateforCanadawillbereducedin2009bythenewworld­wideinterestallocationrulesadoptedrecentlyintheUnitedStates.

net effects on ftC positions

Historically,theneteffectofthesefactorsandothershasbeenthatasignificantfrac­tionofUSfirmshavebeeninanexcessFTCposition.Ontheonehand,onewould

corporate income taxation in canada n 437

expectthatthisfractionwoulddeclineovertime,foratleasttworeasons.First,theratereductionsthathaveoccurredaroundtheworldinrecentyearsimplythattheUnitedStatesisnowahigh­taxcountryrelativetothecountriesinwhichitinvests(includingCanada).Second,theincreasinguseofthetax­avoidancetechniquesdescribedabovesuggeststhatMnEswillincreasinglybeabletoshiftincomeoutofhigh­taxcoun­tries,therebyreducingthelikelihoodthattheywillbeinanexcessFTCposition.

Ontheotherhand,thepreviousdiscussionsuggeststhattherelativelynewtax­avoidance techniques that allow the “manufacturing” of FTCs—for example, asdescribedabove,throughtheuseofreversehybridentitiestoseparateFTCsfromtheassociatedincomeanddeductthecreditscurrentlywhiledeferringtaxontheincome—wouldresultinanincreasedavailabilityofFTCscreatedtoshieldrepatri­ated income from US taxation. Furthermore, the income allocation rules in theUnitedStatesincreasetheamountofUSexpenses,includinginterestexpense,allo­catedtoforeign­sourceincomeforthepurposesofdefiningsuchincomeandtaxesavailableforthecredit,andthusincreasethelikelihoodthatUSfirmswillbeinanexcessFTCposition.

EvidenceprovidedbytheUSTreasuryshedssomelightonthisissue.Inparticu­lar,arecentestimate,whichassumes2005lawwithonlypassiveandactiveincomebasketsandthenewinterestallocationrulesthatwillbeineffectin2009(whichthusreducesthelikelihoodthatexcessFTCswillariseinthecalculation),suggeststhat in the manufacturing sector (not including petroleum­related industries),which accounts for 51.3percent of foreign­source income in the United States,roughly36.7percentofforeign­sourceincomeisearnedbycompaniesinanexcessFTC position. Virtually all companies in petroleum­related industries, whichaccountfor17.8percentofforeign­sourceincome,areestimatedtobeinanexcessFTCposition,asare24.8percentofcompaniesinthefinanceindustry(6.9percentofforeign­sourceincome)and53.5percentofcompaniesinthe“otherindustries”category(23.9percentofforeign­sourceincome).169Thus,asignificantfractionofUSfirmsare still in anexcess FTCposition, raising thepossibility that the FTC­reducingeffectsoflowerhost­countrytaxrates(relativetotheUSrate)andincomeshiftingoutofhigh­taxcountriesmayhavebeenoffsetbyUSMnEs’increaseduseoftax­planningstrategiesthateffectivelycreateFTCsasneededtoshieldincomerepatriatedtotheUnitedStatesfromdomestictaxation.

Deferral of Credits Until RepatriationThird,andmostimportant,becausehome­countrytaxesandcreditsaretypicallynotassessedatthetimethatforeigntaxesarepaidbutratheraredeferreduntilthe

169 Inanearlierstudybasedon1992dataonforeign­sourceincomeforUScorporations,grubert,Randolph,andRousslang,supranote47,estimatedthat35percentofgeneralbasketforeign­sourceincomewasattributabletofirmsinanexcesscreditposition;theyalsofoundthatvirtuallyallUSfirmsengagedinthepetroleumandmineralextractingindustrieswereinanexcessFTCposition.Althoughnotdirectlycomparable,thesefiguresdonotsuggestthatthenumberoffirmsinanexcessFTCpositionisdecliningsignificantly.

438 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

incomeisrepatriatedtotheparentfirm,thehost­countrytaxisoftentheprimarytaxburdenoninvestmentbytheMnE.Indeed,itisimportanttonotethatHart­man170andSinn171haveconstructedmodelsinwhichthehome­countryrepatria­tiontaxisentirelyirrelevanttoinvestmentsfinancedwiththeretainedearningsofthesubsidiary,whicharethusaffectedonlybythehost­countrytax.Thebasicargu­mentisthatforinvestmentfinancedwithretainedearnings,thepresentvalueofthetax savingsobtainedby avoiding the repatriation tax equals thepresent valueoffuturetaxespaiduponeventualrepatriation.Thisargumentis,ofcourse,thesameasthatofthe“trappedequity”or“new”viewoftheeffectsofdomesticdividendtaxation,whichsimilarlyholdsthatdividendtaxesattheindividuallevelareirrele­vantforinvestmentsfinancedwithretainedearnings;the“traditional”viewofdivi­dendtaxesholdsthattheysignificantly increasethecostof investmentsfinancedwithretainedearnings.

Thedebateoverthevalidityoftheseviewsisstillragingintheliterature.Inpar­ticular,althoughmostoftheearlyempiricalevidencefavouredthetraditionalview,172several recent studies support the new view, including Auerbach and Hassett;173desaiandgoolsbee;174andHarris,Hubbard,andKemsley.175Moreover,thepri­maryrationalesfordividendsunderthetraditionalviewinadomesticcontext—thatdividendsprovideanimportantsignalregardingcurrentandfutureprofits,andthatthepaymentofdividendsprovidesaconstraintontheempire­buildingtendenciesofnon­profit­maximizingfirmmanagers—appeartobesignificantlylessrelevantinaninternationalcontext,wheretheprofitsandmanagerialdecisionsofsubsidiariesaremorereadilyobservablebytheparentfirm.TheseargumentssuggestthatthelevelofFdI,atleastintheempiricallysignificantcategoryofinvestmentfinancedwithretainedearnings,isdeterminedprimarilybythehost­countrytaxratherthanthehome­countrytax,regardlessofanycreditingarrangements.Forexample,reinvested

170 davidg.Hartman,“TaxPolicyandForeigndirectInvestment”(1985)vol.26,no.1Journal of Public Economics107­21.

171 Hans­WernerSinn,Capital Income Taxation and Resource Allocation(Amsterdam:north­Holland,1987).

172 georgeR.Zodrow,“Onthe‘Traditional’and‘new’ViewsofdividendTaxation”(1991)vol.44,no.4,Part2National Tax Journal497­509.

173 AlanJ.AuerbachandKevinA.Hassett,“OntheMarginalSourceofInvestmentFunds”(2003)vol.87,no.1Journal of Public Economics205­32;AlanJ.AuerbachandKevinA.Hassett,The 2003 Dividend Tax Cuts and the Value of the Firm: An Event Study,nBERWorkingPaperno.11449(Cambridge,MA:nationalBureauofEconomicResearch,2005);andAlanJ.AuerbachandKevinA.Hassett,Dividend Taxes and Firm Valuation: New Evidence,nBERWorkingPaperno.11959(Cambridge,MA:nationalBureauofEconomicResearch,2006).

174 MihirA.desaiandAustand.goolsbee,“Investment,Overhang,andTaxPolicy”(2004)vol.35,no.2Brookings Papers on Economic Activity285­338.

175 TrevorS.Harris,R.glennHubbard,anddeenKemsley,“TheSharePriceEffectsofdividendTaxesandTaxImputationCredits”(2001)vol.79,no.3Journal of Public Economics569­96.

corporate income taxation in canada n 439

earningsaccountedforroughly40percentoftotalFdIinflowsusedtofinancenewinvestmentinCanadain2005.176

The Treasury Transfer Effect: Empirical EvidenceSeveral studies have examined the importance of the treasury transfer effect byinvestigating whether FdI is responsive to home­country tax rates. On the onehand,ifthetreasurytransfereffectisoperative,thenthehome­countrytaxratewillbe theprimary taxdeterminantof initial investmentdecisionsbyMnEs.On theotherhand,ifthevariousfactorsthatmitigatethiseffectaresufficientlyimportant,thenhome­countrytaxesshouldnothavemuchofaneffectonFdI,whichisdeter­mined primarily by host­country taxes. Slemrod177 finds that host­country taxeffectsonFdIintheUnitedStatesarelittleaffectedbywhethertheMnEisbasedinacountrythatallowsFTCsorexemptsforeignincome,lendingsupporttothelatterview.178ThisinterpretationisreinforcedbyearlierevidencethatFdIfinancedwithretainedearningsismoresensitivetohost­countrytaxesthaninvestmentsfinancedwithdebtor equity transfers from theparent to the subsidiary;179deMooij andEderveen180obtaina similarfinding.grubert andMutti181find that repatriationtaxesdonotseemtohaveaneffectonlocationchoicesamongalternativecountries.Theissueisnotclearcut,however.Slemrod182alsofindsthatonlyFdIintheUnitedStates that is financed with parent transfers (and not FdI that is financed withretainedearnings)isresponsivetoUStaxes,anddeMooijandEderveencautionthattheir results are not statistically significant and that there are numerous econo­metricproblemswiththeearlystudiescitedabove.

Theseresults,whilenotdefinitive,suggestthatmostoftherelevantempiricalevidence implies that great caution should be exercised in putting significantweightonthetreasurytransfereffectwhendesigningcorporateincometaxpolicy

176 ThesefiguresdonotincludetheamountofFdIaccountedforbysalesofexistingintereststoforeigners;takingthisintoaccount,retainedearningsaccountedforroughly25percentoftotalFdI.

177 JoelSlemrod,“TaxEffectsonForeigndirectInvestmentintheUnitedStates:EvidencefromaCross­CountryComparison,”inTaxation in the Global Economy,supranote83,79­122.

178 Asnotedabove,asimilarresultisreportedbyHuizinga,Laeven,andnicodème,supranote85.

179 davidg.Hartman,“TaxPolicyandForeigndirectInvestmentintheUnitedStates”(1984)vol.37,no.4National Tax Journal475­87;MichaelJ.BoskinandWilliamg.gale,“newResultsontheEffectsofTaxPolicyontheInternationalLocationofInvestment,”inMartinS.Feldstein,ed.,The Effects of Taxation on Capital Accumulation(Chicago:UniversityofChicagoPress,1987),201­19;andKanH.Young,“TheEffectsofTaxesandRatesofReturnonForeigndirectInvestmentintheUnitedStates”(1988)vol.41,no.1National Tax Journal109­21.

180 deMooijandEderveen,supranote22.

181 grubertandMutti,ibid.

182 Slemrod,supranote177.

440 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

inCanada.Moregenerally,itseemslikelythatinmanycasesthecumulativeeffectofthethreequalificationsdescribedabovewillgreatlydiminishtheimportanceofthetreasurytransfereffect.This is theconclusiondrawnbygordonandHines,whoarguethatingeneral“itisdifficulttoarguethattax­creditingarrangementshavemucheffectonequilibriumcorporatetaxratesinhostcountries.”183Thisviewisbynomeansuniversallyshared.Inparticular,Bird184arguesthattheworldwideprevalenceofcorporateincometaxeswithcreditabilityimpliesthatanyrelativelysmallcountrycannotdeviateveryfarfromthenormofutilizinga“conventional”corporateincometaxwithoutincurringlargerevenuelosses.note,however,thatBird’sargumentwasmadebeforethepassageoftheUScheck­the­boxregulations,whichgreatlyfacilitatedtheuseofreversehybridentitiesandotherstructurestocreateFTCsasneededbyseparatingtaxcreditsfromtheassociatedincome.

The Benefits of Taxing Location-Specific Economic Rents

In addition to the firm­specific rents discussed above, both multinational anddomesticcorporationsmayhave investments thatgenerate location­specificeco­nomic rents. In addition to resource rents, location­specific rentsmayarise as aresultoffactorssuchaslowertransportcosts,localeconomiesofagglomeration,inexpensivebutrelativelyproductivelocalfactorsofproduction,productivegovern­mentinfrastructure,andeasieraccesstocustomers,185inadditiontotheabilityofcorporationstoavoidtradebarrierssuchastariffsandquotas.Inparticular,econ­omiesofagglomeration,attributabletofactorssuchasreducedcostsoftransportinginputsortechnologicalandknowledgespillovers,playanimportantroleinthelit­eratureontheneweconomicgeography.Forexample,BaldwinandKrugman186arguethatagglomerationeconomiesleadtospatialconcentrationofmanufacturingandhigh­endservicesinadvancedhigh­income“corecountries,”whoseresidentsdemandhighlevelsofpublicservicesandsupportrelativelyhightaxratesoncapitalincome.These relativelyhighratesare sustainablebecauseagglomerationecon­omiescreatelocation­specificeconomicrentsthatcanbetaxed—aslongasthetaxratesarenotsohighthattheydriveoutcapitaleveninthepresenceofagglomera­tionrents.187

Moregenerally,taxinglocation­specificrentsofbothdomesticandforeignfirmsprovidesanefficientandthushighlydesirable(nottomentionpoliticallypopular)

183 gordonandHines,supranote20,at1955.

184 Bird,supranote101.

185 Foreconomiesofagglomerationtooccur,thebenefitsofagglomerationmustbesufficientlylargetooutweighanycrowdingeffectsattributabletomorecompetitionwithinasinglegeographicalarea.

186 BaldwinandKrugman,supranote42.

187 AndreasHauflerandIanWooton,“CountrySizeandTaxCompetitionforForeigndirectInvestment”(1999)vol.71,no.1Journal of Public Economics121­39.

corporate income taxation in canada n 441

means of raising tax revenue.188 Moreover, increasing globalization implies thatforeignownershipofdomesticcorporationsisincreasingovertime,sothatthetaxa­tionofdomesticfirmsmayalso imply the taxationof someeconomic rents thatwouldotherwiseaccruetoforeigners.189

Political Realities

Politicalrealitiesmaymakesomeformofcorporateincometaxationinevitable.Inparticular,especiallyinlightofthelonghistoryofbusinesstaxationinmostcoun­tries,taxingbothdomesticandforeign“rich”corporationsmaybeindispensablefromapoliticalviewpoint,irrespectiveoftheargumentsagainstsuchtaxation,andnomatterhowcompellingthoseargumentsmaybetoeconomists.190Inaddition,inaninternationalcontext,sourcecountriesoftenassertasovereignrighttotaxtheincomegeneratedwithintheirboundaries,beyondanynaturalresourceroyalties.Thisargument is tenuousbecause itdependsonthevalidityofclaimsrelatedtoterritorialsovereigntyortheprovisionbythehostcountryofasuitableinvestmentenvironmentandaccesstolocalmarkets.nevertheless,itisbelievedtobecompel­ling,atleastinmanyquarters,anditthusprovidesanotherrationaleforsource­basedtaxationofcapitalincome.191

Finally,thecorporateincometaxisanexcellentexampleofahiddentax—onewhoseburdenisnotreadilyapparenttoCanadiancitizens,andindeed,assuggestedbythediscussionabove,isstillacontentiousissueamongpublicfinancespecialists.Publicchoicetheoristsarguethathiddentaxesareespeciallyundesirablebecausetheypromotetheoverexpansionofthepublicsector(assumingthatotherfactors,suchasinternationaltaxcompetition,donotresultintheunderprovisionofpublicservices).Fromapoliticalstandpoint,however,hiddentaxesareextremelyattract­ivebecausetheyallowpoliticianstoclaimcreditforhighlyvisiblepublicserviceswhile effectively disguising their costs. It is difficult to assess the importance oftheseargumentsintheCanadiancontext;theypresumablyprovidesomesupportfortheexistingcorporateincometax,butrecentreformssuggestthatthatmaybeofdecreasingimportanceasthespectreofincreasingglobalizationandinternationaltaxcompetitionreceivesmoreattentioninpublicdiscussionoftaxpolicy.

188 Mintz,supranote101.

189 HarryHuizingaandSorenBonielsen,“CapitalIncomeandProfitTaxationwithForeignOwnershipofFirms”(1997)vol.42,no.1Journal of International Economics149­65.note,however,thatincreasedforeignownershipmayimplythatincomeshiftingtothecorporatetaxbasefromthepersonalincometaxbasewillbelessofaproblem,creatingatendencyforlowercorporatetaxrates.SeeFuestandHemmelgarn,supranote70.

190 Bird,supranote101.

191 PeggyB.Musgrave,“InterjurisdictionalEquityinCompanyTaxation:PrinciplesandApplicationstotheEuropeanUnion,”inSijbrenCnossen,ed.,Taxing Capital in the European Union: Issues and Options for Reform(Oxford:OxfordUniversityPress,2000),46­77.

442 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

ImplIc AtIo ns fo r co rp o r Ate Income tA x AtIo n In c A n A dA

ThediscussionthusfardemonstratesclearlythatpolicymakersinCanadafaceadifficultprobleminsettingtheparametersofthecorporateincometax,especiallygiventheimportanceofattractingFdIfromlargeMnEsbasedintheUnitedStatesandinothercountries.192Ontheonehand,internationaltaxcompetitionforhighlymobilecapital,includingcapitalthatgeneratesfirm­specificeconomicrents,coupledwithaggressiveeffortsbyMnEstoreducetheirtaxliabilitiesbyshiftingrevenuesandcostsacrossjurisdictions,resultsinconsiderabledownwardpressureonbothmar­ginalandstatutorycorporateincometaxrates,atendencythatisreinforcedbyanaturalreluctancetouseataxinstrumentthatishighlydistortionary,evenifitwereassessedonlyondomesticfirms.Ontheotherhand,thesetendenciesaremitigatedbyseveralotherfactorsthatsupportasignificantlevelofcapitalincometaxation.Thesefactorsincludeadesiretoappropriatebothdomesticandforeigneconomicrents,especiallylocation­specificeconomicrentsearnedbyforeign­ownedMnEs;thepotentialtotakeadvantageofthetreasurytransfereffectwhenpossible(forex­ample,totheextentthatitisnotlimitedbytheUSaccountingrules,therulesforexpenseallocation,ortheotherqualificationsdiscussedabove);thedesiretolimittax

192 Asnotedabove,theoptionsconsideredinthisarticlearelimitedtoreformswithinthestructureofanincometax.Inparticular,alternativeconsumption­baseddirecttaxes,suchascorporatecashflowtaxortheACE(allowanceforcorporateequity)tax,areexcludedfromconsideration;fordiscussionsoftheseoptions,seeCharlesE.McLureJr.andgeorgeR.Zodrow,“AHybridConsumption­BaseddirectTaxProposedforBolivia”(1996)vol.3,no.1International Tax and Public Finance97­112;georgeR.Zodrow,“AlternativeFormsofdirectConsumptionTaxes:TheCroatianApproach,”inMichaelAhlheim,Heinz­dieterWenzel,andWolfgangWiegard,eds.,Tax Policy: Theoretical Foundations and Practical Applications(Heidelberg:Springer,2003),391­413;andZodrow,supranote48.Inaddition,theanalysisgenerallyassumesthatpoliticalandadministrativeconsiderationsimplythatthesamecorporateincometaxsystemmustbeappliedtobothdomesticandforeigncorporations;thatis,differentialtreatmentofforeigncorporations,eveniftheforeigncorporationsareperceivedtobesignificantlymoremobilethandomesticfirms,isnotpermitted.(Ashortdiscussionoftheadvantagesanddisadvantagesofapreferentialtaxrateforthemanufacturingsectorinordertoattractrelativelymobilecapitaltothatsectorisprovidedbelow.)Inparticular,theanalysisrulesouttaxholidays(orothertaxpreferences)designedsolelyforinvestmentsbyMnEs.Foradiscussionoftheproblemsassociatedwithtaxholidays,seeJackM.Mintz,“TaxHolidaysandInvestment,”inAnwarShah,ed.,Fiscal Incentives for Investment in Developing Countries(Washington,dC:WorldBank,1995),165­94;georgeR.Zodrow,“IncomeTaxReformandInvestmentIncentives,”inZeljkoBogeticandAryeHillman,eds.,Financing Government in Transition: Bulgaria(Washington,dC:WorldBank,1995),71­96;RobinW.BoadwayandAnwarShah,“PerspectivesontheRoleofInvestmentIncentivesindevelopingCountries,”inAnwarShah,ed.,Fiscal Incentives for Investment and Innovation(Oxford:OxfordUniversityPress,fortheWorldBank,1995),94­102;andHowellH.Zee,Janetg.Stotsky,andEduardoLey,“TaxIncentivesforBusinessInvestment:APrimerforPolicyMakersindevelopingCountries”(2002)vol.30,no.9World Development1497­1516.Fortheoreticaldiscussionsofthedifferentialtaxtreatmentofmobileandimmobilecapital,seeBeckerandFuest,supranote31;andguglandZodrow,supranote150.

corporate income taxation in canada n 443

avoidanceunderthepersonalincometax;andtheneedtosatisfypoliticaldemandsforcorporatetaxation.Inaddition,theseconcernsmustbecoupledwithuncertaintyabouttheextenttowhichtheburdenoftaxesoninternationalcapitalisshiftedtolocalfactorsofproduction(asisassumedinmosttheoriesofinternationaltaxcom­petition),andtheextenttowhichtheavailabilitytoMnEsofvarioustax­avoidancetechniques may limit the deleterious effects otherwise associated with relativelyhighhost­countrycorporateincometaxrates.

ThefollowingdiscussionattemptstoidentifytheimplicationsoftheanalysisforcorporateincometaxreforminCanada,weighingtherelativeimportanceofthevariousargumentsdiscussedatlengthabove.Itbeginswithanecessarilysomewhatsubjectivegeneraldiscussionthatreviewshowtheargumentsmightbeweighed.ItthendrawsonthisdiscussiontoevaluatetherecentlyenactedcorporateincometaxratereductionsinCanada.Theanalysisthenturnsbrieflytomoredrasticreformoptions,includingtheimplementationofanordicdualincometax,anddiscussesseveral variations on these themes. The basic conclusions are that (1)the inter­national tax competition, income shifting, and efficiency cost considerationsstressed in the analysis thus far provide considerable support for the traditionalprescriptionofabase­broadening,rate­loweringreformofthecorporateincometaxstructure,eveninlightofthevariousqualificationstothebasicargument,and(2)aweighingofthevariousargumentssuggeststhatthecorporateratereductionsrecentlyenacted(areductioninthefederalcorporateincometaxrateto15percent,whichimpliesacombinedfederal­provincialstatutorytaxrateof27.6percent in2012,withanultimatetargetofacombinedrateof25percent,tobeachievedbyfurther provincial rate reductions) were a desirable direction for tax reform. Asdetailedabove,thesechangesimplythatthetaxationofcapitalincomeinCanadawill be the lowest of the g7 nations and will be relatively competitive with thesmallerdevelopedcountriesand theemergingand transitionaleconomies,espe­ciallythosemostlikelytobeseriouscompetitorsforpotentialFdIinCanadaandinvestmentbyCanadianMnEs.Absentoffsettingchangesinthecorporateincometaxesinothercountries,theseratereductionsshouldenhancetheefficiencyoftheCanadianeconomy,resultinginincreasedinvestmentbybothdomesticandinter­nationalfirms, includinginvestmentbyMnEsthattendtogeneratefirm­specificrents,aswellastheassociatedincreasesinwagesandinreturnstorelativelyimmobilefactors.Thereformshouldalsogenerateincreasedrevenuesbyreducingtaxincen­tivesforincomeshiftingoutofCanada.

Theprimarypotentialconcernsabouttherecentrate­reducingreformarefourfold,aswillalsobediscussedindetailbelow.First,lowercorporatetaxratesnecessarilyimplylowertaxationoflocation­specificeconomicrents,includingthoseearnedinthenaturalresourceandbankingsectors,someofwhichareearnedbyforeigners.Second,ratereductionsmayraisethepossibilityofrevenuelossesduetothetreasurytransfereffect.Third,thepositiveimpactofratereductionsintermsofattractingnewFdImaybereducedtotheextentthatfirmsarenowmitigatingthenegativeef­fectsofcorporate incometaxeswithaggressive taxplanning.Finally, thereformcreatessomepotentialfortaxavoidancebytheownersofcloselyheldcorporations

444 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

whomayconvert labour incometoundistributedcorporateearnings inorder totakeadvantageofrelativelylowcorporaterateswhiledeferringahigherpersonaltaxliability;thatis,ascorporateratesfallrelativetopersonalrates,thecorporatetaxmaynolongercompletelyfulfillitsroleasabackstoptothepersonalincometax.

Weighing the Arguments: A General Discussion

IntheabsenceofafullyspecifiedgeneralequilibriummodelofCanada,theUnitedStates,andtherestoftheworld—onethatwouldincludeperfectlyandimperfectlycompetitivefirmswiththelattergeneratingbothfirm­specificandlocation­specificrents,atreatmentofthecomplexinteractionsbetweenCanadianandforeigntaxsystems, an analysis of the possibilities for income shifting by both MnEs anddomesticentrepreneurs,andaccurateempiricalestimatesoftherelevantkeypar­ameters—it is difficult to systematically weigh the various arguments presentedabove.ThefollowingrepresentsmypersonalweighingoftherelativeimportanceoftheseargumentsintheCanadiancontext.

Asafirststep,itseemsreasonabletoassumethatCanadashouldbetreatedasarelativelyopeneconomy,andthustotakeseriouslythebasicargumentsforlimitingthetaxationofcapitalincome.Thatis,evenifcapitalislessthanperfectlymobile,andeveniftaxexemptionorsubsidizationofcapitalincomeisnotdesirable,Canadamustsetitstaxpolicyinaworldeconomyinwhichinternationaltaxcompetitionisincreasinglythenorm.

ThetaxcompetitionargumentappliestothetraditionalcaseforlowMETRsastheprimarydeterminantsofthelevelandallocationofmarginalinvestments,andtothemorerecentargumentsforlowstatutorytaxratesandAETRsastheprimarydeterminantsofthelocationofinvestmentsthatgeneratefirm­specificeconomicrentsandtheextenttowhichthetaxsystemencouragestaxavoidanceintheformofincomeshiftingbyMnEs.

Loweringcorporatestatutorytaxratesisanattractiveoptiononmanyfronts.ItsimultaneouslyproduceslowerMETRs;reducesthetaxationofhighlymobilefirm­specificeconomicrents;reducesincentivesforincomeshiftingintheformoftransferpricing,debtreallocation,andotherfinancialaccountingmanipulations;andreducesrelianceonarelativelyhighlydistortionarytaxinstrument.Moreover,becauseem­piricalevidence,especiallyinthemostrecentstudies,suggeststhatsuchfinancialreallocationsarerelativelyeasytoaccomplish—incomparisonwithreallocationsofphysicalcapital—thecaseforlowerstatutoryratesbecomesmorecompelling.

Inparticular,itshouldbenotedthatthealternativepolicyofreducingMETRswhileholdingconstantorincreasingstatutorytaxrates—forexample,byintroduc­inginvestmenttaxpreferencessuchasinvestmenttaxcreditsorotherinvestmentallowances—hassomedistinctdisadvantages.Inparticular,itisdifficulttodesigninvestmenttaxpreferencesthatareneutralacrossbusinessassetsandsectors;taxpreferencescreateopportunitiesfortaxavoidanceandevasionandaddcomplexitytobothtaxadministrationandcompliance;anddifferentialtreatmentcreatestheperception, and arguably the reality, of unfair treatment of existing capital. Ofcourse,thecombinationofinvestmenttaxpreferencesandhigherstatutorytaxrates

corporate income taxation in canada n 445

hassomeadvantages.Inparticular,higherstatutoryratesareappliedtorelativelyimmobile firms that earn location­specific rents, although, as discussed furtherbelow,analternativetohighergeneralstatutoryratesinthiscaseistheapplicationofspecialtaxesinthesectorsthatgeneratelocation­specificrents—atleasttotheextent that such sectors can be readily identified and segregated. nevertheless,lowerstatutoryratesunderthecorporateincometaxnecessarilyimplylesstaxationoflocation­specificrents,includingthoseaccruingbothtodomesticfirmsthatearnsuchrents(forexample,thoseinthenaturalresourcesectorandperhapsthoseintheprotectedfinancialservicessector)andtoMnEsthatfindCanadaanespeciallyattractivelocationtoservetheUSmarket(inadditiontotheCanadianmarket).Thisdisadvantage of lower rates must be weighed against the advantages describedabove,includingthefactthatlowertaxratesattracthighlymobileinvestmentsthatgeneratefirm­specificrents.Inaddition,thealternativeofloweringstatutoryratesimpliesthatthereturnstooldcapital—thatis,investmentsthatweremadeunderthehigh­tax regime,presumablyunder the assumptionof roughly constant statutoryrates—willreceiveawindfallgain,whilethegovernmentwillsustainrevenuelosses.Thistopicisdiscussedfurtherbelow.

Empiricalevidenceontherelativeimportanceofsuchlocation­specificrentsinCanadawouldbeespeciallyhelpfulingaugingtheimportanceofthisargument.Forexample,itwouldbeusefultoknowwhetherCanadianfirmsthatprimarilyexportto the US market generate sustained above­normal returns to capital relative tothoseinthesameindustrythatserveonlythedomesticCanadianmarket;suchananalysis should attempt to account for any differential returns that represent areturntoother factors, includingfirm­specificadvantagessuchas theownershipandinternalizationadvantagescommonlyattributedtoMnEs.

Theargumentsforlow(orzero)taxationofcapitalincomearestrengthenedtosomeextentby contentions that capital income should actuallybe subsidized toindirectlyoffsetsomeofthepricedistortionsattributabletoimperfectcompetitionand to compensate for imperfect information on the part of potential investorsregarding theeconomic and legal environment inCanada;however, these argu­mentsseemtobeoflimitedimportance.Theargumentthatcapitalincomeshouldbesubsidizedtooffsetmarketimperfectionsassumestheexistenceof100percenttaxationoftheeconomicrentsattributabletomarketpower;sinceCanadadoesnothavesuchaconfiscatoryprofitstax,acorporateincometaxisclearlyawaytopar­tiallyachievethisgoal.Inaddition,boththepublicfinancialaccountingsystemandthe legal system in Canada are sufficiently well developed that the asymmetricinformationproblemshouldberelativelyunimportant.

Intheirextremeform,theargumentsdiscussedthusfarimplytaxexemptionorevensubsidizationofcapitalincome.HowimportantarethevariousqualificationstothisstrongresultinCanada?

Taxing Economic RentsSometaxationofbothdomesticandespeciallyforeignrents—especiallythosethatcan be classified as location­specific—is surely desirable, particularly since the

446 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

increasingcross­ownershipofMnEsassociatedwithglobalizationimpliesthatanincreasingfractionoftheserentswillaccruetoforeigners.Asignificantfractionoftheserentsislikelyconcentratedintheresourcesector.Undercurrentlaw,theonlywaythefederalgovernmentcantaxresourcerentsisthroughthecorporateincometax. However, to the extent that location­specific rents are concentrated in theresource sector, they might be taxed with alternative instruments (for example,mineralproductiontaxesandroyalties)ifsuchmeasureswerepoliticallyfeasible.193In the absence of such changes, however, resource rents, rents in the protectedfinancialsector,andotherrentsgeneratedoutsidetheresourceandfinancialsec­tors,suchaslocation­specificrentsearnedoninvestmentsmadeinCanadainordertoobtainrelativelyeasyaccesstotheUSmarket,areanattractivesourceofrevenuesthat is lostwith lower statutory tax rates.Theresulting tendency towardhighercorporateincometaxratesinordertocapturelocation­specificrents,however,istemperedbyconcernsovertaxingthehighlymobilefirm­specificeconomicrentsassociatedwiththeinvestmentsthatarethemostlikelytogeneratesignificantposi­tiveexternalitiesfortheCanadianeconomy.Anadditionalmoderatingfactoristhatthepresenceoflocation­specificrentsisoneindicatorofmonopolypower;thus,theJudd194argumentthatcapitalincomeshouldbesubsidizedtoreducedistortionsinthemonopolymarketassumessomerelevance.

The Treasury Transfer ArgumentThetreasurytransferargumenthassomevalidityincertaincircumstancesandthusmayprovidearationaleforsometaxationofcapitalincomeinCanada.Althoughitisdifficulttoevaluatetheimportanceoftheargument,severalfactorssuggestthatatcurrenttaxrates,includingtherecentratereductions,thetreasurytransfereffectisoflimitedrelevanceinCanada.

Ofcourse,asexplainedabove,thetreasurytransferargumentis irrelevantforinvestmentfromcountriesthathaveaterritorialtaxsystemorallowtaxsparing.

193 Beyondtraditionalapproachessuchasseverancetaxesandroyalties,theresourcesectormightbesubjectedtotaxationoneconomicrents;forexample,denmarkandnorwayrecentlyproposedtaxingrentsinthepetroleumsectorwithanACEtax:seediderikLund,“PetroleumTaxReformProposalsinnorwayanddenmark”(2002)vol.23,no.4Energy Journal37­56.Firmsintheresourcesectorcouldbemadesubjecttoasupplementarycashflowtax,oftenreferredtoasa“resourcerenttax,”suchasthatutilizedinAustralia:seegeorgeFaneandBenSmith,“ResourceRentTax,”inC.d.Trengrove,ed.,CentreofPolicyStudies,Australian Energy Policies in the 80’s(Sydney:AllenandUnwin,1986),209­41;andBenSmith,“TheImpossibilityofaneutralResourceRentTax”(manuscript,AustraliannationalUniversity,1999).Similarly,thefinancialsectorcouldbesubjecttoaspecialtaxonnetcashflow,assometimesdiscussedinthecontextofthe“taxprepaid”formofconsumption­basedtaxation:see,forexample,thereportofthePresident’sAdvisoryPanelonFederalTaxReform,Simple, Fair, and Pro-Growth: Proposals To Fix America’s Tax System(Washington,dC:USgovernmentPrintingOffice,2005).

194 KennethL.Judd,“CorporateIncomeTaxationinaModernEconomy”(manuscript,HooverInstitution,StanfordUniversity,2006).

corporate income taxation in canada n 447

However,sincethevastmajorityofforeigninvestmentinCanadaisfromcountriesthatoperatecreditsystems,thisargumentisoflittleimportance.

Inaddition,evenforinvestmentfromtheUnitedStates,whichoperatesaresidence­basedsystemwithanFTCandnotaxsparing,thetreasurytransferargumentisofminimalimportanceforfirmswithexcessFTCs.In2000,61percentofallforeign­sourceincomeinthe“general”incomebasketofUSMnEswasearnedbyfirmsinanexcessFTCposition.195(Thisfigurefluctuatesconsiderably;thesedataindicatethatthefractionwas49percentin1996,but65percentin1990.)notsurprisingly,virtuallyallofthefirmsinthepetroleumindustryareinanexcessFTCposition;however,evenifoneexcludesthepetroleumindustry,slightlyoverone­halfofin­comeinthegeneralbasketisattributabletoUSMnEsinanexcesscreditposition.196However, a1996estimate suggests that the fractionofCanadian­source incomeearnedbyUSMnEsinanexcesscreditpositionissignificantlysmallerat36per­cent.197Sincethesedataarequiteoldandthusofmarginalrelevance,morerecentCanadian­specificdataonthisissuewouldbeusefulingaugingtheimportanceofthetreasurytransfereffect.

Inadditiontotheconsiderablevariationintheseestimates,thesedataarediffi­cult to interpretowing to thepossibility thata significantnumberofcompaniescountedasexcesscreditfirms,atleastoutsidetheresourcesector,maybeclosetotheboundarybetweenexcessanddeficitcreditpositions,andthuslikelytoexhausttheircreditsinthenearfuture.198ThisisanissuethatcanberesolvedonlywithdetailedempiricalinvestigationofspecificUSMnEsthatinvestinCanada.Evenifthisisthecase,however,itmaybelargelyirrelevanttotheextentthatUSMnEsareincreasinglyabletoengageintax­planningactivitiesto“manufacture”excesstaxcreditswhentheyareneededandthusareabletomaintainanexcessFTCpositionvirtuallyatwill;asdiscussedabove,thisresultcanbeachieved,forexample,bysepar­atingFTCsfromtheassociatedincomebyusingreversehybridsandusingthecreditscurrentlywhiledeferringUStaxontheincome,perhapsindefinitely.

Therelevanceofthetreasurytransfereffectisalsodiminishedtoasignificantextentbythedetailsofitsoperation,atleastwithrespecttotheUnitedStates.Inthesimplestmodels,thetreasurytransfereffectoperatesassoonasthehost­countryratedropsbelowthetaxratefacedbyanMnEbasedintheUnitedStates.Inprac­tice,however,theUSrulesforgrantingFTCssignificantlyreducetheiravailabilityfortworeasons.

195 ThisestimatewasprovidedbyCanada’sdepartmentofFinanceandwasbasedonIRSdata.

196 However,lessthan25percentoftheincomeinthefinancialservicesbasketisattributabletofirmsinanexcessFTCposition.

197 ThisestimatewaspreparedbyPricewaterhouseCoopers,“Canada­U.S.TreatyInterestWithholdingRates:RevenueandPolicyConsiderations”(manuscript,1999),usingIRSdata.

198 Inprivateconversation,HarrygrubertoftheUSTreasurydepartmenthasindicatedthatthereissomeevidencethatthisisinfactthecase.

448 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

First, income earned abroad must be defined using US generally acceptedaccountingpracticestodetermineforeignearningsandprofits(E&P),whicharethenusedtodeterminetheamountofcreditabletaxes.TheserulesimplythatE&PistypicallygreaterthantaxableincomeasdefinedundertheCanadiantaxsystem,primarilybecausecapitalconsumptionallowancesaremoregenerousunderthelat­ter.Inthesecircumstances,theUnitedStatescalculates“deemedtaxespaid”suchthattheeffectivetaxrateonrepatriateddividendsequalstheratioofactualtaxespaid (including withholding taxes) to E&P. Thus, deemed taxes paid under theCanadiancorporateincometaxarelessthanactualtaxespaid,bothbecauseE&Pisgreaterthantaxableincomeandbecauseactualtaxespaidincludewithholdingtaxes.ThisinturnimpliesthatexcessFTCsaregeneratedeveniftheCanadianstatutoryrateequalstheUSstatutoryrate.Alternatively,theCanadianstatutorytaxratemustbelowerthantheUSrateinordertoavoidexcessFTCsandtheprospectofdoubletaxationofincomeearnedinCanadabyUSMnEs.

Second,asdescribedabove,taxableincomeinCanadaasdefinedforUStaxpur­poses is adjusted forcertain typesofexpenses incurred in theUnitedStatesbutallocatedtoCanada,includinginterestexpense,R&dexpenditures,andadminis­trative andoverheadexpenses.Again, this allocationhas theeffectof increasingtaxableincomeinCanadaandthusreducingtheamountofFTCthatcanbeclaimedagainstthedomesticliabilityofUSfirms.Asnotedpreviously,effectivein2009theoriginalextremelystringentwater’s­edgerules forallocatinginterest (whichcur­rentlymakeuproughly30percentofallocatedexpenses)willbereplacedwiththemorefavourable(toCanada)worldwideallocationrules.nevertheless,theremain­ingexpenseallocationswillstillincreasethelikelihoodthataUSparentwillhaveexcessFTCsandbesubjecttodoubletaxation.

Finally,itisimportanttonotethatboththeoreticalmodelsandsome(althoughnotall)empiricalresultssuggestthatthetreasurytransferargumentislargelyirrel­evantforinvestmentsfinancedwithearningsretainedbyCanadiansubsidiariesofUS MnEs, which make up a significant fraction of FdI in Canada by US firms.Althoughtheeconomictheoryunderlyingthisargument—thenewviewofdividendtaxation—isstillasubjectofcontention,aconsiderableamountofthemostrecentempiricalevidencesupportsthisinterpretationoftheeconomiceffectsofdividends,includingthecentralresultthatthetaxationofdividendsdoesnoteffectmarginalinvestmentdecisions.Moreover,thetwoprimarycompetingtheoriesthatunderliethe alternative traditional view of the effects of dividend taxes in the context ofdomesticcorporatemanagersandfirmshareholders—thatdividendsarerequiredasasignalofprofitabilityorasaconstraintontheempire­buildingtendenciesofcor­poratemanagers—aremuchlessrelevantinthecontextofaCanadiansubsidiaryanditsUSparent,wheresuchissuesshouldbemuchlesscritical.

Thisdiscussionimpliestheexistenceofalargenumberofimportantqualifica­tionstothetreasurytransferargument.Accordingly, it is far fromclear that thetreasurytransferargumentprovidesanimportantargumentforkeepingCanadiancorporateincometaxratesathighlevels,especiallyatcurrentcorporateincometaxrates.

corporate income taxation in canada n 449

The Role of Tax AvoidanceAllowingorevenfacilitatingtaxavoidancecouldbeusedasameansofreducingtheimpactofrelativelyhighstatutoryratesonmobileinternationalcapitalwhilemaintainingthetaxationofrelativelyimmobiledomesticcapitalandthetaxationoflocation­specificeconomicrentsatrelativelyhighrates.Forexample,rulesdesignedtolimittaxavoidance,suchasthethincapitalizationrulesorthetransfer­pricingrulesundercurrentCanadianlaw,couldberelaxedexplicitly,orenforcementcouldbeallowedtobecomelax.TheimportanceofthisargumentforCanadadependsprimarilyontwofactors.First,wouldsuchapolicybeperceivedasfavouritismto­wardMnEs,and,ifso,woulditbepoliticallyacceptableorwoulditbeperceivedasunacceptablyinequitabletotheshareholdersofprimarilyorexclusivelydomesticfirms?Second,howimportantisthiseffectintheCanadiancontext?TheresultsofAltshulerandgrubert199indicatethattaxavoidancereducesthetaxburdenofUSMnEsbyroughly15percent.Suchareductioniscertainlyimportantbutitisnothuge,whichsuggeststhathighercorporatetaxratesstillhaveasignificantimpactonthecostofcapital—aresultthatisreinforcedbyevidencethatsuggeststhatFdIisstillsensitivetoeffectivetaxrates(calculatedwithouttakingintoaccounttax­avoidancepossibilities).Finally,notethatonepotentialwaytohelpgaugetheimportanceoftaxavoidanceinCanadawouldbetoreplicatetheAltshuler­grubertanalysissolelyforUSMnEsthatinvestinCanadatodeterminetheextenttowhichCanadiantaxburdensonUSMnEsarereducedbytaxavoidance.AnotherusefulanalysiswouldbetodeterminewhetherthetaxsensitivityofFdIinCanadahasdeclinedovertime(as suggested by increasing tax avoidance) or has increased over time (owing toincreasingcapitalmobilityandincreasedtaxcompetition).200

The Backstop ArgumentFinally,thetraditional“backstoptothepersonalincometax”argumentprovidesaconvincingrationaleforsomeformofbusinesstaxation.However,therelevanceoftheargumentinassessingthedesirabilityoftherecentratereductionsdependsonmanyfactors,suchastheextenttowhichthecorporatestatutoryratefallsbelowthetoppersonalrateandthedegreeofresponsivenessofincomeshiftingtothistaxratedifferential.SincethesmallbusinesssectorisfairlysizableintheCanadianecon­omy,withsmallCCPCsaccountingfornearly20percentofnetrevenuesunderthecorporateincometax,theproblemiscertainlyarelevantone.giventhatthebusiness

199 Altshulerandgrubert,supranote28.

200 AnotherimportantissueiswhethertheUnitedStateswillchangetherulesthatfacilitatetaxavoidance,especiallythecheck­the­box”rulesdiscussedabove.giventhepopularityoftheserules,aswellasanoverridingconcernwiththecompetitivenessofUSMnEsintheinternationalmarketplace,itseemsunlikelythatthestatusquowillchangesoon.However,anythingispossible,especiallyifthe2008electionresultsinademocraticadministrationcommittedtoeliminatingadvantagesforbusinessesthatinvestabroadratherthanintheUnitedStates.

450 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

andindividualtaxesareroughlyfully integrated,thebackstopproblemisnotanimportantissuefordistributedearnings.Forearningsthatareretainedinthecor­poration,akeyissueistheextenttowhichtheincomeshiftingattributabletothetaxdifferentialrepresentsapermanentlossofrevenueorsimplyadeferraloftax,inwhichcase labour incomewithinacloselyheldcorporationwouldeventuallybetaxedatindividualincometaxrateswithlittlerevenuelossinpresentvalueterms.Thus,althoughthebackstopfunctionofthecorporateincometaxprovidesanargu­mentagainstcreatingahugedifferentialbetweencorporateandindividualtaxrates,itdoesnotprovideacompellingargumentagainsttherecentcorporateincometaxratereductions.

Political ArgumentsPoliticalrealitiesmayargueforasignificantdegreeofcorporateincometaxation,buttherecentreformsinvolvingratereductionsinboththefederalandprovincialcorporateincometaxesareindicativeofpopularsupportforthesemeasures.Thissupportisperhapspromptedbygreaterrealizationoftheprevalenceandincreasingimportance of globalization, international capital mobility, and international taxcompetition.AnotherpotentialfactoristheincreasingawarenessoftheremarkableperformanceofsomecountriesthathaveapparentlysucceededinstimulatingFdIandeconomicgrowthwithtaxpoliciesthattaxcapitalincomeverylightly,withIre­landbeingperhapsthemostprominentexample.201However,largedifferencesininitialconditions,especiallywithrespecttocapitalperworkerandopennesstofor­eign investment, suggest thatanypotentialgainswouldnecessarilybe smaller ifsuchpolicieswereadoptedinCanada.

The Gravelle-Smetters ArgumentsAssuggestedabove,theargumentspresentedbygravelleandSmetters,202whichassertthatcapitalincometaxesarenotultimatelybornebylocalfactorsofproduc­tionasassumedinthederivationofthe“zerotax”resultdescribedabove,donotseemcompelling forat least fourreasons. (1)Canada isamuchsmaller force ininternationalmarketsthantheUnitedStatesis,whichisthesolefocusofthegravelle­Smettersempiricalanalysis.(2)TheincreasingintegrationoftheCanadianeconomywiththerestoftheworldaspartoftheongoingprocessofglobalization,coupledwithempiricalevidenceofincreasingcapitalmobilityovertimeconsistentwithglobal­izationandtheincreasingsensitivityofFdItotaxfactors,suggeststhattaxpolicyinCanadashouldbebasedontheassumptionofahighdegreeofinternationalcapitalmobility. (3)The work of Randolph203 demonstrates that the crucial role of theelasticityofsubstitutionbetweenimportsanddomesticgoodsinsupportingahigh

201 Walsh,supranote3.

202 gravelleandSmetters,supranote102.

203 Randolph,supranote122.

corporate income taxation in canada n 451

levelofcapitalincometaxationinthegravelle­Smettersmodelismuchdiminishedinamoregeneralmodelofinternationaltrade.Inanycase,recentempiricalesti­matesofthisimportsubstitutionelasticityhavebeenrelativelylargeand,asstressedbyHarberger,204smallvaluesimplyanimplausiblylargedegreeofmarketpowerfordomesticproducers.(4)Finally,evenifthegravelle­Smettersanalysisiscorrectandcapitalbearsasignificantportionoftheburdenofthecapitalincometaxationinanopeneconomy,itisfarfromclearthatahighleveloftaxationofdomesticsaversandinvestorsisdesirable.

SummaryTheargumentsforalowleveloftaxationofcapitalincomearecertainlyrelevantinthecontextofCanada,especiallyinanenvironmentofincreasingglobalizationandinternationalcapitalmobility.Althoughthevariousqualificationstotheseargumentsare of sufficient importance to preclude tax exemption in the form of completeeliminationofthecorporateincometax,theyarenotstrongenoughtooverridethepresumptionthattheleveloftaxationofcapitalincomeshouldberelativelylowinCanada.

The Recent Rate-Reducing Corporate Income Tax Reform

Therecentlylegislatedreductioninthefederalcorporateincometaxrateto15per­centinCanadaimpliesacombinedstatutorytaxrateof27.6percentin2012,withanultimatetargetofacombinedrateof25percent,tobeachievedbyfurtherprov­incialratereductions.Anaturalquestioniswhethertheanalysisinthisarticlesug­gests that this reductionwasdesirable andwhether further reductionsmightbeappropriate.

Theextremeformofthetaxcompetitionargumentoutlinedabovesuggeststhatnon­benefit­relatedsource­basedtaxesappliedtocapitalincomeshouldbezero(or,incertaincircumstances,thatcapital incomeshouldbesubsidized),whichwouldimplythattherecentreductionswereamoveintherightdirection.However,thevariousqualificationsnotedabove,aswellasinternationalexperience,suggestthatsomepositivetaxationofcapitalincomeisdesirable.Asalsonotedabove,inprinci­pleonecouldconstructageneralequilibriummodeloftheCanadianeconomyintheworldeconomyandattempttodiscernanoptimalcorporateincometaxrate.However,intheabsenceofsuchanexplicitanalysisofthewelfareoptimizingtaxrate,amoremodestanalysisisrequired.Forexample,ataxenvironmentthatresultsinroughlythesameorasomewhatlowertaxburdenthanthatimposedbyacoun­try’scompetitorsformobilecapitalisareasonablegoal.205

204 Harberger,“CorporateTaxIncidence,”supranote52.

205 Ofcourse,nocountryshouldutilizeacorporateincometaxrateinexcessoftherevenue­maximizingrate—therateatwhichtherevenuegainfromahighertaxrateisjustoffsetbytherevenuelossattributabletotheassociatedreductioninthetaxbase.Mintz,supranote13,estimatesthattherevenue­maximizingtaxrateinCanadaisapproximately28percent.

452 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

Thenext step in theanalysismustbeadeterminationofacountry’sprimarycompetitors for internationally mobile capital. At the most abstract level, inter­nationaltaxcompetitiontakesplacewithallcountries,sinceinternationallymobilecapitalcaninprinciplebeinvestedanywhereintheglobalizedeconomy—takingintoaccountallofthefactorsthataffecttheproductivityoftheinvestment,includ­ingtaxesbutmyriadotherfactorsaswell.Inthiscontext,allcountriesarepotentialcompetitors,andacountryshouldbecarefulnottoattachtoomuchimportancetocurrent investment and trading patterns, since they will not necessarily reflectfuturepatterns,especiallyasthesmallerdevelopedeconomiesandemergingandtransitioneconomiescontinuetogrow.

nevertheless,thesetofcountriesthatcanreasonablybeviewedasCanada’spri­marycompetitorsforinternationallymobilecapital,atleastforasignificantperiodoftime,canbedelimitedconsiderably.Forexample,directcompetitionwithverysmallandextremelylow­taxjurisdictionsislikelytobeundesirablebecauseitwouldresultinsignificantrevenuelosseswithrelativelylittleadditionalFdI.Thesameistrue forcompetitionwiththerelativelysmallcountries thathavespecial low­taxregimesforhighlymobilefinancialcapital.

Instead,existingandlikelyfuturetradeandinvestmentpatternsprovideinfor­mationthatinpracticeishighlyrelevantindeterminingacountry’scompetitorsforinternationallymobilecapital.Forexample,giventhatnearly85percentofCanad­ianexportsaretotheUnitedStates,Canada’sprimesuppliersofmobilecapitalarelikelytobeMnEsfromcountriesthatplantoproduceinCanadainordertoservetheUSmarketaswellastheCanadianmarket.ThisconsiderationreinforcestheconventionalviewthattaxcompetitivenesswiththeUnitedStatesisacriticalmin­imalrequirement,buttheseMnEsalsohavethechoicebetweenproducingathomeand producing in alternative locations close to the US market. An inspection ofinbound FdI flows indicates that Canada’s key non­US investors are the UnitedKingdom, the netherlands, Brazil, Switzerland, and germany, which togetheraccountedforalmost40percentofCanada’s inboundFdIover2001­2006. (TheUnitedStatesaccountedforapproximatelyhalfoftheinboundFdIflowsoverthisfive­yearperiod.)Potential alternative locations fromwhich to serve theUnitedStatesareothercountries innorthandSouthAmerica,particularlyMexicoandBrazil.notethatsomeofCanada’sinboundFdIservesasasubstitutefordomesticproductioncoupledwithexportstoCanadaratherthanasaplatformforexportstotheUnitedStates,butitisnotpossibletodistinguishbetweenthetwomotivationsforundertakingFdIsimplybyinspectingthedata.Finally,CanadamustcompetetokeepitsownMnEsinvestingathome,withcurrentinvestmentpatternssuggestingthatthemostimportantcompetitorotherthantheUnitedStatesandtheUnitedKingdomisFrance;overtime,onewouldalsoexpectthattheemergingeconomiesofChina,India,andRussiawillbecomeincreasinglyimportantinthisdimension.

The recent rate reductions imply that Canada will become competitive withmostofthesenations,withtheonlyexceptionsbeingtherelativelysmallcountriesofMexico,thenetherlands,andSwitzerland,whereMETRsareroughly7percent­age points lower than the corresponding rate in Canada. The netherlands and

corporate income taxation in canada n 453

Switzerlandtogetheraccountforabout15percentofinboundFdI(andlessthan1percentofoutboundFdI),andMexico’staxadvantageislikelytobeoffsetbylessdevelopedinfrastructureandalesseducatedworkforce;therefore,reducingtaxesfarenoughtocompetewiththosethreenationsisunlikelytogeneratesubstantialadditional FdI per dollar of revenue forgone. Thus, in this context, the recentreductiontoaplannedcombinedfederalandprovincialcorporateincometaxrateof25percentseemseminentlyreasonable.

Ofcourse,onecouldextend this lineof reasoning toargue that—at least forgoodswithrelativelylowtransportcosts,includinggoodsthatcanbepartiallyorfullydigitized—internationaltaxcompetitionextendsbeyondthegroupofcoun­triesdefinedabovetotheentiregroupofsmallerdevelopedeconomiesandemerg­ing and transition economies that are also competitors in the market forinternationalcapital.Accordingtothe2007taxcompetitivenessreport,206Canada’sMETRin2012(whichwillbe23.7percent,assuminga25percentstatutoryrate)willbehigherthanthatofmostsmallerdevelopedcountriesintheOECd,whichhaveamedianMETRofabout18percent.WhileCanada’sMETRwillbesubstantiallylowerthantheMETRsinthefourkeyemergingmarkets(Brazil,Russia,India,andChina),itwillbehigherthantheMETRsinalltheEuropeanemergingeconomies,whichhaveamedianMETRofabout12percent.Fromthisviewpoint,therecentcorporateincome tax rate reductions are still quitedesirable;however, asdiscussed above,furtherratedecreasesmayresultinsignificantrevenuelosseswithlittleoffsettingincreasesinFdIandtaxbase.

Thisconclusionisreinforcedbyseveraloftheargumentsmadeabove.Inpar­ticular, a lower statutory tax rate will reduce incentives for income shifting andencourageFdI(anddomesticinvestment)thatgeneratefirm­specificrents.Atthesame time, thepotential counterarguments to the rate­reducingreformsarenotespeciallystrong,giventheratescurrentlyplanned.Inaddition,thereductionintheeffectivenessofthecorporateincometaxasabackstoptotheindividualincometaxwasnotseriouslyimpairedbytherecentreductions.Themostrelevantpotentialdisadvantages of the recent rate reduction are (1)that it reduces the taxation oflocation­specificeconomicrents(althoughifthisisperceivedtobeaseriousprob­lem,itcouldbeaddressed,atleastintheresourceandfinancialsectors,bynewspe­cial sector taxes); and (2)that the availability of tax­avoidance mechanisms maymitigate the negative effects of relatively high taxes, reducing the need for ratereductions (although existing evidence has not yet demonstrated that this is animportantconsideration).Onbalance,therecentreductionsseemhighlydesirable.

It isalsouseful tonote that thecase for therecentratereductionspresentedabove isgenerallyconsistentwith the traditionalbase­broadening, rate­loweringprescriptionforincometaxreformthathasoftenbeenrecommendedaroundtheworld,includinginCanada—forexample,bytheCarterreport207andbytheMintz

206 Mintz,ibid.

207 Canada,Report of the Royal Commission on Taxation(Ottawa:Queen’sPrinter,1967).

454 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

report.208Thebasicthrustofthisapproachistointroducestructuralchangesinthemeasurementofthetaxbasesothatitwillreflectrealeconomicincomeasaccur­atelyaspossible.Ingeneral,thisinvolveseliminatingbusinesstaxpreferencessuchaspreferentialrates,sector­specificpreferences,investmenttaxcreditsandallow­ances,andaccelerateddepreciationdeductions(otherthanaccelerationdesignedtooffsettheeffectsofinflationintheabsenceofexplicitinflationindexing),andusingtheresultingrevenuestolowerthe(uniform)taxrateappliedtobothdomesticandforeignfirms.Asnotedpreviously,muchofthereductioninstatutorytaxratesthathasoccurredinOECdcountriesinrecentyearshasbeenaccompaniedbysuchbase­broadeningreforms.209

Thestandardargumentforsuchareformisthatitisaneconomicallyneutralapproachtobusinesstaxreductionand,atleastincertaincircumstances,minimizestheinter­assetandinter­sectoraleconomicdistortionsassociatedwithtaxingcor­porateincome210whilesimultaneouslysimplifyingtaxadministrationandcompli­anceandtheperceivedfairnessofthetaxsystem.ItresultsinapositivetaxburdenonboththenormalandtheinframarginalreturnstoinvestmentsbyMnEs,aburdenthatisdeterminedprimarilybythelevelofthestatutorytaxrate(andthemethodoffinance).Atthesametime,thebase­broadening,rate­loweringapproachavoidsdistortingthetaxsystemappliedtodomesticfirmsthatinmanycaseswillbefacingintenseinternationalcompetition.Itmayalsobelesssusceptibletopoliticalfavour­itismtotheextentthatuniformandcomprehensivetaxationisperceivedtobetherule.211Inaddition,byavoidingspecialprovisionsandthustheproblemsofdeter­miningwhoqualifiesforthemandenforcinglimitationsontheiruse,abroad­basedlow­rateuniformtaxstructuresimplifiesbothcompliancewithandadministrationofthecorporateincometax.Thus,thetraditionalargumentsforbase­broadening,rate­lowering corporate income tax reform significantly strengthen the case forsuchareformbasedontheinternationalconsiderationsdiscussedatlengthinthisarticle.

Aremainingquestioniswhethertherecentratereductionsshouldbeaccompan­iedbyfurtherbroadeningofthetaxbasetothemaximumextentthatitispolitically

208 Canada,Report of the Technical Committee on Business Taxation(Ottawa:departmentofFinance,1997).

209 devereux,griffith,andKlemm,supranote29;gorteranddeMooij,supranote31;anddevereux,supranote30.

210 Althoughuniformorneutraltaxationofallbusinessactivitiesisnottheoreticallyoptimalinallcircumstances,itislikelytoapproximatetheefficientoutcome,especiallywhentheadministrativeandpoliticalcostsofdifferentialtaxtreatmentaretakenintoaccount:seeAlanJ.Auerbach,“ThedeadweightLossfrom‘non­neutral’CapitalIncomeTaxation”(1989)vol.40,no.1Journal of Public Economics1­36.

211 Ontheotherhand,somepublicchoicetheoristsarguethatenactmentofabase­broadening,rate­loweringreformmerelycreatesnewopportunitiesforspecialinterestlobbyingforpreferentialtaxtreatment.See,forexample,JamesM.Buchanan,“TaxReformasPoliticalChoice”(1987)vol.1,no.1Journal of Economic Perspectives29­35.

corporate income taxation in canada n 455

feasible.Althoughthereissomescopeforsuchreforms(seeWilson212forasummaryofpotentialbase­broadeningmeasuresidentifiedintheMintzreport),thatscopeappearstobefairlylimited.Forexample,adjustmentstoCCAsinrecentbudgets,includingincreasedratesforcomputers,manufacturingplants,othernon­residentialbuildings,naturalgasdistributionlines,andliquefiednaturalgasfacilities,havead­dressedmanyoftheproblemswithinsufficientCCAsidentifiedinthecarefulestimatesof economic depreciation in Canada by Patry,213 but have narrowed rather thanbroadenedthetaxbase;theprimarypotentialbasebroadenerislowerCCAsforsomemachineryandequipmentusedinmanufacturing.ExistingcreditsforR&dexpendi­turesarealsofairlygenerous,butsomepreferencesforR&daredefensibleoneco­nomicgroundstotheextentthatR&dgeneratespositiveexternalitiesintheformoftechnologicaladvancesthatareappropriatedbyotherfirmsandstimulateeconomicgrowth.214Severalbase­broadeningchanges inthetreatmentof international in­come,includinglimitingthedeductibilityofinterestexpenseforinvestmentinfor­eignaffiliates,werealsoproposedinthe2007Canadianbudget.AnotherpossibilityproposedbytheMintzreportisa25percentdividenddistributiontaxagainstwhichcorporateincometaxpaidwouldhavebeencreditable,aprovisiondesignedtoen­surethatdistributionstoshareholderssubjecttoshareholdercreditshave infactpaidtaxatthecorporatelevel.215

Thetreatmentofinflationisalwaysanissueunderanincometax.Becauseinfla­tion is not currently a serious problem and full inflation indexing is reasonablycomplicated, inflation adjustment need not be provided explicitly, with ad hocadjustmentssuchasappropriatelyacceleratingCCAsinawaythatisuniformacrossallassets(althoughsuchanapproachcomesatthecostofadditionalcomplexityinthetreatmentofassetsales).TheexactnatureoftheappropriateinflationadjustmentofCCAsisnotentirelyclear.Theappropriatedegreeofaccelerationdepends,ofcourse,ontherateofinflation;thefigureof2percent—themidpointoftheBankofCanada’stargetrange—assumedbythedepartmentofFinanceseemsreasonable.216Evenat

212 Wilson,supranote7.

213 AndréPatry,Economic Depreciation and Retirements of Canadian Assets: A Comprehensive Empirical Study,StatisticsCanadaWorkingPaper(Ottawa:StatisticsCanada,2005).

214 Onpoliticalgrounds,thecurrentratepreferenceforsmallcorporationsmightalsobemaintained,althoughtheeconomicrationaleforsuchtreatmentisquestionable.

215 Forexample,Mintzdetailshowfirmscanuseconduitentitiesinlow­taxcountriestoeffectivelydeductinterestexpensetwice:JackMintz,“ConduitEntities:ImplicationsofIndirectTax­EfficientFinancingStructuresforRealInvestment”(2004)vol.11,no.4International Tax and Public Finance419­34.

216 Canada,departmentofFinance,supranote10.note,however,thatanobviousissueisthatanydegreeofaccelerationofCCAswillbeaccurateonlyforaspecificrateofinflation.Accurateincomemeasurementinthepresenceofvaryingratesofinflationcanoccuronlyunderanappropriatelydesignedsystemofinflationindexing;foradescriptionofalternativeapproachestoinflationindexing,seeVictorThuronyi,“AdjustingTaxesforInflation,”inTax Law Design and Drafting(TheHague:Kluwer,2000),434­76.

456 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

afixedrateofinflation,however,theappropriatedegreeofaccelerationofcapitalconsumptionallowancesisambiguousbecausetheeffectsofinflationdependonthefinancialstructureofthefirm.Inaninflationaryenvironment,investmentcostsareunderstatedbecausecapitalconsumptionallowancesarebasedonhistoricalcost.However, forthedebt­financedcomponentofaninvestment,thiseffect isoffset(typicallymorethanfully)becausefulldeductionsareallowedfornominalinterestexpense,includingtheinflationarycomponentofinterest;bycomparison,thereisnocorrespondingoffsetfortheequity­financedcomponentofaninvestment.

Oneapproachtodealingwiththisproblemistosetcapitalconsumptionallow­ancessothattheMETRonaninvestmentthatis100percentdebt­financedisthesameas thatwhichwouldoccurwith full inflation indexingofbothcapitalcon­sumptionallowancesandinterestexpense.(Indeed,sinceallreturnsarepaidoutasdeductibleinterestonamarginalinvestment,theMETRattributabletothecorporateincometaxequalszerointhiscase,althoughtheMETRwillstillbepositiveowingtoprovincialandsalestaxesonpurchasesofcapitalgoods.)Inthesecircumstances,however,theMETRontheequitycomponentofanyinvestmentthatispartiallyequity­financed—surelytherealisticsituation—willexceedthestatutoryrate.Alternatively,asillustratedbythedepartmentofFinance,217CCAscanbefurtheracceleratedsothattheMETRonatypicalinvestment,financedwith40percentdebtand60percentequity,isthesameasthatwhichwouldoccurwithfullinflationindexing,includingfulldeductibilityofrealinterestexpense.Thisapproachhastheadvantageofresultingineconomicneutralitywithrespecttoinflationforatypicalinvestment.However,it also results in corporate income tax subsidies to investments that are fully orlargelydebt­financed.

Accordingly, CCAs should at a minimum meet the first criterion—economicneutrality with respect to an inflation rate of 2percent for a 100percent debt­financedinvestment.ButmorereasonablewouldbetheaccelerationofCCAstothepointwheretheMETRonatypicalinvestment,financedwith40percentdebtand60percent equitywith full deductibilityofnominal interest, is the sameas thatwhichwouldoccurwithfullinflationindexingwithfulldeductibilityofrealinterestexpense.Finally,LIFO(last­in,first­out)inventoryaccountingshouldbeallowedasanoptiontomitigatetheproblemsofinflationadjustmentandaccountingforthecostofgoodssold,areformthatthedepartmentofFinanceestimateswouldlowertheaverageMETRbyabouttwopercentagepoints.218

Thetreatmentoflosses,whichisoftencritical,especiallyforstartupenterprisesthatareunlikelytogeneratetaxableprofitsintheirfirstfewyearsofoperation,alsoshouldbeadjusted.Forsuchsmallfirms,agenerouscarryforwardoflosses,perhapswithanominalafter­taxrateofinterest,isessentialtoensurecompetitivenesswithestablishedfirmsthatcanwriteofftheirlossesonnewventuresagainsttheincome

217 Canada,departmentofFinance,supranote10.

218 Ibid.note,however,thatsuchachangemaybedifficulttoimplement,sincetheCanadianInstituteofCharteredAccountantsdoesnotendorseLIFOaccounting.

corporate income taxation in canada n 457

fromexistingprofitableinvestments.Thecaseforthegeneroustreatmentoflosses,however,mustbetemperedbyaconcernthatsuchtreatmentwillattractlossesasMnEsmanipulatetransferpricesandtheallocationofdebttolocatelosseswheretheywillbetreatedrelativelygenerously.Thissuggeststhat,asaroughcompromise,themostgenerous lossoffsetprovisions shouldbe limited to smalldomesticallyownedfirms,althoughtheeffectofsuchanapproachwillclearlybeharshforlargerfirmsexperiencingrealeconomiclosses.

Anothercriticalareainwhichfurtherreductionsarewarrantedisintheprovin­cialtaxationofcapitalincomeoutsidethecorporateincometax,where,asarguedbyChenandMintz,219 capital taxes220 andespecially the sales taxationofcapitalinputs shouldbeeliminated. Indeed,because sales taxesoncapitalgoodshaveahaphazard impact across industries and thus distort the allocation of capital (inaddition to reducingoverall capital accumulation), they arehighlydistortionary,evenrelativetothecorporateincometax.Thus,reducingprovincialsalestaxes,orconverting them to taxeson value added thatwould avoid taxing capital inputs,wouldbeevenmoreefficiency­enhancingthanloweringcorporateincometaxrates(although more difficult to achieve). Indeed, these provincial taxes significantlyaffectMETRs;departmentofFinanceestimatesfor2012showthatprovincialsalestaxesaddasignificant7.1percentagepointstotheaverageMETR.221noteinpar­ticularthatevenrelativelylow­rateindirecttaxesthatarebasedongrosspurchaseprices,suchastheprovincialsalestaxes,havesignificantimpactsonMETRs,whicharebasedonnetincomederivedfromcapitalinvestments.

Additional Issues

ThefollowingdiscussionconsidersseveraladditionalissuesrelatedtothereformofcorporateincometaxationinCanada.

Rate Preferences for the Manufacturing SectorAratepreferenceforthemanufacturingsectorissometimesrecommendedonthegrounds that the manufacturing sector accounts for a disproportionately largeamountofFdI,andthatFdImaybeespeciallymobileandthusparticularlyrespon­sivetotaxdifferentials.

The conventional argument is that such rate differentials should be avoided.Theyintroduceanelementofgovernmentplanning—pickingwinnersandlosers—intheallocationofinvestment.Mosteconomistsbelievethatintheabsenceofsig­nificantexternalitiesforparticular,theallocationofinvestmentisbetterlefttothe

219 duanjieChenandJackM.Mintz,How Canada’s Tax System Discourages Investment,C.d.HoweInstituteBackgrounderno.68(Toronto:C.d.HoweInstitute,2003).

220 Allprovincialgovernmentshaveplanstoeliminatetheirgeneralcapitaltaxesby2012.

221 See2008BudgetPlan,supranote14.

458 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

market.Ratepreferencesaredifficulttoadminister—forexample,itisdifficulttodetermine what qualifies as manufacturing, as demonstrated by recent debatesregardingwhatqualifiesforthenewUSmanufacturingdeduction(doesStarbucks“manufacture”coffee?)—andtheycreatethepotentialfortaxavoidanceandevasion(forexample,incomeshifting)asfirmsattempttoensurethattheiractivitiesqualifyfor the tax preference. Targeted rate reductions can be costly in revenue terms,generatingrelativelylittlenewinvestmentperdollarofrevenuecostandrequiringincreasesinotherdistortionarytaxes.Likealltaxpreferences,ratepreferencesalsocreateincentivesforrentseekingandthepotentialforunexpectedrevenuelossesduetoaggressivetaxplanning.

Althoughallofthesearevalidargumentsagainstaratepreferenceformanufac­turing,thereisapotentiallyimportantcounterargument.Specifically,asshownbyguglandZodrow,222animplicationofoptimaltaxtheoryisthat,atleastincertainplausiblecircumstances,ifacountryfacessuppliesofcapitalwithdifferentelastici­ties(andthesecanbeidentified),itshouldtaxatalowerratethecapitalwiththehighersupplyelasticity(or,inthecasetheyanalyze,introducetaxpreferencesformobilecapital).guglandZodrowalsoshowthattaxpreferencesformobilecapitalcan reduce theproblemofunderprovisionofpublic services associatedwith thetaxationofmobilecapital.223

Itisfarfromclearthattheseresultsoverturnthetraditionalpresumptionagainsttheuseoftaxpreferences,suchasaratepreferenceformanufacturing;mostoftheargumentsoutlinedaboveagainsttheuseofsuchincentives,especiallytheadminis­trativeproblemsandavoidanceandevasionopportunitiestheycreate,arenotcon­sideredinthemodelutilizedinthegugl­Zodrowanalysis.Instead,itisclearthatsuchincentivesshouldbeusedwithgreatcaution,astheargumentsagainstthemarepersuasive.nevertheless,thegugl­Zodrowresultsprovideacounterargumenttothetraditionalcaseagainsttheuseoftaxpreferencesforhighlymobilecapital,andinanycasetheymayprovideapartialexplanationfortheirwidespreaduse.

The Dual Income Tax OptionAsnotedabove,oneoftheproblemswithabase­broadening,rate­reducingreformatthecorporatelevelisthatitcreatesincentivesforlabourincomeshiftingbytheownersofcloselyheldcorporations,providingthebenefitsofdeferralatthecostofcurrentcorporatetaxationandsubsequentindividual­leveltaxationundertheinte­gratedbusinessandindividualtaxsysteminCanada.Concernsaboutsuchshiftinglimittosomeextentthefeasibledegreeofcorporateratereduction.Moreover,withan approximately fully integrated corporate and individual tax system, loweringcorporatetaxratesdoesnotreducethetaxburdenonthereturntosavingsthataredistributedtoCanadiancitizensandfullytaxedattheindividuallevel.

222 guglandZodrow,supranote150.

223 SeeZodrowandMieszkowski,supranote51,foradiscussionofthisproblem.

corporate income taxation in canada n 459

Atone level, suchanapproachmaybedesirable.Forexample,Altshuler andgrubert224 argue that increasing globalization and international capital mobilityimplythatnationalgovernmentsshouldendeavourtoreducebusiness­leveltaxesasmuch as possible in order to attract FdI and minimize business­income­shiftingopportunities,andshouldconcentratethetaxationofcapitalincomeattheindivid­uallevel;thesamereasoningplayedaroleinthedevelopmentoftherecentnorwe­gian reform that provides a rate­of­return allowance at the personal level toshareholdersratherthanatthebusinesslevelasunderaconventionalACEtax.225However,asubstantialliteratureontherelativeadvantagesofconsumptionversusincome taxation—developed largely in the context of closed economies—arguesthatcapitalincometaxationattheindividuallevelishighlyundesirableaswell.226Accordingly,itmaybedesirabletolowerthetaxationofcapitalincomenotonlyatthecorporatelevel,butalsoattheindividuallevel.Oneapproachtoachievingthisgoalisadualincometax,aninnovationthatwasimplementedinthelate1980sandthe early 1990s by the nordic countries and subsequently by several othercountries.227

The dual income tax adopts a schedular approach to taxing income: capitalincomeistaxedatarelativelylowrateunderanintegratedsystemofbusinessandindividualtaxation,whilelabourincomeistaxedatprogressiverates.ThisapproachcontraststothemorecommoncomprehensiveorglobalapproachcurrentlyusedinCanada,underwhichbothcapitalandlabourincomeareaggregatedandsubjecttoasingletaxscheduleatthepersonallevel.

Althoughtherearemanyvariantsoftheapproach,apuredualincometax,asdescribedbyCnossen,228hasthefollowingfeatures.Theessentialelementisthatanextremelycomprehensivemeasureofcapitalincomeistaxedatasingleproportionalrate,typicallyatthebusinesslevelbutsometimesattheindividuallevel,atarateequal to the minimum positive tax rate applied to labour income, while labourincomeistaxedatprogressiveratesundertheindividualincometax.Underatypicalapproach,dividendsarenotdeductibletothefirmbutareexcludedfromtheindi­vidualcapitalincometaxbase;capitalgainsaretaxedattheindividuallevelonarealizationbasis,butshareholdersareallowedtowriteuptheirbasisbynetretainedearningssothatsuchearningsaretaxedonlyatthebusinesslevel.Capitalincometaxesareoftencollectedviawithholdingatsource,whichinthesimplestversionofthe tax (whichdoesnotallowcapital lossoffsetsagainst labour incomeorapply

224 Altshulerandgrubert,supranote28.

225 Sørensen,supranote16.

226 SeeZodrow,supranote55,forareviewofthesearguments.

227 Berndgenser,“MovingTowardsdualIncomeTaxationinEurope”(2007)vol.42,no.3FinanzArchiv116­42.

228 SijbrenCnossen,“TaxingCapitalIncomeinthenordicCountries:AModelfortheEuropeanUnion?”inTaxing Capital in the European Union,supranote188,180­213.

460 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

personalexemptionsor standarddeductionsagainst capital income) represents afinaltax.229

Thebiggestproblemwiththedualincometaxapproach—oftenreferredtoasitsAchilles’heel—isthatitcreatesanobviousincentiveforindividualswhoownsmallbusinessestoconverthighlytaxedlabourincomeintocapitalincome.Thisproblemisespeciallyacuteinthenordiccountries,giventheirrelativelysteeplyprogressivetaxesonlabourincome.Tocombatthisproblem,theprofitsofproprietorshipsandcloselyheldcompaniesaresomewhatarbitrarilysplitintocapitalandlabourincomecomponents.Thecapitalincomecomponentistypicallycalculatedbyapplyingapresumptiverateofreturntothefirm’scapital,whichisthentaxedatthepropor­tionalrateoncapitalincome;thelabourincomecomponentistheresidualprofit,whichispassedthroughtoshareholdersandtaxedatprogressiveratesunderthepersonalincometax.230

Amongotherthings,thefeaturesofthedualincometaxaredesignedtocopewiththetensions,describedabove,facedbyarelativelysmallcountryattemptingtodesignitsbusinesstaxpolicytoattractmultinationalinvestmentinthefaceofinter­nationaltaxcompetition.231Mostimportant,theprovisionofarelativelylowbutneverthelesspositive tax rateoncapital incomereflects the strikingof abalancebetweenthezerotaxrateresultobtainedinthesimplesmallopeneconomymodelandtherelativelyhightaxratessuggestedbythevariouscounterargumentstothisview.232

Thetreatmentofproprietorshipsandcloselyheldcompaniesisofspecialinter­estunderthedualincometaxapproach.Themethodusedtosplitcapitalandlabourincome, if effectively enforced, limits the extent towhich labour incomecanbeshelteredinabusiness;thatis,thedualincometax,despiteitsrelativelylowcapital

229 Ibid.Forfurtherdetails,seealsoPeterBirchSørensen,“FromtheglobalIncomeTaxtothedualIncomeTax:RecentTaxReformsinthenordicCountries”(1994)vol.1,no.1International Tax and Public Finance57­79;SørenBonielsenandPeterBirchSørensen,“OntheOptimalityofthenordicSystemofdualIncomeTaxation”(1997)vol.63,no.3Journal of Public Economics311­29;and,intheCanadiancontext,PeterBirchSørensen,“ThenordicdualIncomeTax:Principles,Practices,andRelevanceforCanada”(2007)vol.55,no.3Canadian Tax Journal557­602.

230 dualincometaxesinpracticediffertovaryingdegreesfromthispureversion;seegenser,supranote15,foracomprehensivediscussionofthedetailsofthelongstandingdualincometaxesindenmark(enactedin1987),Sweden(1991),norway(1992),andFinland(1993),aswellasthemorerecentversionsinAustria,Belgium,Italy,greece,andthenetherlands.Switzerlandandgermanyarealsoconsideringadoptingdualincometaxes.

231 Sørensen,“FromtheglobalIncomeTaxtothedualIncomeTax,”supranote229;andCnossen,supranote228.

232 notealsothat,unlikesomeofthecompetingconsumption­basedtaxalternatives,especiallytheflattax,thedualincometaxmesheswellwithexistingincometaxsystemsaroundtheworld.Foradiscussionoftheseproblems,seeCharlesE.McLureJr.andgeorgeR.Zodrow,“TheEconomicCaseforForeignTaxCreditsforCashFlowTaxes”(1998)vol.51,no.1National Tax Journal1­22.

corporate income taxation in canada n 461

incometaxrate,stillfunctionsasabackstopforthetaxationoflabourincomeunderthepersonal income tax.The experiencewith this approach,however, hasbeenmixed; in particular,norway has recently enacted an alternative approach in anefforttocurbwidespreadabuse.233

Theimpositionofawithholdingtaxatsourceoninterestpayments,evenatareducedrate,isalsoofcriticalimportance.234Ifapplieduniformly,suchtreatmenthasthesameeffectasthedenialofadeductionatthebusinesslevelforinterestpay­ments coupled with exclusion at the individual level, as proposed under the USTreasurydepartment’spreferredbusiness­individualtaxintegrationreformalterna­tive, the comprehensive business income tax (CBIT).235 Since dividends paid aretreatedequivalentlyunderthedualincometax,fullintegrationofinterestpaymentsanddistributedearningsisachieved.Thetreatmentofcapitalgainsdescribedabovealsoachievesintegrationforretainedearnings;however,giventhebasisadjustmentprocedurespecified,theremainingcapitalgainstaxbaseappearstobelargelypurelyinflationarygains,sothateliminationofthetaxationofcapitalgainsattheindivid­uallevelisameasureworthyofseriousconsideration.Inanycase,ifcoupledwithacorporatetaxthataccuratelymeasuredrealeconomicincome,thetreatmentofcap­ital incomeunder thedual incometaxwouldachieve the tax integrationgoalofensuringthatcapitalincomeistaxedcomprehensivelyasingletime.

Finally,given the typically limitedextent towhich interest income isactuallytaxedundermostincometaxsystems,236itseemslikelythatevenwithareducedtaxrate,thetreatmentofinterestunderthedualincometaxwouldtypicallyresultinarelativelysmallrevenueloss,orperhapsevenarevenueincreasethatwouldpermitamodestratereduction.237Inthelattercase,adoptionofthedualincometaxwould

233 Sørensen,supranote15.Sørensenreportsthatnorwegianfirmswouldoftenfindenough“passive”investorstoensurethattheywerenolongerclassifiedascloselyheldbusinessessubjecttomandatorycapital/labourincomesplitting;moreover,generousadditionaldeductions,includingsomeforwagespaidtoemployees,impliedthattheremainingfirmssubjecttomandatoryincomesplittingoftenreportednegativeincome.Theinnovativenorwegianreformreplacestheincome­splittingmethodwithindividual­leveltaxationofallcorporatesharesonreturnsinexcessofanormalrateofreturn(termed“therate­of­returnallowance”)—effectively,anACEtaximposedattheindividualshareholderlevel,coupledwithlow­ratebusiness­leveltaxationofnormalreturnsandfullintegrationofbusiness­leveltaxationofabove­normalreturns.notethatbecausetherate­of­returnallowanceaccumulatesonassetswithunrealizedgains,thetaxdoesnotdistortrealizationdecisions:seeAlanJ.Auerbach,“RetrospectiveCapitalgainsTaxation”(1991)vol.81,no.1The American Economic Review167­78.

234 However,Cnossen,supranote228,at199,notesthatinpracticethelevelofwithholdingoninterestpaymentsunderthenordicdualincometaxesfallsconsiderablyshortoftheidealoffulltaxationatthecapitalincometaxrate.

235 UnitedStates,departmentoftheTreasury,Integration of the Individual and Corporate Tax Systems: Taxing Business Income Once(Washington,dC:USgovernmentPrintingOffice,1992).

236 C.EugeneSteuerle,Taxes, Loans and Inflation: How the Nation’s Wealth Becomes Misallocated(Washington,dC:BrookingsInstitution,1985).

237 TheUSdepartmentoftheTreasury,supranote235,hasestimatedthatadoptionofthecomprehensivebusinessincometaxwouldallowaratereductionfrom34to31percent.

462 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

againsomewhatreducethelikelihoodofrevenuelossesfromtax­avoidancemanipu­lationsbyMnEs.Inanycase,therelativelyharshtreatmentofdebt(incomparisontothestandardtreatmentoffulldeductibilitywithlimitedifanywithholding)woulddiscourageMnEsfromallocatingdebttoanycountrythatadoptedadualincometax.Indeed,internationalexperiencewithwithholdingtaxesoninterestincome(forex­ample,ingermany)hasnotbeenveryencouraging,andexistingdualincometaxesfallshortoftheidealoffullytaxinginterestincomeatthecapitalincometaxrate.

Insummary,bylargelyseparatingthetaxationofcapitalincomefromthepro­gressiveincometaxationoflabourincome,thedualincometaxapproachprovidesamechanismfordealingwiththemanytensionsfacedbytaxpolicymakersinanopeneconomythatisattemptingtoattractdirectinvestmentfromforeignMnEs.Taxingcapitalincomecomprehensivelybutatarelativelylowrateprovidesameansofdesigningataxsystemthatis(1)attractivetohighlymobileinternationalcapital(includinginvestmentsbyfirmsthatareinanexcessFTCposition),(2)reducesthedistortionsofthecorporateincometaxandreducesthedistortionsofsavingundertheindividualincometax,(3)reducestheexposureofgovernmenttaxrevenuestoaccounting and financial manipulation by tax­avoiding MnEs, and (4)allows thetaxationoflabourincometobesetindependentlyofthetaxrateoncapitalincomeinordertobetterreflectsocialtastesforgovernmentexpenditures,includingredis­tributiveexpenditures.Atthesametime,thedualincometax(1)raisespositiverev­enuefrombothmarginalreturnsandfirm­specificandespeciallylocation­specificeconomicrentsfrombothforeignanddomesticcorporations,(2)takessomeadvan­tageofanyrevenuesavailablethroughthetreasurytransfereffect,(3)servesasabackstop to the taxation of labour income under the personal income tax, and(4)satisfiespoliticaldemandsforsomeformoftaxationofcorporations.Thedualincometaxapproachwillnotsatisfythosewho,followingtheSchanz­Haig­Simonstradition,insistontaxingallincomecomprehensivelyunderthesameratestructure.norwillitcompletelyeliminateincometaxationofhighlymobilecapital,asisopti­malunderthezerotaxscenario,orachieveconsumption­basedtaxationofdomesticsavings.nevertheless,thedualincometaxrepresentsapotentiallypromisingcom­promisetotheoffsettingtensionsthatcharacterizetoday’sfiscallandscape,and,asarguedbyMintz238andSorensen,239couldbeconsideredbyCanadaasitattemptstodesigncapital incometaxpolicy in the faceof increasingcapitalmobilityandinternationaltaxcompetition.

Windfall Gains to Old CapitalAsmentionedabove,an importantproblemwithacorporate incometaxreforminvolvingareductioninthestatutorytaxrateisthatthelowertaxrateappliesnotonly tonew investmentsbut also to the returns fromexisting investments.As a

238 Mintz,supranote1.

239 Sørensen,“ThenordicdualIncomeTax,”supranote229.

corporate income taxation in canada n 463

result,theownersofexistingcapitalreceiveawindfallgain,andthegovernmentlosesrevenuewithoutanoffsettingincreaseinmarginalincentivestoinvest.Oppon­entsofsuchreformsarguethatitispreferabletomaintainarelativelyhighstatutoryrate,coupledwithinvestmentincentivessuchasaninvestmenttaxcreditoracceler­ateddepreciationallowancesthatapplyonlytonewinvestmentandthushavemorebangforthebuck—thatis,alowerrevenuecostperdollarofinducedinvestment.Underthisapproach,theMETRoninvestmentincomeissignificantlylowerintheshort run than the average tax rate.Bycomparison,under thebase­broadening,rate­loweringapproach,marginalratesexceedaverageratesintheshortrun,sincethestatutoryratereductionappliestooldinvestments.

Thisargumentcertainlyhassomevalidity,andthereisnoquestionthattheuseofinvestmentincentivesiswidespreadaroundtheworld.However,manycountrieshave recently focused on statutory rate reduction, often financed with base­broadeningeliminationofinvestmentincentives,inresponsetothemanydisadvan­tages of a high statutory tax rate, as described at length above. In addition, theincentiveapproachsuffersfromamultitudeofproblems.Itisdifficultinpracticetodesignan investment incentive system that isneutral acrossbusiness assets; as aresult,incentiveschemesaretypicallycharacterizedbyeffectivetaxratedifferentialsacrossassetsandacrossbusinesssectorsthatdistorttheallocationofinvestment,andthusreducetheproductivityofinvestmentandtherateofeconomicgrowthassociatedwithanygivenlevelof investment.Taxpreferencesthatapplyonlytonew investmentarearguablyunfair to—andcertainlywillbeperceivedasunfairby—firmsthatmadeearlierinvestmentsunderthepreviouslessgeneroustaxsystemand now must compete with firms that benefit from the new incentives. Thisinequityisexacerbatedbythefactthatincentivesthatapplyonlytonewinvestmentcausewindfalllossesoninvestmentsmadeunderthepreviousregimethatdonotbenefitfromtheincentives.240Taxpreferencesalsoinevitablyleadtolargeradmin­istrativeandcompliancecosts.

Anotherissueisthatinvestmentincentivesinpracticeareseldomcombinedwithlosscarryforwardwithinterest;atbest,firmsreceivelimitedlosscarryforwardwithnointerest.Becausedeductionsthataredelayedintothefuturelosevaluewithtime,investment incentivesoftencreateataxbiasagainstnewandemergingfirms(orfast­growingfirmswithinanestablishedindustry)thatcannotusetheirdeductionscurrentlybecausetheydonothavesufficientincomefromexistinginvestments.Inaddition,investmentincentivestypicallyvaryconsiderablyovertime—primarilyforpoliticalratherthancountercyclicalreasons—andthisinstabilityofthetaxsystemcreates uncertainty for business investors. For all these reasons, the lowering ofstatutoryratesappearstodominatethealternativepolicyofmaintaininghighstatu­toryrateswhilemitigatingtheireffectswithinvestmentincentives.

240 georgeR.Zodrow,“TransitionalIssuesintheImplementationofaFlatTaxoraRetailSalesTax,”ingeorgeR.ZodrowandPeterMieszkowski,eds.,United States Tax Reform in the 21st Century(Cambridge,UK:CambridgeUniversityPress,2002),245­83.

464 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

note,however,thattherecentcorporateincometaxratereductionswerephasedinovertime(withnoadditionaltransitionalrules);thus,theyshouldhaveresultedin relativelymodestwindfallgains.nevertheless, if thewindfallgainsassociatedwithfurthercorporatetaxratereductionsinCanadaareperceivedtobeaseriousproblemthatcannotadequatelybeaddressedwithphase­ins,itmightbepossible—althoughpoliticallyquitedifficult—toenactsometransitionrulesthatwouldmiti­gatethisproblem.Theessenceofthisapproachwouldbetosegregatenewcapitalfromexistingcapitalandtoattempttoensurethatthemajorityofthebenefitsfromratereductionwouldaccruetotheformer.

Forexample,oneapproachwouldbetoattempttoidentifynewcapital,imputea return to that new capital, and allow the rate reduction to apply only to theimputedreturns.SuchanapproachisreminiscentoftheAmericanLawInstitute’sproposaltoallowanindividualdividendratereductiontoapplyonlytodividendsdeemedtobepaidfrominvestmentsfinancedwithnewequity(withtheallowableamountoftax­preferreddividendscalculatedbyimputingareturntonewlyissuedequity).241Alternatively,animputedreturntoexistingcapitalcouldbesubjecttotaxatpre­reformtaxrates;tolimitthetimethatsuchaprovisionwouldbeinforce,thepresentvalueofthetransitionaltaxcouldbecalculatedatthetimeofreformandthenspreadoutoveranumberofyears.YetanotherpossibilityisthatCanadamightaccompanyasignificantreductioninthecorporateincometaxratewithaprovisionsimilartothewindfallrecapturetaxproposedbytheUSTreasurydepartmentinthedebateleadinguptopassageoftheTaxReformActof1986.Thattaxwouldhavecalculatedthedeferredincomeduetoaccelerateddepreciationdeductions(definedasthoseinexcessofthedeductionsallowedundertheE&Paccountingmethod)takenbeforetheenactmentofreformandeffectivelytaxedthatincomeatthepre­reformtaxrate.242Forexample,thebookvalueofdepreciabletangibleassetswasapproximately18percentgreaterthanthetaxvaluein2006.243Thisvalue,aswellas thebookvalueof intangibleassets,could inprinciplebesubject toawindfallprofitstax.Anysuchprovisionswouldbecomplicated,wouldbeperceivedasunfair(partlybecausetheywouldsingleoutonlyasingletypeofwindfallgainforaspecialtaxwhenanyreformcausesmanywindfallgainsandlosses),andwouldnodoubtbeveryunpopularpolitically—astheUSTreasuryproposalwas,atleastinmanyquarters.nevertheless,byreducingthewindfallgainsassociatedwithanyfurtherreductions

241 AmericanLawInstitute,Integration of the Individual and Corporate Income Taxes(Washington,dC:ALI,1991).

242 Fordetailsontheproposedwindfallrecapturetax,seeUnitedStates,departmentoftheTreasury,Tax Reform for Fairness, Simplicity, and Economic Growth(Washington,dC:USgovernmentPrintingOffice,1984),and,foranevaluation,seegeorgeR.Zodrow,“TheWindfallRecaptureTax:IssuesofTheoryanddesign”(1988)vol.16,no.4Public Finance Quarterly387­424.

243 Thisfigurewascalculatedusingthevalueofdeferredincometaxesandcapitalassetsshownintable4­1ofStatisticsCanada,Financial and Taxation Statistics for Enterprises,StatisticsCanadacatalogueno.61­219­XIE(Ottawa:MinistryofIndustry,2008).

corporate income taxation in canada n 465

inthestatutorycorporateincometaxrateinCanada,suchprovisionswouldallowtheratereductiontobelargerandwouldincreaseitsbangforthebuck—thatis,theywouldreducetheextenttowhichthereformlostrevenueintheshortrunduetoapplyingthereducedtaxratetotheincomefromexistingcapital.Accordingly,asameansoffacilitatinganotherwisehighlydesirablereform,suchprovisionsdeservefurtherconsideration.

Interprovincial Tax Competitiongivenanyparticularreductioninthefederalcorporatetaxrate,furtherreductionsinthecombinedfederalandprovincialtaxesoncapitalincomecouldbeachievedwithreductions inprovincialrates,andinfactwereenvisionedundertherecentreform.Indeed,becauseprovincialcorporateincometaxratesarerelativelyhigh,provincial governments have considerable room for independent rate reduction.Suchindependencemayleadtosubnationaltaxcompetition,whichisacommonphenomenon in the United States.244 A large body of literature has examinedwhethersuchcompetitionisdesirablefromanationalperspective,andtherearemanyargumentsonbothsidesoftheissue.245However,totheextentthatprovincialcorporateincometaxreductionswouldreflectthemovementclosertobenefittaxa­tionofmobilecapital,suchreductionscouldbeviewedasdesirable.246Thatis,sincetheprovinces are evenmore likely tobe accurately approximated as small openeconomiesandtheirrelativelyhighlevelsofcorporatetaxationarelikelytoexceedbenefit tax levels, theargumentsexpressedabove implyevenmore strongly thatnon­benefittaxationofmobilecapitaliscounterproductivefromtheviewpointofprovincialresidents.Thus,reductionsinindependentprovincialcorporateincometaxratesprovideanadditionalinstrumentforattractinghighlymobileinternationalcapitaltoCanada.

One problem with lowering federal taxes is that the provinces would simplyincreasetheirtaxratestooffsetthefederalreductions.247Tosomeextent,taxcom­petitionamongtheprovincesshouldlimitsuchreactions:theargumentspresentedaboveimplythatbecausethebenefitsoflowerprovincialrateslargelyaccruetothe

244 RobertS.ChirinkoanddanielJ.Wilson,State Investment Tax Incentives: What Are the Facts?CESifoWorkingPaper2006­49(Munich:CenterforEconomicStudiesandIfoInstituteforEconomicResearch,2006).

245 Forreviewsofthisvoluminousliterature,seeWilson,“TheoriesofTaxCompetition,”supranote51;MintzandChen,supranote36;Zodrow,supranote51;WildasinandWilson,supranote51;andFuest,Huber,andMintz,supranote51.

246 Zodrow,“AlternativeFormsofdirectConsumptionTaxes,supranote192.

247 Ingeneral,itisthecombinedfederalandprovincialtaxrate,netofpublicservicebenefits,thataffectstheinvestmentdecisionsofMnEs,sothatthemixoffederalandprovincialrates,whichwouldbecomeunusuallyheavilyweightedtowardtheprovincialrates,isnotespeciallyimportantinefficiencyterms.However,totheextentthatprovincialratesaremorevariableandbecomealargerfractionofthecombinedrate,MnEswouldfacesomewhatmoreuncertaintyintheirinvestmentdecisions.

466 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

citizens of the province, such reactions would be counterproductive from theirviewpoint.Further,moreconcretelimitationsontheabilityoftheprovincestoraiserateswouldbedifficulttodesignandimplement,assuggestedbythedifficultiesencounteredineffortsattaxharmonizationintheEuropeanUnion.Itispossible,however,toattempttodevisesuchapproaches—forexample,makingfederalgrantsexplicitlyorimplicitlyconditionalonthelevelofprovincialcorporateincometaxa­tion.Anotherpossibilityissuggestedbythefactthatprovincialcorporateincometaxesarecurrentlynotdeductibleagainstfederaltaxliability.Inprinciple,suchtaxesshouldbedeductibleasalegitimatebusinesscost(eveniftheyweretocorrespondperfectlytothebenefitsfirmsreceivefrompublicservices,whichisahighlydubiousproposition). Although full deductibility is appropriate, given the existing initialequilibrium,thefederaldeductibilityofprovincialcorporateincometaxeslimitedtotaxesbelowaceilingwouldstillbeanimprovementrelativetocurrentlaw,anditwouldcertainlycreateadisincentiveforprovincialtaxincreasesbeyondcurrentlevels.Itisnotclear,however,howsuchaprovisioncouldvaryacrossprovincestolimitincreasesfromcurrentrateswithoutbeingperceivedasunfair;and,giventherelativelylowfederalcorporateincometaxrate,disallowingdeductibilityforrateincreasesaboveaceilingwouldprovideonlyamodestdisincentiveforsuchchanges.

Withholding TaxesFinally,arelatedquestioniswhethercorporateratereductionsshouldbeaccom­paniedbyreductions inwithholding taxesapplied todividendsand interestpaidabroad,includingdividendsandinterestpaidbyaCanadiansubsidiarytoitsforeignparent.Underthecurrentrules,withholdingtaxesareassessedatthestandardrateof 25percent, with various exceptions, including dividends to US shareholders,whicharetaxedatratesof15percent(portfolioinvestment)and5percent(directinvestment); royalties, which are taxed at rates that vary from 0 to 10percent(except for resource royalties, which are taxed at the full 25percent rate); andexemptionofarm’s­lengthindebtedness,copyrightroyalties,andinterestongov­ernmentdebt.248In2005,withholdingtaxesoninterestanddividendsaccountedforrevenuesof roughly$2.8billion,249 relative to total federalcorporate incometaxrevenuesofroughly$31billion.

Atone level,withholding taxes represent another source­based taxoncapitalincome,so that thesameargumentsdescribedaboveapply, suggestingthatsuchtaxesshouldbereducedoreliminated.250Thisisespeciallytrueinthecaseofinter­est,exceptwhenCanadianwithholdingtaxesarefullyandimmediatelycreditable

248 Theseratesapplytoallotherg7countriesexceptItaly,whichfacesa15percentwithholdingrateonallinterestanddividendpayments.

249 SeeAdvisoryPanelonCanada’sSystemofInternationalTaxation,Enhancing Canada’s International Tax Advantage(Ottawa:Queen’sPrinter,2008).

250 Inaddition,withholdingtaxesreduceopportunitiesfordiversificationinportfolioinvestment.

corporate income taxation in canada n 467

intheUnitedStates.Forexample,Mintz251estimatesthateliminatingwithholdingtaxesbetweenCanadaandtheUnitedStateswouldgenerateanincreaseinCanad­ianincomes(duetotheproductivitygainsfromadditionalinvestment)thatwouldbemorethanfourtimestheassociatedrevenueloss;mostofthisgainisattributabletotheeliminationofwithholdingtaxesoninterestpayments.

note,however,thatbecausewithholdingtaxesondividendsareassessedonlyupon repatriation of funds, they are less onerous than corporate income taxes.Indeed,thelogicunderlyingthenewviewofdividendtaxationsuggeststhatwith­holdingtaxescreatetaxdisincentivesonlyforinitialorsubsequentinfusionsofeq­uitybyaparentintoitssubsidiaries,andthattheydonotdistortdecisionsregardinginvestmentsfinancedwiththesubsidiary’sretainedearnings.Moreover,althoughSinn252arguesthattaxesthataredueuponrepatriationencourageundercapitaliza­tiontoavoidthenegativeimpactofthetaxoninvestmentsfinancedwithequityin­fusions,thisresultisvitiatedifthefirmhassufficientaccesstodebtfinanceatitsinitialstages.253Accordingly,thedistortionaryimpactofwithholdingtaxesmayberelativelysmall.Finally,reductionsinwithholdingtaxesaretypicallyaccomplishedinbilateralnegotiations,sothatinvestorsinbothcountriesbenefitfromsimultane­ousreductions.giventherelativelysmallcostsofsuchnegotiations,itseemsrea­sonable for Canada to continue to follow this approach rather than engage inunilateralreductionsinwithholdingtaxes.

co nclusIo n

ThisstudyhasextendedtheanalyticalframeworkdescribedinZodrow254andappliedit to thecaseofcorporate incometaxation inCanada.Althoughtheapproach issomewhatdifferent,theconclusions—thattherecentlyenactedandplannedcor­porateincometaxratereductionstargetingacombinedfederalandprovincialstatu­toryrateofaround25percent,coupledwithbasebroadeningtotheextentfeasibleandconsistentwithaccuratemeasurementofincome,eliminationofprovincialsalestaxesoncapitalinputs,andreductionsinwithholdingtaxesoninterest—arebroadlysimilartoearlierrecommendations,suchasthosemadebyMintz,255McLure,256and

251 JackM.Mintz,Withholding Taxes on Income Paid to Nonresidents: Removing a Canadian-US Border Irritant,C.d.HoweInstituteBackgrounderno.48(Toronto:C.d.HoweInstitute,2001).

252 Hans­WernerSinn,“TaxationandtheBirthofForeignSubsidiaries,”inHorstHerbergandngoVanLong,eds.,Trade, Welfare and Economic Policies: Essays in Honor of Murray C. Kemp(AnnArbor,MI:UniversityofMichiganPress,1993),325­52.

253 JamesR.HinesJr.,“CreditanddeferralasInvestmentIncentives”(1994)vol.55,no.2Journal of Public Economics323­47;andAlfonsJ.Weichenrieder,“TransferPricing,doubleTaxation,andtheCostofCapital”(1995)vol.98,no.3Scandinavian Journal of Economics445­52.

254 Zodrow,supranote48.

255 Mintz,supranote1.

256 CharlesE.McLureJr.,Tax Reform and Investment: Will the U.S. Sneeze? Will Canada Catch Cold?Benefactor’sLecture(Toronto:C.d.HoweInstitute,2005)(online:http://www.cdhowe.org/pdf/benefactors_lecture_2005.pdf ).

468 n canadian tax journal / revue fiscale canadienne (2008) vol. 56, no 2

Poschmann, Robson, and Banerjee.257 Either explicitly or implicitly, all of thesestudiessuggestthataweighingofthevariousfactorsdiscussedinthisarticleleadstotheconclusionthatevenifonedoesnotacceptargumentsimplyingthatCanadashouldexemptcapitalincomefromtaxation,themovementtomoreuniformcor­porateincometaxationcharacterizedbylowerstatutoryrateswasdesirable.Thereformwas,ofcourse,notwithoutitsproblems.Inparticular,becausetheimpactofrelativelyhightaxrates inCanadaonFdImaybemitigatedbytaxavoidancebyMnEs,therecentlyenactedlowerratesmaynotgenerateassignificantanincreaseinFdIashoped,whilereducingthetaxationofrelativelyimmobiledomesticcapital,andlocation­specificrentsearnedbyforeignMnEs,especiallythoseattributabletoproximitytotheUSmarket.nevertheless,onbalance,therecentandplannedre­ductionsincorporateincometaxratesinCanadaseementirelyappropriate.More­over, in the current environment, the case for further reductions is far lesscompelling—althoughitwillbemoresoif theothercountriesthatareCanada’scompetitorsforinternationallymobilecapital,includingtheUnitedStates,reducetheirtaxratesinthenearfuture.

AmoredifficultquestioniswhetherCanadashouldbefarbolderinsettingitscorporateincometaxpolicyandfollowtheleadofIrelandandothercountriesindramaticallyreducingcorporateincometaxrates.Althougharecommendationtofollowthatpathwouldbeprematureatthisstage,theparallelsbetweentheIrishandCanadiancases—especiallythewidespreaduseofEnglish,theexistenceofawell­educated,highlyskilledpopulation,andtheprospectofservingalarge,rela­tivelyhigh­taxandhigh­incomenearbymarket—suggestthatthisoptionshouldbeconsidered seriously. On the other hand, in the absence of special tax regimesdesignedtocaptureeconomicrentsandtransitionrules,suchadramaticratereduc­tionwouldsignificantlyreducethetaxationoflocation­specificeconomicrentsandresultinlargewindfallgainsfortheownersofexistingcapitalinCanada,withasig­nificantfractionofbothtypesofgainsaccruingtoforeignowners.

257 FinnPoschmann,WilliamB.P.Robson,andRobinBanerjee,Fiscal Tonic for an Aging Nation: A Shadow Budget for 2007,C.d.HoweInstituteBackgrounderno.101(Toronto:C.d.HoweInstitute,2007).