Business Tax Incentives for Economic Development - SSRN papers

4 Business Tax Incentives for Economic Development: Do They Work? John Lester School of Public Policy, University of Calgary

1. Introduction This chapter reviews corporate income tax incentives provided by the federal and provincial governments in Canada to promote economic development. The federal government has nine tax measures that provide assistance to specific industries or activities while provincial governments provide about the same number of additional distinct tax policy initiatives. Only two of the measures address generally recognized market failures; the other programs are often justified by a need to maintain competitiveness. Much of the support is directed at small business, manufacturing, and outbound investment. Official cost estimates are not available for all measures, but my calculations suggest that the federal government forgoes about $8 billion in tax revenue as a result of these tax incentives. The revenue loss for provincial governments is estimated to be $9 billion. These estimates exclude the cost of refundable tax credits, such as the enhanced scientific research and experimental development (sr & ed) tax credit, which are functionally equivalent to grants. The title of this chapter asks if these tax incentives work, which is shorthand for asking if they are successful in raising real income and if they are the most effective instruments to use. Assuming a competitive equilibrium, only those measures addressing a market failure can have a positive effect on real income; other measures harm economic performance by shifting resources from their best uses. What would motivate governments to intervene in the absence of a  117

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market failure? One possibility is to transfer income among taxpayers, either out of a sense of fairness or in an attempt to influence election outcomes. Another possibility is that governments see externalities where none exist, or that they interpret the positive first-round effects of tax cuts as the ultimate impact. A third possibility is that governments are, wittingly or unwittingly, attempting to minimize the efficiency cost of corporate income taxation by reducing the tax burden on highly mobile capital. Finally, governments may reject the assumption that the economy is characterized by a competitive equilibrium, which would support the view that policy-induced shifts in resources could raise income. This chapter applies a benefit-cost framework to assess whether the targeted tax incentives result in a net social benefit. A key factor that influences the results is the way in which the incentives are financed. If they are assumed to be financed by an increase in the general corporate income tax (cit) rate, the average tax rate on business investment will not change. Using this assumption, the benefit-cost analysis assesses how targeting affects the efficiency cost on investment of a given tax burden. Targeting affects efficiency through its effect on the allocation of investment. Further, not all instruments have the same impact on investment per dollar of tax revenue forgone, which also affects the efficiency cost of taxing investment. For example, an increase in the general cit rate reduces the incentive for multinational enterprises (mnes) to book profits in Canada, but not all targeted reductions result in an offsetting inflow, which reduces the social benefit from the targeted measure. Tax base shifting also affects the benefits and costs of provincial measures. A second example is that investment tax credits (itcs) apply to new investment only, so they stimulate more investment per dollar of tax revenue forgone than statutory tax rate reductions, which apply to the income generated by the existing capital stock. However, since virtually any targeted investment tax credit financed by a general rate increase will result in a net increase in investment and thereby raise efficiency, the benefit-cost analysis in this chapter abstracts from the special advantage of itcs. The analysis undertaken in this chapter suggests that few of the business tax incentives implemented by governments in Canada are successful in raising real income. The exceptions are federal and provincial policies implemented to address research and development (r & d) externalities—the transfer of knowledge from r & d performers to other firms—which are successful in raising real income. Provincial tax credits are less cost-effective than their federal counterpart because they induce interprovincial shifts in r & d spending that

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harm efficiency and because they raise administration and compliance costs per dollar of benefit claimed. Preferential income tax rates for small business may be mitigating a capital market failure, but such measures likely reduce real income for at least two reasons. First, there is evidence that average total factor productivity (tfp) is lower in small firms than in large firms, so the resource reallocation effect will be strongly negative. Second, an increase in the general tax rate gives rise to international tax base shifting out of Canada, but reducing taxes on small businesses does not create an offsetting inflow. The Canadian tax regime facilitates the deduction of interest expense associated with outbound investment both at home and in the host country. This treatment amounts to a tax preference because the active business income generated by the outbound investment is not subject to corporate income taxation in Canada. The expectation is that increased outbound investment will result in additional activity in Canada. However, the empirical evidence indicates that domestic investment increases much less than dollar-for-dollar with outbound investment, so the interest deduction for outbound investment will be less cost-effective than a general tax rate reduction. On the other hand, outbound investment may provide additional benefits through a larger volume of repatriated after-tax profits and through induced effects on the productivity of the mne’s domestic assets. The analysis undertaken in this chapter indicates that these benefits are too small to offset the disadvantage imposed by less than dollarfor-dollar complementarity between domestic and outbound investment. The federal and provincial governments provide accelerated capital cost allowances (cca) for most machinery and equipment (m & e) used in manufacturing. The measure distorts choices within m & e used in manufacturing, between assets used in manufacturing, and between manufacturing and other industries. However, a plausible, but far from airtight, case can be made that investment in m & e generates spillover benefits that could be large enough to offset the distortions caused by targeting. Many provincial governments offer either preferential tax rates or itcs for the manufacturing sector. Tax rate reductions result in a social loss in the implementing province, largely owing to tax base shifting. The targeted measure distorts the allocation of resources in the province, causing a loss of economic efficiency.1 Tax base shifting effects are, however, substantially larger. Although 1 Note that the targeted tax reduction results in a shift of manufacturing investment from other provinces, but this is offset by a shift of investment to other provinces when the general income tax rate is increased to finance the targeted reduction.

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interprovincial shifting is a benefit from the implementing province’s perspective, shifting taxable income into manufacturing from other sectors in the province represents a social cost. In addition, the assumed offsetting rise in the general provincial cit rate results in tax base shifting out of the province. itcs for manufacturing have a higher social cost than targeted tax rate reductions because they result in an additional distortion: they cause shifts among assets in the manufacturing sector by reducing the cost of short-lived assets relative to longer-lived assets.2 Governments defend providing support for specific sectors by highlighting the quality of the jobs created. This rationale implicitly rejects the idea that resources are being allocated as efficiently as possible in a market economy so that a tax-induced shift in activity could improve economic outcomes. A necessary condition for such a policy to be successful is that tfp be higher in the targeted sector than in other sectors. There is no evidence that the manufacturing sector meets this condition. Governments also defend support for specific sectors by appealing to the need to maintain competitiveness. One aspect of competitiveness is the ability to attract mobile international capital. Reducing tax rates on mobile capital can be justified on theoretical grounds, and since manufacturing is more dependent on foreign investment than other sectors, there is a plausible argument for a targeted tax reduction. However, there is not enough evidence on how investment by sector varies in response to tax rate changes to determine whether the benefit of such a measure exceeds the costs. The remainder of this chapter is organized as follows. The second section provides an overview of possible rationales for government intervention. The third section briefly describes federal and provincial tax measures implemented to promote economic development. The benefit-cost analysis of key federal and provincial measures is presented in the fourth section. The last section of the chapter contains some concluding remarks.

2. Rationales for Government Intervention Taking a benign view, governments intervene to implement the equity preferences of citizens or to improve the efficiency of free market outcomes. Market outcomes can be improved by implementing measures that address market failures that arise from externalities, asymmetric information, and imperfect 2 The intuition behind this result is that assets benefit from the incentive each time they are purchased and short-lived assets are purchased more frequently than long-lived assets.


competition. Governments may also choose to depart from uniform taxation in order to take advantage of perceived sectoral differences in the sensitivity of investment to corporate income taxation. In general, the cit system is a poor instrument for achieving equity goals, largely because the incidence of the tax in Canada is primarily on workers.3 The cit is also at a disadvantage relative to sales taxes and spending programs for correcting market failures because it is difficult to target the market failure appropriately, in part because only taxable firms are affected. Finally, the cit is a poor instrument for achieving industrial policy goals.

A. Externalities Externalities addressed through the business income tax system are confined to knowledge spillovers from r & d and on-the-job training by employers,4 although grant programs are used as well. In both cases, the knowledge created cannot be retained within the firm that incurs the cost, so the free market outcome underprovides the efficient level of r & d and training. The case for using the tax system to promote on-the-job training is weak. Only firms with tax liabilities can benefit from the subsidy, and there is no reason to suppose that only taxable firms experience externalities related to training expenditures. On the other hand, using the cit to deliver the subsidy has the advantage of keeping administration costs low. But this advantage would be retained if the subsidy were delivered as a refundable credit, which is equivalent to a spending program, and the benefit would no longer be restricted to taxable corporations. The case for delivering the subsidy for r & d undertaken by large firms as a non-refundable tax credit is more nuanced. Non-refundable tax credits reduce the incentive for mnes to shift taxable income to low-tax jurisdictions. However, since they cannot always be claimed as they are earned, non-refundable credits reduce the effective subsidy rate on r & d below its target level.

B. Asymmetric Information Asymmetric information affects almost all credit market transactions. Borrowers know more about the factors affecting the success of their investments than 3 Kenneth J. McKenzie and Ergete Ferede (2017), “Who Pays the Corporate Tax? Insights from the Literature and Evidence for Canadian Provinces,” SPP Research Papers 10(6). 4 In principle, workers should be willing to pay, directly or indirectly through lower wages, to acquire transferable skills. Their failure to do so may reflect difficulties in obtaining credit, which in turn may be caused by information asymmetries, discussed below.

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lenders and can take actions that harm the interests of lenders without the lenders’ knowledge. As a result, the competitive ideal that firms can always obtain funds at a cost that accurately reflects the degree of risk posed by their investment project is not realized. Although they are widespread, departures from the competitive ideal may be too small to justify government intervention for most firms. They may be large enough to justify helping young firms that do not have a credit history and firms dealing with complex technologies and innovative products that require specialized knowledge to assess. Governments in Canada have a wide range of programs to address capital market failures faced by small and medium-sized firms, including loan guarantee and direct lending/ investment programs, along with a special low cit rate to reduce the cost of using retained earnings to finance investment.

C. Imperfect Competition In certain circumstances, imperfectly competitive markets may also justify providing support to specific industries. For example, there is evidence of substantial and persistent inter-industry wage differentials that are difficult to explain in terms of variations in labour quality. As a result, a number of analysts have suggested that efficiency gains would be available, at least in principle, from policy-induced reallocations of labour across industries. The argument is that industry-level rents exist and that workers capture some of them.5 These rents persist because of search frictions in the labour market and different valuations of firms’ non-wage characteristics.6 In a recent contribution, Green7 tests for the existence of industry-level rents using Canadian data by comparing wages in a given sector in different cities, thereby avoiding the criticism that

5 For an early analysis, see Lawrence F. Katz and Lawrence H. Summers (1989), “Industry Rents: Evidence and Implications,” Brookings Papers on Economic Activity (1989): 209-90. More recent contributions include Philip Du Caju, François Rycx, and Ilan Tojerow (2012), “Inter-Industry Wage Differentials: How Much Does Rent Sharing Matter?” The Manchester School 79(4): 691-717 and John M. Abowd et al. (2012), “Persistent Inter-Industry Wage Differences: Rent Sharing and Opportunity Costs,” IZA Journal of Labor Economics 1(1): 1-25. 6 See David Card et al. (2016), “Firms and Labor Market Inequality: Evidence and Some Theory,” NBER Working Paper no. 22850 (Cambridge, MA: National Bureau of Economic Research). 7 David A. Green (2015), “Chasing After ‘Good Jobs.’ Do They Exist and Does It Matter If They Do?” Canadian Journal of Economics 48(4): 1215-65.


wage gaps reflect inadequate controls for differences in firm or worker characteristics. Green finds evidence that the existence of an industry that pays high wages in one city drives up the wages of other workers in that city, but does not affect wage rates in other cities. These spillover effects indicate that some of the wage gap is due to rents: if the higher wages reflected only compensating differentials or differences in worker quality, high wages in one sector would not affect wages in other sectors. The existence of industry-level rents is a necessary, but not sufficient, condition for using the cit system to pursue an “industrial policy” (that is, measures intended to alter the sectoral composition of output). To determine sufficiency, one needs to consider the possible sources of industry-level rents and the appropriate policy responses. Rents may arise owing to factors that are external to the firm. For example, inelastically supplied inputs may generate rents in the resource sector. Government regulations that reduce the amount of competition in certain industries, such as banking and telecommunications, may also be the source of industry-level rents. Targeted cit rate reductions are clearly not the appropriate policy response in these cases. What appear to be industry-level rents could also arise from factors that are internal to firms. As noted by Card et al.,8 there is widespread acceptance of the empirical finding of large and persistent productivity differentials between observably similar firms in the same industry. Card et al. directly link these productivity differences to rents. Industry-level rents could therefore be observed if the distribution of high-productivity firms varies by industry. Syverson9 identifies differences in management practices, use of information and communications technology, investment in r & d, product innovation, learning by doing, and firm structure (particularly the degree of vertical integration) as internal factors that contribute to firm-level differences in productivity. If productivity differences are firm-specific, policies to promote higher productivity would have to be firm-specific, which rules out the use of targeted cit incentives to pursue industrial policies. Support for “infant” industries is also considered part of industrial policy. The case for supporting infant industries can also be framed in terms of imperfectly competitive, or at least incomplete, markets. The simple argument for subsidizing a new industry is that, although production costs for new domestic 8 Card et al. (2016), supra note 6. 9 Chad Syverson (2011), “What Determines Productivity?” Journal of Economic Literature 49(2): 326-65.

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industries may be higher than for their foreign competitors, domestic firms will learn by doing and will eventually equal or possibly exceed the performance of foreign rivals. This version of the argument collapses under the observation that if the net present value of investment in the industry is positive (that is, if the domestic industry does have a comparative advantage), domestic firms should be able to raise the funds necessary to finance the investment in credit markets. A more nuanced version of the argument, presented in Pack and Saggi,10 is based on the idea that it may not be possible to restrict the benefits of obtaining the knowledge required for success to the firm incurring the cost. That is, informational externalities may make it impossible for investors to capture the marginal social return on their investment in learning by doing. Similarly, if an unusual amount of worker training is required for success, a free-rider problem may make it difficult for firms to recoup their investment. Non-refundable tax credits are not an ideal instrument for supporting infant industries, largely because they are unlikely to be profitable when they need support. Grants or refundable tax credits are more appropriate instruments. Governments, primarily at the provincial level, make use of targeted refundable tax credits to promote industrial policy goals. For example, the federal and provincial governments provide refundable tax credits to encourage foreign producers to shoot films and videos in Canada. The government of British Columbia notes that its film and video tax credit supports “good jobs,” but the incentives could also be seen as subsidizing a highly mobile activity, as discussed in the next section. Ontario, Quebec, and British Columbia use refundable tax credits to promote the digital media industry with the objective of creating or expanding a new high-wage industry.

D. Tax Efficiency Governments can also provide targeted support by implementing measures that reduce the distortions caused by tax policies. For example, commodity taxes will be less harmful to efficiency if they alter the level, but not the composition, of spending. This can be achieved by setting tax rates that vary inversely with the elasticity of demand for commodities. Keen11 applies this inverse-elasticity rule

10 Howard Pack and Kamal Saggi (2006), “Is There a Case for Industrial Policy? A Critical Survey,” World Bank Research Observer 21(2): 267-97. 11 Michael Keen (2001), “Preferential Regimes Can Make Tax Competition Less Harmful,” National Tax Journal 54(4): 757-62.


to corporate income taxation, as does Sørensen,12 who makes the case that the efficiency cost of a given cit rate can be minimized if industry-level tax rates are inversely related to the sensitivity of investment to the user cost of capital.13 One reason for differences in the tax sensitivity of investment is the ability to shift investment abroad, which implies that tax rates should decline as the mobility of capital increases. Sørensen’s argument is, to a certain extent, a generalization of analysis by Hong and Smart,14 who draw attention to the potential benefits of lowering the effective tax rate on mobile capital by tolerating tax base shifting by mnes. Sørensen is careful to emphasize the risks of departing from uniform cit rates. Administration and compliance costs are higher with differentiated rates, and the tax loss is likely to be higher than intended as a result of tax planning by firms. Sørensen also notes Auerbach’s finding that the efficiency gains from non-uniform cit rates are generally small.15

3. An Overview of Business Tax Incentives The federal and provincial business tax incentives intended to promote economic development are summarized in table 1, along with an estimate of the amount of tax revenue forgone. Note that refundable tax credits, which are functionally equivalent to grants and which were reclassified as program spending in 2012 following the announcement of a new Public Sector Accounting Board standard, are not included in the table. Three federal measures—the small business deduction (sbd), the regular or large-firm tax credit for sr & ed, and the apprenticeship job creation tax credit—address market failures, although this objective is not explicitly stated. All provincial governments follow the federal lead on the sbd, but only four of them provide non-refundable tax credits for r & d. No provincial governments provide non-refundable tax credits for apprenticeship programs. One federal measure, the Atlantic investment tax 12 Peter Birch Sørensen (2010), “The Theory of Optimal Taxation: New Developments and Policy Relevance,” Nationaløkonomisk Tidsskrift 148: 212-44. 13 Sørensen develops his argument in the context of optimal tax theory, but applying the inverse-elasticity rule to CIT rates optimizes the tax structure conditional on a given average tax rate. In a small open economy, the optimal CIT rate is zero. 14 Qing Hong and Michael Smart (2010), “In Praise of Tax Havens: International Tax Planning and Foreign Direct Investment,” European Economic Review 54(1): 82-95. 15 Alan J. Auerbach (1989), “The Deadweight Loss from ‘Non-Neutral’ Capital Income Taxation,” Journal of Public Economics 40(1): 10-36.

126 / John Lester Table 1 Federal and Provincial Non-Refundable Business Tax Incentives for Economic Development, 2016 Cost Federal

Provincial

Total

$ millions Measures addressing market failures Low tax rate for small businessesa . . . . . . . . . . . . . . . . . . . . . . . . . Non-refundable SR & ED investment tax creditb . . . . . . . . . . . . Apprenticeship job creation tax credit . . . . . . . . . . . . . . . . . . . . . Measures promoting regional development Atlantic investment tax credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other federal targeted incentives affecting the provincial tax basec Deductibilty of cross-border interest expensed . . . . . . . . . . . . . . Accelerated depreciation for M & E used in manufacturinge . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accelerated deductibility of some Canadian exploration expenses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Accelerated depreciation for vessels . . . . . . . . . . . . . . . . . . . . . . . Accelerated depreciation for clean energy generation . . . . . . . . Provincial targeted incentives Low tax rate for M & Pf . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Investment tax credits for M & Pg . . . . . . . . . . . . . . . . . . . . . . . . . Tax holidaysh . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Small business venture capital investments (Manitoba) . . . . . . Development of e-commerce (Quebec) . . . . . . . . . . . . . . . . . . . . Tax credit for international financial centres (Quebec and British Columbia) . . . . . . . . . . . . . . . . . . . . . . . . . . Rebates for aerospace and defence, advanced marine technology (Prince Edward Island) . . . . . . . . . . . . . . . . . . . . . . . Additional CCA for vessels and tax-free reserve (Quebec) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

na

na

Total . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

7,750

9,107

16,857

3,515 1,385 95

6,200 375

185

9,715 1,760 95 185

2,250

1,690

3,940

320

250

570

na na na

na na na

na na na

276 172 68 2 50

276 172 68 2 50

24

24

na

na

a Separate measures provided by all provinces. b Separate measures provided by British Columbia, Saskatchewan, and Ontario. Manitoba’s tax credit is 50% refundable. c Automatically affects tax revenue in all provinces except Alberta and Quebec. d Cost estimated by the author. See text for an explanation. e Illustrative estimate obtained by transforming the federal budget estimate for 2016 into a full-year effect. The provincial cost is based on the federal cost per percentage point of income tax. f Available in Saskatchewan, Ontario, and Quebec (SMEs only). g Available in Saskatchewan, Manitoba, Quebec, Prince Edward Island, and Nova Scotia. h Available in Manitoba (new mines), Quebec (M & P, wholesaling, warehousing, data processing, and hosting), Prince Edward Island (bioscience), Nova Scotia (new small business), and Newfoundland and Labrador (selected firms). Note: SR & ED = scientific research and experimental development, M & E = machinery and equipment, M & P = manufacturing and processing, CCA = capital cost allowance, SMEs = small and medium-sized enterprises.


credit (aitc), promotes regional development. There are five federal measures that affect the provincial tax bases, the largest of which is the deductibility of cross-border interest expense. Manufacturing and processing (m & p) is given preferential treatment by many provincial governments: five provide itcs and three provide a special low income tax rate. Tax holidays are available in Manitoba, Quebec, Prince Edward Island, and Newfoundland and Labrador. British Columbia, Manitoba, Quebec, and Prince Edward Island provide non-refundable tax credits targeted at specific industries and activities.

4. Benefit-Cost Analysis of Selected Tax Measures This section presents benefit-cost analyses of seven federal and provincial business tax incentives. These comprise the federal and Ontario sr & ed tax credits, the sbd, cross-border interest deductibility, federal accelerated cca for m & e used in manufacturing, and various provincial government incentives for the manufacturing sector. These economic development measures are intended to improve economic performance and are therefore evaluated on the basis of how they affect economic efficiency and hence real income. While an increase in the targeted activity is a necessary condition for success, this is not a sufficient criterion because the costs of intervention may exceed the benefits, in which case intervention causes real income to fall rather than rise.

A. The Analytical Framework An important first step in applying the benefit-cost approach is to determine the scope of the analysis required to obtain useful results. For example, assessments of options to reduce greenhouse gas emissions are usually performed using a complete model of the economy in recognition of the strong interactions between the reduction of emissions and overall economic activity. In contrast, the interaction and feedback effects of the incentives analyzed in this chapter are small enough to ignore. As a result, each benefit and cost is calculated independently and added together to obtain a net benefit. The key assumption in the benefit-cost analysis undertaken in this chapter is that the selective, or targeted, tax reductions are financed by an increase in the general cit rate, with no ex ante change in tax revenue. As a result, with two exceptions discussed below, the tax incentives do not affect the overall level of investment. In most cases, then, the cost of a targeted incentive is determined

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by the distortions it creates.16 These distortions include shifts in investment across sectors, across assets, and, in the case of provincial measures, across provincial boundaries. The efficiency cost of these reallocations is assessed using a simple version of the Harberger triangle methodology set out in the appendix. In addition, targeted incentives raise administration and compliance costs. There will be an offsetting benefit if the measure addresses a market failure. There are two circumstances in which a selective tax reduction financed by a general cit rate increase will cause the level of investment to change: 1) Measures such as itcs and accelerated cca apply only to new investment, whereas statutory rate changes apply to shareholder income generated by tangible, intangible, and net financial assets. As a result, the change in investment per dollar of tax revenue forgone is higher for itcs than for a statutory rate reduction. 2) A targeted incentive may result in more or less tax base shifting than a general cit rate change. For example, a statutory tax rate increase will cause tax base shifting out of Canada, but a reduction in the tax rate applied to small firms will not generate an offsetting inflow. As a result, the change in investment per dollar of tax revenue raised is higher for a general cit rate increase than for an increase in the small business tax rate. These differences in cost-effectiveness—the change in investment per dollar of tax revenue forgone—are modelled by making adjustments to estimates of the efficiency cost of increasing the cit rate found in the literature. This efficiency cost is often described as the marginal excess burden (meb) of taxation, and is expressed per dollar of additional tax revenue raised (as explained in box 1). An illustrative calculation suggests that the amount of investment induced by implementing an itc or its conceptual equivalent, accelerated cca, will be at least 1.7 times greater than the investment stimulated by a reduction in the cit rate that has the same direct impact on tax revenue. (See the appendix for details.) Assuming that the change in efficiency is proportional to the change in investment, the efficiency gain from an itc or accelerated cca would also be at least 1.7 times higher.

16 Note, however, that changes in the statutory rate of CIT do not have the same effect on all assets. The gap between economic and tax depreciation allowances varies across assets, so a change in the tax rate has a variable impact on tax liabilities by asset.

Business Tax Incentives for Economic Development: Do They Work? / 129 Box 1: Estimates of the Marginal Excess Burden of Taxation Baylor and Beauséjour17 use a general equilibrium model of the Canadian economy based on 1997 data to develop estimates of the meb of various taxes. Dahlby and Ferede18 develop conceptually similar estimates for major taxes in Canada using revenue shares and the semi-elasticity of the tax base with respect to changes in tax rates. The tax base semi-elasticities are estimated using provincial panel data over the 1972 to 2006 period, but can be used for federal taxes as well.19 The average meb from the two studies for the major taxes is 26 cents per dollar of revenue raised, and the average for the cit is 41 cents per dollar of revenue raised. In contrast to the estimates prepared by Baylor and Beauséjour, the estimate for corporate income taxes developed by Dahlby and Ferede includes the impact of international profit shifting in response to tax rate differentials.

The efficiency cost of corporate income taxation includes, at least partially, the impact of a statutory rate increase on the international allocation of the taxable income of mnes. A tax rate increase in Canada creates an incentive for mnes to shift profits out of Canada. This revenue loss causes the decline in investment per dollar of tax revenue gained to increase, which raises the meb of taxation. The impact is substantial. In a meta-analysis of existing empirical work on international profit shifting, Heckemeyer and Overesch20 develop a “consensus” prediction that a 1 percentage point reduction in the cit rate increases reported profits of mnes by 0.8 percent. This estimate implies that if the statutory cit rate is increased by 1 percentage point, the net revenue gain from mnes can be calculated as the “static” increase (1 percent of their taxable income) less about one-fifth to account for tax base shifting effects.21 The meb 17 Max Baylor and Louis Beauséjour (2004), “Taxation and Economic Efficiency: Results from a Canadian CGE Model,” Department of Finance Working Paper 2004-10 (Ottawa: Department of Finance). 18 Bev Dahlby and Ergete Ferede (2012), “The Effects of Tax Rate Changes on Tax Bases and the Marginal Cost of Public Funds for Canadian Provincial Governments,” International Tax and Public Finance 19(6): 844-83. 19 The calculations are presented in Bev Dahlby (2012), “Reforming the Tax Mix in Canada,” SPP Research Papers 5(14). 20 Jost Heckemeyer and Michael Overesch (2013), “Multinationals’ Profit Response to Tax Differentials: Effect Size and Shifting Channels,” Centre for European Economic Research (ZEW) Discussion Paper no. 13-045 (Mannheim: Centre for European Economic Research [ZEW]). 21 The loss in tax revenue from profit shifting is calculated as Dt ⋅ θ ⋅TB ⋅ t and the direct tax revenue loss is given by Dt ⋅TB, where t is the tax rate, θ is the tax base semi-elasticity, and TB is the tax base. The overall revenue loss is therefore Dt ⋅TB ⋅ (1 + θ ⋅ t), which amounts to a 21 percent gross-up when t = 0.263.

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of a tax that affects firms able to undertake tax base shifting will therefore be higher than a tax on firms that cannot undertake such shifting. As noted above, the financing assumption used in this study leaves the average tax rate on investment unchanged. Alternative financing assumptions result in a lower average tax rate on business investment. Assuming that a targeted investment incentive is financed by higher value-added or personal income taxes therefore involves changing both the level and structure of corporate income taxation, while the financing assumption used in this chapter changes only the structure. Since the cit hurts efficiency more than the other major taxes, alternative financing assumptions would make it much more likely that a targeted investment incentive would pass a benefit-cost test, despite the distortions it creates. A similar point can be made about comparing the efficiency effects of itcs and statutory tax rate changes. Because of its greater cost-effectiveness, implementing virtually any targeted itc and financing it with a higher cit rate will result in a net increase in investment, which will have a favourable impact on efficiency. As a result, the decision to provide support to a specific sector or activity should be based on other considerations, such as addressing a market failure. That is, targeted initiatives should not be considered good public policy simply because a particular instrument is used to deliver the assistance. In most cases, the benefit-cost analysis is performed per dollar of tax revenue forgone instead of in levels. This approach reduces the amount of information required to evaluate the tax incentives. In particular, the fact that official cost estimates are not available for all measures becomes a less important consideration. Similarly, this approach lessens the need to consider the taxpaying status of firms, since the efficiency effects and the tax revenue forgone change by approximately the same percentage in response to small changes in the effective subsidy rate. The exceptions are the analyses of the federal and Ontario r & d tax incentives. Detailed information on these programs is available, including estimates of how the taxpaying status of program participants affects the amount of tax revenue forgone. The benefit-cost analyses undertaken in this chapter should be considered more illustrative than definitive, largely owing to data limitations. There is not always enough information on price elasticities available to determine how the subsidy affects spending on the targeted activity. The estimates of r & d spillovers for Canada are dated and there is almost no information on the costs of capital market failures. Finally, it is usually not possible to take into account differences in the timing of benefits and costs.


B. The SR & ED Investment Tax Credit The federal government and all provincial governments except Prince Edward Island provide tax credits to address an externality created by knowledge spillovers from firms performing r & d to other firms. At the federal level, publicly listed firms are eligible for a 15 percent non-refundable federal tax credit on current expenditures on r & d.22 Adjusted for eligible spending and for delays in claiming the credit, the effective subsidy rate is 11.7 percent. The federal regular or large-firm sr & ed tax credit cost about $1.4 billion in 2016, while provincial non-refundable credits for large firms in British Columbia, Saskatchewan, and Ontario, along with a partially refundable credit in Manitoba, cost approximately $375 million. This section presents benefit-cost analyses of the federal and Ontario r & d tax credits for large firms. The results for the federal credit are presented in table 2. r & d tax credits are implemented to address an externality. r & d performers cannot appropriate all the knowledge they create; as it leaks out to other firms, they are able to use the knowledge to create new products and reduce production costs. This gives rise to a positive external return to r & d. On the other hand, the introduction of new products and processes destroys rents of incumbent firms. These rents are valuable to society and their loss represents a social cost. The spillover rate shown in table 2 is an estimate of the net effect of these two elements. r & d subsidies alter the choice of production inputs. Since by assumption resources are being used as efficiently as possible in the rest of the economy, economic efficiency will suffer. This negative resource allocation effect reduces the net benefit by about $80 million, or almost 6 cents per dollar of tax revenue forgone. The extra resources required to administer and comply with the conditions for claiming the credit also represent a social cost. The program easily passes a benefit-cost test, generating a net social benefit of approximately $260 million, or just under 19 percent of program costs. The finding of a net social benefit is robust. Two key parameters in the framework are the spillover benefit and the price elasticity of demand. These parameters can be cut almost in half at the same time without pushing the net benefit into negative territory.

22 Prior to 2014, the credit rate was 20 percent and M & E used to perform R & D was eligible for the credit.

132 / John Lester Table 2 Benefit-Cost Analysis of the Federal Large Firm SR & ED Tax Credit $ millions Tax revenue forgone, 2016 . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Effective subsidy ratea . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Price elasticity of demand for R & D . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . R & D induced by the credit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Spillover rate (% of induced R & D) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Benefits Spillover benefit to society . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Costs Resource reallocation effect . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Fixed administration and compliance costsb . . . . . . . . . . . . . . . . . . . . . . Net benefit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Percentage of tax revenue forgone . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

percent

1,385 11.7 −0.7 883 44.0 391 −79 −54 258 18.6

a The statutory rate is 15%, but not all R & D spending is eligible for the credit and the credit cannot always be claimed as it is earned. b Variable expenses are captured in the spillover benefit and the resource reallocation effect. Note: SR & ED = scientific research and experimental development, R & D = research and development.

The sr & ed tax credit, like other itcs, applies to new investment only, making it a more cost-effective way of stimulating investment than a cit rate reduction. Financing the sr & ed tax credit with a statutory rate increase therefore reduces the efficiency cost of taxation, which would raise the net social benefit substantially. As discussed earlier, this generic advantage of itcs is not included in the benefit-cost analysis because it would allow any itc to pass a benefit-cost test, even in the absence of a market failure. The benefit-cost analysis summarized in table 2 implicitly assumes that the sr & ed tax incentive and the increase in the general cit rate used to finance it have approximately offsetting impacts on investment with no ex ante change in the amount of cit revenue collected. As a result, the net social benefit is determined by spillover benefits, the efficiency cost of tax-distorted input choices, and higher administration and compliance costs.

C. The Ontario Research and Development Tax Credit (ORDTC) Ontario provides large firms with a 3.5 percent non-refundable tax credit for r & d performed in Ontario. Aside from the rate, the Ontario program parameters are the same as those of the federal program. Adjusted for ineligible


spending and delays in claiming the benefit, the effective rate is 2.7 percent. The Ontario benefit is deducted from the base for the federal credit, which causes the marginal effective rate to decline to 2.4 percent. The benefits and costs of the Ontario and federal programs have to be calculated differently for two reasons. First, the provincial program is in large measure a “top-up” of federal benefits, so the marginal costs of administering and complying with the ordtc are a small fraction of the costs associated with the federal credit.23 Second, the Ontario economy is more “open” than the national economy. The adjustments made to capture the greater openness of Ontario’s economy are: • Higher responsiveness of r & d spending to the price reduction caused by the credit. Price responsiveness in Ontario is increased 25 percent relative to the national value, reflecting interprovincial shifting of r & d spending. This raises the subsidy-rate-weighted price elasticity to −0.73. • Lower spillovers. The spillover rate on the r & d induced by the Ontario credit is set at 45 percent of the national rate, which is equal to Ontario’s 45 percent share of national r & d. As can be seen in table 3, there is a small positive marginal impact of the Ontario credit on the real income of Ontario residents.24 The marginal spillover benefit is positive because the higher subsidy rate and higher price elasticity of demand for r & d offset the downward adjustment to the spillover rate in Ontario. The higher spillover benefit offsets the higher costs arising from resource allocation effects and administration and compliance costs. These results are robust. The Ontario spillover rate can be cut by one-third and the increase in the investment elasticity (relative to the national value) can be cut in half at the same time without causing the net benefit to become negative. Expressed per dollar of Ontario tax revenue forgone, the marginal impact of the ordtc is about one-third as large as the federal program in Ontario.

23 More precisely, it is assumed that per firm administration and compliance costs of the Ontario program are 25 percent of the federal costs. 24 The benefit-cost analysis does not include the efficiency losses resulting from interprovincial shifts in investment induced by the R & D tax credit and the increase in the statutory income tax rate used to finance it. The tax rate changes are small, so the induced effects on efficiency will be small as well.

134 / John Lester Table 3 Net Benefit to Ontario Residents from the Federal and Provincial Large Firm R & D Tax Credits Marginal impact Federal program Federal plus of the Ontario in Ontario Ontario programs program $ millions, except as noted Tax revenue forgone . . . . . . . . . . . . . . . . . . . . . Effective subsidy rate (%)a . . . . . . . . . . . . . . . Price elasticity of demandb . . . . . . . . . . . . . . . Spillover rate (% of induced R & D)c . . . . . . . Benefits Spillover . . . . . . . . . . . . . . . . . . . . . . . . . . . . Costs Resource allocation effect . . . . . . . . . . . . Administration and compliance . . . . . . . . Net benefit Percentage of tax revenue forgone . . . . .

686 11.7 −0.70 44.2

826 14.1 −0.73 40.5

140 2.4 −0.03 −3.7

193.5

218.3

24.7

−38.9 −26.3 128.2 18.7

−50.2 −32.1 135.9 16.4

−11.3 −5.8 7.7 5.5

a The federal and Ontario statutory rates are 15% and 3.5%, respectively, but not all R & D spending is eligible for the credit and the credit cannot always be claimed as it is earned. In addition, the base for the federal credit is reduced by the Ontario credit. b The price elasticity of demand is assumed to be −0.7 for the federal program and −0.88 for the Ontario program. c Interprovincial leakages are assumed to reduce spillovers from the Ontario program to 45% of spillovers from the federal program.

Evaluated from a national perspective, the net social benefit of the ordtc rises to about $19 million, or 13.6 percent of Ontario tax revenue forgone, because the additional benefit from higher spillovers offsets the loss from a lower response of (national) r & d to the credit.

D. The Small Business Deduction The sbd provides a reduced cit rate for small and medium-sized enterprises (smes) that finance capacity-expanding investment with retained earnings. The special low rate is available on up to $500,000 of active business income earned by Canadian-controlled private corporations with less than $10 million in assets. The tax benefit is phased out as assets rise from $10 million to $15 million. The federal small business tax advantage was 4 percentage points from 2012 to 2015 and was increased to 4.5 percentage points in 2016. All provinces provide a similar measure. In 2016, the provincial small business tax advantage ranged from 3.9 to 13 percentage points, with a gross domestic product (gdp)-weighted average of 7.1 percentage points. The combined federal-provincial small business


tax advantage was 11.6 percentage points, which reduced the user cost of capital for small firms by 2.5 percent in 2016. The reported cost of the federal sbd was $3.5 billion in 2016. The cost of the provincial measures was estimated at $6.2 billion.25 As discussed by Lester,26 the reported revenues forgone are overstated because the sbd reduces taxes on retained earnings used for business expansion but the taxes paid on these retained earnings when they are eventually distributed are not deducted from the cost estimate. The sbd is therefore more like a tax deferral than a tax reduction, which suggests that the net cost is likely to be substantially less than the gross fiscal cost, although there is not enough information available to make a precise estimate of the net cost. The implicit objective of the sbd is to address a capital market failure causing smes to have inadequate access to financing for startup and expansion.27 There is general agreement that the market for small business financing does not conform to the competitive model in which funds can always be accessed at a cost that accurately reflects the risk of the investment. The main source of this imperfection is the difficulty lenders and investors have assessing the quality of projects and entrepreneurs. As a result, the departure from the competitive ideal increases with the technological sophistication of investment projects. The departure is also more pronounced for startups than for established firms with a credit history. The social benefit per dollar of tax revenue forgone is therefore likely to be much smaller for broad-based measures such as the sbd than for targeted measures such as the federal loan guarantee program. Further, there is some evidence that small firms are less productive than larger firms, so broad-based measures could hurt overall efficiency by encouraging small-scale production. A static benefit-cost analysis of the sbd is presented in table 4. The social benefit from correcting the capital market failure is assumed to equal the decline in marginal production costs arising from the tax reduction. In other words, I assume that the sbd narrows the gap between the private and social benefit of

25 This estimate was developed by multiplying the amount of federal tax revenue forgone by the ratio of the weighted average provincial tax rate advantage (7.1 percentage points) to its federal counterpart (4 percentage points). 26 John Lester (2017), “Policy Interventions Favouring Small Business: Rationales, Results and Recommendations,” SPP Research Papers 10(11), p. 55. 27 The preferential rate “allows small businesses to retain more of their earnings to reinvest.” Canada, Department of Finance (2016), Report on Federal Tax Expenditures: Concepts, Estimates and Evaluations 2016 (Ottawa: Department of Finance), p. 222.

136 / John Lester Table 4 Illustrative Static Benefit-Cost Analysis of the Small Business Deduction % of the net fiscal cost of the program Social benefits Mitigate capital market failure . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Tax reduction for small business . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Subtotal: benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Social costs Tax increase for large businesses . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Higher administration and compliance . . . . . . . . . . . . . . . . . . . . . . . . . . . Net social benefit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Other elements not quantified Mitigated effect of imperfect loss offsetting . . . . . . . . . . . . . . . . . . . . . . Increased tax evasion . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Threshold effects on investment . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

0.7 33.3 34.0 −42.9 −1.0 −9.9 + − −

finance, which improves economic efficiency. Using the simple version of the Harberger triangle formula shown in equation 5 of the appendix, this benefit is estimated to be 0.7 percent of the tax revenue forgone. In this benefit-cost analysis, adapted from Dachis and Lester,28 it is assumed that the small business tax reduction is financed by an increase in the tax rate on other corporations, leaving the average tax rate on business investment unchanged. The decrease in the relative cit rate in the small business sector causes a reallocation of capital and labour from the large to the small business sector. There will be a social benefit from the tax reduction on small business and a social cost from the increase in tax on other firms. The relative size of these impacts is determined by the relative tfp in the two sectors and by differences in international tax base shifting resulting from tax rate changes. There is some evidence that tfp increases with firm size. Lee and Tang29 compare tfp in Canadian and us manufacturing over the 1985 to 1995 period and find that larger firms are about 15 percent more productive than firms with fewer than 100 employees. Leung, Meh, and Terajima30 analyze tfp by firm 28 Benjamin Dachis and John Lester (2015), “Small Business Preferences as a Barrier to Growth: Not So Tall After All,” C.D. Howe Institute Commentary no. 426 (Toronto: C.D. Howe Institute). 29 Frank C. Lee and Jianmin Tang (2001), “Multifactor Productivity Disparity Between Canadian and US Manufacturing Firms,” Journal of Productivity Analysis 15(2): 115-28. 30 Danny Leung, Césaire Meh, and Yaz Terajima (2008), “Firm Size and Productivity,” Bank of Canada Working Paper 2008-45 (Ottawa: Bank of Canada).


size for all Canadian industries over the 1984 to 1997 period. In their study, tfp in firms with more than 100 employees is 8.4 percent higher than in other firms over the entire period.31 How a tax-induced expansion of the small business sector affects its productivity depends on the source of the productivity gap. If the gap were caused completely by capital market imperfections, a tax preference would narrow the productivity differential. But a variety of factors contribute to the lower productivity of small firms, including all those presented above under the heading “Imperfect Competition,” plus economies of scale and differences in agglomeration economies. These negative factors would persist in a tax-induced increase in small business investment. Assuming that the efficiency cost of taxation is proportional to the productivity of investment, the meb of taxation will be lower for measures affecting small firms than for measures affecting large firms. I use the estimate of the productivity gap from Leung, Meh, and Terajima in the benefit-cost analysis, which suggests that the meb of taxation would be 8.4 percent higher for large firms than for small firms. This estimate relates to average productivity; the impact of marginal changes in the size distribution of firms may be different. Few small firms will be able to shift profits from foreign affiliates in response to tax rate changes in Canada, so the meb will be lower for small firms than for larger firms.32 Considering both the tfp and tax base shifting adjustments, the mebs for small and large businesses are 33.3 and 42.9 cents per dollar of cit revenue raised, respectively. A decrease in the small business tax rate financed by an increase in the large business tax rate therefore reduces real income by approximately 10 cents per dollar of tax revenue forgone. Table 4 also includes an illustrative estimate of the additional administration and compliance costs resulting from the sbd. Plamondon and Zussman33 estimated the compliance costs of the cit system to be 2 to 4 percent of revenue raised in 1995. Vaillancourt, Roy-César, and Barros34 report that the cost of 31 Despite the extensive literature on firm-level differences in TFP, the sources of TFP differences by size of firm have not been analyzed. Differences in labour quality could be a contributing factor. 32 Tax base shifting raises the MEB of taxation for large firms relative to small firms by about one-fifth. See supra note 21. 33 Robert E. Plamondon and David Zussman (1998), “The Compliance Costs of Canada’s Major Tax Systems and the Impact of Single Administration,” Canadian Tax Journal 46(4): 761-85. 34 François Vaillancourt, Édison Roy-César, and Maria Silvia Barros (2013), The Compliance and Administrative Costs of Taxation in Canada (Vancouver: Fraser Institute).

138 / John Lester

complying with and administering all taxes in Canada amounted to 4 to 5 percent of total tax revenue in 2007. If the cost for the cit is similar to the overall average, and if complying with and administering targeted measures adds 20 percent to these costs, the additional cost would be about 1 cent per dollar of tax revenue forgone. The total social cost of the sbd is about 11 cents per dollar of tax revenue forgone; the benefit of mitigating the capital market failure reduces the net social loss to about 10 cents per dollar. The existence of international profit shifting and a productivity gap between small and large firms are driving this result. While there is considerable uncertainty about the precise values of these parameters, their role is not much in doubt: international profit shifting means that the increase in the statutory rate required to finance the sbd is higher than it would be otherwise, which increases the decline in investment and hence raises the efficiency cost of taxing larger firms. It also appears highly likely that small firms are less productive than larger firms, although even if productivity levels are the same, there would still be a net loss from the sbd. In addition, two non-quantified elements of the benefit-cost analysis would increase the net social loss of the small business deduction, as discussed below. There is evidence that the self-employed are less inclined to comply with the tax code. Bruce and Schuetze35 report an estimate that the self-employed in Canada underreported income by 18 percent in 1990. The self-employed are broadly defined to include owners of unincorporated and incorporated businesses, and the underreporting rate may not be the same for both categories of the self-employed. Nevertheless, subsidizing entry into small business is highly likely to result in additional tax evasion and this additional revenue loss has to be financed by higher taxes or lower spending, both of which will harm economic performance. The possibility that a two-tier rate could affect firm size by raising the cost of capital as firms grow is often raised as a further cost of a preferential small business tax rate. However, as discussed by Dachis and Lester,36 in most cases the benefits from growth will exceed the cost of losing the small business tax preference, so most firms will jump over the barrier.

35 Donald Bruce and Herbert J. Schuetze (2004), “Tax Policy and Entrepreneurship,” Swedish Economic Policy Review 2(11): 233-65. 36 Dachis and Lester (2015), supra note 28.


Boadway and Tremblay37 raise the possibility of a missing benefit. Their argument is that imperfect loss offsetting is particularly harmful to smaller firms because they have a higher failure rate than larger firms. Small firms therefore face a higher effective tax rate than larger firms, which is reduced by the sbd. An offsetting consideration is that owing to the integration of the personal and corporate income tax systems, the benefit from the sbd is partially or completely lost when business income is distributed by firms in the form of dividends or wages. As a result, owners of small firms cannot retain the entire benefit of the special low tax rate, which reduces its value as a counterweight to the impact of imperfect loss offsetting on effective rates.

E. Deductibility of Cross-Border Interest Expense 38 Canada’s tax treatment of interest expense on debt incurred to finance expansion in other countries is highly favourable. Canadian-controlled mnes are allowed to deduct from domestic income interest expenses on debt issued to finance a foreign affiliate without being required to include the income earned by the affiliate in their Canadian taxable income.39 Further, firms are permitted to use special financing structures that allow some or all of the investment in the foreign affiliate to be characterized as debt. Finally, interest income received from the foreign affiliate can be shifted to a third country where it is taxed at a lower rate (possibly zero) than in Canada or the host country. The end result is that it is possible to obtain two interest expense deductions for debt incurred to finance outbound investment, one in Canada and one in the host country, without the benefit being eroded by the taxation of interest income flows that were created in order to take advantage of the extra deduction. I estimate that the extra interest deduction reduces the user cost of outbound investment by 4.1 percent for taxable firms. There is no official estimate of the tax revenue forgone as a result of the favourable tax treatment of debt-financed outbound investment. An illustrative calculation suggests, however, that the revenue loss could be substantial. If all

37 Robin Boadway and Jean-François Tremblay (2016), “Modernizing Business Taxation,” C.D. Howe Institute Commentary no. 452 (Toronto: C.D. Howe Institute). 38 The analysis in this section benefited greatly from discussions with Michael Smart. 39 Dividends paid by the foreign affiliate that arise from active business income are not subject to tax in Canada, provided that Canada has a tax treaty with the host country. The net income earned by the affiliate is subject to tax in the host country.

140 / John Lester

Canadian-controlled mnes took advantage of the extra interest deduction on outbound investment, and if this investment was financed at their average domestic debt-asset ratio, the amount of tax revenue forgone could have amounted to about $2.3 billion for the federal government and $1.7 billion for provincial governments in 2016. The benefit-cost analysis is summarized in table 5. A key potential benefit of the favourable tax treatment of debt-financed outbound investment is an induced increase in domestic investment. However, the impact on domestic investment could, in principle, be either positive or negative. Outbound investment has two main motivations: to improve market access by establishing foreign affiliates using the home technology (horizontal investment) and to reduce costs by separating the production process between the home and host countries (vertical investment, or outsourcing).40 If horizontal investment succeeds in expanding the market, the impact on domestic investment could be positive, particularly if more resources are devoted to “head office” functions and if the home country supplies other goods and services to foreign affiliates. In the case of vertical investment, the direct impact on home activity is negative. The direct impact of shifting activity abroad could, however, be offset by the increased scale of operations made possible by lower costs. On the other hand, the direct effect on firms supplying mnes in the home market will be negative, although a positive impact is possible if the scale effects on the mne are strong enough. The empirical literature on the relationship between outbound and domestic investment has shown mixed results, with some authors finding a mild substitute relationship and others complementarity.41 The range of estimates reflects, at least in part, variations in the scope of the analysis.42 For example, studies examining the behaviour of only mnes will not capture the negative impact of outsourcing on other domestic firms. Further, many industry-level studies consider outsourcing only, where substitution effects are strongest. Different techniques for addressing the econometric problems caused by the fact that

40 Other reasons for outbound FDI are to gain access to natural resources and to advanced technology. 41 For a brief summary of the literature up to 2009, see Mihir A. Desai, C. Fritz Foley, and James R. Hines (2009), “Domestic Effects of the Foreign Activities of US Multinationals,” American Economic Journal: Economic Policy 1(1): 181-203. 42 For a discussion, see Özlem Onaran, Engelbert Stockhammer, and Klara Zwickl (2013), “FDI and Domestic Investment in Germany: Crowding in or Out?” International Review of Applied Economics 27(4): 429-48.

Business Tax Incentives for Economic Development: Do They Work? / 141 Table 5 Benefit-Cost Analysis of Cross-Border Interest Deductibility, 2015 per $ of tax revenue forgone Benefits Induced effects on domestic investment . . . . . . . . . . . . . . . . . . . . . . . . . Repatriated after-tax profits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Increased productivity of MNE’s domestic assets . . . . . . . . . . . . . . . . . . Productivity spillovers on non-MNEs . . . . . . . . . . . . . . . . . . . . . . . . . . . .

0.151 −0.001 0.010 0.003

Subtotal: benefits . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Costs Cost of financing with a general corporate tax rate increase . . . . . . . . Substitution between domestic and foreign assets . . . . . . . . . . . . . . . .

0.163 −0.410 −0.012

Net social benefit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

−0.259

Note: MNE = multinational enterprise.

outbound and domestic investment are jointly determined may also play a role in the diversity of the results. Hejazi and Pauly43 examine the impact of Canadian outbound investment on overall business investment. The innovation in their study is the classification of outbound investment into host countries in which substitution or complementarity effects are likely to dominate. A weakness of the study is the absence of a correction for the simultaneity between outbound and domestic investment, which may be causing a downward bias in the estimated coefficient on outbound investment.44 I calculated a weighted average “complementarity index” of 0.31 using their empirical estimates and recent outbound investment shares. In other words, each dollar of increased outbound investment raises domestic investment by 31 cents. No other study provides such directly relevant results. The closest is a paper by Desai, Foley, and Hines,45 who use us manufacturing firm-level data over the 1982 to 2004 period to investigate the relationship between outbound and domestic investment by multinational firms. The authors circumvent the econometric problems caused by simultaneity between domestic and outbound

43 Walid Hejazi and Peter Pauly (2003), “Motivations for FDI and Domestic Capital Formation,” Journal of International Business Studies 34(3): 282-89. 44 For a discussion, see Brian Kovak, Lindsey Oldenski, and Nicholas Sly (2015), “The Labor Market Effects of Offshoring by US Multinational Firms: Evidence from Changes in Global Tax Policies” Working Paper (www.contrib.andrew.cmu.edu/~bkovak/Kovak_Oldenski_Sly .pdf ). 45 Desai, Foley, and Hines (2009), supra note 41.

142 / John Lester

investment by using gdp growth rates in host countries as an exogenous source of variation in outbound investment. The estimated elasticity implies that each dollar of outbound investment raises domestic investment of mnes by 54 cents. This estimate does not capture the impact of outbound investment on nonmnes, so it may overstate the impact on overall business investment. The average value of the complementarity index developed from the two studies is 0.42. Given an meb of corporate taxation for large firms of 41 cents per dollar of revenue raised, the social benefit of cutting taxes on outbound investment, taking into consideration only its impact on domestic investment, would be about 17 cents per dollar of tax revenue forgone. However, as discussed in the context of the sbd, the meb includes the impact of international tax base shifting, which will not occur with an extra deduction for interest expenses related to outbound investment. Making this adjustment reduces the efficiency gain to 15 cents per dollar of tax revenue forgone, as shown in table 5. Another benefit from outbound investment that is recognized in the literature is the increase in profits of the foreign affiliate, net of host-country taxes.46 However, if national savings are (to a close approximation) fixed, this approach overstates the benefit from profits earned on outbound investment. With fixed national savings, increased outbound investment reduces national income by the taxes imposed by the host country on the return to capital. In a small open economy, the outflow of national savings will be replaced by an inflow of foreign savings and national income will rise by the amount of revenue realized from taxing the return to that capital. If all capital earns the same rate of return, the impact on national income depends on the gap between income tax rates in Canada and abroad. In 2016, the weighted average tax rate on income earned by Canadian foreign affiliates was just over 28 percent, compared to a 26.3 percent cit rate in Canada.47 As a result, subsidizing outbound investment has a small negative impact on national income through its impact on profits accruing to Canadians (see table 5). This result is heavily influenced by the United States, which accounted for about 55 percent of the stock of outbound investment and which imposes a cit rate of 39 percent. 46 See, for example, Martin Feldstein and David Hartman (1979), “The Optimal Taxation of Foreign Source Investment Income,” Quarterly Journal of Economics 93(4): 613-29. 47 This estimate was obtained using information on the overseas assets of Canadian majorityowned foreign affiliates (MOFA) by country reported in Statistics Canada CANSIM table 376-0065. An asset-weighted average CIT rate was calculated for the top 17 countries accounting for 90 percent of assets controlled by foreign affiliates.


Two other benefits from subsidizing outbound investment are discussed in the literature. First, outbound foreign direct investment (fdi) may raise the productivity of the investing firm’s domestic assets through access to foreign technology and the creation of economies of scale. Second, a larger mne sector could also have favourable effects on the productivity of non-mnes, particularly the suppliers and customers of mnes, through the transfer of knowledge obtained in the host country. There are a substantial number of empirical studies of how outbound investment affects the productivity of mnes’ domestic assets, other firms, and the overall economy. In a 2012 summary of the empirical literature, Herzer 48 noted findings of both positive and negative effects of outbound investment on mnes and other firms, with the impacts varying substantially by country. In his own analysis, Herzer assesses the impact of outbound fdi on aggregate business sector output using data for Germany over the 1980 to 2008 period. Estimating a Cobb-Douglas production function, he obtains a coefficient of 0.03 on the stock of outbound fdi, which can be interpreted as the elasticity of tfp with respect to outbound fdi, working through impacts on mnes and non-mnes. Herzer also calculates tfp from the regression equation and obtains the same elasticity when he relates tfp directly to outbound fdi. In order to illustrate the potential benefit from outbound investment on domestic productivity, I use Herzer’s results in the benefit-cost analysis, but it is worth emphasizing that the empirical results are mixed. In using Herzer’s results, I assume that the estimated elasticity applies to both the productivity of domestic assets of mnes and the productivity of non-mnes. Table 5 shows that each dollar of tax revenue forgone results in a 1 cent increase in the productivity of the domestic assets of mnes. The impact on the productivity of other firms is much smaller because these spillovers are affected by the complementarity between outbound and domestic investment by mnes. The total spillover benefits from subsidizing outbound investment amount to about 1.5 cents per dollar of tax revenue forgone. The most important social cost of subsidizing outbound investment is the loss in efficiency from raising taxes to finance the subsidy. Since the allocation of mne investment between domestic and foreign locations is assumed to be optimized prior to the tax change, there is another social cost created by the relative-price induced shift from domestic to outbound investment. The impact 48 Dierk Herzer (2012), “Outward FDI, Total Factor Productivity and Domestic Output: Evidence from Germany,” International Economic Journal 26(1): 155-74.

144 / John Lester

of this substitution effect, shown in table 5, is calculated using equation 5 in the appendix. Including these two costs, cross-border interest deductibility causes a net social loss of about 26 cents per dollar of tax revenue forgone. There are other costs associated with the preferential treatment of cross-border interest. For example, the government incurs administration expenses to enforce the foreign affiliate dumping rules announced in 2012. mnes also incur expenses to take advantage of “double-dip” financing structures and to avoid the taxation of interest income received from foreign affiliates. These costs have not been quantified. The current policy regime is motivated by competitiveness concerns. Replacing cross-border interest deductibility with a lower general cit rate would increase the tax burden on domestic multinationals. Outbound investment accounts for about 15 percent of the total assets of Canadian-controlled mnes, so the 4.1 percent subsidy on outbound investment reduces the overall cost of capital for taxable mnes by about 0.6 percent. I estimate that Canadian- controlled mnes account for about 35 percent of the domestic capital stock; a revenue-neutral reduction in the general cit rate would therefore reduce the user cost of capital for all firms by about 0.2 percent. The recommended policy change would result in a slightly smaller Canadian-controlled mne sector that would invest more at home than abroad than under the current tax regime. The benefit-cost analysis makes it clear that the benefits of improving the competitiveness of Canada’s mnes are not substantial enough to offset the disadvantages of targeting outbound investment instead of the overall tax burden on business investment. The key disadvantage is a relatively weak connection between outbound and domestic investment. The ancillary benefits of the policy are about the same absolute size as the cost of distorting the choice between domestic and outbound investment. As a result, outbound investment would have to raise domestic investment approximately dollar-for-dollar for the policy to generate a net social benefit.

F. Federal Accelerated Depreciation for Machinery and Equipment Used in Manufacturing The federal government has a long history of providing preferential tax treatment to the manufacturing and processing industries. As of 2016, the cca rate on m & e assets (50 percent on a declining-balance basis) is 20 percentage points higher than the standard rate for m & e assets. The assets eligible for the accelerated


rate exclude most computer-related equipment, which accounts for about 10 percent of the total m & e used in manufacturing, and not all other industrial machinery is eligible for the accelerated rate. Overall, I estimate that about two-thirds of m & e used in manufacturing benefits from accelerated cca. Since the accelerated cca applies to only about two-thirds of m & e assets used in manufacturing, it causes three types of distortion: it affects asset use within m & e used in manufacturing, between m & e and other assets used in manufacturing, and between manufacturing and other industries. Model-based analyses of inter-asset distortions have typically assumed a base-case elasticity of substitution of 1,49 with sensitivity tests covering a range from 0.15 to 2. Assuming a ces (constant elasticity of substitution) production function, an elasticity of substitution of 1 implies a price elasticity of demand of −1.50 The efficiency loss arising from the three distortions, calculated using equation 6 in the appendix, is about 3 cents per dollar of tax revenue forgone (see table 6). How robust is this estimate? Since a targeted incentive that changes behaviour will always cause distortions, the interest is in assessing whether the distortions have been understated. Increasing the elasticity of substitution to 2, which is at the high end of the range of estimates used in the literature, raises the efficiency cost to about 5 cents per dollar of tax revenue forgone. Accelerated depreciation is conceptually equivalent to an itc—both measures effectively reduce the acquisition price of capital goods. As discussed earlier, these measures have higher cost-effectiveness ratios, so implementing accelerated cca and recovering the revenue loss with a higher general cit rate will result in a net increase in investment, which in turn implies a larger social benefit. This generic advantage of itcs is not included in the benefit-cost analysis because it would allow any itc to pass a benefit-cost test, even in the absence of a market failure. There are a number of elements missing from the above analysis. First, since accelerated cca (and itcs) apply only to new capital, their implementation 49 See, for example, Auerbach (1989), supra note 15; Bob Hamilton, Jack Mintz, and John Whalley (1991), “Decomposing the Welfare Costs of Capital Tax Distortions: The Importance of Risk Assumptions,” NBER Working Paper no. 3628 (Cambridge, MA: National Bureau of Economic Research); and David Joulfaian and James Mackie (1992), “Sales Taxes, Investment, and the Tax Reform Act of 1986,” National Tax Journal 45(1): 89-105. 50 The formula for the price elasticity is −σ + (σ − 1)Ei , where σ is the elasticity of substitution and Ei is the relevant expenditure share. M & E and software account for 73.4 percent of assets used in manufacturing.

146 / John Lester Table 6 Benefits and Costs of Accelerated CCA for M & E Assets Used in Manufacturing per $ of tax revenue forgone Parameters Reduction in the user cost of capital . . . . . . . . . . . . . . . . . . . Eligible assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . All M & E . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . All assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Marginal excess burden of corporate income taxation . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Adjusted for international tax base shifting . . . . . . . . . Adjusted for higher relative cost-effectiveness . . . . . . . Investment demand elasticity . . . . . . . . . . . . . . . . . . . . . . . . Input elasticity of substitution . . . . . . . . . . . . . . . . . . . . . . . . Shares Eligible assets in M & E . . . . . . . . . . . . . . . . . . . . . . . . . . . M & E in total assets . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Benefits and costs Resource allocation effects Inter-asset within M & E . . . . . . . . . . . . . . . . . . . . . . . . . . Inter-asset, M & E versus other assets . . . . . . . . . . . . . . Inter-industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Higher administration and compliance costs . . . . . . . . . . .

−0.015 −0.012 −0.006 −0.010

Net social benefit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

−0.043

percent

−3.0 −2.3 −1.8 0.410 0.356 0.593 −0.7 1 0.68 0.61

Note: CCA = capital cost allowance, M & E = machinery and equipment.

imposes a capital loss on the owners of existing capital equal to the percentage reduction in the price of new capital arising from the tax preference.51 This valuation effect raises important fairness issues, but has no implications for efficiency. Second, there may be an offsetting non-quantified benefit from accelerated cca in the form of spillovers. This issue was first raised by De Long and Summers52 in 1991. Subsequent theoretical and empirical work has both contradicted and supported this analysis.53 There is also some evidence of spillovers from 51 For a discussion of valuation effects caused by tax changes, see Alan J. Auerbach (2006), “Who Bears the Corporate Tax? A Review of What We Know,” James Poterba, ed., Tax Policy and the Economy, vol. 20 (Cambridge, MA: National Bureau of Economic Research), 1-40. 52 J. Bradford De Long and Lawrence H. Summers (1991), “Equipment Investment and Economic Growth,” Quarterly Journal of Economics 106(2): 445-502. 53 For some relatively recent studies supporting the existence of spillover, see Hossein Jalilian and Matthew O. Odedokun (2000), “Equipment and Non-Equipment Private Investment: A Generalized Solow Model,” Applied Economics 32(3): 289-96 and Tahir Abdi (2008), “Machinery & Equipment Investment and Growth: Evidence from the Canadian Manufacturing Sector,” Applied Economics 40(4): 465-78.


investment in a component of m & e—information and communications technology (ict).54 On balance, a plausible case can be made that investment in m & e, particularly in ict assets, generates benefits for both society at large and the purchaser. Unfortunately, the empirical work cannot readily be used in a benefit-cost analysis of accelerated depreciation for m & e assets used in m & p. In particular, it does not appear to be possible to calculate the external rate of return on either overall m & e or ict assets from the studies available. Nevertheless, since a relatively small spillover rate of about 5 percent would be sufficient to offset the distortions set out in table 6, it seems reasonable to endorse the measure as good public policy.

G. Provincial Tax Preferences for Manufacturing Preferential Income Tax Rates

Preferential tax rates for m & p are provided in Quebec (small firms only), Ontario, and Saskatchewan. The rate reduction in Ontario is 1.5 percentage points, which reduces the user cost of capital by 0.2 percent. A benefit-cost analysis of the Ontario measure is summarized in table 7. A targeted tax reduction for manufacturing financed by an increase in the general cit rate is assumed to have (to a close approximation) no net impact on the overall level of investment in Ontario. The net social benefit is therefore determined by the distortions caused by the targeted tax reduction and any revenue leakages from tax base shifting. From Ontario’s perspective, the distortions consist of a shift of activity into manufacturing from other sectors in Ontario. The targeted reduction causes a shift in manufacturing investment from other provinces, but this is offset by a shift in investment to other provinces in response to the general tax rate increase implemented to finance the targeted tax cut. The economic distortions caused by inter-sector shifts in investment are very small given the size of the tax rate change. In contrast, tax base shifting is a more important consideration. 54 See Melvyn Fuss and Leonard Waverman, “Canada’s Productivity Dilemma: The Role of Computers and Telecom,” appendix E-1 to Bell Canada’s submission to the Telecommunications Policy Review Panel, Ottawa, 2005 (www.itu.int/osg/spuold/dtis/ documents/Papers/productivitydilemma.pdf ) and Yen-Chun Chou, Howard Hao-Chun Chuang, and Benjamin B.M. Shao (2014), “The Impacts of Information Technology on Total Factor Productivity: A Look at Externalities and Innovations,” International Journal of Production Economics 158(1): 290-99.

148 / John Lester Table 7 Benefits and Costs of Provincial Tax Incentives for Manufacturing and Processing Evaluated from a Provincial Perspective Statutory rate reduction

Investment tax credit

per $ of tax revenue forgone, except as noted Parameters Federal-provincial corporate income tax rate . . . . . . . . Provincial corporate income tax rate . . . . . . . . . . . . . . . . Reduction in the user cost of capital . . . . . . . . . . . . . . . . Provincial tax base semi-elasticity . . . . . . . . . . . . . . . . . . Input elasticity of substitution . . . . . . . . . . . . . . . . . . . . .

26.3% 11.3% 0.2% −2.20 —

5.7% −2.20 1

Impacts of the targeted tax incentivea Resource allocation effects Inter-industry . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Inter-asset (short versus long-lived) . . . . . . . . . . . . . Tax base shifting into manufacturing Within province . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . From other provinces . . . . . . . . . . . . . . . . . . . . . . . . . . Higher administration and compliance costs . . . . . . . . .

−0.0002 —

−0.008 −0.030

−0.026 0.038 −0.010

−0.019 0.028 −0.010

Impact of the general income tax rate increasea Interprovincial tax base shifting . . . . . . . . . . . . . . . . . . . .

−0.064

−0.064

Net social benefit . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . .

−0.061

−0.102

a Excluding effects arising from changes in the level of investment, as explained in the text.

Ontario would be affected by tax base shifting arising from both the general tax rate increase and the targeted tax reduction.55 An estimate of the impact from the general tax rate increase can be developed from a Finance Canada56 empirical analysis of interprovincial tax base shifting. The Finance Canada results imply a semi-elasticity of the tax base to the statutory rate of −2.2, which in turn implies that the additional revenue loss from tax base shifting into other provinces would be about 25 cents per dollar of direct revenue loss. Assuming 55 This could be achieved by manipulating the formula for calculating the share of M & P profits in a diversified firm. Another possibility would be to set up, if one does not already exist, a separate corporation to undertake all the M & P activities in the group, and shift taxable income into the M & P operation. Tax base shifting could be achieved by inflating the intrafirm sale prices of manufactured products (there are no transfer-pricing rules for corporate groups in Canada) and by decreasing the leverage of the manufacturing operation. I am grateful to Paul Berg-Dick for explaining these mechanisms to me. 56 Canada, Department of Finance (2015), “Interprovincial Tax Planning by Corporate Groups in Canada: A Review of the Evidence,” Tax Expenditures and Evaluations 2014 (Ottawa: Department of Finance), pp. 71-96.


that the revenue loss is recovered by a proportionate increase in the three major taxes, the social cost would be about 6 cents per dollar of tax revenue forgone. The targeted tax rate reduction will give rise to the same amount of tax base shifting, but some of the shifting will occur within Ontario, which will reduce revenues. I have assumed that the share of within-province shifting is equal to Ontario’s share of manufacturing investment. This approach results in a small net gain from tax base shifting owing to the selective tax reduction, so the overall impact of tax base shifting is an efficiency loss of about 5 cents per dollar of tax revenue forgone. Evaluated from a provincial perspective, the combined effect of the distortions created and the loss of tax revenue from tax base shifting results in a net loss of about 6 cents per dollar of tax revenue forgone. Evaluated from a national perspective, the most substantial change is that interprovincial tax base shifting effects cancel out, which reduces the net social loss by about 2.5 cents per dollar of tax revenue forgone. On the other hand, both the targeted tax cut and the general tax rate increase implemented to finance it cause efficiency-reducing interprovincial shifts in investment, but these effects are small. While the net social loss from the targeted statutory rate reduction could be larger or smaller than this estimate, it will remain a loss for all plausible changes in parameter values. Given the financing assumption, the net benefit will be zero in the absence of any distortions. But there will be some distortions arising from a targeted tax incentive, administration and compliance costs will increase, and net tax base shifting effects cannot be positive. Provincial Investment Tax Credits

Quebec and Saskatchewan also provide itcs for investment in m & p assets, as do Nova Scotia, Prince Edward Island, and Manitoba. The credit rates range from 4 percent in Quebec (plus regional enhancements) to 15 percent in Nova Scotia. The weighted average credit rate is 5.7 percent, which drives the marginal effective tax rate well below zero. Evaluated from a provincial perspective, tax credits for investment in m & p create two distortions. First, there is a tax-induced shift across industries in the implementing province. The resulting loss in efficiency is about 1 cent per dollar of tax revenue forgone (see table 7). Second, there is a shift in demand toward manufacturing assets with shorter lives. The intuition behind the second effect is that since short-lived assets are replaced more frequently than long-lived assets, they realize a greater benefit from a credit that lowers the acquisition price of capital goods. The resulting efficiency loss is 3 cents per dollar of tax revenue forgone.

150 / John Lester

Counterintuitively, itcs can result in tax base shifting. Existing provincial measures cause some firms to become non-taxable, which gives them an incentive to shift income so that the credit can be claimed. Within-province shifting has no revenue effect if the counterfactual is application to taxable firms. Interprovincial shifting has a positive effect—the itc is being partially funded by other governments. The distortions and tax base shifting effects created by the itc result in a net social loss of about 10 cents per dollar of tax revenue forgone. Evaluated from a national perspective, interprovincial tax base shifting effects net out, but interprovincial shifts in real activity have to be factored in, leaving the net social loss slightly higher than from a provincial perspective. These results are not sensitive to the choice of parameter values. Simultaneously cutting the tax base elasticity and the elasticity of substitution by 50 percent and reducing the provincial investment elasticity to its national value cause the net social loss to decline by about 3 cents per dollar of tax revenue forgone. Increasing these parameters has a roughly symmetrical impact on the social loss. Governments may not find the preceding benefit-cost analysis of manufacturing incentives convincing because it does not address the quality of jobs created or the perceived need to compete for investment. As discussed above in section 2, a necessary condition for using targeted cit measures as part of an industrial policy is that the targeted sector have above-average tfp. There is no evidence to support this proposition for the manufacturing sector. On the other hand, there is some support for the view that investment in manufacturing may be more sensitive to tax rate changes than in other sectors. There is abundant evidence that fdi is more sensitive to tax rate changes than domestic investment. Manufacturing is substantially more dependent on fdi than other sectors, so preferential taxation of manufacturing could be seen as a way of lowering the tax rate on mobile capital, which would be consistent with applying the inverse elasticity rule discussed above in section 2. While relatively small differences in the user-cost elasticity would greatly strengthen the case for provincial tax preferences for manufacturing, there is little empirical evidence on how the sensitivity of investment to the user cost of capital varies by sector. The benefit-cost analyses undertaken in this section are summarized in table 8.

Business Tax Incentives for Economic Development: Do They Work? / 151 Table 8 Benefit-Cost Analysis Summary Net social benefit Measure

Provincial perspective

National perspective

cents per $ of tax revenue forgone Federal SR & ED ITC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Ontario R & D ITC . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Small business deduction (federal and provincial) . . . . . . . . . Cross-border interest deductibility (federal and provincial) . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . . Federal accelerated CCA for manufacturing M & Ea . . . . . . . . Provincial manufacturing tax rate reductions . . . . . . . . . . . . . Provincial manufacturing ITCs . . . . . . . . . . . . . . . . . . . . . . . . . .

5.5

−6.1 −10.2

18.6 13.6 −9.9 −25.9 −4.3 −3.7 −12.2

a Spillovers associated with the use of M & E could result in a positive net social benefit. Note: SR & ED = scientific research and experimental development, ITC = investment tax credit, CCA = capital cost allowance, M & E = machinery and equipment, R & D = research and development.

5. Conclusion The federal government has a surprisingly small number of business income tax measures that are intended to promote economic development. The list would be substantially longer if refundable tax credits were included, but these measures are functionally equivalent to program spending. Nevertheless, the amount of tax revenue forgone through federal non-refundable tax credits and deductions is substantial, likely amounting to about $8 billion in 2016. Provincial governments have implemented more economic development tax incentives than the federal government, at a total cost of about $9 billion. The general answer to the question posed in the title of this chapter—do tax incentives for economic development work?—seems to be that most of the money is ineffectively deployed. Out of about $17 billion in tax revenue forgone for economic development measures, only the $1.8 billion spent on the federal and provincial sr & ed tax credits for large firms clearly results in improved economic performance. The federal and provincial accelerated cca for m & e used in manufacturing, costing about $575 million per year, may also be contributing to improved economic performance. Replacing about $14.5 billion in federal and provincial targeted incentives with a reduction in the general cit rate would permanently raise real income in Canada by a substantial amount.

152 / John Lester

Appendix This appendix presents the equations used to perform various calculations discussed in the text. These comprise: 1) The efficiency gain that results from correcting a market failure by using a cit reduction. The efficiency gain is expressed per dollar of tax revenue forgone. 2) Cost-effectiveness ratios—the change in investment per dollar of tax revenue forgone—for cit rate reductions, itcs, and cross-border interest deductibility.

A. The Efficiency Gain from Correcting a Market Failure The starting point for the analysis is a simplified estimate of the efficiency loss arising from a subsidy in a competitive market, often described as a “Harberger triangle,” with the sign changed to give an efficiency gain from correcting a market failure: De = 0.5 ⋅ s ⋅ Di, (1)

where e is the change in efficiency resulting from the subsidy, s, and i is investment. The subsidy rate is measured as the percentage change in the user cost of capital, which is in turn calculated from the impact of a change in the cit rate on the user cost of capital. s = μ ⋅ Dt. (2)

In equation 2, μ is the semi-elasticity of the user cost to the cit rate, t. The change in investment can be expressed as a function of the subsidy rate, the price elasticity of investment, ε, and the lagged value of investment: 0.5 ⋅ s 2 ⋅ ε ⋅ i   (1 − s ⋅ ε) 

De = 0.5 ⋅ s ⋅ (s ⋅ ε ⋅ it − 1) = 0.5 ⋅ s 2 ⋅ ε ⋅ it − 1 =   _t   .

(3)

The amount of tax revenue forgone (trf ) from a cit cut is equal to the change in the tax rate, t, times the net income of corporations: trf = Dt ⋅ (uc − δ ) ⋅ α ⋅ kt = s ⋅ μ−1 ⋅ (uc − δ) ⋅ α ⋅ kt . (4)


In equation 3, shareholder income is calculated as the gross-of-tax rate of return to capital times the amount of capital financed by equity. The rate of return to capital is approximated by the user cost of capital, uc, less economic depreciation, δ. Shareholder income is approximated by the share of capital financed by equity, α, times the capital stock, k.57 Note that this approximation understates the amount of tax revenue forgone because the tax base proxy does not include income generated from inventories and from net financial investments. The change in efficiency per dollar of tax revenue forgone is  0.5 ⋅ s 2 ⋅ ε ⋅ It It _   DE    = ______________________            = _    0.5 ⋅ s ⋅ ε      ⋅ ______________         . TRF  (1 − s ⋅ ε) ⋅ s ⋅ μ−1 ⋅ (UC − δ) ⋅ α ⋅ Kt  (1 − s ⋅ ε)  μ−1 ⋅ (UC − δ ) ⋅ α ⋅ Kt 

(5)

Using values for the overall business sector for investment and the capital stock, the last term on the right-hand side of equation 5 had a value of 0.6 on average from 2010 to 2014. Since the tax base is understated, the value of the last term is overstated. Equation 5 is used in the benefit-cost analyses of the sbd and cross-border interest deductibility. A variant is used in the benefit-cost analyses of itcs and their functionally equivalent measure, accelerated cca. The efficiency loss from an itc is given by equation 3, but the tax revenue forgone is given by the product of the subsidy rate and current-period investment. As a result, the efficiency loss per dollar of tax revenue forgone is -0.5 ⋅ s 2 ⋅ ε ⋅ It _   DE    = ______________________        =_    -0.5 ⋅ s ⋅ ε    . (6) TRF  (1 − s ⋅ ε) ⋅ s ⋅ It  (1 − s ⋅ ε) 

In principle, the subsidy rate should be reduced to account for the share of investment undertaken by non-taxable firms. In practice, such information is not publicly available. Note, however, that the efficiency gain per dollar of tax revenue forgone changes almost proportionately with the subsidy rate over a wide range of values. That is, if non-taxable firms account for 10 to 60 percent of total investment, the efficiency gain will decline by approximately the same percentage.

57 In equation 4, UC − δ, which represents the pre-tax rate of return to equity, is calculated from data in Statistics Canada CANSIM table 180-0003, “Financial and Taxation Statistics for Enterprises.” Its average value from 2010 to 2014 is 12.1 percent.

154 / John Lester

B. Cost-Effectiveness Ratios The change in investment arising from an investment subsidy is -s ⋅ ε ⋅ i   (1 - s ⋅ ε) 

t Di = −s ⋅ ε ⋅ it − 1 =  _       . (7)

Using the amount of trf in equation 4, the cost-effectiveness ratio for a CIT reduction is therefore -s ⋅ ε ⋅ i

t  _      It  (1 - s ⋅ ε) DI   =  __  _        = _   -ε      ⋅  ______________        . (8) -1 TRF  s ⋅ μ ⋅ (UC - δ ) ⋅ α ⋅ Kt  (1 - s ⋅ ε) μ-1 ⋅ (UC - δ ) ⋅ Kt ⋅ α 

The tax revenue forgone from an investment tax credit is s times currentperiod investment, so the cost-effectiveness ratio is -s ⋅ ε ⋅ It  _   DI   = _        = _   -e   .  (1 - s ⋅ e) TRF  (1 - s ⋅ ε) ⋅ s ⋅ It

(9)

Using a value of 0.6 for the second term in equation 8, itcs are 1.67 times more cost-effective than cit rate reductions in stimulating additional investment. Since the tax base is understated, the cost-effectiveness advantage of itcs is also understated. Replacing the tax base proxy with actual values of taxable income results in a cost-effectiveness advantage for itcs of around 4. On the other hand, phasing in statutory rate reductions can boost their cost-effectiveness. For example, phasing in the 7-percentage-point rate reduction over the 2001 to 2004 period reduced the windfall gain to both the existing capital stock and (to a lesser extent) new investment that has a lengthy lead time. A credible announcement can also encourage firms to make decisions to invest on the basis of their expectation of lower tax rates when the project will be operational.