The uncertainty that continues to impede the U.S. recovery coupled with political gridlock in Washington poses significant economic threats to not only the United States but also countries like Canada that trade with the U.S. However, imbedded within the many layers of risks lies a significant, long-term opportunity for Canada.
There is little doubt the U.S. economy is suffering from uncertainty. In a recent essay series published by the Fraser Institute, The U.S. Election 2012: Implications for Canada, internationally recognized Stanford economist Nicholas Bloom described how the level of policy uncertainty in the U.S. economy from 2006 to 2011 led to about a 2.5 per cent decline in GDP and about a 2.4 million reduction in employment. This uncertainty encourages entrepreneurs, investors, and businesses to delay making decisions about starting a business, expanding an existing one, and/or investing. Critically, Bloom noted that Canada is suffering from uncertainty “contagion” from the U.S.
Part of the uncertainty and fear from workers and businesses alike in the U.S. is the slew of new and higher taxes coupled with the possibility of even more tax hikes in the future. The combination of the fiscal cliff, enactment of Obamacare, and the expiry of temporary tax relief has meant that a raft of taxes including income taxes, capital gains, dividends, the estate tax, and payroll taxes have all been increased.
Even the proponents of higher taxes admit that the expected revenues – which are almost certainly going to be lower than anticipated – will not make a dent in the roughly $10 trillion in deficits expected over the next decade. The combination of deficits as far as the eye can see, coupled with a trend towards higher taxes in the U.S., presents Canada with a real opportunity.
The Canadian federal government and many of the provinces could feasibly achieve balanced budgets within the next four years with the notable exception of Ontario, which is facing much more serious structural deficits. For the purposes of our argument, let us assume that the federal government and many provinces find the fortitude to balance their budgets in the short term and do so mostly through spending reductions rather than raising taxes.
The key to achieving a competitive advantage over the U.S. once budgets are balanced is materially reducing personal income taxes.
But why focus on income taxes?
First, economists generally agree that income taxes impose greater costs on the economy than other taxes like sales taxes. The reason is that income taxes discourage to a greater degree beneficial activity such as entrepreneurship, investment, work effort, and savings.
Second, most of Canada’s tax rates are already competitive with the U.S. We already have a clear advantage, for example, on business taxes, capital gains, and dividend taxes. The one area where we remain painfully uncompetitive is personal income tax rates.
Lowering personal income taxes can be accomplished through two concurrent initiatives. One, governments need to continue to restrain spending once budgets are balanced so that as the economy grows, surpluses are created that allow for tax rate reductions.
And two, governments can reduce or eliminate special privileges within the tax code. Reducing these privileged carve-outs means more revenues, which would allow for lower personal income tax rates. For example, the federal government spends $3.2 billion exempting employer-provided health and dental benefits, $115 million on the Child Fitness Tax Credit, and $150 million on the public transit tax credit, to name just a few.
Our preference for tax relief is that federal and provincial governments focus on eliminating middle income tax rates, leaving one low, flat rate for the vast majority of Canadian workers and a second higher-income tax rate.
In addition, the threshold at which this high-income rate kicks in should be increased, allowing Canada to better compete with the U.S. for entrepreneurs, investors, and skilled workers like doctors and engineers. Currently, our top federal rate kicks in at a little over $135,000 (Cdn) while the new top rate in the United States applies at $400,000 (US) for singles.
Lower and more competitive personal income taxes would be one of the final pieces required to create a tax advantage for Canada. It would mean a marked, sustainable advantage over the U.S. and many other countries with respect to taxes. That advantage coupled with numerous other strengths such as rule of law, stable government, reasonable infrastructure, and access to markets would make Canada an enviable destination for entrepreneurs, businesses, and investors.