SPECIAL REPORT

CAUTIOUS REFORM

MARY JANIGAN June 29 1987
SPECIAL REPORT

CAUTIOUS REFORM

MARY JANIGAN June 29 1987

CAUTIOUS REFORM

SPECIAL REPORT

It first appeared in 1917 as a patriotic—and supposedly temporary— measure to pay for Canada’s contribution to the First World War. But when the war ended, income tax went on, sprouting amendments and sub-amendments with hearty bureaucratic life. In the past 15 years alone, there have been about 900 amendments to the Canadian Income Tax Act, which now sprawls across 1,400 confusing pages. Using loopholes contained in those copious amendments, four per cent of Canadians with more than $100,000 in income paid no income tax at all in 1984. Even more startling, 110,000 of Canada’s 320,000 profitable corporations paid no income tax in 1983. As a result, when Finance Minister Michael Wilson, sporting a white carnation and a wan smile, rose in the House of Commons last week to

introduce his historic package of tax reform proposals, few disagreed with his white paper’s central thesis: the present system is not fair. “The tax system must have the respect of Canadians,” Wilson declared. “We know that it does not.”

Cuts: To earn that respect, Wilson proposed to overhaul three areas of federal taxation: personal, corporate and sales. In the first stage, which is scheduled to begin next Jan. 1, Ottawa will lower taxes for 8.9 million households—and raise them for 1.5 million others. To pay for that cut, Wilson will reduce or wipe out a range of corporate tax preferences (page 41). He will also apply the federal sales tax to more companies—and, as a result, to more products.

In the second and more controversial stage of tax reform, a multistage sales

tax will replace the existing federal sales tax on manufacturers and some wholesalers (page 40). That tax could affect every transaction, from producer to retailer—covering everything from hairdressing and legal fees to the movement of food from farm gate to supermarket checkout. That tax increase—at an unspecified date—is intended to fund additional cuts in personal and corporate taxes. To Wilson, those changes meet Ottawa’s test of fairness: “Special breaks have made income tax more and more complicated and less and less fair,” he told the House. “Further action is needed to restore faith and trust in the system.

I am taking that action.”

Relief: Still, Wilson’s actions were cautious— and carefully orchestrated to ruffle the minimum number of feathers. In the wake of his announcement, many corporate leaders heaved sighs of relief about what he did not do. John Haag, director of taxes at the Toronto office of Clarkson Gordon, noted, “Everybody expected service and retail taxes to be higher.”

Added Michael Manford, chief economist at Merrill Lynch Canada Inc.: “The document is evolutionary, not revolutionary.” And the research department of McLeod Young Weir Inc. concluded in a report to the firm’s clients that “it appears to be an exercise in soft, shorter-term reform rather than the sweeping revolution that some had feared.”

Despite its limited scope, the package contained enough appealing provisions to attract most interest groups. In fact, finance department officials flatly acknowledged to Maclean's that they designed the first stage of tax reform to appeal to the selfish interests of the majority of taxpayers. John Bulloch, president of the powerful 78,000-member Canadian Federation of Independent Business, happily noted that the small-business tax rate will fall to 12 from 15 per cent. “We have protected small business and we are feeling pretty good,” said Bulloch. “Big business is going to pay its fair

share of taxes for the first time.” Terrance Hunsley, executive director of the Canadian Council on Social Development, applauded the fact that 850,000 low-income Canadians will no longer pay income tax:

“That in itself is a positive thing.”

But there were also major losers. The overhaul and elimination of tax preferences, Wilson estimated, will raise an extra $5 billion in corporate taxes over the next five years. Almost 30 per cent of that money will come from changes in provisions for the financial services sector, including a tax on the investment income of insurance companies. Wilson also cut back the capital-cost allowance program, which allows businesses to deduct the depreciation of assets from their income. Declared Manford of Merrill Lynch: “The corporate tax structure looked like more of a revenue grab than I would have liked.”

Rich: There were oth er bumps on Wilson's road to tax reform. The mere mention of the subject focused public attention on the enor mous tax increases that the Conservatives have imposed since taking of fice in September, 1984. The statistics tell a staggering story: Otta wa's take from personal income taxes is up al most 45.6 per cent-to $42.6 billion in 19871988 from $29.3 billion in 1984-1985. In con trast, revenue from cor porate income taxes has increased by only 8.8 per cent, to $10.2 billion in 1987-1988 from $9.4 bil lion in 1984-1985. The

Tories have also imposed four in-

in the sales tax since 1984— and extended it to such products as pet food and soft drinks. As a result, the revenue from federal sales taxes has shot up to $12.7 billion in 1987-1988 from $7.6 billion in 1984-1985—an increase of 67 per cent.

Reacting to the tax reform white paper, both opposition parties acidly noted the small increase in corporate tax revenue—and the massive increase in sales and personal income tax revenue. Liberal Leader John Turner pointed out that Ottawa will pluck $22 billion more from Canadians’ pockets in 1987-1988 than it did in 1984-1985. Comparing that increase to Wilson’s promise to cut $11 billion from personal income taxes over the next five

AVERAGE INCOME

A teacher in La Tuque, Que., has a salary of $31,880 and his wife makes $2,675 doing part-time work. They have three school-aged children. They gain immediately

under tax reform, paying $396 less than under the current system but, with family

expenses, could be hurt by anticipated new federal sales taxes.

1986 RATES 1988 1988 WITH AND NO REFORM REFORM DEDUCTIONS Income from family wages Family Allowance Interest Income Total Income Personal Deductions Other Deductions Taxable Income 34,555 34,555 34,555 1,164 1,000 1,164 1,000 1,164 1,000 36,719 36,719 36,719 7,815 6,925 7,275 7,086 --3,900 21,979 22,358 32,819 Federal Tax Minus Tax Credits Provincial Tax 3,526 -1,620 3,028 3,646 -1,983 3,028 5,451 -4,202 3,028 Tax Payable 4,934 4,691 4,295

PRODUCED BY ROB ORR, CMA, CA THE SOCIETY OF MANAGEMENT ACCOUNTANTS OF CANADA 1. Difference in 1986 results from lower refundable child tax credit. 2. Increase after tax reform is due to loss of interest deductions. 3. Quebec prosincial tax has been unaffected to date by federal tax reform.

years, Turner declared that “Canadians are still behind.” New Democratic Party Leader Ed Broadbent argued that the rich “will be the only people who will pay less [tax] than when the Conservatives came to power.”

Social welfare groups were also wary of heaping too much praise on the Conservatives. Kenneth Battle, president of the National Council of Welfare, scoffed at Wilson’s claim that tax reform will remove 850,000 Canadians from the tax rolls: his group calculated that Wilson has added at least that many low-income earners to the tax rolls since the Tories took office.

Said Battle: “He is undoing the damage he brought in over the past two years.”

The tax reform package also raised the spectre of another federal revenue grab. Although finance officials refused to speculate when Stage 2 will begin, interest groups voiced concern that a multistage national sales tax would siphon billions from the pockets of unsuspecting consumers. Hunsley from the Canadian Council on Social Development declared, “The other shoe will drop a little later on.”

Credits: The political attractiveness of Wilson’s package lies largely in his changes to personal income tax.

Beginning next year, the current 10 tax brackets will be reduced to three.

And the rates, which now range from six to 34 per cent, will run from 17 to 29 per cent.

At the same time, Ottawa will transform a range of traditional tax exemptions, including the basic personal exemption and the exemption for spouses and dependent children, into credits. Because an exemption is deducted from taxable income, a person who deducts an exemption of $1,000 and pays taxes at 34 per cent saves $340; someone in a 17per-cent tax bracket who deducts the

same $1,000 exemption saves only $170. In contrast, a tax credit is a fixed amount subtracted from a taxpayer’s tax bill. That change is good news for lower-income Canadians, because the

new credits are crafted to lower the overall tax bill of individuals earning less than $27,500.

But while the tax man gives, he also takes away. The controversial lifetime exemption for capital gains introduced

by Wilson in his May, 1985, budget will be cut sharply—to $100,000 from $500,000, except for farmers and gains from small business. The dividend tax credit will drop to approximately 25 per cent of the value of the dividend from approximately 33.3 per cent. Deductions for meals and entertainment expenses will drop to 80 per cent from 100 per cent. The basic $500 employment expense deduction will disappear, as will the deduction for $1,000 of interest and dividend income.

Suffer: Those changes have created winners— and losers. Wilson estimated that most salary and wage earners will benefit. But most who derive their income from investments or self-employment will suffer. Those Canadians could, in turn, alter their investment plans to take advantage of remaining tax preferences. Sol Zuckerman, chairman and chief executive officer of Montreal’s Charan Industries Inc., bitterly decried the reduction in the capital gains exemption and the reduction of the dividend tax credit. Declared Zuckerman: “Wilson is giving business a shot in the head, not a shot in the arm.” Fragile: Reductions in the capital-cost allowance program, which took immediate effect last week, also rocked Canada’s fragile film industry. Until last week, investors could write off 50 per cent of the cost of their investment during the year in ¡ which they made the in; vestment—and the re; maining 50 per cent in : the following year.

! Now, only 15 per cent is ! deductible in the first ■ year —followed by 30 ! per cent of the balance of the investment in subsequent years. From industry representatives’ viewpoint, that amendment adds up to trouble. Michelle d’Auray, national director of the Canadian Conference of the Arts, called the change “devastating. I do not

SELF-EMPLOYED BUSINESSMAN

A successful, self-employed real estate developer in Saskatoon, Sask., is a big winner from tax reform. He earns $857,000 annually from his firm and makes money from stock dividends, inter est and capital gains. He has a wife and two teenage children and takes

full advantage of tax shelters. Increased sales taxes could take a bite, but so far he would pay $43,014 less in tax under the proposed reforms than under current rules.

1986 RATES 1988 1988 WITH AND NO REFORM REFORM DEDUCTIONS Employment Income 857,000 857,000 857,000 Family Allowance 388 388 388 Taxable Dividends 8,000 8,000 8,000 Interest 9,800 9,800 9,800 Taxable Capital Gains 23,500 23,500 31,349 Loss on Flow-Through Shares -250,000 -250,000 -250,000 Total Income 648,688 648,688 656,537 Personal Deductions 4,870 4,740 Capital Gains Deduction 23,500 23,500 31,349 Interest Deduction 1,000 1,000 RRSP 7,500 7,500 7,500 Other Deductions 919 996 Charitable Donations 10,000 10,000 Taxable Income 600,899 600,952 617,688 Federal Tax 220,318 204,340 180,132 Minus Tax Credits -1,333 -1,333 -5,040 Provincial Tax 117,816 117,083 101,984 Tax Payable 336,801 320,090 277,076

PRODUCED BY ROB ORR, CMA, CA THE SOCIETY OF MANAGEMENT ACCOUNTANTS OF CANADA 1. There isa change proposed for 1989 that would limit the writeoff for losses on flow-through shares. 2. Reduction in tax for 1986 to 1988 is due to a reduction in the federal surtax. 3. The decrease in tax payable is due to the fact that the top personal federal rate would never exceed 29 per cent. This means that those with incomes similar to that illustrated above would enjoy a significant tax advantage.

know how the film industry will keep afloat.”

Senior Finance officials say that Wilson will ignore most complaints— although he may be forced to change the film provisions. Instead, Wilson will argue that salary earners will see their average tax bill decline to 19 per cent from 20.1 per cent of income. In contrast, taxpayers who are selfemployed or who rely on investment income will see their average tax bill increase slightly, to 15.6 per cent of income from 15.4 per cent.

As a senior Finance official contended: “They will still be ahead of the average guy. We will make them look like pikers.”

Officials also calculated that two-thirds of all taxpayers have a taxable annual income of less than $27,500; an additional 29 per cent have a taxable income of less than $55,000.

“That means there’s not going to be much sympathy for the guy who can no longer write off his Mercedes,” said one senior official. “And that is precisely the argument we’re going to use.”

Fair: Wilson will pay for a portion of that personal tax cut through changes in the corporate tax structure. Beginning on July 1, 1988, the general federal corporate tax rate will fall to 28 per cent from 36 per cent. The tax rate for manufacturing income will drop to 26 per cent from 30 per cent—and continue to fall by one percentage point per year to 23 per cent in July, 1991. Despite those declining tax rates, Wilson predicted that revenue from corporate taxes would increase by $5 billion over the next five years through changes in tax preferences. Changes in capital-cost allowances mean that companies must write off depreciation of assets at a slower rate. And the portion of capital gains subject to taxation will climb to 66.67 per cent from 50 per cent next year.

Equally important, Wilson tackled the provision that allows companies to trade preferred shares—escaping what he called “their fair share of tax.”

Owners of preferred shares now receive a dividend tax credit that is applied against their tax bill; in effect, the dividend is not taxed. Ottawa offers the credit because the company has al-

ready, theoretically, paid corporate tax on the money that it pays in dividends. But many companies receive their income from preferred shares and, through that mechanism and a variety of other tax preferences, pay no taxes at all. And those companies still sell preferred shares, which are attractive to investors because the dividends are tax-free. Under Wilson’s new rules, corporations must pay a special minimum tax to compensate for the dividend tax credit that their investors will receive.

Toys: Meanwhile, the minister faced a series of questions over his plans for the much-maligned federal sales tax. In the short term, Wilson attempted to close a few loopholes: effective next January, the tax will extend to marketing firms that are related to manufacturers and to the wholesale level of such products as electronic toys. The sales tax will also be extended to such telecommunication services as Telex— and to all long-distance telephone calls as well as local calls made by businesses. Those changes are expected to raise federal revenues by $1.1 billion in 19881989 and $1.2 billion in 1989-1990.

National: But Wilson deferred the imposition of the multistage tax— and so postponed the major thrust of tax reform. The new tax would apply to every transaction from the primary producer to the consumer. At each stage, the seller would compute the difference between the amount of tax he collected from his customers and the amount of tax he paid to his suppliers. He would then send the difference to Ottawa. Wilson speculated that the federal multistage tax could be combined with the provincial sales tax to create a single national sales tax. Or Ottawa could impose a federal goods and services tax on every transaction. A third alternative: Ottawa could levy a federal value-added tax that would apply only to specified items and require a painstaking system of invoices. Revenue from that tax would permit Ottawa to make further cuts in per-

CAREER COUPLE

With two large Incomes and one young child, these Chilliwack,

B.C., residents fit the profile of the modern yuppie family. The husband is a salaried executive earning $45,350; the wife earns $38,800 as a self-employed professional. They take advantage of deductions for such common items as RRSPS and charitable donations. Even in their high-income bracket, they would win under the first phase of tax reform, saving $1,986.

1986 RATES AND 1988 NO REFORM 1988 WITH REFORM DEDUcTIONS Combined employment income Interest and Other Income 84,150 84,150 84,150 2,888 2,888 2,888 Total Family Income Personal Deductions 87,038 87,038 87,038 9,070 9,010 •-Other Deductions Taxable Income 17,048 17,372 12,000 60,920 60,656 75,038 Federal Tax 12,581 12,595 14,889 Minus Tax Credits -3,617 Provincial Tax 6,368 6,298 5,635 Tax Payable 18,949 18,893 16,907

PRODUCED BY ROB ORR, CMA. CA THE SOCIETY OF MANAGEMENT ACCOUNT&NTS OF CANADA

sonal and corporate taxes—and to end the current three-per-cent surtax on personal and corporate income.

Ultimately, the multistage tax proposals were most interesting for what they did not say: when Ottawa will apply the new tax. Critics speculated that the Conservative government would delay imposing the potentially unpopular sales tax until after the next federal election, likely in late 1988 or early 1989. A senior economist at a Toronto brokerage firm told Maclean's that the multistage tax is the heart and soul of tax reform— a genuine reform to the system of taxation—but that the Conservatives are afraid to introduce it. “I don’t think they know what they are doing,” he said. “It is all political. This is not a deficit-controlling package. It is a let’s-win-thenext-election policy.”

Breaks: The Conservatives were not always so eager for sweeping tax reform. In 1985, Wilson ruled out a major tax overhaul, saying that it would lead to “uncertainty and instability.” But last year the U.S. Congress agreed on a comprehensive tax reform package to lower corporate and personal tax rates (page 39). And Canada faced the prospect of corporations moving south of the border for tax breaks. Said Samuel Hughes, president of Ottawa’s

Executive Consultants Ltd.: “Wilson was compelled to do something.”

The finance minister’s response was to lower corporate rates so that the combined federal and

provincial rate will be 42 per cent on July 1, 1988—about three percentage points higher than the comparable U.S. rate. As a senior Finance official

told Maclean's: “At three per cent we are right on the edge, but we just could not afford to go lower.”

In the end, the estimated 1987-1988 deficit of $29.3 billion set the real limits to tax reform. Whatever Wilson did to the tax system, he had to make sure that Ottawa did not end up losing money as a result. Indeed, federal tax revenues are projected to grow to 13.1 per cent of the gross domestic product in 1991-1992 from 11.8 per cent in 19871988. Much of that growth will stem from the increase in the labor force. But those numbers indicate the extent of the pressure on Wilson to keep generating funds for Ottawa. Said William Macdonald, a corporate lawyer with Toronto’s McMillan, Binch: “Asking a fi-

nance minister saddled with a deficit to write a tax reform package is like asking a man in hospital with pneumonia to run a marathon.” Tennis: Whatever the fate of Wilson’s package, he has started a process that may be difficult to reverse. Canadian taxpayers, tantalized by the prospect of minor tax relief, may become a formidable lobby for reform. Small business, lured by the promise of lower taxes, may press for reduced corporate rates. Canadian manufacturers, resentful of a sales tax that penalizes domestic producers, may push for its replacement by the new multistage sales tax. That new enthusiasm for tax reform contrasts sharply with Wilson’s first brush with the issue two decades ago. Hughes wryly recalled a sunny day back in 1967 when he and Wilson were Bay Street brokers delivering an earnest report on tax reform to a meeting of the Investment Dealers Association of Canada in Quebec. “We sat up there and bored the audience stiff,” Hughes told Maclean's. “It was a beautiful day and they all looked like they would rather be playing tennis. Wilson had to wait until he got to Ottawa before people would listen to his ideas on tax reform.”

-MARY JANIGAN with PAUL GESSELL and MARC CLARK in Ottawa and ANN WALMSLEY and THERESA TEDESCO in Toronto

SINGLE PARENT

A mother with two young children, living in Halifax, has $19,449 in income from a full-time job and child-support payments. With an income just barely above the poverty line, her major expense is

child care. Pending any increase in sales taxes, she gains from tax reform, receiving $86 back from the federal government instead of paying $211.

1986 RATES AND DEDUCHONS 1988 1988 WITH NO REFORM REFORM Total Income Personal Deductions Other Deductions Taxable Income 19,423 19,449 19,449 8,550 5,049 8,480 5,049 -4,000 5,824 5,920 15,449 Federal Tax Minus Tax Credits Provincial Tax 853 -1,008 475 878 -1,148 481 712 -1,188 390 Tax Payable (Rebate) 320 211 (86)

PRODUCED BY ROB ORR, CMA. CA THE SOCIETY OF MANAGEMENT ACCOUNTANTS OF CANADA

PAUL GESSELL

MARC CLARK

ANN WALMSLEY

THERESA TEDESCO