Canada

THE TAX WARS

Pressure on governments to cut rates is rising

MARY JANIGAN June 8 1998
Canada

THE TAX WARS

Pressure on governments to cut rates is rising

MARY JANIGAN June 8 1998

THE TAX WARS

Canada

MARY JANIGAN

In their zeal, U.S. recruiters have trolled through the voice-mail system of his software programming firm to obtain individual numbers, gleefully accepted pilfered phone lists from a disaffected employee and approached nearly every staff member with job offers. An exasperated Ian Reid, co-founder and major shareholder of Vancouver-based Sierra Systems Consultants Inc., says that two avid recruiters even offered programming jobs to his secretary—and she does not know how to program. He is now losing technical staff members in his Vancouver office at an annual rate of 25 per cent: almost one-third of those are accepting lucrative positions at other U.S. firms. The “brain drain” is so dire that, at one point, fully half of the employees in his own Los Angeles office were Canadians who had requested transfers.

Pressure on governments to cut rates is rising

And every day he asks himself: why?

There is the attraction of a warmer climate south of the border—and the adrenaline-raising challenge of competing in a bigger market. But Reid has concluded that the “biggest single difference” is the prospect of lower taxes. Much lower taxes. That, he says, has “become a lightning rod issue for firms and for people. I don’t think Canadians realize the damage that the brain drain is doing. Demand has never been as high relative to the availability of people. So not only are we hurting ourselves, we are making a tough business situation much worse.”

In the new, edgy world of the late 1990s, tax revolters do not wave signs or shout protests: they simply move. As borders become more porous, as companies, especially high-tech firms, become more portable, and as skilled people become ever more valuable, Ottawa and the provinces are coming under everincreasing political and economic pressure to lower their tax rates. Pollster Michael Marzolini, chairman of PO LIARA Inc. of Toronto, told Maclean’s middle-class concern about high taxes has risen to almost unprecedented levels. “The middle class is saying, We are overtaxed. We have been patient. We are being hit pretty hard here and we would like a break,’ ” says Marzolini, who is also the federal Liberals’ pollster.

Meanwhile, provinces are competing with one another —and with adjoining U.S. states—to attract and keep

thriving companies and gifted workers. “A lot of the new jobs we are competing for, whether it is shooting movies or high-tech research and development, move very easily,” Ontario Premier Mike Harris told Maclean’s. We wanted to be as competitive as we could with other jurisdictions. That recognizes a global economy.” As a result, on July 1, Ontario will lower its basic personal income tax rate to 40.5 per cent of federal tax—the lowest in the nation. “If the federal government wants the rest of the country to have the kind of job growth we are getting,” adds Harris, “it should get on the bandwagon.”

It is a fierce, and occasionally losing, campaign. As Torontobased brokerage firm Nesbitt Burns Inc. has tartly noted in a recent report, one-quarter of all Canadian doctoral students— the “best and brightest”—now leave Canada within two years of graduation. The outflow of engineers, computer scientists, doctors and professors throughout the early 1990s alone was staggering. Nesbitt Burns pins a large chunk of the blame on the “near-record gap” between the Canadian and U.S. household tax burden. And middle-class taxpayers, who have waited patiently while governments wrestled with their annual deficits, are now demanding payoffs for their efforts. We can’t sustain the kind of tax system that we have today without inhibiting our opportunities for economic growth and job creation,” says University of Toronto economist Jack Mintz, who just completed an in-depth study of federal corporate taxation. “The world is getting smaller. You cannot just tax sectors or people to death and think that nothing will happen.” The problem, of course, is that not all provinces are equally wealthy—or have managed their finances with equal skill.

THE BRAIN DRAIN

Average annual

migration,

1990-1995

Hi Entering Canada Leaving Canada

THE ‘OUCH’ FACTOR

Engineers

Computer

Scientists

Personal tax

Doctors

SPECIAL REPORT

As a result, although all governments have balanced their budgets or are on the brink of balancing them, some are far more laden with debt than others. Provinces such as Newfoundland or Quebec, for example, may be unable to deliver much lower taxes—because interest charges are consuming too much of their revenues. Footloose companies may look at that fiscal situation—and decide to relocate in a province that is better able to afford continuing tax relief.

A difficult chain of events could ensue. As its economic prospects grow increasingly grim, a debt-laden province may make tax cuts that it can barely afford, putting pressure on its social programs. If there is an economic downturn or if wealthier provinces make further tax cuts, that poorer province will be torn by competing needs: it must pay the interest on its debt, maintain competitive tax rates and provide social services to its citizens. Meanwhile, wealthier

provinces will be able to boost services and cut taxes because their debt-servicing costs are lower. Something has to give. “There is a huge force right now pushing so many provinces to cut tax rates,” warns Teresa Courchene, senior economist at the Toronto Dominion Bank. “My concern is that if you go forward six or seven years, you are going to get increasing gaps among some provinces, especially higher-debt provinces like some in Atlantic Canada and Quebec and low-debt provinces such as Alberta.”

Federal and provincial finance ministers are so worried about this looming problem that it was on the agenda at their last two meetings—and it will again be discussed when they next meet, probably this month. Few ministers fear that they will become embroiled in an all-out war to drive tax rates into the floor—if only because their voters would not accept the necessary cuts to social services and because today’s firms and workers also require quality health care

and an educated workforce. “The lowest tax rate in the world is not enough—because it is not just the tax cut,” argues Harris, who recently put more money into education and health care after voters complained that he was funding tax relief through service cutbacks. “Companies and employees also want quality of life: health care, education, clean environment. It is balance in everything.”

Many ministers are concerned, however, that it will be easier for some provinces to find that balance than others. David Perry, senior research associate at the Canadian Tax Foundation, notes that social programs have gradually deteriorated across the board after a decade of deficit-inspired cuts. “The question arises: how long will people accept the gentle erosion of government services?” he asks. “Will those problems eventually deflect pressure away from tax cuts? That trade-off revolves around the undebated question as to what the role of government should be. It ain’t going to be a quiet couple of years.”

The growing public focus on taxes is fuelled by some unsettling statistics. Canada’s overall tax burden—including federal and provincial income taxes, sales taxes, corporate taxes, social security and property taxes— is about average among the 29 Western industrial nations who are members of the Organization for Economic Cooperation and Development—but it is well above that of Canada’s largest trading partner, the United States. (It was almost 10 percentage points higher in 1995, the last year for which figures are available—although Perry notes that the disadvantage declines at least a couple of percentage points when the benefits of Canada’s national health-care system are weighed against the costs of U.S. private systems.)

But the weight of Canada’s personal income taxes—federal and provincial—is the heaviest of all Group of Seven industrial nations—and it is exceeded by only a handful of OECD nations, such as Belgium and Denmark. Worse, there are problems that cry out for immediate tax reform: taxpayers who earn about $30,000 face steep tax rates because Ottawa starts to claw back benefits ranging from the Child Tax « Credit to the Goods and Services Tax 1 credit just below that income level. As a « result, those taxpayers could pay rates as g high as 65 per cent on every dollar they ^ earn over approximately $26,000—which § could discourage incentive to work.

I Vancouver’s Diana Barkley winces “ whenever she fills out her tax forms— because almost 50 per cent of her salary has evaporated. A partner in the public relations firm Barkley-Gazeley Communications Group Inc., she worries about the connection between high rates—and the loss of talented graduates from Canada’s taxpayer-supported universities. “Especially our young people,” she says. ‘We get them all educated and primed and our southern neighbor comes knocking on the door.” The 40ish Barkley, who is single, says resolutely that she doesn’t see herself moving: “I’m a Canadian—I will always be a Canadian.” But then she pauses, and qualifies that statement. “Right now, no,” she says. “Just in the past couple of years, you look at what you’re doing and what you’re earning and what you’re taking home and you start asking those questions. Sure, everyone thinks I earn a good salary—but my take-home is not great.”

Such discontent is evident among many taxpayers. After a decade of stoic resignation, middle and upper-middle income earners are chafing under the brutal combination of high taxes and slipping

SPECIAL REPORT

services. Pollster Marzolini told Maclean’s that an unprecedented 58 per cent of the 1,200 respondents in his regular quarterly survey in early May said they were very concerned about the level of taxation—as opposed to 49 per cent at the same time last year. The issue has catapulted unexpectedly from a relatively low-level problem into second place among Canadian concerns, just below worries about the quality of health care. More important, middle-income taxpayers are the most distressed: 65 per cent of those earning $45,000 to $54,000 and 68 per cent of those earning $55,000 to $64,000 are very concerned about taxes. ‘Taxes are the issue that governments should watch,” warns Marzolini.

“They certainly have the capacity to be a make-or-break issue in future elections.”

It is not hard to see why.

Royal Bank of Canada data indicate that, on a per capita basis, real personal disposable income, after income and social insurance taxes, has fallen far behind 1990 levels. At the start of this decade, that figure was $17,236.06; this year, it is merely $16,306.72. And with the turn of the century, it will still lag behind 1990 levels at $17,014.42. Canadians have simply gotten poorer.

It is equally easy to see why the hard-pressed middle class has become particularly impatient. Last February, when the federal government finally balanced its books, it cut taxes by almost $880 million in 1998-1999—but the bulk of the benefit this year went to lowand lower-middle income Canadians. ‘The people who missed out in the last federal budget are starting to come after us,” concedes a senior Liberal.

That includes people like Vancouver’s Brenda Clark, owner of Direct Results Marketing Ltd., a direct-mail marketing firm. Personal income taxes in every province except Quebec—which has its own personal income tax system—are calculated as a percentage of the federal tax that each taxpayer pays. And British Columbia’s surtaxes ensure that its take from higher-income earners is the steepest in the country. The 48-year-old mother of an 11-year-old son must pay 54.2 per cent of any income above $78,000 to the federal and provincial governments. And she is fuming. “Striving to get ahead just doesn’t get you anywhere,” she says. “The more I gross, the takehome doesn’t change: the taxes just go up. It’s becoming more and more difficult to find good people—you can’t find anyone foolish enough to move here.” Clark has family in the United States—and she believes she could easily qualify as a U.S. immigrant. But the

money that she has tied up in her business holds her—for now. “Given the right situation,” she says firmly, “I would cross that border so fast it would make your head spin.”

The race is under way to placate such voters. In their 1998 budgets, six provinces— British Columbia, the three Prairie provinces, Ontario and New Brunswick—announced plans to lower their personal income tax rates, either this year or at the beginning of next year. (British Columbia also pledged to reduce its surtaxes to bring the so-called marginal rate on high-income earners to 49.9 per cent over the next three years.)

Interprovincial competition is keen. Quebec lowered its personal income taxes last

January, partly in response to neighboring Ontario’s aggressive cuts. Many provinces have stuffed their 1998 budgets with charts and appendices comparing their tax regimes and cost of living with those of their fellow provinces. Saskatchewan favorably compares taxes and household charges in Saskatoon with those in nine other Canadian cities. Newfoundland chronicles why St. John’s is the “most cost-effective business city in North America and Europe.” Don Cayo, president of the Halifax-based Atlantic Institute for Market Studies, notes that no sensible person or company would base its decision solely on tax rates when considering where to locate. “But taxes are perhaps disproportionately more important than any other cost,” he says, “because they are flagrant, they are up front and they get up your nose.”

With the highest basic income tax rates in the nation, ranging from a staggering 69 per cent of federal tax in Newfoundland to 57.5 per cent in Nova Scotia, Atlantic Canadians are the most distressed about the level of taxation. POLLARA reports that 72 per cent are very concerned—compared with 63 per cent in British Columbia, 61 per cent in the Prairies, 57 per cent in Ontario and 49 per cent

Tax revolters no longer wave signs—they move

Northwest

Territories

* VARI ES ACCORDING TO INCOME

Ontario

42.75

in Quebec. Newly retired Patrick Butt, a former Marine Atlantic electrician in Port Aux Basques, Nfld., ruefully admits that tax rates are a factor as he ponders his future. The 48-year-old Newfoundlander, his wife and their 11-year-old son are weighing the advantages of moving to Ontario, British Columbia or New Brunswick.

“It kind of irritates me to realize that over 50 per cent of every dollar goes to taxes,” he says, calculating that more than half of his family’s income of $48,000 goes to sales and income taxes. “With the economy turning around, it would be nice if the federal government would give middle-income people a better break.”

Some provinces are better able to afford that break than others.

Alberta and Saskatchewan, which resolutely tackled their annual deficits in the mid-1990s, have since paid

down their debts—and reduced their inPROVINCIAL TAX RATES

terest costs. The NDP government of Saskatchewan balanced its budget in 1994-1995—and it has lowered ” 1 its debt from 51 per cent of the size of its gross domestic product in 1992-1993 to 31 per cent.

With the debt on a steady downward track, the province is boosting health and education spending—and it is cutting its basic income tax rate to 48 per cent of federal tax on July 1. As Finance Minister Eric Cline says: “It’s not in anybody’s interest to have a race to the bottom. We have to lower our debt—lower taxes will come in a gradual, sustainable way.”

Other governments face less enviable circumstances. Newfoundland’s 1998-1999 deficit is $10 million—and its debt of $4.8 billion is 44 per cent of the size of its economy. Quebec’s current deficit is $1.1 billion—and its debt of $82 billion is almost 44 per cent of its GDP Although Nova Scotia has balanced its books, its estimated debt of $8.6 billion hovers near those two top provincial levels—at 43 per cent of GDP With huge tabs for interest payments—Newfoundland, for one, must divert 16 per cent of its spending to debt charges—it is unlikely that those provinces can match Ontario’s cuts in the near future.

The strain on their taxpayers is showing. In 1991, Cape Breton’s Joan Weeks, 39, opened a home-based company, Folkus Atlantic, employing three full-time workers to develop educational CDROMs and videos. She says that becoming an employer has been an education in itself. “The amount of taxes that we have to take off people’s wages is embarrassing,” she says. “You think you are paying

them a decent wage until you find out what they are actually taking home. You look at your tax slip at the end of the year and say, Where did it go?’ Well, I know where it went: into the government’s pocket.”

With costs down, its deficit conquered and revenues increasing, Ottawa has more funds at its disposal: the so-called fiscal dividend. The problem, however, is its debt: $583 billion—or more than 65 per cent of the size of the entire Canadian economy. Interest costs still consume 30 cents out of every revenue dollar. John McCallum, chief economist at the Royal Bank, figures that the fiscal dividend will hit only $11 billion in 2001-2002, gradually rising to $28.5 ^ billion in 2006-2007. That money has already I been allocated: half for new social and eco8 nomic spending, half for debt reduction and tax I cuts. “While $ 11 billion sounds like a lot of mon^ ey, it is only about 13 per cent of projected revI enues from personal income tax,” warns Mc« Callum. “So even if the government wanted to I devote the whole dividend to a general income m tax cut, which it doesn’t, the best that it could manage would be a 13-per-cent cut by the end of its mandate.”

The beleaguered federal finance minister, Paul Martin, is even blunter. ‘We want to cut taxes as fast as we can to put more money into the pockets of Canadian families,” he told Maclean’s. “But Mike Harris inherited a much better balance sheet than we inherited—and the federal government’s balance sheet is the one that has the greatest influence on interest rates.” Martin says that big tax cuts would spark fears that Ottawa is ignoring its treacherously high debt. That, in turn, would drive up interest rates. ‘We don’t want to get taxes down if the net result is that the average Canadian’s mortgage rates are going to go up,” he warns, “or the business they work for isn’t going to be able to afford its interest costs.”

The finance minister also acknowledges that the disparity between richer and poorer provinces will likely widen over the next decade — as wealthier provinces regularly trim their tax rates. Although federal equalization payments to poorer provinces will somewhat ease that gap, they will not bridge it. (According to the byzantine formula, payments to poorer provinces decline as wealthier provinces cut their tax rates—although that decrease is somewhat moderated if economic growth in the wealthier provinces exceeds growth in the poorer provinces.) “The answer lies in finding ways to increase economic activity in Atlantic Canada,” says Martin. In the end, perhaps Canada’s best hope lies in the fact that all governments are gradually getting control of their fiscal situation. As a result, says Perry, the stage is set for across-the-board tax reform. Ottawa and the provinces—together—could tackle the high tax rates afflicting taxpayers who earn about $30,000. They could examine why Canadian property taxes are the highest among all OECD nations. Because governments are moving into the black, they could give up enough revenue to ensure that everyone gains. “That levels taxes down rather than up,” says Perry. “That’s the ideal way.” The only problem, of course, is that when governments cannot level down as fast as their competitors, they may still lose.

With JOCELYN BETHUNE in Baddeck, N.S., and CHRIS WOOD in Vancouver

Outside Quebec, which administers its own income tax system, Canadians pay provincial income tax as a percentage of federal tax. The rates:

P.E.I.

59.5

ncn N°va Scotia Brunswick 57.5 61