Fed’s small business tax tweaks won’t help the middle class

Fed’s small business tax tweaks won’t help the middle class
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The uproar across the country to Ottawa’s small business tax reforms has triggered more back-pedalling, but no good solutions

By Charles Lammam
and Jason Clemens
The Fraser Institute

Prime Minister Justin Trudeau and the Liberal Party were elected for, among other reasons, their commitment to a more prosperous economy, particularly one where the benefits flowed to the middle class. Since coming to power in 2015, there’s almost nothing the federal government has done without first couching it in prosperity for the middle class.

To that end, the government recently set out to change the tax rules for small businesses, with a focus on ending – or at least significantly curtailing – the ability of “wealthy” Canadians to reduce their tax bill by incorporating. And the government is quite right – eligible professionals can markedly reduce their tax bill by reorganizing their affairs as a corporation rather than as an employee.

But the government is oblivious to why Canadians do this. The main reason to spend the time and money (often significant time and money) to incorporate is to gain a tax advantage between the tax rates applied to individual employees and those available to small corporations. The gap between the two is what motivates people to pursue these mechanisms.

And the government’s hiking of the top personal income tax rate from 29 to 33 per cent made this gap larger. Indeed, the feds’ tax hike came on top of similar hikes in many provinces, including Ontario, Alberta and New Brunswick. These changes increased incentives to incorporate because the tax gains available were made larger.

The uproar across the country to Ottawa’s small business tax reforms has triggered more back-pedalling by the government. A number of tweaks are being made to the proposed reforms to try to exempt most small businesses, in effect targeting only very successful small businesses.

In addition, the Liberal government recently announced it will reintroduce the previous Conservative government’s plan to lower the small business tax rate from 10.5 to 9.0 per cent by 2019. This was bad policy when the Tories announced it and even worse now, given the larger spread between personal and business tax rates.

It exacerbates the gap between tax rates for small businesses compared to employees, which is the underlying reason people pursue these mechanisms. The Liberals are encouraging the very behaviour they set out a few months ago to discourage. The real solution is to move to a lower, more uniform set of tax rates between types of income and levels of income.

And the federal government’s changes to small business taxes will increase the incentives for firms to stay small. This is not a recipe for economic prosperity.

The cut in the small business tax rate means the tax wall that small firms face as they grow and expand has increased. A number of studies note how the enormous jump in taxes for businesses as they move from small to general is a disincentive for growth.

The change in federal tax rates for businesses, given the announced reduction, increases by more than 50 per cent when a firm moves from a small business to a normal or general corporation. This is exacerbated by similar tax preferences imposed by the provinces.

The tweaks announced recently to quell political and public opposition to the small business tax reforms will discourage businesses from investing and growing, encourage more tax planning through the use of corporations, and further complicate an already anachronistic and costly tax code.

This isn’t the way to grow the economy for middle-income Canadians – or any Canadians.

Charles Lammam and Jason Clemens are economists with the think-tank Fraser Institute (www.fraserinstitute.org).

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