Looking Forward: New Approaches to Small Business Taxation

By Evelyn Jacks, Marco Iampieri with Dr. Jack Mintz

According to a recent study by Philip Cross, the former chief analyst at Statistics Canada, economic growth in Canada over the past ten years has been the weakest since the 1930s, our competitiveness has faltered to such a degree that we can’t capitalize on trade deals, our productivity has stalled, and even more startling for a nation with such highly educated and tech-savvy people:  our lack of innovation and weak economic growth has persisted for decades.  In conversation with Dr. Jack Mintz, who co-authored a study on small business tax competitiveness, we discussed alternative tax strategies as a potential solution.       

Evelyn Jacks: 

“Hello Jack and Marco. Thanks so much for your thoughtful responses to a very important issue for today’s business climate, which on so many fronts is challenging, especially for micro and small businesses.  Marco as a tax lawyer, we asked you to review 'A New Approach to Improving Small-Business Tax Competitiveness' by Dr. Mintz and his co-authors for KBR.  At the outset asked your opinion on the important issue of corporate tax reform in response. To begin the discussion, do you agree that removing the small business deduction in favor of a single corporate income tax would have certain advantages?”

Marco Iampieri: 

Yes, I agree that a single corporate income tax would reduce compliance costs, and that a flatter dividend tax rate for entrepreneurs with significant ownership in the small business would mitigate against the financial effects of removing the small business deduction, as suggested in this paper.

Evelyn Jacks:

Dr. Mintz, you raised the issue of creating a “tax wall” should we consider a flat tax option for business taxation.  Can you please elaborate on that concept?

Dr. Jack Mintz: 

This paper is a second of two works, an earlier one done in 2011 by Duanjie Chen and myself when we first initiated the discussion around tax walls. 

We were struck a decade ago by data that have shown many small businesses get created but do not grow. There was also evidence that firms break up to take advantage of small business tax breaks such as the low corporate income tax rate and enhanced R and D tax credits, unhampered by associated company rules. We were not the only researchers finding that result. 

The lack of small business growth was demonstrated in the 1998 report of the Technical Committee on Business Taxation as well as discussed by Bank of Canada reports and more recent papers such as one done by Pierre Lortie of Dentons. Our recommendations at that time was to replace business tax incentives that are only available when companies are small with those that encourage growth such as those found in the United States and the UK. The same applies to the spirit of this paper.

The recent 2021 paper makes an important point often missed.  It is not just the rising corporate income tax rate that can discourage growth but also the graduated personal income tax.  In this paper, we recommend moving to a single corporate income tax rate that would substantially reduce compliance costs but also flatten the dividend tax rate for entrepreneurs with significant ownership in the small business.

We compared our tax wall with other G7 countries and Australia, showing that Canada has the lowest marginal tax rates for very small companies but the steepest tax wall compared to others.  We were also surprised that a number of countries have a flat final tax on dividends, which is why we considered the idea.  It is not a perfect solution but we would argue a far better one than what we do now.

Evelyn Jacks: 

Flat taxes, in principle, do tend to be regressive at the lower end of the earnings scale and the integration of the personal/corporate tax system is not perfect; especially when there are wide variations in provincial taxes payable. Marco, you had some thoughts on this in particular.

Marco Iampieri: 

I largely agree with Dr. Mintz’s paper, and I commend him on an excellent report. My concern about the paper is the suggestion to move towards a flat tax rate for all Canadian businesses.  Moving to a single corporate income tax would inevitably create a more significant financial burden for smaller businesses than established businesses. An advantageous tax rate for smaller companies, as we currently have, provides an opportunity for entrepreneurs to reinvest profits into their business, which offsets the lack of access to capital investment facing small businesses. I have two suggestions that would avoid a flat-tax rate for all Canadian businesses and, hopefully, foster Canadian firm growth:

1) Place a time limit on the small business deduction. Anti-avoidance rules may be drafted that prevent strategic corporate dissolution to re-access the small business deduction; and,

2) Implement a flat tax rate for all businesses, but shift towards a tax credit system rather than a deduction system for Canadian small businesses. Small business tax credits may create a similar net tax effect as a small business deduction. However, this credit system may be designed to gradually reduce the tax credits yearly to foster small business growth. Also, this suggestion provides for greater tax administrative flexibility than a tax deduction system.  

Dr. Jack Mintz: 

We agree. Moving to a single corporate income tax rate is one way of flattening the wall but it would increase taxes on smaller companies.   To offset this effect, we suggest flattening and reducing the dividend tax rate as discussed above or, alternatively, introduce income-averaging for entrepreneurs (a policy that applied more generally years ago). 

Similar to the UK, we also recommend expensing capital expenditures up to a $1 million each year that would apply to all companies (thus a growing small business would not lose the incentive).  Finally, we recommend capital gains tax reductions for investors purchasing shares of initial public offerings made by smaller companies.   

Marco Iampieri:

I agree that Dr. Mintz’s suggestions will encourage business growth. I like the innovative idea regarding a capital gains tax reduction for investors purchasing shares of public offerings made by smaller companies.

Evelyn Jacks: 

There is much concern about future governments introducing higher capital gains inclusion rates and wealth taxes.  Translating that into a wealth management issue, it’s important to keep in mind that retained earnings in a corporation must backstop operations in the absence of venture capital or ability to borrow. 

Potentially rising interest rates, inflation and corporate taxes, will reduce those earnings, which also must ensure retirement income for business owners. Further, the pandemic has affected business valuations.  Finally, that challenges faced by professionals, such as doctors come to mind in this discussion, because they will not be able to count on saleable value in their practice to finance their retirement nest egg.  Higher corporate taxes against those backdrops will affect their future wealth and could affect hiring in the present.  Is there anything we can do in imaging future tax reforms to ensure fairness and equity for private corporations concerned with these issues?   

Marco Iampieri:

As retained earnings within private corporations have less buying power due to high levels of inflation, coupled with potentially rising interest rates and decreased share valuations due to the pandemic, from a wealth management perspective, it is understandable that shareholders of private corporations are concerned about their retirement. From a tax reform perspective, reforms may focus on mitigating the financial effects on private corporations caused by the pandemic in order to raise the economic footing for shareholders of private corporations to a pre-pandemic predictable economic footing.

By raising the economic footing for shareholders of private corporations to an economic footing that was predictable from a pre-pandemic economic forecast, the retirement worries for shareholders of private corporations would be significantly alleviated. The retirement worries for shareholders of private corporations would be significantly alleviated because the net economic effect would reconcile with their forecasted personal financial statements for their retirement.

A suggestion for a tax reform aimed at fairness and equity concerned with the mentioned issues is to raise the lifetime capital gains exemption for shareholders of private corporations on sales of qualified small business corporation shares by a percentage amount that is reasonably equal to the deleterious financial effects on the valuation of shares of private corporations caused by the pandemic.

Jack Mintz:

Canada needs to up its game in productivity.  Otherwise, with falling labour participation rates in this decade due to aging, we won’t have sufficient growth in incomes and taxes to support an aging population even with robust migration.  The only solution will be a policy framework that focuses on capital-deepening and innovation.  However, our governments are more focussed on spending to be financed by taxing higher income Canadians and corporations, which will worsen our ability to achieve higher per capita economic growth (1 percent per year this past decade). Small business tax reform is one element of a much larger agenda needed for economic prosperity.

Evelyn Jacks:

To conclude this interesting discussion, it is worth circling back Philip Cross’s observations about Canada’s lacklustre innovation culture: “Canada needs a root-and-branch re-examination of its public policy mix and its commitment to markets, competition, and capitalism, with the goal of creating an environment more conducive to greater business formation and investment

Innovation in corporate tax reform to spur on economic growth is a critical component to lift Canada out of its current slump.Fortunately, in Canada, we have the advantage of calling on learned and experienced tax experts to help spur on the right solutions for the future.To that end, I would like to thank Dr. Jack Mintz and Marco Iampieri for participating in this discussion and to invite our reader to add their thoughts to the discussion.

Please answer our January poll… now live! “Do you think personal/corporate tax reforms can spur on economic growth in Canada in 2022 and beyond?”