As I write this article on the latest version of private corporate tax reform, not all the details have been revealed. Nor has there been sufficient time to fully digest the October amendments to the historic July 18, 2017 proposals and understand their economic impacts.

As a reminder, the July 18 pro‎posals included three major changes. Any related persons (spouses, kids and other relations) would need to contribute capital or labour to be entitled to a share of the profits of a Canadian-controlled private corporation (the government called this “income sprinkling” but it is more commonly referred to as income splitting). The proposals would also more heavily tax retained earnings if invested in assets earning investment income (these assets are referred to as “passive assets” to perhaps suggest they are “dead money” even though retentions are critical to reduce credit costs, provide a cushion against risk and provide funds for future expansion). Further, the “surplus stripping” proposals would limit the ability to convert dividends into lower-taxed capital gains (this was a common strategy — pay out income as the least heavily taxed source of income).

The federal government has begun a process of backtracking on the controversial proposals that would raise revenue to fund the deficits they have created since 2015. The October 16 announcement lowers the federal small business tax rate on “active” business income from 10.5 to 9 percent over the next two years as well as drop of a July proposal to reduce multiple claims of the Lifetime Capital Gains Exemption by family members. The income splitting proposal will remain with respect to dividends. Announcements will be made with respect to the investment income and surplus stripping rules, all likely to provide further relief from the impact of the July 18 proposals.

How did the federal government so badly mismanage this reform‎? I would suggest three reasons. First, insufficient attention was paid to trade-offs involved in developing a good tax structure. Second, the analysis presented to justify reform was lacking. Third, the rhetoric used to justify the reform simply got people’s backs up.

1. Objectives and trade-offs involved with tax ‎reform packages

Experts identify three major reasons for improving a tax system: economic growth, fairness and simplicity. The role of taxation is to raise revenues to fund public services, but the total requirement depends on spending. Once knowing the level of spending, the tax structure should be chosen to minimize economic costs and complexity while achieving greater fairness (the latter defined as equal treatment of equals and those with more income pay more). Balancing these objectives is the tough part of any tax reform exercise.

When the July proposals were introduced, the prime minister and minister of Finance only talked about fairness — making the rich to pay more. Little was said about reducing complexity — indeed the proposals did the opposite. Nor was there any focus on economic impacts. Raising taxes on small businesses would deter investment as well as reduce competitiveness given that the United States is looking at tax reductions, not tax increases on their small firms.

Obviously, the government had set itself up for widespread criticism. Many suggested that many middle class small business owners and their families would be hurt. Venture capital, manufacturing and other growing businesses would be adversely affected. To avoid the new rules, owners looked at whether their company should become a non-Canadian controlled private company — such as selling out to pension plans, to foreigners or moving to another country. Family succession would be discouraged as assets transferred to children would be more heavily taxed than if sold to unrelated persons.

Tax reform is a contract with voters. It is never wise to only focus on one issue — fairness — not taking into account other tax policy objectives.

2. Limited Analysis

The July 18th Finance proposals played up the importance of neutrality — reducing distortions and improving fairness by reducing the incentive for individuals to arrange their affairs as a corporation rather than sole proprietorship or partnership whereby the latter’s income is taxed at the investor level. A critical point was shown that business income in private corporations increased substantially as a share of GDP since 2001.

This type of analysis was important but did not go far enough. I can think of four reasons for the growth of private corporate‎ income. First, many businesses have been shedding employees in favour of contractors, the latter typically organized as corporations either to limit liability or reduce taxes. Second, the provinces enabled many professionals, ranging from doctors to social workers, to incorporate since 2001, although they would not be able to extinguish their personal liability with respect to their performance. Third, many public corporations de-listed to become Canadian-controlled corporations with increased security regulation. And fourth, the differential between corporate and personal rates opened wider — in 2001 the difference between the top federal-provincial personal tax rate and small federal-provincial tax rate was about 28 points while in 2017 became 37 points.

It was the differential personal and corporate rates upon which the July 18 proposal focused. Yet there was no particular evidence provided to understand as to which factor was most salient. This is critical to provide. In order to make a case for change one wishes to understand the source of the problem. For example, if the concern was professionals incorporating, a different set of measures would have been better to propose.

Nor did the government make a clear case as to the impact of their proposals in dealing with problem at hand. Philip Bazel and I have estimated that over 800,000 households receive dividends from private corporations. Only 75,000 households have two members or more in a household receiving private company dividends, about half of which is in middle-class groups. ‎It is quite possible in many cases that a spouse or child is working in the company so such income splitting is legitimate. But little of this data was provided except for a ballpark revenue estimate of $250 million without clarifying who would pay.

Also, little data was provided with respect to the importance of surplus stripping or investment income ‎across different types of corporations and income groups. Without this information, it was hard to make a case only the rich are involved.

The discussion paper also did a poor job dealing with transition. Taxpayers basing past decisions on the existing system found out their estate transfers to children would be subject to exceptionally high tax rates ranging from 67 to 93 per cent.‎ Little time was given for restructuring their plans as some rules were effective on July 18th. These are the areas now a focus for change.

And even if only the upper income group was involved, no analysis was provided about the economic cost of the proposals and their impact on competitiveness. Perhaps the new tax increases would not have a significant impact but for a government interested in evidence-based policy, the discussion paper came up short in analysis.

3. Rhetoric 

When the private corporation proposals were issued, the PM and minister of Finance talked about loopholes, unfairness in favour of the rich and nefarious ways of avoiding taxes. Those owning close to two million private corporations got their backs up. They believed the system in place since 1972 ‎was meant to encourage small business growth, which obviously would result in less taxes to be paid. The incentives are no different than other preferences such as accelerated depreciation, exemptions under the GST, and so on, that taxpayers use to avoid paying taxes. The class warfare rhetoric encouraged over 50 organizations to band together to oppose the changes with potential fallout of political support for the government.

Overall, however, it would be far better to move to a single corporate tax rate by abolishing the small business deduction, not the increase announced this week. We could then eliminate the differential dividend tax rates reflecting large and small corporate tax rates and equalize capital gains and dividend tax rates. This type of reform would have made surplus stripping and investment income rules less necessary. It would encourage growth as companies would be able to use retentions to fund investment without facing a tax wall of higher rates. Further, better investment-related incentives for small business could have been introduced as in the UK and U.S. while improving the overall system. This would have been real tax reform.

The better way, however, was not chosen.

Jack Mintz is President’s Fellow at the School of Public Policy, University of Calgary, of which he was Founding Director and Palmer Chair from 2008-2015. He chaired Ottawa’s Technical Committee on Business Taxation in 1996-97, leading to corporate tax reform after 2000.