Corporate tax cuts: cui bono?

Whenever the NDP announces its intention to raise corporate taxes, critics always jump all over them, pointing out that the tax on corporations is not really a tax on corporations, since corporations can easily pass these taxes on to others (such as consumers in the form of higher prices, or workers in the form of lower wages). Yet these critics seldom stop to note that the argument cuts both ways. If corporations don’t really pay these taxes, then what is the point of cutting them either? Indeed, the Progressive Conservative party in Ontario is currently campaigning on a platform that calls for a dramatic reduction of corporate taxes – by 3.5%, from 11.5% to 8% (much more significant than the NDP platform, which calls for an increase of 1%). So why are the Conservatives so much more exercised about this issue than the NDP?

Before getting too far into it, I should mention that underlying the criticism of the NDP there is an important point, which relates to the concept of tax incidence. It reflects the fact that the person who writes the cheque to the government is not necessarily the person who pays the tax, because he or she may be able to pass the cost along to someone else. So just because something is called a “tax on x” does not mean it is actually a tax on x. For example, an income tax is not necessarily a tax on income. If savings are exempt – which for the average person they are, because of RRSPs and TFSAs – then it’s not really a tax on income, but rather a tax on consumption (because income – savings = consumption). Similarly, a tax on corporations is not necessarily a tax on corporations. The HST/GST, for instance, is technically a tax on corporations, because it’s corporations who have to write a cheque to the government in order to pay the HST/GST. But we call it a consumption tax, because corporations invariably pass it along to consumers. So the basic point is an important one: just because something is called a “corporate tax” does not mean that it is actually a tax on corporations.

So the question is, if the tax on corporations is not really a tax on corporations, why do corporations (or “the business community”) care how high it is? Just like the GST, it gets passed along to others. Even if they can’t pass it on to consumers or workers, the worst case scenario is that it gets passed along to shareholders (who are, in principle, the ones whose dividends are reduced by payment of a tax on profits). And there’s no reason to think that large corporations care very much about the absolute rate of return enjoyed by their shareholders. As long as their returns are competitive with what everyone else is paying, then managers are unlikely to spend much time worrying about how high they are. This suggests that corporations should be indifferent to the rate of taxation on profits (just as they should be indifferent to how high or low the GST is).

All of this generates something of a mystery, which is why conservatives are so keen to cut corporate taxes. Other than just “government is bad, business is good” ideology, or general complaints about deadweight losses, it’s difficult to see who really benefits from it.

There is, however, one important constituency who do stand to benefit. Most genuinely wealthy Canadians – in the top 1% say – do not just own stock in large public corporations, they also have their own private corporations, which they use to manage their personal wealth. They create these corporations largely to shield their income from taxation – first and foremost, as a vehicle for sheltering their retirement savings. As a result, the corporate tax rate is also their personal tax rate on a large fraction of their income, particularly their investment income. Understanding how this works is essential to understanding why they are such strong supporters of corporate tax cuts.

Let me sketch out roughly how things go. Suppose you are earning $500,000 per year, living in Ontario. Now the first thing you have to realize is that T4 income is for the little people. Nobody who is anybody makes T4 income. Why? Because you pretty much have no choice but to pay taxes on it, and there are practically no deductions. So once your income starts creeping above $150,000, you start looking for ways of converting it into non-T4 income (e.g. you work as a “consultant” on contract, rather than as an employee). Then you create a corporation (cheap and easy to do), and get people who hire you to pay your corporation instead of giving the money directly to you. This is called “shifting to more tax-efficient modes of compensation.”

Once you have the money coming into your corporation, you start by paying yourself a salary, around $136,270 – enough take you up to the point at which the top marginal rate kicks in. Maybe a bit more, so you can max out your RRSP contributions and TFSAs. Now it’s time to get creative with the rest. Does your spouse make less than you? Hire her (for simplicity, let’s say her) as a bookkeeper. Got young kids? Don’t pay your nanny out of regular income (the childcare deduction is ridiculously low), have the corporation hire her as an “executive assistant.” Kids gone off to university? Don’t pay their rent, have the corporation buy a condo and hire them as “property managers.” And don’t buy a second car, have your corporation buy it. Don’t go on vacation, go on business trips paid for by the corporation. The only limits are your imagination (and of course the law, loosely interpreted).

But even with all this “creativity,” chances are that when you’re finished you’ll still have some money stuck in the corporation, which you can’t take out without paying income tax at the top marginal rate. So what do you do? There you are like a kid outside a candy shop, with your face pressed up against the glass, looking at all that money you can’t spend. It’s so close, and yet so far… You’ve already maxed out your RRSP contribution room. What to do?

Well one thing you can do is keep it in the corporation and invest it somewhere. There’s only one problem with this. If you keep it in the corporation, it shows up as a profit, so you have to pay corporate tax on it – 15.5% at the (lower) combined provincial-federal rate. And then, when you take it out – which you will eventually need to do if you intend to spend it – you will have to pay income tax on it, probably at the top marginal rate. So where’s the gain?

It turns out though that if you do the math, there is a gain, if your objective is to save for your retirement. Why? Because of the effects of compounding on your investment returns. If you take the money out and invest it, you pay 46.4% upfront, then you pay 46.4% again on all the investment income you earn and reinvest. If you keep it in the corporation, you pay 15.5% upfront, then 15.5% again every year on the investment income you earn and reinvest, then 46.4% at the end when you take it out (or maybe a bit less, if your income goes down in retirement). Because of the effects of compounding, the advantage of having your money “grow” within the corporation, taxed at the low rate of 15.5%, outweighs the disadvantage of having to pay tax on it twice (once as profit, then again at the end as income).

What this means, in effect, is that a private corporation basically functions like a giant RRSP, with unlimited contribution room and extremely flexible rules on withdrawals.

This also explains why the very wealthy are particularly sensitive to the corporate tax rate. It’s because the way they use corporations to shield their retirement income from income taxes depends on the effects of compounding on their returns, and so the effects of the corporate tax rate are amplified – a small change in the rate has very large effects on the tax advantages of keeping one’s income in the corporation. Furthermore, there are a lot of very wealthy people with very large stacks of money locked up inside such corporations. This makes them the primary personal beneficiaries of corporate tax cuts.


*Disclaimer: None of this should be construed as tax advice, and I am not counselling tax fraud. I am simply describing one of the ways that people who earn very high incomes in Canada minimize their tax liabilities.


Corporate tax cuts: cui bono? — 3 Comments

  1. Hi,

    I’m enjoying reading this blog in general, but there are two problems I see with this post.

    1. Corporations may pass on the tax to customers/employees/others, but that doesn’t make them indifferent to the tax rate. With a higher marginal tax rate on investments, they will make fewer investments and operate at a smaller scale. That is, with a declining marginal product of capital, a higher pretax return is needed given a higher tax rate, so the amount of capital employed is pulled back. If we think that companies investing in new plant, new technology, and new equipment is a good thing, then one can form an argument for lower corporate taxes.

    2. Investment income inside a corporation is taxed at the highest personal rate, not the corporate rate. I don’t have a definitive link for this at my fingertips, but here is one commentary among many that google delivered to me Now, the distinction between active business income and investment income is surely fuzzy, and someone with a good accountant can surely slip some of the ‘passive’ into the ‘active’ category. But it is a bit more complicated than this post lets on.

    Thanks for providing this forum for your always-interesting thoughts. I’m an avid reader.

  2. Kevin: thanks for the comments (and the tweets)
    1. I was simplifying a bit for rhetorical purposes (but did include the nod to “deadweight losses”). One of the ideas I’ve had on the back burner for a while is to write an academic article called “Why tax corporations at all?” — because the standard line of reasoning seems to suggest that the rate of taxation on profits should be zero (just tax it as income whenever someone takes it out). When I shop around for arguments, why there should be any tax at all, the only suggestions I seem to hear have to do with minimizing tax evasion. But I’ve never looked properly to see if anyone has ever put forward a principled basis for why corporations should be taxed.
    2. Thanks, that’s an important clarification. I found a pretty good discussion of it here. I’m not really an expert on this, most of what I know comes from hanging around with rich people — who must have those crafty accountants, because they all seem to be doing it!

  3. Hi,

    My first public finance course was with Richard Bird at UofT. This is now 18 years old, but does an good job of laying out the case for and againstbtaxing corps at all.

    The argument about the US is interesting. A case can be made that the right corp rate in Canada is epsilon less than the US rate, since with credit for taxes paid abroad, the Canadian choice of tax rate only allocates revenue between the Canadian and US treasuries with no marginal consequences.