Along with the unfolding NAFTA saga, the passage of the Tax Cuts and Jobs Act (TCJA) by the U.S. Congress in December and the potential impacts on Canada has been front and centre in our interactions with clients so far in 2018. In this note, we don’t get into the nitty gritty of the potential impacts of this reform plan – the 560 page TCJA is a highly complex piece of legislation that will occupy the time of tax lawyers, accountants and economists for years to come. Instead, we provide our take on some of the more general questions and themes, with a particular focus on the changing competitiveness landscape.

Q: What are the key changes in the TCJA?

Immediately following the passage of the TCJA in December, TD Economics put out an analysis that summarized the most important changes in the legislation along with their expected impacts on our U.S. economic and financial outlook. While our lens tends to be macroeconomic in scope, accounting firms and consultants have provided detailed coverage on the many nuanced elements of the tax bill in response to their client demands, with much more invariably to follow.1

Most analysts would agree that the most important changes are the reduction in the statutory corporate tax rate from 35% to 21%, the ability to fully expense equipment spending for 5 years, a cap on interest expense deductions, and a tax on un-repatriated foreign earnings. It also moves the U.S. from a worldwide taxation system to a territorial one. On the personal tax side, rates have generally been reduced, alongside reductions of a number of income thresholds.2

Q: Where do these changes leave Canadian tax competitiveness?

Based on one of the simplest international benchmarks, the U.S. has historically been among the most tax competitive jurisdictions within the OECD (Chart 1). The tax burden in the U.S., which includes all forms of government revenue as a share of GDP, runs at around 27%, compared to 32% in Canada and 34% in the OECD. The lower overall average tax rate in the U.S. is largely due to the absence of a federal consumption/VAT tax and a relatively small personal income tax take. The personal and business tax relief provided by the TCJA is expected to further lower this ratio relative to business as usual levels.

That being said, economists argue that it is not the average tax rate but the marginal rate on the next dollar of income earned that is the more important driver of investment or other economic decisions. A key vulnerability in the U.S. tax system has been its high statutory corporate income tax rate. The TCJA has addressed this relative weakness (Chart 2). Including state levies, U.S. rates have been brought down to a level that is roughly in line with the OECD average, and slightly below Canada’s.3

If only life were that simple. Tax systems also include a number of offsets in the form of exemptions, depreciation allowances and other features of the tax code that serve to create a wedge between the posted marginal (statutory) rate and what corporations actually pay (the effective rate). For businesses looking at cross-border investment opportunities, the marginal effective tax rate or METR becomes the most important standard of comparison.

Given the complexities of corporate tax systems, calculating METRs is highly dependent on the various inputs into the model and underlying assumptions. A further challenge is finding Canada-U.S. comparisons that use a consistent methodology.

Conveniently, Canadian tax experts Jack Mintz and Phil Bazel of the University of Calgary have provided updated estimates of marginal effective tax rates on investment in Canada/U.S. across a number of industries that build in the impact of the reform plan.

According to their calculations, Canada’s METR has been substantially lower than that of the U.S. since 2006, an advantage that was driven by moves by the federal and provincial governments to slash general corporate income tax rates and eliminate capital taxes. Several provinces also implemented other measures that further lowered METRs. Chief among them were eliminating input taxes on capital spending through harmonizing provincial sales taxes with the GST and providing bonus depreciation. As recently as 2016, Canada’s METR on corporate investment was as much as 8 percentage points lower (Chart 3).4

U.S. tax reform has changed the math, slashing the U.S. METR on investment from 28.4% to 18.8%, compared with Canada’s 20.3% rate.5 The rate would have fallen even lower had Congress not scaled back some longstanding business tax incentives, such as deductibility of business interest expenses.

The effects of the TCJA across the industry landscape are widespread. Mintz and Bazel show that Canada’s relative tax competitiveness advantage has evaporated in all but two sectors (oil and gas and ‘other services’). Keep in mind that these are national computations. In some states (i.e., South Dakota, Wyoming) burdens are lower since there is no corporate income tax levied. In Canada, the METRs of the largest provinces are estimated to be clustered close to the national average rate.

Q: What about personal income tax competitiveness?

Unlike business tax rates, U.S. personal taxes have been historically lower than those in Canada, particularly for high income earners. With the TCJA, this gap widens further. The top combined federal-provincial income tax rate in Canada averages just above 50%. Pre-reform, the comparable rate in the U.S. was about 45%. The TCJA cuts this top levy to about 42.5% and 37% in states with no income tax such as Florida. Even in ‘high tax’ states, top rates are below Canada’s (Chart 4).

What’s more, the top rate kicks in at a much higher threshold in U.S. states relative to Canadian provinces. As an illustration, an Ontarian making more than C$220,000 a year would face a marginal tax rate of 53.5% on all income above that threshold. In comparison, the equivalent income level of US$178,000 would face a 41.3% combined marginal rate in California (the state with the highest combined top income tax rate). Moreover, while a Californian may face a top marginal rate of 50.3%, not far off Ontario’s, the threshold for this rate is much higher, at US$1 million (roughly C$1.23 million).

Similarly, Congress has funded part of the cost of the income tax cuts through new limits on personal deductions. The deduction for personal state and local taxes is capped at $10,000, and the mortgage interest deduction is capped at $750,000 for new loans. The impact of these changes will vary, but are likely to be most significant in high income, high tax states such as California and New York. But just the fact that the U.S. still makes tax deductions available to higher income earners increases the Canada-U.S. tax differential more than that implied by income tax rate comparisons alone. This is in addition to capital gains taxes that are generally lower in the U.S., particularly for earners not in the top tax bracket.

Since the TCJA was introduced and signed into law, some U.S. state legislators have been contemplating ways to mitigate some of the negative consequences of the reforms on their constituents. States that link their income tax systems to the federal definition of taxation income will, all things equal, see their revenues increase. States may offset this impact through cuts in their state tax rates. California is considering setting up a vehicle that could allow residents to pay taxes through a federally-deductible state-run charity.

Q: Will the U.S. tax advantage continue to widen going forward?

There are two main reasons why at least part of the improvement in U.S. tax competitiveness owing to the TCJA will be temporary.

First, in order to keep the price tag of the TCJA at $1.5 trillion over 10 years, Congress opted to make a number of the tax provisions temporary. Cuts to personal tax rates are set to expire in 2025. Full expensing of capital investment expire earlier, in 2023, pushing up the METR on investment. A projection carried out by Jason Furman of the Harvard Kennedy School highlights this dynamic (Chart 5; note that in contrast to Mintz and Bazel’s calculations, these figures are for federal taxes only).6 By his calculations, the expiry of both TCJA measures and those in place pre-TCJA push up the U.S. corporate METR sharply in 2023-27, eventually rising above the rate that would have prevailed under prior legislation. This suggests that the corporate tax advantage could be temporary if the tax breaks are allowed to lapse.

Second, projections of a sharp deterioration in the U.S. federal deficit increase the risk that tax rates will need to be hiked over the longer term. Even with the expiry of the various measures in 2023, the U.S. federal deficit is on track to widen from its current level of about 3.4% of GDP to approximately 6% by 2022.

The ultimate reversal of several aspects of the TCJA is not carved in stone. The tax cuts could be extended, particularly if current deficit projections prove too lofty. Growth could be stronger than forecast. Spending cuts could ultimately be implemented; the administration has released a 10-year budget framework that envisages dramatic cuts to non-defense spending. Even under a Republican-controlled Congress, it will be difficult to get agreement on such massive spending reductions.

Uncertainty doesn’t just prevail around U.S. tax rates, but also Canadian rates, which have been trending upward in recent years. Based on fiscal sustainability measures alone, there is a good case that Canadian tax rates could experience less upward pressure. Canada’s federal government boasts a relatively low budget shortfall (a deficit of around just 1% appears likely for the current fiscal year) and low debt-to-GDP ratio (31%) and both are projected to continue to decline over the medium term. However, the picture is generally less favourable at the provincial level in light of relatively high debt and, in some regions, lofty deficits.

Q: Are corporate taxes the only factor that drives investment decisions?

A key rationale for governments to lower the business tax burden is that it will spur investment and longer-term economic growth prospects. While results vary from study to study, international research generally supports the case that lower corporate tax rates provide a lift to capital spending.7 Case in point, a report issued by the Canadian Federal Department of Finance found that a 10% reduction in the tax component of the user cost of capital is associated with an increase in the capital stock in the 3-7% range.8

The other common finding in research is that taxes are only one part of the equation. Other cost factors (i.e., wages, facility costs, transportation), timing of the business cycle, risk factors, access to labour and the regulatory environment are all important drivers of investment and location decisions. The complex array of variables that go into investment decisions is reflected in investment performances across the G7. Investment growth in the U.S. has topped the charts since 2011 despite a higher corporate tax rate (Chart 6).9

How has Canada been stacking up in terms of overall cost competitiveness? In the 2016 edition, researchers at the accounting firm KPMG ranked Canada second most favourable of 10 countries in terms of overall costs, behind Mexico, while the U.S. placed 10th. KPMG used cost levels in Toronto and Montreal as their Canadian benchmark. The report cites considerable increases in Canadian leasing and industrial land costs in their 2016 report, but that was counterbalanced at the time by a decline in the loonie.

A key cost advantage for Canadian firms is the lower private healthcare costs relative to the U.S.. Stateside, roughly 20% of overall health spending is borne by corporations. In Canada, the comparable share is about 4%.10

The passage of the TCJA and the strengthening in the Canadian dollar close to its fair value of 80 US cents over the past year has undoubtedly chipped away at any cost advantage that Canada enjoyed in 2016. There is a good argument that Canada needs to maintain a significant business cost edge over the U.S. to compensate for some natural disadvantages, such as a smaller relative market size. Businesses may seek a higher compensation factor going forward in light of brightening U.S. growth prospects and growing NAFTA uncertainties, the latter of which might prompt companies to locate in the U.S. as a hedge against the risk that the agreement is scrapped.

Q: So what’s the bottom line? Should Canada fear an investment exodus to the U.S.?

In the current environment, the risk of a significant near-term migration of investment from Canada to the U.S. is real. Still, there are a number of influences that should lessen this likelihood, chief among them:

The U.S. is operating at full capacity. Canadian companies might struggle to secure the space, suppliers and labour required to set up shop at reasonable return rates.

The temporary nature of key elements of the TCJA and uncertainty about the future path of tax rates could give businesses pause about deploying investment stateside.

Canada’s economy continues to hold up well, which in turn partly reflects solid U.S. growth prospects and the knock-on effects to Canadian trade.

Accordingly, we don’t expect to see a near-term exodus in investment to the U.S. from Canada. However, the recent significant change in the landscape is more likely to manifest in the form of a longer-term “bleed” in capital flows to south of the border. A greater difficulty in attracting and retaining investment in Canada would weigh on the country’s longer-term growth prospects.

Q: Does Canada risk another brain drain?

Access to a skilled labour force is an area that Canada stacks up comparatively well. This country is a leader in the rate of post secondary education attainment and has a strong reputation for its openness to new migrants. At the same time, all signs point to a more restrictive U.S. immigration policy, including for high skilled workers.11

The further widening in the tax differentials are raising some concern in Canada about the potential for highly educated and mobile residents to gravitate to opportunities south of the border. It was exactly this notion that underpinned the fear of a Canadian “brain drain” in the 1990s, as Canadian governments increased taxes to help battle high debt (federal net debt peaked at 68% of GDP in 1995, more than double current levels).

However, while these fears may have been well-founded, they proved to be somewhat overdone. Statistics Canada research suggests that although there is evidence that a ‘brain drain’ occurred, the effect was small in both absolute and relative size.12 What’s more, Canada also appeared to see a ‘brain gain’ at the same time, as immigrants tended to be more highly educated.

Thus, the risks of some brain drain have increased post TCJA, but not significantly. Labour tends to be less mobile then capital, and the tax gap was already sizeable prior to the reform. The story is analagous to business investment decisions: personal tax rates are only one of many factors that individuals look at.

Q: Will the TCJA lead to higher Canadian interest rates and a lower loonie?

The timing of the TCJA’s implementation – adding stimulus to a U.S. economy that is already operating at full employment – has been pushing up both inflation expectations and U.S. Treasury yields. Since December, the U.S. 10-year Treasury has increased by 40-50 basis points – reaching a four year high in late January. This pressure has rippled into markets globally, including Canada, where 10-year yields have risen by roughly the same amount.

Our 2018 baseline rate view currently includes three rate hikes by the Fed and two by the Bank of Canada (last month’s hike, as well as one additional move in July). We do not expect a major thrust on U.S. growth and inflation from the TCJA – GDP growth is likely to be lifted by 0.1-0.2 ppts and 0.2-0.3 ppts in 2018 and 2019, respectively. This relatively modest growth effect should not translate into a substantial increase in bond yields from current levels. We acknowledge that the balance of risks around our projection is tilted towards higher rates.

Another market question relates to the implications of TCJA on the Canadian dollar – and notably the one-time lower tax rate on the repatriation of previously-deferred offshore earnings of U.S. companies. Rough estimates of this foreign pool of capital are large – as high as US$2 trillion to US$3 trillion. However, analysts have been downplaying the potential for this forced repatriation to impact the currency markets. For one, the capital can be brought home over eight years. Second, an important share of the cash held in Canada and other markets is already held in U.S. dollars. Other factors, notably central bank rate differentials and growth prospects, are likely to dominate currency moves in the months ahead.

Q: How should governments respond?

Peak government budget season in Canada is fast approaching. Both the passage of the TCJA and NAFTA worries has been upping the heat on the federal and provincial governments to take action to mitigate growing competitive risks. There are even calls to match the U.S. cuts tit-for-tat.

That strategy is convenient but too simplistic since it ignores the many trade-offs of policy choices. As we have discussed, competitiveness is driven by a complex array of variables (perhaps even more so in today’s era relative to the past). For instance, depending on program structure, providing incentives for the private sector to upskill workforces in the accelerating age of automation might deliver a greater bang for the buck on competitiveness than, say, matching the U.S. move to full expensing. Moreover, each region of Canada faces different competitive challenges and vulnerabilities.

A more detailed policy prescription goes beyond the scope of this report. We would offer up the following for governments to consider:

First, and perhaps most obvious, governments need to avoid implementing actions that would make Canada less competitive than it is today.

Measures to strengthen competitiveness need to be balanced against longer-term fiscal sustainability. Rising budget shortfalls and increasingly elevated debt burdens are counterproductive over the longer haul, as was observed in Canada in the 1990s.

Governments need to consider the stage of the business cycle. Similar to the U.S., Canada’s economy has little spare capacity. Injecting significant fiscal stimulus in Canada at this point could lead to higher interest rates and raise pressure on highly-indebted households.

This speaks to our preference of tax reform over tax cuts. 13 Governments can reduce taxes that are most harmful on investment (i.e. corporate income taxes) and offset the impact on revenue by increasing levies that are less damaging (i.e., sales taxes). Simplifying the tax system through eliminating inefficient tax credits and other tax expenditures could free up room for productivity-enhancing actions. There also remain a number of provinces that have not harmonized their sales taxes with the GST, which is an impediment on investment and growth.

Governments can reduce taxes that are most harmful on investment (i.e. corporate income taxes) and offset the impact on revenue by increasing levies that are less damaging (i.e., sales taxes). Simplifying the tax system through eliminating inefficient tax credits and other tax expenditures could free up room for productivity-enhancing actions. There also remain a number of provinces that have not harmonized their sales taxes with the GST, which is an impediment on investment and growth. More broadly, resources could be freed up by efforts to reallocate public spending from areas of low priority to areas of greater importance. But barring fundamental reforms in areas such as health care, such savings tend to be relatively small or unsustainable.

Lastly, regulatory systems in Canada remain challenged with many out-dated and inefficient rules. Efforts to remove inefficient regulations and modernize systems need to be stepped up.

The 2018 federal and provincial budget season offers a significant opportunity to strengthen Canada’s defenses against the growing U.S. competitiveness challenge.