Cutting Corporate Taxes Is Not the Way To Support Business Investment

Jim Stanford, Director of the Centre for Future Work, Vancouver

In 2001 the Liberal government, under then Finance Minister Paul Martin, began to significantly reduce the general federal CIT rate, cutting it from 28 to 21 percent over the next three years. Later, starting in 2008, the Conservative government of Stephen Harper cut the rate further, lowering it to 15 percent by 2012. Many provincial governments have also cut their CIT rates. The average combined federal and provincial rate has thus declined by about half in the last generation: from around 50 percent, in the late 1980s, to just over 26 percent today. Thanks to various deductions and exemptions, effective CITs are even lower: from 2016 through 2019, for example, on average, Canadian corporations paid income taxes equal to 18 percent of their pre-tax profits.

The main argument in favour of reducing CIT rates is that doing so will spur new capital investment by firms, which will be lured by the prospect of keeping a larger share of their subsequent profits in after-tax income. Faster investment, according to this argument, will spur faster economic growth, more job creation, and—thanks to the beneficial effects of new technology and equipment on workers' efficiency—higher productivity. Indeed (so the argument goes), if all goes according to plan and competitive labour markets automatically reward that higher productivity with higher wages, then workers will benefit, too. In fact, some advocates of this view have argued that workers, not businesses, are the biggest beneficiaries of lower CITs. (See, for example, Jack Mintz's article in the January 17, 2011 edition of the Financial Post.)

I am a big advocate of the benefits of stronger business investment spending. My previous writing has catalogued the many benefits of private capital formation for macroeconomic performance, technological innovation, sectoral composition, export competitiveness, and—yes—wages. (See, for example, my book Economics for Everyone: A Short Guide to the Economics of Capitalism, 2015.) To a large degree, society as a whole has a greater interest in business investment than businesses themselves do: the broad spillover benefits of strong capital spending help explain why governments are always so anxious to attract new investment projects. That eagerness contrasts with the often apathetic attitude of private businesses toward investment spending: many prefer distributing after-tax profits through dividends or share buybacks to putting money at risk in new investment projects.

After decades of experiments with lower CITs, however, the verdict is definitely in: across-the-board cuts in CIT rates are a terribly ineffective way to foster more business capital spending. In fact, according to both Canadian and international data, it's hard to see that lower business taxes have any positive investment impact at all.

Measured as a share of total GDP or disposable corporate cash flow, business capital investment spending has declined markedly in Canada since the turn of the century. That has undermined our economic performance, according to indicators such as GDP growth, innovation, exports, and incomes. And that decline has coincided almost perfectly with substantial CIT reductions implemented both federally and in most provinces—reductions justified by the need to increase investment.

Gross non-residential business capital spending declined from 13 percent of GDP in the late 1990s to 10.5 percent by the end of 2019. That's weaker than at any time since the recession of the early 1990s. The weakness in non-residential investment has been especially clear in the strategically critical areas of machinery and equipment (M & E), and of intangible intellectual property. As a percentage of GDP, M & E spending has fallen by half since the late 1990s, to only 3.3 percent. Innovation investment has declined by one-third relative to GDP since the dotcom collapse of 2001, falling to 1.6 percent by the end of 2019. Of course, all of that occurred before the economic shock of the coronavirus. This year, business investment will likely fall to the lowest levels in our post-war history.

Because of such weak business capital spending, Canada's performance in technology and innovation has slipped badly, especially compared with the performances of global leaders such as Germany, Korea, Sweden, and now even China. After accounting for depreciation, Canada's net private capital stock has hardly been growing at all. In fact, since 2015, net capital has grown more slowly than employment, so the aggregate capital-to-labour ratio in Canada is now actually falling. These data contradict the notion, which now obsessively dominates much public discourse, that automation and robots are replacing human workers. Far from being replaced by machines, Canadian workers actually have, on average, less equipment and technology to work with than previously, and this is because Canadian businesses failed to invest in real capital, even as their taxes fell.

The failure of across-the-board CIT cuts to stimulate robust capital spending is also strikingly visible at an international level. The countries that have achieved the strongest rates of capital investment since the global financial crisis (for example, Korea, Mexico, and Australia) typically have CIT rates as high as Canada's or higher. On the other hand, some countries with comparatively low CIT rates have experienced very weak rates of investment. Across the OECD as a whole, no statistical correlation at all exists between CIT rates and business investment. This lack of correlation is illustrated in the accompanying figure, which is based on my article "Dimensions and Implications of the Slowdown in OECD Business Investment" (chapter 16 in Economic Growth and Macroeconomic Stabilization Policies in Post-Keynesian Economics, 2020). A linear trend line fitted to a scatter plot of CIT rates versus investment performance has a slope of almost zero, implying no relationship at all between CIT rates and business investment.



Advocates of lower CIT rates will suggest that the lack of correlation between lower tax rates and increased investment is owing to the suppression of investment by other factors, which neutralize the benefits of lower taxes. But that is exactly the point. A decision by a business to commit long-term capital to a productive venture depends on a huge range of factors and influences. These include expectations of future demand growth, capacity utilization, regulatory and legal certainty, production costs and competitiveness, technological innovation, and product differentiation. Tax rates are merely one factor in a huge range of investment determinants. And the fact that lower taxes have not visibly stimulated investment, either in Canada or internationally, confirms that those other determinants are in fact more important than lower CITs.

Countries that have attained strong investment performance have successfully assembled strong, multifaceted investment regimes. They have nurtured home-grown innovative businesses; they have fostered innovation and commercialization; they have ensured strong market demand; they have supported inputs of skilled labour, affordable finance, and technology. Compared with those factors, CIT rates are of secondary importance. And tax cuts, furthermore, can even be counterproductive to the stimulation of investment if they undermine the public fiscal base that supports pro-investment initiatives such as spending on training, infrastructure, and innovation.

Indeed, as my research into corporate taxes and investment in Canada during the 1960-2010 period shows, the federal government would have elicited more new private business investment if it had taken the forgone revenue from corporate tax cuts and spent it on public infrastructure projects instead. As I demonstrate in one study, the "crowding in" effects that stronger aggregate demand conditions have on business investment are greater than the very weak impact that lower CIT rates have on capital spending. And the increase in total investment (counting both direct public capital projects and crowded-in private investment) from that expansionary strategy would be more than 10 times as great.

The failure of Canadian businesses to invest cannot be attributed to a lack of profits or available finance. To the contrary, business profits have increased as a share of GDP since the turn of the century, and gross cash flow exceeds gross business investment by a wide margin. As a result, corporations have increased their payouts of cash to investors (via dividends and share buybacks) and have accumulated unprecedented holdings of liquid assets. By the end of 2019, holdings of currency and deposits by non-financial companies in Canada reached $545 billion, or 23 percent of national GDP—doubling these holdings relative to GDP since Paul Martin's tax cuts were introduced in 2001. In other words, Canada's businesses have literally been pulling in more money than they know what to do with. Giving them even more money through further tax cuts will not encourage more investment.

The recession left by the current COVID-19 pandemic and emergency shutdowns will, of course, dramatically undermine profits, investment, and output across the economy. Would cutting CIT rates significantly alter that grim situation? Not likely. Business confidence is fragile, owing to the lack of aggregate demand, enormous overcapacity, disruptions in global trade and supply chains, and the risk of new outbreaks posed by the pandemic. Cutting the CIT rate will hardly affect investment decisions in such an uncertain climate. Indeed, with businesses facing huge losses, lowering the rate would be irrelevant in the near term. Far more effective would be for government to rebuild aggregate demand and business confidence through its own expansive projects, including infrastructure investment and expanded public services. And these projects will require more revenue, not less. Again, cutting corporate taxes (and, ultimately, the government spending that depends on CIT revenues) is more likely to hurt future capital investment than to help it.

Fostering more productive investment, both public and private, should certainly be a central goal of economic, fiscal, and tax policy. Investment is crucial for lifting productivity and incomes, fostering innovation, and addressing climate concerns. And strong investment will be critically important in leading Canada's economy out of the unprecedented economic contraction caused by the coronavirus pandemic.

There is no reason to believe that more across-the-board tax cuts will have any measurable effect in reaching that goal. To the extent that taxes are a factor in investment at all, tax incentives focused on investment decisions are more effective than tax cuts. These incentives are created through tools such as accelerated depreciation, investment tax credits, and public co-investments, and they help get strategic or large projects off the ground. Other policies are likely to be more important than taxes in fostering strong investment—for example, sector-specific strategies to build innovation-intensive industries, more effective R & D incentives, and skills and training supports.

The main priority for CIT reforms in coming years should not be cutting the rate even further; it should be to increase compliance and strengthen the integrity of the system. Advocates of CIT reductions often imply that rates must be cut to prevent businesses from transferring net revenues to lower-tax jurisdictions (through transfer pricing and other tricks of the trade). To this I would reply that no matter how much we lower taxes in Canada, there will always be a tropical island somewhere with even lower rates. To pretend that cutting rates can somehow stop such tax avoidance is fanciful. More seriously, we should not ratify the power of companies and their owners to avoid paying democratically determined contributions to the public services and infrastructure that they, among others, benefit from. More and more countries, rather than accepting the self-interested tax avoidance of global companies as a fait accompli, are developing new tools, both unilateral and multilateral, to tax these companies fairly on the basis of the location of their sales and activities. Canada should join them. France, Australia, and other OECD countries are undertaking to close these enormous loopholes and ensure that global firms, especially the super-profitable technology giants whose physical presence is particularly ethereal, make a reasonable contribution to the fiscal capacity of the countries where they do business.

Businesses and their owners have a responsibility to contribute to the health of the communities and society in which they do business, and CITs are one way that they should continue doing that. Current rates should be maintained, not cut, and the integrity of their enforcement should be strengthened. Fiscal incentives for capital investment spending should be far more focused and contingent on companies actually making those investments (through accelerated depreciation or investment tax credits). And if we really want to spur more business capital spending (as we should), then let's implement tools in other areas of policy that will accomplish that goal more effectively—through macroeconomic, technological, and sectoral strategies.


Perspectives on Tax Law & Policy
Volume 1, Number 2, June 2020
©2020, Canadian Tax Foundation