A Gladwellian moment on taxation

I have always struggled to understand why people seem to think that cutting corporate tax rates is so important to economic development.  There is no data to back that up – beyond the need to have reasonable/average levels of corporate taxation.  The Conference Board last week issued a study finding zero correlationb between lower corporate tax rates and levels of business investment.

And yet, I was talking to a guy yesterday who said Shawn Graham’s biggest contribution to New Brunswick was his cutting the corporate tax rate.  It’s dropping to 11% by next year for manufacturers and general businesses – 5% for small businesses.  The small biz rate was even lower under Bernard Lord.

Then this guy said “I’d like to have an 11% income tax rate”.

And then I had a Gladwellain moment.  This guy, and many others, are equating in their minds personal income taxes and corporate income taxes.  When they hear that a government has given a corporation a cut in their corporate income tax rate from 18% to 11%  – in their minds they see a 7 percentage point drop or a 39% drop in the rate and equate that in a blink to the impact they would feel on their own taxes if they received a 39% drop in the amount of taxes they need to pay.

Apples & oranges, folks.

You pay taxes on your total income – all the money coming in.  Corporations pay taxes only on their profits – a small percentage of the total money coming in.

For example, a typical family likely pays around 19% of their total income in personal income taxes in New Brunswick.  If you brought their effective income tax rate down to 11%, it would cut the average family’s cost base by a significant amount.    If a family earns $80k, dropping their net income tax rate from 19% to 11% would drop the amount of taxes paid by $15,200 to $8,800 per year.  That is an 8% reduction in their total costs ($6,400 over the $80,000).  That’s a big deal.

However, when the NB corporation gets a cut in their income tax rate from 18% to 11% – it cuts their overall costs (taxes are just another cost of business) by a far lower amount.  Assume a company with $10 million in sales and a profit of $1 million per year (10% profit margin).   Remember that provincial income taxes owed are based on a formulat that includes both where your operations are (manufacturing, etc.) and where your sales are.  So if you are in New Brunswick, you will not pay the full 18% here – but you might end up paying half – the rest of your provincial income taxes will be levied by other provinces and jurisdictions where you have sales.

So, on your $1 million in profits you pay – for example’s sake – $90,000 in provincial income taxes in New Brunswick.  Now the government comes along and drops your rate from 18% to 11%.  That means your $90,000 tax liability drops to $54,900 – or you saved $35,100 total dollars from the tax cut or about 0.4% as a percentage of your total sales (or cost base + profit).

So when you think about a cut in corporate income tax rates from 18% to 11% in New Brunswick, you should understand that the effective cost benefit to the company is more like less than one half of one percent of revenue – not nearly enough to trigger any kind of new investment decisions.

By contrast, a cut from the current net rate of 19% to 11% for a household would reduce the total cost base by 8% – overall. 

So when my friend was thinking about Shawn Graham’s greatest legacy he was thinking 8% when he should have been thinking 0.4%. 

Why does this matter?

Because, as I have pointed out before 0.4% of your total cost base (cost + profit) is virtually nothing.  If that company with $10 million in sales and $9 million in total costs ($1 million in profit) is energy intensive, that cost escalation has been far more impactful in recent years.  Say they spend 20% of their total costs (the $9 million) on energy (gas and electricity).  Their energy costs have risen by at least 40% in the past few years.  A 40% increase on the 20% energy costs means their energy costs have pushed up their total cost base by 8% – and the government comes along with an effective cut in their costs by 0.4% (from the tax cut).  The energy cost increase has dwarfed any cut in taxes.

Or let’s say you are a labour intensive firm and 70% of your $9 million in costs is labour.  If your labour costs rise by 25% (which they have for many firms in the past decade) that would be a 17.5% increase in your overall cost base (the $9 million) – far outstripping any benefit from the 0.4% cost reduction from the tax rate.

Or how about you are an 100% exporter to the USA and you have watched the currency appreciate from 85 cents to par within a short period of time.  That has pushed up your costs by 17.6% – dwarfing any benefit from the 0.4% tax cut.

I hope this makes some sense.  Obviously my examples are based on a realistic model – 10% profitability for example.  If a company was making 50% profit, that would change the benefit but that is unlikely.

We need to understand the cost structure of industries before we look at tax and other policies that impact their competitiveness. 

These feel good moves – like a cut in corporate income tax rates – are not based on good evidence.

The truth is that a growing number of NB companies right now are facing significant increases in wages and benefit costs, rapidly escalating energy costs, the impact of the high value of the Canadian dollar and years and years of governments promoting inefficiency by incentivizing only job creation (by giving out money in relation to how many jobs you create). 

We need a large scale productivity and innovation agenda as the only way to structurally bring back competitiveness to our export industries.  I am not as worried about our local industries because they face the same competitive environment (the 12 architectural firms in Moncton all face the same rising cost structure so they can build it into their costs).

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2 Responses to A Gladwellian moment on taxation

  1. richard says:

    I hope this makes it into one of your TJ columns soon. Should be an op-ed in every newspaper in the province.

  2. mikel says:

    It IS very important, but also somewhat convoluted in a “give it to me straight” kind of way. It should really be a “schoolhouse rock” video to make it clear to EVERYONE. It would also be worth pointing out that even the decrease in tax cuts to the wealthy is a bit of joke. Canadians make fun of the Bush cuts, but here was Shawn Graham doing the exact same thing. Its HIGHLY doubtful that if somebody earns $160,000 per year, and now saves an extra $30,000, that that money will get ‘invested’ back into the province. Its more likely to get invested overseas, and used to buy cheaper large scale items from the states than end up within NB. Where exactly would they invest it?

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