Federal tax expenditure review: The savings

The federal government gives up about $30 billion in revenue through tax-based spending programs. This cost is split approximately one-third for measures promoting economic development and two-thirds for measures with a social objective. A tough but fair review of these measures could easily come up with about $6 billion in savings.

As discussed in last week’s blog entry, eliminating tax incentives and raising general tax rates are alternative ways to reduce the budget deficit. Choosing between them involves comparing the benefit from maintaining a targeted measure with the cost of raising a broader tax rate.

Recommendation 1: Eliminate the small business deduction (SBD)

The SBD supports investment by small and medium-sized enterprises. But if the SBD is financed with an increase in the general corporate income tax rate, the net impact on investment will be close to zero. And the new distribution of investment will reduce real income because small firms are less productive than larger firms. The gross savings from eliminating the SBD would be $4 billion in 2017. The net savings would be much less because the SBD amounts to an interest-free loan that is repaid once the firm stops expanding and starts distributing the profit on its investments.

Recommendation 2: Eliminate extra support for R&D performed by small firms

There is a solid case for supporting R&D performed by firms. When a firm undertakes R&D, some of the knowledge created inevitably spills over to other firms, which they use to reduce production costs, create new production processes or introduce new products and services. A firm is focussed on its own benefits and costs when deciding how much to spend on R&D. It does not consider these spillover benefits, so society has an interest in encouraging additional R&D.

On the other hand, the case is weak for providing more support for R&D performed by small firms. Extra support would be justified if small firms respond more strongly than larger firms to the incentive or if the spillovers from small firms are larger. There is no evidence to support these assumptions. Reducing the small firm R&D tax credit from 35 per cent to 15 per cent — the same as for large firms — while maintaining refundability would result in fiscal savings of about $900 million a year. In addition, the real income of Canadians would be higher by eliminating the extra support for R&D performed by small firms instead of increasing general income tax rates.

Recommendation 3: Eliminate the film and video production services tax credit

The subsidy that encourages non-residents to produce films and videos in Canada is unusual in that it reduces real income even without considering the cost of financing it with higher taxes. This measure is harmful in itself because all of the subsidized output is exported, so an unusually large share of the incentive is transferred to non-residents, which directly reduces real income in Canada. The fiscal savings in 2017 from elimination of this measure would be $120 million.

Recommendation 4: Make employer contributions to private health plans a taxable benefit

The largest savings are available from ending the preferential tax treatment of employer contributions to private health and dental insurance plans. These contributions are a deductible business expense but, unlike other employee benefits, are not taxed in the hands of employees. The subsidy encourages more use of private insurance plans and a shift to employer-based from individual plans. In contrast to the economic development measures discussed above, economic performance is not being significantly affected by non-taxation of employer contributions – a selective personal income tax reduction – and financing it by higher statutory rates. But the subsidy does have favourable effects on the efficiency of health spending.

The shift to employer-based plans reduces delivery costs because such plans allow for greater risk pooling by insurance companies. This benefits society overall. But the impact on delivery costs is likely to be small. Large firms get such a substantial advantage from greater risk-pooling that they can offer competitively-priced plans with or without a tax preference. Although smaller firms are more sensitive to the tax preference, they get less of an advantage from risk-pooling, so a smaller share of them offer employer-based plans. As a result, ending the tax preference would have its greatest impact on a minority of firms that have the smallest delivery cost advantage.

Increased participation in private insurance plans could also reduce overall health care costs if it enables participants to seek treatment early, thereby avoiding more serious illnesses that are more expensive to treat. On the other hand, supplemental insurance can drive up costs with no change in health outcomes. The evidence points to a small positive or negative impact.

Non-taxation of contributions means that the benefit rises with income. Making employer contributions a taxable employee benefit eligible for the 15 per cent medical expense tax credit, which would be consistent with the treatment of employee contributions, would eliminate a regressive element in the tax system. Participation in private health plans would decrease, but in the absence of a substantial impact on health care costs, the case for a subsidy is weak. According to Finance Canada, this policy change would save almost $3 billion in 2017.

Recommendation 5

Smaller but still substantial savings are available by rationalizing pension income splitting. This measure levels the playing field with the self-employed who are able to split retirement income by using spousal RRSPs. However, pension income splitting raises a number of fairness issues. It transfers income from younger to older taxpayers and favours higher-income Canadians because the benefit rises with the income gap between the individuals involved. Pension income splitting also allows relatively well-off pensioners to increase their OAS benefits and raises the cost of the pension income credit. The government could save at least $300 million a year by eliminating the impacts on OAS payments and pension income tax credits. Additional savings could be realized by capping the benefit from pension income splitting, which would mitigate fairness concerns.

Other savings

Other measures ripe for change include the age and pension income credits, flow-through shares for mineral exploration and the capital gains exemption for donations of publicly-traded securities. Including changes to these measures would bring total fiscal savings up to about $6 billion, with a small improvement in economic efficiency as a bonus.

Further reading

Dachis, Benjamin, and John Lester. “Small Business Preferences as a Barrier to Growth: Not So Tall after All.” CD Howe Institute Commentary 426 (2015).

Lester, John. “Benefit-Cost Analysis of R&D Support Programs.” Canadian Tax Journal/Revue Fiscale Canadienne 60, no. 4 (2012). http://papers.ssrn.com/sol3/papers.cfm?abstract_id=2215681.

Lester, John. “Tax Credits for Foreign Location Shooting of Films: No Net Benefit for Canada.” Canadian Public Policy 39, no. 3 (2013): 451–472.

Lester, John. “Reviewing Federal Tax Expenditures” Canadian Tax Journal, Forthcoming.

Lester, John. “Tax Incentives for Business Investment: Do They Work?” SPP Research Paper, Forthcoming.