Corporate tax cuts are good policy, always and everywhere

Article published exclusively on the Montreal Economic Institute’s website.

A recent article by Karen Howlett in The Globe and Mail raises valid questions about the possible effects of a reduction in the corporate tax rate. She points at data from Statistics Canada showing that in recent years, businesses accumulated cash reserves while investment in physical capital declined. In this light, she wonders if the corporate tax reductions enacted since 2000 were that beneficial. This is an important issue, especially considering the fact that the positions of federal political parties in this electoral campaign are strongly polarized.

Before we try to provide answers to her question, it is necessary to point out that there is no inherent conflict between “making life more affordable for families” and “giving corporations additional tax cuts.” As a matter of fact, the two are closely related. A high rate of taxation on corporate profits means that investors will move abroad and businesses will invest less to improve their productivity and to raise wages for workers.

In the same period that the federal corporate income tax was reduced, a decline in physical capital investment was observed. At this point however, Ms. Howlett’s article falls into the trap of an old fallacy: two events happening at the same time do not necessarily imply a causal relationship. All things being equal, higher corporate tax rates reduce investment and entrepreneurship and the costs are borne by workers in the form of lower wages. The report of the Quebec Task Force on Business Investment, released in 2008, clearly documented this statement. It mentioned a study by Oxford University researchers who studied the behaviour of 23,000 companies in ten industrialized countries during 10 years. The study found that in the short run, 54% of every corporate tax increase is passed on as lower wages to employees. Moreover, in the long run, nearly 100% of the tax increase is passed on as reduced wages, caused mainly by the drop in productivity resulting from lower business investment.

Now, why is it that investment has declined? As Ms. Howlett remarks, many factors may come into play. For example, expectations of currency appreciation may push firms to build up cash reserves and take advantage of a stronger Canadian dollar to acquire new equipment and machinery from foreign markets. Another significant possibility is that of strategic behaviour by businesses: corporate savings and cash reserves can be used by firms to better cushion economic fluctuations, repay debt, resist hostile takeovers by other firms or even acquire the resources to buy other companies. This is a very important point since Canadian firms are very active abroad.

In fact, since 1997, foreign direct investment by Canadian businesses exceeded direct investment by foreign businesses in Canada by $672 billion. The fact that Canadian firms are so eager to invest abroad might suggest a lack of desire for investment in Canada. Public policy uncertainties are likely culprits. In the United States, a similar rise in cash reserves held by businesses has been noticed. As the budget deficit of the United States grows bigger, so do the chances of higher taxes. Facing uncertainty with regards to future returns on their investment, businesses prefer to stockpile their cash reserves in the hope of better days or to invest abroad. In Canada, we have a similar but less dire problem with regards to deficits.

However, cash reserves are just that: reserves that will be used sooner or later to invest, create jobs and pay dividends to shareholders (which will be beneficial to Canadians as savers in their RRSP or TFSA, for example) when businesses are more confident. The money has not been “wasted” and did not magically disappear.

Considering all of this, we should also wonder how much lower investment would now be if corporate taxes had not been cut at all since 2000!

Vincent Geloso and Jasmin Guénette are respectively economist and vice president at the Montreal Economic Institute. They co-authored The negative effects of corporate taxes on investment and on workers.