Although COVID-19 will still be with us in some form over the next year, a rebound of the world economies is occurring. The necessary fiscal and monetary stimulus measures undertaken by most countries will help us to survive the period of shutdowns and historically large declines in GNP. On a world-wide basis, aggressive monetary stimulus is occurring to prevent disruption to our financial systems. However, the strength of the economic recovery may be affected by the reduced purchasing power of individuals as well as lingering fears of COVID-19. No one really knows what the new “normal” will look like. We do know that most people will come through this period feeling poorer. At the same time, all levels of government will be affected by the substantial amounts of deficit financing necessarily being undertaken.
COVID-19 RELATED SPENDING
In the United States, a two trillion dollar stimulus package was approved. As part of that package, the Senate Republicans slipped in a tax break for wealthy real estate investors. This tax break (which will also help Trump and his family) could cost the US Treasury $150 billion over the next ten years. Additional assistance programs, including further loans to small business have been agreed upon. A further stimulus package will await the successful conclusion of negotiations between the Democrats and the Republicans.
In Canada, a 107 billion dollar package was first approved with further assistance having been announced. On a continuing basis, improvements or additions to these programs are being made. In Canada, a $343 Billion deficit is now forecast for the current fiscal year, thereby increasing the debt to GDP ratio to 49%. The Prime Minister has recently prorogued Parliament and a further stimulus package is likely when Parliament resumes. The new Minister of Finance, Chrystia Freeland, will be instrumental in the process of developing such a proposal.
It is now evident in both countries that many of these spending programs were designed in great haste. Consequently, there has been some fraud as well as an inability of many deserving individuals to access program benefits. Finally, funds were often allocated in a manner inconsistent with the stated goals.
The resulting amount of required deficit financing will be much greater than the total amount of the announced assistance amounts, as tax revenues will decrease significantly during the period affected by the pandemic. The accumulated outstanding federal debt In Canada is expected to reach $1.2 trillion. This estimate is based on the present situation and takes no account of additional significant deficits to be incurred in succeeding fiscal years. The cost of this debt and the deficits to be incurred by other levels of government (which are also experiencing revenue shortfalls) will be a substantial burden upon the average taxpayer. The one positive factor is the ability to now finance these deficits at very low interest rates.
RECENT HISTORY OF DEFICIT FINANCING FOR THE UNITED STATES AND CANADA
Donald Trump’s first budget after coming into office cut taxes sharply, with wealthy individuals and large corporations being the main beneficiaries. Taxpayers in the top 1% received 20% of the total tax cut. Trump said that this would result in increased investment benefiting the economy. The reality was that the tax money saved by corporations was used for stock buy-backs (one trillion dollars in 2018). In 2019, the US Federal Deficit ballooned to $984 billion dollars. In Canada, the Deficit was $14 billion. So, Canada did much better with its finances when taking into account the smaller size of its economy.
RATIONALE FOR TAX CHANGES
The purpose of these proposed tax changes is to shift some of the tax burden (resulting from big deficits) to wealthy individuals and corporations that are undertaxed. It is now estimated that the wealthiest Americans pay taxes at the same rate as the average worker. Also, many large profitable corporations pay little or no taxes. These corporations benefit from preferential tax provisions resulting from lobbying efforts, as well as the shifting of corporate income to low tax jurisdictions. Wealthy individuals benefit from their corporate share ownership, the preferential treatment of capital gains and the deductibility of mortgage interest on residences (in the US). The resulting low effective tax rates for wealthy people have caused their share of total wealth to sky rocket. In the United States, the top 1% own 40% of the nation’s wealth.
Lobbying efforts in the United States are very well organized with lavish spending on re-election campaigns made possible by very permissive regulations. These efforts have resulted in special low tax rates for hedge fund income, advantageous write-offs on real estate and many other special interest tax provisions. Detailed study of applicable income tax rules and much political effort will be needed to remove these special arrangements.
On a world- wide basis, large companies have transferred their income to low tax jurisdictions like Ireland and Bermuda. Technology companies have found it easiest to accomplish that result. These companies earn substantial advertising revenues in countries where they pay little or no income tax. When asked about this, the usual response is that the Company pays all of the income tax it is legally obligated to pay. So, to address this problem, we need to change the rules of the “game”.
As a practical matter, Canada must co-operate with the United States in making the major tax changes being suggested. The political will to accomplish this difficult task will exist only with Trump’s defeat and the Democrats controlling both the House and the Senate. The likelihood of these political changes occurring is increasing as President Trump ignores the pandemic, and continues to support conspiracy theories.
SPECIFIC TAX RECOMMENDATIONS
Large international corporations need to be subject to much tighter rules on how their income is allocated to the countries in which they do business. The simplest approach would be to allocate their total income (computed in accordance with agreed upon rules) to each country in proportion to the sales of the corporate entity. This will require international co-operation.
I have referred previously to the many special interest tax provisions which have been passed as a result of lobbying activities and improper influence upon legislators. Detailed study by tax specialists will be needed to remove these improper benefits to special interest groups. When wealthy companies can avoid paying their fair share of taxes, it brings the whole tax system into disrepute.
In both Canada and the United States, individuals can donate securities to charities and receive a full donation receipt. At the same time, they do not have to pay any tax on the capital gain related to those securities. The average person has no such securities to donate and pays taxes on all of their income. We do not want to quash the incentives for charitable giving, and so it is suggested that only half of that capital gain be subject to tax.
In both countries, capital gains are taxed at about 50% of the rate applied to other income. Raising this rate to 75% would still preserve the incentives for capital formation. Also, in the United States, there is no deemed disposition of assets at death (as exists in Canada) so that there is no tax payable on the capital gains related to assets owned at death. The heirs assume ownership of such assets at a cost basis equal to the market value at death. These capital gains are economic income and there is no justification for not subjecting them to tax. Those individuals (and their heirs) have already had the benefit of a substantial tax deferral. So, a deemed disposition at death should be the general rule. In this way, accumulated capital gains would be taxed at death.
In the United States (but not in Canada), the deductibility of mortgage interest for tax purposes particularly benefits wealthy individuals. Interest on a residential mortgage of up to $1,000,000 can be deducted from income subject to tax. This interest deduction should be limited to only the interest related to $400,000 of such mortgages. In that way, substantial tax revenues could be raised while still preserving the tax benefit for average home owners.
It was most encouraging to hear in July that Joe Biden (US Presidential candidate) is recommending tax changes consistent with most of the above suggestions. The only areas he did not address relate to the deductibility of mortgage interest, the country allocation of corporate income and the overall review of tax loopholes. However, he did propose an increase in tax rates for corporations and high income individuals, as well as the elimination of certain specific areas of tax preference.
The Covid-19 pandemic will cause a very large increase in the outstanding debt of all levels of government. This burden will be very costly for taxpayers. Consequently, we cannot afford to subsidize wealthy individuals and corporations by allowing them to artificially reduce their income and pay taxes at a low rate. A fairer sharing of the tax burden is needed to avoid social unrest and to move towards greater tax equity. Therefore, the suggested tax changes are a necessity.
Bachelor of Commerce -University of Manitoba
MBA -Harvard Business School