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CHAPTER 4: TAX REDUCTION: BUILDING ON PAST MEASURES

The most effective way to ensure that the recent regimentation of the nation's finances translates into sustainable improvements in Canadians' standard of living is to use the gains made to build Canada's economy. The government affirms that any initiatives undertaken within a balanced budget must be conducive to ensuring a strong competitive economy. Measures for the short term will have to remain relatively modest, and will have to be carefully chosen. A strong, competitive economy is a necessary foundation for a prosperous and healthy nation.

With the budget in balance, Canadians have a right - and we have a responsibility - to ensure that more money is left in their pockets. This is one key to raising the standard of living and increasing disposable incomes for all Canadian families.

The Honourable Paul Martin, The Economic and Fiscal Update, October 14, 1998.

One of the benefits of the new era in which the federal government's balanced budgets begin, is the promise of a reduction in levels of taxation. Many of the witnesses who came before the Committee share our belief that a reduction in tax rates would be of benefit to all Canadians. The critical questions to consider are how any reductions should be distributed, and to what degree.

Tax relief, though it may appear straightforward, actually presents the government with a wide range of possible policy options. Given these options, the government sets its priorities as follows. First, the government has provided targeted tax relief in all its budgets to those most in need, even with a deficit, as such action could not wait. This has included assistance for students, charitable donations, Canadians with disabilities and children. Second, as a small fiscal surplus began to emerge, the government provided general tax relief, but starting with low-and modest-income Canadians. Third, the government ensured that general relief will be broadened and deepened as fiscal resources emerge over time.

[T]he government has to reduce taxes. This is the main answer that we make to the second question put by the committee. We were asked what changes and what new strategic investments were required for the tax system to help the goverment carry out its priorities. Ms. Lachapelle has just pointed out the gap between the American and the Canadian tax systems, wich is considerable. We believe that it's time for the government to take action on this issue.

Now, it is time to focus on broader tax relief measures. Testimony heard by the Committee confirmed the belief that Canadians pay too much of their income in taxes. The Minister of Finance believes it. The Committee believes it. What we need to ensure, however, is that tax relief is sustainable, so that we do not embark on a roller-coaster ride of tax cuts followed by tax increases whenever the budgetary position is threatened by financial turmoil and economic slowdown.

The second important consideration is to give ourselves the most efficient and effective tax system possible. It could be argued that our overall competitiveness is harmed by the tax system as it is configured. Because the future prosperity of our country depends on having a competitive economy, the Committee makes no excuses for placing economic efficiency high on our list of priorities.

[W]e believe that Canadian taxpayers have made huge sacrifices in the past several years to get us to where we are today. That burden should be relieved.

Michael Murphy (Chairman of the Pre-Budget Task Force, Saint John Board of Trade

In addition to tax reductions, a second option for putting more money into circulation is to reduce employment insurance premiums. It is well known that recent contributions to EI have exceeded EI payouts by about $6 billion per year.

Targeted Tax Relief

Last year, the Committee recommended a set of actions in its pre-budget consultations report with respect to tax measures. It was argued that, before reducing the overall tax burden, it would be more appropriate to reinvest in certain social programs and direct these investments toward those who need it most.

The government followed the Committee's advice in this regard. For example, the basic personal amount and the spousal and equivalent-to-spouse amounts were increased by $500 via a supplementary, non-refundable amount that limited the measure to low-income taxpayers. As a result of these measures, approximately 400,000 low-income individuals have been removed from the tax rolls while another 4.6 million taxpayers have received some tax relief (up to $85 for an individual and $170 for a family).

In addition, the 3% general surtax, a "temporary" tax introduced by the previous government in 1986, is eliminated in its entirety for individuals with an annual income up to $50,000 and partially reduced for those between $50,000 and about $65,000. About 13 million taxpayers will no longer pay the surtax while another 1 million will pay a reduced amount. In combination, these new measures will reduce significantly the tax burden of low- and middle-income taxfilers. For example, a one-income family of four with $30,000 in annual income should see its federal tax burden reduced by almost one third.

The government also introduced tax relief targeted specifically at enhancing access to education and to supporting the concept of lifelong learning. For example, all students will now be able to deduct from income the interest payments on their student loans. The education credit is extended to part-time students, the childcare expense deduction is extended to part-time students and Canadians are able to withdraw money from their RRSPs to support learning endeavours.

The childcare expense deduction was increased by 40%, and federal spending on the Canada Child Tax Benefit was increased by an additional $850 million.

Also, in order to equalize the tax treatment between the self-employed and incorporated businesses, self-employed Canadians will be able to deduct health and dental insurance premiums from their business income.

It would cost $1.1 billion annually to reduce the 26% rate facing middle-income Canadians by 1 percentage point.

In addition to these measures regarding the personal income tax, employers will be given an employment insurance premium holiday, starting in 1999, to encourage the hiring of young people between the ages of 18 and 24 years.

The 1998 budget contained tax measures that would provide low- and middle-income Canadians with most of the approximately $7 billion in cumulative tax relief over the next three years. These measures are consistent with our own recommendations, and constitute a wise investment on the part of the federal government. We believe that the government's choices reflect favourably on the value of this pre-budget consultation process and the report of the Committee.

The state of the government's finances limited what the government could do last year. There is always a temptation to reduce taxes across the board, as suggested by some. For such an action to have any meaningful impact it would have had to be of such magnitude that it would jeopardize the fiscal gains achieved so far.

Last year we said, "patience is a virtue." We then argued that by waiting a bit longer we would be able to offer sustainable tax cuts. The Committee believes Canadians have waited long enough. It is now time to plan for and deliver what this Committee has promoted in the past.

A $100 tax reduction for all taxpayers would cost about $1.5 billion annually. The Economic and Fiscal Update, October 14, 1998

Now that the fiscal position of the federal government has become more sustainable, it is far more likely to be able to afford additional tax reductions. As was stated above, now that tax measures aimed at the low- and middle-income Canadians have been introduced, the Committee believes the government must begin to offer broad-based tax relief.

It is only because the government acted responsibly in recent years, and because Canadians from coast to coast to coast have accepted the need to make substantial sacrifices that we should be in a position to implement tax reduction measures, which will benefit all Canadians.

Canadians need as much individual tax relief as the government can afford. They have sacrificed mightily to get the nation's finances in order. They deserve a break. ... Cuts in personal income taxes will get more money to more people than any of the alternatives.

Thomas D'Aquino (President
and CEO, Business Council on National Issues

Giving Canadians a Tax Break

It is time now for the federal government to review the tax burden facing all Canadians. For example, the Canadian Federation of Independent Business recently surveyed its members and discovered that their priorities have changed during the course of the year. Today, 80% of respondents feel that a reduction in the total tax burden should be a priority. But if the federal government is to cut taxes, where should the reductions be made?

One way of addressing this issue is to ask where the tax system is least efficient, and concentrate efforts there. This is not an easy task. There is a great deal of inconclusive debate over the consequences on the economy of the various taxes, and this report is not the place to settle these matters. There is, however, a great deal that we can learn from the international evidence, as shown by the following table.

Canada is currently the country with the highest tax rate. This huge burden considerably limits consumers' spending power, while encouraging tax evasion and undeclared work. We feel that the next federal budget should contain some concrete provisions to cut personal income tax, along the same lines as the inital measures set out in the previous budget...

Lise Bergeron (President,
Sainte-Foy Regional Chamber
of Commerce)

Overall, our tax regime is not out of line with other industrial countries (see Table 1 - Tax Revenues as a percentage of GDP-1996). Canada's taxes are significantly lower than in France and Italy. The tax burden in Canada is similar to the one in the UK. In fact, when we compare the 1996 data with data for 1995, the gap between Canada and the UK is seen to be getting smaller. The differential between Canada and the United States is also declining. Canada is still in the middle rank of the G-7 nations.

Table 1
TAX REVENUES AS A PERCENTAGE OF GDP-1996

Source: OECD

A 1-percentage-point reduction in the 3 tax rates of 17%, 26% and 29% would cost upwards of $3.7 billion annually

We cannot afford to have a tax system that is not competitive with our key economic partners.

Peter Rollason (Chair, Government Affairs Committee, Financial Executives Institute Canada)

The challenge we face is not necessarily with respect to our overall tax burden, or the burden in relation to other industrialized nations, whether G-7 or OECD nations. Canada's problem rests primarily with its tax burden in relation to the United States, our primary market for the sale of goods and services and our primary competitor for capital and labour. Not only is our tax burden higher than in the U.S., our reliance upon the personal income tax (PIT) is about 30% greater than it is south of the border.12 This situation makes our tax regime uncompetitive.

Clearly ... our tax rates for individuals are not competitive on an international basis and we have to do something if we're going to ensure ourselves a stable supply and retention of highly qualified people within this country.

Barry W. Pickford (Chairman, Stentor Tax Committee, Vice-President, Taxation, Bell Canada - Stentor Telecom Policy Inc.)

The disparity in the tax burden on Canadian workers and American workers at the personal income level has always put pressure on us to review and streamline our tax regime to make it more competitive. Many Canadian skilled workers (e.g. nurses, radiology technicians or occupational therapists) are in high demand in the United States, where they face a lower tax burden. In addition, some very highly paid, highly skilled professionals, such as physicians, pilots, software engineers, and computer experts are also being lured south. These professionals receive a substantial tax benefit by crossing the border, in addition to higher rates of pay.

The majority of the manufacturing companies in our industry are subsidiaries of multinationals primarily based in the U.S. so their bosses are in the U.S. and quite often they take the better people from Canadian companies. Those are the ones who get promoted and get an offer to go south. Now I don't say that the move is necessarily made because of lower income tax but they don't come back because of that, I can tell you that.

Dean H. Wilson (President - Automotive Industries Association of Canada)

A study published by Statistics Canada concludes that the so-called "brain drain" is, in fact, a net "brain gain" if one considers that Canada has more immigration of skilled workers from the rest of the world than losses to the United States.13 It remains to be seen, however, how significant the brain gain theory turns out to be.

The C.D. Howe Institute recently published a study that concludes that the "brain drain" of talented Canadians to the United States is real and costly. For example, it found that the "number of managers, doctors, scientists and nurses emigrating from Canada to the United States in 1993-94 represent the equivalent of 18%, 14%, 14%, and 40%, respectively, of the 1991 Canadian graduating classes." During the 1982-96 period, the net loss to Canadian society was $6.6 billion. The authors concluded that pre-and after-tax returns that skilled emigrants can earn by moving to the United States were only one of the determinant factors. The authors do not conclude that relative high taxes are the dominant factor.

Clearly, the federal government's first priority should be to recognize the importance of scientific research and technology development as drivers of the New economy. Canada's research community represents our most significant asset in becoming more globally competitive, and in transferring knowledge and technology to the private sector, Canada's largest job provider.

Dr. Denis Gagnon (Senior Vice-President, Canada Foundation for Innovation)

There is also substantial anecdotal evidence that some of Canada's most talented and gifted individuals are leaving for the United States. Since 1993, the percentage of people working at IBM Canada Software Laboratory in Toronto who choose a U.S. employer when leaving the company has risen to approximately 25%. Nortel has argued that retaining highly skilled workers in Canada is challenging as it is difficult to compete for skilled workers, already in short supply, given the income tax burden differential. The Canadian Medical Association presented statistics, showing that in 1996, 522 doctors, 1,103 nurses and 352 other health workers, i.e. a total of 1,977 emigrants moved to the United States.

The Coalition for Biomedical & Health Research has surveyed Canadian universities with faculties of medicine on this issue. The data collected shows that, over the past 6 years, 5 faculties of medicine have lost 62 faculty/clinical positions, 232 research technicians, 39 post-doctoral/clinical fellows and 68 graduate students.

We ... have a concern that we need to do more effectively to develop through training courses and retain qualified people. Particularly qualified people in the high technology area, within Canada and not let them escape from here.

Barry W. Pickford (Chairman, Stentor Tax Committee, Vice-President, Taxation, Bell Canada - Stentor Telecom Policy Inc.)

ADDRESSING THE TAX GAP

One thing is certain, we are losing our best and brightest to the United States and this has had a detrimental impact on Canada's economic future. In a knowledge-based economy, the valuable resource resides with individuals. Losing our best people can only harm our long-term economic prospects and jeopardize our standard of living. Canada is facing increasing competition from capital and knowledge intensive countries such as the United States. Never before has skilled labour and knowledge been so important. In order to take advantage of future economic opportunities, not only does Canada have to attract capital investment but it must also compete to attract skilled workers from abroad and, above all, invest adequately in its own human capital.

A reduction in personal income taxes would contribute, among other things, to stemming the brain drain.14 Even with lower taxes in Canada, high-skilled workers could still be lured to the U.S., where the world's most productive and innovative economy offers a higher standard of living for that segment of the population and where the best research environment is found. It would help in stemming the flow, nevertheless.

Average family income tax in 1996 reached an all-time high of $11,597, up 4.2% from 1995. A combination of higher earnings and more taxpaying families was responsible for this increase. Income taxes have been trending upward since 1993 (by an average of $330 per year), mainly due to increased earnings, as employment recovered from the losses of the recession.

The Daily (Statistics Canada),
June 22, 1998.

The time has come for our tax regime to be more competitive and adjust our tax system in relation to that of the United States. Globalization is no longer limited to trading goods and services, it also means more labour and capital mobility. Canadian workers have more international work opportunities than ever before. Human capital held by Canadians is almost as mobile as their financial capital. Our brightest citizens can go wherever the working conditions are best and the financial reward the highest. The United States offers precisely these conditions.

Achieving income tax rates comparable to those of our largest trading nation, the United States, would be very beneficail to the Canadian economy as that would allow its citizens and businesses to be more competitive. In today's open and highly competitive business environment countries are obliged to manage their attractiveness in order to attract and retain entrepreneurs, those primarily responsible for job creation. Many industrialized countries are reducing taxes and Canada cannot afford to be left behind.

Helmut Pastrick (Chief Economist, Credit Union Central of British Columbia)

Thus the government must address the tax gap that presently prevails between our two countries. It must also recognize that high taxes can only be detrimental to our economy in the long run.

Canadian workers face very high combined marginal tax rates at a modest income level when compared to their American counterparts. The contrast to after-tax earning opportunities in the U.S. is striking. For 1998, a Canadian taxpayer will face a combined federal-provincial marginal tax rate ranging between 45.4% and 53.3% at a salary and interest income level of approximately $63,400.15 In 1996 an American worker faced a marginal rate of 45.26% on an income level of $263,750 American, assuming a state income tax rate of 5%. This ignores the effect of capital gains taxes, which in Canada are double those in the United States. In Canada, more than 53.2% of personal income taxes collected by the federal government is paid by taxpayers with income in excess of $50,000, even though they represent only 11.7% of taxfilers. Nor is it surprising that similar American workers, such as business executives, demand large bonuses to come to Canada in order to compensate for the higher tax burden.

Income taxes represented 20.5% of family total income in 1996, surpassing the previous peak of 19.8% reached in 1990. The percentage of income paid in taxes also reached an all-time high for the two top quintiles.

The Daily (Statistics Canada),
June 22, 1998

The statistical picture painted by the accompanying table is consistent with that painted by the testimony and other evidence received by the Committee. All of this suggests that the personal income tax system, and not EI premiums, should be the primary focus of the federal government's tax reduction measures.

[A] big point for us is the need to address the problem that our income tax levels are too high. In our industry, we have several member companies who are in effect the headquarters for operations in both Canada and the U.S. It's perfectly logical for those companies to look, from time to time, at bringing a manager from the U.S. to headquarters to assume some important role here, but it's very difficult to do that when the income tax rates are so high that the person would in effect have a substantial decline in their standard of living by coming here.

Jean Van Loon (President, Canadian Steel Producers' Association, CSPA)

Canada has the most progressive personal income tax system amongst G-7 countries. This progressivity has increased substantially in the past two decades, in sharp contrast to the other G-7 countries that have tended to flatten their tax systems over the same period.

These high-marginal tax rates produce a wide range of negative incentives that can have significant adverse effects on our economy. By reducing productivity, these high-marginal tax rates reduce our standard of living.

It is not because high-marginal taxes reduce household spending power that they generate adverse consequences. Rather, it is due to the fact that high-marginal tax rates reduce savings and work effort. These effects directly reduce the rate of economic growth and hence limit growth in our standard of living.

Put another way, reducing marginal tax rates is an initiative that would be consistent with the criteria of the Productivity Covenant as discussed earlier in this chapter.

As a result, we conclude that the time has arrived to review the tax burden imposed on all Canadians. The Committee recommends that the next budget introduce personal income tax reductions for all Canadians. Furthermore, the Committee recommends that the government commit itself to future tax reductions, by presenting a 3-year tax reduction plan.

In order to make our tax regime more competitive with the U.S. tax system, one could reduce our marginal tax rates and/or the income levels at which they apply. For example, the middle-marginal tax rate could be cut from 26% to 23%, as originally announced in the 1987 tax reform package. If implemented all at once in 1999, this option would cost the federal government $3.3 billion. If this option is too expensive, the government could spread the reduction over a 3-year period, announcing a timetable for such cuts in the next budget.

Another option is to increase the income level at which the top-marginal tax rate would take effect. Increasing the income level at which the 5% surtax takes effect, to $23,092 from $12,500, would cost the federal government $280 million. Moving the top taxable income threshold to $100,000 from $59,180 would cost the federal government almost $860 million. To move that level to $250,000 would cost the government $1.4 billion. If the government both increased the income threshold, as proposed in the last two scenarios, and also reduced the middle-marginal tax rate from 26% to 23%, this would cost the government substantially more, respectively $5 billion and $6.1 billion.

The Committee recommended last year that the government gradually remove the temporary surtaxes introduced by the previous government. The Committee still believes this to be the best option for Canadians looking for wider-based tax relief. The marginal tax rates, including the lowest one, are higher than they were originally designed to be. This is why, as noted previously, actions in this regard were taken in the 1998 budget.

The 1998 budget eliminated the 3% general surtax in its entirety for individuals with income up to $50,000 and partially for those between $50,000 and about $65,000. It is now time to finish the job and remove the surtax completely.

Reducing by 1 percentage point the 3% general surtax costs $350 million.

The Committee recommends that the temporary 3% surtax be completely eliminated in the next budget.

The 5% surtax on high-income earners is also a measure that was introduced as a temporary deficit reduction measure. This too should be eliminated, as it constituted a distortion in the tax system as it was designed. Its total elimination would cost the government about $665 million per year. The Committee believes it, too, has served its purpose and hould be eliminated on a gradual basis.

Reducing by 1 percentage point the 5% surtax costs $130 million.

The Committee recommends that the government announce a timetable for the elimination of the 5% surtax, starting with a 1-percentage-point decrease in 1999.

As noted above, another measure in last year's budget was the $500 increase in the basic personal and spousal amounts. That increase was limited, however, with the full benefit being enjoyed only by individuals with incomes below $7,500 and single earner married couples with incomes below $13,500.

Increasing the basic personal amount by $100 costs $250 million. Increasing the married / equivalent to married amount by $100 costs $40 million.

The Committee believes that this measure should be extended to all Canadian taxpayers, not just those with low incomes. Raising the basic personal amount by $700 would cost the government about $1.7 billion per year. A similar increase in the spousal amount would cost the federal government $295 million. As lower income taxpayers already enjoy this benefit, the total cost to the government would be just over $1.8 billion per year.

Raising the basic personal amount by $700 will reduce taxes payable by as much as $180, assuming a 50% provincial tax rate, for a single taxpayer. A married taxpayer, or a single-parent taxpayer, can receive as much as a $360 tax cut.

The Committee recommends that the 1998 budget measures, that increased the basic personal amount and spousal amount by $500 for lower-income taxpayers be increased by a further $200, bringing to $700 the amount of additional income that can be earned tax free.

The Committee further recommends that this $700 increase in the basic personal and spousal amount be available to all Canadian taxpayers.

Employment Insurance

The Employment Insurance Program is one of the largest programs operated by the federal government. Employment Insurance premiums are the only federal payroll levy. When compared to other countries, the overall payroll tax burden (EI premiums plus CPP/QPP premiums) relative to the GDP in Canada is small, only 6.0%. (See Table 1). In fact, Canada had the lowest level of payroll taxes relative to the GDP of all G-7 countries in 1996.

Raising the basic personal amount by $100 will reduce taxes payable by as much as $180, assuming a 50% provincial tax rate, for a single taxpayer. A married or single-parent taxpayer can receive as much as a $366 tax cut.

The government has already reduced the burden of EI premiums substantially. They have been reduced from $2.90 to $2.70 per $100 of insurable earnings for 1998.

For 1998, the 20-cent reduction combined with the reduction in maximum insurable earnings and the New Hires Program, has reduced the EI premiums by $2.6 billion. These measures meant reduced EI contributions for 14 million Canadian workers and are part of a long series of gradual EI premium reductions that began in 1993 when the premiums were set at $3.07 as opposed to $3.30 as required by the statute. In total, this government has already cut EI premiums by about $5 billion. The Committee agrees that more must be done, but in a way that is prudent and does not jeopardize the government's budgetary balance.

The EI premium holiday for all firms for the hiring of young Canadians will provide a total of $200 million relief over the years 1999 and 2000.

Many witnesses forcefully argued in favour of substantially reducing EI premiums. They argued that the current surplus in the EI account is more than sufficient to cover any future liability during the next recession without leading to higher premiums. They argued that the "surplus" in the EI account exceeds the ideal amount of reserve estimated by the program's chief actuary. As a result, they called for a $0.60 reduction to the actuarial break-even rate of $2.10. This would cost $4.2 billion. Some went further and recommended a $0.90 reduction. To go to $1.80 would reduce government revenues by more than $6.3 billion. This would be highly imprudent, in our view.

Reducing EI premiums would not benefit all Canadians. First, it would benefit businesses more than workers. A $0.60 reduction would mean a saving of $2.6 billion for employers and only $1.76 billion for workers. Second, reducing EI premiums would do nothing for elderly citizens, students or self-employed individuals. The Committee believes that broad-based personal income tax cuts would be beneficial to more Canadians.

The CFIB strongly recommends that the federal government publicly state and deliver a three-year plan to bring the EI premium into balance with the costs of running the EI Program.

As was mentioned before, payroll taxes in Canada are low and already competitive when compared to other G-7 countries. Canada has a competitive problem at the personal tax level. Canada relies more on personal income tax revenues than any other G-7 country.

To substantially reduce EI premiums would limit our ability to further reduce the debt-to-GDP ratio. It would impede government flexibility - it is generally accepted that it is increasing premium rates, not the level of the rate that leads to higher unemployment. As stability is so important, any downturn in the economy would force the government to make unwanted cuts to spending programs or increase other taxes so as to keep from going into a deficit once again. In the current volatile environment, a return to deficit financing is not a viable option.

Several witnesses before the Committee argued that the surplus in the EI account should not be used to reduce premiums but to enhance benefits. With about 40% of the unemployed receiving benefits, as opposed to the two-thirds to four-fifths who received benefits in earlier years, it was claimed that those who are paying into the system are not receiving the benefits to which they are entitled.

The Committee feels that much misunderstanding exists with respect to this phenomenon. Many of the unemployed receive no benefits, not because of the EI reforms, but because they do not meet the criteria that have always existed - in other words, they receive no benefits because the system was never designed to cover them. This includes the almost half million unemployed who did not work in the previous 12 months, the self-employed and those who quit work to return to school. It also includes the 100,000 who quit their job without "just cause."

The Committee believes that, after examining the evidence, the EI system is accomplishing what it was meant to accomplish and hence we see no need to consider an increase in benefits at this time. The EI reforms were designed primarily as a way to facilitate the improved functioning of the labour market. Simply increasing coverage to more of the unemployed would negate these benefits.

The EI Account and EI Premium Rates

The surplus in the notional EI account will likely be $19.58 billion at the end of this calendar year. Not so long ago, in 1993 in fact, the cumulative EI account was in deficit in the amount of $5.9 billion. The notional EI Account has been part of the Public Accounts since 1986, as recommended by the Auditor General. This means that when it is in deficit, the government covers that deficit. There has been a deficit in this account in 10 of the last 17 years. In years of surplus, the government's fiscal position improves as a result. This approach has proven to be a benefit to Canadians as a whole as well as those who rely upon and contribute to the EI program.

Premiums must be set at levels that ensure there will be enough revenue to pay for authorized expenditures, and to maintain stable premium rate levels. To assess the recommended premium level, forecasters use different hypothetical unemployment rates. The Employment Insurance Act does not set premium rates or the balance in the account. The Chief Actuary has estimated that a reserve of between $10 billion and $15 billion should be sufficient to cover the cost and to ensure that payroll taxes will not have to increase during recessionary periods. This estimate is based on the simulation of costs for the current program over the next 15 years, assuming a recurrence of recessions similar to the last two.

A 10-cent reduction in EI premiums costs the federal government $700 million per year.

There might be a need for more caution, however. It has been observed that the unemployment rate has tended to ratchet upwards over the last 50 years. Global economic events also suggest the need for additional caution.

A 15-cent reduction in EI premiums costs the federal government $1.05 billion per year.

In the United States, the state programs are asked to maintain reserves worth between 100% and 150% of recession level costs. In Canada, the reserves are set to represent between 110% and 150% of the regular benefit forecast. Thus the accumulated surplus is not as excessively prudent as some would have us believe.

A 20-cent reduction in EI premiums costs the federal government $1.4 billion per year.

The Committee heard from a number of witnesses, such as the Charlottetown Chamber of Commerce, the Business Council on National Issues and the Toronto Board of Trade, that EI premium reductions had to be approached from a gradual perspective. Many businesses are willing to wait a bit longer before attaining the break-even premium rate. Meanwhile many Canadians have been long awaiting significant broad-based personal income tax reductions. The Canadian Federation of Independent Business (CFIB) supports such a gradual approach as well. Its members are more concerned with the total tax burden they face than with individual components of that tax burden. In the spring of this year, one in four members said there should be more focus on tax cuts. Today, 80% of members argue that tax reductions should be the top priority. Next on the list of priorities are EI premiums and government debt.

CFIB members are concerned with EI premiums because, when combined with rising CPP/QPP premiums, the payroll tax burden on employers will have more than doubled in the past two decades.

The CFIB strongly recommends that the federal government publicly state and deliver a three-year plan to bring the EI premium into balance with the costs of running the EI program.

To satisfy the CFIB's request would require a 60-cent reduction in premiums over three years, to $2.10 per $100 of insurable earnings. This is not entirely inconsistent with the past actions of the government or the recommendations of this Committee. We continue to believe that premiums should be reduced, in such a way that does not threaten the fiscal balance of the government. Once fully implemented, the CFIB recommendation would reduce federal EI premium revenue by $4.2 billion per year.

Hence the Committee recommends that the government reduce EI premiums by a minimum of 10 cents per $100 of insurable earnings.

INDEXATION REVISITED

The measures proposed so far would benefit mainly middle-income earners. Despite the targeted tax measures introduced in the 1998 budget, a balanced approach is still needed to make sure all Canadians benefit in this new era of budgetary surplus.

The total impact of restoring indexation of tax parameters, based on an annual inflation rate of 1.5% would be $840 million in the first year and $1.7 billion in the second year.

The Committee argued against the reintroduction of full indexation last year because of the potential effect it could have on government revenues - the return to full indexation takes away a certain degree of government flexibility, and could cost the government substantial amounts in future years.16 Being cautious, the Committee recommended, instead, the restoration of full indexation only when the fiscal situation would permit. Now that the budgetary surplus is sustainable, the Committee feels the government should carefully review the indexation issue.

Introduced in 1986, the "CPI minus 3 rule" is still in place. It is now well known that a tax system which is not indexed against inflation has three perverse effects.

Income tax brackets that were not adjusted for inflation also contributed to higher taxes. These increases were not as great as those during the recovery that followed the recession of the early 1980s, when average taxes rose and average $504 per year between 1984 and 1990.

The Daily (Statistics Canada),
June 22, 1998.

First, it increases the tax base, since taxable income grows faster than total income because exemptions and credits decline in red value over time. Low-income Canadians become subject to income tax as a result of the erosion of the real value of their credits. Second, as income grows with inflation, a larger proportion of income is taxed at higher rates; thus the average rate of tax increases. And third, because of the "bracket creep" effect, the marginal tax rate increases as the thresholds diminish in real terms. A tax system not indexed to inflation is regressive.

The OECD recommended full inflation indexation in a report published last year.17 According to this study, partial indexation has pushed 1.4 million low-income individuals onto the tax rolls over the 10-year period ending in 1998. Over 1.9 million individuals have been pushed from the lowest marginal tax bracket to the middle bracket,18 while 600,000 were pushed from the middle to the highest tax bracket.

This lack of full indexation can explain why Canada relies on personal income taxes more than other G-7 countries (See Table 1). Restoring full indexation is not so much a tax reduction as it is an end to automatic tax increases that now occur solely on account of inflation.

With 1.5% inflation per year, full indexation of the tax / transfers system would be $840 million in year 1, $1.7 billion in year 2, $2.6 billion in year 3 and $3.4 billion in year 4.

The Committee recommends that the government reintroduce indexation when the fiscal situation permits, in the meantime measures should be taken to offset the impact of de-indexation.

Enhancing Rates of Return: The 20% Foreign Property Rule

Canada has, since 1994, had a 20% Foreign Property Rule limiting the amount of foreign investments that may be held in tax-assisted pension and retirement savings plans. It was increased gradually from the 10% limit that applied before 1990. A number of witnesses argued that this restrictive 20% limit is detrimental because it limits the potential return that could be earned in a more diversified portfolio and increases the riskiness of a retirement portfolio.

Even though the Canadian equities market accounts for less than 2.5% of global stock market capitalization, 80% of Canadians' tax-assisted retirement savings must be invested here. This severely limits our ability to diversify globally and across economic sectors - it must be remembered that Canada's economy is still relatively resource-oriented. It is precisely because of the relatively small size of the Canadian capital market that an appropriate degree of diversification requires a relatively large foreign content. Sophisticated investors can use derivatives to effectively increase their share of exposure to foreign assets beyond 20%, without violating the income tax regulation. Some mutual funds are now also offering this ability.

The Committee believes that limiting diversification increases risk and can reduce the overall return. The Investment Funds Institute of Canada commissioned a study on the impact of the Foreign Property Rule on investor returns. It found that a 30% foreign content limit over the last 25 years would have allowed Canadian investors to earn up to 1.6% more per year on their retirement savings portfolios. The cumulative impact of this is enormous; for an average investor it means the loss of $32,000 in capital at retirement. Thus the existing rule makes some Canadian seniors poorer than they would otherwise be.

Forcing Canadians to invest 80% of their retirement savings in 3% of the world's capital markets is unwise and imprudent. - (Retirement Income Coalition)

The 20% rule only affects savings in tax-assisted retirement vehicles such as RRSPs, RPPs, and the CPP investment fund. Thus it penalizes the returns of those whose savings are mainly in these instruments. Taxpayers who hold most of their savings outside of tax-assisted savings plans are less affected by the 20% rule. They can achieve maximum diversification to protect against risk and enhance their rates of return.

As the Canadian population ages, we are going to become bigger savers than we are now and I can imagine a situation where we will run persistent current account surpluses and we will be net lenders to the rest of the world and in those circumstances, I think you will want to allow Canadians to have a wider range of investment opportunities.

Gordon Thiessen, Governor, Bank of Canada, November 17, 1998

The Committee recommends that the 20% Foreign Property Rule be increased in 2% increments to 30% over a five-year period. This diversification will allow Canadians to achieve higher returns on their retirement savings and reduce their exposure to risk, which will benefit all Canadians when they retire.

Some witnesses before the Committee argued against raising the 20% limit on the grounds that the turmoil in global markets would put at risk the savings of Canadians. They also contended that such a move would deprive the Canadian economy of much needed capital.

It's to the Finance Minister's credit that he resisted the strong financial lobby to raise if not remove the 20% ceiling on investment abroad of tax-subsidized pension funds ... We have long advocated gradually reducing that ceiling.

Bruce Campbell, Executive Director, Canadian Centre for Policy Alternatives

To those who believe that investment in foreign property would have an adverse effect on the Canadian economy and its capital markets, we note that the increase in the limit from 10% to 20% had no deleterious effect, according to the Conference Board of Canada. As well, three-quarters of the Canadian investment pool is not subject to this rule because it is outside of tax-assisted investments. Increasing the foreign property limit to 30% would affect only 2.4% of the total domestic investment pool. Even if all of it were invested in foreign property, the effect on the Canadian capital market would be minimal.

To those who believe that increased exposure to foreign capital markets would put Canadians at financial risk, the Committee cites the evidence put forward by many groups, including the Retirement Income Coalition, that increased diversification would not only have increased returns, it would have reduced risks. The 20% limit that protected Canadians from risky ventures in emerging markets also "protected" us from blue-chip investment in the United States. Indeed, over a 15-year period, there are few major countries that would have provided Canadians with as low a return as our own market according to the Retirement Income Coalition.

The Committee supports the arguments by those who believe the limit should be raised and therefore we repeat last year's recommendation.

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12 Canada relies more heavily on the PIT than do all other G-7 nations, and the difference is substantial in many instances. It is more than double that of France and Japan, for example.

13 In his study entitled "Brain Drain or Brain Gain" (Statistics Canada, 1997), Ivan Fellegi agrees that there is a brain drain to the United States and to other countries. It is estimated that in 1995, about 11,000 knowledge workers left Canada, of which 5,600 left for the USA, including 1,600 health care professionals. But the overall evidence shows there is a net brain gain. In 1995, 34,300 knowledge workers came into the country from the rest of the world (42,600 in 1996).

14 The decision to move to the United States is influenced by many variables on which the government has little or no control, such as weather, geography, cost of living and quality of life. Important variables influenced by policy makers will also play a role when deciding to move to the United States, such as the existence of a vigorous and stimulating pool of knowledge (for example: Silicon Valley type of business concentration, presence of laboratories or research hospitals or important universities). This pool of knowledge depends on public spending (such as the three granting councils in Canada, R&D tax incentives) and private R&D expenditures (the Biocherma, Nortel, Newbridge, Corel and JetForms of this world...). The final two main elements in the decision-making process of an individual to cross the border is the overall compensation and the tax burden. The compensation of highly skilled workers is dictated by market conditions. Real income has been rising in the United States because of higher productivity. If one applies the exchange rate, the compensation discrepancy between Canada and the United States is even bigger. Combined federal/provincial personal income taxes have a significant impact on the after-tax disposable income of Canadians.

15 The marginal tax rate for BC residents with salary income in excess of $79,500 reaches 54.2%.

16 The Committee recommended instead increasing the basic personal amount, the spousal amount and the equivalent-to-spousal amount. The government responded positively to this recommendation in the 1998 budget when it increased all these amounts by $500.

17 OECD, OECD Economic Survey 1996-97, Canada, 1997.

18 This has a particularly dramatic effect, as the middle tax rate is nine percentage points higher than the low rate.