LSVCC Tax Credit is Bad Tax Policy

Justin Trudeau today unveiled his party’s economic platform going into the 2015 federal election. There are lots of interesting pieces in the platform, but one particularly has caught the eye of many economists. Trudeau is going to bring back the Labour Sponsored Venture Capital (LSVCC) tax credit. That is bad tax policy and means the Liberals now join my wall of Stupid Tax Policy Initiatives. I have a fair bit of knowledge in this area as I had this file for many years when I worked at the Department of Finance in Ottawa. The background is also detailed here.

LSVCCs were the original creation of the Quebec government in 1983. On the heels of the 1981-1983 recession the Quebec government created the Fonds de solidarite des travailleurs de Quebec (FSTQ), which was a venture capital mutual fund directed by the Federation du Travalleurs de Quebec (FTQ), a very large trade union, to invest in Quebec small and medium-sized enterprises (SMEs). The idea was that labour should be more directly involved in capital markets with the goal to assist with job and business creation (or perhaps more aptly, preservation). Again, this was on the heels of a very sharp and deep recession which had hit Quebec particularly bad. This came with a maximum $1225 provincial tax credit (35% on a maximum investment of $3500). Over time the tax credit was reduced and the maximum investment increased.

In 1985, the federal government introduced a number of measures to stimulate venture capital, including a matching federal tax credit for individuals who invested in provincial LSVCCs (despite there only being one in existence at the time). It also encouraged other provinces to follow Quebec’s lead and establish LSVCCs and many followed suit. In 1988, the federal government permitted federal LSVCCs. The first federal LSVCC was the Working Ventures Canadian sponsored by the Canadian Federation of Labour and funded with a $14.55 million federal grant.

In 1992, the federal tax credit was increased to 20% on a maximum investment of $5000 and that tax credit was also available if the investment was made through an individual’s RRSP. This latest regime is what really caused the investments to take off. Through the various tax credits and RRSP deduction, investors actually shouldered very little of the investment cost (~20%), with the bulk of the cost (~80%) shouldered by tax payers. The end result was a massive uptake in LSVCC investments (via the RRSP route) and a corresponding drain on the treasury.

In 1996, then Finance Minister Paul Martin attempted to plug the drain by reducing the tax credit to 15% on a maximum investment of $3500, but political lobbying resulted in the maximum being increased to $5000 in 1999. By 2002, the federal government was foregoing $260 million in tax revenues as a result of the tax treatment of LSVCCs .

This regime remained largely in place until Budget 2013 which announced the phase out of all LSVCC federal tax credits. The credit was reduced to 10% in 2015, will be 5% in 2016, and eliminated starting in 2017. The rationale for the phase out was that:

“the economic environment and structure of the venture capital market have changed significantly…[and] the LSVCC tax credit has been criticized by academics, international organization as well as venture capital industry stakeholders as being an ineffective means of stimulating a health venture capital sector. Recently, several commentators, including the Organisation for Economic Co-operation and Development (OECD), have called for the elimination of the tax credit.” (Budget 2013, page 207-208).

Ontario also began the phase out of its tax credit in 2012, something it had threatened to do since 2005. PEI was the first to see the writing on the wall, eliminating its tax credit in 1997.

What were the critiques of the tax credit regime? Well, they are essentially the same as those levied against the Mineral Exploration Tax Credit. Those criticizing the tax credit as being detrimental include many of our top business academics, including:

  • Alan Riding and Miwako Nitani at the Tefler School (U of Ottawa),
  • Douglas Cumming at the Schulich School (York U),
  • James Brander at the Sauder School (UBC), and
  • Jack Mintz at the School of Public Policy (Calgary).
  • Jeffrey MacIntosh in the Faculty of Law (Toronto)

Douglas Cumming wrote a very detailed critique for the C.D. Howe Institute and Jeffrey Macintosh wrote one for the School of Public Policy at Calgary, saying it represents a “squandering of both federal and provincial resources.”

LSVCC funds have usually posted negative returns on pre-tax capital in Canada and only make money (if at all) through the generous instituted tax breaks. The low returns were the combined result of very high management fees, commissions, bad management, and the poor exits (usually through buybacks or write-offs which are two of the worst exists for venture capital funds). In fact, many LSVCCs went insolvent and many investors lost most if not all of their investment (and hence, the tax payer was never repaid). You might also remember the Crocus Fund scandal, where very bad management led to its shut down.LSVCCs have underperformed the easiest asset class to beat: 30-day risk free T-bills. There is no evidence these LSVCCs helped create jobs or SMEs. The worst side of these funds, outside of the tax sink, is that they crowd out investments in other, and likely more productive, areas. Those investing in LSVCCs were either naïve investors, many of who lost of lot of money, or wealthy sophisticated investors who invested solely for the tax benefits (much like the METC). It is also interesting to note that no other country followed suit with similar tax policy.

I would like to know why, in the face of academic and international evidence, Justin Trudeau wants to breathe new life into something a putrid as the LSVCC tax credit. What does he know that the experts in the field don’t know? What evidence does he has to support this revitalization?

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The Great Tampon Tax Debate

You might have heard that there is a petition being circulated calling on the federal government to end the GST on tampons, sanitary pads, and other menstrual products.

This is nothing new. There have been similar campaigns in all countries that have value added taxes. The most successful one that I know of was on the one in the UK. The UK originally these products were taxed at a rate of 17.5% (now 20%) which is the standard rate. The campaign successfully saw this rate reduced to 5%, which is the reduced rate. I also know that in the provinces in Nova Scotia and Ontario, these goods are not subject to the provincial portion of the HST.

Those involved in the Canadian campaign do not seem to have much knowledge of the GST system, so I want to wade in with some information here.

As I hope most understand, the GST/HST is a value added tax (VAT). A value added tax avoids the cascade effect of sales tax by taxing only the value added at each stage of production. Through the use of input tax credits, if the purchaser is not an end user the goods or services purchased are instead a costs to its business then the tax it has paid for such purchases can be deducted from the tax it charges to its customers. This ensures that the tax is only paid once.

All goods and services in Canada are subject to the GST/HST unless they are either zero-rate or exempt (most goods and services are taxable). This anti tampon tax campaign does not seem to make it clear if it wants these goods exempt or zero rated, and I expect those involved don’t know the difference. Zero rated means that the GST/HST is not charged on the final sale of these goods, but the GST/HST can be recovered along the way via an input tax credit (ITC) on expenses incurred to make the zero-rated good. Exempt means no GST/HST applies to them. You do not charge the GST/HST on your goods/services and you cannot claim input tax credits (ITC). For example, in Canada groceries, medical devices, and road tolls are zero rated whereas legal aid service, child care services, educational services, bridge tolls and the like are exempt.

Why are some things zero rated or exempt? The short answer is politics. Economists designing tax system want broad base and low rates. Politicians want to win votes. The list of zero-rated goods was developed solely in response to public opinion and the agricultural sector lobby. Financial services were left out only due to administrative complexities. The exempt list was developed to ensure that these sectors would not pay more taxes under the GST than under the MST (the GST replaced the MST in 1991).

What is the problem with zero-rating goods and services? The exclusion benefits high income earners more than the lower income classes which these exemptions were design to protect. Instead of excluding goods and services, the better model is to target transfers to low- and middle-income households so that they are not worse off. And that is exactly what we do with the HST/GST tax credit. We compensate these households for the lost purchasing power. That tax credit would be bigger and better without the zero-rated goods.

What do we learn from the above? If we are going to exempt tampons, we won’t really be better off. If we are going to zero-rate them, then the GST/HST tax credit should be reduced accordingly, but I doubt that would go over well (damn logic).

It seems that the main argument about taxing these goods is that they are used predominantly by women and are a necessity good. There are lots goods and services that meet these criteria, but which I don’t hear calls for the same treatment. This includes treatment for yeast infections, nipple cream used when breast feeding, breast pads, bras. There are also lots of goods and services that are used predominantly by men and are necessity goods that are taxed. We even tax income and that too is a necessity goods.

I am a women with a regular menstrual cycle who is a high-income earner in a high-income household. I support the tax on the tampons, sanitary pads, and other menstrual products I buy and by doing so I am helping fund the GST/HST tax credit that helps low and middle income women buy theirs.

Implementing Local Income Taxes in Toronto: The Devil is in the Details

As you may be reading, The City of Toronto is mulling over imposing a municipal income tax for the city in an effort to plug its never ending budget deficit. There are a few things to know about this.

Municipal governments may only raise revenue through any means authorized by the province. Here is the City of Toronto Act, and income taxes are a tool that have not yet been devolved. In fact, income taxes are expressly forbidden under section 267(2)1. In order to obtain that power, the City must seek the authority from the province and the City of Toronto Act would have to be modified accordingly. Expanding municipal tax authorities in this way would set a potentially undesirable precedent (not only in the granting provinces, but others as well) and likely to get lukewarm reception since provincial governments have traditionally been unenthusiastic about granting additional authorities to municipalities. Perhaps then it is time to have a broader discussion about devolving this revenue tool.

While municipal income taxes are unheard of today, they were an important source of municipal revenue before WWII. Municipal income taxes were abandoned in 1941 when the provinces signed onto the wartime tax rental agreement.Despite no longer being popular in Canada, municipal income taxes are used in some areas in the U.S (as well as in many European countries). To my knowledge, about 5,000 jurisdictions in 17 U.S. states levy a local income tax. Local income tax rates in the U.S. are typically low but broad based (an economists tax dream).

Local income taxes are more popular in the U.S. for two reasons. First, their origin is the Great Depression and were turned to when property tax revenues dried up. Second, many U.S. states have a long history with property tax revolts, making property taxes unpopular and have placed strong restrictions on rates and rate increases. In fact, many ballot initiatives for local income taxes occurred around the same time as a rejection of property tax increases. So in the U.S., the issue became would you rather a property tax or a local income tax and residents choose the latter.

Another benefit in the U.S. is that local income taxes are deductible for income (state and federal) tax purposes (though so are property taxes). At one point Obama considered eliminating the deduction, but I believe that did not go forward. In Canada, local income taxes (and property taxes) are not deductible and I doubt the federal government has any plans to go down that road.

In the case of Toronto, I expect that the choice is really would you like an income tax or a larger property tax (or possibly both?). Which is possibly too bad, because median house price to medium income ratio is quite high in Toronto a local income tax would probably be more progressive than property taxes and better linked to income rather than an imputed measure of wealth so dissociated with income in such a market. And it would mean less reliance on provincial property assessments, which is a whole other kettle of disgruntled fish. Local income tax is also better suited than a property to pay for regional-wide needs, such as poverty, social services, crime, and transportation, all substantial issues in the City of Toronto.

Now there is no talk yet about how a local income tax in Toronto would be implemented, which leaves lots of questions about the feasibility and burden of this tax. I have not seen any talk about who the tax would be levied on. People, unlike property, are mobile, very mobile. What would be the implication for mobility of a local income tax? How you implement it and the rate matters to understanding this.

And would you impose it on residents in the City of Toronto or employees in the City of Toronto? The City of Toronto has many people that work in its region that do not live in the region. Workers still consume services provided by the City. In fact, many local income taxes in the U.S. are imposed on workers. That said, you have residents that consume services but do not work in the City boundaries. These issues lead many U.S. municipalities to impose one rate for residents and one rate for non-residents. But you need a way to define who is who.

I also see no talk about the burden a local income tax would place on businesses. How would a local income tax rate work for businesses and business owners? Would they be expected to collect and remit the tax? If the tax base is not workers, how would they sort out who to withhold and who not to withhold? And to whom do they remit the tax to? In the U.S., there are models where the local income tax is embedded into the income tax system, but in the U.S., you file state taxes. In Canada, through the tax collection agreements, CRA collects on behalf of all provinces (except Quebec which has the opposite model).

So a City of Toronto local income tax may require a lot of work with CRA to determine eligibility, how the tax form would be modified, how the funds would be returned, and who would pay for these administrative costs. In addition, going this route means that the City of Toronto would have to accept the federal government’s definition of taxable income. More commonly though, U.S. local income taxes are collected by local tax authorities which imposes a huge burden on both the tax filer and the local authority. That is not a tax structure though that I would have a lot of faith in.

We should not necessarily be opposed to local income taxes, in fact, they have a lot of benefits over a property tax, but we need to understand the details before knowing how this would all play out. I’d like to see the City of Toronto (and even more broadly the provinces) envision such implementation issues before going too far down the road of seeking authorities for such a tax.

Improving the take up of the BC training and Education Savings Grant

BC’s 2015 budget reminded us, again, of the commitment made in the 2013 Budget regarding the BC Training and Education Savings Grant. The BC training and Education Savings Grant is a $1,200 lump sum contribution to a child’s RESP in the year they turn 6.

To qualify for this lump sum payment:

  1. The child must be born on or after January 1, 2007
  2. The child must have an RESP
  3. The child must be a resident of BC when the grant application is made
  4. The child must be enrolled in an educational program
  5. And the application must be made between the child’s 6th and 7th birthdays

Many kids of low income families are likely missing out on this very important grant because their parent are unaware of it and because they don’t have an RESP.

BC has this penchant for opt-in programs, which is quite unfortunate, especially when compared to the process for getting federal matching funds. The RESP system for the federal top-up grant is quite seamless. The bank remits information of your contributions to the federal government and between 30-60 days later the top up is deposited in the RESP provided you qualify. No need for the parents to submit an application directly and it is unfortunate that the BC government can’t simply do something similar for their grant. This would certainly ensure 100% take up rates for those when meet the qualifications. It is disappointing that the BC government is not more progressive is this area.

However, the fact that the child must have an RESP provides a barrier to many families to get this funding. And this is where, once again, the federal government comes into play. The federal government offers the Canada Learning Bond. If you receive the National Child Benefit Supplement you qualify for it. It is a total of $2000 in funding for a child’s RESP and no requirement to put in of your own money into the RESP. That money is allocated as follows

  • $25 to help cover the cost of opening an RESP
  • $500 to add to the RESP when it is opened
  • And $100 each year until the child turns 15

So go forth and spread the word and let’s work to get this valuable money into the hands of those that need it most, even if the BC government won’t help.

BC 2015 Budget

BC 2015 Budget

While I appreciate those of you East of the Rockies might not care, the BC government tabled its Budget today and the budget plan is available here for you to read for yourself.

I’ll point out a few things. First, the government is posting a surplus, yes you read that correctly, of nearly $1 billion in 2014/2015 and further surpluses around $543M-$749M in each of the next three years. That is based on real GDP growing around 2.5% a year, and personal income tax revenue growing at around 4% a year.

You always have to be careful reading these things as Budget documents contain a lot of stuff that has already been announced, like the BC Early Childhood Tax Benefit and the BC Training and Education Savings Grant. I talked about the BC Early Childhood Tax Benefit last year.

What did the budget announce? I won’t go through everything, instead provide some interesting tax highlights. First, BC has eliminated the temporary personal income tax rate of 16.8% on individuals with incomes over $150,000 effective the 2016 tax year. This surtax was announced in the 2013 budget with a shelf life of 2 years. So no renewal of it, for a loss of about $227M a year in tax revenues. This means that those with incomes over $105,592 all pay the same rate of 14.70%

Second, as expected, BC will stop the claw back for people on income and disability assistance when they receive child support payments. This has been discussed for some time now and nice to see some action on it.

Third, BC continues is subsidization of high income earners through its extension of the mining flow through share tax credit. I talked about that here and here. More people should be talking out against this tax credit since there is no evidence it supports any economic development.

Fourth, BC will once again raise MSP premiums and rely on premium assistance for low income residents, something that I said was a bad idea (the premium assistance model).

Fifth, the BC government has gained an appetite for boutique tax credits, similar to the Harper government. There are two new non-refundable tax credits (non-refundable means you can claim it, but you don’t get the benefit from it if your tax owing is already $0).

  • Children’s Fitness Equipment Credit worth a grand total of a maximum $12.65 per child. In order to get it you must claim the BC children’s fitness tax credit and it is worth 50% of that claim. I have written a lot about the federal version of this (here, here, and here), and my critiques apply here: this is a tax credit that predominantly benefits high income earners. I especially don’t know why we bother with such nonsense when there is a better vehicle that targets low income residents: the Sales Tax Credit.
  • The BC Education Coaching Tax Credit worth $23.50 per eligible tax payer. The tax credit is only available to teachers/assistants (and we don’t have a definition of a teacher or assistant yet) who do at least 10 hrs of extra-curricular coaching a year. I don’t understand why all these restrictions are placed on the tax credit because there is no way the benefit of the credit would outweigh any administrative costs, suggesting there will be no real audit of it and easily open to fraud. Why not provide funding for having these extra-curricular coaching or compensate coaches directly?

Though as Kevin Milligan notes, we are not talking a lot of money for these boutique tax credits. According to the budget document, about $3 million. But again there is always an opportunity cost.

So while there is some good news in the BC budget about surpluses, there is a lot of wasted money put towards useless tax credits that are really of no benefit for most families.

Tax Policy Advice to Christy Clark

Dear Christy Clark on this the day before budget day. I know it is hard but it is time to let the British Columbia Mining Flow-Through Share Tax Credit die. I know it only costs you $10 Million a year, but all your are doing is providing a tax advantage for high income individuals with no discernible economic benefit. I know the mining industry says otherwise, but its not their money that is being used. It is ours. And have you heard of the saying about putting the fox in charge of the chicken coop? It is like that. But then again, perhaps you don’t understand how it all works so let me explain. As you can see, there is no rationale for this tax expenditure and its time to end it. And if you don’t believe me, perhaps you’ll believe Jack Mintz.

Advice for the BC Finance Minister on MSP premiums: listen to the Green Party

You might not know this, but BC charges premiums for public health care coverage (one of only two provinces).

BC MSP premiums are currently $72 a month for a single person, $130.50 for a family of two, and $144 for a family of three or more, and these premiums have been rising steadily over the last few years as BC works to balance its budget.

As BC is now on track to post a healthy surplus, there have been calls to eliminate these premiums. Andrew Weaver, the Deputy leader of the BC Green Party, is currently leading this charge noting that the premium is the same “whether you make $30,000 or $3,000,000 per year.”

The BC Finance Minister, Mike DeJong, recently dismissed this proposal, noting that low income residents can apply for premium assistance. Premium assistance exists for individuals are families with adjusted net income below $30,000 which reduces the premium to $0-$51.20 a month, depending on income.

The are two problems with Mike’s argument. First, it does not address the concern that once at $30,000 a year, a family must pay the whole portion of the premium. Second, he assumes that anyone who would qualify for the assistance would obviously apply for it. Yet it is well known that the take up rate of assistance program are less than 100%.

My colleague, Rebecca Warburton has examined this exact issue: what is the take up rate of the MSP premium subsidy. Her finding? A whopping 26% of families eligible for premium assistance did not apply. This rate is much higher than is found for most benefit programs which is great cause for concern.

The current system in place in BC for premium assistance is what is called an ‘opt-in’ system, similar to that which exists for organ donation, vaccinations, and RRSP/RESP contributions (and we are all learning how successful opt-in has been in these areas). The trouble with opt-in systems is that: (1) you need to know that you can opt in and (2) it imposes the cost to ‘opt-in’ on the potential recipient.

A much better approach, and one that is supported by Nudge Economics, is one based on opting-out. In this case, you are automatically entered into the system and then apply to opt-out. An opt-out system does not require you to have knowledge that the system exists and reverses the application cost to those not wanting to participate.

With respect to health premiums, this is the procedure in place in Ontario, where health premiums are also paid but are embedded into the tax system. You are automatically assessed based on the information known to the tax authority, including income and family size, thereby substantially lowering administrative costs over an opt-in system. The added advantage is that given that it is already rested in the tax system, the premium can also be based on a sliding scale with those with higher income paying higher premiums.

Moving BC to a premium model similar to that which exists in Ontario would be a substantial improvement over that which currently exists. It streamlines the process, ensures that those who qualify for assistance get it, and reduces administrative costs. Of course, you can achieve the same outcome by simply adjusting provincial statutory tax rates, but that might be too much to accept in one go. Further, the advantage of the premium is that there is strong accountability as the governmetn reports what it collects and that money has to be spent on what is was collected for: health care. And what is even better, as BC struggles with a burgeoning health care budget, is that you could actually raise more money to fund health care.

Perhaps the BC Green Party knows more about economics, and tax policy, than many give them credit for.

Tax Policy that no one will listen to: CCA systems is overly complex and not a political tool

I previously provided my views on the NDP proposal to yet again extend the ACCA. I would like to follow up on that post by giving them (or any political party for that matter) advice on what they should focus on with respect to the CCA system in Canada. I realize no one will listen to me, but being an academic, a mum, and a wife, I am quite used to be ignored by the men in my life.

As I previously discussed, the rationale for the CCA system is the matching principle: matching income to expenses. Since its introduction with the Income Tax Act in 1949, the CCA system has been used and abused to achieve policy objectives separate from the matching principle (notably to stimulate pet industries/activities/purchases during economic recessions). The result is an increasingly complex CCA system that is neither ‘fair’ nor ‘neutral.’

When the CCA system was first established, there were 12 assets classes, but that grew to a whopping 56 classes by 2012. In many cases the expansion in the classes is the direct result of politicians introducing ‘special’ classes for some perceived economic benefit (cough, subsidy, cough) or futzing with the depreciation rates (repeat cough) that have no relationship to economic reality of the asset.

It makes absolutely no sense to depreciate equipment in, say, 2 years when it has a useful life of more than 20 years. These ACCA rule really only benefit small number of large businesses. And, little attention seems to be paid to the problems that this creates with CCA recapture. See when a depreciable fixed asset is sold (like when the business is sold to a new owner), its capital cost allowance (CCA) class is reduced by deducting the lower of its original cost, or its proceeds of sale.  If, at the end of a fiscal year, the balance of the class is negative, a gain has occurred.  This gain is referred to as a “recapture” of CCA, and must be included in business or property income for the year. Where there is still much useful life in an asset there will be a large tax bang at the end that could have been avoided. This large tax issue makes owners want more for their business (despite the fact they got it already) and can make negotiation for sale more difficult. Given that we are entering into a period where we expect a lot of business to be bought and sold given the aging population, this will become a bigger problem in the near future.

Have these changes been effective at achieving the federal government’s policy objectives? While the industry being targeted will say ‘yes,’ there is no evidence to support their views. Accountants are fairly unanimous in their views that the tax rules fail to stimulate the acquisition of an asset. In addition, there is little economic benefit in favouring one industry or asset acquisition at the expense of another. While I understand that we seem to be currently living through a period dubbed ‘decision-based evidence making’, a return to evidence-based decision making would be a welcome change to policy development in Canada.

Most of the existing CCA classes are not commonly used (CRA indicates that only 18 are commonly used) and many of them overlap making it difficult for businesses to identify the ‘right’ class (thereby wasting time and effort). These 56 classes need to consolidated, some even eliminated, and the descriptions revised which would provide for a more simple CCA system. You can put this initiative under reducing red tape for businesses. The CCA rates should then be modified to best reflect the useful life of these new asset class.

While more of a fringe element, the half year rule needs to go the way of the do-do bird. The half-year rule, introduced in 1981 and applied to some asset classes, means only half of the expense can be included in the purchase year for purposes of that year’s CCA deduction calculation. The rationale for the half year rule is to prevent a flurry of tax motivated purchases at the end of a tax year, for many assets. So on one hand we want to discourage tax motivated purchases, and then on the other, we want to, wait for it, encourage a flurry of tax motivated purchases. That my friends is the problem with political interference in the tax system. The problem with the half- year rule is that it is only used for tax purposes, not accounting purposes, so you have what is called a book-tax difference. And you wonder why businesses need to keep two books! Again, the half-year rule adds a layer of complexity that most likely has no real benefit.

So instead of futzing the the existing system and adding in more and more complexity and irrationality into the CCA system, I would love to see someone come out and say they want to simplify and stop using the tax system for political reasons.