The federal NDP recently announced “concrete proposals that will help Canada’s manufacturers and small businesses create good-paying, full time middle class jobs for Canadians.” As many pundits have already suggested, their tax plan seems to be nothing more than extending either Conservative or Liberal tax policy.
One pillar in this proposal is to extend “for an additional two years the accelerated capital cost allowance, scheduled to expire later this year.” Since this proposal has been given little attention to date, I thought I would parse it for you.
Generally, under Canada’s tax code costs incurred to earn income are deductible from the income earned for tax purposes. This is called the matching principal: it matches expenses with the income generated. When an expense is incurred to acquire a capital asset, the expense is typically allocated over the useful life of the capital asset since the one-time expense generates a flow of income.
The capital cost allowance (CCA) rate determines how much of the cost of a capital asset may be deducted each year for tax purposes. The CCA deduction is non-refundable (though as a discretionary deduction can be carry forward indefinitely) and the CCA rates vary according to the useful life of the capital asset. In addition, to prevent a flurry of tax motivated purchases at the end of a tax year, for many assets only half of the expense can be included in the purchase year for purposes of that year’s CCA deduction calculation. This is commonly referred to as the half-year rate. To calculate the CCA deduction, most asset classes use the declining balance. The declining balance method produces relatively larger CCA deductions during the earlier years of an asset’s life, decreasing deductions over time, and an asset balance that never reaches zero. The other method is called a straight-line method and generates equal CCA deductions each year until the balance reaches zero.
The CCA rate for machinery and equipment used for production is normally 30%. Budget 2007 implemented a temporary 50% straight-line CCA rate for purchases of these assets made before January 1, 2009. Budget 2008 extended this to include purchases made in 2009 and provided for a declining basis for assets acquired in 2010 and 2011. Budget 2009 waived the declining basis and extended the 50% straight-line CCA rate into 2010 and 2011. It was extended again in Budget 2011 to end at the end of 2013. Unsurprisingly, it was extended again in Budget 2013 and is not set to end in 2015. I hereinafter refer to this policy as the accelerated capital cost allowance or ACCA.
Mulcair is saying he will extend this ACCA a further two years. I am completely confident that the Conservatives will also extend the ACCA, meaning that this announcement does not in anyway separate the NDP from the ruling Conservatives.
What does this ACCA treatment mean? It means that purchases of machinery and equipment can be fully deducted in the first two years of the assets useful life. This measure is to “assist businesses in the manufacturing and processing sector to meet the current economic challenges, boost productivity, and position themselves for long-term success.” (FC 2009, p. 168)
Increasing the CCA rate permits an asset to be depreciated more rapidly than the presumed decline in the asset`s value; thereby providing an immediate tax advantage. There are several things to note about accelerating CCA rates, assuming no changes in tax rates and positive taxable business income.
- First, the total tax savings under an accelerated regime and the normal regime is essentially the same in nominal terms.
- Second, the total taxes paid by the corporation under the two regimes are the same but the accelerated regime allows the business to defer corporate taxes to future years.
- Third, because of the deferment, an accelerated CCA regime can be viewed as an interest free loan from the government. However, if the tax rate is scheduled to drop in the future, the accelerated CCA regime actually reduces overall taxes paid corporations by allowing business to claim more of the deduction during years in which the tax rate is higher. If instead the tax rate is schedule to increase, the accelerating regime increases overall taxes paid (and if set to increase, a tax minimizing entity will defer this discretionary deduction to a higher tax year).
The underlying assumption of this policy is that the temporary acceleration rate will incentivize businesses to increase their investments in these assets, thereby increasing the long-term productivity and growth.
Accelerating CCA rates have several key shortcomings.
- First, in any year some firms will be investing in these assets regardless and the accelerated rate simply subsidizes behaviour that would have occurred anyway. (Of course this is a common problem with most incentive programs, such as SR&ED, but any such programs should stipulate the currently level of activity and the anticipated increase in activity due to the new initiative.)
- Second, businesses with no taxable income in the years the accelerate rate applies do not benefit from the change despite making the desired purchase.This is because it is nonrefundable.
- Third, it is assumed that accelerating the purchase of the specific assets has a bigger benefit than increased purchases of other assets. That is, accelerated rates cause investment dollars to be shifted from other asset classes which, for any given business, could have induced higher productivity growth than an investment in an accelerated class. (One justification for accelerated CCA is that the specific assets generate externalities. There is some evidence that investment in machinery and equipment generates spillover effects (e.g. Long and Summers (1991) but this is a highly controversial view (e.g. Auerback, Hassett, & Oliner (1994).)
- Fourth, an accelerated rate essentially subsidizes the sector that produces the asset at the expense of other sectors in the economy. In particular, the program leads to an increase in demand for certain assets and a decrease in demand for others. Further, the increase in demand will likely lead to increases in the prices of specific assets because of the increase in demand. Fifth, accelerated rates distort the matching principle underlying the Canadian tax system.
- Fifth, the ACCA causes provincial revenues to take a hit since the provinces must accept the federal calculation of taxable income.
- Finally, as pointed out by the the Technical Committee on Business Taxation (TCBT) (Canada 1998) “when assessing the appropriateness of certain accelerated deductions, it should be remembered that there are a number of other significant deductions, which, while recognized for financial accounting purposes can only by deducted later – perhaps many years later – for tax purposes. These rules may more than offset the advantages accruing to businesses that are able to claim capital cost deductions more rapidly than they depreciate them in their own records.” (Canada 1998, p. 4.9)
A better policy to promote investment in the short-term to ensure long-term increases in productivity without subsidizing certain businesses and sectors would have been to reduce the corporate tax rate, something that Mulcair is saying he is going to increase. Decreasing tax rates would be a more efficient way to incentivize businesses to increase investments in capital assets. Indeed, most economists would agree that in the absence of spillovers from certain types of assets, the preferred tax structure is one with a broad base and a low statutory rate.
Alternatively, if there was a desire to target specific assets, then an investment tax credit (ITC) would be preferable to the ACCA. As noted by the TCBT, ITCs “are generally a more efficient incentive than accelerated allowances, because the benefit is provided up front where it can assist in financing the cost of the asset, rather than over some period of years. The use of investment tax credits makes the incentive more visible and therefore imposes accountability as well as avoiding distorting the income tax base. The use of federal investment tax credits instead of accelerated allowances minimizes the entanglement of federal and provincial tax systems. The cost of a federal initiative is thus borne by the federal government and not shifted in part to the provinces (through alterations in the common tax base), thus preserving the integrity of the taxable income base for both levels of government. (Canada 1998, p. 4.11-4.12) But wait, Mulcair announced an ITC “to encourage manufacturers and businesses in other industries to invest in machinery, equipment and property to further innovation and increase productivity.” So he wants both the ACCA and an ITC at the same time. Take about subsidizing businesses!
As a result, it is clear to me that Mulcair and the federal NDP does not understand the tax system and how different measures intermingle with each other. That is a scary thought for a party that so desperately wants people like me to support them.