the canadian parliament and library during the fall

Canada’s federal government is likely to find itself with little room to manoeuvre in tax policy as the Liberals look ahead to tabling an election year budget in early 2019.

Although Canada’s healthy economy and the certainty provided by the new trade deal with the U.S. and Mexico are positives for the Liberals, difficulties persist. Large deficits, rising interest rates, the loss of relative competitiveness in the wake of U.S. tax reforms and the risk of negative economic events rob Canada’s federal government of flexibility. Thus, the feds will have scant leeway, either in providing tax relief or to introduce new spending programs.

“There are factors that have eroded business confidence that go beyond [trade uncertainty],” says Ian Russell, president and CEO of the Investment Industry Association of Canada in Toronto. “And they have to be dealt with in the forthcoming budget.”

Certainly, the new U.S./Mexico/Canada Agreement, announced on Oct. 1, was a win for the Liberals. Says Russell: “[The deal] will be a shot in the arm for the business community.”

Solid economic growth also is putting wind in Ottawa’s sails. A report from Royal Bank of Canada’s economics department, published in September, forecasts growth in Canada’s real gross domestic product (GDP) to rise by 2.1% in 2018 and by 2% in 2019 after a strong 2017, in which real GDP rose by 3%.

Still, Canada’s deficit is a major roadblock, especially if global interest rates continue to rise, which would leave the government with little wiggle room to stimulate the nation’s economy if a recession hits, says Pedro Antunes, executive director of economic outlook and analysis and deputy chief economist with the Conference Board of Canada in Ottawa. The feds have prioritized keeping the debt/GDP ratio in check vs balancing the books.

“Seeing the government, when the economy is doing well, aim for something that is much more balanced in terms of the budget deficit itself would be nice,” says Antunes, who projects Canada will post a $15-billion deficit in 2018-19.

The size of the deficit makes responding to the effects of U.S. tax reform very difficult. Those reforms, announced in late 2017, led to a decline in U.S. tax rates for both corporations and individuals. Canadian business groups and leaders have been sounding the alarm about the risk to the domestic economy attributable to the widening cross-border tax gap.

In the 2018 budget, the Liberals chose to take a wait-and-see approach to the U.S. tax reform, but that’s no longer a tenable strategy, says Aaron Wudrick, federal director of the Regina-based Canadian Taxpayers Federation in Ottawa.

“[The government] really needs to do something to demonstrate that they take the threat to our competitiveness seriously,” Wudrick says. “Simply pretending tax reform didn’t happen in the U.S. is definitely not going to help.”

The Department of Finance Canada has signalled in recent months that Finance Minister Bill Morneau will address Canada’s business tax competitiveness in the government’s autumn economic update. There are indications that Morneau is looking at providing businesses with targeted relief – perhaps accelerating the depreciation of capital expenditures to match similar moves made in the U.S. – rather than reducing corporate tax rates.

Accelerating writeoffs of capital expenditures “would make investing more attractive [for businesses],” says Rick Robertson, associate professor with the Ivey School of Business at Western University in London, Ont.

But Morneau risks inflaming public opposition if he chooses to slash corporate rates, Robertson suggests: “There would be some real political challenges to that.”

Cuts to personal income taxes don’t appear to be in the cards either, says Russell, adding that the Liberals actually may look to raise personal income tax rates, particularly on high earners.

“The fear that’s out there in the business community is … that we’ll see even higher tax rates at the personal level,” Russell says.

In 2016, the Liberals cut personal income tax rates for middle-class Canadians, but raised rates for those with high incomes. However, a recent report from Alexandre Laurin, director of research at the C.D. Howe Institute, suggests that Ottawa generated less revenue from that increase than projected.

High earners may have taken steps, such as reducing work effort or shifting the timing of when income is realized, to plan around the higher tax rates, the report argues: “This level of taxpayer responsiveness means that the [tax] hike likely yielded about a third of the tax revenue that would’ve been raised without the behavioural response.”

Wudrick, for his part, believes the government won’t raise personal income tax rates this time around. He suggests that doing so would be a hard sell politically: “I think they’re going to hold the line on that front.”

Wudrick also suggests that the Liberals may be gun-shy about announcing major tax reforms or initiatives in the 2019 budget, particularly after the party mishandled their overhaul of the taxation of small businesses in July 2017.

Widespread backlash from the small-business sector and professional groups forced Ottawa to scale back its original proposals significantly during the following months. Tax simplification or tax reform, which had been stated priorities in the early years of the Liberal government, now appear to be on the policy back burner.

“The [Liberals] really have only themselves to blame for trying to slip through [the small-business tax changes] the way they did,” Wudrick says. “I don’t foresee them going anywhere near tax reform before the next election.”

To be sure, the Liberals have had their share of tax policy wins. The cut to the middle class’s taxes, along with the consolidation and reform of various child benefit programs into the Canada Child Benefit program, were popular politically and generally good policy too, Wudrick says: “We supported the middle class tax cut. We applaud [the Liberals] for it; we’re glad they did it. And the same with the Canada Child Benefit – we think that was a smart move.”

The two initiatives also were “on message” in terms of the Liberals’ overall tax and economic policy theme of “building a strong middle class,” Robertson says: “They’ve been consistent in what they’ve been trying to do.”

In terms of spending in the 2019 budget, Antunes anticipates the feds will “probably stay the course” on infrastructure investments and continue to direct resources toward raising women’s participation rate in the economy. “Longer term,” he says, “if we can achieve that goal, that’s very positive.”

Wudrick believes the Liberals will propose a universal drug plan program in the next budget, although “how comprehensive that will be remains to be seen,” he says. In the 2018 budget, the feds announced the creation of an Advisory Council on the Implementation of National Pharmacare. That council is scheduled to issue a final report, including recommendations, in the spring. “We’re talking billions of dollars,” Wudrick says. “[Pharmacare] is no small thing.”

One way in which the government will continue to look for tax revenue is to clamp down even more on offshore tax evasion and aggressive tax avoidance. The feds recently introduced a stricter voluntary disclosure program through which taxpayers can choose to come clean with the Canada Revenue Agency in exchange for full or partial relief from penalties. (See Changes to VDP raise questions) Ottawa also has tightened rules on the reporting of foreign assets and by certain trusts. (See Coming clean on foreign property and New trust rules coming, respectively.)

Ensuring Canadians pay their fair share of taxes is a laudable goal, but will not be sufficient to increase tax revenue, says Russell: “The best way to find tax revenue is to grow the economy.”