Effective Tax Rates and the Formation of Manufacturing Enterprises in Canada

In a recent survey of investment fund managers, respondents were asked to rank policy areas in order of their importance in fostering a positive investment climate. The top four of ten policy areas were all related to taxation: corporate income tax, personal income tax, corporate capital tax, and capital gains tax.Policy analysts and government are increasingly concerned with the competitiveness of the fiscal system relative to other jurisdictions. This is particularly true in the case of tax policy and, even more particularly, in the case of taxes levied on businesses. In a recent survey of investment fund managers in Canada, respondents were asked to rank policy areas in order of their importance in fostering a positive investment climate. The top four of ten policy areas were all related to taxation: corporate income tax, personal income tax, corporate capital tax, and capital gains tax.

In order to understand the competitiveness of a tax structure, it is imperative to consider the broad range of taxes that affect the costs of all inputs into production. We argue that simply comparing things like statutory Corporate Income Tax (CIT) rates does not provide a very clear picture of the overall tax structure. Surprisingly, the over-all pattern of the Canadian business tax system has not been carefully examined. This publication addresses this by presenting and analyzing a summary measure of the tax structure for 21 Canadian manufacturing industries in six provinces (British Columbia, Alberta, Saskatchewan, Manitoba, Ontario, and Quebec) over 28 years, from 1970 to 1997. The summary measure is known as the Effective Tax Rate on Marginal Cost (ETRMC). The ETRMC is the effective excise tax rate imposed on the cost of producing an incremental unit of output. It provides a consistent measure of the tax structure based on the economic theory of the firm and allows the comparison of the tax structure across industries, provinces, and time.

We find that the ETRMC increased on average over this period rather than declining along with the observed reductions in statutory CIT rates. Beginning in 1970, there was a general decline across the six provinces until 1972 followed by a slight upward trend throughout the 1970s. ETRMCs increased at a higher rate throughout the 1980s and have generally declined throughout the 1990s. Over the nearly three decades, Ontario and Alberta had nearly the same ETRMC while the other four provinces have higher ETRMCs. We find that the increase in ETRMCs was primarily due to increases in labour taxes.

Moreover, the variation in ETRMCs across space, time, and industries in Canada is extremely large. For example, in 1997 the ETRMC in Ontario ranged from a low of approximately 7% in Leather to a high of over 23% in Beverages. There is also significant variation across provinces. For example, in the Wood industry in 1997, the ETRMC was 8.6% in Alberta and 16.1% in Quebec.