For the last few years, the Canadian economy was thriving. Rich with natural resources, foreign investment and the export of minerals, energy, and lumber gave Canada a strong currency. Priced in Canadian dollars, imports were cheap, exports profitable, and Canadians had a high standard of living. Without the colossal military costs of its neighbor the USA, Canada was a friendly, tolerant, country. There are squabbles between the French in Quebec and the English there and elsewhere, but they have been conducted within the rule of law.
But unfortunately the Canadian government chiefs suffer from a mental disorder common to almost all state officials: taxitis. Anywhere government officials see money flowing, they have a compulsion to tax it. Their motto is, “tax anything that moves.”
So it came to be that on October 31, 2006, Canadian finance minister John Flaherty declared what has been called the “royalty trust bomb.” He saw that there was an investment that was bringing money into the country and yielding high earnings. This was the Canadian royalty trust, a structure created for corporations that invest in the energy industry. Like mutual funds, these income trusts have not been taxed if they pay out at least 90 percent of their profits to the shareholders. Investors from all over the world have put money into these trusts. The minister thought that these investors were getting a “tax break,” so he proposed to impose a heavy tax on the income from these trusts.
The Canadian corporate tax applies to the world-wide income of a company. The favorable tax treatment of the energy trusts were inducing companies in other fields such as banking and communications to become income trusts and escape corporate taxation. The Canadian government was alarmed at this loss of tax revenue, which spurred it to close the tax break.
The proposal has not yet become law, and the details are still being worked on. According to reports of the plan, Canadians will pay more than 30 percent in taxes from the income of these trusts, and Canada will withhold 41.5 percent from the income going to Americans. The combined federal and provincial income tax rate on corporations can be higher than 40 percent.
The immediate impact of the announcement was a steep fall in the value of these trusts. The Canadian stock market fell by $25 billion. The impact went beyond the stock market panic to the whole economy. The Canadian dollar had been rising relative to other major currencies as foreigners invested in Canada. During 2006, the Canadian dollar seemed like it was on its way to equal the value of the U.S. dollar, reaching a high of over 90 US cents for a Canadian dollar. But during the last months of 2006, the Canadian dollar suffered a decline to 85 US cents. The problem was not just the looming tax on the Canadian trusts, but a fall in the price of commodities and the prospect of a less business-friendly government.
The main problem in the Canadian tax system is that it does not distinguish income from natural resources from income due to labor and capital goods. The corporate income tax draws from both sources, as does the personal income tax. Much of the income from natural resources is economic land rent, a surplus beyond normal payments for labor and capital goods, including exploration. The policy that would be friendly to entrepreneurship as well as investment and labor would be to tap only the economic rent of land, including all natural resources, and avoid taxing labor and enterprise. Abolish the general tax on corporate and personal income, and abolish the GST, the sales tax on goods and services. Replace these with taps on natural resource rents and levies on pollution.
With such efficiency taxes, dividend income to shareholders would not be subject to any tax. The economic rent would be tapped at the corporate level. There would be no withholding of dividend income. The shares of energy companies would adjust to reflect the profits from the operation.
Indeed, if the finance minister proposed to tap only the rent of natural resources and not the overall income from the trusts, the share prices of many of the companies would have fallen. The economic problem is not the fall in the price of the shares of stock, but the taking of income due to entrepreneurship and investment, and the uncertainty of future takings.
But Canadian people do not understand the economics of taxation and their chiefs of state suffer from taxitis, so it looks like the Canadian government will pursue its plan to plunder the earnings of labor and enterprise along with some of the resource rents. If the Canadian dollar continues to decline, the Canadian standard of living will suffer as imports become more expensive, exports earn less revenue, and foreign investment falls.
Taxation and other interventions will ruin the economy of Canada just like they have crippled the economies of western Europe. Wherever prosperity arises, government chiefs have a compulsion to tax it until it surrenders. It’s a shame, because Canada was such a nice country.
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FRED E. FOLDVARY, Ph.D., is an economist and has been writing weekly editorials for Progress.org since 1997. Foldvary's commentaries are well respected for their currency, sound logic, wit, and consistent devotion to human freedom. He received his B.A. in economics from the University of California at Berkeley, and his M.A. and Ph.D. in economics from George Mason University. He has taught economics at Virginia Tech, John F. Kennedy University, Santa Clara University, and currently teaches at San Jose State University.
Foldvary is the author of The Soul of Liberty, Public Goods and Private Communities, and Dictionary of Free Market Economics. He edited and contributed to Beyond Neoclassical Economics and, with Dan Klein, The Half-Life of Policy Rationales. Foldvary's areas of research include public finance, governance, ethical philosophy, and land economics.
Foldvary is notably known for going on record in the American Journal of Economics and Sociology in 1997 to predict the exact timing of the 2008 economic depression—eleven years before the event occurred. He was able to do so due to his extensive knowledge of the real-estate cycle.