Finance Minister Bill Morneau did not have a very good summer. So far the fall has also not been good to the Finance Minister and, unfortunately, it is unlikely that the months leading up to the 2018 budget will get any better for him. He has only himself, or perhaps his department, to blame for his unhappiness.

This past July the Finance Department released a set of proposed tax changes for Canadian Controlled Private Corporations (CCPCs) which they stated was to “improve the fairness of Canada's tax system by closing tax loopholes and amending existing rules to ensure that the richest Canadians pay their fair share of taxes and that people in similar circumstances pay similar amounts of tax.” These proposals were a follow-up to a commitment made in the 2017 budget.

It is hard to understand what the Finance Minister and his Department hoped to achieve with these proposed tax changes that impacted so many different groups in the small business sector. It is as if they didn’t appreciate that they were proposing some of the biggest tax changes since the Carter Commission 45 years ago.

The primary justification for the proposed tax changes was that high-income individuals (e.g., doctors, small business owners, farmers, among others) were using the tax system to reduce their income tax by incorporating CCPCs to conduct their businesses or carry on their professional practises This meant that individuals with the same income could end up paying different taxes and this, according to the Finance Minister and the Prime Minister was “unfair”.  The government intended to sell its tax changes for CCPCs on the basis that they would mean higher income Canadians would no longer be able to avoid paying their fair share of tax.

To no one’s surprise, other than the Finance Department, the backlash to the proposed tax changes was quick, broad based, and furious and the Finance Minister was completely unprepared on how to respond. All he could say was "We did it the way we intended to do it, which was to go out with proposals and get some feedback." 

Well he got a lot of feedback, 22,000 submissions. This predictable response to the proposed tax changes showed that the Finance Department, and the Finance Minister, had not done the policy analysis and targeted consultations, necessary to develop and implement an income tax reform strategy.

As a result of this failure, the Finance Department released a set of proposed tax changes: that were unnecessarily complex; deficient in addressing certain double taxation issues; not well thought through in addressing intergenerational transfers of family businesses; and that were not understanding of the application of the alternative minimum tax to minors in order to access the lifetime capital gains exemptions through the proposed election procedure in 2018.  To make matters worse, some of  the proposed changes would be impossible to administer.  

“Unintended consequences”, in tax policy changes can happen, but they can be avoided to a large extent through prior consultations and good policy analysis. But in this case the list is embarrassingly long. This only shows that the Department failed to take the time to consult with those groups likely to be affected and with relevant tax experts. Let’s hope the Finance Minister takes a serious look at the 22,000 submissions and gets it right the next time.

The real puzzle, however, is why the Finance Minister felt that the CCPC problem was so serious that it was imperative that he act immediately without adequate consultations and analysis. It is certainly true that there has been a dramatic increase in the number of CCPCs over the last ten years. But this has not led to a major direct loss in federal tax revenues. The Finance Department estimates, for example, that the proposed tax changes would yield savings of only $250 million.

The communications people advising the Finance Minister felt that the best way to sell the proposed tax changes was by arguing that they would lead to greater tax fairness, even though the Finance Minister himself claimed the tax changes would only affect a small group of high-income earners.

It is very difficult to sell bad tax policy proposals. These tax proposals were bound to fail for at least the following three reasons. First, the proposals were not well thought out and the “unintended consequences’ were overwhelming and ignorant of  basic tax policy principles. Second, the income tax system is full of situations of tax unfairness.. For example, pension splitting among spouses creates unfairness where there is only one spouse. Of course no government will ever take away this tax unfairness.

Ironically, the new proposed rules affecting passive investment income of CCPCs are not extended to small public business corporations, who actually compete on the same basis as CCPCs. They will still be entitled to use their retained earnings any way they see fit.

There are many other examples in the Income Tax Act to demonstrate that tax fairness was never a strong argument to justify the proposed tax changes.

The third for failure is that a successful tax reform strategy requires a broad based approach not a piece meal approach, such as that adopted by the Finance Minister.  Releasing the proposed changes to CCPCs on their own made it impossible for affected individuals to see how they fitted into a broader and consistent tax reform strategy. 

Unfortunately, the government has never articulated a tax reform strategy setting out fundamental goals and underlying tax principles. This would have been a useful starting point for a public discussion on how to bring the income tax system into the 21st century. Perhaps the Finance Minister needs to consider starting over?

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