## cr18222 - TAXING BUSINESS IN A CHANGING WORLD (June 28, 2018) ## Source details **Canonical URL:** [cr18222 - TAXING BUSINESS IN A CHANGING WORLD (June 28, 2018)](https://www.imf.org/-/media/files/publications/cr/2018/cr18222.pdf) ## Other formats - [Markdown version](/-/media/files/publications/cr/2018/cr18222.pdf.md) - [Structured JSON version](/-/media/files/publications/cr/2018/cr18222.pdf.json) --- ### Overview - Paper reviews and suggests possible improvements to Canada’s system of business taxation, focusing on implications of wider developments in the global tax environment and the U.S. Tax Cuts and Jobs Act (TCJA). - Sections covered: overview of current arrangements; likely impact on Canada of international tax developments including the TCJA; options for reform. ### Revenue and Rates - Key statistics: - CIT generates around 10 percent of total tax revenue in Canada. - For the provinces, their CIT accounts for about 15 percent of their total own-source revenue. - Combined (federal plus provincial) average CIT rate is about 27 percent. - Total CIT revenue in Canada is about 3.2 percent of GDP. - US MNCs pay about 15 percent of CIT revenue in Canada. - Comparative observations: - CIT revenue in Canada has consistently accounted for a larger share of GDP than in most other G7 countries. - Post-TCJA, Canada’s combined average rate is "virtually the same as" the comparable average rate for the U.S. - U.S. state variation: highest all-in rate in the U.S. is 6.5 percentage points above the lowest rate in Canada; lowest U.S. rate (21 percent, in the six states that have no CIT) is 10 points below the highest in Canada. ### ‘Small’ Companies and Preferential Rates - Structure of preferential treatment: - CCPCs: first CAN$500,000 of profit taxed at reduced federal rate of 10 percent (falling to 9 percent in 2019) and 0-7 percent at provincial level. - Phase-out of the reduced rate occurs at higher levels of taxable capital (between $10-15 million at federal level). - Distortions and concerns: - This creates a gap of around 39 points relative to the top rate of PIT. - Critiques: small companies are commonly not key drivers of growth and innovation; high effective marginal rates on withdrawal of benefit can discourage growth; reduced rates create avoidance opportunities (highlighted in Department of Finance consultations in October 2017 and February 2018). ### The Tax Base — Key Features - Federal and provincial CIT bases are closely aligned; provinces in Tax Collection Agreement adopt the federal base. - Central features and exact policy details: - Depreciation allowances are likely somewhat accelerated relative to true economic depreciation (example: machinery and equipment for manufacturing depreciated at 50 percent declining balance vs. estimated economic depreciation of 17 percent for industrial machinery). - Interest is fully deductible, subject only to a thin capitalization rule on payments to related parties abroad; the rule appears weak (e.g., excludes interest on third-party debt guaranteed by the parent and does not cover financing element of financing leases). - Only 50 percent of capital gains realized by corporations are included in the CIT base. - Corporate tax incentives are modest (except for a generous R&D credit and mainly provincial investment tax credits). ### International Aspects of the CIT - Canada operates a de facto territorial form of international taxation for active income with four key elements: - Distributions from subsidiaries in jurisdictions with which Canada has a tax treaty or Tax Information Exchange Agreement (TIEA) are untaxed as “exempt surplus” subject to FAPI rules; Canada has treaties or TIEAs with 116 jurisdictions. - FAPI rules bring certain types of passive income earned abroad immediately into tax in Canada; difference between exempt surplus and CFC rules places extreme pressure on definitional rules of the CFC regime. - Canada has a full range of withholding taxes on outbound payments which are reduced, but often not eliminated, under tax treaties; under the treaty with the U.S., interest and royalties on copyright, patents and software are not subject to withholding, while dividends (on shareholdings of more than 10 percent) are withheld at 5 percent. - Canada has little in the way of rules that allocate interest and other expenses between domestic and foreign source income, risking excessive allocation of expenses to Canada. - Evidence gap: - There appears to be some stock of unrepatriated earnings accumulated abroad that would be liable to tax in Canada; the scale is unknown and would be useful to quantify. ### Personal Income Tax — Features Affecting Business Taxation - Key parameters and effects: - Top (federal plus provincial) marginal PIT rate is in the order of 53-54 percent (in New Brunswick, Nova Scotia, Ontario, and Quebec) and sets in at a relatively modest level of income. - Lifetime capital gains exemption for qualified small business shares of around $850,000 in 2018. - Widespread availability of savings schemes (Registered Pension Plan, Registered Retirement Savings Plan, Tax-free Savings Accounts) that effectively exclude the normal return from tax. - Boadway (2017) cited: if full advantage taken of PIT-free saving opportunities, about 70 percent of all capital income of Canadian taxpayers could be in some way excluded from tax. - Only 50 percent of realized capital gains are included in the PIT base. - Non-refundable dividend tax credits are provided (federal and provincial), based on notional, not actual, Canadian CIT paid; full credits can be granted for redistributed foreign dividends paid from exempt surplus. - Critique: rationale for credit when no Canadian tax has been paid is unclear and may forgo an efficient source of revenue. ### Distortions to Investment and Tax Incidence - METR and incidence observations: - Marginal effective tax rates (METRs) have fallen substantially in the U.S., on average, to around the same level as those in Canada. - Comparison of METRs accounts for CIT parameters and unrecovered sales taxes on business purchases; unrecovered sales taxes are more prevalent in the U.S. given GST treatment in Canada. - In a small open economy benchmark, after-corporate tax return on investments is fixed exogenously in world capital markets. - Measures reducing or offsetting taxes at corporate level (e.g., dividend tax credits) may have no impact on domestic investment but can dissipate efficient tax revenue. - If CIT bears on rents, dividend tax credits merely dissipate tax revenue rather than affecting investment. ### Interpretation of METRs (cautions and heterogeneity) - METR interpretation caveats: - Calculations are sensitive to underlying assumptions and should be treated as indicative; small differences have little significance. - Averages conceal significant variation across provinces and states, across assets, and across source of finance. - Exact heterogeneity examples: - METR on debt-financed investments in plant and machinery commonly negative. - Equity-financed METR in Canada ranges from 10 percent for plant and machinery to 40 percent for buildings. - Debt-financed METR for plant and machinery in Nova Scotia is -75 percent. - Retention-financed investment in buildings in Newfoundland and Labrador the METR is 31 percent. - Implication: - Dispersion in METRs signals distortions to the composition and financing of investment decisions. - Any positive METR implies a tax disincentive to investment in real assets. ### Distortions to Financing - Incentives: - Larger corporations have a strong incentive to use debt finance as a means of profit shifting and because debt is tax-preferred (interest deductible, return to equity not). - Evidence and scope: - Ratio of corporate debt to GDP in Canada has risen markedly since 2012 and is now at an all-time high; but broadly in line with international norms; ratio of corporate debt to equity and assets has not increased markedly. - A substantial body of evidence from other countries suggests debt shifting and debt bias can be substantial. - CCPCs: - For high income owners of CCPCs, the primary distortion is likely towards retention finance due to the very low CIT rate and light taxation of capital gains, while significant taxation of dividends remains for higher rate payers after the dividend tax credit. ### Federal-provincial Interactions - Institutional and fiscal interactions: - Provinces have prominent role in corporate taxation, counter to prescription that central government control taxes on mobile bases such as capital. - Equalization arrangements can reduce horizontal tax competition incentives. - Some evidence provincial CIT rates may be so high as to cause significant efficiency losses and in several provinces may be above revenue-maximizing levels. - Coordination between federal and provincial governments is critical; record shows limited cross-province variation in rate or base. ### Changing Times — international context - Drivers of fluidity and uncertainty in international tax matters: - ‘BEPS’ implementation: Canada is a member of the OECD Inclusive Framework on BEPS and is committed to implement the four minimum standards, with peer reviews underway. - Digitalization: debates on taxing business practices involving substantial activity with little physical presence; OECD remained agnostic; European Commission proposed temporary turnover tax on selected services and argued for expanded notion of permanent establishment. - Unilateral reforms elsewhere: global trend towards lower statutory CIT rates; structural measures such as diverted profits tax adopted by the UK and Australia. - The TCJA is a major novel reform with potential to reshape international tax norms; proximity and integrated North American markets make it especially germane for Canada (more than half of all FDI in Canada is U.S.-owned). ### Impact of the TCJA on Canada - Sources of uncertainty: - International provisions remain to be fully described; novelty, complexity, projected changes over time; questions on consistency with WTO rules, tax treaties, and BEPS minimum standards; lack of bipartisan support. - Mechanisms of impact: - Sharp reduction in U.S. federal CIT rate substantially reduces Canada’s relative appeal for mobile investments and increases exposure to profit shifting to the U.S. - Including average state and provincial CIT rates, what was a substantial advantage for Canada in statutory CIT rates has now turned into broad equality. - Two consequences matter: - Potential impact on real investment: locating where profits are most lightly taxed. - Potential impact on profit shifting: taking deductions where statutory rates are high and receipts where taxes are low. - Provincial/state heterogeneity matters: gap in statutory rates between British Columbia and Washington state is 12 percentage points; between Manitoba and North Dakota about 4 points. - Move to immediate expensing in the U.S., combined with rate reduction, substantially erodes the gap in METRs between the U.S. and Canada. ### Three Novel International Provisions of the TCJA (summary) - FDII: - Domestic corporations receive a 37.5 percent deduction from the corporate tax base for FDII. - Effectively reduces the CIT rate for such income from 21 to 13.125 percent. - Had FDII been in effect in 2014, around 9 percent of all U.S. companies and 13 percent of multinationals would have been eligible, with concentration in manufacturing. - GILTI: - Imposes a minimum tax on overseas income in excess of 10 percent of the return on tangible assets; deduction for 50 percent of that income; credit for 80 percent of foreign tax paid. - Effect is to impose a minimum rate on GILTI income of 10.5 percent when no tax paid abroad. - BEAT: - Applies to multinationals with annual gross receipts over US$500 million in the preceding 3 years that make cross-border payments to affiliates exceeding 3 percent of total deductible expenses. - Rate schedule: 5 percent for 2018, 10 percent for 2019-2025, and 12.5 percent thereafter. - Targets interest, royalties, and management fees; does not apply to cost of goods sold. ### FDII, GILTI and implications for Canada - Repatriation and investment effects: - Move towards territoriality (qualified by GILTI) means earnings repatriated to the U.S. will no longer be subject to taxation there (with credit for Canadian taxes paid). - Reduction in effective tax rate on repatriated earnings could encourage U.S. investment and reduce lock-in, making it easier to withdraw profits from Canada and thus reduce reinvestment in Canada. - FDII may amplify the tax advantage of serving Canada from the U.S.; estimated scope noted above. - GILTI creates an incentive to locate tangible assets outside the U.S., including in relatively high tax countries such as Canada, because doing so increases deemed tangible income outside the U.S., reducing GILTI. - BEAT impacts on Canada likely limited. ### Firm-size differentiated effects - Small businesses in Canada (with generous small business treatment) may be less affected by TCJA. - Larger corporations face several aspects of TCJA that switch balance of advantage away from Canada toward the U.S. - Even with U.S. reforms, low CIT rates in Canada for small corporations combined with dividend tax credit and 50 percent exclusion of capital gains will often preserve more favorable treatment in Canada for small firms, with exceptions for dividends to high income CCPC-owners. ### Empirical estimates of U.S. multinationals’ response (preferred point estimates, Appendix I summary) - Preferred point estimates from short panel of aggregate FATS data: - Real assets held in Canada by U.S. multinationals are projected to fall, in the long run, by 6 percent (95 percent confidence interval between 0.4 and 14 percent). - Reduced profit shifting into Canada by U.S. multinationals is estimated to reduce the profits they report in Canada by around 15 percent. - Together imply a reduction in the CIT paid by U.S. multinationals in Canada (currently about 15 percent of all CIT revenue) of close to one quarter (overall long-run loss in CIT revenue from U.S. corporations estimated to be about 23 percent of their current payments). - Quantitative revenue implications (Appendix I): - Investment channel: estimated reduction in CIT revenue around 0.03 percent of GDP (about 6 percent of CIT currently paid in Canada by U.S. corporations). - Profit-shifting channel: estimated reduction in annual reported profits in Canada of U.S. corporations of 0.31 percent of GDP; at combined statutory rate of 26.9 percent, this reduces CIT revenue by about 0.08 percent of GDP (approximately 17 percent of current CIT revenue from US multinationals). - Overall long-run loss from U.S. corporations: about 23 percent of their current payments, with a 95 percent confidence interval of between 0.16 to 0.31 percent of GDP. ### Broader responses and concerns - Non-U.S. businesses may respond by producing in the U.S. for sale into Canada (FDII effect), shifting financing of U.S. subsidiaries toward more equity, and shifting tax revenue from Canada to the U.S. - Business surveys: - Ernst and Young (2018): more than half of 165 surveyed executives thought it likely they would shift revenue or risk functions to the U.S. following TCJA; nearly one-third expected to reduce investment in Canada. ### Looking Forward — coherence and pressures on the Canadian tax system - Canada’s tax strategy key elements: - Heavy reliance on a sharply progressive PIT rate structure (weighted average top marginal rate of about 52 percent), beginning at a relatively low level of income—around one-third of that in the U.S. - Significant degree of integration with the corporate tax. - Particularly favorable treatment of small businesses. - Consumption tax treatment for a broad range of savings. - Relatively modest reliance on the GST as a source of revenue (accounting for about 23 percent of total taxation, compared with the OECD (unweighted) average of 33.3 percent). - Main pressure: - Large differential between the top rate of PIT and the rate of CIT, averaging around 25 points (and around 39 points for small businesses)—the highest in the G-7 and 9 points above the OECD average. - Recommendation: - A holistic and independent review of the Canadian tax system is recommended given interlinkages and substantial changes in the tax environment; last comparable review was the Carter Review of 1966. ### Box 2 — Improving the Coherence of the Current System (selected measures) - Selected policy options: - Exempt corporate gains on the disposal of shares while, consistent with imputation logic, fully taxing other gains. - Reconsider the purpose and role of the small business rate. - Rebalance tax treatment between small business taxed to individuals on a transparent basis and small business taxed as a company; consider taxing small companies on a transparent basis or taxing sole proprietorships and partnerships like companies. - Review dividend tax credit arrangements with a view to restructuring and reduction; consider limiting exempt surplus treatment to distributions from subsidiaries in countries that have a full tax treaty with Canada (not simply a TIEA). - Canada should play an important role in international dialogue seeking a coordinated way forward to address BEPS-identified risks and reflect on whether Canada might ultimately move towards greater taxation of profits to ensure Canadian enterprises competing at home are not disadvantaged. ### Navigating the International Tax Environment — guidance and policy instruments - Cautionary guidance: - Exercise caution in CIT reform given unprecedented uncertainty in international tax matters and risk of fragmentation undermining BEPS progress; OECD aims to arrive at a consensus approach by 2020, or perhaps 2019. - Avoid hasty action in response to the U.S. tax reform; extent of risks will become clearer over time. - Anti-base erosion protections (possibilities): - Extend thin capitalization rules to borrowing from unrelated parties, and perhaps to domestic transactions too (thin capitalization rules are a blunt instrument and do not address the fundamental debt bias). - Consider similar anti-base erosion measures for other deductible payments subject to minimal or limited withholding tax (rents, royalties, service fees); coordinate anti-base erosion measures for all relevant deductible payments. - Adopt more prescriptive rules allocating expenses between domestic and foreign activities; reconsider allowing deduction of foreign losses against domestic income for foreign branches. - Instruments to encourage investment and discourage profit shifting: - Reductions in the statutory rate targeted to discouraging profit shifting, though expensive because they confer windfall benefits to past investments; one estimate is that the rate reduction in the U.S. may eventually spur reductions elsewhere in the order of 4 or so percentage points. - Phase reductions in the rate to mitigate revenue loss, recognizing phasing creates distortions and timing incentives. - Close coordination between federal and provincial governments to share any reduction in combined rates; maintain and potentially increase provincial uniformity of rates and bases. - Increased generosity of investment allowances (movement towards immediate expensing of a wide class of assets) to support real investment; expensive and timing-related but potentially desirable. - More generous treatment of investment may need to be accompanied by tighter limits on interest deductibility applying to all interest, not just borrowing from related parties, to avoid exacerbating a marginal corporate tax subsidy to investment and to recoup some revenue loss from enhanced investment allowances. ### Corporate Rent Taxation — options, transition, and revenue considerations - Rationale: - Moving towards corporate-level rent taxation would eliminate corporate-level distortion to investment; remove bias towards debt finance; reset corporate-level METRs for all investments to zero. - Leading candidates: - Allowance for Corporate Equity (ACE) / Allowance for Capital (ACC): retains interest deductibility and allows deduction for a notional return on equity (or common notional rate on debt and equity for ACC). - International experience: ACE-type schemes adopted in several countries; Italian experience seen as positive. - Cash Flow Taxation (CFT): full expensing for all investment and denial of any deduction for interest. - Experience: wide use of full expensing for smaller firms; almost no international experience of full expensing accompanied by complete denial of interest deductions. - Transition and applicability in Canada: - ACE better suited for financial institutions; cash flow approach simpler for smaller businesses. - Transition issues manageable under either approach; U.S. TCJA shows movement towards a CFT. - Neither ACE nor CFT resolves profit shifting problems. - Tax-shifting implications: - Taxation of the normal return would need to be shifted to personal level; impute normal return on assets and tax at personal level (flat or progressive). - Revenue consequences and offsets: - ACE: unambiguously base-narrowing (absent behavioral responses). - CFT: denying interest deductions may offset revenue loss from full expensing. - Potential revenue offsets include increased investment and reduced base dissipation through excess leverage; unlikely to offset first-order revenue loss. - Example ready reckoner: a loss of revenue of one percent of GDP would be recouped, roughly speaking, by a 1.2 percentage point increase in the federation wide rate of GST. - Mitigations: - Elimination of dividend tax credit could cover ACE revenue costs (Boadway and Tremblay (2014)). - Tighter limits on interest deductions as mitigation within CIT. ### Empirical methods and key quantitative results (Appendix I and provincial analyses) - Data and estimation (investment effects): - Main dataset: Inward Foreign Affiliate Statistics (FATS) for 2010-2015, merged with country-level statutory CIT rates, METRs, and macro variables; unbalanced panel of FMOCAs from 34 countries including assets, revenues, profits, and corporate tax rates. - Dynamic gravity-like panel specification relating ln(Assets) of foreign corporations in Canada to tax variables and controls; country and year fixed effects included; preferred results from IV estimation with country and time effects (Column (4)). - Preferred empirical findings: - Applying a 14-point reduction in the statutory rate differential (weighted by revenue share) and a 13-point reduction in the U.S. METR implies a long run reduction in U.S. companies’ assets held in Canada of around 6 percent (95 percent confidence interval between 0.4 and 14 percent), equivalent to about 3 percent of GDP. - For profit shifting, implied semi-elasticity for US multinationals of reported profits with respect to statutory CIT rate differential is around 1.2. - Revenue implications (exact figures repeated): - Investment channel: reduction in CIT revenue of around 0.03 percent of GDP (about 6 percent of CIT currently paid in Canada by U.S. corporations). - Profit-shifting channel: reduction of around 15 percent of total profits of U.S. multinationals reported in Canada (around 0.31 percent of GDP); at a combined statutory rate of 26.9 percent, estimated reduction in annual reported profits of 0.31 percent of GDP reduces total CIT revenue by about 0.08 percent of GDP (approximately 17 percent of all current CIT revenue from US multinationals). - Overall long-run loss in CIT revenue from U.S. corporations estimated to be about 23 percent of their current payments, with a 95 percent confidence interval of between 0.16 to 0.31 percent of GDP. ### Policy recommendations and strategic guidance (synthesis) - Overarching guidance: - Exercise caution and avoid hasty CIT reform given international uncertainty and possible fragmentation. - Strengthen anti-base erosion protections and consider measures that apply broadly (extend thin capitalization rules, tighter limits on interest deductibility, prescriptive allocation of expenses). - Coordinate federal and provincial actions to manage combined rate changes and to limit profit-shifting incentives. - Consider targeted investment allowances (immediate expensing), phased rate changes to mitigate revenue loss and timing distortions, and trade-offs with personal taxation and GST adjustments. - Undertake a holistic and independent review of the Canadian tax system to address interlinkages, given last comparable review was in 1966. *cr18222 — International Monetary Fund (chapter/section content provided).* ### References _______________________________________________________________________________ 29 ### TAXING BUSINESS IN A CHANGING WORLD ### Overview - Paper reviews and suggests possible improvements to Canada’s system of business taxation, focusing on implications of wider developments in the global tax environment and the U.S. Tax Cuts and Jobs Act (TCJA). - Sections: overview of current arrangements; likely impact on Canada of international tax developments including the TCJA; options for reform. ### Revenue and Rates - CIT revenue in Canada has consistently accounted for a larger share of GDP than in most other G7 countries (Figure 1). - CIT generates around 10 percent of total tax revenue in Canada. - For the provinces, their CIT accounts for about 15 percent of their total own-source revenue. - Combined (federal plus provincial) average CIT rate is about 27 percent. - Post-TCJA, Canada’s combined average rate is "virtually the same as" the comparable average rate for the U.S. - Post-TCJA U.S. state variation: highest all-in rate in the U.S. is 6.5 percentage points above the lowest rate in Canada; lowest U.S. rate (21 percent, in the six states that have no CIT) is 10 points below the highest in Canada. ### ‘Small’ Companies and Preferential Rates - Preferential rates available to Canadian-Controlled Private Corporations (CCPCs): first CAN$500,000 of profit taxed at reduced federal rate of 10 percent (falling to 9 percent in 2019) and 0-7 percent at provincial level. - This creates a gap of around 39 points relative to the top rate of PIT. - Phase-out of the reduced rate occurs at higher levels of taxable capital (between $10-15 million at federal level). - Critiques: small companies are commonly not key drivers of growth and innovation; high effective marginal rates on withdrawal of benefit can discourage growth; reduced rates create avoidance opportunities (highlighted in Department of Finance consultations in October 2017 and February 2018). ### The Tax Base — Key Features - Federal and provincial CIT bases are closely aligned; provinces in Tax Collection Agreement adopt the federal base. - Central features: - Depreciation allowances are likely somewhat accelerated relative to true economic depreciation (example: machinery and equipment for manufacturing depreciated at 50 percent declining balance vs. estimated economic depreciation of 17 percent for industrial machinery). - Interest is fully deductible, subject only to a thin capitalization rule on payments to related parties abroad; the rule appears weak (e.g., excludes interest on third-party debt guaranteed by the parent and does not cover financing element of financing leases). - Only 50 percent of capital gains realized by corporations are included in the CIT base. - Corporate tax incentives are modest (except for a generous R&D credit and mainly provincial investment tax credits). ### International Aspects of the CIT - Canada operates a de facto territorial form of international taxation for active income, with four key elements: - Distributions from subsidiaries in jurisdictions with which Canada has a tax treaty or Tax Information Exchange Agreement (TIEA) are untaxed as “exempt surplus” subject to FAPI rules; Canada has treaties or TIEAs with 116 jurisdictions. - FAPI rules bring certain types of passive income earned abroad immediately into tax in Canada; difference between exempt surplus and CFC rules places extreme pressure on definitional rules of the CFC regime. - Canada has a full range of withholding taxes on outbound payments which are reduced, but often not eliminated, under tax treaties. Under the treaty with the U.S., interest and royalties on copyright, patents and software are not subject to withholding, while dividends (on shareholdings of more than 10 percent) are withheld at 5 percent. - Canada has little in the way of rules that allocate interest and other expenses between domestic and foreign source income, risking excessive allocation of expenses to Canada. - There appears to be some stock of unrepatriated earnings accumulated abroad that would be liable to tax in Canada; the scale is unknown and would be useful to quantify. ### Personal Income Tax — Key Features Affecting Business Taxation - Top (federal plus provincial) marginal PIT rate is in the order of 53-54 percent (in New Brunswick, Nova Scotia, Ontario, and Quebec) and sets in at a relatively modest level of income. - Widespread availability of savings schemes that effectively exclude the normal return from tax (Registered Pension Plan, Registered Retirement Savings Plan, Tax-free Savings Accounts); individuals disposing of qualified small business shares have a lifetime capital gains exemption of around $850,000 in 2018. - Boadway (2017) cited: if full advantage taken of PIT-free saving opportunities, about 70 percent of all capital income of Canadian taxpayers could be in some way excluded from tax. - Non-refundable dividend tax credits are provided (federal and provincial), based on notional, not actual, Canadian CIT paid; full credits can be granted for redistributed foreign dividends paid from exempt surplus. - Critiques: rationale for credit when no Canadian tax has been paid is unclear; in small open economy such credits may have limited impact on domestic investment and may forgo an efficient source of revenue. - Only 50 percent of realized capital gains are included in the PIT base, creating wedges between taxation of ordinary income/dividends and capital gains and encouraging retention of profits within companies. ### Distortions to Investment and Tax Incidence - Marginal effective tax rates (METRs) have fallen substantially in the U.S., on average, to around the same level as those in Canada (Figure 4). - Comparison of METRs accounts for CIT parameters and unrecovered sales taxes on business purchases; unrecovered sales taxes are more prevalent in the U.S. given GST treatment in Canada. - Economic incidence discussion: - In a small open economy, reasonable benchmark assumption: after-corporate tax return on investments fixed exogenously in world capital markets. - Measures reducing or offsetting taxes at corporate level (e.g., dividend tax credits) may have no impact on domestic investment but can dissipate efficient tax revenue. - If CIT bears on rents, dividend tax credits merely dissipate tax revenue rather than affecting investment. ### Boxes, Figures and Appendices (not exhaustive) - Boxes: "Three Innovative International Provisions of the TCJA"; "Improving the Coherence of the Current System". - Figures cited: "CIT Revenue in G7, 2016"; "CIT Rate by Government Levels"; "Statutory CIT Rates"; "Marginal Effective Tax Rates". - Appendices include: "Estimating the Potential Impact of the U.S. Tax Reform on Canada" and model/estimation appendices. *cr18222 - TAXING BUSINESS IN A CHANGING WORLD (June 28, 2018)* ### 11. Care is needed, however, in drawing conclusions from comparisons of average METRs. All ### 11. Care is needed, however, in drawing conclusions from comparisons of average METRs. All ### Interpretation of METRs - METR calculations need to be interpreted with great caution; their sensitivity to a variety of underlying assumptions means they should be interpreted as no more than indicative, with little significance attached to small differences. - Measures that stimulate investment in the U.S. do not necessarily reduce investment in Canada or elsewhere. - Investment decisions may be independently affected by the statutory rate: two countries might both offer rent taxes levied at different rates but both providing an METR 26 of zero; a multinational faced with the discrete choice of where to locate would be expected to choose that with the lower tax rate. - Averages conceal significant variation across provinces and states, across assets, and across source of finance: - The METR on debt-financed investments in plant and machinery is commonly negative, implying at the margin the tax system induces such investments even though, in the absence of tax, they would be unprofitable. - For equity-financed investments the METR is generally positive, ranging within Canada from 10 percent for plant and machinery to 40 percent for buildings. - Taking account of variation in statutory CIT rates across the provinces, the debt-financed METR for plant and machinery in Nova Scotia is -75 percent, whereas for retention-financed investment in buildings in Newfoundland and Labrador the METR is 31 percent. - Dispersion in METRs signals distortions to the composition and financing of investment decisions that is a distinct source of efficiency loss. - Any positive METR implies a tax disincentive to investment in real assets. ### Distortions to Financing - Larger corporations have a strong incentive to use debt finance for two reasons: - As one means of profit shifting. With few effective limits on interest deduction, there is potential to use interest payments to reallocate taxable income from high rate jurisdictions to low, both internationally and within Canada. The primary policy concern with such ‘debt shifting’ is that it erodes revenue. - As inherently tax-preferred to equity. The deductibility of interest but not of the return to equity creates a distinct CIT advantage to debt finance, inducing excess leverage and amplifying risks to financial stability. - Evidence and scope: - There appears to be no direct evidence for Canada on severity; the ratio of corporate debt to GDP in Canada has risen markedly since 2012 and is now at an all-time high; but it is broadly in line with international norms; and the ratio of corporate debt to equity and assets has not increased markedly. 29 - A substantial body of evidence from other countries suggests debt shifting and debt bias can be substantial. 30 - For high income owners of CCPCs, the primary distortion is likely towards retention finance due to the very low CIT rate and light taxation of capital gains, while significant taxation of dividends remains for higher rate payers after the dividend tax credit. ### Federal-provincial Interactions - The prominence of the provinces in corporate taxation is very marked and runs counter to the standard prescription for tax design in federations that the central government have control over taxes levied on mobile bases such as capital. - Equalization arrangements counterbalance horizontal tax competition by giving recipient provinces an incentive to set tax rates higher than otherwise, since a contraction in the provincial tax base from raising rates is offset to some degree by increased transfer receipts. 32 - There is some evidence that provincial CIT rates are so high as to cause significant efficiency losses, and in several provinces may even be above the level that maximizes provincial revenue. 33 - Some have suggested some degree of transfer of powers in corporate taxation to the federal government that can take a more complete view of the national interest. 34 - What is critical is close coordination between federal and provincial governments; the record shows quite limited cross-province variation in either rate or base, and provinces did not increase their own tax rates to take up room vacated by federal rate cuts in the early 2000s. ### Changing Times — international context - Canada is deeply exposed to developments in the wider international tax system and must fashion responses recognizing it is a very open economy and relatively small player in world capital markets. - Key contributing factors to unprecedented fluidity and uncertainty in international tax matters include: - ‘BEPS’ implementation: Canada is a member of the OECD Inclusive Framework on BEPS and is committed to implement the four minimum standards, with peer reviews underway. 35 36 - Digitalization: strong differences of opinion exist on whether current norms deal appropriately with business practices involving substantial activity with little physical presence; the OECD (2018) remained agnostic; the European Commission has proposed a turnover tax on selected services as a temporary response and argued for an expanded notion of permanent establishment. 37 38 39 - Unilateral reforms elsewhere: the global trend towards lower statutory CIT rates continues (examples cited include Belgium, Australia, France); structural measures such as a diverted profits tax have been adopted by the UK and Australia. 40 - The recent tax reform in the United States (TCJA) is a major and novel reform with potential to fundamentally reshape international tax norms; proximity and integrated North American markets make it especially germane for Canada, with more than half of all foreign direct investment in Canada being U.S.-owned. ### Impact of the TCJA on Canada - Considerable uncertainty surrounds the impact of the TCJA due to: - International provisions remaining to be fully described, novelty and complexity, projected changes over time, questions on consistency with WTO rules, tax treaties, and BEPS minimum standards, and lack of bipartisan support. - The sharp reduction in the federal U.S. CIT rate substantially reduces Canada’s relative appeal for mobile investments and increases exposure to shifting of profits to the U.S. - Including average state and provincial CIT rates, what was a substantial advantage for Canada in statutory CIT rates has now turned into broad equality. 41 - Two consequences matter: - Potential impact on real investment: companies serving the same market have an incentive to locate where profits are most lightly taxed. - Potential impact on profit shifting: companies have an incentive to take deductions where statutory rates are high and take receipts where taxes are low. - Provincial and state taxes begin to matter in ways that simple averages may conceal: the gap in statutory rates between British Columbia and neighboring Washington state is 12 percentage points, and that between Manitoba and North Dakota is about 4 points. 43 - The move to immediate expensing in the U.S., combined with rate reduction, substantially erodes the gap in METRs between the U.S. and Canada. - In simple competitive models with unconstrained capital, a reduction in the U.S. METR might not affect investment in Canada; more realistic cases with investment constraints or market rents imply U.S. METR reductions might reduce investment in Canada. ### Empirical estimates of U.S. multinationals’ response (summary of Appendix 1) - Using a short panel of aggregate data on foreign multinationals’ assets held in Canada, preferred point estimates suggest: - Real assets held in Canada by U.S. multinationals are projected to fall, in the long run, by 6 percent. - Reduced profit shifting into Canada by U.S. multinationals is estimated to reduce the profits they report in Canada by around 15 percent. - Together these imply a reduction in the CIT paid by U.S. multinationals in Canada (currently about 15 percent of all CIT revenue) of close to one quarter. - These results must be interpreted with great caution: the sample does not contain any change in the U.S. rate, nor is it long enough to meaningfully capture rate changes in Canada; nonetheless, the results align with wider literature (for example, Beer and others (2018) estimate a loss of CIT revenue attributable to the TCJA of around 1.58 percent of total MNC tax revenue, with the highest percentile of 6 percent). ### Broader responses and concerns - Investment and profit shifting responses can also be expected from non-U.S. businesses: - Canadian companies exporting to the U.S. may find it advantageous to produce in the U.S., perhaps producing there for sale into Canada (especially given the FDII provision). - They may also shift financing of U.S. subsidiaries towards more equity and less debt, shifting tax revenue from Canada to the U.S. - Business surveys and commentary indicate concern: - Ernst and Young (2018) report that more than half of 165 surveyed executives thought it likely they would shift revenue or risk functions to the U.S. following TCJA, and nearly one-third expected to reduce investment in Canada. 44 - Commentators such as Mintz (2018) have highlighted concerns. 45 - These concerns remain unquantified but are a significant cause for concern. ### Box 1. Three Novel International Provisions of the TCJA 1/ - Foreign Derived Intangible Income (FDII): - Domestic corporations receive a 37.5 percent deduction from the corporate tax base for FDII. - FDII is calculated as the income of the corporation in excess of 10 percent of qualified business asset investment multiplied by the share of foreign-derived income to total income (all calculated on a consolidated group basis). - This effectively reduces the CIT rate for such income from 21 to 13.125 percent. - Questions have been raised on consistency with WTO rules and the BEPS minimum standard on harmful tax practices. 46 - Global Intangible Low Taxed Income (GILTI): - Imposes a minimum tax on overseas income in excess of 10 percent of the return on tangible assets. - Taxes, on accrual, the income of U.S. CFC’s earned in all foreign jurisdictions that exceeds 10 percent of qualified business asset investment, with a deduction for 50 percent of that income. - Credit is given for 80 percent of the foreign tax paid on such income. - The effect is to impose a minimum rate on GILTI income of 10.5 percent on such income (when no tax is paid abroad) with the U.S. liability wholly eliminated if the average foreign tax rate paid is at least... *Source: cr18222.* ### 13.125 percent. ### 13.125 percent. ### Base Erosion and Anti-Abuse Tax (BEAT) - Applies to large multinational companies (annual gross receipts over US$500 million in the preceding 3 years) that make certain cross-border payments to affiliates that exceed 3 percent of their total deductible expenses. - Targets payments commonly associated with profit shifting (interest, royalties, and management fees) but does not apply to items characterized as cost of goods sold. - Imposes a minimum tax that is a fixed percentage of a concept of “modified” taxable income that adds back into income the deductions claimed for these categories of cross-border payments to affiliates. - Questions have been raised as to the consistency of this provision with tax treaties. - Rate schedule for the minimum tax: 5 percent for 2018, 10 percent for 2019-2025, and 12.5 percent thereafter. - Note: 1/ These descriptions are much simplified: for instance, the allocation of domestic expenses to foreign earnings can mean that U.S. tax is payable under GILTI even when the foreign tax rate exceeds 13.125 percent. ### FDII, GILTI and implications for Canada - Move towards territoriality (qualified by the GILTI provisions) means earnings repatriated to the U.S. will no longer be subject to taxation there (with credit for Canadian taxes paid). - Effects on investment and repatriation: - Reduction in effective tax rate on repatriated earnings could encourage such investments. - Removal of a lock-in effect may make it easier to withdraw profits from Canada and thus reduce reinvestment in Canada. - Experience in the UK and Japan: movement to territoriality associated with an increase in outward investment in lower tax countries. - Distinctive measures and their potential implications: - FDII may amplify the tax advantage of serving Canada from the U.S.: for producers able to achieve a return on tangible assets located in the U.S. over 10 percent, that part of the return is taxed at the still lower rate of 13.125 percent. - Transactions costs likely limit shifting of tangible assets back to the U.S., but for companies already producing for export in the U.S. the implied tax advantage may already apply. - Estimated scope: had FDII been in effect in 2014, around 9 percent of all U.S. companies and 13 percent of multinationals would have been eligible for FDII, with a particularly heavy concentration in manufacturing. - FDII can also encourage location of tangible assets outside the U.S., to increase the return on tangible assets in the U.S. and thereby increase the likelihood of the reduced rate applying. - GILTI creates an incentive to locate tangible assets outside the U.S., including in relatively high tax countries such as Canada, because doing so increases the ‘deemed’ tangible income outside the U.S., reducing the amount of GILTI subject to tax. - A wider effect of GILTI may be to induce changes in business models of some low tax jurisdictions, reducing exposure to profit shifting towards such jurisdictions and indirectly benefiting Canada and other relatively high tax countries. - Impact on Canada of the BEAT seems likely to be limited: reversal of the differential in statutory rates for larger companies largely eliminates incentive to shift profits directly from the U.S. to Canada; indirect effects possible where Canadian operations finance U.S. operations through low tax jurisdictions. ### Firm-size differentiated effects - The generous treatment of small businesses in Canada means they may be less affected by the TCJA. - For large corporations, several aspects of the reform tend to switch the balance of advantage away from Canada and towards the U.S. - Even with the rate reduction and FDII for C-corporations, and the top federal marginal rate for eligible pass throughs in the U.S. of 29.6 percent, the low CIT rates in Canada for small corporations combined with the dividend tax credit and 50 percent exclusion of capital gains will often preserve more favorable treatment in Canada. - Exceptions: possibly dividends paid to high income CCPC-owners. ### Overall assessment and risks to Canada - The balance of risks to Canada from the TCJA (to investment, activity and tax revenue) is firmly to the downside and focused on larger corporations, but the extent of the risk remains very unclear. - Provisions are complex, incompletely defined, and their continuation into the medium term is not universally regarded as assured. - Transition tax bringing unrepatriated earnings into tax in the U.S. over the next eight years is a one-off and seems unlikely to have significant impact even in the short term, other than reducing the cost of repatriation of existing profits from Canada (Canadian dividend withholding tax will now be the only barrier for repatriation of existing retained profits). ### Looking Forward — coherence and pressures on the Canadian tax system - Key elements of Canada’s tax strategy: - Heavy reliance on a sharply progressive PIT rate structure (weighted average top marginal rate of about 52 percent), beginning at a relatively low level of income—around one-third of that in the U.S. - Significant degree of integration with the corporate tax. - Particularly favorable treatment of small businesses. - Consumption tax treatment for a broad range of savings. - Relatively modest reliance on the GST as a source of revenue (accounting for about 23 percent of total taxation, compared with the OECD (unweighted) average of 33.3 percent). - Main pressure: large differential between the top rate of PIT and the rate of CIT, averaging around 25 points (and around 39 points for small businesses)—the highest in the G-7 countries and 9 points above the OECD average. - Reducing the overall rate of CIT risks exacerbating difficulty distinguishing between income taxable immediately at high marginal rates and income sheltered behind the corporate tax rate until distribution. - A holistic and independent review of the Canadian tax system is recommended given interlinkages and substantial changes in the tax environment; last comparable review was the Carter Review of 1966. ### Box 2 — Improving the Coherence of the Current System (selected measures) - Exempt corporate gains on the disposal of shares while, consistent with the logic of imputation, fully taxing other gains — addressing tension between excluding 50 percent of the capital gain on inter-corporate shareholdings and exemption of inter-corporate dividend payments. - Reconsider the purpose and role of the small business rate. - Rebalance tax treatment between small business taxed to individuals on a transparent basis and small business taxed as a company; consider whether small companies could be taxed on a transparent basis or sole proprietorships and partnerships taxed like companies. - Review dividend tax credit arrangements with a view to restructuring and reduction; consider limiting exempt surplus treatment to distributions from subsidiaries in countries that have a full tax treaty with Canada (and not simply a TIEA). - Canada should play an important role in international dialogue seeking a coordinated way forward to address BEPS-identified risks of substantial market penetration without taxation and reflect on whether Canada might ultimately move towards greater taxation of profits to ensure Canadian enterprises competing at home are not disadvantaged. ### Navigating the International Tax Environment — guidance and policy instruments - Exercise caution in CIT reform given unprecedented uncertainty in international tax matters and risk of fragmentation undermining BEPS progress; OECD aims to arrive at a consensus approach by 2020, or perhaps 2019. - Avoid hasty action in response to the U.S. tax reform; extent of risks will become clearer over time. - Strengthen anti-base erosion protections to guard against enhanced profit shifting out of Canada. Possibilities include: - Extend thin capitalization rules to borrowing from unrelated parties, and perhaps to domestic transactions too; thin capitalization rules are a blunt instrument and do not address the fundamental debt bias. - Consider similar anti-base erosion measures for other types of deductible payments subject to minimal or limited withholding tax (rents, royalties, service fees); consider coordination of anti-base erosion measures for all relevant deductible payments. - Address inappropriate allocation of expenses to Canada by adopting more prescriptive rules in allocating expenses between domestic and foreign activities; reconsider allowing deduction of foreign losses against domestic income for foreign branches. - Instruments to encourage investment in Canada and discourage profit shifting: - Reductions in the statutory rate targeted to discouraging profit shifting, though expensive because they confer windfall benefits to past investments; one estimate is that the rate reduction in the U.S. may eventually spur reductions elsewhere in the order of 4 or so percentage points. - Phase reductions in the rate to mitigate revenue loss, recognizing phasing creates distortions and timing incentives. - Close coordination between federal and provincial governments to share any reduction in combined rates; maintain and potentially increase provincial uniformity of rates and bases. - Increased generosity of investment allowances (movement towards immediate expensing of a wide class of assets) to support real investment; expensive and timing-related but potentially desirable. - More generous treatment of investment may need to be accompanied by tighter limits on interest deductibility applying to all interest, not just borrowing from related parties, to avoid exacerbating a marginal corporate tax subsidy to investment and to recoup some revenue loss from enhanced investment allowances. *Source: cr18222 - 13.125 percent.* ### 34. A central issue for any broad review of the tax system is the case for moving towards some ### 34. A central issue for any broad review of the tax system is the case for moving towards some ### Overview - A move towards corporate-level rent taxation would in principle: - eliminate corporate-level distortion to investment; - remove the bias towards debt finance; - reset corporate-level METRs for all investments to zero. ### Forms of corporate rent taxation (leading candidates) - Allowance for Corporate Equity (ACE) / Allowance for Capital (ACC) - Under an ACE: interest deductibility is retained and a deduction is allowed for a notional return on equity. - Under an ACC: a common notional rate is applied to debt as well as equity. - No restriction on the schedule of depreciation allowances. - Potential concerns: - biases from setting the notional rate inappropriately; - revenue loss from narrowing the corporate tax base (mitigations include providing the equity deduction only for equity added after introduction). - International experience: - ACE-type schemes adopted in several countries; - Italian experience is widely regarded as positive, especially in alleviating debt bias. - Cash Flow Taxation (CFT) - Full expensing for all investment and denial of any deduction for interest (or of equity finance). - Ensuring full neutrality requires full loss offset, or carrying forward of losses at interest. - Experience: - wide experience with full expensing for smaller firms; - almost no international experience of full expensing accompanied by complete denial of interest deductions. - Applied in extractive industries (e.g., Norway) and Mexico operated a CFT (IETU) as a minimum CIT from 2008 to 2013. - Revenue impact is context-specific: full expensing reduces the present value of receipts (by bringing depreciation allowances forward); denial of interest deductions may offset this to varying degrees. ### Transition issues and applicability in the Canadian context - Each form has merits and drawbacks in Canada. - ACE is better suited for financial institutions (retains interest deductibility). - Cash flow approach simpler for smaller businesses. - Transition considerations: - Transition issues appear manageable under either approach. - The U.S. is to some degree showing the way towards a CFT (TCJA parallels). - Transition issues may be even less under ACE (no need to handle pre-existing debt or change depreciation arrangements). - Neither ACE nor CFT resolves potential problems of profit shifting. ### Shifting taxation of normal return to personal level - Taxation of the normal return to capital would need to be shifted to the personal level under rent taxation. - The CIT would be focused on raising revenue rather than withholding against personal income tax. - One approach: - impute to corporate owners a normal return on assets subject to the rent tax and tax that at the personal level; - apply some notional return to the capital value of assets (irrespective of actual dividends and capital gains); - that return could be taxed at a flat rate or, aggregated across assets, by a progressive schedule. - Examples/notes: - The Netherlands ‘Box 3’ arrangement applies a notional rate to the capital value of net assets (subject to a flat rate of tax, though progressive taxation is possible). - There would be no efficiency grounds for giving a credit in respect of taxes charged on rents. ### Revenue consequences of corporate rent taxation and policy options - Rent taxation at an unchanged statutory rate could involve some loss of corporate-level tax revenue. - Under ACE: movement is unambiguously base-narrowing (absent behavioral responses). - Under CFT: less clear-cut because denying interest deductions may offset some revenue loss from full expensing. - Potential revenue offsets: - Some revenue gain from increased investment if a positive METR currently deters infra-marginal investments. - Some revenue gain from reducing base dissipation through excess leverage. - These effects are unlikely to offset first-order revenue loss. - Raising the statutory corporate rate to recoup revenue losses risks exacerbating profit shifting problems. - Policy implications: - Attention must shift to other revenue sources. - Example: Boadway and Tremblay (2014) argue revenue costs of an ACE could be amply covered by elimination of the dividend tax credit. - Tighter limitation on interest deductions is a mitigation measure within CIT, but some measures (e.g., restricting loss carry forward/back) would increase METRs and amplify distortions. - With strongly progressive personal income taxation, a wider review should consider heavier reliance on indirect taxation, notably the GST. - As a ready reckoner: a loss of revenue of one percent of GDP would be recouped, roughly speaking, by a 1.2 percentage point increase in the federation wide rate of GST. ### Appendix I — Data and estimation overview (investment effects) - Main dataset: Inward Foreign Affiliate Statistics (FATS) for 2010-2015, merged with country-level statutory CIT rates, METRs, and macro variables; unbalanced panel of FMOCAs from 34 countries including assets, revenues, profits, and corporate tax rates. - Estimation approach: - Dynamic gravity-like panel specification relating ln(Assets) of foreign corporations in Canada to tax variables and controls: - Controls include lnGDP, lnGDPPC, exchange rate relative to USD, unemployment rate, and index for current account openness. - Country and year fixed effects included. - Preferred results: Column (4) (IV estimation with country and time effects) — effects of both the METR in the parent country and the differential between Canadian and originating statutory rates (weighted by revenue share) are significant at 5 and 10 percent respectively. ### Appendix I — Empirical findings (investment effects) - Applying in the estimated equation both: - a 14-point reduction in the statutory rate differential (weighted by the revenue share of U.S. companies) and - a 13-point reduction in the U.S. METR, - the implied long run reduction in U.S. companies’ assets held in Canada is around 6 percent (with a 95 percent confidence interval of between 0.4 and 14 percent), which is equivalent to about 3 percent of GDP. ### Appendix I — Profit shifting estimation approach - Equation relates profits reported in Canada by multinationals from each originating country to the difference between the CIT rate there and in Canada, allowing for: - asymmetries in inward- and outward shifting; - threshold effects (profit shifting concentrated where absolute tax differential is particularly large). - Specification details: - |CIT_Diff| interacted with dummy Low_j (1 for countries with a lower CIT rate than Canada throughout the sample) and High_j (1 for countries with higher CIT rate than Canada throughout). - Dummy I_low = 1 for a CIT differential larger than 5.1 percent in low-tax countries. - Dummy I_high = 1 for a CIT differential larger than 12.8 percent in high-tax countries. ### Appendix I — Empirical findings (profit shifting) - Results point to: - large outward profit shifting to low-tax countries; - no inward profit shifting from high-tax countries except those with a CIT rate at least 12.8 percentage point higher than the Canadian rate (in sample: Japan and the US). - Implied semi-elasticity: - For US multinationals, the implied semi-elasticity of reported profits with respect to statutory CIT rate differential is around 1.2. - Comparable references: Dowd et al (2017) reported 1.4; consensus semi-elasticity of 1.5 for year 2015 in Beer et al (2018). ### Appendix I — Revenue implications (quantitative) - Investment channel: - Relative to assets, the effective tax rate paid in Canada by U.S. corporations is about one percent. - Applying this to the estimated reduction in U.S. assets in Canada of 0.3 points of GDP gives a reduction in CIT revenue of around 0.03 percent of GDP, which is about 6 percent of CIT currently paid in Canada by U.S. corporations. - Profit-shifting channel: - Applying a 14-point reduction in the statutory rate in the U.S., Column (6) of Table A2 implies a reduction of around 15 percent of total profits of U.S. multinationals reported in Canada, which is around 0.31 percent of GDP. - At a combined statutory rate of 26.9 percent, the estimated reduction in annual reported profits in Canada of U.S. corporations of 0.31 percent of GDP would reduce total CIT revenue by about 0.08 percent of GDP, which is approximately 17 percent of all current CIT revenue from US multinationals. - Overall long-run loss in CIT revenue from U.S. corporations is estimated to be about 23 percent of their current payments, with a 95 percent confidence interval of between 0.16 to 0.31 percent of GDP. - Contextual numbers: - Total CIT revenue in Canada is about 3.2 percent of GDP, of which US MNCs pay about 15 percent. *International Monetary Fund — cr18222 (chapter/section content provided)* ### References ### References ### Key findings and context - Housing market imbalances are a key source of systemic risk and can adversely affect housing affordability in Canada; rapidly-rising house prices are usually coupled with rising household indebtedness. - Toronto and Vancouver regions are becoming severely unaffordable relative to other metropolitan regions. - Macroprudential policy can be more effective than property-transfer tax adjustments because property-transfer taxes entail excessive volatility in tax rates. - If property-transfer taxes are used, taxes targeted at a broader-set of homebuyers can be more effective than measures targeted at a smaller subset of homebuyers (for example, nonresident homebuyers). ### Model (framework and estimation) - A simple Dynamic-Stochastic-General-Equilibrium (DSGE) framework is used, including: - Households divided into borrowers and savers; borrowers face collateral constraints tied to an LTV limit, savers do not. - Two sectors producing housing and non-housing consumer goods. - Three policy instruments: an interest rate (central bank), an LTV limit (macroprudential authority), and a property-transfer tax rate (property-tax authority). - Government runs a balanced budget in each period using lump-sum transfers to households. - Estimation: - The model is estimated using Bayesian methods and quarterly data ranging from 1993 to 2017. - Measurement variables: real GDP per capita, real consumption per capita, real residential investment per capita, employment per capita, headline CPI inflation, house price inflation, and the overnight policy interest rate. - Monetary policy assumed to operate according to a standard Taylor-type rule. - During estimation, the average LTV on new mortgages is set at 60 percent and the property-transfer tax is assumed to be fixed at 5 percent. - Model fit: - Simulated data from the estimated model have comparable standard deviations to those seen in historical data; the model fits the historical volatility reasonably well. ### Policy objectives (loss functions and overall objective) - Central bank objective: - Minimizes loss L_cb that depends on asymptotic variances of consumer-price inflation (π_c), output (y), and changes in policy interest rate (Δr). - Baseline weights: Ω_π_cb = 1, Ω_y_cb = 0.5, Ω_Δr_cb = 0.1. - Macroprudential authority objective: - Minimizes loss L_mp that depends on the debt-to-GDP ratio (z) and variability of the LTV ratio (ΔLTV). - Baseline weights: Ω_z_mp = 1, Ω_ΔLTV_mp = 0.1. - Loss function symmetric: dislikes both excessively high leverage and excessively low leverage. - Property-tax authority objective: - Minimizes loss L_tp that depends on the house-price-to-income ratio (u) and variability of the property-transfer tax rate (ΔTAX). - Baseline weights: Ω_u_tp = 1, Ω_ΔTAX_tp = 0.1. - Property-transfer tax can be applied to either all home purchases or only to purchases by savers not subject to collateral constraints. - Treatment of nonresident buyers: - Nonresident homebuyers are encompassed by savers and are assumed not to be collateral constrained; they are less likely to have access to mortgage loans in Canada and more likely to purchase houses with cash. - Overall economy loss: - Aggregate loss L = Ψ_cb L_cb + (1 − Ψ_cb)(Ψ_mp L_mp + (1 − Ψ_mp) L_tp), with Ψ_cb and Ψ_mp between 0 and 1. ### Optimal policy and implementation notes - Authorities select policy rules that minimize the intertemporal total loss L; optimal policy rules determine paths of the policy interest rate, the LTV ratio, and the property tax rate as functions of model variables and Lagrange multipliers. - Baseline assumption: the standard deviation of monetary policy shocks is set to zero; all other parameters set to estimated values. - Results (qualitative): - Deploying more policy instruments when policymakers face multiple objectives can lead to better outcomes. - Macroprudential policy (e.g., LTV limits) can be more effective and smoother than property-transfer taxes for achieving combined objectives of macroeconomic stability, financial stability, and housing affordability. - Property-transfer taxes targeted broadly are more effective than narrowly targeted taxes (e.g., only nonresident homebuyers). ### Policy-relevant numeric parameters and calibration (preserved exactly as in source) - Sample period for estimation: 1993 to 2017. - Average LTV on new mortgages set at 60 percent. - Property-transfer tax assumed fixed at 5 percent during estimation. - Baseline weights in loss functions: - Ω_π_cb = 1 - Ω_y_cb = 0.5 - Ω_Δr_cb = 0.1 - Ω_z_mp = 1 - Ω_ΔLTV_mp = 0.1 - Ω_u_tp = 1 - Ω_ΔTAX_tp = 0.1 *International Monetary Fund — cr18222 (References and chapter excerpts provided in the source content).* ### 15. Six different optimal policies are examined, depending on which of the four policy ### 15. Six different optimal policies are examined, depending on which of the four policy ### Policy scenarios examined - Six optimal policy configurations based on which of the four policy instruments operate: interest rate (r), loan-to-value (LTV), property-transfer tax rate (TAX), and property-transfer tax rate on savers only (TAX (savers)). - When an instrument is not in operation (LTV or TAX), the policymaker responsible for that instrument is assumed to be “passive” and relies on other authorities to adjust their instruments to minimize total loss in the economy, including the objectives of all other policymakers. - Summary of active policy instrument combinations (as displayed in Table 1): - Monetary Policy: r - LTV Policy: r, LTV - Tax Policy: r, TAX - Tax Policy (savers): r, TAX (savers) - ALL Policies: r, LTV, TAX - ALL Policies (savers tax): r, LTV, TAX (savers) ### Objective-weighting (robustness) scenarios - Three specifications for how each policymaker’s objective weights into the overall loss function (Table 2): - Baseline: Ψ_cb =0.5, Ψ_mp = 0.5 (central bank’s loss function has a 50 percent share in overall loss; remainder allocated evenly across macroprudential and tax authorities) - Debt Focus: Ψ_cb =0.5, Ψ_mp = 0.9 (overall loss places more weight on managing household debt levels than affordability) - Affordability Focus: Ψ_cb =0.5, Ψ_mp = 0.1 (overall loss places more weight on managing affordability than on household debt) ### Main results (optimal policy frontiers and comparisons) - General findings from the optimal policy frontiers: - Having more policy instruments leads to better outcomes. - Monetary policy alone leads to higher losses than when monetary policy is augmented with LTV and/or tax policy. - Having all policies in operation leads to even greater gains. - Macroprudential policy (LTV) is better than tax policy. - LTV policy reduces overall loss by more than tax policy, regardless of whether the tax is applied to all homebuyers or only to savers that are not subject to collateral constraints. - The ‘best’ policy depends on the focus of objectives. - Baseline: applying all policy instruments leads to slightly better outcomes than when tax policy is not operating. - Debt-focus and all policies operating: a tax on savers is better than a tax on all homebuyers. - Affordability-focus and all policies operating: a tax on all homebuyers is very similar to imposing a tax on savers alone. - Overall: the loss-minimizing ‘best’ policy depends on the focus of policymakers’ objectives. - Consideration of instrument volatility is important for policy viability over the business cycle. ### Policy-instrument volatility findings - Property-tax policy leads to excessive volatility in tax rates: - In the baseline specification, the asymptotic standard deviation of the property tax rate is about 45 percent. - This implies a 99 percent confidence interval around typical dynamics would require the tax rate to swing by around 150 percentage points around its steady state level — producing negative tax rates in downturns and rates above 100 percent in expansions. - Tax rate volatility is even higher when taxes are targeted at savers alone, irrespective of the focus of policymakers’ objectives. - Targeting taxes narrowly increases volatility: - Property-transfer taxes targeted at savers alone lead to greater volatility in taxes than a tax that targets all homebuyers. - Volatility of the tax rate is particularly high when taxes are targeted at savers and the share of savers in the economy is low. - Tax rate volatility tends to decline when the share of savers increases, but targeting a narrower set of homebuyers always leads to greater volatility than targeting all homebuyers. ### Summary and policy messages - Multiple instruments dominate single instruments: - Multiple policy instruments can lead to better outcomes when policymakers face multiple objectives (macroeconomic and financial stability, and housing affordability). - Prefer LTV limits to property-transfer taxes when choosing between them: - Policymakers should choose an LTV limit because it can be more effective in achieving desired objectives. - Caution on deploying multiple instruments that include property taxes: - Deploying multiple policy instruments can induce excessive volatility in property-tax rates, especially when taxes are targeted at a narrower base of homebuyers. - Broader tax bases are preferable: - Targeting property-transfer taxes at a broader set of homebuyers is more effective than measures aimed solely at savers (or nonresident home buyers). - Targeting taxes at savers alone would require greater swings in tax rates to achieve desired objectives. - If nonresident homebuyers are not collateral constrained, property-transfer taxes targeted at them would require greater swings in tax rates than taxes targeted at all homebuyers. - Evidence suggests nonresident homeowners represent only a small fraction of the existing housing stock in Vancouver and Toronto, potentially limiting the effectiveness of BC and Ontario property transfer taxes on nonresidents. - If speculators (resident and nonresident) drive excessive house price inflation and reduce affordability, tax measures targeting speculative demand of residents and non-residents alike would likely be more effective than targeting nonresidents alone. ### Caveats and directions for future research - Model limitations: - The model is stylized and simple; it does not explicitly include systemic risk—the key distortion macroprudential policy should address—reflecting difficulty modeling systemic risk rigorously. - The impact of housing affordability on consumer welfare has not been studied in models of this type; a purely welfare-based analysis is therefore beyond reach here. - Analysis uses ad-hoc objective functions for policymakers rather than micro-founded, welfare-based objective functions. - Assumptions to relax in future work: - The present policy experiments assume policymakers cooperate to achieve overall objectives. Future work could relax cooperation to assess optimal policy under non-cooperative policymaker behavior. - Future work could explicitly model nonresident homebuyer behavior instead of assuming they behave the same way as domestic savers. *Source: cr18222 - chapter content as provided* ### 16. Retailers are assumed to produce final goods in sector 풋 by combining domestic ### 16. Retailers are assumed to produce final goods in sector 풋 by combining domestic ### Production and pricing - Retailers produce final goods in sector 풋 by combining domestic intermediate goods using a constant elasticity of substitution production function. - The wholesale sector produces intermediate goods using a Cobb–Douglas production function, 푌_{j,t}(k)=퐴_{j,t}푁_{j,t}(k), where 퐴_{j,t} is a sector specific productivity measure. - Price adjustments follow a variant of Calvo pricing: - A randomly-selected fraction of firms in each sector (1−휃_{j}) adjust prices; the remaining fraction 휃_{j} do not adjust. - A fraction (1−휄_{j}) of firms behaves in a forward-looking way; the remaining fraction 휄_{j} uses the recent history of the aggregate price index (휄_{j} is a measure of backward-looking price-setting). - These assumptions yield the conventional mark-up rule: firms set price as a mark-up over current and future real marginal costs (푚푐_{k}). - First-order log-linear approximation around the steady states yields New Keynesian Phillips curves for consumption and housing sectors: - (1+훽_{s}휄_{C}) 휋̂_{C,t} = 훽_{s} E_{t} 휋̂_{C,t+1} + 휄_{C} 휋̂_{C,t−1} + 휅_{C} 푚푐̂_{C,t−1} + 휖^{t}_{휇_{C}} (14) - (1+훽_{s}휄_{H}) 휋̂_{H,t} = 훽_{s} E_{t} 휋̂_{H,t+1} + 휄_{H} 휋̂_{H,t−1} + 휅_{H} 푚푐̂_{H,t−1} + 휖^{t}_{휇_{H}} (15) - 휅_{j} = ((1−휃_{j})(1−훽_{s}휃_{j}))/휃_{j} is the slope of the New Keynesian Phillips curve and 휖^{t}_{휇_{j}} is a sector-specific cost-push shock. ### Equilibrium and government - Government purchases a time-varying fraction 풇_{t} of output of each good in each sector, financed by lump-sum taxation (see Gali, 2003). - Aggregate goods market clearing for each good k in each sector j: - (1−푓_{t}) 푌_{C,t}(k) = 퐶_{D,t}(k) + ∫_{0}^{1} 퐶_{D,t}^{i}(k) (16) - (1−푓_{t}) 푌_{H,t}(k) = 퐼_{t}(k) (17) - where 퐶_{D,t}^{i} represents non-durable consumption from country i. - Defining a government expenditure shock g_{t} as log(1−푓_{t}) = exp(−g_{t}), linearized approximations around a symmetric steady state: - 푦̂_{C,t} = (1−훼) 푐̂_{t} + 훼 c^{*̂}_{t} + 훼(휁+휂(1−훼)) ŝ_{t} + g_{t} (18) - 푦̂_{H,t} = î̂_{t} + g_{t} (19) - Aggregate consumption of non-durable goods and the housing stock: - 퐶_{t} = 휔 퐶_{t}^{b} + (1−휔) 퐶_{t}^{s}, 퐻_{t} = 휔 퐻_{t}^{b} + (1−휔) 퐻_{t}^{s} - Aggregate labor supply and real debt: - 푁_{t} = 휔 푁_{t}^{b} + (1−휔) 푁_{t}^{s}, 퐵_{t} = 휔 퐵_{t}^{b} + (1−휔) 퐵_{t}^{s} - Aggregate real output (denominated with the aggregate producer price index, 푷_{PD,t}) must satisfy: - 푷_{PD,t} 풀_{t} = 푷_{C,PD,t} 풀_{C,t} + 푷_{H,t} 풀_{H,t}, where the price index of aggregate output is a weighted average of prices of domestic consumption and housing. ### Monetary policy - Monetary policy follows a Taylor-type rule (log-linearized deviations from symmetric steady state): - r̂_{t} = ρ_{r} r̂_{t−1} + (1−ρ_{r})(φ_{π} π̂_{C,t} + φ_{y} Δŷ_{t}) + ν^{t}_{r} (20) - Central bank responds to CPI inflation deviations and output growth deviations from trend. - Parameters: φ_{π} (inflation responsiveness), φ_{y} (output growth responsiveness), ρ_{r} (policy inertia), ν^{t}_{r} (monetary policy shock). ### Exogenous processes - Model is log-linearized; all variables are log-deviations from steady state. - Exogenous driving processes (AR(1) except monetary policy shock): - a_{C,t} = ρ_{a_{C}} a_{C,t−1} + ν^{t}_{a_{C}} (21) - a_{H,t} = ρ_{a_{H}} a_{H,t−1} + ν^{t}_{a_{H}} (22) - c^{*̂}_{t} = ρ_{c^{*}} c^{*̂}_{t−1} + ν^{t}_{c^{*}} (23) - 휖^{t}_{휇_{C}} = ρ_{휇_{C}} 휖^{t−1}_{휇_{C}} + ν^{t}_{휇_{C}} (24) - 휖^{t}_{휇_{H}} = ρ_{휇_{H}} 휖^{t−1}_{휇_{H}} + ν^{t}_{휇_{H}} (25) - 휖^{t} = ρ 휖^{t−1} + ν^{t} (26) - g_{t} = ρ_{g} g_{t−1} + ν^{t}_{g} (27) - ν^{t}_{r} = ν^{t}_{r} (28) - All ν^{t}_{i} ~ N(0, σ_{i}^{2}). Equations (21)-(22): technology shocks in non-durable consumption and housing sectors. Equation (23): foreign demand shock. Equations (24)-(25): cost-push shocks. Equation (26): housing preference shock. Equation (27): government spending shock. - For estimation, LTV and tax policy are assumed inactive over the sample period (i.e., 휖^{t}_{τ} and 휖^{t}_{LTV} set to zero). ### Data and estimation - Data used: quarterly data from 1993 to 2017. - Measurement variables: real GDP per capita, real consumption per capita, real residential investment per capita, employment per capita, headline CPI inflation, house price inflation, and the overnight policy interest rate. - Each variable expressed in log deviations from steady states; steady states computed using Hodrick-Prescott filter for real variables and sample averages for nominal variables. - Estimation method: Bayesian methods (see An and Schofheide, 2007). Model log-linearized with first-order Taylor approximation. - Parameters determining steady-state calibrated to produce reasonable steady-state values and ratios; some parameters difficult to estimate given observables. - The Metropolis-Hastings algorithm used to draw 500,000 parameter sets from the posterior; the first half of draws discarded to ensure convergence. ### Calibrated parameters (Appendix I. Table 1) - 훽_{s} Discount factor (savers): 0.99 - 훽_{b} Discount factor (borrowers): 0.98 - 훿 Depreciation rate of housing stock: 0.01 - (1−휒) Loan-to-value ratio steady state: 0.60 - 휏 Property tax steady state: 0.05 - 훼 Degree of openness: 0.30 - 훾 Share of housing in utility: 0.30 ### Estimated parameters (Appendix I. Table 2) — Prior, Posterior mean, Posterior [10%, 90%] - 휎 Elasticity of substitution (consumption/labor): Prior 훽(1,0.05) — Posterior mean 1.05 [0.97, 1.12] - 휓 Elasticity of substitution (labor): Prior Γ(2,0.1) — Posterior mean 1.97 [1.81, 2.13] - ℎ Habit persistence: Prior 훽(0.5,0.05) — Posterior mean 0.69 [0.67, 0.71] - 휔 Share of borrowers: Prior 훽(0.3,0.05) — Posterior mean 0.61 [0.59, 0.63] - 휁 Elasticity of substitution (foreign): Prior Γ(1,0.05) — Posterior mean 1.13 [1.06, 1.21] - 휂 Elasticity of substitution (domestic/foreign): Prior Γ(1,0.05) — Posterior mean 1.09 [1.01, 1.17] - 휖 Elasticity of substitution (domestic goods): Prior Γ(4,0.1) — Posterior mean 4.05 [3.89, 4.21] - 휌_{r} Monetary policy rule: Interest smoothing: Prior 훽(0.8,0.05) — Posterior mean 0.76 [0.72, 0.79] - 휙_{휋} Monetary policy rule: Inflation reaction: Prior Γ(2,0.1) — Posterior mean 2.10 [1.83, 2.36] - 휙_{y} Monetary policy rule: Output reaction: Prior Γ(0.2,0.05) — Posterior mean 0.21 [0.13, 0.29] - 휃_{C} Calvo parameter (consumption): Prior 훽(0.5,0.1) — Posterior mean 0.71 [0.67, 0.74] - 휃_{H} Calvo parameter (housing): Prior 훽(0.5,0.1) — Posterior mean 0.50 [0.47, 0.54] - 휄_{C} Inflation inertia (consumption): Prior 훽(0.8,0.05) — Posterior mean 0.80 [0.72, 0.89] - 휄_{H} Inflation inertia (housing): Prior 훽(0.8,0.05) — Posterior mean 0.79 [0.71, 0.88] - 휌_{a_{C}} Persistence (technology in consumption sector shock): Prior 훽(0.5,0.1) — Posterior mean 0.56 [0.50, 0.62] - 휌_{a_{H}} Persistence (technology in housing sector shock): Prior 훽(0.5,0.1) — Posterior mean 0.52 [0.47, 0.56] - 휌_{c^{*}} Persistence (foreign consumption shock): Prior 훽(0.5,0.1) — Posterior mean 0.60 [0.50, 0.70] - 휌_{휇_{C}} Persistence (consumption cost-push shock): Prior 훽(0.5,0.1) — Posterior mean 0.82 [0.77, 0.86] - 휌_{휇_{H}} Persistence (housing cost-push shock): Prior 훽(0.5,0.1) — Posterior mean 0.56 [0.47, 0.66] - 휌 Persistence (housing preference shock): Prior 훽(0.5,0.1) — Posterior mean 0.93 [0.92, 0.94] - 휌_{G} Persistence (government spending shock): Prior 훽(0.5,0.1) — Posterior mean 0.64 [0.58, 0.70] ### Estimated shock standard deviations (Appendix I. Table 2, concluded) - 휎_{a_{C}} Std dev: Productivity in consumption sector shock: Prior Γ^{-1}(1,2) — Posterior mean 1.09 [0.67, 1.51] - 휎_{a_{H}} Std dev: Productivity in housing sector shock: Prior Γ^{-1}(1,2) — Posterior mean 0.79 [0.18, 1.38] - 휎_{r} Std dev: Monetary policy shock: Prior Γ^{-1}(1,2) — Posterior mean 0.18 [0.11, 0.24] - 휎_{c^{*}} Std dev: Foreign consumption shock: Prior Γ^{-1}(1,2) — Posterior mean 1.95 [1.21, 2.67] - 휎_{휇_{C}} Std dev: Consumption cost-push shock: Prior Γ^{-1}(1,2) — Posterior mean 0.50 [0.30, 0.69] - 휎_{휇_{H}} Std dev: Housing cost-push shock: Prior Γ^{-1}(1,2) — Posterior mean 1.36 [0.18, 2.44] - 휎 Std dev: Housing preference shock: Prior Γ^{-1}(1,2) — Posterior mean 2.19 [1.30, 3.11] - 휎_{g} Std dev: Government spending shock: Prior Γ^{-1}(1,2) — Posterior mean 0.55 [0.34, 0.76] --- ### Housing affordability in Canada’s dynamic regions — key findings and policy implications - Affordability context: - Housing affordability becoming an increasing social and economic concern in Canada, with most acute unaffordability in Greater Toronto Area (GTA) and Greater Vancouver Area (GVA). - House prices nearly doubled between early 2010 and spring 2018 in Vancouver and Toronto; appreciation slower elsewhere. - Main demand-side drivers in GTA and GVA: - Robust economic growth. - Population growth from international and interprovincial migration. - Low interest rates. - Ample credit supply. - Increasing investor demand (domestic and foreign). - Some tax incentives for investment in housing (e.g., expenses, including mortgage interest, tax deductible if rented out) for domestic buyers. - Demand-side policy measures implemented: - Federal macroprudential measures to address direct financial stability risks and indirect macroeconomic risks related to high household indebtedness. - Provincial tax measures, notably property transfer taxes for nonresident buyers in British Columbia and Ontario. - Federal tightening of tax treatment on home sales: capital gains exemption claimable only by Canadian residents. - Assessment: current measures appear to be containing housing-related financial sector risk, but banking system remains highly exposed to household debt and vulnerable to a sharp reversal in house prices. - Supply-side constraints and policy needs: - Broad set of supply-side policies needed to durably improve housing affordability, alongside demand-focused policies. - Complementary strategies required for infrastructure and public services, immigration, and housing supply policies. - Key constraint: shortage of serviced land ready for development and supporting infrastructure (roads, public transportation, public services). - Other supply-side frictions: natural barriers, urban containment, zoning restrictions, permitting inefficiencies, extensive specification requirements, mismatch in type of supply vs demand, construction labor shortages, infrastructure bottlenecks. - Despite urban containment (Agricultural Land Reserve around Vancouver, Greater Golden Horseshoe Greenbelt), there appears to be sufficient land usable for future development, particularly in the GTA; main issue is delivery of land with necessary infrastructure. - Data availability on land supply and serviced land is inadequate in several municipalities. - Economics of housing supply: - If market price roughly equals cost of producing the housing unit, market is well-functioning (Glaeser and Gyourko, 2018). - Where housing prices are above production cost, the gap can be considered a regulatory tax. - In heavily regulated markets with rising demand, supply curve slopes up: additional demand translates into prices substantially above minimum profitable production cost. - Highly inelastic housing supply limits effectiveness of macroprudential and tax-based demand measures; without adequate supply response, demand-targeting measures squeeze buyers, especially first-time buyers. - Observed supply outcomes: - Supply response in GTA and GVA inadequate — divergence between trend house prices and permits; cities with inelastic supply and high demand experience extreme price run-ups. - New supply mix tilted toward higher-end one- and two-bedroom condominiums and investment-oriented units; not enough affordable-end units, rowhouses, and medium-density housing. - Condominium supply elasticity remains low overall; Vancouver saw more elastic supply after 2014 but elasticity fell between 2015-16 while demand increased prices from 2014. - Policy direction emphasized: - Increase delivery of serviced land and accelerate supporting infrastructure to expand housing supply. - Complement infrastructure upgrades with targeted supply-side reforms to permit more diverse and affordable housing types. - Improve municipal data on land supply and serviced land to better assess constraints and guide policy. *International Monetary Fund. Content unit: cr18222.* ### 13. Increasing urban density in Toronto and especially in Vancouver is widely recognized ### 13. Increasing urban density in Toronto and especially in Vancouver is widely recognized ### Density and cultural implications - Increasing urban density is identified as key to improving affordability. - Canada is one of the world’s most urban countries, but the urban density of its major cities is in the low-to mid-density range compared to major cities in high-income countries (Figure 4), suggesting significant scope to further increase density. - Increasing density requires cultural adjustments: greater acceptance of condominiums and rental apartments as opposed to low-density housing for raising families. ### Land markets, developer incentives, and public land value capture - In markets with significant imbalance between supply and demand, developers can be incentivized to delay construction and release of units to keep prices high and engage in land banking. - Authorities could consider public land value capture policies and legal means to purchase land at existing use value so that uplift in land value is captured for the public good. - Local authorities can assemble and bank land to maintain a healthy supply of potential construction sites: - Example: In Germany, “urban development measures” allow local authorities to assemble land by paying private owners the existing value of the plot, then sell after redevelopment at the final value. - Example: In the Netherlands, local authorities can purchase land at existing use value, develop cheaply for social housing, and sell some to commercial developers at a profit. ### Development charges and timing - Determining development charges can significantly extend the time before actual development: - Municipalities capture uplift in land value by imposing development and other charges. - Pricing the value of services and arriving at the final amount of development charges involves judgment and negotiation with developers and can take time. - In Vancouver, determining the Community Amenity Contribution (CAC) is noted as a relatively opaque process. CACs are negotiated when a site requires rezoning to fund off-site community amenities. ### Building approval and permitting delays - The lengthy and non-transparent approval process for building permits is frequently cited as a major obstacle to ramping up supply. - Building approval, particularly for multiple family residences, is complex and involves many stakeholders and regulatory agencies. - Regulatory inefficiencies (excessive restrictions on design specifications, intra-regional variations in codes and requirements) are likely to slow approvals. - Building approval for high-rise buildings can take "1.5 to 3 years" in the GVA and GTA. - Insufficient municipal staffing, lack of clarity on standards and process, and conflicts between agency requirements are potential causes of lengthy approval timelines. - A study by the Centre for Urban Research and Land Development at Ryerson University (2017) found average approval times in Ontario for more complex buildings, such as condominiums, is "28 months." ### Rezoning constraints and NIMBYism - The slow and unpredictable re-zoning process is a major impediment to increasing density in the GTA and GVA. - The City of Vancouver is overwhelmingly zoned for single-family dwellings (Figure 5); rezoning on a case-by-case basis is slow and cumbersome in both Vancouver and Toronto. - Re-zoning is often delayed by extensive consultations and local opposition (NIMBYsm). - Survey evidence: - Green and Filipowicz (2017) found the average time for re-zoning was "around 10 months" in the City of Vancouver. - Green, Herzog and Filipowicz (2016) found re-zoning adds on average "7 months" to the approval timeline for the City of Toronto. ### Measures to shorten re-zoning and approval timelines (policy recommendations) - Conduct a comprehensive assessment of bottlenecks in the process. - Explore ways to re-zone larger areas at a time rather than project-by-project. - Improve transparency and certainty about timelines for the different steps in development approval. - Provide greater certainty to developers by guaranteeing that if an application meets conditions of the designated zone where planning permission is being applied, permission would be granted. - Consider time-limiting development plans after a building permit is granted (sunset clauses) to incentivize timely development and avoid construction delays. - Modernize permitting system technology, particularly in Ontario, to allow easier file transfer between municipal and provincial agencies. - Increase human resources dedicated to the approval process. ### Rental market dynamics and supply - The rental market in the GTA and GVA has become increasingly tight: - Rental vacancy rate has hovered "below 1 percent" for years in Vancouver and recently fell "below 1 percent" in Toronto. - Low vacancy rates have pushed rents higher and reduced rental turnover. - A healthy rental market is important for labor mobility; affordable rentals retain and attract workforce needed by dynamic labor markets. - Many young households cannot purchase first homes due to price increases in the GTA and GVA; rentals are an alternative for households ineligible for social housing. ### Composition of rental housing and implications - A mix of purpose-built rentals and secondary rentals (rentals provided by individual owners) is desirable to achieve professional management and economies of scale. - Landlords of secondary rentals may lack skills to responsibly manage properties. - A run-up in investment properties intended for rent can worsen affordability, compete with primary home buyers, and create financial stability risks if investors sell into an illiquid market during downturns. ### Supply of purpose-built rental housing and incentives - New supply of purpose-built rental buildings has been low for decades in the GTA and GVA, compared both to demand and some advanced countries (e.g., US and Germany). - Fast rising condo prices incentivized condo construction with higher profit margins; investor demand tilted supply toward higher-end rental properties. - CMHC Rental Market Surveys indicate about "a quarter" of condominium apartments in Vancouver and "one-third" in Toronto are occupied by renters. - Renewed policy interest in reviving purpose-built rental markets: - Ontario’s Fair Housing Plan: - Property tax for new multi-residential apartment buildings should be charged at a similar rate as other residential properties (province-wide). - Introduce a targeted "$125-million, five-year" program to encourage construction of new rental apartment buildings by rebating a portion of development charges; target projects in communities most in need of new purpose-built rental housing. - British Columbia’s Homes for B.C.: - Qualifying purpose-built rentals are eligible for waiver of municipal property taxes; the province will match these waivers by eliminating provincial property taxes. ### Assessment of existing municipal incentives and rent control - Municipalities in the GVA and GTA offer incentives (density bonuses, property tax breaks, reductions in development costs, expedited processing), but a comprehensive assessment of effectiveness is recommended given scarcity of new purpose-built rental construction. - Role of rent control should be evaluated to ensure it does not constrain new supply: - Both British Columbia and Ontario have long-standing rent control policies. - Ontario’s Fair Housing Plan expanded rent control to all private rental units in Ontario, including those built after 1991. - If limits for rent increases are set too low, adverse consequences can include inhibiting new rental supply and reducing profitability and quality of rental housing. ### Conclusion - Addressing housing supply constraints requires complementary transportation, immigration, and housing strategies at all government levels. - Some constraints can be addressed relatively easily (streamlining and modernizing processes, establishing databases and information sharing). - Other constraints (accelerating rezoning and delivery of serviced land) reflect deeper structural issues and are more difficult to resolve. - Addressing housing supply should be handled urgently as social and economic costs of deteriorating affordability are increasing. *Source: IMF staff chapter text (cr18222).* ### 5. The structure of Canadian industry has evolved markedly over the past decades. As in ### 5. The structure of Canadian industry has evolved markedly over the past decades. As in ### Evolution of industry structure and shift-share decomposition - Manufacturing industry share halved from over 20 percent in the 1960s to about 10 percent today. - Given higher labor productivity growth in manufacturing relative to most other industries, the shrinking manufacturing share could explain part of the long-term declining trend of labor productivity growth. - Shift-share decomposition (labor productivity, excluding the public sector), split into 1984-2000 and 2000-16: - The productivity slowdown mostly results from “within effects,” rather than “shift effects.” - “Within effects” contribution of the mining, oil and gas sector fell from 0.3 percentage points (annual average) in 1984-2000 to –0.1 percentage point in 2000-16. - “Within effects” contribution of the manufacturing sector decreased sharply from 0.5 percentage points in the first period to 0.2 percentage points in the second period. - In both mining, oil and gas and manufacturing, “shift effects” were small or negative, reflecting a decline in employment shares. - In the U.S., the contribution of the mining, oil and gas sector and the manufacturing sector also fell, but less so than in Canada. - “Shift effects” in Canada turned positive in 2000-16 (from -0.1 percentage points in the first period to 0.2 percentage points in the second period), implying more labor was allocated to sectors with higher labor productivity growth. ### Growth accounting: multifactor productivity vs. capital accumulation - Growth accounting by Statistics Canada indicates: - The deceleration in labor productivity growth in the 2000s mainly reflected a decrease in multifactor productivity (in part due to the impact of the 2008-09 global financial crisis). - Capital intensity (defined as capital stock per total hours worked) increased its positive contribution to overall labor productivity growth in the 2000s. - Since 2010, multifactor productivity growth has recovered, but capital intensity growth has slowed markedly, with its contribution to overall productivity growth halved. - The decline in capital intensity growth was broad based: all industries (except for few industries, such as mining, oil and gas, and transportation) had lower capital intensity growth, with some (such as manufacturing, construction, retail and finance) incurring negative growth. ### How firm productivity (markups) relates to investment - Measurement approach: - Estimated firms’ markups (price over marginal costs) following De Loecker and Warzynski (2012). - Analysis focuses on markups for large Canadian (non-energy) firms using Worldscope database. Energy firms excluded. - Empirical relationships: - Markups and business investment are positively associated, but less so when markups are too high — implying a nonlinear (non-monotonic) relationship. - Tobin Q-style investment models (sample 1997-2016; OLS with fixed effects): - The coefficient on markups is positive and highly significant (Model 1). - Association stronger for exporters than domestic firms (Models 2 and 3). - For exporters, Model 2 suggests that a 10 percent increase in markup is associated with 0.6 percentage points increase in the investment to capital stock ratio for non-energy exporters. - Evidence of nonlinearity: Models 4 and 5 show negative coefficient on the quadratic term of markup, indicating that if markup is too high, business investment would decline (results tentative because coefficients not statistically significant). ### Industry competitiveness indicators and investment determinants - Firm dynamism: - Entry and exit rates (number of firms starting or exiting as percent of total firms) show a downward trend; a partial recovery after the global financial crisis was followed by resumed decline in most sectors since 2012. - Decreased entry and exit may signal weakened firm dynamism. - Import competition and market shares: - The share of Canadian non-energy goods and services in the U.S. import market has been steadily declining while China’s share has risen. - Barnett and Charbonneau (2015) shift-share analysis attributed two-thirds of the decline in Canada’s share of the U.S. non-energy import market (between 2002 and 2014) to reduced competitiveness, and 16 percent to changes in U.S. import demand composition. - Additional regression findings (Tobin Q models): - Coefficient on entry and exit rate is positive but not statistically significant (Model 6). - FDI inflows (percent of GDP) coefficient nearly zero and not statistically significant (Model 7). - Interaction of FDI inflows and entry/exit: cross term positive and highly significant, suggesting higher FDI combined with entry and exit rates is associated with higher business investment (Model 8). - China import penetration: Model 9 (all firms) finds a one percentage point increase in China’s share in total U.S. imports led to a 0.2 percentage points decline in Canada’s investment ratio; the competition effect is more evident for exporters (Model 10) than for domestic producers (Model 11). ### Technology, R&D, and productivity spillovers from the U.S. - R&D stock trends: - U.S. R&D stock: about 9 percent of GDP in the early 1970s, increased to 17 percent of GDP in 2016. - Canada R&D stock: about 3 percent of GDP in the early 1970s, increased to about 9½ percent of GDP by 2008, and flat over the past decade. - Spillover hypothesis and empirical setup: - Hypothesis: U.S. labor productivity growth or U.S. real R&D expenditure affects Canada’s productivity through trade channels. - Data: 10 Canadian provinces (AB, BC, MB, NB, NS, NL, ON, PE, QC, SK), sample 1990-2015, annual data averaged into five 5-year periods (balanced panel). - Weighting: Wi,j = province i’s total trade (=exports + imports) with U.S. state j as percent of province i’s GDP; used to weight U.S. labor productivity growth or U.S. real R&D expenditure (percent of employment). - Regression results (Table 3 summary): - OLS fixed-effects Models 1-4: U.S. labor productivity growth and U.S. R&D spending growth are positively and significantly correlated with Canada’s labor productivity growth. - Coefficients are greater when U.S. measures are weighted by trade share, consistent with productivity and technology spillover via trade. - GMM estimators (Models 5-10) used as robustness checks (addressing “small T, large N” concern): results confirm robust relationships; estimated coefficients are much larger and more highly significant compared to OLS estimates (Models 5-8). - Model 9: when including both simple average U.S. productivity growth and weighted U.S. productivity growth, the coefficient on the simple average is insignificant while the coefficient on the weighted measure remains highly significant, supporting productivity spillovers through trade channels. - Model 10: similar pattern for R&D spending; coefficient on weighted U.S. R&D spending greater than simple U.S. R&D spending, but coefficients not significant — suggesting spillover channels are complex and factors beyond R&D and trade could matter. ### Conclusion: key empirical findings - The recent slowdown in labor productivity growth can be explained mainly by a deceleration in capital intensity growth. Disaggregated analysis shows that the slowdown in capital intensity and labor productivity has been broad-based and not attributed to particular industries. - The firm-level panel data analysis suggests positive relations between markups and business investment, together with some evidence of nonlinearity. - Lackluster business investment in recent years could also be associated with weakened firm dynamism (as reflected in lower entry and exit rates). - There is evidence consistent with spillover effects from U.S. productivity or U.S. technology investment to Canada productivity through trade channels. *Source: IMF staff analysis in cr18222.* ### 18. The Canadian authorities’ renewed efforts to boost labor productivity are welcome. ### 18. The Canadian authorities’ renewed efforts to boost labor productivity are welcome. ### Key findings on investment, innovation, and technology diffusion - The authorities are focusing on measures to enhance innovation activity because spending on R&D and the density of industrial robots in Canada are much lower than top performers in OECD economies. - Trade and technology diffusion: - A heightened level of trade tensions in the North America region is a concern given the importance of trade in supporting Canada’s productivity through the diffusion of technology. - Earlier resolution of trade disputes will help put Canada’s growth path on a higher and sustainable path. - A further reduction of the preferential treatment given to domestic firms and suppliers could be considered to maximize potential benefits from trade. - Internal trade and regulatory barriers: - Reducing barriers to internal trade should be important to enhance the diffusion of technology across Canadian provinces. - The implementation of the Canadian Free Trade Agreement should be accelerated, aimed at reducing barriers to internal trade, investment, and labor mobility, and harmonizing regulations and standards. - Product market reform is required: OECD (2016) shows Canada’s regulatory framework is relatively restrictive compared to other OECD economies, with room to reduce barriers in professional, retail, and network services and to streamline licensing and registration requirements. ### Productivity decomposition (Shift-Share Analysis) - Aggregate productivity growth decomposed into: - Sum of sector productivity growth (“within effects”) - Sectoral shifts in employment shares (“shift effects”) - Cross-sectoral component (“co-movement effects”) - For both Canada and the U.S., decomposition uses 6 sectors: agriculture, forestry, fishing, and hunting; mining, quarrying, and oil and gas; manufacturing; construction; utilities; and other sectors (including services). - Canada — Table 1: Productivity Growth Decomposition (percentage points) - 1984-2000 - Productivity growth within sector: 1.71 - Employment share shifts: -0.18 - Cross-sectoral: -0.14 - Total change in productivity: 1.40 - By sector (1984-2000): Other sectors (incl. services) contribution to total change: 1.05 - 2000-2016 - Productivity growth within sector: 0.51 - Employment share shifts: 0.16 - Cross-sectoral: -0.13 - Total change in productivity: 0.55 - By sector (2000-2016): Other sectors (incl. services) contribution to total change: 0.72 - United States — Table 1: Productivity Growth Decomposition (percentage points) - 1984-2000 - Productivity growth within sector: 1.87 - Employment share shifts: 0.14 - Cross-sectoral: -0.27 - Total change in productivity: 1.73 - By sector (1984-2000): Other sectors (incl. services) contribution to total change: 0.87 - 2000-2015 1/ - Productivity growth within sector: 1.07 - Employment share shifts: 0.12 - Cross-sectoral: -0.09 - Total change in productivity: 1.11 - By sector (2000-2015): Other sectors (incl. services) contribution to total change: 0.71 - 1/ Comparable US 2016 data not available. ### Firm-level determinants of investment and markups (selected results) - Markup estimation approach: - Markups estimated at the firm level following De Loecker and Warzynski (2012): markup = 휃_it^l / 훼_it^l, where 휃_it^l is the output elasticity of labor and 훼_it^l is the labor expenditure share. - Output elasticity estimated via a production function with Olley-Pakes style control for unobserved productivity (sample 1997-2016, excluding energy firms). - Data: Worldscope (net sales deflated by industry GDP deflators), industry-level wages from Statistics Canada. - Caveats: output elasticity is estimated using industry-level panel data and assumed constant through the sample period; markup movements driven by changes in labor shares. - Firm-level panel regression (investment to capital, log) — selected coefficient estimates from Table 2 (robust standard errors; ***, **, * indicate 1 percent, 5 percent, and 10 percent significance): - Log markup: 0.071*** (Model 1) - Lagged log return on assets: 0.176*** (Model 1) - Log effective interest rate: -0.160*** (Model 1) - Tobin's q: 0.149*** (Model 1) - Log REER: -0.258* (Model 1) - Observations (Model 1): 4026 - Memorandum: Fixed effects included; sample excludes energy firms. - Interpretation: - Higher markups are associated with higher investment (baseline coefficient 0.071***). - Profitability (lagged return on assets) and Tobin’s q are positively associated with investment. - Higher effective interest rates are negatively associated with investment. ### Provincial-level spillovers (selected results) - Table 3: Provincial level spillover regressions — dependent variable: log labor productivity growth (five year average). Selected estimates (robust standard errors; ***, **, * indicate 1 percent, 5 percent, and 10 percent significance): - Log initial labor productivity (GDP/hour worked): -14.270*** (Model 1) - Change in net-migration in provinces to population: 1.980** (Model 1) - Exports to other provinces (growth rate): 0.054 (Model 1) - Rule of Law: 4.296*** (Model 1) - Unweighted US labor productivity growth: 0.055* (Model 1) - Weighted (with X+M/GDP) US labor productivity growth: 0.080* (Model 1) - Unweighted US R&D per employee growth: 0.035*** (Model 1) - Weighted US R&D per employee growth: 0.093* (Model 1) - Observations (Model 1): 60 - R-squared (Model 1): 0.583 - Interpretation: - Initial productivity displays strong negative convergence coefficients. - Net migration, rule of law, and US productivity/R&D growth (unweighted and weighted measures) are positively associated with provincial labor productivity growth, indicating spillovers from population flows, institutions, and external R&D/performance. ### Policy recommendations and areas for reform - Trade and procurement: - Resolve North American trade disputes early to support productivity-enhancing technology diffusion. - Consider reducing preferential treatment of domestic firms and suppliers to maximize potential gains from trade. - Address foreign ownership restrictions in some sectors and limitations on foreign suppliers participating in public procurement in selected sectors. - Internal trade and labor mobility: - Accelerate implementation of the Canadian Free Trade Agreement to reduce internal trade barriers, promote labor mobility, and harmonize regulations and standards. - Product market reform: - Reduce regulatory barriers in professional, retail, and network services. - Streamline licensing and registration requirements and limit regulatory protection of incumbents. - OECD indicators suggest Canada’s regulatory framework is relatively restrictive compared to other OECD economies (Table 4 indicates sectoral PMR measures and subcomponents). - Innovation and technology diffusion: - Increase spending on R&D and promote adoption of automation/robotics to close gaps with top OECD performers. - Encourage policies that enhance the diffusion of technology across provinces and across firms, including measures to strengthen spillovers from U.S. R&D and productivity gains. *Source: IMF staff report chapter 18 as provided in the content unit.* ### Appendix III. Provincial Level Analysis: Regression Model ### Appendix III. Provincial Level Analysis: Regression Model ### Specification - Estimated model: - ΔLP_it = β_0 + β_1 ∑_{j=1}^k Weight_{ijt} ΔLP_{jt}^{US} (or ΔR&D_{jt}^{US}) + γ X_it + μ_i + ε_it - i, j, and t denote Canadian provinces, US states, and time, respectively. - μ_i denotes an unobserved fixed effect capturing time-invariable heterogeneity across Canadian provinces. - ε_it is a white-noise error term. - Dependent variable: - ΔLP_it — labor productivity growth for each Canadian province. - Key explanatory variables: - ΔLP_{jt}^{US} — labor productivity growth for each US state. - ΔR&D_{jt}^{US} — real research and development expenditure per employee growth for each US state. - ΔX_it — control variables including: - initial level of labor productivity; - growth rate of interprovincial trade; - change in net migration inflows as a percent of population; - rule of law index (proxy for quality of institutions). ### Estimation methods and identification - Estimation techniques: - OLS with fixed effects. - Generalized Method of Moments (GMM) — specifically the difference GMM estimator from Arellano and Bond (1991). - Rationale for difference GMM: - Addresses inconsistent estimators due to variable endogeneity. - Suited to a relatively short sample period combined with a fairly large cross section data (“small T, and large N”). - Instruments: - The initial level of labor productivity is used as an instrument. ### Data description (variables and sources) - Canada productivity growth: - Growth rate of real GDP divided by hours worked. - Gross domestic product at market prices, chained 2007 from CANSIM Table 384-0038. - Provincial GDP prior to 1980 estimated using nominal GDP data (CANSIM Table 384-0015) divided by the GDP deflator for Canada. - Actual hours worked (all Jobs, both sexes, 15 years and over) from the Labor Force Survey. - Exports and Imports as a percent of GDP: - Canada nominal exports and imports from the US by province from https://open.canada.ca/data/en/dataset?sort=metadata_modified+desc&q=CIMT&organization=statcan. - Nominal GDP from CANSIM Table 384-0038. - Change in net-migration in provinces to population: - Net migration from CANSIM Table 051-0018. - Total population from CANSIM Table 051-0001. - Growth rate exports to other provinces: - CANSIM Table 384-0038. - Rule of Law: - Worldwide Governance Indicators database, World Bank Group. - U.S. productivity growth: - Growth rate of real GDP divided by number of employees. - GDP (chained 2009) by state from Gross State Product database (Bureau of Economic Analysis). - Number employed from U.S. Regional Household Employment database (total U.S., states and selected areas). - U.S. R & D per employee growth: - Total R & D expenditure (constant PPP prices) from OECD Statistics. - Number employed from U.S. Regional Household Employment database (total U.S., states and selected areas). ### Empirical considerations - Panel structure: - Cross-sectional units: Canadian provinces. - External peers: US states used in weighted spillover terms. - Endogeneity and dynamics: - Use of initial labor productivity as instrument addresses potential endogeneity of productivity dynamics. - Difference GMM chosen because of “small T, and large N” panel properties. *International Monetary Fund — Appendix III. Provincial Level Analysis: Regression Model* --- _Source: https://www.imf.org/-/media/files/publications/cr/2018/cr18222.pdf_