Why tax reform is a bigger deal than trade

By Bryan Borzykowski on October 9, 2018
Estimated reading time: 4 minutes

A trade deal may be done, but uncertainty over U.S. policy remains.

Whatever one thinks of the new U.S.-Mexico-Canada Agreement, having a deal in place is good news for investors. For the last 13 months, trade uncertainty has put pressure on stocks—it’s partly the reason why the S&P/TSX Composite Index is down 2.2% since January. The trade issue, though, while important, has distracted Canadians from what could be an even bigger threat to our economy over the long-term: U.S. tax reform.

It seems like a lifetime ago now, but last December America passed the Tax Cuts and Jobs Act of 2017, which slashed its corporate tax rate from 35% to 21%—or 39% to 26% when taking into account state taxes—and made it easier for companies to bring offshore cash back into the country. As well, small business owners, which typically claim business income on their personal tax returns are now allowed to deduct 20% of that income tax-free.

Once the tax reform bill was signed into law, Canada’s tax gap—KPMG ranked Canada first among G7 nations for cost competitiveness in 2016—narrowed significantly. In Canada, the Federal corporate tax rates on companies earning at least $500,000 in revenue is 15%, while provinces tack on another 12% to 16%, depending on the location. Ontario-based companies, for example, pay 26.5% in tax.

More trouble than trade

While having a similar tax rate to the U.S. may not seem like a huge deal, Rob Edel, chief investment officer with Vancouver-based Nicola Wealth Management thinks that tax reform could be a much bigger issue for Canadian investors than trade. “The advantage that Canada had goes away,” he says.

Now, companies may be less inclined to set up head offices in Canada. Many companies, such as Valeant (now Bausch Health) and Tim Horton’s owner Restaurant Brands International created headquarters in Canada, and listed on the Toronto Stock Exchange, because of Canada’s more attractive tax regime. U.S. Businesses, which also face the added pressure of following an “America First” agenda, may also decide to invest more heavily in U.S. operations than in Canadian ones.

According to Ernst & Young: “These significant personal and business tax changes affect the relative prices of labour and capital in both countries and returns on business investment. Eliminating the tax competitiveness that Canada has enjoyed over the U.S. for the last number of years could affect the outcome of many companies’ tax planning and investment location decisions.”

Concentration will continue

While it could be years before we see the implications of U.S. tax reform on the Canadian economy, Edel still think it’s bad news for investors. Our market is already so concentrated in energy, materials and finance, if even a few companies decide to stay in America and not list on a Canadian exchange, then our market has little chance of becoming more diversified.

With President Trump also relaxing regulations in the U.S., companies on both sides of the border have less incentive to invest in Canada. Will U.S.-based energy companies continue invest in Canada if both tax reform and regulations make it easier to grow closer to home? Will a manufacturing company set up a plant in Mississauga versus Buffalo? Would RBI have made Oakville its head office if there wasn’t a tax incentive? “That’s an open question,” says Edel. “There was a tax benefit, now there’s not.”

According to a new report by PwC, U.S. tax reform would hurt the Canadian economy overall. It said that Canada could lose 650,000 jobs over the next decade and risk potentially cutting $85 billion, or 4.9%, off Canada’s GDP. Any meaningful damage to our economy will certainly impact investor sentiment and bring even more uncertainty to our markets.

There’s not much investors can do right now, other than owning U.S. stocks, which continue to climb, despite stretching valuations, but tax reform is something people should be paying attention to, says Edel. If Canada becomes less competitive, then our markets may start looking less attractive, too. “It’s complicated,” says Edel, “The bottom line is that the advantage we had is now gone and the U.S. government is helping people do more business in the U.S.”