Wednesday, September 2, 2009

A political primer for the Liberals on Income Trusts by Professor Stanbury



Leadership? Here’s Ten Reasons Why the Tax on Income Trusts Was a Public Policy “Train Wreck”


There’s considerable evidence to indicate the Harper government created the appearance of a crisis or phony crisis to sell the tax.

By W.T. Stanbury (Professor Emeritus, UBC) Sept. 22,2008
The Hill Times

Introduction: Let’s start with Stephen Harper’s proposition that the central issue in the current election campaign is “leadership.” Effective leadership should produce good public policies. In this piece, I argue that there are ten reasons why the huge tax on income trusts announced on October 31,2006, and made into law on June 22,2007, is the greatest public policy “train wreck” in decades. It puts in question Mr. Harper’s leadership skills, and that includes his willingness to tell the truth. The tax may also be an albatross for Finance Minister Jim Flaherty.

1. Harper Denied He Reversed Himself

The income trust tax was an obvious reversal of repeated promises by Stephen Harper when he was Opposition Leader in 2005 and during the last election campaign. This reversal was widely perceived to be a serious ethical fault and Harper provided no convincing reason why such a reversal was justified. Harper did not lie because he did not intend to mislead the public with his promises. However, on November 1,2006 in the Commons, Mr. Harper did lie about what he said during the election campaign. The clearest statement was in the party’s election platform released on January 13,2006. “A Conservative government will…preserve income trusts by not imposing any new taxes on them.”

During Question Period on November 1,2006, the PM said: “The commitment of this party ….. was a commitment to protect the income of seniors”. On November 2, the PM said, ”this government will not apologize for trying to protect the interests of individuals and a tax system that makes big business pay its fair share.” You decide.

2. Huge Capital Losses

The S&P/TSX Income Trust Index. closed on October 31, 2006 at 164.86. Two days later, the index was at 138.21. That represents a loss of $32.5 billion to the owners of trust units. Two weeks later the index was at 135.51 representing a loss of $35.6 billion. To the extent that the Trust Index later rose to higher levels does not diminish this loss for two reasons. First, some investors had to have sold shortly after the announcement—otherwise the index would not have fallen. The index reflects real transactions at real prices. Second, any subsequent increase in the index is the result of the myriad variables that affect market value, such as interest rates, and energy prices (particularly
important to the energy trusts), and the further one gets from the initial announcement date the more one has to factor in the relative price movement of other indices to which the trust index is historically correlated, i.e., the broader TSX common share stock index and/or the energy subsector thereof.

3. Using a Methodology Known to be Greatly Biased

The Department of Finance’s methodology used to estimate the so-called “tax leakage” of $500 million for the federal government in 2006 omitted the present value of deferred taxes on the 39% on trust units held in tax deferral accounts like RRSPs. The officials knew as early as March 2004 and again in the summer of 2005 that their methodology was seriously biased toward generating revenue losses when income trusts were compared to regular corporations. When these deferred taxes are included, there was no “tax leakage.” Thus a serious omission may well have resulted in misleading policy advice by officials to their Minister, and the PM.

4. An Orwellian “Tax Fairness Plan”

The stated justifications for the 31.5% tax on income trusts were at best seriously questionable. The Government’s use of language in the so-called “tax fairness plan” was reminiscent of George Orwell’s Ministry of Truth.

The government made a great effort to frame the new 31.5% tax on income trusts as a matter of “tax fairness.” A frame is a conceptual structure intended to call up a wider/deeper set of constructs that will help to define a concept or issue in the way the framer desires. It makes use people’s prior modes of classifying information and issues; it takes advantage of embedded mental habits. The objective of such framing is to “ make a silk purse out of a sow’s ear.” The trust tax was bundled with three small tax cuts, two of which benefited seniors. But the benefits for seniors amounted to about 2% of their capital losses on trust units.

An analysis of the new tax on some income trusts shows that the measure did not achieve “tax neutrality” as repeatedly claimed by the government. The tax added to the variegation in effective tax rates across types of business organizations, and by types of owners of these assets. The tax did not “level the playing field” as the Minister claimed so loudly and repeatedly. In fact, the tax was highly discriminatory--- it exempted REITs ( which accounted for about 15% of the total market value of trusts on the TSX), and private flow through entities like those used by many law and accounting firms.



5. Phony Crisis to “Sell” the Policy

There is considerable evidence to indicate that the Harper Government created the appearance of a crisis or phony crisis to sell the tax. The government proceeded in secret during 2006, then made a dramatic announcement of strong action. Then it justified the move by claiming that there was a crisis which forced it to act as it did. The claims were couched in emotive rhetoric, primarily by Finance Minister Flaherty. Here is one of many possible examples. On November 9,2006, before the Commons Finance Committee, Flaherty was asked: “if we had maintained the status quo, was there any threat of it driving us into the red?” He said: “Over time, yes. There was a clear and present danger that Canada was going to become an income trust economy…” Ridiculous! The claimed tax revenue losses of $500 million in 2006, were a minute fraction of corporate income tax revenues of over $37 billion, and the current surplus of over $12 billion in 2006.

A few minutes later, the Minister claimed that the “ erosion of the tax base [ said to be due to trusts ] would have meant that, to pay for… the health transfers, the post-secondary education transfers, the social transfers, and infrastructure, we would have had to tax more and more individuals and their families…” This apocalyptic rhetoric is false.

6. A Zero Revenue Tax?

The income trust tax is an extremely unusual tax.. No revenue will be collected, but the entities subject to the tax will disappear from public capital markets -- which was the apparent point of the effort. The Department of Finance never gave any estimate of the amount tax revenue the new tax was expected to generate in any of its documents. This was most unusual; the officials evidently knew that no revenue would be collected because the tax did not apply until 2011 and by then there would no longer be any of the income trusts subject to the tax.

7. Many Misleading Statements By the Minister

Finance Minister Flaherty was the point man for the trust tax. He made endless misleading statements in support of the government’s action. He claim that the tax would result in $2 billion in revenue losses for the provinces over four years was unfounded as it failed to take into account the redistribution affects among provinces. Flaherty claimed that the proposed conversion of Telus and BCE to trusts would cause huge tax losses was false since both companies had already stated that their cash corporate income taxes would be negligible for the next several years.

The Minister ( and an official!) testified on January 30,2007 that the drop in the market value of trust units immediately after the announcement of the new tax was evidence of so-called “tax leakage.” This is an elementary, but serious error. The drop was due to the introduction of the tax. Asset values and changes in taxes on those assets move inversely to each other. The fall in value would have occurred even if the tax rate on trusts had been higher than on corporations!

8. Very Large Adverse Economic Consequences

Most serious, was the evident failure of the Harper Government to anticipate the reasonably predictable adverse consequences of the tax. They have been huge (and are still being felt in September 2008). One of the most important induced effects of the tax has been (and will continue to be) a decline federal (and provincial) tax revenues due to the takeover of the devalued income trusts by entities which pay lower taxes than did the trusts, i.e., foreign interests, domestic-private equity funds, and domestic pension funds. With some leveraging, foreign owners, subject only to the 15% withholding rate, can reduce the effective tax rate to near zero.

9. Punitive Remedy, When Better Alternatives Were Available

The government’s “remedy” for the purported problems associated with the rapid growth of income trusts ( a 31.5% tax on the distributions of some publicly-traded trusts ) was far hasher than it needed to be. What were the practicable alternatives? a) Suspend the advance approval of proposed new trusts as the Liberals did on September 19, 2005 (recognizing that that such an action would likely cause a drop in the market price of income trust units due to uncertainty). – and simultaneously announce a transparent, consultative process to review the issue with a public report in three months; b) Declare a moratorium on new trusts – and simultaneously announce the same process; c) Impose a tax on income trust distributions at source of 7% to 10%. Witnesses made it clear that such a tax would be sufficient to actually level the playing field based on the effective corporate income tax rates—which vary by sector and firm; d) Apply alternative c), but make the tax refundable to Canadian residents. (This might violate the “national treatment” provision of NAFTA.); e) Lower the corporate income tax. The Liberals had started to lower the corporate income tax (and they increased the dividend tax credit) to reduce the gap between the two different legal forms of organization of businesses, trusts and corporations. On October 30,2007, Flaherty---but it came far too late for the trusts. announced much larger cuts in the corporate income tax. One expert, Dennis Bruce, pointed out that the various reductions since 2004 effectively eliminated the claimed “tax leakage’—even using Finance’s biased methodology.

10. Closed Process—But Secret Lobbying by Certain Interests.

There was no public consultation process in 2006 preceding the imposition of the 31.5% income trust tax like that which occurred in 2005 under the minority Liberal government. The growth of income trusts could have been temporarily halted in the fall of 2006 by doing what the Liberals did on September 19, 2005: suspending advance tax rulings for proposed trusts by the Department of Finance.

There was secret lobbying in 2006 of the PM and Finance Minister by CEOs and company directors ( see Globe and Mail, Nov.2,2006 ). They wanted the trend to convert corporations to income trusts stopped due to the pressure of competition, and the reduced discretion they would have as head of an income trust. It appears that contrary arguments were not heard. How come only the opponents of trusts knew it was a good time to lobby?

To summarize—the income trust tax is an outstanding example of how not to make tax policy. It resulted in a “train wreck” whose effects continue to reverberate—perhaps in the current election campaign.

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Dr Mike said...

Ok Libs , now we will see exactly what you are made of , won`t we.

The trust issue is like the golden egg , ripe with goodies enough to bring down the best of tyrants.

The issue is quantifiable & easily promoted along with other issues to show the people of this country exactly what the make-up of the current PM involves---deceit , pandering to the elite , & an all-around attitude that it is "my way or the highway".

Come on Libs let`s do thing but let us do it right.

Dr Mike

Anonymous said...

Who says the Liberals will get into power, to fix the Income Trusts. They have to get in first, slay a massive deficit.
That in itself is a monumental task.

Dr Mike said...

Anonymous

What better way to slay the massive deficit from the Con "non-existent" recession than by boosting tax revenue by reversing the trust decision.

Only makes sense.

A reversal would cost zip & bring in yards of cash well into the future.

Dr Mike

Anonymous said...

One only need listen to Flaherty's vocabulary today from the G20, to perceive that when the word "entrenching" was used, it's akin to giving "the finger" to Canadians and Canadian democracy.