By W.T. STANBURY
Published December 20, 2010
The Hill Times
Speaking truth to power is one of the highest ideals of public servants (see Aaron Wildavsky, Speaking Truth to Power, Little Brown, 1979). It is even more important in the case of appointees who have been given a great deal of independence such as officers of Parliament, and the governor of the Bank of Canada.
Prior to Oct. 31, 2006, then-Bank of Canada governor David Dodge's statements about income trusts were carefully circumscribed by the limited research the Bank of Canada had done, and by Dodge's knowledge of other research. Then things changed dramatically. I try to determine why Dodge changed his views on income trusts after the huge tax on certain publicly-traded trusts was announced on Oct. 31, 2006. I omit his testimony before the Senate Banking Committee on Oct. 26, 2005 as much of the same ground was covered a year later.
Standing Senate Committee on Banking, Trade and Commerce, Oct. 25, 2006
Dodge's comments on income trusts are from the Q&A period. I focus on Dodge's statements and omit the questions for reasons of space. Note that he was speaking just five days before the new tax on trusts was announced on Oct. 31.
"[I]ncome trusts...have a risk return characteristic sufficiently different from either equities or bonds to allow investors to achieve portfolio risk-return combinations not otherwise available. ... They made markets more complete and, hence, were a good additional instrument for markets to have."
"[T]wo areas ... need improvement—those related to accounting and those related to corporate governance."
"We have not done work on how income trusts affect overall Canadian economic performance or productivity. We will not be doing that work. Indeed, that work is incredibly difficult to do...."
"Finally, none of the work we have done relates to the appropriateness of all of the tax system as it relates to the incentives to operate either in the form of an income trust or in the form of a corporation....None of what we have done should be taken to say that we think that the current tax system—taken in its entirety—is necessarily ideal."
"Turning to the two more difficult questions, the impact on research and development and the impact on machinery and equipment, we are not competent to talk about those, and in abstract, it is really not possible to talk about them."
"[I]t is true...that tax exempts [sic. trust units in tax deferral accounts ] and foreigners face a rather different set of incentives or net returns than does the individual Canadian investing outside of his or her RRSP. That is an obvious fact, but I cannot comment on what one might do about it."
Dodge Changes His Views
On Nov. 1, 2006, the day after the new high tax on distributions by income trusts was announced, Reuters quotes a statement by Dodge, distributed by email, saying: "The actions that the government took yesterday... would appear to eliminate the tax incentive to use one form of corporate organization over another. Businesses now face a level playing field in choosing the form of corporate organization that allows capital to be allocated to its most efficient use." The Reuters report also cited Dodge's statements on Oct. 25, 2006 quoted above.
Comments: Why would the then-governor of the Bank of Canada make any statement regarding the new tax—let alone such a bold and unqualified one? Dodge's Nov. 1, 2006, statement contradicts his October 2005 Senate testimony in which he said: "I think the idea of an income trust was a sensible one to try to have a level playing field." On Oct. 25, 2006, Dodge told the Senate that "none of the work we have done relates to the appropriateness of all the tax system as it relates to the incentives to operate either in the form of an income trust or in the form of a corporation." Dodge made no reference to any research in support of his new position. Gone also were the qualifiers Dodge used in the past such as "limited evidence suggests."
Was Dodge prompted to send out the e-mail as part of the larger effort mounted by the Harper Government to create allies and to undermine potential opponents? And if Dodge was prodded, why did he not assert his independence and refuse?
House of Commons Finance Committee, Feb.1, 2007
Dodge began with a statement to the committee (edited slightly). I have inserted some comments in bold.
"[In] our June 2006 Financial System Review... we noted that limited evidence suggests that income trusts can enhance market completeness in a number of ways. Income trusts can provide diversification benefits to investors because trusts can have different risk-return characteristics than either equities or bonds. Second, the income trust structure appears to allow some firms to improve access to market financing."
"... We note ...two areas... where improvement is clearly needed in standards related to accounting and distribution of revenue, and those related to governance. ..."
" Of course, there are very important public policy questions related to income trusts that fall outside the Bank's mandate. The Bank has done no specific research on how the income trust structure affects economic performance, or would affect future productivity in Canada."
"Based on general economic principles and our understanding of the structure of the Canadian economy, I can say that while the income trust structure may be very appropriate where firms need only to manage existing assets efficiently, it is definitely not appropriate in cases where innovation and new investment are key. [ No research cited, and contradicted by empirical research on trusts and the rate of investment.] To the extent that the system was favouring the use of the income trust structure in these cases, the incentives for innovation and investment were reduced, and the potential for future productivity growth was reduced." [ No research cited, and not supported by available research.]
"[D]ifferent risk-return characteristics of trusts may not enhance market completeness if they arise from differences in tax treatment. Clearly, there has been a very significant tax incentive to use the income trust form of organization in cases where this would not have been an appropriate form of organization from a business efficiency point of view."
"By giving incentives that led to the inappropriate use of the income trust form of organization, the tax system was actually creating inefficiencies in capital markets—inefficiencies that, over time, would lead to lower levels of investment, output, and productivity. [In his Senate testimony on Oct. 25, 2006, Dodge referred to the efficiency promoting nature of trusts, and refused to comment on their effect on investment etc., as the Bank had done no research on these matters.]
"We at the Bank have not done any research on how the rules of the tax system could or should be designed so that they do not give inappropriate incentives. [But on Nov. 1 Dodge endorsed the new tax.] The changes proposed by the government last October would appear to substantially level the playing field. [Contradicts Dodge's Senate testimony on Oct. 25, 2006.] For the income trust sector to deliver the efficiency benefits through its enhancement of market completeness, it is absolutely critical that the tax system provide a level playing field." [Dodge cites no research or studies to demonstrate that would be the actual outcome of new tax.]
In response to a question by the NDP finance critic, Dodge said, he had "reasonable faith, that ... a big chunk of that $20-billion to $25-billion [decline in the TSX trust index] has got to be the present value of tax losses to governments, federal and provincial." [Wrong: see below.]
Conservative MP Diane Ablonczy, then-Parliamentary secretary to the minister of finance, sought to get Dodge to endorse the government's action. After a very long and carefully-qualified response by Dodge, Ablonczy said: "So you're telling the committee that you believe what Mr. Flaherty, the finance minister, did, with this announcement, was the right thing to do."
Dodge said, "I think so, I guess from a strict point of view... the right thing is to have a tax system with low rates and a broad base and that is as neutral as possible..."
When asked to clarify his previous statement, Dodge said, "What I said was that a step was taken to levelling the playing field and it was a step absolutely in the right direction..."
Discussion and Conclusions
Why did Dodge so clearly change his position on the taxation of income trusts after Oct. 31, 2006? In his previous statements on income trusts in October 2005 and October 2006, Dodge emphasized the limited research the Bank of Canada had done, and he refused to make statements beyond its limited confines. In his Nov.1, 2006, and Feb. 1, 2007, statements that were supportive of the new tax, Dodge cited no research in support of his new position. Worse, the available research did not support Dodge's claims.
Dodge said he was using general economic principles and his general knowledge of the Canadian economy. But he then made remarks about the relationship of trusts to innovation, investment and productivity—and cited no evidence in support of his claims.
Worse, Dodge said that " a big chunk" of capital losses suffered by owners of trusts "has got to be the present value of tax losses to governments...." That was an elementary error—inexplicable for the governor of the Bank of Canada. The TD Bank Financial Group (news release, Nov. 1, 2006) explains: "Since the valuation of any stock is a reflection of the discounted present value of the future revenue stream, the imposition of the distribution taxes will lower the market assessment of valuations. And.. markets [being] forward looking and will factor in the changes immediately."
Dodge changed his views dramatically on aspects of the income trust issue for which he had previously said the Bank had done no research. Yet an hour on the internet would have revealed to Dodge the careful studies of consultant Dennis Bruce re: the claims of "tax leakage," and contrary evidence on the reinvestment, growth, and competitiveness argument that were available at the time cited in Stanbury, The Hill Times, Nov. 8, 2010).
During his Feb.1, 2007, testimony, Ablonczy refused to accept Dodge's carefully-framed answers even though they had gone far beyond anything he had said in the past. For all his record of bluntness, it is a mystery why Dodge did not tell Ablonczy to stop trying to put words in his mouth. He had a great deal of experience in testifying before Parliament. He would have won such a "face down," given his status in Ottawa was far greater than hers. But Ablonczy was able to "break the witness" as the lawyers say. Later, the Harper Government played up the fact that the governor of the Bank of Canada had endorsed its new tax, even though his comments only amounted to "I think so, I guess..."
When it really counted, Dodge failed to speak truth to power—which is the central justification of having a position of great independence as a public official.
W.T. Stanbury is professor emeritus, University of British Columbia. This column is drawn from his forthcoming book on income trusts which contains a longer discussion of the change in David Dodge's views.
Thursday, December 23, 2010
Posted by Brent Fullard at 11:46 AM