Aligning tax policy with economic goals

The Canadian government uses tax policy to achieve many objectives, including economic ones. But it’s difficult to judge whether tax incentives are helping to achieve overall economic goals because tax policy tends to be treated as a silo rather than as part of any larger industrial policy. Further, tax incentives to promote economic outcomes tend to be evaluated infrequently, if at all, making it difficult to determine their effectiveness in encouraging the desired activity. 

For example, recent federal budgets have included various policies to promote “innovation,” including tax incentives. The need for greater innovation to bolster lagging productivity and improve the standard of living of Canadians is used to justify these incentives.   

The federal scientific research and experimental development (SR&ED) tax credit gives R&D performers a tax credit linked to the volume of qualifying R&D expenditures in a tax year. Recent budgets have included investment tax credits to encourage investments in various “green” technologies thought to be of strategic importance for the economy. Provincial governments also fund innovation through various grants and tax incentive programs. 

Without a clear rationale, the effectiveness of a particular tax incentive cannot be evaluated. For example, is the purpose of the scientific research and experimental development (SR&ED) program to entice firms to carry out R&D leading to spillovers that benefit society?  Or perhaps is the goal to encourage firms to change their business strategies to compete based on innovative goods or services?  

Determining the overall usefulness of these and other tax incentives is made more difficult because Canada lacks a coherent industrial policy to guide economic decision making, including tax policies. An industrial policy should answer questions such as: What are the economic outcomes desired by federal and provincial government?   Why are those outcomes not being achieved? What economic actors should be targeted for support?  How can both levels of government address barriers to achieving desired economic outcomes?  What economic activities should be supported? How will success be measured?  Tax policy toward innovation and other economic goals should be situated within this broader industrial policy.   

The role of tax policy in such an industrial policy is also a subject of much debate. Tax incentives are but one policy tool to promote economic activities associated with innovation. Governments can promote beneficial economic activity through, for example, providing grants to firms or by funding universities.  

Tax incentives have advantages and disadvantages when used to promote industrial policies that must be weighed against the advantages and disadvantages of other policy instruments. On the advantage side, tax incentives can be delivered efficiently and, unlike direct grants to taxpayers, do not require “picking winners”.  

The use of the tax system to promote economic activities has several disadvantages. Tax incentives tend to operate on the belief that economic actors will change their behavior in response to the incentives. We often see little empirical evidence that taxpayers will respond in the desired manner. For example, many jurisdictions have implemented a “patent box” that taxes income relating to certain forms of intellectual property at a much lower tax rate than would otherwise be the case. Proponents argue that a patent box will encourage both research and development and related commercialization in the implementing jurisdiction. Empirical research suggests that firms either do not increase their R&D expenditures or that the responsiveness of R&D to the tax break is weak.  

Further, the effectiveness of tax policy at achieving beneficial economic outcomes is tempered by potential interactions with other parts of the tax system. For example, a tax incentive might not entice a large multinational to locate activities in the jurisdiction if the incentive could be clawed back by the global minimum tax. 

To learn whether current tax incentives are achieving their intended effects or promoting overall economic outcomes, they need to be evaluated. Unfortunately, this evaluation does not seem to be happening. The Auditor General of Canada noted in his 2015 Spring Report that spending through the tax system (“tax expenditures”) are not systematically evaluated or subjected to proper Parliamentary scrutiny. A further criticism is that the public generally cannot find out the dollar amount of incentives provided to individual firms through the tax system to evaluate value-for-money.  

Are tax incentives doing any good? We don’t really know. A coherent industrial policy that includes tax policy and systematic evaluation of tax incentives would go a long way towards answering important questions about the role of tax incentives in achieving Canada’s economic goals.