Broad is Better

Flaherty is boosting overall growth through tax cuts. That beats McGuinty's support of a few declining industries.

The war of words between the federal Finance Minister, Jim Flaherty, and the Premier of Ontario, Dalton McGuinty, is more than just a political debate. It represents a fundamental difference in views as to how to best conduct industrial policy. Ontario favours policies aimed at specific business activities. The federal government pursues broad industrial policies aimed at economic growth. Which one is right?

In recent years, Ontario has provided targeted subsidies for specific industries, especially in the auto, forest and film sectors in reaction to declining fortunes resulting from a rising dollar. True, Ontario has followed through on some broad policies to help all industries, the smartest being the elimination of the capital tax, not just for non-financial but also financial companies.

However, Ontario did hike its corporate income tax rate to 14% in 2004, reversing plans to achieve an 11% tax rate. Ontario's corporate tax rate is only slightly lower than that in Nova Scotia, Prince Edward Island and the Yukon, which are not exactly economic stars and can receive federal equalization payments to make up for their poor industrial tax base.

Even after federal corporate tax cuts scheduled by 2012, Ontario's effective tax rate on new capital projects will remain highest in the country at 31.2%. This places Ontario in the same league as Japan and France, which have the most onerous tax regimes on business investments in the world, now that the U.S. is bringing back bonus depreciation to support business investments in machinery and equipment.

Ontario has such a high effective tax rate on capital investment partly because it relies on an antiquated retail sales tax that has grown little as a source of revenue in the past five years. The sales tax hurts business competitiveness since one-third of revenue is collected from levies applied to intermediate and capital purchases. The Ontario retail sales tax has a much bigger impact on capital investment than had the capital tax. Moving to a value-added tax, similar to the federal GST or the Quebec sales tax, would remove most of the tax on business inputs and sharply reduce the effective tax on capital in Ontario to 23%, making it much more competitive.

This is the beef that Mr. Flaherty has with Mr. McGuinty. Ontario is criticizing the federal government for not doing enough to help business competitiveness and looking for the feds to provide major subsidies to support manufacturing and forest companies. In the meantime, Ontario maintains an unhealthy tax regime.
Moreover, the federal government has been helping Ontario industries with its own subsidies and tax reductions. The federal government has been sharply reducing corporate taxes on businesses and getting little credit from the province. Ontario is the biggest beneficiary since it has about 45% of Canada's corporate tax base and its businesses have enjoyed a much lower federal corporate tax rate, which will be 15% by 2012, down from 28.12% in 2000. The federal government has also eliminated capital taxes and replaced, in 1991, its anti-competitive manufacturers' sales tax with the federal GST. All these policies have helped Ontario.

Nonetheless, Ontario is facing a major challenge today and the Premier is right to be concerned about it. It would a real blight on his record if Ontario is declared a have-not province - its per-capita GDP has already tracked down to be close to the national average.

Canada is undergoing a major restructuring of its economy as Asian economic growth has created a continuing commodity boom:High prices for Canada's agriculture and resource industries will continue for at least a decade and half, repeating the 1950s and 1960s, when Canada had its last commodity boom and high dollar. Ontario's forest sector, which is in the doldrums now, has a better future. Its woes reflect the decline in demand for housing in the U.S., induced by the subprime mortgage fiasco, which will work itself out in the next few years.

Ontario will find that its northern and rural areas will benefit from the boom, but manufacturing industries, which only make up 20% of Ontario's economy (less than services, finance and insurance), will be challenged to maintain competitiveness.

All this raises a very troubling issue for Ontario. It can provide relief for specific industries, but to protect them from a world economy that is vastly different would mean large subsidies for a long period of time. Instead, the federal strategy of pursuing broad policy support that allows the market to sort out how best to be competitive seems far better. It allows resources to move to those business activities with the best economic returns.

It is sometimes argued that a targeted approach to industrial policy, similar to Asian countries like Korea, Singapore, Malaysia and Taiwan, can be successful. However, these countries aimed their support to grow new industries, not to support declining ones. The policies, generally fiscally costly tax holidays, require companies to perform according to certain standards, thereby blunting their effect on investment. It is questionable that targeted tax-relief measures and subsidies have been any more successful than the broad industrial support measures provided in Hong Kong, Chile and Ireland, which have grown equally well. Most countries, as they grow richer, see their manufacturing base move to low-cost countries. Meanwhile, they attract high value-added production involving business services and intangibles.

Overall, the Flaherty approach is right. Ontario needs to rethink its industrial strategy. Targeted subsidies won't cure competitiveness problems. Ontario should consider revamping its tax structure and look at other broad polices to support its industrial structure.

--- - Jack M. Mintz is the Palmer Chair of Public Policy, University of Calgary.
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