Post on 13-May-2023
The GST Cut and Fiscal Imbalance
Michael Smart
and
Richard Bird
University of Toronto
Revised version
3 April 2007
Many public finance economists think that consumption taxes, especially value-added
taxes like the GST, are about the best way we know to collect revenue for public
purposes. No tax is perfect; but as taxes goes the GST is, at least to an economist, about
as good as they get. At first sight, the federal government‘s commitment to reducing GST
rates is thus not very appealing from an economic perspective: if any rates are to be cut it
should be income tax rates. Nonetheless, cutting the federal GST rate may, if done right,
make a good deal of sense for Canada.
To understand why we say this, one must go beyond the simple pleasure any Canadian
taxpayer must feel at the prospect of any rate cut, anywhere, and begin to think more
broadly of the potentially critical role a federal GST reduction might play in resolving a
broad range of fiscal and economic issues currently confronting Canadian policy-makers
at all levels of government.
Consider first the famed ‗fiscal imbalance‘ of which we have heard so much in recent
years. Essentially what this discussion is about is simple: at current tax rates the feds
have more revenue than they need for ‗their‘ expenditures, and the provinces (as a
group) have less revenue at their current tax rates than they need for ‗their‘ expenditures.
2
So far, we have closed the resulting ‗gap‘ essentially by moving large amounts of federal
revenues to provincial expenditures through intergovernmental transfers. This transfer
system served Canada well for decades. Now, however, it is, if not broken, then badly
bent. It is certainly under strong attack from all sides, albeit often for contrary reasons.
Some want more money for the provinces with fewer strings; others want more money
with more strings to ensure it goes to whatever they support; still others think the result
of shifting taxpayer money around this way has on the whole been bad both for economic
development and political accountability.
One solution is simply to ‗rebalance‘ the federal fiscal structure by reducing federal tax
rates and thus federal revenues, while at the same time reducing transfers to the
provinces by about the same amount. For example, a further GST rate cut of 2
percentage points would cost about $10 billion in lost federal revenues. In addition to
the cut, federal transfers might also be cut by $10 billion – leaving the provinces $10
billion short in revenues, which doubtless they would perceive as something of a
problem. But we suggest that this ‗problem‘ is better be seen as an opportunity not only
to make Canada‘s fiscal structure more rational in terms of who pays for what but also, if
the provinces do as we think they should and seize the occasion to shift to a more logical
consumption tax base, more ‗growth-facilitating‘ at the same time. Indeed, we think it
may also stimulate moves towards a more fiscally sustainable health system than we now
have in place. How all these good things can be done is the topic of this paper.
We proceed as follows. First we describe the broad outlines of Canada‘s present fiscal
arrangements, and explain why we think a reduction of cash transfers and realignment
of federal and provincial tax rates would benefit the federation. Next we turn to the
specifics of how consumption taxation can best be shifted from Ottawa to the provinces,
focusing on the difficulties in doing so in the five provinces – British Columbia,
Manitoba, Prince Edward Island, and Saskatchewan – that currently operate so-called
retail sales tax (RST) systems, rather than value-added tax systems similar to the federal
GST. We then estimate the surprisingly considerable benefits that would flow from
simply reforming provincial RST systems. Finally, we sketch more briefly how and to
what extent the equalization system would have to be adjusted to accommodate such a
shift in taxation and conclude by touching on the potentially beneficial implications of all
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this for dealing with Canada‘s major expenditure problem – what to do about public
health spending.
Transfer Games
Under our current system, the fiscal gap between Ottawa and the provinces is large and
persistent. Currently the federal government raises some $40 billion in taxes each year
that it simply transfers to the provinces to spend on health, education, and social services
The result is what can only be described as Canada‘s ‗co-dependent‘ constitutional
relations: with our current fiscal arrangements, Ottawa raises the money, and the
provinces spend it. The result of this fiscal churning is that no government has clear
responsibility for delivering key programs, and both sides readily blame the other when
something goes wrong.
The dynamics of the blame game are evident in the history of the Canadian Health and
Social Transfer (CHST), where the level of federal cash allocated to the program has been
increased in virtually every federal budget since the initial cuts of 1995 (Smart 2005).
The result is a federal government that is unable to commit credibly to a stable transfer
system with clear and consistent incentives. Provincial governments have little incentive
today to set their own fiscal houses in order, since spending restraint weakens the case
for future increases in federal transfers.
Of course, federal bailouts of provincial spending tracks inevitably come at the expense
of federal taxpayers — who are provincial taxpayers and voters as well. Shouldn‘t this
eliminate incentives for the provinces to attempt to finance provincial spending with
federal revenues? Not in the current environment, given the extent to which federal
transfers are borne by taxpayers in only two provinces (Ontario and Alberta), and the
evidence that each province may obtain its own deal from Ottawa through bilateral
negotiation. In these circumstances, federal tax revenues are in effect a ‗common pool‘
of resources that is available to whoever is the first to exploit them. Like all poorly
managed common property resources, the result is an inevitable tendency to
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overexploitation. We end up with a race among provincial governments to exploit
taxpayers who reside in other provinces through federal transfer negotiations.
The common-pool problem cannot, however, explain the observed tendency for even the
have provinces to push for greater per capita federal transfers, since the only reasonable
expectation is that equal per capita transfers will be financed disproportionately by
taxpayers in Ontario and Alberta (Ontario Chamber of Commerce 2005). Current
transfer arrangements, then, create a further problem of ‗fiscal illusion‘ on the part of
voters and their elected leaders -- as Winer (1983) pointed out decades ago. When the
premiers call for more federal transfers, they pretend this could be done without
increasing the federal tax and debt burden on their own citizens. Naturally, the premiers
would like to spend more without raising taxes themselves. It is only the current system
of murky shared responsibility that makes this seem like more than a pipe dream.
The point is that, in the absence of clean lines of accountability in tax and spending
decisions, the current policy stance of both federal and provincial governments is self-
reinforcing: Canada is stuck in a sort of ‗low-level‘ intergovernmental fiscal equilibrium.
The real issue facing Canadian taxpayers is whether further increases in public health
care spending per capita are warranted, or whether more fundamental reforms to the
health system are desired. But provincial governments have little incentive to frame the
question this way for voters when the option to argue for transfer increases is available.
The federal government too faces an implicit incentive to accommodate provincial
demands, as long as voters apparently reward federal governments that do little more
than write larger and larger cheques. What is needed is a reform that improves
accountability and helps to eliminate these transfer games.
A properly designed tax point transfer would put an end to the continued renegotiation
of federal transfers and the resulting fiscal illusion for voters. If provinces wished to
spend more on health care they would have to increase taxes directly, and face the wrath
of voters on election day if their decisions were the wrong ones. The change might
increase voter satisfaction with the federal government as well. No longer would federal
tax payments seem to disappear into thin air. Both levels of government would have
much stronger incentives to act responsibly. That all sounds good – at least to us – but
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the question is: how can it be done without wrecking Canada‘s sometimes precarious
regional and political equilibrium?
Moving to Provincial Consumption Taxes
As we have said, a reduction in federal cash transfers would have the desirable effect of
taking the federal government out of the cabinet rooms of the provinces. But it might
leave those seated in those rooms, particularly in the poorer provinces but not only there,
in a bit of quandary about how to meet their bills. Some realignment of taxes in the
federation will also be required. Some commentators1 have suggested that the solution
to fiscal imbalance is in fact now a very simple one: as the federal government reduces
the GST rate, the provinces can simply increase their own sales taxes unilaterally if they
choose, in effect transferring tax powers without further reforms or negotiations between
levels of government. But two wrongs don‘t make a right:2 the sales taxes currently
operated by a majority of the provinces are extremely badly designed, and they should
not be substituted for the relatively efficient though unpopular federal GST. One key
issue is that Ontario, Manitoba, Saskatchewan, British Columbia, and Prince Edward
Island operate what are usually called ‗retail‘ sales taxes – though they certainly do not
apply only to retail sales to final consumers – with bases very different from the federal
GST. This difference in bases creates a problem for shifting tax effort to the provinces,
but it creates an opportunity for reform as well. Lesser issues are that Quebec‘s sales tax,
the QST, while a VAT like the GST, is not levied on exactly the same base, and, more
importantly, that under the present HST imposed in Nova Scotia, New Brunswick and
Newfoundland and Labrador, the provinces are unable to decide on their own tax rates.
The federal government‘s commitment to reduce the GST should be seen as an
opportunity finally to reform the provinces‘ badly broken retail sales tax (RST) systems
and also to alter the HST legislation to permit provincial determination of their own tax
rates.3 Admittedly, earlier federal governments had only limited success in getting
1 For example, John Ibbitson, ―The fiscal imbalance bogeyman,‖ The Globe and Mail, March 3, 2006, p. A4. 2 In fact, in the theory of taxation, two wrongs often do make a right, a concept known as the ―theory of the second best‖. This is not one of those times. 3 As discussed later, while it would clearly better – not least for Quebec residents – if the QST was imposed on the same base as the GST, this is not a critical issue. Experience shows that the system can function so long as the base differentials are not too great.
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agreement with the provinces on ‗harmonizing‘ sales taxes, in part, we think, because of
the unduly restrictive (uniform rate) way in which the feds defined harmonization. The
important new factor is that the current federal government has demonstrated
willingness to reduce the federal tax rate on the value-added base. That opens up ―tax
room‖ that brings with it useful room to negotiate with the provinces for a better sales
tax system for all Canadians.
Before dealing with the situation in the RST provinces, let us consider the easier case of
the four provinces that have already adopted value-added bases for their sales taxes. In
our proposal, further reductions in the federal GST rate would be accompanied by
corresponding reductions in federal cash transfers. In the VAT provinces, governments
would have a unilateral option to increase their own rates or not – they might cut
expenditures or raise some other tax if they prefer.
This approach would of course be simplest in the three HST provinces (Nova
Scotia, New Brunswick, and Newfoundland and Labrador). Ideally, they would
simply have maintained the 15% rate, with a new 10/5 split instead of the
previous 8/7 split. Since the HST rate has now been cut to 14% -- an 8/6 split –
they should at the very least maintain the 14% rate, with the split becoming 9/5
in favour of the provinces and, when they get their courage up, and fiscal needs
press, eventually go back to the 15% level (and a 10/5 split) or, alternatively, the
rate might stay at 14% and the federal share go down to 4%. As we discuss
elsewhere, it would in any case be best if they were also freed from the present
requirement to impose uniform rates, but this is not essential.
While the Quebec Sales Tax (QST) has a slightly different base than the GST, it
too is a value-added tax and so it would not be difficult for Quebec too to juggle
the present QST rate to make up any transfer loss.4 Again, while it would be
better if the QST and GST bases were further harmonized, it is not essential.
4 To be revenue-neutral in Quebec, the tax point transfer would be a little more complicated, since the QST taxes sales including the GST itself. So to keep the total rate of tax constant in Quebec at the level that applied before the current reforms, each percentage point reduction in the federal GST rate must be accompanied by an increase in the provincial rate of about 1.01 percentage points.
7
The situation of Alberta is special because (lucky Alberta!) it has no provincial sales tax
of any sort. Given attitudes to sales taxation in Alberta, and given its current fiscal
environment, the province must be regarded as unlikely to occupy any room vacated by
Ottawa.5 For some, indeed, this is a further virtue of the proposal, since it would tend to
reduce the pressures on the federation caused by the rising tax revenues per capita in
Alberta.6
The other five provinces all face both a problem and an opportunity. The problem is that
raising their present RSTs is a very bad idea in economic terms – and likely not an easy
sell politically either. Of course, these provinces could have moved to a VAT like the
GST/HST or the QST earlier. They have not done so in all likelihood because the only
way to keep the rate of the new Provincial Value Added Tax (PVAT) 7 reasonable would
be to expand the tax base considerably, particularly in terms of services, and the likely
political reaction to what would be seen by most as a new ‗tax grab‘ can readily be
envisaged by anyone who remembers the screams still echoing down Canadian political
halls since the initiation of the GST 15 years ago.
On the other hand, these provinces also have a rare opportunity in that if they use the
occasion to move to a more general value-added tax base like the GST, they would
substantially reduce the current tax on competitiveness imposed because half or more of
the so-called ‗retail‘ sales tax is actually imposed on intermediate business sales and
investment. This would obviously be economically a very good idea not just for these
provinces but for the country as a whole. In this era of global competitiveness when jobs
are always to some degree on the edge of moving to Bangalore or Shanghai from
Brampton or Winnipeg, Canada – and every province – should be removing such excess
baggage as competitiveness-penalizing taxes like RSTs.
5The territorial governments would, however, face a problem because they have neither a sales tax or yet any substantial resource revenues to cushion the blow of any possible transfer reduction. But the territorial transfer is in any case a separate matter that we do not get into in this paper. 6 In this view, the recent increase in Alberta‘s fiscal capacity is seen as undesirable, inasmuch as it is not equalized under Canada‘s ―gross‖ approach to Equalization transfers. A transfer of tax room that only Alberta is unlikely to occupy therefore reduces differences in revenues per capita among provinces and so provides a form of implicit ―net‖ equalization. Naturally, equalization of this kind need not make Alberta taxpayers worse off: their tax liabilities would fall. 7 We label the new tax the PVAT because, as we discuss below, it need not follow either the QST or the HST models.
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VAT Good, RST Bad
The essential public finance criterion for evaluating a tax is its neutrality. The principle
of neutrality holds, loosely, that taxation should raise the revenue required by
government while leaving the relative size of all sectors of the private economy
unchanged. RSTs violate neutrality for a number of reasons. In particular,
RSTs exempt many types of consumption, chiefly services and intangibles, from
taxation entirely, and for the most part do so in arbitrary way that has no policy
justification.8 The resulting changes in relative after-tax prices of various goods
and services are likely to lead to large departures from tax neutrality, as some
sectors of the economy are artificially favoured at the expense of others.
RSTs tax many purchases of intermediate inputs by businesses, while having no
provision for rebating tax paid on inputs, as in a value-added tax system. Indeed,
as we shall see, a remarkable proportion of provincial ‗retail‘ sales tax revenues
actually come from taxing business inputs. The issue here is not one of the ‗fair‘
burden of taxes on business and individuals, as it is usually phrased; taxes on
business inputs will ultimately be borne by consumers anyway, in the form of
higher prices for final goods. Rather, the problem is that different firms and
different sectors of the economy rely on purchases of inputs subject to RST to
different degrees, resulting in unequal increases in costs of production and
prices, and so to further departures from neutrality and competitiveness.
Related, and probably most important, provincial RSTs tax purchases of most
capital goods by firms. Taxes on capital are especially undesirable, inasmuch as
they have long-lasting effects on the economy, limiting the growth of the capital
stock and reducing the long-run growth of productivity and employment.
Approximately one-quarter of the marginal effective tax rate (METR) on capital
in Canada is the result of taxes on business inputs (Chen and Mintz, 2003).
Some provincial governments in recent years have devoted much attention and
8 The sad tale is set out in detail in Robinson (1986): nothing much has changed, and certainly not for the better, since this study was written.
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political capital to reducing their ‗headline‘ rates of corporate income taxation; a
simpler and perhaps more effective (though less visible) choice might be simply
to eliminate the RST‘s implicit tax on capital by moving to value-added taxation.
These problems with the RST base, as emphasized by Dahlby (2005), may be hidden
from public view but are far from inconsequential. Baylor and Beauséjour (2004) report
results of various simulated tax reforms from a dynamic, computable general
equilibrium model of the Canadian economy. According to their estimates, the marginal
cost of a dollar in revenue raised by provincial governments through sales taxes on
capital is about $2.30, compared to a mere $1.13 for consumption taxes like the
GST/HST. Since, as reported below, a move from provincial RSTs to the GST base
would reduce taxes on capital by about $1.5 billion at current rates of taxation, a very
rough calculation suggests the potential long-run gains for the economy could be as high
as $1.75 billion.9
Fiscal consequences of reform
The chief differences between the GST and RST bases are:
The aforementioned tax on capital and other business inputs under the RSTs.
Many services, even those consumed as final demand and purchased at the
‗retail‘ level, are exempted from taxation under the RSTs. Some, notably
financial services, are also exempted under GST.
Consumption of housing services is exempt under the RSTs: that is, payments of
rent are untaxed, and purchases of owner-occupied housing are untaxed as well.
The GST also exempts market rents and implicit rents to owner-occupied
housing, but it taxes purchases of houses new houses, albeit at a lower rate for
properties valued at less than $450,000.10
9 The Baylor-Beauséjour estimate is valid only for small tax changes, and the benefits to large scale reform may be somewhat smaller. Note that this calculation excludes the economic benefits of eliminating RST taxes on non-capital business inputs. 10 There is a 36% rebate (effective GST rate of about 4.5% when standard rate is 7%) for new houses valued at less than $350,000, with the rebate progressively decreasing to zero for houses valued over $450,000. There is a similar system under the QST, but the starting and ending points are much lower ($200,000 and $225,000, respectively).
10
These differences mean that a move by the provinces from their current RST bases to any
true value-added tax base will potentially have large revenue consequences, and will
surely result in big changes in the level of sales tax rates required to produce a revenue-
neutral result. Just how big, however, is an open question. As we show below, only 60 to
80 per cent of the personal expenditure portion of the GST base is taxed under the
provincial RSTs. Furthermore, revenues from taxation of business inputs constitutes
nearly half of RST revenues. The implication is that a move to value-added taxation
would essentially transfer statutory tax liability from business inputs to services. A
closer look at the data suggests some qualifications to that view, however.
As a simple way to present the implications of the base switch, suppose that provinces
move to the GST base, including similar treatment of the ‗MASH‘ (municipal, academic,
schools, and hospitals) sector and of financial services11, similar exemptions (including
the quite illogical ‗basic foods‘ exemption), and zero-rating of exports (including
interprovincial exports, as in the QST) but continue to apply the same statutory rate s
they do under their current RSTs.12 Table 1 presents estimates of the impact of such a
change in the distribution of tax collections from different sectors in each province in
both absolute and per capita terms as well as on total provincial revenues. What we see
is:
Big reductions in statutory burdens on business and especially, in revenue terms,
on current business inputs. We stress that this says nothing about the ultimate,
economic incidence of the proposed tax reform: the only reasonable surmise is
that RST taxes on business inputs are ultimately paid by consumers of final
demand goods and services produced by businesses (or workers employed by
them) so that the proposed reform would in the long run result in a decline in
consumer prices (or an increase in wages) that would offset most or all of the
change indicated in Table 1. As we stressed earlier, however, the important
economic point is that under the RSTs this tax burden is distributed among
11 Note that this does not mean that the GST treatment of these sectors is ‗ideal‘: for an argument that it is not, see e.g. Bird and Gendron (2005). 12 In Prince Edward Island, where the RST base includes GST payments, the statutory tax rate would rise to keep the effective provincial rate constant.
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consumers and industries in an essentially arbitrary way unrelated to their
contribution to national or provincial value-added.
These calculations suggest, somewhat surprisingly, that the taxes initially
imposed on services would indeed increase, but not by very much. This reflects
the rather low effective tax rates on services under the federal GST, as well as
some recent base-broadening reforms in RST provinces that have made parts of
the service sector subject to RST. Effective tax rates are low under the GST
because of the tax-exempt status accorded many large services industries,
including most of the finance, insurance and real estate sector, the health sector,
and the`MASH‘ quasi-governmental sector. We stress that tax-exempt status
implies these sectors do pay some tax under the GST, which is included in the
business inputs section of the table and netted out from the much larger
reduction in input taxes that results when provincial RSTs are removed.
Furthermore, many of the aforementioned service sectors are accorded large
rebates for input taxes under the GST – they are nearly zero-rated rather than
tax-exempt – so that total taxes paid on outputs and use of these sectors are
indeed small. In summary, sales tax harmonization in Canada would result in a
much smaller increase in taxes on consumer services than is generally believed to
be the case.
Taxes on the final demand in the housing sector would rise, primarily because the
GST taxes sales of new houses (albeit at a reduced rate). However, the
construction industry also faces one of the highest effective tax rates on business
inputs under the RSTs, as evidenced by the large decline in input taxes under our
proposal in table 1. (At a rough guess, about half of RST taxes on construction
inputs relate to residential buildings, and half to non-residential structures.)
Thus the reforms would lead to reductions in construction costs that offset much
of the new explicit taxes on housing, leaving changes in true economic tax
burdens that are relatively small. Naturally, these changes are most important in
Ontario and British Columbia, where residential construction is booming.
On balance, provincial revenues would change relatively little – this is nearly a
revenue neutral reform for all provinces. Indeed, the net revenue impacts in
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Table 1 are based on the assumption that the RST provinces would adopt exactly
the tax exemptions and rebates for various sectors that are available under the
federal GST.13 In fact, reforming provinces would have considerable freedom to
increase their revenues under the revenue by reducing the rebates available to
tax-exempt or favoured sectors – just as the HST provinces did in 1997
Notwithstanding the small overall revenue impacts of the reform, the difficulty for
governments is to replace the hidden taxes of the RST with visible ones. The federal
commitment to reduce GST rates might however create political as well as fiscal room for
RST provinces to undertake the reform. Further encouragement from the federal
government may perhaps be needed, either in the form of ―transitional assistance‖
similar to that offered to HST provinces in the 1997 reform, or by bundling the tax
harmonization with other reforms in federal transfers or aspects of the economic union
of mutual interest to federal and provincial governments.
The HST required a common rate in all harmonizing provinces. In principle, however,
this feature seems quite unnecessary and indeed undesirable. If, as we think is
necessary, provinces are to become more responsible and accountable for their own
expenditures, and if, as we think is desirable, they choose to do so in a rational way by
increasing a ‗good‘ consumption tax (VAT) rather than a ‗bad‘ one (RST), then they
should be able to do so at a rate of their own choice. As Bird (2005) shows, a system
with differentiated provincial rates (on a similar base) can be administered with no
technical or administrative problems.14 As the QST shows, a different rate can work:
who runs such a system – the CRA, the MRQ, a new ‗consortium‘ of provinces is very
much a second-level issue. A properly designed ‗dual VAT‘ system can work with any of
these arrangements, as indeed Canadians already know.
As the QST also shows, for better or worse, not every province has to have exactly the
same tax base. See Table 2 for a list of the differences between the GST/HST system and
13 This assumption is required given our data on the GST, which presents revenues net of the effects of the existing exemptions and rebates. 14 It is, for example, no more difficult for the Canada Revenue Agency to distribute HST revenues to participating provinces – a distribution based on estimated provincial consumption data – when rates differ than when rates are the same. Similarly, it adds nothing to compliance costs if suppliers (who already have to charge different amounts of tax depending on whether they ship to an HST, PST, or QST province) had to charge different PVATs depending on the province of shipment.
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the QST. Not all of these differences may make economic sense, but then no tax base in
any real world jurisdiction does either. The point is that some variation can readily be
accommodated within a dual-VAT system: again, Canadians already know this. Of
course, the fewer such variations the lower compliance (and administrative) costs, so the
fewer the better. But provinces that want to demonstrate their independence by making
bad policy decisions that are different than those already made by the federal
government should, within broad limits, be free to do so – so long as they do not act in
ways intended to shift tax burdens outside their borders (the ultimate ‗politically-good
economically-dumb‘ policy).
An alternative reform model would transfer the entire GST base to the provinces, in
exchange for still further reductions in transfers or for the provincial CITs. We are not
keen on the provincial CIT but we do not think that the federal government should get
out of the GST game. 15 We are concerned that this would undermine the critical role of
the federal government tax in helping to maintain a coherent set of provincial VATs. It is
primarily because both levels of government are in the VAT game that Canada, unlike
any other country in the world, already, has a relatively good ‗two-level‘ sales tax system
(Bird 2005). 16 To make it a really good system, as we argue here, what is needed is for
the remaining provinces to get on board the VAT train. To do so, as we argue in the next
section is very much in their own interests. It is a win-win situation: the provinces win,
and so does the country.
Moving to value-added taxation: A look at the evidence
The economic benefits of removing taxes on capital and other business inputs have
perhaps appeared to provincial governments too abstract to be acted on, especially
relative to the long-apparent political costs in Canada of replacing hidden taxes on
consumption with transparent ones. As a preliminary step to making the potential gains
more tangible, therefore, it is worthwhile to examine the actual experience of
15 See e.g. Mintz and Smart (2004 ) on the economic costs of provincial CIT competition and Bird and McKenzie (2001) for a proposal for an alternative form of provincial business tax. 16 Those interested in more detailed discussion of this question are referred to e.g. Bird and Gendron (2001) and the exchange between Keen and Smith (2000), McLure (2000), and Bird and Gendron (2000).
14
Newfoundland and Labrador, Nova Scotia, and New Brunswick since introduction of the
HST in 1997. Figure 1 presents a graph of total private investment per capita17 in 1997
dollars for the 1986-2004 period, on average for the HST provinces and the five
provinces that have retained their RSTs.18 The figure shows that, in the years prior to
the reform, investment per capita was considerably lower in the reforming provinces
than others, reflecting the traditionally lower levels of GDP per capita and of capital per
unit of GDP in the Atlantic provinces; however, year-to-year variations in the two
investment series track each other very closely, as both were affected by nationwide
economic shocks. That pattern changes dramatically following the 1997 sales tax reform
(the vertical line is between 1996 and 1997) as investment per capita in the reforming
provinces began to rise, particularly relative to investment in the provinces that retained
their RSTs. Notice however that the sudden rise in relative investment appears to slow
or even reverse after 1999; this is as expected, since a reduction in the effective tax rate
on capital goods should lead to a permanent rise in capital per unit of output, but not a
permanent rise in investment flows.
Of course, the pattern displayed in Figure 1 is only suggestive of the possible impacts of
sales tax reform, and many other factors may have caused the run-up in relative
investment rates in HST provinces. For example, it may reflect a general rise in
economic growth in the HST provinces, rather than investment per se; it may reflect
long-term trends in the HST provinces unrelated to the reform; and it may reflect
changes in the relative cost of capital there that have nothing to with taxes. To address
some of these concerns in a simple way, we present in Table 3 estimates of the effects of
HST reform on investment based on a multiple regression strategy. In each of the
regressions, the logarithm of real investment per capita in each of the nine provinces is
regressed on the logarithm of real provincial GDP per capita (to control for provincial
business cycle effects) and a dummy variable equal to one in years and provinces for
which the HST was in place and equal to zero otherwise. All regressions also include
estimated fixed effects for each year and separate estimated linear trends for each
province, not reported in the table. That is, this approach allows for the possibility that
investment was on average higher in Canada after 1997 for reasons unrelated to sales tax
17 The data are for business gross fixed capital formation, from the Provincial Economic Accounts. 18 We exclude Alberta from both groups. We include Quebec in the VAT group although the QST continues to tax some business inputs, and did so to a greater extent at its inception (when services were also taxed at a lower rate) and, despite gradual reforms, its base remains slightly different from the GST/HST base, as shown in Table 3. Excluding Quebec from the VAT group does not alter the picture significantly.
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reform, and say that investment grew faster over the sample period in Newfoundland
and Labrador (a HST province) than in other provinces for reasons unrelated to sales tax
reform.19
In the leftmost column of figures in Table 3, the dependent variable is real gross fixed
capital formation per person, as in Figure 1. The estimated coefficient of 0.11 for HST
dummy variable indicates that investment per capita was 11 per cent higher in HST
provinces in post-reform year than in RST provinces in post-reform years. However, the
estimated t-statistic of 1.48 indicates that this difference is not significant at the
conventional confidence levels.
The remaining three columns report estimates of the same regression equation, using
narrower components of investment as the dependent variable. In the second column,
the dependent variable is real business investment in machinery and equipment – the
component most related to economic growth (e.g. Summers and DeLong 2001). The
effect of HST reform on M&E investment is larger at 17 per cent than for the total, and
the impact is now significantly different from zero at the 95 per cent confidence level.
In the third column, the dependent variable is real business investment in non-
residential buildings per capita; the HST impact here is larger than before but not
significantly different from zero. This is not entirely unexpected, since the provincial
RSTs that the HST replaced tend to tax M&E investment more heavily than investment
in building.
The last column of Table 3 performs a further robustness check of the results, using real
investment in residential buildings per capita as the dependent variable. Observe that
HST reform should likely not have a positive effect on housing investment, since housing
final demand is taxed under the GST/HST base, and the direct negative effect of the
reform probably outweighed the indirect positive effect of the reduction in implicit taxes
on residential construction. However, if our results so far simply reflect an improvement
in asset values and investment climate in the reforming provinces relative to the others,
then the regression approach might suggest a positive effect of HST on housing as well.
The results however essentially no change in housing investment in the HST provinces
19 Certainly, investment in Newfoundland has risen with the development in recent years of the offshore oil sector. Note we address this in part in the regressions by including provincial GDP per capita as a control variable; moreover, the qualitative results of the analysis are robust to excluding Newfoundland and Labrador entirely from the data set.
16
relative to the others in the years following the reform, which reinforces the idea that the
results reported so far reflect the sales tax reform rather than other contemporaneous
factors.
We caution that these results are only suggestive, and it would be courageous indeed to
attribute all of the investment gains in HST provinces to the causal effect of sales tax
reform.20 Nevertheless, the results are quite robust and suggest an effect on relative
investment rates coincident with the reform that cannot be attributed to any of the
obvious other influences on investment in the reforming provinces.
Regional Balance
All good things have their price, of course, and the (revised) PST/GST switch suggested
here is no exception. Specifically, all provinces would now be faced with the political
necessity of persuading the constituents that they should pay what most of them would
likely consider, judging by the GST experience, ‗new‘ taxes on such previously untaxed
services, etc. The comfort level of politicians is not what good public policy is about,
however, so this concern should not be decisive.
What is more likely to prove critical are two other problems that need to be worked out
as part of the whole package. The first and probably greatest stumbling block is regional
inequality. Any reform to address vertical imbalance inevitably raises the risk of greater
horizontal imbalances. Specifically, a realignment of consumption tax rates would be
worth more to the rich provinces than the poor ones. The existing Equalization system
would deal with that automatically to some extent, ensuring that the additional
provincial tax room had the same value to all Equalization-receiving provinces.21 But
that still leaves Alberta and (to some extent) Ontario and BC getting more. To be
20 A more informative approach would be to examine the investment plans of individual firms in the two regions, to model capital accumulation and investment adjustment costs explicit with the micro data, and to control for other influences on firms‘ marginal effective tax rate on capital. 21 In fact, under the ‗New Framework‘ agreement that governs the Equalization formula for the current year, the equalization would in effect be paid for by the receiving provinces themselves. But a return to the traditional Representative Tax System approach, as is currently being contemplated by the federal government, would restore full equalization of tax point transfers for the receiving provinces.
17
absolutely clear: the ―do-nothing‖ reform proposed by some, in which the federal
government decreases the GST unilaterally and leaves provinces to raise their tax rates if
they choose, would result in an implicit transfer of resources from ‗have-not‘ to ‗have‘
provinces that a majority of provinces would likely oppose.
In past rebalancing reforms, the federal government has chipped in what is called
‗associated Equalization‘ to the poor provinces, deducting the payments from other
transfers to the rich provinces to ensure that tax point transfers have exactly the same
value to each province as an equal per capita cash transfer. Associated equalization is
controversial in the have provinces, particularly today in Ontario. However, we think the
principle of associated equalization is the best way to make deficit-neutral (at all levels)
reforms that will strengthen accountability in the federation. Nonetheless, in this case it
might not be too egregious to forget about associated equalization: since Alberta does not
have a sales tax, the transfer of tax points to Alberta would have no direct effect on the
relative fiscal situations of the provinces. The transfer of tax room to the other have
provinces, if they occupy it, would create some fiscal pressures, but these would be small
given current inequality in the distribution of consumption per capita.
Equity Issues
A second problem is that some people will simply dismiss our suggested approach as the
simple ranting of insensitive economists, apparently deprived at birth of the fine-tuned
‗equity‘ meter with which so many commentators on tax matters seem to be born. As far
as such critics are concerned, the only good consumption tax is a low one – or at least
one on something that is considered socially undesirable such as smoking or driving. We
think that this is simply wrong – a good consumption tax (such as a broad-based GST) is
both an economically sensible and a defensibly equitable way to raise revenues for
government purposes. Furthermore, however one views the equity properties of a value-
added tax like the GST, it is extremely unlikely to be substantially less progressive than
the existing RSTs.
While one of us has made this case at length in another context, it may nonetheless be
useful to sum it up briefly here (Bird and Zolt 2005). Countries use taxes for many
18
reasons – to finance government services, to encourage or discourage certain types of
behavior, and to correct market imperfections. And of course countries may also use
taxes (and expenditures) to change the distribution of income or wealth. More generally,
achieving a politically acceptable degree of fairness in taxation that allows governments
to extract funds from the private sector without adding to inflationary pressure is an
essential ingredient in achieving the quasi-constitutional and sometimes precarious
equilibrium necessary to maintain a sustainable political structure (Bird 2003). A
country‘s tax system is thus both an important and a highly visible symbol of its
fundamental political and philosophical choices.
All this is true. Equity in taxation definitely matters. Redistribution is about balancing
efficiency losses against equity gains. Moral philosophers, economists, and law
professors have long wrestled with the question of calculating equity gains. It is difficult
to discuss the benefits of redistribution without some notion of the appropriate role of
government and the success of government in fulfilling that role. In examining the
redistributive role of taxes it is equally difficult (and often not really very useful) to
disentangle the following issues: the amount of resources available to the government,
the tax regime that provides those resources, and the effectiveness with which the
government uses the resources. Even if one thinks bigger governments are good for
redistribution, it remains unclear how to estimate gains from redistribution through
progressive taxation.22
Ideas about the appropriate distributive role of taxation not only differ sharply but also
have changed over time. In the 1950s and 1960s, for instance, tax policy discussion and
to a lesser extent tax reform in many countries reflected optimism about the possibility
of constructive state action to remedy perceived ills that was engendered by wartime
experience. Most analysts at the time seem to have taken it for granted that a highly
progressive personal income tax (sometimes with marginal rates ranging up to 60 or
70%), buttressed by a substantial corporate income tax (often levied at rates on the order
of 50%), constituted the core of an ideal tax system. Consumption taxes were grudgingly
accepted as necessary for revenue purposes, but the sooner such levies could be replaced
by decent income taxes the better. The two main aims of taxation were generally seen to
be, first, to raise substantial revenue to finance the state as the engine of development
22As Browning ( 1989), shows, in some cases, redistribution may involve equity losses.
19
and, second, to redistribute income and wealth. Not only did the need for redressing
inequality through fiscal means seem obvious, but the ability of taxes to do the job was
largely unquestioned. Indeed, many optimists thought that both goals, revenue and
redistribution, could be achieved simply by imposing high effective tax rates on income.
The costs of doing so received little attention because the depressing effects of taxes on
investment, saving and growth were considered to be small.
In the not too distant past, most tax policy advisors thus saw the personal income tax as
the center of the tax universe. Countries were urged to put into place a sufficiently
effective tax administration to spread the cost of government among members of society
in accordance with some appropriate concept of ability to pay. And income—especially
the comprehensive Haig-Simons concept—was, by general agreement, the best proxy for
ability to pay. The Carter Report of 1966 represented the high point, both intellectually
and in terms of policy impact, of such thinking.
The rise of the personal income tax is a relatively recent phenomenon, even in developed
countries. Although progressive income taxes were first adopted around about the early
and mid-1800s, it was not until World War II that they became a major source of tax
revenue in most developed countries. Personal income taxes started small. Few were
taxed and tax rates were low. Wartime revenue needs, however, coupled with the critical
administrative innovation of wage withholding, turned the class tax into a mass tax. Both
the need for revenue and the desire to curb war profiteering played a critical role in the
imposition of highly progressive income tax rate structures. After the war, central
governments in developed regions continued to expand on the basis of high and growing
revenues from the progressive income tax, buttressed in many cases by the adoption and
expansion of social security (payroll) taxes which not only extended the income tax‘s
coverage of labor income but probably also improved compliance.
As the world economy slowed in the 1970s, however, concern for growth began to trump
equity, and the dominant view on the appropriate role and structure of taxation began to
change. By the end of the century, most analysts and policy makers had come to believe
that high tax rates not only discouraged and distorted economic activity but also were
largely ineffective in redistributing income and wealth. Moreover, the decline of taxes on
international trade associated with economic liberalization and widespread adherence to
20
the World Trade Organization (WTO) together with increased competition for foreign
investment caused both developed and developing countries to focus on the
international consequences of their tax systems. Growth-oriented (supply-side)
economic policies became popular, and views on the appropriate role for government
moved from dirigiste to laissez-faire, emphasizing reducing the size of state through
privatization and other means. One outcome of all these factors was that income tax
rates on both persons and corporations were cut sharply and are now almost universally
in the 20-30% range. At the same time, a new form of general consumption tax, the
value-added tax (VAT), became the mainstay of the revenue system in most developing
countries, as well as a prominent feature in almost every developed country but the
United States. (Ebrill 2001)..
What matters for income distribution are the distributional consequences of all taxes,
not just income taxes. Even in countries like Canada, in which taxes are, most agree,
moderately progressive (Sharpe, 2003), the most important redistributive tool is clearly
expenditure policy and to the extent the attempt to impose progressive taxes reduces
economic welfare the ‗pool‘ from which such expenditures can be financed shrinks. What
matters is the final distributional outcome, not the incidence of any particular piece of
the fiscal puzzle, and since a good broad-based consumption tax is the least distorting
way to raise revenue of which we are aware, the GST is not, as myth has it, a ‗bad‘ tax but
rather a relatively ‗good‘ tax. Certainly, and this is our main point here, it is a much
better tax in terms of both its allocative and distributive effects that the RSTs that exist in
a number of provinces. Nonetheless, when it comes to ‗progressivity‘ the evidence seems
to be that ‗perception rules‘ so governments attempting to make Canadians better off by
rationalizing the tax system, in this as in other ways, will no doubt face significant vocal
opposition. To the extent that it is felt that ‗something‘ has to be done in response to
such comments, instead of maintaining an antiquated and growth-destroying tax like the
RST it would be better to adjust provincial income tax credits (and, if necessary, welfare
payments) to offset any (small) perceived equity problems as a result of the tax
substitution.
Why This Should Be Done
21
We have argued that new provincial value added taxes (PVATs) could be designed to
replace the existing RSTs and some part of the federal GST, with the new tax designed
along the lines of the existing Quebec Sales Tax, the HST or – as we would prefer – a
new ‗model‘ PVAT with a uniform base (unlike Quebec) but variable provincial rates
(unlike the HST) as well as continued federal or joint federal-provincial administration.
However it is implemented, the new PVAT would achieve three important goals.
First, by shifting more tax resources to the provincial level it may – though
perhaps this is too optimistic – reduce the endless blame-shifting game to which
much Canadian fiscal federalism has been reduced in recent years.
Second, it would improve Canada‘s competitive position (and that of provinces
such as Ontario) by (1) reducing substantially the tax burden currently imposed
on business investment by the misnamed ‗retail sales tax‘ and (2) also reducing
the complexity of tax structure in general by eliminating five unnecessary and
costly retail sales taxes. Both these measures would help all Canadians by e.g.
making the country more attractive to FDI and making Canadian exports more
competitive.
Third, and most importantly, it would restore fuller responsibility to spending
governments to raise their own funds and hence increase accountability.
We conclude by sketching how this might work when it comes to health spending. Some
critics will undoubtedly see our proposal as undermining the role of the federal
government in health and other social policies, leading to a long-run decline in services
throughout the nation. Under successive governments, Ottawa has long positioned itself
to be the champion of pan-Canadian standards in health care – and cash transfers are
the carrot and stick believed to keep the provinces in line. Perhaps, but it may be time to
trust provincial governments to give their citizens the health-care systems they want.
National standards could be stifling needed reforms in the health-care system, and they
have little economic rationale, since health-care policies do not create spillover effects for
other provinces. This is in contrast to education policies, which affect the quality of our
mobile labour force.
22
While our proposal has no direct implications for the level of consolidated (federal-
provincial) spending on health care, we acknowledge that ‗hardening‘ government
budget constraints and forcing politicians to confront fiscal and demographic realities is
likely to lead to long-run, fundamental changes to the system. This is a good thing: the
system needs such change. It is not enough simply to pour public money into the
existing system. The increased demand for funds of the present system seems on the
evidence to be virtually unlimited. The only alternative is to limit growth of health care
spending, and this will surely involve ‗equality‘ access rationing, catastrophe insurance,
and price rationing in a sensible way. We must recognize as well that the fiscal flow
supporting the current equilibrium is not unlimited. It hinges on expanded productivity,
and dumping more and more money into health is not the way to expand productivity. It
seems ineluctable that a greater proportion of public resources must be devoted to
education and infrastructure in future, and less to health – or we run the risk of having
less to spend on anything. Until people stop pretending that more public money is ‗the
solution‘ we will never be able to reach a solution, and we might do a lot of damage to the
health of our economy in the process.
An important benefit of placing more of the explicit fiscal burden on the fiscally more
challenged level of government – the provinces – is precisely because it should make us
face up to these fundamental problems sooner. Moreover, and on past evidence with
good reason, we might expect that 10 minds are better than one, so to speak: that is, give
the provinces a freer hand, and a stronger stimulus, to find solutions and some of them
will indeed try different things. One of the conventional arguments for the superiority of
the federal system is that provinces are ‗laboratories‘ in which we can work out different
ways of dealing with public policy problems. One size does not fit all, but some ways of
cutting the cloth might prove better than others. Saskatchewan led the way to our
current health system in the 1950s. Perhaps it, or some other province, may equally lead
the way to a sustainable health system for the 2010s. We should let federalism do its job.
23
Table 1: Revenue consequences of implementing provincial VATs
Prince Edward British
Island Ontario Manitoba Saskatchewan Columbia
- $ millions -
Estimated change in statutory tax burdens on:
Consumers
- Goods +28 +1252 +67 +200 +353
- Services +11 +754 +70 +115 +722
- Housing +16 +1816 +73 +52 +549
Business
- Construction inputs -25 -1553 -116 -130 -519
- Other intermediate -16 -1516 -106 -119 -516
- Capital -12 -1021 -125 -79 -351
Government -4 +147 -14 -24 -15
Total -1 -121 -151 +16 +224
Tax rate 10.7% 8% 7% 7% 7%
Source: 2002 Input-Output tables and Statistics Canada calculations.
24
Table 2. Differences between GST and QST
Item Rate of Tax Treatment of Input Costs Rebates for: Municipalities Schools Universities and Colleges Hospitals Charities and other qualifying NPOs Treatment of Financial Services Sales to Federal Government Sales to Quebec Government New housing rebates Books (including audio recordings of printed books)
GST 6% of taxable sales Full Input Tax Credit (ITC) for all taxable and zero-rated sales 100% 68% 67% 83% 50% Exempt2 Taxable Exempt 36% rebate of GST if house price is $350 K or less; phased to zero rebate at house prices of $450 K or over Taxable
QST 7.5% applied to taxable sales including GST (7.95% on price excluding GST) Input Tax Refund (ITR) Subject to limits specified below1 0 47% 47% 51.5% 50% Zero-rated Exempt Exempt 36% rebate of QST if house price is $200 K or less; phased to zero rebate at house prices of $225 K or more3 Zero-rated
1. Under the QST, all financial institutions and other businesses with taxable sales above $10 Million are not eligible for ITRs on: motor vehicles (except vehicles above 3000 kg), fuel, services or parts for motor vehicles; electricity, gas or fuel (except used for the production of taxable goods for sale), telecommunications services (except for toll free and internet access services); meals and entertainment (subject to the 50% income tax deduction limit). 2. Under the GST financial institutions can only claim ITCs for operating expenses incurred solely in relation to commercial activities (taxable sales). ITCs for capital property of financial institutions are pro-rated on the basis of the percentage used in commercial activities. 3. The QST otherwise applicable to the GST rebate is also rebated.
Source: Bird, Mintz and Wilson (2006).
25
Figure 1: Gross investment per capita in HST and RST provinces
Source: Statistics Canada and authors‘ calculations.
26
Table 3: Regression-based estimates of the investment impact of HST
reform
Total Machinery and Non-residential Residential
investment equipment construction construction
HST 0.11 0.17** 0.26 0.02
[1.48] [2.11] [1.17] [0.25]
logarithm of GDP 1.34*** 1.92*** 0.96 0.90**
[4.57] [5.92] [1.26] [2.16]
Observations 190 190 190 190
R-squared 0.95 0.95 0.87 0.9
Notes: All specifications include province-specific linear trends and year fixed effects,
coefficients not reported. Robust t statistics in brackets.
* significant at 10%; ** significant at 5%; *** significant at 1%
Source: Authors‘ calculations.
27
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