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

5

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.

6

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.

8

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.

9

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.

11

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.

15

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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819-30 Chen, Duanje and Jack Mintz (2003) ―Assessing Ontario‘s Fiscal Competitiveness,‖ a paper prepared for the Institute for Competitiveness and Prosperity. Dalhby, Bev (2005), ―Dealing with the Fiscal Imbalances: Vertical, Horizontal, and Structural,‖ Working paper, C. D. Howe Institute. Ebrill, Liam et al. (2001) The Modern VAT (Washington: International Monetary Fund). Keen, Michael and Stephen Smith (2000) “Viva VIVAT!” International Tax and Public

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Mintz, Jack and Michael Smart (2004). ――Income shifting, investment, and tax competition: Theory and evidence from provincial taxation in Canada,‖ Journal of Public Economics 88(6), June 2004, pp. 1149–1168. Ontario Chamber of Commerce (2005). ―Fairness in Confederation: A roadmap to recovery,‖ unpublished working paper. Robinson, A.J. (1986) The Retail Sales Tax in Canada (Toronto: Canadian Tax Foundation). Sharpe, Andrew (2003) ―Linkages Between Economic Growth and Inequality: Introduction and Overview,‖ Canadian Public Policy 29 (Supplement).. Smart, Michael (2005). ―Federal Transfers: Principles, Practice, and Prospects,‖ C. D. Howe Working Paper, September 2005. Winer, Stanley L. (1983) ―Some Evidence on the Effect of the Separation of Spending and Taxing Decisions,‖ Journal of Political Economy, 91: 126-40.