Most economists would agree that reforming our tax system is imperative and that it is perhaps one of the most important conditions for improving the productivity and growth of the Canadian economy. While a substantial part of the fiscal room avail- able in recent federal budgets has been used to provide tax relief, efforts have focused largely on reducing tax rates rather than implementing more substantial reforms of the tax system. Of course, some of the most important measures that have been taken include reductions of the GST rate and of corporate income tax rates.
However, what really matters for economic efficiency and growth is not so much the overall level of taxation but the form of taxation. In fact, cross-country evidence gener- ally suggests that economic growth is more sensitive to the tax mix of countries than it is to the share of government revenues in national income.
A non-exhaustive list of tax policy areas where reforms could contribute to making the tax system more growth-oriented, and which will be the focus of the discus- sion below, includes the treatment of savings in the person- al income tax system, the differential effective taxation of capital investments across industries and sales tax harmonization. With respect to the last two of these, much remains to be done. With respect to the tax treatment of savings, an important step was taken in the 2008 budget with the introduction of tax-free savings accounts (TFSAs). This new saving instrument will help in moving, to some extent, the personal income tax system toward a consump- tion base as opposed to an income base. As a result, it will likely lead to increased savings and investment.
There are different ways of shifting the overall tax sys- tem toward a consumption base. One option is to rely more heavily on indirect taxation (sales taxes). However, doing so restricts the degree of progressivity that the tax system can achieve. Another option is to use direct personal taxation but define the tax base so that it reflects consumption rather than income. Again, different approaches to do so are avail- able depending, among other things, on the treatment of savings and capital income. As with the tax treatment of registered retirement savings plans (RRSPs), savings can be deducted from the personal income tax base, but later taxed, along with the capital income earned, when the funds are used for consumption. Alternatively, savings can be included in the tax base, but not the capital income earned, as will be the case with the tax- free savings accounts.
Using a consumption base is gen- erally considered more efficient and more equitable than using an income base, for a number of reasons. A tax system that uses an income base effectively taxes savings and capital income, which increases the cost of future consumption relative to that of current consumption. Therefore it dis- torts the optimal allocation of con- sumption of individuals over time.
For the economy as a whole, taxing capital income reduces savings and investment. Even though there is fair- ly high capital mobility across coun- tries, so that domestic investment can be financed by foreign savings and domestic savings can be invested abroad, the level of domestic invest- ment is not independent of domestic savings. Ultimately, the relatively low supply of domestic savings reduces capital accumulation and productivity growth. Indeed, the taxation of capital income is generally found, at the cross- country level, to have a significant negative impact on investment and economic growth.
As a result of its impact on invest- ment, the efficiency cost of capital income taxation is much higher than the efficiency cost of a consumption tax. Hence, transferring part of the overall burden of taxation from capital income to a consumption base can generate substantial net gains for an economy. Such a transfer of tax burden reduces the total amount of resources that are effectively taken away from the private sector in order to generate a given amount of government revenues.
Aside from efficiency and growth considerations, there are also equity arguments that would favour using a consumption base. For one, it may be more equitable to tax con- sumption if we take the view that con- sumption, rather than income, better reflects the well-being of individuals. Because of inheritances and bequests, among other things, individuals’ dis- counted lifetime income and con- sumption may not be equal. More importantly perhaps, using a con- sumption base treats more equitably individuals who make different choic- es about how to allocate consumption over their lifetime. Under income- based personal taxation, among indi- viduals with the same lifetime pattern of labour income, those who save more for retirement or other purposes will face higher total tax liabilities than those who save less, which would generally be viewed as inequitable. Finally, a tax system that uses a con- sumption base will usually treat more equitably individuals with fluctuating incomes by allowing for better averag- ing of taxable income over time.
Overall, the introduction of tax- free savings accounts is a growth-ori- ented tax policy measure with desirable efficiency and equity proper- ties. It is also a tax reform measure with little revenue cost for the federal government in the short run, which is particularly suitable given the relative- ly small fiscal room that is projected for the next few years.
Although increasing further the contribution limits to RRSPs would also shift the tax base closer to a consump- tion base, the short-run revenue cost for the government would be much higher. In any case, there are also ben- efits from allowing both types of saving instruments, in particular for individu- als who expect their incomes to grow significantly over their lifetime.
Apart from the tax-free savings accounts, the budget did announce other growth-oriented tax policy measures, including the three-year extension of the accelerated capital cost allowance for new investments in machinery and equipment. However, relatively little progress has been made in the current and previous budgets on two critical fronts: achiev- ing more uniformity in the effective tax rates on capi- tal investments across industries and sales tax harmonization.
Effective tax rates on capital investments vary significantly across industries. They are generally lower in resource and manufacturing industries and higher in service sectors. Even though the scheduled reductions in corporate income tax rates will con- tribute to mitigating this problem, the disparities in effective tax rates that result from the differential treatment of capital investments in different industries will remain. Differences in effective tax rates distort the allocation of resources across sectors and ulti- mately reduce the economy’s overall productivity. The relatively lower effective tax rates in resource indus- tries may be particularly harmful in the current context of high resource prices, given that they likely exacer- bate the large flows of production fac- tors toward resource industries.
Although inter-industry variations in effective tax rates partly result from provincial and municipal tax policies, the lack of uniformity in the treatment of different types of investments and of investments in different sectors by the federal tax system also contributes to the problem. Addressing this issue should be a high priority.
Of equally high concern is the lack of sales tax harmonization in the federation. In order to maximize eco- nomic efficiency, all general sales taxes should be value-added taxes using an identical base in all provinces and at both levels of government. Although the problems largely arise from the use of single-stage retail sales taxes in five provinces (Prince Edward Island, Ontario, Manitoba, Saskatchewan and British Columbia), it is quite clear that harmonization of provincial sales taxes, either with the GST or otherwise, will occur only if the federal govern- ment provides financial incentives for provinces to do so. It may have been appropriate to use part of the $10-bil- lion surplus for that purpose.
The lack of sales tax harmoniza- tion is possibly one of the greatest impediments to the productivity and competitiveness of the Canadian econ- omy. Provincial retail sales taxes are highly inefficient compared with value-added taxes, such as the GST.
Retail sales taxes are levied on some business inputs, which results in the multiple taxation of value added. Of course, value-added taxes are not sub- ject to this problem. Thus, the existence of retail sales taxes creates a competitive disadvantage for domestic firms relative to foreign firms in domestic as well as in foreign markets, given that most countries use value-added taxes. To the extent that the taxation of business inputs is not uniform in all production activities, it may also distort the alloca- tion of resources across sectors, reduc- ing aggregate productivity.
Another problem with retail sales taxes is that they are imposed on several capital goods, which increases the effective tax rates on capital and reduces investment. Estimates of effec- tive tax rates generally indicate that not only are Canada’s effective tax rates on capital relatively high com- pared with those of other countries, but a substantial share of these effec- tive tax rates results from the imposi- tion of retail sales taxes on capital goods.
In addition to the negative effects of retail sales taxes on investment and competitiveness, the lack of sales tax harmonization across provinces and levels of government reduces the effi- ciency of the internal common mar- ket. The differential treatment by the sales tax system of producers located in different provinces dis- torts the efficiency of inter- provincial trade and the optimal allocation of pro- duction. The lack of sales tax harmonization also increases the administra- tion and compliance costs of firms that are active in multiple provinces or that engage in interprovincial transactions.
These problems would largely go away if provinces agreed to harmonize their sales taxes with the federal GST, as was done when the harmonized sales tax was introduced in Newfoundland, Nova Scotia and New Brunswick in 1997. At the time, the federal government offered generous financial incentives to these provinces, and it would likely need to do the same in order to convince the five provinces that still use retail sales taxes to participate in a similar agreement. Using any available fiscal room in the near future for that purpose should be considered a high priority.