Surprisingly, last week the Conservative Party of Canada announced that it wishes to go in the opposite direction. Instead of the income tax cuts proposed by the Liberal Party, it would cut the federal Goods & Services Tax (GST) from 7% to 5%. While the amount put into consumer's pockets ($8 billion a year) is larger than under the Liberal plan, it was surprising to see the Conservatives advocate a reduction in a sales tax, rather than an even deeper cut in income tax rates.
There have been a number of good editorials on the subject, such as this one from the National Post which supports the proposal and this one from the Toronto Star which takes the opposing view. Here's my contribution to the debate.
Taxation is necessary as it's required to generate the revenues the government needs in order to finance their activities. However, not all taxes are equal. There are a few factors the government needs to consider when deciding where to raise or cut taxes:
1. Compliance costs for the government - How much does it cost the government to collect the tax? What percentage of the revenue goes into collecting and enforcing the tax.
2. Cost to the economy - Any tax imposes a cost to the economy beyond the dollars taken away from consumers. Filling out tax forms takes away time that could be better spent doing more productive things. That harms the economy. As well, taxes discourage activity. Often that's why they're implemented - high taxes on cigarettes are often used as a measure to deter people from taking up smoking. Similarly, high taxes on gasoline are often promoted as a way to cause consumers to use less fossil fuels. But taxes on income, used to generate revenues from the government, cause a disincentive to work.
3. Who pays - Are the brunt of the taxes felt mainly by high income earners and the wealthy, or shared equally by everyone? Who feels the impact of a tax is not always apparent at first glance - a large portion of a tax on a corporation may be passed along to consumers or workers.
Based on these factors, there are two things wrong with the Conservative proposal:
1. It does nothing to reduce compliance costs, to either the government, or to consumers. In fact, compliance costs will be raised slightly in the short run, as forms, accounting software, etc. will all have to be changed to reflect the new changes in tax rates. A program of income tax simplification - say eliminating loopholes and deductions but at the same time reducing overall tax rates would reduce compliance costs.
2. More importantly, cutting sales tax rates is possibly the most inefficient way possible to stimulate economic growth. Every tax has an associated cost to the economy, which is typically measured by the concept of "marginal efficiency cost" (MEC). The MEC measures how much economic damage is done to the economy for every extra dollar generated in tax revenue from an existing tax.
An excellent 2002 Fraser Institute study titled The Corporate Capital Tax: Canada's Most Damaging Tax discusses the MEC for a number of taxes collected in Canada. It cites a 1997 federal government study which estimated the MEC for four types of taxes in Canada:
MEC in CDN$ for 4 classes of taxes
$1.55 - Corporate Income Taxes$0.56 - Personal Income Tax
$0.27 - Payroll Tax
$0.17 - Sales Tax
Thus it costs the Canadian economy an extra $1.55 every time it wishes to collect an extra dollar in corporate income taxes.
Note how that currently sales taxes are the least damaging way for the federal government to collect income in Canada. In fact, corporate income taxes, per extra dollar collected, do almost 10 times more damage to the economy than sales taxes!
Sales taxes are considered regressive, since low income earners tend to pay a higher proportion of their income on spending than high income earners. Cutting sales taxes does make the current system more progressive, but if the Conservatives were worried about the progressivity of the tax system, they could achieve much better results by slashing corporate taxes while cutting the lowest income tax brackets and giving cash transfers to low income Canadians.
As an economist, I suspect Stephen Harper realizes this. The Conservative proposal, while it may be good politics, is bad economics.
