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 Economic survey of Canada 2008: Tax reform for efficiency and fairness

Tax cuts have been a good use of budget surpluses, but there is plenty of scope left for efficiency enhancing, revenue neutral tax reform. Business tax competitiveness is being enhanced by deep cuts in taxes on corporate income and capital. Labour supply has been boosted by in work tax credits. Yet, attractive opportunities for base broadening and shifting remain to be exploited and could enable still lower income tax rates. Remaining provincial retail sales taxes, penalising business inputs, should be converted to more efficient value added taxes, harmonised with the federal GST. Numerous tax breaks to traditional sectors and small firms should be phased out to unleash supply side dynamism. To further improve capital allocation and build on recent initiatives, personal income should be taxed on a neutral consumption basis, with vertical equity achieved by targeting tax credits on vulnerable groups.

The Canadian government has set a high priority on reducing the economic burden of taxation. In a context of fiscal surpluses, it has been: markedly reducing corporate income and capital taxes; providing more personal tax relief especially at lower incomes and above all for saving; and cutting the federal value added tax (GST). While such measures, in particular income and capital tax cuts, reduce the economic damage caused by tax and improve business competitiveness, Canada should go further along this route with significant revenue neutral reforms to achieve a more efficient tax mix that also retains its redistributive features. Numerous tax preferences to favoured activities, firm types, investments and savings vehicles narrow the tax base and create loopholes, keeping statutory rates higher than otherwise and distorting resource allocation. They should therefore be removed. It would also help to shift the tax mix toward more user fees and indirect taxes – including VAT, environmental levies and property taxes – which do not distort inter-temporal economic choices as income taxes do. Lower corporate and personal income taxes could improve the incentives for capital formation, FDI, innovation, entrepreneurship, labour force participation, work effort, and the pursuit of higher education. The result would be higher standards of living.

Growth enhancing tax reform should continue, even if surpluses are limited in the short run

Making good use of sizeable budget surpluses has been a key policy issue in Canada, and governments have appropriately used them as a justification for tax cuts. Whereas debt reduction contributes to fiscal sustainability by pre funding implicit demographic liabilities, tax cuts may serve the same purpose indirectly: lowering taxes can improve incentives to work, save and invest, thereby boosting labour supply, productivity and growth, and expanding the tax base to recoup part of the revenue lost while significantly improving long run welfare. Given the economic outlook, there is no fiscal room for further net tax cuts over the next few years, but plenty of broadly revenue neutral, growth enhancing reforms could still be made in both the business and personal income tax systems.

One priority should be to broaden the business tax base and lower tax rates on capital further

Marginal effective tax rates on business investment have been cut sharply in recent budgets: the federal corporate rate is being reduced by a third and the federal capital tax (an inefficient tax on wealth) eliminated. Most provinces are also phasing out their capital taxes, in part in response to federal incentives. But more could still be done. Businesses in some provinces pay retail sales taxes on inputs, penalising investment. A variety of permanent preferences in the tax code divert resource flows away from their most productive uses toward tax favoured ends, notably in “traditional” sectors like manufacturing, natural resources and agriculture to the detriment of market services sectors that have been some of the key sources of recent US productivity growth. Small Canadian owned firms are also unduly advantaged, which may discourage them from growing and becoming more productive. Given the need to raise productivity growth, revenue neutral tax reforms to reduce distortions inherent in the current tax system should now be pursued. The top priority is to convert retail sales taxes in the five provinces that still have them to a harmonised VAT, whose broader base (including non financial services) would offset lost provincial revenues from retail sales taxes on business inputs. As well, accelerated capital cost allowances in manufacturing should not be renewed when they expire in 2011, existing generous deductions for mining and other resource activities should be removed, and the general corporate income tax rate should be lowered to the level of the small business rate, with base broadening measures largely paying for the statutory corporate income tax cut.

Marginal tax rates on personal incomes should also be smoothed

Recent years’ tax/benefit reforms have helped lower income families, but they have also inadvertently produced higher marginal effective tax rates as refundable tax credits or cash benefits are withdrawn with higher earned income. This reduces work incentives for groups whose labour will be needed so as to counteract ageing and present labour shortages in the booming areas. Low income retirees face similarly high marginal effective tax rates (METRs) due to the claw back of their old age cash benefit as taxable pension savings are withdrawn, reducing their incentive to save for retirement, although the newly announced Tax Free Savings Account should help to alleviate this problem. High METRs due to benefit withdrawals continue up to middle incomes. The top marginal tax rate has been reduced but is still the second highest in the G7. These factors inhibit longer working hours, and efforts to achieve upward mobility and pursue higher education, all of which are necessary to raise labour utilisation further and reverse declining multifactor productivity growth. Hence, high METRs should be reduced by earlier but more gradual benefit phase outs, eliminating “middle class welfare benefits”, and by better co ordination of federal and provincial tax/benefit systems, or though broad based tax reductions.

A shift toward consumption based taxation is warranted

The generous but still partial alleviation of taxes on personal capital income is designed to improve savings incentives but also misallocates capital, as post tax rates of return on marginal, non tax sheltered savings are low. Moving toward consumption based taxation (by eliminating taxation of the normal return to all savings) may be politically difficult because expected efficiency increases come at a cost: large gains to rich savers against losses to the non saving poor insofar as consumption taxes are raised to cover the resulting revenue shortfall. Nonetheless Canada has already taken significant steps in this direction and is well positioned to go further since two thirds of Canadian individuals already hold all their financial assets in tax efficient savings vehicles. With the recent introduction of the Tax Free Savings Account, this proportion is expected to increase over time to 90%. Hence, revenue losses and the resulting increase in consumption taxes should be modest. Another reason is that Canada does not allow mortgage interest deductibility on primary residences, which would be incompatible with consumption based taxation and very difficult to remove once in place. Thus, present tax preferences to certain savings vehicles should be extended to all forms by taxing personal income on a consumption basis. Any revenue shortfalls, including those needed to pay for desirable cuts in the top marginal tax rate on personal income, should come from increases in efficient tax bases. These would include environmental taxes at all levels of government, property tax and user fees for various public services, and provincial VATs (once all have converted their retail sales taxes). VATs should have as large a base as possible so as to keep rates as low as possible. Exemptions are costly, benefit the rich as well as the poor, and are an inferior way to enhance equity relative to increasing low income credits. As such, the current GST exemptions for basic groceries should be eliminated and the adverse distributional consequences neutralized by boosting the GST tax credit. Municipal property taxes should be increased for households and reduced for firms, with net tax increases allowing reductions in provincial transfers and hence further provincial income tax reductions.

Source: Organisation for economic co-operation and development, Economics department, Economic survey of Canada 2008

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