In the last few years, the Federal government cut the GST (the federal sales tax
ID: 2496089 • Letter: I
Question
In the last few years, the Federal government cut the GST (the federal sales tax on goods and services which Ontario later blended into the PST to create the HST) by two percentage points. The federal government could have transferred this cut to income taxes instead, i.e. it could have decreased taxes on income instead of on the GST. Sources of income that taxes are paid on include labour (work) as well as investment earnings. Assuming that taxes are to be cut, which tax cut do you believe is more beneficial for long run economic growth, a GST/HST reduction or an income tax reduction? Assume that either of the reductions would be revenue neutral, i.e., the federal government would forfeit the same amount of revenue with either tax that is cut
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Explanation / Answer
The tax system has a fundamental impact on a society’s economic activity and performance, since it influences matters such as labour supply, household savings, and companies’ business decisions (production, employment, investment). While it is utopian to seek to eliminate taxes completely, a good tax mix can be a central element of an economic policy that supports a country’s or a government’s prosperity.
Since a key issue in the last federal election campaign was whether to reduce the rate of the goods and services tax (GST) – a consumption tax – or cut personal income tax (IT), it may be helpful to consider various elements of the optimal tax mix in Canada. Referring to recent economic literature, this paper attempts to summarize the main pros and cons of changes in the two tax instruments with respect to eight factors. The analysis highlights certain theoretical concepts and some empirical results discussed in the economic literature.
One of the major differences between personal IT and consumption taxes (CT) is that the latter do not apply to savings and hence do not influence an individual’s decision whether to consume now or to save now and consume later. IT, however, takes away a large share of the gains realized by saving (interest income, dividends); it thus makes immediate consumption more attractive and discourages saving. In a country with an aging population, favouring a tax system that discourages saving may not be the best solution – which suggests that a reduction in IT might be preferable.
Furthermore, saving encourages investment and thus promotes the purchase of new equipment and technologies, along with growth in research and development (R&D) activities. These forms of investment are the cornerstone of a more productive and prosperous economy. All in all, CT encourage capital accumulation in an economy, since by definition they apply to income only when it is spent.
On the other hand, a number of aspects of the tax system, such as registered retirement savings plans (RRSPs), allow taxpayers to grow at least part of their savings sheltered from IT. Such programs reduce the effective impact of a change in the tax system that would raise CT or cut IT.
As well, CT have a narrower tax base. If the government wanted to keep its level of revenue constant, any change in personal income tax rates would have to be offset by a proportionally larger inverse change in the GST rate. Thus, though there is wide agreement that raising the GST would encourage individuals to save, there is no consensus among specialists regarding the real impact of such a move.
Labour Effort
Compared to consumption taxes such as the GST, IT is reputed to have negative effects on labour effort and to be less conducive to economic growth. Nevertheless, it is primarily the progressive nature of taxes on labour income, rather than the tax base per se, that is said to be demotivating for workers and likely to discourage additional work that would earn additional income.
In this regard, a new tax mix that slightly reduced the GST rate would not affect labour supply differently than would a cut in the lowest personal income tax rate, in so far as the progressive nature of taxation would not be radically altered.
Economic Efficiency
A tax is judged to be more efficient when it imposes fewer distortions on the allocation of resources in an economy. As noted above, IT produces distortions in the choice of whether to consume now or later, and it also affects labour supply. IT is also discriminatory, since it does not apply uniformly to all classes of assets. The favourable tax treatment, for example, on the purchase of a residence increases demand for one asset at the expense of others. The issue is balancing the efficiency losses stemming from these distortions and the potential gains from such measures, in this instance the benefits of becoming a property owner.
The debate on efficiency is also ideological, since it pits the free market against interventionism. Nevertheless, viewed from the limited perspective of economic efficiency, CT are superior to IT, since they reduce distortions in the economy.
The Underground Economy and Tax Policy
Empirical data make it increasingly clear that high income taxes and consumption taxes promote development of the underground economy. It has also been shown that the introduction of the GST in 1991 caused the underground economy to grow.(1) Indeed, most people have at some time been offered the option of paying cash to save on “taxes,” allowing the merchant to avoid declaring income that is taxed at a higher rate than total CT.
Even though the presence of CT may encourage buying some services (home renovations, child care, catering) and goods (cigarettes) under the table, the underground economy is said to be in general 2.5 times more sensitive to changes in personal IT than to changes in CT such as the GST.(2) This ratio changes over time, particularly according to the economic situation and tax rates.
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