Cutting the GST

The Globe and Mail has a story by Steven Chase this morning on the federal government's plan to reduce the rate of the GST from 7% to 6% in the budget.  In the story, Chase claims that the staff of the Department of Finance is not supportive of the plan, primarily on the basis that the GST is, in several respects, a "better tax" than the income tax.  Let's examine the two main arguments countering the "let's cut the GST" idea.

The first objection is that other OECD countries rely more heavily on consumption taxes than  Canada.  This may come as a surprise to some, since our perspective of international practice in Canada is clouded to some extent by the United States, which has no tax corresponding to our GST.  The objection extends also to the direction of change--the movement internationally tends to be toward greater reliance on consumption taxes rather than less.  For example, Germany plans to increase the rate on its value-added tax (the equivalent of our GST) to 19% from 16%.  This new German rate is more than three times our new rate of 6%.  Even at 7% our GST is reportedly already the second-lowest rate in the world.  Leading economists and tax scholars in the United States are becoming more consistent in their calls for a value-added consumption tax like our GST.  Some would, at least rhetorically, go so far as to abolish the IRS and replace the Internal Revenue Code with a flat rate consumption tax.  According to the smart money the IRS is, of course, not going away any time soon.  But the point remains that most developed countries are taking quite seriously the idea that we should be placing more, not less, reliance on consumption taxes.  Nevertheless, this first objection isn't really an argument in support of consumption taxes, any more than all your friends jumping into the proverbial lake is support for the same.  So let's turn to the second argument.

The second claim, which is attributed to economists within the Department of Finance is that a consumption tax is least damaging to economic growth because it does the least to discourage working, saving and investing.  This is at least a sound argument, if it can be made out.  To see the logic, consider that an income tax directly taxes the fruits of working and also investment returns.  To some economists, this looks like double taxation.  So, for example, if one works, earns salary income, pays income taxes on that salary income, and reinvests the remainder, earning interest or dividends on the saved after-tax earnings, the interest and dividends--the returns to saving--are taxed.  A consumption tax such as the GST avoids this by imposing tax only when earnings are spent on consumption.  Advocates of cutting the GST would argue, however, that with RRSPs, we already have many of the benefits of a consumption tax built-into the income tax.  The person who works, earns salary and invests will receive a deduction for an RRSP contribution and not pay tax on the earnings within the RRSP until retirement, when the original earnings and any interest / dividends / capital gains within the plan will be taxed upon withdrawal.  So, the argument goes, we already have a hybrid income-consumption tax in the Canadian income tax.  One significant problem with this is the fact that corporations cannot make use of RRSPs and are subject to full income taxation on corporate income, and are taxed on the returns to corporate investment.  This explains the position of Don Drummond, chief economist at TD Bank, who would prefer to reduce income taxes--both personal and corporate--and increase the rate of the GST.  For its part, the Deparment of Finance claims that the increase to economic well-being is three times greater for a reduction to income taxes than to the GST.

This all gives rise to a puzzle.  Why, if the GST is such a good tax, is the government still planning to reduce it rather than income taxes?  What's missing from the above account?  Comments are welcome.

Comments

[Kaz Nejatian]

There is no question, I think, that a VAT is a more efficient tax than other forms of taxes. However, efficiency is not the only thing guiding taxation policy. (Not that it shouldn't be, I am just suggesting that it is not. If it were, we would have a straight head tax as well which would be most efficient or a linear income tax which much more efficient than the current one.)

GST is a good tax to cut for two reasons:

1. It is most obvious therefore if the over all goal is to reduce taxes in general, GST is the most obvious one to cut because it would be hard to bring it back. This in turn would increase consumption. If the goal is to increase consumption, then there is no better tax to cut.

2. GST is a very regressive tax. It hurts the poor more than income taxes. I am not making a value judgment, but a political one. The question is this: do we want an efficient tax that hurts the poor? I am not sure if tax policy is the place for redistribution, but if this is the case then we should abolish the current taxation system altogether come up with what is most efficient and deal with redistribution through the spending side.

[benalarie]

These responses raise questions of their own.

The argument that the GST is a good tax to cut because it will be difficult to bring back seems odd. A government in need of revenue in the future will, if the claim is correct (which it probably is), instead of returning the GST to a higher level, increase taxes that are more amenable to change--i.e. income taxes. Thus, the bias in the tax mix bias in favour of personal and corporate income taxes will be exacerbated. In other words, this point far from justifying a reduction in teh GST, undermines calls for reducing the GST, since it will predictably lead to a more inefficient tax mix in the future.

The line, "If the goal is to increase consumption, then there is no better tax to cut" is rhetorically attractive, but empty. For one, it's not necessarily true. And second, why should we simply want to increase short-term consumption, and not increase productivity, savings and investment, which will lead to sustainable, long-term increases in consumption?

Finally, the claim that the GST is a "very regressive tax" may or may not be right. Assuming it is correct, then the GST credit must to some extent offset this regressivity. And in theory, at least, changes to the income tax could be made as progressive as one would like, without requiring people to spend in order to benefit. If your concern is regressivity, a 1% reduction in the GST is like giving everyone a credit card with a 1% rewards program. It's common sense that you're not going to make yourself better off by spending money to enjoy a 1% reward. And yet this is arguably equivalent to the logic underlying cutting the GST.

[Kaz Nejatian]

Prof Alarie,

I agree with your analysis.

Perhaps I can make two additional points.

1. The reason why a GST cut makes the poor better off is not that they'll now spend more money because of it. It is that they will have more money to spend if they wish to. GST takes up a much bigger chunk of a poor family's expenditure than a rich one’s.

To the less fortunate, a GST cut is not a reward programme, it may be to the rich, it is simply more money, 100% of which will be spent because these families have a hard time making ends meet. The “choice” of spending is illusory one for Canada's least wealthy, much like it is for Canada's students. We will spend 100% of the money we have, the question is how much we will get back for it.

2. I agree that increasing consumption should take a backseat to increasing productivity. But surely, we can do both.

[Carl Irvine]

I've been thinking about the argument in favour of cutting income taxes instead of the GST. There is no doubt that a pure consumption tax is a more efficient way to raise revenue than a pure income tax because it does not tax savings, and thereby distort the decisions between current consumption and savings (hence future consumption).
But this really misses the issue here because it ignores the nature of the "income tax" cut that was proposed as an alternative to the GST cut. It would be one thing if the alternative to cutting the GST was to make an accross the board tax cut of all tax rates. Such a tax cut would affect the marginal tax rates of all Canadian and therefore would affect their incentives to invest. Of course, such a tax cut is politically unfeasible because, by their nature in a progressive tax system, across the board tax cuts are regressive (and expensive). Instead what was proposed by the Liberals (and partly retained by the Conservatives) was a reduction in the tax rate in the lowest tax bracket.
Now, this tax plan has the advantage of being politically feasible (since it benefits most Canadians, to some extent, and it is not very regresive), But in terms of efficiency, I'd suggest it offers little benefit. We can see this for two reasons.
First, for anyone who has a taxable income greater than $36,000 reducing the 16% rate to 15% has no impact on their marginal tax rate, and therefore should have no impact on their decision to invest at the margin. For them, the Liberal's "income" tax cut was really a lump-sum tax cut, no different in effect than the "Ralph-Buck" cheques in Alberta. So, at best, the Liberal plan could only affect the savings rates of those Canadians who earn less than $36,000.
Of course, it's still fair to say that, in theory, cutting the marginal tax rate for people who earn less than $36,000 will have some impact on their savings decisions. Whether that impact is large is beyond me, though I suspect that people earning more than $36,000, whose marginal tax rates are unaffected by the Liberal plan, account for a disproportionately large percentage of domestic savings. So it isn't clear that Canada is getting much efficiency bang for its buck by cutting the bottom tax rate.
Moreover, the foregoing analysis ignores the reality that the Canadian "income tax" system is really a hybrid tax system, since many Canadians can deduct their savings from their income using RRSP's and RESP's(explicitly) or RPP's (implicitly). To the extent that these tax-deductible savings account for a significant percentage of total savings, our "income" tax system is really a "consumption" tax system. Again, I don't have the figures on hand, but I would have thought that RRSP's, RESP's or RPP's would account for a significant portion of any savings made by individuals with incomes less than $36,000. If this is true, than not only would the Liberal plan not affect the savings of people earning more than $36,000 a year, it wouldn't have much effect on those earning less than $36,000 a year either. In this case, we're not really debating whether we should cut income or consumption taxes, but rather which consumption tax we should cut. Cutting one instead of the other might have progressivity implications (though what they are, much less whether they are good or bad, is beyond the scope of this post), but I'd suggest that in terms of efficiency there isn't much to choose between them.
Finally, on a purely personal (and totally greedy) note, I have to say that, at least for this year, I much prefer a GST cut to an income tax cut. While an income tax cut would reduce the value of my tax liabilities, it would also reduce the value of the $38,000 or so in non-refundable tax credits that I'm going to claim this year (mostly for tuition fees). So the net effect of an income tax "cut", at least of the bottom rate, would be a wash. Granted, I don't imagine that there are a lot of taxpayers with vast amounts of refundable credits to their name (although I'd imagine most professional students would). Still for people with dependent spouses or adult children with disabilities, or people with significant medical expenses (and of course greedy law students), the effect of these non-refundable credits would be to reduce the actual value of the Liberal's tax cut, perhaps significantly. Anyhow, a little something to think about.

[Ben Alarie]

Another thing to consider is that a cut to the GST is a boost to all those who are able to avoid or evade income taxes. Those operating in the black market (think drug dealing, for example) almost certainly do not report all income for tax purposes, but will generally have significant trouble escaping paying GST for new cars, new houses, or other big ticket items. A similar argument applies to small business owners who under-report income for tax purposes. The GST cut is, perversely, a nice way to ensure that income tax evaders get to enjoy a tax cut as well.