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Duelling HST Studies: Voodoo Economics from Ontario Finance?

On Tuesday, the Ministry of Finance released “Ontario’s Tax Plan for Jobs and Growth: Technical Paper on How the Tax Changes Affect People.” This study is an attempt to counter the Statistics Canada study released by the NDP a month ago.

Until recently, proponents were claiming that the HST will simultaneously deliver huge savings to business, create loads of new jobs, reduce consumer prices, and bolster provincial finances at no cost to anyone! Ontario budgets did not even disclose the total amount of additional sales tax that consumers will pay.

Instead, budgets presented only a net figure ($2.2 billion in 2011-12): additional sales tax collected from consumers minus input tax credits (ITCs) provided to business. Of course, bragging about the dollar amount that business would save made it fairly easy to deduce how much more consumers would pay.

So, it is good that the government is now presenting data on the HST’s costs and benefits for different groups. The NDP deserves credit for forcing a more honest debate.

What do the two studies conclude about Ontario’s tax changes? Statistics Canada estimated a cost of $470 per year for the average household, or $316 if businesses pass ITCs through to consumers.

Finance estimates savings in the first year, but costs of $385 million for 5.3 million Ontario households in the third year (pages 6 and 9). That implies an average cost of $73 per household.

Pass-Through and Transition Payments

There are a couple of obvious differences between the studies. First, the purpose of harmonization is to remove provincial sales tax from business inputs.

A key issue is whether or not business will pass these ITCs along to consumers through lower prices. While Statistics Canada provided estimates with and without pass-through, Finance assumes 90% pass-through by year three.

Second, the federal government is paying Ontario $4.3 billion to adopt the HST. The provincial government is disbursing these funds directly to Ontario households and small businesses. While Statistics Canada excluded these one-time “transition” payments, Finance included them.

To avoid these differences, one can compare the Statistics Canada estimate with pass-through and the Finance estimate for year three (after the transition payments). Still, a substantial discrepancy remains between average costs of $316 and $73.

This discrepancy reflects three other differences: construction, compliance costs and corporate tax cuts. Ontario Finance makes dubious assumptions in these areas.

Construction

Since building materials are the main business input currently subject to provincial sales tax, most of the ITCs will flow to the construction industry. But the HST also extends provincial sales tax to purchases of new homes and contractor services for renovations.

Academic estimates (page 20) suggested that housing accounted for half of the potential revenues from harmonization in Ontario. In fact, the provincial government is extending only 2% sales tax (rather than the full 8%) to the first $400,000 of new home purchases (page 14). Still, housing accounts for a substantial share of additional HST revenue.

The Social Policy Simulation Database and Model does not include real estate. So, Statistics Canada did not count the additional sales tax charged on it. On the other hand, Statistics Canada assumed no pass-through from construction to consumers.

By contrast, Finance adds real estate onto the Social Policy Simulation Database and Model. It amortizes the additional sales tax over 25 years for new homes and 5 years for major renovations (page 15).

In other words, Finance does not count the additional sales tax paid on a new home in year three as a cost to consumers that year. Instead, it spreads this cost between year three and 24 subsequent years.

Finance also amortizes the ITCs assumed to be passed to consumers through residential construction (page 24). But to the extent that the additional tax on real estate exceeds the ITCs for residential construction, amortization serves to understate the HST’s cost to consumers in the early years.

Finance’s tally of business savings includes non-residential construction as well. In the long term, lower construction costs may mean less expensive commercial buildings, which may mean lower consumer prices. However, Finance posits that ITCs on non-residential construction will accrue to consumers right away, in year three (page 24).

While Finance explicitly assumes that households amortize the cost of residential structures (including additional sales tax) over 25 years, it implicitly assumes that businesses do not amortize the cost of non-residential structures (including ITCs). These asymmetric assumptions minimize the estimated cost of HST on real estate, but maximize the estimated pass-through from non-residential construction to consumers.

Compliance Costs

In addition to actual ITCs, Finance hypothesizes that “over $500 million in annual compliance costs savings” are passed-through to consumers in the same proportion as ITCs (page 23). It offers no explanation of this number.

The theory is presumably that it will be cheaper for businesses to comply with a single HST than with separate federal and provincial sales taxes. However, in reality, business will still have to comply with two different sales taxes.

The Ontario government is temporarily restricting about $1 billion of ITCs (page 23). So, business will still pay provincial sales tax on some inputs. (Both Statistics Canada and Finance appropriately assume no pass-through of these restricted ITCs.)

The Ontario government is exempting a variety of consumer items from the HST’s provincial portion. It will continue to apply the provincial sales tax to insurance premiums and private sales of used vehicles, neither of which are subject to federal GST. So, Ontario’s HST falls well short of “harmonizing” the federal and provincial sales taxes.

Corporate Tax Cuts

Statistics Canada only examines the HST plus accompanying personal income tax cuts and credits. By comparison, Finance also assumes that a portion of provincial corporate tax breaks will be passed-through to consumers.

Specifically, Finance posits that Ontario consumers will save $345 million from corporate tax cuts (page 25). Removing this amount would double the tax package’s total estimated cost to households (page 6).

By modelling extensive pass-through to consumers (along with income tax credits targeted to the low end), Finance suggests that households with combined incomes under $60,000 will actually save money in year three. Households making above $60,000 will pay more (page 7). On this basis, it argues that “Ontario’s tax system will be more progressive as a result of the tax plan” (page 5).

But Finance glosses over two aspects of corporate tax cuts that have the opposite effect. First, it acknowledges that a significant portion of corporate tax cuts will flow to shareholders (page 28), but makes no attempt to model this flow.

Clearly, most shareholders live in households with incomes above $60,000. Indeed, shares are likely concentrated among households making more than $300,000, a group completely excluded from the study (page 8).

The estimated pass-through of corporate tax cuts to consumers has a progressive effect. However, the unquantified pass-through to shareholders would have a regressive effect.

Second, while the HST plus accompanying personal income tax cuts and credits are almost revenue neutral, the corporate tax breaks entail a huge revenue loss. When fully implemented, Ontario’s cuts in corporate income tax and corporate capital tax will cost $2.4 billion and $1.6 billion annually.

Because public expenditures are distributed quite equitably, reducing them by $4 billion per year is highly regressive. Therefore, it is misleading to claim that “Ontario’s Tax Plan for Jobs and Growth” is progressive.

Conclusion

By combining ITCs with imaginary compliance savings and corporate tax cuts, Finance considers $6.5 billion of business savings in year three. Even with aggressive pass-through assumptions, only $1.9 billion finds its way to Ontario consumers (page 29). In fact, more will be passed through to consumers outside the province, who buy goods and services from Ontario.

When combined with $2.4 billion of personal income tax cuts and credits, $1.9 billion of pass-through still does not offset $4.7 billion of additional sales-tax costs to Ontario consumers (page 6). Even as the provincial government gives up billions of dollars of revenue, households will pay more tax.

By Finance’s own reckoning, the tax changes impose a net cost on middle-income households making more than $60,000 (page 7). Two people working full-time at Ontario’s average wage would make $90,000 per year.

Perhaps there is a case to be made that Ontario residents should pay more tax and lose some public services in order to enhance the competitiveness of Ontario-based businesses. The Statistics Canada and Finance studies have forced the provincial government to start making that case, rather than simply claiming its tax changes will deliver financial benefits for everyone.

The real debate is about using public money, whether taken from consumers (the HST) or from general revenues (corporate tax cuts), to support business. We should ask whether across-the-board tax breaks on business inputs and profits are the best way to promote investment and employment in Ontario. As I have suggested elsewhere, more targeted measures could prompt more investment and employment at less cost to consumers and the provincial treasury.

Note: Except for the hyperlink to a Rotman paper, all page references are to the Ministry of Finance paper.

UPDATE (June 15): Quoted by Canadian Press

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Comments

Comment from asp
Time: June 11, 2010, 9:24 pm

“A key issue is whether or not business will pass these ITCs along to consumers through lower prices.”

One would think that business that operate in a monopoly field would not, while those with significant competition will have no choice but to lower the price of the services they provide.

As a consumer, I will be spending my money at places that offer a good deal, and avoiding those that don’t. Anybody with less than an unlimited budget will do the same, whether they want to or not.

Comment from Purple Library Guy
Time: June 12, 2010, 12:15 am

Doesn’t have to be a true monopoly. Seems to me there are a number of major fields where a small number of big players have tacit agreements to compete mainly on aspects other than price.

Comment from asp
Time: June 12, 2010, 7:51 am

PLG, the few true monopolies, like cable companies, have their prices set by government. So it is up to the governments which implement an HST to make them pass the savings on to consumers.

The kind of tacit agreements you mention are actually illegal in cases where government has not granted a monopoly. If you know of specific companies doing this, call the RCMP.

Comment from Erin Weir
Time: June 12, 2010, 9:28 am

The absence of a pure monopoly or price-fixing conspiracy does not necessarily mean perfect competition. The point is that the timing and extent of pass-through will vary across a range of market structures. Therefore, it seems ambitious to assume that pass-through will average 90% in three years among all markets in Ontario.

Comment from Willard
Time: June 13, 2010, 10:52 pm

Doesn’t have to be a true monopoly. Seems to me there are a number of major fields where a small number of big players have tacit agreements to compete mainly on aspects other than price.

Very true. The best example I can think of is Canada’s mobile telecommunications industry. Rogers, Bell, and Telus compete mainly on the strengths of their networks and the phones they offer — there’s not much difference in their monthly service fees. Only Canadians in large urban centres really have the option of going with lower-cost, small-network providers like Fido and WIND Mobile.

Needless to say, the pass-through assumptions from the provincial gov’t are dishonest.

Comment from Purple Library Guy
Time: June 13, 2010, 11:09 pm

asp, you seem to be castigating me for being insufficiently naive. We do not inhabit a world of ideal Platonic forms.

To put it a different way, yeah, I know they’re illegal. So? Falsifying your drilling rig’s blowout-prevention procedures is illegal too. Why don’t you go report British Petroleum? Or perhaps Exxon, who are surely doing exactly the same sort of illegal skimping on safety on their offshore wells. Do you suppose that nice Mr. Salazar will listen to you if you take a complaint? No? Why then do you have such touching faith that if something is illegal then, of course, corporations couldn’t possibly be doing it? Lest we forget, the core mandate of a corporation is “Make profit”, not “Obey the law” or “create perfect marketplace competition”.

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