More truthiness from the Fraser Institute

Last week the Fraser Institute released a report arguing for a shift in Canada’s tax mix that would increase the GST to pay for personal and corporate income tax cuts. The proposal would be a massive gift to the richest among us. It is kind of like asking everyone to make out a cheque for $300 to Jimmy Pattison. Such an increase in inequality, by making the tax system less progressive overall, at a time when market income inequality has surged in the past couple decades, would be a mistake, especially given the pressing matter of dire poverty and homelessness in our cities. But the sales pitch is that such reforms would boost economic growth rates.

Needless to say, I am pretty skeptical of this proposal. I doubt there would be any change in economic growth or productivity growth as a result, and do not think any broad-based tax reform that increases inequality is what is needed in Canada right now. The good news, I suppose, is that the federal Tories are looking to reduce, not increase, the GST, so their proposal is not likely going anywhere.

That said, there is something to the notion that the “tax mix” matters, but the Fraser manages to distort the key message. The reason tax mix matters is because it explains the Nordic countries, who have much larger public sectors than does Canada, so much so that according to the usual Fraser Institute logic that lower taxes overall would lead to faster economic growth, they ought to be complete basket cases. But as has been pointed out many times on RPE, the Nordics manage to rank highly on economic competitiveness rankings while have superior social outcomes, especially in regards to poverty and inequality. To get to those higher levels of taxation, they have relied to a greater extent on value added taxes, recognizing that there are limits to how high personal and corporate income taxes can go. While value added taxes are generally considered regressive, the expenditure side is highly progressive.

What this means is that if Canada were to try and emulate Scandinavian levels of taxation (a big “if ” given the anti-tax sentiments sown by the right in recent decades) we might want to examine higher value added taxes as part of a strategic bargain to get there. I personally would be in favour of a higher GST if it meant a dramatic reduction in poverty. But I do not think that Canada’s personal or corporate income taxes are so out of line, either, and the personal income tax could certainly be made more progressive. In the Fraser report they cite Canada for having a higher share of total taxes going to income tax, but this is due to the fact that other countries rely more on value added taxes not that they tax income and profits less. For example, if we look at income and profit taxes as a share of GDP for OECD countries, we find that the Nordics and other countries like Australia and New Zealand have higher income and profit taxes than does Canada.

For the pro-growth argument, the Fraser primarily draws on a small but influential tax mix literature that sounds convincing on the surface, yet is a flawed quasi-empirical approach. There are tables that look like data is being presented but are really just putting numbers to theory. The argument goes something like this (page 9):

The department of finance concluded that corporate income taxes impose a marginal cost of $1.55 (MEC) for one additional dollar of revenue. This compares with a cost of $0.17 for an additional dollar of revenue raised through consumption taxes. Payroll taxes were also determined to impose relatively low costs on society.

The problem with this approach is that it is rooted in theory that starts with a perfect market equilibrium unfettered by government, so any taxes therefore deviate the equilibrium from its place of perfection. Progressive income taxes by definition “distort” more than sales taxes do in this framework, so income taxes are singled out for blame as adversely affecting the “proper” allocation of resources. I’m not convinced that this is indeed the case. An analogue is the argument that lower income taxes will lead people to work more, but studies find the elasticity of the response to be close to zero, largely because most people cannot choose to work longer or shorter hours, or to withdraw from the labour market (standard economic theory posits both income and substitution effects making the response to a tax cut ambiguous).

Is there any reason to believe the Fraser plan would deliver faster growth? In a word, no. Income taxes, personal or corporate, are not so high or out of line with other countries that there are huge gains to be had. If Canadian rates were way out of line with those of other countries, perhaps there would be some merit to the argument. But they are not. The real bottom line is that instead of moving towards greater equality as the Nordics do, the Fraser would move us in the direction of greater inequality.

UPDATE: After a debate with one of the authors on CBC yesterday, I have been “re-educated” (just joking). One of the points Neils Veldhuis made was that he would also favour an increase in payroll taxes, ie CPP and EI. Right now CPP is on a sustainable footing, while EI has had an annual surplus in the $3 billion range. Rather than reduce premiums for EI, I would support expanding benefits (only two in five unemployed people are eligible under current rules, due to things like non-coverage of the self-employed) and significantly increasing retraining programs (think Denmark).

But the point is that these are structured as social insurance programs, where ostensibly there is a connection between benefits and premiums. The Fraser would break that link so that these are just taxes to go into general revenue, and would actually be much greater than the needs required by CPP or EI. This could be a bad deal in that it makes the taxes less defensible vis-a-vis what they are paying for.

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