Harmonizing Sales Taxes: The Spending Power in Action

Three weeks ago, I wrote, “Budget 2007 used the federal spending power quite aggressively to pay provincial governments to eliminate their Corporate Capital Taxes. A similar use of the power will be needed if the Conservatives are serious about harmonizing provincial sales taxes with the GST.”

The front page of Friday’s National Post reported, “The Conservatives will encourage the five provinces that do not have harmonized sales taxes – Ontario, British Columbia, Saskatchewan, P.E.I. and Manitoba – to take part by setting up a $5-billion trust fund that would compensate them for lost revenue over the phase-in period.”

Notwithstanding Wednesday’s promise to limit the federal spending power, paying provincial governments to change their tax structures is a rather assertive use of it. Clearly, Conservatives are happy to deploy the federal spending power as a means to conservative ends.

The fact that five provinces apply their sales taxes to business inputs allegedly increases the cost of business investments and reduces competitiveness. Harmonization would shift some $7.5 billion annually of provincial sales tax from business purchases onto consumer purchases.

While neoclassical economists uniformly support this proposal, I pose a couple of questions. Given $7.5 billion, is removing sales taxes from business inputs the most effective way of encouraging business investment? Is applying sales taxes to a broader range of consumer goods and services a progressive way of raising the $7.5 billion? The answer to both questions is a resounding, “No.”

The provincial sales taxes that generally apply to business inputs largely exempt machinery and equipment, the type of investment most strongly associated with improved productivity. For example, Finance Canada recently observed:

In Canada, the five provinces that levy retail sales taxes generally offer some exemptions for capital inputs, particularly for machinery and equipment used in manufacturing, that substantially reduce the effective sales tax rate on capital goods in the manufacturing sector. As a result, retail sales taxes raise the Canadian METR [marginal effective tax rate] by approximately 2.5 percentage points, compared to the 9 percentage points that would prevail in the absence of any exemptions.

American state sales taxes provide fewer such exemptions and increase the American METR by a greater amount. Chinese provinces also levy sales taxes on business inputs with exemptions for certain capital investments. Therefore, provincial sales taxes do not place Canada at a competitive disadvantage.

Statistics Canada’s input-output figures for 2002 indicate that, in the five provinces combined, harmonization would have reduced business payments by $1.6 billion on capital inputs, $2.3 billion on intermediate inputs (like office supplies), and $2.3 billion on construction supplies. Consumers would have paid $1.9 billion more for goods, $1.7 billion more for services, and $2.5 billion more for housing. Jon Kesselman reasonably estimates that economic growth since 2002 has pushed these totals of $6.2 billion and $6.1 billion to around $7.5 billion.

Only about one-quarter of funds given to business ($1.6 / $6.2) through harmonization would reduce the cost of productivity-enhancing capital investments. Targeted measures, such as accelerated depreciation and/or an investment tax credit, would provide far more incentive for such investment at much less cost. All capital investments could be exempted from provincial sales taxes at an annual cost below $2 billion.

It is not clear that the construction sector would be better off with $2.3 billion less tax on its inputs, but $2.5 billion more tax on new-home sales. Jack Mintz, Bill Robson, et al have strongly criticized the City of Toronto’s proposed real-estate-transfer tax. Surely some of their arguments also militate against taxing new-home sales. In theory, a value-added tax should apply to the value added in building a house rather than to its gross value, which also includes the land value. Taxing construction inputs, as the five provinces do, may come closer to this ideal than taxing the sale price of new houses, as the GST does.

Perhaps businesses should pay tax on their profits rather than on their inputs. Exempting business inputs from sales taxes and increasing corporate income taxes by $7.5 billion might make sense. However, no such proposal is on offer.

Instead, the Conservatives would recover the money by applying sales taxes to a broader range of consumer products. Mainstream economists are quick to suggest that there would be no additional burden on consumers since businesses already pass along their sales-tax payments through higher consumer prices. However, to the extent that taxes on business inputs are shifted onto consumers, reducing these taxes would not lower business costs or improve competitiveness.

There is no free lunch. Clearly, harmonization aims to help businesses at the expense of consumers. Regarding harmonization in the Atlantic provinces, Michael Smart concedes, “prices rose somewhat for shelter and clothing and footwear, which tended to make the reform slightly regressive.” Provincial governments unwilling to apply their sales taxes as broadly as the GST would suffer a net loss of revenue, but could be partially compensated from the $5-billion trust.

In summary, the likely results of sales-tax harmonization would be: huge savings for business, mostly unrelated to productivity-enhancing investment; slightly higher consumer prices; lower provincial revenues; and $5 billion less for important federal programs.

The Conservatives’ proposed limit on the federal spending power is to “allow provinces and territories to opt out with reasonable compensation if they offer compatible programs.” Will any of the five provincial governments have the spunk to request an opt-out from this harmonization initiative in order to instead use their share of the trust to finance targeted tax measures or other industrial strategies that promote capital investment?

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