Why the GST is a good idea

It occurs to me that although most of the media coverage on the cuts to the Goods and Services Tax - and the various proposals to reverse those cuts to the GST - makes note of of the fact that there is a broad consensus among economists about the merits of consumption taxes, I haven't yet seen a good explanation for why they are so popular with economists. This is a problem: it makes it too easy for dim-witted politicians - which is to say the Conservatives, the Liberals and the NDP - to dismiss the merits of the GST without being called on it.

So below the fold, I'll try to explain the logic behind the GST.

The basic idea comes down to the role of taxes in determining the rate of return on investment. If an economy has a large number of high-return investment projects, then it will have higher levels of investment and - as investment accumulates - higher levels of productive capacity. That increased capacity in turn generates higher output, employment and wages. These are assumed to be Good Things in what follows.

So consider an investment project - the sort of project that involves purchasing machinery and equipment, employing labour and producing something that people are willing to buy - that offers a rate of return of 20%. And let's also suppose that a 20% rate of return is enough for investors to fork over their savings and let the project go through.

Suppose now that there's a corporate income tax of (say) 30%. The gross return on an investment of $100 may be $20, but after applying 30% tax on those profits, the return sent to the investor is $20 - $20*0.3 = $14. Although the investment project is still paying out 20%, the return that the investor sees is now 14%.

The same story goes for the case in which investors pay a 40% tax in their income. A $100 investment (out of income after taxes) is a sacrifice of $100 of consumption goods. That investment may generate a return of $20, but only $20 - $20*0.4 = $12 will be available to spend. Again, the return that the investor sees is reduced from 20% to 12%.

And now suppose that both sorts of taxes are in force. After the corporate tax is applied, the $20 profit becomes $14 sent to the investor. After income taxes are applied, that $14 becomes $8.40 available for expenditure on consumption goods.

This example illustrates the problem with income taxes: they introduce a wedge between the rate of return that is generated by the investment project and the rate of return that the investor actually sees. If there are many investment projects, each with a different rate of return, income taxes can reduce net rates of return to the point where marginal projects are not carried out. Output, employment and wages will be lower than what they would otherwise have been.

Now suppose that instead of corporate or income taxes, the investor is faced with a consumption tax of - say - 100%. This means that the $100 the investor has burning in her pocket can purchase $50 worth of consumer goods. Since there are no taxes on profits or on income, the entire $20 return is remitted. That $20 can then be used to buy $10 worth of consumer goods. Since the sacrifice of $50 in consumer goods has generated a return of $10 of consumer goods, the effective rate of return is still 20%. Contrary to income taxes, consumption taxes do not introduce wedges between the rates of return generated by an investment project and the rates of return that the investor sees.

That's a very, very simplified story, but the basic intuition carries over to more sophisticated models. It is possible to construct models in which consumption taxes have less-than-benign effects, but there don't seem to be any models that

1. Show that consumption taxes have worse effects than income taxes and
2. Are consistent with the data.

At least, if there are any, they seem to have escaped the attention of the Canadian economists who have been working on the GST issue over the past generation.

Moreover, this lesson has already been learned by countries that wish to finance government spending without tanking the economy. Here's a graph that I made for this post on how the Nordic countries manage to maintain high levels of spending without sacrificing economic growth:

These are all rich countries; the only important effect of higher consumption taxes is to make available higher levels of revenue for government. And even if you subscribe to the small-government low-tax view, it still makes more sense to focus on cutting stupid taxes and leaving the GST alone.

Comments

[Brett]

So what is the effect of Ontario harmonizing its sales tax with the GST? Given that it won't be implemented until next year, when we may be out of this mess, could it have something of the effect of the GST fiscal stimulus you suggested a few months ago, esp for housing?

[Stephen Gordon]

I'm not sure - I haven't been following that story too closely, so I don't know what the net effect of harmonisation is supposed to be on revenues. If harmonisation ends up increasing taxes, then it could have those stimulus effects I mentioned, namely bringing forward expenditures. If I understand correctly, the Ontario PST doesn't currently apply to new houses, so you could imagine a rush to have new houses started before the tax kicks in.

But the main arguments in favour of the GST are based on the longer run. In a recession, you might want to play with the timing of when it comes into effect, but that's a secondary consideration.

[Phil]

The simple argument for harmonization in Ontario is simply that two levels of government are applying two not-compatible commodity tax regimes to the same tax base. The GST and Ontario PST are both commodity tax regimes, but are different sets of rules, so have different sets of exclusions, etc. So businesses have to deal with (at a first order) twice the compliance costs. If you harmonize the regimes, so that the items that are taxed are (as much as possible) identical, it should simply the compliance costs. So at a first order, it's a good idea. The tax community and broad based business lobbies have been pushing harmonization for a long time.

But in practice, it means in part expanding the tax base to cover a variety of specific goods and services that were not previously tax, and that incentivizes those sectors to protest against the expansion of the tax. For example, legal services in Ontario are subject to the GST, but not the PST. So the Ontario lawyers professional groups are trying to fight harmonization. I don't know, but presumably there are exclusions under the GST that don't currently exist under Ontario PST, so some sectors that don't currently pay GST but do pay Ontario PST would no longer pay PST with harmonization. Net net, the effect is probably not revenue neutral, but I would expect that harmonization is not by designed intended to be a revenue grab.

[alou]

My guess is that it doesnt matter what you tax.

[Phil]

Stephen - Econbrowser has had a couple of great posts about the composition of the Fed's balance sheet. I'd be interested in some explanation about what's going on with the Bank of Canada's balance sheet. It looks like in October / November 2008 that the BOC dumped about 10B of T-Bills and put that, plus another 20B into the new asset purchase facilities. That would seem to significantly increase the riskiness of the BOC's assets.

The expansion in the balance sheet seems to largely come from increases in deposits from the Government of Canada, with minimal expansion in the currency base. Are those government deposits from new debt issuances by the government or from reallocation of government deposits away from private sector banks (which wouldn't seem to me to make much sense, by withdrawing deposits from the private banking system)? Unlike the US, it doesn't look like Canadian banks are holding very significant reserves with the central bank.

[Two Hats]

" Net net, the effect is probably not revenue neutral, but I would expect that harmonization is not by designed intended to be a revenue grab."

Phil, you are very, very naive. Harmonization will bring the whole suite of services, plus a few currently exempted goods, under provincial tax. Unless, as the gov't is now implying (but not declaring), current PST exemptions are maintained, in which case it's not really "harmonization". The additional tax revenue (& the one-time fed. transfer) to the province (partly offset by corp. tax cuts) are surely big considerations in this proposal.

[Phil]

Two Hats - Why implement a revenue grab in the middle of a recession? Everyone is calling for fiscal stimulus. And the rationale for harmonization is not to raise revenue. I don't deny that it very likely isn't revenue neutral - the part that you included but didn't bold made that clear. My point was that the overall first order rationale for doing it wasn't the revenue grab -- that's evidenced by the attempt to include some counter-balancing stimulus. As I noted, it will increase taxes on some sectors and people in those sectors (perhaps including you) no doubt view it as a pure revenue grab. But that doesn't mean the driving rationale was to raise revenue.

[westslope]

Why now?

To add to Phil's explanation, recall that Canada's federal value-added sales tax (VAT) replaced the manafacturing sales tax (MST) that, in a fashion similar to provincial sales taxes, applied to gross values. The MST was perceived as penalizing domestic manufacturing businesses.

The provincial sales taxes are applied to gross values and also apply to manufacturing and other business inputs. Ultimately that leads to double or n-taxation though that effect is somewhat blunted by businesses deducting sales taxes as a cost of business.

I suspect that some grey heads in Ontario have made the following calculations. Parts of the southern Ontario economy are in danger of becoming a rust belt. This nasty recession is imposing some radical restructuring on the NA economy. With increasing regional economic integration and increasing global trade and investment flows, the harmonization of provincial and federal taxes will make Ontario all the more attractive to greenfield business investment. Moreover, the widespread implementation of information technologies in recent years has removed some of the earlier objections of a transactions cost nature to the GST.

That is a great chart. Note that the emphasized countries all have slow or near stagnant population growth, yet if I am not mistaken, enjoy robust, dynamic economies that exhibit high per capita wealth levels--including much free time--and significant per capita income growth.

[Two Hats]

At a policy-development level within the Ministry of Revenue, it could well be that there are rationales similar to what Phil & westslope are describing. But a major tax move like this is a political decision, not a policy decision, and I think the provincial gov't needed some way to offset the corp. tax cuts they're being pressured to implement. I think in better times, they just would have cut the corp. rates without changing the PST. It may or may not be a good move ultimately, but I think other considerations were at play. I think if there was no additional revenue coming in from the change, then it wouldn't have been made. (It'll hurt me, in the short term at least, so I'm somewhat biased. I'm also speaking with no special information and far less expertise than our host and most of my fellow commentators.)

[Two Hats]

To follow up on the last part of my parenthetical comment above, a completely off-topic question:
What happens when the gov't stops borrowing money? And specifically, for whom is this a problem? Because it seems whenever we get close, someone finds a reason to turn the spending taps on (or cut the tax inflow). Could there be political pressure at play to ensure a supply of gov't debt, or is that just conspiracy-theorist thinking?

[Paul Fraser]

RBC Bank President Gordon Nixon - Salary $11.73 Million

$100,000 - MISTAKE (FISHERMEN'S LOAN)

I'm a commercial fisherman fighting the Royal Bank of Canada (RBC Bank) over a $100,000 loan mistake. I lost my home, fishing vessel and equipment. Help me fight this corporate bully by closing your RBC Bank account.

There was no monthly interest payment date or amount of interest payable per month on my loan agreement. Date of first installment payment (Principal + interest) is approximately 1 year from the signing of my contract.
Demand loan agreements signed by other fishermen around the same time disclosed monthly interest payment dates and interest amounts payable per month.The lending policy for fishermen did change at RBC from one payment (principal + interest) per year for fishing loans to principal paid yearly with interest paid monthly. This lending practice was in place when I approached RBC.
Only problem is the loans officer was a replacement who wasn't familiar with these type of loans. She never informed me verbally or in writing about this new criteria.

Phone or e-mail:
RBC President, Gordon Nixon, Toronto (416)974-6415
RBC Vice President, Sales, Anne Lockie, Toronto (416)974-6821
RBC President, Atlantic Provinces, Greg Grice (902)421-8112 mail to:[email protected]
RBC Manager, Cape Breton/Eastern Nova Scotia, Jerry Rankin (902)567-8600
RBC Vice President, Atlantic Provinces, Brian Conway (902)491-4302 mail to:[email protected]
RBC Vice President, Halifax Region, Tammy Holland (902)421-8112 mail to:[email protected]
RBC Senior Manager, Media & Public Relations, Beja Rodeck (416)974-5506 mail to:[email protected]
RBC Ombudsman, Wendy Knight, Toronto, Ontario 1-800-769-2542 mail to:[email protected]
Ombudsman for Banking Services & Investments, JoAnne Olafson, Toronto, 1-888-451-4519 mail to:[email protected]

http://www.pfraser.blogspot.com

http://www.corporatebully.ca

http://www.youtube.com/CORPORATEBULLY

http://www.p2pnet.net/story/17877

"Fighting the Royal Bank of Canada (RBC Bank) one customer at a time"

[alou]

Getting back on topic, I just wanted to say that my comment was about a closed economy. Countries like Ireland have out competed on the investment side because of their corporate tax policies.

[Andrew F]

I'm also guessing that in a small, open economy like Canada's, you can have low corporate taxes and high personal income taxes and still reap the benefit from foreign investment at whatever rate the world pays.

[Alex Plante]

I think all personnal & corporate income taxes & EI & CPP premiums + welfare, unemployment & old age pensions should be replaced with a GST + guaranteed minimum income (a kind of monthly flat payment to everyone). Calibrate the amounts & percentages so it's roughly equivalent to what we have now, but it would be so much simpler + respect privacy (since you don't need to declare income anymore).

[reason]

Alex Plante....
Yes, but you need some sort of anti wealth concentration measure as well (my favourite is inheritance taxes or income taxes on very high incomes). You are forgetting that money makes money (and big concentrations of wealth distort democracy).

[bob]

reason:
ah, but you are forgetting that that is really the whole point. Charles Koch & Bruce Kovner pay Kling & co. to spout this nonsense for precisely that reason. When you hear wingnut-welfare "libertarians" talk about a tax that they really really like, your bullshit detectors should be ringing red.

The reason that consumption taxes were popular with governments orginally is because they allow for a de facto tariff on imported goods that does not require an actual tariff, and levels the playing field between importers, exporters, and domestic producers (as opposed to manufacturers taxes) - but you would never know this from the conservative revisionist arguments.

The whole supply-side ex post facto argument is largely a conservative fiction (why Stephen can't really find much on the supposedly overwhelming arguments in favor) to justify a bad tax, because it overwhelmingly favors the ultra-wealthy (who fund GMU, CATO, AEI etc.). In their ideal world, there are no corporate taxes, no income taxes, no inheritance taxes, and giant ever expanding trusts that rule the world. Basically, they want the good old Gilded Age back, and they see consumption taxes as an easy step in that direction because they are regressive and so poorly understood, hence the bizarre libertarian pro-tax campaign.

The new arguments in favor of consumption taxes are the same supply-side anti-corporate tax pro-investment theories in new clothes. The argument that Stephen gives above is (correct me if I'm wrong) essentially the same argument that is made against the corporate income tax. I imagine that he is against the corporate tax as well.

The basic argument is that we have too many disincentives to investment, and that if we remove them we will get more investment, and through the investment-led supply-side magic Stephen outlined above (which I fundamentally disagree with), this will give us more jobs & growth in the long-term.

The reality is that there is no shortage of investment, and the real argument is about benefitting existing large-scale investors (capital rentiers) at the expense of everybody else, rather than generating new investment or growth. Don't take my word for it, take the word of the world's top expert on investment and especially investment-related taxes:

"Even so, tax breaks for corporations (and their investors, particularly large ones) were a major part
of the Administration’s 2002 and 2003 initiatives. If class warfare is being waged in America, my class is
clearly winning. Today, many large corporations – run by CEOs whose fiddle-playing talents make your
Chairman look like he is all thumbs – pay nothing close to the stated federal tax rate of 35%. "- Warren Buffett
http://www.berkshirehathaway.com/2003ar/2003ar.pdf

"Supporters of making dividends tax-free like to paint critics as promoters of class warfare. The fact is, however, that their proposal promotes class welfare. For my class." - Warren Buffett
http://www.andrewtobias.com/newcolumns/030522.html

The arguments behind consumption taxes are pretty much exactly the same as those against corporate tax, against capital gains tax etc., and originate from the same manufactured polyphony of right-wing think-tanks that finds a way to support anything that is in the interests of plutocrats - even, quite hilariously, when this leads to libertarians arguing for a tax simply because it is regressive. Remember, taxes are only theft if they take from the wealthy.

If you believe in the old Club for Growth Say's Law variants, then Stephen's argument above makes sense. If however, you are like me or Warren Buffett, you might see right through the "pro-growth" "pro-investment" supply-side theories, and see them for what they really are: pro-plutocracy, pro-inequality, pro-gilded age.

As I said before, the Scandinavian examples only really tell half the story, because Stephen is excluding the figures on income tax vs. spending that were in his original post:
http://worthwhile.typepad.com/worthwhile_canadian_initi/2005/12/nordic_canada_t.html

A better example of a consumption tax experiment (no income tax) would be that libertarian paradise.... Tennessee. gee, that has worked out great, hasn't it?

How about the poster-boy for low corporate tax rates - Ireland? whoops:

Spreads highlight Ireland fears
LONDON (MarketWatch) -- Fears that Ireland's banking woes will send the Emerald Isle the way of Iceland has sent the cost of insuring sovereign Irish debt against default to record levels.
http://www.marketwatch.com/news/story/ireland-default-fears-rise/story.aspx?guid=%7B56269F08-B818-4D69-A704-D73D2E8DE43E%7D&dist=TNMostMailed

That worked out REAL great, didn't it. Looks like this supply-side nonsense has pretty much bankrupted them. As it turns out, all those marginal investment opportunities that Stephen sees ended up costing the government billions to clean up when the "marginal" investments inevitably turned out to simply be "stupid" reckless investments. Gee, didn't see that one coming... not like we went through the 80s or anything.

I thought we had got this nonsense out of our system with Mulroney (father of the GST), and learned our lesson while trying to get out of the hole that Mulroney put the country into - the same supply-side hole that Ireland has now fallen into. I guess some zombie ideas never quite die, especially when there is a league of economists out there being paid to propagate them, and repackage them as "Bleeding Heart Libertarianism" *gag*, the close cousin of "Compassionate Conservatism"

The battle on consumption taxes is just getting started. A lot of people have yet to realize what is going on, and like Krugman when he briefly supported the Social Security scare, don't realize the faulty theories at work, and questionable political aims.

[Patrick]

Say you are poor ($20K per year), save nothing, have no deduction and therefore you pay the full shot on the lowest marginal tax rate of 15%. Ignore provincial taxes, CPP, and EI just to make it easy. So you pay ($20K-$9.6K)*15% = $1560 to Jimbo.

Ok. Now suppose we had a 20% GST and no income tax for most individuals (not sure if this would pay for gov't, but this is just a thought experiment so we'll ignore it for now). Supposing the rules are the same as today, there would be no GST on rent and no GST on most food you buy in a grocery store. So, assuming a poor persons spends 1/3 of their earnings on rent, $200 per week on food ($50/wk), and the rest on stuff that has GST charged you get $911.11 * .2 = $182.22 per month or $2186.67 per year.

Going back to the first case, we have to add 5% GST to the tax total to reflect the current reality, so that would be $546.67 per year using the previous set of assumptions. In total they pay $2106.67 to Jimbo. For a difference of $80. Looks more or less like a wash for the poor in this simplistic example with the current system looking slightly better.

The more of your income you spend, the worse the GST option is. So it seems like a bad deal for the middle class who have a higher proportion of disposable income but not so much that they have money sitting around. For the very rich who have much more than they need, it looks like a great deal because they don't spend anywhere near all their money. They can toss it into investments and essentially hide it from taxation.

Obviously, we don't want to discourage savings and investment, but not all savings and investment are equal. Example: CDO's (and the fees for originating them) are not productive, whereas providing working capital to a new business is - at least potentially. Similarly, an investor who makes lots of money investing/risking her money in a business should enjoy the rewards, whereas a CEO earning a $10 million salary should, in my view, be subject to confiscatory marginal income tax rates.

All this to say that I think a more progressive tax system that is structured to encourage investment and not only discourage but to severely punish rent seeking is devoutly to be wished for.

[Andrew F]

By using the model of Scandinavian countries, I don't think Stephen thinks that high personal income tax rates are a problem. In other words, I think the last few posters are using the strawman fallacy.

[alou]

The bust in Ireland isnt due to their corporate tax policy. I mean just because you make it a low cost place for manufacturers to set up shop doesnt mean that your banks have to be making housing bubbles.

[Stephen Gordon]

Just a couple of comments:

- On its own, the GST is indeed a regressive measure; I'm very much in favour of boosting the GST credit to counter those effects.

- As I indicated in the post to which I lined earlier, there is indeed room to increase taxes on earned income. But since English-speaking Canadians have the option of emigrating to many low-tax jurisdictions without having to learn a new language, there are limits to how aggressive those measures can be.

[Frances Woolley]

I think there's some good equity arguments for mixing income-type taxes and GST-type taxes in an economy with a substantial amount of tax evasion (what's BC's largest cash crop again?)

A person with a grow-op, say, will not charge GST on their products or pay income tax. So it might be thought there's no difference between the two.

But when our grower goes to spend their hard-earned (and so far untaxed) profits on, say, a new car, he or she will pay GST.

The income tax paying ordinary worker who buys a little (GST free) weed for a weekend smoke will get an evasion opportunity there, too.

So having both income-type taxes and consumption-type taxes evens things out a little bit.

The argument between income v. consumption as a tax base isn't really relevant for the 90 or so percent of Canadians (just making up that number, but it's large anyways) who have not yet used up their RRSP room (and, now, tax free savings account room). Only a fairly small number of fairly well off Canadians pay tax on investment income anyways.

This year's undergrads don't remember a time before GST - they just don't care that much about it.

Frances

[westslope]

The option of driving across the border to fill up on low-tax gasoline and diesel explains why Canada is limited in how high it can drive up fuel excise or "green" taxes.

[Andrew F]

west, that isn't really a practical way for Canadians to obtain a significant amount of their fuel.

[bob]

Patrick: The estimates for the Fair Tax put the effective rate at 36% if I recall. I would guesstimate that a full shift from income taxes to consumption taxes would result in an effective rate closer to 40% when all is said and done.

Stephen:
"- On its own, the GST is indeed a regressive measure; I'm very much in favour of boosting the GST credit to counter those effects."

Well, you can fix the regressive elements at the bottom of the income distribution with credits, but the more important effects happen at the high end of income earners. I'm not actually that concerned about the burden at the very bottom, as many expenditures are already exempt, and they get rebates.

But how can you make a consumption tax progressive at the top end? You can't, by definition. As Reason noted, you would need to institute something that looks a lot like an income tax on high earners. There have been attempts to design a fully progressive consumption tax that end up exempting the bottom from the tax, leave it on the middle, and use some sort of income calculation to levy additional taxes from the highest earners. But then we have pretty much come full circle - the pro-investment advantage that you see is neutralized by this additional income tax on the investor class. In order to make the system progressive, the wedge has to be reintroduced.

Any shift from income taxes to consumption taxes amounts to a tax break for the rich. IMO, there is no realistic way to fix this without resorting to income taxes, in some sort of convoluted corrective system that is not likely to be implemented. That is why I think it is better to stick with income taxes.

In terms of the more pragmatic concerns about evasion etc., I actually agree. Maybe the GST is good for the reason of diversifying revenue streams, collecting many lower taxes rather than one high tax, and taxing the black market. I can see good reason to support what to my mind are sub-optimal taxes if it is necessary to raise revenues, although my preference would be to close loopholes and beef up enforcement of other taxes.

Personally I think capital gains ought to be taxed at the full marginal rate, rather than half. IMO preferential capital gains tax treatment in most countries is a travesty. Sweden and co. have a very strongly enforced capital gains tax of ~30%, and up to 45% in Denmark I believe. In Canada the highest marginal rate is 21%. If we were to adopt a more civilized capital gains tax rate with adequate enforcement, I would be more willing to consider increasing consumption taxes, and lowering corporate taxes. I think the capital gains tax ought to be factored in to your earlier article, as it would not be captured under income, consumption or corporate tax rates but does contribute to social spending in Scandinavian countries.

Also, I shouldn't really lump you in with the FairTax/hardcore libertarian proponents of consumption taxes. The way I see it is that your arguments are very similar to those put forth in the late 70s by Feldstein and Summers (decidedly pro-investment and conservative, but kept within reason) while the libertarians are equivalent to early supply-siders like Jude Wanninski and Art Laffer who take the arguments to an untenable extreme, for political purposes. I don't agree with either, but it's really the second type that I'm worried about.

[Andrew F]

In the post Stephen links to, he points out that there is room to tax the upper percentiles of employment income in Canada. We can only impose progressive income taxes on investors in Canada. Attracting investment from the investor classes of other countries through low CIT rates would not necessarily cause regressivity.