Economic policy advice for the NDP, Part III: The GST

The NDP has never been a fan of the GST, and persuading Canadian progressives of its merits is a never-ending variation on the theme of "but these go to eleven:"

Progressive Person: How do we raise the tax revenues we need for the social programs we want to implement without tanking the economy?
Economist: Consumption taxes. Theory says that consumption taxes such as the GST are the least-disruptive way of generating tax revenue, and available evidence appears to be consistent with the theory.
PP: But consumption taxes are regressive!
E: Yes, but we can correct for that using targeted transfers to low-income households so that they aren't worse off; that's what the GST rebate is for. And there will still be lots left over to fund those social programs.
PP: But consumption taxes are regressive!
E: I know. But they introduce fewer distortions than the alternatives, and we can recompense low-income households for their lost buying power.
PP: But consumption taxes are regressive!
E: I'm not disputing that point, but there's more to the analysis than that. Okay, let me explain the effects of the various forms of taxes...
<15 years later>
E: ...and so we see that a consumption tax accompanied by direct transfers to low-income households is the most effective way of generating the tax revenues you want.
PP: But consumption taxes are regressive!

Clearly, that's a dramatisation: in real life, it would never have occurred to a progressive to ask an economist how to finance social programs without tanking the economy. But below the fold, I'll try to summarise once again why the NDP should abandon its traditional antipathy to the GST and start to view it as an important instrument in advancing its agenda.

This is a theme I've played on many times, and most of what follows is recycled from this post: Why the GST is a good idea.

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.

That's the theory. In the current context, we're looking at a post-recession structural deficit that is roughly equal to the lost revenue associated with reduction of the GST from 7% to 5%. So here is my recommendation:

• Announce in increase in the GST back to at least 7% (more if you want to promise more spending), effective Jan 1, 2011. Do it gradually, if you must. Sell it as correcting the Conservatives' mistake, one that threatens to send us off into another deficit-debt spiral.
• Accompany this with a top-up of the GST rebate, effective immediately.

I realise that this is likely to be a hard sell. But then again, the reason it's a hard sell is that you've spent the last 15 years saying 'The GST is regressive!' over and over again.

This is part of a series:

• Economic policy advice for the NDP, Part I: Inequality
• Economic policy advice for the NDP, Part II: Defending big government
• Economic policy advice for the NDP, Part IV: Corporate income taxes
• Economic policy advice for the NDP, Part V: Give money to low-income households
• Economic policy advice for the NDP, Part VI: Climate change
  

Comments

[Mark Dowling]

Hiking consumption taxes is problematic in an economy where the vast majority of people live within reasonable distance of a jurisdiction with much lower ones.

This leads to spending flight and resentment of customs (US-Canada) or just spending flight in a customs union (Ireland-Northern Ireland). The impact on Republic of Ireland retail created by the hiking of Southern VAT to 21.5pc and the reduction of GB+NI VAT to 15pc has been marked, especially since the Pound tanked and the Euro appreciated. By contrast, you can get away with high rates in Scandinavia because the tax differentials are much less pronounced.

One thing the Republic of Ireland has is multiple VAT rates (apart from zero rated items). While most things clock in at 21.5pc (included/not broken out at sticker and register), some services attract 13.5pc and agricultural goods 4.8pc. The NDP could deal with the backlash on a consumption tax by creating a lower GST/HST rate on electricity and other items to which the lower-income groups are most price sensitive.

[Patrick]

Mark, have you been through US customs recently? The days of getting waved through are long over. Everyone in the car better present a passport, and everyone gets the third degree. And if anyone looks even vaguely middle eastern, you're in for hard time. Who needs the hassle and the risk of running afoul of a border guard with essentially unlimited power and the IQ of a piece furniture, just to save a few bucks in taxes? Remember, foreign nations seeking admission to the US have almost no rights under American law.

[Declan]

I agree that it would be smart to increase the GST back to 7%, but that story about the investment rates always seems overblown to me - sooner or later (preferably later, I admit) you'll have to pay the consumption tax unless your goal is simply to sit scrooge-like upon the value of your investments and never buy anything with your earnings.

As for concerns about progressivity, in addition to gst rebates, you can always increase the progressivity of the income tax (per your previous post) at the same time to compensate.

Also, it's not true that raising the gst will be a hard sell because of progressive concerns about the lack of progressivity in sales taxes (unless you meant a hard sell within the NDP party itself?). It will be a hard sell because people's natural preference for free lunches combined with the right wing noise machine creates a storm of pitiful whining any time taxes are raised (or even shifted from one source to another).

I recall the B.C. carbon tax debate. The B.C. Liberals, after 6 years of relentless cutting of taxes and with the provincial budget in good shape (which you think might have established some credibility on the issue), shifted a small percentage of the provincial tax base to carbon from other sources. They mandated the revenue neutrality of the shift in legislation, tracked the neutrality of it in the budget and set up an oversight group to monitor it, and yet, despite all the measures taken to show its neutrality, despite there being no reason why a government which had been cutting taxes since being elected would suddenly decide to raise them for no reason, even the Prime Minister wasn't above dishonestly claiming in the media that the government was lying about its revenue neutrality, and never mind the level of the debate at levels lower than the Prime Minister.

There was some concern about whether the changes were progressive or not, but that was a very minor element to the overall debate.

I'm off topic a bit here, but only slightly in the sense that all the economic advice in the world (and much of your advice has been sound, in my opinion) is useless to the NDP in the current detached from reality political/media climate. As long as a decisive chunk of the population can be convinced by a few commercials and a compliant/complicit media that a vote of no confidence is a 'coup' or that Stephane Dion is notaleader then any comments about the saleability of tax measures that are based on the actual merits as opposed to spin and political considerations are irrelevant. (And your starting premise of social spending implying a threat to 'tank the economy' is a good example of the sort of political spin embedded in people's minds that is more important than the specifics on any taxes)

[Too Much Fed]

"That increased capacity in turn generates higher output, employment and wages."

Not necessarily. What if there are productivity gains and an oversupplied labor market?

[Too Much Fed]

About corporate and income taxes, what if there are excess corporate profits and excess wage income for the few?

[Too Much Fed]

Is it harder to "go overseas" with a consumption tax vs a corporate or income tax?

[westslope]

Stephen: Good piece! I like the National Post op-ed though I think the title (Yes, there is a defence for bigger government) was tad unfortunate.

Perhaps once you have convinced the NDP and other left-leaning Canadians of the merits of consumption-based value-added taxes, you can try to convince them that the ideology of entitlement-driven open access to valuable public assets is guaranteed to suck the wealth out if not destroy the asset.

[reason]

"Consumption taxes. Theory says that consumption taxes such as the GST are the least-disruptive way of generating tax revenue, and available evidence appears to be consistent with the theory."

LVT?

[reason]

Mark,
don't worry the price of oil will take care of that.

[Robert McClelland]

Sorry, but I have to ask my question from the other day again. Why should the NDP listen to economists? The GST is unquestionably one of, if not the, most hated taxes in Canada. Suggesting that the NDP campaign to raise it is not only impractical, it borders on the absurd. You might as well suggest they drown a sack of kittens.

[Matthew]

One of the other advantages of consumption taxes such as the GST is that they are transparent and relatively simple. People better understand the true cost of government. This is a problem in the US where a lot of taxes are more hidden - people tend to think government is cheaper than it really is.

Stephen:

How do you feel about the idea the NDP was kicking around at its recent convention, to phase out small business taxes? May be a political winner - there are lots of small buisness people in this country who vote and tax "burden" has long been one of their main concerns. But from an economic policy standpoint, I can't think of a better way to ensure small businesses will stay small.

[Matthew]

"They mandated the revenue neutrality of the shift in legislation, tracked the neutrality of it in the budget and set up an oversight group to monitor it, and yet, despite all the measures taken to show its neutrality, despite there being no reason why a government which had been cutting taxes since being elected would suddenly decide to raise them for no reason"

The reason, I think, was Gordon Campbell's vanity.

[Matthew]

Reason:

Nobody is going to *campaign* on raising the GST. It is something you do after you get into power.

[westslope]

Robert McClelland,

Why should the NDP listen to economists? There are a whole bunch of reasons.

For one, the NDP should be about results, not ideologically-entrenched methods or myopic expediency.

For two, amour propre. Many of us are pointing to the northern European social democracies as sophisticated modern and highly successfuly economies and societies. Canadian 'socialists' (sic) come across as increasingly populist and reactionary.

For three, future generations of Canadians might appreciate federal and provincial governments that remain strong, well financed and able to both deliver public services and redistribute income.

For four, Stephen Gordon is only scratching the surface of what is wrong with the NDP. The populist, open-access, entitlement attitude to public assets (artificial and natural) is and will continue to hurt ordinary Canadians.

For five, the NDP keeps pushing left of centre social democrats into the arms of the Liberal Party.

For six, you need to listen to guys like me, for example, who used to knock on doors for the NDP, worked in progressive social groups and unions that electorally benefited the NDP, and still maintain friendships with past cabinet ministers and perhaps a future leadership candidate. We still believe in the idealism, the accomplishments and the goals of the original CCF and the early days NDP.

[Matthew]

Sorry, my last comment was in response to Robert McClelland's post, not reason's.

[Patrick]

The NDP is supposed to be progressive, right? So be progressive! Propose some bold policies with sound intellectual underpinnings. It might actually raise the level of debate above the circus masquerading as parliament.

My short list:

1. Eliminate income taxes. Yes, eliminate it completely.
2. Replace income taxes with a combination of consumption taxes and Pigovian taxes.
3. Replace EI and welfare with a guaranteed national income that pays a premium to the working poor over the long term idle poor.

I'd love to the other parties in the position of defending income taxes!

[Robert McClelland]

2. Replace income taxes with a combination of consumption taxes and Pigovian taxes.

How would you deal with all the low income people who don't pay any income taxes that would suddenly be paying much higher consumption taxes?

[Robert McClelland]

For one, the NDP should be about results, not ideologically-entrenched methods or myopic expediency.

Raising the GST would only get them bad results.

[Patrick]

Robert McClelland: see the opening salvo in Stephen's post.

[Patrick]

"How would you deal with all the low income people who don't pay any income taxes that would suddenly be paying much higher consumption taxes?"

I would say: sure, you pay more consumption taxes, but now because of the national guaranteed income you actually have more income. So your kids can have warm boots in the winter, you can afford their school supplies and - get ready for it - you can afford to buy fresh vegetables!

I know ending poverty by simply ending poverty is a shocking idea, but I hope it eventually catches on with progressives.

[Jim Rootham]

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.

I don't believe you managed to type that with a straight face. Have you not noticed what that particular idee fixe just lead to?

[Patrick]

Jim Rootham:

Exactly. Investment it bad. I already have my cave picked out.

[Matthew]

"...ending poverty by simply ending poverty is a shocking idea..."

But Patrick, what about all the social workers, program managers, associate program managers and community engagement consultants? What will they do for work?!

[Mark Dowling]

@Patrick - as a Canadian Permanent Resident I have had the beady eye of US Customs Homeland whatever long before now, welcome to the club. All they require of Canadians is a passport, not an I-90 form which requires a visit to the facility (at least at Queenston). The municipalities around Buffalo are highly sensitive to a drop in sales tax from Canadian visitors so there's plenty of pushback against throttling incoming Canadian shoppers.

@reason - have you forgotten that one of the best reasons to shop in the US is a cheap fill-up?

[Mark Dowling]

@WCI folks - as we're talking about sales tax, any chance of a post about how Ontario is selling harmonization with one-off cheques and so on? Interested to see your take on what the end result will be once the interim measures wear off.

[Jim Rootham]

The converse of the idee fixe that I was referring to is not that investment is bad, but that the idea of choosing investments solely by their profitability will lead to socially optimal outcomes.

[Jim Rootham]

There is another problem with this advice. We live under a first past the post Westminster democracy. the examples cited are proportional representation systems. Some of the return to capital goes into TV stations, radio stations, newspapers, think tanks, and (as an afterthought) political parties. This moves about 10% of the population who would benefit by redistribution into supporting parties that oppose redistribution. These people will combine with the 30% of the people who don't benefit from redistribution into the 40% required to get a majority government. Voila, no redistribution.

If the NDP advanced the idea to drop income tax rates so that the GST could be raised to support redistribution the likely outcome would be a reduction in income taxes and a concommitent reduction in redistribution (see the result of the report on Ontario hospitals that said improvements in efficiency would permit hospital closings).

The Scandinavian countries were once known for exceedingly high income tax rates designed to support redistribution (either via money or services). The transformation into VAT was a politically required historical arc.

[Bob Smith]

Of course, you could have a consumption tax in a form other than the GST. In fact, for most Canadians what we call "income tax" is really a consumption tax, because most of our investment income is sheltered from tax because it's earned in some form of tax-deferred or tax pre-paid savings plan, such as a RRSP, RPP or TFSA.

It's easiest to show that our "income tax" can be a "consumption tax" in the case of an RRSP. If your income is equal to the sum of your consumption and savings, and you receive a deduction for your savings in computing your taxable income (as you do with an RRSP or RPP), then at the end of the day, you only pay tax on your consumption (because your taxable income equal to your total income minus your savings, i.e., your consumption). Any investment income earned in an RRSPis tax exempt and you only pay tax on it when you take it out of the RRSP (presumably to spend it). You get the same result with a TFSA, though the math is a bit more complicated (because you pay the tax up-front, but aren't taxed on that money or the income generated by it down the road).

Granted, some Canadians have savings outside of their RRSPs or TFSAs (though, over time, those will get moved into TFSAs, as people build up more contribution room), but I'd imagine for most of us, those sorts of plans make up the bulk of savings (to the extent we have any).

[tyronen]

It is possible to ameliorate the effects of the GST on the poor with credits. But sales taxes do not have brackets. It is not possible to make the very high income pay a higher rate than the middle class. Your own previous post on inequality shows how dramatically it has increased in the past 15 years.

Furthermore, economic theory says only that the GST has efficiency benefits. But you have to balance that with the equity tradeoff. To choose efficiency over equity (or the reverse) is fundamentally a values judgment. It is a political decision, not an economic one. A party of the left values equity highly and will, to some extent, be willing to sacrifice efficiency slightly to meet that goal.

The public anger at the GST back in 1990 is virtually without precedent of any tax in Canadian history - it led to the destruction of the 150-year-old Progressive Conservative Party. The public clearly also feels that equity has been sacrificed too much, and the NDP, of all parties, should respect that choice.

As an aside, your argument that the income or corporate taxes reduce investment is not even that convincing. Rates of return are decisive in choosing *which* investment an investor makes, but whether to invest at all in the first place? As an example, I put the same amount into my RRSP each month, regardless of whether rates go up or down, regardless of whether the stock market is expected to rise or fall, regardless of whether taxes go up or down. I save because I believe I will need the money more later than now. Certainly there may be some who do indeed behave as you predict, but there's no reason to believe everyone will.

[reason]

Mark Dowling -
no I meant the price before tax and the cost of commuting. Never mind.

I'm a bit disappointed that no one picked up on LVT. LVT is SURELY the least disruptive tax economically, and that has been known for a long time. Its just it is politically difficult in a society where most people "own" land (really just own the liabilities associated with land - but that is another story).

[Andrew F]

It sounds difficult and expensive to implement. How do you value land? It's only possible to know when it is sold what it is worth, and that even requires stripping out the cost/value of improvements. So to determine what it is worth without selling it, you need evaluators, an appeals process, etc. With VAT, the value of the thing being taxed is pretty unambiguous: the transaction price.

[reason]

I believe that is basically a solved problem. There are statistical methods available based on rents and sales prices that are regarded as reliable and fair.

[Andrew F]

If it is anything like the current method used to assess home values for the purposes of property tax, I have little doubt that it would be highly politically contentious.

Has there been any pilots of this sort of tax, and what was the result?