The federal government should not cut taxes

The federal government has announced that, once the budget is in balance, its first priority will be "to provide tax relief to hard-working Canadian families." 

In 2013, the federal deficit had shrunk to $13 billion. This year it may disappear entirely.

But it does not follow that the federal government should cut taxes.

The deficit is equal to government spending less government revenues. It is the excess of expenditures over taxes and other receipts in any given year.  The deficit is distinct from the debt: the total amount that the government owes. Even though the federal deficit is shrinking, the federal government still has a substantial debt: its "net worth" at the end of 2013 was negative, at -$547 billion dollars (Fiscal Reference Table #47). Measured relative to the size of Canada's economy, that's around 29 percent of GDP.  

There is no consensus as to what the "right" ratio of debt to GDP should be. Comparing our net financial liabilities - gross debt less governments' financial assets - to that of our G7 counterparts, Canada appears to be a model of fiscal prudence:

(As an aside: Canada had Conservative governments briefly in 1979/80, from 1984 to 1993, and from 2006 onwards; Canada had Liberal governments from 1970 to 1979, 1980 to 1984, and from 1993 to 2006.)

The net financial liabilities pictured above include provincial balances, with Alberta's reserves netted out against other provinces' debts. They also set the Canada and Quebec Pension Plans' reserves against governments' liabilities. If one looks only at what Canadian governments owe, the picture is not quite so rosy:

While the federal government might not actually lose money this year, it is still carrying hundreds of billions of dollars of liabilities, as are most of Canada's provinces.

Moreover, although the federal government's budget is close to being in balance, the provinces' budgets, especially those of Ontario and Quebec, are distinctly unbalanced:

In the long run, provincial deficits  - and provincial debt - create problems for the federal government.  

Ever since Confederation, provincial governments have found themselves unable to raise enough taxes to pay for roads, education, policing, health care, and social services - the goods and services that are provincial responsibilities according to Canada's constitution. Basically, provinces aren't very good at raising tax revenue. If one province tries to raise its tax rate, people and businesses can move to another province with lower taxes. Once upon a time equalization protected provinces from the base-eroding effects of high tax rates - any loss in tax base was offset by increased equalization payments (see this paper by Michael Smart). However there is now a ceiling on equalization payments: total equalization payments can grow no faster than Canada's nominal GDP.  Yes, the provinces could make some dent in that $50 billion or so deficit by raising taxes - but it will be tough.

Moreover, population aging is facing provinces with a double-whammy:  as the Baby Boomers hit their senior years, they start paying less in taxes (because they've retired) and start demanding more in health care and other services. With limited scope to raise taxes, Ontario and Quebec (the big indebted provinces) will inevitably find themselves having to cut spending.

There is some scope for some provinces to cut some spending - Ontario's Drummond Report made a few suggestions. Unfortunately, provincial spending cuts have the potential to rebound upon the federal government. First, provinces finance education, roads, policing, infrastructure - things that are necessary to the functioning of a strong and just economy. If the inability of provinces to pay for goods and services hurts economic growth, and increases poverty or inequality, this is a problem for a federal government that cares about these things.

Provincial spending cuts also cause political challenges at the federal level. When people can't get the health care they feel they need, they don't sit down and read the 1982 Canada Act to figure out who to blame. When health care once again becomes a hot political issue, the federal government will come under intense political pressure to increase transfers to the provinces (see also this analysis by Marc Joffe).

While the federal government is currently in a much stronger fiscal position than the provinces, it also faces challenges in the longer-term, as I have argued before. With increasing numbers of retirees and fewer workers, and rising income inequality, more income is coming in the form of capital income. However capital income is harder to tax than employment income. Other changes, such as the growth of the service and virtual economies, as well as rising self-employment, are also making taxes harder to collect. On the corporate side, tax avoidance remains a concern. All the signs suggest that governments will face increasing difficulties collect tax revenues going forward. 

The federal government may have (temporarily) restored the budget to balance. But Canada as a nation is facing some serious fiscal challenges. This is not the time to cut taxes.

Comments

[Ron Waller]

You made a slight mistake with the OECD measure of debt/GDP. They only report on central government debt. You will have to reference the IMF's gross debt numbers to get all levels of government debt: World Economic Outlook Database.

But the esteemed professor Gordon has pointed out why the Harper Government is big on tax cuts: Starving the beast: What Canadian Conservatives can teach Republicans.

He shows it's a "quiet" 4 point plan:

1. Cut taxes
2. Manufacture a budget crisis
3. Justify big cuts to spending
4. Go to 1.

Mr. Harper has, of course, moved things ahead of schedule going to step 1 now rather than after the election — given Mr. Trudeau has been riding high in the polls since announcing his leadership bid 18 months ago.

I imagine the question remains, whether Harper will have done a moderate job bankrupting democratic government compared to the botched job the Republicans did south of the border. Once you start "starving the beast" it's hard to stop. If you go too far, which is very tempting, the people may rise up and turn the tides — raising taxes on the rich and all manner of populist barbarism. Then all your good work is for naught.

[Frances Woolley]

Ron, thanks, I've tidied this up. These OECD numbers are different from the world bank ones because they report net financial liabilities. This is how the OECD defines general government:

The general government sector consists of the totality of institutional units which, in addition to fulfilling their political responsibilities and their role of economic regulation, produce principally non-market services (possibly goods) for individual or collective consumption and redistribute income and wealth.

And this is how the OECD defines general government net financial liabilities:

Definition: Net financial liabilities are defined as the gross financial liabilities of the general government sector less the financial assets of the general government sector. Such assets may be cash, bank deposits, loans to the private sector, participation in private sector companies, holdings in public corporations or foreign exchange reserves, depending on the institutional structure of the country concerned and data availability.

I don't really see a revolution in the offing. More a quiet crumbling of a nation.

[Nick Rowe]

Frances: good post. But I think I disagree with one bit. If provincial governments use taxes to provide local public goods, and do so efficiently, an increase in provincial taxes should not cause migration to other provinces.

[Frances Woolley]

Nick, good point. That may or may not be the case depending upon who benefits and who pays for the local public good.

For example, if provincial governments increase taxes to pay for beautiful provincial parks, and the people who use provincial parks are the people who pay taxes, then, yes, the government can increase taxes without causing migration.

However if the provincial government increases taxes to pay for a playground in low-income neighbourhoods, and the people who pay taxes never use playgrounds at low-income neighbourhoods, then taxes will lead to migration.

Empirically, most of the money goes to things like health care, education, and social services. I can see the increased taxation = increased services argument working for education, but for the most part health care spending goes to people who are old and sick, and old and sick people generally speaking don't have much income thus don't pay that much in taxes.

I'm participating in the House of Commons Finance Committee's pre-budget consultations, so these posts are my way of getting my thoughts in order.

[Nick Rowe]

Frances: Ah, OK, yes. Also, if a provincial government got things wrong in the past, and so has inherited a higher debt burden, what I said won't work. Or if it is "lucky/unlucky" with natural resources etc.

With free migration, all taxes (except those for local public goods for those who can migrate) end up being taxes on "land". (Which is why us landowners should be the only ones who vote in provincial elections, of course. Everyone else votes with their feet.)

[Bob Smith]

Frances,

A couple of observations.

First, persumably the same arguments against cutting taxes apply equally to spending on new programs (e.g. $15 daycare). If Canadian governments, collectively, can't afford current program spending (or won't be able to afford current spending in the future), presumably the only two policy options on the table should be (i) increased transfers to provincial governments (to address current shortfalls) and (ii) paying down debt/funding unfunded liabilities (to fund future shortfalls). I don't get the sense that either option (but particularly the latter) is a serious priority for any political party in the next election (understandably).

Second, with respect to the merits of federal vs. provincial taxation, I don't think its accurate to say that the provinces lack the fiscal tools to fund their spending obligations. After all, their fiscal tools, namely income taxes, payroll taxes and PST/VAT are the same as those available to the federal government (and revenue from uniquely federal tools, customs duties and excise taxes, amount to a rounding error in the federal budget). Provincial whining about inadequate fiscal tools is an old one, and one that was at one time a fair complaint (in the 19th century custom duties and excise taxes were the heavy hitters of the fiscal universe), but one that is too conveniently dragged out by current premiers (of all political stripes) to justify their own fiscal irresponsibility.

I take your point about the risks of inter-provincial tax competition, but I think those risks can be overstated. As Nick points out, the "costs" of taxes have to be weighed against the "benefits" they provide. I think you understate the extent to which taxpayers value those services - the benefits of health care may accrue largely to the old and sick, but we're all old someday and people tend to get sick regardless of their income (indeed, there is some evidence that the wealthy tend to get better access to health care in the public system than the poor - the same could be said of many provincial programs such as education or public daycare). Moreover, I do think there are externalities associated with higher social spending that even right-wing suburbanites like myself value (i.e., no matter how otherwise nice they are, I always find that the poverty in US cities makes them feel less safe and pleasant than their Canadian counterparts). Too often the people who make the strongest case for social spending completely discount the merits of that spending when the discussion turns to tax competition and the purported "race to the bottom".

Moreover, the practical reality is that for individuals (who pay the bulk of federal and provincial taxes) the costs of tax-related migration often far outweigh the benefits (and arguably, with the rise of the two-income family, we've probably become even more "sticky" than we used to be). To be sure, at the very top of the income spectrum, either the benefits of shifting income to other jurisdiction (as opposed to other means of tax avoidance) are so large, or they have opportunity to shift their income without their residence (i.e., moving capital income to other jursidictions, by using Alberta trusts for example) that this is a real cost. On the other hand, the number of people who can successfully engage in such strategies are so small that we're talking about a marginal hit to provincial revenues. Similarly, in the corporate tax space, we've seen a convergence of the provincial general corporate tax rates at the 10-12% range over the past few years with little evidence of any willingness to go below that (and indeed, both Ontario and BC have increased their corporate tax rates from 10%). I don't know if there's any empirical evidence on this, but my impression is that most internal migration to, say, Alberta is driven by real economic opportunities there, rather than low tax rates.

In any event, to the extent tax competition is an issue, in a globalized economy, the real issue isn't competition between 10 provincial governments (as it might have been 50 years ago), but competition between 200+ international jurisdictions (plus god knows how many subnational jurisdictions). If someone is considering leaving Ontario for Alberta to reduce their tax bill by 20%, why not move to Florida and cut it in half, or Bermuda and cut it by 96%? Moreover, the reality is that small jurisdictions, such as the Scandinavian countries, have developed tax policies which generate significant revenue while mitigating the effects of tax competition (i.e., taxing employment income and consumption at high rates, while taxing capital income and corporate income at relatively modest rates). There's no obvious reason why provincial governments couldn't emulate those regimes if they are so inclined.

Moreover, there is a real policy risk in splitting the revenue raising/spending functions of government between different levels of government, in that it distorts provincial (and federal) decision making. On one level, it encourages greater federal meddling in provincial affairs (on the theory that she who pays the piper calls the tune) - the hash that we've made of medicare over the past 30 years, while other social democracies have experimented with the provision of public health care is a good example of that. On the other hand, it encourages provincial government to spend on programs that their voters, left to their own devices wouldn't choose. Or, alternatively, if provinces have free rein on how they deal with federal transfers, it allows them to cut their own source revenue, creating the environment for tax competition that federal taxation is intended to avoid (and we've seen that in recent years with, for example, Quebec cutting its federal taxes after extorting more money from the feds complaining about the fiscal imbalance). All this while confusing lines of federal and provincial responsibility and undermining democratic accountability.

[JF]

Can the Canadian national government enact a net-worth tax regime (perhaps while cutting the other taxes)? Provinces could not enact such a tax as high net worth people are highly mobile, so a national effort is the only one that makes sense. Of course I realize this isn't in line with the ruling party's views of the world, but thought I'd ask.

You might look at the US Natl Academy of Public Administration's report on the Revenue System of the US, where you'll read a discussion very similar; it is based on an intergovernmental view. I managed this 10-month study effort and was the main staff drafts-person of the report.

[Frances Woolley]

Bob: for recent research on the extent of tax competition in Canada, see here. "We also find that the behavioural response to higher tax rates at the provincial level is quite strong. This puts limits on how high a new provincial tax bracket could go."

[Phil Koop]

"If provincial governments use taxes to provide local public goods ..."

This doesn't matter as much as you might think. It is possible to physically reside in one province but be a taxpayer in another by setting up a trust structure. There are fixed costs to this, but for high-income individuals these costs can be outweighed by tax savings if, for example, one resides in Ontario but pays taxes in Alberta. So the wealthy can have their cake and eat it too. That is important because an individual does not necessarily have the same income opportunities in every province.

[genauer]

Before cutting taxes,

shouldnt return Canada to what it did between 1994 and 2007, paying down debt?

The law in Europe (http://en.wikipedia.org/wiki/European_Fiscal_Compact) demands paying down 5% of the difference to the target level of 60% GDP, which should include provincial liabilities but not pension fund assets, since they can not really be sold.

the 107% GDP to 75% reduction Canada did, is pretty close to that.

And the next crisis will come, as always, from somewhere

[Nick Rowe]

Genauer: Eurozone countries are like Canadian provinces. They cannot print money. The Eurozone disaster suggests that provinces should reduce debt, not the federal government.

[Frances Woolley]

Phil - Kevin Milligan and Mike Smart have done research on the Alberta trusts - basically their findings support what you're saying.

Nick and Genauer - I agree with your description of where we should be, Nick, but how do we get there from here? Ontario had expenses of $126 billion last year, and a deficit of $10 billion http://news.ontario.ca/mof/en/2014/09/ontarios-deficit-13-billion-lower-than-forecast-in-2013-budget.html. To make the math easy, let's do some rounding and say the deficit is 10% of revenues. Say we increase taxes 5% and cut spending 5% - that's not going to bring the budget into balance, because spending cuts will lead to lower revenues (if our salaries are cut, or we're out of a job, we'll pay less taxes), and tax increases will lead to an erosion of the base. So maybe we're talking about tax increases of 8% and spending cuts of 8%? That might bring things into balance now, but once population aging starts getting serious, we're looking at big increases in the costs of health care and social services. I just don't see Ontario and Quebec making significant progress against their debts without federal help.

[Frances Woolley]

Nick - the Eurozone disaster suggests we shouldn't have got in this mess in the first place!

[genauer]

Eurozone countries are not provinces.

The budget of the EU accounts for only about 1% of GDP

I have my own national army.

That other Euro countries can not live within their means, since long before the Euro, see e.g. Italy in the plots above, and people doubted getting their money back is not a problem of the Euro

[Bob Smith]

Frances,

Yes, I'm familiar with that literature, but Smart and Milligan's work focused on the response of the top 1% to increasing the tax rate. I don't disagree that that at the very top of the income spectrum ( people are quite responsive to changes in tax rates - indeed I said as much in my comment - although I think you see most of that action is driven at the very top of the 1% (i.e., a university professor, judge, lawyer, making $200K may well be in the top 1%, but their opportinties for tax-motivated mobility are pertty slim). More to the point, I think the evidence is that the tax elascity of income for that group is also very high at the federal level (i.e., it's just as easy to move from Canada to Florida or the Bahamas as it is Ontario to Alberta).

More to the point, you're implicitly assuming that any tax increases will/should come from increasing the top marginal rate- that may well be tapped out as a meaningful revenue source. Of course, if Ontarians (for example) believe that health care, education, social services, etc. are worth funding, it's an open question why they don't believe that they should all be paying for them to some degree or another. It's worth noting, for example, that while the Ontario Liberals have been steadily increasing taxes on top income earners, they've left untouched the large middle-class tax cuts implemented by the Harris government in the mid 1990's. Nor is it clear why income tax, rather than, say, increasing the provincial portion of the HST by 2% (as Quebec and Nova Scotia have, effectively, done) to eat up the Harper GST cut, is the appropriate policy response to the purported underfunding of provincial coffers (which may be why Ontario's coffers are in worse shape than those of Quebec and Nova Scotia).

On the Alberta trust structures, those are probably somewhat vulnerable these days due to recent court decisions dealing with trust residency. Once upon a time, people got comfortable that a trust was resident in a particular jurisdiction if the trustee was located in that jurisdiction. However, recent jurisprudence suggests that you have to look at effective management and control of a trust to figure out where it's resident. If you're comfortable taking all your money and handing it over to a complete stranger in Alberta to manage, than the Alberta trust structure works. If you're not, and insist on appointing a protector, or meddling in the management of the trust, expect to get a visit from your friendly neighbourhood Ontario tax collector.

[Majromax]

@genauer:

> Eurozone countries are not provinces.

> That other Euro countries can not live within their means, since long before the Euro, see e.g. Italy in the plots above, and people doubted getting their money back is not a problem of the Euro

That's why the Euro countries are fiscally equivalent to Canadian provinces: they carry independent credit risk, face free movement of people and capital, and cannot issue their own currency to devalue debt. Their situation is somewhat worse because of the lack of a central, EU-wide fiscal authority to provide a measure of equalization, but that's a difference of degree and not kind.

If I'm reading the post's graphs correctly, Italy was always something of a basket case. It seems to be the top light blue line rather than the bottom light blue line (UK). Regardless, prior to adopting the Euro Italy had the freedom to devalue its currency, in effect making its labour cheaper compared to foreign labour.

[Bob Smith]

"To make the math easy, let's do some rounding and say the deficit is 10% of revenues. Say we increase taxes 5% and cut spending 5% - that's not going to bring the budget into balance, because spending cuts will lead to lower revenues (if our salaries are cut, or we're out of a job, we'll pay less taxes), and tax increases will lead to an erosion of the base. So maybe we're talking about tax increases of 8% and spending cuts of 8%? That might bring things into balance now, but once population aging starts getting serious, we're looking at big increases in the costs of health care and social services. I just don't see Ontario and Quebec making significant progress against their debts without federal help."

Why are you assuming that increasing provincial taxes reduces revenues, but increasing federal taxes (relative to what they might otherwise be) wouldn't? Or conversely, why wouldn't increasing federal spending offset provincial spending cuts? Presumably the macroeconomic effects are the same regardless of whether a dollar comes from the feds or the province.

Sure, if we're talking about transfer to PEI or Nova Scotia, than equal per-capita transfers from the feds to the provinces result in significant redistribution from richer provinces to poorer provinces (i.e., every dollar in federal spending might cost provincial taxpayers 70 cents). But, let's be honest, Ontario and Quebec are too huge and too rich for any meaningful inter-provincial transfers of that magnitude to be politically or economically sustainable. Even as a "have not" province Ontario pays, what, 95, 98 cents out of every dollar it receives from the feds? It's out of one pocket into the other.

There's no doubt that Ontario will have to make some hard choices over the next few years (having refused to do so for the last 10 years), but it's not clear to me how getting the feds to make those hard choices is somehow better for the Ontario economy (at least in any meaningful sense) than Ontario doing it itself. It's worth noting, as Livio as posted here before, that Ontario has (or had as of 2009) the lowest tax revenue per capita of all the provinces (http://worthwhile.typepad.com/worthwhile_canadian_initi/2011/06/provincial-revenues-another-view.html). That Ontario has a hefty deficit is a testament its governments willingness to provide Cadillac public services at a Chevy price. I doubt there's any appetite at the federal level (or amongst the other provinces) to remedy that problem for Ontario.

[genauer]

Majromax

quite frankly I doubt whether Canada would really let a province go bankrupt.

The same goes for German provinces, ("Bundesländer").

But Greece did go bankrupt, and I would not hesitate to let Italy and others go.

When Cyprus tried to renege on ECB loans in March 2014 ("ELA") they were told with a 21/1/1 vote, either they man up or get cut out, get cut off Target2, and can do their financial transactions with shipping bullion Gold. Stupid criminals get treated that way.

When you look at OECD Annex 58, you will find that the private Italian is richer (higher wealth/income ratio) because they privatized wealth and try to push their public debt onto the rest of Euroland.

And before that happens we would let the Euro blow up

There is an AID program in place , the ESM, with 500 billion Euro capital, but this would only come with the strings of a turn-around program in place, like an european IMF, and the same size of capital as this world wide organization.

And there will be scolding, anti-German hatemongering, every three months the next tantrum of trying to fudge the numbers, kicking and screaming, and in the end they will live, mostly, by the rules.

Because the alternative, bankruptcy, expulsion from the EU and free trade, would be MUCH worse, at least 10 % permanent GDP loss, possibly 20%

All,

and the faster Ontario gets told by the rest of Canada, that not balancing the budget in mid terms is not an option, the less overall pain there will be. I dont know enough Canada to judge whether this would come with some assistance program or changes of tax distributions, or ....

Things we constantly bicker about in Germany as well : - )

[Ron Waller]

"Ron, thanks, I've tidied this up. These OECD numbers are different from the world bank ones because they report net financial liabilities. This is how the OECD defines general government:"

You must have better access to OECD stats that I have. I tried looking up their debt numbers and I got central government debt. But their gross debt numbers look like the IMF ones.

Harper likes to boast Canada has low net government debt. Of course, we pay interest on gross debt. I have to wonder if net debt has any meaning. It's not as if a government can convert its major assets like pension funds to cash to pay down debt. It would seem the most significant factors in determining a government's ability to fund its debt (besides debt/GDP) is how much is held internally and whether the country has its own currency.

"I don't really see a revolution in the offing. More a quiet crumbling of a nation."

Inequality breeds more inequality. It also produces boom to bust business cycles and never-ending slumps. When the market economy no longer appears to function people start looking for an alternative form of society: the economic instability spills over to political instability. The last economic meltdown led to the rise of fascism and world war. Communism was also a reaction to inequality. Today environmentalists see economic growth as the threat to civilization and demand an alternative to the market economy.

Today's economic conditions are worse than what they were during the 1930s. The biggest problems are very high and growing levels of personal and government debt, falling incomes and anemic growth. If another bubble bursts or another boom founded on illusory prosperity busts we will be facing a crisis worse than the 1930s.

We are in uncharted territory. The pseudo technocrats envision slow but stable long-term growth. But their economic models are only reliable in consistently failing to predict the future. We don't have a solid foundation for sustainable growth. We have a crumbling foundation. A collapse is not unlikely. My bet is that it's inevitable. The ensuing revolutions are coming. What forms they will take is an interesting matter to contemplate.

Last time around, democracy and the market economy were saved by Keynes. Of course the threat of a communist domino effect in Europe made a move to the economic center more palatable to plutocrats. Today they could favor a police state: the West becoming more like Russia and China than the other way around.

[Frances Woolley]

Bob: "you're implicitly assuming that any tax increases will/should come from increasing the top marginal rate"

That wasn't my intention.

"Why are you assuming that increasing provincial taxes reduces revenues, but increasing federal taxes (relative to what they might otherwise be) wouldn't?"

I'm assuming that increasing provincial tax rates increases revenues, but shrinks the tax base, so the increase in revenues is less than the increase in tax rates. The same holds true for federal taxes as well, but because the federal tax base is less elastic - it's harder to move to Florida for tax purposes than to BC - a given increase in federal tax rates would be expected to lead to greater increases in tax revenues than the same increase in provincial taxes.

One could make an argument that the appropriate role for the federal government would be to vacate some tax room, giving the provinces space to raise their taxes. I'm not sure if I agree with this, but it's not a stupid proposition.

[Bob Smith]

Frances,

I'm not sure that it's true that it's easier to move to BC than Florida or Barbados for tax purposes, certainly not if you've got a lot of money.

In any event, I would have thought that clearing federal tax room, on your account, would be no different than a tax cut (since presumably wealthier provinces could simply increase their taxes). I think that is probably the right move (and one in keeping with Tory ideology about not interfering in provincial affairs), but I doubt that it's politically sellable in an election year.

In any event, given the projected magnitudes of federal surpluses and provincial deficits, even clearing tax room by the feds isn't going to save Ontario. It'll have to start making hard choices.

[genauer]

I coompiled a comparison of debt numbers from CIA, OECD Annex 32,33,61, Eurostat, and IMF
for the years 2013, 2007, 2000

to be at least somewhat readable, I show only the year 2013

Source CIA IMF Annex 32 Annex 33 Annex 61 Maastricht
Year 2013 2013 2013 2013 2013 2013
Canada 86.3% 89% 97% 43%
France 93.4% 94% 113% 73% 94% 92%
Germany 79.9% 78% 86% 49% 79% 77%
Italy 133.0% 133% 146% 117% 133% 128%
Japan 226.1% 243% 227% 144%
Norway 30.1% 30% 34% -181%
Spain 93.7% 94% 100% 67% 93% 92%
UK 91.1% 90% 107% 74% 92% 87%
US 71.8% 105% 104% 82%

It seems that the CIA is significantly understating US debt,

and that otherwise the IMF represents more closely the authorative Eurostat data than the OECD

I could make the whole table available, if Frances or somebody else knows to bring this in readable form here.