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HANDS OFF THE GST!
Andrew D. Kosnaski
The GST may be the most hated tax in the land, but it is a consumption tax, and
consumption taxes favour economic growth by eliminating the bias against savings
inherent in an income tax. But even more importantly, large cuts in taxes are risky.
The economy is unlikely to continue to grow at more than twice its historical rate of
growth for much longer. With the baby-boom generation creeping ever closer to
retirement, a more prudent fiscal plan would be to keep the GST and reduce income
taxes and government debt, thus preparing for the harder times that are bound to
come.
De toutes les taxes qui ont cours au pays, la TPS est peut-être la plus détestée. Mais
c’est une taxe sur la consommation, et les taxes sur la consommation favorisent la
croissance économique, en éliminant le parti pris contre l’épargne inhérent à l’impôt
sur le revenu. Chose plus importante encore, la réduction massive des taxes et
impôts est une option risquée. Car il est peu probable que l’économie continue bien
longtemps de croître au rythme actuel, c’est-à-dire deux fois plus rapidement que la
moyenne historique. Au fur et à mesure que la génération des « baby-boomers »
approche de la retraite, on devrait s’en tenir à une planification financière plus
prudente : garder en place la TPS et réduire la dette du gouvernement, pour parer
aux temps durs qui ne manqueront pas de venir.
S
ome Canadian political parties have recently begun to
muse publicly about reducing the level of the muchhated goods and services tax. The proposal seems to
make great political sense: The GST was the visible replacement of a previously invisible manufacturer’s sales tax, and
it came to symbolize the rapid build-up in taxes that
Canadians have railed about ever since. But does such a
proposal make economic sense? In fact, reducing a consumption tax instead of an income tax reduces economic
efficiency and has the potential to reduce living standards
below where they would be were the income tax reduced
instead. There is also the long-term health of the federal fiscal balance to be considered.
Those who offer Canadians a long laundry list of tax
cuts seem to believe that good times are here to stay, and
that the factors driving the current economic expansion are
structural and will persist. The would-be tax-cutters also
seem to believe that the long-term structure of federal government expenditure will remain unchanged, and that revenues and spending can be analysed using a static, rather
than dynamic analysis. In my view, neither assumption is
correct and as a result, we should be cautious about making
long-term changes to fundamental tax policies.
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OPTIONS POLITIQUES
OCTOBRE 2000
A
s mentioned, most arguments for the taxation goods
and services hinge upon incentives. In a nutshell,
income taxes discourage work, investment, and other types
of productive activity. Sales taxes, on the other hand, discourage consumption. In the interests of economic growth
and productivity, it is much better to discourage the purchase of that $1000 Sony television set than it is to stop the
next Nortel Networks from being founded in some young
entrepreneur’s garage by levying extremely high marginal
rates of income taxation that discourage both the effort
needed to nurture a company from inception and the
investment needed to finance such a company’s growth.
Boston University Professor of Economics Laurence
Kotlikoff has studied the economic effects of income and sales
taxes, and in a 1993 article for the Cato Institute had this to say
about the long-run impact of replacing the US income tax with
a national sales tax: “[such a replacement would] raise the stock
of US capital by at least 29 per cent and potentially by as much
as 49 per cent and ... raise US living standards by at least 7 per
cent and potentially by as much as 14 per cent.” It would do
this, in part, by “end[ing] encouragement of current relative to
future consumption ... and the work disincentive associated
with the progressivity of the present tax structure.”
Hands off the GST!
Kotlikoff explains that the main impacts of a
sales tax are on the investment/saving decision
and offers the following example. Consider a person earning $10,000 a year and facing a 20 per
cent income tax. In deciding how much of his
$8,000 after-tax income to spend and how much
to save (i.e., spend at some point in the future),
the interaction of income taxes with this decision
are crucial. If our individual spends all of his pay
in the year he earns it, this year’s consumption is
$8,000. Alternatively, if he consumes none of it
this year, then next year he will be able to consume the original $8,000, plus the after-tax interest income he earns by investing his $8,000. Take
an interest rate of 10 per cent. In one year, an
$8,000 investment becomes $8,800. However, 20
per cent of these earnings are taxable, so, after
taxes, the $8,800 in principal and interest
becomes just $8,640. In other words, by foregoing consumption now, our individual can afford
to consume only $8,640 next year, and so on. In
our simple example, each dollar of consumption
that is “given up” this year becomes $1.08 that
can be consumed next year.
Now let’s assume the income tax is replaced
with a 20 per cent consumption tax. Under this
scenario, a dollar consumed this year means
$1.10 less to be consumed next year. If our individual spends his whole $10,000 on this year’s
consumption, he’ll end up consuming, after paying consumption taxes, $10,000/1.2 or $8,333.
Alternatively, if the individual saves the entire
$10,000, then after paying the 20 per cent consumption tax he will be able to consume
$11,000/1.2 or $9,167. Under a consumption tax,
the ratio of next year’s maximum consumption
to this year’s maximum consumption jumps
from 1.08 to 1.10. Our taxpayer has a greater
incentive to defer consumption. In short, a consumption tax increases the relative reward to saving. Now few of us would argue that more saving
can be bad for an economy.
real growth ran at only 2.3 per cent per year.
Is it prudent or reasonable to assume that
economic growth will continue at almost double
its recent historical rate? As the baby boom generation retires, total employment in the economy
may actually fall. Moreover, the short-term business cycle very likely is not dead but merely
sleeping. When it awakens, fat surpluses that had
been cashed in as massive tax cuts will turn into
growing deficits, and rising public debt.
Consider the following scenario. Assume that
a vote-seeking Liberal government promises a one
percentage point reduction in the GST rate, causing a reduction in revenues of $2.1 and $2.3 billion in 2000 and 2001 respectively. According to
Budget Plan 2000, this eats up almost half the
Government’s contingency reserve for each of
those years. Now, assume that an economic
downturn similar in magnitude to the 1990-1991
slump strikes the economy. Taking the levels of
taxation as a percentage of nominal income as
fixed in the short term, the politically-popular
reduction in the GST from seven to six per cent
results in deficits of $3.4 billion in 2000 and $9.6
billion in 2001—even without increases in spending related to the economic downturn. It is clearly dangerous, even foolhardy, to simply assume
that robust economic growth is here to stay.
If instead we assume that the government
commits another $2.1 and $2.3 billion to reducing the net public debt in those two years, then
although the downturn still produces deficits in
each year—$1.3 billion in 2000 and $7 billion in
2001—the more prudent policy results in $5 billion less public borrowing than under the tax cut
scenario.
None of this is an argument against cutting
taxes. It is an argument for placing greater
emphasis on debt reduction, and for cutting
income taxes rather than consumption taxes,
which may be politically unpopular but are generally economically efficient.
B
F
ut there are two more reasons why politicians should resist the urge to make headline-generating promises to cut taxes. The first is
that the good times are not likely to last forever.
Canada’s politicians have been climbing over
each other in an effort to spend a surplus that
will not last forever. Consider this. Since 1996,
real economic growth has averaged 4.0 per cent
per year, and in 1999 it ran at a robust 4.5 per
cent. Since 1961, real economic growth has averaged just 3.7 per cent per year. Since 1980, it has
averaged 2.5 per cent. From 1980 through 1995,
Is it prudent or
reasonable to
assume that
economic
growth will
continue at
almost double
its recent
historical rate?
As the baby
boom
generation
retires, total
employment in
the economy
may actually fall.
inally, we are all aware of the demographic
phenomenon known as the baby boom, but
fewer of us seem aware of the long term implications of this phenomenon for the economy and
the federal budget. On average, baby boomers are
retiring at a younger age than their predecessors.
This also has implications for economic growth
and therefore, the capacity of the federal government to raise taxes to pay for essential services.
How so? Consider this. First of all, baby boomers
have been saving for retirement, plowing cash
into mutual funds, equities, and other securities
POLICY OPTIONS
OCTOBER 2000
37
Andrew D. Kosnaski
Canadians
face a higher
personal
income tax
burden than the
citizens of any
other G7 nation.
Canada’s public
debt ratio is
also high by G7
standards.
By comparison,
our taxes on
consumption
and sales are
relatively
low.
that ultimately end up financing investment.
Investment accounts for a major portion of economic growth by allowing expansion, business
start-up, product innovation, and research and
development. Just as an increase in the supply of
labor will lead to an increase in output, the
increase in capital financed by all this investment
will lead to an increase in the level of output—
and quite possibly, in the steady-state growth rate
of output, if the increase in capital has any effect
on the level of technology. A 1994 study published by the Federal Reserve Bank of Kansas City
found that a 10 percentage point increase in the
ratio of investment to GDP (a crude measure of
the amount of investment being undertaken in an
economy) led to a 1.3 percentage point increase
in the long-run growth rate of per capita GDP.
As baby boomers retire, however, the opposite happens: They dis-save, spending their retirement nest eggs. The result is easily predicted. All
else equal, less saving means less investment, and
less investment means a smaller increase in the
stock of capital, and therefore weaker economic
growth.
In addition to their role as savers, baby
boomers are productive members of the economy. Their transition to summer homes in
Florida and volunteer work at the community
center will not come without an economic cost.
A 1998 Bank for International Settlements study
concluded that “Decreases in labour force participation rates associated with projected demographic trends alone would depress the growth
of GDP by as much as one half to one percentage point per year in many of the G-10 countries between 2010 and 2030.” This is also bad
news for fiscal authorities since as the economic pie shrinks, so too does tax revenue’s share of
that pie.
A
decline in tax revenues just as the baby
boom cohort retires could not come at a
worse time. As populations age, governments
must spend more and more on keeping those
populations healthy and happy through health
care expenditures and income support programs.
The degree of aging present in a given population
can be summarized in one simple, yet telling statistic—the dependency ratio. The dependency
ratio tells us what proportion of our population is
65 years of age and over, relative to the supporting population, defined as those aged 20 to 64. In
other words, it measures the ratio of those who
are normally retired to those who are not normally retired.
38
OPTIONS POLITIQUES
OCTOBRE 2000
At the moment, the dependency ratio stands
at about 20 per cent. By 2031 it is expected to
almost double, to 38 per cent. This means that
whereas there are currently five persons of working age for each retired person there will be just
2.6 working persons for each retired person by
2031. The strain on publicly-funded health care
and pension plans will obviously be considerable.
As the need for public funds (or fiscal capacity to borrow) increases, the ability to raise those
funds will be constrained by past policy choices—that is, the policy choices we make today.
Again, just as our earlier example showed how
reducing debt rather than the GST would lead to
a “safer” budget surplus, reducing debt in this
instance, rather than reducing the GST, would
also help free up the fiscal capacity needed in the
future to deal with an aging population. By
increasing the attractiveness of investing, reducing less efficient forms of taxation, such as the
tax on income or capital, would also help counter the effect of a decline in the absolute number
of persons saving for retirement.
I
am not arguing that governments can or
should forego tax cuts in favor of reducing
debt. Canadians are overtaxed, especially in comparison with our counterparts in the United
States. Marginal tax rates are far too high, and
kick in levels of income that are much too low.
Indeed, the arguments I have outlined provide an
excellent reason for reducing income taxes—to
make investment and work more attractive than
consumption, and thereby counter the decline in
savings that inevitably occurs as a large cohort
like the baby boom moves into retirement.
Canadians face a higher personal income tax burden than the citizens of any other G7 nation.
Canada’s public debt ratio is also high by G7
standards. By comparison, our taxes on consumption and sales are relatively low. The message is clear. Income taxes and debt require the
most attention, while the GST, one of Canada’s
more efficient taxes, should be left as is—both to
provide a cushion against economic shocks in
the short term and to help fund the massive
health and pension benefits that baby boomers
will collect as they leave the work force
Andrew Kosnaski is an economist with the New
Hampshire Public Utilities Commission. He has
degrees in economics and political science from
Carleton University and between 1995 and 1995 was
a senior economic advisor to Canada’s Official
Opposition.