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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. 36 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.