In the past decade, while the federal government ran surpluses, Canadians benefited from a host of tax cuts. Personal tax reductions meant a bigger paycheque to take home to the family. The cut to the GST rate enabled Canadians to buy cheaper goods and services. Corporate tax reductions boosted investment, jobs and profits, helping them to stay at home.
With deficits looming for several years, are the days for tax-cutting now at an end? Some of our corporate chief executives think so, not only arguing against any tax reduction, but also supporting a hike to the federal GST rate in order to balance our books within the next few years. In the United States and several European countries with widening deficits and sharply rising public debt burdens, many governments are now increasing taxes. This trend includes a sales-tax bump in Germany, rising top income-tax rates in Britain and new U.S. levies on financial institutions to pay for bailout costs.
Reducing taxes has been the bedrock philosophy of Conservative government in Canada. Yet Jim Flaherty, the federal Minister of Finance, struggling to balance the books within five years, will likely leave broad tax cuts out of this year's March 4 budget. Nonetheless, he has clearly indicated that he won't increase taxes, contrary to the musings of those who are looking for more revenues to eliminate the federal deficit.
The no-tax-increase promise will not prevent the federal government from raising user fees, as they have done this week for new airport security costs. Expect more fee increases in the coming years. While being accused of raising taxes, Mr. Flaherty is, in principle, correct to argue that a fee is not a tax. By OECD definitions, the new security fee paid by airline passengers is a "non-tax" revenue, since the levy is a payment for individual use of a public service. So essentially by splitting hairs, governments relying on user fees can still maintain the mantra that they have not increased taxes. They are raising more revenues, nevertheless.
THE REAL ARGUMENT
The debate as to whether taxes and other public charges should be raised or cut is really an argument about the size of government. Just before the financial crisis in the fall of 2008, all levels of Canadian government extracted 40 per cent of Canada's economy in taxes and non-tax levies to fund expenditures on public goods and services, the cost of serving public debt and a small surplus. No doubt government spending as a share of the economy is even larger now, with the significant economic stimulus program adopted in last year's budget.
The critical debate will be whether Canadian governments should take a bigger or smaller bite of the economy's resources.
Tax hikes to balance the books will ultimately lead to a larger government in Canada, unless the increases are only temporary. Back in the Trudeau-Mulroney years, when public deficits were the order of the day and Canada's debt piled up to extraordinary heights, supposedly temporary measures were brought in reduce the deficit. These included personal and corporate income tax surtaxes and capital taxes on businesses.
Once temporary taxes are introduced, however, it takes an awfully long time before they are eliminated, if at all. The income tax itself was a temporary measure brought in to fund the First World War. Governments become reliant on them and very reluctant to give them up.
A legitimate question to ask is whether governments need to extract public revenues that are more than two-fifths of the economy. At one time, Canadian government spending reached 50 per cent of GDP, but that was at the height of the 1990-92 recession. With deficits near 10 per cent of GDP at that time (far worse than today), spending did move downward to close the gap, but revenues continued to climb upward. From 40 per cent of GDP in 1990, total government revenues reached almost 45 per cent by 2000, when the federal and most provincial governments were running surpluses. With Canadians concerned about job creation and many of them fed up with high tax burdens and inefficient public programs, governments of all stripes reduced taxes in the past decade. As a result, public revenues returned to their 1990 level in 2008.
It is therefore not surprising the Minister of Finance is reluctant to raise taxes. It would likely lead to a long-term increase in the size of government, once deficits are dealt with, which is anathema to his philosophy. From a practical view, it is far from clear that larger government will translate into greater prosperity. Certainly, governments play a crucial role in providing basic services and the rule of law; public revenues are needed for these purposes. However, as several studies have shown, once governments become larger than one-third of the economy, it is not clear that the citizens are better off, because public spending, with high tax burdens, erodes productivity.
Given the current size of government cannot be characterized as small, wouldn't the Conservatives be interested in further tax cuts especially on the personal side? No doubt the size of the current deficit - over 3 per cent of GDP - is unacceptable to Canadians, so tax reductions will not be on the agenda any time soon. This does not, however, mean that tax reforms cannot be considered, for the sake of growth and fairness.
REVENUE LOSS
Tax reductions are affordable if they result in little revenue loss. As governments have found in recent years, reductions in corporate income-tax rates don't cost much revenue, because companies shift profits to jurisdictions with low rates. The federal and provincial governments understand this well; reductions in corporate rates in the past 10 years have not much diminished total corporate tax collections - in fact they have grown over time. The planned federal reduction in corporate rate reductions to 15 per cent by 2013 should go ahead as legislated, with accompanying reductions in the dividend tax credit and the capital-gains exclusion rate, which are based on existing corporate rates. With further provincial reductions, Canada's combined federal-provincial corporate rate will be 26 per cent, in the mid-range of OECD countries. This will not only boost investment but also lead to greater shifting of profits into Canada, yielding Canadian government revenues as a result.
Other tax rate reductions would hurt fiscally, especially on the personal side. These could be made affordable, however, if inefficient and unfair targeted tax incentives and grants that fail to achieve their objectives are eliminated. Tax incentives may seem to be creating jobs in one sector, but this is often at the cost of taking people already employed in others. Or the incentives may result in higher costs and capital prices, blunting the impact of the incentives.
JUSTIFIABLE ELIMINATIONS
If a quick look is taken at the long list of federal tax incentives, several could be justifiably eliminated since they have been found to be ineffective or no longer needed, or to undermine fairness. The federal Atlantic investment tax credit ($250-million) is no longer needed, thanks to corporate tax reductions in the past 10 years. Film production tax credits ($205-million) have been used to fund Canadian movies of questionable significance or help the bottom line of Hollywood producers. The labour-sponsored venture capital credit ($120-million) has failed to generate venture capital, squeezing out the possible funding available from others in the private sector. The enhanced research and development tax credit for small business (an unpublished cost worth millions) enables employees to quit larger companies only to sell innovations back to their former employers. The lifetime capital-gains exemption for small-business shares and farming and fishing property ($1-billion) should be integrated with the RRSP system, to reduce its costs. Flow-through-share deductions and credits for mining ($280-million) have been shown to encourage investments in low-profit ventures. The deduction of union and professional dues ($715-million) seems unfair when other associations or club dues are not deductible. The non-taxation of employer-paid health premiums and workers' compensation ($3.5-billion) distorts labour compensation, with insurance markets that become reliant on employer-provided benefits.
And the tax mix could change. Further income tax reductions are possible, if Mr. Flaherty is willing to increase other taxes more based on consumption. And that of course includes the GST. However, such rebalancing might be better left to the fiscally challenged provinces, now that most of them have harmonized their provincial sales tax with the federal GST, assuming that Ontario's and B.C.'s intelligent reforms proceed on July 1.
To say that further tax cuts cannot be afforded is therefore questionable, given the plethora of special credits and deductions in the tax system. However, Canadians should not hold their breath. None of the political parties are calling for a rebalancing of the tax system, to improve its efficiency and effectiveness, so that we could have more broad-based tax reductions.
So are the days of tax cutting over, because of deficits? There will certainly be a pause, but we should not lose sight of the need for tax reforms to improve the economy.
Jack Mintz is director and Palmer Chair of the School of Public Policy, University of Calgary.