An Economy Lab reader recently wrote: "I often find economic explanations simplistic rather than simplified. In that vein, could I ask to have someone explain why GST/HST/VAT is supposed to be a more efficient tax than Corporate/Personal income tax?"
Stephen Gordon replies:
Whenever the Goods and Services Tax (GST) appears in the news, it is invariably noted that it enjoys a broad consensus of support among economists. But explanations for why it is so popular with economists are relatively rare, so here is a short introduction to the theory and evidence on the relative merits of taxing consumption instead of income. (Frances Woolley's notes on the difference between the GST/HST and sales taxes are here.)
The basic idea comes down to the role of taxes in determining the rate of return on investment. Higher returns generate higher levels of investment and - as investment accumulates - higher levels of productive capacity. That increased capacity in turn generates higher levels of output, employment and wages.
Consider an investment project that offers a rate of return of 10 per cent. The gross return on an investment of $100 may be $10, but after applying a (say) 30 per cent corporate tax on those profits and a marginal income tax of (say) 40 per cent, the return that the investor sees on her savings is reduced from $10 to $4.20.
This example illustrates the problem with income taxes: the wedge between the gross rate of return that is generated by the investment project and the net rate of return that the investor actually sees can reduce net returns to the point where marginal projects are not carried out. Output, employment and wages will be lower than what they would otherwise have been.
Suppose instead that the investor is faced with a consumption tax of (say) 100 per cent so that $100 can purchase $50 worth of consumer goods. If there are no taxes on profits or on income, the entire $10 return is remitted, which can then be used to buy $5 worth of consumer goods. The sacrifice of $50 in consumer goods has generated a return of $5 of consumer goods, so the effective rate of return is still 10 per cent. Contrary to income taxes, consumption taxes do not introduce a tax wedge between gross and net rates of return.
The main drawback of consumption taxes is that they hit low-income households hardest, so it is important to complement them with measures such as the GST rebate in order to correct these regressive effects.
This of course a very simplified story, but the basic intuition carries over to more sophisticated models and its predictions are consistent with available data (see this OECD study for a recent survey of the empirical literature): taxes on consumption are generally found to be less harmful to economic growth than taxes on income. This lesson has already been learned by countries that have pulled off the trick of combining high levels of government spending with high rates of economic growth: VAT rates in Scandinavia are 25 per cent.
Stephen Gordon is a professor of economics at Laval University in Quebec City and a fellow of the Centre interuniversitaire sur le risque, les politiques économiques et l'emploi (CIRPÉE). He also maintains the economics blog Worthwhile Canadian Initiative.