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...framework for tax reform is the place to start.
The Study in Brief
This inaugural Tax Competitiveness Report is issued on September 20, the 88th anniversary of the promulgation of the 1917 Income Tax War Act in Canada.
While taxes are critical to funding public services, they discourage people from working and saving and businesses from investing in capital. The most competitive tax system is efficient, fair and simple, doing the least harm to the Canadian economy. This is accomplished by keeping tax rates low and bases broad so that the tax system distorts least the decisions made by Canadians in their pursuit of opportunities to raise their standard of living.
Specific findings in this report include the following:
* Canadian governments in 2003 raised taxes and other revenues equal to 41.7 percent of GDP, in the middle range of 28 OECD countries.
* Canadian governments impose taxes on businesses' capital investments at an effective rate of 39 percent. Taking into account corporate income taxes and other capital-related taxes, in 2005 Canada had the second highest effective tax rate on capital among 36 industrial and leading developing countries.
* Saskatchewan and Ontario have the highest effective tax rates on capital. Newfoundland, Nova Scotia and New Brunswick have the lowest effective tax rates.
* Business taxes vary considerably by business activity with burdens greatest for construction, communications, trade and service industries.
* Marginal tax rates on employment income for families with children may be 60 percent or higher for parents with modest incomes, owing to payroll taxes with earnings limits and clawbacks of federal and provincial income-tested programs.
* Seniors face extraordinarily high taxes on their investment income, with rates reaching or exceeding 80 percent for those with modest incomes.
Governments should develop multi-year tax plans to address the many existing problems in the tax system to achieve better economic growth and higher standard of living for Canadians. This Commentary offers a number of recommendations for tax reform at federal and provincial levels.
This inaugural Tax Competitiveness Report focuses on tax policies that affect Canada's competitiveness. Canada faces the dual challenge of an aging population and mobile working people and capital. The analysis and recommendations in this report would redesign Canadian taxes to encourage entrepreneurship, effort and investment and build the income and wealth needed to finance private consumption and fund public services. The most competitive tax system is fair, simple and efficient with low rates and broad bases. Lowering tax rates, broadening tax bases and decreasing reliance on the sources of government revenues that are most harmful to Canada's potential growth would unleash the Canadian tiger.
The challenge for any country today is to provide an economic environment that promotes economic growth and job creation in a dramatically changing world. With aging populations, the work force in industrial countries will grow less quickly and declining saving rates will make capital scarcer. At the same time, new growth centres, especially in Asia, create opportunities and challenges for industrial economies to attract workers and to provide an investment climate that underpins job and wage growth.
While Canada offers many attractive features to investors--a strong rule of law, a good communications and transportation infrastructure, a well-trained work force and political stability--many other developed economies have similar attractions. One of the policy challenges facing Canada if we are to attract investment concerns taxation. It is to our detriment that Canada has the second highest effective tax rate on capital (taking corporate income and other capital-related taxes into account) out of 36 developed and leading developing competitors, as highlighted later in this report. Canadian governments also tax Canadians heavily on their work effort and savings, with marginal tax rates, averaged across provinces, often reaching 80 percent on investment income and 60 percent on employment income earned by people with modest incomes.
In the upcoming budget cycle, federal and provincial governments should encourage work, investment and risk-taking by shifting taxes from investment and savings to taxes on expenditures and applying these on broad bases with low rates. What is most crucial to Canada is to develop a set of policies that will improve our competitiveness, in particular:
* Reducing marginal income tax rates to correct the severe cases where marginal tax rates exceed 50 percent and to provide more general tax relief,
* Increasing the incentives for Canadians to accumulate income for their retirement in RRSPs or pensions or by other means that would reduce taxes on investment income,
* Removing the tax discrimination against corporate equity financing by reducing dividend taxes,
* Reducing corporate income tax rates to far more competitive levels,
* Eliminating provincial capital taxes,
* Reducing withholding taxes and other tax barriers to outbound and inbound foreign direct investment, and
* Broadening the tax bases to make them more neutral especially with respect to incentives that are ineffective in accomplishing their aims in improving the economy.
The above proposals would generally result in a net reduction of taxes that could be accommodated by governments spending less rapidly than in the past. Fiscally-prudent governments should develop five-year tax plans that would provide room for tax relief as part of an overall fiscal framework. Further, base-broadening initiatives would offset the cost of some tax rate cuts. And some taxes, such as those related to the use of public services and those applied to less sensitive tax bases could be adjusted upward as part of an overall plan to reduce the most harmful taxes in the economy.
The Tax Competitiveness Report does not deal with spending issues. It also focuses on personal and business taxes, especially the income tax, which was adopted by Canada on September 20, 1917. The report will not focus on sales and property tax reform, which is taken up in forthcoming papers from the C.D. Howe Institute.
The following section analyses the competitiveness of Canada's tax system. It is followed by a set of tax policy recommendations for federal and provincial governments' budgeting and longer term planning.
How Do Canada's Taxes Compare to Those of Other Countries?
Tax competitiveness is related to the size of the tax burden: The more resources used by governments to fund public services, the more taxes will impinge on the private sector's desire to work, save, invest and take risks. While wise public spending can improve economic growth, taxes--especially poorly structured ones--will undermine growth and job creation.
Tax competitiveness is often measured by comparing across countries the size of the tax burden, or government revenues as a percentage of Gross Domestic Product (GDP). (1) Presumably, a lower revenue/GDP ratio would imply that the economy would be more competitive although, as highlighted below, this need not be the case.
Table 1 ranks the industrialized countries by their revenue/GDP ratios, which are broken down between tax and non-tax revenues. As of 2003, the latest year for which comparable figures are available, Canada's government revenue as a share of GDP was close to 42 percent, or eleventh lowest of 28 OECD member countries.
Canadian governments collect considerable amounts of non-tax revenues (7.8 percent of GDP), with a substantial portion thereof from resource royalties. While Canadian governments collect less revenue than the governments of many continental European countries--where public pension plans funded by payroll taxes are far more significant--in Canada governments raise more revenues than in its most important trading partners--the U.S., the U.K. and Asia. Further, government revenues are not the only measure of government size. With deficits, government expenditures are larger than revenues. Deficits will require governments to cut future spending or increase taxes, while surpluses will provide opportunities to increase future spending or cut taxes.
Rich countries are those with the greatest capacity to provide both private and public goods and services to their citizens. To what extent do these revenue/GDP ratios matter for economic growth? Most experts would agree that neither the absence of government nor the absorption by government of 100 percent of the economy's resources would maximize economic growth. Governments provide important services, such as law and order, infrastructure and education, that support economic growth. On the other hand, large centralized government--as in the former Soviet Union--undermines innovation and incentives to work and invest because the failure to use pricing mechanisms in markets makes it difficult to achieve an allocation of resources according to their best economic use.
Several studies have examined what size of government, as measured by the revenue/GDP ratio, maximizes economic growth (Branson and Lovell 2001 and Tanzi and Schuknecht 2000). The overall conclusion is that the size of government that maximizes growth is no more than 30 percent of GDP. In some calculations, we examined whether the growth in real per capita GDP has any relation to the revenue/GDP ratio. For example, during the period 1986-2003, Irish per capita GDP grew an astonishing 160 percent while its revenue/GDP ratio fell almost 10 percentage points to 34.6 percent. On the other hand, Korea grew by over 150 percent in the same period and its revenue/GDP ratio rose by a little over 13 percentage points to 31.3 percent.
Those figures suggest that countries with small governments might find that they need to have larger public spending to provide services for development whereas countries with large governments might achieve higher economic growth rates with lower spending and revenues. Our analysis, which accounted for the size of government in 1986, found that an increase of one percentage point in the revenue/GDP ratio lowered growth in real GDP per capita over the period 1986-2003 by 1.7 percentage points, although the relationship is weak. (2)
The weakness of that finding is due to the aggregation of different revenue sources. The aggregate...
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