...change would have desired effect on investment at very low revenue cost to governments and would lower the compliance costs to taxpayers: that would be to reform the antiquated provincial retail sales taxes (RSTs) to bring their bases into conformity with that of the federal Goods and Services Tax (GST). My estimates show that provincial RSTs are remarkably high on business inputs, including--and perhaps most important--purchases of capital goods. Taxes on capital are especially undesirable because they have long-lasting effects on the economy by limiting the growth of the capital stock and reducing the long-run growth of productivity and employment. Approximately one-quarter of the marginal effective tax rate on capital in Canada is the result of taxes on business inputs. Harmonizing provincial taxes with the GST would eliminate most of this distortion.

To show that the investment effects of the reform would be substantial, I estimate the effects of the 1997 Harmonized Sales Tax (HST) reform on business investment and consumer prices in the Atlantic provinces. In keeping with theory, I find that the reform led to significant increases in machinery and equipment investment, in the short run at least, which should raise the capital stock and labour productivity there in the long run.

A political stumbling block to the reform is that it is thought that harmonization would reduce taxes paid by business and increase the taxes paid by individual consumers. But taxes on business inputs are very likely to be no more than hidden taxes on consumers--since they are shifted forward in the form of higher prices. Examining the effect of the 1997 HST reform again, I show that the pattern of relative price changes there was remarkably close to the estimated changes in tax rates and business costs that resulted from the reform. Thus the tax changes were shifted forward, leaving after-tax consumer prices on average slightly lower than before the reform. On the basis of the evidence, then, I conclude that a similar reform in the provinces that still have a retail sales tax would result in increases, possibly substantial, in capital stocks, while there would be very little change in consumer prices.

In this issue ...

Provincial retail sales taxes are remarkably high on business inputs, including purchases of capital goods that spur growth in productivity and employment. Evidence from Eastern provinces with a Harmonized Sales Tax (HST) suggests that harmonizing provincial sales taxes with the federal GST would eliminate most of this distortion, without leading to an increase in consumer prices.

Recent developments in federal-provincial relations in Canada have led to a renewed interest in the possibility of reforming the provincial sales tax systems. At present, five provinces have a retail sales tax (RST), which is collected separately and on a very different basis from the federal Goods and Services Tax (GST), which is a value-added tax on consumption. Four other provinces, in contrast, have value-added taxes that are largely combined with the federal GST.

Conventional wisdom among public finance economists has it that, for a variety of reasons, retail sales taxes are inferior to value-added taxes that raise the same revenue. Those reasons include the narrowness of their base (which distorts relative prices of marketed goods), their susceptibility to tax evasion, and their tendency to cascade through the value-added chain, thereby distorting the relative prices of business inputs, particularly capital goods. Indeed, by one much-cited estimate (Baylor and Beausejour 2004), the excess burden of the RST tax on capital goods exceeds that of all other major Canadian taxes. This paper goes beyond conventional wisdom and provides quantitative estimates of the likely economic effect of converting provincial RSTs to a value-added base like the GST, with particular emphasis on the effects on business investment and on consumer prices and the distribution of tax burdens resulting from the reform. To obtain those estimates, I compare what actually happened in the four provinces that have already adopted value-added bases (the "harmonizing provinces") (1) to what happened in the same period in the provinces that kept their RSTs. Thus the asymmetric nature of past sales tax reform in Canada can be viewed as analogous to a "natural experiment" that allows us to control contemporaneous changes in the economic environment that would otherwise confound the analysis. This permits better inferences about cause and effect than previous studies, which have not considered a similar "control group" for the reform.

In the simplest terms, the policy implications of the analysis may be summarized as follows. In Ontario and British Columbia (the two largest provinces that still have RSTs), effective tax rates on business inputs, including capital goods, are remarkably high--indeed, more than 40 percent of RST revenues in Ontario are estimated to come from taxes on business inputs. Eliminating such taxes through harmonization would have substantial effects on business investment. By my estimates, annual investment in machinery and equipment in the harmonizing provinces rose 12.1 percent above trend levels in the years following the 1997 sales-tax reform. Given the high taxes on capital inputs in the remaining provinces, it seems reasonable to expect a similarly large short-run effect of reform on investment in the RST provinces as well.

It is important to emphasize that the increase in investment caused by the HST reform is a short-run phenomenon, as firms have acted to adjust to the new, higher-capital stock that is desired when taxes are lower. Whereas the investment effect is transitory, the effect on capital stock and labour productivity is presumably long-run and permanent. However, my empirical methodology, discussed below, does not allow these long-run effects to be estimated directly.

The necessary implication of high taxes on business inputs under RSTs is that if reform were to be revenue-neutral, then the taxes paid by consumers on their personal expenditures would rise substantially. The analysis of effective tax rates shows that if the GST base were to be adopted, this would be achieved through the broadening of the base to include new homes and, to a lesser extent, some goods and services, rather than through increases in the headline statutory rate of the provincial sales taxes.

This shift in burdens from business to consumers is usually regarded as a major obstacle to such a reform. But all taxes are ultimately paid by some people, somewhere--and never by businesses. That is, we must distinguish between the "statutory burdens" of a tax--who the tax law says must pay the tax--and the true "economic burdens" of a tax. True economic tax burdens depend on how taxes levied on businesses are shifted forward to consumers through higher prices, or shifted backward to factors of production, like labour, capital, and land, through lower wages and rental prices. Estimating true economic burdens is difficult, but it is the key to understanding the ultimate impact of a tax on consumers and on the distribution of real income in the economy.

To give some sense of the true economic distribution of burdens under the RSTs, I examine the relationship between changes in consumer prices and changes in effective tax rates in the harmonizing provinces in the years following the 1997 reform. Again I use comparisons with the non-reforming provinces to control for economic and especially monetary factors that otherwise affected consumer price inflation at the same time. The results show that the pattern of relative price changes among broad categories of consumer expenditures was quite similar to the pattern of relative changes in taxes and business costs induced by the reform--that is, each I percent increase in costs induced by taxes leads to approximately a 1 percent increase (or perhaps more) in the price paid by consumers.

Indeed, overall, consumer prices in the harmonizing provinces fell with the 1997 reform, although prices rose somewhat for shelter and for clothing and footwear, so that the reform was slightly regressive. The pattern of tax changes today would presumably be different if harmonization were extended to the remaining RST provinces, since their current tax systems differ from those replaced in the 1997 reform. What is important is that the results are consistent with the notion that taxes are fully shifted forward (or even "overshifted") in most sectors, so that the change in statutory burdens would not result in large distributional effects.

The rest of the paper is organized as follows. The second section describes the sales tax systems of the provinces and discusses the presumed deadweight costs of the RSTs. The third section presents an accounting analysis of the changes in revenues and statutory tax burdens resulting from a hypothetical reform in which RST provinces adopted the federal GST base but without changing their...

NOTE: All illustrations and photos have been removed from this article.




More articles from C.D. Howe Institute Commentary
Reducing poverty: what has worked, and what should come next.(Report), October 01, 2007
Falling poverty rates, rising employment among poor, reflect social po..., October 01, 2007
2007 Tax Competitiveness Report: a call for comprehensive tax reform.(..., September 01, 2007
Recent C.D. Howe Institute Publications.(List), July 15, 2007

Looking for additional articles?
Search our database of over 3 million articles.

Looking for more in-depth information on this industry?
Search our complete database of Industry & Market reports by text, subject, publication name or publication date.

About Goliath
Whether you're looking for sales prospects, competitive information, company analysis or best practices in managing your organization, Goliath can help you meet your business needs.

Our extensive business information databases empower business professionals with both the breadth and depth of credible, authoritative information they need to support their business goals. Whether it be strategic planning, sales prospecting, company research or defining management best practices - Goliath is your leading source for accurate information.