Equity Versus Efficiency in the Design of the Tax Mix
27 Pages Posted: 26 May 2013
Date Written: November 1, 2012
It is frequently argued that it would be beneficial to move the tax mix towards greater reliance on consumption taxes, with offsetting reductions in income taxes. Proponents argue that this would increase the incentives to “work, save, and invest” and would help improve productivity growth.
However, these claims rest on weak foundations and are not well supported by empirical evidence. Most studies have found that reducing personal income tax rates would have only a modest impact on labor supply and work effort. It is a fallacy to suppose that consumption taxes do not reduce work effort simply because they are not levied directly on income. The primary purpose of working is to earn income to spend. A higher consumption tax rate also reduces real after tax income, and dollar for dollar would have the same effect on the incentive to work as a flat income tax. In addition, when a higher sales tax rate is applied to services, it increases the incentive for “do-it-yourself” work to replace purchased services, which can range all the way from gardening to self-representation in court. This also leads to lower national productivity.
The evidence that taxes have a significant impact on saving is also quite weak. In the case of people who are aiming for a certain level of investment income after retirement, a lower real after-tax rate of return on their investments forces them to increase their saving rate. Therefore, an income tax cut could have the perverse effect of reducing the national savings rate. Even if lower taxes did increase personal saving, it would be unlikely to have a significant impact on capital investment by Canadian corporations. The primary source of capital is from retained earnings, which are more than adequate for this purpose. A substantial portion of personal portfolio investment in stocks goes to foreign countries.
By far the largest and clearest impact of changing the tax mix is on the distribution of income. Canada's GST is not a very regressive tax, as it has been offset by credits for low income people, and exempts basic necessities such as groceries and rent. However, unlike the GST, personal income taxes are highly progressive. Any shift in the tax mix away from income towards consumption taxes would therefore significantly reduce the overall progressivity of Canada’s tax system.
In Canada, analysis of this issue has not placed much emphasis on fairness in taxation. In the United States, by contrast, leading legal scholars of taxation such as Barbara Fried, Alvin Warren and Reuven Avi-Yonah have viewed the policy question of fairness as central to the issue.
The most credible estimates from economic models indicate at best a small positive impact on economic efficiency from changing the tax. Therefore, the positive impact on income would be too small to compensate most taxpayers, and middle income earners in particular are likely to be net losers from changes in the tax mix. Designing changes in the tax mix so as to make everybody better off is a complex task.
Keywords: income tax, sales tax, consumption tax, income distribution, equity, labor supply, saving, productivity
JEL Classification: H21, H22, H23, H24
Suggested Citation: Suggested Citation