GST cuts, harmonization and other blessings in disguise

The case for cutting consumption taxes

When the federal Conservatives promised two years ago to cut the GST, Canadian economists replied with a single voice. Or so it seemed. Cutting consumption taxes is regressive, many warned, because it rewards the rich with proportionately greater discounts (two per cent off the price of a BMW, they reasoned, is worth a lot more than two per cent off a Chevy Cavalier). Better to provide targeted income tax cuts, they said, to the earners you hope to help.

Yet average Canadians seemed pleased with the relief. They rewarded the Tories with consecutive minority governments, while a proposal by then Liberal leader Stéphane Dion to restore the GST fell flat. The current Grit leader Michael Ignatieff has said he will leave the cuts in place if elected.

Now, without warning, consumption taxes are back in the news. The Ontario government plans to harmonize its provincial sales tax with the GST. That will subject many household items previously exempt from provincial tax to a new 13-percent tax. Opposition politicians have branded it taxation by stealth.

Meantime, the former governor of the Bank of Canada, David Dodge, has called for the federal government to restore at least one percentage point to the GST when the economy begins recovering from its swoon: otherwise, he suggested, the country is headed toward a pit of debt.

But not all economists favour consumption taxes. Patrick Grady, who held several key posts with the federal Department of Finance, counts among the minority of influential economists who have voiced support for the GST cut. Grady is now an economic consultant. Maclean’s reached him in Cambodia, where he is participating in a World Bank mission to enhance that country’s public financial management.

Q: You’ve argued that the federal Tories two-point GST cut “wasn’t so stupid.” What is your rationale?
In my view, it’s hard to find a discretionary tax change that was made at a more appropriate time. It was made in advance of the need [i.e. the economic downturn], and it did provide significant support to consumers. These kinds of cuts can be more expansionary than an income tax cut because of their impact on the price level. When prices hold steady, that allows a much more expansionary monetary policy. You could certainly see the opposite effect when the GST was imposed. It was a revenue-neutral shift—they were removing the manufacturer’s sales tax. But there was a huge run-up in inflation, which resulted in a very large tightening of monetary policy. And that, in effect, produced the recession of the early ’90s.

Q: What about at the level of guy on the street? How do consumption taxes affect, say, low or middle-income earners?
If you look at consumer spending patterns, you’ll see lower income people tend to spend a higher proportion of their income on consumer goods, so a consumption tax cut benefits them disproportionately compared to upper income people. It becomes a bit more complex if you provide exemptions for food and things like that. But the point is that upper income earners spend a smaller share of their income on household goods.

Q: Why, then, do so many economists think so highly of consumption taxes today?
The notion is that they’re less distortionary because they don’t double-tax savings by taking money first as income tax, then claiming still more as capital gains taxes. That’s true of pure consumption tax versus a pure income tax. But we don’t have a pure income tax in Canada.

We don’t?
A: Not when you add in things like RRSPs and tax-free savings accounts. They allow people to save on a tax-free basis.

Q: Still, a lot of economists argue things like GST cuts are not nearly as progressive as an income tax cut.
A: Well it depends on the nature of the income tax cut. If it were all for low-income people, that would be more progressive.

Q: What do you think of Ontario’s plan for a harmonized tax?
A: I haven’t seen the details yet, but I’m a big proponent of harmonization. I was actually hired by federal Finance in the mid-’90s to help negotiate the harmonized sales tax now in use in three Atlantic provinces. You have to understand, one of the biggest problems in the Canadian tax system is the taxation of business inputs at the provincial level. It tends to discriminate against investment and that undermines productivity. It’s very pro-productivity to move a provincial sales tax to a model like the GST, which is not imposed on exports, and not on business and investment inputs. It also saves on administrative costs to just have one tax. Then business have to deal with only one bureaucracy and one set of tax regulations [when they remit taxes].

Q: We’ve been told again and again that we need to get out to the malls to revive the economy. Yet some things are taxed under harmonization that weren’t previously subject to the PST. If that’s true, won’t it actually discourage consumer spending? And isn’t that counter-productive?
A: It is a problem, yeah, and the timing may not be perfect for harmonization. These things almost never get done when the timing is best. But I would imagine the implementation will get delayed, and if we’re into 2011, well, what’s the economic situation going to be then? So it will probably have some impact, in the short term, in terms of raising prices. But in the long run, the lower costs of production and capital will be passed on.

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