This article is from the RIIB blog of May 22, 2009.
One of the more unpopular taxes in Canada is the Federal Goods and Services Tax (GST). Stephen Harper and the Conservative Party of Canada recognized this and made a two percentage point cut to the GST part of their campaign platform in 2005/2006. Ontario Premier Dalton McGuinty promised in his most recent budget to harmonize the Provincial Sales Tax (PST) with the GST come 2010. He is now facing the backlash from this decision. Since taxes are an unavoidable consequence of government spending programs, how do we decide which taxes are “better” taxes and which are “worse” taxes?
One simple portrayal of tax policy is that taxation is a matter of taking money from one group’s pocket and transferring it into the pocket of another group. Under this view, one’s ideology determines what are good and bad taxes. An advocate for the poor, for instance, might view a “good” tax as one that takes money from the pockets of corporations and wealthy individuals and transfers that money to the poor via programs such as public housing, welfare, child care support and the like. Under this view, harmonization of the PST and the GST is bad policy because harmonization will require the PST to be imposed on various food and clothing items – necessities previously exempted from the PST – and so will impose additional burdens on the poor. An advocate for business, on the other hand, might see too much money coming from the pockets of business and believe that taxes on this group should be reduced. Such a reduction, the advocate might argue, would allow business to flourish and to create jobs that alleviate poverty. Under this view, harmonization of PST and GST is a good idea – harmonization will allow businesses to claim credits for PST payments on materials, thus reducing business costs and enhancing competitiveness.
If taxation really is a matter of transferring money from one set of pockets to another, then tax policy must come down to ideology. A “good tax” is one that takes money from pockets that are “too full” and transfers that money to pockets that are “too empty”. Depending on your point of view regarding full and empty pockets, a tax reduction for business may be competitiveness enhancing or mere corporate welfare; a tax increase may be a job killer or simply a matter of the wealthy paying their fair share.
Almost invariably, however, tax policy is more than a simple transfer of income from one group to another. Taxes and subsidies have impacts on the ways that resources are used in the economy and so on the amount of wealth the economy creates. As a consequence, different tax policies can result in the creation or destruction of more or less value in the economy. From an economist’s perspective, a “good tax policy” is one that either creates value or destroys as little value as possible. A “bad tax policy” is one that destroys significant value.
All of this, of course, begs the question of how this process of value creation or destruction works and how we decide what are better and worse tax policies.
The way that a tax creates or destroys value may be familiar. Think of cigarette taxes. Increased cigarette taxes have resulted in increased prices for cigarettes. As a result, fewer people are purchasing cigarettes from traditional outlets and fewer are smoking. This has resulted in reduced production of tobacco, reduced cigarette manufacturing and increased smuggling of untaxed cigarettes. In the long run, we should expect to see fewer cases of lung cancer. All of these changes have impacts on individuals and the society, some positive and some negative. The principles behind carbon taxes are the same. Increased taxes on carbon-based electricity consumption, gasoline consumption and the like will lead to increased prices and less consumption of these products. Carbon taxes will also lead to increased demands for products with a smaller carbon footprint. The result is that resources will move from production of carbon-based products to production of products with less carbon content and, in principle, less global warming.
These familiar ideas apply to virtually all taxes. An increase in income taxes reduces the returns from working and so reduces incentives for individuals, both rich and poor, to generate as much income. An increase in the capital gains tax reduces returns on investment and so reduces incentives for individuals to invest rather than consume. An increase in the sales tax increases the price of the taxed goods and so causes individuals to consume less of these goods and more of untaxed goods. In all cases, the principle is the same: A tax on a particular good raises the price of the good relative to the prices of other goods. This price increase results in relatively less consumption of the taxed good and relatively more consumption of other goods. This, in turn, results in resources flowing out of the taxed good sector and into other sectors.
These shifts in resources out of taxed sectors and into other sectors can either create value or destroy it. As market prices tend to reflect private, and not social, benefit, typically there will be too much consumption of goods that create pollution and other externalities – too many resources are in polluting sectors and so there is too much pollution. A tax on polluting goods that causes prices to reflect social benefit will result in resources moving out of polluting sectors, in less pollution and in greater value. When there are no externalities, prices reflect private benefit and then the tax-induced reallocation of resources will destroy value on net.
There is one exception to this principle. If all products are taxed the same, then there is no change in the price of one good relative to another. As a result, there is no change in the consumption of one good relative to another and so no reallocation of resources in one sector relative to another. Incentives for work, for consuming, for saving and investing are not distorted and so wealth and value are not destroyed. This is the idea behind the GST: If virtually everything is taxed equally, we destroy as little value as possible. This is why the Harper cuts to the GST are bad tax policy and why Premier McGuinty should be commended for harmonizing the GST and PST. What about the increased tax burdens on the poor? These can, and should, be corrected and the fix is an income-based GST/PST rebate.