Finance Committee on March 31st, 2008

[The Chair, Conservative, Rob Merrifield]

I would like to call the meeting to order.

Mr. Jon Kesselman, professor of the public policy program at Simon Fraser University, is appearing by video conference today.

Can you hear us, Mr. Kesselman?

[Professor Jon Kesselman, Professor, Public Policy Program, Simon Fraser University]

Yes, I can.

[Rob Merrifield, Conservative, Yellowhead, AB]

Perfect, and we can hear you.

This is the beginning of our study on the structure of Canada's federal revenue-raising system. It's great that you're here to kick it off, and we're looking forward to your presentation and to the many presenters who hopefully will be coming before committee as we proceed through this study. We expect it will be very fruitful for the people of Canada as we do this on their behalf.

We have two presenters, Mr. Kesselman and Mr. Jim Davies, from the University of Western Ontario. We will start with Mr. Kesselman.

The floor is yours, and we are prepared to hear what you have to say to us.

[Prof. Jon Kesselman]

Thank you very much.

I appreciate the opportunity to appear today to share my research findings and thoughts on the broad issues of taxation policy in Canada. My presentation will be based largely on my 2004 study for the Institute for Research on Public Policy, titled “Tax Design for a Northern Tiger”. I think the study was distributed to committee members in advance, with an executive summary in both official languages--

[The Chair, Conservative, Rob Merrifield]

I'll just stop you there. For the committee's information, it was not translated into both official languages. Members will get it. It has been sent for translation. We have the summary, and it has been translated. But the entire report has not yet been. That's just to let you know what we have.

Please continue.

[Prof. Jon Kesselman]

Okay. Translating the entire study will be a major work project for someone.

At any rate, the major message I hope you take away from the study and my presentation is that an economically efficient and socially equitable tax system hinges on its overall structure and design, not its overall level.

Other countries have applied taxes at much higher levels than Canada while still attaining very good levels of productivity growth and enviable standards of social programs. The key to achieving an efficient and growth-oriented tax system, whatever the desired overall level of taxes and size of government, is to shift the taxable base further toward consumption and labour income, and away from capital and investment income.

In the four years preceding my 2004 study, Canadian governments at both the federal and provincial levels made significant progress in pushing the tax system in the desired direction, and further constructive changes have been made in the four years since then. Some examples include large reductions in corporate income tax rates, reduction and elimination of corporate capital taxes, expanded allowances for depreciation of business investment, reduction in personal tax rates, reduced tax rates on capital gains, the rise in contribution limits for pension plans and RRSPs, and, most recently, the introduction of tax-free savings accounts. All of these measures move the tax system further toward consumption-based levies, and away from income- and capital-based levies.

But there remains room for further improvements in the tax system at all jurisdictional levels in Canada. I will briefly describe what I believe to be the eight most important areas for future tax reforms.

First, I begin by noting an item that applies at the provincial and municipal levels, the disproportionately high rates of property tax applied to business and industrial properties relative to residential properties across most of Canada. This discourages productive business investment, and it sends the wrong signals to provincial and municipal actors about what voters are willing to pay for additional local services. That, of course, is because most voters are homeowners rather than business owners.

Reforms to restrict the differential rates between business-industrial and residential property tax rates could easily be implemented through provincial legislation—though, undoubtedly, issues of public acceptance would arise.

Second, at the combined federal and provincial levels, the most urgent tax reform is to achieve a harmonization of indirect consumption taxes for the five provinces that still utilize a retail-level tax. In those provinces, nearly 40% of the total sales tax revenues are paid by business inputs rather than final consumers, inhibiting business investment and the efficient allocation of resources.

The federal government missed an opportunity to achieve this goal when it reduced GST rates without any linkage to provincial sales tax harmonization. To get the provinces on board with this change—especially Ontario and B.C.—the federal authorities will have to provide greater fiscal compensation than they have offered to date, and greater flexibility to the provinces as to the taxable base of the harmonized tax.

Third, at the federal level, one of the more important tax changes would be to raise the annual dollar limit for contributions to tax-deferred savings plans, like registered pension plans and RRSPs. The introduction of the tax-free savings accounts is helpful for individuals in efficiently arranging their lifetime savings on a consumption tax basis, particularly for lower and moderate income households. But Canada lags other countries, such as the U.S. and the U.K., in its limits on tax-recognized savings for higher earners. The current annual limit of $20,000 should be substantially increased, say to $30,000. This change would also make the Canadian tax system more competitive with other countries in attracting and retaining highly skilled technical and managerial talent.

Fourth, also at both the federal and provincial levels, the upper-bracket personal tax rates bite at incomes that are low, relative to where they bite in some competing countries. The top federal marginal tax rate of 29% kicks in at just over $123,000 of taxable income. This could be raised substantially—for example, to $180,000. The provincial personal tax schedules mostly hit their top marginal rates at taxable incomes below $100,000, with three provinces reaching their top rates in the $60,000 range. While the federal top tax rate is not excessive internationally, some of the provincial rate schedules are more steeply progressive than they should or need be.

These changes, as well as stretching out some of the intermediate tax brackets and reducing their rates, will be helpful in improving incentives for individuals and in attracting and retaining the most productive workers for our economy.

Fifth, while on the topic of direct personal tax, which is still called an income tax but in reality is closer to a consumption-based tax, another aspect warrants change. The major tax reforms of 1987 converted a number of items that had previously been deductible in computing taxable income into non-refundable credits. However, a few of those items are more properly allowed as tax deductions because they define the taxpayer's ability to pay tax. Thus, they should not be credited at a common rate independent of the individual's marginal tax rate. Three items in particular should be restored to tax deductible items: employee contributions for Quebec and Canada pension plans, employee contributions for employment insurance, and medical expenses.

Sixth, another aspect of the personal tax also deserves careful thought and reform. Unlike most other countries' tax systems, Canada seeks to attribute taxable income on assets transferred between spouses to the donor for tax purposes. This leads to highly complex attribution rules and equally complex manoeuvres by taxpayers to skirt the rules.

Based on my analysis and a study on income splitting published also by the IRPP, but just last month, I recommend that Canada follow the British practice of allowing full splitting of investment incomes between spouses when there is a bona fide transfer of assets. In conjunction with that change, I would also recommend that Canada simplify its complex and cumbersome rules for deductibility of investment interest expenses by allowing them up to the filer's taxable investment income, following U.S. practice.

Seventh, the payroll taxes, or so-called premiums, for the employment insurance program are levied at uniform rates on employers and employees, independent of the risk of unemployment in particular industries and firms. This structure leads to highly inefficient cross-industry and cross-firm subsidies as well as to disincentives for individual employers to stabilize their employment levels. A remedy to this problem is to differentiate the premium rates—at least those applied to employers—to reflect the differential rates of layoffs and employment stability. This system of so-called experience rating has been applied to good effect in many of the provincial workers' compensation programs as well as in the U.S. states' unemployment insurance programs.

And eighth and final on my list, which is certainly not an exhaustive list, is an item that appeared in a limited form in my 2004 paper, which was increased excise taxes on transport fuels, mainly gasoline. Given changes since then in our thinking about environmental issues and climate change, we should pursue higher taxes not only on gasoline but on a wide range of carbon-dioxide-emitting fuels and activities. The revenues from these levies, which could become very large over time, should be recycled in the economy through reductions in other taxes, such as some of the reforms that I've suggested here. Sensibly pursued, such environmental levies will yield the so-called double dividend; that is, reduced climate and environmental degradation along with a more efficient economy through reduction of distorting taxes.

You might note one item that was not on my list of tax reform priorities—tax-free rollovers of capital gains as promised by the current government in the last election. I would cite several reasons for not including that on a list of priorities.

The TFSAs and expanded access to tax-deferred savings that I've recommended provide tax-free treatment for capital gains and also for interest and dividend incomes. So unlike a capital gains rollover, they do not distort portfolio holdings.

Tax-free rollovers of past-accrued gains provide an inefficient windfall for past behaviour rather than incentives for future savings behaviour. Tax-free rollovers would provide large tax savings highly concentrated in the very top income classes. Tax-free rollovers are technically more difficult to implement and enforce than the existing tax-deferred saving schemes and the forthcoming TFSAs. And finally, Canada's effective tax rates on capital gains are already competitive with those in the United States, especially for short-term gains, where the U.S. applies full tax rates. So I commend the government in choosing not to pursue that particular item of its campaign platform.

To conclude, Canada at both the federal and provincial levels has made major strides since 2000 to improve our tax system, but additional steps are needed. These changes will move our revenue system further toward an economically efficient consumption base. Regardless of whether one seeks larger government or smaller government, it is important that revenues be collected using an efficient, smart design.

I have outlined briefly what I believe to be the top priorities and I'll be glad to answer any questions that members of your committee might have.

[The Chair, Conservative, Rob Merrifield]

Thank you.

We'll now move to Jim Davies, professor of economics, University of Western Ontario.

[Professor Jim Davies, Professor, Economics Department, University of Western Ontario]

Thanks very much.

Like John, I'm very pleased to be here. I think it's very important work that your committee is embarking on, and I wish you well in this enterprise.

My goal today is just to talk about some important areas in the federal tax system that I think still require attention. My comments will reflect my particular interests, which are mostly in the personal income tax area. I'm by no means presenting something exhaustive or comprehensive. It's not possible to do that; the tax system is too huge a thing.

When I started to think about this, I thought it would be useful to cast my mind back, and I'm going to invite you to cast your minds back as well, 10 years to 1998 and think about what's happened since then. A lot of good things have happened, in addition to some problems continuing. I think it's important to remember that Canada has a pretty good tax system, and it's the result of a lot of people thinking about it very seriously and trying to improve it over time, just as this committee is trying to do at the moment. We shouldn't have any notion that there are horrendous, terrible problems in the Canadian tax system that need to be fixed up.

At any rate, here's my little list of things that were wrong 10 years ago.

The first thing is the top tax rate, as John has pointed out, kicked in at too low a threshold. That problem has been quite significantly addressed. I think the $123,000 threshold for 2008 is still a bit low. I was talking to an Australian economist yesterday, and their top rate kicks in at $150,000, so I think we could move further there.

We used to have surtaxes in the PIT, and we don't have them any more. The last surtaxes and the corporate income tax were removed this year. These are good things because those raised the top marginal rates quite a bit.

Ten years ago we only had partial indexation of the personal income tax, which is a bad thing. It increases tax rates every year. We've had full indexation since the year 2000, so that's a big improvement.

Again, the RRSP contribution limit was too low. Ten years ago it was only $13,500; now it's $20,000. We should keep going up, but we've made some progress.

We didn't have a tax-free savings account. Actually, by the way, a better term for this, and it's a term that John has used in his previous work, and others have used, is tax prepaid savings account, because you've paid tax on that money you're saving; you're just not going to get nailed with a second tax in the future. This is something economists have called for, for a long time, in the theory of a consumption tax approach. You should have both the RRSP-type vehicle and you should have the TFSA-type vehicle. It's not some strange thing that came from nowhere; it's been thought about for a long time. I also think the contribution limit should go up, and I hope it will rise more than it's slated to do as we go forward.

Personal income tax progressivity was too strong ten years ago, partly because the top rate kicked in at such a low tax level. But that does have some interesting impacts. One thing I've worked on in my research is the impact of that progressivity on the incentive for people to invest in human capital. So people are thinking about taking graduate programs at university, becoming doctors, lawyers, engineers, whatever, and they ought to think about the material as well as the moral rewards to doing that. Those are reduced the more you enter into high tax brackets after you graduate. This is the impact of progressivity, and it's now been well established that it really does reduce the rate of return to investing in human capital. If people are thinking along these lines, it reduces that incentive.

That's something where the situation has improved quite a bit, and this is something that I don't think people expected. Raising the threshold for the top marginal tax rate has an impact, and there are a lot of other initiatives that have been pursued over the last 10 years to increase the assistance through the tax system for students.

Back in 1998, my research with Kirk Collins at Western indicated that for a median person taking a bachelor's degree in Canada, the effective tax rate on that investment was 15%. A neutral tax system would have an effective tax rate of 0%. Our 2006 results indicate that for this median person this rate is now down to 1%. So it's gone down from 15% to 1% as a result of various changes in the tax system. That is an important victory.

The child tax benefit in 1998.... Due to the clawback, if your net income was above about $70,000, there was no tax recognition for having children, which is a violation of horizontal equity. So, as John pointed out in a paper in 1994, if you had an income of $100,000 and three kids, you paid the same tax as somebody else with an income of $100,000 and no kids. The tax system was effectively treating the kids as if they were a fancy boat. This has been addressed with recent initiatives like the universal child care benefit and the tax credit for kids that was introduced in 2007.

There's a problem a lot of people talk about, about high effective marginal tax rates for low-income people. It's a very difficult problem. It's been addressed to some extent through the working income tax benefit. Federal capital taxes are gone, and it's a very good thing. The corporate tax rate has come down. It was 28% ten years ago and this year it's going to be 19.5%. So there's real progress there.

Lack of harmonization of the GST and provincial sales taxes is still with us. There's a problem with the GST that there are relatively high compliance costs. This is partly or perhaps largely due to the complexity that comes from having multiple rates and different treatment for different kinds of goods. In principle, as an economist, that's a problem that I would like to see addressed in the future, even if it's probably not very high on the agenda for non-economic reasons.

Okay. So that's my little checklist from ten years ago. Now, we could also talk about what's changed. Have problems arisen that we didn't have then? I have a little list of those. There have been some improvements in other areas that I just haven't had a chance to talk about.

Now I'm going to talk about some problems that have arisen more recently. I wouldn't like you to think that I just think it's problems that have come onstream. On these problems that have arisen, the new ones, the introduction of the credit for interest on student loans was unnecessary. In the tax system, the main approach, the way the costs of getting educated are recognized is through immediate expensing. If you have immediate expensing of capital expenses, you don't need interest deductions later. Quantitatively it's not a huge issue, but in terms of a precedent for how we treat interest deductability or credits, I wasn't too happy about that.

Tax mix.... Most economists across the country have been disappointed that the GST rates were reduced rather than having PST rate reductions. We're certainly in favour of rate reductions, but we are more concerned about the impact of PIT, personal income tax, and also about corporate income tax on incentives to save and invest.

It appears, and I think it's probably true, that there's been a bit of an increase in the use of special purpose tax credits to achieve social objectives. This is not something I would rule out entirely. I'm thinking of the public transit tax credit, the children's fitness tax credit, for example. If we want to change people's incentives and if we're convinced that through the tax system is really the best way to do it, then we should do it. We need to be on our guard about trying to do too many things through the tax system. It makes the tax system more complex, but it also reduces the revenue. So you have to keep the rates up, in general, to pay for these additional credits.

The final thing I would touch on is carbon tax. Like many people now, I'm in favour of carbon taxes. There's this benefit that you certainly don't want to use as some kind of revenue grab. If it's introduced in a revenue-neutral way, then you can reduce other taxes that are distorting things like labour supply and saving and investment. So there could be economic payoffs from introducing these taxes if we feel we need to reduce our emissions.

So that's more or less all I had on that.

[The Chair, Conservative, Rob Merrifield]

I want to thank you both.

We'll now move to questioning and answering. We will start with Mr. McKay. You have the floor for seven minutes.

[John McKay, Liberal, Scarborough—Guildwood, ON]

Thank you both for your presentations. They were very thoughtful and very useful, and a good lead for our study.

I'll start with Professor Kesselman.

A consumption tax seems to be regarded by most economists as the last tax that you would reduce. What is difficult to explain in the public is why you would reduce any other tax first, before you'd reduce a consumption tax. As I understand it, it has something to do with a multiplier effect, the benefit of tax moneys floating in the system, and the productivity enhancements that are gained by reducing corporate taxes or reducing personal income taxes rather than consumption taxes.

I wonder if you could, first of all, for the purposes of the committee, explain the multiplier effect. If I have time after that, there are a couple of other questions I want to go with.

[Prof. Jon Kesselman]

The common popular understanding of a consumption tax is associated with sales-type taxes--provincial sales taxes and the federal sales tax, which is the GST. This differs from an economist's notion of a consumption-based tax, which is much broader than that. A consumption-based tax in economic terms is one that does not distort investment and savings choices--in other words, people's choices about how to consume over their lifetime and how to allocate their savings to various forms of investment.

Viewed in that light, our personal income tax in Canada is actually very close to being a consumption-based tax. Why is that? Well, for most people the allowable contributions through your pension plan and through RRSPs are like consumption-based taxes, because you can deduct from your taxable “income” the amount that you save. What is left is consumption. And when you withdraw it, it gets added to, again, your taxable “income”. You withdraw from those funds only when you want to consume.

So that's one reason. Another is that the personal income tax does not tax savings in the form of owner-occupied housing, or principal residences. Capital gains on such homes are tax-free. Still another reason is that even for non-registered savings--in other words, savings not in an RRSP or a pension plan--when you realize capital gains on them they're taxed at a very preferential rate, at only half of the individual's normal rate.

The personal income tax in Canada, like that of some other countries, is called an income tax but it actually is much closer to a consumption-based tax for the great majority of the population. Only the top maybe 2% or 3% of the population is actually constrained by the $20,000 limit on annual contributions to these tax-deferred plans. Therefore, only—

[John McKay, Liberal, Scarborough—Guildwood, ON]

You don't regard the GST as a consumption tax then. That's a curious analysis.

[Prof. Jon Kesselman]

Yes, the GST is also a consumption-based tax. A lot of the uproar--including from a number of my fellow and sister economists--that cutting the GST was bad because it's a consumption tax and consumption taxes are good, so we should cut income taxes, was overlooking the fact that the personal side, not the corporate side but the personal income tax side, is very much consumption-based at progressive rates. The GST, of course, is consumption-based at a flat rate, which works out to be a regressive pattern.

So one could certainly argue that cutting the GST was no better and no worse than cutting the PIT, the personal income tax, but was actually better than cutting the personal income tax in terms of its distribution over various income classes. In other words, cutting a regressive tax, like the GST, would be a progressive move.

[John McKay, Liberal, Scarborough—Guildwood, ON]

Sorry, Professor, I have only a few minutes left.

Professor Davies, do you agree with Professor Kesselman's analysis that personal income tax is in fact a consumption tax, as opposed to any other...?

[Prof. Jim Davies]

Clearly it is for the great majority of people, but what I would throw in is that the top percentage of people, for whom it's not truly a consumption tax, are very important in economic terms. Savings rates rise very steeply with income towards the top of the income distribution. So the people who are very active in the markets, who are saving a very high fraction of their income, who have a lot of income to save--they are beyond the contribution limits.

[John McKay, Liberal, Scarborough—Guildwood, ON]

So is it your position, both of you, that it's a matter of indifference to you which tax is cut, whether it's a GST or a PIT?

[Prof. Jim Davies]

No. But I think you're picking up the nuance that there's a slight difference of opinion between us, right?

[John McKay, Liberal, Scarborough—Guildwood, ON]

I am, yes. And I'm a little confused, frankly.

[Prof. Jim Davies]

Yes, well, I guess not all economists think exactly the same, although we do have large areas of agreement.

I think the reason that the majority of economists reacted by saying that it would have been better to have PIT and CIT cuts is that they're thinking about the impact of the top marginal rates on the people who are not operating in a consumption tax system within the PIT. Then, of course, we go to the corporate income tax, and clearly this is not a consumption tax.

[John McKay, Liberal, Scarborough—Guildwood, ON]

If I understand your position, you would prefer a personal income tax cut over a GST cut because the people at the top end are the ones you would really like to retain in the economy.

[Prof. Jim Davies]

Well, I'd like to give them the right incentives for saving and investment.

[The Chair, Conservative, Rob Merrifield]

Thank you very much.

We'll now move to Mr. Laforest.

[Jean-Yves Laforest, Bloc, Saint-Maurice—Champlain, QC]

Thank you, Mr. Chair.

Mr. Kesselman, perhaps I am mistaken, but it seems to me that you did not deal with the question of tax evasion in your presentation. The system as we know it allows a number of companies to evade taxes. Are the consequences of this significant? How do you see the system? Should evasion not be completely eliminated? There must be some way to do it. I would like your opinion on that. Then I will have more questions for you.

[Prof. Jon Kesselman]

I'll be glad to give you my thoughts.

We do not have very precise measures on the extent, nature, and structure of evasion. From very indirect types of methods, we know it is substantial. Estimates range between 10% and 15%, and some are a bit higher, on the total potential revenue lost due to evasion of various forms. There are certainly grey areas of compliance, where companies that operate in Canada and in other countries can shift their financing to the countries where they get the higher tax deduction, and shift their revenues through so-called transfer pricing into the jurisdictions that have the lower tax rates. That is not a simple issue for Canada or any country to address.

On your question of whether we can fully eliminate tax evasion, we certainly cannot. No country has been able to do that. No country can fully eliminate it. If you think of small businesses that operate partly in cash and in the underground economy, the best we can do is have our tax enforcement people out there trying to nab a few of them. We cannot nab all of them.

It is a real problem, and the relevant aspect of it is to ask how evasion interacts with our design of the tax system and questions about personal income tax rates: how do we withhold those taxes? Empirical studies have found that the GST has increased the incidence of evasion, because in part it has given small-business people the incentive--

[Jean-Yves Laforest, Bloc, Saint-Maurice—Champlain, QC]

Thank you. Given that my time is limited, I will move to another question that I will put to Mr. Davis.

In Canada, we calculate the individual incomes of each person in a family whereas in other countries, in France specifically, tax is calculated using family income. Would that kind of approach not be of interest for Canada? In fact, our tax system is so complex that families are often penalized. They have difficulty following it and do not understand their place in the system, especially when it comes to taxing their income.