Finance Committee on April 9th, 2008

[The Chair, Conservative, Rob Merrifield]

Our witnesses today are by teleconference, and we have enough members here to begin today's study. It's pursuant to Standing Order 108(2), a study on the structure of Canada's federal revenue-raising system.

I want to thank our witnesses for being here through teleconference. This is the first time we've actually had the opportunity to watch you dialogue. This is kind of new technology for the committee. I certainly appreciate you both being here.

From the University of Calgary we have Professor Jack Mintz, from the school of policy studies.

Which one is Jack?

[Prof. Jack Mintz, Professor, School of Policy Studies, University of Calgary]

I'm here. I'm in Toronto right now.

[The Chair, Conservative, Rob Merrifield]

Excellent.

From Vancouver, the University of British Columbia, we have Kevin Milligan.

We want to thank both of you for taking the time to contribute to our study and to be with us today. We'll yield you the floor in order, and then move into a question-and-answer period.

We'll start with you, Jack. The floor is yours for your presentation. Thank you.

[Prof. Jack Mintz]

Thank you very much. It is a pleasure to come back to the House of Commons finance committee. I have been involved many times in various sessions over the past number of years.

I find the question-and-answer period particularly useful, and I am sure useful to the members. I am going to be as brief as possible about several things, to leave more time for discussion with the committee.

Let me, first of all, start by saying that since 2000 a considerable effort has been made in Canada to reduce the impact of taxes on investment and savings that are critical to ensuring that Canadians can enjoy economic growth and provide resources for their retirement as our population ages. Both Liberal and Conservative governments have achieved much in the past eight years.

Federal-provincial general corporate income tax rates have been cut from 43% in the year 2000 to 32% today and will be further reduced, to 28%, by 2012.

Capital taxes have been or are being phased out. In this, I am referring to both federal and provincial capital taxes. The federal one has already been phased out.

Capital cost allowances are being matched better to economic depreciation, although some tax preferences have been scaled back and others enhanced.

Income taxes have been reformed to remove the tax penalty on savings, for example by broadening contribution limits for RRSPs and pension savings and introducing the new tax-free savings account, which I thought was a terrific idea, in the last budget.

However tax reform is a process that continually reacts to new changes. Given the state of the U.S. economy and global imbalances and the continued concerns over productivity, Canada should keep moving the agenda forward.

Tax issues that should get some attention are the following.

First, while Canada has made tremendous strides in reducing business taxes, personal income taxes should be reformed, especially to remove high rates induced by high marginal tax rates and clawbacks of income-tested benefits and credits. It might make sense to cut down the number of tax brackets to three—15%, 20%, and 25%, as examples. We should also consider that various approaches can be taken for removing clawbacks, based on RSP asset sales, or by pooling benefits to reduce overlapping clawback rates.

Second, Canada should consider the demographic trends, which in the long run are quite important in terms of labour shortages, even though in the next couple of years we will be challenged by a contracting U.S. economy.

The separation of employment insurance into a separate fund, which the last budget has introduced, I think gives opportunities to rethink EI reform to put it more on an insurance basis. Employment insurance provides important insurance to help people cope with job loss, but also gives them an opportunity to adjust to new jobs, and that is where retraining programs could be useful.

It should also be changed to reduce contribution rates on businesses that do not lay off workers as much. This has been referred to as experience rating and is used quite well in worker compensation programs at the provincial level. In the case of unemployment insurance worldwide, the United States has practised experience rating for many years now.

Third, Canada should look at the tax treatment of small businesses, which undermines growth and job creation. Incentives such as the lifetime capital gains exemption and the small business deduction tend to impose a penalty on growth, since incentives are lost above a threshold or when the small business becomes public. Instead, small business incentives should be developed to improve growth prospects, such as the U.S. half capital gains tax reduction for investors holding initial public share offerings, for a certain number of years.

Fourth, the federal government could encourage provincial tax reforms by providing a grant for those provinces that undertake sales tax reforms through adopting a value-added tax similar to the GST. This was done more than ten years ago for the Atlantic provinces, and it would be good if Ontario, British Columbia, Saskatchewan, Manitoba, and Prince Edward Island all fixed up their antiquated sales tax systems, which are distortionary and less elastic with growth in the economy.

Fifth, many of the above proposals suggested will cost money at a time of a slowing economy. The finance minister would like to avoid deficits and should do so, and to help pay for tax reforms, the federal fuel excise tax should be converted into a true broad-based environmental tax that would be comprehensive and affect all regions of the economy in a fair and neutral manner. The revenues could be used to reduce corporate and personal income tax as well as being used to support investments to new technologies needed by businesses to deal with environmental costs.

And that, sir, is what I would like to mention as the main issues that I want to cover today.

[The Chair, Conservative, Rob Merrifield]

Thank you very much for that.

We'll now move on to Kevin Milligan, assistant professor, economics department, the University of British Columbia. Mr. Milligan, the floor is yours.

[Kevin Milligan, Assistant Professor, Economics Department, University of British Columbia]

Thank you very much, and thank you for the invitation to speak to the committee.

I'm pleased that the committee has a really broad mandate, because while details are important, it's also useful to maintain a focus on the long-term target, which is a tax system that raises revenue in the most efficient and equitable way possible.

I'm going to start my presentation with five quick suggestions and then move on to a broader proposal.

First, on the GST, strong efforts should be made to harmonize the GST with provincial retail sales taxes in provinces that have not done so. Evidence strongly suggests that business investment would grow.

Second, on capital gains, the proposal to allow deferral of capital gains needs really careful consideration. As the income trust experience has shown us, problems can arise when one type of capital income is taxed differently from other types.

Third, the extension of boutique tax credits for expenditures such as sports and transit passes should stop. While these might be popular in some circles, I don't think they're a good tax policy.

Fourth, I urge you to consider a role for environmental taxation. Environmental taxes are supported by a very broad spectrum of economists. The recent initiatives of the government here in British Columbia in this area should provide some encouragement to our federal politicians in this area.

Fifth and finally, I would like to address the issue of deductibility for registered education savings plans. I understand that legislatively this has been killed. Good. As tax policy, this idea of RESP deductibility is folly, and as education policy, it is farce.

While I believe all five of these items deserve careful consideration, I'm going to defer further comment on them until the time allocated for questions. I'm very happy to speak in more detail about those. But for the rest of my time, I'd like to talk about more fundamental reform that could be considered.

The income tax system that we have today in Canada was built on the recommendations of the royal commission on taxation from the 1960s, commonly referred to as the Carter commission. The backbone of the Carter commission was the idea that income from all sources should be treated equivalently. Whether it's a capital gain, earned income, social benefits, scholarship income, it should all go in the same pot. Economists call this comprehensive income taxation, but it's often distilled down to the phrase “a buck is a buck”.

In theory, there are two principal merits to this type of system. First, there's a sense of equity embedded within it. No matter what is the source of one's economic power, it is treated equally. Second, in theory, it can generate efficiency gains because it avoids preferential treatment of certain types of income, so there's no incentive for individuals to rearrange their affairs and decisions in order to channel their incomes through preferred income categories.

Whatever the merits in theory, the complexity of implementing such a system has proven difficult, especially with respect to capital income. Moreover, the greater mobility of capital that has arisen since the 1960s brings into question whether the Carter framework still resonates with Canada's needs in 2008.

An alternative is available. One alternative is referred to as the “dual income tax”. A dual income tax combines a progressive schedule for the taxation of labour with a separate flat schedule for capital income. Corporate income, capital gains, interest, and dividend income could all be taxed at the exact same rate.

A dual income tax has been in place in Sweden and other Nordic countries since the early 1990s. Aspects of this system are also in place in Belgium, Ireland, the Netherlands, the United States, and elsewhere.

What are the advantages of a dual income tax system? I see three. First is simplification. The complex rules for the taxation of capital income create vast administrative challenges as inventive accountants and lawyers find ways to avoid taxation. By taxing all capital income at the same rate, much of this waste can be avoided.

Second is neutrality. A primary goal for tax policy is to avoid changing decisions about how and when to invest. By taxing all capital income in a simple and equal way, neutrality in investment decisions can be achieved.

Finally, it allows some freedom in the setting of the tax rate on capital income from concerns about equity. With comprehensive income taxation, any attempt to make Canada more attractive as a location for investment dollars by lowering tax rates runs into the problem that tax rates on labour income must be lowered as well. By separating the taxation of labour income from that of capital income, an appropriate rate for each can be chosen.

Let me close by giving you two concrete examples of how a dual income tax system could make the Canadian tax system better. First, consider the income trust episode. At its root, the problem originated in the lopsided treatment of interest income compared to corporate dividend income. The recent changes to the dividend tax credit and corporate tax rates have restored some of the balance for now. But under a dual income tax such a problem couldn't occur, because all types of capital income are automatically going to be treated equally. This might well put an army of tax accountants and tax lawyers out of work, as it renders the search for tax advantage less fruitful, but that's a good thing for our economy, because we can put those minds to more productive use.

For the second concrete example, consider income inequality. In work with my colleagues David Green and Marc Frenette, of Statistics Canada , we have documented a sharp increase in pre-tax and transfer income inequality since 1980 in Canada. The greatest source of this continued increase in income inequality is from labour income. The labour earnings of the highly paid are increasing very quickly. But taxing these big earners at higher rates is difficult, because it means we will also increase the tax on capital income and potentially scare away investment.

So a dual income tax can solve this problem by freeing the tax system to continue to tax labour incomes progressively, without having the fear of scaring away capital investment. Of course a dual income tax would raise several problems in implementation. Potential difficulties might arise in the treatment of the self-employed, pensions and savings, federal-provincial concerns, and various international tax issues, to name just a few. I admit that today I don’t have the answers for all those problems, but I do know that the potential gains of a dual income tax for Canada make it worth while to consider such a change. If it is good enough for a progressive, small, open resource-based economy like Sweden, it might be good enough for Canada. I therefore advocate serious study of a dual income tax.

Thank you for your time and attention. I'm happy to answer your questions.

[The Chair, Conservative, Rob Merrifield]

Thank you both for your presentations.

We'll now move to the question-and-answer session. We'll start with Mr. McKay, for seven minutes. The floor is yours.

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

Thank you, Chair.

Thank you both for your presentation.

I have three questions, the first to Professor Milligan. I found your suggestion of dual income very intriguing and on the face of it a rather attractive idea. The working premise is that you can make a distinction between capital income and labour income. The sanctity of the idea, if you will, rests on that distinction.

In the latter part of your paper you talk about the problem with the self-employed but also with those who are in the upper margins, say basketball players and CEOs and individuals of that nature, who have enormous economic clout in the marketplace.

If capital is taxed at a flat rate and income is taxed at a progressive rate, at the intersection of rates is where the labour income will want to become capital income. So I'd be interested in your thoughts as to how you would curb that rather obvious and potentially excessive abuse of those who are probably the most privileged in our society.

[Kevin Milligan]

Thank you for the question. It's a good one, because that's exactly where some of the problems with dual income tax arise.

First, on the self-employment problem, the issue there is to try to separate what's a return to capital and what's a return to the labour of the self-employed. Right from the early days of this kind of dual income tax in the Nordic countries, that's always been a contentious issue. I know that in Norway they have developed a pretty innovative way of trying to deal with this. The broader point I'd like to make is that we wouldn't have to start from a blank piece of paper; we could learn a lot from how things have gone in the Nordic countries.

The second point about potentially high-income individuals—basketball players, hockey players, highly compensated executives, who might have some ability through paying their accountant to do some tricks of transmitting some of their labour income into capital income—is a valid concern. The question, though, is whether you can design a system that can limit that kind of substitutability.

That is the exact right question to ask. I think a good study of the dual income tax would take a look at the experience of the Nordic countries and how they've tried to quell those problems.

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

Professor Mintz, in your second point, with respect to EI, you think that the transfer to the fund is a good idea, and then you talk about the potential of experience rating.

As I understand it, a lot of companies and essentially their employees.... I guess the entire system functions on the assumption that EI premiums will be paid but not be drawn by the vast majority of workers. And yet wouldn't your suggestion of experience rating exacerbate that problem? Because the companies that lay off employees, say the forestry sector or currently the manufacturing sector, are the ones that hire and lay off and hire and lay off—GM being a classic example. Presumably their experience rating would be higher and therefore their premiums rating would be higher, whereas the banks—to pick on them again—such as the Bank of Nova Scotia, continuously hire and very seldom lay off employees or draw on the EI system.

Wouldn't that effectively create a more expensive system for seasonal and more marginal industries and therefore almost be a disincentive for those companies to get back into manufacturing or forestry, as the case may be?

[Prof. Jack Mintz]

First of all, tomorrow is the tenth anniversary of the report of the technical committee on business taxation, which did recommend experience rating, and it was recommended on an individual firm basis.

Let me say first of all that Statistics Canada has done a number of studies, and while it's true that in some industries you have a higher incidence of layoffs, there's actually quite a differential experience across companies, even within the same industry. Therefore, in my view, experience rating—if we ever move in this direction—should really be done on an individual firm basis and not on an industry basis, which is an alternative approach.

With respect to compliance costs, this approach is often remarked to be more expensive, perhaps, but in some of the studies I've seen for the United States, the cost of complying with the unemployment insurance system, even with experience rating in some states, like Washington, is actually less than what we have in Canada. So I think we must ask some questions about what we are actually doing here in Canada, in terms of the administrative and compliance costs of running the system.

I would agree that there could be some additional expense, but then we have to remember the economic benefits associated here, because, effectively, EI is being used as a way of really helping companies to avoid making their own payments to keep individuals available to them when they're laid off, and then to bring back those individuals at a later time.

Really, what we're doing now is that we're imposing a significant tax on many sectors in the economy, including service companies. You mentioned banks, but you didn't mention a lot of the small companies that really have very little experience with unemployment and yet are paying very high premiums too.

The studies have actually shown that you could reduce unemployment rates by almost a percentage point if you did introduce at least some, or partial, experience rating for the EI system. That's why many economists are actually very favourable to the concept of experience rating, because it would have some significant economic benefit, especially at a time when we're worried about labour shortages.

I must say that one of the things that would need to be addressed is the way we handle regional benefits under the employment insurance system, which is particularly important for the Atlantic region.

[The Chair, Conservative, Rob Merrifield]

Thank you very much.

Monsieur Laforest.

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

Thank you, Mr. Chair.

Good morning. My question is addressed to both of you; you could answer it in turn.

I expected that you could talk to us about some ratio. The day before yesterday, we looked at the proportionate amounts in the aggregate revenues of the Government of Canada... There is some sort of ratio between income tax and consumer taxes. I may be wrong, but I believe that you have not talked about this.

In terms of our study, this is still a concern. Should we at some point increase consumer taxes in Canada in order to decrease income taxes so that at the end of the day the revenues remain the same? This is another aspect of our study.

There are some aberrations within the fiscal system. During the same presentation, we have seen that couples, individuals or single-parent families earning between $35,000 and $40,000 were not really being encouraged to earn an additional amount of $5,000 because then they would only keep $1,500 of that money. One must admit that it is a problem. We will have to correct this eventually.

I would like to hear you both on this.

[Kevin Milligan]

I could start, if that's okay with Jack.

[The Chair, Conservative, Rob Merrifield]

Go ahead.

[Kevin Milligan]

I'm going to pick up on the last thing that Monsieur Laforest said, which is about child benefits and the marginal tax rates that are faced by families in middle income ranges as they earn a bit more income. This is something that Professor Mintz mentioned in his presentation as well.

I think it is really important to consider how our child benefit system functions right now. We have a plethora of child benefits, certain parts of which overlap with each other. There's the new working income tax benefit, the national child benefit supplement, provincial national child benefit payments, the Canada child tax benefit, and the GST tax credit, which is paid to families as well. All of these things, as you earn more money, are reduced.

Having five different messy acronyms for child benefit programs seems to me like not the ideal way to proceed. Having a more universal approach to our child benefit system would allow our tax system to be more transparent in exactly what those tax rates are that are charged to families so that we could focus better on improving the system.

[Prof. Jack Mintz]

Let me add a number of comments.

First of all, to me, putting a lot of weight on what's consumption versus income taxes could be a bit of an exercise, because under the income tax today, there are elements of what you would call “consumption taxation”. That's because we have brought in provisions that allow people to avoid paying tax on their savings income, or effectively, in the case of the RRSPs and pensions plans, you're able to deduct your contributions from the income base. In other words, you deduct your savings, so you're only paying tax on your consumption at that point. Then, when you withdraw your money from the RRSP account or receive your pension, you're being taxed on your consumption.

With the introduction of the tax-free savings account, that's another way, actually, of doing consumption taxation. Of course, our tax treatment of housing in Canada is very much based on a consumption system. You don't get a deduction for the contributions, but you don't pay any tax on the imputed rental income you get by owning the house and renting it to yourself, or capital gains taxes on the ownership of that house. Therefore, all these elements, once you take them into account, are equivalent to an RRSP-type system, as long as you have similar tax rates over time when doing the treatment of this type of asset.

As a result, many Canadians actually are on what's called a “consumption-based system” under the income tax, because all their assets are being held in either owner-occupied housing or in RRSP pension accounts, and they now have available to them the tax-free savings account. Effectively, to the extent that everything is in those kinds of assets and they do not pay any tax on their return on savings, they are really being treated as one would have as a consumption tax under the personal income tax.

There are other ways that I think you can bring in consumption taxes and increase the weight. Clearly, one of them is to encourage provincial sales tax reform, to eliminate the retail sales taxes in favour of value-added taxes. Currently, retail sales taxes collect about one third of the revenues on businesses' intermediate and capital good inputs, and that actually has an impact on their competitiveness.

If we move to a value-added tax, which has now been adopted in more than 150 countries around the world today, and of course we have it at the federal level with the GST, and we have the Quebec sales tax in Quebec and the harmonized sales tax in—

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

I am sorry to interrupt you.

You talked earlier about the adjustment, about an experience rating refund for corporations that do not lay-off workers. You were saying that corporations that do not make any lay-offs should benefit from a better rating. Is this counter-productive for the system itself? Does this go against some form of universality for the system?

[The Chair, Conservative, Rob Merrifield]

Who would like to take that? Our time is up, but I'll allow a very short answer from each of you, if you'd like.

[Prof. Jack Mintz]

Okay, I'll be very brief on that.

First of all, there is a principle with insurance that if you don't have the issue of what's called “moral hazard”—where people will take undue risks, including deciding to take more unemployment—you would like to have full insurance, and you could make an argument for a no experience rating in that case, because all the unemployment is due to cyclical changes.

On the other hand, if the system of insurance encourages people to take more layoffs than they normally would—and of course businesses may actually participate in that as well.... For example, I know of teachers at private schools who only have a one-year contract and then go on unemployment insurance over the summer. That allows them basically to collect insurance, and that saves the private school from having to pay higher salaries as a result.

If you get those situations, you could argue for partial experience rating—not full experience rating, but partial—with the idea that those businesses that tend to have a higher layoff experience would end up paying more. So they would try to avoid some of the actions they take that lead to layoffs when it's not just a matter of cyclical effects.

[The Chair, Conservative, Rob Merrifield]

All right. Thank you very much.

We'll move to Mr. Dykstra.

[Rick Dykstra, Conservative, St. Catharines, ON]

Thank you, Chair.

Just to start out, I know that both you gentlemen have a broad depth of understanding of the issues we're challenged with here and are trying to work through. I guess my only request would be that you shorten your answers just a bit. That might allow us to get a few more questions in, if that is possible. I mean that with the greatest respect, of course.

One of the questions I had, Kevin, was on your approach. I guess I'm trying to get a handle on the direction most of you who have appeared before the committee have taken with respect to income tax versus consumption tax. It seems, from all your perspectives, that you would prefer a consumption tax to an income tax .

I wouldn't mind getting your comments on that very quickly. The reason I note it, especially with you, is that in the opening of your presentation you talked about the fact that you're not a big supporter of boutique tax credits.

Clarify this for me, because I may not see this as you're seeing it. You're supportive of a consumption tax, but you're not supportive of a consumption tax credit. I do not see the two as mutually exclusive. In fact, I see them very much working hand in glove with each other.

[Kevin Milligan]

Sure. Let me address that briefly.

There are a couple of issues I have with what I refer to as the boutique tax credits. One is that you're eroding the tax base. The government is giving you credits and costing revenue in that way, which means that the tax base is getting smaller. In order to raise the same amount of revenue, rates must go higher.

The general preference, which I think many of the people in front of the committee have likely expressed, is a system that has low rates but a broad base. So that's where part of the concern comes in.

The other part of the concern ties in with the other part of your question. With these kinds of tax credits, the difference between that and more general consumption taxation is that you're picking and choosing which types of expenditure are eligible for these tax credits, whereas with the general consumption tax, it's neutral across different types of expenditure.

As an example, for the fitness tax credit, I remember reading last year a presentation by the representative from the Federation of Canadian Archers, who was worried that archery wasn't going to be considered to be enough of a physical activity to qualify for the fitness tax credit.

So you have meetings and lots of interest about how you define where you're going to draw the line and what's enough fitness. My point is that you're picking and choosing what's good for kids and what's not. I'm not sure if archery is good or bad for kids, but I'm pretty sure that having a system that treats archery the same as the chess club the same as hockey is actually a pretty good system.

[Rick Dykstra, Conservative, St. Catharines, ON]

That may be the case. I guess the reason I question it is because your preference is to move away from that, yet your fourth point basically urges us to do exactly what you're suggesting we not do, and that is focus on a tax on the environment. I hear what you're saying, but am I wrong in saying that it's a bit of an inconsistent argument you're making?

[Kevin Milligan]

I think there is something to what you say. Let me try to defend it this way. The question is how broad a target you're trying to hit. When you try to have a credit for something that is very narrow, you create the incentive to shift things around and you have the difficulty of defining what's in and what's out.

So my preference in greater environmental taxation would be having a very broad base for environmental taxation. As Professor Mintz mentioned, something that is very broad-based, that is neutral across jurisdictions, would be the best way to go.