BP-377E

THE GOODS AND SERVICES TAX:
THE GOVERNMENT'S ADMINISTRATION COSTS

Prepared by:
Michelle Salvail
Economics Division
February 1994

TABLE OF CONTENTS

INTRODUCTION

STARTUP AND ADMINISTRATION COSTS OF THE GST

   A. Startup Costs

   B. Current Administration Costs

EFFECTIVENESS OF ADMINISTRATION OF THE GST

FACTORS DETERMINING ADMINISTRATION COSTS

   A. Treatment of Different Goods and Services

   B. Tax Rates

   C. Number of Registrants

   D. Frequency of Filing

CONCLUSION

THE GOODS AND SERVICES TAX:
THE GOVERNMENT'S ADMINISTRATION COSTS

INTRODUCTION

In 1987, the federal government undertook the reform of the federal Manufacturers' Sales Tax (MST) that led to the introduction of the Goods and Services Tax (GST) on 1 January 1991. Since that time, the GST has been continually and sharply criticized from all quarters. Many people think that the GST has not fulfilled its promise and has come nowhere near meeting the two principles of public finance on which the federal government based its introduction: (i) the tax should not hinder the efficiency of the economy; and (ii) the tax should minimize compliance costs for business and administration costs for government.(1)

This paper, will focus on the administration costs of the GST. First, we shall establish what these costs comprise and, since the GST was introduced relatively recently, examine startup costs. Second, we shall look at ways measuring the effectiveness of administration of a tax, and compare the administration of the GST with that of the former MST and of value added taxes (VATs) in other countries. Lastly, we shall examine the factors that determine the administration costs of a tax, how they affect the GST, and how they could be reduced.

STARTUP AND ADMINISTRATION COSTS OF THE GST

   A. Startup Costs

Well before the GST came into effect, officials were already laying the foundations for administering it. Once the design of the tax was completed, capital expenditures were necessary for developing information systems and purchasing additional equipment, such as desks and computers. Officials then had to identify potential registrants so that each one could collect the tax and be eligible for the credits.

All these activities contributed to the startup costs of the GST. Although several departments were involved in introducing the tax,(2) Revenue Canada was by far the most important. According to the department, its own startup costs amounted to $320.3 million. This figure assumes that only costs incurred before 1 January 1991 were for planning and preparation. In the 1992 Report of the Auditor General,(3) Auditor General (AG) Denis Desautels refined this definition, explaining that some of the administration costs incurred after 1 January 1991 were also startup costs; for example, registering registrants had begun before 1 January 1991 but continued after that date. If such costs are also taken into account, the AG estimates Revenue Canada's startup costs to be $678 million. If expenditures by the other departments are included, the AG's estimate amounts to $820 million.

The variance between Revenue Canada's figures and those of the AG can be attributed to their different definitions of startup costs, rather than to an underestimate by Revenue Canada. Still, as the AG noted in his 1992 report, although the startup expenditures for the GST were reported each year in the budgets of the participating departments, these costs should have been consolidated and reported to Parliament together.(4)

   B. Current Administration Costs

The 1991-92 fiscal year marked the first full year of operation of the GST. Initial forecasts of its administration in 1989 had been $200 million annually.(5) The question was: were the administration costs of the GST more or less than anticipated? In 1991-92, administration costs for all departments involved amounted to $486.1 million. Table 1 shows where these expenditures were made. Administration and collection of the GST took 3,960 person-years, half of which were assigned to the compliance activity.

At first glance, the amount spent on administration seems high. However, it must be borne in mind that some expenditures were one-time costs that will not recur. It should also be noted that, in light of the short period from the time the GST received Royal Assent (17 December 1990) and the time it came into effect (1 January 1991), Revenue Canada had to spend enormous sums to deal with the huge influx of registrations and requests for information. For the 1992-93 fiscal year, the administration costs of the GST could have been expected to be much lower, since the GST had by that time reached its "cruising speed." However, this was not the case, as is shown in Table 1. Administration costs went from $486.1 to $518.1, an increase   of $32 million. Costs for Customs and Excise climbed by nearly $60 million.

TABLE 1

* Most of these expenditures were related to facilities (Public Works) and changes to systems (Supply and Services).

Source: Revenue Canada, Customs and Excise, internal data.

EFFECTIVENESS OF ADMINISTRATION OF THE GST

It cannot be determined whether or not the administration costs of a tax are acceptable until they have been compared to the revenue the tax generates. The GST system includes an income tax credit and refunds to businesses of the GST paid on inputs; these features account for nearly half of the gross revenue from the GST. Because of this considerable difference, it is all the more important to compare administration costs to net, rather than gross, revenue. Table 2 shows the details for 1991-92 and 1992-93. In 1991-92, the government collected $15.2 billion by means of the GST, and the administration costs for the tax stood at a little more than $486 million. For each dollar collected, the GST cost 3.2 cents. The same calculation for 1992-93 shows a cost of 3.6 cents for each dollar collected.

TABLE 2

* Includes 50% of the administration costs of the Quebec provincial sales tax. Under the Debt Servicing and Reduction Account Act, administration costs are not part of this Account.

Source: Revenue Canada, Customs and Excise, February 1994.

One of the arguments put forward by the Department of Finance to justify replacing the MST was the old tax was too complex to administer; it is interesting, therefore, to compare the cost of the MST with that of the GST. There is no doubt that these two taxes are completely different, but it is still important to compare them from the perspective of maximizing resources and simplifying administration.

During the last year of the MST's existence (1989-90), the government spent $90 million on administration costs for this tax, which generated $17.768 billion in net revenue: each dollar collected cost the government 0.5 cent. That means that the GST costs six times more to administer than the MST.(6) Some observers might argue that the GST costs more than the MST for each dollar collected because the recession has resulted in lower-than-anticipated revenues. If we assume that the GST could have generated $20 billion in 1991-92 (a generous assumption), each dollar collected would still have cost 2.4 cents in administration costs, or five times more than the MST.

Since other countries have also introduced taxes similar to the GST, it would be tempting to compare their administration costs and revenues with ours, and to come to conclusions about the effectiveness of the respective administrations, based on those figures. However, such figures are not necessarily comparable. Another country's tax, with the same ratio of administration costs to revenue as the GST, but with several rates to apply instead of only one, would actually be more efficient than ours, because that tax system would be more complex. The fact that administration costs may be defined differently also makes comparison difficult. However, for comparison purposes only, we note that in 1986-87 the administration costs of the VAT in the UK accounted for 1.03% of revenue collected.(7) This percentage represents the ratio of administration costs to gross revenue. For Canada, this ratio was 1.64% in 1991-92 and 1.70% in 1992-93.

There is another way to determine the efficiency of administration of a tax. Appearing before the Public Accounts Committee on 25 March 1993, Revenue Canada Deputy Minister Pierre Gravel noted that "a key indicator of a nation's efficiency in administration of value added taxes, recognized around the world, is the calculation of the ratio of person-years [employee] to registrants."(8) This ratio is established by the International Monetary Fund (IMF) and is currently one person-year to 250 registrants (1:250). Table 3 shows the ratio of person-years to registrants in various countries.

TABLE 3

* Tait, Alan T., Value Added Tax: International Practice and Problems, IMF, p. 250.

** Public Accounts Committee, Third Session, 34th Legislature, Issue 47, p. 10.

When he appeared before the Public Accounts Committee, the Deputy Minister did not anticipate that this ratio would increase over the next few years. Using the criterion of the ratio of employees to registrants, then, the Canadian federal government would appear to be fairly efficient. The fact that the Department's employees look after more registrants than the average, does not necessarily mean that they are more productive, however. Nor, in fact, can it be said that a country with one employee for 100,000 registrants would be still more efficient. A higher ratio of employees to registrants can mean that the audit levels are not very high and that each employee can therefore look after more registrants. For example, in Italy, where the ratio of employees to registrants is 1:726, the underground economy accounts for 40% of total economic activity. At the opposite end of the scale, in the UK, with one employee for 149 registrants, the underground economy accounts for no more than between 2 and 4% of total economic activity.

A high ratio of employees to registrants, then, does not always guarantee efficient administration. The point is to find a compromise between the level of resources assigned to audit and other activities and potential lost revenue. Governments must also ask themselves how they can make the tax easier and less costly to administer. It is generally agreed that, in its present form, the administration of the GST is expensive. In the next section, we shall provide an overview of the factors that affect these administration costs.

FACTORS DETERMINING ADMINISTRATION COSTS

   A. Treatment of Different Goods and Services

The larger the tax base, the easier a tax is to administer. For various reasons, however, governments often want to make certain goods and services either zero-rated or tax exempt, and this drives administration costs up. In Canada, zero-rated goods and services are mainly prescription drugs and groceries. In addition, the groceries category includes exceptions that are costly to administer: for example, some grocery items are taxed only if fewer than six of them are purchased. Tax-exempt goods and services include financial services, day care services and educational services.

   B. Tax Rates

Several countries apply more than one tax rate. In general, one rate applies to most goods and services, and the other rates apply to a limited group of goods and services.(9) Some believe that multiple tax rates are very costly to administer and considerably reduce the additional revenue they generate. Most countries that have recently introduced a VAT more have imposed a single rate and countries with more than one rate are tending to reduce the number.(10) In Canada, the GST has a single rate (7%),(11) which is in line with the general trend.

   C. Number of Registrants

Businesses and organizations that are obliged, or choose, to register for the GST are called registrants.(12) In theory, a government must seek to register as many businesses as possible, since these registrants collect the GST on behalf of the government. While registrants must declare the GST amounts they collect, they may claim a credit for the GST they themselves have paid on purchases necessary for their provision of taxable goods and services.(13) These refunds amounted to over $11 billion in 1991-92 and a little more than $12 billion in 1993-93. In practice, a government may wish to limit the number of registrants, for example in a case where the cost of processing a registrant's file is higher than the tax the registrant would pay. It was also clear that some businesses (especially the smallest ones) could not comply with the requirements because of the additional cost the tax would impose on them. Like the government, these businesses have compliance costs equal to or even higher than the tax revenue generated for the Treasury. Several studies have shown that compliance costs are inversely proportional to the size of a business; they decrease as business size increases.

Bearing this in mind, Revenue Canada decided that registration would be optional for businesses with annual sales of less than $30,000. Nevertheless, 400,000 businesses(14) with annual sales under this threshold registered, for various reasons. Some of these businesses did not know that registration was optional or feared that sooner or later Revenue Canada would require them to register. Others registered because their customers wanted to pay the GST in order to claim the input tax credit. Still others registered in order to obtain the input tax credit on purchases from their own suppliers.

Savings could be made, then, if Revenue Canada were to set up an incentive program encouraging some registrants to de-register. It should be possible to convince businesses that the input tax credits for which they would be eligible might be lower than the compliance costs they would incur. Revenue Canada could even require some businesses to de-register if incentive programs did not work. The authors of a study on the compliance costs of businesses, of which one part discusses businesses in New Zealand, note that the number of registrants has become excessive; they urge the government to make the conditions of de-registration easier and thus encourage de-registration by businesses and organizations whose total compliance costs are more or less equal to their GST payments.(15)

   D. Frequency of Filing

Any business with annual sales of over $30,000 must register. Each registrant must file a return, with frequency of filing depending on the amount of annual taxable sales. Registrants with sales of over $6 million must file returns monthly; those with sales of between $500,000 and $6 million must file returns quarterly. Other registrants are encouraged to file quarterly returns, but are allowed to choose the frequency that is convenient to them.

Administration costs depend on the number of returns. According to Revenue Canada, 7.1 million returns--a considerable number--were filed in 1991.(16) Measures could be introduced not only to cut down the number of registrants who need to file returns, but also to encourage registrants to file returns annually rather than quarterly. In the opinion of the Auditor General, if half of eligible registrants had opted to file returns annually, approximately 2.4 million returns would not have had to be processed.(17) Following these observations, Revenue Canada encouraged more small businesses to file returns annually; the department reports that, after two months, 40,000 small businesses had responded. Businesses may now file a joint GST and income tax return, and Revenue Canada feels that this arrangement will encourage even more businesses to select this option.(18) However, if the results are not satisfactory, Revenue Canada may have to consider making annual filing compulsory.

CONCLUSION

Although the Conservative government intended to set up a tax that would be simple for both businesses and government to administer, the result has been quite different. The third anniversary of the coming into force of the GST was 1 January 1994. Although since that time several initiatives have been introduced aimed at simplifying the administration of the tax, it is still considered complex and costly to administer.

The new government has said that it intends to replace the GST in order to make it simpler for everyone. It will have to ascertain the administration cost of each component of the tax. For example, what does it cost to make certain goods zero-rated? When the GST was introduced, the government had decided not to tax basic groceries. While that decision may have been popular, it has resulted in additional administration costs for government and businesses. Administration costs should also be more fully disclosed; the information now published in the various sources of information (the Public Accounts, the Estimates) is not very detailed.

In developing a new tax, the government must take better account of its administration costs. This implies examining compliance costs, since government decisions to increase or decrease some services in administering the tax will have a direct influence on business. For example, some businesses could be obliged to hire an accountant, if they could no longer obtain assistance from Revenue Canada. According to the Canadian Federation of Independent Business, private sector compliance costs amounted to $4.5 billion in 1992. There is also worldwide debate over whether businesses should be paid to collect taxes on behalf of the government. In Canada, a Supreme Court decision in August 1992 denied vendors the right to be reimbursed for costs incurred in collecting the GST.

Government administration costs cannot be decreased by increasing compliance costs for businesses. Ideally, solutions must be found that will reduce total administration costs (those of both government and business). Before introducing a new tax or changing the present one, the government should evaluate the effect of each component or change (such as unrestricted registration, the registration threshold and indexing of it, single or multiple rates, and a broader tax base) on total costs. From the point of view of efficient administration, a business should collect the GST only if its compliance costs together with the government's administration costs, come to less than the tax that the business collects and remits to the government.

If the government decides to replace the GST, any new tax should be simpler to administer and should take efficiency into account.

(1) Canada, Department of Finance, Sales Tax Reform, June 1987.

(2) For example, the Department of Finance worked closely with Revenue in designing the GST, and Public Works Canada was responsible for office space.

(3) 1992 Report of the Auditor General, Minister of Supply and Services, Ottawa, p. 491.

(4) Ibid.

(5) Department of Finance, Goods and Services Tax: An Overview, August 1989, p. 33.

(6) 1991-92 data for the GST; 1989-90 data for the MST.

(7) Plamondon et Associés, GST Compliance Costs for Small Business in Canada, Department of Finance, December 1993, p. 103.

(8) Canada, House of Commons, Public Accounts Committee, Third Session, 34th Parliament, Minutes of Proceedings and Evidence, Issue 47, p. 10.

(9) In most cases, low rates apply to essential goods and high rates to luxury goods.

(10) Alan T. Tait, Value-Added Tax: International Practice and Problems, IMF, Washington, 1988, p. 249.

(11) In theory, there are two rates: 0% for zero-rated goods, and 7% for other goods. In practice, 0% is rarely considered a rate. Also, the tax is effectively reduced by rebates on the purchase of new houses valued at $450,000 or less.

(12) Canada, Revenue Canada, Customs and Excise, GST: Guide for Small Business, April 1992, p. 1.

(13) Ibid.

(14) As of 31 December 1993 there were 50,000 such businesses.

(15) Plamondon et Associés (1993), p. 116.

(16) 1992 Report of the Auditor General (1993), paragraph 20.65.

(17) Ibid.

(18) Canada, House of Commons, Public Accounts Committee, (25 March 1993), Issue 47, p. 17.