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BP-363E
THE GST: AN OVERVIEW OF SOME ALTERNATIVES
Prepared by:
Richard Domingue
Economics Division
December 1993
TABLE OF CONTENTS
INTRODUCTION
THE
GST AND THE UNDERGROUND ECONOMY
THE
COSTS OF ADMINISTERING THE GST
SOME
ALTERNATIVES
A.
Business Transfer Tax
B.
Tax on Consumption
C. A Simplified GST
D.
Federal Retail Sales Tax
E.
GST Handed over to the Provinces
F.
Increased Federal Individual Income Tax
CONCLUSION
THE GST: AN OVERVIEW OF
SOME ALTERNATIVES
INTRODUCTION
A number of experts believe
that the GST has fostered the underground economy and imposes too great
an administrative burden on government and business. The new government
has promised to replace the GST with a tax that would generate the same
revenue, would be fairer to consumers and small businesses, would not
be a headache for small businesses, and would encourage federal and provincial
governments to cooperate and harmonize their tax policies. In this paper,
after examining the GST's impact on the underground economy and on the
administrative burden, we shall discuss possible alternatives.
THE
GST AND THE UNDERGROUND ECONOMY
Undisclosed income is usually
estimated at between 5% and 20% of all economic activity in Canada, or
between $35 billion and $140 billion (the exact figure is probably
closer to 5% than 20%). It is likely that the GST has encouraged a number
of business people to operate underground.
A tax is considered effective
when it does not distort individuals' economic decisions and behaviour.
The government considers it necessary to introduce an effective tax system
that will no longer encourage business people to operate underground.
Some business people have
decided to operate in that way because the GST imposes too great a tax
burden on them and is too complicated to administer. What could be a simpler
response than to stop collecting the GST from customers and thus improve
one's competitive position? The Department of Finance has just completed
an evaluation of the GST's impact on the underground economy, but it has
not published it. Many observers have argued that the GST has encouraged
the underground economy. In his analysis of the increase in cash reserves
in the hands of the public (an indicator of cash transactions) one year
after the GST came into effect, Peter Spiro has shown that Statistics
Canada underestimates consumer expenditures by $5.7 billion. If this
analysis is correct, governments lost an estimated $2.3 billion in
tax revenue in 1992.
THE
COSTS OF ADMINISTERING THE GST
Several observers think
that the GST imposes a heavy administrative burden on government and small
businesses. In 1991-92, administering the GST cost the federal government
over $486 million and required over 4,400 full-time equivalents (FTEs).
Each net dollar collected as GST costs six times more in administrative
costs than did the former federal sales tax (3.2 cents per dollar,
as compared with 0.5 cents). To this figure must be added the private
cost of administering the GST. On 17 December 1993, the Department
of Finance published a report estimating this cost. According to this
report, businesses whose income is less than $100,000 spend 17 cents
for each dollar they collect on behalf of the federal government; those
with income between $200,000 and $299,000 spend 6.6 cents for every
dollar collected; and those with income of over $1 million spend
2.65 cents for every dollar collected. These estimated costs do not
include the value of the time business people must spend administering
the collection of money on behalf of the federal government, and are therefore
lower than actual administrative costs. The Canadian Federation of Independent
Business (CFIB) has estimated GST compliance costs at $5,158 per registrant,
not counting one-time set-up costs. The CFIB has estimated total compliance
costs to Canadian businesses at $6.642 billion in 1991 and $4,573
in 1992, with the private cost to small businesses of administering the
GST at 20 cents for every dollar collected.
SOME
ALTERNATIVES
From the first session of
the new Parliament, the government will give the House of Commons Standing
Committee on Finance a mandate to hold consultations over a 12-month period.
This Committee should meet with representatives of the public and the
provincial authorities in order to find a way to make taxation fairer,
simpler and more harmonized.
Essentially, the alternatives
to the GST are as follows: (1) introduce a business transfer tax;
(2) introduce a tax on consumption (here defined as income less savings);
(3) simplify the GST (eliminate some exemptions; increase the income
threshold above which businesses must register) and harmonize it with
the provincial sales taxes; (4) replace the GST with a more broadly-based
federal retail sales tax; (5) hand the GST over to the provinces
in exchange for greater latitude to impose taxes on corporations (as the
Carter Commission on taxation suggested in 1966) or a reduction of some
transfer payments to the provinces; and (6) drop the GST and increase
individual federal income tax.
A.
Business Transfer Tax
The government may replace
the GST with a business transfer tax. Businesses calculate the amount
of tax payable by applying a tax rate to the difference between the revenue
from their sales and the cost of their purchases. Such a tax is much simpler
to administer than the GST, since it does not apply to every transaction,
as does the present GST. By the same token, a business transfer tax system
makes it very difficult to exempt or zero-rate specific goods or services.
If the government opted for this alternative, the tax base would necessarily
have to be broadened, and thus the list of tax-exempt and zero-rated goods
and services would have to be revised. The government could well be forced
to tax prescription drugs or food, for example. Opponents will claim that
this tax is hidden in the sale price. This situation would be no different
from that under the former federal sales tax system.
B.
Tax on Consumption
Theoretically, the simplest
solution for the government, taxpayers and businesses would be to tax
consumption, rather than individual expenditures. If individuals consumed
only non-durable goods, consumption would be defined as the difference
between their income and the change in their accumulated wealth. However,
if consumption by a taxpayer purchasing durable goods is to be calculated
accurately, the value of the services provided by these goods must be
evaluated. The value of the services provided by the durable goods - but
not their purchase price - must be included in the individual's income.
For example, their imputed rents, that is, the value of the services provided
by their property (an amount equivalent to the rent that would have been
charged) would have to be added to the income of owner-occupants. Since
estimating income from the consumption of durable goods is very complex,
this type of income must be excluded; instead, the value of the goods
must be taxed when they are acquired.
If consumption is to be
taxed, income and savings must be evaluated using the cash basis of accounting
(in which such items are recorded in the fiscal year during which the
transactions take place), not the accrual basis of accounting (in which
expenditures incurred and income earned in advance are accrued to the
appropriate year). For example, capital gains earned but not collected
(such as stocks whose value increases but which are not sold) are not
included in the definition of income, while inheritances and gifts are
included.
This alternative gives rise
to a major problem. Individuals consume more, in comparison with their
income, earlier in life rather than later; they save more in the middle
of their life, while their income is lower at the end of it. This means
that taxing relative consumption imposes a greater tax burden on young
taxpayers, and indirectly taxes consumer debt. In order to tax consumption
without imposing too great a tax burden on already indebted young taxpayers,
a mechanism to defer consumption of durable goods would have to be set
up. For example, the purchase of a residence might be considered a form
of savings, and property-related expenditures deducted from consumption.
The capital gain would be taxable when the property was sold, probably
late in the taxpayer's life, when he or she would be consuming less. Since
reality can be so different from theory, this alternative could, however,
end up being difficult to administer.
C. A Simplified GST
The government may simplify
the GST by broadening the tax base. For example, a review of the list
of goods that are tax-exempt (such as financial services and already occupied
residences) or zero-rated (such as prescription drugs, food and tuition
fees) would allow the government to lower the tax rate and substantially
simplify the administration of this tax for businesses. However, broadening
the tax base could increase the number of registrants.
The government could also
raise the annual income threshold above which businesses must register,
for example, from $30,000 to $500,000. In this way, the government could
theoretically reduce the number of returns filed. In 1992, 1.6 million
registrants had annual taxable sales of $500,000 or less. Raising this
threshold could lower the number of returns filed and encourage some persons
not to operate underground, since small businesses would no longer administer
the GST or collect tax on the goods and services they sold. However, because
their goods and services would be tax-exempt, non-registrant businesses
would be ineligible for the input tax credit and their clients would not
be able to deduct the GST as an input tax credit. (Many businesses find
it is to their advantage to be registered; they can charge the tax, and
their clientele can deduct it as part of their input tax credit.) Even
if the threshold were raised to $500,000, it is likely that a number of
businesses would continue to register. As well, the 1992 Auditor General's
Report showed that of the 1.7 million registrant businesses,
400,000 had taxable sales of less than $30,000; however, even though not
required by law to register, they had opted to do so. According to the
Auditor General's Report, if one-half of the eligible registrants
had filed only a single annual return, processing and many related operations
for some 2.4 million returns could have been eliminated. Department
of Finance records indicate that 7.1 million returns were filed in
1991. Moreover, as we have just seen, unless they are forced not to register
or to file only once a year, even raising the income threshold to $500,000
would quite possibly leave the number of registrants and the frequency
of returns unchanged.
The government may also
seek greater harmonization of the provincial sales taxes with the GST.
Until now, only Quebec has agreed to harmonize its sales tax in this way,
though recently the tax bases of Manitoba and New Brunswick were partially
harmonized with that of the GST. Saskatchewan has dropped its plans for
harmonization. The federal government is in a very different situation
from that anticipated when the White Paper on Tax Reform was published
in 1987. On 24 April 1989, negotiations between Ottawa and the provinces
on harmonizing the provincial sales taxes with the GST broke down. With
the recent change in government, however, there may now be a new dynamic.
Certain provinces may change their positions and agree to negotiate harmonization,
something they have so far refused to do. It was also clear at the First
Ministers' Conference on 21 December 1993 that an atmosphere of cooperation
can be expected in the months ahead.
D.
Federal Retail Sales Tax
In 1966, the Royal Commission
of Inquiry on Taxation (the Carter Commission) recommended that the federal
government introduce a retail sales tax jointly with the provinces (a
sort of national sales tax) to replace the federal manufacturers' sales
tax. The Commission considered that the provinces should assume near-complete
responsibility for one major source of tax revenue; it recommended that
the federal government try to reach an agreement with the provinces, under
which the latter would make greater concessions in direct taxation (individual
and corporate income taxes) in exchange for greater powers in indirect
taxation (sales and excise taxes). The provinces would have been responsible
for collecting this national sales tax. A national sales tax has the advantage
of integrating sales tax systems into a single, nationwide system. Since
it would have a shared tax base, a uniform federal rate, and varying provincial
rates, a national sales tax would be simple to administer and involve
low compliance costs. However, there is no guarantee that the federal
government would be successful in negotiating the introduction of a national
sales tax. If its negotiations failed, it could act independently and
introduce its own retail sales tax.
A federal sales tax would
be simpler to administer than the GST since it would apply only to retail
sales, not to value added. If the tax base were the same, government revenue
generated by a sales tax would be identical to revenue from a value-added
tax. There would be far fewer registrants than the current 1.7 million.
The federal government's administrative costs would be lower than under
the present system; businesses' compliance costs would also be lower,
since businesses would have to calculate taxes on final sales only and
would not have their present cash flow problems while awaiting their input
tax credit.
Exempting producers' inputs
from the tax would be more difficult, however. Under the present system,
with its input tax credit, goods and services required for production
are exempt from GST. If the government introduced a federal retail sales
tax, all businesses would have to be made tax-exempt (which would create
problems when businesses used goods and services used by both consumers
and producers), or it would have to issue tax exemption certificates.
Tax evasion would be easier.
E.
GST Handed over to the Provinces
The federal government could
hand over all jurisdiction over sales and excise taxes to the provinces,
in exchange for a larger share of individual income tax and exclusive
jurisdiction over corporate income tax.
Furthermore, if the federal
government was unable to reach an agreement with the provinces, it could
reduce or simply eliminate some transfer payments it now makes to them.
In other words, in order to offset the shortfall it would incur by handing
over the GST, the federal government could cut transfers of funds, equalization
payments, and income tax transfers by $16 billion. The provinces
could recover the shortfall by filling the taxation vacuum left by the
federal government, that is, by increasing their respective retail sales
taxes. It must be noted here that such a measure would create a problem
for Alberta, which has no retail sales tax, and for the less prosperous
provinces, such as the Maritime provinces, whose retail sales tax base
is probably inadequate to offset such a reduction in transfer payments
from the federal government.
At the conclusion of the
First Ministers' Conference on 21 December 1993, several participants
said they had discussed a redistribution of fields of taxation that would
go well beyond harmonizing the provincial sales taxes with the GST. The
First Ministers agreed to continue their discussions on eliminating overlap
in federal and provincial fields of taxation. It is quite possible that
the federal government will eventually hand the GST over to the provinces
and that the whole system of fields of taxation and transfer payments
will be overhauled.
If the federal government
wishes to propose this redistribution, it will likely have to include
its negotiation of financial agreements with the provinces, which expire
in 1994. It should also be noted that cash transfers are what allows the
federal government to impose national standards, so that eliminating cash
transfers would jeopardize the concept of national standards.
F. Increased Federal Individual Income
Tax
The government could eliminate
the GST and increase individual federal income tax. For this option to
be revenue-neutral, the government would have to increase tax revenues
from $60 billion to nearly $76 billion. Where progressive taxation
is concerned, the government could maintain the status quo or increase
the tax burden of higher-income individuals.
Some opponents of the GST
will certainly argue in favour of this alternative, because it could make
the tax system less regressive by increasing the tax burden of high-income
individuals. They will argue that ability to pay taxes is based on income,
not individual consumption: as income increases, consumption as a percentage
of disposable income drops. However, according to generally accepted economic
theory, consumption taxes are perceived as neutral and more effective
than income taxes, since they do not distort the behaviour of economic
agents. Increasing individual income tax is ineffective because it interferes
with the formation of capital. Taxpayers who tend to save are taxed more
heavily than those who tend to save less (that is, to consume more), since
savings are taxed twice (gross income and interest income on savings are
both taxed). This double tax burden reduces the net yield of savings and
promotes consumption instead of savings. In order to neutralize the adverse
effects on savings of increasing income tax, the government would have
to introduce savings incentives such as making interest tax-deductible
or making the retirement savings plan system more generous. Otherwise,
unless taxpayers' behaviour changes, taxpayers who save would bear a heavier
tax burden than those who consume. Consumption taxes are more effective
because they are neutral and do not affect economic behaviour.
Furthermore, consumers'
well-being is more affected by what they spend than by what they earn.
As economist Nicholas Kaldor suggested in 1955, taxpayers should be taxed
on what they take out of the social kitty (that is, what they consume),
not on what they put into it (that is, what they earn). From the perspective
of economics, this means that consumption taxes are fairer than income
taxes. The government would have to be very careful about opting for this
alternative, which takes little account of economic effectiveness or fairness.
CONCLUSION
We have provided a brief
overview of some of the alternatives to the GST available to the government.
For the moment, the third alternative (simplifying the GST) is clearly
favoured. The new government will realize that significant savings, for
both business and the government itself, can be expected if the tax base
of the GST is broadened and if businesses file fewer returns. As well,
given that a new government is in power and that all the provinces are
having difficulty in balancing their budgets, the provinces may at last
see the economic advantages of harmonizing consumption taxes.
Since the First Ministers
have agreed to eliminate overlap in federal and provincial fields of taxation,
it is quite possible that the fifth possibility (handing the GST over
to the provinces) will become the preferred option in a few months.
One thing is certain: reforming
the present tax system will not be easy. Reform must not be simply a GST
by any other name. The end result of this reform could be as politically
costly for the new government as were the changes to the system introduced
by its predecessor.
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