September 15, 1989

To: The Standing Committee on Finance and Economic Affairs House of Commons

From: Canadian Research Committee on Taxation

Ben Sevack, President
Harry Payne, Secretary-Treasurer
Leo Klag, Director
John R. Ferguson, CFA, President, Ferguson-Alder Investment Counsel Ltd.
Francis K. Peddle, Ph.D. Director of Research

Re: Brief on the Proposed Federal Goods and Services Tax

TABLE OF CONTENTS

• Introduction
• The Principles of Taxation
• The Negative Influences of Consumption Taxes
• Defining Accurately Business Income for Tax Purposes
• Conclusion

INTRODUCTION

The basic assumption behind the proposed federal Goods and Services Tax (GST) is that a commodities tax system is an essential and ineliminable component of the Canada's regime of public finance. What the Canadian Research Committee on Taxation (CRCT) wishes to argue in this Brief is that it is an erroneous assumption to think that the tax mix of the nation's fiscal structure must contain a consumption tax component in order for the total distribution of taxation to be equitable, reliable, competitive and economically efficient.

Consumption is the final stage in the process of producing wealth. It is in effect the point at which value-added is finally determined. Consumption taxes in principle negate the wealth-creation process by inhibiting the determination of value-added. They therefore place a heavy burden on the process of production. This is the primary reason why consumption taxes are an inherently defective means of raising government revenues.

The unavoidable consequences of consumption taxes are economically counterproductive developments such as an increase in inflation, inefficient administrative and compliance costs, higher interest rates and a decrease in effective aggregate demand throughout the economy. Capital investment and job creation are primarily fueled by anticipated effective demand. The economy will inevitably suffer when effective aggregate demand is negated. Consumption taxes are therefore the least desirable way of raising revenues for the goods and services which governments provide.

It is not our intention in this Brief to focus in detail on any particular area of the proposed GST. It is the deleterious consequences to the Canadian economy as a whole, which will in all likelihood ensue if a federal GST is implemented in 1991, that should be the primary concern of commentators.[1] Our objective, rather, is to state briefly an alternative system of raising government revenues which will eventually eliminate the need for any form of commodities taxation.[2] The alternative form of recovering the costs of providing government goods and services outlined in this Brief is non-inflationary, efficient, equitable, job-creating, internationally competitive, and sufficiently reliable and broad-based to provide a stable source of revenues for government at a relatively low rate.

Tax reform is not simply a matter of technical economic adjustments and refinements in the ability to collect taxes. Our system of public finance is interwoven with the fundamental psychological, social and cultural mores of the nation. If governments are excessively intrusive into the autonomy of business enterprises, if they orchestrate unduly the ordinary affairs of citizens and are seen as arbitrary violators of individual freedoms and rights to enjoy the usufruct of labour, then the basic moral and economic fabric of the country will be eroded.

The advocacy of large-scale consumption taxes, which require an expensive and complex bureaucracy to administer, and which do documented harm to national economies, is merely to follow the mistakes of other countries. Canada was once looked upon as a leader and innovator in the field of taxation. With the imposition of a federal GST, that is, a value-added sales tax that is incompatible with a federal state such as Canada, we will have forfeited our position as a fiscally imaginative country which is adept at integrating and harmonizing important tax concepts like equity, simplicity and economic efficiency.

On the other hand, by developing a system of taxation for business enterprises which encourages the control of costs, elevates the status of the ordinary consumer, enhances sound managerial practices and which can be a significant and stable source of government revenue, thereby obviating the need for negative consumption taxes, we will once again assume our prominent international role in the articulation of sound tax policies.

THE PRINCIPLES OF TAXATION

The principles of ability to pay and cost benefit are generally taken as mutually exclusive criteria for designing a tax system. The history of tax economy for most of this century has been dominated by the ability-to-pay approach.[3] For the development of sound tax policies it is necessary, however, to interrelate the principles of ability to pay and cost benefit. This interrelation was the great insight of such classical economists as Adam Smith and Henry George. It is because the modern practice of economics has lost sight of the philosophical and historical origins of its own development that the articulation of tax policy in recent decades has become significantly divorced from the basic functioning of the economy as well as from human nature and psychology.

The interrelation of the principles of ability to pay and cost benefit ensures that tax systems interfere as little as possible with the productive forces operative in the economy. At the same time adherence to the mutual complementarity of these principles will lead to the structuring of tax systems that will bring about a fairer distribution of wealth. Furthermore, by identifying tax bases that reflect the interrelation of ability to pay and cost benefit, the tax systems of the country can be greatly simplified. Fairness in taxation does not require complexity, as is commonly believed, nor is economic efficiency and activity enhanced by the taxation of individual earnings at both the level of income and at the point of individual after-tax expenditures.

The principle of interrelating ability to pay and cost benefit leads to the design of a tax system that need operate at only three levels. With regard to local taxation, all municipalities in Canada should adopt a system of site value taxation wherein capital improvements to property are untaxed and the underlying locational values, which are community created, are taxed so as to provide revenues for the provision of municipal goods and services.[4]

At the level of personal income taxes there should be a low proportional rate on a comprehensive income tax base with few, if any, deductions and exemptions. This not only conforms with the ability-to-pay and cost-benefit principles, but it will also lead to much greater simplicity, neutrality and efficiency in the personal income tax system.

The taxation of business enterprises should be at the point of net value-added. In other words, all businesses should be taxed on their income which is equivalent to their costs that are recovered in the marketplace. The definition of net value-added includes all the factors necessary to add value to goods and services purchased from other businesses, minus profits.[5] A low proportional rate on the net value-added of all business enterprises in the country would ensure that businesses pay their fair share of the benefits they receive from government, while at the same time guaranteeing that the amount remitted to government is in accordance with their respective ability to pay.

It is crucial that a global approach be taken to tax reform. Such an approach necessitates that the same principles be applied to all levels of taxation. With regard to the proposed GST, the alternative the CRCT wishes to present is one which would replace both the current corporate income tax system and the revenues received by the federal government from sales and excise taxes. The supposed lack of a viable alternative to the GST has been one of the main reasons why the government is proposing a general consumption tax of this kind. The primary objective of this Brief to indicate that there is a substantially better alternative to the GST. To understand fully this alternative, however, it is necessary to examine critically the fundamental principles of taxation, to apply globally the unifying concept of the interrelation of ability to pay and cost benefit, and to have some insight into how the taxation of business enterprises must be integrated with the proportional taxation of personal incomes and the site value assessment of properties.

THE NEGATIVE INFLUENCES OF CONSUMPTION TAXES

The proposed GST will be a pervasive tax on all commercial activity in Canada that pushes the incidence of the tax to the final stage of consumption. Since taxes tend to diminish the base upon which they are levied, it follows by definition that a consumption tax will slow down commercial activity. Consumption is the critical final stage in the wealth-creation process of the nation's economy. All citizens are consumers. Without consumers there would be no production, no value-added, no capital investment, no jobs, - in other words no economic activity whatsoever.

In the Goods and Service Tax - Technical Paper (GST-TP) the alternatives to the present Federal Sales Tax (FST) are very narrowly and inadequately conceptualized. The government declares (p.5) that as a practical matter it has no choice but to rely on some form of general consumption tax. It believes that the marginal rates on personal and corporate income taxes would have to be raised inordinately in order to replace the FST. General comment on federal sales tax reform has also assumed, along with the government, that a general consumption tax of some sort is an ineliminable component of the government's fiscal structure.[6]

The narrow conceptualization of viable alternatives to general consumption taxes is a result of insufficient attention being given to fundamental principles in the tax reform debate. For instance, it is assumed that if one is to tax corporations, then they must be taxed on the basis of their profits. Raising the marginal rate on corporate profits would make us a less attractive country for investment and merely encourage tax avoidance. Little consideration is given, however, to the possibility of taxing business enterprises in a more equitable and economically efficient way, while at the same time lessening the opportunities for tax avoidance.

The government readily admits that the GST will increase the consumer price index by 2.25 per cent (GST-TP, p.39). Nevertheless, it places significant, but misplaced and economically risky, confidence in the hope that there will be moderation in wage and price behaviour, (GST-TP, pp. 41, 42, 44, 45). The government is not only significantly increasing the tax burden of middle income Canadians - in general those with household incomes above $30,000 -but at the same time it is asking the very same taxpayers to accept a further erosion of their earnings and standard of living because of the inevitable jump in inflation caused by the imposition of the counterproductive GST to replace an already economically unsound and inequitable tax.[7] There is, then, a very real possibility that the GST will increase rather than reduce the federal deficit, which, incongruously, is one of the government's primary goals in implementing sales tax reform.[8]

In addition, it is not clear what the reaction of the Bank of Canada will be to this increase in inflation. The tight monetary policies of the central Bank in response to current underlying inflationary pressures in the economy will in all likelihood not change appreciably unless there is a noticeable decline in economic activity. There is already evidence that the recent round of high interest rates are beginning to slow down the economy. Fractional decreases in productivity, or the growth of GDP, will make meaningless the government's prediction that sales tax reform will result in the creation of 60,000 new jobs by 1992 (GST-TP, p.41). Indeed, the Conference Board of Canada has already predicted that the GST will result in a loss of 70,000 jobs when implemented.[9] If the GST causes stagflation and tips the economy into recession the job loss and deficit increase could be much greater. Such glaringly inconsistent economic predictions from the government and the private sector erode public confidence in the competence of the government to make sound economic decisions.

Apart from the macroeconomic considerations, there are a myriad of negative and distortionary influences on particular businesses that will be the consequence of implementing the GST. The very nature of the tax politically necessitates various exemptions and integrations with the income tax system.[10] These exemptions greatly increase the administrative complexity of the tax. The inevitable result in the future will be a multitude of court cases to interpret vague and arbitrary distinctions between taxable, tax-exempt and zero-rated supplies - a situation that the GST was suppose to rectify. Exemptions also undermine the important tax concept of neutrality.

The GST could induce unneeded capital purchases thus further contributing to the artificial inflation of business costs.[11] Overstated claims for "input tax credits" may prove to be a significant drain on revenues. On the other hand, as is common with VAT-type sales taxes elsewhere, revenues will probably turn out to be substantially higher than forecasts based on past sales tax bases or on national income accounts.[12]

There could also be cash-flow problems for many businesses, depending on their sales volumes, which determines their reporting period under the GST, and on their inventory turnover.[13] Furthermore, smaller companies have a more difficult time financing inventory and collecting receivables than larger businesses, which can enforce "just-in-time" inventory contracts and so on. The onesidedly detrimental nature of VAT-type taxes on small businesses is well documented in the tax literature.[14] There are also added complications with regard to integrating the GST with the Income Tax Act.[15]

Other aspects to the GST will also undoubtedly require large-scale bureaucratic machinery. For example, the rules governing rebates for tourists such as the minimum rebate of $25.00, the export requirement within sixty days of purchase, exempted items such as alcohol and motive fuels, and so on will require complex administration.[16] Clearance certificates on sales of real property in excess of a $1 million will be required as evidence that the vendor remitted tax before the purchaser is able to claim an input tax credit.[17] There will be added compliance and enforcement costs with regard this provision, which are not estimated by the government.

The fact that the tax applies to real property and the final sale price of new housing, with certain exemptions and rebates, indicates that the government is unaware of how the local property tax system in place throughout most municipalities in the country artificially and excessively inflates land costs. To add a further tax penalty, in the form of the GST, to a situation that is already greatly exacerbated by our system of public finance, is unconscionable. Since locational value is the primary determinant of housing costs, the application of the GST on new housing, even with rebates of one half of the GST below $310,000, is highly discriminatory. Furthermore, most of the housing stock in this country was built twenty or more years ago, when the FST was at low preferential rates on building materials. The application of the GST to new housing is yet another example of how modern tax economists are unfortunately focusing more and more on the taxation of the creation of new assets and thereby negatively affecting productivity in the economy.

The GST is also contrary to the spirit of free trade. One of the primary benefits of the GST, according to the government, is that it will eliminate the present bias in the FST in favour of imports.[18] The complete refunding of "business inputs" will increase incentives to invest, it is thought, by lowering capital costs. The tax will be payable, however, on the duty- and excise-paid value of goods imported into Canada.[19] This means that Canadian goods and services will be cheaper in the U.S. than in Canada because a general consumption tax is exigible only within this country.[20] To favour exports over imports in the general tax system is to inhibit free trade and to force the Canadian consumer to subsidize the export sector.

The tax on imports is also another example of still prevalent "tax cascading" in the application of the GST, since it is on duty-and excise-paid imports. The GST will also apply to airline tickets, for instance, and therefore it will be a tax on top of the current air transportation tax.[21] Furthermore, it is not clear how the provinces will react to the GST. It is quite possible that they will apply retail sales taxes on a large scale to GST-included prices.

The cumulative negative affects of general consumption taxes seriously undermine the equity and efficiency objectives usually alluded to in tax policy. The GST is by its very nature inequitable and economically counterproductive. This is why its implementation requires complex exemptions and integrations with the income tax system. It is a form of taxation that ought to be opposed in principle and replaced with the sound taxation of business enterprises in such a manner that benefits the consumer and at the same time provides a stable, but economically positive, source of revenue for the government.

DEFINING ACCURATELY BUSINESS INCOME FOR TAX PURPOSES

Business enterprises benefit from goods and services provided by the government. These goods and services ought to be paid for by the enterprises which benefit from them. Every productive enterprise incurs costs in adding value or in its creation of wealth. Furthermore, every productive enterprise wishes to minimize costs in the interests of efficiency and the maximization of profit. If business enterprises are going to increase productivity and enhance their international competitiveness, then the tax system ought to encourage the minimization of costs.

There are three components to business income:

• Net income, or profits, represented by the excess of total income over total costs.
• Income expended in employing the factors of production that have resulted in the creation of value added or the creation of wealth.
• Income expended in purchasing goods and services from other businesses.

 The term "income" therefore includes all of the income a business receives and uses in carrying on its business. The corporate income tax is therefore levied under a misleading label, since it refers not primarily to business income but to profits. Profits, however, do not belong to businesses or corporations per se but to shareholders, or those who put up the equity to start and run businesses.

In order to encourage sound business practices and the minimization of controllable costs, it is more logical to tax the net value-added of business enterprises, that is component number two above, rather than profits or goods and services purchased from other companies. A tax on profits is a tax on a marginal and unpredictable base. Furthermore, it encourages businesses to be inefficient and it contributes to artificial cost inflation. A tax on goods and services purchased from other businesses, or "business inputs" as they are now usually termed, would result in double taxation and tax cascading.

It is therefore necessary to define accurately business income for tax purposes. If the federal government levied a low proportional rate on the net value-added of all business enterprises in the country it would be possible to replace both the corporate income tax system and federal sales and excise taxes, which together currently yield slightly more than $31 billion.22 A tax on the costs incurred by businesses in adding value to goods and services would be determined through their cost of sales. It is only possible to determine value-added after costs have been recovered in the marketplace, that is after income has been earned from consumers.

A number of items can be briefly identified here as inclusive of the costs to business in determining that portion of income which should be taxable. The costs to fixed capital such as maintenance and repairs, as well as wages, salaries and employee benefits, advertising and promotion and other employee expenses, depreciation and so on would be examples of items in the creation of value-added the income for which, after recovery in the marketplace, would be taxable under this proposal.

Simplicity, equity, efficiency, and ease of compliance would be best achieved by this form of taxation. The very design of the tax system would encourage accurate cost accounting and not artificial cost inflation and endless re-categorization as under the present system. In addition, the tax system would become harmonized with the basic inclinations of business people and human nature in general. Although it is not possible to enter into a detailed examination of this proposed alternative to the GST in this Brief, a number of benefits can be summarized:

• The proposed tax on business income expended in adding value to natural resources, or to goods and services purchased from other businesses, would conform much more closely than would any possible revision of the corporate profits tax and the federal sales tax to the fundamental tax principles outlined in the government's May, 1985 paper entitled "The Corporate Income Tax System - A Direction for Change" and the White Paper on Tax Reform tabled on June 18, 1987. The principles outlined in these documents include market efficiency, fairness, certainty, simplicity, competitiveness and the stability of tax revenues.
• . The tax base would be considerably broadened, and thus the rate of tax on businesses and economic activity in the country could be kept comparatively low.
• With all business enterprises paying their fair share of the tax burden, the government's revenues could be significantly increased with no one business being unduly burdened.
• As profits would not be taxed, shareholders would no longer be doubly taxed and thus the dividend tax credit would not be required.
• The tax advantage to businesses when funds are raised through debt rather than equity would be eliminated.
• The decision of a business whether to operate through subsidiaries or divisions would be decided on the basis of business rather than tax reasons.
• Decisions with regard to replacing labour with capital would be made for business reasons rather than because of the availability of capital cost allowances and investment tax credits.
• There would no longer be any need for two sets of books - one for the shareholders and another for the tax authorities.
• The incentives and awards for the wealth producing activities of a business would be provided by the market rather than by the government.
• The proposed tax system would be deflationary rather than inflationary as businesses would have two important reasons to reduce costs, i.e. to lower taxes and increase profits.
• The additional revenues that would result from a lower tax rate on a broader base would permit reductions in personal income taxes and eventually lead to the elimination of sales taxes.
• Business expenditures would be made for the right reasons and not to reduce taxes. In addition, tax cascading would be avoided, not by a complicated system of "input tax credits" as under the GST, but by simply factoring out of the tax base the purchases of goods and services from other businesses.
• Since the proposed tax is an income tax on business, the same collection and compliance machinery that is in place for the present corporate income or profits tax can be utilized without having to expand the federal bureaucracy.

CONCLUSION

By properly delineating what is meant by business income and accurately defining value-added, or the income expended by businesses in the creation of wealth and recovered in the marketplace as accounted for in their cost of sales statements, it is possible to devise an alternative to the GST that will bring equity, simplicity and economic efficiency to the fiscal structure of government. This Brief has indicated some of the benefits that will result from the positive taxation of business enterprises on the basis of net value-added.

A fundamental re-evaluation of the principles governing tax policy is necessary if genuine and constructive tax reform is to be achieved in Canada. The proposed GST is yet another example of onesided and flawed thinking with regard to tax policy formulation. If Canada is once again to be recognized as a leader and innovator in the field of taxation, if the government can come to recognize that there is a way to tax commercial activity that helps rather than significantly harms the ordinary consumer, then the taxation of business enterprises on the basis of ability to pay interrelated with cost benefit will have to become an integral aspect of our system of public finance in the near future.

ENDNOTES

1. The introduction of VAT-type taxes in other countries provides ample historical proof of the negative economic consequences which inevitably follow an increased governmental reliance on consumption taxes. See, for example, Graham Bannock, VAT and Small Business: European Experience and Implications for North America (London, 1986), Alan A. Tait, Value-Added Tax: International Practice and Problems (Washington, D.C., International Monetary Fund, 1988), and Derek Coomber, "If the GST Repeats Britain's VAT Experience, We Are in For Trouble, Globe and Mail, August 26, 1989, B2.

2. The proposal of the Canadian Research Committee on Taxation to re-structure the taxation of business enterprises in Canada was outlined in its Brief to the Standing Committee on Finance and Economic Affairs submitted on August 18, 1987. The CRCT concluded in that Brief (p.23) that adoption of its proposal would obviate the need for a new national sales tax, while at the same time eliminating the existing Manufacturers Sales Tax. A more extensive analysis of the taxation of business enterprises, entitled Redefining Corporate Income for Tax Purposes: Creating a More Productive Economy Through Positive Taxation (Ottawa, CRCT, 1987) is available from the Committee.

3. The cost-benefit principle has often been treated as theoretically deficient in this century, see, for instance, Report of the Royal Commission on Taxation (Ottawa, Queen's Printer, 1966), Vol.3, p.3, and E.R.A. Seligman, Essays in Taxation (London, Macmillan, 1919), pp.71 et seq.

4. The positive economic and social consequences of site value taxation are extensively commented upon in Reforming Municipal Property Taxation by Site Value Taxation (Ottawa, CRCT, 1989), 201 pp., Bibliography.

5. A key problem in tax reform is inaccurate and distorted definitions. Value-added is erroneously defined by most tax economists as inclusive of just wages and profits, see Tait, supra, p.4. Furthermore, profits are not a suitable base for business taxation just as purchases from other businesses ought to be factored out of the business income tax base. This is why we find it is necessary at present to refer to our alternate tax proposal as a tax on the net value-added of businesses in order to distinguish it from the VAT sales taxes that are prevalent in many countries.

6. See, for example, the Consumers's Association of Canada, Taxing Your Spending: Consumer Interests In Sales Tax Reform, (March, 1989), pp.10-11.

7. Private sector analysis has already challenged some of the optimistic assumptions in the GST-TP with regard to the effect of the GST on wages and prices, see, for example, the critique by Wood Gundy Economics, Monthly Indicators, September, 1989 and reported in the Globe and Mail, September 6, 1989.

8. GST-TP, p.3.

9. "Federal Sales Tax Will Kill Jobs, Raise Inflation, Board Predicts", Hugh Winsor, Globe and Mail, June 9, 1989.

10. New Zealand is one of the few places where a VAT-type tax has been introduced without exemptions. But such a broad-based consumption tax necessitated significant restructuring of the country's income transfer system. Nevertheless, the New Zealand GST rate is still high, currently 12.5 per cent, and the economy is plagued with high interest and inflation rates, and low government bond ratings. In addition, when the GST was introduced in 1986 substantially higher revenues were generated than had been predicted. It is probable that the Canadian GST will also produce more government revenues than predicted in the Technical Paper with the inevitable drain on disposable income and a consequent decline in investment and job creation.

11. See, for example, Sybren Cnossen, "VAT and RST: A Comparison", Canadian Tax Journal, Vol.35, No.3, May-June, 1987, where he states that: "A VAT is vulnerable to misappropriations of business purchases for consumer use", p.572. Cnossen also notes that retailers are the most troublesome sector under a VAT, because consumers are not eligible for tax credits they are under no tax compulsion to ensure that the retailer's sales are reported accurately, ibid.

12. Tait, supra, pp.23-24.

13. GST-TP, p.75-77.

14. See, Bannock, supra, p.68.

15. See, for example, GST-TP, pp.62-64.

16. GST-TP, p.109, the government does not give any estimations of the compliance costs in this regard.

17. GST-TP, pp.118-119.

18. GST-TP, p.31.

19. Id., p.70.

20. It might be argued that the discrimination against U.S. goods and services is alleviated by the fact that U.S. consumers pay retail sales taxes at the state level. However, the average U.S. sales tax rate of 4.6 per cent in 1985 is only slightly more than half of the average Canadian provincial rate of 8 per cent.

21. GST-TP, p.104. 22. The Fiscal Plan (Ottawa, Department of Finance, April 27, 1989), p.134.