Taxation policy

High taxes: diminishing incentives
and economic growth

Economic theory suggests that by modifying the costs and benefits of a particular activity, taxes can alter the incentive structure faced by individuals and businesses and encourage outcomes that are less likely to have transpired in the absence of taxation (Gwartney and Stroup 1993; Aaron and Pechman 1981). For instance, payroll taxes impose increases in the price of labour and as a consequence persuade business to substitute capital for human resources (OECD 1994b). High marginal tax rates on employment income deprive individuals of the right to enjoy the fruits of their own labour and discourage them from working harder (Heckman 1993; Triest 1990). Taxation on capital gains tends to reduce the rate of savings and aggregate investment (Summers 1984; Ture and Sanden 1977). Moreover, provincial sales tax can promote tax evasion and encourage individuals and business into the underground economy (Starobin 1994). In short, taxes diminish incentives to work harder, place a significant drag on economic growth and the ability to increase the standard of living.

Empirical evidence on the
effects of taxation

Evidence from around the world increasingly shows that jurisdictions that maintain low levels of taxation are those best positioned to experience strong economic growth. In a study by the World Bank on the effects of taxation, states with lower tax rates grew faster, experienced higher levels of investment, and higher productivity gains (Marsden 1983). Another study estimated that increasing a country's taxes by 10 percent has the effect of reducing a nation's GDP growth by almost 2 percent (King and Rebelo 1990). Likewise, Easterly and Rebelo found that there was a strong negative relationship between the rate of economic growth and tax revenue (Easterly and Rebelo 1993). High taxes impede growth in productivity and consequently economic growth.

Taxes have a distortionary effect on the economy and what is required for stronger economic growth is for governments to lower taxes. This is critically important in light of the large body of evidence suggesting that taxes have had an adverse effect on economic growth in Canada. Professor Bev Dahlby has noted that, for each additional tax dollar collected through personal income taxes, the Canadian economy is deprived of $1.38 in output (Dahlby 1994). Moreover, a study conducted by De Matteo and Shannon on the effects of payroll taxes in Canada found that a 1 percent increase in average payroll taxes results in an increase of employers' real wage costs by 0.56 percent, a decrease in real wages of 0.55 percent, and a reduction in employment of 0.32 percent (De Matteo and Shannon 1995). This finding is supported by another study conducted by Ron Parker of the Bank of Canada, who found that increasing payroll taxes from 10.6 percent of wages and salaries in 1991 to 14.1 percent in 1994 may have directly led to a reduction in employment levels in Canada by about 1 percent in 1994 (Parker 1995).

In sum, high tax rates diminish incentives, impede economic growth, and lead to a lower standard of living. Conversely, lower levels of taxation encourage firms to invest more in human and physical capital, lead to greater innovation, higher levels of productivity, and increases in disposable income, and create the climate necessary for generating strong economic growth.

Taxation in British Columbia

Despite the large body of evidence supporting the benefits of cutting taxes, the British Columbia government has been slow in reducing the mounting tax burden on its citizens and businesses. Taxes levied on businesses in the province have increased by 150 percent since 1992 while the tax bill of an average family in British Columbia has increased by $803 ( Joel Emes, personal communication). In addition, British Columbia has the highest marginal (personal) income tax rate in the country at 54.17 percent of the basic federal tax, and maintains the second highest corporate income tax rate in the nation (Alberta 1998). Furthermore, between fiscal 1995/1996 and 1996/1997, individual British Columbians experienced the largest tax increase in Canada, a hike of $107 per year while, in New Brunswick, the next largest increase for the year amounted to only $42 (The Fraser Institute 1997b). These tax policies are in stark contrast to both Ontario and Alberta, where the provincial governments have worked aggressively towards cutting both personal and corporate income taxes (Law, Markowitz, and Mihlar 1997; Mihlar 1995b).

In the Fraser Institute's 1997 Fiscal Performance Index, which rates the taxation and spending policies of provincial governments and of American state governments, British Columbia received an F for its performance. British Columbia had the lowest score among the 32 provinces and states on taxation policy (Fraser Institute 1997a). The Institute's 1998 Tax Freedom Day analysis, which calculates the day Canadians stop paying taxes and begin working for themselves, concluded that tax freedom day fell on June 28 this year; an advance of 16 days over the province's Tax Freedom Day in 1992, which fell on June 12. The study also found that British Columbia is the third to last province in Canada this year to experience Tax Freedom Day (Emes and Walker 1998). In short, British Columbians are having to work much harder and longer than most other Canadians before being able to enjoy the benefits of their labour and in 1997 real disposable income per capita decreased in British Columbia by almost 2.5 percent (Kirby 1998).

However, the pain of high taxes has not been confined to the taxpayers of the province. Business has also been hit hard as taxes have risen by almost 150 percent over the past five years (Sanatani 1998a). The result? In 1996, corporations paid taxes totaling 44.1 percent of their profits in British Columbia, the highest tax burden as a percentage of corporate profits in the country and more than double what corporations paid in taxes in New Brunswick and Saskatchewan. The tax burden has increased significantly from its level in 1985, when corporations in British Columbia paid direct taxes to the government totaling 31.4 percent of their profits (Arman, Samida, and Walker forthcoming).

The government announced some tax relief in its 1998 budget--just $95 million a year. Even after these tax cuts are fully implemented, however, British Columbians will still have one of the largest tax burdens in the country. For example, the government is planning to reduce the marginal income tax rate by only 1.5 percent to 52.7 percent, and the corporate income tax rate from 9 percent to 8.5 percent. Further, these changes are to take effect January 1, 1999 rather than immediately (BCMinFinCorpRel 1998a; Alberta 1998). Many of the recently announced tax measures will do little to provide relief to the taxpayers of British Columbia. According to a recent survey conducted by Angus Reid for the Vancouver Board of Trade, 85 percent of businesses in the Lower Mainland felt that the 1998 Budget did not pay enough attention to the issue of cutting business taxes. In fact, almost 35 percent believe that the budget will actually increase their taxes instead of lowering them. What is particularly disturbing is that most Lower Mainland businesses considering relocation in the near future are considering leaving the province. When asked what was the primary reason for relocating outside of British Columbia, 53 percent responded that it was due to taxes (Reid 1998). It would appear, therefore, that the government's recently announced tax cuts fall far short of what business and indeed the taxpayers of British Columbia urgently require.

Recommendations

In light of British Columbia's high and distortionary tax regime, we suggest that the provincial government adopt the following policy recommendations.

1. Enact a 30 percent reduction in the existing "basic" provincial personal income tax rate of 49.5 percent over three years
   These tax cuts would help British Columbia to become more competitive with provinces such as Ontario and Alberta.
2. Enact a substantial cut in the surtax imposed upon high-income British Columbians
   Currently, British Columbia has the highest marginal tax rate of any province and even in light of the recently announced rate decrease, British Columbia will still continue to have one of the highest marginal tax rates in the country. To correct this undue burden on the most productive citizens of the province, we recommend that the government reduce the top marginal tax rate to the current level in Alberta of 45.6 percent (Alberta 1998).
3. Harmonize the provincial sales tax (PST) with the federal goods and services tax (GST)
   The Clark government should move towards harmonizing the provincial sales tax with the federal goods and services tax. This initiative will allow for businesses to spend more time on actually running their operations than on costly paperwork.
4. Cut the corporate income tax rate
   The government announced in this year's provincial budget that it would cut the small business tax rate by .5 percent in January 1999. We recommend that the Clark government also cut the general corporate tax rate. This measure will help to restore the confidence of the business community.
5. Eliminate the corporate capital tax
   If business is to thrive and have confidence in investing in British Columbia, the Clark government should eliminate the corporate capital tax. This tax is a disincentive for businesses to invest in physical capital, which is necessary for higher levels of productivity growth, strong economic activity, and job creation.
6. Reduce payroll taxes
   Payroll taxes kill jobs. High payroll taxes discourage investment in human capital, reduce productivity, and ultimately induce lower levels of employment. Empirical evidence shows that reducing payroll taxes has the effect of decreasing the cost of labour and consequently increasing the level of employment (De Matteo and Shannon 1995; Dixon and Mihlar 1996). Hence, the provincial government should cut payroll taxes (including WCB premiums) in British Columbia immediately.

Conclusion

While several provincial governments across Canada have begun to make significant cuts in the taxes paid by their citizens and businesses, the government of British Columbia has been slow to move on this front. Instead, in the face of a mounting body of evidence that suggests that tax and transfer schemes have negative economic consequences, the government of British Columbia has continued to play the role of the redistributive agent. They have insisted upon maintaining high levels of personal and corporate income tax, and seem willing to provide only small amounts of tax relief. Thus, for continuing to maintain high levels of taxation and failing to provide significant tax relief to the people of British Columbia, the Clark government deserves an F.

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Last Modified: Wednesday, October 20, 1999.