Flatten the Tax,
Fatten the Revenues?

Should Alberta move to a flat personal income tax? Albertans now pay to the province 44 percent on top of their basic federal tax, plus a small flat tax, plus a surcharge for high earners.

The Alberta Tax Review Committee has put forward a proposal to replace this with a single tax rate of 11 percent on taxable income. Provincial taxable income would be calculated just like federal taxable income, except that it would allow a fully-indexed personal deduction, and a fully-indexed spousal deduction, each of $11,620—more than double the exemptions allowed under the federal tax. When federal and Alberta taxes are combined, both tax rates and total taxes would be lower for most Albertans if they chose not to alter their work effort. The Final Report and Recommendations of the Alberta Tax Review Committee in October 1998 gives some details. Fully 78,000 low income Albertans would no longer pay any provincial tax. The highest marginal tax rate would fall from 45.6 percent to 42.3 percent. Table 1 shows the size of tax saving available to different families.

Click Here to View Table 1

This looks very appealing. But is there a downside from a loss of government programs due to reduced tax revenues for the provincial government? The Tax Review Committee estimates a revenue loss of $500 million. This assumes that people do not alter their work effort or savings and investment behaviour as a result of the tax change. Economic theory suggests that people will, in fact, alter such behaviours, but it doesn’t tell us by how much. But we can get a good estimate from previous instances of tax flattening.

Click Here to View Table 2

Evidence from Canada

The 1987 federal personal income tax reform is an example. In 1987 there were 12 federal tax rates, ranging from 6 to 34 percent. In 1988 there were only 3 federal tax rates: 17 percent, 26 percent, and 29 percent. As in the Alberta proposal, marginal tax rates fell by a few percentage points for most people, with the largest drop for people at the high end. Less generously than the Alberta proposal, the value of the personal and marriage exemptions were increased in the lowest tax bracket, and reduced in the higher tax brackets. All things combined, the 1987 tax reform did save roughly similar amounts of tax for most people, as illustrated in table 2.

How did Albertans respond to the 1987 tax flattening?¹ First, they increased their work effort and taxable incomes. For example, work income, measured by income from self-employment and income from Revenue Canada T4 slips, grew by 4 percent on average between 1986 and 1987, but by 7.6 percent between 1987 and 1988, and by 5.7 percent between 1988 and 1989. Second, tax revenues dropped, but only for one year. On average, taxes paid by each working Albertan increased by about $500 from 1986 to 1987, by $200 from 1987 to 1988, and then by $600 from 1988 to 1989. These changes weren’t due to changes in inflation, changes in the business cycle, or any other new economic or political stimuli. For example, the Free Trade Agreement and its impact was yet to come. The only big event in this period was the tax flattening. All provinces responded similarly to it.

Evidence from the US

Two more examples of the effect of tax flattening come from the United States. The US tax reform of 1981 cut all marginal tax rates. The reductions in the tax rates were larger than those we’ve been talking about so far. In the US, the top rate fell from 70 to 50 percent. The lowest rate fell from 14 to 11 percent. The cuts in the top brackets more than paid for themselves as taxable incomes increased. Overall, however, federal tax revenues as a percentage of GDP fell to the lower half of the range seen during the 1960s and ‘70s.

The US undertook another tax reform in 1986 that replaced 14 tax brackets ranging from 11 to 50 percent with two tax brackets of 15 and 28 percent. Reductions in allowable deductions and increased corporate taxes were introduced to compensate for expected revenue loss from the marginal tax rate cuts. As a result of these compensating tax increases and the increase in taxable incomes, overall federal tax revenues as a percentage of GDP did not suffer, but rose again to the average level of the previous two decades. This experience shows that with large enough cuts in marginal tax rates, tax revenues may suffer, even with an increase in work effort and taxable incomes.

Conclusion

What can we conclude will be the likely effect of the Alberta flat tax proposal? If implemented, the proposal will likely prompt an increase in work effort and taxable income. Since in size the Alberta proposal is more like the 1987 Canadian tax flattening than the US 1981 or 1986 tax flattenings, we can also deduce that tax revenues, or the growth of tax revenues, will drop temporarily, but will recover within a year or two. The final result of this short-term pain would be long-term gain for Alberta taxpayers.

Notes

1  The data related to the 1987 tax flattening was extracted from the longitudinal administrative database maintained by Small Area and Administrative Data Division, Statistics Canada.

References

Alberta Tax Review Committee (1998). Final Report and Recommendations, Future Direction for Personal Income Taxes in Alberta. Government of Alberta.

M. A. Akhtar and E. S. Harris (1992). “The Supply-Side Consequence of U.S. Fiscal Policy in the 1980s.” Federal Reserve bank of New York Quarterly Review, Spring, 1-20.

E.S. Rubenstein (1994). The Right Data. New York: National Review Inc.

Bureau of the Census (1990). Statistical Abstract of the United States, The National Data Book. Washington DC: US Department of Commerce.

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Last Modified: Wednesday, October 20, 1999.