May 2001
Taxes & Government Spending: The Root of BC’s Economic Problem
by Jason Clemens & Joel Emes
British Columbians have been grappling with what ails the province’s economy for the better part of a decade. BC’s disastrous economic performance is well known: among its legacies are stagnant economic and income growth, sub-par private sector employment creation, and a dismal investment record. Many British Columbians are realizing that it is neither declining commodity prices nor the Asian flu that explain the province’s lacklustre performance, but rather, poor public policy.
The main public policies that have contributed to the deterioration in British Columbia’s economic performance are increased government spending and high taxes.1 The policies that will return the province to its traditional position of economic prosperity are limited government and lower taxes.
Goal #1: The optimal size of government
The first step on the path to economic recovery is to achieve an optimal size of government in British Columbia. Intuitively, most of us understand that there is some optimal level of government that provides, finances, or regulates the provision of necessary services such as a functioning judicial system, police services, basic education, and infrastructure. It is limited in scope and judicious in its takings.
A number of researchers have examined the size of government question.2 The bulk of their research indicates that as government exceeds some optimal level, rates of economic growth decline. Declining growth rates ultimately result in lower incomes for citizens, less investment and savings, and fewer opportunities.
Social progress and government
Some argue against cutting government spending. Their argument depends on the faulty premise that we can only gain greater social progress (in terms of improved literacy, health care, infrastructure, etc.), when government spends more on these amenities. A series of studies completed by International Monetary Fund (IMF) economists Vito Tanzi and Ludger Schuknecht refute this assertion. They conclude that countries with governments that spend more than 50 percent of GDP do not outperform countries with smaller government—those that spend less than 40 percent of GDP on a wide range of social indicators.
Tanzi and Schuknecht’s findings are supported by Professor Gerald Scully’s recent research. Scully has found that there is little difference in social progress—measured on 16 indicators, including literacy, mortality, and life expectancy—between countries that spend less than 40 percent of GDP and those that spend in excess of 50 percent of GDP.
Spending drives taxes
Ultimately, government spending must be financed by taxation, whether levied simultaneously with the spending, or deferred through debt. Taxes necessarily imply economic distortions which partially account for reduced economic growth rates. The key public policy challenge is to balance the need to minimize economic distortions in order to maximize economic growth, while at the same time providing necessary government services.3 When such a balance is achieved, both economic growth and social progress are maximized.
Government spending in British Columbia
One way to measure the size of government is to compare spending to the size of the economy. Figure 1 illustrates government spending as a percent of the economy (GDP) between 1975 and 2000 for Ontario, Alberta, and British Columbia. The figure illustrates two points. First, all three provinces began the period with similar levels of government spending relative to GDP: Ontario at 16.1 percent, Alberta at 15.4 percent, and British Columbia at 16.7 percent. Second, while Alberta and Ontario ended the period with nearly identical spending levels as when they started (16.2% and 16.1%, respectively), British Columbia diverged significantly. Government spending as a percentage of the economy increased 5.9 percentage points in British Columbia, from 16.7 percent in 1975 to 22.6 percent in 2000. Much of the increase occurred during the 1990s.
Where are we going?
Unfortunately, the British Columbia government does not seem to comprehend the severity of its current spending problem. The 2001 Budget called for an irresponsible 10.0 percent increase in total government spending over 2000/01, representing a nominal increase of $1.849 billion (BC Ministry of Finance & Corporate Relations). This is more than three times the expected rate of economic growth.
The experiment with bigger government, as measured by government spending over the last decade, has yielded only small social gains, if any, while ravaging the province’s economic growth. British Columbia desperately needs a rational and prudent plan for shrinking the size of government. Our recent study, Returning British Columbia to Prosperity, provided a number of examples of how government could curtail spending in core areas such as health care, education, and welfare, while improving the quality of services by reforming the way those services are delivered.
Lack of tax competitiveness
Not surprisingly, as government spending accelerated, so did taxes. Over the last decade, the British Columbia government increased both taxes and the stock of debt. Real provincial own-source revenues—both tax and non-tax revenues—increased from $16,862.3 million in 1991/92 to $21,312.6 million in 1999/00, an increase of 26.4 percent.
In real terms, between 1991/92 and 1999/00, personal income taxes increased 12.5 percent, consumption taxes increased 35.2 percent, provincial sales tax increased 42.7 percent, and property and related taxes increased 41.7 percent. The largest increase occurred in capital taxes, which rose from a mere $15.0 million in 1991/92 to $441.0 million in 1999/00, a 2,834 percent increase.
Personal income tax
British Columbia clearly has a challenge to make its personal income tax (PIT) system more competitive. Not only do BC’s rates need to be reduced, but thresholds must also be increased. Further, greater attention must be paid to the top marginal rates in order to make not just British Columbia’s tax system, but the whole economy more competitive.
Business income taxes
Although business income taxes represent a small portion of provincial revenue—only 4.3 percent in 2000—they are nonetheless an important driver of (or deterrent to) economic activity. British Columbia’s general corporate income tax rate and its manufacturing and processing corporate income tax rate will be more than double the rates for those taxes in Alberta and Ontario once reductions in those provinces are fully implemented. British Columbia must move quickly to ensure that its business tax regime regains its competitiveness, both within Canada and, more broadly, within North America.
The particularly damaging capital tax
Capital taxes are another problem facing British Columbia. As Jorgensen and Yun note in their 1991 study of the cost of taxes, capital taxes are a particularly poor way to raise revenue as the economic distortions associated with them are high. In other words, it costs a great deal to raise revenue using capital taxes as opposed to other, more efficient taxes, such as payroll or consumption taxes.
Tax challenges
British Columbia is faced with a tax competitiveness challenge. Rate reductions and reform of the province’s tax system is as important as the overhaul of government spending. In particular, reduction and reform must take place in personal income taxes, business income taxes, capital taxes, and the provincial sales tax.
Specific policy recommendations
The following is an abbreviated list of specific policy recommendations put forward in the recent study, Returning British Columbia to Prosperity.
-
Decrease the percentage of the economy accounted for by government.
Provincial government spending on a consolidated basis represents 28.3 percent of total provincial GDP, 33.3 percent more than Alberta and 24.3 percent more than Ontario. British Columbia must forcefully implement fiscal policies aimed at reducing the portion of the economy accounted for by government. -
Broadly restructure government to focus on outcomes.
British Columbia must move away from simply throwing more money at programs; problems facing programs do not stem from a lack of resources. -
Reduce personal income tax-rates by a minimum, across-the-board, 20 percent.
The maximum estimated loss incurred by this cut is $1.2 billion. However, as Professor Maurice Levi from the University of British Columbia estimates in a paper commissioned by the Business Council of BC, "cutting taxes is expected to actually increase BC’s revenue." -
Eliminate the two top personal income tax rates.
Doing so will stimulate entrepreneurial activity, and promote greater work effort, increased risk-taking, and innovation. It would also make BC’s top marginal tax rates more competitive with other jurisdictions in Canada. This change could cost a maximum of $228 million in foregone revenue. -
Reduce business income tax rates.
In accordance with other Canadian provinces, particularly Ontario and Alberta, British Columbia should immediately announce corporate tax rate reductions for the province, with a target rate of 8.0 percent. The BC Ministry of Finance and Corporate Relations estimates a static revenue loss of $74 million per percentage-point decline in corporate business income tax rates. -
Immediately eliminate capital taxes.
Eliminating these particularly inefficient taxes would have cost a maximum, in 1999/00, of $441.0 million. -
Harmonize the provincial sales tax with the GST.
One of the main problems with the current provincial sales tax is that business inputs are taxed. Harmonizing the provincial tax with the federal GST and collecting it as a value-added tax would alleviate this problem. -
Introduce a strong tax and expenditure limitation law.
Strong Tax and Expenditure Limitation laws (TELs) have proven successful in stemming the growth of government and ensuring fiscal responsibility in the United States. These laws effectively constrain governments from increasing either taxes or spending without popular approval. In the US, these laws have forced states to focus on the goods and services actually required of them, as opposed to projects driven by special interest groups. -
Introduce a legislated program of debt reduction.
British Columbia should legislatively require that any unused portion of the contingency fund be applied each year to the province’s debt. In addition, all unexpected surpluses, whether garnered from higher than expected revenues, lower than expected interest costs, or lower than expected expenditures, should be exclusively used to reduce the province’s debt.
Conclusion
Only a radical divergence in public policy, equal to the change initiated by the current provincial government in 1991, will return the province to a position of economic leadership and prosperity. Such a drastic change will require reductions in core areas of government spending coupled with large-scale tax cuts for both individuals and businesses. A reform of government services that begins to focus on results could more than offset any program funding cuts, such that services will actually improve. British Columbians must chose between two clear paths: continued economic stagnation or prosperity.
Notes
1 For a fuller discussion of taxes and government spending in British Columbia including references and citations please see: Returning British Columbia to Prosperity, chapters 2 and 3. Available on the Internet at http://www.fraserinstitute.ca/publications/pps/47/index.html.
2 Daniel Landau (1983) and Robert Barro (1991) concluded that countries with smaller governments experienced higher rates of economic growth. Similarly, Keith Marsden (1983) and William Easterly and Sergio Rebelo (1993) found that countries with lower marginal tax rates experience faster economic growth than countries with higher marginal tax rates. A number of studies completed by The Fraser Institute’s Economic Freedom of the World project corroborate these findings.
3 Government that is below the optimal size will not maximize economic growth even though taxes will be lower than in other countries. This is because a government that is too small cannot provide needed government services. For example, a country with a limited judicial system, where property rights are not secure, will not experience high (optimal) rates of economic growth even though taxes are low.
4 In a paper commissioned by the Business Council of BC, Professor Maurice Levi of the University of British Columbia estimated that BC would actually increase its revenue by reducing tax rates.
References
BC Ministry of Finance & Corporate Relations (2001). Budget 2001: Reports. Victoria, BC: Government of BC. Available on the Internet at www.gov.bc.ca.
Jorgensen, Dale W. and Kun-Young Yun (1991). "The Excess Burden of Taxation in the United States." Journal of Accounting, Auditing and Finance 6: 487-508.
Kesselman, Jonathan (2000). "Flat Taxes, Dual Taxes, Smart Taxes: Making the Best Choices." Policy Matters. Vol. 1. No. 7. Montreal, QC: Institute for Research on Public Policy. Digital document available on the Internet at www.irpp.org/indexe.htm.
Scully, Gerald W. (2000). Public Spending and Social Progress. Policy Report No. 232. Dallas, TX: National Center for Policy Analysis. Digital document available on the Internet at www.ncpa.org.
Statistics Canada (2000). Provincial Economic Accounts. Ottawa, ON: Statistics Canada.
Jason Clemens (jasonc@fraserinstitute.ca) is the Director of Fiscal Studies
at The Fraser Institute. He has a Masters Degree in Business Administration
from the University of Windsor.
Joel Emes (joele@fraserinstitute.ca) is Senior Research Economist at The Fraser Institute. He has an M.A. in Economics
from Simon Fraser University.
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