Returning British Columbia to Prosperity

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Government Tax and Revenue Policy: Aggravating BC's Lack of Competitiveness

Tax policy is often viewed in isolation from related policy issues such as government spending and deficits. However, taxation is ultimately driven by government spending. It is important to assess government deficits and the accumulation of debt in the context of taxation since debt is simply the accumulation of deferred taxes. Thus, deficits and debt should also be considered part of tax policy.

This section analyzes both tax policy and the use of deficits in British Columbia. First, it asesses debts and deficits, then presents the economics of tax policy. A detailed empirical analysis of taxation in British Columbia follows, along with inter-provincial comparisons. Finally, it provides tax and debt policy recommendations.

I. Balancing the Books: A Government Failure

Over time, all economic participants, whether they are individuals, firms, or governments, must balance their budgets. In other words, over time, the present value of expenditures must equal the present value of revenues for all economic actors (Blanchard and Fischer, 1993; Romer, 1996; Good, 1995; Law and Clemens, 1998).

For government, this principle implies that a current deficit will translate into a future tax. Put differently, if a government runs a deficit today, it must run a surplus tomorrow to generate the financial resources required to pay the principal and interest accumulated on today's deficit.

Tax Smoothing: Optimal Public Finance

Given the general principle that governments, like all other economic participants, must balance their books, the pertinent question becomes: what is the most efficient (i.e. best) way for the government to finance spending over time? According to economist Robert Barro, governments should choose the mix of deficits and surpluses that minimize the "excess burden" of taxation (Barro, 1979). The foundation of this argument is that government spending must ultimately be financed by taxation, which causes economic distortions by altering relative prices and economic incentives (Aaron and Pechman, 1981).

A fiscal rule requiring the government to balance its budget every year would not be optimal. Tax collections and government spending fluctuate according to cyclical patterns, but such a rule would require tax rates to fluctuate in unison with cyclical fluctuations, implying higher tax rates in periods of slow economic growth or recession, and vice versa. The economic costs of tax collection would increase because tax rates and spending would have to increase and decrease according to the cyclical behaviour of the economy. A far better strategy would be to run deficits during economic downturns and pay these deficits later with surpluses when economic conditions improve. This would enable government to smooth tax rates over time and minimize the inefficiencies caused by distortionary taxes (Aiyagari, 1989). In other words, government budgets should be balanced over the business cycle.

British Columbia's Debt Record:
Recent Failure

Unfortunately, the simplicity of this concept has been completely lost over the last decade in British Columbia. During a period of slow but positive growth both in the economy and in revenue, the government of British Columbia has nearly consistently failed to balance its books.

Tax Figure 1 illustrates the real per capita deficits posted by the government of British Columbia between 1975 and 2000. It is based on the Financial Management System published by Statistics Canada rather than the budgets used by government because the FMS is a more consistent and broad measure of fiscal performance than that provided by budget information.

Although it is not unusual for a government to operate in deficit during a recession, Tax Figure 1 clearly shows that British Columbia failed to post surpluses during ensuing expansionary periods.⁴ In its analysis of BC's 2000 Budget, the Royal Bank of Canada's Economics Department characterized the province's fiscal performance as having an "exceedingly long timetable for deficit elimination, particularly in light of BC's improved economic outlook" (Royal Bank Economics, 2000).

Tax Figure 2 provides further evidence of the difficulty the BC government has had in balancing its books. It depicts the five-year average deficit or surplus as a percent of GDP for the five periods between 1975 and 1999. British Columbia fares quite well relative to Canada as a whole and Alberta and Ontario for the three five-year periods 1975-1979, 1980-1984, and 1985-1989. In fact, British Columbia led the nation with a five-year average surplus of 0.2 percent between 1985 and 1989 while nearly all other jurisdictions experienced deficits.

Unfortunately, this performance did not continue in the 1990s. Although British Columbia posted the smallest deficit (as a percent of GDP) of the three "have" provinces for the period 1990-1994, it did so during a period in which the country as a whole, and in particular Ontario, were experiencing either sharp declines in economic growth or outright recession. British Columbia did not experience nearly as difficult an economic period.

The last five-year period illustrates the fiscal challenge facing the province. Although Ontario continued to incur deficits larger than British Columbia's, it did so in a period of tax reduction. Alberta, on the other hand, was able to post large budget surpluses even as it reduced taxes. The province has used those surpluses to eliminate its net debt and place it in the unique and enviable position of being able to cut taxes further without compromising government spending.

The British Columbia government's deficit spending has resulted in a vast increase in the province's debt. As Tax Figure 3 illustrates, the amount of real per capita debt has increased significantly since 1984. In fact, prior to 1984, British Columbians actually had a negative per capita net debt position. That is, the province's financial assets exceeded its financial obligations. In its analysis of British Columbia's 2000 Provincial Budget, Nesbitt Burns noted that the debt load of the province was rising "inexorably," and that it had squandered its position as the province with the lowest level of tax-supported debt (Nesbitt Burns Economics, 2000).

Statistics measuring debt as a percentage of GDP present a similar picture of fiscal mismanagement over the last decade. In 1975, debt represented -7.6 percent of GDP (i.e. financial assets exceeded liabilities). By 1990, this advantage had deteriorated such that debt represented 0.8 percent of GDP. Debt now stands at 15.3 percent of GDP. This accumulation of debt means that increasing levels of budgetary resources must be allocated to servicing the debt rather than providing for goods and services. In fact, debt-servicing costs are expected to increase by 7.3 percent between 1999/00 and 2000/01, according to recent budget figures (BC Ministry of Finance & Corporate Relations, 2000a).

Budget Performance Index:
Jurisdictional Comparisons

The Budget Performance Index provides some inter-jurisdictional performance data for debts and deficits. British Columbia ranked 8th out of 10 provinces in debts and deficits with a score of 38.0 out of a possible 100 (Emes, 2000). Unfortunately, the Fiscal Performance Index, which includes US states, does not include debt and deficit data. Nonetheless, it is clear that British Columbia's performance in the area of deficits and debts has not been competitive with other Canadian jurisdictions.

II. Tax Policy: Part of BC's Lack
of Competitiveness

Introduction

Tax policy should focus on raising adequate revenue to cover government expenditures in the least distortionary manner. That is, tax policy should aim to supply enough monies for government to provide necessary and demanded goods and services while at the same time minimizing the amount of economic distortion.

Economics of Taxation

The traditional criteria for assessing and guiding tax policy are: equity (fairness), efficiency, and simplicity (Technical Committee on Business Taxation, 1997; Kesselman, 2000; Clemens and Emes, 2001). Efficiency refers to the minimization of economic distortions created by the introduction of a new tax or the expansion of an existing tax. Simplicity refers to whether the system can be generally understood by those it affects. Equity, or fairness as it is often now called, relates to two distinct concepts: vertical equity and horizontal equity. Vertical equity requires that the amount of taxes paid increases as the amount of income earned increases. Horizontal equity requires that individuals with similar incomes face similar levels of taxation. Vertical equity has more recently come to mean that people should pay a greater percentage of their incomes in taxes as their income increases.

The Cost of Taxes

Taxes create economic distortions by altering incentives and changing the relative prices of certain activities, goods, and services (Aaron and Fechman, 1981). A large body of research illustrates the negative effects of taxation. A number of the more high-profile studies investigating the negative effects of taxation are summarized below.

• High marginal tax rates on labour reduce labour supply. By lowering the cost of leisure, high marginal income tax rates encourage people to substitute leisure for work (Heckman, 1993; Triest, 1990).
• Payroll taxes increase the cost of labour, both absolutely and, more importantly, relative to capital. An increase in payroll taxes will cause firms to change the mix of labour and capital, moving away from labour towards capital so as to minimize their costs. Payroll taxes can, therefore, been seen as a tax on employment. Empirical evidence supports the assertion that payroll taxes have a negative impact on employment (OECD, 1994c; De Matteo and Shannon, 1995). For instance, De Matteo and Shannon found that a 1 percent increase in average payroll taxes increases the employers' real wage costs by 0.56 percent, reduces workers' real wages by 0.55 percent, and reduces employment by 0.32 percent (De Matteo and Shannon, 1995).
• Taxes on capital gains and dividends reduce both savings and total investment. Taxes on capital gains and investment income reduce the net rate of return and, thus, result in lower overall levels of investment since what investors care about is the rate of return net of taxes, as opposed to gross, pre-tax returns (Summers, 1984; Ture and Sanden, 1977). Since productivity improvements are often embodied in new capital investment, the impact of such taxes in the long run is to slow down the rate of capital accumulation and the rate of economic growth (Marsden, 1983).
• Punitive taxation levels encourage the growth of an underground economy. When faced with high tax rates, individuals will tend to engage in untaxed activities and avoid taxed activities (Feige, 1989; Lippert and Walker, 1997). For instance, provincial sales taxes, in some cases, have been shown to promote tax evasion and the growth of a black market "underground" economy (Starobin, 1994). Empirical estimates suggest that the size of the underground economy in Canada could be anywhere from 4.5 percent to 20 percent of GDP (Mirus, Smith, and Karoleff, 1994; Drummond, Ethier, Fourgere, Girard, and Rudin, 1994).
  
• The deadweight costs of taxation are particularly high in Canada. It has been estimated that each additional dollar of taxes collected through the Canadian federal personal income tax system reduces output by $1.38; a dollar increase in taxes collected through the provincial income tax reduces output by $1.66. Surtaxes in certain provinces impose extremely large deadweight losses and may even result in diminished tax collections (Dahlby, 1994).

One of the critical issues in tax policy is the mix of taxes particular jurisdictions use to raise the revenue they require. The list of taxes that government can use to raise revenue is almost endless: income (both personal and business), payroll, property, sales, licenses, fees, capital, etc. A key aspect of tax policy is selecting the appropriate mix of taxes in order to satisfy the traditional criteria for taxes (efficiency, simplicity, and equity).

Different taxes introduce different types of distortions with varying costs. A number of studies have attempted to document these costs. For example, a study by Dale Jorgensen and Kun-Young Yun calculated the marginal efficiency cost of an additional dollar of tax revenue raised by different types of taxes. They calculated the marginal efficiency cost of certain taxes as: consumption taxes ($0.26), labour taxes ($0.38), capital income taxes at the business level ($0.45), and capital income taxes at the individual level ($1.02) (Jorgensen and Yun, 1991). Put differently, it costs the economy $0.26 to raise one dollar of tax revenue using consumption taxes. At the other end, it costs the economy $1.02 to raise one dollar of tax revenue using capital taxes assessed on the individual. In order to achieve the principle of efficiency, one of the three tenets of tax policy, taxes which minimize the amount of economic distortions in the economy (i.e. consumption taxes) should be employed to the greatest extent possible.

Government Revenue in
British Columbia

As was the case in the analysis of government spending, Statistics Canada's Financial Management System and Provincial Economic Accounts along with the province of British Columbia's 2000 Budget will form the basis for the analysis of BC revenues.

Tax Figure 4 shows the real (inflation-adjusted) growth in provincial government revenues between 1975 and 2000 for BC, Alberta, Ontario, and Canada as a whole. Government revenue growth in British Columbia significantly outpaced that in all the other jurisdictions over this period. In fact, the increase in government revenues in British Columbia over the entire period outpaced that in the province with the next highest increase, Ontario, by 30.2 percent.

During the last decade, while BC government revenues did increase, they did not do so nearly to the extent necessary to cover government spending increases. The difference was reflected in large increases in provincial debt. Thus, increased government revenues or future spending restraint will have to pay for the use of deferred taxes and the resultant accumulation of debt during the 1990s.

Examining aggregate increases in government revenues, similar to simply examining aggregate increases in government spending, can be too simplistic. To effectively estimate government revenues, two measures should be used: per capita government revenues and government revenues as a share of the economy.

Per Capita Government Revenue

Tax Figure 5 presents real per capita government revenues for British Columbia between 1975 and 2000. Real per capita revenues in British Columbia rose steadily up to and including 1994/95. Specifically, they increased in real terms from $4,212 in 1975 to $6,066 in 2000, an increase of 44.0 percent. Since peaking in 1994/95 at $6,734, real per capita government revenue has declined to $6,066 in 1999/00, a decrease of 7.2 percent.

Interestingly, both Canada as a whole and Alberta now extract more government revenue per capita than British Columbia in dollar terms, but take less as a percent of GDP. Specifically, Canada now receives $6,455 in real government revenue per capita, while Alberta extracts $7,078.

Unfortunately, a large part of the explanation for this difference rests on the fact the British Columbia has a lagging economy. That is, both per capita GDP and disposable income growth have been dismal in British Columbia over the last decade. The tremendous economic growth experienced by Alberta has enabled it to take less of the economy in revenue while actually taking more in dollar terms. Simply put, when economic growth translates into income growth it is possible for the government to take less (as a percent of the economy) but generate more revenue (measured in dollars). This effect is illustrated by viewing government revenue relative to the size of the economy.

Government Revenue as a
Percent of GDP

Tax Figure 6 presents government revenue as a percent of GDP for all three "have" provinces and for Canada as a whole. Government revenue in Ontario and Alberta now accounts for significantly less of their provincial economies than it does in British Columbia. Government revenue in British Columbia now accounts for 20.2 percent of GDP while in Ontario and Alberta it accounts for 16.4 percent and 17.3 percent, respectively.

Interestingly, British Columbia previously maintained a tax advantage over both Alberta and Canada as a whole. In 1975, Ontario consumed the smallest portion of the economy in government revenue at 14.4 percent, followed by British Columbia (16.8%), Canada as a whole (18.3%), and Alberta (20.6%). While Alberta has experienced a dramatic decline in the amount of the economy consumed by government revenue, British Columbia has, unfortunately, experienced the opposite. In fact, between 1975 and 2000, the portion of the economy consumed by government revenues increased by 20.3 percent in British Columbia while it declined 16.1 percent in Alberta.

Tax Freedom Day for British Columbia

Another way to assess the tax burden for British Columbians is Tax Freedom Day, which was pioneered by The Fraser Institute. Tax Freedom Day measures the burden of all taxes levied by all levels of government on the average family. This burden is then translated into the number of work days required in a year to pay the tax bill. Tax Figure 7 gives the Tax Freedom Days for British Columbia, Alberta, and Ontario for the years 1981, 1985, 1992, and 2000.

Two trends are evident from Tax Figure 7. One, the burden of taxes on the average family in all three jurisdictions has been increasing since 1981. Two, the tax burden for the average family, as measured by Tax Freedom Day, was higher in British Columbia than in other provinces in each year for which data is available.

Consolidated FMS Data:
A Comprehensive View

[Note: Due to a limited time series, we were not able to provide an analysis prior to 1989/90.]

In addition to the provincial-only data, Statistics Canada also publishes information on provincial government revenue which is consolidated to include local activities. It, therefore, provides a more comprehensive view of government revenue differences among provinces.

This is an important addition to the provincial-only data since it adjusts for differences in local revenue collection authority among provinces. In other words, it eliminates any advantage or disadvantage a province may have when more or less revenues are collected at the local rather than at the provincial level.

Per Capita Analysis

In 1999/00, there was over a 10-percentage point difference in the ratio of local to consolidated provincial revenues among the three "have" provinces (see Tax Figure 8). Ontario had the highest proportion of consolidated revenues at the local level of government, with 31.9 percent of consolidated revenues generated at the local level. British Columbia had the lowest proportion of consolidated revenues at the local level, with only 19.4 percent. Put differently, of the $7,529 in consolidated per capita government revenues generated in British Columbia in 1999/00, $6,066, or 80.6 percent, was collected by the provincial government with the remainder generated by local revenues (Tax Figure 8).

An important aspect of per capita analysis is population growth. Over the 1990s, Ontario experienced the lowest population growth rate of the three provinces, with an increase in population of 12.7 percent. It similarly recorded the lowest growth rate in real consolidated government revenues (17.6 percent) over the decade, due to a combination of factors including lower population growth and, more importantly, large-scale reductions in taxes. It is important to recognize, however, that the large-scale tax reductions implemented in Ontario have not resulted in accordant large-scale reductions in government revenues. Government revenues have actually increased over the decade while tax rates have been reduced. Real per capita government consolidated revenues increased by 3.2 percent in Ontario.

Alberta experienced the largest expansion in real consolidated government revenues (18.5 percent) over the decade, while its population increased 17.3 percent, resulting in a real per capita decrease in government consolidated revenues of 0.1 percent (Tax Figure 8).

British Columbia recorded the largest increase in population, 23.1 percent and the second largest increase in real government consolidated revenues of 17.8 percent, just outpacing Ontario by 0.2 percentage points. Real consolidated per capita government revenues fell by 6.4 percent in British Columbia over the decade (Tax Figure 8).

Percent of GDP Analysis

An alternative way to view consolidated government revenues is by comparing them to the size of the economy. Tax Figure 9 depicts the consolidated real provincial revenues as a percent of provincial GDP between 1989/90 and 1999/00. British Columbia recorded a 1.3 percentage point reduction in the amount of GDP consumed by government revenues over the 1990s. Ontario's consolidated revenues actually increased as a share of the economy by 0.3 percentage points. Alberta more dramatically reduced the size of government, decreasing consolidated provincial and local revenues as a share of the economy by 3.2 percentage points, representing a decline of 12.4 percent.

The government revenue figures underestimate the size of government since the provincial governments in British Columbia and Ontario consistently operated in deficit over the decade. That is, the governments used deferred taxes in the form of borrowings to finance current operations. The differences between British Columbia and Ontario and Alberta in terms of the prominence of government revenues would have been more pronounced had British Columbia and Ontario been using current taxes to finance current operations, as opposed to borrowing funds to pay for current outlays.

Budget & Fiscal Performance Index: Jurisdictional Comparisons

The Fraser Institute produces two studies that compare jurisdictional performance in fiscal policy: the Fiscal Performance Index (2001) and the Budget Performance Index (2000). The Fiscal Performance Index compares government revenue and spending performance among Canadian provinces and US states while the Budget Performance Index compares spending, revenues, and debts and deficits among Canadian governments.

British Columbia ranked 53rd out of 54 in the Fiscal Performance Index (2001) for tax policy with a score of 40.8 out of a possible 100 (Emes 2001). Overall, the province ranked second last for tax policy among the participating Canadian provinces and US states.

British Columbia fared somewhat better in the Budget Performance Index (2000) as different variables were measured and the index only includes Canadian provinces and the federal government. In this ranking, British Columbia ranked 5th out of 11 jurisdictions in tax rates and revenue with a score of 58.9 out of a possible 100 (Emes, 2000).

Composition of Taxes in British Columbia

Overall, according to the Financial Management System (FMS), real provincial own-source revenues increased from $16,862.3 million in 1991/92 to $21,312.6 million in 1999/00, an increase of 26.4 percent. Tax Table 1 contains the specific contributions made by each type of government revenue in 1999/00 according to FMS data. The largest components of provincial revenues are personal income taxes, sales taxes, property and related taxes, and government transfers.

Using data from the FMS, let us examine the specific revenue areas in which real increases occurred between 1991/92 and 1999/00. In inflation-adjusted or real terms, personal income taxes, representing 22.6 percent of total government revenue in 1999/00, increased in real dollar terms by 12.5 percent between 1991/92 and 2000/00. Consumption taxes, another major category of revenue, increased in real dollar terms, by 35.2 percent over the same period. Revenue garnered from the provincial sales tax increased 42.7 percent in real terms over the period. Property and related taxes, yet another important category of government revenue, increased 41.7 percent in real dollar terms. The largest increase—and one that should be particularly worrisome for British Columbians concerned with economic efficiency—occurred in capital taxes, which increased from a mere $15 million in 1991/92 to $441.0 million in 1999/00, an increase of 2,833.7 percent.

Personal Income Tax (PIT)

Personal income taxes remain a challenge for British Columbia. The province maintains relatively high statutory tax rates across the board, with one of the highest top marginal tax rates in the country. Tax Table 2 summarizes the rates, thresholds, and exemptions for the three "have" provinces and the federal government for 2001.

In assessing the effective tax rate for low-income earners, it is critical to combine the exemption value with the applicable rate. A higher applicable rate combined with a higher exemption, as is the case in Alberta, often results in a lower effective tax rate for low-income earners. Put differently, the value of the exemption or the amount of money individuals are able to earn tax-free, has a much greater affect on low-income earners than the applicable rate. Low-income earners are generally better off with a higher exemption and rate than with a lower exemption and rate.

More critical for British Columbia is the lack of personal income tax rate competitiveness at higher income levels. In both the middle- and high-income tax brackets, British Columbia maintains the highest applicable tax rates of the three "have" provinces. In addition, British Columbia introduced two new high-income statutory rates applicable at $70,000 and $85,000, respectively.

British Columbia has also consistently maintained one of the highest top marginal tax rates in the country. For instance, prior to the 2000 round of provincial budgets, British Columbia had the third highest top combined federal and provincial marginal tax rate (51.26%), just narrowly behind Newfoundland (51.31%) and Quebec (51.66%) (Alberta Tax Review Commission, 2000). Unfortunately, as illustrated in Tax Table 3, after the tax reductions contained in the 2000 round of provincial budgets, British Columbia still had one of the highest top provincial marginal tax rates. In fact, the province's top marginal tax rate in 2000 (20.9%), based on the new tax-on-income structure, tied BC with Newfoundland for the second highest top marginal tax rate, behind only Quebec (Kesselman 2000).⁵

British Columbia clearly has a challenge in making its personal income tax system more competitive. Not only will the rates have to be reduced, but thresholds will also have to be increased. Further, greater attention must be paid to the top marginal rates in order to make British Columbia's tax system more competitive and indeed, to make the economy as a whole more competitive. Eliminating the top two statutory personal income tax rates, formerly assessed as surtaxes, would be a good beginning.

Business Income Taxes⁶

Although business income taxes represent a small portion of provincial revenue, only 4.3 percent in 2000, they are nonetheless an important driver or deterrent to economic activity. It is, therefore, essential that British Columbia maintain a competitive business tax regime.

Tax Table 4 contains business income tax rates for all of the provinces. The differences between British Columbia's business income taxes and those of the other Canadian provinces, particularly Alberta and Ontario, make business tax reform and reduction a high priority. For instance, British Columbia's general corporate income tax rate, as well as its manufacturing and processing corporate income tax rates, will be more than double the rates of Alberta and Ontario once reductions in these provinces are fully implemented. Although British Columbia made a great deal of noise regarding its planned reduction in the income tax rate for small business, it remains above the applicable rate in Alberta.

The announcements of business income tax reductions by Alberta and Ontario will clearly force other provinces to make similar cuts in their up-coming budgets. Alberta's and Ontario's announced cuts will not be fully implemented until 2005 and 2006, respectively. This gives provinces like British Columbia time to announce their own equal, or better yet, more aggressive business income tax reductions.

Tax Table 4 provides evidence that British Columbia's business income tax rates are currently uncompetitive; this situation will deteriorate further as reductions announced by other provinces are implemented. It is imperative that British Columbia move quickly to reduce its business income tax rates to levels found in other major Canadian provinces.

Capital Tax: A Particularly Damaging Tax

Capital taxes are another tax problem facing British Columbia. Businesses face capital taxes whether they generate a profit or not. Increasingly in recent years, governments have relied on profit insensitive taxes, such as capital and property taxes, to avoid or at least mitigate the cyclical nature of government revenue, which is a result of the close relationship between business income tax collections and business profits, both of which rise and fall with the business cycle.

The quest for stabilization in government revenue has come at a cost. As discussed previously in this section, by their very nature, taxes distort economic activity. The greater the distortion, the greater the cost to the economy. A number of studies have examined this phenomenon and concluded that some types of taxes are more efficient than others (Jorgensen and Yun, 1991; Kesselman, 1997: Kneller, Bleaney, and Gemmell, 1999). As the Jorgensen and Yun study (1991) notes, capital taxes are a particularly poor way to raise revenue as the economic distortions associated with them are quite 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 Table 5 gives the capital taxes for both non-financial and financial companies in each Canadian province. Only three provinces—Alberta, PEI, and Newfoundland and Labrador—do not assess a capital tax on non-financial companies. Effective April 1 of this year, Alberta became the only province not to assess financial companies a capital tax. British Columbia could excel in one area of tax policy by immediately eliminating capital taxes for both financial and non-financial companies.

The Laffer Curve and BC Taxes

In an important paper for the BC Business Council, Professor Maurice D. Levi of the University of British Columbia's Faculty of Commerce and Business Administration assessed fiscal policy, taxation, and the potential for future prosperity in British Columbia.

The study's most interesting and relevant finding is that British Columbia's tax rate is beyond the optimal rate. Professor Levi specifically discusses the concept of the Laffer Curve, a theoretical construct illustrating the relationship between tax rates and tax revenue (Tax Figure 10). Simply put, having a non-optimal tax rate, one that is either too low or too high, fails to yield the maximum amount of revenue.

Professor Levi concluded that British Columbia's tax rates are beyond the peak point of the curve, and thus result in less, not more, tax revenue than could be generated with lower tax rates (Levi, 2000). Tax Figure 10 shows that British Columbia's current tax rates (Y) are to the right of the optimal (X). Thus, according to the Laffer Curve, a shift in tax rates to the left (reduction) would result in greater tax revenues. Lower tax rates would yield greater tax revenues because people would have more of an incentive to work and save.

Professor Levi included a number of specific tax recommendations, including:

• reduce both personal and business income tax rates to bring them in line with other major Canadian provinces;
• eliminate capital taxes;
• ultimately introduce a low, flat tax, offset by higher sales taxes (if required for revenue generation) (Levi, 2000).

Professor Levi's conclusion is clear: British Columbia must reduce its tax burden. When it has done so, it will actually be in a position to generate more tax revenue.

Obstacle or Opportunity?

Instead of viewing the tremendous tax challenge facing the province as an overwhelming obstacle, British Columbia should see this as an opportunity to fundamentally change the province's tax system.

Flat Tax: A Real and Effective Tax Advantage

Much was made of the notion of a flat tax in the most recent federal election. Unfortunately, a full and frank debate regarding the efficacy of a flat tax—distinctly different from the Canadian Alliance's proposal—was not undertaken during the election. A flat tax based on the work of Professors Robert Hall and Alvin Rabushka would revolutionize the tax system in British Columbia.

Hall and Rubushka's flat tax proposal represents a coherent integration of the personal and business tax systems. It ensures that all three tenets of tax policy—efficiency, simplicity, and equity—are achieved. Further, it would create an enormous tax-based advantage for British Columbia over other jurisdictions, both in Canada and abroad.

In summary, the Hall-Rabushka tax system contains no tax credits, deductions, or exemptions, except personal, spousal, and child exemptions. The myriad tax credits and deductions present in the current system and the attendant complicated and time-consuming paperwork are eliminated. Business income and personal income are taxed in an integrated manner in order to ensure that income is taxed uniformly and only once.

A flat tax system would move the tax system away from one based on income towards one based on consumption. Economists generally agree that the taxation of consumption is one of the most efficient ways to raise tax revenue. The net economic effect of flat tax reforms include improved incentives for work, increased entrepreneurial activity, and greater capital formation leading to a substantially higher level of national output and standard of living.

The Fraser Institute's upcoming study on flat tax systems contains a section calculating various different flat tax rates for each province. The following table summarizes the rates and specifics from the various proposals in the study. Note that the flat tax reforms presented in Tax Table 6 are revenue neutral compared to the current, existing tax systems.

As the results in Tax Table 6 reveal, there are a number of possibilities for an integrated flat tax system in British Columbia. Rates would vary according to the number and extent of tax deductions included in the flat tax. For instance, if RRSP and RPP deductions were permitted, the applicable provincial flat tax rate would increase by roughly 1 percentage point. Regardless, however, of the particular flat tax system implemented, the economic benefits accorded the province from simplifying the tax system and focusing on economic efficiency would be overwhelming.

Conclusion

British Columbia is clearly faced with a taxation problem based on competitiveness and economic efficiency. Reduction and reform of British Columbia's tax system is nearly as important as the overhaul of government spending. British Columbia must act decisively and immediately to re-focus its tax policy on achieving the traditional measures of tax success (efficiency, simplicity, and equity) while at the same time focusing on jurisdictional competitiveness.

Policy Recommendations

British Columbia must act immediately to eradicate its tax-based disadvantage by reducing some taxes and eliminating others. However, more fundamentally, the province must begin implementing longer-term, broad-based tax reform.

We have included several static revenue loss estimates for the tax reduction/elimination we have proposed. These estimates do not account for supply-side affects which will likely increase government revenues. As summarized in Professor Levi's paper, British Columbia's tax rates and total take of the economy are well beyond their optimal level. Thus, reducing the tax rates and size of government will likely actually boost government revenue by encouraging entrepreneurial activity, risk-taking, innovation, and diligence. Therefore, the estimates provided should be taken as the worst-case scenario of the potential revenue losses. Actual losses will likely be considerably smaller than projected and the attendant improvements in the tax system may increase tax revenues.

Intermediate Policy Recommendations

(1) Reduce personal income tax-rates by a minimum across-the-board 20 percent.

A rate reduction of this magnitude will bring British Columbia's statutory personal income tax rates in line with those of other major Canadian jurisdictions. The maximum revenue effect of such a reduction, based on the Social Policy Simulator Database/Model produced by Statistics Canada for 1999/00, is $1.2 billion. That is, without considering the dynamic effects of tax reduction, such as supply-side efficiency gains, the amount of revenue lost through across-the-board personal income tax rate reductions would be $1.2 billion.

(2) Eliminate high-income surtaxes, now constituted by the two new top statutory tax rates.

British Columbia should immediately eliminate the high-income surtax, now present in the form of the top two personal income tax rates, in order to stimulate entrepreneurial activity, greater work effort, increased risk-taking, and innovation. Eliminating the high-income surtaxes would also make British Columbia's top marginal tax rates more competitive with those in other jurisdictions in Canada. This change could cost a maximum of $228 million in foregone revenue, based on Statistics Canada's estimates derived from the Social Policy Simulator Database/Model.

(3) 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, aiming for a target rate of 8.00 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.

(4) Immediately eliminate capital taxes.

As discussed, capital taxes are a particularly inefficient way to raise revenue. Also, their elimination would create a tax-based advantage for British Columbia given only Alberta does not assess capital taxes currently. The maximum revenue effect of such a reduction, based on FMS data for 1999/00, is $441.0 million. That is, without considering the dynamic effects of tax reduction, such as supply-side efficiency gains, the amount of revenue lost through the elimination of capital taxes would be $441.0 million.

(5) Harmonize the provincial sales tax with the GST

Although not specifically discussed in this section, there are serious problems inherent in the current provincial sales tax, chief of which is that business inputs are taxed. Harmonizing the provincial system with the federal GST and collecting it as a value-added tax would alleviate this problem and may reduce collection costs for both business and government.

(6) Introduce a strong Tax Limitation Law.

Strong Tax and Expenditure Limitation laws (referred to as TELs), as discussed in the Spending section, have proven successful in the US in stemming the growth of government and ensuring fiscal responsibility (Krol, 1996 and 1997; Stansel, 1994; Matsusaka, 1995). Both tax and expenditure limitation laws effectively constrain the ability of governments to increase either taxes or spending without popular approval. For instance, successful tax limitation laws require any tax increase to be specifically approved by referendum. Such a system has caused re-prioritizing in the US as states are forced to focus on the goods and services actually required of them, as opposed to programs driven by special-interests.

(7) Introduce a legislated program of debt reduction.

British Columbia should immediately move towards legislatively requiring 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 restricted to reducing the province's debt. This would mean that last minute, year-end spending of unexpected surpluses, as the federal government has been disposed to engage in (Clemens and Emes, 2000) would be precluded.

Long-Term Policy Recommendation

(1) Implement a broad-based flat tax.

British Columbia should immediately undertake to implement a flat tax based on the work of Professors Hall and Rabushka (See Clemens and Emes, 2001). The flat tax system should fully integrate personal and business taxes, and ensure that all sources of income are taxed uniformly at one rate, one time. A flat tax would also move the tax system in general away from the taxation of income towards the taxation of consumption, which is inherently more efficient. Such a system would facilitate economic growth and achieve the basic tenets of prudent tax policy (efficiency, simplicity, and equity). Finally, as Tax Table 6 illustrates, a flat tax could be implemented in British Columbia on a revenue neutral basis; it could be implemented without jeopardizing the amount of revenue BC currently raises, and would, in all likelihood, increase the amount of revenue raised by stimulating and encouraging entrepreneurship, risk-taking, investment, and diligence.

Fraser Institute Policy Contacts

Jason Clemens, Director of Fiscal Studies
Phone: (604) 714-4544
E-mail: jasonc@fraserinstitute.ca

Joel Emes, Senior Research Economist,
Fiscal Studies
Phone: (604) 714-4546
E-mail: joele@fraserinstitute.ca

Recommended Readings

[Note: For complete publication data, please see the list of references.]

Herbert G. Grubel (2000). Unlocking Canadian Capital: The Case for Capital Gains Tax Reform.

Herbert G. Grubel (1998). How to Use the Fiscal Surplus: What is the Optimal Size of Government?

Jason Clemens and Joel Emes (2001, forthcoming). Flat Tax: Issues and Principles.

Joel Emes and Michael Walker (1999). Tax Facts 11.

Robert E. Hall and Alvin Rabushka (1995). The Flat Tax, 2nd ed.

Robin W. Boadway and Harry M. Kitchen (1999). Canadian Tax Policy, 3rd ed.

W. Michael Cox and Richard Alm (1999). Myths of Rich & Poor. Why We're Better Off Than We Think.

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