The Fraser Institute: Tax Reform in Canada:  Our Path to Greater Prosperity

A Fraser Institute Conference,
October 11, 2001, Toronto, Ontario, Canada

Flat Tax: Model for Personal & Business Tax Reform

Jason Clemens and Joel Emes
with Rodger Scott¹

Introduction

The following paper is based on a comprehensive study of the flat tax published by The Fraser Institute earlier this year, entitled Flat Tax: Principles and Issues. Although this paper is focused more specifically on personal income tax reform, the flat tax is a viable model for broad-based tax reform incorporating both personal and business taxes.

This paper consists of three sections. The first summarises the problems in the current tax system vis-à-vis the traditional tax policy criteria: efficiency, fairness, and simplicity. Also contained in the first section is a review of previous economic research on the costs of increasing marginal tax rates, one of the main problems with the current personal income tax system. The second section presents an overview of the flat tax model developed by Professors Robert E. Hall and Alvin Rabushka of the Hoover Institution. The final section presents a number of flat tax alternatives to the current federal and provincial personal income tax systems.

I. Failures in the Current Tax System

The traditional evaluation criteria for tax policy are efficiency, fairness, and simplicity. Comparing today's tax system with a flat tax according to these three criteria results in a strong case for the introduction of reforms based on a flat tax. The following section summarises the failures of the current system and illustrates how a flat tax system based on the work of Messrs Hall and Rabushka overcomes such problems.

(1) Efficiency

Efficiency requires that economic distortions be minimized when taxes are imposed. That is, the tax revenues raised to finance government spending should be raised in the least distortionary manner possible.

The current Canadian tax system distorts economic decisions, that is, the allocation of resources in myriad ways. These distortions show up as tax incentives that effectively make some activities less expensive and punitive taxation which makes other activities more expensive.

For example, there are a number of tax-based distortions in the field of investments. There are a variety of investment-based tax incentive programs including ones for resource exploration and venture capital investment that effectively reduce the cost of making investments in these areas and, therefore, increases the marginal cost of making investments in other areas.

Another example of a tax-based distortion exists in the area of education. The tax system makes formal post-secondary education at an accredited university or college less expensive through the provision of tax credits. This, therefore, makes those programs which are not eligible for tax credits, such as professional and job-specific training programs more expensive. This type of tax-based distortion can lead to too many resources being allocated to formal post-secondary education and not enough resources being allocated to professional and job-specific training.

A flat tax removes all or nearly all of these tax-based programs, thus minimizing the economic distortions attributable to the tax system. A flat tax would reduce the economic distortions caused by the tax system and therefore, allow a more efficient allocation of resources.

(2) Fairness

Fairness, or what is now referred to as equity, has two components: horizontal and vertical.

Horizontal Equity

Horizontal equity requires that individuals or households with similar incomes face similar tax burdens. This means that different types of income must be treated equally—which they are not in today's system. Certain types of income, such as some work-related benefits, face no taxation while other types of income, particularly business-related income, face multiple layers of taxation.

For instance, income earned from corporate sources (i.e. equity investments) are taxed several times. The underlying investment, assuming it is an equity, is subject to corporate income tax and a variety of other taxes. The investor will then pay dividend taxes on any remittances from the corporation received in the form of dividends. The investor will also pay capital gains taxes when the asset is sold, assuming that there is a nominal gain.

The government has responded to this particular issue by reducing certain types of taxes. For example, the current top marginal tax rates for the federal government varies depending on the type of income received: 29.0 percent for interest and ordinary labour income, 14.5 percent for capital gains, and 19.6 percent for Canadian dividends (PWC 2001). The differing rates and accordant complexity were all implemented in an attempt to alleviate part of the problem associated with the multiple taxation of business-related income.

There are also biases towards two-income families and against one-income families based both on the difference between the value of the basic and spousal exemption as well as on the concentration of income coupled with increasing marginal tax rates. For example, in our analysis in Flat Tax: Principles & Issues we found that the personal income taxes of two sample families with similar incomes and similar deductions (credits) varied considerably; by $3,564 on a gross family income of roughly $55,000. That is, the family in which there was one dominant income earner paid over $3,500 more in income taxes than the family in which the income was more evenly earned. This resulted from both the difference in the value of the exemptions and more importantly from the concentration of income by one-earner who then faced higher marginal tax rates. Other studies have confirmed this bias in the tax system (See: Boessenkool 1999 and Boessenkool and Davies 1998).

Interestingly, a similar phenomenon exists in the business tax system. The amount of taxation levied on corporations can vary considerably depending on the particular industry within which the firm operates. For instance, prior to the 2000 federal budget, there were preferential corporate income tax rates applied to manufacturers and processors. Also, many provinces still maintain this preferential tax treatment. This tax-based bias is further exacerbated when capital taxes are included. Thus, two firms with similar incomes, profitability, and assets can bear significantly different tax burdens depending on their industry and province of operation.

Another benefit of a flat tax is that it ensures that income is taxed once and at a uniform rate by fully integrating personal and business income. In other words, regardless of where households receive their income, they will face similar income taxes when their incomes are proximate. A more detailed assessment of the effect a flat tax has on families with similar incomes is contained in Flat Tax: Principles and Issues.

Vertical Equity

The second component of fairness is vertical equity, which requires that individuals pay more tax as their incomes increase. Unfortunately for Canadians, this is achieved through progressively higher marginal tax rates. Table 1 summarises the current federal statutory personal income tax rates and the thresholds at which they apply.

Not only do individuals and families pay more tax as their incomes increase (vertical equity), but they also pay more tax as a percentage of their incomes (progressivity).

One of the consequences of de-linking the federal and provincial income tax systems is that there are now differing thresholds among some jurisdictions. This has the effect of increasing the degree of marginality in the income tax system in some provinces. Table 2 summarises the combined federal and provincial statutory tax rates and the applicable thresholds for the province of British Columbia.

Economic Effects of High & Increasing Marginal Tax Rates

When deciding whether to work an additional hour, to increase one's human capital through education, or to invest one's savings, the tax rate most important to an individual or business is the marginal tax rate. It matters most because it directly affects the proportion of increased income that can be kept. The higher the marginal tax rate, the lower the return to productive activity and, thus, the lower the incentive for the individual, family, or business to engage in the additional productive activity.

The folly of demanding higher marginal tax rates for those in the upper income brackets is that this effectively erects disincentives for the most productive members of society. In so much as this reduces the economic growth that benefits all members of society, increases in tax rates can eventually result in all of us being worse off than we might otherwise have been.

The following is a brief overview of studies investigating the negative economic effects of high and increasing marginal tax rates.

• Gruber and Saez (2000): The finding of the study is that for each of the tax-spending cases investigated, the optimal structure of marginal tax rates should be declining as you move up from lower to higher income brackets. In other words, the marginal rates of taxation should be relatively higher for low-income earners and relatively lower for high-income earners. Given the behavioural responses of individuals, the authors conclude that in order to maximize social welfare "the optimal tax system should feature declining (or at least not increasing) marginal rates..."

• Sillamaa and Veall (2001): This paper used panel data to investigate the effects of the 1988 flattening of marginal tax rates in Canada. The study concluded that the responsiveness of income to changes in marginal taxes is smaller in Canada than in the US. However, the authors also found evidence of a much higher response in self-employment income and in the labour income of seniors and from those with high incomes.

• M. Feldstein (1995): Using data from the 1986 tax reform in the US, Feldstein concludes that "a decrease in marginal tax rates causes not only an increase in labour supply (broadly defined), but also a shift in the form of compensation and a reduction in deductible expenses... Taxable income therefore rises substantially more than aggregate hours." He also concluded that capital gains realizations are far more sensitive to tax rates than had been assumed by government agencies.

• M. Feldstein and D. Feenberg (1995): This paper assesses the economic effects of increasing the former top statutory tax rate from 31 percent to 36 percent and the introduction of a new top rate of 39.6 percent at $250,000 in 1993 in the United States. The study concludes that high-income taxpayers would have reported 7.8 percent more taxable income had the tax rates not been increased. The decline in taxable income for these groups caused the Treasury to lose more than half the extra revenue that would have been collected if taxpayers had not changed their behaviour. In fact, the deadweight loss associated with the higher marginal tax rates (including the labour supply effect) was estimated at roughly twice the $8 billion in revenue raised by the tax increase.

• Carroll, Holtz-Eakin, Rider, and Rosen (1998): The Carroll et al study investigated the effects of high marginal tax rates on capital formation. The study found that "a 5 percentage point rise in marginal tax rates would reduce the proportion of entrepreneurs who make new capital investment by 10.4 percent. Further, such a tax increase would lower mean capital outlays by 9.9 percent." In other words, an increase in marginal tax rates results in less investment by entrepreneurs and subsequently less aggregate capital formation.

• Gustavo Ventura (1999):   Ventura concluded that the elimination of taxes on capital, based on a Hall-Rabushka type tax reform, would have a positive effect on capital accumulation and that aggregate labour supply, measured in efficiency units would increase.

• Koester and Kormendi (1989): This study isolated marginal tax effects from average tax effects. They found that after controlling for average tax rates, increases in marginal tax rates had negative effects on the level of economic activity. In other words, reducing the "progressivity" of the tax system while allowing the government the same tax revenue (measured as a percent of GDP) led to higher levels of national income.

• Mullen and Williams (1994):  This paper used similar methods employed by Koester and Kormendi (1989) using state-based data in the United States to assess the relationship between marginal tax rates and growth in the capital stock and labour force. They concluded that "lowering marginal tax rates can have a considerable positive impact on growth . . . creating a less confiscatory tax structure, while maintaining the same average level of taxation, enabling sub-national governments to spur economic growth."

• F. Padovano and E. Galli (2001): This study adjusts the underlying data used in previous studies to properly specify marginal tax rates across income groups and different countries. After doing so, the authors conclude that high marginal tax rates and tax progressivity are negatively correlated with long-run economic growth.

• Becsi (1996): Becsi, again using a method similar to that of Koester and Kormendi (1989), derived marginal tax rates for the U.S. states to assess the relationship between marginal tax rates and economic growth. He found that differences in marginal tax rates across states have a statistically significant effect on relative economic growth rates.

• J. Long (1999): This study assesses the relationship between marginal tax rates and taxable income across US states. It concludes that an increase in the marginal tax rate reduces taxable income. It also concluded that high-income taxpayers were much more responsive to tax rate changes than lower-income individuals.

• Engen and Skinner (1996): This study reviewed previously completed research investigating marginal tax rates and economic growth. They concluded that "a major tax reform reducing all marginal rates by 5 percentage points, and average tax rates by 2.5 percentage points, is predicted to increase long term growth rates by between 0.2 and 0.3 percentage points." While this may appear small, the cumulative effective can be enormous. They speculated that if a less efficient tax structure had been in place in the United States from 1960 to 1996, the amount of output currently lost would have totalled more than $500 billion annually or 6.4 percent of 1996 GDP.

Given the improvement in available data sets and the deepening collection of empirical analysis regarding marginal tax rates, it is increasingly clear that high and increasing marginal tax rates impede capital formation, retard economic growth, hinder per capita income growth, and constrain aggregate labour supply, as measured in efficiency units. This is a rather high price to pay for vertical equity and progressivity, which could be achieved with a flat tax.

A major advantage of a flat tax is the manner in which it achieves vertical equity and progressivity. By including a personal (and spousal) exemption, a flat tax ensures that as individuals and households earn more, they also pay more in taxes (vertical equity). In addition, the percentage of income paid in taxes increases as the earnings of the household increase, achieving progressivity. However, by eliminating increasing marginal tax rates, a flat tax avoids many, if not all of the costs outlined in the literature reviewed above, namely, lower economic growth, reduced savings and investment, and lower aggregate labour supply. Put differently, a flat tax can achieve vertical equity and progressivity while at the same time maintaining incentives for hard work, savings, investment, risk-taking, and innovation—all of which Canada needs more of.

(3) Simplicity

The final criterion, simplicity, refers to the ease to which citizens can comply with the tax code and the costs associated with said compliance. Put differently, simplicity requires that the administrative and compliance costs associated with a tax system be minimised. The various tax forms and regulations in Canada have spurred an entire industry of tax accountants, lawyers, and planners who do nothing but attempt to legally reduce their clients' tax bills.

The costs associated with the current system imply that the tax system is far from simple. Much of the recent work completed on administrative and compliance costs associated with taxation have focused on business taxes. Robert E. Plamondon and David Zussman (1998) estimate that compliance costs for Canadian businesses were $3.4 billion per year in 1996. This is actually the midpoint estimate between $2.3 and $4.5 billion. The midpoint estimate represented 2/5 of 1 percent of GDP or 1.5 percent of total tax revenue in 1996.

Two studies completed by Professor Brian Erard of Carleton University for the Technical Committee on Business Taxation (otherwise referred to as the Mintz Commission) provide estimates of business compliance costs that buttress the Plamondon and Zussman estimates. One of Erard's studies showed that the burden for the 500 largest non-financial corporations in Canada in 1995 was $250 million, or about 5 percent of total taxes paid (Erard 1997a).

Professor Erard's second study for the Mintz Commission confirmed that many small and medium-sized businesses feel overwhelmed by the compliance requirements associated with Canadian taxation. In fact, the central finding of the study was that the vast majority of small and medium-sized enterprises relied on outside professional assistance to comply with the tax system and that the principal compliance cost identified by these businesses were fees paid to said professionals (Erard 1997b).

Some estimates of the administrative and compliance costs of taxation for individuals have been completed. In a major study for the Canadian Tax Foundation, Francois Vaillancourt (1989) calculated administrative and compliance costs for individuals. For the 1985 tax year, Vaillancourt concluded that the average taxpayer spent 5.5 hours completing tax returns or spent roughly $69 (1985 dollars) to have a professional complete the tax return. He then included other related costs to arrive at a total per taxpayer cost of $117.20 (1985 dollars) in administrative and compliance costs. This translates into roughly $1.8 billion in administrative and compliance costs for 1985 for individual taxpayers. Although somewhat dated, the study provides an important foundation for understanding the extent of costs associated with the personal income tax system.

Finally, there is cost of collection by government. The Fraser Institute recently estimated regulatory costs in Canada including the cost of tax collection. In the most recent assessment of regulatory costs, it was estimated that the federal government alone spent some $2.6 billion in 1997/98 to collect taxes and other sources of revenue (Jones and Graf 2001).

Simplifying the tax system is a central part of flat tax reform. By removing most exemptions and nearly all deductions and tax credits, flat tax reform significantly simplifies the tax system and the accordant administrative and compliance costs. Further, flat tax reform simplifies the tax system and lowers administrative costs by eliminating any differential treatment of income by type. In other words, in a flat tax system, there is no benefit in declaring income as one type or another since all income is taxed once and at the same rate.

II. The Hall-Rabushka Model

This section provides a brief overview of the flat-tax reform proposed by Professors Robert E. Hall and Alvin Rabushka, both of the Hoover Institution. The tax reform developed by Hall and Rabushka is based on a single rate of taxation for all sources of income and represents a fundamental change from the way governments currently collect tax revenue. The proposal achieves simplicity, economic efficiency, and fairness, the traditional measures of effective taxation, while collecting the necessary revenues required to finance government.  Those wishing to peruse the proposals of Hall and Rabushka in greater breadth and detail will find their works on the Internet at the Hoover Institution (www.hoover.org) and the American Enterprise Institute (www.aei.org) as well as in most major bookstores and libraries.

Differentiating the Flat Tax from the Canadian Alliance and Alberta's Single-Rate Tax

In discussing Canadian tax reform, it is important to recognize the stark difference between reform based on a flat tax and the replacement of multiple tax rates with a single tax rate. The reforms to personal income tax announced in the Province of Alberta in 1999 replaced the multiple tax rates applied to personal income with a single tax rate. Similarly, the tax reform recently proposed by the Canadian Alliance would replace the multiple federal statutory personal income tax rates with two rates initially, and, near the end of their first mandate, with one rate. However, the replacement of multiple tax rates with a single rate is but one step in the process of broad-based tax reform based on a flat tax model.

Hall-Rabushka Flat Tax

The foremost proposal for a flat tax is also one of the earliest: Professors Robert E. Hall and Alvin Rabushka first proposed a comprehensive flat tax in 1985 and their proposal has subsequently formed the basis for a host of others.

One of the essential aspects of Hall-Rabushka is that income of all types should be taxed once and only once. Under the current system, in both the United States and in Canada, certain types of income, such as some fringe benefits, are not taxed at all, while other sources of income such as dividends and capital gains are taxed more than once or at differing rates.

The other essential aspect of Hall-Rabushka is that income should be taxed uniformly, with no rate differentials between different types of income. In other words, income from dividends, or wages, or benefits should be taxed at the same single rate. In the case of the United States, Hall-Rabushka recommends replacing the then current 5 personal federal rates (15%, 28%, 31%, 36%, and 39.6%) and the various business tax rates with one single, 19% federal tax rate.

Personal Income Tax

One frequently overlooked aspect of Hall-Rabushka is its rejection of alternative taxes such as a national sales tax or a value-added tax. Both scholars reject the alternatives because of the difficulty of exempting lower-income individuals and families from taxation. Under Hall-Rabushka a significant number of lower-income families pay absolutely no income tax. In fact, under Hall-Rabushka the exemption for a family of four in 1995 was $25,500 (CDN$32,986). In other words, a family of four with total income less than US$25,500 would pay no income tax and families with income above the exemption would pay 19 percent on the amount in excess of the exemption.

While the most significant reforms under Hall-Rabushka occur in taxation of corporate or business income, reforms are nonetheless present for personal income tax. Under Hall-Rabushka, only wages, salaries, and pension benefits are deemed personal income and subject to personal income tax. Income from dividends, capital gains, interest, or fringe benefits are not subject to personal income tax because they are already taxed at the corporate or business level. Recall that, under Hall-Rabushka, whether income is taxed at the personal or business level is irrelevant since all income is taxed at the same rate.

The phrase "postcard-size tax returns" was coined partially in connection with the Hall-Rabushka plan. Individuals and families would simply sum their income from wages, salaries, and retirement benefits and subtract the personal exemption to calculate their taxable income. This amount is then multiplied by one rate (19 percent) to determine the individual or family tax bill for the year. The amount withheld is then compared to the amount owed to calculate whether a refund is due from, or a payment is owing to, the federal government.

This system has no tax credits, deductions, or additional exemptions and the type of income is irrelevant. In other words, the myriad of tax credits, deductions, and different tax rates on different types of income present in the current systems and the attendant complicated and time-consuming paperwork are eliminated under Hall-Rabushka.

Business Income Tax

Another important aspect of Hall-Rabushka and, indeed, most flat-tax proposals, is that they offer an integrated approach to tax reform. That is, they aim to reform not only personal income tax but also corporate or business income tax. Hall-Rabushka assesses tax on all business income after deducting the cost of inputs, salaries, wages, pensions, and investment in plant and equipment.

Although the corporate tax rate is lowered in order to satisfy the requirement for one rate of taxation, more revenue is generated by broadening the tax base through the elimination of tax-based incentives for business, taxing certain benefits that currently escape taxation, and removing interest deductibility.

Hall-Rabushka precludes businesses from deducting the cost of interest, dividends, fringe benefits, and any other payments to owners as expenses. The rationale for excluding these types of deductions and, thus, forcing the business to pay tax on them is to ensure that they are taxed only once. The income individuals and families receive from business is exempt from personal taxation because it has already been taxed at the corporate or business level. Hall-Rabushka is, therefore, a comprehensive tax system that assesses all types of income equally and singularly.

Interest Deductibility and Depreciation Expenses

Two of the major reforms in Hall-Rabushka are the exclusion of interest costs and depreciation expenses as deductible expenses. Interest income is no longer deemed to be taxable income for individuals or families under Hall-Rabushka because it is taxed as business income. This fundamental change in the way businesses are taxed eliminates the preferential treatment accorded debt relative to equity financing. Currently, payments based on debt instruments, such as bonds, are tax deductible while payments based on equity investments, such as dividends, are not. By eliminating interest payments as tax deductions, Hall-Rabushka eliminates the preferential treatment of debt. This is one of the many economic efficiencies gained under Hall-Rabushka.

Perhaps the largest single reform under Hall-Rabushka is the elimination of depreciation expenses. Businesses are currently able to write-off, or deduct, the cost of investing in new plants and equipment on an incremental basis. That is, each year over a period determined by government, business is permitted to deduct a percentage of the total cost of purchasing plants and equipment. Under Hall-Rabushka, the entire cost of investment (plant and equipment) is deducted as an expense in the year of purchase. Thus, depreciation schedules and the bureaucracy necessary to interpret them (accountants and lawyers) and to enforce them (government revenue officials) are eliminated or, at least, reduced in number. There would be no conflict over whether the purchase of certain types of equipment are investments or expenses since Hall-Rabushka considers all such expenditures as expenses.

Focus on Consumption

One of the main, though often overlooked, benefits of Hall-Rabushka is that it effectively moves income tax away from a tax system based on income towards one based on consumption. Economists generally agree that the taxation of consumption is the most efficient manner in which to raise tax revenue (Jorgensen & Yun 1991; Kesselman 1997; Grubel 2000; OECD 1997; and Kneller, Bleaney, and Gemmell 1999). Hall-Rabushka creates a tax system based on consumption by excluding all investment activities from the tax base.² In essence, a consumption tax is levied on any income that is consumed, that is, spent rather than saved. The exclusion of savings (investments) under Hall-Rabushka also enables it to eliminate the heavy taxation of returns to savings. Thus, not only are efficiencies gained by moving towards a more effective base of taxation (i.e., consumption) but considerable incentives are created for increased savings and the formation of capital.

Economic Considerations

There are a number of important economic considerations associated with the implementation of Hall-Rabushka beyond achieving simplification in the tax system, which normally receives the most publicity. The net economic effect of the reforms proposed by Hall-Rabushka include improved incentives for work, increased entrepreneurial activity, and greater formation of capital, leading to a substantially higher level of national output and standard of living.

Various aspects of the proposals included in Hall-Rabushka would lead to increases in the efficiency of capital formation. Although the current system sustains a relatively high level of capital formation, it does so by providing a number of tax-based incentives in the form of tax credits and subsidies that tend to redirect capital to less efficient uses. Specifically, the current system promotes debt-financed investment by permitting interest deductibility while penalizing equity-financed investment through double taxation of dividends and capital gains. The net result is less entrepreneurial activity and greater debt-financed (lower risk) investment. Auerbach and Kotlikoff (1987; cited in Hall-Rabushka) estimate that a flat tax would increase the ratio of capital formation to GDP from 5.0% to 6.2% and, as a consequence, increase GDP by between 2 and 4 percent within seven years.

There are also strong incentives for individuals to increase their work effort. Hall-Rabushka completely eliminates the effect of increasing marginal taxes except for the initial level at which taxation begins. That is, as individuals attain skills and begin to advance in the labour force, they do not face increasing rates of taxation. There is, therefore, no marginal disincentive to work harder and succeed as exists in the current system. Hall and Rabushka estimate that GDP will increase by approximately 3 percent simply due to the elimination of disincentives for work.

Finally, Hall and Rabushka conclude that there would be downward pressure on interest rates within a flat-tax regime. They specifically cite the 1/6 percentage point (17 percent) interest-rate differential present between tax-exempt municipal bonds and comparable taxable bonds. Evidence derived from their analysis suggests that interest rates would be lowered by roughly 25percent. The reduction in interest rates would have a significant effect on the housing and investment market.

We have not, by any means, given a full description and assessment of Hall-Rabushka. However, it is important to note the comprehensive nature of this proposal and the far-reaching economic improvement that it offers. Hall and Rabushka present a clear, concise, and effective proposal for reform of taxation on personal  and business income. They offer a road map for tax reform that increases simplicity, efficiency, and fairness in the tax system.

III. What Would a Flat Tax Look Like in Canada?

Using Statistics Canada's Social Policy Simulation Database and Model (SPSD/M), we calculated nine different flat tax scenarios for the personal income side of the tax ledger. Unfortunately we were not able to calculate integrated personal and business income estimates due to the restrictions of the SPSD/M. It is important, however, to recognise that the Hall-Rabushka model includes both personal and business income while the proceeding estimates are inclusive of personal income only.

A lengthy and detailed discussion of each of the flat tax cases is presented in the main paper, available on the Internet at www.fraserinstitute.ca. However, there are some observations which are worth noting in this overview. First, assuming a simplified system with only personal, spousal, and child deductions, the federal flat tax rate would be 18.3 percent while the provincial average would be 10.3 percent. This implies an average personal income tax rate of 28.6 percent. As detailed in the distributional table of the main study, all income groups earning above $50,000 receive a tax reduction while those earning between $10,000 and $50,000 experience a marginal increase.

The inclusion of an RRSP/RPP deduction, which would effectively create a consumption-based tax system, increases the federal rate to 19.9 percent and the provincial average rate to 11.1 percent, implying an average federal-provincial flat tax rate of 31.0 percent. Again, those earning in excess of $50,000 a year experience a net reduction in their taxes while those earning between $10,000 and $50,000 experience a marginal increase in their taxes. It is important to note the inclusion of an RRSP/RPP deduction represents a tax deferral as opposed to a current tax expenditure, implying that the long-term tax revenue collection of the government would not be affected (See ACPM 2000).

Increasing the basic and spousal exemption, as presented in cases 8 and 9 results in an across the board decrease in personal income taxes paid for all income groups. Both cases represent a fairly simple system—basic and spousal exemption of $11,834, child exemption of $2,000, and current RRSP/RPP deductibility—but are coupled with tax and expenditure reductions at the federal level. In other words, the increase in the basic and spousal exemptions are financed through a moderate (case 8) and a substantial (case 9) tax and expenditure reduction.

As suggested by Messrs Hall and Rabushka, the system should remain as "clean" as possible, avoiding the introduction of additional exemptions, deductions, and tax credits. In particular, caution is made of making exceptions for specific programs or requirements since such initiatives are seen as the beginning of a slippery slope to a complex, inefficient, and unfair tax system (See the discussion of case 7 in the main paper for more details and a discussion of this topic).

Competitive advantages of a flat tax

In addition to the reasons listed above, there are also relative or competitive reasons for adopting tax reform based on a flat tax. Canada is currently searching for ways to be more competitive with the US. When it reduced taxes last year, the federal government stated that one of its reasons for doing so was to make our rates more competitive with those in the US.

Apparently the government ignored the possibility of completely overhauling our tax system—that is, the way in which we collect taxes—to create a competitive advantage over the United States. Currently, there are some 740 different tax forms in the US with 250 or so publications explaining the forms. The US Tax Foundation estimates that Americans spend about 4.3 billion hours a year filling tax forms at a cost to the economy of $125 billion. The recent Senate approval of the Bush tax plan (slightly amended) will only worsen the complexity of the tax system³ (du Pont, 2001).

In fact, amendments made by the Senate to the Bush tax proposal will actually steepen the marginal nature of personal income tax rates in the US. Instead of flattening the personal income tax rates, the Senate amendments create an additional tax bracket, increasing the total number of brackets from 5 to 6: 10 percent, 15 percent, 25 percent, 28 percent, 33 percent, and 35 percent⁴ (Deloitte and Touche). This change will likely worsen the negative economic effects of increasing marginal tax rates.

The complexity of the US tax system provides Canada with a unique opportunity to establish a real economic advantage over our neighbours. By reforming our tax system, specifically by implementing a flat tax based on the Hall-Rabushka model, Canada could greatly simplify its tax system and achieve the three traditional criteria for effective tax policy, and in doing so, establish an administrative advantage over the US tax system. If Canada were to actually combine significant tax reductions with the tax reform suggested we may even achieve an economic advantage.

Conclusion

The fairest, most efficient, and simplest tax system upon which to base reform of the Canadian tax system is a flat tax. Such a system would provide enormous positive incentives for hard work, savings, and investment. The evidence suggests that the economic benefits of implementing a flat tax system would include greater rates of economic and income growth, higher levels of capital formation and investment, and greater social welfare.

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