The sky-high cost of taxes

NationalPost.com – FinancialPost.com/FPComment – Higher corporate tax rates produce less revenue
Mar 17, 2011.    William Watson

This page hardly ever recommends violence as a means to better economic policy, but if a special forces team were to kidnap the country’s finance ministers, lock them up in a mountain hideaway and not let them out again until they proved by written or oral examination that they understood the message of a new C.D. Howe Institute study on the economic costs of current Canadian levels of taxation, the country would be a lot better off.

Perhaps you read Profs. Bev Dahlby and Ergete Ferede’s summary of their study here Thursday. One problem with academics is that they sometimes hide even astonishing results under bushel baskets of dispassionate, unassuming prose. Let me say what their modesty wouldn’t allow them to: Prof. Dahlby is one of the world’s leading experts on the economic costs of taxation. He has a 2008 book on the subject from the MIT Press, which is top of the pops for economics. And his and Prof. Ferede’s findings are nothing short of stunning.

You remember the Laffer curve. Two rates of taxation are guaranteed to produce no revenue: zero and 100%. At some rate in between, revenues peak and then start declining. Now you may think governments generally need more revenues or your political philosophy may say they should get by on less. But nobody wants to get onto the wrong side of the Laffer curve, for if you do, any further increase in tax rates actually reduces tax revenues. It’s one of the few situations in economics where there really is a free lunch: You cut tax rates, which makes you everyone’s friend, and you get more tax revenue as a result.

Guess what? Dahlby and Ferede’s work on the responsiveness of provincial tax revenues to provincial tax rates shows that in 2006, the last year their study covers, four Canadian provinces, including the province that accounts for 40% of the country’s population and even more of its economy, were operating their corporate tax systems on the wrong side of the Laffer curve. Besides Ontario, the other guilty parties — “bonehead provinces” would be an equally apt term — were Saskatchewan, Nova Scotia and P.E.I. If they had reduced corporate tax rates, they would have made more corporate tax revenue.

It gets better — or worse, depending how you look at it. Even in those provinces that weren’t on the wrong side of the Laffer curve, the cost of raising an extra dollar of tax revenue using corporate taxes was ridiculously high. In Alberta, it was $40.83. In Newfoundland and Labrador, $30.31. In British Columbia, $11.64. In Manitoba, where the cost of corporate tax was lowest at the margin, it was still $2.25.

With a cost of funds at that level, good cost-benefit analysis would make you judge proposed public expenditure in a very severe light. If you were going to spend $1 of corporate tax revenue on a project, you’d have to insist that the project pay off $2.25 per dollar spent, for that’s what the $1 cost you.

The payoff needn’t be cash, of course. The returns to public spending sometimes, maybe often, come in kind. But if you’re making your decisions in a reasonable way, you’ll want the beneficiaries of the program to be benefiting by $2.25 for every dollar you spend on them. And in the other provinces mentioned, you’d want them to be benefiting by $11.64 (B.C.) or $30.31 (N.L.) or $40.83 (Alberta) per dollar. No doubt many good things are done through Alberta’s public sector, including funding Professors Dahlby and Ferede’s universities (Alberta and Grant MacEwan, respectively). But how many of these good things do you suppose are worth $40.83 per dollar spent?

In Quebec, the cost of a dollar of corporate taxes is “only” $2.57. That’s the good news. The bad news is that the marginal cost of personal income taxes is $3.85. The province last month pledged $200-million toward the cost of a new arena for Quebec City. Maybe that money will come from income taxes, maybe not. But if it does, do you suppose the benefits the province will get out of the arena will amount to $770-million? It’s hard to believe they will.

Quebec has the highest-cost personal income taxes at the margin. But nobody gets off easy. In Ontario they’re $2.16 per dollar of income raised. Do most new public projects in Ontario pay back more than double what’s spent on them? In B.C., the cost is $1.83 per dollar of revenue raised. New Premier Christy Clark seems to be an enthusiast for public initiatives. How many will pay off at $1.83 per buck invested?

What accounts for these costs? Where do they come from? Taxes cause people to change their behaviour. Tax an activity and people will do it less or, in the case of corporations, they’ll do it somewhere else. They were doing whatever it is you decided to tax because it provided benefits. If the tax kills the activity, the benefits evaporate.

Some of our tax rates are pretty high. Push them a little higher and you lose a lot of beneficial activity. (There’s also, of course, the extra administrative cost of levying and policing the tax, but Dahlby and Ferede don’t even consider that. In that sense, their estimates are underestimates.)

If you’re not already depressed enough, consider this: The federal government subsidizes all this inefficiency by compensating the provinces for the loss in tax capacity that their own fool taxes bring about. Even when the marginal economic cost of a tax is sky-high, provinces may not actually suffer very much, at least revenue-wise, as a result. Equalization bails them out.

I suppose on reflection that kidnapping our finance ministers may not be the best way to get them to absorb the lessons of this crucially important study. But at the very least they should have Dahlby and Ferede’s estimates of the marginal cost of public funds inscribed in neon on their office doors so they’re reminded of it every day they go to work.

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