Canada: Economic Developments and Policies

This paper examines economic developments and policies in Canada during 1990–95. Spurred by the robust growth in the United States and the easing of monetary conditions between 1991 and 1993, economic growth in Canada continued to strengthen during 1994. Real GDP grew by 4.5 percent in 1994 after growing by 2.2 percent in 1993 and 0.6 percent in 1992. Economic growth in 1994 was led by exports and investment in machinery and equipment. However, growth was more broadly based in 1994; private consumption strengthened, and there was a rebound in residential and nonresidential construction.

Abstract

This paper examines economic developments and policies in Canada during 1990–95. Spurred by the robust growth in the United States and the easing of monetary conditions between 1991 and 1993, economic growth in Canada continued to strengthen during 1994. Real GDP grew by 4.5 percent in 1994 after growing by 2.2 percent in 1993 and 0.6 percent in 1992. Economic growth in 1994 was led by exports and investment in machinery and equipment. However, growth was more broadly based in 1994; private consumption strengthened, and there was a rebound in residential and nonresidential construction.

XII. The Federal Goods and services Tax 1/

The Goods and Services Tax (GST)--a federal value-added tax--was introduced in 1991. However, certain shortcomings of the GST have led the Federal Government to begin negotiations with the provinces on the possible introduction of a new value-added tax, involving either a harmonization with, or a replacement of, existing provincial sales taxes. This note provides a brief overview of the GST, including the reasons for its introduction, the problems associated with its operation, and the options for its replacement now under consideration.

1. Sales tax reform: replacing the FST with the GST

The GST was introduced on January 1, 1991 as the second stage of a tax reform process, which was initiated in 1987 with a reform of the personal and corporate income tax systems. The GST replaced the Federal Sales Tax (FST), which was viewed as having a number of defects, including: 2/

  • (i) The FST was levied only on manufactured goods, which represented only about one third of final consumption of goods and services. The base had been further narrowed by the introduction of an abundance of special provisions and exemptions, as well as by tax avoidance by firms. 3/ As a result, the FST’s yield was relatively inelastic and was maintained largely by repeated rate increases amounting to a cumulative 50 percent during the 1980s.

  • (ii) The fact that about half of the revenue from the FST came from taxes on business inputs meant that it was highly distortionary. Because some goods were subject to multiple taxation, depending on the number of intermediate stages in the productive process, a wide range of effective tax rates resulted.

  • (iii) The FST tended to discourage exports, even though they were nominally exempt from the tax, since drawbacks could not be claimed on the tax paid at earlier stages of production. 4/ The FST also tended to favor consumption of imported goods since the tax was levied only on the landed value, which generally did not include any marketing or distribution costs in Canada. Since Canadian manufacturers often had to include these costs in their FST base, the effective tax on domestic products was estimated to be about one third higher on average than on competing imports.

The GST is a multistage value-added tax applied at the rate of 7 percent on most goods and services consumed in Canada. 1/ Basic groceries, agricultural and fish products, prescription drugs, medical devices, and exports are zero rated, i.e., final purchasers of these commodities pay no tax while producers are able to recover the tax paid on inputs. Residential rents, health care, financial, educational, legal-aid, and day-care services are all tax-exempt, i.e., purchasers pay no tax, but producers cannot recover taxes paid on inputs. 2/ To ease the burden on low-income consumers, a tax credit is provided through the income tax system. Several simplified reporting options were provided to small businesses to reduce their compliance costs. 3/

2. Problems with the GST

The introduction of the GST was very unpopular. 4/ Bird et al. argue that the GST’s unpopularity stemmed from the fact that the FST was hidden, embedded in the prices of the goods, while the GST was extremely visible. 5/ Moreover, the fact that GST was applied to a broad range of activities that previously had not been taxed, and that it was introduced at a time when Canada was experiencing an economic recession, added to public resentment. As a result, the GST is thought to have caused a substantial increase in the amount of tax avoidance and in the size of the underground economy. 3/

In the spring of 1994 the Standing Committee on Finance in the House of Commons reviewed the operation of the GST and investigated possible alternatives for its replacement. The Committee’s report focussed on the large compliance costs under the GST and concluded that although the GST contained features designed to reduce compliance costs, small-and medium-sized businesses (comprising 90 percent of the registered businesses) suffered from extensive collection problems and costs. The report suggested that these were largely the result of a lack of harmonization between the federal and provincial indirect tax systems. Businesses are required to comply with two overlapping systems, each with different tax bases, rates, formulas for calculation, and reporting requirements. 2/ 3/

Deficiencies in the GST’s design also contribute to elevated compliance costs. The GST’s tax base, although larger than that of the FST, still includes only about two thirds of consumer expenditures. Because so many goods and services are excluded from the tax base under an extensive set of complex rules, compliance costs for small businesses are relatively high. 4/

In a study commissioned by the Department of Finance, it was estimated that compliance costs were significantly higher for smaller firms than for larger firms. For example, the cost for firms with revenues under $100,000 was 17 percent of taxes remitted or 0.3 percent of average revenues. 5/ By contrast, compliance costs for firms with revenues over $1 million were only about 3 percent of taxes remitted and 0.06 percent of average revenues. 1/

The cost of administering the GST is also considered high. Revenue Canada estimated that in FY 1992/93 administration costs were approximately 3 percent of revenues. This was substantially higher than OECD estimates of administrative costs in the United Kingdom (1 percent of revenues) and New Zealand (1/2 percent of revenues). However, it also should be noted that these ratios are naturally sensitive to the amount of tax collected, and that the United Kingdom and New Zealand have tax rates about twice that of the GST. 2/

3. Alternatives to the GST

The Finance Committee noted five alternatives that were in some respects attractive alternatives to the GST: (i) an income tax surtax, (ii) an income-based flat tax, (iii) a formal exchange of tax bases with the provinces--in which the Federal Government would give the provinces full responsibility for sales tax in exchange for an equivalent reduction in provincial income tax receipts, (iv) a personal expenditure tax (PET), and (v) a business transfer tax (BTT). 3/

The Committee noted a number of drawbacks to each of these alternatives. For example, there was concern that the first three alternatives would imply a substantial increase in the share of government revenue from income taxes, which would not be advisable from a risk allocation standpoint. The Committee was also concerned that administrative and compliance costs of the PET and BTT would not be any lower than for the GST, and that the transition costs could be high and disruptive. In addition, a PET had yet to be adopted elsewhere in the world so that its effectiveness was difficult to gauge.

As a result of these concerns, the Committee recommended that the Government pursue a federal-provincial integrated value-added tax, preserving the beneficial aspects of an invoice-credit VAT, while trying to reduce the costs of compliance for smaller businesses and consumers.

4. Federal and provincial GST reform proposals

Following on this recommendation, the Government has proposed the adoption of a national value added tax at a rate of 12 percent. Of this amount, 7 percentage points would represent the provinces’ share of revenue, and the remaining 5 percentage points would go to the Federal Government. Given that the current GST rate is 7 percent, the Federal Government would make up the loss of revenue by raising excise taxes and by introducing a flat tax on personal incomes at a rate of about 0.8 percent. The federal proposal could imply revenue losses to the provinces since their sales taxes (especially in Ontario) rely heavily on the taxation of business inputs (which are not subject to taxation in a value-added tax system). To accommodate concerns in this regard, the Government’s proposal would phase in the ability of businesses to apply for credits for the tax paid on business inputs. 1/

In October 1994, Ontario proposed instead that the provinces would vacate the sales tax field altogether, allowing the Federal Government to implement its reform as it chooses. In exchange, the Federal Government would give up an equivalent amount of room in the income tax field, as well as give provinces the power to make changes to the income tax base. The differences between the federal and provincial proposals have yet to be resolved.

5. Concluding discussion

While the GST contains a number of important flaws, the elimination of the federal value-added tax (as some have suggested) does not seem a practical alternative. This would require a heavier reliance on excise and income tax systems, with adverse implications for the tax system’s economic efficiency and horizontal equity. Thus, the best possible alternative to the GST would seem to be a national value-added tax.

Ontario’s proposal also would eliminate the problem of overlapping sales tax systems. However, allowing the provinces flexibility in determining their income tax base would tend to introduce differences in income tax regimes across provinces. Thus, the appropriateness of achieving a harmonized sales tax system at the expense of a harmonized income tax base is open to question.

The federal reform proposal has the merit of alleviating many of the problems associated with the overlapping federal and provincial tax systems. However, the proposal would not necessarily reduce the complexity of the GST itself, since these stem from the large number of GST exemptions. Thus, if this approach were to be pursued, it would seen preferable to make up losses in federal GST receipts by broadening the base of the national value-added tax rather than a new flat tax. This would enable a reduction in compliance and tax administration costs, as well as tax evasion, and would likely improve the economic efficiency of the tax system. 1/

1/

Prepared by Trevor Alleyne.

2/

See Department of Finance, Goods and Services Tax: An Overview, (Ottawa: August 1989).

3/

By 1990, there were 22,000 special provisions and administrative arrangements that applied to the FST, which was collected from a total of only 75,000 firms.

4/

It has been estimated that the FST added roughly 1 percent to the sales price of exports.

1/

The GST uses the invoice-credit method of calculation, in which each individual transaction is accounted for at each stage of the production and distribution process. Since each business collecting the tax also receives input tax credits for the GST it has paid out, the tax is effectively levied on the final consumer.

2/

Goods sold to charities, nonprofit organizations, municipalities, universities, schools, and hospitals are partially tax-exempt, in that suppliers can claim rebates on a portion of the taxes paid on purchased inputs.

3/

Firms with annual taxable sales below $30,000 were exempt from charging the tax; firms with sales less than $200,000 could use the “quick method” of computing net GST remittances, i.e., either 2 1/2 percent or 5 percent of their GST-taxable sales, depending on whether they were goods vendors or service suppliers; firms with taxable sales under $500,000 could use the quick method of calculating their input tax credits, i.e., 7/107 of all GST-taxable purchases, and could file annual GST returns (compared with firms with sales between $500,000 and $6 million that had to file quarterly returns and firms with sales over $6 million that had to file monthly.

4/

The Report of the Standing Committee on Finance that reviewed the GST concluded “It is difficult to call to mind a tax that has been as broadly and deeply resented by Canadians as the GST--nor one where the bitterness has lasted so long. See Standing Committee on Finance, Replacing the GST: Options for Canada (Ottawa: June 1994), p. 13.

5/

R. M. Bird, D. B. Perry, and T. A. Wilson, “Tax Reform in Canada: A Decade of Change and Future Prospects,” Discussion Paper No. 1, International Centre for Tax Studies, University of Toronto (November 1994), p. 32.

1/

In a 1994 survey by KPMG/Peat Marwick Thorne, 49 percent of those surveyed said that they might avoid the GST by having work done for cash; also, 32 percent found GST evasion mildly acceptable, compared to 19 percent for income tax evasion.

2/

A statement by the Tourism Industry Association of Canada to the Finance Committee contained the following summary, “Depending on what you buy, I tax you either 0%, 5%, 7%, 8%, 12%, 15%, 17%, and it may be non-refundable, partially refundable, or totally refundable” (See Standing Committee on Finance, p. 18.)

3/

The Government had initially sought to have the provinces harmonize their taxes with the GST but was unable to achieve a provincial consensus, and opted to proceed unilaterally with the GST.

4/

Bird, et al. (p. 36) criticized the design of the GST as “an uneasy compromise between political expediency and conceptual perfectionism” in which the Government sought to temper popular opposition by exempting a large number of goods and services, but at the same time, endeavored to provide intricate rules outlining the conditions for such exemptions. See also Standing Committee on Finance (p. 16).

5/

See Plamondon & Associates, Inc., GST Compliance Costs for Small Business in Canada: A Study for the Department of Finance. Tax Policy (1994), p. 51. The study also found that almost half of the eligible participants in their survey had not heard of the Quick Method reporting mechanism. Also, survey participants who qualified for the new method of calculating input tax credits (i.e., 7/107 of taxable purchases) expected that this method would reduce their compliance costs by 15-20 percent.

1/

However, compliance costs for small firms in Canada compare very favorably with those for similar-sized firms in New Zealand, whose costs are 1.6 percent of average revenues. See C. Sandiford, and J. Hasseldine, The Compliance Costs of Business Taxes in New Zealand, Institute of Policy Studies, Victoria University of Wellington (1992).

2/

OECD, Taxing Consumption (Paris, 1988)

3/

See Standing Committee on Finance, pp. 12-38. A PET is applied to the difference between income and savings (i.e., “expenditure”) for each individual on a periodic basis. In theory it has the same tax base as a value-added tax like the GST. A BTT is a subtraction-method VAT that would be applied to the difference between business revenues and purchases of business inputs.

1/

See Department of Finance, Sales tax Reform: An Updated Federal Proposal (Ottawa: October 14, 1994).

1/

The Finance Committee estimated that eliminating exemptions would mean that the GST tax rate could be lowered to 5 1/2 percent (instead of the current 7 percent) in order to raise an equivalent amount of revenue.