Abstract
This paper documents two aspects of Canada’s regional diversity and compares the results with those across U.S. regions. Although gradually converging, Canadian provinces exhibit a considerably diverse economic structure. The paper suggests that the reduction in macroeconomic volatility in Canada after the introduction of inflation targeting is largely attributable to the reaction of the private sector to the establishment of a credible monetary policy framework. Reduction in personal income taxation provides considerably larger efficiency gains than a reduction in the effective Goods and Services Tax (GST).
III. Efficiency Gains from Reducing the GST Versus Personal Income Taxation in Canada6
1. We assess the efficiency gains from reducing the Goods and Services Tax (GST) versus personal income taxation using the IMF’s Global Fiscal Model (GFM).7 As a multi-country dynamic general equilibrium model with rigorous micro foundations, GFM is specifically designed to explore fiscal policy issues. For the purpose of this paper, we assume that Canada has fiscal space to reduce taxes as a result of a reduction in lump-sum transfers from the government to households. We assume that this space would allow for a reduction in the effective GST by 1 percentage point.8
2. A reduction in personal income taxation provides considerably larger efficiency gains than a reduction in the effective GST.
A reduction in the GST by 1 percentage point generates only modest gains in potential output as the increase in purchasing power leads predominantly to higher consumption (Figure 1). On the other hand, a reduction in the personal income tax (PIT) rate has a stronger effect on private saving by stimulating incentives to invest (Figure 2).
There is also a considerable difference in timing. The effects of a GST reduction impact immediately on consumption and then decline over time, whereas the gain in potential output is larger but takes longer to materialize, given that investment is subject to adjustment costs.
Macroeconomic Effects of a Reduction in the GST1
(Deviation from initial steady state in percent of GDP unless otherwise noted)
Citation: IMF Staff Country Reports 2006, 229; 10.5089/9781451807004.002.A003
Source: GFM simulations.1 Fiscal space results from a permanent reduction in lump-sum transfers. The GST is reduced in a debt-neutral manner.Macroeconomic Effects of a Reduction in Personal Income Taxation1
(Deviation from initial steady state in percent of GDP unless otherwise noted)
Citation: IMF Staff Country Reports 2006, 229; 10.5089/9781451807004.002.A003
Source: GFM simulations.1 Fiscal space results from a permanent reduction in lump-sum transfers. Personal income taxation is reduced in a debt-neutral manner.3. The results confirm the view that the GST is a relatively efficient form of taxation. In net present value terms, the increase in potential output could be substantially larger if other taxes were reduced (Figure 3):
The Efficiency Gains from Reducing Alternative Types of Taxation1
Effect on real GDP (Deviation from initial steady state in percent)
Citation: IMF Staff Country Reports 2006, 229; 10.5089/9781451807004.002.A003
Source: GFM simulations.1 Fiscal space results from a permanent reduction in lump-sum transfers. Taxes are reduced in a debt-neutral manner.Similar to a payroll tax, the GST also affects the consumption-leisure decision. However, since accumulated savings are an implicit component of the tax base, the GST is less distortionary.
Personal income taxes are, in turn, more distortionary than payroll taxes, since their base include dividend income in addition to wage and interest income and transfers.
Finally, corporate income taxation is the least efficient form of taxation, although the presence of monopolistic competition in GFM implies that part of the tax burden falls on rents rather than the return to capital.
4. This order of efficiency is consistent with evidence from various international studies—see Baylor (2005) for a survey—as well as results of a general equilibrium model for the Canadian economy (Department of Finance, 2004).1 The findings are also robust to variations in the underlying assumptions (Figure 4):
Efficiency Gains from Reducing the GST Versus Personal Income Taxation: Sensitivity Analysis 1/
(Deviation in percent of initial steady-state GDP)
Citation: IMF Staff Country Reports 2006, 229; 10.5089/9781451807004.002.A003
Source: GFM simulations.1/ In the baseline, the planning horizon is 10 years, the fraction of rule-of-thumb consumers is 25 percent, labor supply elasticity parameter equals 0.96 (moderately elastic; higher values correspond to less elastic supply), the elasticity of substitution between capital and labor in the production function is equal to .80, the intertemporal elasticity of substitution is .33, and the price markups are equal to 20 and 40 percent in the traded and nontraded goods sectors, respectively.2/ Planning horizon is equal to 100 years.3/ Labor supply elasticity parameter is equal to 0.9.4/ Elasticity of substitution between capital and labor is equal to 1 (Cobb-Douglas case).5/ Intertemporal elasticity of substitution is equal to .20.6/ Price markups in the traded and nontraded goods sectors are respectively 9 and 17 percent.A longer planning horizon of consumers, a reduction in the share of rule-of-thumb consumers, or higher substitutability between capital and labor all imply somewhat larger incentives to save and invest and therefore stronger gains in potential output from reducing either the GST or personal income taxation.
More elastic labor supply implies that reducing either the GST or the PIT causes larger efficiency gains.
If consumption is less sensitive to changes in the real interest rate, efficiency gains from reducing the PIT are even larger. Higher national saving following a reduction in the PIT is followed by higher consumption in the future. The required reduction in real interest rates is larger if consumers have a lower intertemporal elasticity of substitution, leading to larger incentives to invest.
Lower price markups imply larger efficiency gains from reducing taxation of dividends as a larger share of the tax burden falls on the return to capital rather than excess profits.
References
Baylor, M., 2005, “Ranking Tax Distortions in Dynamic General Equilibrium Models: A Survey,” Working Paper 2005-06 (Ottawa: Department of Finance).
Baylor, M., and L. Beauséjour, 2004, “Taxation and Economic Efficiency: Results from a Canadian CGE Model,” Working Paper 2004-10 (Ottawa: Department of Finance).
Bayoumi, T., and D., Botman, 2005, “Jam Today or More Jam Tomorrow? On Cutting Taxes Now Versus Later,” Canada—Selected Issues, IMF Country Report No. 05/116 (Washington: International Monetary Fund).
Botman, D., D., Laxton, D. Muir, and A. Romanov, 2006, “A New Open Economy Macromodel for Fiscal Policy Evaluation,” IMF Working Paper 06/45 (Washington: International Monetary Fund).
Department of Finance Canada, 2004, “Tax Expenditures and Evaluations” (Ottawa). Available on the Internet at http://www.fin.gc.ca/taxexp/2004/TaxExp04_e.pdf.
Prepared by Dennis Botman (FAD).
With the exception of the fraction of rule-of-thumb consumers—set equal to 25 percent—the calibration is identical to Bayoumi and Botman (2005) who analyze the macroeconomic effects of an early cut in taxes versus delaying tax cuts and reducing government debt further. GFM is discussed in more detail in Botman et al. (2006).
A reduction in the effective GST by one-percentage point implies a larger reduction in the statutory rate if in practice GST exemptions are present.
See Baylor and Beauséjour (2004) for a detailed description of the model and a demonstration that the conclusion is robust under alternative values for important model parameters.
