Tax code simplification necessary, long overdue

Hey there, time traveller!
This article was published 27/12/2017 (265 days ago), so information in it may no longer be current.

I have three reactions to the announcement that government will tax marijuana. As a so-called child of the ’60s, I am unimpressed. As an economist, I know that pot will have an inelastic demand and will be a good revenue boost for government. As a political cynic, I can only shrug.

The taxation of weed is just one of many tax stories of 2017. The big one in Canada is that federal government seems intent on revising the corporate tax code in the face of very spirited opposition from small business and some professionals.

For most of us, "income sprinkling" — or, technically, income splitting — seems a curious practice. Just how did we imagine that allowing business owners to reduce taxes by spreading income among family members would be a good idea? It is just one of countless loopholes that have come to litter the tax landscape in Canada.

Let’s imagine a trip back to the Garden of Eden, in a much simpler time when no tax deductions for expenditures on work clothing existed and apple pie was GST-exempt. Nobel laureate Milton Friedman is one of many who, when commenting on the tax code, said, "The road to hell is paved with good intentions."

In the beginning, we can imagine a society in which everyone earns and consumes the same amount. We would all pay a flat tax to create public services and we would live in a place of peace and puppies. Taxes would perform their first function, namely to raise revenues for collective goods and services.

Eventually, someone would observe that by working a little more, travelling farther to get the meat, or staying in the fields longer, they get more stuff. They accumulate assets, such as horses, which allow them to become even more productive in getting stuff and then passing this stuff on to their children. However, there are some who are willing to work but have bad luck, through accident or illness and lose out on getting stuff.

Over generations, society evolves into the haves and have-nots. Troubled by this, we call on taxes to start to serve their second function, which is to reduce inequality, by taking less from the poor and more from the rich.

The concept of progressive income tax rests on a simple idea: a dollar is worth more to someone earning $25,000 than to someone earning $250,000, so as income rises, the income tax takes a bigger bite. A consensus exists on the fairness of this idea, but rich people then start thinking of ways to avoid the tax. One way to do this is to reduce work effort, but instead, most seek some form of legal tax shelter.

Those shelters emerge when we ask taxes to perform their third function, which is to punish and reward behaviours.

Carbon taxes, for which I have advocated, punish fossil-fuel users. The theory is that the tax will raise the cost of vehicle usage, nudging people to drive less, take the bus, walk or — more likely — purchase a more efficient vehicle when the current car wears out.

These rewards emerge because politicians are adept at bribing us with our own money. During elections, promises of deductions and tax-rate reductions proliferate like dandelions in spring. So we accept the inevitability of election promises to create tax deductions, such as for soccer uniforms to encourage physical activity by our children. Next time, we imagine, it will be our turn to receive preferential treatment.

An example of a tax provision as arcane as income splitting comes from the 1960s, when professionals who invested in creating rental properties could transfer losses on those properties as deductions from their income as doctors and lawyers. This reduced their taxes considerably and is a major reason we see so many older three-story apartment buildings in Canadian cities. The Benson tax reforms of 1969 eliminated these deductions.

This example aside, our tax code has become an inefficient Rube Goldberg-esque nightmare. Income-splitting is a poor tool for supporting small business (reducing the general corporate tax rate is much more efficient), in the same way that transferring losses from rental properties to professional income was a poor way to support rental housing.

It is simple arithmetic that deductions, however well intentioned, are forgone revenue — and tax favours for specific groups leave more for the rest of us to cover. They also raise the costs of compliance, as those seeking to employ available deductions hire accountants to ensure they have every tax break allowed.

Piecemeal approaches to tax reform invariably produce more political heat than economic benefit. The federal Liberals are playing a risky game, particularly as the Republicans in control of U.S. government succeed in passing a new tax regime that dramatically reduces corporate income taxes.

If this move attracts investment back to the United States — and uncertainty exists on that point — then increasing the effective tax on Canadian business in the name of equality, as Finance Minister Bill Morneau proposes, may backfire if capital flows south at exactly the time Canada needs new investment.

In my next article, I will outline proposals to increase the fairness and equity of our tax system.

Gregory Mason is an associate professor in the department of economics of the University of Manitoba.