Monthly Archives: September 2014

EYE ON NEW BRUNSWICK: HIGHER TAX RATES DOES NOT NECESSARILY EQUATE TO HIGHER TAX REVENUE

The Liberal Party in New Brunswick has proposed a tax increase on the province’s wealthiest individuals, arguing it is necessary to generate additional revenue in the province (and also citing the need for all taxpayers to pay their “fair share”).

Yet, raising tax rates does not necessarily equate to raising additional revenue. Arthur Laffer, for example, illustrates this effect in the “Laffer Curve“: “At a tax rate of 0%, the government would collect no tax revenue, just as it would collect no tax revenue at a tax rate of 100%, because no one would be willing to work for an after-tax wage of zero. The reason for this is that tax rates have two effects on revenues: one is arithmetic, the other economic. The arithmetic effect is static, meaning that if rates are lowered, the tax revenues per dollar of tax base will be lowered by the amount of the decrease in the rate, and vice versa for increasing tax rates. In other words, this is what happens when a hypothetical 1% tax collects $1 million, so people assume that a 2% tax would collect $2 million… and a 5% tax would collect $5 million. Likewise, under the same scenario, people would similarly assume that a 0.5% tax rate reduction would collect only $500,000. The economic effect recognizes the positive impact that lower tax rates have on work, output, and employment, which provide incentives to increase these activities. By contrast, raising tax rates penalizes people for engaging in these activities.”

Similarly, when the government raises tax rates, especially on the most affluent taxpayers, it gives them an incentive to avoid paying taxes altogether (and, by virtue of their affluence, they have the resources to do just that). Kevin Milligan, an economist at the University of British Columbia, outlined this argument when Ontario proposed a tax hike on the wealthiest individuals in that province: “There are serious, evidence-based concerns about raising revenue through higher tax rates on the rich. The concern is less that high income earners would curtail their productive work, but more that they would have a stronger incentive to find ways around paying taxes. People earning at high levels have access to the best financial advice, and I’d be surprised if they ignored that very expensive counsel and simply hand over bigger cheques to the CRA.” Milligan is the author of a paper that analyzed this phenomenon, which is available online here.

It is possible to raise revenue without discouraging private-sector investment, providing an incentive for folks to flee, or giving them fodder to shift around their income. Milligan provided three solutions in a Maclean’s article one year ago:

1) “Pay more attention to practices that allow top earners to lower their taxable income. This is slow, hard, and challenging work—but it is also a much more effective path to making our tax system fairer than trying to pour more water into a leaky bucket.”

2) “To a large degree, the story of the top one per cent (and especially the top 0.1 per cent) is about executive compensation. … I don’t have the expertise to decisively explain patterns of executive compensation, but if I wanted to get to the source of the increase in top incomes, I might start with a thorough review of Canada’s corporate governance rules to ensure shareholders are getting a good deal from their highly compensated top employees.”

3) “Finally, if we were interested in a more radical tax reform, we could look to Sweden and other European countries with a dual income tax. Under this scheme, employment compensation is taxed on a schedule with progressively higher rates, but all forms of capital income are taxed at the same flat, low rate. A dual income tax has the potential to deliver two benefits. First, taxing all capital income at the same low rate could take some of the air out of tax avoidance because there is no longer a gain from shifting income from one type of capital income to another. (Of course, the strongest possible tax fence must be built around employment compensation to prevent leakage.) Second, since employment income is harder for people to shift around, it is easier to tax it at higher rates. This allows a more progressive rate structure than might be possible when capital income is kept in the mix. In short, a progressive tax structure on earned income (which is the source of high-income concentration) for equity, and low flat rates on capital income for efficiency.”

I have some qualms with Milligan’s suggestions, however, they deserve careful consideration—especially the part about closing the gaps in our income tax system and filling in those parts that are leaking. Simply raising tax rates on the wealthiest individuals, however, is a misguided policy approach.

EYE ON NEW BRUNSWICK: COSTING ELECTION PROMISES

Earlier this year, New Brunswick’s parliament enacted the Fiscal Transparency and Accountability Act, which, among other things, outlined new rules obliging political parties to “cost” their electoral promises within 90 days of an election. These rules would “increase transparency … provide electors with information on the financial consequences of election commitments … [and] promote an atmosphere in which the public does not expect the fulfillment of election commitments for which the cost has not been disclosed in accordance with this Act.”

From the outset, this legislation appears to be a serious step forward in terms of political accountability on fiscal issues. In practice, however, there are several issues.

1) The results have been lackluster and some of the cost estimates seem purely unrealistic. In the Progressive Conservative platform, for instance, out of eight estimates (i.e. online eLearning, wellness and sport funding, senior’s home first strategy, etc.) five of them are simply four-year totals divided by four years. For those unfamiliar with the budgeting process, cost overruns are regular and assuming funding for “online eLearning” will remain constant at $0.40 (in millions) each and every year between 2015 and 2019 is a bit outrageous. Similarly, the Liberal platform promises a strategic review–akin to federal Finance Minister Paul Martin’s in the 1990s–that would generate $250 million in savings on an annual basis beginning in 2016-17. However, Minister Martin’s ambitions weren’t to identify $250 million in savings annually, but, rather, to produce a “cycle of continuous management improvement.” Importantly, Minister Martin first looked into where the government could achieve savings and then made a commitment to achieve them.

2) By virtue of having greater access to the “books,” the incumbent party has a better grasp of the economic and fiscal challenges facing the province. In other words, the ability to develop an accurate fiscal plan is weakened by the inability to fully understand those challenges. Furthermore, even if it were possible to accurately estimate the cost of certain electoral promises, whether they are achievable is likely unknown until after the election.

3) Although debate about the Act lent an impression that parties would have to commission an accounting firm to approve the cost measures, the legislation reads slightly different: “The Lieutenant-Governor in Council may make regulations requiring a cost estimate to include a statement from an accountant and prescribing the format of, the content of, and the manner of preparing such a statement, including incorporating by reference accounting standards and practices applicable to its preparation and modifying those standards and practices.”

4) Before parliament enacted this legislation, voters were to take electoral promises with a grain of salt; subsequent to it, nothing appears to have changed. This morning, the CBC ran a story discussing how accounting firms in the province are shying away from the process: “Deloitte LLP has reviewed over 50 campaign promises submitted to it by Progressive Conservatives, but declared none ‘credible.'” Deloitte responded to each of the Progressive Conservative’s promises by saying, “We do not express an opinion or any other form of assurance on the cost estimate. Actual results will vary from the information presented and the variations may be material.

5) In the words of one commenter on the CBC’s website, “Basically, the accounting firms are not going to touch this with a 10 foot pole.” He added, “When the costs of these items goes over budget, as they invariably do, is the accounting firm that provided a positive opinion [liable] for the cost overrun?”

6) Following an election, the option of judicial review becomes available to those parties that lost, allowing them to challenge whether the elected party complied with the legislation. It seems very obvious that opposition parties will exercise this option perennially: the cost to them is zero. Yet, there exists a counterbalance to bad governance: elections. If a party misleads the electorate, they face the possibility of losing in the next election.

There are several other issues and these musings are by no means exhaustive. Perhaps it would be better to enact legislation prohibiting deficit spending altogether–either annually, semiannually, or every four years. By prohibiting debt-financed spending, it eliminates the need for legislation governing campaign promises. Campaigning parties can promise the sun and the moon to voters, however, once elected, they will need to align expenditures with revenues.