One of the Worst VATS: Canada’s GST/HST exemptions keep rates high

Worth A Look, Taxation, Frontier Centre

You might be surprised that even dour tax experts and federal Department of Finance officials have “religious” beliefs that are hard to shake. For two decades, Canadians have been told that the GST (a value-added tax) is a far better tax than most other levies and that Canada has one of the best GSTS in the world, according to OECD analysis.

This folklore was blown up in a paper presented last week by University of Toronto Professor Michael Smart at the Symposium on Tax and Economic Growth, held by the University of Calgary’s School of Public Policy. Prof. Smart dug into the OECD statistics to discover a major blunder: The GST is not all it’s hyped up to be, due to its massive tax preferences and special provisions. In fact, Canada’s consumption tax is below average in performance.

The error Prof. Smart found in OECD statistics is almost shocking. To measure “performance,” the OECD has calculated the amount of VAT revenues collected by a country divided by the notional revenue that would be raised if the statutory VAT rate were applied to final consumption. According to the fallacious OECD numbers, Canada’s performance index began in 1992 at 44% (below the OECD average of 53%) reaching 66% by 2009 (above the OECD average of 57%). This performance measure suggests that Canada has the sixth best VAT of all OECD countries.

Of course, this hardly makes sense. The GST base has budged little from its inception in 1991 since successive Liberal and Conservative governments have been reluctant to address many of its unfair and inefficient provisions, after the Chretien government reneged on its promise in 1993 to replace the GST with another tax. So if there is little change to the tax, how could its performance be improving so much?

It turns out the OECD has been including provincial VAT revenues (Quebec being the first in mid-1992) as part of collected revenues, but using only the federal GST rate (5% today) to determine the notional VAT revenues that could be collected under a neutral consumption tax. If the prevailing provincial tax rate were included in determining how much VAT should be collected on consumption, Canada’s performance drops from 66% to 48%, 20th best of OECD countries, and well below the OECD average.

Rather than having one of best VATS in the world, Canada has one of the worst. This is not surprising. The list of GST tax preferences is large, resulting in $14-billion in tax reductions, almost half of the $31-billion in GST revenues collected in 2010. The federal tax expenditure accounts list billions in special concessions, the largest being basic grocery exemptions ($3.5-billion), new and rental housing ($2.1-billion) and input tax rebates to municipalities, academic institutions, schools and hospitals ($3.7-billion).

These exclusions from the tax base ultimately make little sense. The GST rate could be dropped to 3.5% if tax expenditures were eliminated. Many absurd complexities could be also be avoided that result in poor compliance and unfairness.

Even the Occupy Wall Street people might agree. The basic grocery exemption provides greater dollars of tax relief to one percenters than to 99 percenters. With the refundable GST credit, we could boost tax relief to the poor rather than provide special tax relief for the rich to consume more bundles of food. New Zealand, with the best VAT in the world, taxes broadly all consumption including food and housing, but provides a generous tax credit to help low-income residents.

The partial refund of GST on input taxes for government bodies and charities is also peculiar to Canada. It too leads to substantial complexity and gives some suppliers competitive advantages in markets over others.

Such special exemptions also lead to mistakes in application of the tax and perverse incentives. A bottle of water should not be taxed, yet Prof. Smart paid HST on his purchase at the airport before coming to Calgary. Retailers push customers to purchase six muffins instead of five to avoid the GST (so much for attempts to reduce obesity). Jamie Golembek of CIBC pointed out map books are subject to HST but other books are exempt under Ontario’s HST, unlike previously with the provincial sales tax.

And then there is whole complex treatment of financial services, today almost 20% of value added in the economy. In principle, financial services should be fully taxed and businesses using financial services should claim a tax credit for GST charged on financial services. In all VAT systems around the world, financial services have been largely exempt, meaning no tax applies on sales but no refund is given for VAT paid on inputs used in exempt financial services.

In Canada, we have applied both tax treatments, unlike some other countries. Some financial services are fully taxable, such as advisory fees charged by mutual funds, while other financial services such as bank GICS are partly taxed to the extent that inputs used to provide services are exempt. The result is that consumers are more heavily taxed on advice unless they purchase financial products from exempt suppliers. Other countries such as Australia address these distortions by providing a more even tax treatment among different financial services.

Finance Minister Jim Flaherty and his provincial counterparts should start paying attention to the under-performance of the GST/HST and clean up its many inequities. The mantra of low rates and broad tax bases equally apply to the GST.

Further adoption of the GST as part of the tax system would be likelier if the tax were better designed. With HST rates as high as 15% in Nova Scotia and Quebec (13% in Ontario, New Brunswick and Newfoundland & Labrador), the distortions in the GST base matter a lot more in harming the economy.

GST tax expenditures should therefore be on Mr. Flaherty’s chopping block. With the money, he could cut the GST rate or income tax rates.