C.D.

Howe Institute

Commentary

Fiscal PoHcy

Lessons in Harmony:

'What Experience in the /ulernic Provinces Shows About the Benefits of a Hertnonized Sales Tax

Michael Smart

Tn this issue .. ,.

Provincial refail sales taxes are rem.arkably high on business inpu;fs, including pu rchasee of m.p#al goods that spu r growth in productivity and. employment, .Evidence from .Eastern provinces with a Harmonized Sales Tax (HST) suggests t:ha;t harmonizing provincia.l salee.taxes wifh the federal CST wouldeUminate most o/this .distort,ion, w#hout leading to an increase in consumer prices.

The, Study in Brief

Covemmen ts in Canada have recently shown a~ desire to reduce marglnal ,effective tax: rates on capital, with a view to increasing investment and productivity In the economy ,~. and a number of tax reforms have alread y boon proposed and enacted to this end. But ona simple chan,ge would have the desired effect on investment at very low revenue CO.5t to governmentsend would lower the compliance costs to taxpayers: that would be to reform the antiquated provincial retail sales taxes (RSTs) to bring their bases into eoaformity with. that of the federal Goods and Services Tax (GST). My estimates show that provincial RSTs are remarkably high on business mputs" indudm,g - and perhaps most W1po:dant ~ purchases of capital goods. Taxes on ca:pital are ,especially undesirable because they have ]ong~l<l!sting effects on the economy hyllimiting the gIlowth of the capital stock and reducing the long-TUn. gIlOwlli of prod u,etivity and employment. Approxim.atelly one-quartet of the marginal effective tax rate on capital m Canada is the result of taxes on business inputs. Harmoruzlng' provincial taxes with the GST would elnninate most of this distortion.

To show that the investment effects of ~he reform would be substaruiel, I estimatetha ,effects ofthe 1997 Harmonized Sales Tax {HST) reform on business investment and consumer prices in. the Atlantic provinces. In keeplng with theory, .1 find that the reform led to significant increases in machinery and equipment in vsstmen t, in the shod run at least, which should raised1le' capital stock and 'labour productivity there in the long run.

A poliHca~ stumbling block to the reform is that it is thought ,that harmonization would reduce taxes paid by business and increase the taxes paid by individual consumers. But taxes on business inputs are v,ery likely to be no more than hidden taxes on consumers - since they are shifted forward in the form of higher prices. Exruninm.g the effect of the 1997 HST reform again, I show that the pattern oJ relative price changes there was remarkably dose lethe ~5timatli!d changes in tax rates and business coststhat resulted from the reform. Thus the tax changes were shifted forward, leaving after-tax consumer prices on average slightly lower than before the reform" On the basis oft1\e evidence, thenl .I conclude that a similar reform in the provinces that still have a. retail sales tax would result in. increases, possibly substantial, in capital stocks, while there would 'be very little change in consumer prices.

The Author of This Issue

Michael Smar: Is a Professor of Economics at the Univel'.s:ity of Toronto and. a Research Fellow of the C,D. Howe Institute.

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CD. HOOle IP'!5titute Commentl1r'y"~' is ~ periodk:mlllY$ffiof, and ool'i'li..mentuy on, C1.U1\ent public policy IsSUtl$. freya. Godard edited the ffimtlSCript Diane King prepar-ed it for publication. As willi all m.snmle publications, the views .expressed ~re are thos~ of the author and 00 not necessarily reflec-t tM opinions crf tJh~ m.stitu~e's me:n\b.ers or Board of Direc~ors. Qaotalion with ,appI'opriate credit is permissible,

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CD. HoWE! Institute Commel1 tary

1

ecent developments in federal-provincial relations in Canada have led. ,to I1en._ewe.-d m ...•. tere. st.' in._:th€ PQSS~bH. hy Of. r'eJ:.cClnmTI .• ' ".Ig the' prov ...•.... m ... dal s.a].~s 'l'3.'X stems. At present, five provinces have a r,effail sales tax (RST)r which JS

. .. llected sepiU'lltely and on a very different basis from the federal Goods and Services Tax: (GSTJ, which is a value-added tax on 'consumption. Four allier proVIDOOS,in contrast, have value-added taxes that are large~y combined 'with the federal GST.

Can ventional wisdom among public finance economists has it thatt for a variety 0.£ reasons, retail sales taxes are inferior to value-added taxes that raise the Saine revenue. Those reasons include the narrowness 0'£ their base (which distorts. relative prices of marketed goods), their susceptibility to tax eV~5]On,. andtheir tendency to cascade through the value-added ChSiID, thereby distorting the relative prices of business inputs, partinllarlycapirnl goods. Indeed~ by One much-cited estimate (Baylor and Beausejenr 2004), the excess burden of the RST tax on capital goods exceeds that of aU other major Canadian taxes, This paper goBS beyond conventional wisdom and provides quan Uta ti ve estimates ,of the likely economic effect of converting provincial RSI's to a value-added base like the GST~ with particular em phasisen the effects on business investment ar:J:d. on consumer prices and the distribution of tax. burdens resulting from the reform, To obtain those estimates, I compare what actually happened in the fonr provinces lliO'll have aheady adopted value-added bases (the "harmoniring provinces"}' to what

ha ppened irI the same period in the provinces that kept their RSTs. Thus the asymmetric nature of past :;;a]es tax reform in Canada can be viewed as analogous to a "natural experimen t" that allows 'us tocontr,o] contemporaneous changes in the ecnnorrucerrvironment that would othenvis€ confound the analysis. This permits better Inferences about cause and effiEd than previous studies" which have not considered a similar "controlgroup" fQ.l' the reform,

In the simplest terms, the policy implications of the analysis may be summarized as follows. In Ontario and British Colutnbia (the two ]argest province-s that still have RSTh), effective tax rates 'On business inputs, including capital goods, are remarkably high - indeed, mom than 40 percent 'Of .RST revenues in Ontario are estimatedto come from taxes On business inputs. Eltmlnating ~1I1ch taxes through harmonization would ha we substantial effects on business investment By my estimates, annual investment in machinery and equipment in theharmonizing provinces rose 12.1 percent above trend levels in the years foUowing the 1997 sales-tax reform. Given the high taxes, on capital inputs in the remaining provinces, it seems. reasonable to expect a similarly large short-run ,effect of reform on investment in the RSi provinces as well.

It is important to emphasize that the increasein investment caused by the HST reform is a short-run phenomerton, asfirms have' acted to adJust to the new, higher-capital stock that is desired when taxes are lower. \'Vhereas the investment effect is trensitory, the effect on capital stock and labour productivity is

1 The four are NewfoW'ldland and Labrador, Nova Seotia and New Brurt$Wick, which introduced the Harmonlaed Sol~ ThJ( (EST) on t'he ~ame base as lhefuderal GST in il997,.omd Q1!.tebec, which dW'ing Ihe 199Qs lntoodu:ced the Quehec Sal.i!s tax {OST,l, a value-added ti'I:X witha base :now quite s.imilar to that of the GST;

2

CD. Howe fnstl,wre Commel'lt.ary

pre.sl..l!nW"bl y long-nm and permanerrt, However, my empirical methodologj, discussed below, do-es not allow these long-tun effects to be estimated directly.

The necessary implication of high taxes On business inputs under RSTs is that if reform were to be revenue-neutral, then. the taxes paid by consumers on their personal expenditures would rise substantially. The analysis of eff@ctiv~ tax rates shows that if the GST base were to be adopted, this would be eehieved through the broadening of the base to inel ude new homes and,ro a lesser extent;. some goods and services, ratherthan through increases in. the headline statutory rate' of the provincial sales taxes.

'This shift in bm-det"!:.S hom business to consumers is usuaUy ll::garde!d as a major obstacle to such a reform. But all taxesare ultimately paid by some' people, somewhere - and never by businesses .. That is; We must distinguiSh between the "statu tory burdens" of a tax- who the tax law says must pay thE! tax - and th€ true" economic burdens" of a lax. True economic tax burdens depend On how -tax_es levied on businesses Me shifited forward to consumers through higher prices, or shifted backward to factors ,o:f production, like labour, capital. and land; through lower wages and rental prices, Estimating true' economic burdens Is difficult;, but it is the key to understanding the uJtimate impact of a tax. on consumers and on the distribu fill on or real income in the economy ..

To give some' sense of the true economic distribu tion of burdens under the RBTs; lexamine the reiationship between changes in consumer prices an.d changes in .effective tax rates in the harmonizing provinces in. the years following the 1997 reform. Again I use cempansons with the non-reforming provinces to control f'Of €'Gonomk and especially monetary factors that otherwise affected consumer price irillationat the sametime, Theresults show tha.t the pattern of relative price' changes among broad categories of consumerexpenditures was quite similar to the pattern of relative changes in taxes and business costs ind need by the reform - I:hatis, each 1 pcrcent increase incosts induced by taxes leads to ,appr-oximate]y a 1 percent increase (or perhaps more) in the price paid by consumers.

Indeed, overall. oonS"umer prices in the .ha~monizing provinces fen with the 1997 reform, altll!ough prices rose somewhat for shelter and for clothiag and footwear, so that the reform "vas slightly regressive, The' pattern of tax changes today would preaumabl y be different if harmoniza t~on were extended to th€ r'€rnaini.n_,g RST provinces, since their current tax systems differ from. those replaced in the 199'7 reform. What is important is that the results, arie.CQNisten:t with the notionthat taxes are fully shifted forward. (or even "overshifted") in. most sectors, so ilia t the change in statutory burdens would not result In large

distribu tional effects.

The rest of the paper: is organized as follows. The second section describe-s the sales tax systems ,of the provinces and discusses the presumed de-adweight costs ·of th~ RSTs. The 'lhird section presents an accounting analysis 0,£ the changes In revenues and staru.tory tax burdens resulting from a. hypothetical reform in which RST provinces adopted the federal GST base but wi thout cJ:w,nging their tax rates. Estima bee of the effuct of the 1997 HSl' tax reform on investment are presented in the fourth section, and On consumes prices in the fifth section. The sixth section con dudes my analysis.

CD. Howe Institute Commentary

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Provincial Sales Taxes

P:rovincial sales-tax reform began in 1992 with the Quebec Sales 'lax, a modified value-added tax system that at fust accorded amy limited input tax credits to fir.ms. However/input tax credits were gradually expanded, and by 1'995 the base of the QS! was largely harmonized with that of the: f~de:ral CST. Further reform followed in 1997 witl'l. the introduction of the Harmonized SaJles Tax m. Newfoundla_nd, Nova Scotia, and New Brunswick, The base of the HST Is essentially the same as that of the federal GST~ collection or the federal and provincial taxes is unified, and the' provincial portion .of the rate is 8percer!.! inall three provinces, replacing the previous RSTsystem, where the effective rates were 11.7 to 12 percent. Traditioti.ilil RSTs remain in Prince Edward Island, Ontario, Manitoba., Saskatchewan, and British Co]umbia. Alberta has Ito direct taxes on consumption.

Provincial RSl's are charged on essentially all purchases of goods thattaka place at retail points Of sale. In contrast, the GST /HST is an invoic€-and~credit value-added tax, which taxes sides of most goods and sendee'S by registered traders, while according full crt!dit f;or taxes. paid on. registered fraders' purchases of taxable goods. In practice, the followmg are the thief differenoes between the GST and NST bases:

• Unlike the GST, RST.s are paid on many purchases of intermediate inputs by businesses. Indeed, as we shall see, a remarkably high proportion of provincial "retail" salestax revenues actually comes from the taxation of business inputs.

• Many services" even those consumed asfinal demand and bought at the "retail" level, are €'xempt from tax:ation under the RSTs. Thetreatment 'Of services is complicated under the GST, with many service sectors receiving tax-exempt status, while international transportation services are in fad zero-rated.f Moreover, the input tax rehates paid under the GST toexempt suppliers in the Municipal, Academic, Schools, and Hospitals (IvlASH) sector makes these services much closer to zem-rated {Le .. ,tax-hee:) under the GST.

Consumption of housing is exempt under the RSTs; that is, rent is not 'taxed, and purchases ,o.f cwner-occupied housing areuntaxed.as welt The GST also exempts market rents and implici t ren is to owner-occupied housing, but it taxes purchases of new houses, albeit at a reduced rate, especially for properties valued at less fhan$450,OOO. :3

2 For supplies that ·;lire tax-exlm'lpt under the GSr, no tax i:5 charged on the sale, but noinppt tax credits may be d<rimed for taxable inputs tha:t went lntQ its producl:ioo. For ~ilted supplles, rnC'Onttast, no tax Wi charged: but input 1;<1i_x credits, Il1lilY be claimed. so that the trlU"!SClCtioo is enlire1y tax·free .

.3 There is a36 percent rebate (implying im effective GST ... te· of about 4,.5 percent when the :st;!t!'lda~d T"ilte was. 7 percent) for n@w hou_ses valued. fft less than .$350))00, ""i:ib ;Iili.e margmlll rebate progressively decreasing to zero for house values oveC $450;000. Th@oo i.s a iSiroil.a:r system lmdi.er the QST. but the starting and ,e:ndfug points are much lower ($:IDOiOOIO and $Zi'S,ooo :respect:iveny)"

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CD. Howe .Institute C-ommentary

It is customary among public-finance eeonemists to cntieize .RSTs because they result in substantial changes in the tela tIDve prices of marketed commodities (both RST and value-added tax: Change the relative price ·of marketed commodities and ncn-markeled ones such tis leisure). In particular; RSTs exempt many 'types of consumption, chiefly services and intafigibles~ frcm taxation entirelYr and for ili€! most part they do so in an ,arbitrary way tiha~ has no policy justification. The resulting changes in tehl'tive after-tax pr~oes of various goods <Ind services are likely to lead to large departures from tax neutrality, because some sectors of the economy ollie artifidalry favoured at the expense of others, Since different firms and different sectors of the economy rely (ttl purchases of inputs subject to .RST to differmt degrees, the result is unequal IDcreases in. costs of producticn and prices, and further departures from neutrality and compedtiveness. Acoording to the Diamond-Mirrlees principle of production efficiency, ~xes, 0]11 business inputs <Ire in general not part of an optimal tax system;4

\'Vhat is related and probably most important is that provincial RSTs tax most capital goods bought by businesses. Taxes On capital aee deemed to 00 especially undesirable because' they have long-lasting effects on the economy by limiting the growth of the capital stock and reducing the long-run growth of productivity and employment. Approximately ene-qtrarter of the marginal effective tax rate on capital in Canada is the result of taxes on business inputs (Chen and Min.tz, 20(3). In recent years some provincial govemmen ts have devoted much attention and political capital! to reducing their "headline" rates of corporat,€ incame tax; but ~t might be simpler and perhaps more effective (though Jess visible) jus! to eliminate the RSTs' Implicit tax 'On capital by moving to value-added taxation,

These problems with. the RS1' base, ae emphasized by Dahl1;ly (2005), may be hidden from public. view; but, they are fur born trivial. Usmg quantitative simulations of the Canadian economy Baylor and Beausejour (2(J04) find that the true economic cost 0'£ a dollar in revenue ralsedbyprovincial governmen ts thrQugh sales-taxes, on capital isabour $2.30, compared to a IDElJ!e $1.13 for consusnption 'taxes lib the GST lHST. Since, as reported below, a move from provincial RSTs to a tax with the CST base would reduce taxes on ~pita.l by about $1.5 billion at current rates oftaxaticn, a very rough calculation suggests that the long-run gains fOI the economy mig'hit be as high as $1.1:5 blllion.5

Fiscal Consequences of Reform

These differences mean that a move by the provinces from their current RST bases to any true value-added tax base might have large consequences for gevernmestt rev en lies and for the distdbu non of tax: burdens between business and consumers

4 In contrast, Piggott and 1,VhaUey (2001) and ethers have emphasized that vlllu12-a!chied taxes e.m ctea.telldditional dis~rtiOllS by favouoog businesses in th@ iruonna1 ~r since they can, evade it more easily than other producers. But, as IlOl.OO by Keen (~),. the' fact rem!lJil:Isfuat rea.1.-wotLdi involoe-and-credU VAT systems do tax p:wduction in the BUolll1Lill sector ind'il"iecUy by denying, inpu.t credlHs to traders that evade the tax on their sales.

:5 The l3aylor~BeIlI~oru estilI\a;re is valid only fur small. tax changes, llnd ·the benei],ts from largescale reJ:orm mOIl' be somewhat s.mall~r. l'1itis calcUlation ,exdudies ~_e eamomic benefits of elimjnOl~ RST taxes, on l:1\.on~ilipi:lal business mpul:s.

C. [1 Howe lnsmut~ Ct)mmentary

5

and among sectors of the economy Just how big the consequences would be, however, is an open question. As a preliminary s.tep~ therefore; I report my €'sti:rnates of the change m tax revenues and statutory tax burdens that would result if the remaining RST provinces were toreplace their tax bases withthe federal GST base but. without changing their tax: rates.6

The estimates 'Of revenue impacts for Ontario and British Cohunbia7 {see Table I} are based on the actual revenues of the GST and. each province's RST in 21002 8I1id on estimates ofeff~tive 'tax rates, The la Uer are calculated from a detailed reading of each tax code, wlti.ch is used to attribute reven ties to various, sectors of Ul€ economy by means of weights from the 2:002 prov~ndal input-output tables, In short, underlying my calculations are very detailed estimates of the s'ftatlliofY tax burdens of the existing.RSI and GST tax systems in 2002.8

To estimate the effects of reform, suppose that provinces move to the GST base, with the current OST exemptions a_nd rebates for the Muni~pal, Academic, Schools" and Hospi taJs rIl.1ASH} sactorand for' fiinarnda[senl,iC'es/ and zero-rating of basic foods and exports {including interprovmciatexpoets, as in the Q5T).lO For the 2002datar the GST statutory rate was 7 percent (although it has sinoe been reduced to 6 pe:rcent),whi1e the RST ratein Ontario was 8 percent and in British Columbia 7 percent. The estimated statu tory tax burdens are therefore just GST reven ues in British Columbia, and eight-seven ths of GST revenues in Ontario,I:;! Table 1 presents estimates of the change in statutory tax burdens (revenues collected) hom different sectors of the economy under such a reform.

In sumrnarj; 'Table 1 shows:

(i) Sta_tutory burdens on business would decline substantially with harmonization to the GST base. Thee revenue changes are largest for current inputs, including construction inputs, but reductions in capital taxes are also substantial. Indeed, revenues iromtaxing machinery and equipment purchases under the RSTsare b€'l.wren 4 and 6 percent of private investment {in.duding 4.4 percent ill OntariO);fli large part of the overall tax burden on investment.

(iO Effectiveb",,, ra tes on services woufd, perhaps surprtsingly, change li ttle~ the reported increase in revenues from taxing' services represents a bout 0.5

6 In p'rince EdwardIsland, where the .RST Is paid on the GST~lU5ive price, the S>tiltI,trorym .r~~ would .i&e to keep the effecHve provincial rate ro:t'l$l:.a.nt.

7 These arethe ]ar~ provinces tQ keep RSTh. EstJmate for the Q~.et pmv:iinc@2s, ,an be (0Wld in an earlier version offuis. paper,. Smart (2007).

S Thus the caleulaticns do nolli:'lcorpor[;lte !he. effocts of the various RST reforms m<llde since 2D()2.

In parl:i:cular. British Columbia has since enhanced the exemptions fo~ business inpul!$ under its RS'f; the resulting reduetion m revmues derived from taxing busm~~ it''l.pYtB would therefore presumably be smaller toda.y than what is reported. in Th'ble 1,

9 This does not mean thal the GST I:reatmentoi these ~ctQ.fS is ideal: for lID :l!!'gtlment that it is nQt, s~~ for eKample Bird and Gel:"ldron (2007).

'10 For more on the issl,l~of a sUibnatlonal VAT with diHeren.tia.l lares among;pwvirLoes, see SlnaL1 and Bird (2007), Bird and Gendron (L007), and McLIll\~ (200.5), in~r alia.

11 My approach assumes that eXmllptiOt:l5 and rebates for housing and the I'0!ASll5€ctor w01illdbe '~he same in peJWntage terms as unde:rthe GST,. 00 that e.ffecti~'e tax raloesunder Ihiil hypotheticaJl Ontario g. percent F'VAT would be ejght"'5e'Venths oftn.e eorresponding GSI effi!ci:lve rates.

(5 CD,. Howe !nsfi~lJre Gommenta:l'Y

Table 1 : Predicted Changes in Statutory Tax. Burden from Sa.les Tax Reform

Oi'It!Il!'io British Co!luttiibia.
fST PvAT Dlil'fe~eRce r-sJ ,PVAT D.ii~
S ~miot1';!;
Consumers
Good~ 5,W M.7S 1,25(2 t!J.20 1,873 .31,53
S~'I~ 2,568 3,,322 754 ;,m ],114 n2
Ho-ucing 1 ~17 lUlHi 2 ssn 549
5us.1ness
COn5'mtctlon inputs '1.553 {I -1,.553 :519 0 -519'
Ot:h(tr in~~te 2,~ 1.173 -1;516 837' J-21 -516·
C,ppitaJ 1,01.13 412 -1..021 ~44 9.3 -351
Government 424 S71 147 155 '],..4£1 -15
ToI:i\I 14,101 13,981 -121 3,Slii} 4..09'2 ill percent of the corresponding base in Ontario and 1.4 per<:€:ntm British Columbia, This reflects the rather low ef£ectiv,etax rates on servlces under the federal GST,as well as some recent base-broadening reforms in .RST provinces that have made parts of the service sector subject to RBI. Effective tax rates are low underthe G5T because of the tax-exempt status accorded many large services industries, including most of the Finance, Insurance, and Housing sectors; the Health sector; and the MASH quasl,governmenta~ sedor.12 Furthermore, many of those service sectors receive large rebates for input taxes under the GST ~ they are nearly zero-rated rather than tax-exempt ~ so that the total taxes paid on. outputs and use of these sectors are indeed small. In summary sales-tax harraonization in Canada would result in ill much smaller increase .in taxes On 'consumer services than generally believed,

(iH)Taxeson the housing sector would rise, primarily because GST is paid on sales of new houses: (although at a reduced rate), However, under the RSTh/ the construction ind us try also pays one of the highest eff~ctive tax rates on business inputs, as evidenced by the large decline in input taxes in Table 1. (As a rough. estimate .. about half of RST taxes 0[1 constructioninputs are related to residential buildings. and half to non-residential buildings,,) Thus the reforms would lead to red uctions ~n construction coststhat would! offse-t much of the new explicit taxes on housing, leaving changes in true tax burdens. that were relatively smaU,l:3

12. T8.x~e>f~pt status impliesthes€· sector.s de pay some tax W'lder the GST, which is included m~he I:msinass lnputs ~ction of lhe taNe .and netted out fromlhe much. larger eeduetton In input taxes that !'e8I1lts when :prov~ciaJ RSTs aee mmove-d,

13 .Policyma~ers concerned about thi.s Sf'ruII1 shlfI: in. the tax: burden may '>;;ish to raise the price threshold (i.e., above $450,GOCl} fa. the GST rebate <!IV.wbte to new-hon:te buyers.

CD. Howe InsU,Wle Commentary

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Ov) Overall provincial revenues would change little - tlcmnling to these estimates" the reform would be nearly revenue-neutral. Th,!;! single exception is in Manitoba; where revenues are estimated to decline by $151 million, or about $130 :per capita in. 2002 • .of course, these estimates fOT a sing[e ye'af may be a poor guide to the future, pardcularly since RSTs rely so heavily on taxation of mv,estment goods, which am one of the most volatile parts of the economy. Note as wellthat the net revenue impactsm Table.l are based on the assumption thal the RSTprovinc·es would adopt exactly the same tax exemptions and rebates for various sectors as exist 'under thEl federal GST. I~ In fact, however, thereforming provinces would have considerable freedom to increase their revenues by red uting the rebates available to tax-exempt or favoured sectors - just as the HS'I provinces did in 1997.

Estima . ting tbe Effects of Harmonization on Investment

The' foregoing shows that a primary effect o.f reform in the' RST provinces WDU[d be to reduce the effective tax r-ates on capital. To estimate the ·effect of such a change on investment, I turn to a retrospective ana].ysis of the effects of the introduction ,of the Harmonized Sales 'Tax in 1997. Though the previous RSTs o,f the harmonizing provinces differed from the re.malmng RSTs in somerespects, they too imposed high effective tax rates on som€: capital goods, with estimated average effective tax rate on machinery and equipment in :1.996 ranging from 2,,6 percent in manufacturing to 110.4 percent in Ccnstructlon, and averaging about 4.95 percent. (Estimates .or pre-reform effective tax rates are discussed in more detail below and presented in Tabled.) My 5,t"rate,gy is therefore to examine change~ in. various measures ofaggrega te investment in the harmonizing provinces compared to the RST provinces in the years Do]1owmg the reform,

Figure 1 shows that, in the ye<lirs before the reform, private tnvestmenr per eapl ta was considerably lower in the HSr provinces than in the others~refieding the 'traditionally lower GDP per capita and Iower capital per uni.t of GDP in the Atlantic provinces. However, year-to-year variations in the two investme:tlLt serles for HST and RST provinces are very similar, since both were affected by nationwide economic shocks, That pattem changes dramatically after the 1997 sates-tax reform as investment per capita in the reforming provinces began to rise" perticularfycompared to investment in the provinces that kept their RSTs. However, the sudden rise in relative investment appears toslow down oreven reverse ,afler 1999; this is as expected; since a :reduction in the ,efi;ective 'tax rate on capital goods should read to a. permanent rise in capital per unit of outpu t but not a permanent rise in investment flows.

A similar pattern appears in fue graph of Investment per capita. fOl: Quebec', although the data in this case are more difficult to interpret. Since value-added taxation was phased iin under ti1€' QST d mmg the 199C1sr there is no clear delineation between pre- and post-reform periods; furthermorerif businesses

14 nus, asswnption is necessary because 'lli~ data on the GST present revenues D@t of the effects of the elcisting e>:~.ptions!lI[ld l!ebates.

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CD. How~ Insti:ture Commentary

0000 •••••• _,--,- --- ••••••••• " •• .,., •••••• '.' •••••••• ,0,0,0'.- __ -'1 .' ••••••••••••• ,0",., •• _ •••••••••••••• - --' ••••••

i 6000 , .. _ •• _ ,. ••••••••••• ,,_ _ ••• '. , ...• " •••• ". ,. - '. ' .

Notes.: 1_ ~ttl arefor business gross l'iMd-capit<i,l !of'I;Mnon. '-' Amo,un:~ ~xe in 1~99'l d!oJ:la~_

3- H5f provlru;~ are N ewfoUl'ld!and ~ndl Lahrin:Im, Nova &otia, ,and New J).ruJ1.Sw'kk, RST ~(ll;'inees are ~ Ed"v,am IsLmcl_, OntArIo, M'aniroba. SilstatchewB_I'l, 11M 'British Cob,l:mbi~_ Albt!rta, dco~ not have II s.i!iles tlllX.

Souroe: Provincial Emnmnjii;' Ac,ooW'ltti.

anticipated the phase-in, they may actually have deferred their investments rather than increase them - that would be consistent with the pattern seen ont.1:l€ graph. Lastly, ,rnamy .of the capita] assets that tend to be taxed under RSts are still not e~igibte for full input tax credits under the QST either, ,at least for large firms; it 3'l.ay be, therefore, fua1 the QSI lies in between a r:etail sales tax and a value-added tax in terms of its effects on the cost of capital. For this reason, I generallyexclude the Quebec data from the empirical analysis.

Of course, the pattern shown in FigUH ] only suggests the possib1e effects of sales-tax reform, and many other factors may have caused the rise in relative investment rates in EST provinces. For example, the rise may be due to a general rise m economic growth in the HST provmces, rather than in investmentper se; it may be due to long-term trends in the HST provinces unrelated to the reform, and it may be due to Changes in the relativecost of capital there that have nothing to with taxes. Certainly; investment in Newfoundland has risen with the development in recent years of the offshore oil sector.

Some of the-se possibilities are addressed in Table 2, which shows esti..mates, 'based on multiple regression, of the effects of fIST reform, on investmerrtIn each of the regressions, the logarithm of real irwestmem per capita in each of the nine provinces is regressed on the logarithm of real provindalGDP per capita {to

C. D. Howe rnstitute Commentary

9

Table ,2:: Regtr~.ss{cm·ba5ed fstlma,tes of Investment Imparu by lndr.l5tty

Total Maclliaery M\d NOIl:"resid'mtial Resklential
~~t &1w~\Il'i:eJl!t Cortstlillctiiotl COI'IBtru.ct:iion
H5T 0.11 0.17"· 0,26 (1.02.
liAS] l2.llJ [Un [0.25]
Logarithm of GDP l . .34··" ll.92· ... 0.96 0,,90'"
[4.57] [5..92] 1[l.26] [2.16]
Obsen'ations 19·(1 1911 l~O 100
R"'SqU.;l;Nd 0.95 0:95 0.87 ();90 NQll.e~ Ml spectrjC1.tloru; include provlnoe-spedfic 1i._I'lel!ir irends and ye.a;r fu;ed] eiJects, coofficlents nzyt"reponed.

Rab1.l.8t t stali5;iics ifI·bl"lldell;.

* ~i~j{kmt at 10 p=t: .•• ~gnillcan.t ~t 5 percent ,,~. signi:ficl'iJ'lt ,~I: 1 poe.rCctlt.

~ Author's calcula:tioN.

control for provincia] business-cycle effects)l5 and a dummy variable equal to One' in years and provirn,ces for which the nSf was in place and equal to zero otherwise, AU regressions also includeestimated fixed ,effects for each year and separate estimated linear trends fox each province, not reported in the table, TI1.at IS, this approach allows for the possibili ty that in vestment was On averarge higher

_ _ .

in Canada ,after 199'7 for reasons unrelated to sales-tax reform and that investment grew faster over the sample period in HST provinces than oth@m roll" reasons unrelated to sales tax Idom't. As well, the inclusion of provinda[ GDP per capita helps to control for the gener,~tr effects of the' oil boom on economic iilJCltivi ty b!!. HST provinces. Mor~over, the qualitative results of the analysis i.'IH? robust to excluding Newfoundland and Labrador entirel Y {TOm. the data set

In the first column of figures in Table 2, the dependent variable is real gross fixed-capital forma tkm per person, as in Figure 1. The estimated coefficien t of 0.111 ~or the HST dummy variable indicates that after the reform.Investment pe:r capita in HST provinces l:'O.S€! H.1 percent higher above the trend thenin RST provinces, The difference is significantly differen t {rom zero at the 95 percent significance level .16

Theremaining three columns report estimates of the same' regression equation, using narrower components of investmentas the dependent variable. In the second 001 umn, the' dependent variable Is reel busirn.ess investment in machinery and equipment - the component most affected by the reform, The effect o.f HST reform. on machinery and equipmen tInvestment is larger, at 16.7 percent, than on the total, and signi.£icantIy different from zero at the 9S percent confidence level. In the tnjrQ eolumn, the dependent variable isreal business investment in non-

1,5 One potlilll:h!il COncern is that provincia] GDP includes Investment and so may be eru:lo~()U5..

R'Placing it. wtth the ]og of the non-investmenr compon-ent of provincial. GDP. howe-veT, dOt..'1ionot ch~'rnge sign±flcO!I!.nt[y the coefficients 0'1l th~ "1;T variablereperted belO'l'!;r.

16 For the. estimates reported! below, Icalculate estimated standard errors of estim;!J;~ that are I'cibu_st to 3Jrbib'aiy hetemskedastidty and 'OOilt~por:lmeQlll$ correlation among provtnce5 within the liST and RST groupings.

residential bujldings per capita; the liST lmpa.d· here is larger than before but not sigrufkantly d.iffuren t from zero. This is not entirely unexpected, since the provincial RsTs that the HST replaced tend to tax rnachmeryand equipment

~ lID ~ 1l. ~:1 th·· !-..... ~. buildi . 77

mves nent more lllE'!aVliJY,alrI. mvestment m " l;llll.'~JJl~gs.

While the results are suggestive, the aggregate investment data may includea number of confounding ,eff1'lds 'of economic changes in the Atlantic provinces that happened at rou,ghly the Same time as the HS'f reform, and which are the1'eI~ not handled adequately by the difference-in-differenc,1; strategy. Most notably, offshore oil and gas proje~ts in N awfoundland and Nova Scotia probably boosted Investment in that sector for reasons unrelated to sales-tax reform, and the

introd netion of the Atlantic Investment Tax Credit and related provincial credits hom 1997 may have had similar effects in manufacturing and processing: industries.

In. the A ppendfx, I present more detailed €"(:,onometric analysis that addeesses these and other possible confounding jnfluertces. Naturally; the estimates, presented there v<lrYi depending 0.1'1 the d<lila used. and the industries considered, and so on. In the interests of brevity. I hlghlight one particular estimate, which shows that private machinery and equipment investment in sectors other than Mining and Dill and Gas rose 12.1 percent in. HST provinces relative TIO others, in the years fcllowtng the reform. Thus the data are consistent with the idea that there was a large increase in investment induced by the tax reform, Although the investment effect is surely transito,ry, it implies a long-run, permanent increasein the capital stock ofreforming provinces and so an increase in output and productivity as well.

Economic Incidence of Harmonization

The analysis thus faT has focused on the efifultls of eliminatmgRST 'taxes, on business inputs, particularly capital goods, by adcpting Instead a tax with the GST base . .But if such a reform were to be revenue-neutral for the RST provinces, the statutory tax burdens on consumer expenditures would necessarily rise. The ao:ounting analysis of sta tutory burdens under Fiscal Consequences of Reform

a bove implies that this change would he achieved primarily through expansion of

- .

the sales tax base (parl:icu1arly to include purchases of new homes) rather than

through changes in tax. rates, This shih in statutory burdens is usually regarded as a major obstacle to such a reform.

The question ]s to what extent .shifts in. statutory burdens result in shifts in true economic effect, which depends on the extent tow hieh, under existing RSTs, input taxes are shifted forward to consumersIn the form of higher prices, Or backward to factors of produ,d:ion. The h.'DUsing sector gives an ap't example of the issue: the fi,gures repoit'edabov,eJ under Fiscal Consequences of Reform, indicate that in Ontario (in the absence of behavioural responses) the tax reform would result in

17 The last coluro.n of Table 2 performs a further robusn~~s Check of the results, showing lhat the e:f£ect of HST r,e~Qrm. on residential investment was negl!igiNe ~ as expected, since taxes in fact rose Or wereunchangadlnthjs category. TN!> mrulJK'eS the idea. that .I:h<t ~s1;!lts :reportedl so fur r'eflectlh~ sales tax reform ·rathe. than 01ll"lB cOJ'i:oompo~ane(}us fador.s in Ih.e eoon@rnI.es of ~IST pr<O\irlI~,

c..D. HoWfJ 'mUwte Commentary

u-,

roughly $1.8 billion annuaHy in new taxes on housing, while redudngtaxes On residential and non-residential construction by about $1.6 billion, It should then be evident that the distrIbutional implica tlOI1S, Qf such a reform depend on the extent to which the reduction in taxes on construction in.p1l.l ts are shifted forward [0 consumers in the form. of lower housing prices and residential "en ts, or shifted backward to the owners of labour, capital, and land used in the production of housing.

The notion that the economlc effeets of a tax are independent of whetherthe 'tax ~s imposed on the seller of <I good (as under the RBI) or on the purchaser (as under the GST) is a fundamental- but largely untested- precept of public finance, However, RSTs a pply to only some business inputs, so that the effects of tl1e reform on consumer prices ara in principle morecomplicated than ill pure, neutral :shift in statutory tax incidence. Purthermore, when firms have market power and consumers are not fully informed about taxes, it may bereasonable to suppose that business markups rise when hidden taxes on business inputs are replaced by explictt taxes on consumers (Chetty, Looney, and Kroft 20(6).

To address the economic-incidence question, I again turn to an analysis of the actual effects of the 1997 reform in the :AST provinces, In this section, Jexamine the relationship between changes in consumer prices and changes in effecti vetax rates in the harmonizing provinces in the yaars fnllowing the 1997 reform, again u.sing comparisons with the non-reforming provinces to control for economic and especially monetary factorsthar otherwise affected consumer price inflation at the Same 'time.

The empirical strategy of examining changes in consumer prices after the' reform was also employed by Murrell and. Y:u (2000). The present analysis differs from. theirs due.fly by incorporating measures D.f changes in the effective tax rarn

_ , -

by expenditure category; and by estimating differences in price chang-es between

HST and]L'IT provinces; in order to control for nationwide factors unrelated to the reform that may have affected price Inflation after 1997. One such factor is monetary poHc:y. From [uly 1997~ when the reform took effect, until the Latter h.aJi of 2000., the' bank rate rose from 3.25 to (5 percent - a change that may wen have impeded price growth in all pr-ovinces.

In some respects.jhe 1997 reform had a different influence' on prices than might be expected from further harmonization in the remaining RST provinces .. In the 1997 reform, :S tatutory tax rates full from 11,7 percent' in Nova Scotia and New Brunswick and 12 percent in Newfoundland and Labrador to 8 percent in. all three provinces under the HST; the analysis in the third section indica tes tha t harmonization to the CST base would be approximately revenue-neutral if

statu. tory tax rates remained unchanged a t S perrel:l. t ill Ontario and 7 percent in British Columbia.1iJ' This might sugg~st that the tax base in tile RST provinces is alraad y broader than it was in the HST provinces befor€ the reform or that provincial revenues declined with the 1997 reform (Blagrave 2005) OI both. Purthsrmore, to the extent that a smaller portion of the value-added chain lies within the FiST provinces "which. are smaller and ha we less-developed secondary and 'tertiary economic sectors] than other ptovtncea.the elimina lion of taxes On

IS The sameis true for 'Prince Bdward Island. Manitoba, and Saskatchewan, £01.' which reVru:lu,e data are not reported! m the second section.

business inputs there had a smaller effect. on business costs than it wouldin the RSTprovmcesr where embedded. input taxes lime ]a(ger In proportion to' consumer expenditures, and elimination of input taxes would "cascade" fhroughthe vahteadded chain and so potentially resalt in. more than proportional reductions in costs. Nevel'thel~s, comparing changes in effectivetax Tates In the 1997 reform to. the oorrespnnding changes in consumer prices allows us to estimate the average degree of "passthrough" of tax dtangestoprice changes. In particular; it lets us test the hypothesis that tax changes are fully shifted forward to QOIlSlUl1er prices, as would be' consistent wHh the standard theory.

To make thos>€ comparisons, I obtained from Statistics Canada's Input-Output division estimetes ,afllie effective tax rates on consumer purcheses 0.£ goodsmd services under all provinces' RS'Ts in 1996; and I(}C the reforming provinces in 1998" afterthe reform, By oomparing the tax-rate change to the actual change in tax-inclusive consumer prices :in HST provinces relative to non-reformlng RST provinces, we can. determine the extent to whkh taxchanges were fn fact passed forward to consumers.'"

The resul is fur each broad Cit uiegmy of consumer expendi ture are reported in the third column of Table 3. The first row shows that overall, CPr prices feU by about 0.3 percent in EST provtncesafter 1991, compared to the corresponding change in .RST provlnces, This difference is sta tistically msigru1icant but extremely close to the estimated 0.5 percent reduction in taxes, under the reform.

Regressions for the eigM component fixpendi ture categories tell. a similar 5l'fuoryr.

On average, prices in HSl' provinces, declined in relation to .RST provinces for five' of the eight categories and rose forthree. 'The signs. correspond to the sign of the estimated Change in the effective tax rate in all categories butone (Transportation, where prices rose despite a decline in taxes), and the magnitudes are generally quite similar.

Particularly notable, perhaps, aI'~ the estimated 1..4 percent price increase for Shelter" reflecting the extension of the tax base to Include purchases of new houses" and 1.5 percent price increase fur Clothing and Footwear, which also likely reflects the broader base ·of the HST. Since expendi fum shares for these categories tend to be larger for low-income households, this suggests the possibilHy that the reform was.regressive in. that it raised average prices for low-income households while lowering prices overall. The notion that ,the federal CST is less prog:I'eS$ive than the Manufacturers" Sales Tax it replacedin ]99'] orthan an ·equ<ll-yie]d[ expansion of federal income t"XI!S has been a matter of deba te since the GST was introduced (see, for example, Ruggeri and Bluck 1990). Differences in the pm,gre.ssivHy of the GST and the RSTs should be smallet since the bases are farmore similar, A simple way of measuring the progressivi ty of the estimated. price changes is to consider a hypothetical household that spends 20 percentagepoints more of its mcome on

the categories for Food, Shelter, and Cloth:ing and Foorwear than the shares in the aggregate CPI bundle reported in. Table 3; this corresponds roughly to the way Statistics Canada estimates low-income cutoff levels, below which familiesare 'Often deemed to be paoli', iO Using these weights to aggregate the astima ted tax and

19 Feu fu_rther detailon the data and empiric",] metlnodruogy beNrid Table 3, see Smal't (2007).

20 Thus the explimditure shares fur Food, Shelter, and Clothing iilfid FOQII:\"',earrise to 23.6 percent, 37,0 percenit, arid! SAl percent ~pe'Clively, while the, ot&\-er shares, are sealed down ... ,'

CD, Ho1t'lf,(i!: InsMture IComment.1i:ry

Ti.lbfe 3: Regre$sion~based Estimates of the fll'v;esanent Impa.ct ,of HSf Retorm 0.fI Consumer Prices

EstimaMd. lmpa~lof HSl Rel''Om'I.

!i:<pendlbu:{: Sham; on Tax Rates on ,crl Pl:i!leS brtpJ1Gi.'I.ffiaS,t!!:!:!1

. All~ food SheUer

Hm.!SQ~d ?peratIoN MId

F1J!ITTiJs.hlng-s

O~i and FOOh .... ear 1l:"~l1lSp C1t ta!!lo.n.

Health iifid 'l'er,;ol1ol1iJ CaR R..etreMi.on, MI1~tlon.. MId

F!le.adln,g

Alrnkol OIrtd ToM!f:!:O Products

l00,O"t • ],&,S 2,6.3 n.i

-0.5% -.Q,J%
--'0.6 ~7
1.0 lA*·
-X,Z '-b9-~
1.6 11..5 ....
--OS Q,S
-{)'.3 ~1.4··"
-4.1) -0..4
-3,4 -3.2" -0 .. 6% l2 1.4, 2A

0.9' -1.6 4.7 1),2

0,9

Notes: Cohrmns 3 and 4 present. diifereno:e-in-d:i:fference CIS estimal'e8 ·of HST priQ~~ses,given pMt!llIPedfic ARO ~ e;r,ro.lts. ,Sei! ~i>tt fq. cl,et.ails..

.• signIDcant at 1(1 pemmrlt level; H significant -m.t 5pi!rPimt Ieve:J; ..... SiglUfiCiUlt at 1 per;;ent level.

price changes, we find that on average, effective tax rates were unchanged £01" low-income households but the corresponding price index rose by 0.24 percent. Thus] conclude that the HST reform had a mild regressive effect, In the absence of similar ly detailed in fo rma tion on the pattern of effective tax: rates In the RST provinces toda y~ however, we cannot determine whether further harmonizafion would also be regressive.

Our primary concern remains with the "passthrough elasticity," that is" with estImating the. degree to whicll tax changes: in each category are shifted forward to consumes prices, One estima tmof thepassil:fu:nugh elasticity is the ratio of estimated changes in column 3 to those in column 2. of Table 3. Excluding the Transportation sectoz where the estimated (Changes are of th,e opposite sign, though insignificant, the elasticity estimates range between 0.5 for Recreation, Education <lnd Reading and 2.4 for Hous-ehold Operations and Fumishi:ngs.~1

In summary; the results show tha t the pattern of relati ve price changes among broad categories of consumer expenditures was quite similar 'to the pattern of

rela ti 'lie changes fulL taxes and businesscosts induced by the reform. Overall,

cons umer prices in the harmonizing provinces fell with the refcrm.although prices rose somewhat for Shelterand fOT Clothing and F oohveaIi and this tended to make the reform slightly regressive. The pattern of reform-induced tax changes would presumably differ in the remaining RST provinces, but the results are

jOOhl(J'e 20' Ctmfd

"" proportionately lnorder fuat tl;,e total wil.1 add! uf'lO '100 percent. This does not correspond exactly to the definii'ionof'!:be .Low-.inoom~ adolf. which is filfl ~i"lCome Level at which a typiC'al household:~ expenditures on. food, shelter, and. dotl:Ung exceeds !hat (If the avel."illge family witt,.

full! same demographic charilC~i$tkS, by 2(11 perce;nbg@ po-in~, .

21 For an alternative, regression-based! es'l:irrnatQr of the passthrough elasticity, which gives similar results, ~. Smart (2.007},

CD. Howe hmftut~ Commenta.ry

consistent with the notion i::hat taxes are fully shifted forward (or evenovershltted) in most sectors, 00 that the change in statutory burdens would! not have large distributional effects.

Conclusion

Conventional wisdom among public-fmMiice economists, has it that retll.U sales taxes are inf~riol' to value-added taxes, that. raise the Same revenue - for a. variety of reasens, including the narrowness of their base (which d!istor~ relative prlresof marketed goods}, theirsusceptibility to tax evasion, and their tendency to cascade through the value-added chain, thus distorting the relative prices of business inputs, parTIcularly capital goods. Indeed, Baylor and Beausejour (2004) find that the economic cost of the RST tax on cap['tal goods, exceeds that of all other major Canadian taxes,

My quantitative estimates - of 'the likelyecenomic impacts of eorwerting provincial RSTs to a ta X with a val ue-added base like the GST - emphasize the ,effects On business investment, consumer prices, and the distribution of tax: burdens, My results are based on an examination 0·£ actual €'ffocts of reform in the fnur provinces that have already adopted value-added bases, and on a cumparison of their experience: ~o what happened :in the same period in provinces that kept their RSTs.

An examination of detailed revenue data. for the RSTs showed that the effective tax rates on business inputs, including capital goods, are remarkably high. Ellini_nating such taxes 'through harmonizatlon would cause a substantial increase in business investment, By my preferred estima te, ami U"'] machinery and equipment investment in the harmonizing provinces rose 12.2 percent above trend levels in the years foHowing the :1.997 sales-tax reform, Given 'the high taxes on capital, inputs in the remaining provinces, it seems reasonable to expect a similarly large short-run effect of reformon irwsstment in the RS1' provinces as well,

Of course, broadening the base to include new-home purchases, in the context of 31 revenue-neutral harmonization, would increase the visible taxes paid. by some consumers.This shift in statutory burdens is, usually re.garded as ill major obstacle' to such a reform, The question, however, is to w hat exten t increases in. taxes are reflected in true economic incidence-s- and that depends on the extent to' which inpu t taxes under the existing RSTs are shifted forward to consumers Or backward to factors of production,

To determine thai. 1 examined the relationship between changes in consumer prices and changes in ·e.ffective tax r-ates inthe harmomzsng provinces in the years follo\¥ing, the 1997 re.foml, again usjng comparisons with the non-reforming provinces tn contra] for eeennmic and especially monetary factors. that otherwise affected. consumer price inflation at thfl same time, The results showed that the pattern. of relative price changes among broadconsumer expenditure categorles w<lsquite similar to the pattern of relative changes in taxes and business, costs '[nduced by the reform . Oeerall, consumer prices in the harmonizing provinces fell wi th the reform, although prices rose' somewhat for shelter and clothing and foohvear,. and that fact tended to make the reform slightly regressive, The pattern o,f reform-induced tax changes would presumably differ in the rm:najning RSI

CD. HQ~' J'tmitu:t£ Commentary

provinces, but the results are consistent with the notion that. taxes, are .fully shifted forw am (0:1:' even overshifted) in most sectors, so tna[ thechange in statu tory burdens would not have huge distributional eHl[lcts.

076

c. O. Howe Institute Commenta.ry

Appendix:

Detailed fsdmates of investment Impact

In the main text I noted that my main estimates of the investment Im pact of the reform may be confounded by oilier economic manges. in the Atlantic provinces, such as the sharp expansionm 'the offshore oil and gas sectors, in Newfoundland and Nova Scotia, and the introduction olf the Atlantic Investment Tax Credit for manufacturing and processing industrIes in 1997.

To go fUlth~r, therefore, I turn to investment data disaggreg~ted to the twodigit industry level from Statistics Canada's Capital and Repair Expenditures survey. Unlike the Provincial Economic Accounts (PEA) data, 'the Capital Expenditures data are available on a consistent basis only fur the 1992~2005 period, and only nominal values of in vestment expenditures are' recorded. I deflate the data with Ute province-specific imp]icit price indexes for gross fixed-capital fonnation derived from. the PEA data.

Table Al presents the average annual investment per' capita fur~~ch of the six industry groups examined, the two-digit industries fur AgrIculture, Mining, Construction, and Finance and Insurance, and for two broader aggregates of W'hJolesale and Retail Trade and Transportatton and for Ollie'!" Services.22 The first column shows the popu]ati.on-weighted a.ver.ag~ D,f provincial total investment per capita in each industry, an indication of the relative importance of each in the aggregates. The remaining two columns report the effective tax rate on capital goods mduced bythe pre-reform RBTs, in. the harmoruting provinces. These tax rates were estimated by Statistics Canada on the basis of the 1996 provincia] InputOutpu t tables and a detailed reading of the tax Iaws of each (If thethree provinces; they are calculated to include the direct e.ffect of taxes paid on capital inputs as well as the fndire.cteffects of the higher costs in c<lpUal~goodsi"produdng industries, assuming full forward shifting of the taxes.

The data show that the highest effective tax rates were for machinery and equipment investment in the Construction sector at 0lJ 10.4 percent aver.age effectiv,er,a te .. 'The rates vary widely among sectors, to a low of 2.6 percent in Manufacturing. Estimated effective tax rates on huiMmgs are above 4 percent in most sectors, whi-ch of course reflects; not the dir-ect retail sales taxes on business purchases of structures, but rather the RSTs on construction inputs that are deemed to be "embedded" ill their producer prices. For stractures, the lowest dfective· rate is in Mining, presumably because' ofthe Iarge share of imported capital goods in use in the sector;

Table A2 reports further differ-el'liClil-in-differmcCl estimates of the effect of HST refom'l, based on the alternati VI:! data. In the interests of brevity, only the coefficients On the d ummy y,acr:iaNe for the HS1' reform are reported; all regressions include controls for ilog real GDP per capita and year fixed effects and province-specific linear time trends, as befnre. The first row is the "baseline" spedficatioll corresponding most closelyto the results for the PEA data; in it, the: investment data are for the aggregate of allindustries, exdudlng Public

22 Oiilieo-.r Berviees includes all other TIVO.dlgHindus-trie-s ,excep~ Puiblic: Adminis:lr<ltiM. Education Services, and Health Care and Sociai Assistance, where in"'"eshn~nt decisions are ]ilely to reflect f~ctws 'other ~an taxes,anqwllicllaFe th<eIe1ore excluded altogether from the arLB.l),sis. Indeed, mmy prod_ucersin these sectors are tax-exempt under the l--IST, 50 tl-mt eHective tax rates on Inws,t:ment were in ,my casCit br,gelyW'ls!{~ by the refo:nn.

C. D. Howe Instlture Commentary

17

Table A1.: Summary Sta,tisUcs: Investment ,and Effective Saleli Tax Rates by Industry

A'\'erage .-\ru'tual. froviru;.i~l. mves!llrent

per C!'!ipita

Pre-rerorm.E.fkdive T~ Rate on I'l:we,strltQji,t i!;t .HSI·l"rovinres:

Machmery Bmldil'lgs

Agriculture

:M'i.rung MId Oil aRd GIIS Construction

199~$Fery~ ss

699

90i 604 192 367 Ul

5--6 4.Z
3.9 2.6
10.4 4_9
2,6 4.6
8.9 U
6_~ ~.l
8,6 4~(I M8l1l.UJ~

Tt<lide and "fillmportation FLJ'\;!ILl'lce lI!ll.d Insurance

N~es: The figQre.li' repru:teiI B<El p(l~~ti=-v.reight'ed lI;'I!Ierag~ (if prnv.incial per 'Cilpita mve:.~trnent ;;b:ta, .and of 'the cstima~ed e'ffet_4iv,~ tax rates on inVll'Stment under sales tM(W in. HST provinces oo."o~1:he fclorm. l1H~se do not mrrespondl to natiQrnd averages bt!Ci!I!ll5e som.e provinda[ a~rv,!ttiON are ~ awilRg ru ,o;ll1:fidenl1lility resl:rilCiJol"IS.

~ Stlttmics C=d~.

Table A2: Further Estimates of the Investment {mpact of liST Reform

Thta] mveslmellt

M!l.drinEI}' !Uld Equip.ment

Non-.re;,:;I,jeJ;1ot~1 Cl;lns1:n!CtiOO

'D.®5 [1.68,]

0.005' [0.19J

0.013 [0.32)

,00I~ [U61

0,096 10.81]

-0.02 . ,[-OA9:]

...[1.00 [..(1.55,]

0.061 ,[1.26]

. n1"'·

p-.4,s)

.. 0'55~

IU~~

;066·~

[2..4I)J

.(J~~' 12.00]1

NoleS~ Robust I stiilti5:ticS in b-rilld;~.

• ,significmt ~t 10 pe:r-re.nt lev~li •• dgrnficlU'lt at.li pel;'Cent level; ... ~ signllk.Mt" at 1 pt!TD!:IIit !evel.

Sou:m!-; Alltho.r's etlm!l!tes oosed. on aggJegilftlo data from the Statistics CE!mda Capital omd Repair bpend.itUh":S S1l!I'\i'ey.

18

labile AS: Rflg:ression-based fstimaU~:$ of Investment Impa,~ by Sri'cto.r

'O:2.61·~ lUl]

0.114 11,64]1

O,02::i ~1:n5]

0.443 .... ~2.761'

M3.5" 12-01]

{I.794'·· 12-.00]

--:Q'..<!R··~ [...:3.46]

tWS? 10.&1]

(1,064 [0.52)

-0.49.2 ... • HI:.87]'

(l.tiO!"" [2.181

-0..022 [-0.18,]

N(!Ites: All .spedfica'OOns Include controls for rro:vincialll;lg: GDP per Ciipila ;mel the user cost 'tIf capibll:msedl on pstl..inci!l! and l'oo~r.tl 'OOFpor~.te t~ ilIiIk.'iI6ur,e.~, 8~ wel.'l as eon1::Jr~ fOr ).J;!1observed rruvin.Qe- ~pediic linear tronds., j'e<ilI:, ~M pro\'iMt. ... iruil;l:5by ,ru.:ed e~, (:geHicieI'llts ,af which a~ not reported. -

• 9igtillkant ~t l() pef~t level; ii sigruikant at .5 pero:m:t kvel; "'" siglillicmt at 1 "peuent r~.

SOl,.!!"ioe: Author's cakulOltioru.

Administration. The estimates in this case ar-e similar but smaller, perhaps,because OIf the shorter sample period or differenoos in definitions, and IlIOW only the estimate far the machinery and equipment category is slgnificantly dMferent from zero.

In casetheresults are confounded by unrelated changes in Oil and Ga:s capital in vestments, I next excl ude Mining sector Investment from the total. The results in the second row show tha t the significant e£fedremains for th€ machinery and equipment category, though 'the pointestsnate for bl!1ildings is now essentially zero. As a further robustness check, the results in the third. row arefor the basefine specification, including the Quebec observations, which are' treated as part of the' trea tment gr,oup begirming In 199.5 ,the year that widespread inpu t tax credlts were available under the CST" Once again, a significant positive effect remains for machinery and equipment. The final row reports results of a ~I pure" difference-indifference specification, w hieh excludes the province-specific time trends, which are also broadly sirrdlar,

Table A3 addresses the' influence of contemporaneous changes in corporate tax systems, ,changes that may in principle confound my estimates of the impact of HST reJOJ:"JlI .. For these calculations, I obtained estimates of the Hall-Jorgensen user cost of capital (DeC) by industry, province, and year for the 1993-2004 period from the federal Department of Finance.2S .fm each of Om broad ind u~h"y groups except.

Wning;i4 The user cost estimates are based on fixed assumptions about the' -

financial structure and financial costs of representa ti ve .firms; they reflect detailed data on theasset mix of the dHiel\ent industries and the statutory tax rates" capital cost allowances, and investment tax credits in the federal and provincial income

2.3 For deta:ils of the user cost methodology, see Canada (20D!)). 24 Corporate- taxation m fh~ Mining sector lis oompl:icated.

tax laws, In fact; an Inspection 0·£ the user cost data shows that the corporate tax treatment of investment remained largely unchanged over the sample period in all seetors other than. Manufacturing, where user costs fellafter the introduction ()£ the Atlanti.c Investmen t Tax Credi t in 1997 and related provincial credits.

To control for such effects, I perform the difference-in-differenee regressions for each industrygroup separately; the log of the estima ted user cost of c.apital is

Ind uded <IS an additional con trol variable, Thus the esfunating equation becomes:

where UCC~s. the computed user cost of capi t~] for the relevant :indush'y, province, and year, and is based On federal and provincial corporate income tax considerations alone - excluding the effect of inpu t sales taxes.

The user cost data exclude two ye·al"s, 1992 and 200~, covered by the investment data, 1:0 keep the sample u_nchanged when [he vee is included, the 1993 UCCs are simply imputed for the 1992. val ues, and the 2004 uee:; For the 2005 values. Nevertheless, fhe investment data at the two-digit industry level is missing for some industries, provinces, and. years. for reasons of confidentiality '!"his problem is especially pronounced among the' reformlng provinces, where industrialconcentration is presumably higher. As a consequence, thE! nvo-digit ind us try panels are unbalanced, and the years and provinces of the regression sample differ from sector to sector in the rows and co]u~ of Table AS. For this reason, caution must be exercised in comparing estimates for different sectors and asset groups.

Table A3again reports only the estimated coefficient for the HSI reform vanable and suppresses the others for brevi.ty. Note, however, that the unreported coefficient estimates for the UCC varlable are usually ve·ry liarge (implausibly so) and occasionally of the wrong sign, but in most cases do not dUrer significantly from zero, This m probably because of the stability of the user cost over the sample period, which makes the variables roughly coUinear with the unobserved province effects, In short; there is notenough variation within provincesin U~[ cost to allow us to distinguish its ·effects on investment from othet.unobserved factors that explain the persistent differences In. per capita. investment among the provinces. In any case, the inclusion of uec has only <Ii negligible impact On the estima ted effect of the HSr reform 1:1'11 all sectors other Hum Manufacturing. In Manufacnmng, the estimated effect of the HST reform is a 20.3 percent increase in machinery and egu[pment investment when the uee is excluded from the regression, but a mere 2.3 percent when it is mel uded,

Indeed, in most of the six sectors, the estimated e.ffect of HST reform. On machinery and equipment investment is small endinsigniflcartt, In. Agriculture, Fish:i1lg, and Forestry, however, machinery investment rose about 26 percent above the trend level after the reform, when the separate impact of UCC chimges is controlled for .. In the Trade and 'Iranspcrtation secter, investment is estimated to have declined significantly after the reform. Aside from Manufacturing, where the eslimatereflecrs the contemporaneous changes in corporate taxes, the smallest point estimate is [or the Fmance and Insurance sector, In fact, Pinance and Insurance ~s the industry with the smallest changein effective tax rates after the

2(J

CD, HDWf'l Jns,d'tute Commentary

liST reform, since a substantial portion of the sector istrea ted as e.xemp~ .from the GSl' IHST and therefore does not receive input credits fertaxes paid on its inputs.

The estimates fer investment in bulldings, reported in the second column of the table, are more widely d~spelsedr.md indeed some of the estimates seem implausibly large, The estimate for Manufacturing is ,iii 79 percent increase, The estimates are s,ignificantly positive .11.1. fourseetorsend significantly negative in one.

C. D. Howe I'nsfiwre Commentary

21

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NOTES

,NOlES

NOTES

Recent C.O, Howe InstUute PubU,cations

],uly2007

Ju]y2007

June 2007

June 2007

May 2007

May 2007

May 200'7

Mlly20117

April 2007

Ap.ri12007

March 2.007

February 2007

February 2!DQi

Fiibruary 20(]l;

February 2Q01

February 200!7

Laidler, D\'l.'V1Jd. &iter wt'f Than Never; T!lwaM's a .s,ystemafic Re.vioew fJ! Cariad,~-{s .NWlI'le,t:ary Policy &gime. CD. HO\I/e Institute ComtI'I..etItiUY 252:.

Chen, D:u~ie, Jad:. Mint" and Androey Tanlsov. "Federal and Provmci.al Tax Refonns:L~l'$ Ccl Back on Tta;;:k:." cn. Howe J];,stitute' B..u::kgtt'{Ji.W1.del' 102.

KoepplThorster1, V,and Jal1l.eS MacGee,.1Jnmr:hing Ouf, The 1l'Sl!t!t Need to Tmnsform CQnad'a's financial lit'1.d;cap!! and Hew to Do n. CD. Howe Instiiute Commentary 251,

jaccard. Mark, and NiC'Rivers. "Estimating theEftie;ct of the Canadian GOVemIDffl'lit's 2D06- 2007 Gnen.hotISe' Gas Policies," cn. Howe InstitUJre \!!,!Ol"k;ingPa.per.

Jaccard, Mark, ,and Nlc Rivers. "'Estimating f;he Effect of the CanlJl,dian Governmen.t's 201)6· 2007 Greenhouse Ga'5 Policies. it C.D ... Howe .fusnrut>e ~brief.

laidle:r.. David, andl VY'illi.am. B. P. Robwn. ID-Defined B.mefits~ 'l'h£ Utilcerta:in Present' and BrJghl'U' future of Employee PetUicns in Cilra,da. CD. Howe fustlluw COmDlffitary 250.

Kn@!l'bone, Ronald, D. fllflllwing I~ Mrmey: Fderal (l1l.d Prot'inciill Budget Baltmres with Utuldrts Majar Cif:ies. CD. Howe wtirnte CommentaJry .2.4.9.

Tomlitt, Ben. "The: Seat Shortage"; Changing Dl!i1!':logra.pNcs and. Representation inl'he House of Cemmcns" CD. How@ Institute ,e-brief.

B~e:J]ee, Robin. and Wi11iam EI.P; Robsen, hGive Canadian Worker.,; the Tools to do the Job~ VVhy Canada N~di> More Roous,t C;Ilpi:l:alfuvestment. n CD" Howe J!l_sutute e-brief

Curnmlng, Douglas. Financing .EI'I.lre:preneu:rs: Better Canadian Policy [or Velllure Capililt CD. Howe Instiru~ Comm.ent;n:y 2~:7.

Brown, Robert Diand Finn Poschmann, NOn Taxes and For,elgn Investment, f:lamerty'~, A~ is Off." CD. Howe mstitute eJhri~f.

HO'WiH, Peter, InncwaHO'lI, CtmtpthHrm and Growth: A. 5diumpeterian fi'eFSfMCti'1Jt1 on ,CanaWi's Economy. cn. Howe Institute Commentary 246,

Herman, Lawrence L " AmeriC'aI'l Com, and Canadlar, Trade Actions: One Step Porward, Two St~psBiilck" CD. Howe ~titt!te e-bnel

Robson, William B .. P; "Feund MOllei': Matchlng: D.M,dLOiIl5' 5avmgs wirth Their Infrastructure N~~cb,u CD. Howe Institute ~b['ief.

Robson" William It P. "Will C~3.6 Undetnline. cpp "9.9"?l3enefit :Er1.hancement aifldthe SustainiilbilHy of the Canada P,e:ns:km Plan." CD. Howe Jmo~iNte' ~bnef.

JOh.nSOD, Davld, "OF1!t:;roo's Best Public Schools: An Upd,a;re to Signposts '01 Success (2005). n CD. Howe Institute e=bdef.

Poschmann, finn, William Rob.son and Robin l3anetj~. "FiScal Tonic for an Aging Nation: A Shadow Federal Budget for 2007.'" C,D. Howe mMitute I3Ild:g[,(Hrnrl.er 101.

Adrian, Reid S., YVat'l GW1I.eme~ and William '6.1:'. Robson. '"Mi~$ed Targcls: CaD_ada's 2007 Fi'scal AcoollI'lmbitity R.trn:kii.ng. ri C.D. How~ wtitute Backgfol.IDder 100.

Adrian, Reid S., ¥Van Gw]le.m.et'te ,et William B.P; Robson. "Cibles raM'eS ~ Ie ClilS5eIDC&'lIt 20017 de Ia responsabUiM fu;;,caJf;l au Canada. " CP. Howe Jnstitut.e Backgrounder 100.

FiruUe, Ross and Alex. Usher. Room at the Top; 5traregi&sior Itlciieasing th£ Num11et of Gradualt

.StJ4knt .. in Can~4a. c.n.. Ho,we Institute ComJ:'ll~tary .245. .

Hurwitz, Stephen A. and Lows J. Marett. Financirrg Cmadi~;n ImtOVtl,ti.(Jti: My Canada S}wuld Ew! RoadblorKs to F~ft.fgn Pdt'ate Equity. CD. Howe Institute Conummtary .2.44"

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CnernlavsKY, Ben andBl!Tljamm, Daehis. E;l!'CeS5 Baggage: Mf'.Qsuring Air Th11"11;p<JriJltion'~ Fisc~l

Ekn;den. C.D. Howe Institute CQ!Tunentiry 242; .

Payne, A. Abigail and H1.I;I2:i Zhao. "Unchar.itable Treat:m.ent? VV'hy DonSltio:nsl:o Private and Public Poundatioas Deserve Equal Tax StlIw.s." en. Howe :hlsIitufe ,e-bricl.

KUd\en,. Hauy. A SfJlt.e 0/ Dtf>repair: H01l!J' to Fix the .Firumcing of Mrmic(pallnjril.5trudu:re in Olnw~ C.D. Howe fusl'ilute C.ommentary 141.