(Nov. 30, 2010) Aldyen Donnelly looks at the major drawbacks to implementing consumption taxes, rather than income taxes.
Question: Most leading economists say that financing income tax rate cuts with new consumption tax revenues is very good for the overall economy (GDP)—the “tax bads and not goods” mantra. But I suggest doing the opposite. Here’s why.
- financing income tax rate cuts by increasing consumption tax rates introduces an highly regressive overall tax shift,
- academic assertions that we can efficiently address the regressive nature of an income-to-consumption tax shift issue are incorrect;
- using carbon taxes to finance income tax rate reductions introduces additional complications that are very hard on the economy;
- every nation that implemented major income-to-consumption tax shifts between 1980 and 1999 has been trying to reverse that shift since 2000 or so;
- the problems with the carbon tax are not addressed simply by dedicating those revenues to energy efficiency instead of income tax rate cuts.
My theory puts me at odds with other economists, as I use actual international historical before- and after-tax shift data to ask questions. Many leading economists believe that is a crucial error. They say that the differences between before and after tax-shift-price and consumption levels are irrelevant.
What matters, they say, is how after-tax-shift price and demand levels compare to what they would have been in the absence of the tax shift.
The problem I have is that their analyses often posit in-the-absence-of-tax-shift counterfactual scenarios that are very difficult to believe. For example, many experts assert that emission taxes created significant incremental green employment in Sweden.
Sweden elected to finance corporate and personal income tax rate cuts with consumption tax increases between 1990 and 1997 or so. Sweden’s employment profile is below. To accept the assertion that Sweden’s tax shift created any new jobs, the counterfactual scenario has to suggest that in the absence of that nation’s income to consumption tax shift, Sweden would have wallowed in a weaker-than-the Great Depression economy for all of the 1990s.
By the way, the government of Sweden officially classifies persons who are receiving disability pay as “employed” even if/when they have been entirely removed from the workforce. In 2006, in a study commissioned by government, McKinsey & Co. found that if persons on permanent disability were re-classed as “unemployed” Sweden’s reported unemployment rate from 2006 would jump to roughly 15% from the officially reported 4% to 6%.
But sticking with the practice of categorizing persons on full-time disability as “employed”, it is still very difficult to make sense of many Canadian analysts’ “green job” claims unless we elect to label all growth in public sector employment as “green” employment. Note:
- Since 1999 Sweden has realized no net employment increases in any of the following sectors: agriculture, forestry, hunting; manufacturing; utilities; transport, communications and storage.
- Other research suggests that government spending has largely supported construction jobs numbers.
- How badly the Swedish economy crashed from 1990 through 1994 (due to the Scandinavian banking crisis). To start from a 1990 baseline and attribute any of Sweden’s job growth to the income-to-emissions tax shift is to ignore the massive direct injections of public resources Sweden executed to try to recover from their banking crisis.
In 2006, a number of Canadian economists and environmental activists attributed “400,000” new green jobs to Germany’s “green tax shift”. It should be noted that Germany does not and has never had a carbon tax, but did introduce a Feed-In Tariff to attract new investment in alternative and renewable energy supplies in 1999.
Overall, Germany’s jobs trend has been superior to Sweden’s, but from 1999 through 2008 over 600,000 jobs were lost from the combined manufacturing, utilities and construction sectors. Three-fourths of the job increase from 1999 through 2008 was in the real estate, leasing and related services sectors.
Within manufacturing, 100% of the job gains realized from 2005 on are in the auto manufacturing sector, not the sectors that feed inputs into the alternative and renewable energy production sectors. What does one have to posit for a counterfactual job scenario to find 400,000 “jobs saved” to justify the doubling of German electricity prices for small consumers (while the government held prices for large industrials relatively flat) between 1999 and 2008?
On “the HST and Carbon Taxes are Good” Stories
To date, all of the leading analysis I have seen on the question of whether or not it is good for the economy to introduce the HST has documented the theoretical benefits of reducing corporate tax liabilities. When we look at the HST and carbon tax shifts, we actually need to ask and answer three unrelated questions, not just one:
- Is a corporate tax cut good for the economy? Most Canadian economists say the answer to this question is “yes”. All other things being equal, I agree that it is.
- Given a commitment to cut corporate tax levels, is the HST the best mechanism to make up foregone tax revenues. I have yet to see a Canadian analysis that addresses this question. They know that reducing corporate taxes should be food for the economy and their defence of the income-to-HST shift often stops there. When asked, most (but not all) leading analysts acknowledge that the HST/VAT is a highly regressive tax measure. The assumption that the regressive nature of the HST can be efficiently mitigated through targeted tax rebates is hard-wired into the modelling. However, across all nations/regions that have VAT-type taxes in place, that tax eats up 13% – 16% of the disposable (after tax credits/rebates) income of the poorest families and 4% to 6% of the disposable incomes of the wealthiest. No nation has achieved the tax rebate redistributive effect that is hard-wired into the current economic modelling and—to date, anyway—I am not aware of a Canadian expert who has studied why this is true or can explain how Canada might achieve a different outcome than those who implemented this tax shift before us. I believe that any models that reflect the real redistribution of BC/Canadian tax burdens from income to HST-basis, even after accounting for rebates, would show that existing and proposed tax shift schemes are both inefficient and highly regressive, as they have proved to be everywhere else. So the answer to this question is “no”.
- Given a commitment to cut corporate and personal income tax rates, is the carbon tax a good mechanism to make up foregone tax revenues? Leading economists tend to deal with this question the same way they deal with the HST question. They acknowledge that the income-to-carbon tax shift is regressive but say (without proving) that this negative impact can and will be addressed efficiently through revenue redistribution, i.e. the issuance of tax rebates to targeted low income taxpayers. This argument falls apart the same way the HST argument does. Further, none of the analyses I have read to date acknowledge a most critical additional problem with the carbon tax, which is:
- public sector agencies and non-profit entities generally pay energy and carbon taxes (while they tend to be HST- and income tax-exempt), so
- financing corporate tax cuts (all kinds) and personal income tax rate cuts) through a carbon or any energy tax shifts overall tax burden from the private sector to the public sector, thereby
- compelling governments to increase mandatory health care and social insurance premiums, tuitions and fees, property taxes and municipal service charges. So the carbon tax is both regressive (typically more so than the HST) and affects a shift of tax burden from the private to the public sector. Neither of these realities normally exist in our experts’ modelling. Of course, each of these two issues—let alone the combination—should mean the financing of any corporate tax cut and personal income tax rats cuts with carbon tax revenues is a big mistake.
These conclusions originate from models that incorporate the assumptions that:
- the regressive nature of HST and carbon taxes can be efficiently addressed through revenue redistribution programmes, which have failed to work anywhere else in the work, to date, and
- when the carbon tax revenues decline—due to the successful adoption of green tech and efficiency measures—those revenues will no longer be required to mitigate the impact of the desired “green tech revolution” on consumer prices.
The theory is that the cost of delivering a zero-emission energy supply will go down as demand for the technology increases. In real life, however, 85% or more of the investment required to build green energy supply chains is “fixed costs” and normal operating lives of the new equipment prescribed—wind turbines, highly efficient furnaces and water heaters, batteries for electric vehicles, etc.— is under 20 years and in some cases under 10 years. Fixed costs must be recovered regardless what demand levels are.
Therefore, the promise that consumer prices per unit of energy used will decline as per customer demand declines is unlikely to be realized. Since 1979, it has not been realized in any developed western nation. The history of natural gas demand and pricing in BC, as outlined in the table below, is not unique in this regard. We see the same pattern in all provinces and EU member nations, for natural gas, electricity and (to a lesser extent) home heating fuel.
The question that the fixed cost nature of energy supply systems raise is: what taxes will governments increase to maintain revenues and support for low income families as per household demand for power, gas and heating fuel decline?
What Does European Experience with the Income-to-Consumption (VAT + carbon) Tax Shift Reveal?
I attach a workbook that breaks down United Kingdom tax revenues by household income level. This data set addresses all taxes directly paid and benefits directly received by households. The estimates do not include any allocation for taxes that are paid by businesses and passed through to the households as retail price increases.
First, I appeal to government officials to consider publishing Canadian federal and provincial tables of information that are identical to that attached. The data is largely available to government Finance officials. Taxpayers should have the opportunity to view this data to form their own opinions about whether our tax collection and redistribution system is fair and efficient and also how to make it more fair and efficient.
The UK Treasury’s dataset goes back to 1977. The primary purpose of this disclosure is to enable the taxpayers to track how well the government is doing at shifting back the bias of the tax regime from over-reliance on regressive consumption taxes to more reliance on neutral or progressive income taxes. The necessity of at least partially reversing the income-to-consumption tax shift that was implemented from about 1985 through 1998 was recognized by the UK parliament in 1999/2000.
I leave you the entire database to encourage you to complete whatever analysis you might wish. I find many, many, many unique lessons in the attached workbook. I am sure you will find even more.
For now, I ask you only to look at the 3rd spreadsheet in the workbook.
During the 1980s the UK government recognized that it had an unhealthy dependence on corporate and capital (wealth) taxes for government revenues, and that this aspect of the UK tax system was stifling capital investment and job creation out of the country. Quite reasonably, the Treasury introduced changes to the tax system to reduce reliance on these sources of revenues and to recover foregone revenues from non-industrial/personal taxpayers.
But Treasury officials were convinced that they could also reduce personal income tax rates at the same time, creating a “fairer” more consumption tax-dependent tax regime.
Looking uniquely at the impact of the tax system changes on households, by 1993/94 the average UK household was keeping over 86% of “original” income, including a 10% increase in their privately earned income that came in the form of government transfers to support household income levels. Earlier, in the 1980s, the average household kept only about 80% of their original income.
By 1999/2000, things had gotten quite out of hand, however, with the average UK household ending up with 22,093 pounds sterling in “final” income, having started with 21,736 pounds sterling in earned “original” income. Of course, this income uptick is only possible in a nation that has access to growing corporate income tax revenues and/or resource rents.
From 1990 through 1999 it had been government policy to cut corporate income tax rates and resource rents in pursuit of the objective of attracting new private capital investment and creating jobs growth. They thought the cuts would lead to revenue increases in all of the corporate tax, royalty and personal VAT accounts. However, the private sector never did generate the job growth required to support the theory that cuts equals revenue growth.
Ever since then, the UK government has been struggling and failing to reduce systemic government deficits.
The picture below shows you the impacts on households of the UK government’s attempts to balance their budget—this time breaking all households into 5 groups—between fiscal years 2000/01 and 2008/09. Overall consumption (“indirect”) tax revenues have not grown much, while government has increased income (“direct”) tax rates—largely by moving thresholds down—to try to raise new revenues. But the perceived need to deliver increased cash and in-kind benefits to lower income households has overwhelmed the overall income tax revenue increases realized.
The largest problem is that most of the real income gains realized since 1990 have been realized by higher income families and the regressive nature of the income-to-consumption tax shift means that under those circumstances government revenues fail to grow apace with aggregate personal income growth. And as the cost of living increases for lower income families who are not experiencing real income growth, the need to increase the share of tax revenues that need to be “redistributed” or “recycled” to those families grows.
One of the side effects of this storm is that increased demand for redistributed tax revenues means increases in the cost of government, mainly, the cost of administering cash recycling programmes. The standard economic models posit that the cost of collecting consumption taxes does not increase as the consumption tax/cash recycling rate increases.
But the costs of addressing the increasingly regressive impacts of the income-to-consumption tax shift through cash recycling/allocation programmes and in-kind services delivery do go up. In most nations that cost of collecting and then returning tax dollars, largely to the same people from whom they were just collected, has increased much faster than the revenue pool has increased.
Second, my own estimates of the impact of taxes and benefits on British Columbian households, for example, though quite uncertain, suggest that the BC situation could already look very much like the unsustainable UK situation in 1999/2000—even though BC is only a few years into the income-to-consumption tax shift.
BC taxpayers, therefore, must ask and answer the following questions: what new taxes should our government introduce—and what services must be cut—to return to sustainability?
Note that further increases in energy consumption and carbon taxes are not a viable option in most developed European nations, given current retail electricity and road fuel prices and the fact that since 2003 every EU government has determined that they have to exempt energy intensive business from all energy taxes to try to stem high energy cost-related industrial job losses. They might appear an easy option in the short-term in Canada, but the resulting tax regime will be neither sustainable nor fair—or administratively efficient.
Canadian officials might want to consider the following questions:
- How is it that aggregate EU electricity demand and aggregate GHGs from electricity and transportation fuel demand have increased since 1990, 1997 and 2000—even with the very high retail electricity rates indicated in the table below, even though
- Overall, EU15 industrial output (quantity, not value) and jobs have fallen over the periods, and
- How will governments make up lost electricity and transportation fuel tax revenues if/when energy demand and GHGs from taxed energy consumption actually begins to fall?
Please note that to the extent that consumption tax increases caused/exacerbated the industrial flight that did emerge in Europe, this flight likely leads to increases in global GHG emissions, not decreases. If/when UK citizens offshore auto manufacturing to China, the global GHG footprint for the cars they buy and use likely goes up, not down.
I advocate for:
- Product standards (obligated party is the vendor of carbon intensive products) to incent entities that supply carbon intensive products to Canada to reduce global supply chain GHGs and to create the regulatory foundation necessary to combat unfair US carbon-based tariffs. US regulations will discriminate against more efficient imported products by regulating a performance standard that is defined as a % reduction relative to a production baseline. Because US carbon-intensive industries are generally much less efficient than their Canadian counterparts, a GHG tariff reflecting progress from a base year GHG production level favours the owners of older, less efficient, higher-emitting US plants at the expense of the operators of more efficient Canadian plants. Any “cap and trade” regime—which is a quota-based supply management mechanism—delivers a perpetual economic windfall to economies that are: (1) less efficient, and (2) net importers of carbon-based fuel, building products and food. The EU and US are both operating with reasonable self interest and will try to impose such a GHG regulatory mechanism on Canada. Product standards address all sales of regulated products equally, are fair without the need to introduce tariffs on imports to level the playing field for domestic producers and foreign suppliers. A cap and tariff regime is inefficient and potentially ineffective. With product standards in place Canadian interests can defeat unfair US market regulations in US courts. Without meaningful product standards in place, Canadian interests have no defence against protectionist unfair US GHG regulation.
- Regulations that define GHG targets in global supply chain GHGs per unit of regulated product sold in Canada, and renewable energy content, terms—NOT regulations that impose GHG reductions at Canadian points of production. Let the regulations make Canadian markets for lower GHG products, and let Canadian producers respond to that new demand.
- Regulations that define GHG intensity targets that become more stringent over time—NOT regulations that cause government to either set market prices or select new technology solutions.
- Termination of overall tax system shift from income to consumption taxes and commitment of our governments to the development and administration of a neutral to progressive tax regime.
Now let’s look one more time at the UK tax system mess.
Go to the first spreadsheet. I asked myself what income tax rate increase would have to be born by the 20% wealthiest of families to maintain government revenues if/after we:
- Eliminate VAT, television license tax and income tax credits for all families at all income levels. Note that most of the taxes paid by lower income families are paid in the form of consumption taxes. So the only tax cuts that will come with the potential for significant reductions in the cost of operating government are consumption tax cuts. I selected the most regressive of consumption taxes for full elimination to maximize government operating savings in this analysis.
- Eliminate tax on mandatory insurance premiums for bottom 6 deciles.
- Eliminate all duties on hydrocarbon paid on in-home energy purchases (leave excise taxes and duties on transport fuels in place).
- Increase tax on mandatory insurance premiums for top 4 deciles by 10%; reduce income support payments.
- Eliminate VAT rebates, home heating rebates and housing allowances to exactly offset listed tax cost savings where possible. Where resulting cost savings exceed total pre-scheme support payments + rebates + housing allowances (this is the case for families in the bottom 6 family income classes) pursue no further offsets. In other words, these families will realize a net increase in take-home income after the tax system restructuring.
- Increase health care premiums for top two deciles to recover 100% of the class-average health care subsidy per household (still allocating all costs on a per capita-shared basis in those two income classes).
- Eliminate income taxes (set the income tax rate at 0 for all incomes) earned by households in the bottom 6 deciles.
- Amend income tax rates, pro-rated to gross income, for incomes earned by individuals living in the top 40% of families to recover any remaining revenue losses arising from the elimination of taxes as outlined above.
Assuming that it costs government 18 cents on the pound to collect and then redistribute VAT and the selected other consumption taxes, and that cost of government saving is passed through to taxpaying families, the table below shows you a comparison of the average after-tax, after-benefits “take home” pay impact of the above-defined tax system shift. Note that in 2008/09 the UK government spent 36% of tax revenues on current government staff wages, not including benefits payable to retirees. Assigning an 18% administrative cost to tax recycling activities is likely conservative.
I applied this analysis only to working families and not to retired families. I leave all benefits to which individuals contribute over their lifetimes at current levels.
Because the cost of government saving is passed through to families, the average family in every income class enjoys an increase in “take home” pay. In reality, most governments should elect to dedicate at least part of this cost savings to debt reduction.
More importantly, the overall tax regime becomes less regressive, while it costs less to administer, and without imposing a prohibitive increase in overall tax liabilities on upper income families.
This is what reversing the income-to-consumption tax shift could get the UK today. I do not mean to imply that such a simple and dramatic move should be in our Canadian futures. But I encourage you to play with the UK numbers to test any range of proposals, as long as you recognize that collecting money and recycling it is not cost-free.
At a minimum, I think every experiment shows that we should use product standards to reduce the fossil carbon content in our national consumer product supply chains, not consumption taxes. On the corporate side, there are a number of ACCA and tax treatments of interest income we could introduce that would be indisputably revenue positive.
We do not need to and should not make our overall tax regime more regressive in the false hope of achieving emission reductions through consumption taxation.
With respect to product standards, I encourage you to look at those we have implemented in the past to address a number of issues including but not limited to: getting lead out of gasoline and paint, lowering sulphur in diesel, getting PCBs out of electricity transmission, removing DDT, etc. Key lessons learned include:
- First regulate pollution or pollution precursor content on a product sales average portfolio basis (as opposed to insisting that every batch of regulated products meets the standard).
- Regulating sales creates a market for innovators, and treats domestic and foreign suppliers equally without the added administrative cost and disruptive effects of an import tariff regime.
- If we are also going to regulate production-level GHG emissions, do so only after or coincident with regulating product standards at the point of sale. Look at Canadian federal PCB and low sulphur diesel regulations for sample wording.
- Allow any combination of regulated product distributors to (1) comply jointly and (2) bank over-compliance for future use. These provisions spawn a real secondary market for the restricted fossil carbon content without obliging government to introduce any form of carbon quota or to finance carbon quota market administration.
- Government should not set price—directly or indirectly through tax measures—or select the new technologies and processes required to meet market demand. The private sector knows how to compete on price, innovation or both. Take either or both tools away from the private sector through government fiat, and any chance at efficient transition to a more efficient, greener economy is lost.
- Recognize, earlier rather than later, that any formal or informal national GHG discharge rights allocation (for Canada, 2005 emissions minus 17% in 2020) is a most precious public good. No government, operating prudently, will ever let any person or entity export bankable carbon entitlements and the jobs they will support. Quebec does not allow Quebec dairy farmers to sell Quebec dairy quota to Alberta farmers, do they?
Our history shows us that efficient product standards will define a schedule for reducing fossil carbon, per unit of product sold, in critical product supply chains. Standards that oblige regulated entities to include prescribed renewable content can also prove highly inefficient. Canada should introduce both forms of product standard.
And if for some reason the income-to-consumption tax shift might look fundamentally different in Canada than it does in the UK, the US and the rest of Europe, I continue to appeal to those of you out there to show me the UK-attachment-equivalent workbook for Canada/any province that tells the story about what is fundamentally different about Canada in an understandable manner.