A modern personal tax on consumed income
At the time the 10-page Income War Tax Act was promulgated in Canada 100 years ago, the underlying principle was to tax Canadians on their “annual net gain, profit or gratuity:” capital gains from holding property would be exempt.
However, 100 years later, this “annual income” approach is no longer appropriate. Consumption is now a more reliable tax base upon which to promote economic growth and fairness.
The notion of taxing annual income was debatable, even in 1917. In response to a question on the taxation of real estate, Sir Thomas White, then-finance minister, responded:
Two men, let us say, are employed by the Bank of Montreal, and each draws a salary of $10,000. One of these men has no outside property at all; he spends the entire $10,000 upon himself and his family. Clearly he is assessable for $10,000, which is his income. The other man spends only $1,500 or $2,000 upon himself and his family—he has a smaller family—and with the balance of the money speculates in stocks or pays taxes upon property which he holds and which gives him no return. Would anybody seriously argue that the first man should be taxed upon $10,000, and that the other man should not be taxed at all, or should be taxed only upon $2,000 or $3,000? (Hansard, September 20, 1917, p. 28)
The 1917 tax was developed with the aim of taxing annual income, as Sir Thomas White makes clear. It was broadened in 1972 to tax capital gains based on the 1967 Carter Commission principle that a “buck is a buck is a buck.” Applying a corporate income tax to ensure that any retained profits do not escape taxation was a hallmark of Canadian tax policy even going back to 1917.
Given a “high” personal exemption level of $2,000, only two per cent of Canadians would pay the income tax in 1917. Today, however, the income tax is much more important, bringing in more than $300 billion in federal and provincial revenues (15 per cent of GDP). Almost every Canadian files—either to pay tax or receive refundable credits. The tax, therefore, can have far-reaching impacts on economic activity by discouraging work effort, entrepreneurship, investment, savings, risk-taking, and ultimately, economic growth.
Given concerns with economic growth, the original intent to tax annual income, whether saved or not, became increasingly challenged. A new approach to personal taxation was developed in the late 1970s, based on the principle that only consumed income—income minus saving—should be taxed. The notion of taxing consumed income rather than annual income became an acceptable alternative among many experts. No longer was annual income necessarily regarded as the appropriate base to measure a person’s well-being. Instead, consumption could be viewed as a better measure of a person’s well being.
A tax on consumed income also reduces the economic cost of taxation. Under an annual income tax, savers pay more tax than consumers over time or, to put it in other words, future consumption is taxed more heavily than current consumption. With a consumption tax, present and future consumption are treated the same.
Consider the example of a consumer and saver with the same earnings. Under an annual income tax, the consumer pays tax only once when income is earned. A saver pays tax not only on the earnings that year but also on the investment income received from saved earnings in the future, resulting in the saver paying more tax than the consumer over time.
Savings is simply consumption deferred to a later time. A dollar saved today is equal in time value to the dollar plus any return on savings received later. Going back to the above quote, Sir Thomas White could have argued that a person should not be taxed on saved income but on the disposal of his or her property and accumulated income consumed at a later time.
Consumption taxes are also simpler to apply in today’s modern world. The essence of consumption taxation is to exempt the so-called normal return on assets, which is the minimum return that savers require to willingly postpone their consumption to the future. By expensing rather than depreciating capital, the investor is provided the equivalent time value of depreciation and financing costs incurred to hold capital. Simplification is further achieved since capital income does not need to be adjusted for inflation. Some complexities in the taxation of international income are also avoided since interest is no longer tax-deductible.
The consumed income approach is consistent with the tax treatment of pension and retirement savings accounts. Taxpayers could deduct their savings from the tax base and pay tax only on account withdrawals (though no tax would be applied to investment income earned in an account). It is also consistent with the notion of simply exempting the return on savings since the tax value of the deduction for savings would be equal to the time value of tax paid on future account withdrawals (which is consistent with the principal-residence exemption, a lifetime capital gains exemption, and Tax-Free Savings Accounts).
In fact, Canada could move to a full-fledged consumed income tax by simply removing existing limits on investments in registered assets. This would not only make the income tax fair by removing the double tax on savings, but it would also provide significant economic benefits by encouraging investment and risk-taking.
To ensure that the consumed income tax cannot be avoided, a business consumption tax would also be imposed, replacing the current corporate income tax. Businesses would deduct investment expenditures from their tax base and pay tax on asset disposals. For both households and businesses, the cost of borrowed funds would not be deductible since the return on savings would not be taxed.
An alternative consumption tax is, of course, the value-added tax (the federal Goods and Services Tax or the federal-provincial Harmonized Sales Tax, based on the invoice-credit method). Value-added—the difference between sales revenues and input purchases from other businesses—is similar to a consumed income tax in that it only taxes consumption. It could also be levied as a “business value tax” that applies to the revenues net of purchases from other businesses with or without wage deductibility and with or without border adjustments for exports and imports.
Those who defend the taxation of capital income argue that because the rich save more than the poor, it is only fair to tax the return to savings. There is also the argument that wealth confers economic and political power. While these arguments have some validity, they are really based on other considerations. Instead of taxing capital income, one could, however, apply the consumption principle to the taxation of estate transfers since giving money to heirs is a form of consumption.
Obviously, a significant share of the tax base would be lost if capital income were to be exempt (a bequest tax would be unlikely to make up the revenue loss). One could adjust marginal personal tax rates and low-income tax credits to make up for revenue losses and achieve redistributive objectives. There might be some limit to how much marginal tax rates can be increased, however, since they could distort work decisions. A better alternative would be for the government to resort to other taxes and user fees or reduce program spending rather than impede economic growth by taxing the return to investment and savings.
To a large extent, many Canadians are already taxed on a consumption basis as all their savings are in housing and retirement accounts from which the investment returns are exempt. There’s no reason not to go further to unleash entrepreneurship, investment, and risk-taking, even if doing so would run contrary to current Canadian public policy trends.