Chapter 3 - Framework and methodology

Introduction

The purpose of this report is to serve as a source of information for parliamentarians, government officials and others who wish to analyze Canada's federal income tax system and the goods and services tax (GST). It is also an important input into the process of evaluating the operation of these tax systems. However, it should be emphasized that this report itself does not attempt to make judgments about either the appropriateness of government policy objectives or the effectiveness of the various tax provisions in achieving those objectives.

The principal function of taxes is to raise the revenues necessary to finance important public programs. This tax revenue is often raised in a way which, at the same time, implements government policy objectives by providing assistance or incentives to particular groups of individuals, businesses or certain types of activities. These measures, which can take the form of tax exemptions, deductions, rate reductions, rebates, deferrals or credits, are typically referred to as tax expenditures. This document provides historical estimates, based on a sample of taxpayer returns, of the cost of these items for the last years for which data are available. In the case of the personal income tax system, these are 1994, 1995 and 1996. For the corporate income tax system, they are 1994 and 1995. The GST estimates are for the years 1994 to 1997. In addition, this document provides projections of these tax expenditures, beyond the last historical year, to 2001.

In order to identify tax expenditures, it is necessary to establish a "benchmark" tax structure which does not contain any preferential tax provisions. Tax expenditures are then defined as deviations from this benchmark. It is important to recognize that reasonable differences of opinion exist as to the definition of the benchmark tax system, and hence what constitutes a tax expenditure. For example, child care expenses could be considered to be a cost of earning income and therefore part of the benchmark tax system; if not, then tax assistance for child care expenses would be a tax expenditure.

This report takes a broad approach – only the most fundamental structural elements of each tax system are considered to be part of the benchmark. By defining the benchmark in this manner, many tax provisions are treated as tax expenditures. This approach provides information on a full range of measures, and so allows readers who take a different position as to the appropriate benchmark system to construct their own list of tax expenditures.

In keeping with this objective of providing as much information as possible, the document identifies several tax provisions that are not generally considered to be tax expenditures even though they reduce the amount of revenue collected. These measures are denoted as "memorandum items" and have been included simply to provide additional information. Three types of memorandum items are included.

• Measures that are considered to be part of the benchmark system. The dividend tax credit, for example, reduces or eliminates the double taxation of income earned by corporations and distributed to individuals through dividends.

• Measures where there may be some debate over whether the item should be considered to be a tax expenditure. The cost of business-related meals and entertainment, for example, may be considered to be an expense incurred in order to earn income (and therefore be part of the benchmark) or may be considered to provide a benefit (and therefore constitute a tax expenditure).

• Measures where the available data do not permit separation of the tax expenditure component from the portion which is essentially part of the benchmark tax system. For example, a portion of tax-free allowances for Members of Parliament (MPs) is used to cover legitimate employment expenses (and is therefore part of the benchmark for the income tax system) while the rest may be used for personal consumption (and is therefore an income tax expenditure). Since it is not possible to distinguish between these two elements, the non-taxation of such allowances is included as a memorandum item.

The federal and provincial income tax and sales tax systems interact with each other to various degrees. As a result, changes to tax expenditures in the federal system may have consequences for provincial tax revenues. In this publication, however, any such provincial effects are not taken into account – that is, the tax expenditure estimates are purely federal in nature.

The remainder of this chapter discusses the tax expenditure concept in order to facilitate understanding of the quantitative estimates. It also discusses the calculation and interpretation of the costs of tax expenditures, including key assumptions used in the analysis. Chapter 2 presented estimates of the costs of tax expenditures and memorandum items in the personal and corporate income tax systems and the GST.

Simplified descriptions of each tax expenditure as well as information on data sources and methodology used in constructing the estimates are presented in Chapter 4 (personal income tax), Chapter 5 (corporate income tax) and Chapter 6 (GST).

Elements of Tax Expenditures in the Personal and Corporate Income Tax Systems

The benchmark for the personal and corporate tax systems includes the existing tax rates and brackets, unit of taxation, time frame of taxation, treatment of inflation for calculating income and those measures designed to reduce or eliminate double taxation.

The definition of income is crucial in determining what constitutes a tax expenditure. Tax provisions that provide for the deduction of current costs incurred to earn income are considered to be part of the benchmark system and are therefore not considered to be tax expenditures. For example, the deductibility of labour costs or economic depreciation of business assets in determining business income would not be considered a tax expenditure.

It is important to emphasize that the definition of the benchmark tax structure, and hence the identification of tax expenditures, is subjective. Reasonable differences of opinion may exist as to the interpretation and categorization of tax measures. For example, employment insurance (EI) premiums paid by an employee could be viewed either as an expense of earning income or as a tax used to finance an income transfer to the unemployed. From the first perspective, the current system of providing employees a tax credit for contributions would not be a tax expenditure. The credit for EI premiums merely recognizes an expense of earning income and, hence, is part of the benchmark tax structure. On the other hand, one could argue that the tax credit for EI premiums represents a tax expenditure because the taxes paid by taxfilers are generally not deductible against personal income taxes. For this reason the tax treatment of EI premiums is reported as a memorandum item. Measures such as these which are subject to debate are discussed on an individual basis in Chapters 4 and 5.

The following provides a more detailed discussion of the features of the benchmark for both the personal and corporate tax systems.

(1) Tax rates and income brackets

For the personal income tax system, the existing rate structure, including surtaxes, is taken to be part of the benchmark system. The basic personal credit is also treated as part of this structure since it is universal in its application and can be viewed as providing a zero rate of tax up to an initial level of income. However, the cost of this credit is included as a memorandum item.

With respect to the corporate income tax system, effective after February 27, 1995, the basic federal corporate tax rate is 29.12 per cent including the surtax but after the provincial abatement. Provisions that reduce this tax rate for certain types of activities or corporations are regarded as tax expenditures. These include the lower tax rate for manufacturing and processing profits and the lower tax rate for small business profits; the latter is available on the first $200,000 of active business income earned by most Canadian-controlled private corporations (CCPCs). The large corporations tax, levied at the existing rate, is also considered to be part of the benchmark tax system.

(2) Tax unit

Personal income taxes in Canada are based on individual income. Consequently, the individual is taken as the benchmark tax unit for the purposes of identifying tax expenditures in this report. This choice leads to the classification of the various provisions related to dependants, such as the spousal credit, as tax expenditures.

The choice of the appropriate unit for the corporate income tax benchmark system raises a number of conceptual issues. There is a wide range of possible tax units, including the establishment or activity unit within a corporation, the single legal corporate entity and the consolidated group of related corporations. The present income tax system contains elements of all these approaches. For example, the view that the activity unit is the appropriate unit of taxation is consistent with the "at-risk" rules, which restrict the amount of investment tax credits and business losses that may be flowed out to limited partners. The view that the single legal corporate entity is the relevant tax unit is supported by the fact that income from one part of a business can be offset by other business losses within the same corporation, whereas losses by one corporation may not generally be used against the income of another corporation in the group. Other provisions in the current tax system allow corporate groups to reorganize their corporate structures without triggering any capital gains or recaptured depreciation. These rollover provisions lead to a deferral of capital gains and recaptured depreciation, which would be appropriate if the taxation unit is the consolidated group of related corporations. On balance, the view most closely related to the existing system is that of the single legal corporate entity. For this reason, the single corporation is adopted as the benchmark tax unit, together with the availability of various rollover provisions which permit the deferral of capital gains when a corporate structure is changed.

(3) Taxation period

In this document, the benchmark taxation period for the personal income tax system is the calendar year. Accordingly, any measures that provide deferrals of taxable income to a subsequent year are considered to be tax expenditures. For example, farmers are permitted to defer the receipt of income from the sale of grain through the use of special cash purchase tickets, and this is listed as a tax expenditure.

The benchmark taxation period for the corporate income tax system is the fiscal year. As with the personal income tax system, deferrals, such as the accelerated write-off of capital assets, are considered to be tax expenditures.

A strict application of the annual taxation period would imply that measures which provide for the carry-over of losses to other years would be tax expenditures. However, the relatively cyclical nature of business and investment income suggests that such income should be viewed over a number of years. Consequently, carry-overs of business and investment losses are treated as part of the benchmark tax system in this report. Estimates of the cost of these provisions are provided in the memorandum items section.

(4) Treatment of inflation

Both the personal and corporate income tax systems are based on nominal income with a number of provisions that account for the impact of inflation. Nominal income is therefore taken as the appropriate basis for the benchmark tax system. Consequently, special measures, such as the partial exclusion of capital gains from taxable income, which may serve to recognize inflation, are identified as tax expenditures.

(5) Avoidance of double taxation

Conceptual difficulties arise in deciding whether certain provisions which reduce or eliminate double taxation should be considered as tax expenditures.

For example, regarding the personal and corporate income tax systems as completely separate would suggest that the dividend tax credit is a tax expenditure. However, the credit is an essential feature of the overall (i.e. both corporate and personal) income tax structure and serves to eliminate or reduce double taxation. In its absence, income earned through corporations would be taxed twice, once in the corporation and once at the personal level. For this reason, the dividend tax credit is not considered to be a tax expenditure.

Similarly, the non-taxation of intercorporate dividends is designed to ensure that income already taxed in one corporation is not taxed again upon receipt of a dividend by another corporation. Without this exemption, double taxation would occur and the corporate income tax system would not be neutral across organizational structures. For example, consider a single corporation that currently operates as a number of divisions. Now suppose it reorganizes into a holding company with wholly owned subsidiaries instead of divisions. The profits from the subsidiaries flow to the

holding company through intercorporate dividends. If these dividends were subject to taxation at both the subsidiary and the holding company levels, double taxation would occur. Consequently, the exemption of intercorporate dividends is not considered a tax expenditure.

Similar reasoning applies to the tax exemption on income of foreign affiliates of Canadian corporations. Canada either exempts from Canadian corporate income tax certain dividend income paid by foreign affiliates or it provides a foreign tax credit for income taxes paid in the other country. In either case, the intention is to ensure that income is not subject to double taxation (i.e. once in the country of residence of the foreign affiliate and once again in Canada when the dividends are paid out). A further discussion of this topic, and the possible benchmarks that could be considered, is contained in Chapter 5.

Information on some of these measures that provide relief from double taxation is provided in the appropriate memorandum sections of this report.

Tax Expenditures in the Goods and Services Tax¹

The benchmark system used to analyze the GST is a broadly based, multi-stage, value-added tax collected according to the destination principle and using a tax credit mechanism to relieve the tax in the case of business inputs. The following provides a more detailed discussion of the features of the GST benchmark.

(1) Multi-stage system

The main structural elements of a multi-stage consumption tax are taken to be part of the benchmark. Under the multi-stage system, tax is applied to the sales of goods and services at all stages of the production and marketing chain. At each stage, however, businesses are able to claim tax credits to recover the tax they paid on their business inputs. In this way, the tax system has the effect of applying the tax only to the value added by each business. Since the only tax that is not refunded is the tax collected on sales to final consumers, the tax rests ultimately on final consumption.

(2) Destination-based

The benchmark system applies tax only to goods and services consumed in Canada. Accordingly, the tax applies to imports as well as domestically produced goods and services. Exports are not subject to the tax.

(3) Single tax rate

The benchmark system has only one tax rate. This rate corresponds to the statutory rate of 7 per cent. As a result, GST provisions that depart from this single rate are considered to be tax expenditures.

(4) Taxation period

The benchmark taxation period is the calendar year.

(5) Constitutional provisions for government sectors

Section 125 of the Constitution Act, 1867, provides that "no land or property belonging to Canada or any province shall be liable to taxation." This means that neither the federal nor the provincial governments (or their Crown agents) are liable to taxation by the other. Accordingly, constitutional immunity from taxation is recognized as part of the benchmark system for the GST.

The benchmark also recognizes that the federal and provincial governments have taken steps to simplify the operation of the tax for transactions involving government sectors.

• The federal government decided to apply the GST to purchases by federal departments and Crown corporations in order to keep the tax as simple as possible for vendors. As a result, the GST and the benchmark system treat federal Crown corporations in the same manner as any other business entity.

• By virtue of Section 125, provincial governments and Crown agents are not liable to pay the GST on their purchases. However, the federal government and most provinces have entered into Reciprocal Tax Agreements. These agreements specify situations in which each level of government agrees to pay the sales taxes of the other. Generally, this involves applying tax to purchases made by Crown corporations. As a result, provincial Crown corporations are treated like any other business entity in the benchmark system.

Unlike provincial governments, municipalities are liable to pay the GST. Therefore, the benchmark system considers them as paying tax on their purchases. Universities, colleges, schools and hospitals are also considered to pay tax on their purchases. The GST and the benchmark generally treat these sectors as final consumers – that is, they pay GST on their purchases, they do not claim input tax credits and they do not collect GST on their sales.

The only exception to this benchmark treatment arises from the fact that municipalities, universities, colleges, schools and hospitals engage in certain commercial activities analogous to those provided in the private sector. For example, some municipalities operate golf courses. Such commercial activities are taxable under the GST, and the GST paid on associated inputs can be claimed as input tax credits.

Types of GST tax expenditures

Comparing the actual structure of the GST to the benchmark system, it is possible to identify four types of tax expenditures:

• zero-rated goods and services;
• tax-exempt goods and services;
• tax rebates; and
• tax credits.

(1) Zero-rated goods and services

Under the GST, certain categories of goods and services are considered to be taxed at a "zero" rate, rather than at the general tax rate of 7 per cent. Vendors do not charge GST on their sales of zero-rated goods and services (whether these sales are to other businesses or to final consumers). However, vendors are entitled to claim input tax credits to recover the GST they paid on inputs used to produce zero-rated products. As a result, zero-rated goods and services are tax-free.

One category of zero-rated sales is basic groceries – i.e. foods intended to be prepared and consumed at home. Other categories of zero-rated sales include prescription drugs, medical devices and most agricultural and fish products.

(2) Tax-exempt goods and services

Some types of goods and services are exempt under the GST. This means that the GST is not applied to these sales. Unlike zero-rated goods and services, however, vendors of exempt products are not entitled to claim input tax credits to recover the GST they paid on their inputs to these products.

Examples of tax-exempt goods and services include long-term residential rents, most health and dental care services, day-care services, most sales by charities, most domestic financial services, municipal transit and legal aid services.

(3) Tax rebates

Certain sectors are eligible for rebates on a portion of the GST paid on inputs. For example, there are rebates for schools, universities, hospitals and municipalities. To the extent that these sectors make taxable sales, they can claim input tax credits to recover the tax they paid on inputs to these sales. Where they provide tax-exempt services, however, they are eligible to receive rebates for only a portion of the GST paid on their inputs to these services. These rebates ensure that these institutions do not bear a greater tax burden on their purchases under the GST than they would have under the manufacturers' sales tax, which the GST replaced. This treatment constitutes a tax expenditure because, under the benchmark system, these institutions are considered to be final consumers.

Other examples of tax rebates include the rebates for charities, substantially government-funded non-profit organizations, newly built housing and book purchases made by qualifying institutions. Also, foreign visitors to Canada are able to claim a rebate for the GST they pay on hotel accommodation and on goods they take home. Only the rebate for hotel accommodation is considered to be a tax expenditure, however, because goods taken home by foreign visitors are effectively exports which are not taxable under the benchmark system.

(4) GST credit ²

To ensure that the GST system is fair, a GST credit is provided through the personal income tax system to single individuals and families with low and moderate incomes. The credit is paid by cheque four times a year in equal instalments. The total amount of the credit people receive depends on family size and income, and it is calculated annually based on information provided in personal income tax returns.

Memorandum items for the goods and services tax

As indicated earlier, some tax measures are presented as memorandum items even though they are not generally considered to be tax expenditures. For example, the refund of GST for certain employees' expenses is included as a memorandum item.

Many employees, such as commission salespeople, incur significant expenses in the course of carrying out their duties. Examples include restaurant meals and automobile expenses. Often, such expenses are not reimbursed by employers except indirectly through the salaries and commissions paid to employees. Since employees are not considered to be carrying on a commercial activity, they are not able to claim input tax credits for the GST they paid on these expenses. However, employees can receive a refund of the GST paid on those employment expenses that are deductible for income tax purposes. The refund of GST paid on employees' personal consumption expenses would constitute a tax expenditure. However, it is not possible to determine exactly what portion of these expenses should be considered personal consumption. Therefore, the refunds of GST paid on employees' expenses are reported as memorandum items. The memorandum items for the GST are discussed in more detail in Chapter 6.

Calculation and Interpretation of the Estimates

The estimates indicate the annual cash-flow impact to the government of each particular measure, and not their long-run or steady-state revenue cost, subject to the following limitations:

• all measures are evaluated independently; and
• all other factors remain unchanged.

These methodological distinctions are important and have implications for the interpretation of the estimates. These concepts are discussed in further detail below.

Independent estimates

The estimate of the cost of each tax expenditure is undertaken separately, assuming that all other tax provisions remain unchanged. An important implication of this is that the estimates cannot be meaningfully aggregated to determine the total cost of a particular group of tax expenditures or of all tax expenditures combined.

As explained in more detail in the following paragraphs, this restriction arises from the fact that:

• the income tax rate structure is progressive; and
• tax measures interact with one another.

Progressive income tax rates

The combined effect of claiming a number of income tax exemptions and deductions may be to move an individual to a lower tax bracket than would have applied had none of the tax measures existed. To the extent that this occurs, aggregation of the individual estimates may under-represent the "true" cost to the federal government of maintaining all of them. For example, consider a taxpayer whose taxable income was $1,000 below the level at which he or she would move from the 17-per-cent into the 26-per-cent tax bracket. Imagine that this taxpayer arrives at this level of taxable income by using two tax deductions of $1,000 each (e.g. home relocation loan and registered retirement savings plan (RRSP) contribution). Eliminating either deduction by itself would increase taxable income by $1,000 and the taxpayer's federal tax liability by $170. Eliminating both measures simultaneously, however, would not raise the tax liability by $170 + $170, but rather by $170 + $260.

Aggregating the individual estimates for these two items would provide a misleading impression of the revenue impact of eliminating both of them. Therefore, the estimates in this document cannot be meaningfully aggregated to determine the total cost of a particular group of tax expenditures or of all tax expenditures combined.

While there is only one statutory tax rate for corporations, the small business deduction creates a de facto progressive tax rate schedule for some corporations. In this way, the above argument is valid for the corporate income tax system as well, although the effect is not as large as for personal income taxes.

Interaction of tax measures

As noted above, the estimates are computed one at a time, assuming all other provisions remain unchanged. Given that tax provisions sometimes interact, the total cost of a group of tax expenditures calculated individually may differ from the dollar value of calculating the cost of the same group of tax expenditures concurrently. This is because adding the independently estimated costs of the tax provisions would result in double counting and so would not provide an accurate measure of the revenue which would be generated by simultaneously altering a group of measures.

For example, consider the non-taxation of veterans' allowances, which reduces the recipient's net income. Many measures, such as the medical expense credit, are calculated on the basis of net income. Thus, the reported estimate for the non-taxation of veterans' allowances represents not only the direct impact on government receipts of not taxing the allowances, but also the indirect impact of the change on the cost of other tax measures (such as the medical expense credit) which depend on net income.

Since estimates for GST tax expenditures are made using the same methodological approach as for income taxes, they too cannot be aggregated because they may interact. The following discussion of hospital rebates and zero-rating of prescription drugs illustrates the differences between independent and concurrent estimates for these two provisions.

• Eliminating hospital rebates: If hospital rebates were eliminated, hospitals would no longer be able to recover 83 per cent of the GST they pay on their purchases³. However, they could continue to purchase prescription drugs on a tax-free basis because these drugs are zero-rated. The estimate for hospital rebates recognizes that the rebate would not have been claimed in respect of zero-rated prescription drugs.

• Eliminating the zero-rating of prescription drugs: If prescription drugs were taxed at the GST rate of 7 per cent, then hospitals would pay the tax on their drug purchases but recover 83 per cent of the tax through the rebate system. Therefore, the estimate for the zero-rating of prescription drugs is calculated as net of the expected increase in the payment of hospital rebates.

• Eliminating the two measures concurrently has a revenue impact greater than the sum of the independent estimates because the GST would be payable on prescription drugs, and hospitals would be unable to claim a rebate for these purchases.

All other factors remain unchanged

The estimates in this report represent the amount by which federal tax revenues were reduced due to the existence of each preference assuming that all other factors remain unchanged.

In order to evaluate the extent of the revenue reduction, the approach taken here is to recalculate federal revenues assuming the measure in question has been eliminated. The difference between this recalculated figure and actual revenues provides the quantitative estimate of the cost of the tax expenditure.

The assumption that all other things remain the same means that no allowance is made for: (1) behavioural responses by taxpayers; (2) consequential government policy changes; or (3) changes in tax collections due to altered levels of aggregate economic activity which might result from the elimination of a particular tax measure (further detail is provided below). Incorporating these factors would add a large subjective element to the calculations.

(1) Absence of behavioural responses

In many instances, the removal of a tax expenditure would cause taxpayers to rearrange their affairs to minimize the amount of extra tax they would have to pay, perhaps by making greater use of other tax measures. Therefore, the omission of behavioural responses in the estimating methodology generates cost estimates which may exceed the revenue increases that would have resulted if a particular provision had been eliminated.

As one example, consider the case of the deduction for RRSP contributions. Eliminating this provision would result in the amount of additional federal revenue indicated in the report only if the contributions were not directed to an alternative tax-preferred form of saving. However, the absence of the RRSP deduction might encourage individuals to place their funds instead in some other tax-favoured instrument, such as shares in a labour-sponsored venture capital corporation. If such a response did occur, eliminating the RRSP deduction would result in a smaller increase in revenues than that indicated.

The effects of this assumption can also be illustrated for the GST by considering the housing rebate. Homeowners are eligible for a rebate of the GST they pay on the purchase of new houses. If this rebate were eliminated, the price of new houses would increase relative to the price of used houses. This, in turn, might reduce the demand for new houses while increasing the demand for used houses (which are tax exempt). Since the dynamics of the housing market are not taken into account, the revenues obtained by eliminating the housing rebate could actually be lower than the indicated estimate.

(2) Consequential government policy changes

The estimates ignore transitional provisions that might accompany the elimination of a particular measure and take no account of other consequential changes in government policy. For example, if the government were to eliminate a particular tax deferral, it could require the deferred amount to be brought into income immediately. Alternatively, it might prohibit new deferrals but allow existing amounts to continue to be deferred, perhaps for a specified period of time. The estimates in this report do not provide for any such transitional relief.

Similarly, the estimates make no allowance for consequential government policy changes. For example, if capital gains on owner-occupied housing were made taxable under the personal income tax system, an argument could be made that the cost of maintenance should be deductible in the same way as other investment expenses. Furthermore, it may not be possible to track and assess small gambling winnings. This may mean that a threshold under which winnings would be non-taxable would be required. However, in calculating the cost of providing the exemption for lottery winnings, no allowance is made for such hypothetical consequential government policy changes.

(3) Impact on economic activity

The estimates do not take into account the potential impact of a particular tax provision on the overall level of economic activity and thus aggregate tax revenues. For example, although eliminating the low corporate tax rate for manufacturing and processing could generate a significant amount of revenue for the government, the amount of manufacturing activity could decline, resulting in possible job losses, a reduction in taxable income and, hence, a reduction in the aggregate amount of tax revenue collected. Furthermore, the derivation of the estimates does not include speculation on how the government might use the additional funds available to it and the possible impacts this could have on other tax revenues.

Developing Historical Estimates

The majority of the personal income tax estimates in this report were computed with a personal income tax model. This model simulates changes to the personal income tax system using the statistical sample of tax returns collected by Revenue Canada for its annual publication Taxation Statistics. The model estimates the revenue impact of possible tax changes by recomputing taxes payable on the basis of adjusted values for all relevant income components, deductions and credits. For example, the removal of the moving expense deduction would result not only in a change in net income but also in all of the credits, such as the medical expense tax credit, whose values depend on net income. For those tax expenditures whose costs could not be estimated using this model alone, supplementary data were acquired from a variety of sources. Details on data sources and the methodologies used for estimating the cost of specific personal income tax measures are provided in Chapter 4.

A corporate income tax model was used to measure most of the corporate tax expenditures. As with the personal income tax model, it is based on a statistical sample of tax returns collected by Revenue Canada, and is able to recompute taxes payable on the basis of adjusted tax provisions. This recomputation of taxes takes into account the availability of unused tax credits, tax reductions, deductions and losses that would be used by the corporation to minimize its tax liability. Where costs could not be estimated using this model alone, supplementary data acquired from a variety of sources were used. Details on these sources are provided in Chapter 5.

Estimating the cost of tax deferrals presents a number of methodological difficulties since, even though the tax is not currently received, it may be collected at some point in the future. It is therefore necessary to derive estimates of the cost to the government of providing such a tax deferral while at the same time ensuring comparability with the other estimates presented here.

In this report, income tax deferrals are estimated on a "current cash-flow" basis – that is, the cost is computed as the forgone tax revenue associated with the additional net deferral in the year (deductions for the current year less the income inclusion from previous deferrals). The estimates thus computed provide a reasonably accurate picture of the ongoing costs of maintaining a particular tax provision in a mature tax system. They can be aggregated over time without double counting and are comparable to estimates of the costs associated with tax credits and deductions.

The costs of the majority of the GST tax expenditures presented in this report were estimated using a Sales Tax Model based on Statistics Canada's input-output tables and the National Income and Expenditure Accounts. In cases where estimates were not derived using this model, supplementary data from a variety of sources were used. Details on both the data sources and methodologies are provided in Chapter 6.

Developing Future Projections

As with the historical estimates, the projections represent the estimated amount by which federal tax revenues would be reduced due to the tax expenditure, assuming that all measures are evaluated independently. This means that the projections cannot be aggregated. In addition, it is assumed that all other factors remain unchanged. Thus, the projections make no provision for any behavioural change that might result from the removal of the provision; for any consequential policy changes that might accompany the change; or for the possible impact of the change on overall economic activity and thus on tax revenues. The projections do, however, take into consideration the impact of announced tax changes.

In contrast to the estimates of tax expenditures for the historical period, when values of the tax expenditures can generally be obtained from tax statistics or other historical data, projections of tax expenditures must rely on estimated relationships between tax expenditures and explanatory economic variables. Using these relationships, the values for the explanatory variables are projected into the future and so permit an estimation of the future expected values of tax expenditures. Key explanatory variables are generally those reflecting the state of the economy.

Projections for the explanatory variables are based either on the 1999 budget forecasts (e.g. gross domestic product, population, employment, corporate profits, inflation, consumer spending) or on past trends in the tax expenditure. Where projected tax expenditures were not obtained using these approaches, information on the alternative methodology is provided in Chapter 4 for personal income tax, Chapter 5 for corporate income tax and Chapter 6 for GST tax expenditures.

Any projections are inherently subject to forecast error, and quite substantial errors at times. Those familiar with forecasts prepared for the Canadian economy or for any other economy recognize that forecasting is not a science. Future values for key explanatory variables are based on best judgments, and unchanged policies are assumed for the forecast period. Furthermore, the relationships between variables that are being explained and those that provide the explanation may not be robust and could quickly change over time. For all these reasons, the projected values of tax expenditures should be treated as "best efforts," which do not have any greater degree of reliability than the variables that explain them. For example, if the level of gross domestic product (GDP) explains a tax expenditure, one would not expect the projected level of tax expenditure to materialize if the expected level of GDP did not occur. Even if the expected level of GDP did occur, the level of the tax expenditure might still not materialize if, in the future, the relationship between the tax expenditure and GDP turns out to be different from that estimated on average in the past. Therefore, in general, one should expect that the degree of reliability of the projected tax expenditures should be less than that of the underlying explanatory variables.

Comparison With Direct Expenditures

In comparing the cost of the tax expenditures in this report to direct spending estimates, it should be noted that a dollar of tax preference is often worth substantially more to the taxpayer than a dollar of direct spending. This results from the fact that, in most cases, government grants (i.e. direct spending) are taxable to the recipients. For example, consider an individual facing a marginal tax rate of 29 per cent. A deduction of $100 would be worth $29. If, instead, the government were to provide the individual with a taxable grant of $29, after-tax income would increase by only $20.59 since the individual would face an income tax liability of $8.41 ($29 x 29 per cent).

The same conclusions do not always apply to tax expenditures provided to corporate taxpayers. Consider, for example, an investment tax credit to a corporation with respect to capital equipment acquired to carry out scientific research and experimental development in Canada. The cost to the government of providing a 20-per-cent tax credit would, in most circumstances, be the same as it would be if the government had provided a direct grant of 20 per cent. This is because investment tax credits are considered to be assistance and are therefore treated in the same manner as direct government grants or subsidies. The 20-per-cent tax credit, like a direct grant, is either included in income, and subject to corporate income tax, or it reduces the capital or other costs deductible by the taxpayer.

Notes:

1. It should be noted that this analysis deals only with the GST and not with other commodity taxes (e.g. excise taxes). The exclusion of these other commodity taxes recognizes the inherent conceptual difficulties of defining an appropriate benchmark system in the context of a tax which is applied to a specific commodity. Work is continuing on defining an appropriate benchmark system which would allow the future measurement of the associated tax expenditures.
2. It should be noted that there was a small business transitional credit which accompanied the introduction of the GST. This temporary measure provided a one-time credit of up to $1,000 to GST registrants whose taxable sales did not exceed $500,000 in their first full quarter of 1991 or in any three-month period beginning in 1990.
3. Most services provided by hospitals are exempt from the GST. This means that no tax is charged on these services but input tax credits cannot be claimed to recover the tax paid on inputs. However, hospitals are able to claim a rebate of 83 per cent of the GST paid on the inputs they use to provide exempt services.

- Table of Contents - Previous - Next -