The Effects of Tax Rate Changes on Tax Bases and the Marginal Cost of Public Funds for Canadian Provincial Governments

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1 The Effects of Tax Rate Changes on Tax Bases and the Margnal Cost of Publc Funds for Canadan Provncal Governments Bev Dahlby a and Ergete Ferede b a Department of Economcs, Unversty of Alberta, Edmonton, and Fellow n Resdence, C.D. Howe Insttute, Toronto b Grant MacEwan Unversty, Edmonton, (revsed January 23, 2011) Abstract The effcency losses from taxaton vary drectly wth the responsveness of a government s tax bases to tax rate ncreases. We estmate the dynamc responses of tax bases to changes n tax rates usng aggregate panel data from Canadan provnces over the perod 1972 to Our preferred emprcal results ndcate that a one percentage pont ncrease n corporate ncome, personal ncome, and sales tax rates are assocated wth a 2.3, 0.76, and 0.63 percent reductons n ther respectve tax bases n the short-run. The correspondng long-run tax base elastcty estmates are hgher 15.50, 3.65, and 1.82 percent respectvely. We use the tax base elastcty estmates to calculate the margnal cost of publc funds (MCF) for the provnces three maor taxes. Our computatons ndcate that the corporate ncome had the hghest MCF and that the sales tax had the lowest MCF n all provnces n The MCF for the personal ncome tax ranged from 1.45 n Alberta to 3.85 n Quebec. Our results mply that there would have been sgnfcant welfare gans n 2006 from reductons n the provncal corporate ncome tax rates. Our computatons also ndcate that the equalzaton grant formula may reduce the perceved MCFs of the provnces that receve these grants and that ncreases n provncal corporate and personal ncome taxes can cause sgnfcant reductons n federal tax revenues. *Fundng for ths proect was provded by a research grant from the Donner Canadan Foundaton. JEL classfcaton: H21; H71 Keywords: tax base elastcty; margnal cost of publc funds

2 1. Introducton It s well known that tax polcy changes affect government revenue and economc effcency. The effects of tax rate changes on government revenue depend not only on the magntude of the change n the tax rates but also on the responsveness of the correspondng tax bases. Consequently, understandng the behavoural responses of tax bases has been a maor focus of academc and poltcal dscussons on taxaton polcy. How responsve are tax bases to changes n tax rates? What are the economc and welfare costs of rasng tax rates? Emprcal studes on the behavoural response of tax rate changes mostly focus on the estmaton of the elastcty of taxable ncome wth respect to the net-of-tax rate (one mnus the tax rate). The maorty of these studes are based on US household tax return data Whle earler studes such as Lndsay (1987) and Feldsten (1995) report relatvely hgher taxable ncome elastctes well above 1, later studes such as Auten and Carroll (1999), Long (1999), Kopczuk (2005), Gruber and Saez (2002), and Gertz (2007) fnd a much lower taxable ncome response. There s a great deal of varaton n the emprcal estmates of the elastcty of taxable ncome. Emprcal results generally suggest elastcty of taxable ncome estmate close to 0.40 (Gruber and Saez, 2002). Saez et al (2009) provdes an excellent survey of ths taxable ncome lterature On the other hand, as Gruber and Rauh (2007) have ponted out, the effects of corporate tax rate changes on ts base have been largely gnored n the lterature. Some of the studes that deal wth corporate taxaton nclude: Mntz and Smart (2004) for Canada, Gruber and Rauh (2007) for the US, Huznga and Laeven (2008) for European countres, and Redl and Rocha- Aks (2009) for OECD countres. There s a paucty of emprcal studes that employ Canadan data. Sllamaa and Veall (2001) and Mntz and Smart (2004) examne the response of personal ncome and corporate ncome tax bases to tax rates, respectvely. Usng tax returns data from Canadan households, Sllamaa and Veall (2001) examne the response of taxable ncome to the 1988 Canadan personal ncome tax reform. They fnd an estmate of elastcty of taxable ncome wth respect to the net-of-tax rate close to 0.25 for workng-age ndvduals. They however obtan a much hgher estmate for the self-employed and hgher ncome ndvduals. Mntz and Smart (2004) nvestgate how ncome shftng by Canadan corporatons affect nvestment, government revenue, and tax base elastctes. Usng ndustry-level data, they also emprcally estmate the elastcty of corporate tax base wth respect to the corporate ncome tax rate. They provde 1

3 separate elastcty estmates for corporatons whch they group as ncome shfters and nonshfters. Ther preferred estmaton result shows a corporate tax base elastcty wth respect to net-of-tax rate of 4.9 for the ncome shfters corporatons. None of the above studes however provdes a detaled nvestgaton of the nterdependence of the tax bases, such as the effect of an ncrease n the corporate ncome tax rate on the personal ncome tax base, or the socal cost of rasng tax revenue. Wth regard to the margnal cost of publc funds (MCF), Dahlby and Ferede (2008) estmate models of the effects of taxes on growth, nvestment, and revenues to compute the MCFs for the Canadan provncal governments corporate ncome tax, personal ncome tax and sales tax. However, that study does not estmate the responses of tax bases to tax rate changes. The prncpal obectve of ths study s to nvestgate the dynamc responsveness of tax bases to changes n tax rates usng aggregate data from 10 Canadan provnces over the perod We focus on the three man taxes: personal ncome tax (PIT), corporate ncome tax (CIT), and provncal sales tax (PST). Our preferred emprcal results ndcate that a one percentage pont ncrease n corporate ncome, personal ncome, and sales tax rates are assocated wth a 2.27, 0.76, and 0.63 percent reductons n ther respectve tax bases. We also fnd that an ncrease n the CIT rate ncreases the PIT base. The long-run tax base sem-elastcty estmates are hgher than the correspondng short-run values. Our long-run elastcty estmates for the PIT s well wthn the range of results found n the lterature. The tax base elastcty estmates for the CIT are however hgher than those obtaned n prevous studes. Our computatons also ndcate that the equalzaton grant formula may drastcally reduce the perceved MCFs of the provnces that receve these grants and that ncreases n provncal corporate and personal ncome taxes can cause sgnfcant reductons n federal tax revenues. The remanng part of ths paper s organzed as follows. In Secton 2 we present a smple framework that shows how to calculate the margnal cost of publc funds (MCF) usng tax base sem-elastctes, tax rates, and revenue shares of the taxes. The emprcal methodology and the data are descrbed n Secton 3. The estmated emprcal results are presented and dscussed n Secton 4. In Secton 5, we compute the MCF for the provnces usng our tax base sem-elastcty estmates. Secton 6 concludes. 2

4 2. Analytcal Framework The amount of tax revenue that a government collects depends on ts tax rates and tax bases. The ncrease n total tax revenue from an ncrease n a tax rate depends not only on the sze of the tax rate ncrease, but also how the changes n the tax bases as taxpayers respond to the changes n the tax rates. In ths secton, we focus on the effects of tax rate changes on tax bases and ther ultmate effects on tax revenue. We are nterested n the three man taxes mposed by provncal governments: corporate ncome tax rate, τ c, personal ncome tax, τ p, and general sales tax, τ s. In almost all provnces these taxes account a sgnfcant part of the provncal total tax revenue. For example, n 2006 the share of these taxes was on average about 68 percent of the total provncal tax revenue. See Dahlby and Ferede (2008). We assume that a partcular tax base depends on all the three tax rates. For example, the corporate tax base depends on the corporate tax rate because ths affects the level of corporate nvestment and therefore the sze of the corporate tax base. However, the personal ncome tax rate n a provnce may affect ndvduals decson concernng whether to ncorporate ther busnesses. Fnally, the retal sales tax rate whch falls on some busness nputs may reduce the proftablty and sze of the corporate sector. These examples ndcate a few of the complex ways n whch the corporate ncome, personal ncome and sales tax rates affect not only ther own tax base but also the magntudes of the other tax bases n a provnce. In ths paper, we do not explctly model the determnants of each tax base. We smply allow for some general, but unspecfed, complementarty or substtutablty among the tax bases that reflect taxpayers responses to these tax rates. For the three man tax rates that we are nterested n, we specfy tax base as a functon of the corporate, personal, and sales tax rates: ( τ, τ, τ ) B = B c p s (1) where = c, p, s denotes the corporate ncome tax (c), personal ncome tax (p), and sales tax bases, respectvely. Government tax revenue from a partcular tax base s smply the product of ts tax rates and the tax base. Consequently, the government s total tax revenue from the three taxes s gven by: TR = τ B (2) Snce a tax base depends not only on ts own tax rate, but also on the tax rates leved on the other tax bases, a change n a partcular tax rate affects the amount of revenue that the government can 3

5 collect from that source and from the other tax bases. Consequently, the effect of a change n a partcular tax rate on the total tax revenue s gven by: dtr db = B + τ = B + R η dτ dτ (3) where R = τ B s the revenue rased from tax base and η = d ln( B ) / dτ s the sem-elastcty of tax base wth respect to tax rate. We expect the own-base elastcty, η, to be negatve because a hgher tax rate leads to greater tax avodance and tax evason whch shrnks the tax base. The cross-base sem-elastcty, η, may be postve f an ncrease n τ causes taxpayers to shft ther actvtes to tax base to avod the tax rate ncrease, or t may be negatve f the two tax bases are complementary. For example, a postve cross-base elastcty between the corporate and personal ncome tax bases mght occur f n response to an ncrease n the personal ncome tax rate some ndvduals may fnd t advantageous to ncorporate ther busness actvtes. A negatve cross-base elastcty between the sales tax and the personal ncome tax would occur f an ncrease n the personal ncome tax reduced dsposable ncome and consumpton spendng. The elastcty of total revenue wth respect to the tax rate on tax base s therefore equal to: τ dtr ρ = TR dτ = s + τ s η where s = R / TR s the share of total tax revenue from tax base. Note the mpact of an ncrease n the tax rate on base on total revenue depends on ts own-base sem-elastcty and on the semelastcty of other tax bases wth respect to that tax rate (all weghted by ther respectve tax revenue shares). We are nterested n assessng the effects of tax rate changes on the total tax revenue n order to calculate the MCFs for the three man tax rates leved by provncal governments n Canada. When governments rase a tax rate, the drect cost to taxpayers s the addtonal revenue t generates. There s also an addtonal cost to taxpayers assocated wth the welfare losses caused by changes n the economc decsons of taxpayers. The MCF measures the loss created by the addtonal dstorton n the allocaton of resource when an addtonal dollar of tax revenue s rased through an ncrease n the tax rate. As dscussed n Dahlby (Chapter 2, 2008), n the absence of non-tax dstortons, such as envronmental externaltes, or nvoluntary unemployment, the MCF for a tax rate ncrease on tax base s n general gven by (4) 4

6 B B (5) MCFτ = = dtr db B + τ dτ dτ Substtutng equaton (4) nto (5) leads to the followng alternatve formula for the MCF: MCFτ = s ρ = s s + τ s η = s s + τ η where η = s η. The other varables are as defned before. The above equaton shows that the MCF from a partcular tax base depends not only on ts own base, tax rate, and semelastcty, but also on the weghted-average of other tax bases sem-elastcty wth respect to the tax rate (weghted by ther revenue shares). Clearly the MCF τ wll be greater than (less than) one f η s negatve (postve). If ρ s negatve, and the government s operatng on the downward (6) slopng secton of ts total revenue Laffer curve wth respect to τ, the MCF τ s not well-defned because a tax rate reducton would ncrease total tax revenues and make taxpayers better off. Smlarly, the MCF τ s nfnte f the τ s set at ts total revenue maxmzng rate of s /η. In general, we expect government to set τ < -s /η to mnmze the dstortons n resource allocaton, subect to achevng an equtable dstrbuton of the total tax burden. It almost always takes some tme for tax bases to adust n response to changes n tax rates. As a result, the short-term and long-term responses of tax bases can be qute dfferent. See Slemrod (1998). As Gertz (2008) and Saez, et al (2009) explan, the effcency costs of tax rate ncreases depend on the long-term responses. Ths may be partcularly relevant for corporate ncome tax as busnesses may take a long tme to adust ther level of nvestment, and n some cases ther producton locaton, n response to tax rate changes. To ths pont, our dscusson of the MCFs has not explctly taken nto account the dynamc responses of tax bases to tax rates. Snce t takes tme for tax bases to adust fully n response to any change n tax rates, we expect the MCF funds would be n general greater n the long-run as the tax base adusts for a tax rate change. Below, we outlne a methodology for computng the MCFs based on the dynamc responses of the tax bases to tax rate ncreases. 5

7 Let δ v be the present value of a dollar receved v years n the future where δ v = 1 /(1 + r) and r s the dscount factor used to value future ncome. Let PV be the present value of a dollar receved for n years where PV = n v= 0 δ. The margnal cost of publc funds from a tax rate v ncrease can be defned as the present value of the harm nflcted on taxpayers n rasng an addtonal dollar (n present value terms) of total tax revenue from a small tax rate ncrease. MCFτ = B 0 PV + τ 0 [ δ ΔB + δ ΔB + δ ΔB δ ΔB ] 0 0 B 1 PV 1 2 where B 0 s tax base n the current perod and ΔB v s the reducton n the tax base from an ncrease n τ n year v n the future. Let β v be the percentage reducton n tax base n v years n the future from the ncrease n τ where β v = ΔB v / B 0. The MCF can then be wrtten as: MCFτ or MCFτ = m B 0 PV = m B = 1 τ B τ B B 0 0 n 0 = 1 v= 0 2 [ δ β + δ β + δ β δ β ] 0 0 B ωv β v 0 PV δ v where ω v =. Multplyng numerator and denomnator by the current tax rate τ and dvdng PV numerator and denomnator by current total tax revenues, R, yelds the followng formula for the MCF: MCFτ = s 2 s s = m s + τ H + τ s H =1 (10) where s s the share of current revenues from tax base, H s the present-value weghted-average percentage reducton n tax base from a one percentage pont ncrease n τ. It s the dynamc equvalent of η n the statc model, and we wll refer to t as the dynamc sem-elastcty of tax base wth respect to the tax rate on tax base. H s the dynamc sem-elastcty of the total tax base wth respect to τ. In secton 5, we use 6 n n H n n n = ωvβ v, and H v= 0 = m = 1 (7) (8) (9) s H v

8 estmates of the sem-elastctes of the tax bases to calculate the MCFs based on the dynamc sem-elastctes. 3. Methodology and Data 3.1 Methodology We are nterested n examnng the senstvty of tax bases to changes n tax rates. Obvously, tax bases may take some tme to adust fully n response to any change n tax rates. Thus n order to account for the persstence of tax base changes to changes n tax rates, followng Buettner (2003) and Redl and Rocha-Aks (2009) we specfy a dynamc tax base regresson by ncludng one-perod lagged value of the dependent varable as an explanatory varable. Ths helps us capture long-run effects of tax rate changes on tax bases (see also Caroll and Hrung, 2005, p.429 and the references contaned theren). More specfcally, we specfy an emprcal model for the three maor taxes: corporate ncome tax (c), personal ncome tax (p) and general sales tax (s). The emprcal model s specfed as: ln B = + η τ + η τ + η τ + X + μ + θ + u (11) gt α0 + λ ln B gt 1 c cgt p pgt s sgt g t t where = c, p, s. In equaton (6), ln B gt s the log of tax base n provnce g n year t, and τ gt s the correspondng provncal statutory tax rate. µ g and θ t denote provncal fxed effects and tme effects, respectvely. X ncludes a vector of varous control varables. We estmate equaton (11) separately for the three tax bases usng provnce-level aggregate panel data. We are nterested n coeffcent estmates, η, whch show the percentage response of the tax base due to a one percentage pont change n the tax rate. Thus the coeffcents of the tax rates n the above regresson provde the short-run sem-elastcty of the tax base wth respect to the tax rates. For example η c denotes the short-run sem-elastcty of tax base wth respect to the corporate tax rate (c). We expect the own sem-elastcty, η, to be negatve mplyng that an ncrease n the statutory tax rate reduces ts correspondng tax base. If the coeffcent s zero, t ndcates that the tax base do not respond to changes n tax rate. Postve coeffcents on the other hand ndcate that tax bases rse when tax rates are ncreased. 7

9 Wth our dynamc specfcaton, t s possble to estmate the long-run tax base semelastctes, whch can be obtaned by multplyng the coeffcent estmates by 1/(1-λ ). We expect that 0 < λ < 1. Note that our basc specfcaton does not control for GDP. Consequently, t captures the dynamc response to changes n tax rates (see also Caroll and Hrung, 2005). Prevous studes n the elastcty of taxable ncome lterature use the net-of- tax rate (that s one mnus the tax rate) rather than the tax rate as an explanatory varable. Such studes provde the elastcty of tax bases wth respect to net-of-tax rate. However, t s straghtforward to obtan the elastcty of a tax base wth respect to ts own net-of- tax rate by multplyng the own semelastcty estmates of equaton (11) by mnus the net-of-tax rate. One can for nstance use the mean value of the tax rates to convenently transform the sem-elastcty estmates nto elastcty wth respect to the net-of-tax rate values. A smlar transformaton can also yeld tax base elastcty estmates from the sem-elastcty estmates. We use such transformaton to make our results comparable wth those from prevous studes. In emprcal analyses of tax base elastctes, one maor problem s what knd of tax base proxy to use. Varous studes use dfferent proxes and results may well depend on whch tax base proxy s used. Ths s partcularly true n studes that rely on aggregate rather than ndvdual-based data. Fortunately n Canada there s a readly avalable tax base dataset whch s used by the federal government n ts equalzaton payments calculatons. Ths s a rch and very useful dataset on whch actual polcy decson s made. Thus n ths study we use busness ncome and general sales tax bases from ths dataset. In our corporate ncome tax base regresson, the dependent varable s the log of the busness ncome tax base. Smlarly n our sales tax base regresson, the dependent varable s the log of general sales tax base. We use personal taxable ncome as a measure of personal ncome tax base. Snce the szes of provnces vary greatly, we dvde the tax bases by the provnce s respectve total populaton to make comparson across provnces possble. Moreover, n order to account for the effect of nflaton all tax bases are deflated by the provnce s respectve GDP deflator. 1 Snce our ultmate obectve s to use the emprcal results to compute the MCF for provncal governments, we use provncal rather than combned federal and provncal statutory 1 We use GDP deflator (1997 =100) rather than Consumer Prce Index (CPI) as complete dataset on provncal CPI s not avalable pror to

10 tax rates n our analyss. Another advantage of ths approach s that t s helpful to assess whether provncal and federal tax rates have dfferental effects on tax bases. There are varous factors that may affect a provnce s tax base other than ts own tax rates. Our sets of control varables nclude the prce of maor export commodtes of the provnce, other provnces tax rate, and the relevant federal tax rate where applcable. The ncluson of the federal and other provnces tax rates helps us check for the presence of vertcal and horzontal corporate tax externaltes n the Canadan federaton, respectvely. In order to assess the cross effects of tax rates on tax bases, we also nclude the tax rates that are not drectly related to the tax base. For example we nclude sales and ncome tax rates n the corporate tax base regressons. One feature of a dynamc panel model, such as used here, s that there s a correlaton between the lagged dependent varable and the provnce-specfc fxed effects. In such cases, the OLS and the wthn group fxed effects estmaton methods gve based and nconsstent estmates. To address ths problem, a number of solutons are proposed n the lterature. The most recent and commonly used estmaton methods are the Arellano and Bond (1991) frst dfferenced General Methods of Moments (GMM) and the Blundell and Bond (1998) system GMM. However, these methods are desgned for dynamc panel data wth large number of panels and small tme perods. For a dataset wth a small number of panels such us ours, these methods provde severely based and mprecse estmates (Judson and Owen, 1999). Thus n ths paper we use a standard Instrumental Varable Estmaton method (IV). As n Devereux et al (2007), we nstrumented for the lagged dependent varables usng ther respectve second-perod lagged values of the dependent varables and other addtonal varables as nstruments. Another related common emprcal challenge n estmatng taxable ncome elastctes s the possble endogenety of tax rates. Ths s partcularly true n a graduated ncome tax system. In Canada s corporate ncome tax system, the statutory tax rate s constant (flat) and t does not drectly depend on taxable ncome. Ths mples that the ssue of the endogenety of the corporate tax rate s less of a concern n our case. Thus followng Mntz and Smart (2004), we treat the CIT rate as exogenous n our corporate ncome tax base regresson. Smlarly, the sales tax rate s bascally constant regardless of the tax base or the amount of one s purchase. Thus we also treat the sales tax rate as exogenous n our general sales tax base regresson. 9

11 It s well known that n a progressve ncome tax system the margnal tax rate depends on taxable ncome. If ths problem s not addressed, t wll bas our own sem-elastcty estmate. Thus as commonly used n the lterature, n our personal ncome tax base regresson we treat the PIT rate as endogenous. The most common challenge n emprcal studes of taxable ncome elastcty s what nstrument to use for the tax rate. A vald nstrument should be farly correlated wth the tax rate but not wth the tax base. In studes based on aggregate data such as ours t s generally very dffcult to come up wth such nstruments. The lterature on the relatonshps between taxaton and the deology of the government ndcates that there s an assocaton between the poltcal deology of the government and taxaton. For OECD countres, Tavares (2004) fnd evdence that rght-wng governments generally focus on spendng cuts to reduce budget defct whle the left tend to rase taxes. Reed (2006) also fnds that n the US the tax burden s hgher when democrats control the state legslature. Thus we use dummy varables for the poltcal party of the premer of the provnce as nstruments for the PIT rate. Specfcally we nclude dummy varables for the Lberal and New Democratc Party (NDP) partes. The Lberal and NDP dummes are equal to 1 f the premer belongs to the Lberal and NDP partes, respectvely and zero otherwse. Our nstrument choce mplctly mples that tax rates are hgher when the premer belongs to the left. We check the valdty of the nstruments usng a standard Hansen over-dentfcaton test. All our regressons nclude tme-nvarant provnce-specfc fxed effects. Where approprate, we also nclude yearly dummes to control for shocks that are common to all provnces. Bascally we employ the full dfference-n-dfference estmaton strategy. The only excepton s when we nclude the federal CIT and PIT rates. These varables change only over tme and ther ncluson n the corporate and personal ncome tax base regressons precludes the use of tme dummes. Thus when the federal tax rates are ncluded as control varables we exclude tme dummes. As explaned n Secton (2), our ultmate obectve s to compute the MCF of the three man taxes for all the provnces. We use the sem-elastctes estmates along wth tax revenue shares and tax rates to calculate the MCFs. We also take nto account the cross effects of tax rates on tax bases n our computaton. Obvously tax shares and tax rates change over tme. In order to shed some lght on the evoluton of the cost of rasng government revenue over tme, 10

12 we compute the MCF annually. We also make smlar calculatons based on fve year movng average values of tax shares. 3.2 Data Our emprcal specfcaton s estmated usng annual aggregate panel data from 10 Canadan provnces for the perod The data on statutory margnal tax rates and personal taxable ncome are obtaned from varous ssues of Fnances of the Naton (formerly Natonal Fnances) publshed by the Canadan Tax Foundaton. The dataset on provncal taxable ncome s obtaned from varous ssues of Income Statstcs (formerly Tax Statstcs on Indvduals) publshed by Canadan Revenue Agency. The busness ncome tax and general sales tax bases are the ones that are used by the federal government n ts equalzaton payment calculatons and are obtaned from Fnance Canada. The busness ncome tax base s used as a corporate ncome tax base. A bref descrpton of the data and defntons of the varables used n our emprcal analyss s provded n Appendx 1. (Table 1 about here.) In Table 1 we present the key varables of nterest for all the provnces. Over the perod under consderaton, there s a great deal of varaton n real tax bases across provnces. On per capta bass, Alberta has the hghest corporate ncome tax base followed by Ontaro and Quebec. Alberta has also the largest sales tax base even though the provnce does not levy a general sales tax. When we look at the personal ncome tax base, Ontaro has the largest tax base followed by Quebec and Brtsh Columba. One of the mportant varables to be used n the MCF computaton s the share of the three taxes from total tax revenue. Table 1 also shows the average tax shares for the perod We calculate the revenue share of the three taxes from total tax revenue. Total tax revenue s defned as the sum of ncome taxes, consumpton taxes, property and related taxes and other taxes. In all provnces the three taxes account a sgnfcant share of total tax revenue. Alberta has the largest corporate ncome tax share as the provnce has no sales tax. Quebec on the other hand has the lowest corporate ncome tax share, but the hghest personal ncome tax share ndcatng the provnce s heavy dependence on personal ncome taxaton. The Atlantc Provnces have the 11

13 hghest sales tax shares. Table 1 also shows the provncal statutory tax rates for the ntal, fnal and whole sample perod. Table 2 below provdes the summary statstcs of the man varables used n our emprcal analyss. (Table 2 about here.) 4. Results In ths secton we present the dynamc tax base regresson results for the three man taxes: corporate ncome, personal ncome and general sales taxes. 4.1 Corporate Income Tax The most mportant tax that busnesses face s the corporate ncome tax. In Canada all provnces and the federal government levy corporate ncome taxes and the applcable tax base s more or less the same across ursdctons. We begn our analyss wth the corporate tax base regresson estmates presented n Table 3. In a dynamc panel data model such as ours, the lagged dependent varable s correlated wth the provncal fxed effects and the error term. Consequently, treatng ths varable as exogenous can lead to based estmates. To solve ths problem we use Instrumental Varable (IV) estmaton method treatng the lagged dependent varable as endogenous. The lagged dependent varable s nstrumented wth two-perod lagged values of the dependent varable and one-perod lagged value of the unemployment rate. Ths mplctly assumes that corporate proftablty falls durng economc downturn and rses durng recovery. We test the valdty of the nstruments usng the standard Hansen over-dentfyng restrcton test. (Table 3 about here.) In column (1) we estmate the corporate tax base on ust the provncal statutory CIT rate. As expected the coeffcent s negatve and statstcally sgnfcant. The coeffcent estmate ndcates that a one percentage pont ncrease n the provncal CIT rate (say rasng the statutory CIT rate from 0.14 to 0.15) results n a reducton n the corporate tax base by 1.71 percent. The 12

14 lagged dependent varable s postve and statstcally sgnfcant. The coeffcent s less than one ndcatng that the effect of CIT rate on ts base gets larger n the long-run. In column (2) we nclude the federal CIT rate and the weghted average CIT rate of other provnces (weghed by the GDP of the provnces) as control varables. Ths helps us check for the presence of vertcal and horzontal corporate tax externalty n the Canadan federaton. In order to accommodate the federal CIT rate we drop tme dummes n column (2). The vertcal tax externalty lterature ndcates that as the provncal and federal corporate ncome taxes cooccupy the provncal tax base, an ncrease n the federal CIT rate reduces the corporate tax base. See Dahlby and Wlson (2003). Thus f the hypothess of vertcal externalty n corporate ncome tax s vald, we expect the coeffcent of the federal CIT rate to be negatve. Our result ndcates that as expected the coeffcent of the federal CIT rate s negatve and statstcally sgnfcant. Ths provdes emprcal support for the presence of vertcal externalty n the Canadan corporate ncome tax system. The provncal CIT rate s stll negatve and statstcally sgnfcant. Note n partcular that the corporate tax base s more responsve to the provncal than to the federal CIT rate as the absolute value of the coeffcent estmate of the former s hgher. Ths s expected because corporatons can easly avod an ncrease n provncal CIT rate by shftng ther profts to other provnces, but they cannot avod federal CIT rate ncreases through ncome shftng to other provnces. See Mntz and Smart (2004). The lterature on horzontal tax competton suggests that due to the moble nature of tax bases, tax rates n other provnces can have a postve effect on a provnce s tax base. That s when other provnces rase ther tax rates, the tax base shfts from the hgher tax ursdcton to a lower tax ursdcton. See Hayash and Boadway (2001). If the standard horzontal tax competton argument s vald we expect the coeffcent of other provnces tax rate to be postve. Our result shows that, contrary to the predcton of the horzontal vertcal externalty, the coeffcent of ths varable s negatve and statstcally sgnfcant. Ths result s surprsng but not mplausble. It s known that provnces are hghly nterdependent and ther relatonshps related to tax bases may not be fully explaned by the smple horzontal tax competton hypothess as commonly dscussed n the lterature. Ths s partcularly true n the case of corporate taxaton. Snce the operatons of corporatons and ther respectve afflates n varous ursdctons are nterrelated, a hgher tax rate n other ursdctons may reduce the proftablty (and hence the tax 13

15 base) of a corporaton even f t s not located n that ursdcton. In fact there may be a negatve horzontal fscal externalty (rather than the usual postve) n corporate taxaton. For example thnk of a corporaton that s based n Quebec but supples ts products to other corporatons based n Ontaro. If the corporate tax rate n Ontaro rses, then the (after-tax) proftablty of corporatons based n that provnce falls. Ths may reduce Ontaro-based corporatons demand for nputs from Quebec-based corporatons (n ths case located n Quebec). Thus n ths case a hgher corporate tax rate n Ontaro adversely affects a corporaton that s located and operatng n Quebec. Ths feature of nterdependence n busness operatng n very nterrelated ursdctons s not fully addressed n the horzontal tax competton lterature. So f ths nterdependence s stronger than the standard horzontal tax competton argument, the coeffcent of other provnces tax rate can be negatve. As compared to column (1), n column (2) the magntude of the coeffcent of the lagged dependent varable, whle t s stll postve and sgnfcant, dropped sgnfcantly. Thus the excluson of tme dummes lowers the coeffcent estmate. In column (3) we nclude addtonal control varables. More specfcally, we nclude the statutory top margnal PIT and the provncal sales tax rates. Unlke personal and corporate ncome taxes, there s varaton n sales tax systems among Canadan provnces. The harmonzed provnces levy a value-added based tax (VAT) on a relatvely broader tax base (whch s the same as, or very smlar to, the federal GST base) the other provnces use a retal sales tax (RST) and the tax base may nclude captal goods. The effects of these taxes can be dfferent on ncome taxes as they may affect economc actvty and nvestment dfferently (see Smart and Brd, 2009). We account for these possble dfferental effects on CIT tax base by ncludng the sales tax rate and the sales tax rate nteracted wth the RSTdummy. The RSTdummy takes 1 n provnces and years n whch RST tax s n place. As n Mntz and Smart (2004), we also nclude the log of an ndex of US producers prces for the provnce s maor export commodty (the log of export prce). Ths helps us capture the effects of fluctuatons n the world prces of maor exports. An ncrease n the top margnal PIT rate may encourage tax payers to shft ther reported ncome away from personal ncome to corporate ncome. See Gordon and Slemrod (2000). Thus we expect the top PIT rate to have a postve effect on the corporate tax base. The PIT rate s as expected postve but statstcally nsgnfcant. Whle the sales tax rate s postve and 14

16 nsgnfcant, the sales tax rate nteracted wth the RSTdummy s negatve and sgnfcant. Ths ndcates that n RST based provnces, retal sales taxes have adverse effects on corporate tax base. The provncal CIT rate, federal CIT rate and other provnces CIT rate are all stll negatve and statstcally sgnfcant. Ths suggests that the negatve effects of provncal and federal CIT rate on corporate tax base are robust to the ncluson of varous control varables. In column (4) we drop the federal CIT rate and nclude yearly dummes to capture shocks that are common to all provnces. Bascally n ths regresson we are employng the full dfference-n-dfference estmator. As n Mntz and Smart (2004), we treat the CIT rate as exogenous. However, as before, the lagged dependent varable s treated as endogenous and nstrumented wth two-perod lagged values of the dependent varable and one-perod lagged value of the unemployment rate. The valdty of the nstruments s confrmed wth the Hansen s overdentfcaton restrcton test statstc. Ths s our preferred regresson that we use n the computaton of provncal MCF n Secton 5. Comparng column (4) wth (3) we see that the coeffcent of the lagged dependent varable s hgher whle the coeffcent of the CIT rate s slghtly lower n the former. As we wll see later, our computaton of MCF depends on these two coeffcents. Our preferred results n column (4) show that the short-run sem-elastcty of corporate tax base s about Ths also mples a long-run sem-elastcty of As expected the corporate tax base s more responsve to tax rate changes n the long-run. How do our estmates compare wth those of prevous studes? Because of dfferences n specfcaton and the types of tax rate measures employed, t s dffcult to make drect comparson wth results from those of the prevous studes. Furthermore, there are only few studes that estmate corporate tax base elastcty. Our long-run corporate tax base sem-elastcty estmate s outsde the range obtaned by Redl and Rocha-Aks (2009), whch s methodologcally the closest to our paper. They, however, employed effectve average tax rate rather than statutory rates. Huznga and Laeven (2008) also report a lower sem-elastcty estmate for European countres, wth an average sem-elastcty estmate of Mntz and Smart (2004) estmate the elastcty of corporate tax base wth respect to the netof-tax rate (that s one mnus the tax rate) usng ndustry-level data for Canada. In order to make our result comparable to ther study, we convert the sem-elastcty estmates to elastcty (wth respect to net-of-tax rate) estmates by multplyng our coeffcent estmates by the negatve of 15

17 the net-of-tax rate. Mntz and Smart use combned federal and provncal corporate ncome tax rate n ther analyss. Thus we evaluate our sem-elastcty estmate at the mean value of the combned provncal and federal corporate ncome tax rate (whch s 45.3 percent for the perod ). 2 Such transformaton ndcates that our preferred long-run sem-elastcty estmate corresponds to elastcty wth respect to net-of-tax rate of about 8.5. Ths mpled elastcty wth respect to the net-of-tax rate s hgher than the 4.9 elastcty reported n Mntz and Smart (2004). In column (5) we check the robustness of our results by ncludng the log of real per capta ncome as a proxy to the provnces macroeconomc condtons as n Mntz and Smart (2004) and Huznga and Laeven (2008). We expect ths varable to be postve on the ground that ths varable s a good ndcator of general proftablty for busnesses. The corporate tax base s lkely to be hgh when the economy performs well. The coeffcent estmates are stll sgnfcant suggestng that our sem-elastcty estmate s robust to the ncluson of ths varable. 4.2 Personal Income Tax Personal ncome tax s the most mportant revenue sources for all provnces. Thus understandng how the personal ncome tax base responds to changes n ts own and other tax rates s of a consderable mportance. In ths secton, we present the dynamc personal ncome tax base regresson results. Currently, n all provnces, except Alberta, margnal tax rates ncrease from one ncome tax bracket to the other. Alberta, however, has had a flat personal ncome tax rate system snce Wth a progressve margnal tax rate structure, one emprcal challenge for studes based on aggregate data, such as ours, s whch tax rate to use. Ideally we would lke to use the weghted average margnal ncome tax rates-weghted ether by ncome or the number of people n the tax brackets. However, a complete data set for the perod under consderaton s unavalable. Thus, as commonly used n the lterature, we use the statutory top personal ncome tax rate. However, ths should not be much of a problem snce most of the responses of personal taxable ncome to changes n tax rates are due to behavoural response of hgh ncome groups (see Saez et al., 2009). Furthermore, the largest part of provncal ncome tax revenue comes from the top ncome group suggestng the mportance of the top margnal tax rate. 2 In the presence of tme dummes, the coeffcent estmates would be the same whether one uses the provncal CIT rate or the combned provncal and federal CIT rate. Ths s because the federal CIT rate changes only over tme and ts effects can be pcked up by the yearly dummes. 16

18 For our personal ncome tax base regresson, we use the log of real provncal personal taxable ncome per capta as dependent varable. We have relatvely a longer dataset for the personal taxable ncome and t covers the perod As Kopczuk (2005) explans the use of personal taxable ncome as a tax base poses an emprcal challenge as ts defnton changes over tme due to tax reforms. In our case, ths problem s partcularly mportant due to the tax reform of 1988 that sgnfcantly expanded the personal ncome tax base by elmnatng a number of exemptons and deductons. The reform also reduced the number of ncome tax brackets from 11 to 4. The change n the tax brackets also affected the provncal governments tax rates as most of the provnces tax rates at that tme were gven as a percentage of the federal rates. We try to address ths problem by ncludng a dummy varable (dum88) that s equal to 1 after the tax reform and zero otherwse. Snce the obectve of the reform was to expand the personal ncome tax base, we expect the coeffcent of dum88 to be postve. (Table 4 about here.) We begn our analyss n column (1) by regressng the log of real personal ncome tax base per capta on personal ncome tax rate. The regresson also ncludes tme and provnce specfc fxed effects n addton to the tax reform dummy (dumm88). As expected, the coeffcent of the 1988 tax reform dummy (dum88) s postve and sgnfcant suggestng that ndeed the tax reform expanded the personal ncome tax base. The coeffcent of the personal ncome tax rate s negatve and statstcally sgnfcant. The result ndcates that the short-run own-sem elastcty of personal ncome tax base s about That s a one percentage pont ncrease n the top margnal PIT rate s assocated wth a 0.22 percent reducton n the personal taxable ncome. Usng a smlar approach as before, the result mples that the long-run own sem-elastcty of personal tax base s about Alternatvely, evaluatng at the mean combned federal and provncal top PIT rate of 53 percent, our basc result mples that the taxable ncome elastcty wth respect to the net-of-tax rate s Ths result s well wthn the range of estmates obtaned n prevous studes. Our result s also surprsngly comparable to those obtaned by Sllamaa and Veall (2001) for hgh ncome ndvduals. In column (2) we nclude the corporate ncome tax rate, the sale tax rate and the sales tax rate nteracted wth the RSTdummy as control varables. The lterature suggests that an ncrease 17

19 n the corporate tax rate motvates people to shft ther ncome from corporate to personal ncome. If ths s true, then we expect the coeffcent of the CIT rate to be postve. A hgher sales tax rate can be also vewed as a tax on labour. In ths case the coeffcent of the sales tax rate s expected to be negatve. The estmated regresson result shows that the personal ncome tax rate s stll negatve and sgnfcant suggestng the robustness of ths relatonshp to the ncluson of the control varables. As expected the coeffcent of the corporate tax rate s postve and sgnfcant. The sales tax rate s negatve but statstcally nsgnfcant. In column (3) we nclude the weghted average tax rate of other provnces PIT rate (weghted by the GDP of the provnces) and the log of the ndex of US producer prces as addtonal control varables. The former s used to check for the possble effects of horzontal tax externalty. The latter captures the effects of changes n the world prces of the man export commodty of provnces. If the hypothess of horzontal externalty n personal ncome taxaton s vald, we expect the coeffcent of other provnces tax rate to be postve. Generally an ncrease n the world prce of maor exportng commodtes has favourable mpacts on the total economy and taxable ncome. 3 Thus we expect the coeffcent of the log of export prce to be postve. However, these addtonal control varables are all statstcally nsgnfcant. In fact the coeffcent of other provnces PIT rate has got the unexpected negatve sgn but t s statstcally nsgnfcant. The log of export prce has the expected postve sgn but t s also statstcally nsgnfcant. In column (4) we control for the federal PIT rate to check for the presence of vertcal externalty n personal ncome taxaton. Snce the federal and provncal governments co-occupy the same tax base, an ncrease n the federal PIT rate reduces the tax base and as a result has a negatve mpact on the provncal tax revenue. If the hypothess of vertcal externalty s vald, we expect the coeffcent of the federal PIT rate to be negatve. Note also that for the reasons explaned prevously, we drop the yearly dummes. The estmated results are more or less smlar to what we fnd n column (2). The only dfference s that now the log of export prce s statstcally sgnfcant and the sales tax rate s also negatve and statstcally sgnfcant. The coeffcent of the federal PIT rate s negatve as expected but t s statstcally nsgnfcant. 3 In some provnces (for example Alberta) the boom and bust cycle of the economy are largely a reflecton of fluctuatons n the world prce of maor export commodtes. 18

20 So far we have treated the PIT rate as exogenous. However t s well known that n a progressve ncome tax system the margnal tax rate depends on taxable ncome. In ths case the PIT rate can be endogenous. In ths case f the problem s not addressed t wll bas our own sem-elastcty estmate. Thus as explaned before, we use dummy varables for the poltcal party of the premer as nstruments for the PIT rate. The valdty of these nstruments s verfed usng the standard overdentfyng restrcton test. Comparng column (5) and (4) we see that when the PIT rate s treated as endogenous there s a sgnfcant ncrease n the magntude of the coeffcent of PIT rate. Now the coeffcent of the federal PIT rate s negatve and statstcally sgnfcant provdng an emprcal support to the hypothess of vertcal externalty n personal ncome n the Canadan federaton. Fnally n column (6), we drop the federal PIT rate and nclude yearly dummes. We also use the same set of nstruments as n column (5). All coeffcents of the tax rates have ther respectve expected sgns and are statstcally sgnfcant. The over-dentfcaton test shows that our nstruments for the PIT rate and the lagged dependent varable are vald. Ths s our preferred regresson whch wll be used n our computaton of the MCF. The preferred regresson estmate ndcates that the short-run and long-run own sem-elastctes of the personal ncome tax base are about and -3.65, respectvely. When we evaluate these estmates at the average statutory top PIT rate of percent, we obtan short-run and long-run taxable ncome elastctes of about and Alternatvely, evaluatng at mean combned top PIT rate of 53 percent, our estmates show a long-run elastcty of taxable ncome wth respect to net-of-tax rate of about Ths s hgher than those obtaned by Sllamaa and Veall (2001) usng ndvdual tax returns data. Snce we use top PIT rate the response of the tax base s generally expected to be hgher. 4.3 General Sales Tax In ths secton we estmate the effects of provncal sales tax rate on sales tax bases. Currently all Canadan Provnces except Alberta mpose general sales taxes. The federal government also mposes a VAT based goods and servces tax (GST). Durng the perod under consderaton, there s no varaton n the GST. It was essentally constant n all years except n Thus we do not nclude the GST n our regresson. As before, we employ an IV estmaton method. However, snce the sales tax rate does not depend on the base, we treat the sales tax rate 19

21 as exogenous. The lagged-dependent varable s however treated as endogenous and as s common n the lterature we use the two-perod lagged value of the dependent varable as an nstrument. (Table 5 about here.) We frst estmate the sales tax base on ust the provncal sales tax rate. The varable s as expected negatve and statstcally sgnfcant. The estmated coeffcent value s Ths suggests that a one percentage pont ncrease n the provncal sales tax rate s assocated wth a fall n sales tax base by 0.55 percent. In column (2) we nclude the corporate ncome tax rate and top margnal personal tax rate as control varables. Whle these varables are nsgnfcant, the sales tax rate s stll negatve and statstcally sgnfcant. In column (3) we nclude the provncal unemployment rate as addtonal control varable to capture the effects of busness cycle on the sales tax base. Durng economc downturn the sales tax base tends to fall as the ncome and confdence of people fall n response to economc uncertanty. Thus we expect that an ncrease n the unemployment rate reduces the sale tax base. As expected, the unemployment rate s negatve and statstcally sgnfcant. The sales tax rate however stll contnues to be negatve and statstcally sgnfcant suggestng the robustness of our result to the ncluson of addtonal control varables. Fnally n column (4), we nclude the weghted-average sales tax rate of neghbourng provnces (weghted by populaton) and the aggregate prce level of the neghbourng provnces as addtonal control varables. If a provnce s sales tax rate s hgher than ts neghbours, t can result n cross-border shoppng and smugglng from ts low sales tax neghbourng provnces. That s a lower sales tax rate of neghbourng provnces can reduce a provnce s sales tax base. Thus we expect the coeffcent of other provnces sales tax rate to be postve. The coeffcent of neghbourng provnces sales tax rate s negatve but statstcally nsgnfcant. The neghbours prce level s also nsgnfcant. More mportantly, the coeffcent of the sales tax rate s as expected negatve and sgnfcant. Ths s our preferred regresson. Our result ndcates that the short-run sem-elastcty of sales tax base s about Ths mples that a one percentage pont ncrease n the sales tax rate results n a fall n the sales tax base by about 0.63 percent. The long- 20

22 run sales tax base sem-elastcty s about Thus as expected the effect of sale tax rate on the tax base s hgher n the long-run. 4.4 Robustness Checks We subect our preferred tax base regressons to varous robustness checks. More specfcally we nclude provncal specfc tme trends, treat the CIT rate as an endogenous varable, estmate the tax bases as a system of equatons, and exclude Quebec from the personal ncome and corporate ncome tax base regressons. We also check the use of combned federal and provncal PIT rate takng nto account the Quebec Abatement. The results for the robustness checks are shown n Appendx 2. As explaned before n our man analyss we nclude yearly dummes to control for tme effects that are common to all provnces. One may want to control for provnce specfc tme trends as well. When we nclude provnce-specfc tme trends there s no much change n our results qualtatvely. Not surprsngly, however, there s a change n the magntude of the coeffcent estmates. In our man analyss we treat the CIT rate as exogenous. As robustness check we also treat the CIT rate as endogenous. The nstruments used are: dummy varable for the NDP party, log of per capta government spendng, and the share of provncal populaton that s 65 and over. The coeffcent estmate s now hgher n absolute magntude and t s sgnfcant only at 10 percent. The coeffcent of the lagged dependent varable s also lower n absolute magntude. As a result the effect on the long own-sem elastcty estmate s actually downward n absolute value. Arguably tax bases n a gven provnce are nterrelated as they are all part of the economy. That s there may be a potental correlaton n the error terms of the three tax base regressons. In ths case one can obtan some effcency gan by estmatng the three tax base regressons smultaneously as a system of equaton. We estmate the three tax bases smultaneously usng the three Stage Least Square (3SLS) methods. The own sem-elastctes are stll negatve and sgnfcant. As compared to our preferred tax base regressons, now the coeffcent estmates of the PIT rate and the sales tax rate are lower n absolute value. The coeffcent estmate of the CIT rate s however s slghtly hgher n absolute value. We also check the robustness of our corporate ncome and personal ncome tax base regresson results to the excluson of Quebec from the analyss. The CIT and PIT own sem- 21

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