Taxes are compulsory payments by individuals and corporations to government, levied to finance government services, to redistribute income and to influence the behaviour of consumers and investors.
Taxes are compulsory payments by individuals and corporations to government, levied to finance government services, to redistribute income and to influence the behaviour of consumers and investors. Of the various methods available for financing government activities, only taxation payments are compulsory. Taxes are imposed on individuals, business firms and property to finance public services or enable governments to redistribute resources, allowing governments to increase expenditures without causing inflation of prices, because private spending is reduced by an equivalent amount.
The CONSTITUTION ACT, 1867 (formerly BNA Act), gave Parliament unlimited taxing powers and limited those of the provinces to direct taxation (seeDISTRIBUTION OF POWERS). The federal government was responsible for national defence and economic development, the provinces for education, health, social welfare and local matters which then involved only modest expenditures. The provinces needed access to direct taxation mainly to enable their municipalities to levy property taxes.
For more than 50 years customs and excise duties provided the bulk of Dominion revenues; by 1913 they constituted over 90% of the total. Provincial revenue derived primarily from licences and permits, public domain and sales of commodities and services; in addition, the provinces received substantial federal subsidies. They hesitated to impose direct taxes but by the late 1800s were taxing business profits and successions. Taxes on real and personal property were the bulwark of local government finance, and by 1930 total municipal revenues surpassed those of the Dominion.
The GREAT DEPRESSION bankrupted some municipalities and severely damaged provincial credit. Customs and excise duties declined by 65% 1929-34. Parliament resorted more to personal and corporate taxation and raised sales taxes dramatically. To finance WWI, Parliament had introduced personal income tax (1917), corporate taxes and, in 1920, manufacturers' sales tax and other sales taxes. Before the Depression was over, all provinces were taxing corporate income; all but 2 levied personal income taxes, and 2 had retail sales taxes.
The Canadian tax structure changed profoundly during WWII. To distribute the enormous financial burden of the war equitably, to raise funds efficiently and to minimize the impact of inflation, the major tax sources were gathered under a central fiscal authority. In 1941 the provinces agreed to surrender the personal and corporate income tax fields to the federal government for the duration of the war and for one year thereafter; in exchange they received fixed annual payments. In 1941 the federal government introduced succession duties; an excess profits tax was imposed, and other federal taxes increased drastically.
By 1946 direct taxes accounted for more than 56% of federal revenue. The provinces received grants, and the yields from gasoline and sales taxes increased substantially. The financial position of the municipalities improved with higher property tax yields. In 1947, contrary to the 1942 plan, federal control was extended to include succession duties as well, but Ontario and Québec opted out, choosing to operate their own corporate income tax procedures. There was public pressure for federal action in many areas, and the White Paper on EMPLOYMENT AND INCOME advocated federal responsibility for employment and income.
As a result, direct taxes became a permanent feature of federal finance. But the provinces also have a constitutional right to these taxes and there is a growing demand for services under provincial jurisdiction, such as health, education and social welfare. The difficulties of reconciling the legitimate claims of both levels of government to income taxation have since dominated federal-provincial negotiations (seeINTERGOVERNMENTAL FINANCE).
From 1947 to 1962 the provinces, with mounting reluctance, accepted federal grants as a substitute for levying their own direct taxes. In 1962, however, the federal government reduced its own personal and corporate income tax rates to make tax room available to the provinces. Because taxpayers would pay the same total amount, provincial tax rates would not be risky politically. Further federal concessions between 1962 and 1977 have raised the provincial share of income tax revenues significantly.
To taxpayers' advantage, provincial income taxes are integrated with federal taxes; all provinces except Québec use the federal definition of taxable income (Québec has operated its own income tax since 1954), while provincial tax rates, which now differ considerably among the provinces, are simply applied to basic federal tax. For all provinces except Québec, the federal government collects personal income taxes; it also collects and administers the corporate income tax for all provinces except Ontario, Alberta and Québec, which administer their own.
In 1986, provincial personal income tax rates, as a percentage of basic federal tax, ranged from 43.5% (Alberta) to 60% (Newfoundland). The federal government allows an abatement equal to 10% of corporate taxable income earned in the province; lower provincial tax rates apply to small businesses rather than to large ones in all provinces.
Principles of Taxation
The criteria by which a tax system is judged include equity, efficiency, economic growth, stabilization and ease of administration and compliance. According to one view, taxes, to be fair, should be paid in accordance with the benefits received, but the difficulty of assigning the benefits of certain government expenditures, eg, defence, restricts the application of this principle. Provincial motor fuel taxes are one instance of the benefit principle.
According to another view, individuals should be taxed on the basis of their ability to pay (typically indicated by income). The personal income tax is in part a reflection of this principle. Horizontal equity (individuals with equal taxpaying ability should be treated equally) is not easily achieved because income alone is an imperfect measure of an individual's ability to pay. Vertical equity (higher incomes should be taxed accordingly) has been opposed by business and those with higher incomes, who claim that progressive tax rates discourage initiative and investment, although with the progressive tax, tax deductions benefit those with high taxable incomes.
Taxes can affect the rate of economic growth as well. Income taxes limit capital accumulation, and corporate taxes, it is claimed, reduce capital investment. Business so strongly opposed the royal commission's recommendations for full inclusion of corporate gains as taxable income that only 50% of capital gains in Canada are taxable - the lowest rate of any Western industrialized country. The cost of taxpayer compliance increased in 1971, although the broadened and complicated income tax base did introduce more equity. Since 1990, the inclusion rate for corporate capital gains has been 75%. There is no data available to indicate how the cost of taxpayer compliance has changed since 1971 because of the many tax-base-broadening measures and significant changes in the methods of calculating income tax.
Tax Shifting and Incidence
Taxes levied on some persons but paid ultimately by others are "shifted" forward to consumers wholly or partly by higher prices or are "shifted" backward on workers if wages are lowered to compensate for the tax. Some part of corporate income taxes, federal sales and excise taxes and local property taxes is shifted, altering and obscuring the final distribution of the tax burden.
The more elasticity (the percentage change in tax revenue resulting from a change in national income) a tax has, the greater its contribution to economic stabilization policy. Income taxes with fixed monetary exemptions and rate brackets have an automatic stabilization effect because tax collections will grow faster than income in times of economic growth and will fall more sharply than income in recession.
In Canada, the revenue elasticity of personal income tax is attenuated by indexing; since 1974 both personal exemptions and tax brackets have been adjusted according to changes in the CONSUMER PRICE INDEX. But sales taxes have less revenue elasticity because consumption changes less rapidly in response to changes in income, and these taxes are not progressive in relation to consumption. While property tax yields do not grow automatically with rising NATIONAL INCOME, they exhibit some revenue elasticity.
Current Tax System
Taxes levied by all levels of government in Canada represented 72% ($238.8 billion) of total government revenues in 1992. The remaining 28% was derived primarily from investment income and intergovernmental transfers.
Total tax revenues break down as follows:
• 42% from personal income tax;
• 10.5% from property tax;
• 9% from retail sales tax;
• 7.5% from the goods and services tax;
• 11.6% from Unemployment Insurance, Workers' Compensation, and Canada Pension Plan contributions; and
• 9.9% from corporate taxes, withholding taxes on nonresidents, and federal customs and excise duties.
Federal Tax Revenues
Tax receipts, particularly from income taxation, accounted for about 90% of total federal revenues in 1992. Personal, corporate, and nonresident withholding taxes combined accounted for about 52% of federal budgetary revenues. Combined with the goods and services tax (13.4% of total revenue) and Unemployment Insurance contributions (13.4% of total revenue), the other federal sources of revenue are modest.
Personal income tax applies to all income sources of residents of Canada, except for such amounts as:
• lottery winnings; and
• veterans' disability pensions.
In addition, certain other amounts, such as Workers' Compensation payments and some income-tested or needs-tested social assistance payments, must be reported as income, but are not taxed.
Federal Tax Reform, 1987-1991
In June 1987, the federal government introduced Stage One of Tax Reform, which included proposals for reform of the personal and corporate income tax structure. Bill C-139 took effect on 1 January 1988, although some changes were to be phased in over a longer period of time.
In line with tax reform in other countries, Bill C-139 broadened the tax base for both personal and corporate income, and reduced the rates applicable to taxable income. The bill replaced exemptions with credits, and eliminated a number of deductions for personal income tax. It also replaced the 1987 rate schedule, with its 10 brackets and rates ranging from 6% to 34%, with one containing only three brackets with rates of 17%, 26%, and 29%.
Bill C-139 also reduced or eliminated a number of special provisions, capped the lifetime capital gains exemption at $100 000, reduced capital cost allowances, introduced limitations on deductible business expenses, and lowered the dividend tax credit.
In 1991, the federal government introduced Stage Two of Tax Reform. As part of this reform effort, the federal government originally proposed a national value-added tax that would merge the new federal sales tax and the provincial retail sales taxes. When the federal government was unable to get approval from the provincial governments for this proposal, it continued with Stage Two of Tax Reform and replaced the manufacturers' sales tax with the goods and services tax (GST).
The manufacturers' sales tax was replaced because it was not only difficult to administer, but was also widely criticized for placing an unequal tax burden on different consumer purchases. With a broadly based, multi-stage sales tax such as the GST, tax is collected from all businesses in stages, as goods (or services) move from primary producers and processors to wholesalers, retailers and finally to consumers.
The GST has a number of advantages over the old manufacturers' sales tax. It eliminates tax on business inputs, and treats all businesses in a consistent manner. It ensures uniform and effective tax rates on the final sale price of products. Finally, it treats imports in the same manner as domestically produced goods, and completely removes hidden federal taxes from Canadian exports.
When the GST came into effect, provincial governments (excepting Alberta, which has no PST) had to decide how to manage the relationship between the federal sales tax (FST) and their own provincial retail sales taxes. Provinces east of the Ottawa River chose to impose their retail sales tax on the selling price, including the goods and services tax, thus raising their retail sales tax base. Provinces west of the Ottawa River, however, opted to impose their sales taxes on the price before the goods and services tax is added, thus reducing their retail sales tax base.
Following the introduction of the GST, the federal government continued discussions on its original proposal with several provinces with the aim of harmonizing the GST with the retail sales taxes of these provinces. At the time of writing, only Québec had agreed to merge its provincial retail sales tax with the federal sales tax.
Effective 1 July 1991, Québec broadened its provincial sales tax base to include movable property subject to the goods and services tax, the telecommunications tax and the meals portion of the meals and hotels tax. On 1 July 1992, Québec partially harmonized its sales tax system with the federal goods and services tax.
While the Québec provincial tax was changed to a modified value-added tax, the Québec provincial system does not provide input credits for business purchases such as electricity, telephone and telecommunications services, meals, entertainment and vehicles used on public roads. Québec's tax treatment of municipalities, universities, schools and hospitals parallels that of the federal government, with rebates ranging anywhere from 19% to 40%.
Provincial Tax Revenues
In 1992, provincial budgetary revenues were raised as follows:
• 64% through taxation;
• 13% from nontax revenue (investment income); and
• 22% came from transfer payments.
Of the total provincial tax revenues, 74% was derived from the retail sales tax, and from personal and corporate income taxation. Québec is the only province that levies succession duties. Alberta remains the only province without a sales tax.
Municipal Tax Revenues
The municipalities derive the smallest proportion of their revenues from taxes. Approximately 50% of total municipal revenues came from transfers from other levels of government, particularly the provinces. Property tax provided approximately 85% of total municipal tax revenue, but only 40% of gross municipal revenue.
Municipal tax bases vary considerably throughout Canada. The principal component of the municipal tax base in all 10 provinces and both territories is real property, which includes land, building and structures. Machinery and equipment affixed to property are included in the property tax base in Newfoundland, Nova Scotia, Québec, Ontario, Manitoba, Alberta (where a municipal business tax does not exist), the Northwest Territories and the Yukon.
In Prince Edward Island, New Brunswick and Saskatchewan, machinery, equipment and other fixtures are liable to property taxation only when they provide services to the buildings. British Columbia removed all machinery and equipment from its property tax base in 1987.
Probably the strongest criticism against the residential property tax is that it is regressive. Since the 1960s, provincial and local government commissions have recommended changes in the existing property tax system to make it more equitable and efficient. In response, Québec, Ontario, Manitoba, Alberta and British Columbia have introduced a property tax credit. Other general reforms have included broadening the tax base by reducing or eliminating a number of exemptions and implementing equalized assessment.
Federal-Provincial Fiscal Arrangements
Three major transfer programs - Established Programs Financing (EPF), Equalization payments, and the Canada Assistance Plan (CAP) - characterize federal-provincial fiscal arrangements.
EPF, which provides provinces with federal financial support in the areas of health and postsecondary education, is the largest single transfer program. Under current EPF arrangements established in 1982, the federal government provides support to all provinces on an equal per capita basis. In addition, the level of federal support under EPF currently increases annually with each province's population. In 1994-95, the EPF program will total over $21 billion in transfer payments.
The equalization program makes it possible for all provinces to provide reasonably comparable public services at reasonably comparable levels of taxation. Under the current provisions of this program, also established in 1982, federal grants have gone to each province whose per capita yields from specified provincial and local revenue sources fell below the weighted per capita average of five representative provinces.
The equalization system includes provisions for minimum equalization payments, as well as a cap. In 1994-95, the Equalization program is expected to total nearly $8.5 billion in transfer payments.
Under the CAP, the federal government helps provinces finance social assistance and social services for Canadians most in need of government support. The growth of CAP is limited to 5% a year for provinces that do not receive Equalization payments - traditionally Alberta, British Columbia and Ontario. All other provinces are exempt from this growth limit. Based on cost-sharing of eligible provincial spending, these transfers will approach $8.2 billion for 1994-95.
Taken together, the EPF, Equalization and CAP programs will account for over an estimated $37 billion in federal transfers to the provinces in 1994-95. This represents approximately 90% of all federal transfers to provinces. In 1994-95, it is estimated that total federal financial support to provincial and territorial governments will reach close to $42 billion.
Federal support for the provinces has grown rapidly in recent years. By the end of fiscal year 1994-95, it is expected that major federal transfers to the provinces will have grown by more than 68 per cent since 1983-84. This represents an average annual increase of 4.9%. By comparison, total federal program spending will have grown by only 4.1% over the same period.
The cash portion of these transfers represents more than 24 cents of every dollar spent by the federal government on programs. For provincial governments, major federal transfers account from over 19 cents of each revenue dollar for the wealthiest provinces to about 46 cents of each revenue dollar for the least wealthy province.