Annex 4: Representative Tax System Simplification

Can the measure of revenue-raising capacity within the RTS be simplified?

While the Panel recommends maintaining the RTS, it also believes that there is considerable scope for simplifying the way that fiscal capacity is calculated. This must be done without losing the essential character of the RTS, its ability to reflect the broad patterns of actual taxing practices exhibited across Canada.

The Canadian RTS started in 1957 with only three bases. Today, it has grown to measure 33 distinct provincial tax bases. In fact, the 33 bases mask the true number, as a number of tax bases are divided into sub-bases. Many of the Equalization bases have become extremely complex and require several pages of data, adjustments, and calculations to derive fiscal capacity. This steady proliferation in complex tax bases, particularly for small revenue sources, raises many concerns. There are currently 15 small non-resource Equalization bases, which together account for less than 20 percent of revenues subject to Equalization.

Concerns raised over the proliferation of small non-resource bases

The proliferation of bases has not necessarily led to greater accuracy in the measurement of fiscal capacity. While the Panel is reasonably confident that the personal income tax, business income tax, and sales tax bases accurately measure fiscal capacity, it is not confident that the same can be said for the many small, non-resource bases that have been incorporated into the Equalization program. For example, the other games of chance base (for casino and related revenues) includes a complex formula with several debatable assumptions used to simulate how much revenue a province could raise if it had the average number of casinos. Similarly, the capital tax base attempts to weave together information from multiple data sources, involving many debatable assumptions and adjustments, to derive fiscal capacity. Federal and provincial finance officials have been struggling for years to improve this base.

In some cases, the establishment of smaller tax bases has interfered with the policy neutrality of Equalization. Some of the small bases create incentives for provinces to change their revenue-raising behaviour in order to maximize Equalization entitlements. For example, fiscal capacity for the lottery ticket base is calculated using the net receipt of lottery tickets. Receiving provinces, therefore, have little incentive to sell lottery tickets; they can reduce their efforts and be compensated by increased Equalization payments. Similarly, the tobacco base uses only officially reported sales to calculate fiscal capacity. Revenues lost through smuggling and non-reporting are compensated through Equalization, leaving receiving provinces little financial incentive to address these problems.

The smaller revenue sources are sometimes not used by most provinces. For example, less than half the provinces collect hospital medical insurance premiums and payroll taxes. Moreover, the structure of these smaller taxes can vary greatly among the few provinces that use them. In this sense, there is no typical tax base – and the related Equalization bases are not representative of taxing practices.

Small tax bases are often more costly to administer than large tax bases, and yet have a minor impact on Equalization entitlements. A number of the smaller tax bases are data intensive, imposing a considerable compliance burden on receiving and non-receiving provinces and on the federal government. Moreover,
significant resources are being used throughout each Equalization renewal to update these bases to reflect the latest changes in taxing practices and the latest theories on how to measure fiscal capacity for each base. When added together, the overall administrative cost for these small bases is substantial.

Finally, the proliferation of tax bases has reduced transparency. The large number of often complex tax bases that are now included in the RTS has made the system much more difficult to understand by academics, Parliamentarians, provincial governments, and Canadians. This reduced transparency means there is less scrutiny of the program and more potential for deals and ad hoc arrangements.

The Panel’s recommendations for simplifying the 15 smaller
non-resource bases

The Panel examined the scope for simplifying 15 smaller, non-resource bases. It considered two approaches to simplification:

1. Consolidating the smaller bases into larger, well-established RTS bases, with which the smaller bases have a natural macro-economic affinity (i.e., their distribution among provinces likely resembles that of the larger base); or
2. Replacing the smaller bases with a new single proxy base (e.g., a macro-economic indicator such as personal disposable income or GDP).

After careful examination of these two approaches, the Panel recommends the first approach, an RTS consolidation approach. This is most consistent with the RTS and avoids mixing together two very different approaches – the RTS and macro approaches. Moreover, using the first approach precludes the need to create a number of additional proxy bases and manage all the complexities associated with determining and maintaining them.

Specifically, the Panel recommends that:

• Payroll tax revenues be equalized in the personal income tax base.
• Capital tax revenues be equalized in the business income tax base.
• Miscellaneous revenues (excluding user fees) be equalized in the property tax base.
• All the other smaller consumption levies be treated as part of the general and miscellaneous sales tax base. The smaller consumption levies include: tobacco taxes, gasoline taxes, diesel fuel taxes, non-commercial vehicle licences, commercial vehicle licences, alcohol sales, hospital and medical insurance premiums, race track taxes, insurance premiums, lottery tickets, other games of chances, and preferred share dividends.

These changes are illustrated in Figure 2.

Figure 1 provides a comparison of the per capita revenue-raising capacity of each province from the 15 small non-resource bases using the current method (with 15 bases) and the method proposed by the Panel. Given the significant uncertainty as to how to accurately measure fiscal capacity for a number of the small tax bases, compared with the small differences resulting from adopting the much simplified proposed approach, the Panel is confident that the proposed measure of fiscal capacity is as valid as the current system, and that there would be no deterioration in the accuracy of the overall measurement of fiscal capacity.

More generally, in the Panel’s opinion, folding the 15 small non-resource bases into the major tax bases would make the RTS simpler, easier to understand, and less costly to administer. It would also eliminate many of the incentive problems of the small non-resource bases without reducing the overall accuracy of the measurement of fiscal capacity.

Figure 1 – Fiscal Capacity for the 15 Targeted Tax Bases Before and After the Panel’s RTS Simplification (Weighted average 2003–04 to 2005–06)

Concerns raised over the 14 natural resource bases

The Panel also examined the scope for improving and simplifying the 14 tax bases that are currently used to measure fiscal capacity for natural resource revenues.

The issue of how to measure resource revenues has been an ongoing policy challenge since the inception of Equalization, and is discussed in detail in Annex 7. In summary, the view of the Panel is that the current measurement of revenue-raising capacity for natural resources (using a complex array of measures including profits, value, volume, proxy and actual revenues spread over 14 tax bases) is inappropriate. In the Panel’s view, the current approach often does not accurately measure the true revenue-raising capacity (economic rent). Also, the system has created some serious incentive problems, where Equalization reductions exceed the net revenues collected by provincial governments, thus undermining the policy neutrality principle of the Equalization program. Finally, as in the case of non-resource bases, the proliferation of resource tax bases has increased the administrative cost and complexity of the program, and reduced its transparency.

The Panel’s recommendations for simplifying 14 resource bases

Given the problems with the current system, and the fact that no reliable measure of economic rent is available at this point, the Panel recommends that the 14 tax bases for natural resources be collapsed into a single base, using actual resource revenues to determine fiscal capacity.

Incentives to reduce tax effort (e.g., lower royalty rates) that are normally associated with using actual revenues as the measure of fiscal capacity would be mitigated by two other Panel recommendations. First, as discussed in Annex 7, only 50 percent of resource revenues would be included in Equalization under the Panel’s recommendations, leaving provinces with sufficient incentives to continue taxing at the rent-maximizing level. Second, as discussed in Annex 8, the Panel recommends using lagged data with three-year moving averages for all tax bases. This means that a provincial government tempted to reduce its tax effort could only reap the full benefits of increased Equalization payments five years later, with all the attendant uncertainty of results.

The Panel believes that adopting a single Equalization base for resources that uses actual revenues would be a significant improvement over the current system. This approach would make the system simpler and more transparent, more accurately measure fiscal capacity, and enhance Equalization’s goal of policy neutrality.

Figure 2 – Representative Tax Systems (RTS) Simplification

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