Current Publications: Economics and finance

Contents

• 1 Introduction
• 2 Overview
• 3 Pros and Cons of the Taxation of Consumption
• 4 International Context
• Notes

1 Introduction

Consumption taxes are often referred to as indirect taxes because they are applied on transactions rather than directly on profits or income. These taxes are applied either on a broad range of goods and services, in which case they are known as “general consumption taxes,” or on a limited number of goods and services, in which case they are known as “specific consumption taxes.”

In Canada, at the federal level, the Goods and Services Tax / Harmonized Sales Tax (GST/HST) is a general consumption tax, while various excise taxes, excise duties and tariffs are specific consumption taxes.

Governments worldwide increasingly recognize consumption taxes, especially general consumption taxes, as an important source of tax revenues. In the past five decades, more than 150 countries have implemented a value-added tax (VAT),1 an example of which is the GST/HST. Revenues from consumption taxes currently represent, on average, 30% of all tax revenues and social security contributions2 in Organisation for Economic Co-operation and Development (OECD) countries.3

Canadian governments rely on consumption taxes to a lesser extent than most OECD countries. As shown in Figure 1, these taxes generated $40 billion for Canada at the federal level in 2008–2009, less than social security contributions and personal income taxes but more than corporate income and other taxes.

Figure 1 – Federal Tax Revenues and Social Security Contributions, Fiscal Year 2008–2009 ($ billions)

Note: “Social security contributions” refers to contributions to the Canada and Quebec Pension Plans (CPP and QPP) as well as Employment Insurance (EI) premiums. Capital taxes on financial institutions are included in corporate income taxes.
Source: Figure prepared by the authors using data obtained from Statistics Canada, CANSIM table 385–0006, and from Receiver General for Canada, Public Accounts of Canada 2010, Volume I, Summary Report and Financial Statements,October 2010.
Text description is available on a separate page.

2 Overview

The GST/HST is a VAT collected at every stage of the production process. Businesses generally remit, to the federal government, the difference between the GST/HST they collect from their customers and the GST/HST they pay on their purchased inputs. The GST/HST, which is applied on most goods and services sold in Canada, is ultimately paid by the final customer.

Some goods and services, such as basic groceries, prescription drugs and medical devices, are zero-rated. In this case, businesses do not have to collect the GST/HST and can redeem the GST/HST paid on their purchased inputs.

As well, some goods and services, such as health care services, rented residential accommodations and financial services, are exempt. In this case, businesses do not have to collect the GST/HST but cannot redeem the GST/HST paid on their purchased inputs.

Municipalities, universities, colleges, elementary and secondary schools, and hospitals are entitled to a full or partial rebate to recover the GST/HST paid on certain purchased inputs.

Since 2008, the GST has been levied by the federal government at a rate of 5%. The HST – currently in place in British Columbia, Ontario, New Brunswick, Nova Scotia, and Newfoundland and Labrador – is a combination of the GST rate and a separate tax rate set by the respective province. In 2011, the HST rate ranges from 12% to 15%. Canada’s remaining provinces charge the GST and a separate provincial sales tax, except for Alberta, which has no provincial sales tax. The three territories charge only the GST.

Administratively, with the exception of Quebec, the federal government collects both the GST and the HST, and then remits the appropriate amount of the HST revenue to those provinces that have adopted the HST. Quebec administers all taxes collected in the province, including the GST.

In addition to the GST/HST, federal excise taxes and duties are applied on a limited number of goods manufactured or produced in Canada. Such levies are applied at different rates and in different ways, depending on the good. Excise taxes are applied on fuel-inefficient vehicles, automobile air conditioners and certain petroleum products. Such taxes are payable at the time of delivery to the purchaser. Excise duties are levied on beer, spirits, wine and tobacco products manufactured in Canada. These duties are applied at the point of manufacturing. The federal government also imposes tariffs on a range of goods. Tariff rates vary according to the good and the country from which it originates.

3 Pros and Cons of the Taxation of Consumption

Consumption is believed by some to be a better proxy of a taxpayer’s well-being than his or her income. According to this view, it is what taxpayers consume rather than what they earn that effectively determines their economic well-being. Consistent with this approach, governments should apply taxes on taxpayers’ actual expenditures, instead of on their ability to spend.

Consumption taxes apply the same tax rate on current and future consumption, assuming that the rate is constant over time. Hence, with this assumption, consumption taxes do not influence an individual’s decision to buy now or to save for later spending. Income taxes, on the other hand, may make immediate consumption more attractive than saving, since the returns on savings,4 such as interest earned, are usually taxed.5 The federal income tax system does, however, allow individuals to invest a portion of their income in tax-sheltered vehicles, such as registered retirement saving plans.  

General consumption taxes are believed to be more efficient than other types of taxes in that their impact on the allocation of resources in the economy is less pronounced. Competitive markets tend to allocate resources, such as capital or labour, to their best or most-valued uses, resulting in relatively less expensive goods and services for customers. General consumption taxes applied on all goods and services do not affect patterns of consumption or the allocation of resources among sectors of the economy. In reality, however, the GST/HST is not applied on all goods and services. The reduced economic efficiency associated with GST/HST exemptions may be weighed against the benefits associated with the public policy objectives of these exemptions.

General consumption taxes that are applied on all goods and services may affect labour supply, with two potential and competing effects. On one hand, all other factors remaining unchanged, individuals must earn higher incomes if they are to consume the same quantity and quality of goods and services as before the implementation of a general consumption tax or a tax rate increase. This situation may lead individuals to work more and engage in less leisure. On the other hand, the imposition of a general consumption tax or an increase in its rate reduces the benefits associated with earning income, since the spending enabled by a given amount of work is reduced as a consequence of the tax or the rate increase, all other factors remaining unchanged. As a result, some individuals may work less and engage in more leisure. The net impact of a general consumption tax or an increase in its rate on labour supply depends on individual preferences.

Consumption taxes are believed to have fewer adverse effects on work incentives than income taxes. In Canada, federal marginal income tax rates6 are higher than the GST/HST rates; income tax rates are at least equal to, and are usually higher than, GST/HST tax rates, and higher income tax brackets have higher income tax rates. High marginal tax rates are often believed to be a disincentive to work. The GST/HST, on the other hand, is applied at a fixed rate on all taxable goods and services.

General consumption taxes are, however, said to be regressive, since they have a relatively greater effect on low-income individuals, who typically consume a greater share of their income. The regressive nature of these taxes is mitigated somewhat by the non-application of the GST/HST on such products as basic groceries. As well, low-income Canadian taxpayers are eligible for a refundable GST/HST tax credit.

General consumption taxes might also discriminate against individuals whose consumption preferences involve taxable goods and services when compared with individuals who spend a relatively greater proportion of their income on non-taxable goods and services.

Moreover, general consumption taxes, such as the GST/HST, are sometimes criticized due to their compliance costs for businesses, which must collect the tax on each taxable sale, keep track of taxes paid on inputs and remit the difference to governments periodically.

General consumption taxes are usually favoured over specific consumption taxes, but the latter are thought to have some benefits. One such benefit is that specific consumption taxes can be applied on products that have “negative externalities.” For example, a specific consumption tax may be applied on cigarettes, which impose costs on third parties in the form of pollution and involve increased public health care costs. These costs are not reflected in the price of cigarettes. By applying a tax equal in value to any third-party costs, customers bear the true monetary costs associated with their consumption of a product, and governments can use the additional revenues to offset some of these costs. It is difficult, however, for governments to determine the tax that should be applied on products that give rise to negative externalities. Often, the rates of specific consumption taxes are set arbitrarily. Furthermore, high specific consumption taxes may lead to more transactions through an underground economy.

4 International Context

Since Canada has a small open economy, the international context may be especially important when analyzing the pros and cons of consumption taxes. Of particular relevance for Canada is the situation in its only bordering country and biggest trading partner, the United States. Consumption taxes that are significantly higher in Canada might induce some individuals to consume in countries where such taxes are lower. A greater reliance on consumption taxes might, however, be favourable for exporters, since most goods and services are exempt from consumption taxes when they are destined for foreign markets.

Collectively, all levels of government in Canada rely on consumption taxes to generate revenues to a relatively lesser extent than do most governments in OECD countries. As shown in Figure 2, general consumption taxes, such as the GST/HST, represented 13.3% of all tax revenues and social security contributions in Canada in 2008, while they represented 19.5% of all taxes collected for the average OECD country.

Figure 2 – General Consumption Taxes Collected as a Percentage of Total Tax Revenues and Social Security Contributions, All Levels of Government, Various Countries and Years

Note: “General consumption taxes” refers to consumption taxes, such as the GST/HST, that are applied on a broad range of goods and services.
Source: Organisation for Economic Co-operation and Development, Revenue Statistics 1965–2009, 2010.
Text description is available on a separate page.

Canadian governments also collect relatively less from specific consumption taxes as a proportion of all tax revenues and social security contributions than is the case with most OECD countries, as shown in Figure 3. The United States collects a smaller percentage of its taxes and social security contributions in the form of consumption taxes than does Canada.

Figure 3 – Specific Consumption Taxes Collected as a Percentage of Total Tax Revenues and Social Security Contributions, All Levels of Government, Various Countries and Years

Note: “Specific consumption taxes” refers to consumption taxes, such as excise taxes, that are applied on a limited number of products and services.
Source: Organisation for Economic Co-operation and Development, Revenue Statistics 1965–2009, 2010.
Text description is available on a separate page.

In Canada and most other OECD countries, there is an increasing reliance on general, rather than specific, consumption taxes. General consumption taxes, especially value-added taxes such as the GST/HST, have gained in popularity; the United States is the only OECD country without a value-added tax. Specific consumption taxes have seen their share of total tax revenues and social security contributions decline over the last 15 years because of factors such as trade liberalization, which has brought about lower customs duties. Nevertheless, excise taxes are still considered by some OECD countries to be an important tax policy tool that is used, for example, to achieve environmental goals or to influence consumer behaviour by discouraging consumption of products that have negative externalities, such as cigarettes.7

Notes

*  This publication is an updated and revised version of A Primer on Federal Consumption Taxes, prepared on 27 August 2007 by Philippe Bergevin, formerly of the Library of Parliament.[ Return to text ]

†  Papers in the Library of Parliament’s In Brief series are short briefings on current issues. At times, they may serve as overviews, referring readers to more substantive sources published on the same topic. They are prepared by the Parliamentary Information and Research Service, which carries out research for and provides information and analysis to parliamentarians and Senate and House of Commons committees and parliamentary associations in an objective, impartial manner. [ Return to text ]