Recommendation in Income Tax

Most economists believe that consumer spending decisions follow the broad criteria set out in the life cycle and permanent income theories—two closely related hypotheses that, in the remainder of this article, are treated as a single theory. This theory holds that consumers wish to maintain a growth path of spending over their lifetimes. Thus, consumers will be reluctant to increase or reduce spending in response to a change in income unless they believe that the income change will persist. The shorthand formulation of this idea is that spending responds to change in “permanent” income. Applying this theory to tax changes, we conclude that consumers will be more likely to alter their spending behaviour if they perceive a tax change to be lasting.

For instance, a reduction in income tax rates or increase in personal exemptions that is placed permanently in the tax code should have a larger effect on consumer spending than a temporary rate reduction or increase in exemptions. Another component of the theory that bears on tax changes and spending is the premise that consumers are forward looking. This premise suggests that consumers not only distinguish permanent from temporary changes in taxes, but also anticipate the impact of a tax change on their incomes even before it takes effect. Thus, consumers might begin to adjust their spending immediately after a tax change is passed into law, or even when the outlines of the change begin to firm up—developments that can occur long before the change actually begins to affect tax payments. Indeed, if consumers do take the long view, then changes in the legal structure of tax liabilities should influence their spending decisions more than changes in the timing of tax payments. After all, one would expect a shift in the structure of annual liabilities to have a greater effect on permanent after-tax income than a revision in withholding schedules or a change in requirements for quarterly no withheld tax payments.

On the other hands, the one of recommendations for business taxation is proposing to abolish the current system of business rates and replace it with a system of land value taxation, thereby replacing one of the more distortionary taxes in the current system with a neutral and efficient tax. Business rates are not a good tax, they discriminate between different sorts of business and disincentive development of business property. Our second proposal concerns the treatment of small businesses and self-employment. The current system distorts choices over organizational form which are the choice between employment and self-employment on the one hand, and the choice between running an unincorporated business or a small company on the other hand, as well as decisions over the form of remuneration. For example, a sole proprietor of a small company whether had pays herself or not in the form of salary or dividends. These discrepancies are inequitable and lack any clear rationale. The difference between the corporation tax rates paid by firms with higher and lower profits also lacks a compelling justification.

Our recommendations would align the taxation of income from employment and self-employment, increasing the NICs paid by self-employed individuals to match those paid by employers and employees combined in relation to employment. Again, this could be done as part of the integration of income tax and NICs. Capital invested by individuals both in business assets of sole traders and partnerships and in equity issued by companies would be eligible for the rate-of-return allowance. In both cases, this would remove the ‘normal’ returns on these investments from personal taxation. Our third proposal on business taxation is the introduction of an allowance for corporate equity (ACE) within the corporate income tax. The ACE provides an explicit deduction for the cost of using equity finance, similar to the existing deduction for the cost of interest payments on debt finance. This levels the playing field between different sources of finance. Like the RRA, the ACE can be designed to eliminate the effect of the corporate tax on the required rate of return for all forms of corporate investment. Different assets that firms invest in are treated equally, with no sensitivity of tax liabilities to the rate of inflation. With this form of corporate tax base, investment projects that just earn the minimum required or ‘normal’ rate of return are effectively exempt from corporate taxation, and revenue is collected from those investments that earn above-normal rates of return, or economic rents.

Besides that, the other recommendation for this standard is changing the approach to corporate tax expenditure. Corporate tax expenditure should be analysed within the same parameters as any other business support initiative. That includes cost-benefit analysis to determine that if they are meeting their public objectives, determining their effectiveness and efficiency in creating incremental economic activity and jobs, and assessing their impact on the broader economy. Furthermore, all business tax credits should be targeted in scope and of limited duration, only those that demonstrate success through a mandatory, comprehensive evaluation should be extended. Sponsoring departments should have budgetary accountability for corporate tax expenditures in their business too. Lastly, the province should ensure that the greater transparency in business support programs by publishing annually a list of direct business support programs and any related spending, including companies receiving direct financial support and the quantum of that support.