Tax reform likely to come in baby steps, not big changes

The U.S. government israising tax ratesfor the wealthiest two per cent of income earners this year and while the tax hike is smaller than what U.S. President Barack Obama wanted, the outcry it has caused in Congress and some sectors of American society is an indication of just how hard it is to make even the smallest changes to a country's income tax system.

In aprogressive income tax system like Canada's, changes usually take the form of smallincreases or reductions in therates applied to each tax bracket or in the creation or elimination of deductionsand credits.

However, as people begin to pore overT4s, T1s and othertax forms in lead up to the April 30 filing deadline, they might begin to call out for an entirely new simpler system.

For those bold enough to adopt them, there is no shortage of ideason howtostructure the ideal tax system.

One of the most-cited, at least by economists, ideas is to replace income taxes withconsumption taxes or at least to rely more heavily on them.Consumption taxesapply towhat people spend on goods and servicesinstead of what they earn and include taxes onthings like retail sales, fuel, tobacco, manufacturing and carbon emissions. Such plans often also favoureliminatingtaxes on savings and investments.

'There are far more examples of failed attempts to do sweeping tax reform.' Lisa Philipps, associate vice-president of research, York University

Another common reform proposal is to change the progressive tax system toone based on a flat rate,where everyone pays the same rate regardless of income. After the collapse of the Soviet Union, Russia and a number of countries in Eastern Europe instituted flat rates.

Some reformerssuggest we simplify the income tax system by reducing the number of income tiers and eliminating credits and deductions, also called tax expenditures.

Regardless of which model a country chooses and there is no shortage of debateabout the respective merits and fairness of eachthe widespread reform of a country's income tax system is no easy task, experts say.

"There are far more examples of failed attempts to do sweeping tax reform [than successful ones]," says Lisa Philipps, a professor of tax law and associate vice-president of research at York University in Toronto. "It's a real puzzle that tax policy people have studied extensively."

Winners and losers

Jack Mintz, an economist and chair of the School of Public Policy at the University of Calgary who has written and lecturedextensively on tax-related issues, agrees that overhauling a country's tax system is no easy task.

"It's quite a challenge, actually, tax reform," he said. "But it doesn't mean that it's not done."

Although the impetus for reform can vary, it is often spurred by one oftwo situations, Mintz said: either the governmentfederal or provincial is facing deficits and accumulating debt, or the economy is doing poorly and there is very little growth.

Before embarking on any project of reform, governments should have a clear idea of the type of tax system they would like to implement, Mintz says.

"What is the best structure that is fair, generates growth and jobsand at the same time provides the same revenues for the government," he says.

It is also important to get all affected groups, including the general public, to buy into the idea of reforming the system by explaining the benefits of the new structure.

"There are always difficulties with tax reform [because] you create winners and losers, and the losers scream and the winners don't say as much, and as a result, you can get a pretty strong reaction," Mintz said.

Mintz cites the implementation of the harmonized sales tax (HST) in Ontario in 2010 as an example of a tax amendmentthat has been implemented without much of a backlash.

The new tax had the support of a number of business groups and the government made various exemptions as a way of softening the blow on lower-income people.

British Columbia, on the other hand, voted to repeal the HST in August 2011 following widespread public backlash to the tax, with opponents saying it unfairly shifted the tax burden onto the middle class.

Tax reform part of a cycle

Michael Smart, an economics professorat the University of Toronto, says wide-ranging tax reform is often a once-in-a-generation sort of event that is sometimes spurred by complexities within the system that end up harming economic growth.

The harm is often the result of politicians putting in place tax measures or programsthat benefit specific groups but over time create less than ideal outcomes.

"We need to look at these things periodically, so I think it is just a natural process," says Smart, who favours incremental over sweeping reform. "The tax system goes through a cycle."

One notableexample of wide-ranging reformare the changes introduced inthe United States in 1986, when the governmentof Ronald Reaganlowered taxrates, reduced the number of income tiers and eliminated a number of so-called loopholes in the tax system.

Those changesprompted the Canadian government to examine its own tax system. Tax changes made by one country can be a catalyst for reform in another country especially when those two nations have close economic ties.

"The last such personal tax reform in Canada was in 1987, [and] that was really prompted by what was happening in the U.S," Smart said. "We knew that [we had to ] move with our biggest trading partner."

During that period of reform in Canada, the number of federal income tax brackets was reduced to just threealthough a fourthwas added in2001 and the top marginal rates were lowered. The government also moved to introduce thegoods and servicestaxin 1991 as part of the reform package.

"Tax reform is hard to do," said Smart. "It is complicated, and the various political forces that have to be aligned in order to make tax reform happen are complex, and I think imperfectly understood. The events, when they have happened in the past, it feels a little bit like a magical process."

'Both sides of the ledger'

One approach to reform that is likely to yield results is to examine individual policy areas instead of looking at the whole tax structure, says Phillips.

She points to a recent review of the federal government's spending on industrial innovation that looked at both tax expenditures and direct spending to determine the best way to achievethe government's goal of promoting research and development.

"Looking at both sides of the ledger" is important, she said,because foregone revenue in the form of credits and money disbursed as grants both cost the government but might not achieve the same policy objectives. They need to be looked at rationally and as a whole.

The same approach can be taken with income tax and the numerous credits and exemptions offered to Canadians.

Philipps says an expert panel could, for example,examine the best way to promotechildren's fitness by assessing the impact of fitness tax credits which are offeredby the federal government and some provinces as well asgovernment spending on projects like community centres.

"What are the most effective programs to promote fitness among children of all socio-economic classes, because we know it is a problem, and we want to reduce our long-term health-care costs," said Phillips.

"Let's rationalize and figure out a better way to do this."