GAAR me maties Part I

This post is not dedicated to pirates, but rather s. 245 of the Income Tax Act.

As of 2010, the federal Income Tax Act alone amounts to 2,847 pages and is one of the worst books every written. There are also the federal Income Tax Regulations and they amount to 1,339 pages. Taxation in Canada is now a very complex system and few Canadians seem to understand it.

Taxes have changed a great deal over time, yet the last time we had a comprehensive review of our tax system was in 1962 with the Carter Commission. Since then, our system has experienced haphazard changes with no framework or unifying theme to them. Our current system is a mish-mash of deductions, exemptions, credits, transfers, and rates with no unifying objective or premise. In fact, our system is now so complex that there are major legal and accounting sectors established not only to understand the system, but also to develop tax minimization strategies.

To circumvent these tax minimization strategies, section 245 was incorporated into the Income Tax Act (ITA) in 1988. Section 245 is the General Anti-Avoidance Rule (GAAR) which allows CRA to challenge abuses under the ITA. In essence, GAAR legislates that where a transaction or a series of transactions achieves a reduction, avoidance or deferral of tax, and those transactions or series of transactions are not conducted for any primary purpose other than to obtain a tax benefit, the tax consequences of the transaction or series of transactions may be invalidated. In other words, GAAR prohibits tax avoidance behaviour that, while complying with the rules as written, violates the spirit of the rules. GAAR turns tax avoidance activities into tax evasion activities.

The complexity of the tax system and the need for GAAR has led many tax experts, including myself, to call for a fundamental review and overhaul of our tax system. I’ll write more about GAAR in my next post.


Conspicuous consumption: parent edition

This post is not really related to taxes but more a recent observation of mine. I am mum to an 8th month old and observe a lot of things about parents I did not previously notice. This blog follows up on my twitter postings from Christmas Day.

I am in the mighty megapolous of Toronto for Christmas. And I do mean Toronto and not the GTA, an important distinction for those that living in Toronto proper itself. I am visiting my in-laws for Christmas, who I like a great deal, and they live in a very affluent neighbourhood in Toronto. Despite the terrible winter weather, I did get out quite a bit and noticed a big difference between Toronto and Victoria (and not just the weather). In Toronto, parents seemed to unanimously chose urban strollers. You know those four wheel jobbies. I found this odd, given how terrible these types of stroller are on terrain such as ice, snow, slush, and more importantly, pot holes. In Victoria, most parents opt for more versatile three wheel strollers such as the Bob Revolution or City Elite (my stroller of choice because you can run with it). Then I began to look more closely. Most of the strollers I was seeing in Toronto were the exclusive UppaBabby strollers and specifically the model that retails for around $900. That, IMO, is a lot of money to spend on a stroller that can navigate the terrain for 6 months out of the year and that you can’t jog with.

As an economist I then begin to think about what drives these preferences for an UppaBabby stroller. This leads me to two considerations. First, signaling. Parents always want to signal to the world how good of a parent they are, but that information about their parental quality is really only known to the parent. What they want to do is somehow signal that they are great parents. How do you do this without any interaction with people and particularly when you child may be showing to the world that perhaps you are not such a great parent? There are important ways to signal quality. Signalling refers to actions taken by an informed party for the sole purpose of credibly revealing private information. Signaling, to be effective, must be costly. If a signal was free, everyone would use it, and it would convey no information. The signal must also be less costly or more beneficial, to the person with the higher-quality product; otherwise, everyone would have the same incentive to use the signal, and the signal would reveal nothing. Conspicuous consumption is an excellent way to signal “quality”. In the case of strollers, parents who perceive themselves to be good parents are signaling they are great parents by purchasing expensive strollers.

The second consideration is a positional externality. A positional externality generates an “arms race” and over investment. An example is “lawyering up” which is based on the notion that the client with the best lawyer wins, so both parties spend heavily on lawyers. Positional externalities lead to a positional arms race. Social norms can also play a role as positional arms agreements. Keeping up with the Jones’ is a positional externality and purchasing expensive strollers could simply be a manifestation of the competition that manifests itself through conspicuous consumption.

I am sure that the plethora of UppaBabby Strollers in Toronto is likely a combination of both these factors (some will try to tell me these are ideal strollers, but that is only true if you don’t want to be outside during the winter months). This example reminds me of how economics can quickly give me answers to things I see in my daily life. Economics really makes you think about the world you see and to find answers using its greatly powerful tools.

How to benefit the rich: property tax edition

There is a lot of focus right now on tax treatments that benefit the rich. Most of the discussion is about income tax loopholes and I have certainly contributed to this discussion with a contribution to the Globe’s Wealth Paradox series. But BC has an interesting policy with its property taxes that also benefits the wealthy.

Like most provinces, B.C. offers property tax relief, but unlike all other provinces B.C.’s program is not tied to income. B.C.’s Property Tax Deferment Program allows anyone aged 55 and over to postpone payment of property taxes until they sell their home or pass away (assuming that have a minimum equity of 25% and have current fire insurance). Interest on the amount deferred is charged, but at a rate not greater than 2% below the prime rate at which the province borrows money. In addition to this plum rate, any interest charge is always based on the amount loaned and does not compound.

Eligibility for the program is not means-tested, meaning it is open to both those that need and those that desire to postpone payment. When property taxes are deferred, they are secured with a government lien placed against the home. The province then transfers the total amount deferred (in that year) to local governments. So municipal government are not out any money but the B.C. government is.

The intent of the program, which dates back to the post war period, is to  provide relief for those who cannot afford to pay property taxes. There are two key problems with this objective. First, households with an ability to pay, it seems, were not expected to choose to defer property taxes, yet without a means test for eligibility, there is no way to prevent them from doing so. Second, the income and wealth profile of those aged 55 and over is no longer dominated by those with a low fixed income. Baby boomers are certainly one of the wealthiest senior populations we have ever seen and this notion of being old and being poor no longer holds water.

Those low-income seniors targeted by the program are not necessarily benefiting from it, which is truly a shame. Programs such as this can help low-income seniors stay in their home a little longer, reducing the burden on long-term care residences. That said, we should be careful about promoting home ownership amongst those who can’t afford it. Owning a home is expensive and sometime it is best to sell the asset and find more afforded housing.

B.C. needs to end this subsidy for high income households. The program needs to modified for the new realities of the income profile of seniors and access based on passing a means test.

Property taxes are not user fees

From 2009-2012, Catalyst Paper fought their property tax bill in four B.C. communities: North Cowichan, Campbell, River, Port Alberni, and Powell River. Catalyst opted not to pay its taxes in these communities and ended up appealing its tax bill all the way to the Supreme Court of Canada. The essence of Catalyst’s argument was that the property taxes were too high and bore not relationship to the municipal services they actually used.

The Supreme Court of Canada (SCC) ruled on the case on January 20, 2012. The SCC dismissed the appeal essentially saying that municipalities can use any factors they deem necessary in setting tax rates, including not only how much municipal services are consumed, but also “social, economic, and political factors that are relevant to the electorate.”

What Catalyst was essentially arguing was that property taxes were user fees: they should only pay for what they consume. What the court was essentially saying is that property taxes are taxes, not user fees, and you pay for whatever the government wants you to pay for.

Given the wealth of case law that exists on user fees and taxes in Canada, I am surprised that Catalyst’s lawyers took the position they did. Their position was, in reality, indefensible. Despite this, this argument is quite common: that property taxes don’t reflect the benefits incurred by payers. In fact, it is the main argument used in several cases of condominium associations suing their respective cities for their property taxes being too high.

Let’s settle this once and for all: property taxes are not user fees. For taxes, there is no requirement for there to be a nexus between the amount charged and the amount of goods and services consumed. As I have written before, “a tax is a mandatory payment for the purpose of raising revenues not connected to the activity being taxed.” These frivolous law suits arguing that property taxes are user fees need to stop or the lawyers representing these cases need to come up with a better argument. At least come up with something that is not easily dismissed with a cursory reading of the case law!

…But It’s Regressive!

This post was inspired by Stephen Gordon over at Worthwhile Canadian Initiative. I had mentioned in my previous post, that user fees work on the principle of fairness because you get what you pay for. This is the benefits-received definition of equity.

Another definition of equity is a person’s ability to pay. With user fees, all consumers pay for the cost of the good or service regardless of their income, a key measure for ability to pay. Ability to pay is the most frequent argument against user fees, specifically that they are regressive. When the financial burden of a service falls more heavily on low income households, it is referred to as regressive. This usually manifests itself as the tax payment taking a larger portion of the after-tax income of low income households. This critique was offered by the Official Opposition in response to a federal government initiative to increase user fees, “NDP Treasury Board critic Alexandre Boulerice said user fees discriminate against the poor because unlike income taxes, they are not geared to income.”

The literature, however, is not conclusive regarding the regressive nature of user fees. In fact the evidence suggests four main arguments against user fee’s regressivity.

  1. First, upper-income households benefit disproportionately from free public services. For example, upper-income households are more likely to live in large households and consume more than their share of sewage, water, and refuse collection than lower income households when these services are funded through property taxes and not user fees.
  2. Second, user fees allow low-income consumers to adjust their consumption to lower levels, thereby paying less than they would under a property tax system.
  3. Third, any regressive or disproportionate effects can be minimized or even reversed with careful design, revenue uses, and compensation mechanisms, particularly discounts and exemptions for readily identifiable groups, a point made clearly in a paper I co-authored on congestion charges. It is possible to accommodate equity concerns not just through fee reductions, but also operational changes. For example, providing more services to low income areas or reducing the burden of the fee by accepting various forms of payment or allowing individuals to pay by month rather than one up front yearly fee.
  4. Fourth, one must examine the incidence of any other tax or taxes that might be reduced at the same time and the incidence of the publicly provided goods and services to which any revenue is devoted. This means that examination of the equity concerns of user fees is an important aspect of user fee implementation and the equity assessment must be comprehensive to ensure a full understanding of the effects of the user fee on other correlated levies and goods and services.

I get very frustrated when someone just dismisses a revenue instrument (like user fees and consumption taxes) on the ground of regressivity. Income taxes, after all, can be regressive. We just choose for them not to be. Same is true of user fees. They are only regressive if you let them be regressive. It is time that we elevate discussions on these type of taxes beyond this hyperbole and talk about what we can do to address these types of concerns during design and implementation.

A tax is a tax is a tax….or is it?

“What’s in a name? That which we call a tax by any other name would smell as putrid?” I am paraphrasing Shakespeare here (from Romeo and Juliet) as it seems apt for this blog topic. People complain a lot about taxes, even when what they are complaining about is, in fact, not a tax. When I try to make this clarification, the end result is not pleasant, at least for me. They usually say that it does not matter, that a tax is a tax is a tax. This attitude seems to reflect a notion that the distinction between taxes and other types of government levies is increasingly blurred. But there are very important distinctions between some revenue instruments. In fact, the courts recognize and distinguish between three main revenue instruments: a tax, a user fee, and a regulatory charge.

What is a tax? According to the courts (under the decision in Lawson) a tax is: enforceable by law, imposed under the authority of the legislature, imposed by a public body, and generated for a public purpose. Hmmm, you say, it seems that all revenue instruments would meet that definition. Not so fast, it is the last element which is the most important. What does a public purpose mean? It means that the instrument is used solely to raise revenues. That means that revenues can be used for any means. That is, a tax is a mandatory payment for the purpose of raising revenues not connected to the activity being taxed. For example, using income tax to pay for national defense or property taxes to pay for police services.

What is a user fee? A user fee, in contrast to a tax (under the decision in Eurig), is: (1) a charge for a publicly provided good or service, (2) where the revenues from the fee are solely used to offset the costs of providing the good or service, and (3) the size of fee is dictated by the cost of providing the good or service. That is, the monies collected from a user fee cannot be deposited into general revenues to offset general expenditures, but instead must be earmarked and spent purposefully. In other words, you get what you pay for. In economics lingo, user fees work on the basic principle of fairness as measured by the benefits received principle because you pay for what you get. This makes user fees ideal for goods or services where each individual user directly benefits from consuming goods or services and where the municipality may want to directly influence the level of consumption by pricing the good to encourage reductions in consumption.

In addition to revenues having to be earmarked, note carefully that the size of the fee must be directly related to the cost of the good or service. The fee can’t just be made up by deciding how high that it can be set without causing outrage. Instead, a nexus must exist between the quantum charged and the cost of the service provided in order for the levy to be constitutionally valid. If it costs $50 to provide a service, you have to charge $50 or less for that service. This also means that user fees cannot generate surpluses. Is it any wonder why economists say, “whenever possible, charge”? We like user fees because not only are the efficient, but they have a high level of accountability built into them. User fees keep the government in check and that check is built right into the revenue instrument.

What is a regulatory charge? These are very similar to user fees except that instead of being a charge for a publicly provided good or service, they are a charge for a right or privilege awarded or granted by the government. Regulatory charge must be ancillary or adherent to a regulatory scheme.  The funds collected under the regulatory scheme are used to finance the scheme or to alter individual behaviour. Like with user fees, the charge must be supported by a proper estimate of the costs of the scheme. For example, fees for gravel or soil removal are regulatory charges.

As you can see, there are clear distinctions between these revenue instruments. They have very different objectives, very different requirements, and very different obligations on the government. A tax is a tax, a fee is a fee, and a charge is a charge.

Dead for Tax Reasons

Shortly after I started my PhD, a paper hit the economics world that made a lot of people open their eyes to the power of the dismal science. This paper, on the heals of the popularity of Freakonomics and behavioural economics, by Wojcieck Kopczuk and Joel Slemrod was entitled Dying to Save Taxes and asked “Do people find ways to postpone their deaths if it qualifies them for a lower inheritance tax rate?” While I don’t see any HT to Douglas Adams in their paper, the paper is testing Adams’ world where people can be ‘Dead for Tax Reasons.’

The punchline of this relatively short paper is that there is a marginally (1.6%) higher probability of people whose estate would benefit from a lower inheritance tax regime dying in such a regime. The authors do note that this effect could be doctor induced, but I am not all that clear on the incentive for the doctor to influence or ex post change the death date so the estate can benefit.

This work contributes to the voluminous literature that taxes do indeed effect behaviour. Taxes have been shown to influence marriage, divorce, labour supply, stock options, births, and now even deaths! Taxes, you see, are a powerful motivator and if you take the time to understand them, you too can benefit from day to day mundane tasks that you were going to do anyway, like dying.