Pro-Growth Tax Reform: Evidence from Canadian Provinces

In the past few years, I’ve bolstered the case for lower tax rates by citing country-specific research from Italy, Australia, Germany, Sweden, Israel, Portugal, South Africa, the United States, Denmark, Russia, France, and the United Kingdom.

Now let’s look to the north.

Two Canadian scholars investigated the impact of provincial tax policy changes in Canada. Here are the issues they investigated.

The tax cuts introduced by the provincial government of British Columbia (BC) in 2001 are an important example… The tax reform was introduced in two stages. In an attempt to make the BC’s economy more competitive, the government reduced the corporate income tax (CIT) rate initially by 3.0 percentage points with an additional 1.5 percentage point reduction in 2005. The government also cut the personal income tax (PIT) rate by about 25 percent. …The Canadian provincial governments’ tax policies provide a good natural experiment for the study of the effects of tax rates on growth. …The principal objective of this paper is to investigate the effects of taxation on growth using data from 10 Canadian provinces during 1977-2006. We also explore the relationship between tax rates and total tax revenue. We use the empirical results to assess the revenue and growth rate effects of the 2001 British Columbia’s incentive-based tax cuts.

And here are the headline results.

The results of this paper indicate that higher taxes are associated with lower private investment and slower economic growth. Our analysis suggests that a 10 percentage point cut in the statutory corporate income tax rate is associated with a temporary 1 to 2 percentage point increase in per capita GDP growth rate. Similarly, a 10 percentage point reduction in the top marginal personal income tax rate is related to a temporary one percentage point increase in the growth rate. … The results suggest that the tax cuts can result in significant long-run output gains. In particular, our simulation results indicate that the 4.5 percentage point CIT rate cut will boost the long-run GDP per capita in BC by 18 percent compared to the level that would have prevailed in the absence of the CIT tax cut. …The result indicates that a 10 percentage point reduction in the corporate marginal tax rate is associated with a 5.76 percentage point increase in the private investment to GDP ratio. Similarly, a 10 percentage point cut in the top personal income tax rate is related to a 5.96 percentage point rise in the private investment to GDP ratio.

The authors look specifically at what happened when British Columbia adopted supply-side tax reforms.

…In this section, we attempt to gauge the magnitude of the growth effects of the CIT and PIT rate cuts in BC in 2001… the growth rate effect of the tax cut is temporary, but long-lasting. Figure 2 shows the output with the CIT rate cut relative to the no-tax cut output over the 120 years horizon. Our model indicates that in the long-run per capita output would be 17.6 percent higher with the 4.5 percentage point CIT rate cut. …We have used a similar procedure to calculate the effects of the five percentage point reduction in the PIT rate in BC. …The solid line in Figure 3 shows simulated relative output with the PIT rate cut compared to the output with the base line growth rate of 1.275. Our model indicates that per capita output would be 7.6 percent higher in the long run with the five percentage point PIT rate cut.

Here’s their estimate of the long-run benefits of a lower corporate tax rate.

And here’s what they found when estimating the pro-growth impact of a lower tax rate on households.

In both cases, lower tax rates lead to more economic output.

Which means that lower tax rates result in more taxable income (the core premise of the Laffer Curve).

The amount of tax revenue that a provincial government collects depends on both its tax rates and tax bases. Thus one major concern that policy makers have in cutting tax rates is the implication of tax cuts for government tax receipts. …The true cost of raising a tax rate to taxpayers is not just the direct cost of but also the loss of output caused by changes in taxpayers’ economic decisions. The Marginal Cost of Public Funds (MCF) measures the loss created by the additional distortion in the allocation of resources when an additional dollar of tax revenue is raised through a tax rate increase. …if…government is on the negatively-sloped section of its present value revenue Laffer curve…, a tax rate reduction would increase the present value of the government’s tax revenues.

And the Canadian research determined that, measured by present value, the lower corporate tax rate will increase tax revenue.

…computations indicate that including the growth rate effects substantially raises our view of the MCF for a PIT. Our computations therefore support previous analysis which indicates that it is much more costly to raise revenue through a PIT rate increase than through a sales tax rate increase and that there are potentially large efficiency gains if a province switches from an income tax to a sales tax. When the growth rate effects of the CIT are included in the analysis, …a CIT rate reduction would increase the present value of the government’s tax revenues. A CIT rate cut would make taxpayers better off and the government would have more funds to spend on public services or cut other taxes. Therefore our computations provide strong support for cutting corporate income tax rates.

Needless to say, if faced with the choice between “more funds to spend” and “cut other taxes,” I greatly prefer the latter. Which is why I worry that people learn the wrong lesson when I point out that the rich paid a lot more tax after Reagan lowered the top rate in the 1980s.

The goal is to generate more prosperity for people, not more revenue for government. So if a tax cut produces more revenue, the immediate response should be to drop the rate even further.

But I’m digressing. The point of today’s column is simply to augment my collection of case studies showing that better tax policy produces better economic performance.

P.S. The research from Canada also helps to explain the positive effect of decentralization and federalism. British Columbia had the leeway to adopt supply-side reforms because the central government in Canada is somewhat limited in size and scope. That’s even more true in Switzerland (where we see the best results), and somewhat true about the United States.