A Nation Can’t Tax Itself into Prosperity April 19, 2024

In his 1904 address to the inaugural meeting of the Free Trade League, Winston Churchill famously said, "For a nation to try to tax itself into prosperity is like a man standing in a bucket and trying to lift himself up by the handle." The then-young statesman and future Prime Minister of the United Kingdom was arguing against tariffs and in favour of free trade-something that he did often throughout his political career.

Churchill correctly predicted that tariffs and other policies like them would prove disastrous for the economies of the and the many other countries that went down that path. And following the stagflation of the '70s and '80s that resulted from these policies, lower taxes, more open trade and freer markets became accepted wisdom among economists and policymakers to spur economic growth. Indeed, smaller and less interventionist government was considered the solution to all that ailed us.

However, the populist shift in politics in recent years, fuelled in part by rising inequality and eroding affordability, has meant that bigger government, larger deficits and greater debt have once again come into vogue. The COVID-19 pandemic helped accelerate this trend. One need only look to our neighbour to the south to see this clearly, as substantial deficit-financed spending leads it to continuously pile on more debt. Many of Canada's other advanced economy peers are following a similar, if less pronounced, playbook.

As we've often pointed outExternal link. , Canada has more fiscal wiggle room than a lot of other countries. The pandemic aside, federal deficits in Canada have tended to be relatively small, adding less debt to an already comparatively low base. And in Budget 2024, the Finance Minister broadly held the line on deficits, increasing taxes because the tailwind to revenues from a better economic outlook was insufficient to pay for all of the new spending. (See our analysisExternal link. of Budget 2024.)

But this begs the question: what is the cost of raising these revenues? The implications of the new tax measures can be examined through the lens of three commonly applied concepts when evaluating any tax policy: fairness, efficiency and administrability.

Some have argued that the tax measures in Budget 2024 come down to fairness. Fairness in tax policy is often thought of as horizontal equity-each taxpayer in similar circumstances should pay a similar amount of tax-and vertical equity-which has typically come to mean the more you earn, the more you pay. (Page, 2017External link. ) And by those criteria, the tax increases introduced in Budget 2024 could be considered fair.

What about the efficiency of the tax system? According to Bartlett (2018)External link. , this "speaks to the ability of the tax system to generate revenue in a manner which is least distortive to incentives and behaviours, thereby having the least impact on economic activity." Extensive research by the federal Department of Finance itself, back when it still published analysis two decades ago, determined that hiking taxes on capital assets or income reduced welfare and real by much more than increasing any other type of tax. (Baylor and Beauséjour, 2004External link. ; Department of Finance Canada, 2004External link. ; Baylor, 2005External link. ) More recent research in Canada and abroad has reached a similar, albeit at times more nuanced, conclusion. (, 2023External link. )

The final criterion for evaluating a tax policy is administrability. Essentially, is the federal government able to implement the tax in keeping with the letter and the spirit of the law? In the past, we've seen that wealthy Canadians have been able to employ sophisticated tax planning for the purpose of tax avoidance, which has led to less revenues being generated than expected. (Parliamentary Budget Officer, 2019External link. ) Corporations can similarly engage in international tax planning, particularly multinationals. Hence the federal government's affection for a global minimum tax.

Taken together, while many may consider the new tax measures to be fair, it is evident that they are likely to lead to distortionary effects on the economy and be difficult to administer. This should cause government revenues to be lower than currently anticipated and investment by both individuals and businesses to be less than it would be otherwise. (Look for our upcoming research on the potential industry implications of the new tax measures.) And it couldn't come at a worse time, as business investment is already in the dumps. So much for taxing our way to prosperity.

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