| Summary: | Households and firms’ responses to higher tax rates alter the volume and the allocation of land, labour and capital in the economy, reducing our income and consumption opportunities. These economic losses from raising tax revenues have increased for provincial governments across Canada in the last decade with the problem being especially acute in Newfoundland and Labrador, Ontario and British Columbia. However, by lowering personal and corporate income tax rates and shifting more of the tax burden to a sales tax harmonized with the federal GST, the provinces could lower the economic cost of raising tax revenues. Taxpayers’ responses to higher tax rates adversely affect the economy. When rates go up, people are less inclined to save for the future because they must pay higher taxes on interest and dividends, and workers react by avoiding overtime and retiring early. When returns on investment generate higher taxes for corporations, they respond by cutting back their capital expenditures. Also, when people and companies can avoid paying a tax by shifting income or consumption to another jurisdiction with lower tax rates, the tax base will shrink as the tax rate goes up, reducing both income and consumption opportunities — an effect known as the deadweight loss from taxation. The larger the tax base, measured as a share of tax revenues, the greater the deadweight loss from a tax-induced decline in the tax base. All of these reactions to higher tax rates change the volume and allocation of land, capital and labour in the economy. The societal cost from raising extra revenue through a small tax rate increase is called the marginal cost of public funds (MCPF). It can be used to determine which taxes are causing the greatest welfare losses and to measure the gains from shifting the tax burden from the high-cost sources of tax revenues to those that impose a lower deadweight loss. Public projects should use the MCPF in doing a cost-benefit analysis, comparing the project’s benefits with the welfare loss from financing ...
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