Abstract
Tax rate changes are some of the most significant and far-reaching decisions a government can take. In this paper we investigate the various fiscal and political factors that influence a government’s statutory tax rate change choices. We employ a multinomial logit model to empirically investigate the likelihood of changes to personal income tax, corporate income tax, and provincial sales tax rates by Canadian provincial governments over the period 1973–2010. Our results indicate that provincial governments that start with higher tax rates are more likely to cut, and less likely to raise, their tax rates. Another important implication of our results is that ideology matters—provinces with left-leaning governments are less likely to cut and more likely to raise their tax rates. The results are robust to various sensitivity checks.
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Notes
While the theory of “tax smoothing” introduced by Barro (1979) suggests that smoothing of tax rates over time is desirable for public debt management, one may also expect tax rates to be sticky if the political and governance costs associated with tax rate changes are higher than any potential benefits from doing so.
Empirical studies that employ time to event data often rely on survival or duration analysis. Such empirical methodologies focus on analysing the factors that affect the waiting time until the occurrence of a certain event of particular interest. See Wooldridge (2002). However, in this paper, we are interested in identifying and assessing the various political and economic factors that influence the occurrence of statutory tax rate cuts or increases by provincial governments rather than in the duration of statutory tax rate changes per se. Thus, we believe categorical data analysis is the appropriate empirical approach for the tax policy problem we want to investigate. In fact such empirical methods are often employed in other similar economic problem settings such as occupational choices, exchange rate regime choices, and locational choices. Further, as is common in the literature, we attempt to account for the adjustment process and the potential stickiness of tax rates by controlling for lagged tax rates within the categorical data analysis framework. See Lunderborg and Skedinger (1998) for the use of a similar approach.
For the province of Quebec, Parti Quebecois is also categorized as a Left-leaning government.
As indicated in similar studies such as Devereux et al. (2007), for subnational governments contemplating to change their sales taxes, one of the important considerations is the possibility of cross border shopping and smuggling associated with differential sales tax rates with neighbouring jurisdictions. For this reason, for sales tax rate, we use tax rate cuts and increases by just neighbouring provinces as commonly used in the literature. On the other hand, for CIT and PIT, we use tax rate cuts and tax rate increases by all other provinces since income is generally more mobile than consumer purchases. The implications of our results, however, would not change if one uses alternative definitions of neighbourliness for all cases.
While statutory tax rates change less frequently, effective tax rates always change due to the way they are constructed even though there is no change in tax policy whatsoever. As effective tax rate changes may occur independently of any tax policy change initiative, we believe that it is not suitable to analyze tax policy change decisions in our case. In fact, this shortcoming has long been recognized in various empirical studies including those who employ effective tax rates. See for example Hayashi and Boadway (2001) and Esteller-Morè and Solè-Ollè (2002).
Prior to 2001, provincial personal income tax rates (with the exception of Quebec) were expressed as a percentage of the federal PIT rate. In such cases, provincial tax rate changes can occur when either the provincial government, or the federal government or both change their respective PIT rates. As our interest is to analyze the factors that affect provincial tax rate changes, we only consider a provincial PIT rate change to have occurred if the provincial government changed its PIT rate regardless of what happened to the federal PIT rate.
Our analysis, however, shows that the results are not sensitive to the exclusion of these very small changes in the PIT rate.
A common problem to the maximum likelihood-based estimation with fixed effects is that coefficient estimators can be inconsistent when the length of the panel is small. This is what is often called the ‘incidental parameters problem’ in the literature. See Heckman (1981). In our case, one may be concerned with the possibility of incidental parameter problem due to the inclusion of provincial dummies in the regressions. As discussed in Greene (2004, 2008), the incidental parameter problem generally diminishes with increasing group size. Thus with 37 years of panel data, we believe that the incidental parameter problem will be less of a concern in our case.
We do not include federal goods and services tax rate changes in our robustness check as this tax rate was almost constant throughout the period of investigation.
For instance, simple computations based on average predicted probabilities for provinces obtained from our preferred results reveal that for Ontario, the largest province in the federation, a Left-leaning government would reduce the probability of CIT, PIT, and PST rate cuts by about 17, 32, and 38 % points, respectively. Similarly, left-leaning governments would increase the probability of CIT, PIT, and PST rate increases by about 13, 53, and 2 % points, respectively.
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Acknowledgments
Funding for this project was provided by the School of Public Policy, University of Calgary. An earlier version of this paper circulated as a technical working paper with the School of Public Policy, University of Calgary. We would like to thank Kenneth McKenzie, Anindya Sen, and participants of the 47th Canadian Economics Association meeting in Montreal and Deloitte Tax Policy Research Symposium in Toronto. All remaining errors are our own.
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Ferede, E., Dahlby, B. & Adjei, E. Determinants of statutory tax rate changes by the Canadian provinces. Econ Gov 16, 27–51 (2015). https://doi.org/10.1007/s10101-014-0153-6
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DOI: https://doi.org/10.1007/s10101-014-0153-6