The case for incentive-based tax cuts

August 31, 2006

Free Market Foundation

Tax relief in Canada must focus on enhancing the incentives for work, savings, investment and entrepreneurship, with the aim of improving the overall economy, says the Fraser Institute.

A 2004 working paper for the Canadian Department of Finance explains how incentive-based tax cuts, such as those on investment and capital, provide larger benefits than broad-based taxes, such as one on consumption. According to the authors:

Every $1 tax cut in the form of a reduction in consumption taxes yields a $0.10 benefit.

Reductions in business taxes yield significantly larger benefits for the same $1 tax cut, ranging from $0.40 for corporate income taxes to $1.40 for changes to depreciation expenses.

The reason incentive-based tax cuts work better at achieving economic growth is because they target its essential components savings and investment, say the authors:

Reduced taxes on investment lead to increased savings by increasing the returns available to these activities; the increased savings lowers the cost of capital, which results in increased investment.

Reducing taxes on capital also results in an increased after-tax rate of return, which increases incentives for savings by increasing the returns available to such activity and lowers the cost of capital for firms.

However, lower consumption taxes decrease the cost of consumption and thus encourage more of it at the expense of savings.

The importance to society of savings and investment is critical, say the authors. Savings lead to investment, which finances the purchase of machinery, equipment and research and development. These types of investments make workers more productive and result in higher wages, says Fraser.

Source: Jason Clemens, Niels Veldhuis and Milagros Palacios, Tax Cuts Must Focus on Incentives, Fraser Forum, July/August 2006

For text: http://www.fraserinstitute.ca/admin/books/chapterfiles/JulAug06ffTaxCuts.pdf#

For abstract: http://www.fin.gc.ca/wp/2004-10e.html

For more on Taxes: http://www.ncpa.org/sub/dpd/index.php?Article_Category=20

FMF Policy Bulletin/ 22 August 2006