This is the first in a series of posts that will examine the tax system in Canada, from an economist’s point of view. If we better understand how the tax system works, we can find ways to improve it. It turns out that there are a number of ways the Canadian tax system can be improved.

Taxation anywhere serves two basic purposes:

1. Collect the money necessary to pay for government programs

The tax revenue collected for this purpose can either go into ‘general revenues’ or it can be collected for a specific purpose. An example of the latter is the Canadian Pension Plan (CPP), where CPP ‘contributions’ paid by employers and employees go into the CPP Reserve Fund.

Taxes are not the only method governments use to collect revenue. The Canadian Government also collects the profits made by Crown corporations, such as the Bank of Canada, VIA Rail Canada and Canada Mortgage and Housing Corporation.

2. Discourage Certain Types of Behaviour

Government uses taxes to discourage certain types of activities by raising the price of those activities. These taxes fall under two broad, though occasionally overlapping, categories. The first category, sin taxes includes taxes on alcohol and tobacco. Placing high tariffs on imported products in order to ‘protect’ domestic manufacturers would fall under this category, though few economists would see imported goods as a ‘sin’.

The second category, Pigouvian taxes are used as a method to correct a negative externality such as pollution. With the negative externality of pollution, the polluter imposes a cost on others that he does not pay. As a result, a higher than socially optimal amount of that activity takes place (that is, we have ‘too much’ pollution). By setting a Pigouvian tax rate equal to the marginal costs the polluting activity places on others, we can ‘internalize’ the externality by making the polluter pay the true cost of the activity.

Isn’t Redistribution Another Goal of the Tax System?

A significant portion of what a government does is redistributive in nature – taking wealth (or income) from one person to another. To analyze this, we need to break the redistribution into two parts – the giving to some and the taking from others.

The giving to some is one of the government programs that make up the first purpose of the tax system as discussed above, so including it again would be double counting.

The taking from others is simply how we pay for the programs that give to some. If our goal is to distribute wealth (or income) to low-income persons, then naturally the taxes to pay for this should be on individuals with higher incomes. Taxing low-income people and giving the money back to low-income people is counterproductive (and likely not to generate a great deal of revenue in the first place). We will discuss these issues in greater detail in Part II of the series.

One could make the argument that taxation can be used as a tool to reduce inequality regardless of where the money goes and as such can be a third goal. Suppose the Canadian government created a higher income tax bracket for people making over $500,000 a year and used it to buy hockey cards from the 1970s. Low and middle-income people are not made any better off (unless they happen to own a bunch of Lanny McDonald rookie cards) but this would reduce income inequality, as measured by the Gini-coefficient of inequality. I do not believe reducing inequality by simply taking away from high-income persons should be a goal of the tax system. Stephen Gordon’s Economic policy advice for the NDP, Part I: Inequality discusses this idea in some detail.

Those are the goals of taxation. When setting up a tax system, however, there are a number of constraints. We will examine those constraints in Part II.