In general terms, the objective of the current rules is to ensure that a dollar of passive investment income earned via a corporation bears a tax burden, when corporate and personal taxes are combined, that is roughly similar to that of a dollar of passive investment income earned directly by an individual. For instance, under current rules, an individual who has inherited $100,000 would generally be indifferent between investing this amount directly in securities, or making the same investment through a corporation set up for that specific purpose – in both cases, expected returns would be similar.
The Government is considering approaches that will improve the fairness and neutrality of the tax system, such that savings held within corporations are taxed in a manner that is equivalent to savings held directly by individuals, for example salaried employees.
The principles of fairness and neutrality are core building blocks of our tax system. The tax system contains many provisions that are aimed at making sure that an individual is indifferent between earning income through a corporation or directly. This concept is generally referred to as "tax integration".
Chart 6 shows the distribution of non-eligible dividends (i.e., generally meaning dividends paid from income—such as income qualifying for the small business deduction—that has not been subject to the general corporate income tax rate) by age of tax-filer for the 2006, 2010 and 2014 tax years. In each year, a substantial amount of dividends earned by tax-filers under the age of 25 is earned by taxpayers who are not subject to the TOSI (area to the left of the dotted line). The total amount of dividends earned by those in the 18-21 age group exceeds the amounts earned by each of the 22-25 and 26-29 age groups. There is no economic rationale for why the 18-21 age group would earn more dividend income than the 22-25 and 26-29 age groups. In other words, dividend income resulting from the contribution of capital would be expected to increase with age for the population of tax-filers under the age of 30. This anomaly in the distribution suggests the presence of dividend sprinkling, because the tax benefits of income sprinkling are higher, on average, when adult children of high-income filers are younger and have lower income.
Americans who are caught evading taxes in one year may be audited for prior years. While the IRS does not disclose its method of selecting tax returns to audit, it is widely believed that a taxpayer's probability of being audited is an increasing function of current evasion. Under these circumstances, a rational taxpayer's current evasion is a decreasing function of prior evasion, since, if audited and caught for evading this year, the taxpayer may incur penalties for past evasions. The paper presents a model that formalizes this notion, and derives its implications for the responsiveness of individual and aggregate tax evasion to changes in the economic environment. The aggregate behavior of American taxpayers over the 1947 - 1993 period is consistent with the implications of this model. Specifically, aggregate tax evasion is higher in years in which past evasions are small relative to current tax liabilities -- which is the case when incomes or tax rates rise. Furthermore, aggregate audit-related fines and penalties imposed by the IRS are positively related not only to aggregate current-year evasion but also to evasion in prior years. The estimates imply that the average tax evasion rate in the United states over this period is 42% lower than it would be if taxpayers were unconcerned about retrospective audits.
More Power to Government and Lawmakers. The more government spends and uses tax and regulatory policies to micromanage economic affairs, the more power it amasses. Private citizens and businesses react to the government’s accrual of power by seeking more access to decision makers. The large benefits that businesses can gain from receiving a VAT exemption for their product will cause them to seek VAT relief from the government. Carve-outs for businesses will give government more power to pick winners and losers in the marketplace and make business success more dependent on procuring government favors rather than providing a product demanded by the public. This concentrates more power in government and increases the power of businesses and industries with strong lobbies at the expense of those with less political sway. This will only increase the alienation that many feel from the government that is increasingly beholden to the powerful.
One major advantage of the VAT in the abstract is that it exerts less influence on the decision making of individuals and businesses. However, once certain goods and services receive preferential treatment, the advantages of a VAT rapidly dissipate because some businesses—more accurately, the goods and services they produce—receive more favorable tax treatment than others.
A VAT can collect a staggering amount of revenue. In the present budgetary context, some experts are calling for a VAT large enough to close massive current and future deficits. For example, the Domenici–Rivlin Task Force report calls for a 6.5 percent “deficit reduction sales tax,” which is in reality a VAT. The additional revenue needed to close the existing budget gap would require a VAT between 15 percent and 20 percent, which would be in line with VAT rates in other economically developed countries. In fact, the EU requires its members to levy a VAT of at least 15 percent, and in some countries, the VAT is as high as 25 percent.
Economic Drag from Exemptions. Many wrongly claim that the VAT is regressive. They argue that the poor consume a higher percentage of their income and therefore would pay a larger portion of their income as VAT than the rich would pay. While measuring income tax paid relative to income is reasonable, measuring VAT tax paid relative to consumption is also reasonable because consumption is the base of a VAT. On this basis, a VAT is proportional because all taxpayers would pay the same amount of tax as a share of their consumption. This is an important distinction because, if lawmakers fall for the flawed regressivity argument, then any VAT law would likely exempt certain necessities, such as food and shelter, which often constitute a larger portion of a low-income person’s consumption spending.
Once a VAT is in place, Congress could easily increase the VAT any time it wants more taxpayer money to pay for new programs. Continually increasing the size of government would become considerably less painful because small increases in the VAT rate could raise substantial sums of revenue. An increase of just 1 percent would raise more than $80 billion per year by the end of the decade.
Increased rewards from incorporation flow in part from the growing gap—illustrated in Chart 5 below—between corporate and personal income tax rates. This growing gap has been the natural result of taking steps to improve the competitiveness of Canada's corporate tax system. Lower corporate taxes encourage new capital investment—for example, in better machinery and more efficient technology—that makes workers more productive and, in doing so, leads to economic growth, more jobs and higher wages. In an increasingly globalized economy where investment capital is highly mobile, a competitive business tax system is crucial. At the same time, the growing gap between corporate and personal income tax rates can lead to tax arbitrage behaviours.
If the government imposed a VAT in lieu of a payroll tax, the worker’s after-tax income would be unchanged, but the VAT would cause prices to increase, reducing the worker’s ability to purchase goods and services. In this case, the true value of the worker’s wages has declined because their purchasing power has declined. From the worker’s perspective, what matters is what he or she can buy in exchange for a certain amount of work. Whether through a payroll tax reducing after-tax wages or a VAT raising consumer prices, both taxes disadvantage the worker equally, reducing the worker’s incentive to work. Economically, the VAT is equivalent to a payroll tax. Both reduce work effort and therefore output and incomes.