Value-Added Tax Lessons from Canada

Editor's Note: There are a lot of ideas on how to "fix" taxes, though many conflict with each other and most fail. From around the world, here is one of several current prescriptions.

Canada has it. Every other major industrialized economy has also adopted it. When it comes to the value-added tax, the U.S. is the only outlier.

Proponents of the VAT say the system is superior to the sort of retail sales taxes currently imposed by many U.S. states. It's simpler to enforce and discourages evasion. More importantly, it provides a broad enough tax base to enable governments to lower income taxes and maintain current spending.

The VAT is applied at every level of production on most goods and services. Businesses collect the tax on what they sell, and they receive credits for taxes paid along the supply chain. So in effect companies pay a levy only on the value they add in production.

For U.S. policy makers pondering the VAT, the Canadian experience offers both positive and negative lessons.

The levy, which in Canada goes by the name of GST (for goods and services tax), was introduced at the federal level two decades ago. The move has allowed Canada to cut its corporate tax rate by about 20 percentage points since the mid-1980s, to about 30 percent, according to the Organization for Economic Co-operation and Development. That puts the Canadian corporate tax rate below the 35 percent rate imposed by the U.S.

What distinguishes Canada's VAT from those of other countries is its transparency. European governments embed it in the final price of goods and services. In Canada, it's applied at the cash register, for every consumer to see. Consumers are reminded of it "every day, multiple times," says Michael Smart, an economics professor at the University of Toronto. "It's a tax that Canadians love to hate above all."

Voters have exacted their vengeance at the polls. The Progressive Conservatives, the forerunner of today's ruling Conservatives, were almost wiped out in the 1993 federal elections after introducing the GST. The party returned to power in 2006 by pledging to lower the tax, which they did by 2 percentage points, from 7 percent to 5 percent.

The latest VAT casualty is former British Columbia Premier Gordon Campbell, who saw his approval rating plunge to as low as 9 percent last year after introducing a provincial VAT. Campbell resigned on Mar. 14, and voters in the province will hold a referendum later this year on whether to abandon the tax.

Nevertheless, the VAT's durability is testament to its effectiveness, according to its proponents. Since the GST was rolled out, most Canadian provinces have followed suit with their own VATs. Ontario, Canada's most populous province, adopted one last year. Today, 85 percent of Canadians pay both federal and provincial VATs. Says Smart: "The Canadian evidence is that it works."

If the U.S. were to consider adopting a VAT, lawmakers would need to assure voters of two things in order to overcome opposition: that the tax is revenue neutral, and that it won't hurt the poor. Len Farber, former director of tax policy at Canada's Finance Dept., recalls that the federal government mollified the public by cutting personal and corporate tax rates before introducing the GST. "It was hard enough to convince the population at the time that this was a revenue-neutral tax," Farber says. "If personal tax rates and corporate tax rates had not gone down, they never would have believed it."

In Canada, lower-income families receive quarterly refunds to help offset the tax, while basic grocery items such as milk and fruit are exempted altogether. "The real issue to overcome there, and that was our problem as well, is the distributive properties of it," says former Bank of Canada Governor David A. Dodge. "It's certainly not progressive."

The bottom line: Canada has proven that a value-added tax works, and that the levy can be politically lethal.

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