Putting an end to Ontario’s archaic retail sales tax and adopting a value-added tax like the GST would sharply lower the effective tax rate on new business investment and offer the province a much-needed economic boost.sales tax, VAT, consumer prices

Finn Poschmann

English

Research Papers in Economics

e-brief
Sales Tax Reform in Ontario: The Time is Right
By
Finn Poschmann
Canada’s federal government, since implementing the Goods and Services Tax in 1991, has repeatedly urged the
provinces to reform their own antiquated retail sales taxes. New Brunswick, Nova Scotia and Newfoundland and
Labrador did so in 1997, by signing on to the Harmonized Sales Tax (HST), which the federal government
administers on their behalf.
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Ontario’s economic outlook would much improve if the province now joined in, by eliminating the province’s
destructive retail sales tax. The time is right because the province’s need for long-term thinking about how to
improve the investment environment, and the outlook for productivity, wages and jobs, has never been clearer.
Were Ontario to eliminate its retail sales tax and adopt a fairer value-added tax, such as the GST, construction
investment would increase, as would business spending on machinery and equipment. The reason is that the tax
burden on business capital investment would drop significantly. Labour productivity would improve, and with it
workers’ wages. The province’s economic potential, including export sales, would improve permanently by half a
percentage point – a tremendous boost in provincial income. 
After discussing the economic benefits of reform, now, in Ontario, this e-brief examines typical objections to
reform, including concerns about the speed with which those benefits would flow, the impact of reform on
consumer prices and on low-income families as well as particular business sectors. In each case, I outline policy
responses that would mitigate the perceived downsides to change. 
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March 20, 2009
 Putting an end to Ontario’s archaic retail sales tax and adopting a value-added
tax like the GST would sharply lower the effective tax rate on new business
investment and offer the province a much-needed economic boost.
 Beginning in the near term, competitive market pressures will ensure that
businesses pass through tax savings to consumers, and provide an incentive
to speed up investment in new plant, equipment, processes and people.
 Concerns over the effects of a revamped tax system, particularly when it
comes to low-income families, can easily be dealt with through targeted
credits and enhancements to the family benefits that are already part of the
tax system.
1 Quebec at the same time adopted its own GST-compatible tax, which it administers alongside the federal GST.Beneficial Economic Impact
By eliminating most provincial tax on business inputs,
2 Ontario’s switch to a value-added base would dramatically lower its
effective tax rate on new business investment. In 2012, post-reform, the province’s effective tax rate on capital investment
would be 21.8 percent, as opposed to 31.9 percent absent reform. The difference moves Ontario from being an
extraordinarily high tax jurisdiction, within North America, to being a medium-tax jurisdiction (Figure 1).
With what impact on real investment? The 1997 HST reform in the eastern provinces drove a pop in investment, measured
on a per capita basis, of 11.1 percent, an extremely large and statistically significant impact (Smart 2007). Assuming an
Ontario GST introduced under current market conditions at a 7.5 percent rate, the positive impact on investment in
nonresidential construction would grow slowly to four percent annually (Dungan et al. 2008). The boost to machinery and
equipment investment would level out at above three percent annually (Table 1). 
A SHORT-TERM INVESTMENT RESPONSE: How quickly will the positive investment impact arrive?  Post-reform competitive
price pressure would tend to drive capital stock renewal at a pace faster than its usual cycle. The impact of lowering the tax
rate on business investment makes itself felt through lower-than-otherwise consumer prices as the economy’s stock of
machinery, plant and equipment grows. Further, ordinary competitive market pressure, in a small open economy such as
Ontario’s, will drive businesses to adjust quickly in response, so that the economic benefits quickly materialize through new
business investment. Faster growth, delivered even sooner than suggested in Table 1, is a likely outcome.
GIVE ANDTAKE FROM OTTAWA: Sales tax reform in Ontario will be a key step in improving the nation’s economic union.
The positive growth impacts of Ontario’s reform will increase federal tax revenue in Ontario, and in other provinces too,
making possible a federal financial contribution to ease the change into place. The federal gain will grow slowly, rising over
time from about $500 million to $2 billion annually (Table 1), which indicates the scale of support Ottawa could supply the
provincial government while making roughly whole the federal fiscal balance.
Addressing Concerns with Smart Policy
Given that improved business investment incentives and near-term growth outlook is obviously in Ontario’s immediate interest, what
could be the objections to reform? Typical examples are concern over whether business savings from a lighter tax on inputs would
flow through to consumers, concern whether a GST-like tax would be harder on poor households than rich ones, and worries
about impacts on business sectors whose products would be newly exposed to provincial value-added taxation.
Considering each in turn suggests that these concerns can be addressed through simple policy moves, and that negative
outcomes are improbable under current circumstances.
Concern One: Impact on Consumer Prices
One good way to estimate reform’s impact on consumer prices is to examine the precedents. The eastern Canadian experience
with moving to the HST is the obvious example. Provincial retail sales taxes were replaced with a slightly broader tax on goods
and services, applied at a lower rate.
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INDEPENDENT REASONED RELEVANT
| 2 e-brief
2 Under Ontario’s retail sales tax, businesses are taxed on many of their intermediate inputs and capital goods, which cascades into higher
consumer prices for products that have multiple stages of production in the province, and makes exports less competitive. Under a value-added
tax like the GST, businesses credit the taxes they pay against GST collected on their sales, and remit the difference.
3 The eastern provinces received generous federal financial support that enabled them to bring down the combined, post-reform HST rate.INDEPENDENT REASONED RELEVANT
e-brief /3
Year 1 Year 2 Year 3 Year 4 Year 5 Year 10
Percentage Change
Real provincial product  0.0 0.2 0.2 0.2 0.2 0.5
Private investment 1.2 2.3 2.5 2.2 1.9 1.9
Residential construction -0.1 0.2 0.3 0.0 -0.2 -0.1
Nonresidential construction 1.4 2.8 3.3 3.3 3.3 4.1
Machinery and equipment 2.4 4.2 4.3 3.8 3.5 3.1
Exports 0.0 0.1 0.3 0.4 0.4 0.5
International exports 0.0 0.2 0.3 0.5 0.6 0.7
Exports to the rest of Canada 0.0 0.1 0.1 0.1 0.1 0.1
Imports 0.1 0.3 0.4 0.4 0.4 0.4
Real capital stock 0.1 0.5 1.0 1.4 1.6 2.4
Federal tax revenue impact in Ontario 
($ millions) 262 547  809  869  966 1,963 
Provincial tax revenue impact
($ millions) -952  -938  -1,130  -1,501  -1,877  -3,737   
Table 1: Effects of RST-GST Harmonization in Ontario at Provincial Rate of 7.5%, Given Current Outlook
Note: Effects are percentage change from the base case, unless otherwise indicated.
Source: Dungan, Mintz, Poschmann and Wilson (2008).
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2008 2007 2012 2012 Harmonized
Figure  1: Marginal Effective Tax Rates on Capital Investment: 2007, 2008 and 2012
Source: Chen and Mintz, 2008.| 4 e-brief
INDEPENDENT REASONED RELEVANT
After those 1997 changes, competitive markets delivered exactly what should be expected: shelter costs and clothing and
footwear prices rose, as items which previously had been exempt from sales tax became taxable; the prices of some things, like
household operations and health and personal care, fell more than others; and overall consumer prices fell by an amount roughly
commensurate with the overall tax rate decline (Smart 2007). 
The message bears special importance to Ontario today, where concern might arise over the prospect of taxing more goods
and services at the existing 8 percent sales tax rate. After all, if businesses failed to pass on savings, or the tax change was
perceived as a general increase in consumer prices that would trigger upward pressure on wages, and thereafter higher interest
rates from the Bank of Canada, the economic impact could be negative. 
We now know, however, that savings indeed are passed on in competitive markets and, furthermore, under current market
conditions there is no chance of tax-driven inflationary expectations evolving and no prospect of a restrictive Bank of Canada response. 
Concern Two: Adverse Distributional Effects
Some Ontarians have expressed concern over broadening the sales tax base to cover items like books, home heating fuels and
children’s clothing, which are generally exempt from provincial retail sales tax but not from the GST. Might these impacts adversely
affect low-income households’ ability to spend on these items?
This is a misplaced worry, as experience with the GST shows. Extending offsetting low-income credits through the income tax
system is simple, and in Ontario’s case could be done with minor dollar-figure changes to the provincial tax return.
It is a matter of fairness and economic common sense that this concern – the ability of low-income households to pay the 
GST on things that form a relatively large share of their household spending – be dealt with through low-income credits or family
benefits and not by exempting particular goods and services. The reason is that home heating fuels and children’s clothing, for
example, are consumed by households of all income levels, and not just the poor. Enhancing provincial family benefits is the better
route to cushioning any unwanted distributional impacts.
Concern Three: Sectoral Impacts
Some sectors, such as financial services and new residential construction, produce outputs that are not taxed under the provincial retail
sales tax but would be under a GST or similar value-added tax, implying that reform could inflict sudden harm on these businesses.
Simple design changes  would mitigate the potentially adverse affects of such shocks. Most financial services are exempt from the
GST – no tax is applied to sales and no refund is provided for taxes paid on inputs. This is not necessarily the best option, because it
distorts the market by embedding tax in the cost of providing financial services. Ontario could be wiser to either (i)  tax financial
services provided to households, and “zero-rate” business services, while allowing credits for all tax paid on inputs; or (ii) follow
Quebec’s approach, zero-rating sales of financial services while disallowing input credits for some business purchases.
Shocks to the real estate market sector are even easier to mitigate. The federal system offers a phased rebate that reduces GST
payable for new houses selling for less than $472,500. That threshold has not moved since the GST’s introduction: a considerably
higher rebate threshold could apply federally and provincially. Ontario could further reduce any GST-induced shock to the housing
market by eliminating its inefficient Land Transfer Tax, which is an impediment to economically rational resource allocation.
Closing the Deal
Ontario workers, employers and consumers, not to mention the rest of Canada, would benefit from an Ontario government
decision to implement sales tax reform, and to do so without hesitation. The province sorely needs near-term and long-term
boosts to its growth and investment outlook, which sales tax reform, with appropriate policy fine-tuning, can deliver.References:
Chen, Duanjie, and Jack M. Mintz. 2008. Limited Horizons: The Report on 2008 Federal and Provincial Business Tax Policies. 
C.D. Howe Institute Commentary 270.
Dungan, Peter, Jack Mintz, Finn Poschmann, and Thomas Wilson. 2008. Growth-Oriented Sales Tax Reform for Ontario: Replacing the Retail Sales
Tax with a 7.5 Percent Value-Added Tax. C.D. Howe Institute Commentary 273.
Smart, Michael. 2007. Lessons in Harmony: What Experience in the Atlantic Provinces Shows about the Benefits of a Harmonized Sales Tax.
C.D. Howe Institute Commentary 253. Toronto: C.D. Howe Institute.
This e-brief is a publication of the C.D. Howe Institute.
Finn Poschmann is Vice President, Research at the C.D. Howe Institute.
For more information call Finn Poschmann at 416-865-1904.
This e-brief is available at www.cdhowe.org.
Permission is granted to reprint this text if the content is not altered and proper attribution is provided.
INDEPENDENT REASONED RELEVANT
e-brief /5

For more information call Finn Poschmann at 416-865-1904. This e-brief is available at www.cdhowe.org. Permission is granted to reprint this text if the content is not altered and proper attribution is provided.

Sales Tax Reform in Ontario: The time is Right

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