Regional support: look out for the perverse effects of tax measures

Montreal, May 10, 2007 – With a provincial budget coming soon, the Montreal Economic Institute is calling on the government and members of the National Assembly to show vigilance in assessing the effectiveness of regional assistance programs that sometimes may actually harm the economy.

These negative impacts result in particular from subsidies and tax preferences provided to businesses in regions with resource-based economies. In an Economic Note published by the Institute, Vice President and Chief Economist Marcel Boyer concludes that “some tax measures, even if well-intentioned, produce perverse effects.”

Major tax expenditures under inadequate control

Aimed at achieving various political goals, tax expenditures cause a loss in revenue by giving preferred treatment to particular groups of taxpayers. This may take the form of income not subject to taxation, tax exemptions or refunds, deductions from taxable income, or tax credits or deferrals.

The growing scope of tax expenditures deserves special attention. In 2006 the Quebec tax system contained more than 280 examples of tax expenditures, at a total cost of $18.6 billion. This amount comes to 32% of tax revenue and is up 30% from 2003 to 2007, whereas the rise in the Quebec government’s autonomous income (excluding federal transfers) is up by only 15%.

Many tax measures, even if based on good intentions, lead to “perverse effects” that go against the intended aim. For the pertinence of a tax measure to be understood, the government should make public the analyses it conducted on possible perverse effects (or perform such analyses if it has not done so). Members of the National Assembly should ask questions on the consequences of these measures, as they would with any more visible spending of taxpayers’ money.

The perverse effects of assistance to resource regions

Unlike its approach to other business subsidy programs, the Charest government has not seriously questioned the Economic Development Strategy for Resource Regions (known by the French acronym SDERR). This program aimed to make government assistance more widespread for traditional production activities in seven resource regions. Its two main measures, still in force, are a refundable tax credit covering 30% of the wages of new workers in processing activities and, for small and medium businesses in the manufacturing sector, a tax holiday on 75% of income tax, capital tax and employer payments to the Health Services Fund.

This causes a displacement of economic activity that is more than just a simple transfer. The economic activity that was prevented in another region may have been more efficient than what replaced it because the former could justify itself economically and could finance itself on the market without such subsidies. In net terms, value and potential wealth are destroyed, and the perverse effects of the SDERR program result in an overall loss to the economy.

This program also produces three other undesirable results: the difficulty of ending it because companies and regions that benefit from it would fight kicking and screaming to maintain their privileges; the development of a culture of dependency on government; and indefinite delays in making necessary adaptations and changes in the regions favoured by these policies. A number of studies ordered by the government have shown that these interventionist policies seem ineffective.

Tobacco and fuel taxes

The study also explains that the tobacco tax, aimed at reducing consumption, ends up stimulating smuggling. A prohibitive tax necessarily spurs black market growth and trims collection of this tax. From a peak of $948 million in 2002-03, provincial tobacco receipts began falling again – by 28% up to now.

Finally, the study analyses exemptions from the 16-cent-a-litre provincial tax on fuel oil intended for domestic heating, farm machinery, fishing boats, and so on. This oil is dyed and must not be used for other purposes, but the situation is different in practice. Tax discrimination in this form gives rise to a black market that in turn requires continuous checks by fuel inspectors. In 2005-06, inspectors issued 280 notices of infraction and imposed $264,000 in fines for illegal use or resale. Revenu Québec does not, however, have any studies evaluating the extent of this black market.

The Economic Note, titled The perverse effects of tax measures, was prepared by Marcel Boyer, Vice President and Chief Economist of the Montreal Economic Institute. He also holds the Bell Canada Chair in Industrial Economics at the University of Montreal.

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Information and interview requests: André Valiquette, Director of Communications, Montreal Economic Institute, Tel.: 514 273-0969 / Cell: 514 574-0969 / E-mail: avaliquette@iedm.org