What Does it Cost Society to Raise a Dollar of Tax Revenue? The Marginal Cost of Public Funds

The marginal cost of public funds measures the welfare loss a society incurs in raising an additional dollar of tax revenue. Tax increases distort economic decisions and erode tax bases because of tax avoidance and tax evasion by taxpayers. This Commentary uses econometric estimates of the effects of higher provincial tax rates on the provinces’ corporate income tax, personal income tax, and sales tax bases to calculate the marginal cost of public funds (MCF) for these taxes. The results indicate that the cost of increasing provincial tax revenues through a corporate tax rate increase is very high, and in some provinces, corporate tax rate reductions in 2006 would have increased the present value of the provincial government’s total tax revenues. The results also suggest that significant welfare gains would accrue from reducing provincial corporate income tax rates. As well, increasing provincial corporate and personal income tax rates can cause significant reductions in federal tax revenues because the federal and provincial governments levy taxes on the same tax bases. Finally, Canada’s system of the equalization grants might reduce the perceived MCF of recipient provinces.