Some Macroeconomic Effects of Tax Reform and Indexing

The period from 1971 to 1974 was one of fundamental change in the structure of the Canadian system of taxation. From the federal budget of June 18, 1971, which brought the long process of tax reform to a close, to the introduction of the personal income tax indexing scheme, the variety and magnitude of the changes in taxation provide a particularly fruitful period for fiscal policy research. In this paper we report upon and discuss the results of simulating a macroeconometric model that includes most of the tax reform measures and indexing. We propose to examine in some detail a number of questions arising from these changes. Generally, we are interested in the implications of tax reform and indexing for stabilization policy. More specifically, we explore two interesting questions relating to fiscal policy. First, "What has been the effect of the 1972 tax reforms and indexing on the yield and elasticity of the income tax system?" By comparing the estimated tax yield over the 1972-1978 period of the pre-reform system with that of the reformed system one can separate the effect of the changes in the structure from the effect on revenue of the current inflation under progressive taxation. In a like manner, the effect of indexing can be determined by comparing the estimated yield of an indexed with an unindexed tax system over the same period. The second question we ask is, "What has been the effect of tax reform and indexing on the built-in stability of the economy?" Here we look at a measure of built-in stability for the pre-tax reform system and for the post-tax reform system with and without indexing. In addition, we apply various expenditure shocks to the model both with and without the indexing scheme in operation. Related to this, we also administer to the model a direct price shock to ascertain the relative stabilizing properties of the various tax regimes under an imported or commodity inflation. The model we use in our analysis is an updated version of RDX2 incorporating the revised tax system, which is well suited for this study. It is a policy model rich in structural detail, particularly in the government sector, facilitating the introduction, also in detail, of complex measures such as capital gains and indexing. Our simulations with the tax model have lead us to draw five conclusions concerning the macroeconomic effect of tax reform and indexing. They are: (1) Contrary to the views expressed in the financial press, tax reform has not raised significantly more money. (2) Tax reform has not materially increased the elasticity of the tax system. (3) Indexing has reduced the elasticity of the personal income tax by four-tenths to within shooting distance of unity. (4) Tax reform has not had an important effect on built-in stability. (5) Indexing has reduced built-in stability with respect to certain types of shocks, and enhanced it with respect to others. We hope that these conclusions demonstrate the utility of what is unique in our approach, that is the incorporation of a disaggregated tax model into a macroeconometric model such as RDX2.