Earlier this week, Liberal finance critic John McCallum mused about increasing the GST back to 7% to pay for income tax cuts: There is not an economist on the planet who thinks it’s better to cut the GST, rather than income tax. Mr. McCallum’s comments come after Liberal leader Stephane Dion made it clear that while there is need for tax relief, cutting the GST is the wrong way forward, I would not cut a second point from the GST. Instead, I would help grow the economy by ensuring that income taxes are low?

Economic research is clear that income tax cuts do more to improve the economy than reductions in consumption taxes like the GST. However, while not all tax cuts are created equal, neither are all income tax cuts.

In total, the Conservatives’ two-point GST cut when (and if) fully implemented is expected to reduce federal revenues by approximately $12-billion per year. Before we can decide whether the Liberals’ plan will be more beneficial, we must first know whether they plan to cut income taxes by the full $12-billion and which income tax rates they plan to cut.

The litmus test for a tax cut should be the degree to which it improves our economy by strengthening the incentives to work, save, invest and undertake entrepreneurial activities. By this test, income tax cuts are generally superior to reductions in sales taxes like the GST.

A lower GST only encourages Canadians to increase their consumption at the expense of savings. Lower savings leads to a reduction in the investment needed to finance the purchase of machinery and equipment that make workers more productive, thereby resulting in higher wages.

Conversely, lower personal income tax rates increase take-home pay for workers, which results in greater incentives to work harder and smarter. In addition, lower taxes on investment income increase the returns for investors, making it more attractive to save and invest. With increased returns and more investment, both investors and workers benefit.

While income tax cuts are more economically beneficial than reductions in the GST, the critical question is which income tax rates to reduce. To answer the question, it is important to keep in mind that the top 30% of income earners already pay approximately 85% of all income taxes. In addition, recent federal budgets have already reduced personal income taxes for low-income individuals.

Targeting tax relief to lower-income earners is intuitively appealing, but does little to improve incentives. Individuals at low-income levels undertake very little saving because they tend to spend most of their income. In addition, the incentives to work harder and/or longer are at best small with such tax cuts, since low-income workers already face the lowest tax rates of any workers.

On the other hand, other personal income tax relief that would actually improve incentives include: reducing middle- and upper-income tax rates and increasing the thresholds at which they apply, eliminating capital gains taxes, reducing taxes on investment income (i.e. dividend and interest income) and eliminating contribution limits for RRSPs and RPPs.

By leaving the GST at 6% instead of reducing it to 5% as planned, the federal government would have approximately $6-billion in revenue to use for income tax relief., allowing it to completely eliminate capital gains taxes (approximately $2.2-billion) and eliminate the top personal income tax rate (29%) and decrease the second-highest rate from 26% to 24.5% (approximately $3.7-billion).

If the GST is increased back to 7% as Mr. McCallum proposes, the federal government could also eliminate the 26% income tax rate and increase the threshold for the 22% income tax rate from $37,179 to $44,451.

It’s critical that the right income taxes are reduced. Ultimately, the details of the Liberals’ income tax plan will determine whether the proposal provides the most economic bang for the tax-cut buck.