Tax reform: dream or nightmare?
A dual rate would shift the burden from higher to lower income earners
Imagine that you are a tax policy analyst, and you have been given the dream assignment of designing Canada’s ultimate income tax system. The only constraint on your choices is that your reformed system must generate the current level of revenues.
OK, first you decide to jettison a host of existing tax credits and deductions in order to make room for reduced tax rates. Terminate such frivolous provisions as the tax credits for disability, medical expenses, charitable donations, pensions, old age, tuition, and education. Ditch superfluous deductions such as those for child care expenses, union and professional dues, and employment expenses. Impose a new tax on veterans’ disability pensions and employer-paid health and dental benefits.
While reconfiguring all those provisions, make sure that you don’t touch the far more costly tax deductions for RRSPs and workplace pensions. Leave unaltered the dividend tax credits and deductions for investment carrying costs — both of which are a disproportionate boon to high-income taxpayers. And retain the half-exclusion of capital gains from tax, with more than 50 per cent of the annual $4 billion of tax savings going to the 0.8 of one per cent of tax filers with annual incomes exceeding $250,000.
This reform recipe allows you to eliminate the two middle tax brackets of 22 and 26 per cent. That leaves only the existing lower-bracket rate of 15 per cent applying to all incomes up to $138,000, above which the upper-bracket rate of 29 per cent kicks in. Two variants of this dual-rate tax would, first, raise the income threshold for the 29 per cent rate to $250,000 and, second, additionally cut the upper bracket rate to 25 per cent. These variants would not meet the assignment’s equal-revenue constraint.
What would be the impact of this tax reform on taxpayers at various income levels? Households with incomes under $60,000 would actually bear higher tax burdens, while those over $60,000 would enjoy reduced taxes. Under the two dual-rate tax variants, the tax relief would be particularly large for households at $250,000-plus incomes, with average annual cuts ranging from $16,000 to $29,000. With this ultimate recipe for tax reform in hand, march it over to the federal cabinet or directly to the voters to seek their approval, and see how far it flies. This astonishing concoction is not just a bad dream, but rather the recipe cooked up in a recent study by analysts at the Fraser Institute.
Apart from the deadly political poison of such a scheme, does it really deliver any aspects of the “efficient, equitable, and simple personal tax system” claimed by its authors? No doubt that the elimination of many credits and deductions would simplify the system for some filers, although most complexity of the system is associated with investment, capital, and business incomes that would be unaffected by the reforms. The claim of improved “equity” hinges in part on one’s views about fairness; is it fair to shift the overall tax burden away from higher earners to lower earners? Still, some of the items proposed for deletion — such as the medical expense credit and the child care expense deduction — are designed specifically to improve fair treatment across taxpayers in different situations, and thus this aspect of equity would be compromised.
But what about the claim that the proposed reforms would significantly enhance the tax system’s efficiency? Here the Fraser Institute analysts refer explicitly to the economic efficiency of work, saving, and investment decisions.
Lower tax rates would improve work incentives for some individuals, but these would be offset by the elimination of employment tax credits and child care expense and employment expense deductions. The abolition of tax credits for tuition and education expenses would discourage the advanced training needed for many types of work. And studies of high earners find their work effort relatively insensitive to tax rate changes.
Similarly, any claims about increased incentives for saving from reduced tax rates are overblown. With lower tax rates on unsheltered saving, an individual can reach any targeted asset level for retirement or other purposes; thus, less current saving is needed to reach that goal. Empirical studies also find that RRSP saving is relatively unresponsive to tax-rate variations; if anything, reducing tax rates weakens the incentive to contribute.
Reducing personal tax rates may also have limited impact on business investment and activity. With a lower tax rate on unsheltered financial investments, the attractions of personal investment in business are reduced. Moreover, most large corporate business investment stems from internal cash flow and not from personal savings. Thus, the claims of large improvements in economic efficiency — as the asserted trade-off for a sharply less progressive tax system — are either exaggerated or unfounded. So, turning to a bit of amateur psychoanalysis, what are the origins of this macabre dream of a dual-rate income tax?
In 2000, the Reform Party first promulgated a flat-rate income tax for Canada. When that idea failed to gain popular traction, largely due to its strong regressive impact, the successor Canadian Alliance shifted to advocacy of a dual-rate tax, with a 17 per cent rate on most taxpayers and those above $100,000 paying at a 25 per cent rate. It seems as if Fraser Institute analysts remain caught in the spell of a distant but scary dream.