The toxic duo of taxes and inflation

Buried in the fine print of the recent Ontario budget is a measure that promises to saddle affluent families with an ever-growing tax burden. While the budget delivered hefty immediate tax increases for taxpayers in Ontario’s two new top tax brackets, the real damage over the coming years will be courtesy of the fact that these tax brackets will not be indexed for inflation.

Many individuals don’t fully appreciate how taxes and inflation interact to corrode wealth. The full toxicity of this measure therefore sits somewhat below the radar screen. When inflation lifts your income, there is no corresponding increase in your real income or purchasing power. In a world of 2% inflation, a 2% increase in income will merely keep your standard of living intact — but only provided you don’t face a higher tax bill.

However, in a progressive tax system such as Canada’s where the marginal tax rate increases at successively higher income thresholds, inflation that lifts your income into a higher tax bracket will also increase your average tax rate and liability. This phenomenon — called “bracket creep” — leaves such taxpayers facing diminishing post-tax real incomes and erosion of their standard of living as their tax bill grinds upwards year after year.

The federal government has been long aware of the corrosive nature of bracket creep. Hence, in the 1970s, as rampant inflation pushed up incomes, tax brackets were indexed to inflation to offset bracket squeeze. Since then, indexation has been in place for fed- eral income tax brackets (although there was a cap on the level of indexation from 1985 to 2000).

Unfortunately, starting in 2000, a number of debt-burdened provinces have elected to opt out of the indexation of provincial income tax brackets. Nova Scotia, Manitoba and P.E.I. have eliminated the indexation of all provincial tax brackets — an even worse situation than that just introduced by Ontario. You can understand why such measures are politically appealing — like the proverbial frog in a pot of ever warming water, the taxpayer doesn’t cotton on to the insidious growth in their tax burden until their standard of living is imperiled.

Where the absence of indexation will really hurt is down the road. Over the next decade alone, even a 2% annual inflation rate will lift incomes by nearly 22%, pushing many individ- uals into higher tax brackets. Worse off will be those relying on RRSPs for their retirement. Once these savings are converted into RRIFs, the everincreasing mandatory withdrawals will be subject to higher and higher tax rates. For some, bracket squeeze will be the coup de grâce to their retirement dreams.

This measure promises to further exacerbate the yawning tax rate differentials between the “have” provinces such as Alberta and the “have-nots” such as Ontario. In fact, one savvy business owner I know is now considering moving to Alberta, reasoning that: “My business is national so why should I reside in Ontario when my tax bill will just keep on climbing.”

For most of us, however, moving is not an option. Instead, Canadians living in the high tax regime provinces, particularly those without indexation, should consider these five tactics:

❚ Examine income splitting strategies Shifting income into the hands of lower taxed family members can eliminate bracket creep.

❚ Overhaul your investment plan to improve its tax effectiveness In particular, examine strategies that focus on capital growth or return of capital over interest income.

❚ Revisit insurance Participating life insurance, in particular, offers tax deferred growth and tax free wealth transfer to the next generation.

❚ Re-examine your retirement plan Look at everything, especially your savings requirements, taking into account expected higher tax burdens.

❚ Reorganize If you are a business owner or a self-employed professional, examine the potential benefits of a holding company or professional corporation.

With taxes and inflation rising, be proactive; don’t be an unwitting frog.