CPP’s dirty tax secret
Proposals to expand retirement benefits are perverse, and disadvantage low- and middle-income Canadians
In anticipation of the fall election, parties are scrambling with proposals to address concerns over income adequacy in retirement. The Liberals are pushing for an Ontario-type retirement income plan that would be mandatory for those without an employer-provided defined benefit plan. After dismissing the need for CPP expansion, the Conservatives are now proposing a voluntary CPP supplementary plan. The NDP supports major CPP expansion.
It is far from clear as to what problem is trying to be addressed. As well documented by the best studies with large sampling — Statistics Canada and McKinsey reports — almost four-fifths of Canadians have sufficient income at retirement. Any mandatory expansion of CPP would therefore force many people to hold CPP assets, thereby making less money available for stretched families to invest in their home or tax-free saving accounts.
Yet, with all the current discussion over CPP reform, a little dirty secret has failed to be pointed out by those supporting CPP expansion. CPP is not a very good investment for many Canadians on an after-tax basis.
While CPP has had an admirable return on its portfolio, its interaction with the personal income tax and income-test benefits makes it a surprisingly poor investment for many low-income and middle-class Canadians. Let me explain this by taking Ontario as an example.
Under the existing personal income tax, Ontarians contributing $100 to CPP receive a tax credit that reduces the cost by $20.50 to $79.50. With personal credit, aged credit and pension credit, a low-income senior with $15,000 in income, would pay no personal income tax on any additional CPP benefits. However, the low-income senior would lose 50 cents in Guaranteed Income Supplement payments for each additional dollar of CPP benefit. At the age of 65, benefits accruing at a riskless return of five per cent, would be about $130 dollars. Once accounting for the GIS clawback, the benefits paid would be worth $65, less than the after-tax cost of the initial investment of $79.50.
It doesn’t take rocket science to figure out that CPP is a poor investment for very low-income Canadians. Even if the return on the CPP portfolio is better than the riskless return of alternative investments, the tax consequences would turn the investment into a money-loser. Several years ago, it was correctly pointed out that RR SPs were a bad deal for low-income Canadians since the tax on withdrawals from the plan was extraordinarily high, leading to a nega- tive return on RR SP savings. The same is true for CPP investments.
What about middle income Canadians? An Ontario worker with $50,000 in income at the time of retirement pays federal and provincial tax at 33 per cent. Taking the same example, the after-tax cost of $79.50 for a CPP contribution would provide a CPP benefit at retirement five years later of $87.10. This paltry benefit barely covers inflation at two per cent per year with a return less than typical government bonds.
Other examples abound. OAS payments are clawed back 15 cents for each dollar above $71,592. Therefore, a worker with $80,000 in retirement income would lose 48 per cent of additional CPP benefits due to personal income taxation and the OAS clawback. With this excessive tax on benefits, these Canadians could earn a poor return on CPP investment similar to the lowest-income Canadians.
Unlike contributions to private pension plans and RRSPs, which are deductible from income, governments have been penny pinching by giving Canadians a CPP tax credit at the low income tax rate. If the CPP contribution were deductible for the $50,000 Ontario worker, the after-tax cost would be $67, yielding the market return of five per cent for CPP investments.
I remember once speaking at a conference pointing out this anomaly. I wondered why union members support the expansion of the CPP since many employer-provided pension plans are integrated with the CPP. For each extra dollar of CPP contributions, an Ontario union member with income ranging from $50,000 to $80,000 loses 12 cents in personal tax savings as pension deductions are turned into CPP credits. The result is almost $300 in extra personal income tax payments for 2015.
The push to expand CPP for many Canadians is therefore a raw deal. I am sure Tom Mulcair and Justin Trudeau don’t want to attack many poor or middle-class workers, but that is exactly what would happen with a mandatory expansion of the CPP.
The Conservative proposal for a voluntary CPP is no better as an idea. The tax credit for CPP contributions is insufficient given much higher taxes to be paid on benefits once received.
Besides, a voluntary CPP that provides a defined benefit after retirement is a hard sell due to the so-called adverse selection problem. Those individuals who expect to live shorter than the average plan member would not want to invest in CPP since they would prefer higher benefits. The plan would be left with those living a long time, thereby requiring higher contribution rates to cover actuarially fair benefits.
For this reason, most observers would suggest that a voluntary supplementary CPP would need to be like the RR SP or Pooled Registered Pension Plan, which are defined contribution plans, whereby retirement income depends on the investment experience of the plan. However, CPP has never been organized that way since accounts would need to be kept for individuals who would want to monitor them. Besides, a government providing a voluntary pension plan better not mess up. With bad investment experiences such as in the fall of 2008, demonstrations at Parliament Hill would surely result.
Before federal and provincial governments even consider expanding CPP, they should at least convert contributions from tax credits into deductions for personal income tax purposes. This would improve the implicit returns making CPP a better investment. It would also be a welcome tax break for many Canadians.
The benefits paid would be worth less than the after-tax cost of the initial investment
Jack M. Mintz is the Palmer Chair, School of Public Policy, University of Calgary.