A better way to pay for the middle-class tax cut

Posted on November 5, 2015 in Governance Policy Context

NationalPost.com – FPComment
November 5, 2015.    Jack M. Mintz

Rather than raise the top marginal tax rate on high-income individuals, Trudeau should reduce the tax preferences they receive.

One of the Liberals’ most advertised policies in the run up to the election was its middle-class tax cut, which would lower the second lowest federal rate from 22 per cent to 20.5 (individual incomes roughly between $45,000 and $90,000). “A Liberal government will introduce, as its very first bill in Parliament, a tax cut for the middle class,” Prime Minister Trudeau has said. However, to pay for the middle-class cut, the top personal income tax rate would be increased by 4 percentage points for individual incomes over $200,000.

See Tax Rate Table: < http://wpmedia.business.financialpost.com/2015/11/fe1105_taxratetable_c_jr.png?w=350&h=597 >.

The cut to the middle-tax rate is sound public policy. Far better to provide a general tax rate reduction than focus on various targeted tax credits as the Harper government pursued in the past.

However, Bill Morneau, the new Minister of Finance, should seriously question whether the top personal tax rate should be increased to pay for the middle-class tax cut. Superior options are available, even revenue-raising opportunities that would improve the efficiency and fairness of the tax system.

The increase in the top rate is ill-considered for five reasons.

1. Canada will signal it is a high-taxed country to many businesses looking to move operations to Canada. Currently, the average top personal income in Canada is 50.2 per cent, seventh highest among 33 OECD countries. With the Trudeau four-point hike, Canada will have a French-like average top rate of 54.2 per cent, third highest amongst all OECD countries. Only Sweden (which will controversially raise the rate by four points soon) and Denmark will have higher personal income tax rates than Canada. Most OECD countries keep their personal income tax rates below 50 per cent.

2. A high top personal income tax rate discourages growth, next only to corporate income taxes. A recent survey by the Tax Foundation in the United States concludes that academic consensus has evolved to believe that increasing the personal income tax rate is one of the most harmful taxes on growth: a one-point increase in the average marginal personal tax rate reduces GDP per capita by 1.8 per cent. Bigger effects arise when the top personal tax rate is increased since the harm in terms of effort and risk-taking rises by the square of the tax rate. Given Canada’s plodding growth rates, tax reform should support both growth and fairness, not just the latter.

3. A high personal tax rate will discourage skilled labour coming to Canada. With the demographic time bomb, Canada needs skilled labour if we are to improve growth. A higher personal tax rate especially relative to the United States will discourage skilled migrants to choose Canada as a destination. Many Canadian businesses, ranging from engineering companies to sports teams, bring in workers from other countries but pay “equalization” to offset higher personal taxes in Canada. The Trudeau hike will raise employee costs especially for large businesses.

Canada will have a French-like average top rate of 54.2 per cent, third highest among OECD countries
4. High top rates can reduce personal tax revenues at the highest income levels. The substantial academic research on the sensitivity of the personal tax base to changes in top rates suggest, at least for the 0.1 per centers, that an increase in the top rates could actually lower personal tax collections. As suggested by some economists, the revenue-maximizing personal tax rate could even be below 50 per cent, commonly found in most OECD countries. Sure, some will argue to plug the loopholes but often governments create loopholes to take off the pressure of high tax rates in discouraging economic activity. Canada did have marginal tax rate above 80 per cent prior to 1971 but high-income individuals paid as little as 30 per cent in tax with various exemptions including capital gains.

5. Revenue-raising maximum tax rates are good for governments but not the economy. Some studies have shown that the top rate to maximize government revenues could be as high as 60 per cent. But public revenues should never be the sole consideration for tax policy. People care far more about prosperity. When governments take over half of a person’s gains, people will be more willing to avoid high tax rates by shifting income into tax-preferred opportunities like flow-through shares and low-taxed Canadian-controlled private corporations or simply go golfing rather than work a bit more. It is for this reason that the vast majority of countries keep personal income tax rates below 50 per cent.

Given the provinces have already pushed up top personal income tax rates to 50 per cent, the Liberal promise to raise the top rate should be shelved. But the middle class tax cut is the right thing to do. So how can a government finance it?

Obviously, deficits are back so maybe the government should absorb $3 billion in lost revenues. However, the Liberal government will have enough difficulty keeping to a $10-billion deficit so this option could be tough if its extraordinary list of spending promises, including the new child tax plan, is to be funded.

If the new Liberal government wishes to improve equity, it would be advised to go after the various tax preferences that undermine both economic growth and fairness in the tax system. The federal government has more than enough money to raise personal taxes, especially from high income individuals, by reducing some of the following: the small business tax deduction ($3.2 billion), lifetime capital gains exemption ($600 million), donation credit related to gifted securities ($52 million), flow-through shares ($125 million) and bringing capital gains tax rates in line with the top tax rate on dividends ($1.25 billion). Space does not allow me to discuss whether these preferences are good or bad but the removal of some would be particularly good ideas to improve the tax system.

And of course many middle-class boutique tax credits remain that simply add to complexity of the tax system without economic gain. Much better to lower rates and keep bases broad.

In fact, perhaps the best choice for the new Minister of Finance is to look at tax reform in general to clean up what is becoming an unwieldy tax system. Much better option than messing up the tax system further.

Jack M. Mintz is the President’s Fellow, School of Public Policy, University of Calgary.

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