It's time to pay more attention to marginal effective tax rates
There may not be much sympathy out there for the top one per cent high-income earner who, in 2018, will face a marginal tax rate of over 50 per cent in more than half the provinces in Canada. But there should be some attention given as to why a lower-earning parent of a dual-earning couple, with two kids and a combined family income of $50,000, can face a marginal effective tax rate of over 70 per cent.
To better understand what’s going on here, we first need to revisit the concept of a statutory tax rate and compare that to your marginal and average tax rates. Then we can look at your marginal effective tax rate (METR) and participation tax rates (PTR), two concepts highlighted in a new report out this week from the C.D. Howe Institute entitled, “Two-Parent Families with Children: How Effective Tax Rates Affect Work Decisions.”
In the report, researcher Alexandre Laurin finds that working parents with children — particularly low-income families — “face prohibitive tax rates that discourage taking on extra employment to get ahead … (with) mothers and poorer families … the most adversely affected by this tax trap.”
Before we look at Laurin’s findings and potential fixes, let’s take a look at the different types of tax rates.
The statutory tax rate is the rate of tax applied to a given level of income. Canadian individuals (but not corporations) pay taxes at graduated rates, meaning that your rate of tax gets progressively higher as your taxable income increases.
Last year, the federal government announced that the inflation rate used to index the 2018 brackets and amounts would be 1.5 per cent. Thus, for 2018, the five federal tax brackets are: zero to $46,605 (15 per cent), $46,605 to $93,208 (20.5 per cent), $93,208 to $144,489 (26 per cent), $144,489 to $205,842 (29 per cent), with anything above that taxed at 33 per cent. On top of this we add provincial or territorial tax (and in at least a couple of provinces, provincial surtaxes), to get our combined federal/provincial statutory tax rate, which ranges from about 20 per cent to over 50 per cent, depending on your income and province of residence.
Marginal & Average Tax Rates
Your marginal tax rate is the amount of tax you would pay on an additional dollar of income. Your average rate is calculated by taking the total amount of income tax you pay and dividing it by your total income. For most Canadians, your average rate is significantly below your marginal rate, due to the progressive, graduated rates discussed above.
METRs & PTRs
But perhaps the most important tax rates we should be considering is our METR and PTR. The “marginal” effective tax rate (METR) conveys the financial loss, through additional taxes and diminished benefits, associated with an additional dollar of earnings. For a working parent, it represents the financial penalty that must be paid from any small addition to their income.
The “participation” tax rate (PTR) is the cumulative effect of all taxes, fiscal contributions, payroll deductions and loss of fiscal benefits on the entire earnings from work. For a stay-at-home parent, it represents the financial penalty that must be paid out of the total income derived from entering the workforce.
The C.D. Howe report examines how Canada’s federal and provincial tax and benefit system impacts take-home pay by combining the effects of both taxes paid and loss of government benefits to produce METRs that show the tax bite from each dollar of extra income. Because benefit programs are targeted at the lower end of the income scale, low- and middle-income families’ effective tax rates are generally higher than those of higher-income families.
Mr. Laurin finds that METRs generally peak at family incomes between $35,000 and $50,000. For example, in Ontario, the family METR on extra earned income peaks at 64 per cent while in Quebec, it peaks at 73 per cent.
The study showed that in 2017, about 9 per cent of employed parents contemplating earning a few extra dollars, and about 13 per cent of stay-at-home parents contemplating getting a job, faced an effective tax rate higher than 50 per cent.
The report proposes a couple of fixes. First, the government could subsidize childcare. Under our current tax system, childcare expenses are tax deductible, but only on the tax return of the lower-earning spouse or partner. In addition, the maximum claim is limited either by a dollar amount (generally $8,000 for kids up to age six and $5,000 for children age seven through 16) or by two-thirds of the income of the spouse, whichever is lower. Due to these restrictions, up to one-third of families cannot fully deduct their childcare expenses because of the two-thirds-of-income limit (mostly among those at lower income levels) or the maximum claim limits (mostly among those at higher income levels).
Laurin proposes a federal refundable credit for childcare costs with very generous rates for lower-earning families, designed along the lines of the Quebec childcare expenses credit. “Parents, especially mothers, have been shown to be particularly sensitive to changes in childcare costs,” says Laurin. “A more generous tax treatment would likely encourage about 15 to 22 per cent of stay-at-home mothers to join the workforce and stay employed over the long term.”
Another solution proposed by Laurin and one I’ve touched on in a previous column is income averaging. If workers were allowed to average their income over a number of years, it would lessen the impact of fluctuating income on their tax liability and thus, their government benefits. That way, any single large earning year wouldn’t lead to higher tax payments along with a disproportionate loss of fiscal benefits.