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It’s April 2012 — do you know what your tax rate is?
The answer to that question, of course, depends on what rate we’re talking about. Is it your marginal tax rate? Or your average effective tax rate? The difference may surprise you.
What may also surprise you is that your tax rate, however calculated, is largely dependent on the type of income you earn. Employees or entrepreneurs with an unincorporated small business will likely pay tax on the majority of their income at full ordinary income rates, whereas investors who earn a significant portion of their income in the form of Canadian dividends or capital gains will face much lower rates.
To get a good picture of how much tax Canadians pay and what our tax rates actually are, let’s take a closer look at our tax system.
Federal & provincial tax rates
Federally, and in all provinces other than Alberta, which has a 10% provincial flat tax, we have graduated, progressive tax brackets. The 2012 federal tax brackets, common to all Canadian individual taxpayers regardless of province, begin at 15% for the first $42,707 of income and go up to 29% once income is over $132,406. These income levels are for taxable income after all deductions have been claimed. If, for example, you maximize your 2012 RRSP deduction to the tune of $22,970, this translates into taxable income of over $155,376 before you even enter the top federal tax bracket.
Each province has its own set of tax rates and brackets, which, in some cases, differ significantly from the federal brackets. Some provinces, like Ontario and Prince Edward Island, have provincial surtaxes that further complicate the calculations.
Marginal vs. average rates
Your marginal tax rate is the rate of tax you would pay if you were to earn an additional (“marginal”) dollar of taxable income. Your average tax rate is calculated by dividing your total tax liability by your total income. For most Canadians, your average tax rate is significantly lower than your marginal tax rate. This is partially due to the graduated brackets as well as the effect of various deductions and/or credits. The more deductions and credits you are able to claim, the further your effective tax rate will drop below your marginal rate.
A tale of two taxpayers
To really see the difference between marginal and average tax rates, take two taxpayers, Jack and Diane. Jack is in the top 1% of Canadian taxpayers and earns $250,000 of income while Diane earns $50,000.
Assuming Jack is single and he only avails himself of the basic personal tax credit, his 2012 tax bill will vary from a low of $83,770 in Alberta to a high of $103,390 in Nova Scotia. His marginal tax rate would range from 39% in Alberta to 50% in Nova Scotia while his effective or average tax rate ranges from 33.51% in Alberta to 41.41% in Quebec.
Diane is among the 78% of Canadian tax filers that reported less than $55,000 of income in 2009, the most recent year for which income filing statistics are available. Assuming she is single and only claims the basic personal credit, her federal/provincial tax bill for 2012 would range from a low of $8,685 in British Columbia to a high of $11,544 in Quebec. Consequently, her marginal tax rate ranges from 29.7% in B.C. to 38.37% in Quebec, with her corresponding average tax rates falling significantly below these, ranging from a low of 17.37% in B.C. to 23.09% in Quebec.
Tax-preferred income
These numbers assume that all of Jack and Diane’s incomes consist of fully taxable ordinary income. But what if the type of income Jack earns was tax-favoured, such as Canadian dividends and capital gains?
Let’s assume that Jack’s income consisted of 33% interest income, 33% Canadian dividends and 33% capital gains, and that he lives in Alberta. Since the dividends are eligible for the dividend tax credit and only half of his capital gains are taxable, his total federal and provincial tax bill would drop to $51,097, a decrease of nearly 40% from the $83,770 he would owe if all of his income was fully taxable at ordinary rates. His average effective tax drops to a mere 20.4% from 33.51%.
Jack’s situation is hardly atypical of the top 1%. A close look at income statistics released by the Canada Revenue Agency shows that in 2009, the 0.7% of taxpayers who reported income of more than $250,000 generated 23% of their income from interest, dividends and capital gains. Not surprisingly, for the average taxpayer, interest, dividends and capital gains total just 7% of actual income.
The favourable treatment of tax-preferred investment income plays a significant role in lowering a taxpayer’s average tax rate. The average tax rate for the 19,073,000 taxpayers who filed a return in 2009 and who reported less than $50,000 of income was 6.66%. For the fortunate 183,000 who reported income of $250,000 or more, the average rate jumps to 24.82%, which is still a far cry from the top marginal tax rate of 50% often associated with high-income earners.