Perhaps it was my Grade 10 introductory economics high school course that first piqued my interest in taxation policy, eventually leading to a career dedicated to helping Canadians navigate the complexities of our tax system while trying to understand the policy rationale behind our myriad tax rules and regulations.
One of the economics lessons I learned early on is that governments essentially have two choices when it comes to managing a budget: cutting spending or raising taxes. But what if raising taxes actually leads to lower tax revenues? That possibility was not covered in our Grade 10 class but seems to be playing out right here in Canada.
According to a new study out this week from the C.D. Howe Institute, the federal government's decision to raise taxes on the top one per cent of income-earners likely only yielded about a third of the tax revenues that would have been raised without what's known as the "behavioural response." In turn, this also resulted in provincial budgets suffering fiscal losses greater than the federal revenues raised.
The field of behavioural economics brings psychology into traditional economic theory to help us understand why people sometimes make irrational decisions and why their behaviours sometimes do not necessarily follow the predictions of traditional economic theory.
You'll recall that in 2016 the government decided to increase the top federal tax rate by four percentage points to 33 per cent from 29 per cent for the highest income earners - those whose net income exceeded $200,000 (indexed to $205,842 in 2018).
As a result of this tax hike, the combined top federal/provincial tax rate is now over 50 per cent in the seven provinces east of Saskatchewan (for example, 54 per cent in Nova Scotia and approximately 53.5 per cent in Ontario and Quebec), and is slightly less than 50 per cent in the three western provinces.
For years, it has been long-argued by various economists that a government is only able to raise taxes so high before the rate itself creates a psychological barrier to work such that reduced economic activity by those high income earners leads to a reduction in tax revenues.
Indeed, the idea of a top rate capping out at 50 per cent can be found in the 1966 Carter Royal Commission Report on Taxation, which suggested that even though a government's revenue needs may call for a higher rate, once the rate reaches 50 per cent, it begins to threaten productive efforts.
As the Commission wrote, "We are persuaded that high marginal rates of tax have an adverse effect on the decision to work ... (and) on the decision to save. ... We think there would be great merit in adopting a top marginal rate no greater than 50 per cent. With such a maximum marginal rate, taxpayers would be assured that at least half of all gains would be theirs after taxes. We think there is a psychological barrier to greater effort ... when the state can take more than one half of the potential gain."
This view was echoed most recently by the Québec Taxation Review Committee, which in March 2015 recommended that the maximum federal/provincial tax rate should not exceed 50 per cent.
The C.D. Howe Report, entitled Unhappy Returns: A Preliminary Estimate of Taxpayer Responsiveness to the 2016 Top Tax Rate Hike, and authored by its director of research, Alexandre Laurin, uses newly-released preliminary tax statistics to assess the impact of the federal 2016 high-income tax rate hike on the reported income of the top one-percenters. When the tax was introduced, many commentators warned that high-income taxpayers would react to the hike by reducing their earned income or engaging in "tax avoidance."
Previous studies have shown that top income earners, when confronted by a tax rate increase, are likely to change their behaviour in various ways: some may reduce work effort by choosing leisure over more work, while others may plan their affairs in a way to minimize their tax burden. In other words, high tax rates may discourage earning additional income and may encourage shifting taxable income to different forms, times and jurisdictions. High rates may not only negatively affect the economy, but they may add little to, or, as the study shows, even reduce, government revenues. Mr. Laurin estimates that the federal tax hike would likely have yielded Ottawa about $1.2 billion - a small fraction of the more than $3 billion the hike would have yielded without the behavioural response and $0.8 billion lower than the government budgeted. Furthermore, the erosion of the national personal taxable income base affected provincial revenues as well since both federal and provincial governments share the same taxable base.
In fact, it's even worse for the provinces because the provinces suffered reduced taxable income bases without any compensating rise in their tax rates. As a result, Mr. Laurin estimates that the federal hike likely cost provincial treasuries about $1.3 billion in personal income tax revenues in 2016. Since the provincial losses exceed the $1.2 billion federal gains, the report concludes that the hike was "a revenue loser on a national scale."
To address this issue, Mr. Laurin recommends that Canada take steps to improve its personal income tax competitiveness vis-à-vis both the U.S. and the world as Canada's top combined federal/provincial personal income tax rate is among the highest of the OECD.
Specifically, Mr. Laurin would like to see a small reduction to the top tax rate, bringing combined federal/provincial top tax rates back to around the 50 per cent mark. He estimates that this would cost very little federally and the provinces would enjoy a windfall because of its positive impact on the taxable income base.
He also suggests doubling the income threshold at which the top tax rate applies. This would reduce Canada's disadvantage in relation to the U.S. where the top federal rate only kicks in at income above US$500,000.
"High personal taxes disadvantage Canada in the competition for global talent. Lower personal income taxes in the U.S., in particular, hurt Canada's attractiveness to high earners, and its appeal as a location for head offices," writes Mr. Laurin.