Declining federal revenue no excuse not to cut income taxes
Sliding oil prices and a weakening economy will slice into federal revenues and make it increasingly difficult for the government to balance its budget next year as planned. While there is seemingly little fiscal room for bold initiatives in the upcoming federal budget, now is the time for the government to think big on policy reforms that could contribute to higher economic growth. Personal income tax reform should be at the top of the list.
The last fundamental reform to the personal income tax system took place in 1987. The changes stemmed from a major federal Department of Finance paper on taxation which identified the proliferation of “special preferences” and the maintenance of high marginal tax rates stating specifically: “an income tax system with high rates relieved by an unfair patchwork of special incentives is not what Canada needs. What Canada needs is a fundamentally different approach: lower tax rates and a broader, fairer tax base”.
The government responded with a series of changes to the federal personal income tax system. The top marginal tax rate was cut, the number of federal tax brackets was reduced and a number of exemptions and deductions were eliminated to broaden the tax base.
Fast forward to the present and the number of “special preferences” otherwise known as tax expenditures (tax credits, deductions, and exemptions) has been increasing steadily. Virtually every federal budget since 2006 has contained new or expanded tax credits related to a specific activity or group of individuals. There are, for example, credits for using public transit, placing a child in an athletic or recreational activity, and even for those who volunteer in search and rescue operations. These tax credits rarely change desired behaviour; rather they subsidize behaviour that taxpayers would likely have undertaken anyway.
Tax expenditures currently cost the federal government approximately $124 billion a year, close to the $130 billion the government collects annually in personal income taxes. The proliferation of tax credits narrows the tax base, meaning that higher tax rates are required overall to raise the same amount of revenue.
Eliminating some of these tax expenditures would allow for lower tax rates. Of the $124 billion in annual tax expenditures, there are about 68 specific expenditures totaling $20.2 billion that should immediately be on the chopping block.
And what would $20.2 billion buy?
There are currently four federal personal income tax brackets: 15 per cent tax on incomes between $11,139 and $43,953; 22 per cent on incomes between $43,954 and $87,907; 26 cent on incomes between $87,908 and $136,270; and 29 per cent on incomes above $136,270.
Eliminating $20.2 billion in tax expenditures would allow the government to eliminate the two middle rates (22 per cent and 26 per cent). Doing so would reduce the number of brackets and thus the system’s complexity, improve economic incentives and greatly diminish the need for income splitting.
The result would be that an overwhelming majority of Canadians would pay a single 15 per cent marginal tax rate and a small minority—roughly two per cent of tax filers—would pay the higher rate. Maintaining the top rate of 29 per cent at its current income threshold means that this tax reform package, fully implemented, would cost $21.4 billion (in static terms).
Ideally, the government would also decrease the top rate to 25 per cent and increase the threshold at which this rate applies to income over $250,000. The estimated annual cost of this alternative, including elimination of the two middle rates, would be $28.6 billion and could be phased-in as revenues rebound.
Such tax reform would help Canada’s economic performance by improving the incentive for many Canadians to work, save, invest, and undertake entrepreneurial activities. Once these incentive effects are accounted for, the initial revenue loss would at least be partially offset.
The big barrier of course is that tax reform is an inherently political exercise. Certain voices may wish to retain the tax expenditures. However, the need to reduce personal income tax rates has been identified by consecutive federal governments, both Liberal and Conservative. In 2005, then-prime minister Paul Martin's economic plan, A Plan for Growth and Prosperity, stated: "Lower personal taxes would also provide greater rewards and incentives for middle-and high-income Canadians to work, save and invest." Prime Minister Stephen Harper's economic plan, Advantage Canada, also stresses that: "Canada's tax burden on highly skilled workers is too high relative to other countries ... Canada needs lower personal income tax rates to encourage more Canadians to realize their full potential."
The federal government does not need a healthy surplus to reduce personal income tax rates. It needs to think big on tax reform. Eliminating special tax privileges that do little to change behaviour or have little positive economic impact, and cutting personal income tax rates for middle income Canadians, would be a major step towards improving Canada’s tax competitiveness. It would also create an economic environment that is pro-work, pro-savings, pro-investment, and pro entrepreneurship.
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