Income splitting not the best economic bang for the buck

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posted October 31, 2014

After seven consecutive years of budget deficits, the federal government is finally set to balance the budget. While the government has long expressed that tax relief is its top post-deficit priority, the major question has always been: what form will the tax relief take?

Now we finally know. Prime Minister Stephen Harper recently announced his government will introduce income splitting for tax purposes at an annual cost of roughly $2 billion. The government is right to focus on tax relief and address a distortion in the tax code, but it missed an opportunity to think big and enact tax reform that lays the foundation for stronger economic growth.

Income splitting tackles a distortion in Canada’s tax system between households. Households with similar incomes can face very different income tax bills depending on who earns the income. If a household has two earners at say $50,000 each, it would ultimately pay lower combined income taxes than a one-earner household with the same amount of income.

In principle, households with similar incomes should face similar tax burdens. The distortion between dual-income households and those where most income is earned by one spouse is due to Canada’s progressive personal income tax system – tax rates increase significantly as income increases. Since income tax rates apply to individual earnings, rather than family income, single earner families are taxed at higher rates than dual-income families with the same family income.

By allowing households to move income from one spouse facing higher rates to the other spouse, income splitting is one way to help fix this distortion. Income splitting, however, does virtually nothing to improve economic incentives or Canada’s competitiveness. Therein lies the missed opportunity.

Other reforms would allow the government to both fix the tax distortion while at the same time strengthening our economy and improving our tax competitiveness.

Consider a recent Fraser Institute study that surveyed the existing research on marginal tax rates. The weight of the evidence clearly shows that high and increasing marginal personal income taxes discourage investment and entrepreneurship, which form the basis for a thriving economy.

Consecutive federal governments, both Liberal (in 2005) and Conservative (in 2006), have identified the destructive effect of Canada’s personal income tax rates. Indeed, the Conservatives highlighted the need to reduce personal income tax rates well before any mention of income splitting.

Tax relief in the form of lower personal income tax rates would achieve the dual purpose of diminishing the tax bias between households and strengthening Canada’s economy.

One option is to eliminate the two middle-income tax brackets of 22 and 26 per cent, leaving one tax bracket (15 per cent) for the overwhelming majority of Canadians and a single high-income bracket of 29 per cent, which would only affect approximately two per cent of taxpayers.

Such a change reduces the number of brackets and thus the income tax system’s complexity, improves economic incentives, and diminishes the need for income splitting for almost all households. If fully implemented, it would cost an estimated $21.4 billion.

The government could use expected future surpluses to finance part of the proposal to eliminate the two middle-income tax brackets. The remainder could be financed through the elimination or reduction of tax expenditures (this includes tax credits for particular activities such as enrolling kids in arts or sports classes).

The totality of government resources consumed by tax expenditures is actually quite large. In 2013, the latest year of available data, the federal government spent over $140 billion on personal income tax expenditures while collecting $130.8 billion in personal income taxes. Yes, the federal government spent more money providing carve-outs and special treatment than it collected in personal income taxes.

Reducing personal income tax rates would provide broader-based tax relief and an enormous improvement in our tax competitiveness while strengthening the incentives for work effort, savings, investment, and entrepreneurship. Canadians would get far bigger bang for their buck with big-picture reforms such as broad-based personal income tax cuts than tinkering with income splitting.

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