In Canada, child care costs to a maximum of either $4k, $7k , or $10k (depending on the tax payer’s situation) can be deducted from income. These costs are deductible from gross income, as opposed to a tax credit, as they are incurred to help the taxpayer earn an income. That is what a deduction is all about, to allow you to deduct costs incurred to earn an income. Deductions of this nature against earned income from employment can be used to reduce your taxable income to zero, but not below that. Only those with business income can use deductions to incur a loss.
One of the main criticisms of the deduction is the cap on the amount claimed. Parents with a child under 6 where the child is not disabled can claim a maximum of $7000. This maximum pales in comparison to what these parents are paying out in child care expenses as full time daycare for one child can cost upwards of $24,000 of year, depending on where you live, the age of the child, and the type of care. This was the topic of my Budget wish list post on the Globe and Mail’s Economy lab this year.
While this is certainly a valid consideration, it is not the topic of this blog post. Instead, I want to talk about the constraints on claiming the expense. In cases where there is more than one parent in the household, the expenses must be claimed by the parent with the lower net income: the lower the net income, the lower the marginal tax rate, which means the lower the value of the deduction. I assume that this constraint is in place as it assumes the lower income spouse is the secondary earner. That is, that was the spouse that returned to work and is forcing the household to incur child care expenses. As those expenses were incurred to allow that spouse to earn their income, they are given the privilege of the deduction.
The problem with the deduction is that is does not benefit those households where one of the earners earns low or no income, despite still having to incur the costs of daycare that allows them to earn that income. First, this is because the deduction cannot exceed two-thirds of your earned income.This effectively means the deduction is worthless for a lot of low and middle income households, a fact of which they may not be aware. Second, a particular area where the requirement that the lower income spouse claim the deduction is questionable is the case where one spouse is a business owner and the other is an employee. I have written about business owners before and how they can benefit from the tax system, but in this case they are penalized.
For the purposes of this example, we assume that the employee is the primary care giver to the child and has elected to return to work full time after 12 months on maternity leave. In order to return to work, the employee must incur child care costs, which are paid out of their income.
The other spouse is an entrepreneur. They may be working about 80-90 hours a week in their business and because it is early years of the business, the business is not paying much, if any, of an income. Instead, all profits are returned to the business. Because of the growth phase of the business, this is likely to be the case for the next 4-5 years. The entrepreneur is working long and hard hours and is unable to care for the child in place of the employee spouse who has returned to work. Yet, the individual does not have enough net income for tax purposes for the household to derive any benefit from the child care expense deduction.
In this case we have two individuals who are working full time and beyond, are incurring valid expenses to earn income, yet are unable to deduct those expenses from their income because of the way the deduction must be calculated (if child care expenses are a valid business expense in this case, I would love to hear from you citing the case law behind this). This is a household who should be able to benefit from the deduction given the spirit that the deduction was offered yet are unable to given the nature of the implementation of that deduction.
I previously blogged about GAAR (here and here). GAAR is invoked by CRA when actions of a taxpayer violate the spirit of the Income Tax Act. We need a similar clause for when actions of CRA violate the spirit of tax policy. The spirit of the deduction was to recognize the expenses that working parents have to incur in order to earn an income yet the constraint that the lower earner spouse must claim those expenses makes assumptions about the relationship between child care expenses, income, and hours worked that are not true for some households. Instead of the deduction being limited to the lower income spouse, the deduction should be granted to the primary care giver of the children as it done for the payment of CCTB. It is the primary care giver that is incurring those child care expenses and the deduction should benefit that spouse. The change would make a big difference to households where the secondary earner is a low income earner. Modifying the child care expense deduction makes much more sense to me than the proposed income splitting for families.