Problems with the Child Care Expense Deduction

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.

In Search of… tax edition

Back in the late 70s there was this excellent TV show narrated by legendary Leonard Nimoy called In Search of…. The show was devoted to mysterious phenomena like the Bermuda Triangle and the Loch Ness Monster. This also seems fitting for the topic of taxes, which many people also find mysterious. And since tax season is once again upon us, it seems like a good time to talk about taxes.

When it comes to models of tax compliance, the models are typically based on a rational individual (someone who makes decisions that makes them the happiest) who weighs the benefits of tax compliance against the risks and costs of tax noncompliance. That is, the act of tax compliance is a strategic decision. What I do not like about this standard set up is that it ignores many factors that affect taxpayer compliance, notably knowledge and information both of which are very costly to acquire. Clearly, an individual’s knowledge about taxes influences their ability to comply with tax rules. Most of the existing research on tax compliance takes knowledge and information as given, which is grossly naive.

There is ample anecdotal evidence that suggests that taxpayers struggle to understand and comply with tax regulations. In some cases this leads to underpayment, but which can also lead to overpayment, an oft overlooked problem in tax compliance.

There is some research that has begun to examine this problem.  In a study conducted in Australia, McKerchar (1995) found that small business taxpayers may be unintentionally non-compliant because they are unaware of their own shortfall of taxation knowledge. In other words, they did not know what they did not know. More recently, Hoopes, Reck, and Slemrod (2013) examined the acquisition of tax information and find that taxpayers do attempt seek information around tax time in an attempt to comply with their tax obligations. This search for information is important since Fallan (1999) found that improved tax knowledge significantly changed attitudes toward the fairness of the tax system. Finally, Chetty, Friedman, and Saez look at how differences in knowledge influences the Earned Income Tax Credit refund and earnings in the US.

I personally wonder whether tax software helps or hinders taxpayer knowledge. Modern software asks the taxpayer simple questions to generate their return. I shudder at the thought of a taxpayer blindly clicking through these questions without taking the time to understand the relationship to their tax position. For example, I have to wonder how many taxpayers think they benefit from the Child Fitness Tax Credit because they claim these expenses, but fail to understand because the credit is nonrefundable they actually derive no benefit at all from the credit because of their tax position.

Overall, there is currently little academic understanding of not only the role of knowledge and information on tax compliance, but also how tax payers seek information and the quality of the information they obtain in their quest to be compliant as well as the relationship on compliance. This is a ripe area for a budding scholar, particularly for a PhD dissertation, particularly one not afraid of qualitative research methods.

McKerchar, M., 1995, ‘Understanding Small Business Taxpayers: Their Sources of Information and Level of Knowledge of Taxation’, Australian Tax Forum, Vol.12 No.1, pp.25-41.

BC Budget 2014

BC’s latest budget was tabled in the legislature this afternoon. Much like the federal budget, there is not a lot of new stuff announced in the budget but a few interesting pieces caught my eye. I, of course, focus on the tax measures.

The budget introduces the BC Early Childhood Tax Benefit. This benefit will pay $55 a month to eligible families. This actually looks like really smart public policy. The benefit will be a refundable tax credit. This simple act, making the credit refundable, means that low income families who are already in a tax neutral position will benefit from the credit. If you are a low income family and not currently filing your taxes, this should really make you want to rethink that decision.

The maximum benefit of $55 a month is payable to all families with net incomes up to $100k and then is partially clawed back such that it is fully phased out by $150k in net income. Given that BC has the highest rate of child poverty in Canada it is too bad that the payment is not higher for lower income families which could be offset by an earlier clawback threshold. But overall, putting more money into the hands of families gets a thumbs up from me.

Much like the federal budget extended the Mineral Exploration Tax Credit, the BC government extended their provincial version of this credit. I have written before why mining flow through shares is stupid tax policy and you can read all about it here.

I also see that the BC government fiddled a bit with the B.C.’s Property Tax Deferment Program. I have also written about this policy before, which also ranks in my stupid tax policy list. My problem with BC’s program is that it is not means tested meaning that wealthy households that qualify derive a substantial benefit from a program meant to keep low income seniors in their homes.

The fiddling also extended to the Distant Location Tax Credit. The Greater Victoria area now qualifies as a ‘distant location’. I have to wonder if the filming of Gracepoint influenced this decision in any way. By the way, Victoria is not, in my books, distant. Also these film tax credits are just races to the bottom, which makes for bad tax policy.

So I give the government a thumbs up for the child benefit, but I don’t see many other positive tax measures (though increasing tobacco taxes is a positive IMO). What I dislike is that the special tax credits like the flow through shares piece and the property tax deferment benefit high income Canadians and need to be scrapped. Had the flow through shares credit been axed, the child benefit could have been enriched for low income households. That, my friends, is a lost opportunity.

Income vs. winnings vs. prizes

My previous post on the taxation of Olympic winnings sparked some questions about the difference between income and winnings. See in Canada, unlike the US, under the Income Tax Act, windfalls are exempt from taxation. In order for money to qualify as windfall income, it must meet eight criteria set out in IT-334R2:

a)      the taxpayer had no enforceable claim to the payment,

b)      the taxpayer made no organized effort to receive the payment,

c)      the taxpayer neither sought after nor solicited the payment,

d)     the taxpayer had no customary or specific expectation to receive the payment,

e)      the taxpayer had no reason to expect the payment would recur,

f)       the payment was from a source that is not a customary source of income for the taxpayer,

g)      the payment was not in consideration for or in recognition of property, services or anything else provided or to be provided by the taxpayer, and

h)      the payment was not earned by the taxpayer as a result of any activity or pursuit of gain carried on by the taxpayer and was not earned in any other manner.

Most lottery winnings are, therefore, not taxable in Canada as is money won on beer night down at the bowling alley or dart night at the pub. In order for Olympic winnings to be categorized as windfall income, CRA would need to amend items b, c, d, f, and h. Poker winnings can be categorized as either windfall income or taxable income depending on whether or not item f applies (why the winnings from participating in your beer sports league are not taxable). They are taxable if the gambling activities constitute carrying on the business of gambling. When a poker (or any other) player goes from being an amateur to a professional player, however, is a central legal difficulty that has faced many a poker players.

In addition to windfall winnings, income from prescribed prizes is also exempt from taxation. The exemption for a prescribed prize dates back to 1987 after John Polanyi won a Nobel Prize. In a terrible fit of flag waiving pride, the Mulroney Government created the prescribed prize exemption so that Polanyi could collect his $1M prize tax free. A prescribed prize exemption is “any prize that is recognized by the general public and that is awarded for meritorious achievement in the arts, the sciences or service to the public.”  Prescribed prizes contain two essential features. First, they are awarded to individuals who did not offer themselves up for competition but were nominated by an arm’s length body. Second, prescribed prizes are those where the underlying activities have a broad-based and tangible beneficial effect on the economy or the society. This must go beyond a “warm glow.” Examples of prescribed prizes include the Nobel Prize, the Governor General’s Literary Award, and the Donner Prize. Olympic winnings also do not meet either of these criteria. Olympic awards are similar to other athletic awards and do not qualify as a ‘prescribed prize.’

If Olympic winnings don’t qualify under these existing exemptions, why don’t we just create a new one? First, we don’t need to. As I previously wrote, if an Olympic athlete is paying tax on these winning, either they are a high earning athlete or needs much better tax advice. Second, adding more exemptions to our tax system further reduces the fairness and adds unnecessary complexity. Third, what makes Olympic athletes that much more special than any other individual competing on behalf of our country? What about the Canadian’s competing in the annual World Toe Wrestling Championship?

It’s not fair!

its-not-fair1Any and all parents have to deal with this exclamation on a nearly daily bases. Their toddler, tween, teenager, and even adults utter this phrase on a regular basis when faced with something they don’t like and usually don’t understand: It’s not fair. Usually, the parent mutters under their breath “yah, well, life is unfair” and then proceeds to smile at the child and provide some reassurance like “I know”.

This seems to be what is going on with the income splitting proposal. It is not fair that a single earner pays more in tax than two people making the same amount. Apparently, though it is only unfair if they are seniors or if they have children. For everyone else, it is perfectly reasonable. That complexity, though seems to be a moot issue.

Most of us agree that the tax burden should be distributed fairly and that all of us should pay our “fair share”.  However, there is endless debate about what constitutes a fair tax system.  When someone tells me a tax is not fair, I always ask them to define fair. I have yet to get a reasonable answer to this question. Either the person splutters for a while before caving and realizing that it was more a feeling they had or they eventually storm off in a fit about how I am being unfair.

Economists, however, do define fair quite clearly. In fact, ‘fairness’ or as we say, equity, is a key pillar of assessing taxes. There are essentially two leading theories on which to describe the “fairness” in a tax system.

The first is the benefits-received principle. This principle dates back to Adam Smith and means that taxpayers should pay taxes in proportion to the benefits that they receive from public expenditures. This means that those who benefit the most, pay the most.  If taxes are based on the benefit principle, the people who “enjoy” the largest benefits pay the most for them. For example, people with children would pay more to build and operate schools.  Thus primary beneficiaries of schools are thus taxed in rough proportion to their use of those schools.

The difficulty is that the bulk of public expenditures are for public goods or goods with externalities where the benefits of them fall collectively on all members of society, like public education. Hence, there is no way to determine what value individual taxpayers receive from them. Clearly this is not the definition of ‘fair’ that is being used to support the income splitting proposal, since seniors and families disproportionately benefit from public expenditures.

The second is the ability-to-pay principle. This is a theory of taxation that holds that citizens should bear tax burdens in line with their ability to pay taxes. The ability-to-pay principle has dominated the formulation of the tax policy in Canada. The ability-to-pay principle involves comparing people along two dimensions: horizontally and vertically.

  1. Horizontal Equity: those with equal ability to pay should bear equal tax burdens. Horizontal equity is easy to agree with in principle, but difficult to implement in practice. If two people are identical in every respect, horizontal equity is easy to apply, but how do we compare people who are similar but not identical?  The greatest difficulty arises in working out differences in ability to pay that arise from the state of a person’s health and from a person’s family responsibilities. The Canadian income tax has many special deductions and other rules that aim to achieve horizontal equity in these circumstances.
  2. Vertical Equity: those with greater ability to pay should pay more. This proposition easily translates into the requirement that people with higher income should pay higher taxes, but it provides no help in determining how steeply taxes should increase as income increases. How much more should the rich pay? If horizontal equity is difficult, vertical equity comparisons are impossible.

The ability-to-pay principle can also be tricky when a tax system is based on individuals because individuals form households. Many households pool income and share expenditures. In many households, one spouse supports another. Is it “fair” that a household with one income earner pays more tax than a household with two income earners earning the same income as the one income earner? And that is the question that matters for the income splitting proposal. But equally, is it “fair” that households with dual earners have to shoulder the burden of vast expenses of child care?

The ‘unfairness’ notion with single earners arises solely because of our progressive tax system, yet we all feel that people who earn more should pay more. What is overlooked is that our tax system does try to offset these situations where single earners pay more than dual earners to obtain a more fair outcome. The single earner households do obtain a tax benefit that other households do not. They get the claim the spousal amount. The dual earner family gets to claim a portion of their child care expenses. There are ways we can use our existing system to further address fairness so that lower income households can benefit more without increasing the benefit to higher income households. The spousal amount could be made refundable, the child care deduction could be increased, various tax credits like the CCTB and GST/HST credit could be modified so that single earner households face a higher clawback threshold, and the like. This is much more ‘fair’ than the income splitting proposal that disproportionately benefits wealthy households at the expense of low AND middle income households.

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The 2014 Federal Budget Overlooked Measure to Help Low Income Canadians

The 2014 Federal Budget has now been tabled, and the newspapers and twitter are filled with analysis of this budget.  While many are slamming the budget for being ‘all talk and no action’ there is a very important measure announced in it that is getting almost no coverage in the media. This measure helps address many of the regressive features of the GST/HST and gets more money into the hands of low income Canadians.

One of the biggest challenges levied against the GST is that it is regressive. As I have said before all taxes can in fact be regressive. Whether or not any particular tax is truly regressive depends specifically on how the tax is implemented. For example, income tax can easily be regressive but we in Canada have decided to design our income tax system as progressive. So questions about regressivity can only be answered by looking at the implementation of the tax.

With respect to the GST there were features of the GST implementation that offset its regressivity.

  1. the zero rating and exemption of some goods. 0 rated goods include basic groceries while exempted goods include things like health and financial services.
  1. general tax reform. This last one is important and gets and making sure you understand the history of policies before making statements. Our tax system underwent significant reform just before the GST (it should have been in tandem but politics got in the way). These tax reforms benefited low income Canadians and were meant to also overcome the regressivity of the GST.
  1. the GST tax credit. The tax credit is meant to offset the tax paid not to bring a household above the poverty line. It is a very specific credit with a very specific purpose.

The current administration of the GST tax credit requires individuals to apply every year by “checking the GST/HST Credit application box on their annual income tax return.” (Budget 2014, p. 327) Once checked, the CRA then considers whether this individual is eligible for the credit. CRA does not review returns for qualification for this credit when this box is unchecked. This is a curious method for administering this tax credit. CRA knows who is eligible, so why not use CRA to determine eligibility. This is a system that is used for many of our other credits. While it is not a huge burden to check the box, it begs the question of why we have it. By using this opt-in method low income individuals who overlook the box miss out on this very important tax credit.

In Budget 2014, the federal government is proposing a very significant and important reform to the administration of the GST/HST Tax credit:

Budget 2014 proposes to eliminate the need for an individual to apply for the GST/HST Credit and to allow the Canada Revenue Agency to automatically determine if an individual is eligible to receive the GST/HST Credit. A notice of determination will be sent to each individual who is eligible for the GST/HST Credit. In the case of eligible couples, the GST/HST Credit will be paid to the spouse or common-law partner whose tax return is assessed first. (p. 328)

I applaud the government’s proposal to move the GST/HST credit away from the opt-in method and towards this assessed method. This credit is important money to get into the hand of low income Canadians and this simple change will likely make a big difference to some very needy households.

Getting the Taxman to Strike Back

As we come up on the federal budget, I asked my tweeps what was their budget wish list. I received an interesting reply.

strike pay

Many Canadians might not know that Canada’s treatment of strike pay is, in a word, curious. This paper by the esteemed Ben Alarie (who you really should follow on twitter: @BAlarie) walks you through the details which I will summarize here. If you are in a union, you are paying union dues. These union dues are deductible from income for tax purposes, much like RRSP contributions. If these union dues, in whole or in part, are diverted to a strike fund, then the union does not pay tax on these funds. If you then go on strike and receive funds from this strike fund in lieu of your salary, then these funds are….not taxable.

Huh, you say. That does not make sense (or at least I hope you are). After all, consider the tax treatment of RRSP contributions. Your contributions are deductible for tax purposes in exchange for withdrawals being taxable. TSFA contributions are the opposite. TSFA contributions are paid from after-tax dollars in exchange for withdrawals being not taxable. By the same logic, payments into the strike fund should be deductible if and only if payments from the strike fund are taxable. Because the union also does not pay tax on these funds, it means this income is never, ever subject to tax. I can’t think of a single other example where income is not taxed at any point.

So what is the ‘logic’ of these funds not being taxable? This comes from the Supreme Court decision in 1990 in Fries v. The Queen. The court ruled that strike pay is not income. Instead, as noted by Alarie, “strike pay is generally concerned with providing workers and their families with day-to-day sustenance over the course of a given labour dispute. Strike pay is not usually concerned with income replacement as such.” (p. 440) But the problem is that this policy is not fair based on horizontal equity grounds. As noted by Ronald Beer in our twitter exchange non-unionized and unionized workers without a strike fund workers facing a labour dispute are unable to fund their day-to-day substance during a labour dispute out of pre-tax dollars. They instead cover these costs out of savings from after-tax dollars or are forced to go on EI, which is a taxable payment. So unionized workers are treated favourably compared to non-unionized workers and unionized workers without a strike fund.

So what can we do? We could somehow set up a system where those without strike pay can set up a fund that is treated the same as strike pay. However, the administrative and compliance costs of such a fund would be ridiculously high. Alternatively, we can make strike pay taxable. While Alarie notes the difficulties with doing so, this certainly seems to be the more logical thing to do.