Any 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.
- 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.
- 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.