Spring break

It’s March 17 and the beginning of Spring Break. I’ll be taking two weeks off to enjoy the lovely Spring weather here in Victoria and recover from yet another daycare cold. I’ll be back at work April 1 (ending my maternity leave) and much needs to be done around the house and in the garden before that happens. I’ll be back posting around April 1.

Taxes and Economic Growth

A really neat natural experiment has advanced our knowledge of the effect of taxes on economic growth.  In the 1980’s, Iceland changed its tax system in a way that provided a natural experiment to show how taxes effect the economy.  Before the reform, people paid taxes based on their previous year’s income.  After the reform, people paid taxes based on their current income.  Thus, in 1987, taxes were based 1986 income but taxes in 1988 were based on 1988 income.  Income earned in 1987 was never taxed.  For this one year, the marginal income tax rate fell to zero.  The citizens of Iceland took advantage of this tax holiday.  Total hours worked rose by 3% in 1987 and fell back to its normal level in 1988.  The production of goods and services in 1987 as measured by real GDP was 4% higher than the average the year before and year after.  This shows how people respond to the incentives inherent in the tax system.

A Short History of Canadian Income Taxation

A little known secret about me is that I had a strong interest in history. Indeed before I majored in Political Science (my first degree is in poli sci, the remainder are in economics), I majored in Canadian history. I am one of those odd people who find Canadian history really interesting. When I started studying taxes, one of the first things I did was get a good understanding of our tax history and I thought I would do a short summary of income taxation in Canada for you.

Income tax was not imposed federally until 1917 when it was imposed as a temporary measure to help finance WWI.  The legislation, which was embodied in the Income War Tax Act, was relatively simple document of some ten pages in length (I even had a copy in my office). The provisions were effective September 20, 1917 and implemented a 4% on all income of single men over $2,000. For others, the personal exemption was $3,000. For those Canadians with annual incomes of more than $6,000, the tax rate ranged from 2 to 25 per cent.  Because of what were in fact high exemptions for the time, only about 2-8% of individuals had to file tax returns during this initial tax period. Indeed, in 1934, only 199,000 people paid income tax which represented just under 2% of the total population.

In 1948, the Income Tax Act was passed.  It was similar to the Income War Tax Act but was double in size (20 pages). By this time, there were ten different federal tax brackets which ranged from 15% to 84% and far more people were now paying income taxes (17% of the population).

A major reform of federal income tax legislation began in 1962 with the establishment of the Royal Commission on Taxation under Kenneth Carter (Carter Commission).  The Carter Commission presented its 7-volume report in 1967 recommending fundamental changes in tax legislation that would use a comprehensive tax base.  This culminated in the budget address of June 18, 1971 that proposed Bill C-259 to amend the Income Tax Act that became effective Jan. 1 1972.  The number of brackets peaked at 14 in 1973 and ranged from 4.58% to 61.34% and by then 37% of the population where paying taxes. The result was a considerable change in taxation in Canada and since that date, every budget address has presented a considerable number of amendments to the tax legislation.

Another major tax reform took place in 1987, the key change of which was to reduce the number of tax brackets which numbered nine at the time to three. In addition, tax rates were only indexed to inflation over 3% (this resulted in no change to brackets or benefits between 1991 and 1999 due to low but not 0 inflation – hence bracket creep).  In 1991, the GST was introduced.

Finally, substantial tax changes took effect in 2000 including the provincial moving away from the tax on tax system to one where they tax income directly and tax rates and benefits became fully indexed to inflation. The number of federal tax brackets was increased from three to four and by 2006 nearly 50% of the population of Canada paid income taxes.

As of 2010, the federal Income Tax Act alone amounts to 2,847 pages and is one of the worst books every written. There are also the federal Income Tax Regulations and they amount to 1,339 pages. Taxation in Canada is now a very complex system and few Canadians seem to understand it.

Tax Disclosure

Did you know that in Scandinavia tax information has been public for over a century? In Sweden copies of the Taxation Calendar, which lists the earnings of those with middle to high incomes, can be requested. The Finnish tax administration publishes the tax list online, and searches on individuals cost about 36 cents per search. But no one trumps Norway that publishes what every single taxpayer paid in taxes along with their income and net worth. This list, or skatteliste, has been available online since 2001 and is searchable. Italy, believe it or not has also jumped on this band wagon, albeit momentarily. In 2008, the deputy finance minister made taxpayer income and taxes paid available online but the data was pulled down by Italy’s data protection agency less than 24 hours after it was made available.

Disclosure of this nature is foreign to us here in North America. Well, at least in modern times. The 1861 US federal income tax law made tax filings public information and newspapers regularly published this information. That said, back then, very few people actually paid taxes. The public nature of tax filings only lasted until 1894, except for a short lived experiment in 1923-24.

To us the release of information related to income and taxes paid would not pass our modern privacy laws. This might be a good thing since in Norway there seems to be a link between the release of the annual data and robberies at the homes of high income earners as well as related fraud cases. However, it might also be a bad thing as disclosure appears to aid with tax compliance.

How does disclosure aid with compliance? Well it: provides transparency, can be used to detect and prevent tax evasion, and maintain public confidence. After all, given that your neighbours can search your information and rat you out if you submit erroneous information, you are more likely be compliant with tax laws.

Recently Bo, Slemrod, and Thoresen put this theory to the test. These authors exploit the change in Norway where tax information was put online in 2001. They find that there was a 3% higher average increase in reported income among business owners once information was freely and easily available online. Slemrod has also argued that tax disclosure should be the norm for corporations. He rightfully argues that public financial statements provide no information about the corporations tax status. Instead, corporations tend to report high book income the public yet low income to the tax authorities, resulting in very low tax amounts being paid. However, when Paul O’Neill was Treasury secretary he opposed such disclosure as it would subject the corporations to “misinformed, inexpert analysis.”

Whatever your position, the notion of tax disclosure is an interesting one. For public sector workers whose income is already publicly available in most provinces it might even the playing field if everyone’s income is made public. In addition, making tax data freely available would be a gold mine for any academic working in the field of tax. That said, the individual costs might be high if it subjects you (and your children) to robberies, bullying, and other negative behaviours. What do you think?

Tax Withholding and EI benefits

I have written about tax withholding before for the Globe and Mail. In this post for the Economy Lab, I outline the history of withholding, the economic rationale for withholding, and some unintended consequences of withholding. While many accountants and economists abhor withholding, I demonstrate the key benefits of having withholding as part of our tax system.

Today, I want to talk about the relationship between EI and withholding, specifically EI maternity leave benefits. This is a topic of interest to me as I received EI maternity leave benefits in 2013 and as I sit down to do my taxes, I am again reminded of how fortunate I am to have the knowledge I have about the tax system. See, this year I am going to owe CRA a small amount, unless I choose to make a last minute RRSP contribution or can find some additional business expenses. This is an usual position for me, as usually I am in a refund position due to substantial medical expenses or at or near a $0 owing position otherwise.

I am in a tax owing position this year because of my EI mat leave benefits. How you say? Does not ESDC withhold taxes on EI mat leave benefits? Why yes it does, but for reasons that I think need to be revisited, that withholding does not take into account a common position many people are in while on EI mat leave benefits. For many employees, their employer pays a top-up to employees on mat leave. ESDC, however, does not take this into account when deciding on the amount to withhold. It is possible to have this corrected by filling out a TD1 form, but the form does not contain a box for employee top-ups. Instead, the employee can fill out the last box, directing ESDC to withhold a specific amount, but that would require the employee to guess at how much extra needs to be withheld. How many of us would get that amount right?

Given the amount of communication between my employer and ESDC in order for me to collect mat leave benefits, why is there not also communication to ESCD that I am getting an employer top-up and to increase their tax withholding? It is much simpler for my employer to report this information at the time of my application than it is for me to fill out a new TD1, guess at the additional withholding amount, and submit the TD1 to ESDC.

Fortunately for me, I knew I was going to owe a little bit at tax time, and I set this money aside. So I am not caught off guard, but I wonder how many parents are? How many parents fill out their taxes after receiving mat leave benefits and are shocked to see that they owe several hundred or thousand dollars? How many of them, some of whom are still on mat leave, have that money set aside to pay? Given that we know that people in a tax owing position are more likely to engage in tax noncompliance, this seems something that we can and should avoid.

So I call on ESDC to make a small modification to their system of communication between themselves and employers and require employers to report if an employee top-up is being provided and to modify their tax withholding calculations based on this information. Doing so eases the tax time financial burden of these individuals and will increase tax compliance rates.