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.

The curious case of income splitting

It is well known that the Harper Conservative government has pledged to allow income splitting for families with children under the age of 18 once the Budget is balanced. We will find out more about how far away the government is from the goal on February 11 when the federal budget comes down, but suffice to say this proposal will likely become a reality within the next year regardless of the evidence against the policy.

This issue of income splitting in the Canadian tax system is not remotely a new idea. It was floated back in the 1960s by the Carter Commission and several times since then. The Conservative Party first signaled their interest in income splitting for single income families with children in 1999. The idea was investigated by the Standing Committee on Finance which rejected the proposal for a variety of reasons including costs and the failure of the proposal in valuing home production. This post by Frances Woolley over on Worthwhile Canadian Initiative nicely summarizes the history of the proposal as well as some excellent research in the area.

While not much has been said about what the objectives of Harper’s policy are, which focuses on families as opposed to all households,  I imagine that it has something to do with trying to address child poverty, particularly in those households where one spouse elects to stay home with the kids. As readers may recall, in 1989 the House of Commons resolved to eliminate child poverty by 2000 and this commitment is what launched our current system of child benefits in Canada. Despite this commitment, however, child poverty rates are pretty much at the same level as they were in 1989, hovering around 15%.

This raises the question of whether this income splitting proposal will have any legs in helping reduce child poverty or benefiting lower to middle income households in anyway. It would seem that the answer is a resounding, no. Last week the left-leaning (slanted?) Canadian Centre for Policy Alternatives dropped a report on Income Splitting in Canada. The report comes out against income splitting noting that it disproportionately benefits wealthy households, a sentiment that I tend to agree with.

An area not discussed so far is how this proposal can benefit those with personal corporations. Take the case where one spouse is an employee earning $130,000, more than enough money to pay their bills and then some, and the other spouse is a business owner who pays themselves a small salary out of the business.

They recently had a child. Once the income splitting policy comes into effect, they change their approach to their business income. The business owner elects to no longer pay themselves a salary. Instead of paying themselves a salary, the business owner  keeps their earnings in their corporation where it is subject to corporate tax but at a far lower rate than had they paid themselves a salary and paid personal income taxes. They can now split the employee’s salary, thereby reducing their tax bill. But here is the kicker. The income accruing in the corporation will remain in the corporation until such time as the owner disposes of their shares. This triggers a capital gain but because the shares are in a Canadian-controlled private corporation (CCPC), up to $750,000 of the capital gain on the disposition of the shares is completely tax free. They now get to benefit from the tax savings from income splitting but also from the CCPC capital gain exemption. The family wins but the taxpayer loses. After all, this is a family who might like the taxpayer funded help but honestly does not need the help. I know this because this is my family.

There are much better ways at getting more money into the hands of low and middle income earners other than income splitting. This includes enriching the child deduction, personal exemption, child tax benefits and the national child benefit, HST credit, child care tax deduction (a topic of my next post where our business owner makes a reappearance), WITB, and the like. The CCPA argues that instead we should provide universal child care, which I find curious as that too disproportionately benefits the wealthy. In addition, universal child care is of no benefit to those families where a spouse elects to stay home with the kids, which are the families mostly targeted by the income splitting proposal.

What I do know, though, is that we will see income splitting because it very much benefits Harper’s core voting base. This is disappointing because we are once again throwing money at something that is not a substantial problem (the problem of a $130,000 earner paying more in tax than two $65,000 earners).

How to benefit the rich: property tax edition

There is a lot of focus right now on tax treatments that benefit the rich. Most of the discussion is about income tax loopholes and I have certainly contributed to this discussion with a contribution to the Globe’s Wealth Paradox series. But BC has an interesting policy with its property taxes that also benefits the wealthy.

Like most provinces, B.C. offers property tax relief, but unlike all other provinces B.C.’s program is not tied to income. B.C.’s Property Tax Deferment Program allows anyone aged 55 and over to postpone payment of property taxes until they sell their home or pass away (assuming that have a minimum equity of 25% and have current fire insurance). Interest on the amount deferred is charged, but at a rate not greater than 2% below the prime rate at which the province borrows money. In addition to this plum rate, any interest charge is always based on the amount loaned and does not compound.

Eligibility for the program is not means-tested, meaning it is open to both those that need and those that desire to postpone payment. When property taxes are deferred, they are secured with a government lien placed against the home. The province then transfers the total amount deferred (in that year) to local governments. So municipal government are not out any money but the B.C. government is.

The intent of the program, which dates back to the post war period, is to  provide relief for those who cannot afford to pay property taxes. There are two key problems with this objective. First, households with an ability to pay, it seems, were not expected to choose to defer property taxes, yet without a means test for eligibility, there is no way to prevent them from doing so. Second, the income and wealth profile of those aged 55 and over is no longer dominated by those with a low fixed income. Baby boomers are certainly one of the wealthiest senior populations we have ever seen and this notion of being old and being poor no longer holds water.

Those low-income seniors targeted by the program are not necessarily benefiting from it, which is truly a shame. Programs such as this can help low-income seniors stay in their home a little longer, reducing the burden on long-term care residences. That said, we should be careful about promoting home ownership amongst those who can’t afford it. Owning a home is expensive and sometime it is best to sell the asset and find more afforded housing.

B.C. needs to end this subsidy for high income households. The program needs to modified for the new realities of the income profile of seniors and access based on passing a means test.

…But It’s Regressive!

This post was inspired by Stephen Gordon over at Worthwhile Canadian Initiative. I had mentioned in my previous post, that user fees work on the principle of fairness because you get what you pay for. This is the benefits-received definition of equity.

Another definition of equity is a person’s ability to pay. With user fees, all consumers pay for the cost of the good or service regardless of their income, a key measure for ability to pay. Ability to pay is the most frequent argument against user fees, specifically that they are regressive. When the financial burden of a service falls more heavily on low income households, it is referred to as regressive. This usually manifests itself as the tax payment taking a larger portion of the after-tax income of low income households. This critique was offered by the Official Opposition in response to a federal government initiative to increase user fees, “NDP Treasury Board critic Alexandre Boulerice said user fees discriminate against the poor because unlike income taxes, they are not geared to income.”

The literature, however, is not conclusive regarding the regressive nature of user fees. In fact the evidence suggests four main arguments against user fee’s regressivity.

  1. First, upper-income households benefit disproportionately from free public services. For example, upper-income households are more likely to live in large households and consume more than their share of sewage, water, and refuse collection than lower income households when these services are funded through property taxes and not user fees.
  2. Second, user fees allow low-income consumers to adjust their consumption to lower levels, thereby paying less than they would under a property tax system.
  3. Third, any regressive or disproportionate effects can be minimized or even reversed with careful design, revenue uses, and compensation mechanisms, particularly discounts and exemptions for readily identifiable groups, a point made clearly in a paper I co-authored on congestion charges. It is possible to accommodate equity concerns not just through fee reductions, but also operational changes. For example, providing more services to low income areas or reducing the burden of the fee by accepting various forms of payment or allowing individuals to pay by month rather than one up front yearly fee.
  4. Fourth, one must examine the incidence of any other tax or taxes that might be reduced at the same time and the incidence of the publicly provided goods and services to which any revenue is devoted. This means that examination of the equity concerns of user fees is an important aspect of user fee implementation and the equity assessment must be comprehensive to ensure a full understanding of the effects of the user fee on other correlated levies and goods and services.

I get very frustrated when someone just dismisses a revenue instrument (like user fees and consumption taxes) on the ground of regressivity. Income taxes, after all, can be regressive. We just choose for them not to be. Same is true of user fees. They are only regressive if you let them be regressive. It is time that we elevate discussions on these type of taxes beyond this hyperbole and talk about what we can do to address these types of concerns during design and implementation.