Middle-class tax cut right in principle but Liberals taking the wrong approach

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Appeared in the National Post, December 10, 2015

The federal Liberals delivered their much anticipated Throne Speech last week outlining the main priorities for the coming Parliament. The government emphasized its first and “immediate priority” is to “deliver a tax cut for the middle class,” with legislative changes being announced in the coming days.

The government should be lauded for this commitment. However, there are two major problems with the proposed tax reform. First, it’s not bold enough. Second, the government plans to raise personal income taxes on upper-earners to help finance the tax cut, which will reduce the competitiveness of Canada’s personal tax system.

Cutting personal income taxes is, in principle, a good idea. All taxes impose costs on the economy in terms of reduced economic growth, but income taxes—and particularly progressive income taxes—are more damaging than taxes on say consumption due to their adverse incentive effects. An extensive literature finds that high and increasing personal income tax rates discourage people from working, saving, investing, and being entrepreneurial—all the activities that form the basis for a thriving economy.

The need for personal income tax reform is particularly clear considering that Canada’s middle and upper personal income tax rates, and the income levels at which they apply, compare poorly to a number of other industrialized countries.

In fact, this is something identified by consecutive federal governments, both Liberal and Conservative. In 2005, the Liberal economic plan, A Plan for Growth and Prosperity, stated: “Lower personal taxes would also provide greater rewards and incentives for middle-and high-income Canadians to work, save and invest.”

The Conservative economic plan in 2006, Advantage Canada, also stressed that: “Canada needs lower personal income tax rates to encourage more Canadians to realize their full potential.”

So cutting income taxes for middle-earners is a good idea, but the specifics of the current government’s approach are flawed. One problem is that it does not go far enough to reform the existing system, which consists of four rates (15, 22, 26, and 29 per cent) that apply to different income brackets. Simply put, reducing the second rate from 22 per cent to 20.5 per cent is too minor a change, given how uncompetitive Canada’s system is.

An even bigger problem is that the Liberals plan to “pay” for this tax cut by creating a new, top income tax rate of 33 per cent on those earning more than $200,000. For many of the same reasons that cutting the 22 per cent rate will be good for the economy, increasing the top marginal tax rate would be harmful.

With the new proposed top tax rate, Canada’s international competitive standing will worsen, bringing the top federal and provincial combined rate to more than 50 per cent and making it the fourth highest among industrialized countries, according to OECD data. Critically, the federal tax increase will exacerbate recent rate increases in several provinces including Ontario and Alberta.

And for what? As a recent study found, the tax hike will bring in a fraction of the revenue the government is expecting (about one third). The reason is that tax hikes—particularly on upper-earners—encourage people to change their behaviour in ways that reduce the impact of tax increases on their tax bill. This can come in many forms: taking more leisure time, accepting more compensation as untaxed fringe benefits, incorporating as a business to take advantage of lower business tax rates, and shifting income to, or perhaps even physically moving to, a lower tax jurisdiction.

Thankfully, there is a better reform option that would provide much more tax relief for middle-income families while improving, rather than harming, Canada’s economic competitiveness. The better way forward is to simply eliminate the two middle personal income tax brackets, leaving one tax bracket (15 per cent) for the overwhelming majority of Canadians and a single high-income bracket of 29 per cent, affecting approximately two per cent of taxpayers. This would put more money in the pockets of middle-income earners, but without the harmful economic effects of a new top rate.

To help finance this tax change, the government could eliminate or reduce ineffective tax expenditures—one of the stated priorities of the Liberal government. This is the type of fundamental tax reform that Canada needs to truly spark economic activity.

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