The tax credit snowball; More people don't have any skin in the game - they don't pay taxes

With economic growth slowing and a goal of balancing the budget by 2015, Finance Minister Jim Flaherty will have little fiscal room for major new initiatives in Thursday's federal budget. The risk is that the Conservatives continue with their fondness for new and/or expanded tax credits which have been sprinkled through federal budgets over much of the past five or six years (i.e Working Income Tax Credit, and tax credits for family caregivers, children's arts and fitness, and volunteer firefighters to name but a few).

While some of these credits are fairly targeted at low-income households, there is an increasing risk that expansion of these credits will result in an increase in the proportion of Canadians exempt from personal income taxes. For example, the percentage of tax-filers who faced no income tax has already increased from 32 per cent in 2000 to 37.7 per cent in 2010.

The trouble with removing individuals from the income tax rolls through credits or other means (i.e. increasing exemptions) is that it establishes the foundation for ever-increasing demand for more government programs and services, irrespective of their benefits. Indeed, one of the explanations for the dysfunction of U.S. politics, which is often ignored or dismissed, is the marked change in the balance of Americans who contribute to taxes compared to those exempted from this burden.

Canadians should take note of what's happened down south as the building blocks of such changes are a rising threat to Canada.

The data for the U.S. in terms of who pays taxes and who doesn't is fairly clear. In 2011, according to the left-leaning Tax Policy Center, 46.4 per cent of American tax units - individuals or households - paid no income tax. Further, 27.6 per cent paid neither income nor payroll taxes.

A key reason such large percentages of Americans are exempt from these two key taxes is tax credits, which reduce the tax liability for certain people. In particular, the U.S. Earned Income Tax Credit (EITC) has served to shelter a considerable number of Americans from paying either income or payroll taxes.

This has not always been the case. When the EITC was first introduced in 1975, about nine per cent of American families were eligible. In 2009, the latest year for which data is available, almost 24 per cent of American families received EITC benefits.

Another change of note is the share of EITC benefits that are refundable, which means they not only reduce or eliminate income taxes but can also result in a refund that offsets other taxes such as payroll taxes. In 1975, 72 per cent of EITC benefits were refundable while in 2009 a little over 91 per cent of EITC benefits were refundable.

The result of these changes is that the U.S. now relies more on top earners for revenues than any other industrialized country.

When all federal taxes are considered, the top 20 per cent of earners in the U.S. shoulder almost 70 per cent of the total tax burden while earning 54.6 per cent of total income. They are the only group in the U.S. whose share of income is less than their share of taxes. For example, the bottom 40 per cent of earners pay 2.9 per cent of total federal taxes while earning a little over 12 per cent of total income.

This data only accounts for the cost side of government, namely taxes. It does not adjust for the nature of government spending financed by taxes. Such adjustments result in an even more concentrated burden for high-income earners because so much of what government does is either targeted for low-and middle-income families or spent broadly across the economy on things like defence.

This change in the distribution of who pays and who gets has had a profound effect on the functioning of the U.S. political system. The traditional framework for political decision-making, which is simplified here, is that citizens are offered competing views regarding the efficacy of government action and decisions are reached through elections.

This democratic decision-making process has fundamentally been distorted in the U.S. in a number of ways, including the large and increasing proportion of American house-holds not contributing to taxes in any meaningful way. Put colloquially, a large and growing number of U.S. households have no skin in the game, which fundamentally changes their decision-making. Given the real absence of costs to these households for government services, even bad services make economic sense to them.

Citizens make decisions about the advisability of a new or expanded government program based on the expected benefits versus the expected costs. In elections, highly concentrated tax burdens can become a factor.

The experience of the United States is a cautionary tale for Canadians. Specifically, Canada has introduced two tax credits that parallel U.S. programs that increasingly shelter middle-income households from the burden of taxes: the Working Income Tax Benefit (WITB), which is almost exactly identical to the U.S. EITC, and the Child Tax Credit (CTC), which actually shares its name with its U.S. counterpart.

The risk is that like their U.S. equivalents they will grow over time and become programs for the middle class. Indeed, WITB has already been expanded significantly in 2009, just two years after it was introduced. The cost of WITB went to $1.025-billion in 2009 from $480-million in 2008.

The key to avoiding the problems observed in the U.S. is restraint and continued targeting of tax programs like WITB. Let's hope that Mr. Flaherty avoids the mistakes of the United States.