High marginal tax rates aren’t just for ‘the rich’

When people talk about changing the tax code to encourage productive activity such as working, there’s a popular misconception that those analysts refer exclusively to the activities of high-income-earners. Nothing could be further from the truth. In fact, work-discouraging high tax rates are a serious problem and disincentive to economic activity throughout the income spectrum.

Even though most modest and moderate-income families pay a relatively low average income tax rate because they pay little or no income tax on the initial dollars that earn in the year, they often face high tax rates “at the margin,” which means the tax rate that they face on the next dollar they earn.

This concept includes the loss of government benefits, which are often (and generally for good reasons such as keeping costs down and targeting money where it can do the most good) “clawed back” as income rises. The Canada Child Benefit is a good example of a large benefit that shrinks as income rises. Again, this has benefits, but there are economic drawbacks as well.

In other words, people consider the “marginal tax rate” when making economic decisions. They want to know how much of the next dollar they earn they will keep before deciding whether to make the sacrifices needed to earn it. Very high marginal tax rates naturally discourage extra work and production.

A recent Fraser Institute study by Philip Bazel of the University of Calgary shows this is a serious problem in all Canadian provinces including Ontario. Bazel described the problem well when he wrote “high rates are a real concern as they diminish the net-of-tax return on paid work… and thereby create a potential barrier for economic advancement.” Again, high marginal tax rates can actually create negative incentives that prevent people from climbing the economic ladder and making a better life for themselves over time.

So how bad is the problem? Bazel shows that in Ontario, a family with a total household market income between $30,001 and $60,000 can face a marginal tax rate of up to 44 per cent on the next dollar they earn. In other words, they only get to keep 56 per cent for themselves. And that’s even before they have to pay taxes on things they buy with the extra money through the HST and other taxes.

It’s easy to see why somebody may make the choice not to spend extra hours or take on harder better-paying work in this situation—keeping only about half of their extra wages—and choose instead to engage in any other activity. This isn’t being lazy, it’s being rational. And it’s bad news for the overall economy’s performance.

When people hear economists and analysts talk about the work-discouraging impact of high tax rates, they often assume we’re talking only about high earners. But it’s just not so. Many families of modest means face a very high marginal tax rate when they’re considering taking on extra work.

There’s no simple solution to this problem, but it’s long past time for policymakers to recognize the steep marginal taxes families across almost the entire income spectrum face. If they can find ways to reduce those marginal rates, they can encourage work and help contribute to stronger economic growth in Ontario and elsewhere in Canada.