Families with modest incomes face high marginal tax rates

It’s widely accepted that the share of additional income a person retains influences the degree to which they pursue additional work or other activities to earn more income in the future.

Typically, this discussion surrounds tax rates. High tax rates mean people retain less of the additional income they receive from engaging in more work. This is generally seen as a disincentive for people to pursue additional income and invest in skills and education.

However, this issue is much more complicated because there are a host of tax measures including tax rates and credits that influence the share of additional income a person retains, as well as government-provided benefits that are scaled back when a person’s income increases. The latter point is critical in understanding the incentives people face when deciding to work extra hours, accept a promotion or invest in their education.

Put another way, when government-provided benefits (such as credits and transfers) are scaled-back, individuals may decide it’s no longer worth engaging in more work because the financial benefits from doing so are reduced. This trade-off between increased employment income and reduced credits and transfers may prompt some individuals to decide not to take on additional work.

A recent study quantified the combined effect of tax rates, credits and the scaling back of government-provided benefits for the average family at select income levels. These calculations are referred to as marginal effective tax rates or METRs.

The marginal effective tax rate measures the percentage of an additional dollar of income paid in taxes after accounting for the scaling back of credits and transfers (including the Canada Child Benefit, which is slated for an increase after the Liberal election win), which transfer income to eligible families.

The chart below shows the average METR for families earning between $30,001 and $60,000 (modest-income earners) and those earning $300,001 or more (high-income earners). A family, in this case, includes various forms, such as one- and two-earner households and between one and three children (under the age of 18). This provides a useful look at average METRs across different types of families.

The study found that families with relatively modest levels of income face high METRs, ranging from 38 per cent in Alberta to 53 per cent in Quebec. In contrast, the METR for high-income families ranges from 40 per cent to 46 per cent, significantly less than the highest METR for modest-income families.

This trend is fairly consistent across Canada. In eight provinces, the METR for modest-income families is higher than, or equal to, the METR for high-income families. On average, the METR for modest-income families stands at 46 per cent compared to 43 per cent for the highest-income families.

Notably, the difference in METR between high-income and modest-income families is particularly stark in Manitoba and Quebec. In Quebec, modest-income families face a marginal effective tax rate that’s nine percentage points higher than top-income families. In Manitoba, the METR for modest-income families is four percentage points higher than the METR faced by high-income families.

Clearly, modest-income families face high effective tax rates, which frequently exceed the METRs of Canada’s highest-income families. This relatively high tax effective tax rate reduces the incentives for low- to middle-income families to engage in additional work or pursue other activities such as education and skills development that could increase their income in the future.