Higher tax rates tend to only work if you disregard human behaviour

Tim Cestnick, FCPA, FCA, CPA(IL), CFP, TEP, is an author, and co-founder and CEO of Our Family Office Inc. He can be reached at [email protected].

It was J. Paul Getty who said: “If you get up early, work late and pay your taxes, you will get ahead – if you strike oil.” And if you’re a Canadian taxpayer, it’s not clear that even striking oil is going to help you. As Canadians, we pay personal income taxes at a higher rate than most developed countries. In fact, personal tax revenues in Canada, at close to 12 per cent of GDP, are almost 50 per cent higher than the average for member countries of the Organization for Economic Co-operation and Development.

You’ll recall that, in 2015, the Liberals made changes to our tax system to, among other things, increase the top marginal tax rate by 4 per cent effective Jan. 1, 2016. An article in The Globe and Mail on Aug. 27 revealed that, despite the tax hike, the Canada Revenue Agency actually collected about $4.6-billion less in taxes in 2016 from Canadians earning about $140,000 or more.

The response from Finance Minister Bill Morneau’s office was that the drop in revenue was largely a one-time event since many higher-income Canadians shifted income from the 2016 tax year to the 2015 tax year when they found out that tax rates were going up in 2016. This tactic is known as “forestalling,” where taxpayers are aware of an approaching tax hike and take steps in advance to minimize the impact.

As an aside, higher tax rates often cause taxpayers to shift taxable income to different years, forms of income and jurisdictions. These are defence mechanisms that kick in when marginal tax rates become far too high.

Although Mr. Morneau’s explanation for reduced tax revenue in 2016 was largely that Canadians shifted income to 2015, is this really the whole story? Evidently not. Last week, the C.D. Howe Institute released a research brief showing that, even after adjusting for forestalling, the total taxes collected in 2016 were not only lower than expected, but overall taxes collected by the federal and provincial governments combined were lower than before the tax hike.

The research

Most tax experts recognized in advance that the tax hike on the top 1 per cent of income earners in 2016 would bring about some type of response. Behaviour would change. There’s now enough data to assess what that behaviour has been.

Sure, it was expected that folks would accelerate income (mostly dividends) and report that income in the 2015 tax year rather than facing tax at higher rates in 2016. And so, we all expected that 2016 would show lower taxable income among the highest earners in the country than 2015. The C.D. Howe research stripped away the impact of this forestalling and demonstrated that even beyond this there was a fairly strong behavioural response to the tax hikes, consistent with what has been observed in prior studies, both in Canada and abroad.

The research showed that if high-income earners had not reacted at all to the 2016 tax hikes, the federal government would have collected about three times the amount of additional tax actually collected. But taxpayers did respond, and managed to avoid about two-thirds of the projected additional taxes.

In the C.D. Howe study, our federal government collected about an additional $1.2-billion in 2016 as a result of the tax hikes, which is a small fraction of the more than $3-billion the tax hikes would have gathered had taxpayers not responded by changing their behaviour. Further, the $1.2-billion actually collected is about $800-million less than the government itself was expecting.

Here’s the kicker: High-income earners took steps to reduce their taxable income in 2016 because of the higher rates and this lower taxable income caused the provinces to collect less tax revenue to the tune of about $1.3-billion. That is, the additional federal taxes collected were more than offset by the tax revenue lost by the provinces (since, over all, they did not increase tax rates) – and the federal government made it more difficult to attract talent and capital to this country in the process.

The moral

Our government needs to improve our tax competitiveness, particularly relative to the United States, by lowering our highest marginal tax rates. There’s room to do this without creating a meaningful loss in overall federal-provincial tax revenue, and the reductions would help to attract talent, head offices and capital to Canada.

Another idea would be to increase the threshold at which the highest marginal tax bracket kicks in. According to the C.D. Howe Institute, if our government doubled our current top bracket threshold from $205,842 to $411,600 (still lower than the US$500,000 threshold south of the border), it would cost the federal government about $500-million, but would add about $700-million to provincial coffers.