Ottawa’s tax-the-rich plan will cost the federal and provincial treasuries billions
The newly elected government in Ottawa has committed to increase the tax burden on the richest 1 per cent of earners and redistribute the proceeds by reducing the burden on middle-income earners. More specifically, the federal tax rate on taxable income greater than $200,000 would rise from 29 to 33 per cent. The tax rate on taxable income from $45,000 to $90,000 would drop from 22 to 20.5 per cent. The Liberal platform expects these changes to cost nothing: The new top rate is anticipated to bring in as much as the decreased middle-income rate is supposed to forgo.
There is one potential hiccup to the plan, however: The electoral platform may have been overly optimistic with respect to how much additional revenues the new tax bracket at the top will raise. Starting with Nova Scotia in 2010, six provinces have already increased their top tax rate, with Quebec, Ontario, and four other provinces having combined federal/provincial top tax rates equal or greater than 50 per cent. The tax room at the top is shrinking.
Both real-world experience and the economic literature show that very high-income taxpayers are more sensitive than others to tax rate hikes. The reason: High-income earners find ways to reduce taxable income, leading to a shrinkage in the tax base.
Confronted by a marginal income tax rate increase, high-income taxpayers may respond in various ways. Some may do nothing, but others may reduce their work and entrepreneurial efforts. Others may postpone an important taxable transaction, modify their sources and forms of compensation, and move out to, or avoid moving from, a lower-tax jurisdiction. Whatever the behavioural changes, studies have shown that tax hikes on very high incomes yield less than expected.
In a C.D. Howe Institute study published today, I estimated that the proposed federal tax changes could cost federal and provincial governments’ $4 billion in lost tax revenue. So the stakes are high.
The cost of the broad-based middle-income bracket tax rate reduction can be fairly reliably estimated at around $3.5 billion. This tax relief has been drawn up with the expectation that revenue losses will be fully compensated by additional revenues from the high-income tax hike. But using a measure of behavioral response consistent with a large body of recent economic literature, I estimated that the high-income tax rate would more likely yield less than $1 billion in revenue for the federal government, well short of expectations.
The result has the potential to create yet another negative fiscal surprise for the new federal finance minister. But it gets worse. Erosion of the national personal taxable income base will affect provincial revenues as well since both orders of government share the same income base. The negative impact on provincial revenues will be larger than for federal revenues because the provinces will suffer reduced taxable income bases but without any compensating rise in their tax rates. The proposed federal hike would likely cost provincial treasuries about $1.4 billion in personal income tax revenues. Since the provincial losses exceed the $1 billion in federal gains, the proposed hike would be a revenue loser on a national scale.
In theory, taxing those who need the money less to give to others who need it more is welfare improving. To that end, the current tax and benefit system is already highly progressive in nature. And whether it should be made even more progressive is a collective decision worth exploring. But in doing so, it would be a big mistake to turn a blind eye on potential tax revenue leakage and economic costs. The extent of the potential revenue shortfall highlighted here will result in deficits to be financed with higher taxes elsewhere, or with unplanned spending cuts – a burden in all likelihood that would fall on those same taxpayers that the reform is intended to relieve.
At the very least, the federal government should proceed with caution by adopting prudent budgeting practices with respect to potential behavioural responses, consistent with the level found in the literature. And instead of raising income taxes on high-income earners, the federal government could explore other progressive, but less economically damaging ways of raising revenues. Markets and taxpayers tend to prefer positive budget surprises to negative ones.
Alexandre Laurin is Director of Research at the C.D. Howe Institute.
Published in the Financial Post
