Tax law is driven by policy. Every rule has an underlying rationale, which is purportedly translated into legislative language in the statute. However, sloppy drafting or interpretation can distort the policy of a rule, Tax policy concerns the efficiency with which we implement transfers of resources from the private to the public sector, the value and benefit that society derives from the process.
A tax system should raise sufficient revenue to finance government operations. A good tax system, however, is also concerned with the manner in which we collect the revenue. It should be neutral and efficient, fair and equitable, certain, administratively simple and easy to comply with. These are often conflicting goals, and all the more so if we use tax law to implement economic, social, political and cultural objectives. Hence, ultimately, all tax law is a compromise of competing values. Tax policy analysis should evaluate the effectiveness and efficiency of the comprises.
REVENUE GENERATION
The Tax Base
Governments levy income taxes to raise revenues for public purposes. The amount of revenue that a tax system raises for government is a function of a simple mathematical formula:
Revenue = Tax Base x Tax Rate
Alternatively, the amount of income tax that a taxpayer must pay is a function of the same formula:
Tax payable = Tax Base x Tax Rate
Thus, there are only two variables that directly determine the amount of revenue that a tax system raises. The formula (tax base x tax rate) is simple, but the interplay between these two variables is not as simple as it appears. The tax base can be manipulated through prohibitions, exemptions, credits and deductions. In Canada, notwithstanding the Carter Commission's recommendations in 1966 that a "buck is a buck" and should be taxed as such, we do not have a comprehensive tax base (CTB). Indeed, as we shall see in succeeding chapters, the tax base is riddled with exclusions, exemptions and special reductions that ensure that a buck in not a buck. For example, we tax employment income, business income and capital gains at different rates, which can vary from zero to more than 50 per cent.
The relationship between the tax base and tax rates also influences the manner in which we achieve other non-revenue objectives. For example, the size and character of the tax base and tax rates can affect the fairness of the system, economic efficiency certainty of tax laws, the costs of compliance, and tax avoidance.
When non-lawyers talk about tax, they usually focus on tax rates. For example, an individual may complain that the top federal tax rate of 33 per cent is too high. However, tax lawyers spend most of their time trying to manipulate the tax base to a lower level. Hence, for example, a tax lawyer would try to reduce the threshold at which an individual's top rate kicks in ($205,842 in 2018) to a lower level, in order to reduce the overall tax bill.
A tax system with a broad tax base is usually simpler, and more certain, than a system with a narrowly constrained base. This is because a broad-based system requires fewer lines of demarcation between classifications of income, expenditures, and exclusions than a narrowly based system. For example, a system that taxes all forms of gains, regardless of their source, requires fewer rules than a system that distinguishes between business income, investment income, and capital gains. Similarly, a system that taxes all forms of capital gains in the same manner will be simpler than one that differentiates between different forms of capital gains that taxes each type at different rates.
The tax base for federal income tax purposes is "taxable income". The provinces can elect to use one of two bases for the purposes of provincial tax: (a) federal "taxable income", or (b) "federal tax payable". The provincial tax for individuals (except in Quebec) piggybacks on the federal tax base. Hence, any changes to the federal taxable base almost invariably affect provincial revenues.
The political interplay between the tax base and rate is also important. Governments do not generally like to raise rates prior to an election, unless the rate increase is on the top 1 per cent of the population. However, they like to lower the rate on the middle class, which has obvious benefits. At the same time, they can broaden the base by eliminating deductions and credits, which has the less obvious advantage of increasing taxes without appearing to do so.
TAX RATES
The second element in determining government revenues is the rate that one applies to the tax base. The term "tax rate" is ambiguous and leads to misunderstandings in discussions about taxes. In theory, if we ignore behavioral responses to tax rates, a rate of 40 per cent will produce a greater amount of revenue than a tax rate of 20 per cent. However, we cannot ignore behavioural responses to rate changes. A reduction in tax rates may actually stimulate economic growth and enhances overall revenues, which, in turn, will lead to additional tax revenues.
Hence, we must consider three different tax rates, marginal, average, and effective, to determine their ultimate effect on taxes raised and taxes paid.
- Marginal rates
The marginal tax rate is the level of tax that applies to the next dollar of taxable income.
Marginal rates are the key to tax planning. As marginal rates rise, the total tax payable increases by a rate that is more than proportional to the increase in income.
For example, the following are the five federal marginal rates on taxable income for individuals in 2018:
Hence, for example, if Harry earns $30,000 taxable income, he would pay basic federal tax at a marginal rate of 15 per cent. In contrast, if Janice earns taxable income of more than $205,842, she would have a federal marginal rate of 33 per cent, but would pay that percentage only on her income over that amount.
The marginal rate is important in tax planning because it tells us how much more tax a taxpayer will pay as income increases, and how much he or she will save in taxes as income falls. Thus, marginal rates tell us the tax cost or tax benefit of the next transaction, which is what concerns tax lawyers and bankers.
For example, an individual with a 33per cent marginal rate will save tax at that rate if she contributes to a registered pension plan, and reduces her current taxable income. If she is taxed at a lower marginal rate (say 26 per cent) when she retires, she will save tax in the long run. Hence, she saves 7 per cent in the long run. Additionally, she will defer her current tax liability to a later date, which is another form of saving.
- Average rates
The average tax rate tells us the tax rate payable on the taxpayer's entire income. Hence, it measures the total tax burden of the taxpayer. We obtain the "average rate" of tax by dividing the total tax payable by the tax base. If Jane earns $25,000 and pays $3,750 tax, her average tax rate is 15 per cent. This is the rate that people implicitly refer to when they complain that their taxes are too high, or that their neighbour's taxes are too low.
The average rate reflects the weighted average of all the marginal tax rates. Hence, by definition, an individual's average rate of tax is usually lower than his or her marginal rate. For example, the average federal tax rate of an individual who earns taxable income of $30,000 is $4,500, that is, 15 per cent. In this case, the average and the marginal rates are equal because only one federal marginal rate (15 per cent) applies to all of the income. However, if Janice earned taxable income of $250,000 in 2018, she would pay (before credits) federal tax of $62,242, which makes her average rate of tax 25 per cent — that is, 8 per cent lower than her federal marginal rate of 33 per cent.
In a flat tax system, the average rate is equal to the marginal rate. For example, if the flat tax rate is 26 per cent, an individual who earns $1,000,000 would pay $260,000 in tax. An individual who earns $100,000 would pay $26,000. Both individuals would have also have the same marginal rate of 26 per cent.
This form of flat (proportional) taxation is politically controversial as being "unfair", but there are serious arguments on both sides.
Canada uses progressive marginal rates, where the rate of tax increases as income rises. The rate starts at 15 per cent, and then rises in steps to 20.5 per cent, 26 per cent, 29 per cent, and, finally, to 33 per cent. An individual pays tax on the first bracket of income at 15 per cent, 20.5 per cent on the second bracket, 26 per cent on the third bracket, 29 per cent on the fourth bracket, and 33 per cent on the fifth bracket. The marginal tax rate is always equal to the individual's highest tax bracket.
The marginal rate is the key to tax planning because it measures the amount of tax or benefit resulting from a decision or change. For example, in decisions involving buy or lease, agreements to enter a new contract or pay damages to exit an old one, we calculate the tax cost or benefit at the margin for engaging in the activity.
Example
Assume the following simplified marginal rate structure: Taxable Income Tax Rate
Amanda earns $60,000 and has $5,000 in savings, which she want to invest in financial investment that will return $5,000 and pay an additional $1,000 interest at the end of one year. Without the investment, Amanda will owe $9,000 in taxes — that is, $5,000 on the first bracket, and $4000 on the second bracket.
The $1,000 of investment income will be taxed at 40 per cent because Amanda is in the second bracket. Hence, her total tax bill will rise to $9,400. She will retain only $600 net of taxes from her investment. Thus, her after-tax rate of return is 12 per cent — that is, $600 divided by $5,000. The marginal rate of tax times the increment in income gives us the result without having to recalculate her entire tax liability.
At the same time, Amanda's average rate of tax after the investment is 15 per cent — that is, $9,400 divided by $61,000. However, since, the average rate of tax merely reflects her total tax burden, she will not find the rate of tax helpful in making her investment decision. She should make her decision using her marginal tax rate, which reflects her incremental cost or savings.
- Effective rates
The "effective rate" of tax is the total tax payable divided by net income for tax purposes, before exclusions, credits, and exemptions. For example, since only one-half of capital gains are taxable as income, the effective tax rate on capital gains is only one-half of the taxpayer's marginal rate. For certain exempt capital gains, the effective rate is zero [section 110.6].
In the above example, assume that an individual has income of $210,000, including $60,000 of capital gains in the year. By excluding one-half of the capital gains from taxable income, the individual reduces her taxable income by $30,000. The individual's effective federal tax rate is the actual tax payable divided by her "real" net income of $210,000.
Effective tax rates are a yardstick for comparing taxes between individuals, and between different countries. Every exemption and credit reduces the tax base, which, in effect, lowers the effective tax rate. Thus, one can broaden the tax base and lower the tax rate to promote fairness and achieve economic efficiency.
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