Alexandre Laurin is associate director of research at the C.D. Howe Institute.
The Ontario budget rejected by opposition parties is now at the heart of the provincial Liberals' election campaign. At its heart was a proposed tax increase on personal income over $150,000 by 1.56 per cent (including the surtax) and a drastic lowering of the top income-tax bracket threshold, which means that the top combined Ontario-federal tax rate of nearly 50 per cent would apply on incomes over $220,000, down from the current $514,090.
Faced with a $12.5-billion deficit, raising taxes may sound like a good idea. But it is foolish to think that a targeted increase on high-income earners will yield enough to poke a hole in the deficit, or pay in any substantial way for enhanced public transit or public service wages and benefits. Experience has shown that taxpayers will adjust their behaviour to reduce the impact of the hikes on their tax liabilities, leaving the province with yet another shortfall of revenues over planned spending.
The first effect of tax changes is mechanical; higher rates generally lead to higher revenues. If taxpayers don't react to the tax hike, I calculate that the higher tax rates would lead to about $300-million more going to the government next year. The proposed budget estimated the proposed hikes would yield more than $600-million. These estimated amounts are very small. They represent a tiny fraction of the budget deficit, and revenues of this magnitude could be generated by economic growth of about half a per cent.
Actual tax receipts would almost certainly turn out even lower than that. We know that taxpayers, especially at higher levels of income where they already face high rates, respond to tax changes by adjusting their behaviour. When faced with higher taxes, taxpayers may reduce their paid work or substitute employment income for other less-taxed sources of income, such as capital gains. Or they may plan their affairs by, for example, adjusting the timing of significant transactions, moving elsewhere just before concluding important transactions or legally using trusts located outside the province. In short, taxpayers will react to a tax hike by attempting to reduce their taxable income as much as possible, reducing tax receipts in the process.
On the basis of Finance Canada's tax responsiveness estimates, I calculate that the proposed tax hikes would result in affected taxpayers reporting approximately 2 per cent less taxable income, costing the Ontario tax base about $1-billion a year. This erosion of the tax base – comprised of taxable income taxed at the highest marginal rate – would reduce expected tax receipts from the hike by two-thirds, delivering to the government only about $100- to $200-million annually in the next few years.
But these are only near-term impacts. In the long run, higher top tax rates will negatively affect education, career and other personal investment decisions. Whether it would be training for skills upgrading or expansion of small business activities, those are often investments demanding sustained efforts for an uncertain payoff. The more governments take away from the potential rewards, the less the incentive to invest time and money. These issues are critically important when thinking of top tax rates and the extent to which they may dampen incentives for career advancement, training, business development and entrepreneurship.
We do not have many empirical estimates on the magnitude of these long-run effects, but that does not mean that policymakers should ignore them. A 2011 study published by the C.D. Howe Institute, looking at both short- and long-run impacts, estimated it would cost Ontario's economy $1.16 to raise one additional dollar of tax revenues through a top tax rate hike.
The proposed budget tax hike would not raise enough tax revenues to justify the high costs it would impose on the tax base and the economy. Worst, trying to finance newly budgeted spending by counting on additional tax revenue that will never be collected would actually grow – instead of reduce – the province's huge budget deficit.