Tax policy is about more than collecting enough revenues to pay for government services. It is a powerful policy tool that has a significant impact on individual decisions such as whether to save and invest, work extra hours, and invest in one's education and skills, as well as business decisions regarding hiring and investment. Getting it right matters. And this means we need to think carefully about marginal tax rates.
What are marginal tax rates and why should we care about them?
A marginal tax rate refers to the tax rate an individual or business pays on the last dollar of income earned. As a taxpayer moves into a higher income level, the marginal tax rate applies to his or her additional income. As a point of illustration, the federal government taxes an individual's first $43,561 at 15 per cent, then taxes any income between $43,561 and $87,123 at 22 per cent. So if a taxpayer earns $45,000, his or her marginal tax rate is 22 per cent.
The evidence is clear: Marginal rates impact individual behaviour and, ultimately, overall economic activity. High marginal rates can discourage people from working more hours, or businesses from starting or growing. There is some debate among economists about the extent to which marginal rates influence individual decisions, but there is no real dispute over the basic premise.
What does this mean for Canada? As demonstrated in a new Fraser Institute paper released Thursday, Canada's marginal tax rates are relatively high when placed in an international context.
It may not appear that way on the face of it. The federal government's top statutory rate of 29 per cent is low compared with other industrialized countries. But this only tells part of the story. Any assessment of Canadian tax rates needs to account for the provincial tax rates (which are applied on top of federal rates) and the income level at which top marginal rates take effect.
Canada places a greater emphasis on provincial taxation than do other countries. For example, both Quebec and Ontario have steeply progressive income tax codes, with top rates of 24 per cent and 18.97 per cent, respectively. Canada's top marginal rates also kick in at lower income levels than in other countries, where the highest rates are limited to a small group of very high earners.
The combination of these factors means that Canadians pay higher marginal rates than Americans, Japanese and even the French. These high marginal tax rates represent a powerful disincentive for wealth creation and economic growth.
In light of these findings, what should be done? Two words: Tax reform.
Canadian governments should look at broadening their tax base by eliminating ineffective tax credits, deductions, and other special privileges, and flattening the tax rates. This policy – one that has achieved positive results here and elsewhere – can help to increase individual incomes and encourage higher rates of overall economic growth over the long term.
The federal government is set to articulate its vision for the next two years in the Speech from the Throne on Oct. 16. It has been a national leader in tax policy in the past, and its governing blueprint can serve as a useful catalyst for further progress in this area. Tax reform that is informed by the considerable body of evidence could be a critical part of its agenda, and in turn could galvanize a multi-jurisdictional step in the direction of lower marginal tax rates.
Clearly, marginal tax rates matter. They can be a disincentive for individuals and businesses if they are too high – especially if the rates are uncompetitive compared to the United States and other jurisdictions. Since its bold spending cuts and later tax relief of the mid-and-late 1990s, Canada's federal government has been a model of fiscal prudence and discipline compared with the rest of the world. If only the provincial governments would follow suit with comparable reforms, Canada would be in an excellent position to attract capital and skilled workers from around the world, and take full advantage of our own domestic resources and labour force.
Jason Clemens is executive vice-president, and Sean Speer is associate director of Fiscal Studies, at the Fraser Institute. www.fraserinstitute.org