Kevin Milligan is Associate Professor of Economics at the University of British Columbia
President Obama's proposal to add a new $1-million tax bracket for high income Americans has generated much discussion both in the United States and here in Canada. I think this is a productive and important discussion for Canadians to undertake.
However, an informed discussion requires some information. Here are five nuggets of information Canadians should keep in mind as the high income taxation discussion unfolds.
First, pre-tax income inequality has grown tremendously in Canada over the last 25 years. The effect is concentrated among those with highest incomes. The higher incomes comprise predominantly earned income, not passive capital income. These trends mean that if we just want to keep the after-tax income distribution where it was during the Mulroney years, we would need a substantial shift in taxation toward higher-earners.
Second, our existing income tax structure is nothing short of crazy. The graph shows the marginal tax rate (the tax owed on the last dollar earned) across different income levels for a two-child family in Manitoba in 2010, the clawback of both federal and provincial refundable tax credits. (Similar graphs for more provinces are here.) What redistributive goal is such a bizarre tax structure designed to achieve? A strong argument can be made that we should improve and reform our existing income tax structure before slapping more confusion on top of it.
Third, the threshold at which one reaches the highest tax bracket is exceedingly low in Canada compared to other countries. In the United Kingdom, one reaches the highest tax bracket of 50 per cent at the Canadian dollar equivalent of $234,000. In the United States, currently the highest federal rate of 35 per cent is reached at incomes of $379,150 (U.S.). In Canada, the highest federal rate is 29 per cent, reached only at $128,800. Just to reach the level of income tax progressivity observed in the United States under President George W. Bush, Canada would need to increase this high income threshold dramatically.
Fourth, we aren't in dire need of revenue. In the United States, there is a substantial long-run budget gap to close. It is reasonable to ask how much the closing of this gap should be borne by high earners compared to low earners. In Canada, our budget gap is much smaller, and trending down. We aren't faced with the same 'share the pain' question.
Finally, higher tax rates on high income earners cause reported taxable incomes to drop, leading to lower revenues than if we assume incomes just stay the same under higher taxation. If revenues drop a lot, it is possible in theory that we could see the new higher tax rate yield less revenue than the old lower tax. That is, we might be on the wrong side of the peak of the Laffer Curve. However, at current rates, we are unlikely to see such an effect. In the United Kingdom, credible evidence suggests the 'revenue maximizing tax rate' is around 55 per cent. My own rough calculations for Canada show a slightly higher number (around 57 per cent). The Laffer Curve phenomenon is a serious concern at higher income tax rate levels, but we're not there yet.
In closing, we should remember that Nova Scotia instituted a higher tax bracket starting at $150,000 in 2010. As data start rolling in, the rest of Canada should be able to learn from Nova Scotia's recent experience.
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Kevin Milligan