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Two-thirds of Canadians are owed money by Canada Revenue Agency at the end of the year, and the average refund is $1,200.

Lindsay Tedds is an Assistant Professor in the School of Public Administration at the University of Victoria

A key element of our tax system since the Second World War is tax withholding. Withholding is the amount of money deducted per pay cheque and sent to the Canada Revenue Agency by your employer to cover your tax liability for the year. The intent of withholding is to collect the amount of taxes owed by an individual in a given year through a series of small regular payments. Why is withholding a key feature in most personal income tax systems?

Withholding was added to our tax system in the 1940s, thanks in part to Milton Friedman, who was involved in the development of the withholding tax in the United States. Once implemented in the U.S. it did not take long for it to be effected in Canada. During the war, governments in the U.S. and Canada were faced with having to fund a very costly endeavour, and these costs were incurred daily. There became an immediate need to raise an enormous amount of revenues regularly to fund these regular costs. If you ignore the effects of inflation, the answer to the problem of raising revenue quickly was easy: print or borrow. But if you want to avoid inflation, you need to use tax money. Hence, withholding was implemented.

But if it was implemented to feed the war machine, why was it not abolished when the war ended? Even Milton Friedman argued that withholding should not be used outside of wartime. Much like income tax itself, which was invoked during wartime, withholding has become a staple of our tax system. Given the size of government and number of programs, particularly social programs with regular payment streams (including Old Age Security, GST credits, and the Universal Child Care Benefit), abolishing withholding would likely cause governments to increase short-term borrowing, which increases debt payments and feeds inflation -- both of which cut into economic growth. Indeed, the State of California recently increased its withholding rate by 10 per cent because of its budgetary crises.

Withholding is also meant to ease the perceived burden of paying taxes and hence minimize the negative effect of taxes on economic growth.

So it seems that withholding may be a positive feature of our tax system. But it is interesting to note that tax withholding rarely equals the actual amount owed. In fact, more is withheld than is necessary. According to an unpublished paper by Ling Chu and Alan MacNaughton, two-thirds of Canadians are owed money by CRA at the end of the year, and the average refund of $1,200 is significant.

Most economists would argue that excess withholding means poor tax planning on the part of the individual, as it means that the government was provided with an interest-free loan. Why is the average refund in Canada so sizeable? The amount employers withhold is based on the information provided by employees on the TD1 form, assuming your employer even thought to get you to fill one out. A quick gander at this form makes it clear that individuals have very little opportunity to reduce the amounts withheld. It misses many of our boutique tax credits and makes no allowance for one time RRSP contributions. An alternative is the T1213 form but the current terms of use of the form (e.g. filed annually and stated burden of proof) render it ineffectual for most working Canadians.

There may, however, actually be unintended long-term benefits to the incidence and intensity of tax refunds.

First, people spend lump sum payments versus streams of payments very differently. In particular, people spend 65 per cent of their regular income but only spend 32 per cent of income from lump-sum payments. That is, extra withholding results in increased savings. Withholding tricks people into substituting present consumption for future consumption, which aids economic growth.

Second, over-withholding also increases tax compliance: It encourages people to file a return; and those in a tax-owing position at tax time are more likely engage in noncompliant behaviour (like understating their income or overstating deductions).

Last, without withholding, more people will be shifted into a tax-owing position come tax time. It is certainly much more costly to collect money that is owed than it is to return money that has already been collected. Most people do not have enough knowledge of the tax system and enough discipline to set aside their tax liability from each dollar they earn.

While Milton may not have agreed with the continued use of withholding, its benefits may outweigh the costs.

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