This article has come out two months too late. If you have followed the trajectory that Queen’s Commerce (or equivalent programs) have lobbed you in, your tax rate has, as of January 1st, increased from 0 to one of the highest brackets. In 2014, you likely worked just enough to use up all of your deferred education credits. Now you venture unshielded into bonus-season. You have never filed a tax return, and so have no idea that metro-passes are tax-deductible. $2.70 tokens probably made sense two months ago. Last month, after applying a 40% tax shield, a metro-pass easily becomes more economical, requiring only one ride a day to break-even.
There are real economic implications of understanding taxes. That seems sensible. But it isn’t. The point of taxes is to provide revenue to the government and encourage or discourage certain behaviors. If you had to think about it, a tax isn’t doing what it’s designed to do. If you didn’t know you could get a tax credit from a metro-pass, then you are not being encouraged to take a metro. More importantly, if you are deviating from value-maximizing behavior as rational people generally take, then the tax is creating deadweight loss.
So a tax regime has failed when people move from a 0% tax rate to a 40% tax rate overnight. No underlying economic condition has changed yet the difference in tax regime causes different behaviors. One of these two sets of behaviors must be inefficient.
To illustrate the inefficiency, consider the job market for incoming graduates. One company offers a signing bonus while another offers a one-time year-end bonus that is of equivalent value. Graduates will be unnaturally drawn to the company offering a signing bonus because it would be taxed in the low-tax-rate year whereas a year-end bonus would be taxed in the high-tax-rate year. Thus resources are being allocated according to tax-related policies, instead of real economic effects.
There are a few takeaways from this brief discussion. First, companies should always offer new graduates a signing bonus, even if it means a lower salary. Second, the tax regime should correct for these inefficiencies. One idea is apply tax rates based on average income over a period of time. This is particularly meaningful for people in more volatile professions. People who make the same amount of money as others over a long period of time, but have more volatile incomes should not be subject to more tax as more stable income earners. Another idea is the prospect of lifetime progressive taxation. Here, the marginal tax is calculated based on income made over a lifetime. In theory, this method appears the most sensible. But it would only work if people saved prudently, and that isn’t likely.
Finally, we should consider the goals of taxation in more detail. The view that taxation should intrinsically be progressive (i.e. richer people are taxed more) is wrong. If that were true, the populous would never allow governments to implement the HST. No, taxes are primarily based on short term views on how to raise the most amount of money. The famous laffer curve says that no taxes would be raised should rates be 0 or 100%. The laffer curve should be maximized somewhere in between. Thus the ideal policy should encourage people to make enough money such that such money can be taxed.
For normal earnings, such as primary employment income, the current marginal tax system works well. Again, the reason is not because taxes should intrinsically be progressive. Instead, rising marginal rates keep marginal utility constant. Generally, people’s basic expenditures are similar and fixed regardless of income. A low starting marginal tax rate allows people to have access to basic needs. Further income is taxed higher, but you need less further income to improve life. (In fact, I would advocate for much fewer tranches of marginal tax rates, probably three. The first tranche is taxed at 0 or very little and allows people to satisfy their fixed expenses; the second tranche is taxed at a low amount, say 20-30%, that satisfies the needs of most middle income families, such as car, cell phones, birthday parties, movie tickets, books etc. This tranche should end higher than the median income to encourage the majority of people to earn more money. Anything above that should just be taxed at a flat rate. It would be assumed that any income in this tranche is used for discretionary activities that provide people a high utility, even when discounted at a higher tax rate. Note that our current taxation system follows this to an extent.)
Where our current taxation becomes problematic is for alternate sources of income. Under the current system of taxation, it makes more sense for a lower income individual to undertake new positive economic activity than a higher income individual, even when the positive economic activity is equivalent. This is exacerbated by higher income individuals potentially having less time, and thus an even higher opportunity cost to create extra positive economic activity. These perverse incentives are contrary to effective tax policy and should be changed. Secondary income, perhaps defined as the lower stream of income, should be taxed at some fixed rate (say ~20%).
Of course this kind of policy is subject to gaming, so certain restrictions must apply. People should not be allowed to take two part time jobs and have that count as two separate streams of income. If the second stream of income is similar to the first one, they should be combined. I would not say that anything like this is likely to be implemented, but thinking along these lines should be helpful in establishing a more economic tax policy.
As a final note, I will explain one tax-gaming idea that, to my knowledge, has since been closed by the government. The idea was to use the TFSA to hold securities in companies you own yourself (these companies can be ghost corporations that hold your property, etc). The companies would then dividend everything out to the TFSA, and pay no income. Doing this is illegal, but there are probably many other “loopholes” that aren’t. Clearly, understanding tax is essential to every economic decision. The first thing you therefore do is memorize this table http://www.taxtips.ca/taxrates/on.htm.