Does your income vary significantly from one year to the next?
If so, you’re likely already well aware of the “tax penalty” you suffer due to the progressive nature of our tax system and its graduated rates. In other words, the more you make in a given year, the higher up the graduated rate ladder you climb, resulting in a higher tax bill.
A new report out last week from the C.D. Howe Institute entitled “A Question of Fairness: Time to Reconsider Income-Averaging Provisions,” takes a deeper look at this issue and attempts to quantify the “unfair” tax penalty Canadians face on swings in their income from year to year. The report’s co-authors, Jean‐François Wen and Daniel V. Gordon, economics professors from the University of Calgary, found that the tax bite is worst for lower-income Canadians and, not surprisingly, small business owners with fluctuating incomes, who are already facing looming tax changes to the taxation of their private corporations.
“Individuals whose incomes are irregular or fluctuate year-by-year face a greater tax burden than people with steady incomes,” says Professor Wen. “I call it the ‘fluctuation penalty.’ Reintroducing income-averaging provisions in the tax code would make the tax system fairer and encourage entrepreneurship.”
In what the Institute has labelled, “groundbreaking research,” the authors track the individual incomes of Canadians for six consecutive years from 2005 to 2010 using a Statistics Canada’s database. They identify the characteristics of individuals with “high penalties” and assess the fairness of the outcomes.
To illustrate the issue, the authors use the following example of an Ontario taxpayer, with no dependents who earns $50,000 in 2016 and $100,000 this year. Her resulting average income is therefore simply $75,000 per year.
But when it comes to computing her tax bill, however, she will pay about $1,900 more in total taxes for 2016 and 2017 than if she had earned, instead, $75,000 in each of the two years. If we annualize that $1,900 over the two year years, that means that on an annual basis, her extra tax liability is nearly $1,000 or 1.3 per cent of her average annual income.
A similar tax penalty on fluctuating income would occur if her 2016 and 2017 earnings were reversed — in other words, if her income had fallen from $100,000 in 2016 to $50,000 in 2017.
“The fluctuation penalty is a policy concern for reasons of fairness and the adverse incentives it may create for risk-taking activities, such as entrepreneurship, notes Wen. “Further, we find the fluctuation penalty is most acute for lower-income persons.”
For those who are old enough to remember, we did have income averaging in our tax system nearly thirty years ago. Indeed, prior to 1989, the tax rules permitted taxpayers to smooth their taxable incomes by using an average of more than one year’s income as the basis for calculating the tax liability. Those provisions were ultimately removed when the number of federal tax brackets was reduced from 10 to three to simplify the tax code.
But in 2017, we have five federal brackets: zero to $45,916 (15 per cent), $45,916 to $91,831 (20.5 per cent), $91,831 to $142,353 (26 per cent), $142,353 to $202,800 (29 per cent), with anything above that being taxed at 33 per cent, the new high-income bracket introduced by the government in 2016. Each province also has its own set of provincial tax brackets, which vary widely from the federal ones. This results in an Ontario taxpayer, for example, actually having 11 effective tax brackets, ranging from a total combined federal/provincial rate of 20 per cent to 53.5 per cent once the federal, Ontario and surtax rates are taken into account.
The authors say that the time for tax reform is ripe, with the recent increase in the number of federal and provincial tax brackets combined with the fact that incomes have been less stable in Canada since the 1970s, particularly with the growth of the part-time work in the so-called sharing economy. They advocate for the reintroduction of the income-averaging provisions which they feel would help address the fluctuation penalty.
So how would income averaging work?
The authors focus on two main methods that could be used: general income averaging and general forward averaging. The methods are quite complex, but here’s a high-level simplification of each method.
General Income Averaging
This method looks at “threshold income” which is 110 per cent above the previous year’s income or 120 per cent above the average of the preceding four years’ income, if this is greater. The taxpayer would then get a break in the form of a lower tax rate, but only on the portion of the current year’s income that is above the threshold.
The general income-averaging provision existed in Canada between 1972 and 1982 and applied to all types and sources of income.
General Forward Averaging
Unlike general income averaging, which is backward looking, another method is general forward averaging in which you elect to defer taxes by shifting current income to future years, in anticipation of earning less income in those later years and thus facing lower marginal tax rates.
With this method, an individual has the option to exclude a certain amount of income from tax in the current year. A withholding tax is applied to the excluded amount and this exclusion is added to the taxpayer’s total “accumulated averaging amount.” This balance is drawn down in the future years by adding amounts of it to your income in those years. In those years, the prepaid taxes are credited against the taxes currently owed.
Both the prepaid tax and the accumulated averaging amount are indexed for inflation and a formula determines how much income is eligible to be excluded from tax in a given year.
The forward income-averaging mechanism was applied in Canada from 1982 to 1988.