A policy issue that permeated political debates around the world in 2012 was the idea of raising taxes on high-income earners. In the U.S., it stood front and centre in President Obama's re-election. Several governments in Europe went beyond debate and introduced higher tax rates. Here at home, higher taxes on upper-income earners have been proposed at the federal and many provincial levels; Ontario's government recently instituted a new tax on those earning more than $500,000.
Unfortunately, the debates have been almost exclusively about the need to raise new revenues to reduce deficits rather than the broader issue of whether such taxes make good economic sense. The reality is that raising taxes on upper-income earners comes at a large economic cost.
It's true that polls consistently show majority support for increasing taxes on the wealthy. But so what? Populism is hardly a sufficient yardstick for good policy.
And consider what these polls measure. They essentially ask respondents if they want someone else to pay for their public services. So it's actually surprising that a recent poll found only 57 per cent of British Columbians support higher taxes on those making $100,000 or more.
Think of it this way: How many people would you expect to say yes if asked in a store whether they'd like to be given products at no charge because the store will charge only high-income shoppers? Wouldn't all but high earners favour such a plan?
The surprise in such polls is that support is not closer to 80 per cent. Why 80 per cent? Because only the top 20 per cent of earners pay more in taxes proportionately than they earn in income. Specifically, the top 20 per cent pay 54 per cent of all taxes (federal, provincial, and local) while earning 47 per cent of income. The remaining 80 per cent pay less in taxes than they earn in income.
Once we discard the populism of polls, we can better discern the real costs and benefits from imposing higher taxes on upper-income Canadians. A key policy objective of such taxes is the collection of more revenues. In reality, however, the amount of revenues flowing to the government is almost always less than expected. Part of the reason is that high-income earners can afford lawyers, accountants, and other tax specialists to arrange their affairs in a way that minimizes their tax burden.
A more vexing problem for those advocating higher income taxes is the economic costs of such taxes. Although economists disagree on many issues, there's a general consensus on the economic costs of various taxes. Research shows that income taxes generally impose higher costs compared to consumption taxes because income taxes more adversely affect people's decisions to work, save, invest, and be entrepreneurial. Because income taxes tend to discourage these growth-enhancing activities, relying on consumption taxes to raise the same amount of revenues would lead to a more productive and thriving economy.
Another cost to consider is competitiveness. Canada is simply not competitive when it comes to personal income taxes. Our tax rates are high compared to other G-7 countries and particularly the United States, with whom we compete most in trying to attract and retain skilled workers and entrepreneurs. Consider that the average highest combined federal-provincial income tax rate in Canada is roughly 45 per cent. In 2012, that combined average federal-provincial top rate was higher than the comparable rate in every U.S. state except three. Indeed, the top federal-provincial income tax rates in most provinces exceeded those in competing U.S. states.
In addition to high tax rates, Canada has relatively low income thresholds at which the rates apply. In other words, our personal income tax rates are high and kick in at low levels of income compared to those of our competitors. For example, in 2012 our top federal rate kicked in at $132,406 (Cdn) while the top federal rate in the U.S. started at $388,350 (US).
While raising taxes on high earners might generate popular support, doing so will have a modest impact on government revenues and will only make Canada less competitive and less attractive for investment, entrepreneurship, and business development. Canada has done much right in the past 15 years to get tax policy correct. Backsliding now will undo some of those gains.
A popular policy isn't necessarily the right policy. In this case, it's the wrong one.