BUDGET PLANNING FOR THE 2015 ELECTION
The Conservative government is in a quandary about what to do with the surpluses projected to begin in 2015-16. As for the Opposition Parties, they aren’t saying much.
In the 2011 election campaign, the Conservative party promised a number of initiatives that they would implement once the budget was in balance. These included income splitting for families with children eighteen years of age or under, the doubling of the existing child fitness tax credit, the introduction of a similar tax credit for adults, and the doubling of the Tax Free Savings Account (TFSA). No one paid any real attention to these promises until the February Budget.
After the February budget, Mr. Flaherty commented that income splitting might not be the best way to use the rather modest surpluses he was projecting. This caused quite a backlash against Mr. Flaherty in the Conservative Party. Despite abundant evidence that income splitting was bad tax policy, proponents of income splitting argued that the Conservative Party always lived up to election promises, and this could not change now.
The political spin was that a surplus had not yet been achieved and until then all options regarding the use of the surpluses would be considered. The spin message, however, has recently changed. The Prime Minister has now said he is still committed to income splitting and Mr. Kenney has said that income splitting would be of great benefit to “stable families”. In his view, high-income families with one spouse at home are “stable”, and therefore deserving of tax support, while other families are not.
Of course Mr. Flaherty’s instincts are dead on. Income splitting is bad policy. The evidence is very clear. Only 15 per cent of families would benefit from income splitting and over 40 per cent of these families would have income over $125,000. Single parent families and families with two earners in the same tax bracket would get nothing. The Opposition parties are no doubt hoping that the Conservative Party will include income splitting in their 2015 election platform. It would clearly separate the policy objectives of the Conservatives from those of the other parties.
The Conservative government has for the most part been following a tax reduction strategy that targets specific groups. These include: the fitness and art tax credits for children; the tax credit for public transport; tax free savings accounts; splitting pension income for tax purposes; tax credits for volunteer fireman; and a Search and Rescue Volunteer Tax Credit; to mention only a few. High-income families would benefit most from these targeted tax cuts.
Apart from their 2011 election promises, the Conservative government is also committed to paying down debt. This commitment has been made in a number of budgets, beginning with Budget 2006. The commitment is to pay down $3 billion annually from the projected surpluses. This seems like a reasonable commitment, given the $160 billion in debt that has been created since the Conservatives were elected. The problem is, however, that this commitment would use up a large part of the modest surpluses that are projected. Mr. Flaherty is already ruminating that this commitment may be “postponed”. It will be interesting to see how the Conservative base will react to this postponement.
The budget implications for the Conservatives of living up to their commitments are set out in the table below. About three-quarters of the projected surpluses would be used up by these commitments made more than three years ago. Over the four years, 2015-16 to 2018-19, the total cost of the commitments amounts to about $24 billion, evenly split between debt reduction and targeted tax relief. This leaves little left for new policy initiatives, if the Conservatives are re-elected.
The cost for the doubling of the Tax Free Savings Account (TFSA) was estimated at $30 million in 2015-16. These costs will increase significantly over time. In a recent article in the Globe and Mail (March 4), Professor Rys Kesselman of Simon Fraser University noted, “While the revenue cost of doubling the TFSA would be modest, the long-run budgetary impact would be enormous…with the annual revenue loss of potentially more than $10 billion”.
Budget Planning: Conservative Commitments ($ billions)
2015-16 2016-1 2017-18 2018-19 Total
Budget 2015 Balance 6.4 8.1 8.1 10.3 32.9
Debt reduction -3.0 -3.0 -3.0 -3.0 -12.0
2011 Election promises(1)
Income splitting -2.5 -2.6 -2.7 -2.7 -10.5
Child Fitness Tax Credit -0.1 -0.1 -0.1 -0.1 -0.4
Adult Fitness Tax Credit -0.3 -0.3 -0.3 -0.3 -1.2
Tax-Free Savings Acc’t -0.0 -0.0 -0.0 -0.0 -0.1
Total -2.9 -3.0 -3.1 -3.1 -12.2
Small business tax rate ? ? ? ? ?
Defence re-profiling ? ? ? ? ?
Total -5.9 -6.0 -6.1 -6.1 -24.2
Remaining Balance 0.5 2.1 2.0 4.2 8.7
1. Conservative Party’s Election Platform 2011 and authors’ calculations. Doubling of Tax-Free Savings Account estimated at $30 million in 2015-16. Budget 2014 promised reduction in tax rate for new small businesses. Budgets 2012 and 2014 re-profiled $6.5 billion of defence spending to future years.
Equally troubling is his conclusion that “only the top 2 per cent of income earners would reap the gains from doubling the TFSA limits”. The TFSA not only has all the worse characteristics of income splitting but eventually will cost a great deal more.
In addition, no profile has been attached to the $6.5 billion of defence spending that was postponed in the 2012 and 2014 budgets “into the unknown future”. It may not appear in the period 2015-16 to 2018-19, but some government in the future is going to have to face up to the implications of not restoring defence funding.
What makes this budget plan and its policy commitments even more inadequate is that none of them will contribute to a strengthening in the economic growth potential of the economy, at a time when such strengthening is absolutely critical. After years of restraint and expenditure cutting, the first thing the Conservative government proposes to do is give tax breaks to high-income Canadians, along with a tax credit to encourage them to start exercising, something they are already probably doing.
Surely the Conservative government can think up a better budget plan than this.
What is required is a budget plan that would contribute to achieving a number of objectives. First, the budget should propose a way to find new financial resources without raising taxes on middle-income Canadians. Second, the budget plan should strengthen potential economic growth through improved productivity growth and higher labor force participation. Third, the plan should improve the progressivity of the income tax system. And lastly, the plan should help reduce income inequality on an after tax basis. The current Conservative budget plan does not meet any of these objectives.
There is pretty much unanimity among tax practitioners and economists that the Federal Income Tax System needs to be simplified. The Income War Tax Act of 1917 consisted of 11 pages. Today, including regulations and commentary, the Income Tax Act (ITA) is 2800 pages long
Not only has the ITA grown in size, it has also grown in complexity. In addition to raising taxes, governments have used the ITA to implement economic and social policies through special tax preferences or expenditures for all sorts of purposes, groups, industries, sectors, and regions. It is estimated to day that these tax preferences cost over $100 billion annually in lost revenues, an amount not much smaller than total direct program spending.
Unfortunately, Parliament has no mandate to examine tax expenditures even though many tax expenditures are simply program spending in disguise. In the 2010 and 2012 reviews of government spending there was no attempt to find any savings by eliminating ineffective and unnecessary tax expenditures. As a number of commentators have pointed out, the use of non-refundable tax expenditures distorts the true size of government – reducing both revenues and expenses as a share of the economy.
Simplification and reform of the tax system could easily yield $5 billion or more in additional revenues.
So why have governments been so reluctant to undertake simplification of the tax system. The reason is simple. Every special tax preference has a constituency that believes it is “entitled” to this tax preference simply because they already have it. Tax simplification would require immense political will to withstand the political lobbying that would descend on Ottawa.
The House of Commons Standing Committee of Finance has repeatedly called for an overhaul of the tax system. They have recommended that establishment of a Blue Ribbon Panel to look at tax simplification. Others are recommending a Royal Commission. In our view a Royal Commission would be a mistake since it would only drag out the process and weaken the chances of success. In order to succeed, tax simplification needs to be undertaken as part of a broader reform of the tax system, which allows the benefits of simplification to be re-cycled into lower taxes for Canadians.
The current ITA provides a major impediment to stronger productivity growth. The special tax benefits that “litter” the tax system, distort market decisions and resource allocation, and create market inefficiencies. Tax simplification, in addition to raising additional revenues, would make a major contribution to improving the potential economic growth of the economy.
The table below sets out the fiscal cost of an Alternative 2015 budget plan, which we believe meets all four objectives. Panel A shows the modest surpluses that the government projected in Budget 2014. Panel B summarizes how additional funds could be raised: first, through tax simplification; and second, by raising the highest Personal Income Tax rate rate from 29% to 30%. This would apply to income above $136,270. These two initiatives alone would increase the cumulative funds available over the four years from almost $33 billion to $50.5 billion.
Panel D demonstrates how these funds could be used to mee-t the four objectives set out above over the four years. First, $12 billion would be used to reduce federal debt. Second, $22 billion would be used to reduce taxes for low- and middle- income Canadians. The tax reduction package consists of three elements: a doubling of the Working Income Tax benefit; an increase in the National Child Tax benefit of $300 per child; and, increases in the first and second tax brackets by $5000. Every taxpayer in Canada would benefit from this tax reduction package. Finally, $16.5 billion would be available for new infrastructure investments.
The income tax system, as it applies to low- and middle-income families, is “plagued” with high marginal effective tax rates (METR), which can create major disincentives for those seeking additional work. As income rises through prescribed brackets in the tax system, the tax paid on every additional dollar of income also rises. In other words, the marginal effective tax rate rises. This is what makes the tax system progressive.
Budget Planning: Alternative Budget ($billions)
2015-16 2016-17 2017-18 2018-19 Total
Budget 2014 Balance 6.4 8.1 8.1 10.3 32.9
Source of New Funds
Tax simplification 0.5 3.5 5.0 5.0 14.0
Raise highest PIT Rate 0.3 1.1 1.1 1.1 3.6
Total 0.8 4.6 6.1 6.1 17.6
Total Source of Funds 7.2 12.7 14.2 16.4 50.5
Uses of Funds
Debt reduction -3.0 -3.0 -3.0 -3.0 -12.0
Doubling WITB -1.2 -1.2 -1.2 -1.2 -4.8
Increase CTB by $300 -1.2 -1.5 -1.5 -1.5 -5.7
Raise 2nd/3rd tax brackets -0.0 -3.4 -3.5 -3.7 -11.5
Total -6.3 -9.1 -9.2 -9.4 -34.0
Balance (infrastructure) 1.0 3.6 5.0 7.0 16.5
Source: Department of Finance, Parliamentary Budget Officer and authors’ calculations.
For low- and middle-income earners, however, who receive additional income support through government (federal and provincial) programs (e.g. working income tax benefit, child tax benefit), these METRs can be quite high. This is because these benefits start to be “clawed back” or “taxed back” after a certain income threshold is reached.
According to a study (July 17, 2013) released by the C.D. Howe Institute “These Marginal effective tax rates, on each extra dollar of income for a working family with two children, can be as high as 80 per cent in Quebec, and higher than 60 per cent in most provinces”. In other words, for every extra dollar earned by working, these families would lose 80 cents and 60 cents in benefits.
Government income support programs that have tax claw backs inevitably create high marginal effective tax rates and these can create major impediments for low- and middle-income families with one spouse involved in part time work. Federal and provincial programs interact with each other, thereby making the work disincentive problem even worse. This has been a problem ever since “universality” was done away with.
The C.D. Howe study concluded “Government benefits are valuable to low-income families, but their effects on METRs make taking on extra work less worthwhile than otherwise. This dilemma cautions against further expansion of the targeted transfer system. Alternatives aimed at supporting low-income families, through universal, in-kind programs, such a community facilities and services aimed at neighborhoods, would be better”. Perhaps the expansion of the universal child-care program would be an alternative worth considering. At a minimum, the federal and provincial governments should work together to find a way to simplify these programs and reduce the high METRs that currently exist.
The Alternative 2015 budget plan provides a tax reduction focused on low- and middle-income Canadians more than twice the size of the tax reduction for high income Canadians promised in the Conservative budget plan. In addition, there would still be sufficient funds left over for needed infrastructure investments (Panel E). If these investments were financed through debt rather than current revenues, (insert reference to last politics article) then it would be possible to provide even larger tax reductions for all Canadians.
Finally, what more could a small ”c” fiscal conservative ask for? All of this could be done, while still maintaining a low and stable debt burden.