Flat Tax
Principles and Issues

3 The flat tax applied: nine cases

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This section contains nine quantitative analyses based on Statistics Canada's Social Policy Simulation Database and Model (SPSD/M) of various implementations of a flat tax at the federal and provincial levels. The reforms included in each of the nine cases considered show the flat tax implemented to the extent possible within the SPSD/M. The application of the flat tax is, thus, restricted to personal income and does not include other major sources of tax revenue such as corporate income.

Cases 1 through 4 present the simplest scenarios. The first eliminates all tax credits, exemptions, and deductions in order to present the simplest, most straightforward case possible. The remaining three add a personal exemption of varying value, illustrating the rather large trade-off that exists between the value of the personal exemption and the corresponding tax rate.

Case 1

• no tax credits, exemptions or deductions

Case 2

• personal exemption ($7,231)
• no other deductions or exemptions

Case 3

• personal exemption ($8,766)
• no other deductions or exemptions

Case 4

• personal exemption ($17,532)
• no other deductions or exemptions

Cases 5, 6, and 7 introduce an exemption of $2,000 per child, and deductions for both contributions to retirement plans (RRSP/RPP) and donations to registered charities, illustrating the effects associated with the introduction of a variety of tax deductions and exemptions.

Case 5

• personal exemption ($8,766)
• exemption of $2,000 per child

Case 6

• personal exemption ($8,766)
• exemption of $2,000 per child
• current RRSP/RPP deduction

Case 7

• personal exemption ($8,766)
• exemption of $2,000 per child
• current RRSP/RPP deduction
• current deduction for charitable donations

Cases 8 and 9 introduce a reduction in spending by the federal government and a corresponding reduction in taxes. In the the previous seven cases, federal government spending was held neutral (constant).

Case 8

• $13.4 billion spending and tax reduction
• personal exemption ($11,834)
• exemption of $2,000 per child
• current RRSP/RPP deduction

Case 9

• $22.3 billion spending and tax reduction
• personal exemption ($11,834)
• exemption of $2,000 per child
• current RRSP/RPP deduction

Each case contains the respective tax rates charged by the federal and provincial governments. The combined or total flat-tax rate for each jurisdiction is also shown.

Analysis of tax distribution, which provides information on which income groups actually pay the income tax bill, is presented for all nine cases.

The study also presents relative measures of the tax distribution, specifically, the combined federal-provincial flat tax as well as the federal-only rate of flat tax relative to total income for each income group. The relative measures are presented in a separate table following the absolute measures of the tax distribution. In both cases, a brief discussion of the results contained in the tables is presented.

In addition to the overall distribution of taxation, analyses of five sample households from Ontario are presented. The five households were selected in order to highlight specific experiences with tax reform. Household 1 is a single individual aged 31, with no children, and earning $37,635, roughly the average industrial wage.

The second and third examples are family households with proximate incomes, both with two parents and two children. Household 2 is a family of two working parents aged 34 and 32, with two children aged 14 and 11, and earning a combined income of $55,840. Household 3 is a family of two parents aged 37 and 33, with two children aged 5 and 8, and earning a combined income of $56,783. The difference between these two households is that household 3 has one predominant income earner while household 2 has two people earning nearly equal incomes. In other words, one of the parents in household 3 essentially works in the home.

These two households are presented in order to illustrate the different effects the nine cases would have on households where incomes are similar but the work status of the parents differ. Thus, rather than viewing each household in isolation the two should be viewed simultaneously in order to compare the effect of the flat tax on a family of dual earners with the effect on a family supported by a single earner.

Households 4 and 5 are presented to illustrate the effects of the various tax cases on different levels of household income. Household 4 has two parents, aged 43 and 39, with two children aged 18 and 8 and earning a combined income of $24,849. Like household 3 (single income-earner), this family's income is predominantly earned by one of the parents. Household 5 is meant to illustrate the effects of the various tax scenarios on a relatively affluent household. This household has two parents, aged 49 and 39, with two children aged 19 and 14 and earning a combined income of $98,585. Although both parents in this particular household work, the income of one of the earners is significantly higher than the other parent's income.

These examples are just five of approximately 65,000 families included in the SPSD/M. These particular examples were chosen in order to highlight specific effects of the flat tax upon the personal income tax of typical Canadian households. The households were chosen by inserting the general family specifications into the Record Selection Facility of the SPSD/M.

It is important to note that, in all of the cases except 8 and 9, there is no effect upon government revenue. That is, Cases 1 through 7 provide the same revenue to the federal and provincial governments as the status quo. Any reduction in spending that results in the need for less tax revenue necessarily reduces the rates of the flat tax.

Also, there is no federal tax abatement allowed for Quebec in this study. Therefore, the value of the abatement is removed from the provincial revenue that a flat tax in Quebec would generate. While the federal and provincial tax rates presented below would differ if the abatement were allowed, the total tax rate faced by taxpayers in Quebec would remain the same.

Methodology

The model used to analyze all cases was built using a glass-box application of the Social Policy Simulation Database and Model.⁷ A new executable SPSD/M was created by copying the relevant SPSD/M files, changing existing or adding new C++ code segments, and compiling the changed files using Microsoft Visual C++.

Net income is equal to the Canada Customs and Revenue Agency's definition of total income for tax purposes except for Cases 6 through 9 where RRSP/RPP contributions are deducted from total income.

The only exemptions and deductions from income allowed are those discussed in the various cases; all other personal income tax credits, exemptions, and deductions have been eliminated. All spending programs (including programs such as GST rebates and child-tax benefits that depend on income as determined by the annual tax return) remain in place.

The federal tax abatements to Quebec as they currently exist were not modelled as this arrangement between the federal and Quebec governments is one of the unnecessary complications in the current tax system that tax reform should eliminate. In all relevant cases, more federal and less provincial revenue is collected from Quebec's taxpayers than would be the case if the abatements were included in the calculations. A note to the tables showing the flat-tax rates (tables 3.x.1) provide the tax rates that would exist if the abatement were included in the model. For example, Case 6 shows Quebec with a federal tax rate of 19.9% and a provincial rate of 15.7%. If the abatements were included, the federal rate for Quebec would be 16.2% (resulting in less federal revenue from Quebec taxpayers) and the provincial rate would be 19.4% (resulting in more provincial revenue from Quebec taxpayers). The overall rate remains unchanged at 35.6%.

The various cases presented in this section do not incorporate any behavioural responses to the changes in the tax system. That is, the analysis does not account for the possibility that the various changes proposed in each case might facilitate or encourage particular changes in the behaviour of taxpayers. For instance, the replacement of high and increasing marginal taxes with one single-rate of taxation is expected to encourage greater work effort and higher levels of savings that lead to higher rates of economic growth but such benefits are not included in the analysis. Thus, our analysis is conservative in estimating the total effect the proposed tax changes would have on government revenue and personal income levels.

Case 1

No tax credits, exemptions or deductions (base case)

Case 1 eliminates all tax credits, deductions, and exemptions, including the personal exemption. Put another way, this case represents a basic tax system for personal income that excludes all types of incentive-based exemptions and tax credits. For instance, in addition to the elimination of the personal exemption, other popular exemptions such as those for Registered Retirement Saving Plans (RRSP) and Registered Pension Plans (RPP), the child expense deduction, and the tax credit for charitable donations are also eliminated. Eliminating the myriad exemptions, tax credits, and deductions presents a nearly flat rate of taxation for personal income. The system is not completely flat because it does not include other types of income such as corporate income. It is, however, to the fullest extent possible within the structure of the SPSD/M, a flat system of taxation on personal income.

Case 1 is presented not because the authors do not believe a personal exemption should be present but rather to present a base-case to which other cases can be compared. One of the important insights gained from presenting a base case is the effect the introduction of exemptions and deductions have on the applicable rates of flat tax.

The pattern present in Table 3.1.1 will persist: Quebec maintains the highest provincial flat-tax rate, followed by the prairie and Atlantic provinces clustered closely together, with Ontario consistently having the lowest provincial rate of flat tax. Eliminating all tax credits, exemptions, and deductions results in a base federal flat tax rate of 12.7%, 4.3 percentage points lower than the current lowest federal statutory rate of 17%.

The elimination of the personal exemption that shields a large portion of lower-income Canadians' income from income tax causes a pronounced shift in the distribution of tax from upper-income Canadians to lower-income and middle-income Canadians. For instance, Canadians earning between $1 and $10,000 experience, on average, an increase in personal income tax of $614. The largest absolute, per-capita increase, $1,614, occurs for individuals earning between $10,000 and $20,000 annually.

Table 3.1.1: Flat tax rates (Case 1)

Table 3.1.2: Tax distribution (Case 1)

The first income group to experience a net reduction in personal income tax are those earning between $40,001 and $50,000, who receive a decrease of $303 per capita (table 3.1.2). Income groups below this level all experience a net increase in personal income taxes. The largest absolute, per capita tax reduction occurs in the highest income bracket, those earning in excess of $250,000, who receive a net reduction of personal income tax of $105,882. It is interesting to note that those earning in excess of $250,000 annually represent roughly 2% of all those filing tax returns (Emes and Walker 1998).

Table 3.1.3 supports the findings contained in the previous tax distribution table (table 3.1.2). Specifically, the gains from eliminating all exemptions, deductions, and tax credits is largely concentrated at upper-income levels. The reason for this is that the value of the personal exemption eliminated in this base case is more valuable for lower-income Canadians because it shields a greater portion of their income from income tax than it does for middle- and upper-income Canadians. For instance, an individual earning $10,000 annually has almost three-quarters of her entire income shielded by the personal exemption while someone earning $35,000 only has approximately one-fifth of his income shielded by the personal exemption.

It is important also to recognize that the personal exemption is one of only a few exemptions from which all taxpayers benefit. Increasing or decreasing the personal exemption can, therefore, have significant effects on the tax rates. This trade-off between the value of the exemption and the rate of tax required will be a recurring theme throughout this section of the study as different exemptions and deductions are re-introduced into the personal income tax system.

Table 3.1.4 shows the effects upon the personal income tax of the five sample households when deductions and the personal exemption are eliminated. The single individual (household 1) enjoys an $896 reduction in her income tax, representing an 11.3% reduction from the status quo.

Income tax for the dual-earner family (household 2) increases by $1,248, an increase of 14.0% from the status quo. On the other hand, income tax for the single-earner family (household 3) decreases by $2,187, representing a decline of 17.5% compared with their current income tax bill.

The divergent experiences of the two households with similar incomes is worth discussing.⁸ The implementation of a flat tax with no exemptions or deductions effectively equalizes the percentage of total family income allocated to personal income tax at 18.2% of total income. In other words, under the reformed system, the two families with approximately equal income are assessed approximately equal tax bills relative to their income.

The equalization of the income-tax liability under the new system is a change from the current system. Under the current system, due, in part, to different exemptions and income brackets, two-income families will pay tax bills much different from those of one-income, two-parent families. For instance, the two-income family (household 2) splits the income of the two working parents and thus has its income taxed at lower tax rates. Recall that the first positive statutory rate applies to income between $7,231 and $30,005 while the next rate applies to income above $30,004 and below $60,010. Thus, the one-income family (household 3) will incur a larger tax bill simply because they are not able to split their family income as the two-income family can. When this discriminatory effect of the tax code is removed, both families pay approximately the same amount of income tax relative to their total household income.

The most striking result occurs with respect to the low-income family (household 4). By removing the personal exemption and all deductions, the income tax burden for the low-income household increases 237.5% when compared to the amount of income taxes paid currently. The bulk of the income tax increase is due to the elimination of the personal exemption that previously would have shielded more than half of the household's income from income tax.⁹

On the other hand, the high-income household (household 5) experiences a reduction of $8,415 in its income tax, a 31.7% decrease relative to the amount of income taxes paid under the status quo. The reason for the dramatic decrease in the high-income household's income tax bill is that the removal of the personal exemption and various deductions had much less effect relative to the substantial decrease in the tax rates.

Table 3.1.3: Relative measures of tax changes (Case 1)

Table 3.1.4: Effect on sample households (Case 1)

Case 2

Personal exemption of $7,231

Case 2 re-introduces the personal exemption that was eliminated in the Case 1. The exemption is introduced at the 2000 level of $7,231. The rationale for the re-introduction of an exemption from taxation up to a certain level of income is based on fairness.¹⁰ The policy objective is to ensure that a low-income individual does not pay income tax until (at least) most of her basic requirements have been met. That is, an exemption allows taxpayers to earn a certain amount of money without paying tax.

Table 3.2.1: Flat tax rates (Case 2)

Table 3.2.2: Tax distribution (Case 2)

Table 3.2.1 summarizes the various rates of taxation applicable when a flat tax is coupled with the 2000 personal exemption of $7,231. The re-introduction of the personal exemption increases the overall rates of taxation for each jurisdiction by nearly a third. For instance, the federal rate increases 4.0 percentage points, from 12.7% to 16.7%. Similarly, the provincial rate for Ontario increases 1.7 percentage points, from 5.8% to 7.5% while the provincial rate for Quebec increases 3.6 percentage points, from 9.5% to 13.1%.

The combined rates for all provinces increase. Ontario, the jurisdiction with the lowest rate of taxation, experiences an overall increase of 5.7 percentage points, from 18.5% to 24.2%. Similarly, the rate for Quebec, the jurisdiction with the highest rate of taxation, increases 7.6 percentage points, from 22.2% to 29.8%. The reason for the large increase in the rate across all jurisdictions is that the re-introduction of the personal exemption affects all taxpayers.

The re-introduction of the personal exemption not only increases the respective provincial and federal tax rates but also alters the distribution of taxation. Table 3.2.2 includes the distribution of income taxes based on Case 2. The shift in the tax burden from higher incomes to lower- and middle-incomes seen in Case 1 is mitigated by the re-introduction of a personal exemption. For instance, the increased tax burden placed on incomes between $10,001 and $20,000 is reduced from $1,614 to $575 with the re-introduction of the exemption, a decrease of 64.4%. Similarly, for those in the lowest positive earnings bracket ($1 to $10,000), the increased tax burden is reduced from $614 to $30.

Conversely, the reduction in the tax burden for those with high income is less than it was in Case 1. For instance, those earning in excess of $250,000, the highest income group, experience a reduction in personal income tax of $77,424, $28,458 less than the tax reduction of $105,882 experienced without an exemption.

One of the interesting effects of the re-introduction of the personal exemption is that it raises the income group in which individuals receive a net reduction in personal income tax from the range of $40,001 to $50,000 to the next range of $50,001 to $60,000. Thus, in order to receive a net reduction in personal income tax from the flat tax in this case, individuals must earn in excess of $50,000. Interestingly though, in 1997, a full 57% of income tax was paid by the top 12% of tax-filers, those earning in excess of $50,000 annually (Emes and Walker 1999). It is, therefore, not unexpected that the shift in the tax burden would benefit those who now bear the greatest proportion of income tax.

Table 3.2.3 supports the general findings of the data contained in the tax-distribution table (3.2.2). Since taxpayers in the income group earning $50,001 to $60,000 are the lowest income group to show a reduction in their income tax bill relative to their income, the introduction of a personal exemption to a flat-tax system significantly mitigates the shift in the tax burden from upper-income groups to lower-income and middle-income groups.

Table 3.2.4 presents the income tax for our household examples. The individual's income tax, although reduced by 5.9%, is reduced much less than it was under the previous case. Again, we notice the diverging experiences of the two households with similar incomes. The two-income family (household 2) experiences a marked increase in income tax while the single-income family (household 3) experiences a marked decrease in income tax. It is again important to recognize that both family households pay approximately the same percentage of their total household income (17.6%) in income taxes under the flat tax.

The re-introduction of a personal exemption has a noticeable effect on the tax paid by the low-income and high-income families. The tax increase experienced by the low-income household (household 4) is significantly less than it was in Case 1, where any personal exemption was excluded. Household 4 experiences a 53.6% increase in its total income tax bill compared to the status quo.

The introduction of a personal exemption also decreases the size of the tax reduction experienced by the high-income household (household 5), which has a reduction in income tax of $6,267 or 23.6% relative to the status quo, whereas they have a 31.7% decrease in case 1.

Table 3.2.3: Relative measures of tax changes (Case 2)

Table 3.2.4: Effect on sample households (Case 2)

Case 3

Personal exemption of $8,766

Case 3 includes an important addition to the value of the personal exemption. As discussed previously, the inclusion of a personal exemption is based on fairness. The tax system should allow individuals and families to earn a certain amount of money before they begin contributing to income tax revenues. However, the personal exemption in the present income tax system is not based on an objective criterion of how much money individuals and families need to cover basic necessities. It is, rather, quite arbitrary.

The calculation and subsequent inclusion of an exemption valued at $8,766 is based on the pioneering work of Professor Christopher A. Sarlo, Senior Fellow of the Fraser Institute (Sarlo 1996; Sarlo 1998; and a series of articles printed in Fraser Forum over the last three years all dealing with poverty. Professor Sarlo has revolutionized the way Canadians think about poverty by calculating an absolute, as opposed to the conventionally used relative, estimate of poverty. Professor Sarlo's work utilizes a "basic needs" definition of poverty. This basic-needs poverty line determines the cost of a list of necessities required for physical maintenance and good health on an ongoing basis. The list includes items such as nutritious food, adequate shelter, appropriate clothing, necessary health care, required transportation, and basic telecommunications.

The personal exemption of $8,766 is calculated by taking the highest provincial line (British Columbia) and adjusting it by the Consumer Price index (CPI) to reflect a 2000 value. It would, therefore, afford citizens in any province the ability to earn a sufficient amount of money to provide basic needs for themselves and their families. In Case 3, then, the personal exemption increases $1,535, from $7,231 to $8,766, an increase of 21.2%.

If government revenues are to remain unchanged, this increase of 21.2% in the value of the personal exemption requires that the rates of taxation for the provinces and federal government also increase. The federal flat-tax rate increases from 16.7% with an exemption of $7,231 to 17.8% with an exemption of $8,766, an increase of 1.1 percentage points (table 3.3.1). Similarly, Quebec's provincial flat-tax rate increases 0.9 percentage point, from 13.1% to 14.0% and the provincial rate for Ontario increases 0.4 percentage point, from 7.5% to 7.9%.

Quebec maintains the highest combined federal-provincial flat-tax rate. Its combined tax increases 2.0 percentage points, increasing from 29.8% with a $7,231 exemption to 31.8% with an $8,766 exemption. Similarly, Ontario, with the lowest flat-tax incurs rate a 1.5 percentage point increase in its combined flat tax, increasing from 24.2% to 25.7%.

The effect of increasing the personal exemption is the same as the re-introduction of the exemption presented in Case 2. Increasing the personal exemption further decreases the shift in the tax burden from those with high-incomes to those with lower- and middle-incomes. The increased burden or personal income tax for those earning less than $40,000 is reduced relative to Case 2. For instance, the increase in income tax for those earning between $10,001 and $20,000 is reduced from $575 with an exemption of $7,231 to an increase of $317 with an exemption of $8,766 (table 3.3.2).

Table 3.3.1: Flat tax rates (Case 2)

Table 3.3.2: Tax distribution (Case 2)

Similarly, the tax reduction for those earning high-income is also lessened. For instance, incomes above $250,000 show a 9.8% decrease in the value of their tax reduction, from $77,424 with a $7,231 exemption to $69,871 with an exemption of $8,766. The income group at which taxpayers receive a decrease in their personal income tax burden remains the same as in Case 2 ($50,001 to $60,000).

Table 3.3.3 reiterates the findings contained in the previous tax distribution table (table 3.3.2): it shows that the increase in the value of the personal exemption lessens further the shift of the tax burden from upper-income groups to lower-income and middle-income groups.

Table 3.3.4 presents the effects of increasing the personal exemption on our representative households. Like Case 2, the individual earner (household 1) continues to experience a tax reduction but it is less than it is in Case 1 or 2: a decrease of $389, representing a reduction of 4.9% compared to the status quo.

As it did in the previous two cases, the experience of the two households with similar incomes differs. The dual-income household (household 2) again incurs an increase in its income tax, although to a much lesser extent than in previous cases: $741, an increase of 8.3% relative to the amount of income tax paid under the status quo. The single-income household (household 3), on the other hand, shows a $2,644 decline in its income tax, a decline of 21.2% relative to the amount of income taxes paid under the status quo. Again, it is important to note that both family households pay approximately the same percentage of total household income in income taxes (17.4%) under the flat tax.

The increase in the amount of the personal exemption causes the low-income household (household 4) to experience a minor reduction of $23 in the amount of income taxes paid, a 1.9% reduction relative to the tax currently assessed. The affluent household (household 5) also experiences a reduction in income tax, $5,775, which is less than in previous cases.

Table 3.3.3: Relative measures of tax changes (Case 2)

Table 3.3.4: Effect on sample households (Case 2)

Case 4

Personal exemption of $17,532

Case 4 is an extension of the previous case: the personal exemption is doubled to $17,532, about the level at which many social-welfare groups suggest that an individual has sufficient income to enjoy what they consider to be a satisfactory degree of physical and emotional comfort relative to other Canadians.

These relative "poverty lines" that are promulgated by social-welfare groups have no official status as poverty lines. Indeed, Statistics Canada's Low Income Cut-Off (LICO), often referred to as "Canada's poverty line," is always accompanied by a disclaimer that LICOs should not be used as poverty lines (Sarlo 1996). Case 4 is included to show what the effect on the tax rates would be if a flat tax with a very high personal exemption were adopted.

The rates for the federal and provincial governments significantly increase as the value of the personal exemption doubles from Case 3 ($8,766) and increases by 142.5% from Case 2 ($7,231). The doubling of the value of the personal exemption increases the applicable flat-tax rate. For instance, the federal flat tax increases 8.3 percentage points, from 17.8% in Case 3 to 26.1% in this case. Quebec, the jurisdiction that consistently maintains the highest rate of taxation shows a 7.7 percentage point increase in its provincial rate, from 14.0% with an $8,766 exemption to 21.7% with an exemption of $17,532. Similarly, Ontario, the jurisdiction with the lowest flat-tax rate, shows an increase of 3.3 percentage points in its provincial rate, from 7.9% to 11.2%.

Ontario incurs one of the smaller combined percentage-point increases in its combined flat-tax rate, 11.6 percentage points, from 25.7% to 37.3%. Quebec incurs one of the larger percentage-point increases of 16.0 percentage points, from 31.8% to 47.8%. Newfoundland shows the largest percentage-point increase in its combined federal-provincial rate, increasing from 27.7% in Case 3 to 46.2% in Case 4, an increase of 18.5 percentage points.

The substantial increase in the personal exemption has a peculiar affect on the distribution of taxation. The effect of the increase is to restrict tax reductions to very low and extremely high levels of income. In this case, incomes between $0 and $40,000 and above $200,001 show a net decrease in personal income taxes, while incomes between $40,001 and $200,000 show a net increase in personal income taxes (table 3.4.2).

Table 3.4.1: Flat tax rates (Case 4)

Table 3.4.2: Tax distribution (Case 4)

The relative indicators of the change in the distribution of income tax echo the findings above: by doubling the personal exemption those at the very low and high ends of the income spectrum gain while the majority of taxpayers in the middle-income group experience an increase in their income tax bill (table 3.4.3).

Table 3.4.4 shows the effects that doubling the personal exemption has on the personal income tax of the sample households. Case 4, which is characterized by a significant increase in the personal exemption, is the first case in which all five households show a reduction in their income tax.

The individual household (household 1) experiences a tax reduction smaller than in previous examples: $303, a 3.8% reduction relative to the household's current income tax.

Unlike the situation in previous cases, in Case 4 both households with similar incomes experience a reduction in their income tax bills. However, the size of the reduction differs substantially: the two-income household (household 2) shows a $1,483 reduction in income tax, a 16.6% reduction relative to the status quo. The single-income household (household 3) shows a reduction of $4,788, a 38.3% reduction in its income tax compared to its current income-tax liability.

In Case 4 we first notice a very small difference in the percentage of household income paid to income taxes by households 2 and 3. Household 2, the dual-income household, pays 13.3% of its total household income to income tax while the single-earner household (household 3) pays 13.6%. As one would expect, the low-income household (household 4) pays absolutely no income tax since the total household income is well below the value of the combined exemption. Interestingly, the high-income household (household 5) also shows a reduction in its income tax: $3,047, a reduction of 11.5% relative to the status quo.

Please note that Cases 5 through 9 will be compared with Cases 1 through 3 only; Case 4 will be ignored.

Table 3.4.3: Relative measures of tax changes (Case 4)

Table 3.4.4: Effect on sample households (Case 4)

Case 5

Personal exemption of $8,766 + exemption of $2,000 per child

Case 5 is the first to include an exemption of $2,000 per child under the age of 18. Case 5 is the same as Case 3 except for the inclusion of an exemption for children. The nature of the exemption for children, however, is different from the personal exemption in that it is available only to households with children: while the personal exemption applies equally to all taxpayers, the exemption for children does not.

This exemption of $2000 per child demonstrates a consistent approach to calculating exemptions for basic needs. It acknowledges the additional cost of acquiring basic needs that are borne by families in the raising of children. It also stands in contrast to the current tax system, which effectively rewards parents that choose to have other people care for their children part of the time while penalizing parents that choose to look after their children full-time. In other words, the current system discriminates in favour of one group of parents at the expense of all others.

Unsurprisingly, the rate of the flat tax increases for all jurisdictions. For instance, the federal rate for the flat tax increases 0.5 percentage points, from 17.8% with a personal exemption of $8,766 (Case 3) to 18.3% with both the personal exemption of $8,766 and the exemption of $2,000 per child (Case 5) (table 3.5.1).

Table 3.5.1: Flat tax rates (Case 5)

Table 3.5.2: Tax distribution (Case 5)

Quebec has the highest combined federal-provincial tax rate of 32.8%, an increase of 1.0 percentage point from its level of 31.8% in Case 3. Ontario possesses the lowest combined rate of flat tax, 26.4%. It showed a 0.7 percentage point increase in the combined federal-provincial tax rate from its rate in Case 3.

As in the previous cases (excluding Case 4), the addition of an exemption--an exemption for children, in this case--reduces the shift in the tax burden from those earning high incomes to those earning low and middle incomes. Put another way, the amount of tax reduction for those earning high incomes is reduced while the increase in the tax burden for those earning low and middle incomes is lessened. For instance, the tax reduction for those earning in excess of $250,000, the highest income bracket, is reduced from $69,871 with a personal exemption of $8,766 to $66,632 when both the personal exemption ($8,766) and the exemption for children ($2,000 per child) are included (table 3.5.2). Those earning between $40,001 and $50,000 show a reduction in their tax increase from $446 in Case 3 to $372 in Case 5.

Table 3.5.4 presents the effects that the introduction of the exemption of $2000 per child has on our representative households. Like the previous cases, the individual (household 1) continues to experience a tax reduction. The reduction is less than it was in previous cases, however, due to the interaction between the exemption for children, which the single individual cannot claim, and the subsequent increase in the rate of the flat tax.

Both households with similar incomes (households 2 and 3) receive a reduction in their income tax, although once again these reductions differ considerably. The dual-income household (household 2) shows a minor reduction of $54 in its income tax, a decrease of 0.6% relative to the status quo.

The single-income household (household 3) shows a much larger reduction of $3,434, a 27.5% reduction in its income tax compared to the status quo. As in most of the previous cases, both households bear nearly the same burden of income tax: 15.9% (household 2) and 16.0% (household 3) as a percentage of total household income.

The low-income household (household 4) experiences a significant reduction of 86.5% from its current income tax when the needs-based personal exemption of $8,766 is coupled with the moderately valued exemption of $2,000 per child. The high-income household (household 5) also receives a reduction in its income tax bill, $5,737, a 21.6% reduction relative to the status quo.

Table 3.5.3: Relative measures of tax changes (Case 5)

Table 3.5.4: Effect on sample households (Case 5)

Case 6

Personal exemption of $8,766 + exemption of $2,000 per child + current RRSP/RPP deduction

Case 6 introduces deductions from taxable income for contributions made to Registered Retirement Savings Plans (RRSP) and Registered Pension Plans (RPP). Currently, individuals are able to contribute up to 18% of eligible wages to either an RRSP or an RPP, up to a limit of $13,500 per year. These deductions for RRSP/RPP contributions are added to the personal exemption of $8,766 and the exemption of $2,000 for children used in the calculations in Case 5.

There are three important considerations regarding the inclusion of RRSP and RPP contributions. First, contributions are made to savings earmarked for retirement exclusively. Since current government programs for retirement savings do not provide sufficient income for retirement, individuals must save independently of government plans for retirement (Income Security Programs Branch, Human Resources Development Canada 2000; Office of the Superintendent of Financial Institutions 1997a, 1997b; Canadian Institute of Actuaries 1995; Association of Canadian Pension Management 1995, 2000; James 1997; and Peterson1999). For this reason, some tax deferral is offered to those saving for retirement through private retirement savings programs.

The second consideration is much more important and concerns the nature of tax systems. Allowing tax-sheltered contributions to RRSPs and RPPs moves the flat tax closer to a tax on consumption and away from a tax on income. A variety of studies, most notably Jorgensen and Kun-Young 1991, have concluded that a tax on consumption is a much more efficient form of taxation that can reduce economic distortions and increase economic efficiency (Jorgensen and Kun-Young 1991; Kesselman 1997, 1999; Kneller, Bleaney, and Gemmell 1999). Since an overwhelming majority of Canadians save almost exclusively through RRSPs and RPPs,¹¹ a tax system that shelters the contributions made to RRSPs and RPPs from current taxation will be taxing consumption rather than income for the vast majority of Canadians.¹² There is, therefore, an argument from economic efficiency to support the inclusion of deductions for retirement savings programs like RRSPs and RPPs in a proposed flat tax.

Third, deductions from income for RRSP and RPP contributions are not tax reductions or even what are often referred to as tax expenditures. These deductions are tax deferrals (Association of Canadian Pension Management 2000.): contributors delay the requisite tax payment until they have retired and use these savings to finance their retirement. When the original contributions and the accrued investment returns are removed from the RRSP or RPP to fund retirement, they are fully taxable.

Table 3.6.1 contains the rates for the flat tax including deductions from income for RRSP and RPP contributions.

Table 3.6.1: Flat tax rates (Case 6)

Table 3.6.2: Tax distribution (Case 6)

The federal rate of flat tax increases 1.6 percentage points from its level in Case 5, from 18.3% to 19.9%. Quebec continues to show the highest rate of flat tax of any province; it has a 1.2 percentage point increase in its provincial rate, from 14.5% to 15.7%. Quebec's combined tax rate increases 2.8 percentage points, from 32.8% to 35.6%. Ontario, which continues to show the lowest provincial flat-tax rate, incurs a 0.7 percentage point increase in its provincial flat-tax rate, from 8.1% to 8.8%. Its combined federal-provincial tax rate increases 2.3 percentage points, from 26.4% to 28.7%.

The inclusion of a deduction for RRSP and RPP contributions further dampens the shift in the tax burden from those earning high incomes to those earning low and middle incomes (table 3.6.2). This is so for two reasons. First, contrary to popular opinion it is predominantly those earning middle incomes who use RRSPs and RPPs (Emes 1999a, 2000; Clemens and Mihlar 1999: 14-21). Thus, the inclusion of contributions to those programs will mainly benefit middle-income individuals and families. Second, the maximum contribution to RRSPs and RPPs is limited by the absolute cap of $13,500 per annum. Individuals are able to contribute up to 18% of their income each year to RRSPs and RPPs up to the limit of $13,500, which caps contributions by those earning more than $75,000, who cannot, therefore, shelter any of their income beyond $75,000. The value of this deduction for those earning a high income is less than it is for those earning low and middle incomes.

Table 3.6.3 presents the relative measures of the change in the distribution of income tax. As in previous cases, the relative measures in table 3.6.3 corroborate the results found in table 3.6.2. Table 3.6.4 depicts the effects of the flat tax on our representative households after the inclusion of a deduction for RRSP and RPP contributions is added. The individual household (household 1) shows a 5.7% increase in its income tax relative to the status quo.

Of the two households with similar incomes, the dual-income household (household 2) experiences a 7.6% increase in its income tax while the single-income household (household 3) experiences a tax reduction, though to a lesser extent than in previous cases.

The low-income household (household 4) shows a large reduction in its income tax, approximately the same as it was after the exemption for children was introduced in Case 5. Household 4 receives an 85.4% reduction in their income tax relative to the status quo.

The high-income household (household 5) also receives a reduction in its income tax, showing a 17.0% reduction in income tax compared with its current income-tax liability.

The reason for the increase in income tax for the single individual (household 1) and the dual-income family household (household 2) and the relative reduction in the decrease in the tax for households 3, 4, and 5 is that none of the households contributed to an RRSP or RPP for the year in question. Thus, the increased rate of the flat tax associated with the inclusion of RRSP and RPP contributions is not offset by a reduced amount of taxable income for any of these households. Incorporating different household profiles that had contributed to RRSPs or RPPs would result in a different effect depending on the magnitude of contributions to RRSPs and RPPs.

Table 3.6.3: Relative measures of tax changes (Case 6)

Table 3.6.4: Effect on sample households (Case 6)