July 2000 Fraser Forum: Tax Fairness
The issue of fairness, or what some refer to as equity, is increasingly emerging as a yardstick against which tax reform is measured. Traditionally, discussions of fairness centre on what is referred to as "horizontal equity." This term means, essentially, that those earning similar amounts of income should pay similar amounts of income tax. Put another way, regardless of the source, individuals with comparable income should have comparable tax bills.
As it currently stands, however, the Canadian tax system is riddled with differing tax rates depending on the source of income. For instance, business income is not only taxed at a different rate than labour income, but it also faces multiple layers of tax. Business income is taxed at the business level in the form of corporate income tax, as well as at the personal level through personal income tax, on both dividends and capital gains. This results in individuals facing different tax rates depending on the nature of their income, thus violating the principle of horizontal equity.
Another more recent and increasingly advocated form of fairness is "vertical equity," whereby those who earn more pay proportionately more. This progressivity in the tax system has generally been accomplished by high and increasing marginal tax rates. Such marginal rates come at a cost, though, including reduced rates of economic growth, and reduced capital accumulation.
Fairness is also most often discussed in terms of a single year. However, isn't the objective long-term, or even lifetime, horizontal and vertical equity? That is, shouldn't we really be concerned with whether individuals with similar lifetime earnings face similar lifetime tax burdens? And whether individuals who earn more over the course of their lifetime contribute proportionately more? If so, then we should be talking about lifetime income, and lifetime tax burdens, not the transactions from isolated years. As the following example illustrates, there can be material differences in the amount of income tax paid over one's life depending on the variability of one's income.
To illustrate, let us assume that two individuals earn the same total income over a 10-year period. The Steady Individual earns his income in even payments while the Variable Individual earns her income in uneven payments. For simplicity's sake, let us further assume that there is no inflation, and that only federal taxation rates apply. Table 1 presents the income and federal tax liability for each person.
| Year | Steady Individual | Variable Individual | ||||
| Income | Federal Income Tax | Tax as a % of Income | Income | Federal Income Tax | Tax as a % of Income | |
|---|---|---|---|---|---|---|
| 1 | 30,000 | 3,871 | 12.9% | 40,000 | 6,370 | 15.9% |
| 2 | 30,000 | 3,871 | 12.9% | 20,000 | 2,171 | 10.9% |
| 3 | 30,000 | 3,871 | 12.9% | 40,000 | 6,370 | 15.9% |
| 4 | 30,000 | 3,871 | 12.9% | 40,000 | 6,370 | 15.9% |
| 5 | 30,000 | 3,871 | 12.9% | 20,000 | 2,171 | 10.9% |
| 6 | 30,000 | 3,871 | 12.9% | 20,000 | 2,171 | 10.9% |
| 7 | 30,000 | 3,871 | 12.9% | 40,000 | 6,370 | 15.9% |
| 8 | 30,000 | 3,871 | 12.9% | 40,000 | 6,370 | 15.9% |
| 9 | 30,000 | 3,871 | 12.9% | 20,000 | 2,171 | 10.9% |
| 10 | 30,000 | 3,871 | 12.9% | 20,000 | 2,171 | 10.9% |
| Total | 300,000 | 38,707 | 12.9% | 300,000 | 42,706 | 14.2% |
Because of the nature of her income, the Variable Individual faces a higher lifetime tax liability than the Steady Individual. The higher lifetime tax burden results from the higher statutory tax rates placed on higher income levels - the method by which Canada achieves progressivity (or what is called "vertical equity"). Table 2 summarizes the federal statutory tax rates (excluding the Deficit Reduction Surtax) for the 2000 tax year.
| Tax Rate | Income Level |
|---|---|
| No Tax | $0 to $7,231 |
| 17% | $7,232 to $30,004 |
| 25%* | $30,005 to $60,009 |
| 29% | $60,010 and over |
| Source: The Budget Plan 2000, Department of Finance, 2000. *Note: Rate reduction to 24 percent will be fully implemented by 2001. | |
In years when the Variable Individual's taxable income surpassed $30,004, she paid a portion of her taxes at a higher rate. Specifically, her tax bill varied between 10.9 percent and 15.9 percent of income. The net result is that the Variable Individual paid $3,999 more in federal income taxes over the 10-year period than the Steady Individual, a 1.3 percentage point heavier tax burden, even though their total incomes were exactly the same.
Admittedly, a number of tax-planning mechanisms can smooth one's income to minimize the income-variability distortion presented in Table 1. However, these mechanisms come at a price. Individuals incur lawyers', accountants', and tax planners' costs to achieve what should be present in the tax system all along.
Flat tax: a solution-in-waiting
The simplest way to accomplish both horizontal and vertical equity (progressivity) is to implement a flat tax. A flat tax assesses a uniform tax rate on all sources of income once, and only once. Thus, individuals face the same lifetime tax burden regardless of the source of their income, achieving horizontal equity. In our example, Steady Individual and Variable Individual would incur the same lifetime tax bill under a comprehensive flat-tax system.
Apart from that, a flat tax can achieve vertical equity or progressivity by including a basic exemption - an amount of money earned tax free each year. By including an exemption, the mathematics of a flat tax ensure that as individuals earn more, they also pay more in taxes as a proportion of their income.
Finally, a flat tax also minimizes many of the negative economic consequences associated with high and increasing marginal taxes. The beauty of a true, comprehensive flat tax is that it achieves the equity many people are concerned with, while mitigating many of the negative and distortionary effects of the current tax system. If equity is truly the yardstick for tax reform, then the choices for modernizing the tax system must include a flat tax.
info@fraserinstitute.ca
4th Floor, 1770 Burrard Street, Vancouver, BC, Canada, V6J 3G7
Tel: (604) 688-0221 Fax: (604) 688-8539 Book Orders: 1-800-665-3558 ext. 580
You can contact us at the above email address for any comments or information requests. Please report any dead links or technical problems.