THE PERSONAL INCOME TAX Chapter 17 ©2016 by McGraw-Hill Education Limited.

Learning Objectives Describe the steps for calculating personal income tax liability. Define and evaluate the Haig-Simons concept of comprehensive income. Identify sources of money income that are excluded from the personal income tax base. Explain the difference between deductions and credits. Summarize the main deductions and credits in the calculation of tax liability.

Learning Objectives (cont) Explain the difference between a direct expenditure and a tax expenditure. Identify the factors affecting the effective marginal tax rates across ranges of incomes. Explain the tradeoffs in making the unit of taxation the individual or the family. Distinguish between real income and nominal income, and relate the distinction to bracket creep. Contrast territorial versus global systems for treating international income.

Personal Income Tax Revenues in Canada, 1933 to 2012 Table 17.1

Personal Income Taxes as a Percentage of GDP, Selected Countries, 1965 to 2008 Table 17.2

Basic Structure Computation of Personal Income Tax Liability LO1 Basic Structure Computation of Personal Income Tax Liability Step 1: ADD Income from taxable sources Wages and other employment income, interest, dividends, rent, taxable capital gains, alimony received, royalties, pension and employment insurance benefits, net business income, … = Total income Step 2: SUBTRACT Deductions Union dues and certain employment expenses, childcare expenses, moving expenses, interest expenses, eligible RRSP and RPP contributions, alimony payments, qualifying losses, additional deductions = Taxable Inome Step 3: APPLY tax rate schedule to Taxable income = Income tax before tax credits Step 4: SUBTRACT Nonrefundable tax credits for Taxpayer and dependents, medical expenses and disabilities, age and pension income, contributions to QPP and CPP, premiums paid for EI, eligible tuition and education expenses, gifts to charities and to the Crown, and any other tax credits = Federal tax payable Step 5: CALCULATE Provincial tax payable Figure 17.1

Defining Income Haig-Simons (H-S) definition of income LO2 Defining Income Haig-Simons (H-S) definition of income Income = Consumption + DNet Worth Includes all sources of potential increases in consumption, regardless of: Whether the actual consumption takes place The form in which the consumption occurs Decreases in an individual’s potential to consume should be subtracted

Items Included in H-S Income LO2 Items Included in H-S Income Wages and salaries, business profits, rents, royalties, dividends, and interest Employer pension contributions and insurance purchases Transfer payments, including CPP/QPP retirement benefits, EI benefits, and worker’s compensation payments Capital gains Realized versus unrealized Income in-kind Imputed rent Gifts and inheritances

Some Practical and Conceptual Problems LO2 Some Practical and Conceptual Problems Computing income net of business expenses Computing capital gains and losses Measuring imputed income from durables Valuing in-kind services

Evaluating the H-S Criterion LO2 Evaluating the H-S Criterion Fairness (equity) – people with equal incomes should pay equal taxes Efficiency – neutrality; treats all forms of income the same and do not distort the pattern of economic activity

Excludable Forms of Money Income LO3 Excludable Forms of Money Income Capital gains Only realizations taxed Taxes deferred are taxes saved Lock-in effect Gains realized at death Evaluation of capital gains rules Employer contributions to benefit plans Gifts and Inheritances

Capital Gains Example 1: Tax is levied only when capital gains are realized P = $100,000 Rate of return = 12% # Years held=20 Tax rate = 50% $100,000*(1+.1)^20 = $964,629 Capital Gain = $964,629 - $100,000 = $864,629 Tax liability = $432,314 * .5 = 216,157 Net Gain = $648,472 Example 2: Tax is levied as capital gains accrue regardless of whether realized P = $100,000 Rate of return = 12% Net rate of return = 9% $100,000*(1+.09)^20 = $560,441 Capital Gain = $560,441 - $100,000 = $460,441

Evaluation of Capital Gains Rules No justification under optimal tax literature for preferential treatment of capital gains under H-S criterion Other justifications Capital gains are unexpected windfalls Require sacrifice of abstaining from consumption Needed to stimulate capital accumulation and risk taking Counterbalance to effect of inflation

Deductions and Tax Credits LO4 Deductions and Tax Credits Deductions — an amount is subtracted from total income in order to reach taxable income The deduction reduces taxable income Then apply the tax rates to taxable income to obtain the tax payable Tax credits — the amount of the credit is subtracted from taxes that would otherwise be payable the credit directly reduces taxes payable Deductions or tax credits may be used to stimulate private saving for retirement, increased spending on education, and donations to charities

Deductions Deductibility and Relative Prices LO5 Deductions Deductibility and Relative Prices PZ  (1-t)PZ Expenses in earning income Childcare Union dues or professional dues Investment income: interest dividends, capital gains, or business profits Interest paid on consumer debt and mortgages for owner-occupied homes are not deductible Interest rules in terms of H-S criterion Tax arbitrage

Deductions (cont) Employee savings for retirement and other purposes Registered Pension Plans (RPPs) Registered Retirement Savings Plans (RRSPs) Tax-Free Savings Accounts (TFSAs) Alimony

Tax Credits Tax credits and relative prices LO6 Tax Credits Tax credits and relative prices Like deductions alter relative prices Refundable (e.g., Goods and Services Tax (GST)) or Non-refundable (e.g., medical expenses) Fixed amount (e.g., basic personal amount) affected by taxpayer circumstances or behaviour (e.g., medical expenses)

Tax Credits (cont) Taxpayer and spouse CPP, QPP, and EI LO6 Tax Credits (cont) Taxpayer and spouse Nonrefundable tax credit; exhaustible as income increases CPP, QPP, and EI Nonrefundable tax credit Medical expenses Nonrefundable tax credit; medical expenses in excess of 3 percent of net income

Tax Credits (cont) Charitable contributions and education LO6 Tax Credits (cont) Charitable contributions and education Nonrefundable tax credit Working income tax benefit (WITB) Refundable tax credit Boutique tax credits Small nonrefundable tax credits (e.g., Public Transit Tax Credit, Textbook Tax Credit, First-Time Home Buyers’ Tax Credit)

Child Tax Benefits Canada Child Tax Benefit (CCTB) LO6 Child Tax Benefits Canada Child Tax Benefit (CCTB) Universal Child Care Benefit (UCCB)

Tax Credits Versus Deductions Some argue that deductions and exemptions should be converted into credits Proponents of credits argue that they are fairer than deductions A credit reduces the effective price of the favoured good by the same percentage for all individuals; a deduction decreases the price by different percentages for different people

Impact on the Tax Base and Taxes Payable Summary Information from Individual Income Tax Returns, 2012 ($ millions) Table 17.3 17-22

Tax Expenditures What are tax expenditures? Most prominent federal tax expenditures projected for 2014 included: CPP, QPP, and EI credits for employee contributions and the non-taxation of employer-paid premiums (totaling $12.9 billion) The notion of a tax expenditure list and a tax expenditure budget has, however, been subject to several criticisms

The Simplicity Issue The federal personal income tax has been railed for it complexity and the compliance burden it has placed on taxpayers One of five objectives in the 1987 tax reform was that the tax system “be simpler to understand and comply with.” The tax law in Canada is complex and will remain so

Rate Structure Rates and Brackets LO7 Rate Structure Rates and Brackets Federal and Provincial Tax Rates, and Surtaxes, 2015 Table 17.4 17-25

Maximum Federal and Provincial Combined Rates for Three Types of Income, by Province, 2015 Table 17.5 17-26

Factors Affecting Marginal Rates Surtaxes Payroll taxes CPP EI Clawbacks CCTB GST OAS Table 17.6

Marginal Tax Rates, 2015 (Alberta Example) Figure 17.2 17-28

The Alternative Minimum Tax Under most income tax laws it is possible for some individuals with high incomes to pay little or no tax The AMT is payable if it exceeds taxes calculated in the normal way Essentially a shadow tax system with its own rules for computing the tax base applies the normal tax rates to the AMT base

Effective versus Statutory Rates Statutory rates differ from effective rates Tax system treats some forms of income preferentially Tax shifting Excess burden Flat tax Applies same tax rate to everyone and each component of income Limited deductions Arguments in favor Reduces excess burden Reduces incentive to cheat Greater simplicity Equity Arguments against Shifts burden from rich to middle class

The Final Calculation Apply marginal tax rates to taxable income Tax that is due before credits Subtract tax credits from federal income tax otherwise payable when tax rates are applied to taxable income Yields federal tax payable Provincial rates are then applied to taxable income and, with provincial tax credits, determine provincial tax payable

Choice of Tax Unit Background The income tax should embody increasing marginal tax rates Families with equal incomes should, other things being the same (including family size), pay equal taxes Two individuals’ tax burdens should not change when they marry or live in a common-law relationship marriage neutral

Tax Liabilities Under a Hypothetical System Individual Income Individual Tax Family Tax with Individual Filing Joint Income Joint Tax Lucy $1,000 $ 100 $12,200 $30,000 $12,600 Ricky 29,000 12,100 Ethel 15,000 5,100 10,200 30,000 12,600 Fred Table 17.7 17-33

Choice of Tax Unit (cont) LO8 Choice of Tax Unit (cont) Family Equity: families with equal incomes taxed equally Reduces incentive for income splitting Not marriage neutral Inefficient Individual Avoid inefficiency related to high marginal rates on secondary income earner Marriage neutral Families with equal income taxed differently Tax unit in Canada

Taxes and Inflation Indexed for inflation How inflation affects taxes LO9 Taxes and Inflation Indexed for inflation How inflation affects taxes Bracket creep Deductions and exemptions set in nominal terms Real and nominal income Taxation of nominal capital gains Taxation of nominal interest Real and nominal interest rate

Taxation of Nominal Interest Real after-tax rate of return: r = (1 – t)i – π Let t = 0.50, i = 10%, π = expected inflation rate = 4% r = (1 - .50)(.10) - .04 = .01 = 1% Now assume expected rate of inflation and nominal interest rate both increase by 4 percentage points r = (1 - .50)(.14) - .08 = -.01 = -1%

Coping with the Tax/Inflation Problem Historically, indexing has been neither comprehensive nor premanent Full indexing of tax brackets and tax credit levels (restored in 2000) Should indexing be maintained or diminished? No – ad hoc adjustments allows legislators to examine and revise the Income Tax Act Yes – desirable to have a stable and predictable tax law and fewer chances for legislative mischief

Treatment of International Income LO10 Treatment of International Income Territorial versus global systems Equity Efficiency Production decisions Residential decisions

Chapter 17 Summary Income tax systems are the primary revenue source for provinces and for the federal government, with personal income taxes account for 24 percent of total government revenues in Canada. Computation of individual income tax liability has four major steps: measuring total income, converting total income to taxable income, calculating tax before allowable tax credits, and deducting tax credits to obtain taxes payable. A traditional benchmark measure of income is the Haig-Simons definition: Income during a given period is the net change in the individual’s power to consume. Implementation of the Haig-Simons criterion is confounded by several difficulties: (1) Income must be measured net of the expenses of earning it. (2) Unrealized capital gains are not easily gauged. (3) The imputed income from durable goods is not directly observable. (4) It is difficult to measure the value of in-kind receipts.

Chapter 17 Summary (cont) Critics of the Haig-Simons criterion argue that it does not necessarily guarantee either fair or efficient outcomes. The Canadian income tax base excludes (1) imputed income from homeownership and other forms of imputed income; (2) employer contributions to pension, medical, and dental plans; (3) gifts and inheritances; (4) lottery winnings; and (5) half of realized capital gains. Deductions reduce taxable income and are allowed for expenses incurred in earning taxable income, to encourage retirement savings and to recognize alimony payments. Tax credits are provided for charitable donations, medical expenses in excess of 3 percent of net income, certain education and tuition expenses, and required EI, CPP, and QPP premiums. Deductions and credits both change after-tax relative prices, and this affects economic behaviour.

Chapter 17 Summary (cont) Tax expenditures are the revenues forgone due to preferential tax treatment, and in some instances, a tax expenditure may be the most effective way to stimulate a particular private activity. Because of surtaxes, payroll taxes, and clawbacks, the effective marginal rates may be much higher, with a more complex structure, than the basic rates. No system of personal income taxation can simultaneously achieve increasing marginal tax rates, marriage neutrality, and equal taxes for families with equal incomes. Bracket widths, personal and dependant tax credits, and tax-free earnings of dependants are indexed against inflation. Canada follows a territorial, or residence-based, system with respect to the tax treatment of income earned in other countries; Canadian residents are taxed on their global incomes, but Canadian citizens who reside outside of Canada are taxed only on income earned in Canada.