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

2. 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.

3. 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.

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

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

6. 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

7. 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

8. 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

9. 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

10. 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

11. 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

12. 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

13. 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

14. 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

15. 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

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

17. 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)

18. 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

19. 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)

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

21. 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

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

23. 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

24. 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

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

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

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

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

29. 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

30. 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

31. 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

32. 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

33. 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

34. 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

35. 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

36. 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 = ( )(.10) = .01 = 1%
Now assume expected rate of inflation and nominal interest rate both increase by 4 percentage points
r = ( )(.14) = -.01 = -1%

37. 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

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

39. 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.

40. 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.

41. 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.