Kevin Milligan and Michael Smart | November 25, 2015
Over the past five years, provincial governments from coast to coast have introduced higher-rate income tax brackets for top earners. Now, with the election of the Liberals in Ottawa, the federal government will follow the path set forth by the provinces, with a plan to increase the top federal income tax rate to 33 per cent from 29 per cent for income over $200,000. What is the appropriate role for provincial and federal governments in taxing high earners, and how should provinces react to this proposed federal initiative? We think there’s a strong argument for federal action replacing provincial initiatives on high income taxation.
Our recent paper for the Institute for Research on Public Policy looks in depth at provincial taxation of high incomes. British Columbia, Ontario, Quebec, Nova Scotia, New Brunswick, Newfoundland and Labrador and most recently Alberta have added tax brackets aimed specifically at high earners. In most cases, the new rates are only a couple of percentage points higher, but these provincial moves are still noteworthy because they have reversed a two-decade trend of lowering income taxes at both the federal and provincial level.
Our research reveals two main facts about provincial taxation of high earners.
First, higher rates at the provincial level trigger a fairly strong response among high earners – some income gets shifted out of the tax-raising province, which reduces the amount of revenue the new tax ends up generating. This income shifting can happen through accounting and financial strategies, such as setting up a trust in another, lower-taxed province.
Second, the differing circumstances of each province matter. If taxes are already high in a particular province, a further increase will yield less than it would in a province with lower rates. Also, provinces where income is more highly concentrated among high earners have a better chance of raising revenue than those with fewer high earners.
Our findings point to an important tradeoff. Provincial governments can react to local preferences for taxing high earners and also to how many high earners there are. But, provinces acting on their own can lead to some flight of taxable income away from the higher-taxing provinces toward the lower-taxing ones. Without federal involvement, provinces must find a way to balance these pressures.
Federal action changes the calculations. Because a new top tax bracket at the federal level will be the same no matter what province you live in, taxes can no longer be avoided by shifting income across provincial borders. This fact is the main argument in the efficiency case for federal action instead of provincial initiatives on high-income tax progressivity – the idea that those with higher incomes are taxed at progressively higher rates. In addition, the nine provinces (outside Quebec) that rely on the Canada Revenue Agency to collect their income tax have no control over tax administration. In contrast, the federal government can co-ordinate tougher measures against tax avoidance with the new tax policy, increasing its effectiveness.
Several factors have changed since we performed our analysis. A number of court rulings have reinterpreted the provincial residency of trusts, making it a bit harder to shift income out of a high-tax province using a trust. In addition, Alberta’s introduction of a new 15-per-cent tax bracket for high earners has narrowed the tax gap between low-tax Alberta and other provinces.
The provinces should reassess their high-income tax brackets on two fronts.
First, each province will need to decide whether their citizens will view the enhanced progressivity of the federal rate schedule as a sufficient adjustment for high earners, or whether higher provincial rates remain necessary.
Second is the question of revenue. Whether the new provincial high-income brackets are bringing in much revenue is an open question, given the potential for interprovincial revenue shifting. Provinces will need to look carefully at the actual revenue they can expect from their high-income tax brackets in light of the upcoming federal move in that direction.
Income taxation is just one of many areas of federal-provincial interaction that will keep our first ministers busy over the next year. Items ranging from action on climate change to infrastructure, pensions and health care will be up for negotiation and will involve tradeoffs between different orders of government. In all of these files, our federation can be improved if attention is kept firmly on what level of government is best placed to address a given problem. When it comes to taxing high earners, it just might be the case that federal action supplanting previous provincial measures is the right way forward.
Kevin Milligan and Michael Smart are authors of Provincial Taxation of High Incomes: The Effects on Progressivity and Tax Revenue, a chapter from the forthcoming book Income Inequality: The Canadian Story, published by the Institute for Research on Public Policy.