Monday, April 11, 2011

Tax Fairness and TFSAs

Some people on the left dislike TFSAs because they mainly benefit the rich, and are therefore "unfair." It's definitely true that TFSAs will eventually become a large drain on government finances and that the proceeds will mostly accrue to the wealthy. However, they can also enhance the fairness of our tax system.

To see why, one needs to first understand how our system works without TFSAs. Here's a question: between a single BC resident making $50,000 and one making $150,000, who faces the higher tax rate on the next dollar earned? (Assume for simplicity that both are single with no dependents and only have wage income.)

At first glance, the answer is very simple: the first taxpayer is in the 29.7% bracket (combined federal and provincial), while the second is in the 43.7% bracket. So the richer guy pays more, and all is good.

The above answer is actually wrong. To really determine the tax on that extra dollar of income, you need to know whether that dollar will be saved or not. Suppose that the first (poorer) taxpayer is scrimping and planning to put that dollar away (say for 20 years, at 4% interest), while the second is splurging and would immediately spend the extra income.

The tax rate on the richer taxpayer is of course still 43.7%.

The middle-class worker, however, faces a rate much higher than 29.7% because he is trying to save. Indeed, with no tax, he would receive $1*(1.04^20) = $2.191 in 20 years. With tax, he starts out with $0.703 to invest. But then, each year, his return is (1-0.297)*4% = 2.812% because interest is also taxed (assuming he stays in the same bracket throughout). As a result, in 20 years, he will only have $0.703*(1.02812^20) = $1.224. He is giving up $0.967 out of $2.191 in taxes, or 44.1%. If he saves for 30 years instead of 20, the effective tax rate is 50.2%.

Our tax system makes the scrimping middle-class guy face a greater marginal tax rate than the freewheeling rich guy: it penalizes saving, and this penalty can outweigh the progressiveness of the tax brackets. TFSAs mitigate this problem.

Of course, we do have RRSP's and RESP's where saving is not penalized. But retirement and a child's education are not the two only worthy goals that require putting money aside.

Now, it is true that on average, TFSAs will mostly benefit those that are already rich, since they tend to save more. (But due to features of our retirement system, lower-income Canadians might benefit more than you'd expect.) The solution is simple: pay for them by raising the regular tax rates for the highest bracket(s). This way, all savers will benefit (even the rich ones, since they'll probably save more than the extra tax they pay), while rich spenders will pay. This seems eminently fair to me: what's troubling about inequality isn't that some people's bank accounts are bigger than others', but that some eat caviar in mansions while others starve on park benches.

Of course, right now might not be the best time to enact a policy that promotes saving because we need strong consumer spending to keep the recovery going. But eventually, Canadians as a whole need to save more. Expanding TFSAs in 2014 or 2015 sounds pretty good to me - especially if it is combined with (or funded by) a progressive measure. Of course, the party proposing the former is quite unlikely to do the latter...

Politically, the NDP is attacking Harper for a policy that "leaves most families behind." The Liberal response has been more muted (and fair), criticizing TFSAs along with other policies for reducing what's available for health care funding. Whether Ignatieff goes further during the debate might be a good indication of where he is in the Big Red Tent - on the lefty side or on the centrist side.

Now, allow me to be a bit fanciful. What if we enact unlimited TFSAs by phasing out all taxation on interest, dividends and capital gains? Such a move would reduce the unfair and inefficient bias toward consumption over saving (you'd also have to kill the corporate income tax to eliminate it). In addition, imagine the drastic simplification of the tax system - no more need for RRSPs, RESPs, complicated TFSA rules, T3s, T5s, a whole bunch of lines on the T1, Schedules 3, 4 and 7, tax planning, etc. All the time, energy and trees we'd save would be worth hundreds of millions every year!

The downside, of course, is that this would be a highly regressive move unless combined with a strongly progressive element. Paying for it just by raising top tax rates would unfortunately make them transparently punitive. (Keep in mind that current top tax rates are, in fact, even more punitive for savers: somebody facing a 45% combined federal-provincial rate actually pays a whopping 71.3% on an extra dollar of saving earning a 5% interest over 30 years. It's just that the actual tax rate is shrouded.)

A better way to go about this would be to enact a $50/ton carbon tax. This would raise roughly twice the revenue currently generated (at the federal level) by taxing investment income and capital gains. The other half of the money could then be used in ways that mainly benefit the poor and the middle class.

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