Are tax hikes on top earners effective?

Tax hikes are meant to bring in new revenue for the government, while sometimes also re-balancing the tax landscape for Canadians. But taxpayers can adjust their behaviours in response, warns a new report from the C.D. Howe Institute.

The federal government’s tax increase on top earners in 2015 raised the combined federal and provincial tax rate on net income exceeding $200,000 to around 50% or more in all provinces.

Author Alexandre Laurin’s analysis of recently released preliminary CRA data that shows “the steep 2016 federal tax hike on top earners failed to produce the promised billions in new revenue.” Those who earn more than $250,000 annually paid $26.3 billion in federal taxes in 2016, versus $33.1 billion in 2015.

One reason could be economic changes combined with other tax changes, the report said, but another could be taxpayers responding to the tax rate increase by finding ways to minimize their tax burden.

“Many commentators warned that high-income taxpayers would react to the hike by reducing their earned income or engaging in tax avoidance,” Laurin said in a release. “Preliminary data bear out these predictions.”

To measure the possible behavioural responses, C.D. Howe examined the “elasticity of taxable income,” or ETI.

The estimated short-run ETI score for the 2016 tax year was 0.56, indicating “a fairly high behavioural response” to the tax hike on top earners but not a score that’s out of line with the range estimated in other studies. (The report conceded there’s “considerable uncertainty around the estimated value of ETI,” since it depends on factors like assumptions of how income might have grown if a tax hike weren’t implemented.)

To further investigate the issue, C.D. Howe compared the behaviour of top earners with that of “an immediately lower income group who [were] mostly unaffected by the rate increase but otherwise share similar economic and tax circumstances.”

The organization’s analysis shows taxpayers in the $100,000 to $250,000 income group saw total and employment income rise in 2016 alongside capital gains and dividends, “reflecting positive global equity market performance.”

In comparison, taxpayers in the $250,000-plus range saw total income jump in 2015 and fall in 2016, with the 2015 jump “almost exclusively supported by a jump in dividend income (and employment to a much lower extent).”

Taxpayers—primarily business owners—were prepared for the hike. They brought income forward in anticipation of the tax increase, or what’s known as forestalling, the report said, “followed by the unwinding of the advance income recognition in subsequent years.”

The report notes a similar pattern in the U.K. in 2010, when the top tax rate rose from 40% to 50%.

Leaving out the one-off fiscal impact of forestalling, the report said the tax hike likely yielded only about one-third of the tax revenues ($1.2 billion) that would have been raised without the behavioural response. It also resulted in provincial budgets suffering fiscal losses ($1.3 billion) greater than the federal revenues raised.

“The bottom line is that high tax rates may discourage earning additional income, and may encourage shifting taxable income to different forms, times and jurisdictions, so they may not only negatively affect the economy, but add little to, or even reduce, government revenues,” the report says.

Further, when it comes to legitimate tax responses and strategies being used by taxpayers, the impact is “difficult to prevent using anti-avoidance legislation.”

Analysis of CRA’s preliminary data can help inform future tax policy, the report says. It suggests “further tightening of the tax system to make tax avoidance harder can reduce the ETI in future years,” which is the direction recent federal budgets have taken. Think of changes to small business taxation, for example.

Read: How to plan around the small business tax changes

Canada may also have some room to improve its personal income tax competitiveness, the report adds. “Canada’s top combined federal/provincial personal income tax rate is among the highest of the OECD,” and that can impact the country’s ability to attract talented workers and the head offices of major companies.

Two options for the government are reducing the top tax rate or “doubling the income threshold at which the top tax rate applies,” so that Canada can remain competitive, C.D. Howe says.

“Reducing the number of people subject to the highest tax rate by raising the threshold at which it applies from the current $205,800 to $411,600 would cost the federal budget around $500 million annually after accounting for the expansion in the tax base and the positive economic impacts of taxpayers’ behavioural response,” the report concludes.

“The response would yield a dividend of around $700 million for provincial government—a major bonus in an environment where fiscally pressured provinces are pushing Ottawa for more cash.”

Read the full report.