Exploring Taxation Alternatives: Why a penny saved is not always a penny taxed

September 3, 2014 - Taxation and the provision of social services have been policy considerations for provinces, states and nations for well over a century. The problems begin to occur in proposals for the revision of the tax system. With suggestions of basic income tax credits, negative income tax, and flat taxes, the political air is thick with ideas on how to “save the taxpayers money” and “increase social services.”

Ultimately, what can we expect with a revision to the tax system? The answer to that question very much depends on the type of taxation that is being applied. As seen in a model presented by Milton Friedman, negative income tax, for example, seeks to collect tax revenue from a group whose income is above a certain predetermined level, in order to provide social services to a group whose incomes are below that level.[i] A basic income tax provides an income floor to all citizens, and taxes all wages that exceed that floor.[ii] Finally, the flat tax, no doubt the simplest of the three, is simply a singular income tax-rate enjoyed by all citizens. All three have been proposed as potential solutions to improving the overall social welfare of a state, though none is without its drawback. Both the basic income and negative income tax can be considered versions of the Guaranteed Annual Income (GAI). However, the flat tax – the least direct tool for income redistribution of the three – is arguably the most fair.

Basic income sets a floor for all citizens that dictates the lowest point that the income of any Canadian is able to fall, with the possibility of also seeking out additional employment.[iii] Let’s assume that number is $12,000. This means that each month, someone who has no income would collect $1,000 in social assistance. If this person takes a 9-5 job at minimum wage, working 50 weeks a year, they would be making $22,000 before tax, but this would be taxed at a flat rate (let’s assume 30%). With the additional $12,000, they would be receiving $27,400 annually after tax, a 43% increase in total revenues compared to someone who is unemployed. The downside of this is that it marginalizes those who are on disability or are unable to work for other reasons. Nevertheless, this system does not preclude disability, like ODSP, and could be adapted to replace some, if not all, Ontario Works financial services.

Negative income tax works on a similar principle that all citizens receive a “Minimum Amount” (MA) of money. The major difference is that any income earned which is below the MA will be subjected to “claw-backs,” resulting in a proportional tax-rate, and any income above will see the MA taxed out of it.[iv] Hugh Segal provided an alternative solution to the “clawbacks,” in which the NIT is administrated as a tax benefit in which incomes below the MA are “topped-up” to the minimum level, and incomes beyond are dealt with when filing taxes.[v] Not only is the language more positive, but because it is a tax service, the “welfare stigma” is significantly reduced. The major criticism is that, like many social welfare “solutions,” it creates a disincentive to work.

Flat tax, finally, is the outlier. It is not a social program even in the loosest sense, however it creates the strongest incentive to work as a result of disparate impact. Assuming the flat tax is 25%, Bob, who makes $20,000 per year, will face more financial strain than Ben, who makes $200,000 per year, in spite of the fact that they are both being taxed at one quarter of their total income. Even though Ben will pay more than double Bob’s total income just in taxes, he will still walk away with ten times more money. In relative terms, they have lost the same amount, but in absolute terms, the result is quite different. For the flat tax to be equitable to Bob and his co-workers, it is possible to implement an exemption in a flat tax to limit its effect against low-income earners. This can be simply carried out through a basic personal exemption of, for example $20,000. In this way, Bob’s primary income of $20,000 will, in fact, remain tax-free, however income made additional to his primary income will be taxed. The – somewhat idealistic – logic behind the flat tax is that the significant tax revenues from the “Ben’s” of the nation can be used to re-invest into social programs to assist the “Bob’s” of the nation who earn below the established Canadian “poverty-line.”

When we look at this issue in the context of Ontario, with high concentrations of both wealth and poverty, and a politically diverse landscape, it is clear that this issue cannot be immediately solved by leaping into a dramatic taxation make-over. Nevertheless, by slowly fazing in a flat tax, it would be possible to create a more simplified tax system with a positive impact at all socio-economic levels. Ivanova and Keen called the introduction of Russia’s flat tax system ‘the most important tax overhaul of the turn of the century,’ in both global and domestic impact.[vi] While the idea may not the ultimate solution to solving social inequity and economic strife, if phased-in over several years, it would see a change to a taxation and welfare system desperately in need of a sizeable overhaul.

Another consideration beyond the scope of simply the flat tax is the implementation of a low, flat tax on income (10% for example) with a high consumption tax, which ultimately creates the most effective system of waylaying costs onto consumers and over-consumers, and keeping low-income families at a sustainable, financial level. According to Stéphane Buydens of the OECD Centre for Tax Policy and Administration, across OECD nations in 2012, more than 31% of tax revenues came from a variety of strategic consumption taxes.[vii] This figure could be increased with the use of calculated, state-level decision-making and purchasing analyses; a possible consideration for Canada in the coming years.

[i] Friedman, Milton. “Negative Income Tax – I.” Newsweek; September 16. (1968): 1. PDF.

[ii] Widerquist, Karl. “New Perspectives on Guaranteed Income.” Jerome Levy Economics Institute of Bard College (2002): 1. PDF.

[iii] Widerquist, Karl. “New Perspectives on Guaranteed Income.” Jerome Levy Economics Institute of Bard College (2002): 1. PDF.

[iv] Hum, Derek; Simpson, Wayne. “A Guaranteed Annual Income? From MINCOME to the Millennium.” Policy Options (2001): 80. PDF.

[v] Segal, Hugh. “Guaranteed Annual Income: Why Milton Friedman and Bob Stanfield Were Right.” Options Politique (2008): 51. PDF.

[vi] Ivanova, Anna; Keen, Michael; Klemm, Alexander; Pestieau, Pierre; Velasco; Andrés. “The Russian ‘Flat Tax’ Reform.” Economic Policy 20.43 (2005): 400. PDF.

[vii] Buydens, Stéphane. “Consumption Tax Trends 2012: VAT/GST and excise rates, trends and administration issues.” OECD Centre for Tax Policy and Administration (2012): 1-219. PDF.

Authored by Alex Berryman, Student Policy Intern with Northern Policy Institute (Sudbury Office)