Relax, fears over Ontario tax on rich are overblown

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Kevin Milligan is Associate Professor of Economics at the University of British Columbia

The recent NDP-Liberal budget deal in Ontario has ushered Ontario into the debate on the taxation of high income individuals. The new tax bracket for $500,000 and up will lead to taxes 3.12 per cent higher on that income (that's 2 per cent plus a 56 per cent surtax). Some detractors have worried about the economic impact of the tax on high earners. The NDP and Liberals wasted little time in deciding how to use the bounty of cash they expect. I think worries about the effect on high earners are overblown, but so too are the revenue projections.

First, who is affected by this new tax? Earning $500,000 or more is rare in Ontario – only around one quarter of the top 1 per cent qualify for this exclusive club. Decades ago, those at top income levels derived most of their income from business activities or investments. In sharp contrast, a major sea-change in the incomes of the top 1 per cent has occurred over the last 30 years. As of 2007, data collected by McMaster University's Mike Veall shows that two-thirds of the income of the top 1 per cent comes from wages. Only 3 per cent comes from business income and 20 per cent from investment income. For the top one in a thousand of Canadians, the share of wage income grows to 71 per cent. For the top one in ten thousand, wages are 74 per cent. Most people earning at this level are top executives, sports stars and financial industry workers – not business owners or entrepreneurs.

The prevalence of wage earnings at the top income ranges undercuts the arguments that the tax inhibits 'entrepreneurs' or 'job creators' or 'investors'. To be clear, there is no need to question the skills, talent, effort, or achievements of those in the top income positions in our society. These workers contribute much – but they are just employees like many of us; they possess no magic economic beans and know no recipes for secret economic sauce. I doubt that a 3 per cent tax will make executives put in less effort resolving the important challenges facing their organizations, or make the financial wizards of Bay St. work less hard in maximizing portfolio returns. Like anyone, they may be a bit grumpy about paying more, but I don't fear the impact on the economy.

Moreover, If there is a budding Bill Gates or Steve Jobs working long hours in an Ontario garage somewhere in Mississauga, Madoc, or Merrickville she is not facing this new tax now at her current low income levels. What's more, I doubt she would relinquish her entrepreneurial dreams on account of a bigger tax on her possible future riches should the small odds of major success come through in her favour, leading her at some far-off point to the $500,000 bracket.

The revenue projections are another contentious aspect of the debate. As far as I can tell, the projections of $400- to $500-million in new revenue raised by the new tax bracket assume the new tax rate can be applied to last year's reported income to get the projected revenue. In reality, there is very strong evidence of some slippage in taxable income when rates rise. If you account for a realistic response to the new tax rate, my calculations suggest that the revenue projections get knocked at least in half, closer to $250-million. There is little evidence that high earners respond by working less or by moving out of the jurisdiction. The most likely response is an increase in legal tax avoidance.

As the tax rate goes up, the costs of setting up a tax avoidance structure start to make more financial sense. By giving tax planners a few more tax points to work with, their sales pitch for clever schemes becomes easier. The high revenue estimates for the new tax assume this kind of avoidance activity does not occur. This means that the big dollar projections lean heavily on a hope that the $500,000 earners, with access to the best tax advice in the country, will just ignore the advice and carry on as they were. That is unlikely.

Some have suggested working harder to close these loopholes. Such an idea is good in principle, but in practice the CRA plays a constant game of 'whack-a-mole' against a motivated industry of tax professionals who are well-compensated to devise new legal structures to minimize taxes. Moreover, most efforts to tighten the tax system can't be made in provincial capitals like Toronto – it is Ottawa that controls those decisions. Creating a clean and inclusive loophole-free tax base is an effort worth contemplating, but it would take a massive commitment at the national level and a lot of time to complete. For that reason, an effective high-income tax plan needs to be part of a more thoughtful and comprehensive reform, not a deal hatched over late night pizza by politicians at Queen's Park.

I suspect many other provinces are eyeing Ontario as they contemplate high-income tax brackets of their own. If so, Ontario's experience will provide lessons to learn from. But for now, Ontario must rely on the evidence we already have. That evidence suggests that we needn't fear overblown concerns about the economic impact of the tax, but we also shouldn't expect it to raise much revenue.