UBC Reports
October 16, 1997


Forum

Cutting top bracket tax rates makes economic sense

by Jon Kesselman

Jon Kesselman is a professor of economics and director of the UBC Centre for Research on Economic and Social Policy. An earlier version of this article appeared in The Financial Post.

Now that the election campaign rhetoric is behind us, we can consider the real needs for tax policy in Canada.

It is increasingly recognized that broad tax cuts will be possible in two or three years, but the wisdom of cutting taxes now to stimulate demand has not been settled. Government deficits have not yet been vanquished, and pressures are building to restore public funds for health care and other services.

Nevertheless, a special type of tax cut would be justified immediately to stimulate supply, improve incentives, and enhance economic efficiency. It is a cut in the marginal tax rates faced by top bracket taxpayers. While this change is not the end-all for tax reform, it is a pressing need that can be achieved at modest if any revenue cost.

Top bracket taxpayers -- those with taxable incomes above roughly $75,000 -- are relatively small as a group but highly influential in the economy's performance. They face marginal tax rates exceeding 50 per cent in all provinces except Alberta, which has a top rate of 46 per cent. B.C. has the highest combined federal-provincial marginal tax rate, at 54 per cent.

Cutting tax rates for upper earners poses obvious political difficulties, even for right-of-centre parties. In the last B.C. election campaign, the Liberals proposed a 15 per cent cut in provincial income taxes, but remarkably, they would have left the top marginal tax rate unchanged. Ontario's Tory income tax cuts are being offset in part by a new surcharge on those at higher incomes, which will still leave the top marginal rate at nearly 50 per cent when fully implemented.

Economic analysis for Canada and the U.S. has found the costs of imposing high marginal tax rates to be very large. With B.C.'s income surtaxes, for example, the loss of valued economic activity has been estimated at $65 or more for each extra dollar of tax revenue. Using plausible assumptions about behavioural responses, the costs are found to be infinite; that is, tax revenues would actually be increased by cuts in the top bracket marginal rates.

These strong results can be explained by individuals' actions to curtail their taxable incomes when confronted with very high tax rates. They will reduce their work effort, substitute untaxed production of home services for taxed market work, take more compensation in untaxed fringe benefits, decline promotions, postpone the sale of appreciated assets, invest in legal tax shelters (including home equity), and find ways to evade taxes.

Clearly, no one benefits if tax rates are set so high that revenue is actually decreased. Even short of these rates, the costs to the economy in reduced supply of productive labour and capital services and entrepreneurial activity is high. Employment is reduced for other individuals at more modest wage and skill levels, which in turn reduces the income and sales taxes that they pay.

High tax rates on upper incomes further discourage the location and expansion of business in Canada as opposed to lower taxed locales. Canada becomes less attractive to potential immigrants with special skills, business acumen, and high wealth. B.C. has lost immigrants and their economic stimulus from our high income tax rates combined with the new reporting rules for foreign assets.

Why can't politicians appreciate these economic truths and moderate the top tax rates? They are captives of rhetoric about "tax equity," which in common usage assumes that ever higher tax rates on upper earners is necessarily equitable. But if those higher rates do not produce greater revenues, or if they do so only at great cost to the economy, we are all victims of the rhetoric.

A desirable target for top marginal tax rates would be in the low 40 per cent range. This could be achieved by cuts in the federal top tax rates, along with elimination of the high income surtax rates applied in provinces such as B.C., Ontario, and Saskatchewan. These moves would place Canada in the company of other major Western economies.

The top U.S. marginal tax rate is 39.6 per cent, though this arises only for taxable incomes above $264,000 US, or about $370,000 Cdn--five times the threshold for top rates in Canada. (Most states also impose an income tax but at much lower rates than the Canadian provincial taxes.) In Britain the top marginal income tax rate is 40 per cent. New Zealand cut its top rate from 66 to 33 per cent, with beneficial effects on productivity and real wages.

Even egalitarian, heavily taxed Sweden has come to appreciate the damaging effects of high tax rates. Its top marginal rate on labour earnings is now down to 51 per cent, and capital incomes face a flat tax rate of just 30 per cent. Germany's plans to cut its top tax rate from 53 to 39 per cent were scuttled this year by the Social Democratic opposition on the grounds of "tax equity."

For those concerned about the loss of equity from reducing the top tax rate, the response is twofold.

First, since taxing at very high rates is generating little if any incremental revenue, the loss of equity would be more symbolic than substantive.

Second, if there were much revenue loss, other taxes could be applied to those at upper income and wealth levels -- such as taxes on higher valued homes, cars, and estates -- with significantly less damage to the economy.

The burden of high tax rates on managerial, professional, and technical workers is shifted partially into higher prices for the goods and services they produce. Cutting those tax rates will increase their productive supply and thereby yield price cuts that benefit consumers at all income levels. Lower dental and legal fees, for example, will be welcomed by moderate income families.

High marginal tax rates also cause upper earners to press the political process for special tax preferences. Moderating top tax rates would enhance the ability of governments to apply a broadly based income tax. Hence, reducing high tax rates may itself be a prerequisite to more fundamental tax reforms to accompany the broader tax cuts that will become feasible in the coming years.