Can the Family Tax Cut entice parents to work less?

Most media coverage last week of the Parliamentary Budget Officer’s report on the Family Tax Cut led with the predictable headline that “income splitting will benefit the rich.” Similar headlines greeted the PBO’s earlier report questioning the Conservative administration’s past promises to double contribution limits for Tax-Free Savings Accounts (TFSAs.)

In fact, as Gordon Pape told me when we discussed the PBO and Broadbent Institute critiques of TFSAs, “while it is true that raising TFSA limits will benefit mainly higher-income earnings, the same is true for any tax-sheltered savings program, including RRSPs.” It’s also true that higher-income earners get disproportionate tax breaks in non-registered plans, because of the favourable treatment of Canadian dividends and capital gains.

These effects are largely the result of the graduated income tax system, whereby the higher your earnings, the more you pay in tax in terms of percentage of income earned. Disregarding tax shelters, this arrangement works in favour of lower-income earners, since they may pay perhaps 20 cents of tax on earnings of $1, while a high-income earner pays closer to 46 cents on the same $1. But when was the last time you saw a headline that screamed “Graduated income tax system benefits poor”?

As Pape notes, if government really wanted to remove the “inequity” of tax breaks favouring the rich, “it would have to eliminate all tax-sheltered programs, including pension plans (higher earners get bigger pensions), and all tax advantages for investment income. Of course, that will never happen unless perhaps with an NDP government.”

With that perspective in mind, let’s look again at the PBO’s critique of income splitting for families with children under age 18. The situation is analogous to pension income splitting for seniors: in either case, the benefits mostly accrue to families where there is a primary earner in the top bracket (whether earned income in the first case, or a large defined benefit pension in the second) and a “secondary” earner or non-pension recipient.

Either way, there is no real benefit to income splitting if both spouses are in the top tax bracket. And even if the secondary earner is making much less, Ottawa has curtailed much of the benefit of the Family Tax Cut, having imposed an upper limit of $2,000 in tax savings per household per year.

» The easy way to claim the Family Tax Cut

What’s interesting about the Family Tax Cut analysis is how much the secondary earner is motivated to earn more money rather than staying home to spend more time raising the kids. Seen as a unit, a family with a sole breadwinner and a stay-at-home spouse can escape the costs of daycare or nannies, or perhaps paying for help to clean a home. Instead of earning money that’s taxed, then paying for those services with after-tax income, the one member can perform their services themselves, tax-free. The PBO’s report finds that in Family Tax Cut-eligible families, primary earners work full-time and have a gross rate roughly twice as high as the secondary earners.

The PBO report also addresses the possible effects of the Family Tax Cut on the broader labour supply, projecting that family income splitting “has a small negative impact on total labour supply.” That’s because various economic studies find that “workers respond to changes in marginal effective wages by adjusting hours, effort or their participation in the labour force entirely.”

Imagine a family with two full-time earners in the top tax bracket, and paying third parties for day care or nannies, home cleaning, meal preparation, handymen (or women) and other services. If I read the PBO report correctly, it’s suggesting the Family Tax Cut may motivate one of the earners to cut back on hours, falling enough into a lower tax bracket that the family as a whole would benefit from income splitting; then they could use the extra leisure time to provide “tax-free” services like cleaning the house themselves or preparing meals for the primary earner instead of eating out. It’s interesting how every government tax measure can change basic family decisions on the tradeoffs of various work/leisure calculations.

So does family income splitting really “benefit the rich?” Perhaps in absolute dollar terms but you could equally argue that income splitting benefits lower-income families (or those with at least one low-income earner) by giving the family as a whole more leisure time and the means to supply their own tax-free services to themselves. That family has “riches” in the form of more time with the children while they’re young, time that is less abundant for a couple where both spouses work full-time in the top tax bracket.

Would you rather be “money rich” or “time rich?” Each of us has to make our own assessment of that question.

Jonathan Chevreau runs the Financial Independence Hub and can be reached at [email protected].

About Jonathan Chevreau

As MoneySense’s Investing-Editor-at-Large, he is also author of Findependence Day and co-author of Victory Lap Retirement. Reach him at [email protected], where he is the founder of Financial Independence Hub.