Does taxing the rich actually work?

President-elect Donald Trump will soon celebrate his inauguration and with his ascent to power, he has promised to reduce marginal tax rates, cut taxes, and allow businesses to expense new investments rather than deducting interest costs.  In Canada, meanwhile, we await a new federal budget.  What happens in the U.S., however, is relevant and could shape future taxation policies in Canada.

Top criticisms of the Trump plan: the top beneficiaries of the changes will be the 0.1% with incomes over $3.7 million who would save 14% of after tax income, compared to an 8% saving for middle income household; this according to research by the Tax Policy Centre.

For these reasons, a look at what happens when the rich are taxed provides interesting food for thought. According to a 2012 CD Howe Institute study, rich people do indeed pay their fair share here in Canada. The 25,000 families who will be subject to the high-income tax in Ontario, for example, already pay 20% of all taxes. In fact, the top 1% of earners make about 12% of all income from taxable sources in Ontario but pay 27% of all income taxes.

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The top 10% of earners are responsible for 66% of all net income taxes, and the top 25% are responsible for 88% of all provincial income taxes. Meanwhile, the bottom 75% of all taxpayers pay only 12% of all taxes.

What happens when we overtax the top 25% of taxpayers? According to the report, “rich” people respond to over-taxation in a variety of different ways, and the outcomes, not surprisingly, have the effect of reducing revenues to governments. In a nutshell, while some people will do nothing, many will do the things that make everything worse: reduce personal productivity by refusing overtime shifts, for example, or move to a jurisdiction with lower taxes.

That’s a particular challenge for indebted provinces. Because wealthier people have the resources to move, they will, especially if they also have skills that are in demand. In Canada, such moves tend to be inter-provincial, so those provinces that tax too aggressively may, in fact, find they will lose their top tax producers to other lower-taxed provincial jurisdictions.2

Other taxpayers will do the wrong things: they will enter the underground economy and become tax evaders, making it difficult for legitimate business owners to compete against those who don’t pay taxes. Everyone else will need to cover the tax gap, and may indeed suffer the consequences of increased audit activities and potential penalties and interest.

Most people don’t want to experience those negative outcomes. A better strategy may well be to work hard at raising the bell curve on wealth accumulation. As Former Finance Minister Michael Wilson controversially quipped in a speech to the Canadian Economics Association in 1985, after introducing the capital gains exemption and a number of other significant tax rate reforms, “Canada has an acute shortage of rich people.”

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When tax policy is designed to help more middle income Canadians build more tax-efficient wealth, Canadian households can better weather market volatility, temporary unemployment, health changes, new business starts or economic uncertainty. That appears to be the direction our upcoming federal budget process will take: to champion middle class growth at the expense of top earners.

Whether any tax savings end up in the right investments, however, is up to individual choices. This is a key opportunity for investors and their professional advisors. High-income earners can respond to the possibility of rising taxes by making it their priority diversity income sources, split income within the family, and invest in a diversity of capital assets that will appreciate over time.

This strategy works just as well for the middle class; which has less disposable income to work with. Reducing taxes that are withheld from paycheques is a good place start raising wealth accumulation opportunities.

Evelyn Jacks is president of Knowledge Bureau, which offers e-learning at knowledgebureau.com. Evelyn tweets @evelynjacks and blogs at evelynjacks.com

This was first published on KnowledgeBureau.com

About Evelyn Jacks, RWM, MFA, MFA-P, FDFS

Evelyn Jacks is the best-selling tax author of 55 books, an award-winning business leader and the Founder and President of Knowledge Bureau, an online financial education institute.

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