The Flat-Tax Fantasy

April 23rd, 2010 by Potato

Larry McDonald is back at it with the flat-tax fantasy. Now, in part my hackles get raised whenever anything the Fraser Institute champions comes up, but there are a number of good reasons why a flat tax either will not come to Canada, or if it does, why it won’t be the miracle many hope for.

First off, the government needs a certain amount of revenue for all of its programs. So the total tax grab would have to be the same at the end of the day, no matter which tax system is used, which means that for the majority of middle-class Canadians, their tax bill will not change. Flat taxes are often championed by rich people since whatever the new flat tax is, it will be lower than the highest marginal rate — this naturally means that people in the lower tax brackets will have to pick up the slack. To some, this is fairness. To others (such as myself), it’s not. For a long time we’ve had a progressive tax system, such that there is some point at which you stop paying the government, and the government supports you instead — and that to date has been the Canadian idea of fairness. It’s still possible to achieve that with support systems (direct welfare payments, etc), but then it becomes a little disingenuous to claim to have a simple flat tax system when the reality is that the complexity and progressivity just gets moved somewhere else.

Next, many of those special tax situations and tax breaks are there as incentives to drive behaviour. Just look at the temporary initiatives brought in specifically because of the economic crisis last year: the home renovation tax credit, the 100% write-off of computers, the first-time home buyer’s tax credit, all to get people out spending money. Now, I think that there was far too much focus on the wrong areas of the economy there (real estate, which was the one sector that was already overheated with the emergency interest rates, and computers which are overwhelmingly not made in Canada), but the fact is that they were possible and fairly easy to implement into the existing hodge-podge of tax credits and deductions. And bizarrely enough, people seemed to respond better to saving a little bit of tax on their home reno or bus pass than I suspect they would have if the government had directly subsidized renos or bus passes to the tune of 10-15% — either because the math escapes them (which is a point I need to get to) or because people take more joy from not paying $X in tax than they do in saving $X up front (probably the same reasons why there are huge line-ups whenever the superstore has a tax-free event, when their regular sales often lead to more savings). Again, in a flat tax system these incentives could probably be implemented in a different way, but that’s just moving the complexity elsewhere — a tax-return on a postcard, plus an additional form HRTC-1 to mail in to a different department, and a TCD for your business, and a FTHBTC to fill out in triplicate and send in…

Now, that’s not to say that I think the current system is perfect. I like the basics of the progressive tax system — and indeed, that part is not the complex part of the tax return. You could still have a tax return on a post-card even with a couple of tax brackets. However, the current tax system is very complex. Indeed, Wayfare was lamenting last weekend as we were compiling our taxes and having to stop and look stuff up that “it shouldn’t be this hard for two people with a master’s degree and a PhD to figure out their taxes!!” There is definitely room for improvement. The hard part is figuring out what your net income is after all the deductions and various classes of income (dividend vs scholarship vs T4 vs self-employment vs interest vs capital gains) — the part about then dividing that net income line up and paying tax according to different progressive brackets is trivial. Unfortunately, the most complicated parts for us were in dealing with tracking our adjusted cost base over the years on securities with DRIPs and RoC — which probably isn’t going to go away in a flat tax system unless the government wants to stop considering capital gains as taxable income — and in dealing with what is and is not an expense/deduction for self-employment income. The self-employment issue is going to torpedo this notion that a flat tax would automatically be simpler, because there’s no simple way to implement that unless you start taxing revenue rather than income.

There is a huge amount of room for simplification there too though. For example, Wayfare bought a new business computer in 2009. There were at least four different classes for depreciating a computer (or, “general purpose electronic data processing equipment (commonly called computer hardware)”) which is absurd. I also don’t think that we need to have as many round-about tax breaks for natural resource exploration, such as flow-through shares — drilling for oil and gas is its own reward (and indeed, should be a generator of revenue for the government). On the other hand, the guys at MaRS make a good case for bringing that kind of incentive to medical and technology start-ups.

As we move into the digital age, it may be possible to have the CRA create its own tax software with an interview method like QuickTax, and hide the complexity that doesn’t apply to most Canadians (it would, naturally, have to be open-source so if you wanted you could see where your tax liabilities came from and to optimize your tax situation). Because while I can see a number of ways to simplify the tax code, not all of the web of deductions will go away.

Though there are interesting consequences if they do. Consider one deduction that many average tax-payers take: charitable donations. Much overhead is wasted in charities proving that they’re charities, soliciting donations, in tax-payers tracking their donations, and audits, etc. What if there were no registered charities? Right now, even some of the best charities can only promise that about 80% of your donation will actually go to, for example, medical research. But, I’m a medical researcher. You could give me some money directly and I can guarantee you that 100% of what you give me will go to medical research (I currently study pain and brain imaging applications, but hey, if cancer’s your bag I’m all over it). No more wasting weeks and months writing grants for peer-review funding committees, no more wasting time sitting on said committees (for older scientists, not me yet) — I just need to come up with a pitch geared to the average donating Canadian!

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