Understanding Canadian Tax Rates
I have sometimes heard it said, “There’s no point in earning extra income; it’s just going to be taxed away.” Oddly enough, no one seems to turn away a raise.
Graduated vs. Flat Tax
Canada has a graduated income tax regime. This means that the more you earn in taxable income, the more you pay in income tax. This contrasts with a flat tax, in which you pay the same tax rate regardless of your income. Canada does have flat taxes but those are charged on consumption, not income. I am referring to the Provincial Sales Taxes (PST), the Goods and Services Tax (GST), and in certain jurisdictions, the Harmonized Sales Tax (HST). For items that are subject to these taxes, you pay the same percentage, 13% HST in the case of Ontario.
Some argue that a flat tax rate should apply to income, too. The argument is that it would simplify the tax code dramatically and eliminate loopholes.
Different Kinds of Income
Not all income is taxed at the same rate. Income from employment, income from interest, and income from foreign dividends are taxed at the standard rate. Income from Canadian dividends is grossed up and then reduced through a dividend tax credit. Eligible dividends get a better rate than non-eligible dividends. Finally, capital gains are taxed at half the rate of income from employment/interest/foreign dividends.
Below is a table of the Federal Personal Income Tax Brackets and Tax Rates (source taxtips.ca):
One thing you may notice is that the tax rate thresholds adjust from one year to the next. This is reasonable given increases in the cost of living. Of course, we are experiencing inflation the likes of which we have not seen in many years so the increase – about 2.4% – may seem inadequate to some.
Second, wouldn’t it be nice to earn only eligible dividend income and actually have the government owe you money?! However, that is the case, and it still applies even after you add in provincial income tax in several, but not all provinces. Even non-eligible dividends are better than straight employment or interest income.
Third, as income goes up, the value of 50% inclusion rate on capital gains taxes becomes increasingly valuable on an absolute basis.
On these second and third observations, you can see that the government tax regime incentivizes investing. Straightforward income from employment or interest gains no particular advantage. I do not recall ever reading this as the definitive explanation, but my understanding is that, since there is risk associated with investments from which an investor hopes to receive capital gains or dividends, these investment returns should be taxed more lightly to encourage investment in Canadian businesses. The downside of this policy is that those with relatively lower incomes generally have less extra money available with which to invest, meaning that little to none of their income will be tax-advantaged.
Basic Personal Amount (BPA)
On the other hand, relatively speaking the basic personal amount (BPA), a non-refundable tax credit, will have a greater impact on the tax paid by lower-income earners. Most federal non-refundable tax credits apply a rate of 15% to the credit, which is the lowest federal rate. That is, if the credit is $10,000, then the credit is multiplied at 15% to arrive at the tax reduction. In this case, 15% of $10,000 is $1,500.
Note that in recent years, a change has come to the BPA. The government has introduced a minimum and maximum. To use the lower table for 2022 as an example, up to taxable incomes of $155,625, the maximum of $14,398 applies. In the fourth tax bracket, the BPA amount is gradually “clawed back” until it reaches the minimum of $12,719 at $221,708 and above.
Here is a simple example of someone with $40,000 of taxable income. The federal income tax rate in the first bracket is 15% which leads to tax owing of $6,000. When the BPA of $14,398 is applied and multiplied by 15%, tax is reduced by $2,159.70, leading to tax owing of $3,840.30. In real life, you would need to add on your provincial rate and likely apply other credits as well as deductions.
Marginal Tax Rates
At the top of this post, I observed that some complain that tax rates make it so that a raise goes entirely to taxes and that the person earning it sees none of it. Certainly, with combined federal and provincial income tax rates, income over $221,708 gets rather high at 53.53% in Ontario, for example, but that generally doesn’t stop people from seeking higher-paying jobs. Staying with federal rates alone, let’s look at someone who will earn $150,000 in taxable income in 2022.
You can see that the higher income earner is still paying the same rate on her first $50,197 as the lower-income earner above is paying on his $40,000. However, as taxable income reaches into the higher brackets, a higher rate is charged. Still, the average tax rate after the basic personal amount is applied is considerably less:
The Basic Personal Amount has a more significant impact on low-income earners than it does for those earning a high income.
While high-income earners do pay a higher tax on their employment income, they often have the means and opportunity to invest in income-generating assets that are taxed at lower rates, thereby reducing their average tax rate. Although this is an anecdote from the United States, investing legend and multi-billionaire Warren Buffett has observed that his secretary pays tax at higher rates than he does because of the type of income he earns, which comes primarily from dividends and capital gains.
While few of us aspire to Buffett’s levels of income and assets, as the tax-rate table above indicates, developing tax-advantaged sources of income can be a good thing.
This is the 131st blog post for Russ Writes, first published on 2022-01-17.
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Disclaimer: This blog post is intended for general information and discussion purposes only. It should not be relied upon for investment, insurance, tax, or legal decisions.