Income-splitting – who does it serve?

Having prepared tax returns both for pay and as a volunteer for close to a decade now, I’ve come across a wide spectrum of taxpayers.  One thing that I regularly realize, and have to remind myself, is that the average Canadian has relatively little knowledge of how our tax system works.  That’s not to say that only accountants, lawyers, and tax preparers understand it – there are certainly a lot of Canadians that are very financial savvy, and are quite educated on how their taxes work.  But quite a few do not.  I won’t pass judgment on that, we all have different priorities in life, not to mention different strengths and weaknesses.  But what this means is that when political parties tell Canadians their plan will save them money, or their opposition’s plan will cost them money, a lot of Canadians believe them.

The latest ploy the Harper Conservatives have tossed out there is income-splitting. The Greens ran on this in the last election (Elizabeth May even questioned Harper on it in the debate, and he said we could never afford it (see starting at 1:42:55)).  I’m not sure where she got her $5 billion number; it seems quite high.

Income splitting is a very American concept – in the US, married couples can file one single return where the tax brackets are essentially doubled, basically allowing some married people to take advantage of their spouses’ tax brackets.  This doesn’t seem to be what is proposed in Canada, since we file individual tax returns (each spouse files their own tax return, but has access to certain credits of their spouse to reduce their combined tax liability).  If income-splitting in Canada follows the direction of pension-income-splitting that the Conservatives already provided, basically one spouse would take a deduction on their return, and the other would add it into their income on their return.  Essentially the same concept, but not exactly the same approach.

But who would benefit from this?

First, the obvious: single people, divorced people, separated people, and widowed people will not benefit from income splitting.  Based on 2007 StatsCan data this eliminates 51.7% of the population of Canada.  Only married and common-law spouses could possibly benefit from this.

Next, some basics:

Canadians are taxed based on brackets (the following are all 2011 numbers, mostly available on the CRA website, and I’m ignoring provincial taxes here but the concepts are the same).  If your income is under $41,544, it’s easy – you pay 15% tax on your income.  If you earn a bit more than this, you pay 15% on the first $41,544, and 22% on the rest of it – up until $83,088 of income.  Above that, you pay 15% on the first $41,544, 22% on the next $41,544, and 26% on the next… this continues up to $128,800, after which the remainder of your income is taxed at 29%.  Despite a common misconception, going $1 into the next tax bracket cannot possibly lead to you having less cash at the end of the year than if you hadn’t – since only that extra $1 is taxed at the higher rate.

SO – if you’re earning less than $41,544 in the year, and your spouse is also earning less than $41,544, there is zero benefit to income splitting. You are both paying tax at 15%, and (save for the ability to use otherwise unavailable deductions or credits) transferring income to your spouse’s return will not change this.   Taking the most extreme possible assumption that one spouse earns nothing, this should eliminate all “Couple families” (as defined by StatsCan to include, basically, everyone who would qualify) who had income of less than 40,000 (the nearest round number here).  There goes (based on 2008 numbers) at least 20.4% of couples – or 9.9% of the total population.

So, at a bare minimum, at least 61.6% of the population won’t qualify.  If you’re in any of the categories above, you’re already at a $0 benefit, so if that’s why you were considering voting for this, stop now.  As a rough benchmark, if you earn approximately the same amount of income as your spouse you would not benefit from income-splitting — I don’t have stats to determine what percentage of the remaining population this would represent, but I suspect quite a number of people.  I’m giving the benefit of the doubt to those in favour of income-splitting by assuming all single-income families, which I recognize is completely unrealistic.

Now, continuing with the extreme assumption that one spouse is earning all of the income (I wish there were statistics on single-income vs dual-income families – I unfortunately can’t find any but PLEASE link me to some if you have them), let’s calculate.  Those families earning between $41,544 and $83,088 will save 7% of the excess over $41,544 (i.e., for a family where one spouse earns $42,500 and the other nil, $956 would be transferred to the no-income spouse so that now instead of being taxed at 22% that income is taxed in the spouse’s hands at 15%, saving the family $956 * (22% – 15%) = $67).  The calculation gets more complicated than that when you get to higher incomes so I’ve once again prepared a spreadsheet!  Basically those in the next tax bracket save $2,908 (which is $41,544 * 7%) plus 4% (26%-22%) of the remaining income.  A similar calculation occurs for the next bracket.

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I should note that this is all based on “pure” income-splitting (where up to 100% of the income can be split).  The Harper Conservative proposal is to limit income-splitting to $50,000, which would lead to less benefit for people in the higher income categories.  But what can be seen is that, at a bare minimum, 70% of the population would see less than a $1,000 advantage on their taxes.  And the remaining 30% of the population are Canada’s wealthiest families, earning combined incomes of $60,000 or more (as with my HST post, I’m not passing judgment on this being a lot of money – it’s not, especially for a family with children – just pointing out who would benefit from this).

If you’re curious as to how “pure” income-splitting would affect your family, try this spreadsheet (will download a .xlsx file)– I make no promises about its accuracy and it’s obviously not intended for tax planning.  I’ve left the sheet unprotected so you can see the formulae for yourself.

The point? Wealthy, single-income, families stand to benefit the most from income-splitting.  Those of us who are in the majority, single people, stand to gain nothing.  This plan essentially provides a bonus for families where one spouse works and the other stays at home.  While it could be viewed as a way of compensating families for having a spouse stay home, many families simply can’t afford this – it’s not easy to get an $85,000 per year job!  Remember, the family where two spouses earn $41,544 per year each gets zero benefit from this system.  At a time when dual-income families are on the rise, this proposal works primarily to serve high single-income earners.  I have nothing against high single-income earners, but I don’t think they really need much advantaging in our tax system – let’s come up with some proposals to reduce taxes for low- and middle-income individuals and families, who really need it.