Alberta Premier Rachel Notley speaks during an onstage interview following a business luncheon in Calgary, Alberta, on Friday, Oct. 9, 2015. Notley's was among a collection of the memorable quotes from the past year. THE CANADIAN PRESS/Larry MacDougalThe Canadian Press
The Alberta NDP have announced that they are getting rid of the misnamed "flat tax" on incomes in the province. Once a cornerstone of the "Alberta Advantage" that former premier Ralph Klein touted so enthusiastically, the former Progressive Conservative government of Jim Prentice had already signalled this bold tax experiment's demise. All the NDP are doing is moving up the funeral date.
The reason for the policy change, however, is worth spending a moment on. Premier Rachel Notley proudly announced that the province was abandoning the flat tax in favour of a "progressive" income tax just like all the other provinces. Now, "progressive" is an interesting word in the tax context. It is usually taken to mean that people with higher incomes should pay proportionately more than people on lower incomes, and that the tax burden should become steeper as your income rises.
But then if that's what progressive means, the flat tax achieves this quite successfully, while avoiding some of the well-known problems associated with the so-called progressive model of income tax used in Ottawa and the other provinces.
How can that be if the Alberta flat tax is 10 per cent on all incomes? Well it couldn't be if the flat tax meant people paid 10-per-cent income tax on every dollar that they earned. But that is not what a flat tax does, and that's why I said it is a misnomer.
You can't understand how a flat tax works unless you rid yourself of the idea that it is a single tax rate applied on all income. It is in fact two tax rates: The first rate is zero per cent, applied on some basic amount of income, and then all other income after that is taxed at the flat rate – in Alberta's case, 10 per cent.
It is the interplay between these two tax rates that creates a perfectly defensible level of "progressiveness" in the income tax system.
Consider a few examples using a hypothetical flat tax system where the first $20,000 of income is taxed at the zero-per-cent rate and all other income above that basic amount is taxed at a flat 10-per-cent rate without any other credits or deductions.
If you earn $20,000 under this system, you pay no income tax whatsoever. If you earn $25,000, you would be taxed on the amount your income exceeded the basic amount, in this case $5,000. A 10-per-cent tax rate would therefore net the Treasury $500. That is an average tax rate on your total income of 2 per cent.
If you earned $50,000, you would pay $3,000 in income tax, an average tax rate of 6 per cent. Note that not only are you paying more tax, but the share of your income going to tax is rising as well.
At an income of $100,000, your tax bill is $8,000 but your tax rate has risen to 8 per cent. At $200,000 you pay $18,000 in taxes but your tax rate is now 9 per cent, or half again higher than someone earning $50,000. And so on. So far so progressive.
Now note two things about this approach.
First, the progressiveness of the system results from the interplay between the size of the basic exempt amount and the tax rate applied to the income above that. Suppose for example that we lowered the exemption to $10,000 and increased the tax rate to 15 per cent. Then our $25,000 earner would face an average tax rate of 9 per cent, and our $200,000 income now attracts a tax rate of 14.25 per cent.
The second thing to note is that such a flat tax avoids the disincentives inherent in a multi-rate income tax. The economist's rule of thumb is that if you tax something, you'll get less of it. What does a tax on income tax? Work, effort and success, which are beneficial things Canada could use more of.
Under a flat tax, every dollar you earn above the basic exemption attracts the same flat tax rate so there is no disincentive to work at higher income levels. Not so under the kind of multi-rate system used elsewhere in Canada. There, each time you pass another tax threshold, the share of the next marginal dollar in income that goes to tax rises. Unless rates are kept within bounds, high earners can face big incentives to work less and take their reward in, say, untaxed leisure time.
So contrary to the NDP's claims, Alberta's flat tax is progressive – just not as steeply so as some revenue-hungry politicians might like. But its abolition comes at a cost: It will rob us of a valuable and courageous experiment in trying to reconcile progressiveness and efficiency in the tax system.
Brian Lee Crowley (twitter.com/brianleecrowley) is the managing director of the Macdonald-Laurier Institute, an independent non-partisan public policy think tank in Ottawa: www.macdonaldlaurier.ca.