Imagine a worker who gets a raise and ends up paying more than 50 percent of that raise in taxes. This is the case where a Canadian worker earns 48,124 Canadian dollars. With a wage increase of C$822, he faces 59 percent marginal tax. This Canadian worker’s net pay will only increase by C$334, while most of the increase goes directly to employee social security contributions.
That’s why the margin tax wedge is relevant to understanding how workers may benefit (or not) from higher wages once taxes and social security contributions enter the picture.
High marginal tax rates at different wage levels, such as that seen in the case of this Canadian worker, act as barriers to upward mobility, discouraging people from advancing in their careers. Very often these high stakes are hidden in complex policy structures. However, a a recently published study The Archbridge Institute and Tax Foundation examines the key policies driving the marginal spikes in tax rates to which workers are subject in a number of countries.
|Average labor cost of a single Canadian worker: C$80,929 (US$64,905)|
|Total labor costs||53,233 Canadian dollars||79,399 Canadian dollars|
|Net income before promotion||38,205 Canadian dollars||54,518 Canadian dollars|
|Amount of increase||822 Canadian dollars||765 Canadian dollars|
|Amount of reduction in additional tax/benefits due to increase||488 Canadian dollars||328 Canadian dollars|
|% of raise eaten by MTR||59.33%||42.84%|
|Net profit after promotion||38,539 Canadian dollars||54,956 Canadian dollars|
Source: OECD, “Payroll taxation – Decomposition of the tax wedge”, https://stats.oecd.org/Index.aspx?DataSetCode=TXWDECOMP; OECD, “Taxation of wages – comparative tables”, https://stats.oecd.org/Index.aspx?DataSetCode=AWCOMP; and tax fund calculations.
During the promotion, Canadian workers could face two significant tax rate hikes and lose 60 per cent of their extra earnings due to the province’s health care premium.
In 2021, the first marginal spike in the tax rate was 65 percent of the median wage and approximately 73 percent of the median wage. As shown earlier, when this Canadian worker’s employer increased his compensation by another CAD 822, the net wage increase for the worker was only CAD 334, while the largest portion of the increase, CAD 202, went directly to workers’ social security contributions. This childless Canadian worker faced a marginal tax rate of 59 percent for a 1 percent increase in gross earnings on top of a gross annual salary of C$48,124.
Moving up the income ladder, the worker faced a marginal tax rate of 43 percent for a 1 percent increase in gross earnings on top of a gross annual salary of C$72,556.
This is because provincial health award switches to a different rate at these two income levels. Although there is no federal health plan, the provinces of Quebec, Ontario and British Columbia charge health premiums to individuals.
In Ontario, the Canadian province used by the Organization for Economic Co-operation and Development (OECD) to model its tax wedge, the premium is based on taxable income and works across income groups. The award has fixed and variable components that change upwards to a different amount and rate at a taxable income of CAD 48,000 and CAD 72,000, where there are two spikes.
That could keep some workers in those provinces just below the salary threshold that triggers tax rate spikes. Eliminating these barriers by eliminating the health care premium or implementing a unique and lower rate would allow workers to access higher wages without facing this barrier.
To reduce the complexity of this contribution system, Canadian provinces could follow the example of Australia and Lithuania by applying uniform social insurance contributions. In the case of Australia, a single earner without children has a generally uniform marginal tax wedge profile, starting at 32.1 per cent and reaching 49.7 per cent for labor costs above A$189,658. The increase in the marginal rate of the tax wedge is due to a progressive central income tax, while social security contributions have a flat rate.
Lithuania also has a relatively flat marginal tax rate of around 44.1 percent. In addition, in 2019, Lithuania also shifted most of the employer’s social insurance contributions to the workers’ side, resulting in a 28.9 percent increase in gross wages. By closing the gap between total labor cost and gross earnings, labor taxation has become more transparent and simpler.
While many of the underlying policies creating these marginal tax rate spikes were designed to help finance skyrocketing health care costs in Candian provinces, many involve trade-offs that policymakers must keep in mind when planning to reform taxation system. This is particularly problematic when these high marginal tax rates affect Canadian workers who earn less than the average wage. Reshaping some of these policies to produce smoother variations in marginal tax rates for different income levels is likely to increase labor supply and encourage upward mobility of workers and especially low-income workers.
A note: This is part of a five-part blog series covering the results of the recently published research by the Archbridge Institute and the Tax Foundation and examines the policies behind the sharp jumps in tax rates that workers in a number of countries are subject to.