Income splitting redux

With a surplus that has swelled in recent months to around $13 billion, the Conservatives may be once again contemplating income splitting for next week’s federal budget. The annual cost is high at $5 billion, but this is a perfect wedge issue for Canada’s New Harperment, reducing the size of government while giving most of the tax benefit to its base. But economically, it is a bad idea, says Jon Kesselman in today’s Globe:

A splitting headache: Income splitting is the least efficient and equitable way to reduce the personal tax burden

JON KESSELMAN

… The intense interest in income splitting is understandable. Income splitting permits couples to average their individual incomes and thereby reduce their total taxes. Allowing the splitting of all incomes would be of significant benefit to most single-earner couples with a stay-at-home parent; thus the “family values” lobby has pushed the issue. And the largest tax savings from general splitting would go to top-income single-earner couples. However, the savings would be smaller or nil for the more common case of both spouses working.

… To assess the fairness of splitting, we need a rigorous concept such as that of “horizontal equity” — the notion that individuals with the same total economic resources should bear the same tax liabilities. Proponents argue that pension splitting would be horizontally equitable, and they argue further that allowing pension splitting without extending to all taxpayers the right to split all incomes would violate horizontal equity. Each of these assertions needs to be assessed separately.Long-established provisions for spousal RRSPs allow many couples to split their retirement incomes. In contrast, employer-based pensions cannot be split. Hence, couples with divergent earnings and good employer pensions have little or no ability to use spousal RRSPs for splitting purposes. That situation unfairly penalizes such couples relative to others with the same total retirement income, but without employer pensions. Extending tax splitting to all forms of pension incomes would correct this horizontal inequity.

If splitting improves equity for couples receiving various types of pension income, wouldn’t it be equally justified for all incomes? The great bulk of income for non-elderly families flows from labour earnings. All wages and salaries are taxed in the hands of the employee, with scant opportunity for shifting tax liability to a spouse. Therefore, labour incomes do not encounter the inequity that justifies pension splitting.

A different kind of horizontal equity argument is commonly raised for one-earner couples, especially with an at-home parent caring for children. The one-earner couple with the same total income as a two-earner couple will pay more income taxes on account of the progressive rate schedule. Is it fair that a one-earner couple with $80,000 pays more tax than a two-earner couple with $30,000 plus $50,000?

Even though those two couples have the same income, the one-earner couple has a spouse at home full-time to produce diverse goods and services, from child care to cooking, cleaning, laundering, and repairing. The one-earner couple with $80,000 chooses to keep one partner at home because the value of their home activities exceeds potential earnings in the labour market. So the one-earner couple’s total economic resources exceed $80,000, and it is not comparable to a two-earner couple with the same income, but without all the home-produced goods and services.

Proponents of general income splitting typically refer to the non-working spouse as a parent or more explicitly the “mother.” Yet this policy would also extend benefits to top earners who can afford to support a non-working spouse without kids at home. An income splitting policy could be restricted to couples having preschool children, but the gains would still be sharply tilted to the top earners. Better policies might be to expand the National Child Benefit, universal child-care benefits or employment insurance maternity benefits.

The case of two-earner couples with the same total earnings but a greater split in income raises the issue of equitable treatment of couples vis-à-vis singles given the economies of scale of living together. The United States has addressed this issue through joint tax filing by married couples (a limited form of splitting), but this creates a “marriage penalty tax” for many two-earner couples with similar spousal earnings.

In fact, neither pure splitting nor joint taxation can avoid creating marital biases –bonuses or penalties or both. Income splitting further imposes a bias against paid work by the lower-earning spouse, most often the wife, because she faces the marginal tax rate of her husband’s full-time earnings upon entry into the labour force.

For two-earner couples, splitting would cause many wives to face higher tax rates even while their spouse faced lower tax rates. In view of women’s greater labour supply responsiveness to tax rates, splitting would increase the tax system’s inefficiencies. In contrast, devoting the $4-billion annual cost of general splitting to cutting all taxpayers’ rates would augment the economy’s efficiency.