Understanding Personal Taxes – Historical Evolution

Taxation is a very fundamental topic for economics and finance. Taxation policy represents one half of fiscal policy, and it drives how portfolios should be constructed, and how assets are priced. I will be writing a few articles on different issues raised by taxation over the coming weeks. I am starting with an overview of how tax policy has evolved over time, which explains their current structure. Tax rules are different in every country, and so I cannot really discuss the topic in depth for my international reading audience. I will instead start with some general observations about the basic principles of tax policy that I believe hold for many of the major developed economies.

Post-World War II Income Tax Policy: An Extremely Brief Summary

Although income taxes did exist before World Wars I and II, they tended to have very low statutory rates, reflecting the fact that governments were much smaller in the pre-Welfare State era. War time finance needs, and the rise of progressive politics led to very high statutory marginal tax rates for high income earners; for example hitting 98% in the United Kingdom.

Many progressives look nostalgically at those high statutory rates. What is often ignored, however, is that the tax code was as full of holes as Swiss cheese. The rich managed their affairs to avoid realised income (i.e., income that would show up on tax forms). Although the income distribution as measured by the tax code was more equal than it is now, it is unclear whether the true economic income distribution was as flat as what the tax return data implied. Very simply, when the government taxes anything heavily, that thing tends to hide from the government’s view.

The result was that the tax system was widely perceived as unfair as a result of the massive use of tax loopholes by the rich. There was a broad ongoing international movement starting in the 1970’s towards tax reform: lowering marginal tax rates in exchange for closing the loopholes. (Canada had a large reform in 1972, and the United States passed the Tax Reform Act of 1986.) Note that I am discussing here the personal tax system; corporate tax systems remain fairly complex.*

One extreme interpretation of these reforms is that the effective tax rates were about the same, it’s just that the system now is now more transparent about how those effective tax rates are achieved. Under this interpretation, those high published marginal tax rates were just a smoke screen to pacify the Left - no one was expected to actually pay tax at those rates, and only people with lousy accountants did. Although I believe this interpretation goes too far, I do feel that the effective reduction in tax rates was definitely smaller than the drop in statutory rates would suggest.

I will now introduce a few consequences for personal income tax for personal finance that result from this evolution.

1. The tax code has been flattened, and the incoherence of previous decades has been greatly reduced. Other than taking advantage of tax breaks that are designed to meet the public interest, there are essentially no secret ways to legally reduce your tax burden within the domestic personal tax system.
2. Although the system is more coherent, it is not perfect. If you have an inherently complicated tax situation - owning a family business, second home or cottage - there are bad ways to organise your tax affairs. For example, what are the tax consequences for your estate when you pass away? Rich people will tend to have more complicated tax situations, since many rich people own businesses. Since these rich people will use professional advice to avoid bad tax structures, it could appear that they are "gaming the system". 
3. My guess is that even though fiscal policy will need to be tightened in response to demographics (see my discussion here), I do not expect to see dramatic changes in tax rates.  (Well, they may appear dramatic to some people, but not from where I am sitting. Québec has a marginal combined tax rate of  42% at $44,000 income, and it maxes out at 54.75% on incomes over $140,000.) The very large historical variations in tax rates are not a good precedent for future changes, as the change in the effective tax rate was much lower. Future changes will probably occur within the context of a coherent tax code, and so relatively small changes to tax rates will have a strong impact on economic activity. As a result, I would not assume dramatically changed tax rates in personal financial planning. The uncertainty around asset returns and inflation is probably much larger than the uncertainty about tax rates.

Tax Law Is (Somewhat) More Sensible Than It Appears

For the rest of this article, I refer to the book “Tax Planning for You and Your Family (2014)”, by KPMG, which is written for a Canadian audience. I discuss the book in more detail in a follow up review.

Taxation is complicated, and that is the result of how the legal system operates. For example, note how the Tax Planning guide (page 90) describes capital:

There are no clear rules defining capital property [emphasis theirs]. The Income Tax Act’s only comment is to define a “business” as including “an adventure or concern in the nature of trade”. The courts have developed guidelines over the years, from which a general picture emerges. 

Keep in mind that the Income Tax Act is the size of a phone book. This lack of a definition does not represent particular incompetence on the part of Canadian legislators. Bruce Bartlett notes in Chapter 3 of the book "The Benefit and The Burden": "the term 'income' is nowhere defined in [U.S.] law." The reality is that it is the interaction of court cases with legislation that creates the principles of taxation - with considerable murky areas left over. (As an aside, Piketty's recent book spends a good amount of space advocating the taxation of “capital”. Think about that, and then read the above quotations again.) This murkiness is why online writers cannot offer tax advice (in addition to not offering investment advice). Additionally, the fact that court cases in different countries have different circumstances helps drive a wedge between tax laws in different countries, creating holes in international tax law.

About the only thing that is clear is that income from paycheques is taxable. Since they are taxed at source, there’s no way getting around it. Since most people draw wage income, this may give the false impression that the whole tax code is just as cut and dried.

In addition to the difficulties with basic definitions, tax reform has moved in the direction to make taxes as neutral as possible. This sometimes results in calculations that appear extremely strange. An example  is the case of the Canadian taxation of dividends. Dividends from Canadian corporations are treated in a weird fashion – the amount received is multiplied by a factor greater than one and then added to your income, and then you receive a tax credit based on that increased amount. What’s that all about? Is this a subsidy to capitalists?

Not really. The calculations are done that way so that owners of firms are indifferent to paying themselves dividends or salary**. If the dividend credit was not given, the owners of a firm would just pay out all profits to themselves as salary, eliminating the double taxation that arises from the taxation of corporate income. (The increased salary expense would reduce corporate profits to zero.) The government does not want to warp economic behaviour too far with the tax code; they want activities to continue as they would have otherwise, they just want a slice of the income generated. This is why income taxes are an extremely effective automatic stabiliser.

In addition to moving to making tax laws internally consistent, many countries have introduced legislation similar to what is known in Canada as the General Anti-Avoidance Rule. By way of background, there are three categorisations of how people can deal with taxes:

1. Tax planning: Actions to arrange your affairs to minimise your tax bill while acting in a fashion consistent with the spirit of the tax law. For example, contributing to a tax shelter aimed for building assets for retirement.
2. Tax Evasion: Actions that break tax law.
3. Tax Avoidance: Actions that do not break tax law, but do violate the spirit of the tax code.

Some people mistakenly use the term “avoidance” as being interchangeable with “tax planning” or “tax minimisation”. With the advent of the General Anti-Avoidance Rule, this is no longer true. Under that rule, the tax authorities can look at true economic effect of transactions, and can overrule the transactions if they make no economic sense (other than lowering taxes). In other words, functionally equivalent actions will be taxed equally (at the higher rate, of course). Tax avoidance can therefore be defined as actions that are about to be reclassified by tax authorities.***

This rule gives considerable power to the tax authorities, and the Canadian courts are tending to limit its application so that it remains consistent with existing legal principles. Nonetheless, the core of the rule remains, and so attempting to game the tax system is even more difficult. Even if you find a hole in the law, the anti-avoidance rule can close it on you retroactively.

The book also makes it clear that the treatment of international or corporate taxes is very complex. In most cases the advice is the same – talk to your local tax professional. It is no surprise that international and/or corporation taxation are the areas of greatest political controversy.

Concluding Remarks

In this article, I outlined the post-war evolution of tax laws in the developed economies. The move towards reform led to a flatter tax structure, and one that is intended to be more internally consistent. I will discuss in later articles how taxation matters for personal finance, and how taxation fits within economic analysis. And in particular, I expect to write a review of Piketty’s book on capital, and the issue of using taxation in order to reduce inequality.

Footnotes:

* Corporate taxation is moving in the Swiss cheese direction, particularly in the United States. This is because Congress has decided to transfer money to corporations via “tax expenditures”. Rather than handing out a cash subsidy for doing something, instead the government reduces the corporation's tax bill. Since these tax expenditures are highly targeted, I would consider them to be disguised Industrial Policy rather than pure loopholes. Congress acts in this way because the Establishment does not approve of Industrial Policy, but it does approve of policies that cause industry to act in a certain way.
** The dividend tax credit calculation does not perfectly equalise the tax consequences of whether the owner receives a salary or dividend. For example, the fact that provincial tax rates are not equal messes up the calculation. "Talk to your friendly local tax professional."
*** I am not a legalist, and there may be more formal definitions within Canadian law. What I gave here is a paraphrase of the wording within the KPMG book.

See Also:

• Financing of Government pensions. This is associated with the issue of demographics and the long-term fiscal outlook.
• My technical comment on a point raised about inequality in Piketty's book. I based my comment on a column by Paul Krugman. Since then I have read most of the book, and I stand by my original analysis. However, my point is technical ("wonkish") and is not really addressing the policy issues Piketty raises.
• I have partially based my comments here upon the book by Bruce Bartlett: The Benefit and The Burden: Tax Reform-Why We Need It and What It Will Take (affiliate link) The book discusses the history of taxation in the United States, along with the need for reform. There are some international comparisons in the book, along with an extensive set of references.

(c) Brian Romanchuk 2014