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Most economists would agree that high marginal tax rates, which reduce the reward of earning more income, discourage people from engaging in productive economic activity, which can ultimately hinder economic growth and — although there is some debate about the exact magnitude of this effect.

Knowing this, why then do our Canadian governments insist on raising rates? The obvious answer is to raise more revenue as they pay for more spending, while trying to tackle deficits and an increasing debt load. But, as the Institute points out, the tax increases are unlikely to raise as much revenue as governments expect since taxpayers, and, in particular, upper-income earners, tend to change their behaviour in response to higher tax rates in ways that reduce the amount of tax they pay. In other words, tax rate increases often don’t raise the amount of revenue governments were expecting.

To understand why, keep in mind that the amount of revenue collected from an income tax depends not just on the tax rate itself but on the total income that is subject to the tax or “the base,” to use the economic lingo. The tax rate times the base equals the amount of income tax a government will collect. But, when a government chooses to increase the tax rate, studies have shown that taxpayers often respond by changing their behaviour in ways that actually shrink the tax base, resulting in less total government revenue.

Prior research by the Institute found that there are a number of ways that taxpayers can respond to a tax in­crease that would reduce the tax base, including working less and thus re­porting less taxable income or negotiating with an employer to substitute taxable income with certain tax-free fringe benefits.

The study cites the U.K. example whereby the government introduced a 50 per cent tax rate on upper-income earners in 2010 which was expected to bring in £2.5 billion. A government report estimated that it brought in £1 bil­lion or less and the U.K.’s top rate has since been reduced to 45 per cent.

Jamie.Golombek@cibc.com

Jamie Golombek, CPA, CA, CFP, CLU, TEP is the Managing Director, Tax & Estate Planning with CIBC Financial Planning & Advice Group in Toronto.