This Selected Issues paper reviews empirical evidence on the main determinants of the real bilateral exchange rate between the Canadian and the U.S. dollars, with particular emphasis on the role played by cyclical and longer-term economic factors. The paper aims to identify the nature of the shocks that have contributed to the recent downward trend in the Canadian dollar. The analysis shows that fluctuations in the real bilateral exchange rate can be explained reasonably well by its long-term fundamentals. The paper also analyzes inflation and the natural rate of unemployment in Canada.

Abstract

This Selected Issues paper reviews empirical evidence on the main determinants of the real bilateral exchange rate between the Canadian and the U.S. dollars, with particular emphasis on the role played by cyclical and longer-term economic factors. The paper aims to identify the nature of the shocks that have contributed to the recent downward trend in the Canadian dollar. The analysis shows that fluctuations in the real bilateral exchange rate can be explained reasonably well by its long-term fundamentals. The paper also analyzes inflation and the natural rate of unemployment in Canada.

IV. THE CANADIAN PERSONAL INCOME TAX SYSTEM1

1. The personal income tax system in Canada creates a number of disincentives to save and distorts the allocation of resources as a consequence of high marginal tax rates. The lack of full indexation of the personal income tax since 1986 has drawn individuals who were previously exempt from tax into the tax base, while it has pushed existing taxpayers into higher tax brackets. These problems could be addressed through a reduction in marginal tax rates and adjustments in nominal income thresholds (the income levels at which different tax rates apply), and standard credits. In addition, moving to full indexation of the personal income tax system would address the problem of bracket creep. Ameliorating the disincentives created by the personal income tax system, however, would likely be costly in terms of revenue foregone.

2. In Canada, personal income is taxed at both the federal and provincial levels. The federal income tax is progressive, with four marginal rates: 0, 17, 26, and 29 percent.2 The progressivity of the federal income tax is increased further by a system of refundable tax credits that provides assistance for low-income individuals and by surtaxes that rise with income.3 In some cases, credits are used instead of deductions to limit the tax relief to high-income earners.

3. From 1988 to 1998, effective federal marginal rates rose as a result of increases in both the general surtax and the high-income surtax, while average federal tax rates also increased as a result of the shift from full to partial indexation in 1986. Over the period from the early 1980s to 1994, Davies (1998) reports that average federal income tax rates rose from about 10.4 percent in 1980 to nearly 14 percent in 1994. Provincial income taxes are generally calculated as a percentage of the basic federal tax plus any applicable surtaxes.4 Combining federal and provincial taxes for 1998, marginal tax rates were 25 percent for those with incomes between $7,000 and $30,000, 40 percent for those with incomes between $30,000 and $60,000, and 51 percent for individuals with income in excess of $60,000. Compared to U.S. tax rates, Canadian tax rates generally rise more quickly and the highest tax rate becomes applicable at a relatively low level of income. For example, the combined federal and average state marginal tax rate in the United States was only 32 percent for those with incomes between the Canadian dollar equivalent of $60,000 to $95,000. The highest combined marginal tax rate in the United States was 45 percent and did not become applicable until an individual reached an income level in excess of the equivalent of $430,000 Canadian dollars.

4. Compared to other OECD countries, Canada’s marginal income tax rates in 1995 were above the OECD average for middle- and high-income earners, while marginal rates for low-income individuals were below the OECD average (OECD 1997). For example, an individual who earned 100 percent of the average production wage in 1995 faced a combined marginal tax rate of 45.9 percent, compared with the OECD average of 41.4 percent. An individual who earned 200 percent of the average production wage in 1995 faced a combined marginal tax rate of 48.1 percent, compared with the OECD average of 47.2 percent. Conversely, an individual who earned only 66 percent of the average production wage in 1995 faced a marginal tax rate of 31.4 percent, well below the OECD average of 37.9 percent.

5. The federal income tax system is indexed annually if the rate of inflation (as measured by the consumer price index) exceeds 3 percent. If inflation exceeds 3 percent, the excess of the rate over 3 percent is used to create index factors to adjust (increase) tax thresholds. Because inflation has remained below 3 percent since 1992, there have been no indexing adjustments to the tax system. As a consequence, individuals that were previously exempt from being taxed have been drawn into the tax base, and existing taxpayers have been pushed into higher tax brackets (bracket creep). The Department of Finance estimates that partial indexation since 1988 has drawn 1.3 million individuals into the tax base who would have been exempt if the system had been fully indexed, while another 2 million individuals were pushed from the 17 percent to the 26 percent tax bracket and another 562,000 people were pushed from the 26 percent to the 29 percent bracket. KPMG (1997) has calculated that for 1997, the lack of full indexation costs an individual with taxable income between $35,941 and $59,180 an extra $1,210 in taxes, and it costs an individual with taxable income in excess of $71,883 an extra $1,782.

6. Recipients of income support through the Old-Age Security (OAS) and Guaranteed Income Support (GIS) system face serious disincentives to save as a result of tax-back rates.5 While GIS payments are not explicitly taxed, they are taxed implicitly because the amount of GIS benefits are reduced by 50 cents for each dollar of income in excess of the OAS/GIS minimum. Thus, recipients of GIS, who are in the lowest income groups, face a tax-back rate of 50 percent, which makes it unattractive to save for retirement. Middle- and high-income recipients do not face the high GIS tax-back rate, but face a disincentive to save as a consequence of the OAS tax-back rate of 15 percent.

7. The disincentives to save noted above are offset to some degree by provisions in the tax system that are designed to encourage saving, such as the deductibility of contributions to a registered retirement savings plan (RRSP) and the deferral of tax on interest income from this source. While this provision encourages savings to some extent, its effects are constrained by the fact that there are limits on the amounts that can be deducted from taxable income for retirement.6 Furthermore, these limits are frozen in nominal terms over the period from 1997 to 2004, which will erode the real value of this deduction. Also, these incentives are likely to be used by those with higher-than-average incomes, and so they do not mitigate the disincentives to save facing low- and middle-income savers. For this reason, these incentives may be perceived as inequitable.

8. The Department of Finance estimates that the costs of addressing the problems of the personal income tax system, principally through reductions in marginal tax rates and restoring full indexation, is substantial in terms of foregone revenue (Table 1). In 1999, the cost of reducing all marginal tax rates, the general 3 percent surtax, and the high-income 5 percent surtax by 1 percentage point is estimated to be about $4.2 billion (0.5 percent of GDP), with about $0.4 billion attributable to the cut in the general surtax, $0.1 billion to the cut in the high-income surtax, and $3.7 billion to the cut in all basic marginal rates. Restoring full indexation to the personal income tax would result in a revenue loss that grows from about $0.6 billion in the first year to $2.4 billion in the fourth year. The combined costs of reducing all marginal tax rates by 1 percentage point and restoring indexation (in the first year) are estimated to be $5 billion, about 0.5 percent of GDP.

Table 1.

Fiscal Costs of Personal Income Tax Reductions

(Full-year impact estimates for 1999)

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Source: The Economic and Fiscal Update: Strong Economy and Secure Society, Department of Finance, 1998.

Nonrefundable.

The general 3 percent surtax was eliminated for all taxpayers earning less than $50,000 and reduced for those with incomes between $50,000 and $65,000 in the 1998 budget. The cost refers to the remainder of the surtax.

Currently applies on basic federal tax in excess of $ 12,500 on an income level of about $65,000.00

17 percent rate applicable to taxable incomes up to $29,590; 26 percent rate applicable to taxable incomes from $29,591 to $59,180; 29 percent rate applicable to taxable incomes from $59,181 and up.

Current credit value of base Canada Child Tax Benefit (CCTB) is $1,020.

Estimates assume 1.5 percent annual inflation. Impacts are cumulative.

List of References

  • Davies, James, 1998, “Marginal Tax Rates in Canada: High and Getting Higher,” CD. Howe Institute, Toronto.

  • Economic and Fiscal Update: Strong Economy and Secure Society, 1998, Department of Finance, Government of Canada.

  • KPMG, 1997, “The Tax Cost of Bracket Creep,Canadian Tax Notes, pp. 1314.

  • OECD Economic Surveys: Canada, 1997, Organization for Economic Cooperation and Development.

1

Prepared by Stephen Tokarick.

2

For 1998, federal income tax rates were 0 percent for income between $0–$6,456, 17 percent for income between $6,456–$29,590, 26 percent for income between $29,590–$59,180, and 29 percent on income over $59,180. Effective July 1, 1998, a supplement of $500 to the basic personal credit became available to low-income filers, which effectively eliminates the income tax on incomes up to $6,956. The supplement is phased out at a rate of 4 percent of income in excess of $6,956.

3

Prior to July 1998, all individuals were subject to a 3 percent surtax. Effective July 1, 1998, the 3 percent surtax on incomes less than $50,000 was eliminated, while it was reduced for those with incomes between $50,000 and $65,000. No reduction was granted for those with incomes above $65,000 in order to focus tax relief on low- and middle-income earners. Also, an additional 5 percent surtax applies to individuals who owe $12,500 or more in basic federal tax (those with incomes of approximately $65,000 and above).

4

An exception is Québec, which administers its income tax separately from the federal tax.

5

OAS pays benefits to Canadians age 65 and over, based on years of residence in Canada. Benefits are taxable and paid to all qualified individuals. GIS provides additional benefits to low-income seniors based on income and marital status.

6

In 1997, individuals may deduct contributions to a registered retirement savings plan (RRSP) up to a limit (18 percent of income in 1996 or $13,500) and these limits are frozen at $13,500 until 2004 when the new limit will become $14,500. In 2005, the limit will rise to $15,500 and be indexed thereafter to increases in the average industrial wage.