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Should I be worried about rising taxation?

November 15, 2012 by Editor, Investingforme

Not yet, but it is an interesting question as raising income tax rates is now hotly discussed as one method to reduce persistent government deficits and their rising debt burdens. Another reason people worry about rising taxation is because of the negative impact this would have on Canadians, that is, their savings and investments. For the past 40 years, the majority of Canadians have accumulated their savings nest eggs inside tax-deferred savings plans like Registered Retirement Savings Plans (RRSPs).


The RRSP strategy

The main benefit of an RRSP is its ability to defer income taxes until some date in the future. In theory, the strategy involves contributing money during our higher-income years and then withdrawing it in future years when our taxable income is smaller. So far, this strategy has worked fairly well and it has been aided by a 40-year decline in income tax rates.

Let’s look at some of those income tax rates from the past 40 years that have helped many Canadian investors:

  • In 2012, the top personal income tax rate (Ontario) is currently 40% on income above $132,406.00. (Compare that to 40% on income above $60,009.00 in 2000, and 70% in 1972 when the top-income tax bracket started at $60,000.00.)
  • Corporations today are only paying 27% (compared with 43% in 2000 and 52% in 1972).

Based on these figures from the past 40 years, savings built up inside an RRSP since 1970 and then withdrawn during retirement would have worked as planned in providing a safe strategy for retirement planning as the past trends in income tax rates have supported this strategy.

Note: The declining contribution of corporate income tax revenue is even more dramatic in the United States. In the industrial era of the early 1950s, corporate income tax contributed almost 33% of the total tax revenue raised by the federal government, equivalent to about 6% of the nation’s income. By the 1970s it generated about 3%. And in the last decade it raised around 2% of national income — only about $1 in $10 of all federal tax dollars collected. - The New York Times

So, why worry now?

Some Canadians worry because the ongoing success of our investment and retirement plans will depend on income tax being lower when money is withdrawn from our RRSP than they were when we made our contributions.

Because income tax trends have played a central role in how and where our savings are invested – favouring capital gains and dividends over interest and employment income – these income tax trends have therefore skewed our savings toward stock market investments.

In fact, we have come to accept as carved in stone that capital gains and dividends should always be taxed at lower rates and our savings should first be deposited to an RRSP during our higher earning years, only to be withdrawn in our retirement years when our income tax rate is lower.

And because income tax rates have been going down for years and years, your investments and retirement plans have pretty much just assumed they always will. But what if income tax rates stop going down and start going up? Should your savings still be deposited into an RRSP? Will capital gains and dividend income still be better than interest income – after all your taxes have been paid? These are all important timely questions.

But income taxes are not increasing, so why worry about something that is not happening?

Well, in fact there are a few reasons to give us all pause:

  • Simple math: government deficits = government spending – revenue (corporate and individual income taxes). For the past four years, governments have been talking austerity and spending reductions. But governments can only cut spending so much before they are forced to raise revenue through higher taxes.
  • Governments have stopped talking about lower income taxes and started to talk about raising taxes on wealth and the wealthy. Will you and your family be classified as wealthy? You might be, but it is more important for you to realize the long accepted trend of lower and lower taxes has changed. Tax increases might start with the wealthy because that is always the easiest place to start, but eventually everyone is impacted.
  • Canadians have put all their eggs in savings and investment baskets that benefit from lower future income taxes, but will get hurt if the trend reverses. Over the decades, Canadians have slowly exposed themselves to big risks if income tax rates begin to rise. (Ask yourself: What percentage of your savings and pension plan assets are invested in stocks and personal real estate –the two asset types that benefit tremendously from current income tax advantages that just might disappear!)

So, if these worries don’t materialize – great! But if they do, many Canadian investors could be in trouble.

Some of the writing is already on the wall

I’m not saying it’s time to panic. But there are some fiscal facts Canadian investors just shouldn't ignore:

  • Government deficits are not disappearing like they were supposed to. Our federal and most of our provincial governments continue to spend more than they collect in tax revenue.
  • The federal government debt load is now $594 billion today, up $124.6 billion since 2008 and the government is projected to keep borrowing and over spending until after 2018.
  • The provinces are just as bad. By the end of 2012, they will have a combined total debt of $479.9 billion, up $133.7 billion, since 2008, and they are still over-spending. Their combined debt has increased 69% since the end of 2000, when it was only $284 billion.

So, can our governments eliminate the deficits simply by cutting spending and keep the current lowered income tax levels? Or will they need to raise income taxes at some point? It makes you wonder. 

Canada is not alone in this matter. Countries around the world are struggling with their deficits – The United States, Great Britain, France, Germany, Italy, Spain, Portugal, Greece, Ireland, Japan, etc. And for the past few years they have all been singing the same tune – austerity, austerity, cut spending, eliminate jobs, reduce services and social entitlement, and so on.

So, the question becomes, when do they start to sing a new chorus – increase taxes, tax wealth of investment holders, increase tax on capital gains and dividends, and so on?

In fact, the new chorus has already begun. Governments are introducing new and higher taxes already. France and Italy have introducing a tax on wealth and raised the upper income tax rates on wealthy citizens. And closer to home, Ontario and Quebec are introducing (or attempting to introduce) higher income tax rates.

Even here in Canada, Ontario and Quebec are attempting to introduce new income taxes and surtaxes on wealth and the wealthy. And the income tax rates on capital gains and dividend income are also prime for re-evaluation.

Note:The income tax benefit that dividend income enjoys over interest income has been shrinking for years now. For example, the interest-rate equivalent multiple (a simple measure of the dividend tax credit benefit over interest income, after tax) for Ontario investors has declined from 1.3702 in 2010 to 1.3400 in 2011 and 1.3148 in 2012.

So, what can Canadian investors do in light of these fiscal changes?

There’s no easy answer, but you might consider the following ideas:

  • Watch for ongoing discussions concerning provincial/federal deficits and all mentions of raising income taxes. (Especially watch for suggestions around increasing taxes on dividends and capital gains. Canadians have huge exposure to these after decades of declining interest rates and a growing investment industry that constantly prefers investments that earn capital gains and dividend income and hate interest income.)
  • Start to think about how your current investments might change if the unthinkable happens – tax increases on dividend income and capital gains.
  • Start to think about where your savings should be deposited if income tax rates begin to rise (TFSAs over RRSPs?, Taxable accounts?).
  • If you work with an advisor, ask for their thoughts and ideas should tax rates begin to rise and how might your current investment and retirement plans change?
  • Most important: be open to this decades-old shift. Don’t simply assume that what worked for you in the past will work in the future. Changes in long-term trends and assumptions dictate you adapt your saving and investment strategies. (In the world of investing, you should try to think ahead of the crowd and position your savings and investments for changes before they occur.)

 

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