An excise tax is the easiest tax to analyze, making it a good vehicle for understanding the general principles of tax analysis. However, in Canada today, excise taxes are actually a relatively minor source of government revenue. In this section, we develop a framework for understanding more general forms of taxation and look at some of the major taxes used in Canada.

Every tax consists of two pieces: a base and a structure. The tax base is the measure or value that determines how much tax an individual or firm pays. It is usually a monetary measure, like income or property value. The tax structure specifies how the tax depends on the tax base. It is usually expressed in percentage terms; for example, homeowners in some areas might pay yearly property taxes equal to 2% of the value of their homes.

Some important taxes and their tax bases are as follows:

Once the tax base has been defined, the next question is how the tax depends on the base. The simplest tax structure is a proportional tax, also sometimes called a flat tax, which is the same percentage of the base regardless of the taxpayer’s income or wealth. For example, a property tax that is set at 2% of the value of the property, whether the property is worth $10 000 or $10 000 000, is a proportional tax. Many taxes, however, are not proportional. Instead, different people pay different percentages, usually because the tax law tries to take account of either the benefits principle or the ability-to-pay principle.

Because taxes are ultimately paid out of income, economists classify taxes according to how they vary with the income of individuals. A tax that rises more than in proportion to income, so that high-income taxpayers pay a larger percentage of their income than low-income taxpayers, is a progressive tax. A tax that rises less than in proportion to income, so that higher-income taxpayers pay a smaller percentage of their income than low-income taxpayers, is a regressive tax. A proportional tax on income would be neither progressive nor regressive.

The Canadian tax system contains a mixture of progressive and regressive taxes, though it is somewhat progressive overall.

Most, though not all, people view a progressive tax system as fairer than a regressive system. The reason is the ability-to-pay principle: a high-income family that pays 29% of its income in taxes is still left with a lot more money than a low-income family that pays only 15% in taxes. But attempts to make taxes strongly progressive run up against the trade-off between equity and efficiency.

To see why, consider a hypothetical example, illustrated in Table 7-3. We assume that there are two kinds of people in the nation of Taxmania: half of the population earns $40 000 a year and half earns $80 000, so the average income is $60 000 a year. We also assume that the Taxmanian government needs to collect one-fourth of that income—$15 000 a year per person—in taxes.

One way to raise this revenue would be through a proportional tax that takes one-fourth of everyone’s income. The results of this proportional tax are shown in the second column of Table 7-3: after taxes, lower-income Taxmanians would be left with an income of $30 000 a year and higher-income Taxmanians, $60 000.

Even this system might have some negative effects on incentives. Suppose, for example, that finishing college improves a Taxmanian’s chance of getting a higher-paying job. Some people who would invest time and effort in going to college in hopes of raising their income from $40 000 to $80 000, a $40 000 gain, might not bother if the potential gain is only $30 000, the after-tax difference in pay between a lower-paying and higher-paying job.

But a strongly progressive tax system could create a much bigger incentive problem. Suppose that the Taxmanian government decided to exempt the poorer half of the population from all taxes but still wanted to raise the same amount of revenue. To do this, it would have to collect $30 000 from each individual earning $80 000 a year. As the third column of Table 7-3 shows, people earning $80 000 would then be left with income after taxes of $50 000—only $10 000 more than the after-tax income of people earning half as much before taxes. This would greatly reduce the incentive for people to invest time and effort to raise their earnings.

The point here is that any income tax system will tax away part of the gain an individual gets by moving up the income scale, reducing the incentive to earn more. But a progressive tax takes away a larger share of the gain than a proportional tax, creating a more adverse effect on incentives. In comparing the incentive effects of tax systems, economists often focus on the marginal tax rate: the percentage of an increase in income that is taxed away. In this example, the marginal tax rate on income above $40 000 is 25% with proportional taxation but 75% with progressive taxation.

Our hypothetical example is much more extreme than the reality of progressive taxation in Canada today—although, as the Economics in Action explains, in previous years the marginal tax rates paid by high earners were very high. However, these have moderated over time as concerns arose about the severe incentive effects of extremely progressive taxes. In short, the ability-to-pay principle pushes governments toward a highly progressive tax system, but efficiency considerations push them the other way.

Table 7-4 shows the revenue raised by major taxes in Canada in 2012. Some of the taxes are collected by the federal government and the others by provincial, territorial, and local governments.

There is a major tax corresponding to five of the six tax bases we identified earlier. There are income taxes, payroll taxes, sales taxes, profits taxes, and property taxes, all of which play an important role in the overall tax system. The only item missing is a wealth tax. In fact, most Canadian provinces and territories do have a wealth tax, called probate fees, which depends on the value of someone’s estate at the time of his or her death.

Probate fees are charged by the provincial court to recognize the validity of a deceased person’s will and the appointment of the executor. When the court grants letters of probate this notifies the public that the will is adequate and that it was not being challenged. Thus probate protects the executor and all parties who received an inheritance payment under the will from future legal challenges or claims. These fees vary significantly from province to province, in Quebec probate costs about $100 while in Ontario probate fees depend on the size of the estate rising to 15% of the value of the estate above $50 000. The deceased’s assets are deemed to have been sold on the day of the death, and any tax owing from this sale is payable through the regular income tax system on a final tax return. There is one important exception when someone dies: the assets can be passed, tax free, to a spouse.

In addition to the taxes shown in Table 7-4, provincial and local governments collect substantial revenue from other sources as varied as driver’s licence fees and sewer charges. These fees and charges are an important part of the tax burden but very difficult to summarize or analyze.

Are the taxes in Table 7-4 progressive or regressive? It depends on the tax. The personal income tax is strongly progressive. Payroll taxes, except for the CPP and EI portions paid only on earnings up to about $50 000, are somewhat regressive. Sales taxes are generally regressive, because higher-income families save more of their income and thus spend a smaller share of it on taxable goods than do lower-income families.

Property taxes, which together with sales taxes represent the largest source of revenue for provincial, territorial, and local governments, are somewhat regressive. In addition, those other taxes principally levied at the provincial and local level are typically quite regressive: it costs the same amount to renew a driver’s licence or pay your vehicle licensing fee no matter what your income is.

Overall, the federal income tax is quite progressive. The second column of Table 7-5 shows the share of all income earned by different percentiles of income earners. The third column of this table shows that as we move higher up the income distribution the share of federal income tax paid declines more slowly than the share of income earned does. In 2011, the people in the top half of the income distribution earned 83% of all income earned but paid 96% of federal income tax. The table shows that the federal tax income is indeed progressive, with low-income families paying a relatively small share of their income in federal income taxes and high-income families paying a greater share of their income.

Since the mid- to late-1990s, the federal government and most provincial governments have cut income taxes for most families. The largest cuts, both as a share of income and as a share of taxes collected, have gone to families with high incomes. As a result, the personal income tax system is less progressive (at the time of writing) than it was in 1995 because the share of income paid by high-income families has fallen relative to the share paid by middle- and low-income families.

And the overall tax system is likely even less progressive than in the past. The reduction of the GST from 7% to 5% helped make the tax system less regressive (or more progressive). But, increases in payroll tax rates and other fees charged by governments make the tax system more regressive. Also, corporate tax rates have fallen very significantly since the mid-1990s. Of course people with higher incomes are more likely to own a greater fraction of Canada’s corporations than lower income people. So you could argue that corporate tax cuts also make the tax system more regressive.

In summary, the Canadian tax system is somewhat progressive, with the richest tenth of the population paying a somewhat higher share of income in taxes than families in the middle, and the poorest Canadians paying considerably less. Although our tax system is progressive, the degree of progressiveness varies with the nature of the taxes. The federal income tax is more progressive than payroll taxes. And personal income taxation is more progressive than sales and property taxes.

Why are some taxes progressive but others regressive? Can’t the government make up its mind?

There are two main reasons for the mixture of regressive and progressive taxes in the Canadian system: the difference between levels of government and the fact that different taxes are based on different principles.

Provincial and especially local governments generally do not make as much effort to apply the ability-to-pay principle. This is largely because they are subject to tax competition: a province or local government that imposes high taxes on people with high incomes faces the prospect that those people may move to other locations where taxes are lower. This is much less of a concern at the national level, although a handful of very rich people have given up their Canadian citizenship to avoid paying Canadian taxes.

Although the federal government is in a better position than provincial or local governments to apply principles of fairness, it applies different principles to different taxes. We saw an example of this in the preceding Economics in Action. The most important tax, the federal income tax, is strongly progressive, reflecting the ability-to-pay principle. But the federal payroll taxes, the second most important tax, are somewhat regressive, because most of this tax revenue is linked to specific programs—Canada Pension Plan and Employment Insurance—and, reflecting the benefits principle, payroll taxes are levied more or less in proportion to the benefits received from these programs.