Monday, 19 December 2011

Why is employing legal tax avoidance strategies a bad thing?

There is a tax code that all Canadians have agreed to (through their elected representatives who have voted on the various provisions and passed it into law come budget time). The Canada Revenue Agency enforces this tax code by making sure that everyone pays their fair share. But what is this "fair share". In my opinion, a "fair share" is what you must pay as per the tax code. You might think that I am just repeating myself. But there is a subtle difference.

Consider this scenario of 2 identical families with 2 adults and 2 children (say 5 and 9 years old). Both families have a single income and for the sake of simplicity let us assume that they both have employment income as their sole source of income. Both are neighbours living in the same kind of home as well so everything is identical between them. Again to keep things simple, neither has any RRSP deductions or any deductions for that matter except what I list below.

Family 1: 
Annual Income : $40,000
Charitable Donation deduction: $0
NET income after taxes, CPP & EI deductions: $35,073
Average tax rate: 12.32%
Net disposable income after accounting for Charitable Donation: $35,073

Family 2:
Annual Income : $61,600
Charitable Donation deduction: $21,600
NET income after taxes, CPP & EI deductions: $57,995
Average tax rate: 5.85%
Net disposable income after accounting for Charitable Donation: $36,395

As you can see above, Family 1 with a pre-tax income of $40,000 pays 12.32% of their income in taxes and takes home $35,073.

Family 2 on the other hand, in trying to be identical to Family 1, donates every dollar of their income that is in excess of their neighbour's income to charity. Their effective tax rate is 5.85% and after accounting for their charitable donation and taxes, they take home $36,395.

Most people will simply look at the tax rate and the pre-tax annual income and scream bloody murder.

How is it fair that a family making 50% more income pays taxes at a rate that is half that of the lower income family? And to add insult to injury, they end up with more money at the end of the year.

This is where all the "Occupy" folks are dead wrong. Family 2 is simply taking advantage of the tax code and coming out ahead. It is difficult to find fault with Family 2 in this example because they are giving away so much money to charity. So even the people who would normally have an issue with this case will likely hold back. But Family 2 could have very easily used other deductions to achieve similar results ex RRSPs, Dividend Investments, Capital gains, Public transit credits, Children's Activity credits, Medical expenses credits, tuition credits etc.

And I do not see anything wrong with that. They are simply paying their fair share of taxes and using the existing tax code to do what works best for them. If their effective tax rate turns out to be lower than their neighbours, its not their fault.

Millionaires and Billionaires like Warren Buffet likely use all these strategies and more to end up with an effective tax rate that is lower than what their chauffeur or secretary has.

So why do we frown on folks that follow the letter of the law and come out ahead?

No comments:

Post a Comment