Every year tax time is a good reason to complain about paying too much tax. One of the big misconceptions I hear over and over again is this notion that we pay half of our money to the government. Just recently, someone showed me an insurance proposal where the advisor used a 50% tax rate to illustrate the benefits of a tax sheltered life insurance policy. We pay a good chunk of tax but this is very misleading to me!
Tax Freedom Day
It’s nearly impossible for the average Canadian to really figure out how much tax they pay especially when you include all forms of tax from all three levels of government like sales taxes, import duties, excise taxes, gas tax, payroll tax, etc.
The Fraser Institute in Canada calculates tax freedom day every year. Tax Freedom Day is the theoretical day in the year the average Canadian family has earned enough money to pay the taxes imposed on it by the three levels of Canadian government: federal, provincial, and local. Taxes used to compute Tax Freedom Day include income taxes, property taxes, sales taxes, profit taxes, health taxes, social security and employment taxes, import duties, licence fees, taxes on alcohol and tobacco, natural resource fees, fuel taxes, hospital taxes, and a host of other levies.
Tax freedom day has lead many people to believe 50% of their money goes to tax in some way shape or form. In 2016, Tax Freedom day was June 7th. In theory this means we pay 43% in tax, not 50%. Here's some tax freedom dates from the past:
- June 7. 2016
- June 10, 2015
- June 9, 2014
- June 10, 2013
- June 11, 2012
- June 10, 2011
- June 6, 2010
- June 3, 2009
- June 22, 2005
- June 25, 2000 (latest tax freedom day)
- May 3, 1961 (earliest tax freedom day)
Tax freedom day is also different from province to province. Here in Alberta, we enjoy the lowest tax freedom day in Canada, which was May 17 in 2016. On that basis, this translates to a 38% tax rate, which is far from 50%.
Even at the peak of tax in 2000, tax freedom day in Canada was June 25th, which makes it closer to that 50% figure.
I’ve been following the tax freedom day for quite some time now but I’m always skeptical of the dates given because they seem to be inconsistent. I think it’s an interesting view of tax but another perspective is to look just at marginal tax rates (including both Federal and Provincial Income Tax).
Marginal tax may not a true reflection of tax
A lot of times, people use marginal tax to reflect how much tax we pay but this can also be misleading. Marginal tax is the amount of tax we pay on any additional dollar we earn. As we make more money, we pay more tax. To understand your marginal tax rate (MTR), you can start with the federal tax rates (2016):
|Lower limit||upper limit|
These rates do not include provincial tax. Once you add the provincial income, tax, every province has it’s own marginal tax rate. For example, here are the combines tax rates for Alberta (2015):
|Lower limit||upper limit|
If you want to know the marginal tax rates for other provinces, you can download this handy one page summary of all the Marginal tax rates for all provinces and territories in Canada.
Nova Scotia is the only province in Canada with a marginal tax rate of 50% and you have to make more than $150,000 to pay that rate.
Doing the math
If you earn $50,000 in income in 2016, then you would be in the 30.5% marginal tax bracket and you would pay 30.5% on any additional dollar you made to the government. If you earned $100,000, then you would be in the 36% marginal tax bracket.
One of the biggest misconceptions about tax rates is that your entire income will be taxed at your marginal tax rate. Here's an example to show you how it actually works:
The person making $50,000 per year would not pay $16,000 in tax ($50,000 x 32%). Instead, his/her tax would be calculated like this:
|Lower limit||upper limit||$50,000|
|Average Tax Rate (%)||19.8%|
|Marginal Tax Rate (%)||30.5%|
When you understand the average tax rate calculation, it is easy to see how misleading a 50% tax rate is. In fact, whether you look at tax freedom day, marginal tax or average tax, there is not 50% tax rate. We pay a significant amount of tax but do not fall into the trap of believing that 50% of our money goes to tax. Be careful of people who are using too high of tax rates to sell you tax savings products. As you can see, you might pay less tax than you think.
The marginal tax rate of 32% is the amount of tax paid on any additional dollar made up to the next tax bracket. In this example, the average tax is only 19.8% ($9,891 divided by $50,000 of total income). Average tax is the percentage of tax paid based on your total gross income and reflects the total tax you are paying. It is the total amount of tax you will pay through all the brackets divided by total income and will mathematically always be lower than the marginal tax rate.