Governments getting their fiscal houses in order are asking taxpayers to depend less on government services and take more responsibility for the future. But those same taxpayers are wrestling with two layers of taxes: taxes on income, which erodes current income, and taxes on capital appreciation, which erodes future income.
This seems counter-productive to the concept of self-reliance.
That begs questions about our tax system. Should current income be taxed more than the future income that capital appreciation provides, as happens now? Should they be taxed equally? Or should capital appreciation — often seen as the purview of the wealthy — be taxed more than current income? These are very important considerations, especially in these volatile times, and there are arguments to be made on both sides.
On the side of lower taxes on current income is the time value of money.Thanks to high taxes on current income, taxpayers have fewer after-tax dollars to put into the tax-advantaged savings vehicles at their disposal: Tax-Free Savings Accounts, which create tax-exempt income from after-tax dollars, and tax-deferred registered accounts such as Registered Retirement Savings Plans or employer-sponsored pension plans.
When governments take tax dollars off the top of taxpayers’ employment income, they remove important wealth-compounding opportunities. At the outset, savings balances are lower, and the advantage of whole dollars compounding over time is lost. The most important defence a responsible taxpayer can have is the ability to keep more of the first dollar he or she earns and invest it promptly in a tax-protected account. Then, he or she is in a position to create the self-reliant income desired by cash-strapped governments. (After all, governments still have an opportunity to tax future income.)
Unfortunately, millions of Canadians are using their after-tax dollars to fund non-discretionary needs and do not have enough “redundant income” to save, so they cannot be self-reliant (see “Contribute to your RRSP,” Knowledge Bureau Report, Feb. 1).
But if you are saving and accumulating wealth, you come up against a second erosion of wealth — the tax on accumulated capital.
Many think the asset-rich should pay more and government taxes at the time of actual sale or “deemed disposition” (death or emigration, for example) should be higher. We want to be very careful here. If governments are encouraging self-reliance, they don’t want to rob future generations of the ability to earn income on that inherited capital — or future governments to tax it.
As the large, baby-boom generation moves into retirement, boomers will pay less personal income taxes — the largest line of revenue for governments in recent years — and their contribution to federal coffers will decline accordingly. That presents a challenge for overcommitted governments. If future government revenues are to be maintained, that capital, intact, must be available for both future generations and governments.
Yet another factor affects capital accumulation: because the adjusted cost base of a capital asset is not indexed to inflation, any increase in inflation subjects the value of capital to a powerful and hidden tax, one that’s based on inflated values rather than real values. Government coffers win in times of high inflation; investors lose on a net basis.
Together, inflation and taxes quickly erode the real value of wealth — that is, purchasing power — and that risk is inherent in capital appreciation.
So, which should be taxed more — current or future income? There is no easy answer. Both the performance of the investments you choose and their ability to grow your capital, and the time value of money are important. And you can’t discount current market risks or the risk future taxation and inflation pose to your capital and income. All affect the sustainability of family net worth. Your best strategy is knowledge.
It’s Your Money. Your Life. Do you understand how your current income and future income from accumulated assets are taxed? If you are not sure, ask your tax and financial advisors. Given that we are in the midst of a long period of volatility and low returns, you should protect your capital from the eroding effects of tax and inflation and manage it — on an individual, family and community basis.
Evelyn Jacks, President of Knowledge Bureau, is author of Essential Tax Facts 2012 and co-author of Financial Recovery in a Fragile World. Mrs. Jacks will be launching her books and addressing today’s financial and tax issues in Winnipeg on Feb. 9. To register, click here.