Lately the Conservatives have been pushing their agenda of federal income tax reform. The stated objective is to reduce the number of income tax categories (marginal rates). Finance Minister Jim Flaherty explained this move with the following:

With multiple categories, what you do is you discourage some people from working harder and earning more money [which would end up] pushing themselves into a higher tax bracket,

- Jim Flaherty

This puzzles me to no end and gives me the worrying impression that Flaherty fails to understand how the Canadian tax system works.

How the Canadian Tax System Doesn't Work

A very common misconception about the Canadian tax system, which Flaherty appears to be using, is that as you earn more money the tax rate on your total income rises.

Here is an example: Larry earns $40,000 and pays 15% tax so his income after tax is $34,000. The following year Larry gets a raise and earns $42,000, this pushes him into a higher tax bracket so his tax rate is 22% and his income after tax is $32,760.

Following this logic, it is understandable that some people near a tax bracket threshold may not want to earn more since it would decrease their after tax income. The problem with this logic is this isn't how our tax system is structured.

How the Canadian Tax System Works

Canadian income tax is based on marginal tax rates. The word marginal here means that the tax rate applies to the next dollar you earn. So you would pay 15% on the first $41,544 of income, 22% on the next $41,544 of income, 26% on the next $45,712 of income, and 29% on any income after that.

Time for another example: Alice earns $40,000 and pays 15% tax so her income after tax is $34,000. The following year Alice gets a raise and earns $42,000, so her marginal tax rate moves up to 22% on any income beyond $41,544. Her total income after tax for the year is $35,669.

Notice how moving into the next tax bracket does not cause a reduction in income using this system. There is always motivation to earn more money since at no point can moving into a new tax bracket cause an overall reduction in income.

A Pleasant Graph

For you visual learners out there, here is a graph. The green line is income before tax, the blue line is the after tax income under our current system, and the red line is the popular misconception of how tax rates affect after tax income.

Notice that in the real world (the blue line), moving into a higher tax bracket doesn't cause a decrease in your income.

So What is Flaherty Thinking?

Back to the important question, what on earth was Flaherty talking about? Personally, I fail to see how paying an extra 7 cents on a dollar is going to discourage people from attempting to earn more money. Even if you move into the next tax bracket you are still earning more money than before.

Since any change in the tax brackets will require some changes in the tax rates, if anything, the quote above sounds like a flimsy excuse to make some large changes to the tax system. The next great mystery is what are those changes going to be, and who do they favour?