An Analysis of Personal Income Tax Flows to Provinces Under the Income Tax Collection Agreements
(1995, 1996, 1997)
The federal government has Tax Collection Agreements with all provinces except Quebec to collect personal income tax on their behalf and to pay them on the basis of taxes assessed. Under the terms of these agreements, the federal government absorbs all bad debts and administrative costs and retains any interest and penalties collected from late taxpayers.
In the wake of the acceleration of tax collections introduced over the last several years, a question was raised at the beginning of 1997 by some provinces as to whether the income tax revenues collected by the federal government on behalf of all the provinces participating in the TCAs were in fact still being transferred to the provinces quickly enough. To answer this question a consultant was engaged to undertake a detailed assessment of the timing of payments relative to collections1. A spreadsheet model of tax collections and assessments and the tax payments to provinces was constructed using daily data provided by Revenue Canada for the 1995 taxation year (the last year for which data on all the components of the analysis were available). Using this model, the present value of the provincial personal income tax (PIT) collections and assessments was compared to the present value of the tax payments to provinces.
If there is a substantial delay in the transfer of funds to provinces, the federal government retains these funds for its own use for a period of time and thus keeps the interest earned on the funds. On the other hand, if cash flows to provinces are in advance of collections of the tax assessed, the provinces benefit from the interest earned on the transferred funds. The present value of the difference between provincial tax collected and assessed and the tax payments made to the provinces provides a measure of the extent to which the flows are not of equivalent value.
The central conclusion of the Grady study was that the net present value of the difference between the streams of PIT collections based on assessments and payments to provinces favoured the federal government to the tune of $99 million in 1995, implying late payments to provinces. Based on the analysis, and on the belief that 1995 was representative of the situation going forward, two steps were taken:
- As the study of payments was initiated in 1997, a payment of $99 million (plus interest) in respect of that year was provided to the provinces by the federal government.
- Effective with the 1998 taxation year and going forward, the schedule of payments under the TCAs was adjusted forward by two payments.
A total of forty-eight payments, four per month, are made to the provinces in respect of a taxation year. Payments are made on the:
- 6th working day of the month;
- 3rd working day following the 15th;
- 1st working day following the 20th;
- 2nd last working day of the month.
Prior to the payment schedule being adjusted forward by two payments, the first payment in respect of a taxation year was made on the 3rd working day following the 15th of February. Starting in 1998, the first payment is provided on the 2nd last working day of January. Using 1995 as an example, the first payment to the provinces was made on FebruaryÂ 20,Â 1995. Had the adjusted schedule been in effect, the first payment would have been provided January 30, 21 days earlier.
An important assumption made in providing a one-time payment to the provinces in respect of the 1997 taxation year and in adjusting the schedule of payments forward by two weeks was that the 1995 taxation year (which formed the basis of the study) was representative of the situation going forward. To verify the validity of this assumption, the federal government agreed to repeat the exercise internally on the basis of the 1996 and 1997 tax years using the Grady framework.
The results of the initial Grady study on the basis of the 1995 taxation year, and of the current study on the basis of the 1996 and 1997 taxation years, the two most recent years for which data are available, were provided to the provinces in June 1999. However, the methodology used in the initial Grady study was modified slightly and the exercise was re-done, following concerns raised by some provinces about the magnitude of the accounts receivables presented in the study.
The following summary, and the attached Appendix provide greater detail regarding the data sources used in the analysis, and a summary of the estimated monthly provincial taxes collected and cash flows to provinces for the taxation years examined under the modified methodology.
Summary of Revised Analysis
The methodology used was identical to that used by Grady. Three major steps were carried out:
- A daily time series of net provincial tax collected was constructed. As the daily collections information was not available for all the components of collections and was not identified with respect to taxation year, it was necessary to construct an estimate based on a number of assumptions. It was also necessary to estimate the collections of provincial tax since, at the time tax payments are received, there is no indication of the split between the federal and provincial components.
- A time series of cash payments to the provinces was constructed. As the payments are equal and the payment dates are set out in the Agreements (the payment schedule used was that which was in effect prior to 1998), it was a trivial exercise to line up the payments with the due dates. In establishing this time series of payments which was necessary to properly assess the adequacy of the cash flow to provinces, it was assumed that the value of provincial tax assessed was accurately forecast at the beginning of the period before the cash flows to the provinces began (year-end adjustments are made to compensate for such inaccuracies). This eliminated forecasting errors as a factor influencing cash flow and focussed the analysis on the differences in timing of the collections and payments stream.
- The collections and payments were then compared by taking the present value of the differences in the two series at the beginning of the taxation years. The assumption is that, if offered a choice, provincial governments, fully appreciating the importance of the time value of money, would prefer the cash flow stream with the greater present value.
Results of revised analysis
The results of the revised study for the 1995, 1996, and 1997 taxation years are shown in Table 1 below.
|Present Value of Difference Between Net Provincial Tax Collected and Payments to Provinces*
|Approximate Forward Adjustment Required for a Neutral Payment System|
*Payments schedule used was that which was in effect prior to 1998 taxation year.
As mentioned earlier, on the basis of the revised results for the 1995 taxation year, a payment in the amount of $99 million (plus interest) in respect of the 1997 taxation year was provided to the provinces in 1998. With modifications to the Grady model to take into account arrears, the $99 million figure is now $81.6 million. The revised analysis of 1996 and 1997 revealed that the net present value of the difference between the time streams of personal income tax collections based on assessments and payments to provinces benefited the federal government by $59.4 million for 1996, and by $22.3 million for 1997.
The second and probably more important issue at this time is whether the new schedule for payments to the provinces, in effect since 1998, benefits one level of government over the other. Effective with the 1998 taxation year, the schedule of payments under the TCAs was adjusted forward by two payments (i.e. payments are made about 13 days earlier on average). The analysis shows that for 1995, 1996, and 1997, adjustments of about 15, 16, and 8 days respectively (three year average of about 15 days) would have been required to achieve a neutral payment system. On this basis it would appear that on average the new schedule of payments to the provinces achieves the objective of a neutral payments system. Chart 1 provides a graphic illustration for the 1997 taxation year of provincial tax collected versus payments to provinces using the new schedule of payments.
The results are sensitive to the taxation year being examined. The following is a list and brief explanation of some of the factors that may affect the results.
Factors Affecting Value of Benefit
Discount Rate. In years where the payments system is not neutral, the discount rate has a direct effect on how much money is involved. For example, in 1997 the average government of Canada three-month T-Bill rate was 3.21%. Each 1% variation in the rate would lead to an increase or decrease of about $7.1 million in the present value of the difference between the net provincial tax collected and the payments to provinces.
Factors Affecting Adequacy of Timing of Payments to Provinces
Timing of collections. The timing of collections differs from year to year and this has an effect on the results. If one examines source deduction remittances (which account for 85% to 90% of taxes collected) for 1996 versus those for 1997, the cumulative source deduction remittances for 1996 were consistently ahead of the 1997 remittances until the 10th of February, and ahead about half of the time from the 11th of February until mid-April. This is the case despite the fact that total source deductions for 1996 were $90.3 billion versus $94.7 billion for 1997.
"Timing" of the timing of payments. The "timing" of the timing of payments itself can affect the results. If one compares the payments schedule for the 1996 tax year to that of the 1997 tax year, payments were made a cumulative 51 days earlier for 1997 than for 1996. While the same formula was used to determine the payments schedule for both years, the end result differs because of when weekends and statutory holidays fall in each year.
Mix of source of income taxes. The mix of the source of income taxes collected affects the results. For example, 10% of net collections in 1995 were in the form of instalment payments, compared to 11% for 1997. Where a greater percentage of taxes collected comes from sources that begin to be collected later in the taxation year (such as instalment payments and payments on filing), the provinces are favoured. Where a greater percentage of taxes collected comes from sources that begin to be collected earlier in the taxation year (such as source deductions), the federal government is favoured. This would suggest a cyclical influence in the receipt of payments.
The basic approach to constructing the daily data in the spreadsheet used in the analysis is described below. The monthly data are shown in Tables 1, 2, and 3 for 1995, 1996, and 1997 respectively. A thorough understanding of how the data are organized is necessary to carry out analysis using the spreadsheet. Table 4 shows the annual collections data that provided the benchmarks for the daily data. Table 5 provides the data on tax assessed and the provincial share from the Final Determination of Payments under the Tax Collection Agreements.
This analysis has not taken into account the cost to the federal government of administering the provincial tax account on behalf of provinces. Administrative costs, except for those occasioned by the tax credits and rebates, are totally absorbed by the federal government.
Net Provincial Tax Collected
Income taxes are collected in a number of ways. Table 4 provides the annual breakdown of the ways that total net federal and provincial tax is collected.
The following provides documentation for the columns in the spreadsheet used to calculate the present value of the difference between provincial tax collections and payments (see Tables 1, 2, and 3). Additional columns necessary to calculate the data for the eleven columns described below are contained in the spreadsheet.
Deductions at Source (Column 1). This is the major vehicle for collecting personal income tax. Data on daily deductions at source are available from Revenue Canada's PAYDAC. Deductions at source and transfers to Revenue Canada in respect of the Canada Pension Plan and Employment Insurance contributions are also made and these must be deducted in order to arrive at deductions in respect of income tax for the given year. The monthly contributions for CPP and EI are divided equally among the business days of the month and subtracted from the PAYDAC daily source deductions to estimate daily income tax receipts. It is also necessary to make adjustments for the timing of deductions at source. In January and even early February some of the deductions are for the prior tax year.
Remitters are divided into regular remitters and two groups of accelerated remitters. Regular remitters are required to remit on or before the 15th of the following month. Accelerated remitters paying over $15,000 per month are required to remit twice a month on or before the 25th of the month and the 10th of the following month. Accelerated remitters paying over $50,000 per month are required to remit on or before the 10th, 17th, and 24th of the month and 3rd of the following month. According to data provided by Revenue Canada, 17.75 per cent of the remittances are made by regular remitters, 9.3 per cent by the first group of accelerated remitters and 72.95 per cent by the second group. It is thus assumed that 100 per cent of the source deductions made up to January 10th are for the prior taxation year, 27.05 per cent of the source deductions made between January 11th and January 24th are for the prior taxation year, and 17.75 per cent of the deductions between January 25th and February 14th are for the prior taxation year.
The estimated daily source deductions for income tax are scaled to equal the annual figures shown in Table 4 provided by Revenue Canada.
Instalment Payments (Column 2).
These are made by the self-employed or by those with substantial investment income. These payments are included as received over the period from April in a given year to March of the following year. Monthly instalment payments data provided by Revenue Canada are distributed in the months of March, June, September, and December using the CINDAC daily data provided by Revenue Canada. In these months the largest portion of the CINDAC receipts stems from instalment payments. In other months, the monthly payments are distributed equally across business days.
Payments on Filing and Arrears (Column 3).
Income tax payments are also made upon or after the filing of tax returns after the end of the tax year. Payments in respect of a given taxation year made upon filing are included as receipts during the period January to December of the following year, with the bulk of the payments falling in April and May. The monthly collections provided by Revenue Canada were distributed across the days of the month in April and May using the CINDAC distribution since in these months most of those collections were for payments upon filing. In other months, payments on filing were prorated across all of the business days in the month. Payments made after the filing of tax returns (for example, where post-dated cheques are enclosed with tax returns or where taxpayers make payments after the reassessment of tax returns) are included as receipts during the period of January to December of the following year. The monthly collections provided by Revenue Canada were prorated across all of the business days of the month.
Receivables (Column 4)
. Taxes assessed but not paid in respect of a given taxation year can be established as accounts receivable in May of the following year. For this exercise, accounts receivable were estimated as the difference between total tax assessed and the sum of deductions at source, instalment payments, and payments on filing minus refunds for overpayment of tax all taken from Table 4. Some receivables turn out to be bad debts and are not collectible. The receivables used in the analysis have not been reduced by the amount of the bad debts as these debts are absorbed by the federal government under the terms of the TCAs.
Refunds (Column 5).
Refunds of tax collected are made to those whose tax assessed is less than the deductions at source or instalment payments they have made. Refunds due to overpayment of tax in respect of a given taxation year are assumed to extend from January to December of the following year. The monthly data on refunds provided by Revenue Canada exclude refunds arising out of items other than overpayment of tax (i.e. federal refundable credits, refundable provincial credits, employment insurance and CPP overpayments) so it is not necessary to adjust the series as was done in past studies. The monthly data are prorated daily across business days of the month.
Net Collections (Column 6).
The time stream of total net collections of federal and personal income tax is equal to the sum, day by day, of the deductions at source, instalment payments, payments on filing and receivables less refunds.
Provincial Share (Column 7).
The ratio of provincial tax assessed to total federal and provincial tax assessed for each taxation year is calculated in the spreadsheet and is shown in Table 5. The annual ratio is applied to net collections for each day to determine the provincial share of net collections for each day.
Provincial Credits and Rebates (Column 8).
Provincial credits and rebates have been deducted over the period from January to December of the following taxation year. The monthly data provided by Revenue Canada are prorated daily across the business days of the month and the total is scaled to equal the total from the Final TCA settlement book.
Net Provincial Tax Collected and Assessed (Column 9).
Credits and rebates are deducted from the provincial share of tax collections to determine net provincial tax collections.
Tax Payments to Provinces
To assess the functioning of the system of payments to provinces, it is necessary to make a valid comparison between the time stream of net provincial tax collected and the time stream of the cash flows to provinces. This requires the assumption be made that the value of provincial tax assessed has been accurately forecast when the monthly cash flows to provinces began.
Under the terms of the TCAs the amount payable to provinces and the amount the federal government is obliged to forecast for payments purposes is the income tax assessed under the provincial income tax acts plus the provincial share of taxes that are collected but that do not result in assessments because the returns are not filed by the taxpayer. It is assumed that such unapplied tax collections are also accurately forecast. The unapplied taxes are built into the provincial tax estimated at the beginning of each period.
Under the terms of the TCAs the federal government makes payments to provinces based on provincial tax "assessed". Taxes assessed will exceed taxes collected by the value of bad debts which the federal government absorbs.
Tax Payments (Cash Flow) to Provinces (Column 10)
. Instalment payments to provinces in respect of a given taxation year are made in 48 equal payments over the period from February of the tax year to February of the following year. The payments are made on the 6th business day of each month, the 3rd business day after the 15th of the month, the first business day following the 20th, and the second to last business day of the month. Deductions in respect of provincial credits and rebates in respect of a given taxation year are made during the period from April to September of the following taxation year in 24 equal amounts on the same days the regular payments are scheduled. This roughly corresponds to the period over which the provincial credits and rebates are assessed and paid to taxpayers.
Comparison of Net Provincial Tax Collected and Assessed and Tax Payments to Provinces
Surplus or Deficit (Column 11).
A time stream of the differences between net provincial tax collected and assessed and the tax payments to provinces is determined.
. By applying an appropriate interest rate to the difference between collections and payments, it is possible to determine the present value of the difference between the two time series. The present value is a measure of the extent to which there is a lack of coincidence between net provincial tax collections by the federal government and cash flow to provinces. The present values of the differences between the two time series were calculated using the annual average of the Government of Canada three-month treasury bill rate for the taxation year as the discount rate. This is appropriate as the treasury bill rate represents the cost of short-term funds to the federal government. Such short-term borrowings are the usual source of funds for cash management.
Appendix Table 1
Comparison of Net Provincial Income Tax Collected and Cash Flows to Provinces Under Income Tax Agreement â€" Monthly Summary for 1995 Taxation Year
|Month||Year||Deductions at Source||Instalment Payments||Arrears & Payments on Filing||Receivables||Refunds||Net Collections||Provincial Share 31.86%||Provincial Credits & Rebates||Net Provincial Tax Collected||Cash Flow to Provinces||Surplus + Deficit -|
|Government of Canada 3-month T-Bill Rate||6.98%|
|Net Present Value of Surplus/Deficit (Beginning of 1995)||81.6|
Appendix Table 2
Comparison of Net Provincial Income Tax Collected and Cash Flows to Provinces Under Income Tax Agreement â€" Monthly Summary for 1996 Taxation Year
|Month||Year||Deductions at Source||Instalment Payments||Arrears & Payments on Filing||Receivables||Refunds||Net Collections||Provincial Share 31.56%||Provincial Credits & Rebates||Net Provincial Tax Collected||Cash Flow to Provinces||Surplus + Deficit -|
|Government of Canada 3-month T-Bill Rate||4.31%|
|Net Present Value of Surplus/Deficit (Beginning of 1996)||59.4|
Appendix Table 3
Comparison of Net Provincial Income Tax Collected and Cash Flows to Provinces Under Income Tax Agreement â€" Monthly Summary for 1997 Taxation Year
|Â Month||Year||Deductions at Source||Instalment Payments||Arrears & Payments on Filing||Receivables||Refunds||Net Collections||Provincial Share 30.33%||Provincial Credits & Rebates||Net Provincial Tax Collected||Cash Flow to Provinces||Surplus + Deficit -|
|Government of Canada 3-month T-Bill Rate||3.21%|
|Net Present Value of Surplus/Deficit (Beginning of 1997)||22.3|
Appendix Table 4
Total Federal and Provincial Tax Collected By Source for the 1995, 1996, and 1997 Taxation Years
|1. Deductions at Source||86,397||90,278||94,691|
|2. Instalment Payments (collections)||9,610||10,862||12,010|
|3. Payment on Filing and Arrears||11,964||13,504||13,987|
|4. Accounts Receivable||1,947||883||3,724|
|5. Refunds due to Overpayment of Tax||(13,904)||(14,643)||(15,659)|
|6. Net Collections||96,014||100,884||108,753|
|Refundable Provincial Credits||1,356||1,249||1,225|
|Source: Revenue Canada|
Appendix Table 5
Determination of Federal Tax Assessed
|BFT (Assessed as of Dec. 31)||65,179.9||68,611.5||74,989.1|
|Federal Tax Reductions||(597.5)||(458.8)||(478.2)|
|Special Quebec Abatement||(2,299.3)||(2,396.0)||(2,537.1)|
|Supplementary Taxes of Prior Years||0.0||0.0||0.0|
|Unapplied Adjusted(1) for Quebec Abatement||688.1||633.2||834.3|
|Total Federal Tax Assessed||65,421.1||69,042.9||75,769.6|
|(1) Total unapplied less provincial share less Quebec abatement applicable to Federal share of unapplied.|
Determination of Provincial Tax Assessed
|Gross Provincial Tax (Assessed as of Dec. 31)||28,317.2||29,249.8||29,509.7|
|Provincial Tax Reduction||(462.3)||(452.8)||(494.5)|
|Foreign Tax Credit||(62.8)||(70.6)||(79.9)|
|Surtax and Flat Taxes||2,470.9||2,815.0||3,675.1|
|Unapplied (provincial share)||330.1||300.2||373.2|
|Total Provincial Tax Assessed||30,593.1||31,841.6||32,983.5|
Determination of Provincial Share of Total Tax Assessed
|Federal Tax Assessed||65,421.1||69,042.9||75,769.6|
|Provincial Tax Assessed||30,593.1||31,841.6||32,983.5|
|Total Tax Assessed||96,014.2||100,884.5||108,753.1|
|Provincial Share (%)||31.86%||31.56%||30.33%|
|Source: Department of Finance, Final Determination of Payments under the Tax Collection Agreements|
1 An Analysis of Personal Income Tax Flows to Provinces Under the Income Tax Collection Agreements, December 1997, Patrick Grady, Global Economics.