Tax Expenditures and Evaluations 2003 : 4

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Appendix: Description of Tax Expenditures Introduced Since 2000

All tax provisions introduced since Tax Expenditures: Notes to the Estimates/Projections was published in September 2000 are described below.

Personal Income Tax

Education 

Apprentice Vehicle Mechanics’ Tools Deduction

Objective:

To allow apprentice vehicle mechanics to deduct from their income the extraordinary portion of the cost of new tools they have to provide as a condition of their on-the-job training. (The Budget Plan, 2001)

Starting in 2002, apprentice vehicle mechanics can deduct the extraordinary portion of the cost of new tools they purchase in the taxation year or in the last three months of the previous taxation year if the apprentice is in his or her first year.

In order to be eligible, the apprentice must be registered with a provincial or territorial body in a program leading to designation as a mechanic licensed to repair automobiles, aircraft or any other self-propelled motorized vehicle.

The eligible deduction is the portion of tool costs that exceed $1,000 or 5% of the individual’s apprenticeship income for the year, whichever is greater. Any part of the eligible deduction that is not taken in the year can be carried forward and deducted in subsequent taxation years. The apprentice’s employer must certify that the tools are required as a condition of, and for use in, the apprenticeship.

The cost of the individual’s tools for other income tax purposes is the acquisition cost less the deductible portion of that cost. If an individual (or a non-arm’s-length person) disposes of the tools for proceeds in excess of this reduced cost, the excess amount is included in income in the year of disposition. However, tools are eligible for the existing rollovers that apply to transfers of property to a corporation or a partnership.

The individual is also eligible for a rebate of the goods and services tax/harmonized sales tax paid on the portion of the purchase price of the new tools that is deducted in computing employment income.

These measures apply to the 2002 and subsequent taxation years.

Adult Basic Education-Tax Deduction for Tuition Assistance

Objective:

To provide a taxable income deduction for tuition fees for adult basic education. (The Budget Plan, 2001)

Individuals may deduct, in computing their taxable income, the amount of tuition assistance received for adult basic education or other programs that are ineligible for the tuition tax credit, to the extent that this assistance has been included in their income. In order to be eligible, the tuition assistance must be provided under:

This measure was made retroactive to 1997 and subsequent taxation years.

Employment

Canada and Quebec Pension Plan Deduction for the Self-Employed

(now included in memorandum items under “non-taxation of employer-paid premiums”)

Objective:

This measure ensures that self-employed individuals are not disadvantaged relative to an owner-operator who is also an employee of the corporation. (Economic Statement and Budget Update, October 2000)

Under the Canada Pension Plan and Quebec Pension Plan (C/QPP), self-employed individuals are required to pay both the employer and employee portion of C/QPP contributions. As of January 1, 2001, self-employed individuals are permitted to deduct the portion of C/QPP contributions that represent the employer’s share.

Farming and Fishing

Deferral of Capital Gains Through Intergenerational Rollovers of Family Farms and Commercial Farm Woodlots

Objective:

To facilitate intergenerational rollovers of commercial woodlot operations that are farming. (The Budget Plan, 2001)

A taxpayer may make an intergenerational transfer of farm property in Canada on an income-tax-deferred rollover basis, if the property was principally used in a farming business in which the taxpayer or a family member was actively engaged on a regular and continuous basis. Similar rules apply to intergenerational transfers of shares of family farm corporations and interests in family farm partnerships.

The operation of a commercial woodlot may, in certain circumstances, constitute a farming business. However, the intergenerational rollovers are generally not available for commercial woodlots because, aside from monitoring, the management of a woodlot may not demand regular and continuous activity. As a result, many commercial woodlot owners are subject to income tax on intergenerational transfers of their woodlots. This can be detrimental to the sound management of the resource if woodlots are harvested prematurely to pay the tax.

Where the regular and continuous activity test set out in the existing rollover rules cannot be met, a new test will be implemented strictly for the purpose of applying those rules to commercial woodlot operations. The new test allows an intergenerational rollover where the conditions of the existing rollover rules are otherwise met and the transferor or a family member is actively involved in the management of the woodlot to the extent required by a prescribed forest management plan.

This measure applies to transfers that occur after December 10, 2001.

Health

Child Disability Benefit

Objective:

To assist low- and modest-income families with the extra expenses associated with the care of a child with a disability. (The Budget Plan, 2003)

In recognition of the special needs of low- and modest-income families with a child with a disability, the 2003 budget introduced a $1,600 Child Disability Benefit (CDB). The CDB will be a supplement of the CCTB and will be paid for children who meet the eligibility criteria for the disability tax credit (DTC).

The full $1,600 CDB will be provided for each eligible child to families having a net income below the amount at which the National Child Benefit (NCB) supplement is fully phased out (i.e., $33,487 in July 2003 for families having three or fewer children). Beyond that income level, the CDB will be reduced based on family income at the same rates as the NCB supplement. For the 2003-2004 benefit year, benefits will be reduced by 12.2% for one child with a disability, 22.7% for two children with disabilities, and 32.6% for three or more children with disabilities. The CDB amount and income thresholds will be indexed to inflation.

The CDB was effective in July 2003 but will become payable and be included with the CCTB payment starting in March 2004. Accordingly, in March 2004 eligible families will receive a retroactive payment for the July 2003 to March 2004 period.

Families will continue to be able to claim the DTC and the DTC supplement for children with disabilities. For example, in 2003, a one-earner family with one child with a severe disability and an income of $30,000 will receive $1,600 from the CDB, plus a tax reduction of $1,591 under the DTC and DTC supplement for children, for a total of $3,191.

Small Business

Federal Tax Credit for Flow-Through Share Investors

Objective:

To promote mineral exploration activity, particularly in rural communities across Canada that depend on mining. (Economic Statement and Budget Update, October 2000)

This temporary investment tax credit is available to individuals (other than trusts) at a rate of 15% of specified surface “grass roots” mineral exploration expenses incurred in Canada pursuant to a flow-through share agreement.

The credit applies to eligible expenditures incurred by a corporation before 2005 and renounced to an individual pursuant to a flow-through share agreement. The credit also applies to eligible expenditures incurred by a corporation before 2006 that are deemed to have been incurred by a flow-through share investor under the “look-back” rule. The look-back rule allows a corporation that incurs expenses in a given calendar year to renounce those expenses to a flow-through share investor, effective as of the last day of the preceding year.

The flow-through share investor is entitled to use this tax credit to reduce federal personal income tax otherwise payable. This non-refundable credit will reduce the cumulative Canadian exploration expense pool of investors in the years following the year in which it is claimed.

Corporate Income Tax

Mineral Exploration Tax Credit

Objective:

This tax credit is part of a package of income tax changes that will improve the international competitiveness of the resource sector and promote the efficient development of Canada’s natural resource base. (News Release: Finance Minister Tables Notice of Ways and Means Motion to Implement Resource Sector Tax Changes Announced in Budget 2003, June 9, 2003)

The Government proposes to introduce a 10% tax credit for qualifying mineral exploration expenses. The new credit will apply to exploration and pre-production development expenditures for diamonds and base or precious metals. The new tax credit will be available only to corporations, and will be neither refundable nor transferable under a flow-through share agreement. The new corporate mineral tax credit will apply in respect of eligible expenditures made on or after January 1, 2003, at a rate of 5%. The rate will rise to 7% on January 1, 2004, and will be fully phased in at a 10% rate on January 1, 2005.

Transitional Arrangement for the Alberta Royalty Tax Credit

Objective:

This transitional arrangement for smaller oil and gas producers is part of a package of income tax changes that will improve the international competitiveness of the resource sector and promote the efficient development of Canada’s natural resource base. (News Release: Finance Minister Tables Notice of Ways and Means Motion to Implement Resource Sector Tax Changes Announced in Budget 2003, June 9, 2003)

Under the new resource tax structure, which allows deductibility of royalties and mining taxes, it is appropriate to deduct only the amount of Crown royalties or mining taxes actually paid. The Province of Alberta refunds a minimum of 25% of the first $2 million in Alberta Crown royalties paid by corporate groups, under the Alberta Royalty Tax Credit (ARTC) program. Under the new structure for resource taxation, refunds provided under the ARTC will reduce the amount of Crown royalties deductible or be included in income if the taxpayer has already deducted Crown royalties that include the refund. The transitional arrangement will reduce, during a 10-year transitional phase-in period, the portion of the refund that reduces deductible royalties or that must be included in income for tax purposes. Specifically, only half of the ARTC will reduce royalties or be included in computing income for tax purposes for calendar years 2003 through 2007. For years 2008 through 2012, the rate will increase by 10 percentage points per year to 100% in 2012.

The transitional measure will be available in full to individuals who receive the ARTC, and to taxable Canadian corporations that pay no more than $2 million in Alberta Crown royalties, as defined for ARTC purposes. For corporations that pay more than $2 million in Alberta Crown royalties, the benefit of the transitional arrangement will be reduced on a straight-line basis, such that the benefit of the additional transition is completely removed for corporate groups that pay $5 million or more of Alberta Crown royalties.


Part 2
Tax Evaluations
and Research Reports

Long-Run Projections of the Tax Expenditure on Retirement Savings

1. Introduction

The aging of the Canadian population and the movement of the baby boom cohorts into their retirement years will increase pressures on government spending in areas such as health care and the Old Age Security and Guaranteed Income Supplement programs (OAS/GIS). Governments have responded by improving their fiscal positions not only to address immediate problems but to begin to prepare for these pressures.

Population aging will not have only negative effects on governments’ fiscal balances, however. The shift of the baby boom cohorts into retirement will reduce the cash-flow tax expenditure cost of registered pension plans (RPPs) and registered retirement savings plans (RRSPs) as taxable withdrawals from the plans grow faster than tax-deductible contributions. Some analysts have projected tax expenditure declines sufficient to offset a large portion of the expected increases in health and public pension costs.

In this context, this paper analyzes the determinants of the tax expenditure cost of RPP and RRSP saving and projects the cost to 2041 under a variety of assumptions. While considerable uncertainty must be attached to any long-run projection, the general conclusion of the paper is that the tax expenditure cost will likely decline but that the reduction in the tax expenditure may be small in relation to the projected increases in health and public pension costs.

Background

Canada provides favourable tax treatment for saving in RPPs, RRSPs and deferred profit-sharing plans. Contributions to these plans are deductible from taxable income and investment income earned inside them is tax-exempt, while benefits paid out of them are taxable. In this way, income set aside for retirement is taxed when it is received rather than when it is saved. This deferral of tax has the same effect as a complete exemption of tax on the investment income earned on a non-deductible investment (see example in Appendix A). Where the taxpayer faces a lower marginal tax rate in retirement than while saving, an additional “income-averaging” benefit is provided.

The Department of Finance Canada currently publishes two annual estimates of the tax expenditure on saving in RPPs and RRSPs. The cash-flow tax expenditure measures the amount of revenue foregone in the current year due to the tax treatment-that is, the amount of additional revenue that would be collected in the year if the tax preference were eliminated without any change in the pre-tax flow of funds into and out of the plans.

It is calculated as: (a) the tax foregone on income contributed to the plans plus (b) the tax foregone on investment income in the plans less (c) the tax collected on benefits paid out of the plans. This tax expenditure varies with short-term conditions such as the prevailing rate of return on investment as well as longer-term factors such as the maturity of the pension system and demographic trends that affect contribution and benefit levels.

Because of the variability of this cash-flow measure and because it does not reflect the eventual taxation of the deferred income, the Department of Finance Canada has begun to supplement it with a present-value tax expenditure estimate. This is a measure of the lifetime cost to the Government of the RPP and RRSP contributions made in a year. It is equal to: (a) the current cost of the deduction provided for the contributions plus (b) the discounted cost of the tax foregone on the investment income earned on the contributions less (c) the discounted value of the taxes collected on pension benefits and RRSP withdrawals derived from the contributions and associated investment income.

It is the cash-flow tax expenditure that best measures the effect of the tax provisions on the fiscal position of governments as the pension system evolves over time with an aging population.

Some analysts have pointed out that the uncollected tax on RPP and RRSP balances could be treated as an asset of governments and that governments will see fiscal gains as the aging of the baby boomers brings an acceleration of withdrawals from the plans.1, 2, 3 The projected declines in the tax expenditure appear sufficient to offset much of the increase in health and public pension costs that is projected to accompany the aging of Canada’s population over the next 40 years.4

Given the potential importance of these fiscal effects, the aim of this paper is to examine closely the determinants of the tax expenditure and to provide projections of it to 2041 using the best available data. The paper proceeds as follows. Section 2 explores the relationship of the tax expenditure to economic variables and other trends using simplified models of the population of retirement savers. Section 3 outlines the data, assumptions and methods employed in our tax expenditure projections. Section 4 provides the results of our simulations, using various assumptions with respect to key parameters. Section 5 concludes.

2. Simple Models of the Tax Expenditure

The cash-flow tax expenditure, TEt, for year t may be expressed as

 

finance - image

(1)

where Ct and Bt are contributions to and benefits paid out of RPPs and RRSPs in year t, At-1 is the level of assets in the plans at the end of the previous year, i is the nominal pre-tax rate of return on plan assets in the year and mC, mA and mB are the average marginal tax rates applicable to contributions, investment income and benefits (with i and m assumed constant over time).5

The formula makes it evident that changes in the level of the tax expenditure over time depend primarily on differences in the growth patterns of contributions, assets and benefits. While any change in the level of the tax expenditure affects the fiscal balance, it is of particular interest to see what is needed to produce a negative value of TEt. To begin with, it is clear that simply having a higher level of benefits than contributions is not sufficient. For TEt < 0, the tax collected on benefits must exceed the foregone tax on both contributions and asset income.

Further general information on the relationships can be obtained by making the simplifying assumption of a single marginal tax rate, mC = mA = mB = m. With this assumption, and noting that

At = (1+i)At-1 +Ct - Bt

or

At - At-

1 = iAt-1 + Ct - Bt

(2)

the tax expenditure may be written as

TEt

= m(At - At-1).
   

(3)

This tells us that a year-over-year decline in the current-dollar level of RPP/RRSP assets is necessary to produce TEt < 0.

Steady State Cases

We can learn more about the tax expenditure by examining steady state cases in which the pension system is mature (i.e., the contribution and benefit rates as a percentage of earnings are unchanging), there are no demographic shifts (i.e., the population at each age group is equal and grows at a constant rate over time), the rate of return on assets is constant, and earnings (and GDP) grow at a constant rate. In such cases, contributions, assets, benefits and the tax expenditure will all occupy constant fractions of GDP. Let Yt be GDP, take At = kYt and take g as the growth rate of earnings and GDP so Yt = (1+g)Yt-1.

Then, using (3), we can express the tax expenditure as a fraction of GDP as

finance - image

   

(4)

This demonstrates that in a steady state case, the tax expenditure will be positive as long as g > 0, meaning that GDP growth, produced by any of population growth, real wage growth or inflation, is positive. For example, with plausible values, m = 0.20, k = 1.33 and g = 0.0302 (1% real growth and 2% inflation), we would have a federal TEt = 0.78% of GDP if we were in a steady state.6

Another interesting steady state result concerns the relationship between contributions and benefits. By rearranging (2) and using the previous assumptions, we can write the excess of benefits over contributions, as a fraction of GDP, as

finance - image

   

(5)

This shows that benefits, funded out of both contributions and investment income, can exceed contributions on a permanent basis. The size of the excess depends on the asset level and the difference between the rate of return on assets and the GDP growth rate. With the same parameter values as above and i = 0.0557 (a 3.5% real interest rate and 2% inflation), for example, the excess of benefits over contributions equals 3.3% of GDP. With a contribution rate of 3.0% of GDP, benefits are permanently 110% higher than contributions (6.3% vs. 3.0% of GDP).

Even where there is a preponderance of benefits over contributions, the tax expenditure remains positive in a steady state case with nominal GDP growth. Expressions (2) and (3) show how this occurs. For TE > 0, the amount of investment income in the year must be greater than the excess of benefits over contributions. This point is relevant to non-steady-state cases as well. In most situations where benefits substantially exceed contributions, they will be accompanied by high levels of assets and investment income.

Maturing Pension System

Steady state results provide only a limited guide to future tax expenditure levels. As well as ignoring possible trends or fluctuations in economic variables such as investment yields and the rate of wage growth, they cannot take into account two key determinants of the tax expenditure level in Canada: the maturing of the RPP/RRSP system and the aging of the baby boom cohorts.

By the maturing of the pension system is meant an increase in age-specific contribution rates toward a reasonably stable level during the developmental phase of the system, and the consequential increases in asset and benefit levels.7 The degree of maturity of the system will be examined more closely in Section 4. However, it may be noted that, while pension plans have existed throughout the 20th century, RRSPs were introduced in 1957 and became popular starting in the 1970s. In addition, improvements in pension standards in the 1980s (e.g., earlier vesting, portability options) increased the effectiveness of RPPs in delivering pension benefits.

To investigate the effects of a maturing pension system and the aging of the baby boomers, we constructed a simplified model of the retirement saving process. In this model, individuals save from age 25 to 64 and draw pension benefits from age 65 to 84. The pension of each individual is drawn in a level (un-indexed) life annuity that, by age 84, exhausts the assets accumulated at age 64. In the first cases, there are an equal number of people in each single-year age cohort.

Figure 1 presents time series of tax expenditure levels for two cases. In Case 1: Steady State, contribution rates are constant across (pre-retirement) age groups and constant over time. As above, the yield on plan funds is 5.57% and the rate of wage growth is 3.02%. With an aggregate contribution rate of 3% of GDP and a constant marginal tax rate of 20% on contributions, investment income and benefits, the resulting tax expenditure is constant at 0.78% of GDP.

Figure 1 - Tax Expenditures

In Case 2: Maturing Pension System, we assumed that there were no contributions before 1961. The pension of someone reaching age 65 in 1971, for example, is based on only 10 years of contributions. Here, the tax expenditure first rises well above its steady state level before declining back to it. As we assume that contributions are made at year-end, there is no investment income and no pension benefits in 1961. For that year, TE = mCt (20% of 3% of GDP = 0.6% of GDP). The system attains full maturity and its steady state TE level of 0.78% of GDP only in 2020, the first year in which the 84-year-olds, who were age 25 in 1961, have contributed for their full careers.

Figure 2 helps to explain the simulation result by displaying how the three components of the tax expenditure, Ct, iAt-1 and Bt, evolve over time. As the history of contributions progresses from its 1961 start, asset and investment income levels grow and so, with a lag, do benefit levels. The lag in the growth of benefits behind that of assets and investment income is what creates the temporary increase in the tax expenditure above its steady state level.

With regard to the prospect of fiscal gains in the years to come, we see that a maturing pension system can create a fairly long period of declining tax expenditures-from 1990 to 2020 in this stylized model-but only from a level that is temporarily above its steady state value.

Figure 2 - Tax Expenditure Components

Note: While benefits are subtracted in determining TE, they are shown as positive here. This allows us to see how the difference, iA - B, contributes to TE.

Aging of the Baby Boom Cohorts

As seen in Figure 3, the numbers of births in Canada during the 20 years from 1946 to the mid-1960s were 25% to 45% higher than a trend-line connecting the numbers in adjacent periods.

Figure 3 - Number of Births in Canada

To investigate the effects of such a population bulge on pension flows and the tax expenditure, we modified the “Maturing Pension System” model, simply increasing by 35% the level of contributions for the cohorts born between 1946 and 1965. These baby boomers entered the model by reaching age 25 between 1971 and 1990; they reach age 65 between 2011 and 2030, and by 2050 they have disappeared from the model. Since the pension benefits of each single-year age cohort are calculated so as to exactly exhaust the savings it has accumulated at age 64, the higher contributions of the baby boomers translate into higher asset and benefit levels as the baby boomers reach retirement age. The results are shown in Figures 4 and 5.

Figure 4 - Tax Expenditures

 

Figure 5 - Tax Expenditures Components

The tax expenditure for the baby boom case rises above that of the mature-system case to a peak in 2010 and then declines sharply to reach a minimum value at 2030, the only year in which baby boomers make up 100% of the retired population. After 2030 TE rises again, reaching its steady state level in 2050.

Comparing Figures 2 and 5, we see that asset and benefit levels are slightly lower as percentages of GDP up to 2010 than with no population bulge. After that point they rise to higher levels. This is because the first effect of the high-population cohorts is to raise the aggregate levels of earnings, GDP and contributions. Asset and benefit levels increase only with a lag. It is also worth noting that the kinks in the TE and benefits lines in Figures 4 and 5 result from the simplifying assumption that benefits commence abruptly at age 65 for everyone in the population. This assumption is relaxed in the projections of Section 4.

In summary, these simple models of the tax expenditure and the retirement saving process tell us that both a maturing pension system and the aging of the baby boom generation can create substantial declines in the tax expenditure level. However, so long as the economy continues to grow in nominal terms, they should not be sufficient to reduce the tax expenditure to zero or below.

3. Development of the Projections

In this section, we outline the data, assumptions and methods employed in our projections of the cash-flow tax expenditure on saving in RPPs and RRSPs for the period 2001 to 2041. The results are presented in Section 4.

The projected tax expenditures are for savings in RPPs and RRSPs together. Projecting tax expenditures separately for the two types of plans would provide misleading results since individuals frequently transfer RPP assets to RRSPs at retirement or when changing jobs before retirement.

The projections follow the simpler models of Section 2 in the key respect that the RPP/RRSP benefits received by each single-year age cohort are exactly determined by the cohort’s contributions and the investment income earned on them. Second, while contribution rates (contributions as a percentage of earnings) vary with age, the age-specific contribution rates are assumed to remain constant throughout the projection period. This assumption is maintained as well for benefits received by those under age 65. It is the level of benefits received by those age 65 and over that are determined by the flows of contributions and investment income. The following specific components of the projection are elaborated in the balance of this section:

Economic Parameters

The projections depend on key economic parameters, each of which is subject to a considerable degree of possible variation over time. For the first projection, or “reference scenario,” we employ the following parameter values:


Table 1 Key Economic Parameters


 

Real

Nominal8


 

(% per annum)

Inflation rate

n/a

2.00

Wage growth

1.00

3.02

Return on investment

3.50

5.57


As a comparison, in his most recent long-run projection of Canada Pension Plan (CPP) costs, the Chief Actuary chose the following parameters for the long run: inflation, 3.00%, real growth in the average wage, 1.10%, and real rate of return on investment, 4.10%.9 A higher real rate of return may be expected on CPP assets than on RPP/RRSP assets because of the greater diversification opportunities and lower administration costs available to a single, very large fund.

Population Projection

The population projection, from 2001 to 2041 by single years of age, is Statistics Canada’s “medium” growth scenario extended from 2026 to 2041 under the assumption that fertility, mortality and migration rates remain constant at their 2026 levels (fertility: 1.48 births per woman; life expectancies at birth: 80.0 years for males and 84.0 years for females; immigration: 250,000 persons per year).10 It is the projection used by Jackson and Matier.11

Figure 6 illustrates the age structure shifts embodied in the projection. It shows the populations age 65+ (“seniors”) and 60+ as percentages of the “adult” population age 20+. The proportion of seniors in the adult population begins to rise quickly after 2010. For obvious reasons, the corresponding increase in the proportion of adults age 60+ starts five years earlier. Over the period, seniors’ share of the adult population increases by 83% and the share of the 60+ population by 72%. These populations increase even more strikingly-by about 120%-in relation to the “working age” populations (20-64 and 20-59). In the context of the tax expenditure projections, the growth of the age 60+ population is the more important trend since by age 60 benefit payments out of RPPs and RRSPs substantially exceed contributions to them.

Figure 6 - Age Structure Shifts

Form of Benefit Payouts

Modelling the payout of RPP/RRSP benefits involves several considerations:

Each of these factors can affect the tax expenditure level. In general, the later that benefits commence, the more back-loaded they are through inflation adjustments, other ad hoc increases and payments at death, and the longer their duration, the greater will be the degree of tax deferral and the level of TE. For example, in the steady state case of Section 2, shortening the benefit payout period by five years to age 79 would reduce the value of TE from 0.78% to 0.71% of GDP. For a given level of contributions, shortening the payout period reduces both investment income and benefits, but the reduction in investment income is greater than the reduction in benefits.

Based on an analysis of current payout patterns outlined in Appendix B, the benefit payouts in the projections are determined in the following manner:

Base-Year Values for Earnings, Savings Flows and Marginal Tax Rates

We obtained aggregate levels of earnings and RPP/RRSP contributions and benefits by single years of age from the T1 microdata file for taxation year 2000 and then adjusted them in certain ways to produce estimates for base year 2001.12 For each of the variables, we allocated the amounts reported by tax filers under age 20 to those age 20-24 and the amounts reported by those age 85+ to those age 65-84. The allocations were made in proportion to the existing amounts in the 20-24 and 65-84 age groups. These minor adjustments ensured that the total reported levels of earnings, contributions and benefits were captured in the projection model.

Earnings

include several items identified on the T1 file: employment income, commissions from employment, other employment income, net business income, net professional income, net commission income, net farming income and net fishing income. For 2000, 16.1 million tax filers reported total earnings of $504.7 billion. To obtain earnings aggregates by age for 2001, we adjusted the 2000 levels by the factor 1.045. This is the 2001-to-2000 ratio of the National Accounts totals of wages and salaries plus unincorporated business income.

RPP/RRSP contributions

include employer and employee RPP contributions and RRSP contributions. (No data is available on employer contributions to deferred profit-sharing plans.) Employee RPP contributions totalling $6,722 million were reported on the T1 file. To account for employer contributions not reported on the T1 file, we inflated the contributions at each age by the ratio $19,362/$6,722 to bring them to the Statistics Canada estimate of total RPP contributions for 2000.13 RRSP contributions totalling $28,212 million on the T1 file were added to the RPP contributions. Next, we divided the 2000 contributions by the corresponding earnings levels to calculate contribution rates by age. These vary from 1.3% at age 20 to over 11% for the 50-64 age group and to over 15% for those with earnings at age 66. Applying the contribution rates to the 2001 earnings levels produced estimates of contributions by age for that year.

RPP/RRSP benefits

on the T1 file include RPP income, RRSP annuity income, other RRSP withdrawals and withdrawals from registered retirement income funds (RRIFs). They totalled $48,926 million in 2000. As noted in the previous section, we treated benefit payments up to age 64 in a parallel manner to contributions, calculating benefit rates by dividing benefits by earnings for 2000 and applying these rates to projected earnings levels to produce benefit levels by age for 2001. For benefits received by seniors in 2001, we had two possible information bases. We could use an annuity formula to impute benefit levels from RPP/RRSP asset holdings by age from the 1999 Survey of Financial Security (SFS) or we could take pension income levels directly from the 2000 T1 file.14 We chose the T1 data, as it is one year more recent and based on a large sample of tax returns rather than a smaller sample of household interviews. To obtain 2001 benefit levels, we updated the 2000 levels by the factor 1.084, the average rate of increase in aggregate RPP/RRSP benefits over the period 1997-2000.

RPP/RRSP assets

do not show up in taxation data but are reported in aggregate by Statistics Canada on an annual basis. In addition, the SFS provided estimates of the distribution of these assets across households in 1999. There are some inconsistencies between different Statistics Canada estimates. For example, the 1999 estimate of RPP assets in the SFS was $604 billion while the current estimate for that year is $781 billion.15 In contrast, the annual estimates of RRSP assets do not include assets held in self-administered plans or RRIFs, so the 1999 estimate of $268 billion is considerably lower than the estimate of $408 billion in the SFS.

Another difficulty in arriving at reasonable base-year asset levels is the behaviour of stock markets since 2000, the last year for which we have estimates. Using Statistics Canada’s annual data together with an adjustment of RRSP assets by the factor 408/268 to include self-administered plans and RRIFs, we have aggregate estimates of $1,189 billion for 1999 and $1,250 billion for 2000. However, with the market downturn these estimates are likely to be too high as a basis for projecting future retirement benefits.

Since the tax expenditure formula for year t includes assets at the end of year t-1, 2000 is the base year for assets in our projection. In response to the data difficulties noted above, we have taken the following approach to estimating these assets. For ages 64+, we have calculated asset levels directly from the 2001 benefit levels given the assumption that the benefits are paid out in the form of a term-certain annuity to age 84 with indexing at a rate of CPI growth less 1%.16 For ages up to 63, the assets are based on those reported in the SFS for 1999. Statistics Canada provided us with a distribution of RPP/RRSP assets by single years of age for ages 25-74. We smoothed this profile by taking a three-age moving average of the single-year estimates and we extrapolated it by allocating the assets held by those under 25 to the 20-24-year-olds. Then we inflated the levels by a factor of 1.1 to obtain estimates for 2000. The resulting asset total of $1,065 billion for 2000 is purposefully lower than the Statistics Canada estimate to allow in an ad hoc manner for the asset declines that have occurred in 2001 and 2002.

The resulting age profiles of contributions, investment income (equal to assets times the assumed interest rate of 5.57%) and benefits are presented in Figure 7. Two points are of particular interest. First, even though the median retirement age is currently about 62, RPP/RRSP benefits begin to exceed contributions as early as age 56. This suggests that the effects of the aging of the baby boom cohorts on the TE level should be expected to start showing up very soon rather than only in 2011, when the first baby boomers reach age 65. Second, and more important, we see that older cohorts dominated by beneficiaries rather than contributors still account for a substantial proportion of total assets and investment income. For example, those age 56 and over hold 48% of the assets. This implies that the foregone tax on investment income should remain high as the baby boom moves into retirement, thus limiting the reduction in the tax expenditure caused by the demographic shift.

Figure 7 - Age Profile of Total Contributions, Investment Income and Benefits, 2001

The marginal tax rates (MTRs) on contributions, investment income and benefits are the final component of the TE estimate for the base year. We have estimated these for single-year age cohorts, using microdata on contributions and benefits. Since we are projecting federal tax expenditures we consider only federal tax rates. Since tax reductions have been legislated that are not yet in effect, we use the 2004 tax structure as the basis for all the rates.

In describing further how the rates are calculated, it is necessary to be quite precise about their nature.

First, they are “average” marginal tax rates in two separate ways. The rate on contributions for an age cohort, for example, is an average of that for all contributors in the cohort. In addition, the rate for each contributor is an average of that for each dollar contributed. For example, in 2004 the federal MTR rises from 22% to 26% at an income threshold of $70,000. For a contributor with income of $75,000 and an RRSP contribution of $10,000, the MTR on the first dollar of contribution is 26% but the average MTR on the total contribution is 24% ($5,000 at 26% and $5,000 at 22%).

Second, the MTR on investment income is determined in conjunction with the MTRs on contributions and benefits, and the effects differ in the two cases. For contributors, elimination of the tax preference means loss of the deduction on the contribution plus an income inclusion of some amount of formerly sheltered investment income.

In the case of the contributor earning $75,000, for example, this means an increase in taxable income from $65,000 to $75,000 due to the elimination of the RRSP contribution deduction plus a further increase to, say, $80,000 on account of the investment income. Computed in this manner, the average MTR on the investment income is likely to be as high or higher than that on contributions. (In the example, it is 26% as compared to 24% for the contribution.) For beneficiaries, on the other hand, the inclusion of investment income offsets, fully or partly, the tax reduction from excluding RPP/RRSP benefits from taxable income. Consider an individual with reported income of $35,000 of which $15,000 is RPP income, and with sheltered RPP/RRSP investment income of $10,000. Eliminating the tax on benefits reduces this individual’s taxable income to $20,000, but taxing the sheltered investment income raises it back to $30,000. Based on the tax brackets of 2004, the average MTR on both changes is 16%. In general, the average MTR on investment income for beneficiaries will be very similar to that on the benefits.

We calculate for each age cohort average MTRs on investment income as a weighted average of MTRs for contributors and beneficiaries. The weights are the total levels of contributions and benefits for the age cohort. For contributors, the MTR is based on an estimate of the average RPP/RRSP investment income of contributors in the cohort. For beneficiaries, we assume the same MTR for investment income as for benefits.

Overall MTRs for contributions, investment income and benefits are calculated as weighted averages of the MTRs for each age cohort. For base year 2001, Table 2 presents the results.


Table 2 
Marginal Tax Rates on Savings Flows for 2001


   

(%)


Contributions

 

21.4

Investment income1

   

Contributors

23.7

 

Beneficiaries

17.6

 

Total

 

20.6

Benefits

 

17.6


1MTRs for 2000.

   

Tax expenditure for 2001

. Based on the TE formula from Section 2, the projected 2001 tax expenditure is:

TE

= (0.214)($49,714 million) + (0.206)($59,334 million) -    (0.176)($52,207 million)

 

= $13,677 million.17

This tax expenditure amounts to 1.25% of Canada’s GDP for 2001 (estimated at $1,092 billion).

Projections to 2041

Projected TE values are based on projections of earnings, contributions, benefits, assets and MTRs over the period.

To project aggregate earnings by age, we first obtained per capita earnings levels for 2001 by dividing the 2001 aggregates by the population in each age cohort. Next, we projected the per capita earnings levels to future years by the assumed rate of wage growth (3.02% in the reference scenario). Finally, we obtained aggregate earnings by inflating the projected per capita wage levels by the projected population at each age. As we assume that total earnings represent a constant fraction of GDP throughout the period, projected total earnings define projected GDP levels.

The projection of contributions is based on the assumption that age-specific contribution rates remain unchanged at their 2000 values. Thus, aggregate contribution levels by age are obtained simply by applying the contribution rates to the projected levels of earnings at each age.

As noted above, the methods used in projecting benefits are different for those under age 65 than for seniors. For those age 20-64, benefits are assumed constant as a percentage of earnings for each age cohort. As in the case of contributions, aggregate benefits by age are obtained by applying the benefit rates to the projected earnings levels. For seniors, we calculated the aggregate amounts of benefits received at each age and for each year from the expression that relates the initial benefit amount of an indexed term-certain annuity to the asset available to fund it.18 It should be noted that this procedure results in benefits for a particular age cohort that increase over time at a slightly higher rate than CPI growth less 1%. The reason is that the assets held by seniors are modified each year not only by the payout of benefits but by the modest levels of contributions they continue to make.

The level of assets held at a given age, x, at the end of any year, t, in the projection is obtained directly from the simple accounting expression

finance - image

   

(6)

The average MTRs by age for contributions, investment income and benefits are assumed constant over the projection period. With changes in the age distribution of these savings flows, the overall MTRs can vary from year to year. However, in practice the variation is slight. The MTR on contributions drops from 21.4% to 21.3% and then regains its initial value; that on benefits declines from 17.6% to 17.4% and then rises to 17.7%; and that on investment income declines from 20.6% to 20.2% over the period.


1 Robbins and Veall have provided an estimate of $200 billion for the present value of the future stream of personal income tax revenues attributable to RPP and RRSP accumulations existing in 1999. (Jenna Robbins and Michael R. Veall, “Future Taxes on Pension Savings as a Government Asset,” C.D. Howe Institute backgrounder, No. 63, October 2002.) [Return]

2 Marcel Mérette has simulated future savings flows and projected a decline in the cash-flow tax expenditure for the federal and provincial governments together from about 3.5% of gross domestic product (GDP) in 2001 to about -1.5% of GDP in 2043. This corresponds to a drop in the federal tax expenditure from 2.3% to -1.0%. In 2001 dollars, a reduction of 3.3% of GDP in the federal tax expenditure implies a fiscal gain of $36 billion. (Marcel Mérette, “The Bright Side: A Positive View on the Economics of Aging,” Institute for Research on Public Policy, Choices, Vol. 8, No. 1, March 2002. The tax expenditure estimates are taken from the baseline projection presented in Figure 4.) [Return]

3 Robert Brown has projected a decline in the federal tax expenditure, expressed in 1991-1995 dollars, from $14.6 billion in 2001 to -$15.5 billion in 2041. Note that Brown excludes a portion of the tax expenditure as normally calculated, namely the foregone tax on investment income earned by seniors. This reduces the tax expenditure and increases the extent of its decline as the population ages. (Robert L. Brown, “Paying for Canada’s Aging Population: How Big Is the Problem?”, Canadian Institute of Actuaries Member’s Paper, March 2002, and “An Argument for Higher RRSP Limits,” Benefits Canada, September 2002.) [Return]

4 See, for example, Harriet Jackson and Chris Matier (JM), Public Finance Implications of Population Ageing: An Update, Department of Finance Canada, Economic and Fiscal Policy Working Paper No. 2003-03, available at www.fin.gc.ca, and Chief Actuary, Office of the Superintendent of Financial Institutions, Actuarial Report ( 5th) on the Old Age Security Program as at 31 December 2000, May 7, 2002, available at www.osfi-bsif.gc.ca. In the JM projections, which assume that age-specific per capita costs rise in line with wage growth, population aging raises public spending on health care by 3.0 percentage points of GDP by 2041 and OAS/GIS costs by 2.4 percentage points. In the Chief Actuary’s projections, which assume slower growth in age-specific benefits, population aging increases OAS/GIS costs by about 0.7% of GDP. From these projections, population aging may increase health and OAS/GIS costs by between 3.7% and 5.4% of GDP by 2041. In 2001 dollars, the range of increases is $40 billion to $59 billion. [Return]

5 Use of the nominal interest rate reflects the fact that nominal income, rather than real income, is used as the benchmark tax base in the annual tax expenditure reports. [Return]

6 As detailed in Table 1 in Section 3, the federal average marginal tax rates on contributions, investment income and benefits (under the 2004 tax structure) are 21.4%, 20.6% and 17.6% respectively. The weighted average of these rates is very close to 20%. In a steady state system, the value of k depends on the contribution rate (Ct/Yt), i, g, and the duration of the contribution and payout periods. For the model and parameter values of Case 1 in this section, k = 1.33. [Return]

7 There are really two phases in the maturing of a pension system: one in which age-specific contribution rates are increasing and a second in which contribution rates are constant but asset and benefit levels are still affected by the lower contribution rates of earlier years. Only when the oldest beneficiaries have contributed at the steady state rate since the beginning of their working careers is the system fully mature. [Return]

8 The nominal wage growth rate = 1.01*1.02 - 1; the nominal rate of return on investment = 1.035*1.02 - 1. [Return]

9 Chief Actuary, Office of the Superintendent of Financial Institutions, Actuarial Report (18th) on the Canada Pension Plan as at 31 December 2000, December 10, 2001. These parameters apply for years beginning in 2015. For the years 2001-2014, the assumed rates are variable, averaging 2.4% for inflation, 0.7% for real wage growth and 4.4% for the real rate of return on investment. [Return]

10 Statistics Canada, Population Projections for Canada, the Provinces and Territories, March 2001, Catalogue No. 91-520. [Return]

11 Harriet Jackson and Chris Matier, op. cit. [Return]

12 All the statistics presented in this paper on the distribution of benefits and contributions across tax filers are taken from T1 files created by the Canada Customs and Revenue Agency. These annual files are stratified samples of tax filers. The latest available file is for the 2000 taxation year. [Return]

13 Statistics Canada, Canada’s Retirement Income Program: A Statistical Overview (1990-2000), Catalogue No. 74-507. [Return]

14 Statistics Canada, The Assets and Debts of Canadians: An Overview of the Results of the Survey of Financial Security, Catalogue No. 13-595, and The Assets and Debts of Canadians: Focus on Private Pension Savings, Catalogue No. 13-596. [Return]

15 Statistics Canada, Canada’s Retirement Income Program: A Statistical Overview, Catalogue No. 74-507. Statistics Canada has recently revised its RPP asset estimates to move from a book value to market value basis for trusteed funds. [Return]

16 With Bx representing benefits received at age x and a = 
(1+ CPI - .01)/(1+i), the formula for the asset held at age x is finance - image

Due to differing assumptions concerning asset levels and MTRs (e.g., we assume that tax reductions phased in to 2004 are fully implemented), this estimate is lower than the corresponding estimate of $16,165 million in the annual TE estimates presented in Part 1 of this Tax Expenditures and Evaluations report. 

For assets Ax-1 held at the end of the previous year and with the other variables defined as in footnote 16, the formula is
  finance - image. [Return]

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