How Income Tax Inequality Affects Your Finances

Economists and tax theorists agree that a tax system should be such that it balances out economic efficiency and equity. It should be efficient enough to avoid distorting the allocation of resources in the economy which would, thus, allow for maximum production. Therefore, the government should avoid applying any kind of taxes that would end up changing consumer or investor behavior. Another thing to take care of is equity. While every scholar agrees that the tax system should be fair, they do not necessarily have a unanimous choice regarding the most appropriate tax system.

Canada has a progressive tax system, which means that the more the Canadians earn, the more taxes they have to pay. This increase in taxes related to the increase in income is exponential; that is, it is not based on a flat percentage. In the Canadian progressive tax system the Canadians are required to pay the same percentage of tax till the first tax bracket; when they cross that limit any money they have earned above that amount is taxed at a new rate which applies till they cross the next tax bracket limit. And this is how it keeps going on. This means that not only are higher earning Canadians paying more amount as taxes, their tax rate is also more. Due to this progressive nature of taxation one-fifth of Canadians end up paying one-half to two-thirds of all income taxes.

It is thought that this progressive tax system makes up for the inequality in income. Since the tax amount to be paid increases with a rise in your income, taxes are distributed among the people according to their affordability. Taking more from those with a higher income and less from those who earn little helps address the issue of income inequality. University of Chicago economist Henry Simons writes:

The case for drastic progression in taxation must be rested on the case against inequality — on the ethical or aesthetic judgment that the prevailing distribution of wealth and income reveals a degree (and/or kind) of inequality which is distinctly evil or unlovely.

But is this system fair enough? Why should the rich pay a higher percentage of their income? It would be fair if everyone is dishing out the same proportion of their earnings for taxes. But one person paying more and the other paying comparatively less sounds kind of unfair. Just because a person has worked harder and is more successful financially he is supposed to pay more. Actually, this is a pretty opinionated topic and depends on what you think is fair. If you consider fairness to be when everyone is required to pay the same proportion of their income as taxes then you would definitely call progressive tax system unfair. On the other hand, however, if you feel people should be charged taxes according to their ability to pay then progressive tax system is surely what you are looking for. Although it is unequal it is still fair when looked at from this perspective.

So what is the connection between inequitable income tax and loan accumulation? For loan repayments you are normally required to pay a certain percentage of your income once it has reached a certain threshold. In case of progressive tax system as in Canada, if you are earning less you are also paying less taxes and, therefore, have more money available from your income that you can use for your expenses and repayments. On the other hand, if you are earning more you are also required to pay more taxes and are eventually left with a lower proportion of your income available for you. So, in spite of your earnings being more you have lesser income available to use but you have to take out the same percentage from the remaining amount for loan repayments. This could end up making the repayments unaffordable because now you are paying more for taxes but the percentage of your income that goes for loan repayments is the same.

When you are unable to pay up because of unavailability of funds the interest rate on your unpaid amount keeps adding and increasing the amount you owe. This leads to loan accumulation. Deferment or forbearance is an option in this case but if you go into default before that due to not making the payments on time there are consequences you have to face. And these are definitely not pretty. For one, you are put under default status which makes it next to impossible to get further loans. You can no longer apply for deferment or forbearance. Any tax offset that you might be eligible for would also not reach you anymore but would be going directly to your debt collection agency. In order to solve this issue you have to opt for loan rehabilitation or consolidation.

When looked at from this perspective charging unequal income tax is a problem for Canadians and instead of helping with redistributing wealth and making up for the existing income gap it just makes it more difficult for them.

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