Our tax system is characterized by a progressive rate and bracket structure and accounts with special tax rules designed to incentivise specific behaviour. It is difficult to explain the rate and bracket structure of our tax system without using a fictional, simplified rate and bracket structure. I’ve delivered tax system explanatory presentations using the actual rate and bracket structure and eyes gloss over quickly. It doesn’t work.
Now I start out with this. A simplified, fictional tax structure with three tax brackets and progressive rates. We go through examples. If taxable income is $40,000, tax is $4,000. My average and marginal tax rate are both 10%. If I get a raise to $49,000, my tax bill increases to $4,900. My average and marginal tax rates are both 10%.
If I get another raise to $60,000, I enter the second tax bracket. I ask, “what is my tax bill now?” and wait for answers. Half the audience replies $12,000. Not so. I still owe 10% on the first $50,000 and 20% on the remaining $10,000 for a tax bill of $7,000. Instantly the audience gets it. I go on to explain that my average and marginal tax rates now differ. My average tax rate is $7,000 / $60,000 = 12% and my marginal is 20%. If I get a raise to $70,000, the $10,000 raise is worth $8,000 after tax. It is never the case that after-tax income is lower after a raise.
If I get a raise to $130,000 I have now entered the top tax bracket. The basic tax column shows tax owed by the end of the previous tax bracket. I ask the audience for my tax bill and my average and marginal tax rates on $130,000 of taxable income. The audience quickly calculates I owe $30,000, with an average tax rate of 23% and a marginal rate of 30%. Any future raises are taxed at 30% and as income climbs my average tax rate approaches, but never reaches, 30%.
All income is taxed this way except dividend income from Canadian corporations and triggered capital gains. If I earn $60,000 and rent out my basement for $20,000 per year my taxable income is $80,000.
I also explain that our tax bill does not climb throughout the year as we enter higher tax brackets. My January remittance to the government is similar to my December remittance. The human resource department estimates total annual income for the year and remits the commensurate tax evenly though the year. If I earn $130,000 and get paid monthly, $30,000 / 12 = $2,500 is remitted per pay cheque. I settle any potential difference between what I payed and what I should pay at tax time.
Then I drop the bomb and show them this. This is the combined federal and provincial brackets for Ontario. You can find your province here at the bottom of the page. It now seems less daunting. The first bracket is tax free money and the last bracket has a marginal tax rate of 53%. I explain the preferred tax rates for dividends from Canadian corporations and capital gains and the fact that this is relevant for non-registered accounts only. They get it.
If I showed our actual tax structure first, who wouldn’t tune out?
I then move on to the specific tax rules per the three main account types.