Taxing benefits - theory and reality

October 19, 2017

In case you’ve been living under a rock inside of a cave, there’s been a recent snafu between the government and the CRA, as this screenshot of a search for “benefit taxes Canada” can attest.

 

 


The government/CRA have been accused of going after “de minimis” benefits for tax purposes (think the subway worker who gets a good deal on his sandwich for lunch, or the retail employee who can take 20% off their clothing purchase).
So what’s the concern here? First there’s an issue with how regressive this tax change would be (regressive=disproportionately detrimental to low income households)… and other than that there’s little to suggest that this is necessarily a bad idea. Allow me to explain using a simple model.

 

Suppose that we live in a world where companies turn a profit (not hard to imagine unless you’re Sears). They must pay wages to their workers (this one is a little tougher to picture), but can offer a wage package in terms of an employee discount and an hourly wage. Employees who actually want to take advantage of this discount will see it as a bonus on their wage (hourly earnings plus the non-zero value they attribute to their discount). Employers see the employee discount as a way to recoup some of what they pay in wages (as employees will buy more of the cheaper good than they ordinarily would have). Now think of two firms, a landscaper and a retail store. The landscaper can’t offer a meaningful employee discount, but the retailer can. Even if workers get paid their marginal product (a fancy way of saying they get paid what they earn for the company – which has happened exactly nowhere) the retailer can offer the same “wage” as the landscaper without spending as much in an environment where this is untaxed. Because the tax system discriminates between the two wages, we wind up favouring retail vs. landscaping. Long-run, this leads to more retail firms, and fewer landscaping firms than would be seen without this discrimination (the optimal number). This is even worse in a world where firms buy labour and sell output in an imperfectly competitive market (a place sometimes referred to as the real world).
Efficient taxation usually asks that the smallest total distortion be introduced by the tax code (a fancy way of saying efficient taxation likes after-tax prices to be (on average) close to the prices we would see in an efficient market while still raising enough revenue for the government). In the case of untaxed benefits, the income tax distorts the decision over number of hours to work and the ability to shift part of the wage offer to an untaxed element distorts the distribution of firms. If benefits were taxed, the policy wouldn’t skew the distribution of firms because workers would pay tax on whatever benefit they received as if they had earned it as salary (although they would still buy more things from their employer because still somewhat lower prices - we'd like to get rid of the income effect in fancy parlance).


Of course in the real world keeping track of every employee discount of the variety described above is prohibitively costly, most employers wouldn’t bother, cancelling their discounts leaving their employees to seethe quietly at the PM for taking away something to which they had previously been entitled. Some would keep going with it, but the employees’ response would be to use their discount less, and thus the revenue gains forecasted would not be: (tax-rate x $-amount of employee benefits used). Major benefits such as healthcare plans, child-care services, company cars, mileage are taxed for the reason described above. There is nothing in this policy for the CRA (ie. implementing it would offer little in terms of increased revenues [citation needed]) and the political economy element is a suicide pill that no government wants to swallow.

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© 2017 by Grant Gibson.