Why the rich pay lower tax rates

Why the rich pay lower tax rates


In case you haven’t heard, the rich get far more tax breaks then middle class Canadians. The problem is twofold, that tax deductions are based on your marginal rate, and how different sources of income are taxed differently.


Neither of these seem fair to most people, but it’s not my job to decide on what is fair and what isn’t. Rather my job is to understand it and educate anyone willing to listen.


To start, let’s look at why the rich get better tax deductions.


When you deduct anything off of your taxes, it saves you tax based on what your marginal tax bracket is. What this means is that someone who earns $70,000 will save 28.20%. While someone who earns over $220,000 will save 53.50%.


Let’s just assume Bob earns $70,000 and Sarah earns $220,000. They both have $10,000 in deductions they are going to claim on their taxes. Bob’s claim of $10,000 saves him $2,820 in taxes, while Sarah’s claim saves her $5,350 in taxes. Whatever deduction you have, saves you taxes based on your marginal tax bracket. Since Sarah is paying higher tax on her income, she also saves more by reducing her income through a deduction.

Rich and working class tax deduction information


This is why you always hear that tax deductions favour the rich. The higher your marginal tax bracket, the more $$$ you save for each dollar of tax deductions.


Next up, how different sources of income are taxed.


There are four primary sources of income in Canada:


Working class earned income


The first is earned income. This is the income you generate from working a job. It is taxed at the highest possible rate and does not have any special tax considerations.


A jar showing how interest income is taxed


The second is interest income. This is what you get from a savings account or from investing in interest bearing investments. It is also taxed at the highest possible rate and does not have any special tax considerations.


Two houses illustraing capital gains taxes

The third primary source of income is capital gains income. You generate this from buying an asset and selling it for more than you paid for it. This type of income is traditionally taxed the lowest, as only 50% of it is included in your income. What this means is that if you made a $100,000 capital gain, you only have to pay tax on $50,000 of it. Which results in the tax payable being half of what a similar income would be taxed if it was earned income.


A piggy bank highlighting Dividends


Finally, the fourth primary source of income is dividend income. This is the money a corporation pays you for owning shares in it. This can either be a public company, or a private company. It can be from running your own private practice and paying yourself a salary through dividends as many realtors or doctors do, or from investing in a multinational corporation that trades on the stock market.


Dividend income is a more complex subject when it comes to taxes. Technically you can have negative tax rates with dividends. You pay a different tax rate if they are an eligible Canadian corporation or non-eligible corporation. For most tax brackets, dividends are taxed more favourably than earned income, but less favourably than capital gains.


Then why does this allow the rich to pay lower taxes?


Well if you make $100,000 you are going to be paying 38.29% on the next dollar you earn. Whereas if an individual with a $50 million dollar income has a $100,000 capital gain, they only have to pay tax on 26.75% of that. While you pay 38.29%, the rich individual pays 26.75%.


Most middle class individuals earn 90% or more of their income from either earned income, or interest income. The wealthy, however, earn the majority of their income through capital gains and dividends. Which allows them to have a lower effective tax rate, compared to someone in the middle class.


Remember, your marginal tax rate is the rate you will pay on the next dollar of earnings. Your effective tax rate is the amount of tax you paid, divided by your total taxable income. While the rich will always have the highest marginal tax rate, they often have a much lower effective tax rate than the middle class.