Friday, April 4, 2008

North American income tax rates

I will be putting up a post about the Laffer curve shortly, but first some background:

Republican presidential candidate McCain is citing the Laffer curve as part of his argument for making permanent Bush's cut of the top income tax rate from 39.6% to 35%. Both Democrat candidates are opposed. While seven states impose no additional state taxes, citizens in California pay about another 10%, as would citizens of New York City who pay a city income tax of about 3% in addition to the New York state tax of about 7%. The top US rate can thus range from 35% in Miami or Vegas to 45% in LA or NYC.

The lowest top rate in Canada is in Alberta, where it is 29% federal plus 10% provincial for 39%. This rate, however, kicks in at $120K, whereas the $77K to $160K bracket in the US is 28%. All of the US thus has lower income tax rates than all of Canada for incomes between $120K and $160K. The top 35% bracket for US citizens does not kick in until $350K (the $160K to $350K bracket is 33%). The top rate for Albertans on capital gain income is 19.5%, which was comparable to the US rate on capital gains income until 2003 when Bush cut it to 15% (and just 5% for individuals earning less than $32K).

The top US rate from 1944 to 1964 was in excess of 90%. When Reagan took office it was 70%, and when he left it was just 28%.

Is it possible to make $80K in unearned income (from capital instead of from employment), have no donations, and still pay no income tax in Canada? Yes. Borrow $1M at 8% and invest that along with $1M you already have (unless you are applying for a US home loan circa 2005, you generally can't borrow a million unless you are already have a million). Sell after a year for $2.16M (a 8% return on $2M) to realize a $160K capital gain. Pay back the $80K you own on the loan and you've got $80K in after-tax disposable income for the year. On your tax return you report $80K on line 127 (the capital gains inclusion rate is 50%), but you also get to report $80K on line 221 ("carrying charges and interest expenses") so you net out to zero! Not bad for someone who never worked an hour that year!

Can this be scaled up so that you make a million and still pay no income tax? No. As soon as your capital gain starts going over $165K you'll have to pay the AMT (Alternative Minimum Tax). The feds will begin calculating with 30% of your capital gain, allow you to subtract just $50K (assuming a $10K personal exemption) from that, and then make you pay 15% of that remainder. So on an income of a million (a $2M cap gain and $1M in deducted interest) that's a federal tax bill of $83K. The province would then grab 35% of that federal bill, for a total tab of $112K. Still, 11.2% to both the feds and the province combined isn't all bad when you've got a million in pre-tax income. If you should ever get a real job and pay taxes normally you could also use the AMT you paid in the past against your new employment income tax. Finally, no tax is paid on a capital gain donated to charity.

What's bad is if your investment returns just half of the rate you borrowed at such that you only have a cap gain of $1M instead of $2M. Now you have an income of zero after paying the $1M in interest you owe. But you still have to pay tax (albeit just half as much this time because your capital gain was half) because the AMT formula still applies to your capital gain!

No comments: