PERSONAL TAXES. by Pierre Vanasse Director, Financial and Business Research Group

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1 The Conference Board of Canada HIGHLIGHTS Brain drain is real: Canadian tax filers with higher incomes are more than 10 times as likely to leave the tax base as the average Canadian tax filer. Even if all the proposed tax reduction measures are implemented immediately, a large personal tax gap with the United States remains, one that grows substantially with income. In this light, the personal tax changes proposed in the budget: constitute only a start, will have to be accelerated, and will need to cut deeper into Canadian taxes at higher income levels if they are to reduce the tax wedge significantly. APRIL 2000 PERSONAL TAXES Is the Grass Still Greener on the Other Side? VIEWPOINT by Pierre Vanasse Director, Financial and Business Research Group The Focus for This Brief The recent interest in the migration of highly skilled Canadians to the United States the so-called brain drain continues to receive considerable coverage in the media. The reason for this attention is summarized in the main conclusions of the August 1999 report from The Conference Board of Canada entitled Are We Losing Our Minds? This report suggests the need for swift action by business and governments to offer more attractive compensation and redress the tax wedge to stem the flow of valuable Canadian talent across the border. Few analysts were expecting the federal government to respond as quickly as it did to the call to action. In its efforts to redress many of the factors that influence departing Canadians, the February budget sought a balance between increased program spending in key areas and the need for tax relief. It also sought to provide more manoeuvring room for Canadian organizations wanting to offer more innovative compensation packages involving stock and stock options. However, it left a number of questions unanswered: Will the proposed changes effectively address the current tax wedge between Canada and the United States? Do the proposed changes contribute significantly to a solution to the brain drain? The current report updates the January 1999 Conference Board study entitled Personal Taxes: How Green Is the Grass on the Other Side? Its intent is to quantify the impact of the federal budget on the tax wedge, one of the key factors contributing to the brain drain. The Context In its August 1999 report Are We Losing Our Minds? the Conference Board was able to: 1. provide empirical evidence of a gap in economic factors (income, job opportunities and tax levels) between Canada and the United States for the last 15 years; 2. establish a quantitative link between brain drain and factors responsible for it, such as earnings, job opportunities and, especially, taxes; 3. conclude that almost all factors favour the United States and therefore exert a significant influence on the decision to emigrate; and 4. show how brain drain is growing fastest in the knowledge-based industries, the same industries that are expected to lead future growth in Canada. This report was followed in quick succession by a number of studies by other organizations confirming the basic trends surrounding brain drain and providing more detailed profiles of those Canadians choosing to work in the United States. Canada U.S. migration trends are no longer in question too many studies over the past 12 months 1 The Conference Board of Canada

2 A Conference Board of Canada publication from the Business Research Group Vice-President: Directors: Staff: Charles A. Barrett Pierre Vanasse Hugh Williams Val Balderson Penny Brady David Brown Debra Brown Lynn Conway Tricia Finter Doug Forsyth Mahmood Iqbal Susan Lapointe Dan Lemaire Lorraine Pigeon Carla Ridley Theresa Shutt Karen Thiessen Joanne Warren Marcia Willows 2000 The Conference Board of Canada* Agreement No Printed in Canada All rights reserved *Incorporated as AERIC Inc. have demonstrated a rising trend in the migration of highly skilled individuals from Canada to the United States. As a result of these reports, the brain drain is recognized as a serious policy issue by many stakeholders, including governments. The importance of the issue is summed up in the Conference Board s 1999 Performance and Potential report: It goes without saying that a modern economy cannot function at its peak unless it retains access to the talents of its best and brightest. Migration is not inherently problematic. Indeed, it can have a positive economic impact, allowing countries to effectively export surplus skills. In Canada, however, it is now recognized that the brain drain is both real and a challenge. Departing Canadians are often working in occupations that are in short supply in Canada: doctors, nurses, computer scientists and professors. There is also evidence that the brain drain particularly affects relatively well-paid Canadians this is demonstrated by a Statistics Canada study of tax filers showing that almost 1 per cent of high-income tax filers left the country between 1995 and 1996 (see Chart 1). This number is almost 10 times the average. It is likely that many of the departing Chart 1 Percentage of Tax Filers Who Ceased to Reside in Canada in 1996 (by 1995 income class) $150,000+ $100,000 $149,999 $75,000 $99,999 $50,000 $74,999 $20,000 $49,999 Less than $20,000 Sources: Revenue Canada income tax files. All tax filers, 0.12% higher income tax filers are among Canada s best and brightest talents. Numerous studies, including those of the Conference Board, have pointed out that brain drain is not related simply to taxes it is a multi-dimensional issue. Decisions to move to the United States are based on a variety of determinants, including opportunities, lifestyles and compensation in general. Because the issue is multi-dimensional, a concerted effort on many fronts will be necessary to redress the negative aspects of the Canadian situation. Taxation will have to be one of those fronts. The Budget At first blush, the latest federal budget appears to offer a significant response to the main conclusion of Are We Losing Our Minds? and to provide relatively swift action. A number of measures in the budget help to redress factors that influence departing Canadians. Specifically, these proposals may both allow Canadian organizations to offer more attractive compensation packages to their knowledge workers (through stock options, for example) and reduce the tax wedge. 1. In response to the need for more attractive compensation, the February 2000 federal budget introduced changes in the capital gains tax, allowing those knowledge workers who are compensated according to the success of their businesses to keep more of the fruits of their efforts. 2. Important changes were announced in the way income from stock options is taxed in Canada. The budget proposals would allow recipients of stock options including many knowledge workers from fast-growing small and medium-sized businesses to defer the full impact of taxation until the stock is actually sold. Contrast this to the pre-budget situation, where many knowledge workers found themselves liable for tax on shares received as compensation for their valuable efforts but not yet disposed of. 2 The Conference Board of Canada

3 The Conference Board of Canada. All rights reserved. Please contact cboc.ca/ip with questions or concerns about the use of this material. Given the assumptions, the analysis suggests that there is still a significant tax gap, at all levels, between the United States and Canada. The impact of these changes on the ability of leading corporations to offer attractive compensation packages to knowledge workers cannot be overstated. The treatment of capital gains and stock options had been identified as a major impediment to offering competitive compensation to high-technology and software workers in Canada and a major stumbling block to the retention of this talent. The proposed measures relative to capital gains and stock options allow many organizations to offer stock to key knowledge workers. Thus they are able to augment compensation significantly without having to offer in-canada salaries that are out of line with the domestic marketplace and make them less competitive globally. The federal budget also proposes to increase exemptions, reduce the middle income tax rate and eliminate the income surtax for broad categories of taxpayers, including many of the knowledge workers most susceptible to brain drain. The estimates presented here repeat the methodology of the previous studies. Methodology The sample used in the research consists of six Canadian cities and six U.S. cities where many skilled emigrants reside. The availability of local/ property tax data also influenced the selection of U.S. cities. Our calculation of the tax burden encompasses federal income tax, provincial/state income tax, surtax, social security related taxes (such as pension plans, employment insurance, Medicare), sales tax and property tax. It also takes into account various tax deductions and credits available in both countries. It excludes taxes on items like gasoline, cigarettes, alcoholic beverages, etc., which account for less than 5 per cent of total taxes paid by the average consumer. All income and tax calculations are based on national currencies. Canadians who move to the United States not only receive their salaries in U.S. $ but also pay their taxes and make all purchases and transactions in U.S. $. It is only that portion of U.S. income that is saved and repatriated to Canada that needs to be converted into Can. $. Our Analysis In order to assess the impact of the federal budget on the tax wedge, the Conference Board made the following assumptions: All of the tax-related measures are implemented immediately instead of over a five-year period. Tax levels in U.S. jurisdictions are unchanged over the period. Gross earnings levels are calculated using national currencies and are the same in both the United States and Canada. Canadian dollars are equivalent to U.S. dollars. Given these assumptions, the analysis suggests that there is still a significant tax gap, at all levels, between the United States and Canada. More importantly, the gap grows with the success of the taxpayer, i.e., as his/her salary increases over his/her career. Tax Levels The 1999 study of personal taxes determined that tax levels were significantly higher in Canada at all income levels. For example, in 1999, a person earning $50,000 paid 36.8 per cent of gross income in various taxes in Canada compared to 31.7 per cent in the United States. These figures include all tax costs (income, payroll, sales and property at all levels of government) and account for private health care and associated costs in the United States (to ensure comparability). If all the measures announced in the federal millennium budget were implemented today, the same person would pay 34.4 per cent of gross income in Canada, still 2.73 percentage points more than in the United States (see Chart 2). However, the gap continues to be most significant at higher incomes. Progressivity in tax rates is still a basic feature of both the U.S. and Canadian tax systems. Yet, because the top marginal rates take effect at much lower incomes in Canada than in the United States, the post-budget tax wedge continues to be 3 The Conference Board of Canada

4 At the $250,000 income level, postbudget taxes amount to 38.8 per cent of gross income in Canada compared to 41.2 per cent in Chart 2 Total Tax Comparison, $50,000 Income Note: A household of two adults and two children, tax filed jointly. Canada represents an average of six cities: Calgary, Halifax, Montreal, Ottawa, Toronto and Vancouver. U.S. represents an average of six cities: Charlotte NC, Chicago IL, Jacksonville FL, Houston TX, New York City (Queens) and Los Angeles CA. * Includes Canada/Quebec Pension Plan and Employment Insurance in Canada; FICA (Federal Insurance Contribution Act) and OSADI (old age, survivors and disability insurance) and Medicare in the United States. Sources: The Conference Board of Canada; Canadian Tax Foundation; CCH; and the U.S. Department of Commerce. very significant (see Chart 3). At the $250,000 income level, for example, while total post-budget taxes amount to 38.8 per cent of gross income in Canada (compared to 41.2 per cent in 1999), taxes Chart 3 Canada (pre-budget) Canada (post-budget) U.S. Tax Burden Comparison, $250,000 Income Canada (pre-budget) Canada (post-budget) U.S. amount to only 29.7 per cent in the United States. The major reason for the relative lack of change in the taxation levels in Canada lies in provincial income taxes, which, Note: A household of two adults and two children, tax filed jointly. Canada represents an average of six cities: Calgary, Halifax, Montreal, Ottawa, Toronto and Vancouver. U.S. represents an average of six cities: Charlotte NC, Chicago IL, Jacksonville FL, Houston TX, New York City (Queens) and Los Angeles CA. * Includes Canada/Quebec Pension Plan and Employment Insurance in Canada; FICA (Federal Insurance Contribution Act) and OSADI (old age, survivors and disability insurance) and Medicare in the United States. Sources: The Conference Board of Canada; Canadian Tax Foundation; CCH; and the U.S. Department of Commerce Property tax Sales and use tax Private health care Social security* Provincial/state income tax Federal income tax Property tax Sales and use tax Private health care Social security* Provincial/state income tax Federal income tax 4 The Conference Board of Canada

5 The Conference Board of Canada. All rights reserved. Please contact cboc.ca/ip with questions or concerns about the use of this material. Even after the proposed tax relief is fully applied, the highest level of taxation kicks in at $70,000 in Canada, in contrast to $270,000 in the United States. although they have declined substantially in some provinces, are still extremely high relative to those levied by individual U.S. states. Add to this the higher sales taxes paid in Canada, both federally and provincially, and increasing social security taxes (e.g., Canada/Quebec Pension Plan) in Canada. In the end, it is not difficult to explain the significant tax gap that remains despite the income tax changes brought about by the federal millennium budget. Under present circumstances, it is relatively easy for workers in Canada s high-tech sectors to reach the $250,000 income level. As mentioned earlier, one trend in compensation is to attract and retain knowledge workers by offering either stock or stock options as an incentive. Technology sector stocks have increased substantially in value recently. Chart 4 Disposable Income, $50,000 Income Calgary Halifax Montreal Ottawa Toronto Vancouver Charlotte NC Chicago Jacksonville FL Houston New York Los Angeles Pre-budget disposable income Note: A household of two adults and two children, tax filed jointly. Sources: The Conference Board of Canada; Canadian Tax Foundation; CCH; and the U.S. Department of Commerce. For example, a number of science and technology mutual funds exceeded 60 per cent returns during With such returns from the stock market, one can imagine knowledge workers wanting to realize the gains on all or part of their stock-based compensation by selling stock or cashing in stock options. In the process, an individual could easily move from the lowest to the highest tax bracket in Canada. In fact, even after the proposed tax relief is fully applied, the highest level of taxation kicks in at $70,000 in Canada, in contrast to the United States, where the top tax bracket does not take effect until incomes reach over U.S. $270,000. Disposable Income The size of the incentive is illustrated by Chart 4, which describes the reverse Post-budget disposable income 0 10,000 20,000 30,000 40,000 5 The Conference Board of Canada

6 A worker in the lowest tax jurisdiction in Canada is still $20,000 short in terms of take-home pay relative to a comparable U.S. location. side of the tax burden, disposable income. At the $50,000 income level, it is apparent that the proposed federal tax changes have helped to close the gap. For example, at that level, a Canadian working in Canada would take home between $30,320 and $36,000. This is about $1,200 more than in 1999, when the range was $29,000 to $34,000 in Canada. More importantly, it is now comparable with a number of U.S. jurisdictions where take-home pay for the same income level ranges from $31,500 to $36,320. This suggests that the combination of provincial tax cuts during 1999, as well as the planned reductions announced in the federal budget, will effectively reduce the influence of taxation on migration decisions at lower income levels. At higher income levels, the impact is much less. Taking our example where Chart 5 Disposable Income, $250,000 Income Calgary Halifax Montreal Ottawa Toronto Vancouver Charlotte NC Chicago Jacksonville FL Houston New York Los Angeles Pre-budget disposable income Note: A household of two adults and two children, tax filed jointly. Sources: The Conference Board of Canada; Canadian Tax Foundation; CCH; and the U.S. Department of Commerce. the taxpayer has sold his company stock holdings and now finds himself at the $250,000 income level, take-home pay ranges from $146,000 to $166,000 in Canada, better than the $140,000 to $161,000 in However, this compares to $162,000 to $186,000 in the United States. As demonstrated in Chart 5, higher income levels usually bring greatly increased taxation in Canada relative to the United States. Indeed, at the $250,000 income level, the worst-case scenario for the United States New York City is better than any major Canadian urban centre except Calgary. In other words, take-home pay is higher in Calgary than in the highest tax jurisdiction in the United States; however, Calgary is more comparable to Houston in terms of the industries located there than it is to New York. Post-budget disposable income 0 50, , , ,000 6 The Conference Board of Canada

7 The Conference Board of Canada. All rights reserved. Please contact cboc.ca/ip with questions or concerns about the use of this material. The federal millennium budget made difficult choices in addressing current spending priorities particularly in the case of taxation. The analysis shows that a substantial tax wedge one that increases with income level remains between Canada and the United States. A Canadian worker in the lowest tax jurisdiction in Canada is still almost $20,000 short in terms of take-home pay relative to a comparable U.S. location. Caution The basic assumptions behind the comparison are worth repeating: 1. It assumes that the entire five-year tax reduction plan from the budget has been implemented immediately. In fact, many of the more significant measures, including the income surtax and the top marginal tax range, are being phased in over five years. 2. It assumes that no changes are made to U.S. tax levels. In fact, the U.S. senate has been considering a tax cut for the United States for a number of years now. 3. It assumes that salary levels are the same in the United States and Canada. In fact, a number of studies have shown that salary levels for a number of the knowledge areas covered by Are We Losing Our Minds? are higher in the United States than they are in Canada. 4. Finally, it assumes that Canadian dollars are equivalent to U.S. dollars. In fact, for every U.S. dollar saved, a Canadian can repatriate about Can. $1.50 at current exchange rates (if and when he/she decides to return to Canada). Conclusions and Policy Considerations While many claim that Canada has a number of non-economic advantages relative to other countries, it has been demonstrated that economic considerations weigh heavily in the decisions of many Canadians to migrate to the United States. At the same time, Canadians are realizing that sustaining our culture, the Canadian way, requires resources people, investments, industries, and associated tax revenues for which we must compete at a global level. The federal millennium budget made difficult choices in addressing current spending priorities particularly in the case of taxation, one of the factors influencing brain drain. This study demonstrates how quick, decisive action can have a profound effect on some of the challenges we face relative to the United States from a tax competitiveness point of view. It demonstrates that a substantial change in taxation of incomes and capital gains can reduce the taxation-induced incentives that encourage migration at lower income levels. It also shows how the treatment of stock and stock options can affect compensation another significant determinant of brain drain. However, the analysis overstates the impact of the proposed changes by assuming that all of the changes are implemented immediately. This assumption not only advances the benefits to taxpayers of the reduced tax burden but also implies that taxation in the United States will remain constant while Canada puts the proposed changes into effect. Despite these assumptions, the analysis shows that a substantial tax wedge one that increases with income level remains between Canada and the United States. 7 The Conference Board of Canada

8 Editing: Layout: Laurie Bowes Holly W. Michael Recycled paper About The Conference Board The Conference Board of Canada is an independent, not-for-profit research organization with affiliates in the United States and Europe. Our mission is to help our members anticipate and respond to the increasingly changing global economy. We do this through the development and exchange of knowledge about organizational strategies and practices, emerging economic and social trends and key public policy issues. Since 1954, the Board has been committed to researching innovative practices, designing new strategies and providing our members with the most up-to-date information, analysis and expertise to help them excel in Canada and around the world. About the Business Research Group The Business Research Group is a dedicated program of The Conference Board of Canada addressing issues of strategic significance for corporations in Canada within a rapidly evolving international environment. It provides its members with an independent analytical resource base to identify, analyse and forecast key emerging issues in such areas as corporate governance, risk management, logistics, taxation, international market access and regulatory reform of the financial sector. The Conference Board of Canada, 255 Smyth Road, Ottawa, Ontario K1H 8M7 Canada Tel: (613) Fax: (613) Internet: The Conference Board, Inc., 845 Third Avenue, New York, N.Y U.S.A. Tel: (212) Fax: (212) Internet: The Conference Board Europe, Chausée de La Hulpe 130, Bte 11, B 1000 Brussels, Belgium Tel: (32) Fax: (32) The Conference Board of Canada