Expansion of the Canada Pension Plan: An Irony in Tax Neutrality

On December 15, 2016, Bill C-26, An Act to amend the Canada Pension Plan, the Canada Pension Plan Investment Board Act and the Income Tax Act, received Royal Assent. Representing the culmination of a lengthy discussion on the enhancement of pensions for Canadians, including the previous federal government’s reluctance to discuss expanding the CPP, the introduction and demise of the Ontario Retirement Pension Plan, and the new Liberal government’s platform of assisting middle class Canadians to save more for retirement, the Bill had gone through arduous debate but seems to have finally made the cut.

The expansion of the CPP is set to take place in phases, with a higher benefit rate and increased contribution rate on earnings up to the Year’s Maximum Pensionable Earnings (“YMPE”)[1], being phased in over the course of five years, starting on January 1^st, 2019. The next step, starting in 2024, will be the introduction of a new Year’s Additional Maximum Pensionable Earnings (“YAMPE”) contribution limit, otherwise referred to as the enhanced portion of the CPP. The limit is projected to be $82,700 in 2025, and starting in 2024 both employers and employees will contribute an additional 4% on their earnings exceeding the YMPE, up to the YAMPE, in a two stage phase in. Half of the increase will be effective in 2024 and the full increase will take place in 2025.

The expansion bears the goals of helping Canadians achieve their goal of a safe, secure and dignified retirement and is tailored to assist lower and middle income Canadians[2].

Income Tax Amendments

As a supporting measure for the expansion, and its goals of assisting low and middle income earners, the Income Tax Act is concurrently to be amended to increase the Working Income Tax Benefit, thereby offsetting the effect of the increase in CPP contributions. This is meant to reduce the impact of a higher financial burden on those in the lower income brackets.

Additionally, the employee contributions to the enhanced portion of the CPP, above the YMPE, will be granted a tax deduction instead of a tax credit. The employee contributions up to the YMPE will remain eligible for a tax credit, and employers will continue to receive a deduction on their contributions for both the regular and the enhanced portion. Self-employed individuals will be able to receive a tax deduction for both employer and employee contributions.

The reasoning behind providing employees with a deduction instead of a credit, for the contributions to the enhanced portion, seems to be to maintain tax neutrality. It is stated that the additional contributions to the CPP may cause a corresponding reduction in contributions to pension plans and personal savings vehicles, such as RRSPs, which offer a tax deduction instead of a credit[3]. Thus in an effort to minimize the impact on savings, the enhanced portion contributions will be given the same treatment as the contributions to private savings plans they would potentially be replacing.

Tax Credits vs. Tax Deductions

However, a certain irony exists in attempting to maintain tax neutrality by offering a deduction for higher wage earners, instead of a credit. The reason lies in the mechanical operation of how a tax credit and a tax deduction work. Put simply, a tax credit is income neutral, whereas a deduction is not.

To use an example, suppose John earns $200,000 a year, and Larry earns only $30,000. John’s effective tax rate is 50% and Larry’s is 20%. Each contributes an equal amount to a savings plan, let’s say $10,000, and receives a deduction from their taxable income.  While both receive the same deduction, John effectively receives a much higher benefit; his deduction of $10,000 reduces income that is taxable at 50%. Thus, where John would have previously paid tax of $100,000 ($200,000 x 50%), he now pays tax of $95,000 ($190,000 x 50%). Thus, the same $10,000 deduction is worth $5000 to John, whereas the value to Larry would only be $2,000.

A credit, on the other hand, directly reduces the taxes payable and not the income that forms the tax base. Thus, whether the total income is $200,000 or $30,000 is irrelevant and higher, middle and low income earners all generally receive the same benefit.

The above is precisely why our current tax system provides tax credits for most tax expenditures, as discussed in the 1987 White Paper[4] and implemented in the 1988 Federal Budget. There, in a proposal for a comprehensive overhaul of the tax system that better achieves the goals of a more fair, income neutral and progressive tax system that places higher tax burdens on higher earners[5], the Conservative Government proposed changing numerous exemptions and deductions to tax credits.

These included the disability deduction, tuition deduction, medical expense deduction and, of course, the deduction for contributions to Quebec Pension Plan and the CPP. All of these previous deductions had become credits and remain so to this day.

The Irony

It is thus somewhat ironic then, that while bearing the goals of assisting low and middle income earners in saving for retirement while maintaining tax neutrality and offsetting the negative financial impact of higher contributions, the expansion of the CPP nevertheless seems to benefit and favour higher earners with a deduction, in lieu of a credit, being provided for employee contributions beyond the YMPE. The YMPE is projected to rise to $60,200 by 2019 and continue to rise at a rate of approximately 3.1% each year thereafter.

Further, it is understandable that employers receive a deduction regardless, as they do not receive the benefit of the CPP in the form of a pension down the line. Similarly so for self-employed individuals; the burden of the extra contributions on small business ought not to be underestimated. But hardly a reason exists for providing those earning income between $60,000 and $80,000 with a higher tax benefit than those earning less.

Conclusion

While already a long and hard fought battle, but certainly a welcome development in this author’s eyes, the expansion of the Canada Pension Plan could certainly have been tailored with more attention to detail with respect to the tax impact of the proposed amendments.

If the expansion of the Canada Pension Plan is truly to assist lower and middle income earners, maintain tax neutrality and promote progressivity in our income tax system, perhaps the current federal government could learn a lesson from the past and look at previous tax reforms in order to tailor a more income neutral means to assist Canadians in saving for retirement.

About the author

Hennadiy Kutsenko of EY Law LLP