How Good Intentions Lead to Crushing Marginal Tax Rates on the Working Poor

There was a piece in my city's morning news on how more government subsidized child care spaces will be created. From LondonTopic.ca:

London-Middlesex will receive more than $650,000 in funding to help more families cover the cost of licensed child care. This funding will serve approximately 100 more children on an ongoing basis.

Now 100 spaces is not a lot in a city-county of 425,000 residents but I am certain the 100 families that benefit will appreciate the fact that they are there.

Because the government cannot afford to give spaces to everyone with a small-child, they have put income-limits on which families are eligible for the spaces:

Eligibility for the financial assistance is based on net family income. For example, a family with a net income below $20,000 can receive full child care assistance. A family receiving financial child care assistance with a net income of $40,000 will pay approximately $8 per day. Parents can apply for the financial assistance through their municipality for children up to age 12.

Eight dollars a day is an absolute bargain for child care - the private sector price runs at least 5 times that.

But consider a single-parent with one child in day care. If that parent works full time, that child could easily spend 250 days a year in day care. As that parent's income grows from $20,000 to $40,000, their child care expense goes from $0 to $2000 - a marginal tax rate of 10 percent.

In and of itself, that is not a lot. But we need to consider the other income-based taxes that parent is required to pay. In Ontario, a person earning $40,000 faces a combined federal-provincial marginal income tax bracket of 31.15 percent. Plus they are also required to pay into the Canada Pension Plan (CPP) at 4.95 percent and Employment Insurance (EI) at 1.73 percent. Those figures do not take into account the employer's share of EI and CPP (4.95 percent and 2.422 percent of income, respectively).

If you add together the marginal income tax rate, daycare clawback, EI premium and CPP premium, you end up with a marginal income tax rate of 47.83 percent. But we have not considered the income-based clawbacks from other child and family benefits including the Goods and Services tax credit. Once taken altogether, it has historically been possible for marginal tax rates on the working poor to be or exceed 100 percent:

The Quebec White Paper estimated that a welfare recipient with spouse and two children who takes a job at minimum wage (then $4.00) could expect to keep only 85 cents an hour, after taxes and changes in benefits -- an implicit marginal tax rate of 79%. This is in a province that, unlike others, has a small income supplement for the working poor. And it does not include the loss of benefits in kind -- subsidized housing, drug plans, etc. -- provided to welfare recipients.

A person in similar circumstances in Toronto in 1983, according to a study for the Macdonald Commission, faced an implicit marginal tax rate that started at zero, shot up to 75%, climbed to 100%, fell back to 28%, bounced up to more than 80%, dropped as suddenly to 30%, and thereafter rose to 40%, all before he had earned $20,000.

While aiming social programs at the working poor can be a good way of targetting a government's assistance to those most in need, it often has the unintended consequence of creating crushing marginal tax rates.