Means-testing benefits hurts the middle class and those who want to join it

By Marvin JS Ferrer

Many Canadian federal and provincial government social welfare programs are targeted mainly at lower-income individuals and families.  The rationale behind this “means-tested” approach to welfare benefits is that people who have higher incomes do not need social assistance.

For example, during the 2015 federal election campaign, Justin Trudeau criticized the previous government’s universal approach to child benefits.  Trudeau said that “fair doesn’t mean giving everyone the same thing, it means giving people what they need.” Newly elected New Democratic Party leader Jagmeet Singh also uses the language of “fairness” to justify replacing seniors’ benefits with one targeted at low-income Canadians.

These ideas sound fair and equitable.  However, it is punishing and profound in its unfairness to low-income people who are working hard to increase their incomes. 

Here’s how.

Sidebar: Tax Rates and Clawbacks

Average tax rate (ATR) is simply the amount of tax you pay relative to your total income.

Marginal tax rate (MTR) describes the amount of additional tax you pay relative to additional income you might earn. Think of it as the tax rate you’d pay on the next dollar of income you earn.

Means tested benefits and programs generally provide some maximum base level of benefit and then begin to “claw back,” or reduce, the benefit as people begin to earn income.

The source of getting a new dollar doesn’t matter to a person’s decision about how to spend it; a dollar is a dollar.  Similarly, if a dollar is taken away, why or how it is taken away doesn’t matter either—the end result is that the person has one less dollar.  So taxing income and clawing back benefits both look the same to the person earning the income.

Taking away benefits looks identical to increasing the tax rate

To better illustrate that only the act of losing a dollar matters, and not how or why it is lost, consider Figure 1. 

Alex and Riley both make an extra $4.  Riley receives a benefit that is clawed back by 50% of additional income she makes (she loses $2 of benefit after making $4), and Riley also pays 25% income tax (she loses $1 on the 4$ she has made).  After earning her $4, Riley is only $1 better off, the same as Alex who pays an extraordinarily high 75% marginal tax rate (MTR). 

Essentially, Riley paid a 75% marginal effective tax rate (METR).  After making $4, Alex and Riley were both equally better (or worse) off.

METR is obscenely high for some middle-class Canadians

The CD Howe Institute released a report which tried to calculate the METR inclusive of all provincial and federal benefits and tax breaks.  For a family of four with an income of $40,000, second earners would face METR exceeding 70% in Ontario and 80% in Quebec.

People with higher incomes pay higher MTR through the income tax because of “vertical equity” (discussed in a previous PPGR article).  Vertical equity demands that people who can afford to pay more taxes should pay more taxes, illustrated in Figure 2 (red).

Vertical equity is enshrined in Canada’s income tax system using MTR.  Income taxes are “progressive” because the MTR progressively gets higher as income gets higher.

But Figure 2 also shows that at different income levels, the difference between the METR as calculated by the CD Howe Institute (blue) and the MTR as structured by the income tax system (red) is profound.  The high METR faced by low- and middle-income Canadians is also referred to as a welfare wall.  The METR drop for rich people, which occurs when clawbacks end, is illustrated in Figure 3 with Riley.

Canada’s non-universal, means-tested approach to benefits has resulted in low- and middle-income Canadians facing dramatically higher METR than very wealthy Canadians.

Clawbacks of benefits have bastardized the aims of Canada’s progressive income tax system.

Should the problem be mitigated, or eliminated altogether?

Supporters of the vision of fairness that Justin Trudeau and Jagmeet Singh espouse might say the welfare wall can be mitigated.  Lowering clawback rates is one approach to mitigate the welfare wall.  The Working Income Tax Benefit (WITB) is another approach, which provides benefits as very low-income Canadians start to work, but claws them back once their earnings rise. 

Lowering clawback rates or increasing the WITB will allow more higher-income people to receive benefits, but also lower the peak and shift the highest METR to a higher income level, illustrated hypothetically in Figure 2 (orange).

However, any form of clawback results in a METR higher than an MTR without any clawbacks.  The highest METR should be paid by the highest-income people.  Mitigating the current non-universal benefits system might make it fairer, but it will still be unfair.

The best approach would be to eliminate clawbacks entirely, also illustrated in purple in Figure 2. A typical example of this approach is universal basic income (UBI).

In order to pay for net UBI benefits for low-income Canadians, the MTR at all income levels would likely be higher than the current income tax system (Figure 2, purple).  However, for low- and middle-income Canadians, any MTR with a universal benefits scheme must be lower than the welfare wall formed by METR due to benefit clawbacks.  The METR for the wealthiest Canadians must also necessarily rise above current levels.

Detractors might criticize UBI by saying it gives money to the wealthy who don’t need it.  However, the “clawback” under UBI would simply be built into the tax system, restoring the structure of Canada’s progressive income tax system.  As you earn more, you pay more, and eventually, you will have paid more than the UBI benefits received, as shown in Figure 3. 

In Figure 3, Alex’s $4 benefit would essentially be clawed back by income tax after he earns 12$.  Afterwards, Alex would continue paying the same MTR, (possibly higher in a progressive income tax system).  This is fairer than what happens to Riley.  Riley pays a very high METR while poor, and when no longer poor suddenly pays a much lower MTR after Riley’s benefits are clawed back.

Detractors of universal benefits might also criticize increasing the MTR for the wealthy, claiming that the current MTR of 53% would discourage them from working at all.  However, if 53% MTR is bad for wealthy Canadians, then surely 70% METR is even more so for low- and middle-income Canadians.

Conclusion

At first glance, there is understandable appeal in the idea that rich people do not deserve social benefits and therefore benefits must be clawed back as people begin to earn income.

However, we should stop punishing low-income Canadians to avoid looking like we are giving anything to wealthier Canadians.  It turns out we have just been letting wealthier Canadians pay a lower tax burden this whole time.

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Marvin JS Ferrer previously completed his master’s and doctoral degree in the cell biology of reproduction and fertility at Queen’s University, where he helped many Canadians start new families. His policy interests include science and research policy, industry-government relations, and health policy.  As a politically-minded scientist, he would like to advance the use of the scientific method to improve evidence-based decision making.