Role of provinces in levying personal income taxes has changed through the century
Today’s payroll professionals know that income tax deductions include both federal and provincial/territorial calculations. It has not always been this way. There was a time when only the federal government levied income tax.
As federal income tax marks 100 years in Canada this year, it is a good time to look back on milestones in the history of income tax in Canada. One such turning point came during the Second World War when the federal government got the provinces to temporarily stop levying income tax.
For most provinces, the arrangement lasted for close to 20 years and helped to lay the foundation for today’s approach to income tax calculations.
When the federal government implemented income tax in 1917 to help pay for Canada’s role in the First World War, it was not the first government in the country to levy income tax. A few provinces and some municipalities were already doing it.
“British Columbia, in 1876, was the first province to impose an income tax, although some municipalities began levying income taxes as early as 1831,” wrote authors Munir A. Sheikh and Michel Carreau in a paper called A Federal Perspective on the Role and Operation of the Tax Collection Agreements, presented at a tax policy conference in 1999. The federal government included the paper in its proposal to change federal-provincial tax arrangements at the beginning of this century.
While some politicians initially complained about the federal government entering into a provincial-municipal area of taxation, significant problems did not arise until the 1930s.
“It was not until the Depression, when federal, provincial, and municipal governments were all attempting to raise income tax revenues to meet increasing demands, that joint occupancy became an issue,” Sheikh and Carreau wrote.
“At that time, for the most part, there was little or no co-ordination between governments on the design or administration of their respective tax systems. The lack of a common tax structure and the non-uniformity of tax bases and rates produced large variations in tax burdens between provinces. In addition, tax administration was extremely complex, with a multiplicity of forms, rates, and methods of calculation,” they wrote.
While all provinces faced difficulties, poorer jurisdictions carried a significant burden. To find a way to better deal with the financial pressures, former prime minister Mackenzie King appointed a commission in 1937 to put forward options that would better balance federal-provincial fiscal powers and obligations.
The Rowell-Sirois Commission, which tabled its report in 1940, made broad-ranging recommendations, including having the federal government become the only level of government in Canada to levy certain taxes, such as income tax.
In return, the federal government would take over responsibility for provincial debt, unemployment insurance and contributory pensions, as well as make transfer payments to the provinces to help ensure equal access to health and education services across the country.
However, the federal and provincial governments could not agree on the recommendations, with provinces such as Ontario refusing to give up the right to levy income tax, corporation tax or succession duties.
While the federal government had to shelve the report, it continued to try to convince the provinces to let go of some of their tax power. In the 1941 federal budget, then-finance minister James Lorimer Ilsley announced that the government needed to sharply raise both personal income and corporation taxes, as well as a national defence tax, to pay for costs related to Canada’s participation in the Second World War.
Ilsley suggested that the provinces temporarily give up their right to levy income and corporation taxes. In return, the feds would provide compensation payments to the provinces and pay their debt costs.
He proposed that the provinces allow the federal government to have sole authority in income and corporation taxes for the rest of the war and one year afterwards. With municipalities being creations of the provinces, municipal income taxes would also end.
Despite initial resistance to the proposal, the provinces did eventually agree to leave personal and corporate income tax to the federal government from 1941 until after the war in return for compensation. This was the beginning of a period known as the “tax rental agreements.”
Despite the fact that the arrangement was to be temporary, when the war ended, the federal government proposed that the provinces permanently give up the right to levy certain taxes, including personal income tax, in exchange for increased compensation payments.
While the provinces did not accept a permanent withdrawal, all but Ontario and Quebec agreed in 1947 to extend the tax rental agreements for five years. Newfoundland passed similar legislation when it joined Confederation in 1949.
In 1952, the provinces — including Ontario this time — signed another rental agreement for a further five years. Quebec continued to opt out and eventually set up its own personal income tax system in 1954.
The tax rental agreements remained in place until the early 1960s when both levels of government agreed that the provinces should have the authority to levy their own income tax.
Under a new agreement that came into effect in 1962, provinces began levying personal income tax again, but not in the way they had before the war.
Instead of each province setting up an independent tax system with different rates, income brackets and collection procedures, they agreed to some uniformity. Each province would set a single provincial personal income tax rate calculated as a percentage of basic federal income tax. In addition, the federal government agreed to collect provincial income taxes on their behalf. Quebec did not take part in the new arrangement, opting to continue with its own income tax system.
This method of taxation, called “tax-on-tax,” remained in place, with modifications, until 2000-2001 when provinces/territories (other than Quebec) began moving to the current system called “tax on income.” It allows provinces/territories to directly tax taxable income rather than levy the tax through a percentage of basic federal tax.
Simply put, tax on income requires provinces to use the federal definition of taxable income, but allows them to set their own income tax rates, taxable income brackets and tax credits. The federal government still collects income taxes for the provinces/territories and their residents continue to file one tax return.
The push for the tax-on-income system began in the 1990s, as provinces grew frustrated with what they saw as unfairness in federal-provincial fiscal arrangements and demanded more control over tax decisions.
“Unless the federal government is prepared to address these inequities, Ontario will have to seriously consider withdrawing from the current arrangement,” former Ontario finance minister Ernie Eves said in his 1997 budget speech.
In 1999, former Alberta finance minister Stockwell Day announced that in 2001 Albertans would “officially unhook ourselves from our decades-old attachment to federal tax rates.”
Other provinces made similar announcements in their budget speeches, and the move to tax on income began.
While the tax-on-income approach is now just another part of the source deduction process, in the lead-up to its implementation, it was a significant change for payroll professionals, who had to update their payroll systems and learn a new way to calculate income tax deductions.
The provinces’ role in Canada’s income tax system has changed significantly in the last century. It is unlikely that politicians from 100 years ago ever thought that their successors would give up the right to levy income tax, albeit temporarily.
It is also unlikely that the successors ever imagined that the provinces would have as much control over their income tax systems as they do today.