the child tax benefit: simple, fair, responsive?

Canadian Public Policy

The Child Tax Benefit: Simple, Fair, Responsive?Author(s): Jonathan R. KesselmanSource: Canadian Public Policy / Analyse de Politiques, Vol. 19, No. 2 (Jun., 1993), pp. 109-132Published by: University of Toronto Press on behalf of Canadian Public PolicyStable URL: http://www.jstor.org/stable/3551677 .

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The Child Tax Benefit:

Simple, Fair, Responsive? JONATHAN R. KESSELMAN* Department of Economics The University of British Columbia

La prestation fiscale pour enfants annonc6e dans le budget f&d6ral va changer radicalement le traitement fiscal des enfants ii charge. Cet article dvalue les affirmations officielles voulant que le nouveau r6gime sera plus simple, plus 6quitable et plus souple. Le texte montre que les ameliorations au niveau de la simplicit6 sont plus grandes en thdorie qu'en pratique. Les ameliorations au niveau de l'6quit6 sont surtout assocides au nouveau traitement accord6 aux conjoints de fait et h d'autres changements qui auraient pu itre obtenus sans introduire cette prestation fiscale pour enfants. Toutefois, la rdforme va accentuer l'indquit6 horizontale dans la fagon d'imposer les familles h haut revenu avec enfants et celles sans enfants. De plus, les familles aux revenus les plus faibles vont r6aliser peu de gains. Par ailleurs, si on le compare au r6gime actuel, certaines ameliorations au niveau de la souplesse du r6gime seront contrebalancdes par une moins grande adaptation du regime aux variations de revenu des families. Le texte examine 6galement d'autres imperfections de la r6forme comme l'indexation limitbe. Il suggire des m6thodes partielles et d'autres plus importantes pour r6gler les problimes du r6gime de prestation fiscale pour enfants. Un r6gime plus raffin6 pourrait ambliorer de fagon substantielle le traitement fiscal des enfants i charge.

The Child Tax Benefit announced in the 1992 federal budget will radically alter the tax-transfer treatment of dependent children. This paper assesses official claims that the scheme will be 'simpler, fairer, and more responsive'. Any improvements in simplicity are found to be greater in concept than in practice. The improvements in equity are found to be mostly associated with the revised treatment of common-law couples and other changes that could have been achieved quite apart from the Child Benefit. At the same time, the reforms will worsen the horizontal inequity in the taxation of families with children vis-i-vis childless households at upper incomes. Families at the lowest incomes will gain few additional benefits. Limited gains in responsiveness will be offset by the Child Benefit's worsened response to most variations in family incomes. Other shortcomings of the scheme, such as its limited indexation, are also examined. The paper formulates both partial and more extensive methods to overcome the problems of the Child Tax Benefit. A properly refined scheme could significantly improve Canada's tax-transfer treatment of dependent children.

I Introduction

he federal government released a White Paper proposing a new Child Tax Bene-

fit as part of the 1992 budget. The government described its scheme as 'simpler,

fairer and more responsive to the needs of Canadians' (Department of Finance, 1992:136). This scheme represents the culmination of a series of reforms under- taken since the introduction of the refundable child tax credit in 1979. The Child

Canadian Public Policy - Analyse de Politiques, XIX:2:109-132 1993 Printed in Canada/Imprim6 au Canada



Table 1 Major developments in tax and transfer benefits for children

Year Policy change or proposal 1918 Exemption of $200 per dependent child introduced (one year after income tax was initiated) 1942 Nonrefundable tax credits for dependent children replaced exemptions 1945 Family Allowance program begun; initial monthly payments of $5 to $8 per child based on age; tax

clawback on FA benefits based on income 1947 Exemptions for dependent children replaced nonrefundable tax credits; FA clawback eliminated 1970 Family Income Security Plan proposed by government to make FA income-tested and fully eliminated

above family incomes of $10,000; FISP died on the order paper in 1972 1974 Child tax exemptions indexed annually for inflation; monthly FA payments raised to $20 per child

independent of age, indexed for inflation, and made taxable to parent claiming the child exemption 1979 Refundable child tax credits introduced; monthly FA payments reduced to $20 per child but indexa-

tion continued 1984 Indexation of child tax exemptions suspended; exemptions reduced from $710 to $560 per child under

age 18 in 1987; henceforth nonrefundable child tax credits and FA indexed only to the extent inflation exceeds 3%

1985 Royal Commission on the Economic Union and Development Prospects for Canada proposed a Universal Income Security Plan which would have replaced FA, child (and adult) tax exemptions, and refundable child tax credits with universal demogrant payments subject to a clawback

1986 Refundable sales tax credit introduced, containing benefits for dependent children; converted to an enlarged refundable tax credit for GST in 1991

1988 Nonrefundable credits for dependent children replaced exemptions as part of personal income tax reform; credit levels set below equivalent value of previous child exemptions for middle- and upper- income families

1989 Clawback initiated on FA payments at individual parent incomes above $50,000, with up to 100% recovery effective by 1991

1992 Child Tax Benefit proposed by government to begin in 1993, accompanied by elimination of FA program, refundable child tax credits, and nonrefundable child tax credits except for physically or mentally infirm children over 18

Tax Benefit will abolish the Family Al- lowance program and consolidate most major tax-transfer provisions for dependent children into a single payment. Without question, the Child Benefit will constitute the most sweeping reform of Canada's tax- transfer treatment of children, at least since Family Allowances were introduced in 1945. Bill C-80 was passed into law without substantive changes from the government's recommended design.

While the Child Tax Benefit will achieve some aspects of its claimed advantages, it also carries deficiencies that were over- looked in the White Paper. Moreover, it raises broader issues about the desirable directions for reform of the personal tax and tax-transfer systems. Given the magni- tude of the funds involved - a projected $4.9 billion in 1993 - and the importance of the underlying principles of equity and responsiveness, the scheme deserves close scru- tiny. Indeed, it is surprising that the Child

Benefit has drawn little commentary or critical assessment. Previous similar proposals, such as the ill-fated 1970 Family In- come Security Plan and later suggestions to amend or scrap the universality of Family Allowances, were the subject of extensive analysis and public debate.1

This paper begins by describing the Child Tax Benefit and the associated taxation changes. We then assess the advantages as well as the deficiencies of the scheme under the headings advanced by the government - simplicity, equity, and responsiveness. We also assess two other aspects of the scheme - its limited indexation and its marginal tax rates. Following this analysis, partial remedies to the Child Tax Benefit and related tax provisions are proposed. We close by considering further reforms to the Child Benefit that would have broader implications for the personal tax and transfer systems.

110 Jonathan R. Kesselman



II Description of the Child Tax Benefit

The Child Tax Benefit will sweep away several major provisions that have evolved since the introduction of the Canadian income tax in 1917.2 Table 1 presents the highlights of past developments relating to the tax and transfer treatment of children outside of the welfare system. The Child Tax Benefit will supplant the Family Al- lowance program; the taxation and clawback of FA benefits will thereby be eliminated. Both the refundable and the nonrefundable child tax credits will be abolished. However, the children's portion of payments in the GST credits will remain, as will the equivalent-to-married credit for one child in each single-parent family. The 1992 budget proposed two additional changes in the treatment of families and children. The maximum tax deductions that can be claimed for child care expenses will be raised by $1,000 per child in 1993. And for the first time, common-law couples will be treated the same as married couples for tax purposes.3

Child Benefits will be paid monthly, beginning in January 1993, to all families with one or more children and incomes below specified levels. Like Family Al- lowances, payments will generally be made to the mother. The basic benefit will be $1,020 per year ($85 per month) for each of the first and second child in a family and $1,095 per year for the third and each additional child.4 A family with one child will have its basic benefit reduced by 2.5 per cent of family net income over $25,921. Hence, the basic benefit of $1,020 for one child will taper down to zero at family net incomes of $66,721 and above.5 Basic benefits for families with two or more children will be reduced by 5 per cent of family net income over the same $25,921 threshold. Their benefits will taper to zero at net incomes of $66,721 for two children and at $88,621 for three children.

The Child Tax Benefit also provides an earned-income supplement (EIS) which

will be payable to families with one or more children and low earnings. (Low incomes from unearned sources, such as invest- ments or welfare, will not qualify.) The amount paid will be 8 per cent of the unit's annual earnings over $3,750, to a maximum supplement of $500 which arises for earnings between $10,000 and $20,921, reduced by 10 per cent of family net income over $20,921. Both earned and unearned sources of income are counted in the phase- out of the supplement. If the family receives only earned income, the phase-out of the EIS is complete at annual earnings of $25,921 and higher. This coincides with the threshold for phasing out the basic Child Benefit, so the supplement reduction rate of 10 per cent is never superimposed on top of the basic benefit reduction rate of 2.5 or 5 per cent.

Why was an earned-income supplement included in the Child Tax Benefit? This may have flowed from a desire to enhance work incentives, but a more likely explana- tion stems from the jurisdictional pattern of fiscal responsibilities. Because most welfare costs are shared by the provinces, the federal government may have been reluc- tant to expand the benefits for children in welfare families totally out of federal funds. The federal government may have lacked confidence that the provinces would pass any gains from the Child Benefit forward to welfare recipients. The provinces have wide discretion in setting their welfare benefit rates, and experience following introduction of the refundable child credits suggests that the new federal benefits partially offset welfare rates (Johnson, 1985). The National Council of Welfare (1992) has urged that the $500 EIS component of the Child Benefit be extended to welfare families and that provinces be restrained from cutting their welfare benefit rates. Yet, there is no effective way to prevent provinces from reacting to federal changes - if only by failing to adjust their welfare rates for inflation.

Much like the existing refundable child credits and GST credits, the Child Benefit

The Child Tax Benefit 111



Table 2 Distribution of gains and losses from Child Tax Benefits: families with two children

Gain or loss relative to current systemc Family Child Tax Single- Two-parent incomea Benefitsb parent One-earner Two-earner

0 2,040 0 0 0 5,000 2,140 100 100 100 7,500 2,340 300 300 300

10,000 2,540 500 500 500 20,000 2,540 615 500 500 25,000 2,132 207 92 92 25,921d 2,040 115 0 0 30,000 1,836 277 164 44 40,000 1,336 277 164 44 50,000 836 234 120 120 60,000 336 222 109 -380 75,000 0 -117 -234 -716

100,000 0 -117 -234 -227

Notes: a For purposes of computing the earned-income supplement portion of the Child Tax Benefit, all family income is assumed to derive from earned sources. b Families not claiming child care expenses receive an additional $213 per child under age seven. Taxable single- parent families with children also receive about $1,445 in federal/provincial benefit through the equivalent-to- married credit. Both provisions apply under both existing and proposed systems, so there is no impact on gains or losses. c Gains and losses include provincial as well as federal impacts of the reforms (for provinces other than Quebec). d Income threshold at which the earned-income supplement is fully phased out and above which the basic Child Benefit is reduced. SOURCE: Derived from Department of Finance (1992: Table 4.3, p. 137) plus additional calculations by the author.

payments will be conditioned on the family's total net income for the most recent tax return. Payments for January through June will be based on tax information from two years preceding; the payments for July through December will be based on the immediately preceding year's tax returns. The respective periods are called the 'base year' for benefit computations. Like Family Allowance payments, the Child Benefits will be paid monthly. However, the long delay between variations in a family's income and the adjustment of its Child Benefit payments is very unlike the Family Allowance approach, which pays level monthly amounts independent of income. The net benefits of Family Al- lowance are determined through source withholding, clawbacks at upper incomes, and adjustments to tax liabilities at tax filing time. These potentially long delays of adjustments to Child Benefit payments will

be shown to be a major deficiency of the scheme.

Child Tax Benefits will be issued as nontaxable payments. Yet they are defined in legislation within the Income Tax Act, so that certain differences from ordinary personal taxes have been specified. Benefits cannot be assigned, attached, garnished, or otherwise be committed to creditors or to tax discounters. Any amount of Child Bene- fit payable to a taxpayer cannot be applied by Revenue Canada against any liability of the taxpayer unless it arose from an excess benefit previously paid. Additionally, no interest is chargeable on an excess portion of Child Benefit paid to a taxpayer, and no interest is payable on the portion of a tax re- fund that represents a payment of benefit.

The distribution of gains and losses from the Child Tax Benefit, relative to the existing provisions, is shown in Table 2 for various income levels and family types, all




with two children. The scheme has been de- signed to provide no gain for those at the lowest incomes. Since Social Assistance benefits do not qualify for the EIS, welfare beneficiaries will gain nothing from the scheme unless their year's earnings exceed $3,750. However, welfare beneficiaries with three or more children (not shown in the table) will gain $75 per year for each child beyond two.6 It is clear from the table that the principal gains from the Child Benefit arise through the earned-income supplement. Most of the largest gains are the $500 that represents the maximum EIS for earnings between $10,000 and $20,921. The largest tabulated gain, $615 for single- parent families at $20,000 incomes, arises on account of a peculiarity of the Child Benefit scheme.

Unlike two-parent families with two children, who will lose the benefit of two nonrefundable child tax credits, single- parent families will lose only one nonrefundable tax credit. Their other child will still entitle them to the equivalent-to- married credit even after the reform. Single-parent families with one child will also retain the equivalent-to-married credit and not lose any nonrefundable child tax credits. As a result, the scheme produces significant gains for single-parent families even at incomes of $50,000 to $60,000. For two-parent families in that income range, the scheme yields either smaller gains or losses.

Outside the earned-income supplement range of incomes, the gains from the Child Tax Benefit are generally small. They are notably low at incomes near the $25,921 threshold, where the EIS is fully phased out. The losers from the scheme all arise at the upper income levels. However, the largest losses are incurred by two-earner families at higher, but not the highest incomes.7 This reflects the elimination of the Family Allowance with its deficient clawback design. The clawback is based on either parent having net income above $50,000, not total family income. In con- trast, the Child Benefit bases its benefit re-

duction on total family income, similar to the existing refundable child tax credit.8 Single parents at high incomes lose only about half as much as two-parent families, which again reflects the fact that they will lose only one nonrefundable child tax credit for two children. On the whole, the distributional effects of the Child Tax Benefit stem mainly from the EIS gains at lower incomes and the loss of child credits at upper incomes.

The Child Tax Benefit scheme produces more gainers than losers. It also generates more gains than losses in aggregate, because it contains an estimated $400 million per year of additional net spending by the federal government. The Department of Fi- nance (1992:136) projects revenue losses for the five fiscal years beginning 1992-93 as follows: $520 million, $645 million, $315 million, $310 million, and $300 million, for a five-year total of $2,090 million.9 The bulge in losses for the first two years reflects the overlap between Child Benefit payments and the advance and regular payments of refundable child credits for the 1992 tax year. The subsequent declining pattern of revenue losses reflects the limited indexation of Child Benefits, as we explain later.

Total fiscal impacts of the Child Tax Benefit reforms on the provinces should be relatively small. Benefit payments are not taxable, so that they do not affect provincial income taxes. Similarly, removal of the refundable child tax credits has no direct impact on provincial revenues. Family Al- lowance payments are virtually the same size as the equivalent amount of the nonrefundable tax credits for a family's first two children. Therefore, abolition of both provisions will have no impact on provincial taxes for taxpayers in the bottom rate bracket. For those in the middle and top bracket, there will be a modest loss of provincial revenues from the Child Tax Bene- fit reforms. This loss will be partly offset by families who get the larger tax credits for third or additional children and at upper income levels where the Family Allowance




would have been clawed back. The legislation authorizes the federal

government to allow provinces to vary the basic Child Benefit amount ($1,020 initially) for their residents. The basic amount can be varied only on the basis of children's ages, the number of children in a family, or both, with the modified amount not less than 85 per cent of the standard basic amount. If such an agreement yields total payments to the residents of a province which exceed its normal entitlement by more than 1 per cent, the province must re- imburse the excess to the federal government. This mirrors a provision that has allowed provinces to vary their Family Allowance payments; only Alberta and

Quebec have chosen to do so.10 The fact that basic Child Benefits are about two-and-a- half times as large as the current Family Al- lowance payments may induce more provinces to vary their payments. The ability to augment federal receipts by up to 1 per cent may also attract more provinces to par- ticipate; for Ontario the extra funds could be on the order of $15 million annually.

Administration of the Child Benefit will be a joint responsibility of the Department of National Health and Welfare (DNHW) and Revenue Canada, Taxation (RCT). Current plans are for DNHW to handle new applications and the determination of eligi- bility - such as when a child is eligible, ques- tions of custody, and family or marital status. DNHW will advise RCT, which will calculate the amount of benefit (based on tax information) and authorize the payments. General inquiries will be handled jointly by DNHW and RCT, and Supply and Services will issue the benefit payments under the imprimatur of Health and Wel- fare Canada. DNHW will also administer the new Children's Special Allowances, which will pay the full basic benefit of $1,020 per child to institutions and foster homes caring for children. These amounts will be a large increase over their current FA receipts.

III Simplicity in Administration and Compliance

First we consider the matter of simplicity, one of the government's principal claims in advancing the Child Tax Benefit. Simplic- ity involves the government's administrative requirements and the public's compliance burdens. There can be little doubt that the Child Benefit will be simpler to comprehend than the package of programs and provisions that it will replace. However, this improved conceptual simplicity does not translate into an equally radical reduction in complexity for either compliance or administration. In this section we consider the main issues; additional concerns relating to simplicity are ad- dressed in the section on responsiveness of benefits and in the final section on benefit adjustments.

Some simplifications to individual tax compliance will be possible. Several lines on the income tax return can be removed - nonrefundable tax credits for children, gross Family Allowance receipts, computation of the FA clawback, and the deduction of FA recovered.11 Additional forms for claiming and computing the refundable child tax credit will no longer be required, thus simplifying matters for low-income filers. Nevertheless, the Child Benefit will still require many persons who would not otherwise file tax returns to file a claim form of some kind.12 This problem arose in introducing the refundable child tax credit in 1979; initial estimates were that about 1.5 million previously nonfiling, nontaxable mothers had to file each year. Moreover, the administrative costs of handling the extra returns were estimated to require an additional 350 person-years of staffing in the Department of National Revenue (Kes- selman, 1979:679-80). There is no reason to expect that the administration of the Child Tax Benefit will require significantly less resources. If anything, the provision to adjust Child Benefits for income changes based on marriage breakdowns will increase the administrative burden.




The White Paper argued that 'Child benefit payments will be calculated by the government and sent to families. Taxpay- ers will not have to apply for them annually or make any of the calculations on the tax form ... Other complications, such as reconciliations and recoveries when tax forms are assessed, will also be eliminated' (1992:9). As already noted, the main compliance burden of the Child Tax Benefit will be the continued need for additional tax fil- ings, as with the refundable child tax credits. Reassessments of individual returns which affect net incomes either in the EIS range or the Child Benefit reduction range will also lead to adjustments. In some cases this will require partial repayments of Child Benefits long after they have been paid out. Moreover, the costs of registering newborn and immigrant children, record- ing changes of address and family status, and issuing monthly cheques will continue much like with the Family Allowances.

A curious omission of the Child Tax Benefit is its failure to include the GST credits within the scheme. Claimants must file a form for the GSTC along with their tax returns, and the credits are paid in quarterly sums rather than as an offset to taxes due. It would seem natural to merge the GSTC benefits with the Child Benefit, since the latter will be computed automati- cally and paid monthly. The expanded scheme could be called the Family Tax Benefit, as it would include childless couples and unattached individuals who qualify for the GSTC at low incomes. This approach would avoid the need for separate forms to be filed for the GSTC. It would also eliminate the public expense of mailing quarterly GSTC cheques in addition to the monthly Child Benefit cheques.13 Another

advantage of the expanded scheme is that the GSTC portion of benefits would be re- ceived monthly rather than quarterly.

Under the proposed Family Tax Benefit, the maximum GSTC amounts payable for each adult ($198 per year) and each dependent child ($105) could be added to the basic Child Benefit amounts. The GSTC applies

its benefit reduction above the same $25,921 threshold as the Child Benefit. The 5 per cent reduction rate of the GSTC could be added to the Child Benefit reduction rate, up to the income at which the GSTC portion was fully phased out. Alternatively, an intermediate rate could be chosen to phase out the combined basic benefits, with the GSTC portion effectively phased out only at higher incomes than at present. The GSTC contains a small earned-income supplement that could also be merged with the EIS of the Child Benefit within the Family Benefit approach.

IV Equity and Distributional Effects

We turn next to the equity aspects of the Child Tax Benefit scheme, beginning with the distribution of benefits across the income scale. One could judge the Child Bene- fit either by its pattern of net benefits or by the pattern of gains and losses relative to the current system. As shown in Table 2, the pattern of gains and losses is quite erratic, which reflects in part the earned-income supplement. Whether one believes that expanding benefits for families at lower, but not at the lowest, incomes is an improvement depends upon personal values. Clearly, few family units with children and earnings of $5,000 or less are not receiving Social Assistance or jobless benefits. One might also query whether the distribution of benefits under the earned- income supplement is optimal. The same maximum $500 is paid to families with earnings between $10,000 and $20,921 regardless of whether they have one child or several children.

The erratic pattern of gains and losses from the Child Tax Benefit at higher incomes reflects mainly the removal of anomalies of the existing provisions. A prime example would be the application of the Family Allowance clawback to the higher-income parent's income over $50,000 rather than combined family income. Another example, not shown in Table 2, is the comparative treatment of common-




law and married couples. This will be ren- dered much fairer in 1993 with the application of the same tax rules to common-law as to married couples. In particular, common-law two-earner couples will no longer be able to claim the relatively large equivalent-to-married tax credit for their first child. If the Child Benefit did not proceed in 1993, the shift of rules would have remedied another major inequity of the existing system - the failure to condition refundable child tax credits on the joint incomes of common-law couples. Moreover, the clawback of Family Allowance could have been extended to joint family incomes. Hence, some of the most important equity improvements could have been achieved within the existing system.

Unlike the current system of multiple provisions, the Child Benefit will provide the same net benefit amount to families of all types at any given level of family income. This is shown in Table 2 for single-parent families as well as one- and two-earner married couples; with the revised treatment of common-law couples, it will also apply to one- and two-earner common-law couples.14 At any given income level, the current tax differential by family type can be computed from Table 2 by taking the difference between the gain (or loss) for any two types of families. For example, at family incomes of $25,000 single-parent families with two children now get $115 more than two-parent, two-child families ($207 - $92). From this evidence we might conclude that the Child Benefit will improve the equitable treatment across families with children for any given income. Later, we shall assess whether the Child Tax Benefit scheme provides equitable treatment between families with children and those without children at the same income level.

For the first child in single-parent families, a Child Benefit will be paid in addition to the existing equivalent-to-married credit. The cash value of the credit for taxable families is $1,445 per year, including the federal and provincial (other than Que-

bec) tax relief.i5 This credit is justified by the additional living costs of a child, similar to the marital credit that can be claimed for the living costs of a non-working spouse. If the married-equivalent credit were justified by the high incidence of low incomes among single-parent units, it should be structured as an income-conditioned payment rather than as a nonrefundable tax credit. The Child Tax Benefit provides such an income-conditioned payment. Still, one might ask whether the total benefits from the two provisions for a first child in a taxable single-parent unit - $2,465 per year - are excessive relative to benefits for successive children or other family types. If that is the case, the basic Child Benefit amount for a first child could be reduced in families obtaining the equivalent-to- married credit.

Another issue in assessing the equity of the Child Benefit is how the benefits vary with the number of children in a family for a given level of income. Table 3 shows these values for one, two, and three children at various income levels. Benefits are roughly proportional to number of children at the lowest incomes and rise less than propor- tionately with children in the income range of the EIS. At incomes where the supplement is phased out and the basic Child Benefits are partially reduced, the net benefits are exactly twice as large for two children as for one child. This reflects the 5 per cent rate of reduction applied for two or more children, which is twice the 2.5 per cent rate applied when only one child is present. However, the pattern becomes peculiar for three vis-i-vis two children at middle and higher incomes. At a family income of $50,000 the benefits are more than twice as large for three as against two children; at $60,000 they are more than quad- rupled by a third child. These patterns could be modified by changes to the benefit formula, such as using a higher reduction rate with three children. A change of this kind would not increase the complexity of compliance, since benefits are computed by the government.




Table 3 Annual value of the Child Tax Benefits by number of childrena

Family Number of children income One Two Three

0 1,020 2,040 3,135 10,000 1,520 2,540 3,635 20,000 1,520 2,540 3,635 30,000 918 1,836 2,931 40,000 668 1,336 2,431 50,000 418 836 1,931 60,000 168 336 1,431 66,720 0 0 1,095 75,000 0 0 681 88,620c 0 0 0

Notes: a Figures do not include the equivalent-to-married credit for the first child in single-parent families nor the additional $213 per child under age seven that can be claimed in lieu of child care expense. For computing the earned-income supplement portion, all family income is assumed to derive from earned sources. b Family income at which Child Benefit becomes zero for one or two children. c Family income at which Child Benefit becomes zero for three children. SOURCE: Department of National Health and Welfare (1992: Table 2, p.5) and calculations by the author.

The most striking aspect of the Child Tax Benefit scheme is that it would eliminate all tax benefits for children in families at upper income levels. Of course, deductions for child care expense will remain (and even be expanded), but this provision simply allows for necessary costs of earning incomes. As such, the deductions are required to measure incomes properly for tax purposes. Aside from this, an upper-income unit with one or more children will pay the same amount in taxes as a household with the same number of adults, the same income, and no children.16 This approach reflects a view that the presence of children is irrelevant to a household's ability to pay taxes - in effect, that the costs of raising children are simply consumer outlays like the childless family's choice to purchase a fancy boat. It further 'abstracts from the well being of children, treating them as ob- jects rather than individuals' (Gravelle, 1991:6). Many earlier analyses have centred on whether the tax system should recognize

children through exemptions, refundable or nonrefundable credits, or income splitting.17 No previous findings have suggested that the tax system should ignore the presence of children in households at upper in come levels.18

Since 1971, and particularly since 1986, the Canadian tax-transfer system has moved far in reducing the allowance for children at higher incomes. Figure 1 presents the path of benefits for a child in the top tax bracket, including federal plus On- tario provisions. The current-dollar values rose fairly steadily until they reached a peak in 1986 at $562 for a child; because of inflation, the constant-dollar values have generally declined since 1971. Measured in 1992 dollars, benefits per child began from a peak of $1,345 in 1971, ranged between about $940 and $720 from 1974 through 1986, and thereafter have made a rapid de- scent. Events reducing these values have included cuts in the child tax exemption, its conversion into a nonrefundable credit, the clawback on Family Allowances at upper incomes, and the limited indexation of all provisions (see Table 1). In 1992 the presence of a child under age 18 in an upper- income family is recognized solely by a nonrefundable tax credit, with combined federal-provincial value of $117.19 After the Child Tax Benefit is implemented in 1993, there will be no tax-transfer benefits for children at upper incomes.

Canada's removal of all fiscal recognition for children in families at upper incomes - in both the personal tax and cash transfer systems - is almost without paral- lel among the OECD countries (Messere and Owens, 1979; Pechman and Engel- hardt, 1990). One exception is the United States, which since 1987 has clawed back benefits of the child, and other tax exemptions at very high incomes. Still, at family incomes of US$150,000 each child exemption in the US federal tax is worth 12 times the federal value of a child credit in Canada. The American child exemptions are fully phased out only at taxable incomes above US$275,000, far higher than the Canadian




$/child/year

1345

1200 - - - - - - - - - - - - - - - - - - -

1000 -- -- - -- -- - -- -- - -- -- - -- -- - -- -- - -- -- - -- -- -

Constant 1992$ 800----------------- ----------------------------------

600

----------------'--------------- -

" "\-------

--------------

Current $ ,....,--

"

200 ..----------------------1.............................-

....... -......

200

-

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U

?

-

iiO ?

A i .O

- ill

SOURCE: Computed by the author from Canadian Tax Foundation (misc. issues): figures on Federal-Ontario combined marginal tax rate in the top rate bracket; dependent child exemption or nonrefundable credit (1988 on- wards); Family Allowance benefit level (age 10-15 years for 1971 and 1972); taxation of FA (from 1974) and FA clawback (phased in from 1989 to 1991); and Child Tax Benefit in 1993 taken as zero for family income above $66,721.

Figure 1 Tax-transfer benefits for one child in the top tax bracket, federal plus Ontario, 1971-1993

incomes shown in Table 3 for full phase-out of the Child Benefit.20

In all of its moves to reduce, and now eliminate, the tax recognition of children in upper-income families, the federal government has neglected the underlying principles. It has simply cited the 'inadequate targeting' of existing child benefits as well as a desire to 'concentrate more assistance on those who need it most' (Department of National Health and Welfare, 1992:1, 4). Yet, this approach focusses on vertical equity, or the distribution of tax burdens across income classes, to the exclusion of horizontal equity. Achieving horizontal equity requires that due recognition be given to the varying needs or situation of taxpaying units, such as family size, at any level of income. The Quebec government recognized this point in its last budget: 21

[Flamilies, regardless of their income, are not in as good a position to pay taxes as childless households. This principle, which is a cornerstone of the Qubbec taxation and transfer system, no longer obtains in the federal taxation system, in the wake of the reform that Ottawa will introduce on January 1, 1993 (Gouvernement du Qudbec, 1992:Appendix A, 29).

Eliminating all tax recognition for dependent children in two-parent families at upper incomes is also inconsistent with retaining the marital and equivalent-to-married tax credits.

The Child Benefit scheme in effect finances much of its gains for lower-income families by increasing taxes only on upper- income units with children. Instead, all of the requisite revenues should be obtained from taxpayers more generally including




those without children. Equitable treatment could be accomplished within the Child Tax Benefit format by capping its reduction so as to provide positive benefits for children even at upper incomes. We consider alternative approaches to achieve this goal in the final two sections. The changes need to go beyond the Child Tax Benefit reform itself and undo the effects of earlier budgets that successively reduced the tax recognition for children to very low levels.

V Responsiveness of Child Benefits

We now assess the government's claim that the Child Tax Benefits will be more responsive to family needs than the existing system. It argues, first, that the arrival of a new child will be quickly reflected in higher monthly payments of Child Benefits to the family. Yet the speed of adjustment cannot be any faster than currently arises under the Family Allowance program. Like with FA, under the Child Benefit the expected arrival could be registered before birth. To obtain the benefits of increased nonrefundable child tax credits from an additional child, an employee can file an amended TD-1 form with her employer at any time.22 There are typically longer delays between the addition of a child to a family, through birth or change of custody, and an increase in payments of the refundable child tax credit. Therefore, the Child Benefit reform should achieve some improvement in responsiveness to changes in family needs of this kind.

The government also states that the Child Benefit will be more responsive than the current system to 'changes in family status, such as marriage breakdown ...' (De- partment of National Health and Welfare, 1992:9). A separation or divorce would affect the Child Benefit through the benefit reduction based on family income. The con- cepts of income and earnings for purposes of the benefit computation include the income and earnings of a person who is a 'cohabiting spouse' at the end of the tax year. After a marital breakdown, the caretaking

parent can elect to have her former spouse's income and earnings ignored in the benefit computation for all subsequent months.23 Child Benefit payments will be adjusted relatively quickly after marriage breakdown to reflect the caretaking parent's own income and earnings in the 'base year' rather than the family's total income and earnings including those of the departed spouse.

We now turn to the broader issue of benefits' responsiveness to variations in family incomes that are not the result of marriage breakdown, which surprisingly was not even cited in the White Paper. Such responses need to be distinguished from the frequency of payment. Child Tax Benefits will be paid on a monthly basis, which is somewhat more frequent than the current package of benefits. Family Allowances are already delivered each month, and the nonrefundable credits for children and equivalent-to-married status are delivered through source withholding of tax at the frequency of the individual's pay period. Only the refundable child credit is paid less than monthly, but since 1986 an advance portion of the credit has been paid in November based on the claimant's income in the previous year. Most observers would judge monthly payments as more desirable than less frequent, lumpy payments.24

Responsiveness of monthly Child Bene- fit payments to variations in family income is important for the same reason that targeting in general is desirable. The benefits are most valuable to families when their incomes are lowest - not long after their income has dipped low. Families who sud- denly lose much of their incomes cannot easily wait long periods for their benefits to rise. Over the past 12 years, job losses have become far more frequent and widespread among persons working in a wide range of occupations at middle and higher incomes. Hence, year-to-year variations in income are relatively common, and most families will experience one or more extended jobless spells over the period during which they are raising their children. Computa-




tion of the Child Tax Benefit will reflect drops and rises in family incomes only with long lags. Payment levels will be adjusted just once per year, in July, based on the tax returns filed for the previous calendar year.

We present two examples to illustrate the lags in responses of Child Tax Benefits to changes in family income. First, consider a family (one- or two-parent) with two children and normal income of $60,000 per year. As seen in Table 3, their Child Bene- fits will be $336 per year, or $28 per month. Assume that at the beginning of one year the family loses half its income, due to un- employment, and that its income for the year drops to $30,000. This sharp income fall will be reflected in higher Child Bene- fits, of $1,836 per year or $153 per month, only in July of the following year - one-and- a-half years after its income has fallen. By the time that its benefits have been adjusted upward, there is a good chance that the family will have restored part or all of its normal earnings.

Second, consider a family with one child that has suffered several years of low income, $20,000 per year, based on self-employment or farming in a depressed period. Its Child Tax Benefits will be $1,520 per year or nearly $127 per month. Assume that in the middle of one year the family's business improves and generates income at a sustained rate of $40,000 per year. For that year, its average income will be $30,000, resulting in Child Benefits being adjusted to $918 per year or $76.50 per month in July of the next year. Only two full years after the family enjoys increased income will its Child Benefits be fully adjusted downward to a monthly rate of under $56.

The poor responsiveness of Child Bene- fits to variations in family income cannot be remedied without severe complications to program administration and compliance. One could introduce administrative discretion to recompute a family's benefits when its income drops sharply. Yet this would require relatively complex accounting procedures and annual reconciliations of benefits paid. It would also require a process for

collecting reliable income information on a current or recent basis, independent of the annual T4 slips used for income tax reporting. Individuals in this situation would have to make an explicit application for increased benefits, unlike the automatic computation of Child Benefits by the government. In our closing section, we shall consider other methods of providing greater responsiveness of tax-transfer benefits for children that do not carry such heavy administrative and compliance burdens.

VI Limited Indexation of Benefits

The government proposes to index Child Tax Benefit for increases in the consumer price index above 3 per cent annually. This limited indexation is the same formula that has been applied for several years to Family Allowance benefits and many aspects of the personal income tax, including the rate schedule, personal credits, and the refundable child tax credits.25 The limited indexation will be used for all aspects of the Child Benefit - the basic benefit levels, the earned-income supplement, and the threshold for benefit reduction. Inflation is currently running at rates below the 3 per cent base for indexation, and official forecasts of inflation for the next couple of years are also below 3 per cent. At these rates no in- dexing will occur, so it might appear that the Child Benefits will decline in real value by the rate of inflation.

Since the threshold for benefit reduction is also subject to limited indexation, the Child Benefits will in fact lose real value at a faster rate than inflation. A similar effect has arisen with limited indexation of the threshold of the refundable child tax credit, but this has not been commonly recognized. This effect can be illustrated for a family with initial annual income of Y, assumed to be greater than the reduction threshold but low enough to attract benefits. We assume that the family income maintains its real value by growing at the inflation rate, p, which is taken to be less than the 3 per cent




base for indexation. Then it can be shown that nominal benefits will decline by an amount ofprYper

•ear, where r is the bene-

fit reduction rate. 6 The real value of its benefits will be further reduced by the rate of inflation. Hence, Child Benefits for families with incomes in the benefit reduction range will decline in real value at a rate higher than the inflation rate.

A numerical example serves to show how even low rates of inflation can rapidly reduce the real value of Child Benefits for those in the benefit reduction range. Let us take a two-child family with $50,000 of income, which initially receives a net Child Benefit of $836 per year. If inflation is 2 per cent, and the family's income rises at this rate, it will lose $50 of nominal benefits in the following year (prY = 0.02 x 0.05 x 50,000 = 50). This represents nearly a 6 per cent loss of its nominal benefits. With inflation at 2 per cent, the real value of its benefits will decline by 8 per cent, or four times the inflation rate. An even more striking example arises for a similar family at the $60,000 income level; its real benefits in the following year erode by nearly 20 per cent, or ten times the inflation rate.

Limited indexation undermines the real value of Child Tax Benefits more rapidly than it does for the existing set of child tax- transfer provisions. It has the same eroding effect on the refundable child tax credit portion, since this also has a reduction threshold which is partially indexed. However, the RCTC accounts for $2.2 billion, or just under half of the total $4.5 billion annually of current net federal benefits for children (Department of National Health and Wel- fare, 1992:3). The nonrefundable child tax credits take $0.4 billion, and Family Al- lowances provide net benefits of $1.9 billion. The latter two provisions are similarly subject to limited indexation, but this causes their real values to decline only at the rate of inflation (so long as it is below 3%).27 The remedy for the Child Benefit is to allow full indexation of both the basic benefits and the threshold for benefit reduction. It is hard to justify steadily declin-

ing real benefits for the government's primary tax-transfer provision for dependent children at lower and middle incomes.

VII Marginal Tax Rates and Incentives

The Child Tax Benefit will have some incentive effects not noted by the government in its advocacy of the scheme. The existing nonrefundable child tax credits are reduced for earnings by the child above specified, low levels. For this reason the child's earnings may incur the parent's relatively high marginal tax rate even though the earnings would be too low to be taxable on a separate return for the child. Abolishing the child credits will remove any disincentives for children to earn that result from the existing provisions. There might also be increased incentives for parents to split incomes with their children, given the absence of any offset of child tax credits after the Child Benefit reform.28 This can be done by paying children for their services in the home or the family business or, less legally, by transferring assets to children without imputing the investment incomes back to the parent.

Benefit phase-outs and clawbacks have been introduced into the tax-transfer system to target the net benefits in a pattern desired by policy makers. Social policy analysts often neglect the resultant incentive effects and efficiency costs, although such issues naturally concern economists. These effects relate not only to work effort, but also job choice, training, savings, avoid- ance, and evasion. The disincentives and in- efficiencies of raising individuals' effective marginal tax rates (MTRs) can be large when added on top of the already high marginal rates of the basic tax schedules. These include the federal rates, provincial rates, federal surtax, and some provincial surtaxes. The existing provisions for children impose a complex pattern of MTRs, but it will be seen that their replacement by the Child Benefit scheme would as well. We examine these effects with the aid of Figure 2.




0 C)

t H

•66,721

.,59,180 -

59,180

•IW2ii4i*~id 8,795

56,005 53,215

1 0

49,961

38,041 o

2 child ....................... ,9 4

12 child

= ============================== 35,94 1Il•

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CD0

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- 29,5902

'25.921 25,921

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In its upper panel, the figure depicts the effective MTRs imposed by three existing provisions: 1) the refundable Goods and Services Tax credit (GSTC) including its earned-income supplement (EIS); 2) the refundable child tax credit (RCTC); and 3) the clawback of Family Allowance (FA).29 For each provision we distinguish the relevant income ranges for families with one versus two children. The figure also shows the income ranges of the basic federal MTRs, since the effective MTRs of the tax-transfer provisions are superimposed on top of them.30 Moreover, these federal MTRs can be multiplied by about 1.6 to obtain an ap- proximate total MTR including typical provincial taxes and surtaxes; for example, the middle federal bracket of 26 per cent has a total MTR of about 41 per cent.

The GSTC and the RCTC each impose a separate benefit reduction rate of 5 per cent over a range of lower to middle incomes. As can be seen in the figure, there is a range of income over which both reductions apply simultaneously for a total effective MTR of 10 per cent. Added to the MTR of the regular tax system, the total effective rate exceeds 50 per cent. Clawback of the Family Allowance is nominally at a rate of 15 per cent of incomes above a threshold, but the deductibility of the amounts clawed back implies an effective MTR of about 9 per cent for taxpayers in the middle rate bracket.31 For a family with three or more children (not illustrated), the RCTC reduction rate would cumulate with the FA clawback for a total rate of 14 per cent. The GSTC also offers a small earned-income supplement, of up to $105 per year, for single adults with or without children; it carries an effective MTR of minus 2 per cent.

The lower panel of Figure 2 depicts the pattern of effective MTRs arising under the Child Tax Benefit scheme. Its earned-income supplement provides a subsidy with effective MTR of minus 8 per cent, which is phased out at a rate of 10 per cent at incomes over $20,921. Reduction of the basic benefits, even for a family with one child, extends to incomes that reach into the top

marginal rate bracket. Hence, the 2.5 and 5 per cent rates of benefit reduction will be added to total effective MTRs exceeding 46 per cent (1.6 x 29%). Note that the Child Benefit scheme would replace the RCTC and FA (including clawback) as well as the nonrefundable credits. Yet it would leave intact the refundable GST credits, including their EIS portion. For this reason, a total picture of effective MTRs under the Child Benefit needs to add the benefit reduction rates of the GSTC. For a two- parent, two-child family, this would apply a 10 per cent rate between $20,921 and $38,041. Therefore, it is not clear whether the disincentives posed by the Child Bene- fit (apart from its EIS) would be any improvement over those of the existing system.

As noted earlier, the largest individual gains under the Child Benefit scheme relative to the existing system are all attribu- table to its earned-income supplement. The EIS also may improve work incentives for low earners by tying its net subsidy to earnings.32 The maximum supplement of $500 per year arises at $10,000 of annual earnings and continues for earnings up to $20,921. One might question whether the primary purpose of the EIS is to augment work incentives or to keep the additional benefits of the Child Benefit from going to those reliant solely on Social Assistance or unearned incomes. Still, to the extent that tax-transfer benefits for children, including the basic Child Benefit, can be delivered outside the welfare system, this allows welfare benefit rates to be lower than otherwise. This, in turn, reduces the relative at- traction of welfare and thereby improves overall work incentives. Hence, it might be desirable to fold the EIS into the basic Child Benefit even if the provinces fully offset the amount through reduced welfare benefits.

VIII Partial Remedies for the Child Benefit

Our analysis finds that the Child Tax Bene- fit will achieve only a limited part of the




advantages that have been claimed by the government. The gains in simplicity of practical administration and compliance will not be nearly as substantial as might first be imagined. Improvements in the targeting of net benefits for children by the level of family incomes will be offset by a worsening of horizontal equity in the treatment of children at higher incomes. Other improvements in equity could have been achieved quite apart from the Child Tax Benefit itself. The Child Benefits will im-

prove the responsiveness of payments to income changes resulting from marriage breakdowns but will worsen the responsiveness to income changes from job loss and most other sources. Deficiencies in the

provision for indexation of Child Benefits will cause rapidly declining real benefits for middle income units even at low rates of inflation. And the pattern of effective marginal tax rates from the Child Benefit reforms will be little simpler, and not notably more conducive to work effort or other incentives, than the system it will replace.

The most salient gains in horizontal equity could have been achieved without the Child Benefit itself. Clawbacks of Family Allowance could have been altered to a

family income basis from the higher-income parent basis. The reformed tax treatment of common-law couples would have remedied two major deficiencies even without the Child Benefit. First, it would have denied claims for equivalent-to- married credits by common-law couples with one or more children, placing them on the same basis as married couples. Second, it would have made the benefit reduction of the refundable child tax credits based on the joint incomes of common-law parents, the same as for married couples. Moreover, the main enrichment offered by the Child Benefit, its earned-income supplement, could have been delivered through either the refundable child credit or the refundable GST credit.

Most remaining deficiencies of the Child Tax Benefit and related provisions could be remedied without changing its refundable

tax credit format. By altering the formula for benefit reductions, a substantial positive benefit could be provided for children even at the highest levels of family income. Given that all other tax recognition for the number of children in the taxpaying unit will have been removed, this would provide for horizontally equitable treatment of families of different sizes.33 A cited peculiarity in the relative Child Benefits for three vis-t-vis two children at mid-income levels could be rectified by changes to the benefit reduction formula. Access to the equivalent-to-married credit has been limited by the reformed treatment of common-law couples, but introduction of the Child Bene- fit suggests that some further rationaliza- tion may be needed for single-parent households. Alternatively, this credit could be delivered through an enhancement of some aspect of the Child Benefit for single parents.

Another area where the Child Tax Bene- fit could be improved is the indexation of its benefits for inflation. At the least, the threshold for benefit reduction should be indexed fully for inflation, not just inflation above 3 per cent annually. Given the cen- tral role that the Child Benefit will play in the nation's income security system, it would also appear important to index the basic benefit amounts fully for inflation. Simplifications could be augmented by combining the GST credits with Child Benefits under a broader program of Family Benefits. Payments would then go to childless couples and unattached individuals in addition to households with children. This would simplify overall administrative and compliance burdens and consolidate the two earned-income supplement provisions in a single program. One might also question the rationale for the earned-income supplement of the Child Benefit and perhaps reformulate it to vary with the number of children in the unit. After all, the EIS component accounts for most of the gains offered by Child Benefits.

These principles for refining and extend- ing the Child Tax Benefit into a Family Tax




Table 4 Illustrative Family Tax Benefit scheme combining Child Tax Benefit, GST credit, equivalent-to-married tax credit

Basic benefits $1,125 per child per year ($1,020 Child Tax Benefit plus $105 per child GST credit) $2,570 per year for first child in single-parent household (includes total value of equivalent-to-married tax credit, provinces other than Quebec) $200 per adult per year (approximates $198 per adult GST credit)

Earned income supplement 10% of earned income above $4,000 per year to the following maximums: $250 per child (instead of the $500 amount independent of family size in the Child Tax Benefit EIS) $105 per single adult, with or without children (same as GST credit EIS)

Benefit reductions Applied at the following rates above the stated income thresholds to sum of the above benefits except for $700 per child and $1,445 for the first child in single-parent units; also, first child counts as two children for rate in single-parent units

Children Threshold Reduction rate Rate if single parent 0 $26,000 5% 1 $20,000 7% 10% 2 $23,000 10% 13% 3 $26,000 13% 15% 4 + $30,000 15% 15%

Indexation: All benefit levels and thresholds fully indexed to the Consumer Price Index

Income Family size Total benefits per year level for Children Adults Maximum Minimum minimum

0 1 200+105 = 305 0 32,100 0 2 200+ 200 = 400 0 34,000 1 1 2570 + 200 + 250 +105 = 3125 1445 36,800 1 2 1125 + 400 + 250 = 1775 700 35,357 2 1 2570+1125 + 200+500+105 = 4500 2145 41,115 2 2 2250 + 400 + 500 = 3150 1400 40,500 3 1 2570 + 2250 + 200 + 750 + 105 = 5875 2845 46,200 3 2 3375 + 400 + 750 = 4525 2100 44,654 4 1 2570 + 3375 + 200 + 1000 + 105 = 7250 3545 54,700 4 2 4500 + 400 +1000 = 5900 2800 50,667

Benefit are shown in Table 4. The top part describes a possible structure for the program: 1) basic benefits for children and for adults subsume the amounts of the Child Benefit and the GSTC; 2) basic benefits for the first child in single-parent units also subsume the total value of equivalent-to- married credits;34 3) the earned-income supplement has maximums which vary with the number of children and also includes the GSTC's EIS;35 4) benefit reductions utilize different thresholds and rates, hinging on the number of children, and do not apply to the last $700 per child of basic benefit nor the equivalent-to-married benefit; 5) all benefits and thresholds are fully indexed. The illustrative figure of

$700 is lower in real value than that for any year prior to 1987 (see Figure 1). The bottom of Table 4 shows the maximum and minimum benefit rates by family size and type.36

Some properties of the illustrative scheme are worth noting. Retaining a $700 per child benefit even at upper incomes serves to maintain horizontal equity across families of different sizes. Along with the lower thresholds and higher reduction rates, it also allows the marginal tax rates of the benefit reductions to cease at lower incomes than for the Child Benefit.37 Of course, the higher reduction rates also serve to phase out the counterpart of the GST credits in the Family Tax Benefit. The




$700 per child minimum allowance further avoids the disproportionately large benefits for three vis-a-vis two children at higher family incomes. We might regard the $1,125 basic benefit per child plus the $250 per child in the EIS as about half for income

support at lower incomes and half for horizontal equity at all incomes. The higher reduction rates of the proposed Family Bene- fit will never overlap the top-bracket marginal rate of the income tax, as can be seen from the figures in the final column of Table 4. For childless households, the scheme mimics the existing GSTC, which has a 5 per cent reduction rate and threshold near $26,000.

IX Broader Policy Approaches

If the revisions suggested above were made to the Child Tax Benefit, the scheme would significantly improve simplicity and fair- ness over current provisions - advantages claimed by the government. However, the scheme would still suffer from extremely low responsiveness to changes in incomes other than those due to marriage breakdowns. It would be less responsive than the current system on account of the abolition of Family Allowances and the nonrefundable child tax credits. Its responsiveness would be roughly comparable to the refundable child tax credits. Since most variations in family income stem from reasons other than marriage breakdown, this is an important deficiency. If the Child Benefit were viewed as a model for future reform of the income security system - such as movement toward a guaranteed income - then its refundable tax credit format would be even more of a concern.38

Remedying the low responsiveness of Child Benefits to income variations re-

quires more fundamental changes of program design than do the other deficiencies. We consider the three principal formats that can be used for delivering income support: refundable tax credits, negative income tax (NIT), and demogrants (with or without recovery provisions). These for-

mats differ in their principles for payment, information reporting, accounting, and timing.39 The Child Benefit follows the refundable tax credit format, with administrative refinements introduced to cover income changes resulting from marriage breakdowns. By examining these provisions, we can appreciate the difficulties of this format in handling income variations experienced by a wider part of the popula- tion.

When a parent suffers a marriage breakdown, she can have her Child Tax Benefits recomputed based on her income and earnings alone. Rather than waiting for the routine benefit adjustment the next July, her benefits will be adjusted for the month following the separation. Since the separation must be for at least 90 days, part of the increased benefits will be paid with some lag. The separated parent must apply to the Child Benefits office with a statement of her marital breakdown in order to get the increased benefits. Matters may be further complicated if the departing spouse re- sumes a cohabiting relation after 90 days of absence. In that case, beneficiaries can opt to omit the returning spouse's income and earnings from the 'base year' calculation, thus rewarding marital instability.

If adjustments were extended to families experiencing income declines for reasons of layoff or job loss, this would greatly increase the numbers needing to be served and the administrative complexities. To avoid overloading the system, there would have to be a threshold for the amount of income decline to qualify for benefit adjustment. Unlike the benefit recomputations due to marriage breakdowns, measures of recent or current earnings and incomes would be needed. Moreover, horizontal in- equities would result from the differential periods used to compute benefits. If a recent income decline were allowed to raise benefits, a family's higher income in its normal base year would be disregarded. Then a family with highly variable income could receive more total benefits over several years than an otherwise identical family




with the same average income earned more evenly. Hence, annual reconciliations and benefit repayments would also be required. In short, the refundable tax credit format is poorly suited for benefit responsiveness.40

A negative income tax format could provide much more responsive Child Benefits. It requires the filing of periodic income report forms by all claimants at frequent in- tervals within the tax year - probably monthly, but at least quarterly. Given the broad coverage of the Child Benefits, which are not confined to the poor, this would en- tail a massive expansion of paperwork and administrative and compliance burdens. While the procedures and accounting con- cepts have been refined in the NIT experi- ments, the resources needed to operate the system would be disproportionate to the gains in benefit responsiveness. To justify the operation of the system would require the wholesale replacement of the welfare system and other cash and in-kind transfer programs. The administrative apparatus of an NIT cannot be justified to deliver child- oriented benefits alone.

The demogrant format could also provide fast response in net Child Benefits by paying the gross amounts of basic benefits to all eligible families. Tailoring the net benefits to family incomes would be achieved through tax source-withholding and reconciliations at tax filing time.41 This approach would work like the Family Al- lowance program, except that all of the other child-related tax benefits would be consolidated into the gross payments. At the highest family incomes the payments would be less than fully recovered or clawed back, in order to provide the differentiation needed for horizontally equitable treatment by family size. This demogrant format could achieve fast responsiveness of net benefits without the heavy administrative requirements of either the refundable tax credit or the NIT approach. All families would receive the gross amount of benefits each month, so they would be covered in the event of a sudden loss of income.

Some administrative and compliance overhead would accompany the demogrant approach to delivering child tax-transfer benefits. This would include the procedures that have accompanied the payment of Family Allowances: registration of eligible individuals, monthly cheque issuance, and notices for changes of address or family status. The main additional requirements would arise in the partial recovery of benefits from middle- and upper-income households. Most recovery would be achieved through source-withholding of taxes by employers, using revised withholding tables and computations. To the extent that the benefit recovery was based on family rather than individual income, source withholding methods would be imprecise. Hence the amounts recovered would need to be recon- ciled at tax filing time. The need for repayments would primarily affect middle- and upper-income households, so that problems of recovery would not face many households at lower incomes, where repayments are more onerous.

The main barrier to acceptance of the demogrant approach sketched here is a set of attitudes and misconceptions about universality of benefit payments. These include notions that demogrants are exces- sively costly, inadequately targeted, and economically inefficient. This perspective also focusses on the gross cost of the payments rather than the net cost after sub- tracting the amounts recovered. Similar bi- ases have pervaded the public's comparative attitudes toward direct expenditures and tax expenditures. While the conceptual errors of these claims have been de- monstrated in earlier analyses (Kesselman and Garfinkel, 1978; Kesselman, 1980; 1982; Mendelson, 1981), they continue to wield influence in the policy arena. Simul- taneously, the belief that universal social programs are superior to selective ones by way of their lesser stigma and greater political support (studies in Garfinkel, 1982) has waned in Canada under pressure from fiscal deficits.

A demogrant-based system of child bene-




fits could readily be expanded to include amounts for adults in the monthly payments. Our earlier suggestion that the GST credits be consolidated in the Child Tax Benefits would do this within the refundable tax credit format. Under a demogrant format, the payments for adults could include not only the GST credits but also the nonrefundable credits in the personal tax system for the filer and for married status. One important benefit of this approach is that the personal tax credits would become payable to nontaxable persons at low incomes. Those who work at low wages and are poor or near-poor would derive benefits, even in the absence of children.43 This approach would yield still broader advantages in the operation of the personal income tax. Without personal tax credits, all income would become taxable, so that withholding could be extended at the bottom-bracket rate to additional income sources (Kesselman, 1990). Taxes could be withheld on interest, dividends, pensions, and other payments, thereby improving tax compliance and revenue collec- tions.

With several changes, the Child Tax Benefit scheme could markedly improve the simplicity and equity of Canadian tax- transfer treatment of children. These changes include amalgamation with the GST credits and the equivalent-to-married credits and amendments to direct the Child Benefits more equitably, particularly at the lowest and highest incomes. Improving benefit responsiveness to family income variations by converting the scheme from a refundable tax credit to a universal demogrant would pose new administrative and compliance needs. While these additional burdens are not inordinate, they may be fully justified only in conjunction with more extensive reforms to merge the tax credits for filers and spouses. This change could provide the foundation for a streamlined system of personal taxation. Even without the latter stages of reform, a properly refined Child Tax Benefit would significantly advance Canada's income support and tax

recognition for dependent children. It would provide a sounder basis for future expansion of benefit levels beyond the modest increases for the working poor in the initial Child Tax Benefits.

Notes

* The author gratefully acknowledges assistance with materials from staff of the Social Policy Di- vision, Department of National Health and Wel- fare, and useful comments from Anji Redish, three referees, and an editor. All analyses and findings are the author's sole responsibility.

1 See Canadian Council on Social Development (1971; 1979; 1987), Department of National Health and Welfare (1970; 1985), Kapsalis (1980), Kessel- man (1980), and National Council of Welfare (1983; 1985).

2 See Kesselman (1979) for an account of these developments up to 1979 and Kesselman (1992) for an analysis of subsequent developments prior to the Child Benefit scheme.

3 The broader definition of spouse will be applied to Child Benefit payments beginning in July of 1993.

4 A further $213 will be paid per child under age seven where no child care expenses are claimed on the tax return, which mirrors a provision in the refundable child tax credit. The $213 is reduced by 25% of tax claims for child care expense, vanish- ing when $852 or more is claimed for a child.

5 This figure is computed as follows: $1,020/0.025 + $25,921. Families receiving the additional amount cited in the last note will obtain net benefits up to higher income levels.

6 This reflects the higher basic Child Benefit rate for third and additional children, a provision ap- parently motivated by the higher nonrefundable tax credit provided for third and subsequent children.

7 From the Finance Department table (upon which our Table 2 builds), it would appear that unequal earnings between spouses has been assumed for two-earner families; this is not stated explicitly.

8 Under the refundable child tax credit, common- law couples have not had to combine their incomes for computing the benefit reduction.

9 The reformed treatment of common-law couples will recoup an estimated $985 million over the next five fiscal years, nearly half the revenue cost of the Child Benefits. The five-year cost of the increased deductions for child care expense is $135 million. See Department of Finance (1992:137, 139).

10 FA payments in a province for any type of child have been restricted to at least 60% of the basic rate. Provincial discretion will be only slightly reduced since the maximum 15% reduction (as




against a maximum 40% reduction of FA) applies to a basic Child Benefit that is nearly 2.5 times the FA amount.

11 Nonrefundable child tax credits will remain on the tax return for children aged 18 or more who are physically or mentally infirm, since Child Benefits will be paid only for children under age 18. Other children over age 18 but not yet 19 by the end of the tax year will no longer get nonrefundable tax credits; this removes an apparent inconsistency in the existing law, since such children do not get FA.

12 These are typically individuals at lower incomes or spouses of mid-income earners. Under most cir- cumstances, filing is not required for individuals who do not have taxes due (beyond amounts withheld at source) unless they need to claim a refundable credit or the Child Benefit. Status Indian mothers will be subject to the same filing requirements despite their general exemption from tax on earnings made on reserves.

13 This saving would be partially offset by monthly rather than quarterly mailings of cheques for those units who do not have children and hence now receive only quarterly cheques for the GSTC. For those units without dependent children, the payments could be kept on a quarterly basis, since the GST credit amounts are relatively small. Direct deposits will be allowed for Child Benefit payments, as they have been for Family Al- lowances.

14 At least, it will apply to common-law couples as defined in the new tax provision, which covers only opposite-sex couples; same-sex couples will continue to face several tax advantages and disadvan- tages relative to all other couples.

15 It attains this value for single-parent, one-child households at net incomes of $11,836 and higher in 1992 (assuming no other expenses are claimed for nonrefundable tax credits).

16 For present purposes, we exclude from discussion the equivalent-to-married credit that will remain available for single-parent families even at the highest incomes.

17 See Brannon and Morss (1973), Pogue (1974), Habib (1979), Balcer and Sadka (1982), Steuerle (1983), Gouvernement du Qubbec (1984), Sayeed (1985), Cloutier and Fortin (1989), and McIntyre (1990).

18 Davies (1992) finds that at higher family incomes in Canada the tax relief for children is very deficient relative to the ideal pattern indicated by an 'adult equivalence' procedure based on standard economic welfare analysis.

19 This benefit applies for each of the first and second children in a family; third and other children obtain nonrefundable credit benefits twice this size. All FA benefits are fully clawed back at upper incomes.

20 The figures given in the text apply to married

couples filing jointly. For single parents filing as 'head of household,' the phase-out of personal exemptions begins at US$125,000 of taxable income and is completed only at US$250,000; however, they still derive the relatively favourable tax rates associated with being a single parent rather than an unattached individual with no dependants.

21 The substitution of Child Tax Benefits for Family Allowances may reduce the grounds for a province such as Quebec to opt out and receive monetary compensation, since the FA more clearly inter- vened in the domain of provincial responsibility than the tax-based Child Benefits.

22 Of course, the taxability of FA payments and the nonrefundable child credits are virtually offset- ting, at least for those in the bottom tax bracket and for the first two children, and the TD-1 form does inquire about FA receipts. In these cases, it matters little whether an amended TD-1 form is submitted.

23 This election can also be made after the death of a cohabiting spouse. When a person becomes a cohabiting spouse within a tax year, an election can be made to be treated as spouses only from the end of that year.

24 Yet, when the refundable child tax credit was first introduced, the once-annual payment was sup- ported by some as a way for low-income families to finance lumpy purchases, such as children's furniture.

25 Indexation for the Child Benefit will be based on increases in the consumer price index measured at the end of March each year, whereas other income-tax indexation is based on the end of Sep- tember. The National Council of Welfare (1992) also critiques the limited indexation of the Child Benefits.

26 Take the formula for net benefits: B = A-r(Y-K), where A is the basic benefit amount, K is the threshold for benefit reduction, and the other terms are as defined in the text. Take a family with income initially in the benefit reduction range, K < Y < K + A/r, and assume that its income rises by the rate of inflation to Y' = Y(1 + p) in the next year. Its benefits become B' = A-r[Y(1 + p)-K], and its decrease in nominal benefits can be computed as B'-B = -prY. (Since p is assumed to be less than the base for indexation, the benefit formula does not have to be indexed.)

27 Of the 3.7 million families receiving Family Al- lowances, 0.6 million have their payments partially or fully clawed, back. For those whose benefits are partially clawed back, the limited indexation of the threshold for clawback exerts an effect similar to that cited in the text.

28 Income-splitting will still be possible by investing the Child Benefits to an account in trust for the child, similar to a common practice by upper-income recipients of Family Allowance. But unlike




the Family Allowance, the Child Benefit will not be paid to upper-income families.

29 We do not consider the taxability of Family Al- lowances or the nonrefundable child tax credits. The former provision at most shifts some individuals who are near the boundaries of tax brackets to an adjoining bracket; the latter at most makes some lower-income filers nontaxable but otherwise does not affect MTRs.

30 Note that the Child Benefit operates on joint family income, whereas the personal tax applies to the individual. Hence, in two-earner families, many will face lower individual marginal rates than shown in Figure 2 because the income is divided between two taxpayers; yet each parent will face the marginal tax rate impact of the Child Benefit (and GSTC) reduction formulas.

31 For families with three or more children, it can be seen in Figure 2 that the FA clawback will extend into the top rate bracket; for them the effective MTR of FA clawback will be about 8% (that is, 15% x [1-1.6 x 0.29]).

32 For analysis of work incentives, see the previous treatment of the US earned income tax credit in Hoffman and Seidman (1990) and Steuerle (1990). For earners in the 'flat' range of the benefit schedule, work incentives may actually be reduced, as they are for those in the benefit reduction range.

33 We do not address the issue of how this change would be financed, aside from the obvious point that units without children would pay more taxes than those with children at any given income level.

34 This way of structuring benefits would extend the equivalent-to-married credits to non-taxable units at low incomes; if this were not acceptable, the provision could be converted to the format of an earned income supplement without a benefit reduction. The $1,445 figure also assumes that the provinces, other than Quebec, would agree to finance their share of the total credits.

35 One might additionally choose to abandon the format of an EIS and fold these amounts into the basic benefits; see our earlier discussion of the inter-jurisdictional finance and incentive con- siderations.

36 In the table, the term 'minimum' means the level (and the corresponding income) to which the Family Benefit falls when the benefit reduction is complete; it remains at this level for all higher incomes.

37 Lower thresholds and/or higher reduction rates have been proposed previously for the refundable child credits by National Council of Welfare (1983) and Courchene (1987).

38 There were suggestions in late 1992 that the federal government might be preparing a broad review of income security reform options including

a guaranteed income (Globe and Mail, 29 October 1992).

39 Kesselman (1982) provides a detailed assessment of these characteristics for the NIT and demogrants within a flat-rate tax schedule (called a credit income tax).

40 One could consider more responsive methods such as the advance payments through employers that have been used to deliver some earned-income tax credits in the United States. These have their own complexities and would be appropriate mainly to the EIS component of Child Benefits.

41 This approach was suggested in Canadian Coun- cil on Social Development (1971), Kesselman (1980; 1985), and Kapsalis (1980). The responsiveness advantage of FA was recognized in National Council of Welfare (1983:30), which still recommended expanding benefits through refundable child tax credits.

42 The Universal Income Security Plan proposed by the Macdonald Commission would also have merged the basic personal and marital exemptions (converted to nonrefundable credits by the 1987 tax reforms) into the benefit levels. A universal demogrant was the preferred format, but with a benefit reduction rate of 20% (imposed on top of normal tax rates) the child and adult amounts would have been fully eliminated at middle incomes. Like the Child Tax Benefit, this would have eliminated any tax recognition for children at upper incomes. See Royal Commission on the Economic Union and Development Prospects for Canada (1985); for critiques see Kesselman (1986) and Courchene (1987).

43 This would also allow an offset in basic welfare benefits to improve work incentives, if this approach were desired. The inter-jurisdictional aspects of this problem were discussed earlier.

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the child tax benefit: simple, fair, responsive?

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