Economic analysis

The case for raising the annual TFSA limit is shaky

Expanding the TFSA limit will be of benefit mostly to high-wealth households who have made out very well over the last thirty years compared to those in the middle or bottom

In the 2011 election campaign, the Conservatives promised to double the contribution limit for Tax-Free Savings Accounts during their next term when the budget reached balance. We’re now approaching the end of that “next term,” and the budget is pretty close to being balanced, so we’re now seeing increased attention to TFSAs as we get closer to the 2015 federal budget.

Here’s how TFSAs work. Interest, dividends, and capital gains generated by assets inside a TFSA are exempt from taxes. There is no deduction up front (as with an RRSP) but there is no taxation of any kind applied when funds are withdrawn. The annual contribution limit was $5,000 from 2009 to 2012, and has been $5,500 from 2013 to 2015. If you add that up, most Canadians now have $36,500 in TFSA contribution room available. For a family with two adults, this is $73,000 of TFSA room.

On Tuesday, the Parliamentary Budget Office released a new report on the fiscal impact of Tax Free Savings Accounts. On the same day, the Broadbent Institute released a similar paper by Rhys Kesselman that examines the Conservative proposal to double the TFSA annual limits to allow more contributions. These papers follow a research report from the Department of Finance in 2013, a set of four papers in the Canadian Tax Journal analyzing TFSAs in 2012, and a short analysis piece I wrote in the Globe and Mail in 2011. The TFSA was built on the foundation of the “tax-prepaid savings plan” developed by Jonathan Kesselman and Finn Poschmann in pieces for the C.D. Howe Institute and the Canadian Tax Journal in 2001.

In order to figure out whether the existing TFSA is a useful policy and whether it ought to be expanded, we should first look at what TFSAs might be attempting to achieve. I see three possible policy goals.

Related reading: Jonathan Chevreau, editor-at-large for MoneySense, makes the case for TFSAs

First, TFSAs attempt to help families save more. RRSPs aren’t available or advisable for all Canadians. For example, seniors over age 71 can’t make any new RRSP contributions. For lower-income seniors who will be receiving the Guaranteed Income Supplement, the 50 per cent clawback rate triggered by RRSP income makes RRSPs a poor savings choice. For these Canadians, a TFSA provides a simpler and more effective means to save on a tax-free basis.

Second, there is a substantial body of economic evidence suggesting that taxation of the return to savings can harm the prospects for economic growth, investment and efficiency. This has led many economists to advocate excluding all savings from taxation and taxing only consumption. TFSAs, by further exempting the taxation of savings, move in this direction.

Third, TFSA-holders get a tax break. Since evidence strongly suggests that higher-income Canadians are much more likely to have an account than lower-income Canadians, this means a tax cut for higher-income Canadians.

In my view, the first policy goal of providing savings opportunities for lower-income Canadians is legitimate, but it has largely been achieved with the existing contribution limits. Would doubling the contribution limit really go further to help low-income Canadians save more? I am quite doubtful.

For the second goal of moving us closer to a consumption-tax and away from the taxation of capital income, I have more mixed views. Having a growth-oriented tax system should be a top goal, but it’s not clear that expanded TFSAs are the most sensible way to achieve that goal. In Canada, our tax system tries to integrate our personal and corporate tax systems on the assumption that distributions from firms, such as income-trust payments and dividends, will be taxed when they are paid to individuals—but those distributions are increasingly untaxed. I’d prefer a deeper rethink of our corporate and personal tax system than doing it through the back door with expanded TFSAs.

Finally, for the policy goal of giving high-income Canadians a tax break, it’s a matter of taste about who should get what. As of 2005, only 11 per cent of Canadian families had more than $50,000 of taxable assets. Only 3.3 per cent of families had more than $200,000, and 1.8 per cent had more than $300,000. With the existing $5,500-per-year contribution limit, all but the top few per cent of families will soon be able to shelter all of their assets from taxation. So, expanding the annual limit to $10,000 per year will be of benefit mostly to high-wealth households. I think the evidence is pretty strong that highest-income Canadians have made out very well over the last 30 years, compared to those in the middle or bottom. If tax policy should be doing anything to change the income distribution, I would prefer it lean against these strong winds of inequality rather than making life still easier for those at the top.

Taking this together, I find the case for TFSAs with a modest limit to be solid, but I have doubts about the need for a higher annual limit.

(Disclosure statement is available here.)