The Fuss Over TFSAs

Well, there seems to be a fair amount of fuss over the proposed doubling of the contribution limit to Tax Free Savings Accounts(TFSAs).  Kevin Milligan says the case for raising the annual TFSA limit is shaky as the benefit will be mostly to high wealth households rather than those at the middle or bottom of the wealth distribution.  There have been reports by the Broadbent Institute (the Kesselman study) as well as the Parliamentary Budget Office that also raise concerns about how over time the implementation of the expanded limit will increase the size of the tax exempt base and erode future government revenues.  Indeed, my WCI colleague Frances sees this as part of a long term agenda to constrain the size of government. 

A major theme running under most of these arguments goes something like this - Registered Retirement Savings Plans (RRSPs) at least leave "a legacy of tax revenue to future governments" whereas TFSAs may generate "supernormal" returns that will escape taxation and on top of it will accrue primarily to the well-off. 

However, when I think of RRSPs and TFSAs, I see them both as essentially the same.  They are both "tax expenditures" that are designed to encourage saving by promising some type of tax incentive.  The broader debate should really be about how we want to encourage more saving and then about "tax expenditures" in general rather than how much we should allow as limits to either RRSP or TFSA contributions. 

However, if we are going to argue about RRSPs and TFSAs, to my mind what differs is the timing of the break.  For an RRSP, you are getting the tax incentive upfront and deferring the taxes until you withdraw the money.  For a TFSA, you are making the contribution with after tax dollars and allowing the contribution to accumulate tax free - the tax benefit comes down the road as the money grows.

I suppose there is a clever mathematical way using inter-temporal budget constraints to show how under certain assumptions the two savings vehicles are probably equivalent both as savings vehicles as well in terms of their effects on tax revenues.  I think a key variable is rate of time preference.  Given a desire or need to save, if you are willing to postpone current consumption - a TFSA may be a better vehicle to build savings.  On the other hand, if you need to consume more currently and still want to contribute to savings, the RRSP may be the better vehicle. 

Young households with children who face more cash constraints might find the RRSP more attractive while older households would probably find the TFSA more attractive. All other things given, both vehicles are of greater advantage to higher rather than low income earners because higher incomes are more likely to be able to save - period. If you are going to make the argument that TFSAs are somehow favouring the wealthy or higher income earners, you need to acknowledge that the same argument applies to RRSPs.

As for estimates of foregone revenue ranging from 15 to 9 billion dollars a year some 40 or 50 years down the road, well those also need to be considered as a proportion of GDP yet to come rather than as absolute numbers.  What is the current value of forgone tax revenue to GDP from RRSPs and TFSAs and how might this compare to the estimates of foregone revenue to GDP 40 or 50 years years from now? And regarding those "supernormal" returns - what if the investment in the TFSA yields a "supernormal" loss?  There can be risks to the investments also. 

 

 

 

Comments

[Roger Sparks]

As you discuss long-term-savings-encouraged-by-tax-advantages, you should also consider that government is trying to stimulate the economy by expanding the money supply with an inflation target. Inflation is a direct cost to savings, depreciating the value of the saved dollar.

Of course the two government goals are directly opposite. Why encourage saving and then destroy the savings with inflation?

To your point that the wealthy have the advantage in tax deferred savings plans, we could say the same thing about planned inflation. With planned inflation, only those who have jobs get the advantage.

I think it is easily demonstrated that the less able and not working both pay for the tax-advantaged-savings plans AND planned inflation.

Accepting this observation as a guiding principal, it seems that only a balanced budget without targeted tax advantages is the most fair for both low income and high income economic players.

[Nick Rowe]

Livio: if the marginal tax rate for each individual was constant over time, there would be no difference between TSFAs and RRSPs for the individual taxpayer, and the government would get the same present value of tax revenue if the individual taxpayer's rate of return was the same as the government's discount rate. I think that's right.

But if marginal tax rates vary over time (over the lifecycle) RSPs give a bigger tax break than TSFAs.

And as you say, if the deferred taxes in an RSP aren't counted in the budget deficit/surplus numbers, the government gets a nice surprise when the boomers all retire.

[Chris S]

Maybe I missed some understanding here, but I think there are key differences between the RSP and the TFSA.

RSPs have an initial contribution limit, which caps the loss of government revenue. All of the returns inside the RSP are taxed at withdrawal - possibly at a different rate. If the internal returns are high, then the ultimate withdrawals may also be high enough to trigger higher bands of income tax.

TFSAs do have an initial contribution limit, but all of that contribution is taxed. There is no loss of revenue on the initial steps. However, as far as I can tell, even high internal returns in the TFSA will never result in any tax at all. If investment returns (and interest rates) ever return to the mid 1980's levels, those TFSA balances could soar, but never result in any taxation revenue.

Increasing the contribution limit on TFSAs would appear to have no short term limit on taxation revenue, but possibly a very large long term reduction on taxation revenue.

Moreover, since the ability to place more of your post-tax income into savings would likely be corelated with your income (higher income, higher savings), that would seem to indicate exactly what is being forecast - a tax system that becomes more regressive as TFSA contribution limits climb.

[Chris S]

Hmmm - a closer look finds that TFSAs can hold both publicly traded shares and some private company shares. That suggests that TFSAs can be a side-step around lifetime capital gains exemption limits, making it look even more regressive.

[Lord]

While the young and old may have those preferences, the change in marginal tax rates over time should reverse them, marginal tax rates being low to medium when young and poor, high when old, working, and rich, and low when retired in most cases, though strong savers usually have millionaire retirement daydreams and over estimate their marginal rate when retired. Estate taxes can change these depending on how they are distributed or taxed then.

[Bob Smith]

Chris,

As a practical matter, it's almost impossible to hold private company shares in your TFSA (and RRSP). The restrictions are so narrow and the adverse result if you run afoul of them so punitive (a 100% penalty tax on the value of the shares and on any income from reinvested income) that only the truly foolish would hold private company shares in their TFSA (I'm sure some do, but they're playing with fire). Furthemore, the Tax Act contains certain "advantage" rules with respect to RRSPs and TFSAs intended to prevent people from gaming their tax-advantaged accounts. Holding anything other than the sorts of securities/investments generally available to the public (or at least segements of the public) is a risky proposition.

The other restriction that is very significant is that the Tax Act prohibits the carrying on of a business in your TFSA, so the CRA has been very aggresive in going after people daytrading (successfully - CRA tends not to be too fussed about people with losses) in their TFSA and taxing their gains. (Interestingly, this restriction applies equally to RRSPs, but the CRA has turned a blind eye to day-traders in their RRSP for years - presumably because they know they'll get to tax the income eventually. The result of this CRA practice, however, is that lots of people have been tripped up in their TFSAs).

As an aside, Robin Boadway makes the point in the current Canadian Tax Journal that the exclusion of capital income from the tax base could mean that you could have a more progressive tax system (i.e., with higher marginal rates) since, capital income tends to be more responsive to changes in tax rate than employment income. I believe that Kevin Milligan made a similar proposal (calling for lower tax rates on capital income) for the CD Howe last month. Since much of the increased income inequality observed in Canada (at least) over the last few decades has arisen as a result of significant increases in employment/business income of the top 1%, arguably eliminating/reducing capital taxation could permit a more progressive (and efficient) tax system.

[Bob Smith]

That being said, I think the stronger argument against the increasing the current TFSA limit is that, as a practical matter, for most Canadians their investment income is already tax-advantaged in one form or another anyhow (between TFSAs and RRSPs, the principal residence exemption, the absence of tax on imputed income in respect of housing and consumer durables he cites various studies from Finance and Kevin Milligan putting the range between 90% and 98%). From a political perspective, this might not be worth fighting over.

[Bob Smith]

Nick: "But if marginal tax rates vary over time (over the lifecycle) RSPs give a bigger tax break than TSFAs."

Only if the marginal tax rate goes down. For at least some people, the marginal "tax" rate on RRSP withdrawals might be higher (taking into account clawbacks of GIS, OAS, as well as income tax).

Mind you, I think a good case can be made that GIS and OAS shouldn't be linked to "taxable income" but real economic income. Certainly, it's hard to see how it would be acceptable, for example, for someone with a large TFSA, withdrawing significant amounts every year, to collect the GIS or OAS, simply because the TFSA withdrawals are tax exempt (this isn't limited to TFSAs, you could make a similar argument with respect to someone living in a multimillion dollar house in Toronto with a multi-million dollar bank account earning 0.25% - their taxable income may be low, but they're not poor in any meaningful sense of the term). I think this will become an increasingly sensitive issue as TFSA balances increase.

[Nick Rowe]

Bob: yes, but I was thinking that people wouldn't use RRSPs if they expected their Marginal Tax Rates to go up.

But on the other hand, if you have already maxxed out your TSFA, so your RRSP is the only way you can get compounding at the before-tax interest rate, you might still use your RRSP even if you expect your MTR to rise. So I might be wrong in some cases.

[Majromax]

It's most efficient to avoid the higher marginal rate, which means TFSA if retirement rate (+clawback) is higher than the current rate and RRSP if not. However, either is more efficient than neither, since un-advantaged savings are doubly-taxed on both the initial income and investment returns.

[Bob Smith]

Majro,

That's probably generally true, but might not be true in every case, since withdrawals from RRSPs are fully taxed whereas investment income in the form of capital gains are only half taxed and dividend income is subject to the dividend tax credit (which means it can be effectively tax free below some threshold ~40K or something like that, and the top marginal rate caps out in the mid- to high-30%, depending on your province). In some cases (i.e., where your initial tax rate was low) you might be better off earning income outside an RRSP (the limitations to this point are not well understood by financing advisors, so you sometimes see garbage advice that people shouldn't hold dividend paying stocks inside their RRSP). As a practical matter, with TFSAs, people in those circumstances would use TFSAs.

[Neil]

What's struck me about TFSAs is the substantial regulatory risk. Because the tax benefit comes in the future, there's little reason to believe that changing political winds couldn't take it away. It's a relatively easy program to wind down, simply by declaring future gains in the account to be taxable. There's also the small but non-zero possibility of a one-time tax grab in the future where all accrued gains are taxed.

Either way, current actions only constrain future governments to the extent that TFSA's are popular with the electorate. I always suspected that at some point in the future, after 20 or 30 years of maximum contributions and solid investment returns, there would be enough million dollar plus accounts that it would be politically possible to point to these large tax shelters and get the electorate behind the "rich paying their share" or some such slogan. As you say, most people who struggle with saving will prefer the RRSP, and I would hazard a guess that this is a larger group of voters than the better-off folks who derive most of the TFSA benefit. For that reason, I suspect that increasing the limit will just hasten the policy's demise.

[Frances Woolley]

The real pressure to increase TFSA limits is coming from people like my Dad, who have aged out of the RRSP program, and need a place to put their RIFF withdrawals. The group of contributors that is far and away most likely to max out their TFSAs are the over 71s. Otherwise you're really talking about people in the 5% - people who have paid off their mortgage, maxed out their RRSPs and TFSAs, but aren't rich enough to engage in really sophisticated tax planning.

[Chris S]

@Bob;

I imagined that the private equity rules would likely allow for arms-length angel investors in startups. Granted, you can't put a huge amount in there, but there are a number of companies over the years where small initial inputs have vasted exceeded usual returns once you get to the 5, 10, or 15 year time horizons. $5000 of Google at the IPO price (slightly dreaming) would be worth about $70,000. If you're somehow lucky, and can find that kind of investment every year, you would blow past the exemption quite quickly.

It does matter how likely this is; capturing taxes from 1 or 2 lucky breaks is not a big deal if the same policy enables a better overall result in most of the rest of the populace. However, tax minimization has always been legal. I'm going to always be nervous of anything that gives a complete carte blanche to taxing gains, since it offers an incentive for people to find special ways to leverage it. If "1 or 2 lucky breaks" turns into a large pool of funds, then we do have a problem.

I can see increasing the TFSA input limits, but maybe they need to come with a TFSA specific gains exemption. Right now, it looks like somewhere around 4.7% return from age 20 to 70 generates about $1 million in gains. I'd be happy doubling that and indexing it at the same rate the input limit is indexed. So, start with a $2 million TFSA gains exemption today, and index going forward. That is unlikely to ever touch anyone, but it removes the incentive to find ways to game the system.

[Bob Smith]

Chris,

No, the rules are very narrow. I won't even give "qualified investment" opinions on private companies, adn the "prohibited investment" rules are very tricky.

And keep in mind, for everyone who hits it rich, there are 5 or 10 who strike out

[chris]

I created a spreadsheet to measure the Present Value from the government's POV of an RRSP, discounted at the government's cost of capital. It shows how saver's higher rates of return earned by investing in more risky assets than government debt, can actually create a net benefit for the government. See

The timing of cash flows to the government should not be dismissed as 'equal' when discounted though, because governments need the cash later in your life when you are using government supports strongly, and don't need the cash while you are healthy and working. But in my jaded opinion paying the cash upfront (with TFSA) will inevitably lead to the government frittering it away before it is needed.

Since the major differences between RRSP and TFSAs from the saver's POV is (a)the difference in tax rates between contribution and withdrawal, and (b) the claw-back of GIS and OAS, why are not all the pundits not advising the creation of savings vehicles that (a)stipulate a set tax rate to apply to all contributions and withdrawals (like a tax credit instead of a deduction), (b) change the GIS and OAS qualification rules to include a 'deemed income' equal to the % of TFSA assets (using the same % as the RRSP's required draws), and (c)delay the cash flow to the government until retirement with a EET structure.