Personal Finance

THE INCOME TRAP

Staying home with the kids can prove costly at tax time. Who’s to blame?

KATHERINE MACKLEM April 12 2004
Personal Finance

THE INCOME TRAP

Staying home with the kids can prove costly at tax time. Who’s to blame?

KATHERINE MACKLEM April 12 2004

THE INCOME TRAP

Personal Finance

Staying home with the kids can prove costly at tax time. Who’s to blame?

KATHERINE MACKLEM

NANCY MADONIK is looking through her income tax return for 2002, and notes she deducted the total $14,000 allowed that year for child care for her two children. In the return she’s about to file for 2003, she can’t make a similar deduction, and neither can her husband Allan, even though the family’s child care expenses haven’t changed. “Oh my God—now I’m feeling sick,” she says, closing the yellow file folder on the table in front of her. “I can write off nothing this year.”

The Madoniks are caught in a classic bind. Nancy Madonik left a full-time job in mid2002 to spend more time at home with her two children, now aged 4V2 and IV2, and is establishing a business she can run from her north Toronto home. She isn’t making any money yet, but Madonik, 36, still has a nanny whose salary hasn’t changed from one year to the next. And because Allan, also 36, is the only family member officially working, he can’t claim the nanny’s salary, because Nancy, as far as Ottawa is concerned, isn’t in the labour force. Madonik says the mortgage, basic living expenses, a private parochial school for the children and a nanny eat up all of Allan’s income, and she’s frustrated they can’t make the same child care deduction as a year ago. “Not only am I out my salary, but we are out that benefit,” she says. It adds to the pressure to make her company a success. “This is why my business really needs to provide us not just a decent income, but enough that I can bring those taxable benefits back. I can’t dabble. I need to make serious money.”

Canada’s tax laws allow child care deductions only if both parents are gainfully employed, a rule financial planner Peter Merrick calls a penalty. “The government doesn’t do anything to promote families,” says Merrick, who runs his own business. “This has always been something that bothers me.” Merrick, a father of three whose wife stays home to take care of their kids, has organized his work life to avoid the scenario the Madoniks are in. Because Merrick, 35, is self-employed, not only can he claim more workrelated deductions than Allan Madonik, he can also split his income with his wife, Stacey, paying her a portion for administrative work. The income-splitting in turn allows her to claim child care costs for their three young children. Merrick, who admits he’s “very opinionated about this subject,” is incensed that families such as the Madoniks can’t work the system the same way. “There are major flaws that are systemic—it frustrates me as a financial planner,” Merrick says. “I can’t put a price on having one parent stay home. But the tax system makes it a disadvantage to have children.” The Fraser Institute, a conservative, Vancouver-based thinktank, calls the tax differential a “Leave-It-to-Beaver tax penalty,” after the 1950s TV family, the Cleavers. Niels Veldhuis, an Institute economist, has created a hypothetical family of four with a total annual income of $80,000, which in one scenario is divided

equally between the parents, James and Joan. In the second scenario, James earns the entire sum, and the family ends up paying almost $5,000 more in taxes. The explanation is Canada’s progressive tax system, which taxes big earners more heavily than low-income earners—and the fact that a two-parent family with just one income is not allowed to claim child care. “Our tax system,” Veldhuis says, “is clearly biased toward dual-income families and against singleincome families.”

Not exactly, says analyst-demographer Roger Sauvé. “That’s an unrealistic interpretation of the way the world works,” says Sauvé, who’s worked as a staff economist for major Canadian corporations including the Canadian Imperial Bank of Commerce, and who now runs an independent firm, People Patterns Consulting in Sooke, B.C. By far, most married Canadians with children are working. Using Statistics Canada data, he says 83 per cent of married couples with children have two income earners in the family. As well, individuals only very rarely jump to an $80,000 income from a $40,000 one. “That’s totally non-representative of the real world,” Sauvé says. A second earner normally adds income, he points out, rather than taking it away from the first income earner.

Canada’s tax system doesn’t discriminate against the traditional single-income family, says federal Finance Department spokeswoman Andrée Houde. But it is correct, she says, that at a given level of income, a one-earner couple will pay more than a twoearner couple, all else being equal. This follows both from Canada’s progressive taxrate structure and individual-based taxation, which ensures that the lower-earning spouse isn’t penalized by being taxed at a rate based on the family’s overall higher income. “Family-based taxation would result in a tax on marriage and common-law relationships,” Houde says.

Canada’s system contains provisions that benefit single-income couples, such as the ability to contribute to a spousal RRSP or to pool medical and charitable donations, which can be claimed by the main incomeearning spouse. Even though a two-earner family pays less income tax, it doesn’t follow that this family is better off financially, Houde says. The two-earner family often has less disposable income because it incurs higher work-related expenses, such as transportation and child care.

Using StatsCan data, Sauvé looked at what Canadian families actually paid in taxes from 1980 to 2001. He discovered that during those decades, a two-earner couple paid more on average than the single-income family, except for two short blips in 1989 and 1997-99. In 2001, the dual-earner family paid 19.6 per cent of their income in taxes, compared to 19 per cent for the singleearner family. “There’s another myth busted,” Sauvé says. The other big trend through the 1980s, he says, is both kinds of families saw their taxes rise steeply from about 16 per cent in 1980 to more than 20 per cent in 1989. Since then, the average taxes paid by Canadians have tapered off slightly.

ONE FAMILY, TWO TAX SCENARIOS

The Leave-lt-to-Beaver tax penalty: 2003 federal income tax, including child care deductions, for a two-income and single-income family earning $80,000

SCENARIO 1 SCENARIO 2 James Joan Total James Joan Total Income $40,000 $40,000 $80,000 $80,000 $0 $80,000 Minus personal exemption $7,756 $7,756 $7,756 Minus spousal exemption $0 $0 $6,586 Minus child care deduction $11,000 $0 Taxable income $32,244 $21,244 $65,658 Total tax paid $5,628 $3,399 $9,027 $14,000 $0 $14,000 Leave-lt-to-Beaver tax penalty $4,973 Source: Fraser Institute

a Tax laws allow child care deductions only if both parents work—a rule one planner calls a penalty

That’s not much reassurance to Nancy Madonik. She doesn’t think Canada’s tax system is specifically designed to penalize singleincome families. “I just think it’s incredibly outdated,” she says. “It’s unfair that it puts the onus on both parents to earn enough income to benefit.” Madonik is hoping that within three years her salary will be back up in the top-income bracket and this won’t be a worry. But, she says, “I still want to find that balance with family and work. That’s where the government doesn’t help you.”

katherine.macklem@macleans.rogers.com

WHEN CHEATERS GO STRAIGHT

Fourteen years ago, a Canadian businessman socked away some money in a secret Swiss investment account. Through the years, he put it in the market, and his holdings grew to almost $1 million. Canada Revenue Agency probably still wouldn’t know about this stash had the gentleman, now elderly, not wanted to pass his wealth on to his family. To do that, he had to bring the money home, and pay tax on it. So he contacted Paul DioGuardi. The Ottawa-based tax lawyer negotiated a deal with the CRA that saw his client pay only six years’ worth of taxes, with a reduction on the interest and no civil or criminal penalties. “He still paid a considerable amount of taxes,” DioGuardi says. “But less than had he not been honest.”

The sneaky businessman is part of a small army of Canadians who, whether by working in the underground economy or hiding money offshore, deprive the taxman of hundreds of millions, if not billions, of tax dollars. For those who get caught, the penalties can be severe. Cheating on taxes is a criminal offence punishable by fines equal to several times the amount of tax owing, plus the tax, plus interest.

DioGuardi’s specialty in helping tax cheats come clean may not be unique, but he has a particularly useful background-he spent four years working as a tax cop for the CRA. And while his clients typically are big-time tax evaders who have failed to declare $100,000 or more in income, these days he’s aiming at a new market: the little guys. One recent client is a cab driver who over the years had under-reported his income by roughly $15,000. Now in the midst of a divorce, he is worried his soon-tobe ex-wife will snitch on him. For a fee of $199, DioGuardi offers to assess the tax problem on-line and then quotes a new fee, usually based on the amount of tax he thinks he can save the client.

Fessing up to tax debt is certainly on the rise. Last year, 5,097 Canadians admitted to cheating the taxman under Ottawa’s voluntary disclosure program, and ended up paying a combined $277 million in back taxes-the highest annual amount to date. Taxpayers who come forward on their own get a break, says Dawna Labonté, a CRA spokesperson: all fines and penalties are waived and the individuals are not criminally prosecuted, as long as they provide all required financial data and pay their taxes in full. “The amount of taxes is not negotiable,” she says. Labonté notes that waiving the penalties-and the revenue they would bring to federal coffers-is worth it. “We’re not necessarily losing money. If it means we don’t have to audit 5,000 people, we’re saving money.”

DioGuardi says that since 9/11, it’s gotten a lot tougher to hide money. “It used to be that chances were you wouldn’t get caught. But it’s getting more and more likely, as the tax authorities get more sophisticated, that you will get caught,” he says. “It’s foolish to wait for that because you’re going to end up in criminal court, with all the humiliation that brings you.” K.M.