What is the 'fluctuation penalty' and why should the CRA fix it?

New CD Howe report highlights unfairness in Canada's tax system

What is the 'fluctuation penalty' and why should the CRA fix it?
Steve Randall
Canadians whose income varies from year to year are unfairly penalized by the tax system.

That’s the finding of a report from the CD Howe Institute which looked into incomes of Canadians over a 6-year period (2005-2010) using StatsCan data and considered the fairness of penalties.

As an example, if an individual’s income was $100,000 in year 1 and $50,000 in year 2, they would pay almost $2,000 more tax than if they had earned equally in both years ($75,000).

In the report, “A Question of Fairness: Time to Reconsider Income-Averaging Provisions,” authors Daniel V. Gordon and Jeanā€François Wen call for a change to the tax code.

“Individuals whose incomes are irregular or fluctuate year-by-year face a greater tax burden than people with steady incomes,” says Professor Wen. “I call it the ‘fluctuation penalty.’  Reintroducing income-averaging provisions in the tax code would make the tax system fairer and encourage entrepreneurship.”

The system was different before 1989, with income-averaging part of the tax code but it was removed when the tax system was simplified, including the reduction of tax brackets from 10 to 3, although new tax brackets have been introduced since.

The report notes that there has been a growth in part-time work and the sharing economy, which is increasing the number of Canadians who have irregular income.

“The fluctuation penalty is a policy concern for reasons of fairness and the adverse incentives it may create for risk-taking activities, such as entrepreneurship, notes Wen.  “Further, we find the fluctuation penalty is most acute for lower-income persons.”

“Reintroducing income-averaging provisions would help address the fluctuation penalty today,” he concludes.