Income Tax Basics
Introduction and Context
This article briefly introduces the concept of Canadian income tax, what it is, why we pay it, how it gets calculated, and the potential penalties for not paying. Resources with more information and exact taxation details can be found at the end of the article. Throughout this article, we will use “traditional income” when speaking about the income that income tax is deducted from. In this context, “traditional income” is the income that is typically paid to employees (e.g., income from a 9-5 job). Other forms of income, such as capital gains or dividends, are taxed separately and discussed in a future article.
What is Income Tax?
Income tax is money deducted from your paycheck and paid to the Government to help cover the cost of public services. Taxes can be used for various programs, including social programs to help fellow citizens, infrastructure development and maintenance, and government-run operations like the Canadian Armed Forces. When you earn income in Canada, the Government taxes a percentage of that income to help pay for these services. The amount they deduct depends on a few factors, including the province you live in and the total income earned.
Why do we pay Income Tax?
We have access to many services that we don’t directly pay for, which require investment to maintain. A great example is the road network, which is free to use except for the few privatized highways (such as the 407). While you must pay for a driver’s license and register your car, these fees do not cover the total cost of operating and maintaining the road network. As a result, the Government must find an alternative source to pay for this infrastructure. Income tax is one method the Government uses to help support these investments. One way to look at income tax is the amount we pay on traditional income to enjoy using the infrastructure and programs provided by the Government.
Who does my income tax go to?
The two primary types of income tax are provincial and federal income tax. As their names suggest, part of your income tax bill goes to the provincial government for the province you reside in, and the other goes to the federal government. Traditionally, federal income tax accounts for a much larger percentage of the income tax you pay. This is because the Federal Government also financially supports provincial programs as required.
How does my amount of income tax owed get calculated?
Canada uses a marginal tax system. This means that different amounts of income are taxed at different rates. In other words, as you earn more money, each additional dollar you receive is progressively taxed at a higher rate, based on a scaling system. Let’s look at the Ontario taxation cost by “tier” to make this easier to understand. Highlighted in the table below are the Federal tax rates for 2021.
This table highlights how income tax is levied based on your income in a fiscal year. It is important to understand that if somebody makes $90,000, not all of that is taxed at 20.5%. Instead, the first $49,020 is taxed at 15%, and the remaining $40,980 ($90,000 – $49,020) is taxed at 20.5%. A common misconception is that increasing income to a new tax bracket can decrease the amount of money you take home, but that isn’t true. The increased tax rate is only applied to the income above a certain threshold.
As an example, suppose Jim is offered a promotion from $49,000 to $52,000 annually. Currently, his after-tax income is $41,650. However, with the increased tax rate from 15% to 20.5%, he calculates his new after-tax income is to be $41,340. Jim has miscalculated his new take-home pay because he applied the 20.5% tax rate to his whole income, rather than only to the income above $49,020. With his recent promotion, Jim actually takes home $44,036.
Similarly, you are also responsible for paying provincial income tax. Highlighted below is a table with Ontario’s provincial tax rates, based on income.
Please note that these numbers do not include surtaxes that add to the percent of taxes payable. Surtaxes only apply to significant incomes and will be explored in a future article. For more information about the exact rates, here is a link highlighting Ontario and federal income tax rates combined for 2021 and 2022: https://www.taxtips.ca/taxrates/on.htm
Penalties for Avoiding Income Tax
Each year, Canada has a date by which you must file your taxes. There are financial penalties associated with filing late, with charges starting at 5% of the taxes owed. For more information on exact financial penalties, please use the following link.
Beyond financial penalties, avoiding taxes purposefully is called “tax evasion” and is a serious criminal offense. Tax evasion is only considered when individuals or businesses intentionally ignore Canada’s tax laws, meaning you have to intentionally avoid taxes to be prosecuted criminally. That said, it is important to ensure you are following all the tax rules in the province you reside. For more information on criminal penalties for tax evasion, please use the following link.
https://www.canada.ca/en/revenue-agency/campaigns/tax-cheating-consequences.html