Canadians are dealing with an unfair tax penalty on swings in their income from year to year, finds a report released by the C.D. Howe Institute. Further, the tax bite is the worst for lower-income Canadians and small business owners.

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

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The report tracks the individual incomes of Canadians for six consecutive years from 2005 to 2010 using Statistics Canada’s database. Wen and co-author Daniel V. Gordon identify the characteristics of individuals with high penalties and assess the fairness of the outcomes.

To explain the penalty, they use the example of a person without dependents living in Ontario. Suppose she earns $50,000 in 2016 and $100,000 the following year, so her average income is $75,000 per year. However, her taxes for the two years are about $1,900 more than if she had earned $75,000 in both years. On an annual basis, her extra tax liability is almost $1,000, or 1.3% of her average annual income. A similar tax penalty on fluctuating income would occur in a case where her income had fallen from $100,000 in 2016 to $50,000 in 2017.

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“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.”

Prior to 1989, provisions in the tax code allowed taxpayers to smooth their taxable incomes by using an average of more than one year’s income as the basis for calculating the tax liability, adds Wen. They were removed to simplify the tax code and because the number of federal tax brackets had lowered from 10 to three.

However, the federal and provincial governments have recently added new tax brackets. Taken together with the fact incomes have been less stable in Canada since the 1970s, particularly with the growth of part-time work in the so-called sharing economy, this points to the need for tax reform. “Reintroducing income-averaging provisions would help address the fluctuation penalty today,” Wen concludes.

Read the full report.