Tax Options for Childcare that Encourage Work, Flexibility, Choice, Fairness and Quality

Abstract

Many Canadian families with young children struggle with the cost of childcare. The tax system helps alleviate some of that burden. At the federal level, the Child Care Expense Deduction (CCED) allows eligible expenses to be deducted from taxable income. In most cases, expenses must be deducted on the return of the lower-income parent, whose claim cannot exceed two-thirds of income. The CCED is also applied provincially to reduce provincial taxes, except in Quebec where parents benefit from either a provincially subsidized childcare space or from an income-tested refundable tax credit. Most income tax systems give childcare expenditures special treatment, with different normative motivations in mind. Our approach is more in line with the optimal tax approach in that we evaluate different ways of subsidizing childcare through their contribution to improving efficiency and equity, rather than apply normative rules to determine a single “right” way to treat childcare in the tax system. A tax system that takes account of empirically demonstrated patterns of behavioural response would seek to encourage work where people’s decisions are fairly responsive, improving efficiency and raising more revenue from labour-market earnings. We simulate replacing the CCED with a Quebecstyle refundable tax credit at the federal level, using the same provincial sliding schedule of rates from 75 percent for lower-income earners down to 26 percent for higher earners. The cost of the refundable credit – applied in all provinces other than Quebec – would be about $1.2 billion annually over the current cost of the CCED. However, the fiscal consequences of mothers’ employment response would be to reduce the federal fiscal cost by between one-third and one-half in the short term, and by between two-thirds and nine-tenths in the long term, depending on the scenario. Adding the fiscal effects on provinces would yield substantial gains. In the long term, the policy could become socially self-financing as provincial fiscal gains exceed the federal net fiscal cost. Our analysis suggests that 13 to 19 percent of stay-at-home mothers would enter the labour force as a result of lower net childcare costs. Lower-income families would see a larger reduction in net childcare costs (up to 40 percent on average) than higher-income families, providing relief to the many families of modest income now left out by the existing income test on CCED claims. Our proposed system would allow diverse childcare providers to offer services, rather than the government-driven system in place in Quebec. Families would retain choice, enlivening the ability of the marketplace to innovate with respect to flexible hours, staffing and facilities. Moreover, if providers were mandated to meet quality markers to be able to issue tax receipts, governments could enforce the quality standards they desire. Overall, this childcare solution would generate the social benefits of increased labour-force participation, allow for flexible and decentralized childcare choice, and be designed to meet quality standards to foster child development. It would achieve these goals at a potentially small net fiscal cost because of the extra tax revenue resulting from the increased employment.

Keywords: Fiscal and Tax Policy

JEL Classification: H2; H3