Re-examining the Tax-Free Savings Account Monday, August 9, 2010 (Revised: Thursday, August 12, 2010) F.A. Hayek Institute of Canada In the 2008 Canadian Federal Budget (1), Minister of Finance Jim Flaherty announced the creation of a new investment vehicle known as the Tax-Free Savings Account (TFSA). The TFSA was heralded as an investing revolution for the middle class, an instrument as important as the RRSP. While Flaherty's move was politically astute, as it was largely well received by the Canadian populous and think-tanks such as the C.D. Howe Institute and the Canadian Federation of Independent Business (CFIB), these organizations have seemingly glossed over the true purpose of the TFSA: which is an insurance policy by the state against a run on the banks is an insurance policy of sorts, considering that the actual gain from the TFSA is negligible. Taking a survey of TFSA offerings from banks it seems that the average interest rate one would earn is between 3 and 5 percent. The official rate of inflation during the last decade has been near the 2.5 percent mark; making the actual gains from TFSA earnings marginal at best. Even if one were to discount the official interest rate and expand the basket of goods in the Consumer Price Index (CPI) to something more realistic, such as the 8-10% that the American research firm Shadow Government Statistics suggests (2), one would find that the actual earnings are less than advertised. Thus, any actual gains by interest paid would be less than marginal. The growth would in fact be quantitatively worse in that we could see negative growth when the true inflation rate, as measured by Shadow Government Statistics, is factored into the equation. While it is fair to assume that true Canadian inflation rates are lower than the rapidly increasing inflation in the United States, and that presently difficult to determine these due to the lack of independent measurements, one must wonder how far away we potentially are from the 8-10% rate Shadow Government Statistics measures for our neighbors to the south. Any investment vehicles will have part of their gains rendered null by the seemingly inevitable persistence of inflation. This is not a new revelation as any introductory course in economics will mention this in its curriculum. However, what is interesting about the TFSA is the fact that the actual deposit limit of $5000 falls under the Canadian Revenue Agency's window of taxation. Let's take a look at the flat taxation rate for Alberta which is 10%. If an Alberta resident makes the maximum yearly contribution of $5000 with nominal gains of 4% interest (a rate that varies by every financial institution, and a rate that is influenced by the Bank of Canada through the raising and lowering of the target for overnight rate), the interest earned on that $5000 would be $200.00. The tax owed on this amount, if not sitting in a TFSA (but rather a basic interest-bearing savings account at 4%), Alberta comes to a mere $40.00. No other province in Canada has a flat tax rate. Instead, tax rates are based on the resident's gross yearly income bracket. Even if we calculate every taxable income bracket in every other province against, for example a 4% rate of interest on the TFSA's maximum $5000 contribution, the amount of taxation on the interest rate is so exiguous that a significant number of residents of each province likely would not bother to claim these capital gains on their income taxes to begin with† had this money instead been sitting in a basic interest-bearing savings account. The F.A. Hayek Institute of Canada believes that by the Canadian Government encouraging Canadians to deposit back into the banking system at a time when financial markets around the world were in turmoil during Global Financial Crisis and eventual downturn (3) in the fall of 2008, the banks were able to avoid a crisis of their own should there have been a larger than expected and sudden rise in interest rates and the banks were not able to borrow from the Bank of Canada or other private central banks, as they often do. Such an occurrence would likely cause the credit supply to dry up, hampering the ability of the loan-deposit cycle to continue which could very well mark the beginnings of a liquidity trap. Eventually this would spawn into a general feeling of mistrust of the banking system with the end result of this economic reality potentially being a disastrous run on the banks, as we have seen throughout the world's history. Now in all fairness, it is important to point out that Canada presently has the most stable banking system in the world, according to World Economic Forum Global Competitiveness Report 2008-2009 (4), and our stability does add a layer of protection which in turn offers some assurance to depositors, as did the TFSA (even if we feel it offers little value to Canadians). However, we must not forget that Canada is also the United States' largest trading partner and our very financial stability relies heavily on the United States. Persistent economic issues presently affecting United States and their banks are sure to creep into our country. As history has shown us time and time again, no country in the world has financial institutions that are invulnerable bank runs due to depositor confidence; including our very own which happened to Montreal's District Savings Bank in 1872 (5). While some may accuse the Minister of Finance of dishonesty by not being forward and transparent when announcing the intentions of the investment vehicle, it should be understood that contradictions such as the one we identify here are a rather typical and relatively benign form of 'political mislead'. What is more concerning is the lack of financial literacy in the Canadian public and the Canadian press. These factors should have been investigated more thoroughly during the inception of the TFSA. Cited Sources: (1) Tax Expenditures and Evaluations (Department of Finance Canada 2008) http://www.fin.gc.ca/taxexp-depfisc/2008/taxexp08_1-eng.asp#Personal_ (2) Shadow Government Statistics (Williams June 2010) http://www.shadowstats.com/alternate_data/inflation-charts (3) World Economic Outlook (WEO), Financial Stress, Downturns, Recoveries (International Monetary Fund 2008) http://www.imf.org/external/pubs/ft/weo/2008/02/index.htm (4) The Global Competitiveness Report 2008-2009 (World Economic Forum 2008) http://www.weforum.org/documents/gcr0809/index.html (5) Run on the Montreal City and District Savings Bank (Canadian Illustrated News vol.VI, no. 16, 253. Via Library and Archives of Canada, October 19, 1872) http://www.collectionscanada.gc.ca/databases/cin/001065-119.01-e.php?&nl_id_nbr=2952&brws_s=1&&PHPSESSID=uupk73qs05098c3t4aof2met95 Footnotes: †Although this is legally required for taxing all capital gains, pursuant to the Income Tax Act (R.S.C. 1985). F.A. Hayek Institute of Canada Media Department, 1-877-314-4169 info@hayekinstitute.ca Copyright © 2010, F.A. Hayek Institute of Canada Inc. All Rights Reserved.