Note: Where available, the PDF/Word icon below is provided to view the complete and fully formatted document
Inflation and taxation - Report of Committee of Inquiry, May 1975


Download PDF Download PDF

THE PARLIAMENT OF THE C O M M O N W E A L T H OF AUSTRALIA

1975—Parliamentary Paper No. 78 '

INFLATION AND TAXATION

REPORT OF COMMITTEE OF INQUIRY

INTO INFLATION AND TAXATION

May 1 9 7 5

Presented by Command 26 May 1975

Ordered to be printed 29 May 1975

TH E GOVERNM ENT PRINTER OF AUSTRALIA

CANBERRA 1975 X .

Printed by Kerton Bros (S.A.) Pty. Ltd., Edwardstown S.A.

COMMITTEE OF INQUIRY INTO INFLATION AND TAXATION BOX E369, G.P.O., CANBERRA, A.C.T. 2600

MEMBERS Professor Russell Mathews (Chairman) Mr. J. Canny Mr. R. Jolty Mr. D.G. Block

TELEPHONE: 4 7 4 3 9 6

IN REPLY PLEASE QUOTE:

22 May 1975

The Hon. E.G. Whitlam, Q.C., M.P., Prime Minister, Parliament House, CANBERRA A.C.T. 2600

As members of the Committee of Inquiry appointed to inquire into the effects of inflation on taxation paid by persons and business enterprises, we have the honour to present this our unanimous Report.

R.L. Mathews (Chairman)

t

D.G. Block

A { - ' U — 1

J . Canny/ L

R.A. Jolly

CONTENTS

Chapter Page

Preface i

Summary of Recommendations and Conclusions vii

I INTRODUCTION 1

Relation to the Work of the Taxation Review Committee 2

Significance of the Rate of Inflation 3

The Committee's Proposals 5

Scope of the Report 6

Limitations of the Report 7

PART ONE - TAXATION PAID BY PERSONS

II THE BACKGROUND TO PERSONAL TAX INDEXATION 13

III THE EFFECTS OF INFLATION ON PERSONAL TAXATION 19 Effects on the Distribution of Personal Tax Burden 19

The Mechanisms of Tax Burden Redistribution 20 Alternative Criteria for the Measurement of Tax Burden Redistribution 38

Tax Burden Redistribution and Tax Equity 42

Effects on the Size and Mix of Total Taxation 56 Effects on the Allocation of Resources 69

Effects on Macro-economic Stability 76

Effects on the Government Budget 76

The Differential Lags Argument 87

Wage Retaliation Against Higher Taxation 91 Inflation Induced Government Expenditure 107

IV CONCEPTS AND METHODS OF PERSONAL TAX INDEXATION 109 The Objectives of Personal Tax Indexation 109 Methods of Personal Tax Indexation 115

The Scope of Personal Tax Indexation 133

Automatic Indexation Versus Discretionary Adjustment 138

The Implications of Time Lags 144

Choice of a Price Index 165

Conclusions Regarding Choice of Price Index 184 Appendix - Lagged Indexation and Real Tax Rates 189

V INDEXATION SCHEMES IN OTHER COUNTRIES 193

Inflation Adjustment 193

Average Earnings Adjustment 211

Nominal Income Adjustment 212

Exemption of Cost of Living Wage Increments 213

Chapter Page

VI CHOICE OF METHODS AND PRICE INDEXES AND RECOMMENDED PROCEDURES 221

The Form and Scope of Personal Tax Indexation 221 Automaticity of Indexation 229

The Recommended Price Index 230

Lagged Adjustment 234

Adjustment of P.A.Y.E. Schedules 236

Provisional Taxation 241

Conclusion 249

Appendix 1 - References to Nominal Values in the Income Tax Legislation and the Committee's Recommendations Regarding Indexation 251 Appendix 2 - Consumer Price Index and Private

Final Consumption Expenditure Deflator, Annual Increases 255

Appendix 3 - Consumer Price Index and Private Final Consumption Expenditure Deflator^ Quarterly Increases 257

Appendix 4 - Comparison of Average Tax Rates for P.A.Y.E. Taxpayer and Provisional Taxpayer - 20% Constant Rate of Inflation 259

VII IMPLICATIONS OF PERSONAL TAX INDEXATION 263

The Equity Implications of Personal Tax Indexation 263

Implications of Indexation for Personal Tax Revenues 281

Implications of Personal Tax Indexation for Tax Mix 287

Implications of Personal Tax Indexation for Resource Allocation 289

Implications of Personal Tax Indexation for Macro-economic Stability 298

Effects on the Built-in Stability of the Economy 299

Effects on the Rate of Inflation 311

Appendix - Revenue Estimates of Personal Tax Indexation 323

PART TWO - TAXATION PAID BY COMPANIES AND OTHER ENTERPRISES

VIII EFFECTS OF INFLATION ON TAXATION OF COMPANIES AND OTHER ENTERPRISES 335

The Historical Cost Basis of Business Taxation 336 The Effects of Existing Tax Arrangements: An Historical Cost Model 338

The Significance of Taxation in Relation to Financial Stability 341

Trends in the Financial Stability of Companies 347

Chapter

Responses by Individual Firms 358

Equity Effects 366

Incidence of Company Tax 367

Effects on Resource Allocation 369

IX EXISTING METHODS OF STOCK VALUATION AND DEPRECIATION FOR TAXATION PURPOSES 373

Valuation of Trading Stock 373

Trading Stock Other than Live Stock 373

Live Stock 378

Trading Stock Account 380

Depreciation; The General Scheme 383

The Basis of Operation 394

Appendix - Methods of Calculating Depreciation Allowances 395

X INCOME AND CAPITAL MAINTENANCE CONCEPTS 397

Business Income 397

Valuation Systems 400

Historical Cost (or Historical Record) Accounting 409

Current Value Accounting 411

Current Purchasing Power (or General Price Level) Accounting 416

Relative Price Level Accounting 420

XI THE TAX BASE: CRITERIA FOR BUSINESS TAXATION 423

Business and Taxation Concepts of Income 423

A Pragmatic Approach 426

The Test of Business Survival 428

Tax Criteria 432

Conclusion 435

XII ALTERNATIVE APPROACHES TO BUSINESS INCOME TAXATION 437

Modification to the Historical Cost Concept of Profit 438

Last-in-first-out (LIFO) Accounting for Stocks 443

Base Stock Method of Stock Valuation 451

Accelerated Depreciation and Investment Allowances 452

Cash Flow Concepts of Income 464

Revaluation (or Revalorisation) of Fixed Assets 468

Current Value Adjustments 469

C.P.P. Profit as the Measure of Taxable Income 502

A Relative Price Level Concept of Taxable Income 523

Chapter

XIII PRACTICES IN OTHER COUNTRIES 531

Variations of Historical Cost Accounting 532 Cash Flow Concept of Income 538

Partial Adoption of Current Value Measures 541

XIV INCOME VALUATION ADJUSTMENTS: RECOMMENDED PROCEDURES 557

Income Valuation Adjustments 561

Cost of Sales Valuation (or Stock Appreciation) Adjustment 566

Depreciation Valuation Adjustment 577

Choice of Index 583

Income Valuation Adjustments as Assessable Income 586

Holding Gains, Capital Gains and Purchasing -Power Adjustments 592

Tax Indexation and Adjustment Concepts 598

XV POLICY IMPLICATIONS OF RECOMMENDED ADJUSTMENT SCHEMES 605

Revenue Implications of Suggested Changes 605 Cost of Sales Valuation Adjustments 606

Indexed Depreciation Valuations Adjustments 611 Methods of Limiting the Cost to Revenue of Adjustments 619

Effect of Adjustments on Business Investment and Savings 631

Effects on Equity of Taxation System 634

Effects on Resource Allocation 636

Stabilisation Policy 637

PART THREE - IMPLEMENTATION AND TIMING

XVI IMPLEMENTATION AND TIMING OF RECOMMENDED PROCEDURES 641

Introduction 641

Summary of the Recommended Indexation Scheme for Personal Taxation 641

Alternatives for Implementation of the Adjustments 643

Recommended Procedures for Income Valuation Adjustments for Purposes of Business Taxation 644 Cost of Sales Valuation (or Stock Appreciation) Adjustment 646

Depreciation Valuation Adjustment 647

Limitation of Income Valuation Adjustment 648 Budgetary Implications 650

Conclusion 651

APPENDIXES

Appendix Page

A Income Concepts and Measurement in

Relation to Capital Maintenance, Profitability and Financial Stability 655

B Stock Appreciation (or Cost of Sales

Valuation): Alternative Methods 677

C LIFO Accounting Contracted with

Historical Cost (FIFO) and Current Value Accounting 683

D Effects on Stock Appreciation of

Changes in Bases of Valuation 695

E Methods of Calculating Depreciation

Valuation Adjustments 701

F A Method of Taxation of Purchasing-Power

Gains by Limiting the Deductibility of Interest Payments from the Tax Base 713

G Limitation of Income Valuation

Adjustments to Specified Percentage of Taxable Income 719

H Lists of Persons and Organisations Who

Made Submissions 727

I Lists of Persons Attending Discussions 735

J Copy of Advertisement Containing

Terms of Reference 739

SELECTED BIBLIOGRAPHY 741

i

PREFACE

In his statement to Parliament on 12 November

1974 the Prime Minister announced that the Government would

be appointing a panel to report, by May 1975, on questions

relating to the effects of inflation on taxation paid by

persons and companies.

On 8 December 1974, the then Treasurer (The

Honourable Frank Crean M.P.) announced the membership and

detailed terms of reference of the Committee. The terms of

reference are as follows s

1. To examine the effects of rapid inflation on

taxation paid by persons and in particular -(a) to examine methods which could be used to apply

indexation to the personal income tax system;

(b) to assess their relative merits in terms of:

(i) effectiveness in providing an up-to-date

adjustment for price increases,

(ii) practicability of implementation;

(c) to recommend:

(i) the method considered most suitable, and

(ii) the price index considered most suitable

if the Government should wish to apply

indexation to personal income tax.

2. To examine the effects of rapid inflation on

taxation paid by companies and other

enterprises and in particular -

ii

(a) to examine the various choices available to

taxpayers under the provisions of the income

tax law relating to the valuation of trading

stock and to assess the advantages and

disadvantages of providing other bases of stock

valuation for income tax purposes;

(b) to consider the advantages and disadvantages of

alternative methods of providing allowance for

income tax purposes for depreciation of plant

and equipment, including allowance of

deductions for depreciation calculated at

flexible or accelerated annual rates;

(c) to make recommendations in relation to these

matters.

The following persons were appointed as members

of the Committee:

Professor R.L. Mathews (Chairman)

Mr. D.G. Block

Mr. J . Canny

Mr. R.A. Jolly.

In December 1974 and January 1975

advertisements were inserted in newspapers with an extensive

coverage soliciting written submissions. A copy of the

advertisement is appended to the Report. In addition the

Committee wrote eighty-five letters to individuals,

representative bodies and other organisations specifically

inviting them to make submissions to the Committee. The

views of the several State Governments on the terms of

iii

reference were also sought. Finally, letters were written

to Australian Ambassadors and High Commissioners in 21

overseas countries seeking information about taxation

arrangements in those countries. The Committee records its

appreciation of the considerable assistance it received in

response to this request.

The Committee had asked for submissions to be

forwarded by 28 February 1975 but, owing to the relatively

short time between the date of soliciting submissions and

that date, many submissions were not received until the end

of the following month. In all 154 submissions were received

including 64 from private individuals., 42 from

companies, and 42 from professional organisations and

representative groupings including professional accounting

firms. Six submissions were also received from the

Australian Treasury, the Department of Labor and

Immigration, the Department of Manufacturing Industry, the

National Small Business Bureau of the Department of

Manufacturing Industry, the Government of Tasmania and

the Economic Intelligence Unit, South Australian Premier's

Department.

Because of time constraints, it was not

possible to arrange for public hearings or interviews with

persons or organisations desirous of meeting with the

Committee. However three separate meetings to discuss the

Committee's work were held with (a) academic and Treasury

economists, (b) academic accountants, representatives of

professional accounting and taxation bodies, and accounting

XV

firms, and (c) representatives of industry associations,

business and trade unions. The Committee also followed up

questions arising out of submissions by means of

correspondence or personal discussion.

The Committee records its thanks to all those

who made submissions or who otherwise assisted the Inquiry.

Many of the submissions were substantial documents,

indicating that considerable time and expense were involved

in their preparation.

The Committee also records its appreciation of

the assistance provided by The Australian Treasury in

servicing its day to day operations and by the Australian

Taxation Office in providing technical information on the

existing tax system, evaluation of administrative aspects of

possible options open to the Committee and, especially, for

estimates of the revenue implications of alternative

policies. The Australian Bureau of Statistics also provided

valuable assistance on questions related to the availability

and suitability of various price indices, and the relevance

of national accounting data to the Inquiry. The Committee

was also greatly assisted by substantial research studies

which were undertaken on its behalf by Professor A.D. Barton

and Mr. Geoffrey Brennan.

The Committee records with appreciation the

outstanding contributions to its work which have been made

by Mr. D.A. Dixon (Research Director) and Mr. David Morgan

(Research Officer). Mr. Morgan prepared the first draft of

V

Part One of the Report under the Committee's direction.

Mr. Dixon was responsible for organising the Committee's

research program and he also played a major role in drafting

the Report. The Committee benefited especially from his

knowledge of the Australian taxation system and from his

part in the Committee's deliberations, when among other

things he ensured that opposing viewpoints were fully

considered.

The Committee also places on record its

appreciation of the efficient and conscientious work of

Mr. A.D. Macnaught (as Secretary, Mr. Macnaught was

responsible for the Committee's administrative arrangements),

Mr. Robert Henderson (Research Officer),

Mr. Peter Speldewinde (Clerk), Miss Kay Mitchell,

Mrs. Sylvia Jamison, and Mrs. V. Murray (Steno-Secretaries).

22 May 1975

R.L. Mathews (Chairman)

D.G. Block

J. Canny

R.A. Jolly

vii

INFLATION AND TAXATION

SUMMARY OF CONCLUSIONS AND RECOMMENDATIONS

1. The two principal effects of inflation with

which this Report is concerned are: (a) the tendency for

increases in money incomes which result solely from

inflation to be associated with higher average and marginal

rates of personal income tax; and (b) the tendency for

inflation to change the effective tax base of companies and

other enterprises.

2. When the rate of inflation passes a critical

level, its effects on the taxation system change in kind as

well as degree, and it becomes difficult for the economic

system to adapt in conventional ways.

3. The threshold of adaptation has now been

passed, and substantial changes need to be made in the bases

of both personal and business taxation.

PART ONE - TAXATION PAID BY PERSONS

4. The interaction between inflation and an

unchanged personal income tax rate schedule generates a

redistribution of the tax burden through (a) dependant and

other fixed concessional deductions and (b) the progressive

rate scale.

5. The principal effects of inflation on the

distribution of the tax burden are; (a) it results in a

viii

different distribution from that which is intended or was

legislated, and (b) the low income, large family taxpayer

categories are likely to be the groups most adversely

affected.

6. As a result of inflation, both total tax

collections and the relative weight of income and other

progressive taxes are likely to increase, although these

effects may be offset by discretionary changes in the tax

system.

7. The average rate of personal income tax of a

taxpayer with no concessional deductions, who is in receipt

of average earnings, has increased from 9.7 per cent in

1954-55 to an estimated 21.3 per cent in 1974-75, and the

marginal rate from 17.5 per cent to 44.0 per cent. On

present trends, maintenance of the current rate scale in

1975-76 will result in such a taxpayer paying a marginal

rate of 48 per cent.

8. The automatic response of government

expenditures to inflation is probably less than the

inflation-rate and almost certainly less than the

proportionate response of the taxation system.

9. The existing tax system does not have the

stabilising tendencies which have conventionally been

attributed to it. As a result of lagged responses of

prices, demand and tax yields to output changes, the effect

of the tax system is potentially destabilising.

10. There is widespread agreement that, because of

the effects of high marginal rates on real disposable (i.e.

after-tax) income, the increasing tax burden is having an

accelerating effect on wage claims. On the basis of a 20

ix

per cent rate of inflation in 1974-75, a taxpayer on average

weekly earnings in 1974-75 will need to increase his gross

income by 29.8 per cent to maintain a constant real income

after tax, or by 39.3 per cent to increase his after-tax

real income by 5 per cent. In 1971-72, an increase in gross

income of only 14.2 per cent was necessary to achieve a 5

per cent increase in after-tax income.

11. The major aim of personal tax indexation is the

maintenance of the equity objectives of personal taxation,

which are concerned with relative rather than absolute tax

burdens.

12. Indexation schemes do not, in intent or effect,

tie the government to a fixed distribution of the personal

tax burden, because of their continued ability to make

discretionary adjustments.

13. There are three possible methods of personal

tax indexation:

(a) adjustment of the legislated tax schedule

(taxable income bracket limits and deduction

limits); (b) adjustment of net incomes,

leaving the legislated rate schedule unchanged;

and (c) adjustment of tax rates, leaving the

legislated rate brackets and incomes unchanged.

14. The Committee recommends that personal tax

indexation be effected through the adjustment of taxable

income bracket limits and deduction limits.

15. Indexation should apply to all dependant

deduction limits and to the principal non-dependant

deductions. If the Government wishes to adjust the limits

of non-dependant deductions it should do so explicitly.

X

16. Although indexation has usually been effected

in overseas countries by means of a consumer price index,

some indexation schemes involve the use of an incomes index,

such as an index of nominal per capita incomes or of average

earnings.

17. Time lags, between the current rate of

inflation and the rate of inflation used for indexation, and

between accrual of tax liability and payment of tax

liability, have important implications for tax indexation.

Adjustment procedures may use either an index of current

inflation or a lagged index.

18. The Committee recommends that the Consumer

Price Index (CPI) be used for tax schedule adjustment. The

index should be applied on an annual basis and should be

lagged to the income year by one year. The index should be

calculated as the average increase in the CPI in the four

quarters of the previous income year (ending with the June

quarter) over the average for the four quarters of the

preceding income year. The Committee does not recommend

that any adjustments be made to the CPI to remove the effects

of changes in indirect taxes or the terms of trade.

19. Indexation schemes in overseas countries

sometimes provide for departure from application of the full

index (a) by making it possible for the government to

calculate the adjustment factor as some proportion of the

movement in the chosen index, or (b) by setting the

adjustment factor to zero if movements in the chosen index

do not exceed a specified percentage.

xi

20. The Committee recommends that there should be

no departure from the chosen index and that adjustment

should be automatic in the sense described in para. 4.60.

The Committee recognises that governments must retain the

right to make discretionary adjustments, but believes that

they should do so explicitly.

21. To facilitate tax administration, minimise the

adjustment lag, and make it possible for discretionary

changes in the tax schedule to be effected at the time of

the Budget, the Committee recommends that both the

indexation rate adjustment and any discretionary adjustments

should be announced simultaneously in the Budget. This will

permit P.A.Y.E. schedules to be adjusted with effect from

1 October each year and the assessed liability of

P.A.Y.E. taxpayers to be adjusted by reference to the

inflation rate in the twelve months preceding the income

year. Personal tax indexation should be applied to

provisional taxpayers at the time their tax liabilities are

assessed.

22. Regardless of whether equity is viewed in terms

of the personal tax system, the total tax system, or the

economy as a whole, tax indexation along the lines proposed

is likely to enhance equity.

23. Reductions in revenue yields will result mainly

from taxable income bracket indexation; the revenue loss

will be substantially smaller under the proposed scheme of

lagged indexation than under current indexation, and the

ratio of personal tax to incomes will continue to increase

as a result of the combined effects of lagged indexation and

real income growth.

xii

24. Personal tax indexation does not necessarily

imply a smaller public sector than will otherwise prevail,

but it does imply a more efficient and more responsive

public sector.

25. Personal tax indexation is unlikely to impair

automatic stabilising tendencies of the personal tax system,

or lead to a higher rate of inflation than would otherwise

be experienced. To the extent that indexation succeeds in

moderating wage claims, it will have a stabilising

influence.

26. There is overwhelming support, from all

sections of the Australian community, for the principle of

personal tax indexation. Among those supporting indexation

are trade union organisations, industry associations

(representing rural, commercial, manufacturing, mining and

service industries), many large and small companies,

professional bodies and Australian and State government

departments or agencies.

27. The Australian Conciliation and Arbitration

Commission has indicated that it is impressed by the

contention that the size of wage demands in a period of

rapid inflation is related to the level and structure of

personal income taxation. The view is widely held that

failure to adjust the progressive income tax schedule for

the effects of inflation will lead to an acceleration in the

rate of wage increases.

xiii

PART TWO - TAXATION PAID BY COMPANIES AND OTHER ENTERPRISES

28. Income tax is levied on companies and

unincorporated enterprises largely on the basis of a

conventional measure of business income described as

accounting profit. There is nothing inherently right or

wrong, or true or false, about the use of any particular

income concept for tax purposes.

29. The suitability of any concept of taxable

income depends on the effects which flow from its use.

These effects need to be evaluated by reference to criteria

of equity, simplicity, efficiency and flexibility, but there

is one over-riding test which any business tax system must

meet. This is the compatibility of the tax system with the

maintenance of financial stability in the business sector,

with continuity of business investment and activity, in

short with business survival.

30. There is both theoretical and empirical

evidence that the existing tax system is not meeting this

test under current conditions of rapid inflation. Unless it

is feasible for a firm to continuously raise fresh capital

to maintain the scale of its operations, when the rate of

inflation passes a critical level it ceases to be a viable

economic unit.

31. Although the firm must maintain pricing and

profit distribution policies which are consistent with

long-run financial stability and the maintenance of the

scale of operations, if the rate of inflation becomes

xiv

sufficiently severe the tax base itself becomes a factor of

critical importance.

32. Four kinds of valuation systems have been

developed for the purpose of measuring business income and

wealth, based on actual market prices (historical prices),

the current prices of equivalent transactions (current

prices), historical prices adjusted to constant prices by

reference to a purchasing-power index, and current prices

adjusted to constant prices by reference to a

purchasing-power index.

33. Corresponding to these valuation systems are

four accounting measurement systems, described respectively

as historical cost (or historical record) accounting,

current value (or current cost) accounting, current

purchasing power (or general price level) accounting, and

relative price level (or constant purchasing power)

accounting. Each system needs to be evaluated by reference

to its implications for income measurement, capital

maintenance and financial stability.

34. For financial reporting and taxation purposes,

the measure of accounting profit which is derived from the

historical cost accounting system is still predominantly in

use.

35. The choice of the business tax base must depend

on a pragmatic approach to the definition of income, but

business taxation should not have unintended results.

X V

36. Taxing, accounting and pricing policies which

have traditionally been adopted in relation to business

enterprises, when combined with recent high rates of

inflation, are incompatible with the continued existence of

the private sector.

37. There is a need for a change in the business

tax base, in concert with changes in business policies, to

prevent the winding down of business activity. As far as

possible, any change in the tax base needs to be accompanied

by action designed to limit loss of tax revenue and preserve

the equity and efficiency of the tax system.

38. Proposals made to the Committee to change the

basis of business taxation involved: (a) modifications to

the historical cost accounting approach to income

measurement; (b) the substitution of a current value

concept of taxable income; (c) the adoption of a current

purchasing power (C.P.P.) concept of taxable income; and

(d) the adoption of a concept of taxable income based on

relative price level accounting.

39. Modifications to the existing basis of business

taxation which were suggested to the Committee included: (a)

recognition of the last-in-first-out (LIFO) method of stock

valuation; (b) the use of accelerated or flexible

depreciation allowances and investment allowances; (c) the

use of a cash flow concept of income; and (d) the periodic

revaluation of depreciable assets as a basis for calculating

depreciation allowances for tax purposes.

xvi

40. The Committee generally regards these

procedures as inferior to the ones it recommends as

instruments for countering the effects of inflation, but

accepts that accelerated depreciation and investment

allowances are appropriate policy options for a government

which wishes to influence the level or pattern of private

investment.

41. Although the Committee has concluded that the

current purchasing power (C.P.P.) and relative price level

concepts of income have disadvantages which make the

concepts unsuitable for tax purposes, they have advantages

(of comprehensiveness, objectivity and reliability) which it

is desirable to incorporate in a tax system designed to

insulate business enterprises from the effects of inflation.

42. The Committee recommends that a modified

concept of taxable income, based on the current value

concept of income, should be adopted for continuing

businesses. The same basis of taxation should be used for

both companies and unincorporated enterprises. The

Committee's recommendations are based on a judgment that

they are more likely than any alternative procedures to

achieve the objectives of tax policy, and to restore

stability and confidence to the business sector.

43. To adapt the existing concept of taxable income

to a current value concept, basically only two simple

valuation adjustments need to be made in the form of

allowable deductions from assessable income. These are

xvii

described as the cost of sales valuation (or stock

appreciation) adjustment and the depreciation valuation

adjustment.

44. The Committee recommends that the cost of sales

valuation adjustment be calculated by firms as the

difference between their opening stocks valued at actual

prices and opening stocks valued at the same prices as

closing stocks, using actual stock schedules and price lists

as the basis of the calculation.

45. The Committee further recommends the adoption

of procedures to ensure that, when stock levels or prices

fall or when the ownership of businesses changes hands,

positive cost of sales valuation adjustments are made with

the effect of increasing assessable income. These

procedures will achieve the advantages of the LIFO method of

stock valuation while avoiding its disadvantages; in

particular, they will be simpler to apply and their effects

will be more certain when stock levels fall.

46. The Committee recommends that a method of

indexing depreciation allowances be adopted for the purpose

of calculating the depreciation valuation adjustment. The

adjustment should be calculated by the age co-efficient

method, whereby depreciation charges on depreciable assets

are classified in accordance with the age structure of the

assets to which they relate. A separate co-efficient should

be applied to the historical cost depreciation charges in

respect of each year’s asset purchases in order to calculate

the indexed (or current replacement) cost of depreciation.

The replacement cost co-efficients should be derived from a

xviii

published index of replacement costs prepared by the

Commissioner of Taxation on the advice of the Australian

Bureau of Statistics. For this purpose, the Committee

recommends the use of a single index, based on the Implicit

Price Deflator for Gross Private Fixed Capital Expenditure

(All Other) in the Australian National Accounts.

47. The Committee recommends that indexed

depreciation be calculated only by reference to price

changes from the year preceding the year in which

the depreciation valuation adjustment is first introduced.

48. The Committee recommends that the indexed

depreciation valuation adjustment be treated as a permanent

deferment of tax.

49. The following procedures have been considered

as possible means of minimising the budgetary impact of the

valuation adjustments, or of permitting them to be

introduced over a number of income periods: (a) an increase

in the rate of company tax; (b) the introduction of

purchasing-power gains into the business tax base; (c) a

limitation of the total size of, or the categories of,

inventories or depreciable assets eligible for adjustment;

(d) a limitation of the size of the adjustments by reference

to taxable income; and (e) a limitation by phasing in the

adjustments over time.

50. The Committee has also considered the

implications of reducing the rate of company tax as an

alternative to the proposed income valuation adjustments.

Although it regards the income valuation adjustments as a

preferred method, an interim reduction in the rate of

company tax for 1974-75 might be considered if the valuation

adjustments were not to be introduced until 1975-76.

PART THREE - IMPLEMENTATION AND TIMING

51. The recommended personal tax indexation scheme

could be introduced by one of two principal methods. The

first would be to introduce the scheme in the 1975-76 income

year, simultaneously with an increase in the personal tax

schedule to cover the cost of the Medibank program and make

other desired changes in the rate structure. The second

method would be to introduce a new tax schedule in the

1975-76 income year, with a commitment to adjust that

schedule in the 1976-77 income year for the inflation that

occurred in 1975-76. Under either alternative, automatic

indexation would continue in subsequent years.

52. The Committee recommends the adoption of the

first of these alternatives, unless the tax schedule for

1975-76 is restructured to offset the high rate of inflation

which has been experienced during 1974-75. The Committee

recommends that a decision to implement personal tax

indexation be announced by the Government no later than in

xix

its 1975 Budget.

XX

53. The Committee recommends that the cost of sales

valuation adjustment and the depreciation valuation

adjustment be introduced wholly or partly in respect of the

1974-75 income year.

54. The Committee recognises that its proposals for

changes in the taxation system must be examined in the

context of the Government's budgetary situation, which is

currently one of substantial deficit. But it believes that

failure to make the proposed changes will have both

inflationary consequences (through its effects on the wage

system) and a seriously depressing effect on the level of

business activity.

1

I INTRODUCTION

1.1. This Report is concerned, first, with the

effects of inflation on the personal income tax rate

structure (including both the rate schedule and the

dependant or other concessional deductions) and, second,

with the effects of inflation on the tax base of companies

and other enterprises. The Committee has interpreted its

task as being essentially to determine whether inflation has

a tendency to produce distorting effects on the personal and

business income tax systems, and if so to make

recommendations designed to eliminate or alleviate those

effects.

1.2 The two principal effects to which the

Committee has directed its attention are:

(a) The tendency for increases in money incomes

which result solely from inflation (that is,

which are not reflected in increases in real

incomes) to be associated with higher average

and marginal rates of personal income tax.

This effect results from the interaction of

inflation and an unchanged progressive rate

structure, and the Report shows that it has

important implications for the equity and

efficiency of the personal tax system.

2

(b) The tendency for inflation to change the -

effective tax base of companies and other

enterprises. This effect results from the

interaction of inflation and the way in which

business profits are conventionally measured

for tax purposes, and the Report will show that

it has important implications for the financial

stability of the private sector.

Relation to the Work of the Taxation Review Committee

1.3 Although the effects of inflation on taxation

are pervasive, the Committee has been aware that the

Australian taxation system has recently been the subject of

an exhaustive investigation by the Taxation Review Committee

under the Chairmanship of Mr. Justice K.W. Asprey, and that

our recommendations will no doubt need to be considered in

the context of the more general recommendations of that

Committee.

1.4 The Asprey Committee greatly assisted this

Committee by making available its Full Report as soon as it

had been completed, and by providing copies of some of its

own research papers which seemed to have special relevance

for the work of this Committee. For our part, we have

endeavoured to relate our findings to the Reports'*" of the

Taxation Review Committee where the work of the two

1 Taxation Review Committee Preliminary Report 1 June 1974, Australian Government Publishing Service, Canberra, 1974 (hereafter called the Preliminary Report); and Taxation Review Committee Full Report

31 January 1975, Australian Government Publishing Service, Canberra, 1975 (hereafter called the Full Report).

3

Committees has been mutually supporting. For the rest, we

have adopted a working rule designed to restrict our

investigation to a study of the effects of inflation on the

Australian tax system, either as it exists or as it may be

modified in the light of the Asprey Committee's

recommendations.

1.5 In effect, the Committee has proceeded on the

assumption that the existing tax system may be taken as

given, except to the extent that inflation imposes problems

which would not exist in the absence of inflation. To have

proceeded on any other basis would have unnecessarily

duplicated the work of the Taxation Review Committee and, we

believe, confused the discussion on important issues of

principle which fall outside the scope of our own

investigation.

Significance of the Rate of Inflation

1.6 In both its Preliminary and Full Reports, the

Taxation Review Committee emphasised that the structure of

the present tax system was not designed for, and has not yet

been adapted to, an economy experiencing rapid rates of

inflation. In concurring with that view, this Committee

records that it has not concerned itself directly with the

reasons why the Australian economy has recently been

subjected to rapid and accelerating rates of inflation.

Rather it has concentrated on analysing the effects of

inflation on the taxation system. Nevertheless, the

Committee has been conscious of the current debate about

4

whether the taxation system itself, and especially the fora

of the personal income tax rate structure, has been an

important factor contributing to present high rates of

inflation through its effects on the wage system. This is a

question which is taken up at some length in the Report, and

the Committee believes that adoption of its recommendations

will contribute towards a reduction in inflationary

pressures from this cause.

1.7 Nevertheless, the Committee's main concern has

been to suggest ways of modifying the tax system so that

individuals and business enterprises may more readily

accommodate themselves to, and tolerate, inflation. To the

extent that its recommendations assist in achieving this

more limited objective, this should not be taken as an

indication that the Committee condones inflation or regards

a continuation of high rates of inflation as inevitable.

1.8 In the course of the Inquiry, the Committee has

formed the view that, when the rate of inflation passes a

critical level, its effects on the taxation system change in

a qualitative as well as a quantitative sense - in kind as

well as in degree. This is not only because rapid inflation

generates expectations which, in effect, feed upon

themselves and change the nature of the response of

individuals and business firms. It is also because

5

accelerating inflation eventually passes a threshold, beyond

which it is difficult or impossible for the economic system

to adapt in conventional ways.

1.9 These problems of adaptation are seen more

clearly in relation to the taxation of business enterprises,

because the very survival of many firms is threatened by a

continuation of existing policies. But it also becomes

increasingly difficult for the personal tax system to

respond appropriately to inflation, as discretionary changes

in tax rates become a recurring need if individuals are not

to be driven inexorably into higher and higher effective

rates of taxation.

The Committee's Proposals

1.10 It is the Committee's view that the threshold

of adaptation has now been passed, and that drastic changes

need to be made in the basis of both personal and business

taxation. The reasons for this view and the nature of the

recommended changes are spelt out in subsequent Chapters of

the Report. Briefly, in Part One the Committee recommends

the adoption of a system of personal tax indexation along

the lines of the scheme which became effective in Canada in

1974. This involves the automatic indexation of income tax

rate brackets and most concessional deductions by reference

to changes in the Consumer Price Index during the preceding

income year.

6

1.11 In Part Two of the Report, the Committee

recommends the introduction, under specified and controlled

conditions, of two income valuation adjustments as allowable

deductions from assessable income. These adjustments the

Committee describes as a cost of sales (or stock

appreciation) adjustment and a depreciation valuation

adjustment respectively. They are intended to change the

base for business taxation to a measure of income which more

nearly reflects the current values of transactions, and

which is more compatible with the continued operation of

business enterprises under conditions of rapid inflation.

Scope of the Report

1.12 Parts One and Two of the Report follow the same

broad sequence. The impact of inflation on existing

taxation arrangements is analysed with special reference to

equity considerations, revenue effects, balance between the

public and private sectors, efficiency in resource

allocation and implications for economic stabilisation and

management. Alternative kinds of taxation arrangements are

then evaluated, and the experience of overseas countries is

examined, as part of the process of formulating policies

which the Committee recommends for adoption in Australia.

Finally, the proposed arrangements are subjected to scrutiny

to assess the extent to which they meet required standards

of equity, simplicity, efficiency and flexibility, which the

Committee has followed the Taxation Review Committee in

regarding as necessary attributes of an effective tax

system

7

1.13 Conscious of both the administrative and the

budgetary problems which are implicit in its proposals, the

Committee in Part Three considers alternative methods of

implementing and phasing in the recommended changes. It

realises that the recommendations must be examined in the

context of a serious budgetary situation, but believes that

failure to make the proposed changes will itself have

adverse budgetary and economic consequences.

Limitations of the Report

1.14 The imperfections in this Report - not least

its length - must be justified partly by reference to the

haste with which the Committee was obliged to conduct its

investigations and write the Report. Effectively, the May

deadline allowed only about three working months for the

completion of the task.

1.15 The Committee is aware that the Report contains

much more technical and abstract analysis than is normally

associated with a study of this kind. One reason for this

is that the issues in relation to personal tax indexation

have not been extensively debated in Australia, and it

seemed that the Report could facilitate informed public

discussion by providing detailed analysis and information

about the operation of tax indexation schemes in principle

and practice.

1.16 A second reason is that the Committee was

forced to break new ground in many respects in making its

8

recommendations on business taxation. Although many

overseas countries are grappling with the problem of

inflation adjustments for business taxation, clearly defined

principles and methods have yet to be established for this

purpose. Again, therefore, it seemed to the Committee that

there is an information gap which this Report could help to

remedy.

1.17 Two steps have been taken to assist readability

and facilitate understanding of the Committee's main

conclusions and recommendations. The first has been to

relegate technical analysis and theoretical models to

Appendixes to the maximum extent considered feasible. In

Part One, the Appendixes are usually short and closely

linked to the analysis in the text of the Report; they have

therefore been appended to the Chapters to which they

relate. The Appendixes to Part Two are usually longer and

have been designed to demonstrate or illustrate propositions

which are made in the text; to avoid unnecessary

discontinuity in the analysis they have been placed at the

end of the Report. Despite these changes, the Report is not

easy reading. The Committee has therefore prepared a

summary of conclusions and recommendations to facilitate

understanding of the issues involved and how the Committee

proposes to deal with them.

1.18 Although the main recommendations of the Report

would, if adopted, have far-reaching economic effects, they

9

involve quite simple changes to the tax system. The

Committee has no doubt that, subject to appropriate choices

being made in the light of its recommendations on

implementation and timing, the recommendations are

practicable in both a budgetary and an administrative sense.

i l

TAXATION PAID BY PERSONS

13

II THE BACKGROUND TO PERSONAL TAX INDEXATION

2.1 In analysing the practicability of introducing

personal tax indexation in some future period, it is

impossible to proceed without examining changes in personal

taxation that have occurred in the past; in particular,

those changes in the effective rates of personal income tax

wrought by the interplay of inflation and an unchanged

personal tax schedule. Indeed much of the debate

surrounding personal tax indexation in Australia has

concentrated on the interactions of inflation and personal

taxation in an earlier period, most particularly the period

from 1954-55 to 1969-70, when the basic personal tax rate

schedule remained largely unchanged in nominal terms.

2.2 The Report analyses this period in some detail,

because much can be learned from historical analysis about

current and future problems arising from the combination of

inflation and personal taxation. Nevertheless, the

Committee has been charged with the task of considering

personal tax indexation for some future period; it has not

been asked to determine whether personal tax indexation

would have been appropriate during the past twenty years.

To be sure the two questions overlap in a number of

extremely important respects. Nevertheless, several factors

directly relevant to the issue of personal tax indexation

are today qualitatively different from those operating over

most of the previous twenty years. Such factors include the

rate of inflation and the weight of personal taxation.

14

2.3 For example, even if it were the case that

empirical investigations covering the 1950s and 1960s

produced no evidence that incentives to work, save or take

risks were adversely affected by increasing personal tax

burdens, it does not automatically follow that similar

results would flow from future increases in personal taxes.

This is because future increases would be superimposed on a

much higher base level of taxes. The same point may be made

with respect to wage bargaining in relation to disposable

incomes. If the average wage earner were to face average

and marginal tax rates at levels prevailing in 1954-55, the

difference between gross and net pay would be unlikely to

attract great attention. It is difficult to believe that

this remains true when average wage earners are confronting

marginal tax rates approaching 50 per cent, as they are

today.

2.4 The Committee has noted the following

observations of the Australian Treasury about the current

weight of personal taxation.

'The stage has now been reached where the Australian Government cannot for very much longer continue to rely on growth in personal income tax collections to provide the bulk of tax increases in a fiscal year. Effective rates of personal income tax have risen strongly since 1954-55, but given the increases in the overall level of Government expenditure which have also occurred it is questionable whether present rates of income taxation are

1 too high' in an absolute sense. Nevertheless it is apparent that the potential for further increases in effective rates of income tax, based on a progressive rate schedule of the

type adopted by Australia in recent decades, is

15

limited by the increases of the past twenty years. Arguments to the contrary, based on the view that personal income tax is the most equitable tax, appear to overlook the fact that

it is inevitable that the rate schedule must become less progressive as relatively more revenue is raised.11

2.5 The Treasury has referred to the same basic

problem in another study:

'The case for broadening the base of the indirect tax system can perhaps be summed up as follows:

(a) Government expenditure has been increasing rapidly and continued demands in many fields such as health, welfare, education, defence, development and assistance to the States can be expected. It will be necessary to ensure, therefore, that revenue sources

are available that will enable those demands to be met.

(b) With rising incomes and with a progressive rates scale which remained unchanged between 1954-55 and 1970-71, personal income tax collections played a

substantial role in financing the large increases in expenditure that have taken place in recent years. However, it seems unrealistic to suppose that personal income tax will be able to play

that kind of role in the future. There will be strong pressures to prevent its rising inexorably with inflation.

(c) Those pressures have been very evident in recent years. There was a reduction averaging 10 per cent in personal income tax rates in the 1970-71 Budget. However, so formidable is the combined

effect of inflation and the progressive rates scale that the 1970-71 reduction

1 Summary of Issues, Treasury Taxation Paper No. 13, December 1974, Australian Government Publishing Service, Canberra, 1974, p. 2.

16

only marginally and temporarily halted the increased reliance on personal income tax. In 1969-70 personal income tax as a proportion of total tax was 45.2 per cent; the 1970-71 figure fell to 44.4 per cent, but by 1971-72 the figure had again increased to 48.0 per cent. In 1972-73 tax rates were again cut by an average of 10 per cent.

(d) Despite the tax cuts in 1970-71 and 1972-73, demands for further cuts will be heard in a couple of years. Each rise in money incomes results in a greater proportion of total income being taken in tax. The process is inexorable and regular action would be necessary if it were to be contained or

even slowed. If expenditure needs continue to rise, it will be important to have revenue sources available to allow further such action to be taken without impairing the ability to meet

those increased expenditure commitments.'1

2.6 The Committee has also noted the following

conclusion of the Taxation Review Committee:

'...the Committee has reached one recommendation that it believes should be acceptable to a broad spectrum of public opinion and is consistent with a wide range of attitudes to social policy. It believes that the weight of taxation should be shifted towards the taxation of goods and services and away from the taxation of income. The Committee judges that, in combination with the reforms it proposes in the taxation of capital and capital gains, a strategy of change in this direction would in time go far towards achieving the principal aims set for it in its terms of reference.12 1 2

1 Commonwealth Taxation of Goods and Services, Treasury Taxation Paper No. 5, October 1974, Australian Government Publishing Service, Canberra 1974, p. 6,7.

2 Full Report, para. 28.9.

17

2.7 The foregoing quotations support the

Committee's view that personal taxation is now playing a far

more substantial role than it has done in the past. This has

important implications for the discussion of personal tax

indexation. Indeed, the level of the personal income tax

burden is one of the main reasons why the Committee favours

the adoption of the indexation scheme proposed in this

Report.

i :

19

III THE EFFECTS OF INFLATION ON PERSONAL TAXATION

3.1 This Chapter considers the implications of the

combination of inflation and personal taxation, on the

assumption that the personal tax schedule remains unchanged

during the inflationary period. The first section considers

the implications for the distribution of the personal tax

burden, while the next section considers the effects on the

size and mix of total tax revenues. Later sections examine

likely implications for resource allocation and

macroeconomic stability respectively.

Effects on the Distribution of the Personal Tax Burden

3.2 The most important result of the interplay

between inflation and an unchanged personal tax schedule is

the distorting effect on the distribution of the personal

tax burden. For the purposes of this section, the tax

burden is defined as the average rate of personal income tax

in relation to net income - as defined below. In the

following discussion, attention is directed initially to the

mechanisms by which the tax redistribution is brought about.

The discussion is somewhat technical. Nevertheless an

appraisal of personal tax indexation schemes cannot sensibly

proceed without a clear understanding of the source of the

major problem which they aim to remedy. Consideration is

subsequently given to alternative measures of tax burden

redistribution, and to the equity implications of the

redistribution

20

The Mechanisms of Tax Burden Redistribution

3.3 If the personal tax schedule remains unchanged

during a period of inflation, there is an increase in the

average tax rate on all real income levels subject to

personal taxation. The rate of increase in average tax

rates varies at different levels of real income, thereby

changing the distribution of the tax burden between income

groups. The rate of increase also varies for taxpayers with

different numbers of dependants, those taxpayers with the

largest number of dependants being likely to experience the

largest increase in average rates of tax. Inflation is

therefore likely to generate a redistribution of the tax

burden as between different taxpayer groups classified in

terras of numbers of dependants (such as single, married with

dependent wife, married with dependent wife and dependent

children).

3.4 In order to understand the mechanisms by which

these redistributions are effected, it is necessary to refer

to several income concepts which are defined in the Income

Tax Assessment Act. 'Assessable income' is the statutory

income of taxpayers computed in accordance with the

provisions of the income tax legislation.^ 'Net income'

This definition of income does not cover all of the receipts or material benefits accruing to individuals. The major exclusions are most forms of capital gains, lottery prizes, non-professional betting winnings, and the imputed income attributable to the use of owner- occupied dwellings. For a full discussion of this issue,

see Personal Income Tax - The Income Base, Treasury Taxation Paper No.3, October 1974, Australian Government Publishing Service, Canberra, 1974.

21

equals assessable income minus expenses incurred in gaining

or producing that income, other than expenses of a capital,

private or domestic nature. 'Taxable income' equals net

income minus 'concessional deductions', the most important

deductions being those for dependants, for life assurance

and superannuation payments, for home loan interest

payments, and for medical, dental, funeral and education

expenses.1 With certain minor exceptions,2 tax liability is

calculated by applying the rate scale to taxable income

calculated on the basis outlined above. The average tax

rate is conventionally defined as the ratio of tax liability

to net income. The Committee adopts this definition. The

following discussion assumes that the only concessional

deduction available to the taxpayer is the conventional form

of dependant deduction, namely a deduction fixed in nominal

terms and continuing in the sense that it is available to

all taxpayers regardless of their net income levels. Other

forms of dependant concessions and other concessional

deductions will be considered separately.

3.5 For simplicity, it is initially assumed that

net incomes increase in proportion to the rate of inflation;

A full discussion of these deductions may be found in Personal Income Tax - Personal Allowances, Treasury Taxation Paper No. ?, November 1974, Australian Government Publishing Service, Canberra 1974; and in the Full Report

of the Taxation Review Committee, op. cit., Chapter Ϊ2.

2

See Personal Income Tax - The Income Base, op. cit., p.2.

22

that is, that real net incomes are maintained continuously.*

This assumption is made for purposes of exposition only. It

will be demonstrated subsequently that the same kind of tax

burden redistribution will take place even if net incomes do

not respond to inflation, or if net incomes increase at a

rate in excess of the rate of inflation. Further, no

assumptions are made regarding the source of inflation,

because the redistributions will occur in the same pattern

whatever the source of inflation.

3.6 There are two basic mechanisms by which the

interplay of inflation and an unchanged progressive tax

schedule generate a redistribution of the tax burden. The

first mechanism concerns the relationship between net income

and taxable income. For any taxpayer entitled to dependant

deductions, inflation results in the taxpayer's taxable

income increasing at a more rapid rate than his net income;

this reflects the fact that the dependant deduction is fixed

in nominal terms. This in turn means that the proportion of

net income subject to tax increases, even though real net

income is unchanged. Consider, for example, a hypothetical

taxpayer with a dependent spouse and two dependent children

earning a constant real net income of $8,000. On the basis

of the level of dependant deductions prevailing during

Alternatively, it may be assumed that assessable incomes increase in proportion to the rate of inflation and that deductible expenses incurred in earning that income rise in proportion to the inflation rate. The two assumptions

are equivalent.

1

23

1974-75, a 20 per cent increase in net income results in a

22.3 per cent increase in taxable income. Taxable income

expressed as a proportion of net income increases from 89.6

per cent to 91.3 per cent. Even assuming a tax system with

a proportional tax rate, this phenomenon is sufficient to

result in increased average tax rates for all taxpayers

initially qualifying for dependant deductions.

3.7 For taxpayers in any given dependant category

(say, taxpayers with dependent spouse and two dependent

children), the proportionate increase in taxable income that

results from an increase in net income varies inversely with

the initial level of net income. That is, low income

earners experience the largest proportionate increase in

taxable income. Any increase in net income represents an

equal absolute increase in taxable income, because the size

of total dependant deductions is a fixed nominal amount.

Hence, the elasticity of taxable income to net income (that

is the proportionate increase in taxable income divided by

the proportionate increase in net income) declines

continuously as the level of net income rises and is

independent of the rate of inflation.

3.8 The size of these elasticities may now be

compared for different dependant categories of taxpayers

with the same level of net income. Suppose that the

experience of the hypothetical taxpayer with a dependent

spouse and two dependent children is compared with that of a

taxpayer identical in all respects except that he has no

24

dependent children. For the latter, an increase of 20 per

cent in net income results in an increase in taxable income

of only 21 per cent, compared with 22.3 per cent for a

taxpayer with a dependent spouse and two dependent children.

Since the level of dependant deductions for a taxpayer with

dependent spouse and dependent children exceeds the level

for a taxpayer with dependent spouse but no children, the

initial taxable income level corresponding to a given

initial net income level is lower for the taxpayer with

dependent children than for the taxpayer without children.

It follows that the ratio of initial net income to initial

taxable income, and hence the elasticity of taxable income

to net income, is higher for the taxpayer with dependent

children. The differential between the elasticities for the

two taxpayer categories is smaller, the higher the level of

initial net income under consideration. The same

conclusions hold for those taxpayer categories with a larger

number of dependants. The higher the aggregate level of

dependant deductions, the larger is the proportionate

increase in taxable income, for any given increase in net

income.

3.9 The Committee concludes from this analysis that

low income, large family taxpayers bear the largest

proportionate increase in taxable income for any given

proportionate increase in net income.

3.10 It remains to examine the implications of

relaxing the simplifying assumption that concessional

25

deductions are only of the form specified above. In the

1974-75 Budget, a tax rebate related to concessional

deductions for dependants was announced for low income

families. The rebate is available to those taxpayers for

whom the tax saving resulting from the allowance of the

dependant deductions equals less than 40 per cent of the

amount of deductions. The tax saving from the allowance of

dependant deductions equals the difference between the tax

payable on taxable income and the tax that would have been

payable in the absence of an entitlement to the dependant

deductions. On the assumption that taxpayers are entitled

to no other deductions, the net income qualifying limits for

this rebate, for various dependant categories, are as

follows:

Taxpayer's Dependant Category Net Income Qualifying Limit

Dependent spouse 7121

Dependent spouse plus one dependent child 7208

Dependent spouse plus two dependent children 7277

Dependent spouse plus three dependent children 7346

Dependent spouse plus four dependent children 7415

3.11 If the assumption is maintained that dependant

allowances form the only deduction available to taxpayers,

the rebate system described above may be viewed as a system

whereby an amount equal to 40 per cent of aggregate

26

dependant deductions is subtracted from a taxpayer's

'notional' tax liability. Notional tax liability is

calculated by reference to a notional taxable income that is

equal to the taxpayer's net income. For instance assume

that a taxpayer has a dependent spouse and two dependent

children, and that his net income equals $5932. His

notional tax liability equals the tax on a taxable income of

$5932 (= $978.24) minus 40 per cent of dependant deductions

($832 x .4 = $332.80). Therefore, his actual tax liability

equals $645.44 ($978.24 - $332.80).

3.12 For those taxpayers whose eligibility for

concessional deductions is confined to dependants, a system

of tax rebates for dependants thus means that their net

income and taxable income are equivalent. Obviously in this

case the elasticity of taxable income to net income equals

unity.

3.13. Finally, consideration is given to

non-dependant concessional deductions. The combination of

inflation and progressive taxation raises no direct problems

in relation to those concessional deductions without a fixed

upper income limit. Insofar as deductions with a fixed

income limit are concerned, problems arise only to the

extent that a taxpayer's expenditures on the relevant items

(life assurance and superannuation payments, education

expenses, etc) are initially close to or above these upper

limits. In this case the concessional deduction becomes

equivalent to a fixed dependant deduction, with the same

27

implications for the elasticity of taxable income to net

income which were described above.

3.14 The second mechanism through which the

combination of inflation and an unchanged personal tax

schedule generates a redistribution of the personal tax

burden is found in the progressive rate scale. Under such a

rate scale (except in the case of the first taxable income

bracket), any increase in taxable income generates a

proportionately greater increase in tax liability. All of

the increased taxable income is subject to a marginal tax

rate at least as high as the highest marginal rate payable

on the initial taxable income level. Consequently, even in

a situation where taxable incomes increase at a rate equal

to the rate of inflation (that is, where real taxable

incomes remain constant), the purely nominal increase in

taxable income results in an increased proportion of any

given real taxable income level being taxed at what was

previously the highest applicable marginal tax rate. The

outcome is an increase in the real tax liability for each

level of real taxable income.

3.15 The ratio of the proportionate increase in tax

liability to the proportionate increase in taxable income

(that is, the elasticity of tax liability to taxable income)

varies as between different levels of real taxable income.

It is important to note that the value of this elasticity at

any real taxable income level does not depend simply on the

value of the marginal tax rate payable on a given taxable

income level. It is determined by the ratio of the marginal

28

rate to the initial average tax rate, where the average tax

rate is defined in terms of taxable income. For this reason

it is not necessarily the case that this elasticity is

higher, the higher the level of real taxable income. It is

also important to note that the values of these elasticities

are not independent of the actual rate of inflation. The

actual marginal tax rate borne by any given real taxable

income level in a specified period varies according to

whether the rate of inflation is such that the inflated

nominal taxable income level associated with the initial

real taxable income level lies within the original taxable

income bracket or within some higher taxable income bracket.

That is, the rate of inflation determines whether the actual

marginal tax rate borne by a given real taxable income level

corresponds to the statutory marginal tax rate applicable to

the taxable income bracket in which that real income falls,

or whether it corresponds to some higher marginal rate.*

3.16 If this bracket-crossing phenomenon is ignored,

the following conclusions emerge regarding the pattern of

elasticities of tax liability to taxable income. Within the

first taxable income bracket, the value of the elasticity is

equal to unity throughout the bracket since the marginal tax

rate and average tax rate (defined in terms of taxable

income) are equal. In the case of higher taxable income

1

This higher marginal rate corresponds to a weighted average of the initial statutory marginal tax rate and the next highest statutory marginal rate.

29

brackets, the elasticity exceeds unity because the marginal

rate exceeds the average rate. Further, within each bracket

the elasticity declines continuously because the marginal

rate is constant throughout the bracket, while the average

rate increases continuously."*" Under the current rate scale,

this means that the elasticity declines continuously for all

taxable income levels in excess of $40,000.

3.17 Chart III-l shows the pattern of these

elasticities for the January 1975 rate scale and Table III-l

sets out the data upon which the chart is based. The

pattern is quite remarkable. The zig zag pattern reflects

the phenomenon which has been described above, whereby the

elasticity declines within each taxable income bracket. If

attention is confined to the value of the elasticity at the

lower income level of each bracket, however, it is clear

that this value of the elasticity declines as income levels

rise. Viewing the income scale as a whole, there is a very

marked inverse relationship between the size of the taxable

income level and the value of the elasticity. That is to

say, for any given general proportionate increase in taxable

incomes, the proportionate increase in tax liability is

higher the lower the initial level of income. This pattern

reflects the steep progression in marginal rates of income

tax, especially in the lower income ranges, and is worthy of 1

1 But the higher the income level within the bracket, the greater is the possibility of this income level being moved into the next income bracket by inflation. The closer the initial income level to the upper limit of the bracket,

the greater is the proportion of any given increase in nominal income falling in the next income bracket.

30

elasticity c h a r t i i i - i

Elasticity of Tax Liability to Taxable Income, 1974-75

2 . 5 - -

1 · 5 - -

5 6 7 8

Taxable income $>· ooo

31

TABLE III-l

Elasticity of Tax Liability to Taxable Income 1974-75 Rate Scale, single Taxpayer

Taxable Income Level

Elasticity of Tax Liability to Taxable Income

$

2000 3.50

2500 2.33

3000* 2.73

3500 2.19

4000* 2.48

4500 2.13

5000* 2.35

5500 2.10

6000* 2.28

6500 2.08

7000* 2.23

7500 2.06

8000* 2.11

9000 1.88

10000* 1.87

11000 1.73

12000* 1.73

13000 1.64

14000 1.57

15000 1.51

16000* 1.59

17000 1.54

18000 1.50

19000 1.46

20000* 1.52

25000 1.38

30000 1.30

35000 1.24

40000* 1.26

50000 1.20

75000 1.12

100000 1.09

Note: *denotes lower income limit of taxable income bracket.

32

some emphasis because it is not a feature common to many

overseas personal tax schedules. To take the case of the

United Kingdom progressive rate scale in 1973-74 as an

example, the elasticities tended to increase with the level

of taxable income up to an income level of approximately

£8,000 (approximately $A14,300 at current exchange rates).

That in large part reflected the fact that the first £4,500

of taxable income was taxed at the high initial flat rate of

33 per cent, while rates of marginal tax in Australia

increase to 44 per cent over the same range of income. In

the case of the 1973-74 United States progressive rate

scale, the elasticities tended to increase up to a taxable

income level of approximately $45,000 (approximately

$A33,200),1

3.18 It should be added that the elasticities of

Figure 1 do not apply to those low income families eligible

for the tax rebate related to dependant deductions.

3.19 The product of the two elasticities discussed

above (the elasticity of taxable income to net income and

the elasticity of tax liability to taxable income) equals

the elasticity of tax liability to net income. This

elasticity shows the proportionate increase in tax liability

This estimate relates to the progressive tax scale applicable to single persons in the United States. Different rate scales are applicable to different dependant categories of taxpayers. For a description of the rate scales in the United States and the United Kingdom, see Taxation Review Committee, Preliminary Report, p. 61.

33

TABLE III-2

Proportionate Increase in Tax Liabilities Taxpayer with Dependent Spouse and Two Dependent Children (a)

Net Income Elasticity of Tax Proportionate Proportionate Level Liability to Net Increase in Increase in

Income Tax Liability Average Tax Rate

$ % %

4000 11.93 238.53 182.11

4500 5.94 118.78 82.19

5000 4.61 92.17 60.23

5500 3.83 76.50 47.07

6000 3.51 70.14 41.82

6500 2.98 59.57 32.98

7000 2.78 55.65 29.68

7500 2.58 51.59 26.32

8000 2.53 50.53 25.48

9000 2.27 45.46 21.21

10000 2.11 42.29 18.56

11000 2.01 40.28 16.88

12000 1.91 38.23 15.20

13000 1.83 36.55 13.79

14000 1.73 34.51 12.11

15000 1.70 34.08 11.73

16000 1.69 33.77 11.45

17000 1.67 33.33 11.11

18000 1.63 32.60 10.50

19000 1.61 32.22 10.17

20000 1.60 31.90 9.92

25000 1.44 28.86 7.40

30000 1.34 26.88 5.71

35000 1.29 25.82 4.86

40000 1.29 25.79 4.81

50000 1.22 24.49 3.73

75000 1.14 22.78 2.31

100000 1.10 22.02 1.69

(a) Assumes 20 per cent increase in nominal income; no non--dependant deductions, 1974-75 rate scale.

34

that is associated with any given proportionate increase in

net income, and thereby determines the pattern of average

tax rate increases for the income range as a whole during

periods of inflation.^ Because the two separate

elasticities tend to decline over the income range as a 2

whole, so too must the product of the two elasticities.

Therefore an egui-proportionate increase in all net income

levels which simply matches the rate of inflation results in

the largest proportionate increase in tax liability (and

hence the largest proportionate increase in the average rate

of tax on net income) falling on the lowest real net income

level. Table III-2 sets out the elasticities of tax

liability to net income for a particular dependant category

(taxpayers with dependent spouse and two dependent children)

along with the implied proportionate increases in tax

liabilities and average tax rates on net income, on the

assumption of a purely nominal 20 per cent increase in net

incomes in a given income year.

3.20 These differing proportionate increases imply a

redistribution of the tax burden as between different levels

of real net income. The legislated tax schedule specifies

If e denotes the elasticity applicable to a given real net income level, and p denotes the rate of inflation, the proportionate increase in the average tax rate for that real income level equals __p . 7.

1+p " }

If non-dependant deductions are ignored, the elasticity of tax liability to net income equals the elasticity of tax liability to taxable income for single taxpayers.

35

that a real net income level of $10,000 for this category of

taxpayers should bear a tax liability almost seven times as

large as that on a real net income level of $5,000.

Following a purely nominal 20 per cent increase in net

incomes, the multiple is just above five. More substantial

changes are found if a comparison is made between real net

income levels which diverge to a greater extent, as is

likely to happen if the time horizon is extended beyond a

single income year.

3.21 The combination of inflation and an unchanged

personal tax schedule also results in a redistribution of

tax burden as between different dependant categories of

taxpayers. Table III-3 compares the proportionate increase in

the average tax rate borne by single taxpayers, and

taxpayers with dependent spouse and two dependent children,

at different levels of net income. The Table reveals that,

as a result of the reduction in the real value of the

dependant deductions, the proportionate increase is

invariably greater for the taxpayer with dependants.

3.22 Such a result comes about for two reasons.

First, as noted above, where the allowance for dependants

takes the form of a fixed deduction from net income, the

elasticity of taxable income to net income always exceeds

unity. For single taxpayers without dependants, this

elasticity is equal to unity. Secondly, the taxable income

level is lower for the taxpayer with dependant deductions

than for the single taxpayer, and hence a different

36

TABLE III-3

Proportionate Increase in Average Tax Rates for Different Taxpayer Categories (a)

Net Income Level

$

Proportionate Increase in Average Tax Rate

Single Taxpayer Taxpayer with Dependent Spouse and Two Dependent Children % %

2000 2500 3000 3500 4000 4500 5000 5500

6000 6500 7000 7500 8000 9000 10000 11000

12000 13000 14000 15000 16000 17000 18000 19000 20000

25000 30000 35000 40000 50000 75000 100000

41.75 22.17 28.79 22.98 24.57 22.42 22.57 21.87 22.32 21.30 21.51 19.83 18.51 15.77 14.50

13.13 12.13 10.59 10.10

9.98 9.89 9.22

9.00 8.82 8.67 6.28 4.92 4.31 4.39

3.33 2.08 1.51

182.11 82.19 60.23 47.07 41.82 32.98 29.68 26.32 25.48 21.21 18.56 16.88 15.20 13.79 12.11 11.73 11.45 11.11 10.50 10.17

9.92 7.40 5.71 4.86 4.81

3.73 2.31 1.69

Note: (a) Assumes purely nominal 20 per cent increase^in ^ net income; no non—dependant deductions, 1974—75 rate scale.

37

elasticity of tax liability to taxable income is applicable.

Given the overall inverse relationship between the value of

these elasticities and the level of taxable income, the

married taxpayer is likely to face a higher elasticity of

tax liability to taxable income.

3.23 The combined effect of these two factors is

thus likely to make taxpayers with dependants experience

larger proportionate increases in average tax rates than

single taxpayers. This in turn means that inflation is

likely to redistribute the tax burden as between different

taxpayer categories, the large family taxpayer category

being most adversely affected. Dependant deductions may be

viewed as equivalent to a taxable income bracket subject to

a marginal tax rate of zero. Inflation serves to reduce the

real value of this bracket. When the allowance for

dependants takes the form of a tax rebate, the foregoing

analysis needs to be modified, but the basic conclusions are

not altered. This is confirmed by Table III-3, in which the

calculations in the relevant income ranges take account of

the tax rebate.

3.24 The Committee now makes a final observation in

relation to the mechanisms of tax burden redistribution. It

was assumed above that nominal incomes adjust fully and

instantaneously to the rate of inflation. This assumption

was made for expositional purposes only and the conclusions

are not dependent on the assumption. If, for example, it is

assumed that nominal incomes do not adjust at all to the

38

rate of inflation, average tax rates do not change. But

this does not alter the fact that the average tax rate on

every level of real income, for every dependant category,

has increased. The real income of all taxpayers has

declined, but each taxpayer continues to be taxed at the

same average tax rate to which he was subject when real

incomes were higher.

Alternative Criteria for the Measurement of Tax Burden Redistribution ‘

3.25 From the viewpoint of horizontal and vertical

equity, proportionate changes in average tax rates provide

one criterion for measuring the redistribution of the tax

burden caused by the combination of inflation and an

unchanged personal tax schedule. In terms of the

distribution of the tax burden as between different real

income levels, if an equi-proportionate increase in average

tax rates occurs at all real income levels, then the

distribution of the tax burden reckoned in these terms

remains unchanged. For example, if legislated average tax

rates specify that a real income level of $4,000 must bear a

tax liability four times that on a real income level of

$2,000, this relationship is preserved following an

equi-proportionate increase in average tax rates (of the

kind which results from a percentage tax levy of the type

which has frequently been employed in Australia and other

countries). The same result holds true for the distribution

of the tax burden as between different dependant

categories. If, at the legislated set of average tax rates,

39

a taxpayer with a dependent spouse and with a real income

level of $4,000 bears a tax liability equal to two-thirds

that of a single taxpayer with the same real income level,

this relationship is maintained if both taxpayers experience

an equi-proportionate increase in average tax rates.

3.26 Nevertheless, there are important aspects of

the relationship between inflation and personal taxation

other than those directly related to equity. For analysis

of these other aspects, alternative criteria may be more

appropriate. If the implications of the relationship

between inflation and taxation were to be examined for wage

fixation purposes, for example, then it might be more

appropriate to examine changes in real disposable incomes

resulting from an unchanged personal tax schedule during the

inflationary period. From the viewpoint of stabilisation

policy generally, indeed, changes in real disposable incomes

would seem to provide a more appropriate criterion than

proportionate increases in average tax rates. (Disposable

income is income net of tax.)

3.27 Table III-4 sets out the proportionate decreases

in real disposable incomes for two taxpayer categories that

result from a purely nominal 20 per cent increase in net

incomes, assuming that the January 1975 tax schedule is

operative. Clearly a rather different, albeit no less

complex, pattern of redistributive effects among different

real income levels emerges. Given the assumption that

nominal incomes increase at a rate equal to the rate of

40

TABLE III-4

Proportionate Decrease in Real Disposable Incomes for Different Dependant Categories of Taxpayers fa")

Net Income Proportionate Decrease in Real Disposable Level Single Taxpayer Taxpayer with ]

$ %

Spouse and Two Dependent Chili %

2000 1.72 —

2500 1.40 -

3000 2.27 0.20

3500 2.30 3.31

4000 2.88 4.06

4500 3.11 4.18

5000 3.54 4.49

5500 3.93 4.79

6000 4.46 5.23

6500 4.76 5.02

7000 5.28 5.22

7500 5.37 5.28

8000 5.45 5.65

9000 5.42 5.68

10000 5.58 5.80

11000 5.62 5.96

12000 5.66 5.98

13000 5.37 5.94

14000 5.47 5.66

15000 5.74 5.90

16000 5.98 6.12

17000 5.88 6.25

18000 6.03 6.25

19000 6.17 6.38

20000 6.30 6.50

25000 5.46 5.88

30000 4.81 5.21

35000 4.59 4.84

40000 4.95 5.16

50000 4.21 4.51

75000 3.07 3.31

100000 2.41 2.61

Note: (a) See footnote to Table III-3

41

inflation, the percentage increase in nominal disposable

income is always less than the rate of inflation, since the

marginal tax rate always exceeds the average tax rate for

any income level. Real disposable incomes thus decline as a

result of inflation. For incomes that remain within the

same taxable income bracket during inflation, the

proportionate increase in nominal disposable income is

larger, the higher the initial level of income. Clearly

this phenomenon implies that, for incomes initially above

the lower limit of the top taxable income bracket, the

percentage increase in nominal disposable income varies

positively with the initial level of income.

3.28 This intra-bracket phenomenon has become

substantially more important as a result of the significant

widening of taxable income brackets in the 1974-75 Budget;

the number of taxable income brackets in the rate scale was

reduced from twenty-nine to fourteen.^" Indeed, it could

become more important in the future if the recommendation of

the Taxation Review Committee that the number of brackets be 2

reduced still further is accepted. The greater the width

of taxable income brackets, the greater is the range of

taxable incomes over which there exists an inverse

relationship between the initial real income level and the

The same number of taxable income brackets was retained in the January 1975 tax rate schedule.

Full Report, para. 28.16.

42

proportionate change in real disposable income. The

following conclusion of the Australian Treasury (based on

the 1973-74 rate scale) remains valid, but the figures need

to be changed somewhat in the light of recent rate scale

changes:

"Up to certain income levels the effect of inflation is to reduce disposable income by a greater percentage as taxable income rises because under a progressive tax system disposable income increases at a smaller percentage rate than taxable income".1

3.29 To the extent that the intra-bracket phenomenon

is ignored, that conclusion also remains tenable for a given

dependant category t>f taxpayers. Insofar as the

redistribution of the tax burden between different dependant

categories is concerned, the two criteria do not conflict.

On the basis of both proportionate increases in average tax

rates and proportionate decreases in real disposable income,

the large family taxpayer category is most adversely

affected by inflation.

Tax Burden Redistribution and Tax Equity

3.30 It remains for the Committee to examine the

significance of the redistributions described above in

relation to the equity of the personal tax system. It is

customary to distinguish two dimensions of equity -

horizontal and vertical. Horizontal equity is concerned

with the notion that it is fair that persons in the same

1

Personal Income Tax - The Rate Scale, Treasury Taxation Paper No. 4, October 1^74, Australian Government Publishing Service, Canberra, 1974, p. 12. '

43

situation should pay the same taxes. Vertical equity

involves the notion that persons in different situations be

differently treated, those more favourably placed being

required to pay more tax.

3.31 It is generally accepted that income is not an

ideal indicator of whether individuals can be considered to

be 'in the same situation' for purposes of personal

taxation:

'Further argument is required before it can be concluded that two individuals should pay identical taxes because their incomes are the same. They will certainly be dissimilar in a great many other respects.

Some of these differences would be considered irrelevant for tax purposes by almost everyone ... but others (such as size of family) are widely felt to be very relevant indeed.Ί

More specifically:

'.. a taxpayer on $6,000 per annum will have a different capacity to pay depending on whether he is single or has a dependent wife and children; his so-called "discretionary income" is less in the latter case.'2

3.32 The term discretionary income derives from the

Report of the Royal Commission on Taxation in Canada, in

which it was recommended that discretionary income (or

discretionary economic power) be adopted as the appropriate

base for personal taxation. Discretionary economic power

was defined as:

Full Report of the Taxation Review Committee, para. 3.12.

Personal Income Tax : Personal Allowances, op. cit., p . '7. :

2

44

the residual power to command goods and services for personal use after providing the "necessities" of life and after meeting family obligations and responsibilities.11

The role of deductions (sometimes called exemptions) is to

convert, however imperfectly, gross income into

discretionary income:

'.. exemptions are defended mainly on the grounds that a rigorous application of the ability-to-pay doctrine requires that taxes be based on clear income rather than total income.'2

3.33 The Australian Treasury also refers to such a

view as a possible justification for deductions:

'.. The case for the deduction system rests mainly on the proposition that it is not gross income but discretionary income which is the appropriate measure of ability to pay ..

.. The case for the deductions given above is consistent with the idea of capacity to pay tax not beginning until the taxpayer has enough income to meet them ("essential needs").13

3.34 The deduction system therefore is a major

instrument for achieving horizontal equity in the personal

Report of the Royal Commission on Taxation, Queen's Printer, Ottawa, 1966, Volume 1, p.5.

2

Harold M. Groves, Federal Tax Treatment of the Family, The Brookings Institution, Washington D.C., 1963, p. 23. Groves's concept of clear income (p. 10) would appear to coincide precisely with the discretionary income concept described above:

'.. income minus an uncertain allowance to the taxpayer of personal expense money deemed sufficient to maintain himself and his dependants according to some conventional standard ... it (is) argued that ability to pay begins only after these allowances have been covered'.

3

Personal Income Tax : Personal Allowances, op. cit., p. 8-9.

45

tax system. On the basis of the 1974-75 values of dependant

deductions, for example, the personal tax system treats a

single taxpayer earning $8,000 per annum as having the same

capacity to pay taxes as a taxpayer with a dependent spouse

and two dependent children earning $8,832 per annum;

consequently they pay the same amount of tax.

3.35 The instrument for achieving vertical equity is

the progressive rate scale itself. If the low income family

tax rebate is ignored, the legislated 1974-75 rate schedule

provides that a taxable income of $12,000 per annum should

bear a personal tax liability slightly greater than nine

times the tax liability on a taxable income of $4,000. As

emphasised by the Taxation Review Committee, it is relative

tax totals rather than absolute tax totals that are

important from the equity viewpoint;

'The central and sensitive question here (concerning the appropriate degree of progressivity) is that of the relativity of one individual's tax bill to another's. In analysing this issue it is unavoidable to proceed by

comparing the total taxes they pay, but the argument is probably about the differences between the totals rather than about the totals themselves.1

If inflation did not disturb legislated relative tax

liabilities, then it could not be said that inflation had

violated the legislated vertical equity prescriptions.

3.36 Two important implications follow from the

views of equity above. First, it is consistent for the

legislated equity prescriptions, both horizontal and

1 Full Report para. 4.3.

46

vertical, to be maintained over time within a context of

general increasing personal tax burdens. The legislated

equity prescriptions will be maintained if the revised tax

schedules maintain the desired relative tax totals between

different real income levels and different dependant

categories. The second implication is that the combination

of inflation and an unchanged personal tax schedule is

extremely unlikely to produce such a result, because it is

unintended and not systematically related to the initial

distribution of the tax burden at different levels of real

income. The most likely result is that low income, large

family, tax units will bear disproportionately large

increases; and thereby legislated equity prescriptions are

violated. Legislated equity prescriptions would only be

maintained if the personal tax schedule were adjusted for

inflation or if explicit changes were made in the rate

schedule.

3.37 If conventional notions of horizontal and

vertical equity are expressed in terms of relative tax

totals, it follows that changes in relative tax totals (or

changes in relative average tax rates) may be regarded as

the appropriate indicators for the purpose of analysing the

impact of inflation on the equity of the personal tax

system. Under this approach, legislated equity

prescriptions are also maintained within the context of a

generally increasing personal tax burden if inflation

adjustment is accompanied by a proportionate tax levy

47

equivalent to an equi-proportionate increase in marginal tax

rates. Nevertheless, it has been argued that a more

appropriate indicator of equity aspects of the combination

of inflation and personal taxation is to be found by

examining proportionate changes in real disposable income

(i.e. income net of tax)

3.38 This view of personal tax equity implies

maintenance of the relative real disposable income levels

associated with the different levels of real net income for

the different dependant categories under the legislated tax

schedule. As noted above, the interplay of inflation and an

unchanged personal tax schedule involves a violation of this

notion of equity also. It thus follows that, whatever view

is taken of horizontal and vertical equity, explicit

adjustments for the effects of inflation on the distribution

of the tax burden are necessary if the legislated view of

the equitable distribution of the tax burden is to be

preserved.

3.39 It should be noted that conventional forms of

adjustment for the effects of inflation will restore the

legislated relative real disposable income levels. Viewed

within a context where an increase in the overall burden of

personal taxation is not required, the differing views of

This argument was used by Geoffrey Brennan in a study paper prepared for the Committee: On Indexing the Personal Income Tax Rate Scale, p. (Γ· see also Personal Income Tax - The Rate Scale, op. cit., p. 12.

48

equity may be regarded as being largely irrelevant to the

question of adjustment for the effects of inflation.

However, viewed within a context where an increase in the

overall burden of personal taxation is required, the

alternative view of equity (based on changes in real

disposable income) presents some problems. In order to

maintain relative real disposable income levels under

conditions which provide for (a) adjustment of the personal

tax schedule for the effects of inflation, and (b) a demand

for an increase in the overall personal tax burden, what is

required is not a general levy on tax payable but a general

levy in the form of a constant percentage of initial

post-tax incomes.1

3.40 This means that, on this alternative view of

equity, increments in aggregate personal taxation are not to

be financed by a structure of taxation that is consistent

with the legislated progressive personal tax structure.

Rather that structure must be changed by levying incremental

taxation proportionately to existing post-tax incomes. Such

a levy is still progressive in terms of pre-tax incomes, but

not to the same extent as a straight surcharge on the

existing progressive rate schedule.

3.41 The foregoing discussion does not deny that,

where significant increases in the aggregate personal tax

ratio are required, adjustments may need to be made to the

1 Personal Income Tax - The Rate Scale, op. cit., p. 15.

49

initially legislated distribution of the personal tax

burden. It is in this context that an observation of the

Australian Treasury has relevance:

'.. it is possible to double the taxes of a person paying 10 per cent of his income in tax; a person paying 50 per cent, however, cannot be similarly treated* . - * ·

If a doubling of the aggregate personal tax burden is

required, then some restructuring of relativities is

inescapable. If only relatively small changes in total tax

collections are required, however, proportionate changes in

average tax rates may be appropriate. This is not

inconsistent with the Treasury observation that legislated

equity prescriptions may not remain tenable in the face of a

steep rise in aggregate personal tax collections.

3.42 Other arguments have sought to rebut the claim

that, in past years, inflation-induced redistributions of

the personal tax burden have violated legislated equity

prescriptions. One such argument is that, during the period

from 1954-55 to 1969-70, failure to adjust tax rates for the

effects of inflation was itself a 'discretionary* adjustment

of the personal tax schedule, which reflected the preferences

of Australian society. This argument implies that not only

did societal preferences regarding tax burden distribution

change during this period, but that the particular changes

wrought by the interplay of inflation and the unchanged

personal tax schedule were precisely those changes preferred

1 Personal Income Tax - The Rate Scale, op. cit., p. 12.

50

by society. Whether such changes were intended is

impossible to know. But the Committee notes the view of the

Taxation Review Committee on this matter:

'The general increase in average tax rates over the past twenty years has been accompanied by a change in the distribution of income tax liability. Two aspects of this change were noted in Chapter 6. First,

inflation has narrowed the width of tax brackets in real terms and altered the tax liability of individuals depending on the marginal rate applicable in the region of their taxable income. The resulting change in the distribution of tax liabilities has been arbitrary and it would be fortuitous indeed if it corresponded exactly with Government intentions. Secondly, dependant allowances have been eroded. To the extent that dependant allowances have failed to keep pace with

inflation, the income earner with a larger family has become worse off in relation to somebody with the same income but a smaller family or no family at all. Here, too the redistribution of tax liabilities has not been deliberately sought, and again it would be surprising-

if it reflected the wishes of Government.'i

3.43 The Committee has also noted that, in

introducing a personal tax indexation scheme in Canada, the

Minister of Finance described the scheme as one which would

correct effects that were not simply "unfair", but also

"unintended".

3.44 The argument that the distributional changes

wrought by inflation were fully perceived (and therefore fully

intended) suggests that, if an inflation adjustment scheme

had been in operation during the past twenty years, explicit

discretionary adjustments of the personal tax schedule would

have produced the same changes which were achieved

implicitly as a result of inflation. As far as dependant

1

Full Report, para. 14.42 (emphasis added).

51

deductions are concerned, this would have involved an

explicit reduction in the spouse deduction over the period

1955-56 to 1969-70, from an inflation-adjusted average

nominal level of $348 to the actual average nominal level of

$296. Similarly the average reduction in the deduction for

the first child would have been from $209 to $192. This

analysis could be extended by showing the explicit increases

in marginal tax rates which would have been required to

maintain the same personal tax structure within a system of

inflation adjustment. But the Committee recognises that

this argument is, by its very nature, incapable of proof.

That notwithstanding, the review of the explicit changes

which would have been required lends support to the view of

the Taxation Review Committee that it would have been

'fortuitous indeed' if the inflation induced changes had

'corresponded exactly with Government intentions’. It is

therefore arguable that it is unlikely that the implicit

changes would have been legislated explicitly had an

inflation adjustment scheme been in operation.

3.45 In this context, the Committee has noted the

Australian Treasury's view of the policy implications which

would have resulted from the operation of an inflation

adjustment scheme during the period since 1954-55. The

Treasury argued that one or more of the following three

policy options would have been a necessary corollary of such

a scheme s

(a) discretionary personal tax increases in

association with the scheme;

52

(b) reductions in Government expenditure; and

(c) increases in other forms of taxation.

Option (c) will be examined below; the discussion here is

confined to options (a) and (b). As regards option (a), the

Treasury argued that the superimposition of discretionary

adjustments on an inflation adjustment scheme would create

'obvious problems','*' without mentioning what these problems

were. Presumably, they would include the difficulties which

would face a Government introducing discretionary tax

increases at the same time as tax rates were being

automatically reduced to adjust for the effects of

inflation. In its submission, the Treasury argued that:

'to preclude or render difficult changes in the effective burden of personal income tax, especially in periods when the share of the government sector in total expenditure is increasing, would unnecessarily constrain the freedom of fiscal action of the goverment.'2

As regards option (b), the Treasury had earlier commented:

'Some of the proponents of the automatic adjustment mechanisms under consideration here see the possibility of such an outcome as one of the strongest arguments for such mechanisms. In effect, they argue that

governments cannot be trusted to refrain from expanding expenditure in line with 'inflation-induced' increases in income tax revenues, and that automatic adjustment mechanisms would apply some hobbles to that alleged propensity.'3 * 2

Personal Income Tax - The Rate Scale, op. cit, p. 17-18.

2 Ibid, p. 18.

3

Ibid, p. 18.

53

However, the Treasury concluded that such arguments imply:

a limited faith, to say the least, in the effectiveness of democratic processes.1

In discussing this question in its submission, the Treasury

argued that:

1.. much depends on the importance governments attach to their expenditure programs. If they consider that such programs must go ahead, tax indexation cannot reduce the overall level of taxation - it merely

involves relying less on income tax and more on other forms of tax. Indexation is therefore inseparably bound up with wider questions of taxation policy.1

3.46 The Committee believes that critics of personal

tax indexation cannot have the argument both ways. If the

democratic process has worked well, with Government

expenditure and personal tax outcomes being those desired by

society, then it is by no means clear why the explicit

personal tax increases or other changes necessitated by

indexation would have been difficult to achieve or would

have created obvious problems. It seems to the Committee

that those who claim that discretionary income tax

adjustments would have created severe problems provide

hostages to those who argue that Governments have a vested

interest in inflation. In this connection, the Taxation

Review Committee commented:

1 The windfall yield of tax drift is not without attractions for Governments: extra revenue is obtained without the odium of lifting tax rates by legislation.'2

1

2

Ibid, p. 18.

Full Report, para 6.40.

54

If the past twenty years had happened to be a period of .

price stability, precisely the same explicit tax rate

increases would have been needed as might have been

associated with an indexation scheme under the conditions of

inflation which actually prevailed. In these circumstances,

the question needs to be asked whether explicit personal

tax increases would have been 'difficult', 'raised obvious

problems', or 'constrained the freedom of fiscal action'?

If the answer is negative, the Committee believes that

critics of personal tax indexation need to show why the

situation is different in the context of an indexation

scheme. If the answer is in the affirmative, then doubts

are raised about the effectiveness of the democratic

process. The response of Government expenditures to

increasing personal tax revenues is considered in some

detail in a later section.

3.47 It remains to consider the third alternative

mentioned above, involving increases in other forms of

taxation, particularly indirect taxation. It is frequently

asserted that indirect taxation is intrinsically

inequitable, and that any shift in the balance of total

taxation away from direct taxation towards indirect taxation

necessarily reduces the equity of the total tax system. If

indirect taxes need to be substituted for personal income

taxes as a result of indexation, any decrease in equity

associated with the higher indirect taxation must therefore

be weighed against any equity gains associated with the

indexation.

55

3.48 The proposition that personal taxation is a

more equitable form of taxation than indirect taxation is

not unrelated to the question of relative balance between

the two forms of taxation:

1A rational Government will always use first the means of finance that involve the lowest marginal social costs. That is, tax with the lowest of such costs will be among the first to be implemented. When this first tax reaches a certain level of revenues, however, the marginal social costs of its further use may begin to

exceed those of another. This is where the first tax reaches its capacity. 1^

Although this observation is not confined to equity aspects,

it is relevant to the issue of equity. Given a particular

balance between personal taxation and indirect taxation at a

point in time it may be that, from an equity point of view,

personal taxation is the appropriate instrument with which

to effect increases in total tax revenues. Obviously this

conclusion need not hold for other points in time or for

different personal tax and indirect tax balances. The Committee

notes that the Taxation Review Committee has recommended

that 1 the weight of taxation should be shifted towards the

taxation of goods and services and away from the taxation of

income'.2

3.49 The Committee’s conclusions with respect to the

effects of inflation on the distribution of the tax burden

are:

Amotz Morag, On Taxes and Inflation, Random House, New York, 1965, p~

2 Preliminary Report, p. 145.

56

(a) whatever measure of distribution is considered

most appropriate, inflation results in a

violation of legislated horizontal and vertical

equity prescriptions;

(b) the low income, large family taxpayer

categories are likely to be the categories most

adversely affected by the resulting change in

the distribution of the tax burden;

(c) it is unlikely that the personal tax

redistributions caused by inflation will be

those intended or preferred by society;

(d) the same aggregate personal tax revenues can be

raised in a manner consistent with legislated

equity prescriptions; and

(e) to the extent that increases in other forms of

taxation are substituted for personal taxation,

it cannot necessarily be concluded that the

change in the tax mix is inappropriate from the

viewpoint of overall equity in the tax system.

Effects on the Size and Mix of Total Taxation

3.50 The combination of inflation and unchanged

nominal tax rates for the tax system as a whole is likely to

result in substantial changes in both the overall size of

total tax collections and in the relative contribution of

each of the major taxes to total tax collections. Changes

in total tax collections during the past twenty years are

examined in the next section. Consideration is then given

57

to each major type of tax and, in particular, to the likely

impact of inflation on their relative yields.

Total Tax Collections

3.51 Table III-5 records the total tax receipts of

the Australian Government between 1954-55 and 1973-74, and

expresses these totals as proportions of Gross Domestic

Product (G.D.P.). It will be seen that revenue from

taxation has increased from 18.5 per cent of gross domestic

product in 1954-55 to 21.4 per cent in 1973-74. It is

estimated to increase further to between 23 and 24 per cent

in 1974-75. In order to analyse the contribution of

inflation to this trend, it is necessary to consider the

influence of each of the major taxes, and the impact of

inflation on the yields of each form of taxation. The

Committee has noted the comments of the Taxation Review

Committee on the increasing proportion of total taxes to

Gross Domestic Product:

'.. While several factors have contributed to this upward trend, the tendency for inflation to push taxpayers into higher income tax brackets more quickly than otherwise has undoubtedly been responsible in no

small measure.11

Personal Income Taxation

3.52 The earlier discussion concentrated on the

effects of inflation on the distribution of the personal tax

burden. It was noted that the redistributions occur

independently of the actual response of nominal incomes to

1

Full Report, para. 6.40.

58

TABLE III-5

Total Australian Government Tax Receipts as a Proportion of Gross Domestic Product, 1954-55 to 1973-74

Year Total Tax Total Tax Receipts

Receipts (a) as a Proportion of

G.D.P.

$m %

1954-55 1778 18.5

1955-56 1903 18.3

1956-57 2093 18.5

1957-58 2217 19.2

1958-59 2153 17.3

1959-60 2377 17.4

1960-61 2702 18.6

1961-62 2680 18.0

1962-63 2717 16.9

1963-64 3045 17.1

1964-65 3591 18.4

1965-66 3968 19.4

1966-67 4219 18.7

1967-68 4662 19.4

1968-69 5199 19.3

1969-70 6011 20.2

1970-71 6803 20.8

1971-72 7684 21.1

1972-73 8271 20.1

1973-74 10648 21.4

Notes: (a) Comprise personal income tax, company customs and gift and excise

duties.

duties , sales tax,

Source: Budget Papers for the relevant years.

59

inflation. Movements in the aggregate personal tax ratio

depend on the response of those nominal incomes that

comprise the base for personal income taxation. Such

movements reflect not only changes in the total nominal

income base but also the manner in which the changes are

distributed over the range of nominal incomes.

3.53 Such information as is available seems to

suggest that inflation has not resulted in any significant

change in the pre-tax distribution of income. It therefore

seems reasonable to assume, for purposes of the following

discussion, that all nominal net incomes increase at a

proportionate rate equal to the rate of inflation.

Aggregate personal tax revenues are of course also affected

by real income growth, and by growth in the taxpaying

population. The growth of the taxpaying population is not

independent of the rate of inflation. This is because the

faster the rate of inflation the greater is the number of

people with initial nominal net incomes below the minimum

level of taxable income who become liable for tax.

Nevertheless, for simplicity the following discussion

concentrates on the effects of purely nominal income

increases.

3.54 On the basis of the assumption that has been

made about the response of nominal incomes to inflation, the

average tax rate of every taxpayer increases during a period

of inflation. Also, some individuals who were initially

exempt from tax now bear a positive average tax rate. These

60

results, which imply an increase in the aggregate personal

tax ratio, are a consequence of the property of the

progressive tax schedule whereby the average tax rate

increases continuously with the level of nominal net income.

The results occur whether or not inflation lifts a

taxpayer's nominal net income into a higher marginal tax

bracket than the initial one (although obviously this does

happen for some taxpayers). Where a taxpayer's nominal income

does not adjust at all to the rate of inflation, his

personal tax ratio remains unchanged but is associated with

a lower level of aggregate real income than previously.

3.55 The foregoing discussion needs to be qualified

in two important respects. In the first place, under the

provisional tax system, tax collections in a given tax year

are based not on current income but on income of the

previous tax year. This means that, insofar as provisional

tax is concerned, tax collections in a given tax year tend

to reflect the inflationary experience of the previous year

rather than that of the current year. Secondly, the

personal tax schedule has not remained unchanged in

Australia during the past twenty years. Between 1954-55 and

1969- 70, there were some relatively minor changes involving

mainly surcharges and rebates of tax payable. However, in

1970- 71 provision was made for reductions of approximately

10 per cent of tax payable up to a taxable income of

$10,000, and for progressively diminishing reductions in tax

payable above that level to 4.4 per cent at $20,000 and to

zero at $32,000. The rate scale was again adjusted in

61

1972- 73 to provide an overall reduction of about 10 per cent

in total tax collections, but the adjustment was structured

so that the percentage reduction in tax payable decreased as

income rose. Two further adjustments were made in 1974-75,

providing substantial reductions in nominal rates for

incomes below $10,000.

3.56 These changes notwithstanding, the growth in

personal tax revenues has, on any reckoning, been huge over

the past twenty years. As Table III-6 shows, total (net)

personal tax collections in nominal terms have increased

from $723 million in 1954-55 to $5,490 million in 1973-74.

Personal tax collections in 1974-75 are estimated at $7,635

million, 39.1 per cent in excess of 1973-74 collections

despite two substantial reductions in personal tax rates

during 1974-75. The aggregate personal tax ratio has

increased from 7.5 per cent in 1954-55 to 11.0 per cent in

1973- 74, and is estimated to increase to almost 13.0 per

cent in 1974-75.

Company Income Taxation

3.57 Because Part Two of this Report is concerned

with the implications of inflation for company income tax,

the topic is not discussed here.

Indirect Taxation

3.58 There are many categories of taxation that may

be regarded as falling under the general heading of indirect

taxation, including: sales taxes; import, export, and

excise duties; local rates; entertainment taxes; betting

62

Year

1954- 55 1955- 56 1956- 57

1957- 58 1958- 59 1959- 60 1960- 61

1961- 62 1962- 63 1963- 64 1964- 65 1965- 66 1966- 67 1967- 68 1968- 69 1969- 70 1970- 71 1971- 72

1972- 73 1973- 74

Notes:

TABLE III-6

Australian Government Personal Tax Receipts — 1954-55 to 1973-/4"

Personal Tax Receipts $m .

723 774 807 870

778 884 1037 1075 1083 1272 1571 1731 1923 2177 2379 2858 3178 3769 4089 5490

Aggregate Personal Tax Ratio (a) %

7.5 7.5 7.1 7.5 6.3 6.5 7.1 7.2 6.7 7.1 8.0 8.4 8.5 9.1 8.8 9.6 9.7 10.4

9.9 11.0

(a) Ratio of Receipts to Gross Domestic Product

Budget Papers for the relevant years Sources:

63

taxes; business licences; stamp duties; motor vehicle

taxes; and licence fees for wireless and television sets

(eliminated in the 1974-75 Budget). The common denominator

of these taxes, which generally fall on goods or services,

is the existence of a market price which is different from

the factor costs of producing the goods or services in

question. Attention is confined here to the Australian

Government's excise duties and wholesale tax.

3.59 The major excise duties in Australia take the

form of fixed nominal amounts of duty per unit of quantity.

If these nominal amounts remain unchanged during a period of

inflation, the real value of the duty declines. The likely,

but not necessary, result is a fall in the real value of

aggregate excise duty revenue. The result is not a

necessary one, because a fall in the real value of the duty

may be associated with a fall in the relative price of the

commodity subject to duty, thereby generating an increase in

consumption of that commodity. But the result is likely,

given the low price elasticities of demand for the major

commodities subject to excise duty in Australia (beer,

tobacco products, gasoline).

3.60 The real value of aggregate excise duties has

not in fact declined over the past twenty years, for two

main reasons. First, and most obviously, the growth

reflects the increasing consumption of commodities subject

to excise duty. Secondly, part of the growth reflects

64

discretionary changes in the nominal value of the excise

duties themselves."*"

3.61 Australian Government sales tax is levied at the

wholesale level on an ad valorem basis. During inflation,

revenue yields can therefore normally be expected to

increase automatically in line with the rate of inflation.

The share of the wholesale sales tax in total tax

collections has declined since 1954-55, for two main

reasons. First, increasing exemptions have served to narrow

the sales tax base. Secondly, many goods subject to sales 2

tax have been reclassified to lower rated categories.

Estate and Gift Duties

3.62 Australian Government estate and gift duties

are levied at progressive rates. If the nominal values of

exemptions and rate brackets are not altered during a period

of inflation, revenues from estate and gift duties can be

expected to increase disproportionately. Due to the

relative unimportance of these revenues in aggregate

Australian Government revenues (0.7 per cent in 1973-74),

they are not considered here. A full account of past

movements in estate and gift duty revenues, and of the

For an account of these changes, see Commonwealth Taxation of Goods and Services, Treasury Taxation Paper No. 5, Australian Government Publishing Service, Canberra, 1974, pp. 1-5.

For a fuller discussion of these issues, see the Full Report of the Taxation Review Committee, paras 27.5 to 27.7, and Appendix A to Chapter 27.

2

65

contribution of inflation to these trends, may be found in

the Full Report of the Taxation Review Committee.^"

Changes in the Mix of Australian Government Taxation

3.63 The foregoing brief survey has enabled the

Committee to reach the following conclusions about the

relationship between inflation and total taxation. Even if

it can be assumed that no changes in tax legislation will

take place during a sustained period of inflation, no

a priori conclusions can be drawn as to the likely impact of

inflation on the ratio of total taxation to G.D.P. The

reason is that the impact of inflation on the yield from any

particular form of taxation depends, inter alia, on whether

that tax is levied at progressive, proportional or specific

rates. Information is required concerning the initial

relative weights of each type of taxation in total taxation;

in particular, the weight of progressive taxes relative to

that of specific taxes. However, conclusions can be made as

to the likely change in the mix of the various taxes in

total taxation, regardless of changes in total taxation.

The likely conclusion is that, ceteris paribus, the relative

weight of progressive taxes will increase and the relative 2

weight of specific taxes will decrease.

^ Ibid., Chapter 24.

2

The ceteris paribus caveat is necessary because many factors other than inflation can influence the mix of the various taxes. Inevitably, some taxes are more elastic with respect to real income growth than others. Longer

term changes, such as shifts in the age structure of the population and changes in consumption tastes, are also possible. The discussion puts these factors to one side in order to isolate the effects of inflation.

66

3.64 Once discretionary tax changes are allowed for,

any result becomes possible. If the discretionary changes

are exclusively designed to fully offset the effects of

inflation then, ceteris paribus, the initial relative

weights of the various forms of taxation will be maintained.

If the discretionary adjustments only partially offset the

effects of inflation, then the change in the tax mix will

conform to the general pattern that has been outlined above.

3.65 These points should be borne in mind in

examining Table III-7, which shows the changing

contributions of the major taxes to total taxation in

Australia between 1954-55 and 1974-75 (estimated). There

have been substantial discretionary tax changes over this

period, only a few of which seem to have been primarily

directed towards offsetting the effects of inflation. Real

incomes have changed substantially in this period, as have

other relevant factors such as the age structure of the

population and consumption patterns.

3.66 The dominant trend revealed by Table III-7 is

the dramatic increase in the relative contribution of

personal income taxation to total taxation, increasing from

40.7 per cent of total tax collections in 1954-55 to 51.6 per

cent of total tax collections in 1973-74. The share of

personal income taxation is expected to increase further in

1974-75. Despite the significant nominal tax rate

reductions announced in the 1974-75 Budget, personal income

taxation estimates at that time implied that the share of

67

TABLE III-7

Composition of Australian Government Tax Receipts, 1954-55 to 1974-75

Personal Company Customs and Sales Estate Year Income Income Excise Duties Tax and Gift Total

Tax Tax Duties

% % % % % %

1954-55 40.7 19.3 27.5 11.3 1.3 100.0

1955-56 40.7 19.6 26.9 11.6 1.3 100.0

1956-57 38.6 20.7 27.3 12.0 1.4 100.0

1957-58 39.2 19.4 27.5 12.4 1.4 100.0

1958-59 36.1 20.4 28.7 13.3 1.4 100.0

1959-60 37.2 19.3 28.3 13.8 1.4 100.0

1960-61 38.4 20.9 26.6 12.8 1.3 100.0

1961-62 40.1 21.1 26.2 11.1 1.5 100.0

1962-63 39.9 19.1 27.9 11.5 1.5 100.0

1963-64 41.8 19.3 26.8 10.7 1.5 100.0

1964-65 43.7 19.7 25.1 10.1 1.4 100.0

1965-66 43.6 20.2 25.8 9.3 1.1 100.0

1966-67 45.6 18.6 25.7 9.0 1.2 100.0

1967-68 46.7 17.9 25.0 8.9 1.4 100.0

1968-69 45.8 19.4 24.0 9.5 1.3 100.0

1969-70 47.5 19.2 22.5 9.4 1.3 100.0

1970-71 46.7 20.5 22.3 9.3 1.1 100.0

1971-72 49.0 19.2 21.9 8.9 1.0 100.0

1972-73 49.4 18.9 21.5 9.2 0.9 100.0

1973-74 51.6 18.4 20.3 9.0 0.7 100.0

1974-75(est)55.2 17.9 18.3 8.0 0.6 100.0

Source: Figures for 1974-75 were estimated from data in the 1974-75 Budget and revised personal tax data supplied by the Commissioner of Taxation. Figures for all other years were derived from the relevant Budget papers.

68

personal tax revenues in total tax revenues would increase

to 56.2 per cent. Since that time a further reduction in

personal tax rates has been announced, operative for the

whole of the income year 1974-75 but reflected in

pay-as-you-earn (PAYE) deductions from the beginning of

calendar year 1975. Despite the seemingly large rate

reductions, aggregate net personal tax revenues are

estimated to be only 4 per cent below the original Budget

estimate. If it is assumed that there will be no change in

estimates of other tax revenues, the share of personal tax

revenues in total tax revenues will equal 55.2 per cent in

1974-75.

3.67 The rapid increase in the share of personal

income tax has been accompanied by a substantial decline in

the share of customs and excise duties from 27.5 per cent in

1954-55 to 20.3 per cent in 1973-74, with a further

estimated decline to 18.3 per cent in 1974-75. Sales tax

has followed a similar trend, while the share of company

taxation has fallen from 19.3 per cent to 18.4 per cent in

1973-74 and an estimated 17.9 per cent in 1974-75.

3.68 Two issues remain to be discussed. The first

is the contribution of inflation to changes in the tax mix,

and the second is the implications of these changes. It has

been suggested above that many factors have helped to

produce the pattern revealed in Table III-7. Inflation has

certainly been an important factor because discretionary

personal tax changes over the period were not sufficient to

fully offset the effects of inflation. It is not possible

69

to conclude that inflation has been the prime causal factor,

because it may have been possible for personal taxation to

play the same relative role even in the presence of personal

tax indexation. Nevertheless, it seems reasonable to

conclude that inflation has been the most important enabling

factor in the vastly increased relative role of personal

taxation during the past twenty years.

3.69 The second issue concerns the implications of

substantial changes in the tax mix. Economic theory

provides few, if any, clues as to what mix of taxes may be

regarded as 1 optimal1. Nevertheless, arguments in favour of

maintenance of a 'balanced tax structure' may be supported

on the grounds that large and rapid changes in the tax mix

require significant adjustments on the part of all economic

agents within society. These adjustments are themselves not

costless. Further, there may be significant increases in

net costs of collection, to the extent that an increased

weight of personal taxation involves the introduction of a

large number of new taxpayers at low income levels.

Finally, to the extent that income taxation in general tends

to be less conducive to saving than consumption taxation, a

change in the tax mix towards income taxation may depress

savings.

Effects on the Allocation of Resources

3.70 The Committee now examines the effects of

inflation and taxation on resource allocation, with special

reference to the growth of the public sector and incentive

effects within the private sector. The preceding section

70

showed that inflation has been an important enabling factor

in the rapid rise in total tax collections experienced over

the past twenty years. This has in turn facilitated rapid

increases in government expenditures over the same period.

Table III-8 records government expenditures for the period

from 1964-65 to 1974-75, and also expresses these

expenditures as percentages of Gross National Expenditure

(G.M.E.). It will be seen that the ratio of government

expenditures to G.N.E. has increased from 23.3 per cent in

1964-65 to 25.3 per cent in 1973-74 , and is estimated to

increase to almost 28 per cent in 1974-75.

The Relative Size of the Public Sector

3.71 The question to be considered here is the

contribution made by the combination of inflation and

personal taxation to the increase that has occurred in the

relative size of the public sector. Resolution of this

issue necessarily involves counter-factual argument. In

essence, the question is whether it is likely that the

relative expansion of the public sector would have proceeded

at the same rate had the inflation-induced increase in

personal tax revenues not been forthcoming. Two alternative

standards of comparison are possible. Either it can be

assumed that the period from 1954-55 was one of price

stability or, slightly more realistically and more relevant

to this inquiry, that a personal tax indexation scheme was

operating throughout the period. Clearly, the very nature

of counter-factual arguments renders them incapable of

71

verifiable proof. Discussion of this issue is deferred

until Chapter VII.

TABLE III-8

Australian Government Expenditure as a Proportion of Gross National Expenditure, 1964-65 to l974-T5~Tal

Year Australian

Government Expenditure

$m

Government Expenditure as a Proportion of Gross National Expenditure

%

1964-65 4652 23.3

1965-66 5179 24.7

1966-67 5754 25.3

1967-68 6371 25.9

1968-69 6789 24.8

1969-70 7589 25.5

1970-71 8321 25.4

1971-72 9285 25.8

1972-73 10412 26.3

1973-74 12558 25.3

1974-75 (est.) (b) 16440 27.9

Notes: (a) The expenditure series shown is the most comprehensive available for Australian Government authorities. It is not available on a consistent basis for earlier years.

(b) An increase of 18.6 is assumed. per cent in G.N.E.

Source s Treasurer's Budget 1974-75, Table 5, p Speech and Statements, . 126.

72

Resource Allocation Within the Private Sector

3.72 This subsection briefly examines the

implications, for the allocation of resources within the

private sector, of the interplay between inflation and an

unchanged personal tax schedule. The discussion is brief,

because most of the literature on this subject concerns the

implications of increasing marginal and average rates of

personal taxation, whatever the reasons for the increases.

That is to say, the effects discussed below may well occur

under an indexed personal tax system accompanied by

continuous discretionary tax rate increases. They are not

necessarily exclusive to inflation-induced tax rate

increases. Subject to this important caveat, the following

discussion is concerned with the implications of increasing

average and marginal tax rates for incentives to work, and

incentives to avoid taxation.

3.73 The combination of inflation and an unchanged

personal tax schedule increases the average tax rate on each

real income level and, over time, increases the marginal tax

rate imposed on each real income level. A higher average

tax rate reduces a taxpayer's disposable income; this

income effect increases the pressure on the taxpayer to work

more. A higher marginal tax rate reduces the net monetary

reward to be earned by an extra hour's work, thereby

decreasing the relative price of leisure and exerting a

substitution effect in favour of less work effort. Hence on

73

a priori grounds it is not possible to conclude whether

increased personal taxation will increase or decrease work

effort.

3.74 However, as the Australian Treasury has noted:

'.. commonsense reasoning suggests that the higher are marginal rates of tax in relationship to average rates of tax, the more is the substitution effect likely to outweigh the income effect1.1

Table III-9 shows how the relationship between average and

marginal rates of tax has been changing since 1954-55 for an

individual on average weekly earnings. It is interesting to

note that the 1974-75 tax rate changes have resulted in the

average tax rate on average earnings remaining constant

compared with 1973-74, while the marginal tax rate has

increased sharply from 35.7 per cent to 44.0 per cent. This

is one of the rare occasions since 1954-55 that the marginal

tax rate on average earnings has been more than twice the

average tax. The other point of interest in Table III-9 is

that, on present trends, maintenance of the current rate

scale in 1975-76 will result in a taxpayer on average

earnings being subject to a marginal tax rate of 48 per

cent. These developments imply that the issue of the

relationship between personal taxation and work incentives

may now need to be given more attention. This is not to

deny that institutional arrangements may limit the scope for

individual variations of work effort and that psychological

and sociological forces play an important role in the work

1 Personal Income Tax - the Rate Scale, op. cit., p. 25.

74

effort of many individuals. Nevertheless, the Committee

considers that the recent and prospective changes referred

to above are so striking as to require special note.

TABLE III-9

Rates on Average Earnings, 1954-55 to 1975-76(a)

Ratio of

Average Average Marginal Marginal

Year Annual Tax Rate Tax Rate Tax Rate to

Earnings Average Tax

Rate

$ % %

1954-55 1799 9.7 17.5 1.8

1955-56 1924 10.3 19.2 1.9

1956-57 2012 10.7 21.7 2.0

1957-58 2070 11.0 21.7 2.0

1958-59 2132 11.3 21.7 1.9

1959-60(b) 2304 11.5 20.6 1.8

1960-61 2413 12.5 24.6 2.0

1961-62(b) 2475 12.2 23.4 1.9

1962-63(b) 2543 12.5 23.4 1.9

1963-64(b) 2678 13.0 23.4 1.8

1964-65 2876 14.5 27.1 1.9

1965-66(c) 3011 15.5 27.8 1.8

1966-67(c) 3219 17.2 30.3 1.8

1967-68 (c) 3406 17.0 30.3 1.8

1968-69(c) 3661 18.0 32.9 1.8

1969-70 (c) 3968 19.2 32.9 1.7

1970-71(d) 4410 18.8 32.7 1.7

1971-72 (e) 4836 20.4 36.0 1.8

1972-73(f) 5278 19.1 33.3 1.7

1973-74 6136 21.3 35.7 1.7

1974-75(g) 7500 21.3 44.0 2.1

1975-76(g) 9000 25.6 48.0 1.9

Note: (a) No concessional. deductions have been allowed for (b) 5 per cent rebate (c) 2h per cent levy (d) New tax schedule, plus 2^ per cent levy (e) 4.375 per cent levy (f) New tax schedule (g) Based on estimated average earnings contained in

the Treasury submission to this Committee, and assuming the 1 January 1975 rate scale remains in force.

Based on Table 60, Full Report of the Taxation Review Committee (op"I cit. ). S o u r c e :

75

3.75 With regard to the issue of inflationary as

opposed to real income growth, it is possible that the

income effect will be stronger when the increase in income

reflects a purely nominal income increase rather than an

increase in real income. In the former case, the increased

average tax rate serves actually to decrease the taxpayer's

real disposable income, whereas in the latter case the

increased average tax rate merely reduces the rate of growth

of the taxpayer's real disposable income. When nominal

incomes do not adjust to inflation, it is also possible that

there will be a net increase in work effort. This is

because the taxpayers will have suffered a de facto increase

in average tax rates; their real incomes will have declined

but they will continue to bear the average tax rates

applicable to their earlier higher real incomes. However,

the marginal tax rate facing each taxpayer will not have

changed, so that only the income effect will be operative.

3.76 As marginal rates of tax increase, so also do

the rewards from tax avoidance and tax evasion. There may

be substantial, albeit inconspicuous, economic waste

involved in the alteration of investment and employment

decisions in order to avoid income taxes. Investment

decisions are likely to favour projects on the basis of

their post-tax yield, when other projects nay have higher

pre-tax yields. There nay be a shift of employment into

areas where non-monetary rewards are hiohcst; there is thus

an incentive to avoid jobs associated with smoke, dirt.

76

noise or danger, and to seek jobs offering explicit tax-free

fringe benefits. There may also be a more general shift

towards activities involving income in kind rather than

money income. This may take the form of do-it-yourself

activities (such as working on one's own home, garden or

car), rather than earning money incomes and buying services

from specialists. It may also take the form of barter

transactions in goods and services. The artist may pay the

dentist with a painting, while the bricklayer and plumber may

help each other to build their houses.

3.77 While there is no empirical evidence to support

the view that increasing personal income tax has reduced the

incentive to work, all of the studies of this issue were

undertaken before the rapid acceleration of the inflation

rate. Consequently, it needs to be borne in mind that the

changed economic circumstances may render the earlier

studies irrelevant.

Effects on Macroeconomic Stability

3.78 The Committee now turns to an examination of

the effects of inflation and taxation on macroeconomic

stability, with special reference to budgetary implications,

built-in stability and wage effects.

Effects on the Government Budget^-3.79 This section examines the likely implications

for the Government budget of the combination of inflation

1

For a very useful discussion of this subject, see A.R. Prest, 1 Inflation and the Public Finances', Three Banks Review, March 1973.

77

and an unchanged statutory tax structure. For simplicity,

it is assumed that nominal incomes increase in line with the

rate of inflation, implying that there is zero growth in

real incomes.

3.80 Consider first the likely response of total tax

revenues. On the basis of the foregoing tax mix discussion,

as a first approximation it may be expected that the

increase in personal income tax and estate and gift duties

will be more than proportionate, the increase in company tax

and sales tax will be roughly proportionate, and the

increase in excise duties will be less than proportionate.

The response of total tax revenues will depend on the

relative weight of each category of taxation in total

taxation. Given the dominant weight of personal taxation in

total taxation in Australia, the likely result is a more

than proportionate increase in total tax revenues.

3.81 These broad generalisations appear to be

confirmed by a study carried out by the Committee's research

staff concerning the elasticity of the Australian tax system

between 1954-55 and 1971-72. Table III-10 sets out the

results of that study, which was based on methodology first

developed by Professor A.R. Prest and since refined in work

done in the International Monetary Fund."*"

See, for example, A.R. Prest, "The Sensitivity of the Yield of Personal Income Tax in the United Kingdom", Economic Journal, Vol. LXX II (1962), pp. 576-96; and Charles Y. Mansfield, "Elasticity and Buoyancy of a Tax

System; A Study of Paraguay", IMF Staff Papers, XIX, No. 2., July 1972, pp. 425-46.

78

The Buoyancy and Elasticity of the Australian Tax System, 1954-55 to 1971-72

TABLE III-10

Elasticity Buoyancy

Form of Taxation Current GDP Lagged GDP Current GDP Lagged GDP

Personal Income Tax 1.41 1.45 1.30 1.34

Company Income Tax 1.04 1.07 1.08 1.11

Sales Tax Excise

0.90 0.92 0.81 0.83

Duties Estate

0.64 0.65 0.93 0.95

and Gift Duties 1.15 1.19 0.96 0.99

Total Tax 1.05 1.08 1.11 1.14

3.82 The figures in the Table should be interpreted

as the percentage change in the amount of tax collections

that result from a one per cent change in nominal G.D.P. The

elasticity measures are estimates of the proportionate

response of each tax if the 1970-71 statutory tax structure

had applied over the period from 1954-55 to 1970-71. The

buoyancy measures are estimates of the actual average

response over the period, taking account of the

discretionary tax changes that were made during the period.

Estimates were based on lagged as well as current G.D.P., in

79

recognition of the fact that the income base for some forms

of taxation (company taxation, provisional taxation) is

income of the previous, rather than the current, income

year.

3.83 These estimates are not directly relevant to

the discussion in this section, partly because they are

already somewhat dated but mainly because they compound the

effects of real and purely nominal income changes. The

prime concern here is with inflationary developments. As

regards personal income taxation, there is no a priori

reason to expect that the proportionate response of revenues

will be different in the case of real income growth as

opposed to that of purely nominal income growth. This

proposition implicitly assumes either that inflation affects

the pre-tax distribution of income in the same manner as real

income growth, or that inflation and real income growth

affect the pre-tax distribution in different ways, but that

these differences cancel out so that no differential impact

on aggregate personal tax revenues occurs. As will be

discussed in more detail below, empirical studies concerning

the effects of inflation on the pre-tax distribution of

income have suggested that the effects of inflation are

exceedingly modest. The same conclusion is suggested by the

small amount of empirical testing which has been carried out

on the impact of real income growth on pre-tax

d i s t r i b u t i o n . I t therefore seems reasonable to assume that

See W.H.L. Anderson, 1 Trickling Down: The Relationship Between Economic Growth and the Extent of Poverty Among American Families’, Quarterly Journal of Economics, November 1964; and E7 Thurow, ’Analyzing the American

Income Distribution', American Economic Review, May 1970.

80

the elasticity of personal income taxation is the same for

both nominal income growth and real income growth.

3.84 As regards sales taxation, the real income

elasticity may exceed the nominal income elasticity, because

higher real income can lead to increased consumption of

relatively highly taxed items (such as motor cars,

jewellery, furs, cosmetics). In the case of excise duties,

on the other hand, nominal income elasticity may exceed real

income elasticity. Higher nominal incomes may induce

increased consumption of goods subject to excise duty,

because their relative prices tend to decline during

inflation. As noted earlier, however, the low price

elasticity of demand associated with the major commodities

subject to excise duty tends to exert an opposite influence.

3.85 The foregoing brief analysis suggests that

there are no strong grounds for assuming that the overall

elasticity of the tax system is very different for real

income growth as opposed to purely nominal income growth.

Before considering the impact of inflation on government

expenditure, the Committee adds a cautionary note concerning

the relevance of the estimates in Table III-10 to the

current situation. Discretionary changes to the

progressivity of the personal tax schedule over the past few

years have increased the buoyancy of the personal income

tax. In 1973-74, for example, the estimated buoyancy of

personal tax revenues with respect to nominal net incomes

was equal to 1.8, compared with 1.3 in the Table.

Discretionary changes to the personal tax schedule in

81

1974-75, by increasing the ratio of marginal tax rates to

average tax rates, served to increase the estimated buoyancy

to 2.1. Further, the increased weight of personal taxation

in total taxation has tended to increase the buoyancy of

total tax receipts above that implied by Table III-10.

3.86 In considering government expenditures, it is

again necessary to distinguish real income changes from

nominal income changes. When changes in real income take

place, it is necessary to allow for what is termed the

relative price effect. This effect results from the fact

that productivity increases in the public sector are

generally smaller than productivity increases in the private

sector, so that an unchanged share of the public sector in

G.D.P. at constant prices implies an increase in the share

at current prices. If the analysis is confined to a purely

nominal increase in income, however, this phenomenon can be

put to one side. Rather the question is whether inflation

is likely automatically to generate a proportionate increase

in government expenditures which is less than, equal to, or

greater than the automatic increase in revenues.

3.87 Empirical evidence about the relationship

between inflation and government expenditures is almost

non-existent. One study, carried out for the United States,

concluded that government expenditures do increase in line

with the rate of inflation, but with a lag.^ The prices of

Nancy Teeters, "Built-in Flexibility of Federal Expenditures", Brookings Papers on Economic Activity, No. 3, 1971. See also A.H. Packer, "The Two Way Relationship Between the Budget and Economic Variables", American Economic Review, May 1971.

82

goods purchased by the government are likely to increase

roughly in line with the rate of inflation. Also, public

sector wages and salaries may be expected to move roughly in

line with increases in private sector wages and salaries.

It may also be expected that the real value of public

service pensions will be maintained. However, not all

transfer payments are subject to prompt adjustment and those

inversely related to levels of money income may actually

decline in real terms. Grants to various institutions may

not adjust without a considerable lag, and the real cost of

debt servicing is likely to decline unless interest rates

adjust fully for increases in the rate of inflation. For

many significant items of expenditure, then, expenditure

growth is unlikely to increase more than proportionately to

the rate of inflation.

3.88 Having said that, the Committee notes that

several important components of Australian Government

expenditure are effectively indexed. This is true of

financial assistance grants from the Australian Government

to the States. These grants are determined by a formula

under which the grant paid to each State in each financial

year is calculated by taking that State's grant for the

previous year and:

(a) increasing it by the percentage change in the

population of that State during the year ending

31 December in the year of payment;

83

(b) increasing the amount so obtained by the percentage

increase in average wages for Australia as a whole for

the year ending 31 March in the year of payment; and

(c) increasing this amount by a betterment factor of 1.8

per cent.

It is important to note that, since 1966-67,

item (b) has been calculated on the basis of the percentage

increase in average wages for the year ending March in the

year of payment, rather than for the preceding financial

year. Thus to the extent that wages adjust fully to the

current rate of inflation, and the Statistician's estimate

of the increase in average wages is reasonably accurate,

then there is no significant lag in the adjustment of grants

to the rate of inflation. Financial assistance grants

comprised 15 per cent of total government outlays in 1973-74

and are estimated to be over 14 per cent in 1974-75.

3.89 As mentioned in the Preface, the Committee

sought the views of the respective State Governments on its

terms of reference. Only two State Governments, South

Australia and Tasmania, responded to the invitation, and no

State raised the possibility that personal income tax

indexation may, in the long run, tend to restrict the rate of

growth of revenues available for payment to the States.

Canadian reaction to personal tax indexation is particularly

interesting in this regard, in that several Provinces have

criticised the effects of indexation on their finances. The

Province of Quebec, which levies its own personal tax, has

84

decided not to index its tax. A recent study carried out

for the Ontario Government concluded that Ontario would

suffer a revenue loss of 4 per cent of the Provincial

personal income tax yield in 1974 as a result of indexing,

and that the compounded loss would rise to about 20 per cent

by 1980. The study suggested that similar effects would

apply to all other Provinces with tax agreements with the

Federal Government, but that the indexing losses would be

2

relatively greater in the low income Provinces.

3.90 Social security and welfare outlays, which also

may be expected to adjust fully to the rate of inflation,

comprised over 20 per cent of total Australian Government

outlays in 1973-74, and are expected to be over 21 per cent

of total outlays in 1974-75.

3.91 Two areas of government expenditure, which may

be expected to adjust fully to the rate of inflation, thus

currently comprise over one-third of total government

outlays. However, the response of the remaining two-thirds

of government expenditure to the current inflation rate

remains uncertain.

The Committee has noted the comments of officials of the Province of Ontario on indexation. See Brian Hull and Lawrence Leonard, "Indexing the Personal Income Tax: An Ontario Perspective", Canadian Tax Journal,

July-August 1974, Vol. XXII No. 4, pp. 3Vo-7.

Ontario Tax Studies 9, The Dynamic Impact of Indexing the Personal Income Tax, Ministry of Treasury, Economics and Intergovernmental Affairs, Toronto, 1974.

85

3.92 It may be argued that government expenditures

are heavily concentrated on services, so that their prices

tend to rise more rapidly than prices in the economy as a

whole. However, such an argument relies on the differential

productivity argument which was outlined above, and which is

relevant to the real income growth case. Differential

productivity changes are undoubtedly associated with

differential increases in the prices of goods and services

over time. The analysis here, however, is concerned solely

with the effects of inflation. What is there in the process

of inflation itself which leads to the prices of services

rising relative to the prices of goods? It may be argued

that inflation tends to increase the price of labour

relative to that of capital, and because services are labour

intensive the relative price of services tends to increase.

3.93 If inflation does cause an increase in the

relative price of labour, then the conclusion is valid. But

it is by no means obvious that inflation generates such a

result. The cost of any finished good or service, no matter

what the capital-labour ratio, can only resolve itself into

two sources of costs: payments to labour and payments to

capital. That is, the costs of any good or service can

ultimately be decomposed into labour costs and interest

charges.^" So long as labour costs and interest charges

adjust similarly to the rate of inflation, the relative

price of labour to capital remains unchanged.

For a more detailed exposition of this point see E.J. Mishan, Twenty-one Popular Economic Fallacies, Allen Lane, The Penguin Press, London, 1969, pp. 44-51.

1

86

3.94 Thus it seems that the automatic response of

government expenditures to inflation (the term automatic

being taken to imply no special action by the government

other than the responses described above) may well be less

than proportionate to the inflation rate, and almost

certainly less than the proportionate response of government

revenues (depending on the importance of income tax in the

revenue system).

3.95 This conclusion is consistent with the more

general phenomenon referred to in the economic literature as

1 fiscal drag'. Fiscal drag refers to the tendency of an

increase in aggregate money incomes automatically to

generate an expansion of government revenues in excess of

the expansion of government expenditures. The analysis of

fiscal drag has usually concentrated on the issue of real

income growth, comparing the automatic change in revenues

(an automatic increase due mainly to the progressiveness of

the personal income tax) with the automatic change in

expenditure (usually concentrating on the reduction in the ! i i · '

payment of unemployment benefits associated with declining

unemployment). However, the preceding analysis suggests j

that the same broad conclusions are likely in the case where

the increase in money incomes reflects a purely nominal

increase.

Implications for Macroeconomic Stability

3.96 Conventionally, the tendency for progressive

personal taxation to generate, in response to any increase

in money incomes, a more than proportionate increase in

87

personal tax revenues has been regarded as unambiguously

desirable. This is because it has been seen as contributing

to the built-in stability of the economic system. Rising

money incomes have been regarded as a symptom of an

increasing pressure of demand on available resources. It

has been assumed that automatic personal tax rate increases

reduce disposable incomes in the private sector, thereby

diminishing the pressure of demand. Conventional analysis

has assumed that the additional tax revenue will be frozen

and will not lead to additional government spending.

3.97 Contemporary experience has provided three

important challenges to this conventional wisdom:

(a) increasing money incomes do not necessarily indicate a

state of generalised excess demand throughout the

economy;

(b) increased personal tax rates may not have a restraining

effect on disposable incomes, because of trade union

responses to the increased rates; and

(c) it cannot be automatically assumed that the additional

tax revenue will be frozen.

An attempt will be made to evaluate each of these arguments

in turn.

The Differential Lags Argument

3.98 In industrial countries, a change in aggregate

demand tends to produce a prompt adjustment in real

activity, while price-level adjustments tend to be delayed

and distributed over a number of future periods. There is a

huge body of empirical evidence in support of this

88

proposition. The lagged relationship between real activity

and prices is neither a new phenomenon, nor one that holds

only during periods of rapid inflation. In most developed

countries since World War II, the relationship between real

activity and the price level has consistently confirmed the

existence of a significant lag. This was confirmed for

eleven O.E.C.D. countries during the period from 1956 to

1 2

1966; in general the lag was at least a year. The

pattern was remarkably similar in all countries;

'...the pressure of demand in the labor market, as measured by the statistics of unemployment, responds to changes in the pressure of demand in the markets for goods and services only after some delay. The wage-cost increases which develop during periods of

excess demand, particularly for labor, also take time to be reflected in increases in the prices of goods and services.'3

3.99 The O.E.C.D. study was distinctly partial in

that it involved estimation of single wage and price

equations. However, the evidence from fully articulated

Canada, United States, Japan, Belgium, Denmark, France, Germany, Italy, Netherlands, Norway, and the United Kingdom.

See O.E.C.D., The Growth of Output 1960-80, Paris, December 1970, Appendix VII.

Ibid., p. 102. For supporting evidence see; Arthur M. Okun, "Fiscal-Monetary Activism; Some Analytical Issues", Brookings Papers on Ecoomic Activity 1:1972; R.J. Gordon, "Inflation in Recession

and Recovery", Brookings Papers 1:1971; L.C. Andersen and K.M. Carlson^ "A Monetarist Model for Economic Stabilization", Federal Reserve Bank of St Louis, Review, April 1970; and papers by Klein, Hirsch, de Menil and Enzler, and Hymans in O. Eckstein (ed.), The Econometrics of Price Determination Conference, Board of Governors of Federal Reserve Systems, Washington, D.C., 1972.

89

macroeconomic models confirms the trend revealed by the

O.E.C.D. study. Consider, for example, the sequences of

adjustment revealed by the econometric model developed by

the Australian Treasury and the Australian Bureau of

Statistics. One published study using this model has

examined the effects on selected endogenous variables of a

sustained increase of $50 million in government current

spending at constant prices. The model suggests that real

gross non-farm product responds promptly. In turn this

prompts an increase in desired employment, but because of

adjustment lags the response of actual employment is

relatively slow. However, the average earnings response is

slower still; and the consumption price response,

indicative of all price response, is most gradual of all."1 "

These results are fully consistent with the results of 2

econometric models for other developed countries.

See C.I. Higgins and "V.W. Fitzgerald, 'An Econometric Model of the Australian Economy', Journal of Econometrics, 1 (1973), pp. 229-265.

Compare, for example, the results from the econometric model that is commonly regarded as the most highly developed currently in existence - the Bank of Canada's RDX2 model. Two simulations are published in

J. Helliwell et. al., 'The Structure of RDX2 - P a r t i 1, Bank οΐ" Canada Staff Research Studies No. 7, T57T7 One involves an increase in government expenditure, the other an appreciation of the Canadian

dollar. As regards the first "...the tendency of peak effects on prices and wages to lag the peak effects on constant dollar expenditure by approximately a year implies that peaks in current-dollar expenditure equations generally lag their real counterparts"

(p. 250). For the second simulation; "The maximum reduction in real incomes occurs in the third year. Prices and wages move downward with a lag and do not reach their trough until the fifth year." (p. 252) For a policy based upon such a lag, see also J.V. Jump and T.A. Wilson, "Tax Policy Options for Increasing Employment Without Inflation", Canadian Tax Journal, March-April, 1972.

90

3.100 It remains to consider the implications of this

impressive body of evidence for the combination of inflation

and an unchanged personal tax schedule. The major

implication is that, as a result of the delayed price

response to the real output response:

'...the effect of the price changes on the revenue yield of the tax system is itself potentially destabilising'.

3.101 This result occurs because taxes increase

rapidly in response to an inflation induced by demand

pressures which have occurred in the past, at the same time

as real output falls in response to a current slackening of

demand.

Thus:

'the different timing of price changes caused by inflationary pressures can cause fiscal policy to behave perversely relative to what is appropriate'.

J. Bossons and T.A. Wilson, "Adjusting Tax Rates for Inflation", Canadian Tax Journal, XXI, No. 2, March-April 1973, p. 190.

Ibid., P. 191. Without citing all of the supporting evidence, it can be safely stated that models of the United States economy tend to suggest that today's wage and price behaviour is largely determined by events of the past. A single example which is cited here, because of the concern of this Report with taxation, is the use by Lawrence R. Klein of the Brookings model. Klein sought to ascertain how the economy would have been affected if a 1964 tax reduction had been introduced in 1961. Klein found that the G.N.P. deflator rose less rapidly in the first year (1961) than if the tax cut had not taken place, but that it rose more rapidly in the second year (1962) as a consequence of the stimulus provided by the tax reduction. See L.R. Klein, "Econometric Analysis of the Tax Cut of

1964", in J.S, Duesenberry, e t a l ., The Brookings Model: Some Further Results, Rand McNally & Co, Chicago, 1969, Chapter 13. '

91

3.102 That is to say, a rising price level causes the

real value of taxes to rise under an unindexed system, so

that eventually excess demand is eliminated. However, the

problem of lagged price adjustment does not disappear. The

price level continues to rise even after demand is no longer

excessive. Money income therefore continues to rise and so

also does the real value of taxes. This depresses output

and employment. The problem is that the real value of taxes

continues to increase so long as money incomes are rising,

not merely so long as excess demand persists. As a

consequence, it cannot be taken for granted that the

unindexed system has desirable automatic stabilising

properties which ought to be preserved.

Wage Retaliation Against Higher Taxation

3.103 According to conventional economic theory, an

increase in personal tax rates reduces private sector

disposable incomes and private sector consumption

expenditures and, through the multiplier process, national

income. Profit maximising behaviour on the part of

individual producers implies readjustments which lead to

lower equilibrium levels of output, employment, and prices.

3.104 Recent experience in industrialised countries

has suggested that conventional theory may be rather too

simplistic, in that employees may well attempt to offset the

effects of higher personal taxation by way of higher gross

wage increases. According to the Economic Council of

Canada:

92

"...increases in direct taxes...may also contribute to price increases - in the case of personal income taxes, perhaps largely through the route of increased wage demands".1

In particular, a widely publicised study conducted in the

United Kingdom regards the distributional effects of

inflation and personal taxation as being an important

ingredient in the 'wage explosion1 that occurred in 1970 and

1971:

"...what appears to be quite a large increase in the earnings of lower paid workers may result in an actual decline in real income...[The] widening in absolute differences in living standards may go (because again of the combined effect of inflation and taxation) much beyond that suggested by differences in the nominal rate of pay increase.

...we have a relationship in which a nominally progressive and "levelling" direct tax system necessarily produces, in the presence of inflation, inegalitarian results.

It is thus clear that the negligible increase in net real wages from 1964 to 1969 concealed a situation in which some groups of workers were experiencing an actual decline in real living standards while others were enjoying a palpable improvement."2

The authors suggest that these developments were directly

contrary to the stated Trades Union Congress policy of

achieving preferential treatment for lower-paid workers, and

were important in provoking widespread industrial unrest and

subsequent inflationary wage settlements:

Economic Council of Canada, Third Annual Review, Ottawa, 1966, pp. 223-24.

Dudley Jackson, H.A. Turner and Frank Wilkinson, 'Do Trade Unions Cause Inflation? 1, Occasional Paper Nol 36, Cambridge University Press, 1972, pp. 93-94.

2

93

"There is clearly all the difference in the world between a situation where everybody's income is rising, but at slightly different rates (which is what the nominal, or even gross real earnings for the 1960's

suggest), and one where some groups' living standards are being cut while relative differences in living standards are being widened. Certainly, in four major disputes of the 1970-71 and 1971-72 winters...it could be reasonably argued that not merely were living

standards for these groups as a whole falling behind the external upward movement, but that important sections among their memberships had experienced a fall in net real income. Relative wage effects (which may not infrequently imply an absolute deterioration for

some employees) may thus have been as important in the wage-explosion of 1970 and 1971 as the probable disappointment of established, average expectations, and to these effects the system of taxation on wages made a major contribution. "·*■

3.105 It seems that, in recent years, several

European governments have taken the threat of wage

retaliation very seriously:

"In Austria, the tax reduction of 1972 was the product of a direct negotiation between the unions and the Austrian Government. In Ireland, there is a "social compact", which concedes that government expenditure

and tax restraint are important elements in securing noninflationary wage behaviour. In Sweden, the Swedish Confederation of Professional Associations... set its wage demands in terms of real take home pay in 1966,

and the Swedish Government eliminated the 5 per cent social security withholding tax in 1973, openly recognising the need for tax relief as a means of reducing wage demands."2

3.106 A crucial distinction should be made between

the situation referred to in the above quotation and the

United Kingdom situation described earlier. The argument

Ibid., pp. 94-95 (their emphasis).

Thomas F. Dernburg, 'The Macroeconomic Implications of Wage Retaliation Against Higher Taxation', International Monetary Fund Staff Papers, November 1974, pp. 759-76(3.

2

94

with respect to the United Kingdom was not concerned simply

with increasing personal tax rates per se, but with the

particular distribution of the increase in the personal tax

burden that was produced by the combination of inflation and

an unchanged personal tax schedule. The situation referred

to in the above quotation, on the other hand, appears to

refer to increased personal tax rates per se, whether these

are produced by inflation or by explicit discretionary

adjustments. From the point of view of personal tax

indexation schemes, this distinction is important.

3.107 Before considering the existence of any

evidence in support of the wage retaliation argument for

Australia, the Committee briefly considers the rationale for

such a phenomenon. Superficially the rationale seems

simple:

"...bigger gross wage increases were required to maintain the accustomed rise of real net earnings - or even, for many groups, to prevent real living standards from falling".!

3.108 However, it is not logical to equate reductions

in real disposable income with reductions in real living

standards without considering the increased government

expenditures which the increased personal taxation makes

possible. In particular, the question must be asked whether

trade union attempts effectively to avoid increased personal 1

1

Jackson, Turner, W i l k i n s o n , Op. c i t . , p. 102.

95

taxation, by bargaining in disposable income terms, imply

that they place a zero or near zero value on the incremental

government expenditures? Is it the case that employees do

not regard expansion of the government sector as being of

substantial benefit to themselves, especially when the

taxpayer and the beneficiary of public services are not the

same person? A related but distinct question is whether

employees are simply unaware of increased government

expenditures as the counterpart of increased personal

taxation?

3.109 Of course, increased personal taxation is not

always accompanied by increased government expenditure. To

the extent that it is accompanied by decreases in other

forms of taxation, the increased personal taxation may

simply represent a change in the tax mix. When taxes are

raised for stabilisation purposes, also, they may not be

accompanied by increased government expenditure.

3.110 Putting these cases to one side, however, if

unions are aware of the benefits flowing from increased

government expenditures it is difficult to see why wage

retaliation against higher personal taxes should take place.

It may be a case of the classic 'free rider' problem in

public finance. An individual union may believe that

avoidance of increased personal taxation by its own members

will not jeopardise the overall increase in the supply of

public goods. This does not seem to be a particularly

plausible hypothesis, unless attempts by individual unions

to shift relativities are themselves regarded as action

96

designed to obtain a 'free ride1 in relation to the benefits

of government expenditure. Success by one significant union

in avoiding increased direct taxation may nevertheless be

expected to generate a chain reaction as other unions

attempt to restore pre-existing relativities. Under these

circumstances, it is not rational for the individual union

to assume that its own action will not affect the overall

increase in the supply of public goods.^

3.111 There have been other explanations for wage

retaliation to personal tax increases induced by the

interaction of inflation and personal taxation. One such

argument has already been referred to, in relation to the

United Kingdom situation in the late 1960s. The

distributional implications of the combination of inflation

and personal taxation frustrate union preferences with

respect to net wage relativities, and hence provoke wage

retaliation. A second argument is that inflation results in

an increase in the personal tax burden above that explicitly

agreed to through the political process, as well as a change

in the distribution of that burden. It may be argued that

there is less compulsion against avoiding unlegislated

increases in personal taxes, than against avoiding

legislated increases.

This argument needs to be qualified to the extent that there exist significant time lags in the adjustment process.

1

97

3.112 The Committee finds it difficult to evaluate

these explanations, but they are discussed here because they

bear directly on the implications of personal tax indexation

for the rate of inflation. This issue is taken up in more

detail in Chapter VII below.

3.113 It remains to examine the relevance of wage

retaliation to higher taxation in Australia. Obviously

attempts to avoid higher personal taxation do not imply that

unions actually succeed in such attempts. Further, wage

settlements which provide the nominal disposable income

increases originally sought do not necessarily mean that the

attempts have been successful. Entrepreneurs possess market

power as well as unions, and subsequent reactions by

entrepreneurs may result in part of the cost being passed

back to employees.

3.114 To the extent that wage retaliation does take

place, its importance is likely to vary over time for at

least two reasons. First, the extent to which retaliation

actually succeeds is not independent of the degree of

tightness or slackness in the labour market. Secondly, wage

retaliation is not likely to be independent of the actual

level of personal taxation. It may well be unimportant when

the marginal tax rate of the average employee is only about

20 per cent; a marginal tax rate of nearly 50 per cent may

well produce a different result.

3.115 In its submission to the Committee, the

Department of Labor and Immigration argued that:

98

"...a significant factor in the acceleration in wage claims over the past twelve to eighteen months and the associated upsurge in industrial unrest has been the necessity for wage earners to seek compensation for the

increased burden of income tax".

The Department acknowledged the absence of any econometric

evidence for Australia to support this view. However the

submission included the following two references to this

issue made by central union organisations.

3.116 A decision of the Australian Council of Trade

Unions Special Conference of Affiliated Unions held in

September 1974, which was endorsed by the A.C.T.U. Executive

on 25 September 1974, stated inter alia;

"Conference expresses its general support for the social concepts and economic strategy contained in the Budget for 1974-75. Particularly on the expenditure

side we welcome the significantly increased outlays, for instance, upon education, health, welfare and urban and regional development. On the receipts side, we congratulate the Government for certain initiatives towards greater equity; for the first time tax cuts mean more in money terms to low and middle than to high

income earners.

However, Conference, in endorsing the submissions put by the ACTU officers to the Government in pre-Budget discussions, asserts that until indexation of taxation is introduced, there can be no adequate protection against the erosive effects of inflation on real after-tax income. This effect has continued to be a

significant factor in the level of wage and salary demands."

A recent statement by the Federal Executive of the Council

of Commonwealth Public Service Organisations (C.C.P.S.O.),

The only econometric evidence of which the Committee is aware is contained in J. Carmichael, "Modelling Inflation in Australia", Paper presented to the Fourth Conference of Economists, Canberra, 19-23 August 1974. The personal tax variables failed to show up as being

significant.

99

which was placed before the Australian Conciliation and

Arbitration Commission in the National Wage Case on 6 March

1975, contained the following paragraph:

"...CCPSO reaffirms its intention to pursue the indexation or adjustment of income tax rates to achieve a reduction there in the extent necessary to retain the real value of indexed take-home pay. If the sought

after income tax reductions to achieve this purpose are not introduced within a reasonable time, CCPSO would support wage claims based on this failure, if they were initiated by affiliates".

3.117 This concern with the impact of the progressive

tax structure on disposable incomes during periods of

accelerating inflation has not been confined to union

organisations. In an address to the Winter School of the

New South Wales Branch of the Economic Society of Australia

and New Zealand held in Sydney in August 1974,

Mr. F.J. Darling, Executive Director of the Employers'

Federation of NSW, commented:

"Without doubt one of the most disturbing elements which has emerged as inflation has spiralled is the demand made by workers for even higher wage increases - higher by far than they would have been to cater only

for the depreciation of money values - to offset the inroads made into the take-home pay by the personal income tax scale."

3.118 However, the Committee notes one problem with

the view expressed by the Department of Labor and

Immigration. During most of the period of the last twelve

to eighteen months, nominal income tax rates have tended to

fall as a consequence of the two substantial downward

discretionary adjustments that have been noted above.

Further, moderation of wage claims was an aim of these

adjustments. In introducing the first adjustment in

September 1974 , the then Treasurer stated:

100

"The Government's appeal for restraint on wages and prices will, I believe, be reinforced by the decisions, particularly on the tax side..."1

The Prime Minister was more explicit when introducing the

second discretionary adjustment in November 1974. He said

this adjustment was designed, inter alia, to:

"...attack inflation by reducing the pressure for wage increases through a substantial improvement in after tax take-home pay".^

While it is not possible to ascertain whether these

discretionary income tax adjustments have had their desired

effect, the Committee notes that there was a marked

deceleration in award wage rates changes in the period

following the tax cut. Further, the 1975 National Wage Case

decision refused to grant the total wage increase for the

increase in the Consumer Price Index in the December

Quarter of 1974.

3.119 Among the organisations which argued that the

existing tax system accentuated inflationary pressures

through its effects on wage demands were:

The Australian Council of Trade Unions; The Council of Commonwealth Public Service Organisations; The Australian Council of Salaried and Professional Associations; the Council of Professional

Associations; The Australian Industries Development Association; The Associated Chambers of Manufactures in Australia; The Metal Trades Industry Association;

Budget Speech 1974-75, Australian Government Publishing Service, Canberra 1974, p. 2.

Statement on the Economy, Speech by the Prime Minister, House of Representatives, November 12 1974, p. 2.

101

The Australian Retailers' Association; the Australian Bankers' Association; The Australian Mining Industry Council; and The Institute of Directors in Australia.

3.120 However, the Committee notes that although most

submissions which discussed the issue argued that high tax

rates were an important factor influencing wage demands, a

contrary view was expressed by the Central Industrial

Secretariat. In a letter following the Committee's meeting

with representatives of the trade union movement and

business organisations, Mr. G. Polites, Director of the

Secretariat, said:

"If inflation is to continue at its present rate and these taxes are to be subject to adjustment because of inflation, there will need to be a continued revision of the tax scales or, alternatively, a sharp drop in Government expenditure.

Having regard to community demands, there seems little likelihood that in this democratic society a reduction in the level of Government expenditure in the social welfare field, where the majority of tax revenue is

spent, will take place in the immediate future.

Accordingly, the prospect of any appreciable reduction in the level of revenue achieved from direct taxes occurring in the foreseeable future is somewhat remote.

We appreciate this may be outside the terms of reference of the Committee but it is a pertinent point having regard to the discussion which seemed to have at its base some belief that indexation would result in a

reduction in tax paid.

In these circumstances, discussion about the likelihood of a reduction in demand for wage increases on the introduction of indexation seems to be of little moment, in view of the improbability of a real

reduction in tax paid overall.

Further, the reality of life is that trade unions have a vested interest in and, indeed, their very survival depends upon their aggressiveness in the pursuit of what they believe to be the best interests of their members, which in general terms means wage increases."

102

Mr. Polites concluded that he considered it unlikely that

unions will moderate wage claims if taxation is indexed.

3.121 In the Committee's view, the most significant

statement on the impact of income taxation on wage increases

was recorded in the 1975 National Wage Case decision. In

that decision, the Australian Conciliation and Arbitration

Commission indicated that wage retaliation has become an

important phenomenon in the wage fixation process in

Australia. The Commission departed from its traditional

practice of arguing that income taxation should be divorced

from wage fixation. In an unprecedented statement, the

Commission said:

"We would add that an important adjunct to indexation, underlined by the trade unions and by the expert witnesses, is the structure of income taxation. It was stressed by the three witnesses who appeared before us that the "tax-bite" must have been an important element

in the size of wage claims in recent times. Professor Hogan, who opposed wage indexation, put it this way:

"It seems reasonable to suggest that some part of wage demands advanced recently, involving substantial percentage increases in pay, are based upon a recognition of the impact of the tax structure as much as anything else. Hence the appropriate techniques for anti-inflationary policy are to be found as much in the fiscal area as elsewhere when handling the wage/cost inflation process. This would involve negotiating and increasing the

relative proportion of total money wages taken home. This "take-home-pay" determines the standard of living of each salary and wage recipient. Accordingly, one major aim of policy would seem to be for progressive reviews of the existing income tax structure so as to curtail the impact of that tax structure on all income groups. It provides a basis on which there is a trade-off between reducing excessive demands for total money wage earnings and an

103

increase in take-home-pay. There is an additional impact here because it reduces the wages cost to firms and other groups in the community."

The need for "progressive reviews" if not income tax indexation was stressed by all the unions as an important part of the overall scheme to moderate wage demands. The Resolution of the ACTU Special Conference on 25 September 1974 stated that "until indexation of

taxation is introduced, there can be no adequate protection against the erosive effects of inflation on real after-tax income. This effect has continued to be

a significant factor in the level of wage and salary demands".

It is not for the Commission, of course, to suggest what is an appropriate level and structure of taxation but we believe we have a duty to point out that we are impressed with the contention that the size of wage

demands, especially in a period of rapid price change, is related to the level and structure of personal income taxation; and that the viability of our wage fixing principles will depend in part on the Government's constant sensitivity on this point. In this connection we note that currently there is a committee of enquiry on this very matter whose report to the Australian Government is expected shortly. It

goes without saying that fiscal action which adds to costs and prices will have a direct and rapid effect on wage movements through indexation."1

This quotation leaves no doubt that the Commission feels

that a failure to adjust the progressive income tax schedule

during periods of rapid inflation leads to an acceleration

in the rate of wage increases.

3.122 In the light of this statement, the Committee

believes that the increasing tax burden is having an

important impact on wage claims. Further, the Committee

considers that there has been a rapidly growing awareness of

The Australian Conciliation and Arbitration Commission, National Wage Case Decision 30 April 1975, Melbourne, 1975, pp. 24-25. ;

104

the effects of personal tax increases on changes in

employees' real disposable incomes. The current rapid

inflation, the current rate scale, and this growing

awareness make wage retaliation an important issue. As

mentioned earlier, the current rate scale, by increasing

marginal tax rates relative to average tax rates, has

significantly increased the sensitivity of the personal tax

system to changes in nominal income (see Table III-9).

Table ΙΪΙ-11 below shows the proportionate increase in gross

earnings which employees will require in 1975-76 (a) to

maintain constant real income, and (b) to obtain a 5 per cent

increase in real disposable income over 1974-75, assuming a

20 per cent rate of inflation and maintenance of the current

rate schedule. Table III-12 presents a time series analysis

of the increase necessary, at various income levels, to

obtain a 5 per cent income growth during the period 1954-55

to 1975-76.

3.123 The figures in Tables III-ll and 111-12 are

dramatic for two reasons. First, the situation has changed

significantly in recent years. In 1971-72, for example, the

average wage earner required only a 14.2 per cent increase

to achieve a 5 per cent increase in real disposable income

over the previous year. The corresponding figure for

1972-73 was 23.2 per cent, but for 1974-75 it was 39.3 per

cent. The figure for 1975-76, on the assumption of a 20 per

cent rate of inflation, is 39.8 per cent. Even if no growth

in real disposable income is assumed, a 30 per cent increase

in nominal incomes is required for real disposable income to

be maintained.

105

TABLE III-11

Proportionate Increase in Gross Income Necessary to Maintain Constant Real Disposable Income and to Achieve a 5 Per Cent Increase in Real Disposable Income In 1975-76(a)(b)

Required Proportionate Increase to Maintain

Constant Real

Initial Gross Disposable

Annual Income Income

Required Proportionate Increase for 5 per cent Growth

$ % %

2000 3000 4000 5000 6000 7000

7500 8000 9000 10000 12000 15000 20000 30000 50000 100000

22.4 29.0

23.2 30.1

24.2 32.0

25.9 34.3

28,0 37.2

29.8 39.0

29.8 39.3

30.1 39.8

30.1 39.8

30.8 40.4

30.3 40.1

30.9 41.3

32.2 41.8

28.1 36.8

26.8 34.8

23.4 30.4

(a) Assumes 20 per cent rate of inflation and maintenance of current rate scale.

(b) Single taxpayer, no deductions.

Notes:

106

TABLE III-12

Proportionate Increase in Gross Income Necessary to Achieve 5 per cent Increase xn~Real Disposable Income in Following- Year. Taxpayer on Average Weekly Earnings, 1954-55 to 1975-76 (a)

Required

Average Annual Proportionate Year Earnings Increase

$ %

1954-55 1799 10.23

1955-56 . 1924 12.68

1956-57 2012 6.91

1957-58 2070 7.58

1958-59 2132 8.68

1959-60 2304 10.63

1960-61 2413 6.38

1961-62 2475 6.06

1962-63 2543 6.88

1963-64 2678 10.34

1964-65 2876 10.29

1965-66 3011 9.20

1966-67 3219 10.13

1967-68 3406 9.31

1968-69 3661 10.16

1969-70 3968 12.53

1970-71 4410 14.78

1971-72 4836 14.16

1972-73 5278 23.23

1973-74 (b) 6136 28.01

1974-75 (c) 7500 39.28

1975-76 (c) 9000 39.80

Notes; (a) Based on the rate scales applying in each year, ignoring rebates and levies.

(b) Inflation rate of 16.15 per cent assumed.

(c) Based on average weekly earnings contained in the Treasury submission to the Committee. The Table assumes that the 1974-75 rate scale remains in force and that a 20 per cent inflation rate applies in both years.

107

3.124 The importance of this development lies not

only in the fact that the 'disposable income multiplier' is

likely to increase dramatically in 1975-76. The second

reason for noting the figures in the Tables is the

increased awareness of the relationships between inflation,

taxation, and real disposable income. The Committee

believes that the multiplier is more likely to be an

important element in the ultimate level of gross wage

settlements in 1975-76. In view of the fact that it is

gross wage settlements which enter into employers' costs,

the implications for the rate of inflation in 1975-76 are

obvious.

Inflation Induced Government Expenditure

3.125 The final issue is concerned with arguments

that governments may develop a vested interest in

inflation. This idea is scarcely a novel one. Writing in

1919, Lord Keynes observed:

"[By a] continuing process of inflation, governments can confiscate, secretly and unobserved, an important part of the wealth of their citizens. By this method they not only confiscate, but they confiscate

arbitrarily; and, while the process impoverishes many, it actually enriches some. The sight of this arbitrary rearrangement of riches strikes not only at security, but at confidence in the capacity of the existing distribution of wealth."1

3.126 The emergence of broad-based progressive

personal tax systems over the past half century may have

1

J.M. Keynes, The Economic Consequences of the Peace, in Volume 2 of The Collected Writings of J.M. Keynes, Macmillan, 137Ϊ, pp. 148-149 (author's emphasis).

108

increased the relevance of Lord Keynes's observation. The

possibility that the level of taxation acts as an

independent determinant of government expenditures is

considered in Chapter VII. For the purposes of the present

discussion it is sufficient to note that, to the extent

that this effect does occur, one important assumption of

the traditional view of the stabilising properties of

inflation and personal taxation is called into question.

3.127 If in fact there is a tendency for governments

to spend their revenues, the inflationary impact of such

behaviour depends on the magnitude of the increased

expenditures relative to the increased tax receipts, and on

the division of the additional expenditures between

purchases of goods and services and transfer payments.

Equal tax and transfer payments tend to cancel each other

out to the extent that marginal propensities to consume of

taxpayers and transfer recipients are similar. Higher

taxes may well be inflationary if they cause government

purchases to increase, provided that the marginal

propensity of the government to spend its tax receipts on

goods and services exceeds the marginal propensity of

taxpayers to consume their disposable income.^-

1 This presumes that the direct import content of government purchases and private consumption goods is roughly the same.

109

IV CONCEPTS AND METHODS OF PERSONAL TAX INDEXATION

4.1 The most common response of governments to the

problems discussed in Chapter III has been to make

adjustments from time to time to the major income deductions

defined in money terms, and to effect discretionary

reductions in personal income tax rates. However, in recent

years an increasing number of countries has introduced

provisions intended to produce a more automatic adjustment

of the personal tax schedule in response to inflation. This

Chapter examines the concepts and methods of personal tax

indexation. The first section considers the objectives of

personal tax indexation, and the following section examines

the methods which have been proposed or adopted to achieve

these objectives. The Committee then examines the

possibility of using an incomes index rather than a price

index, considers the scope of personal tax indexation and

takes up the issue of whether indexation should be automatic

or discretionary. Consideration is then given to the

implications of time lags for personal tax indexation. The

Chapter concludes with an examination of the appropriate

price index to be used for personal tax indexation.

The Objectives of Personal Tax Indexation

4.2 Personal tax indexation schemes may be based on

two types of indexation. The first is indexation by

reference to some measure of the rate of change in prices,

while the second involves indexation on the basis of some

110

measure of the rate of change in nominal incomes. These two

types of indexation schemes have different aims and

different implications. Their effects may, in some

circumstances, overlap, but their basic rationales are

distinctly different. This Report is mainly concerned with

the first type of indexation scheme, and the term personal

tax indexati^ . scheme is generally used here to imply

adjustment act irding to some measure of change in the

general level of consumer prices. But proposals for

indexation according to changes in incomes are briefly

considered below.

4.3 Equity considerations constitute the major

rationale for personal tax indexation schemes although, as

will be evident from the preceding Chapters, they are not by

any means the only relevant considerations. The legislated

personal tax schedule (meaning the taxable income rate scale

and the concessional deductions) aims to provide an

equitable distribution of the personal tax burden between

taxpayers with different real income levels, and between

taxpayers differing in certain other relevant respects, such

as size of family. The combination of inflation and an

unchanged personal tax schedule significantly alters the

distribution of the personal tax burden between different

real income levels and different dependant categories of

taxpayers, thereby violating the equity prescriptions

expressed in the legislated schedule:

Ill

"The redistributive consequences arising from a combination of inflation and progressivity in the tax structure constitute the most important argument for linking the main parameters of the personal income tax to an index of retail or consumer prices."1

Personal tax indexation schemes aim to neutralise the effect

of inflation on the distribution of the personal tax burden,

thereby preserving the equity judgments implicit in the

legislated personal tax structure.

4.4 That these equity judgements are of central

importance to the personal tax system, indeed to the tax

system as a whole, does not seem to be a matter of dispute.

The Taxation Review Committee has commented that:

"establishing the "right" degree of progressivity by reference to the criterion of equity is ... fundamental to tax policy ..."2

This statement emphasises progressivity as the vehicle for

the achievement of tax equity, as well as the central

importance of the equity objective of taxation.

4.5 In discussing progressivity, the Taxation

Review Committee highlighted a point that is crucial to a

proper appreciation of the objectives of a tax indexation

scheme:

"The central and sensitive question here (concerning the appropriate degree of progressivity) is that of the relativity of one individual's tax bill to

another's. In analysing this issue it is unavoidable to proceed by comparing the total taxes they pay, but 1

1 R.I.G. Allen and D. Savage, "Inflation and the Personal Income Tax", National Institute Economic Review, No. 70, November, 197ΊΓ; p^ W6~.

2 Full Report, para. 3.18.

112

the argument is properly about the differences between the totals rather than about the totals themselves."1

4.6 That is to say, progressivity and therefore

equity are concerned with relative, rather than absolute,

tax burdens. It scarcely needs saying that increases in

personal tax rates per se are in no way intrinsically

inequitable. Indeed if such a proposition was to be

accepted, virtually every developed country in the world

could be accused of having made its personal tax system less

equitable since World War II. Aggregate personal tax

revenues need to be determined in light of the government's

expenditure and stabilisation requirements. As regards

expenditure requirements, these have displayed a secular

upward trend in relative terms in Australia and most other

industrial countries since 1945, reflecting societal demands

for an increase in the quantity and quality of publicly

supplied goods and services. A concomitant of this trend

has been increasing overall tax rates, including increased

rates of personal taxation. To argue that there is anything

intrinsically inequitable about such a development is

clearly absurd. It is equally absurd to claim that

increases in tax rates made for stabilisation purposes,

whereby the resulting increases in tax revenue are frozen,

are intrinsically inequitable. Economic stabilisation is a

publicly supplied service of benefit to society at large, in

the same way as is any other publicly supplied service. 1

1 Ibid., para. 4.3.

113

4.7 Concern about the interplay of inflation and

progressive taxation does not result from increasing tax

rates per se. Concern arises from the fact that the

increase in the personal tax burden is distributed in a

manner which is inconsistent with the equity objectives of

personal taxation, as expressed by the legislative

representatives of society. Equity is concerned with the

distribution of the total tax burden, and indexation schemes

for personal taxation aim to maintain the relative real

burdens which are legislated between different real income

levels and different dependant categories. The most obvious

method of maintaining these relativities is to adjust the

personal tax schedule in line with the rate of inflation,

and to effect no further discretionary adjustment. Such an

adjustment will restore the initial average tax rate on each

real income level for each dependant category. If it is

estimated that the aggregate personal tax revenues

forthcoming under such an adjustment will be inconsistent

with the government's expenditure or stabilisation

requirements, a discretionary adjustment in the form of a

proportional across-the-board tax surcharge or rebate may be

effected. A discretionary adjustment of this kind will not

vitiate the achievement of the indexation scheme in

maintaining relative tax burdens, and will ensure that the

aggregate revenue requirement will be met. Indexation

schemes do not aim to freeze the absolute level of real tax

burdens? they do aim to maintain legislated relative tax

burdens until a conscious decision is taken to change them.

114

4.8 It must also be noted that indexation schemes

for personal taxation do not regard the relative tax burdens

legislated in some base year as sacrosanct. An indexation

scheme takes any given legislated rate structure as its

starting point, and maintains the relative tax burdens

contained in that structure until it is explicitly altered

by the government. The indexation scheme will then maintain

the relative tax burdens contained in the newly legislated

structure. Indexation schemes do not, in intent or effect,

tie the government to a fixed distribution of the personal

tax burden for all time. On the contrary, in an unambiguous

sense they provide governments with more, rather then less,

control over the distribution of the personal tax burden.

The relatively short history of indexation schemes in

overseas countries seems to confirm that governments which

have implemented such schemes do not regard their existence

as constraining their freedom to effect significant

discretionary adjustments.

4.9 The discussion so far has emphasised the

distinction between the size of the personal tax burden and

the distribution of that burden, and pointed to this

distinction as crucial to a proper appreciation of

indexation schemes for personal taxation. Such a

distinction does not imply that there is no relationship

between the two, or that such a relationship is unimportant,

especially over the longer term. The distribution of the

115

personal tax burden considered appropriate for an aggregate

ratio of personal tax to personal income of 15 per cent may

not be considered appropriate for an aggregate personal tax

ratio of 25 per cent. But indexation schemes do not regard

any single tax burden distribution as inviolable. They

simply maintain the legislated distribution for that period

during which the government deems such a distribution to be

appropriate.

4.10 The Committee concludes that the major aim of

personal tax indexation is the maintenance of the eguity

objectives of personal taxation. In order to achieve this

aim, indexation schemes are concerned not with tax totals

per se (at either an aggregate or individual level), but

with tax relativities at the individual taxpayer level.

Introduction of an indexation scheme does not imply that an

ideal distribution of the personal tax burden has been found

and should be maintained for all time. It simply serves to

reflect society's notions of personal tax equity, as

expressed in explicitly legislated tax schedules, through

time.

Methods of Personal Tax Indexation

4.11 There are three possible methods of personal

tax indexation. The first involves adjustment of the

legislated tax schedule (taxable income bracket limits and

deduction limits), leaving net income denominated in nominal

terms. The second method involves adjustment of net income

for inflation, leaving the legislated rate schedule

unchanged. The third method involves adjustment of tax

116

rates, leaving rate brackets and incomes unchanged. The

following discussion of each method first assumes that all

personal concessions take the form of fixed nominal amounts

which are deductible from net income for the purpose of

calculating taxable income. Other types of concessions are

considered subsequently. Initially it is also assumed that

indexation takes place by reference to a price index. The

possibility of using an incomes index is examined later.

Tax Schedule Adjustment

4.12 The most common method of indexation which has

been adopted overseas involves increasing taxable income

bracket limits and deduction limits at a rate equal to the

rate of inflation. Such an increase in deduction limits

maintains the real value of deductions, and means that the

same proportion of any given real net income level for any

given dependant category is exempted from tax as applied

initially (and as would have been the case in the absence of

inflation). Similarly, the adjustment of taxable income

bracket limits maintains the real width of taxable income

brackets, and ensures that the same proportion of any given

real taxable income level is subject to each marginal tax

rate as applied initially (and as would have been the case

in the absence of inflation). If it is assumed that there

is no change in marginal tax rates, the two adjustments

together ensure the maintenance of the legislated average

tax rate on each real net income level for each dependant-

category. Such adjustments ensure that inflation does not

117

give rise to a redistribution of the tax burden between

different net real income levels or different dependant

categories. They also ensure that the same level of real

disposable income is associated with the same level of real

net income for each dependant category as is provided for in

the legislated tax schedule.

4.13 It was noted earlier that these results emerge

independently of the actual response of nominal incomes to

inflation. If a taxpayer's net nominal income increases at

a rate in excess of the rate of inflation, his real net

income increases; his average tax rate also increases under

the tax schedule adjustment scheme. Similarly if his real

net income declines, so too does his average tax rate, to

the level specified in the legislated tax schedule for such

a real net income level.

4.14 The Committee also emphasises that such a

scheme does not exempt from taxation purely inflationary

increases in net income. Nor are such income increases

taxed at a single proportional rate for all taxpayers. They

are taxed at a progressive rate, in the sense that the

inflationary component of increases in net income bears a

higher marginal tax rate, the higher the initial level of

real net income of any given taxpayer. To the extent that

nominal incomes increase in line with the rate of inflation,

the adjustment scheme involves the maintenance of the

initial level of taxation for any given real net income

level. However, the marginal tax rate required to achieve

118

this result for different taxpayers varies with the level of

real net income. The marginal tax rate borne by the

inflationary increase at each level of real net income is

equal to the initial average tax rate on each real income

level. The adjustment scheme may be viewed as allocating

the inflationary increment in net income to the various

income brackets in the same proportions as the initial real

income level. (Deductions for this purpose may be regarded

as being equivalent to a first income bracket subject to a

marginal tax rate of zero.)

4.15 If dependant and other personal concessions take

the form of tax rebates of fixed nominal amounts, these

amounts need to be increased in line with the rate of

inflation in order to maintain their real value. In the

case of the tax rebate for low income families introduced in

the 1974-75 Budget, increases in dependant deductions in

line with the rate of inflation will automatically ensure

that the real value of the rebate is maintained. This is

because the rebate is calculated by multiplying the nominal

amount of dependant deductions by a factor of 0.4. Further

adjustment of taxable income brackets will ensure that the

real income groups for whom the rebate was intended will

continue to be eligible for it.

4.16 In order to index concessional deductions which

vary with the level of expenditure, but which are subject to

an upper limit, it is necessary to increase the upper limit

in line with the rate of inflation.

119

Net Income Adjustment

4.17 The second form of indexation involves

adjustment of income for inflation, leaving the legislated tax

schedule unchanged. The procedure is as follows. First,

nominal net income is expressed in terms of base year

prices, and taxable income and tax liability are calculated

in terms of the base year tax schedule. Secondly, the tax

liability so calculated is converted back into current price

terms. Deflation needs to be applied to net income rather

than to taxable income, in order that real value of

deductions is maintained. Reflation of tax liability

calculated in terms of the base year tax schedule is

necessary, in order that the real value of the personal tax

liability is maintained.

4.18 Where deductions take the form of fixed nominal

amounts, the conversion from net income to taxable income at

base year prices is straightforward, involving merely a

subtraction of the base year legislated amount of deductions

from deflated net income. In the case of deductions which

vary with the level of expenditure, however, the procedure

is somewhat more complicated. Under these circumstances,

the nominal value of these deductions also needs to be

expressed in terms of base year prices. Such a procedure is

likely to involve increased administrative costs for the

Commissioner of Taxation and increased compliance costs for

taxpayers. When allowances for dependants take the form of

120

tax rebates, the relevant calculation involves a

straightforward deduction of the base year amount of the tax

rebate from the base year tax liability.

4.19 There may be administrative savings to offset

the likely increased administrative and compliance costs

involved in deflating deductions which vary with the level

of expenditure. This is because new tax tables only have to

be issued when discretionary adjustments take place.

However, income deflation factors and tax reflation factors

need to be issued to employers to enable them to calculate

the amount of tax to be withheld during the course of the

income year. Therefore any administrative saving from the

use of unadjusted tax tables needs to be balanced against

increased compliance costs for those responsible for

calculating the amount of tax to be withheld from wage and

salary earners. On balance, it seems likely that this

method of adjustment involves higher administrative and

compliance costs than result from the adjustment of the

legislated tax schedule.

4.20 Both methods yield identical results by

restoring the initial distribution of the tax burden between

different real net income levels and different dependant

categories of taxpayers. However, implementation of an

indexation scheme using the income inflation method would

represent a significant departure from present practice,

while indexation of taxable income bracket limits and

deduction limits would not. This fact, coupled with the

121

increased administrative and compliance costs that are

likely to be associated with the income deflation scheme,

seems to favour legislated tax schedule adjustment. It is

relevant to add that, in overseas countries currently

employing tax indexation schemes, only the Swiss Canton of

Basel-Land employs an income deflation method.

Tax Rate Adjustment

4.21 The third form of adjustment involves

indexation of tax rates. A scheme involving

equi-proportionate reductions in marginal rates of tax (or

what amounts to the same thing, a proportionate tax rebate)

will not achieve the objectives of a personal tax indexation

scheme.^" Such an adjustment can prevent inflation from

generating an increase in the aggregate personal tax ratio.

But it is not able to restore the initial distribution of

the personal tax burden between different real income levels

and different dependant categories. On the contrary, such

an adjustment preserves the new distribution of burdens

generated by the interplay of inflation and personal

taxation.

4.22 A more discriminating approach to the

adjustment of the various marginal tax rates may, in the

short run, approximate the effects of a personal tax

indexation scheme on the distribution of the tax burden 1

1 For a confirmation of this point, see Personal Income Tax - The Rate Scale, op. cit., pp. 13-14; and The Full Report of the taxation Review Committee, paras. 14.55 and 14.59.

122

between different real income levels for a given dependant

category. However, such a result is not possible in the

longer run; and this aporoach cannot solve the problem of

redistribution between different dependant categories, even

in the short term.

4.23 A submission received from Mr. B.J. White

suggested that the existing rate structure be changed from

the present discontinuous one containing fourteen steps to a

continuous function with a systematic relationship between

average and marginal rates of tax. Mr. White described his

proposed tax function as follows:

"The major advantage of the equation is the ease with which it can bo adjusted. For example with an inflation rate of 20 per cent, after-tax income is maintained in real terms only by increasing both co-efficients a and b by 20 per cent. The

function is thus effectively shifted to the right and both average and marginal rates of tax arc left unchanged as a result of inflation. Variations on across-the-board percentage rebates or levies can also be implemented by adjustments to the maximum rate, m. The simplicity of the equation should result in a reduced lag both in the determination of a new tax function and imp]cmentation through the PAYb system."

4.24 Unfortunately, such a fundamental change in the

tax schedule would, as .Mr. White acknowledged, increase the

complexity of the system and make it more difficult for

taxpayers to assess their tax liabilities. That was the

experience when a continuous tax function was used in

Australia in the period prior to 1933.

123

Indexation by Reference to Changes in Incomes

4.25 It was observed above that, although indexation

is usually effected by means of a price index, some

indexation schemes involve the use of an incomes index. Of

these, the Committee considers two schemes, the first of

which involves the use of an index of nominal per capita

incomes and the second the use of an index of average weekly

earnings.

Adjustment According to changes in Nominal Per Capita Income

4.26 A scheme has been proposed whereby taxable

income bracket limits and deduction limits are adjusted in

line with the rate of increase in nominal per capita

incomes.^ Such a scheme has operated in Iceland

intermittently since 1966. Superficially such a scheme is

similar in its effects to indexation schemes which use a

price index, differing only in that they provide adjustment

for real income growth as well as for inflation. On closer

examination, however, the schemes are seen to be quite

different in principle, and to have different implications

for both the distribution of the personal tax burden and the

size of the aggregate tax burden. 1

1 Vito Tanzi, "A Proposal for a Dynamically Self-Adjusting Personal Income Tax", Public Finance, Volume IV, 1966, pp. 507-520. Tanzi suggests changes in either the nominal personal income/population ratio, or the nominal gross national product/population ratio, as the index to be used

for adjustment.

124

4.27 It will be recalled from Chapter III that the

effects of inflation in redistributing personal tax burdens

are independent of the actual response of nominal incomes to

inflation. The earlier analysis in this Chapter has shown

that these redistributive effects are offset by schemes

which index tax schedules or by reference to a

net incomes price index, regardless of the response of

nominal incomes. An important difference between these

types of indexation schemes and adjustment according to

actual changes in nominal income is that the latter provides

adjustment for inflation only to the extent that nominal

incomes adjust fully and rapidly to the rate of inflation.

This may be seen by assuming that nominal incomes increase

at a lesser rate than the rate of inflation.

4.28 Adjustment on the basis of the rate of change

in nominal incomes ensures that the situation of declining

real incomes is automatically accompanied (a) by increases

in tax rates on all real income levels? and (b) by a

redistribution of the tax burden broadly equivalent to that

which would have occurred if the tax schedule had not been

adjusted and if the rate of inflation had equalled the

discrepancy between the actual rate of inflation and the

rate of change in nominal incomes.

4.29 In the case where nominal incomes increase at a

rate in excess of the rate of inflation, that is where real

incomes rise, adjustment according to changes in nominal

incomes means that increases in real incomes are

125

automatically accompanied by decreases in personal tax rates

on each level of real income. Again a redistribution of the

tax burden ensues, in the opposite direction to the case

where real incomes fall. To the extent that real incomes

increase continuously over time, real tax rates continuously

decline. Only in the situation where nominal incomes adjust

fully and rapidly to the rate of inflation, and where there

is no real income growth, does adjustment according to

changes in nominal incomes yield the same results as the

first two indexation schemes based on price indexes. It

therefore seems that the purpose of adjustment according to

changes in nominal incomes is not directed towards

offsetting the effects of inflation on the distribution of

the tax burden.

4.30 The primary objective of such an adjustment

scheme seems to be to maintain the initial overall size of

the aggregate personal tax burden, rather than the initial

distribution. On the assumption that the pre-tax

distribution of personal income does not change

significantly, then adjustment according to changes in

nominal per capita incomes result in the aggregate personal

tax ratio remaining constant through time (if it is also

assumed that no significant discretionary changes accompany

such adjustment). Such constancy is achieved by a decline

in real tax rates (relative to legislated rates) when real

per capita incomes increase; and by an increase in real tax

rates when real per capita incomes decline. As noted

previously, constancy of the aggregate personal tax ratio is

126

not an objective of personal tax indexation schemes.

Movements in the aggregate personal tax ratio are properly

determined by reference to the Government's expenditure and

stabilisation requirements. Adjustment for the effects of

inflation constitutes a separate issue.

4.31 Adjustment according to changes in nominal per

capita incor .s may be said to maintain the initial

distribution ->f the tax burden in a different sense from the

one described earlier in this Report. If it is assumed that

the pre-tax distribution of income remains relatively

constant over time, adjustment according to changes in per

capita incomes means that the same proportion of total

personal tax receipts is forthcoming from the same

proportion of total personal incomes. That is to say, the

first 10 per cent of total personal income continues to

contribute the same proportion of total personal tax

receipts as initially, as does the next 10 per cent of total

personal income, and so on. To be sure, as the Australian

Treasury has pointed out:

'... over time increases in real income will result in substantial changes in the levels of income of all taxpayers requiring readjustments in attitudes towards what may be considered as "poor", "wealthy",

"lower income", "middle income", "higher income" or similar broad categories of taxpayers. For example, even if it could be assumed that there is no inflation, in a growing economy the use of an unchanged income tax rate scale over a very long period of time would eventually result in all taxpayers being subject to the highest marginal rate of income tax.11

1 'Personal Income Tax - The Rate Scale', op. cit., p. 11.

127

This proposition is of course completely valid. Real income

growth may change societal preferences in relation to the

distribution of the tax burden between different real income

levels. Whether a system of adjustment according to changes

in nominal incomes can provide desired distributional

changes of the type just referred to is not an issue which

is relevant to adjustment for the effects of inflation.

4.32 The Committee has noted some potential problems

associated with the use of an incomes index for purposes of

tax schedule adjustment. In the first place, personal

income is a wider concept than either assessable income or

net income as defined for purposes of personal taxation.

For Australia, net income was equal to only 78.4 per cent of

household income in 1971-72. Household income includes cash

benefits from governments and certain types of imputed

incomes, neither of which are generally subject to personal

taxation. So long as the ratio of net income to household

income remains constant, no problems arise. But if it is

assumed that the ratio declines, say as a result of an

increase in cash benefits from the government, a problem

arises. In these circumstances, ceteris paribus, adjustment

on the basis of household income results in a decline in the

aggregate personal tax ratio at a time when the expenditure

commitments of the government are tending to increase. Such

a result appears to be the opposite of that required. The

potential for a lack of consonance between nominal Gross

128

Domestic Product and nominal net incomes seems to be even

greater than in the case of household income. Further

potential problems arise if the ratio of the work force to

total population tends to fluctuate over time. If, for

example, this ratio tends to increase over time then, all

other things equal, adjustment on the basis of per capita

incomes tends to lead to a decline in the aggregate personal

tax ratio.

4.33 Finally, the fact that tax schedule adjustment

on the basis of movements in per capita incomes may lead to

severe revenue constraints for the government is crucial to

any evaluation of such a scheme. The most important point

to be made about a scheme of this type is that only in one

special case does such an adjustment scheme restore the

initial distribution of the personal tax burden. That case

is where the proportionate increase in per capita incomes

equals the rate of inflation. Any other rate of increase in

per capita incomes distorts that initial distribution. The

efficacy of such a scheme from the point of view of

providing adjustment for the effects of inflation is

therefore extremely limited, and cannot be recommended for

that purpose.

Adjustment According to Changes in Average Earnings

4.34 At the beginning of 1975, Denmark changed from

a system whereby taxable income bracket limits and deduction

limits were increased in line with the rate of increase in

129

consumer prices, to a system whereby the same limits were

increased in line with the rate of increase in average

hourly wages of industrial workers. In Australia, it has

been suggested that taxable income bracket and deduction

limits be adjusted in line with the increase in average

weekly earnings. The submission which the Committee

received from the Australian Council of Salaried and

Professional Associations made such a proposal.

4.35 Use of an hourly index may be expected to

correct partially for the influence of overtime on average

weekly earnings. But the effect would be partial to the

extent that overtime hours are remunerated at higher rates

than normal hours, and hence affect average hourly wages.

4.36 As a scheme for offsetting the effects of

inflation on the distribution of the personal tax burden,

tax schedule adjustment on the basis of the proportionate

increase in average weekly earnings is subject to much the

same criticism as adjustment according to changes in per

capita incomes. Such an adjustment scheme restores the

initial distribution of the personal tax burden only to the

extent that the rate of increase in average weekly earnings

is equal to the rate of inflation. If average weekly

earnings increase at a rate less than the rate of inflation,

such an adjustment scheme results in increased real personal

tax rates and a redistribution of the personal tax burden in

the manner described in Chapter III. If average weekly

130

earnings increase more rapidly than inflation, real tax

rates fall and an opposite redistribution of the tax burden

occurs. The larger the increase in average weekly earnings

relative to the rate of inflation, the greater is the

decline in real tax rates. Assuming that all net nominal

incomes increase at a rate equal to the rate of increase in

average weekly earnings, such an adjustment scheme results

in constancy of the aggregate personal tax ratio.

4.37 Recent Australian experience suggests that

there may be an inverse relationship between real wage rates

and employment. It is possible that very rapid increases in

real wages may be associated with declining employment. The

fall in employment will not be reflected directly in average

earnings figures, because these figures are calculated with

respect to the employed work force. Hence an adjustment

scheme based on average earnings may result in a situation

where a contraction in the personal tax base (due to the

reduction in employment) is accompanied by a large fall in

real tax rates (due to adjustment on the basis of average

earnings). Whilst such a situation may be considered

desirable on stabilisation grounds, the likely implications

for personal tax revenues cannot be ignored.

4.38 It has frequently been claimed that personal

tax indexation schemes may assist in securing a moderation

of wage claims. It is difficult to see such a benefit

flowing from an adjustment scheme based on movements in

average weekly earnings. The reason is that the larger the

131

increase in average earnings relative to the rate of

inflation, the larger is the decline in real tax rates

relative to legislated rates.

4.39 The Committee has concluded that, as a system

of adjustment for the effects of inflation, indexation

according to changes in average earnings cannot be

recommended.

Exemption of Cost of Living Increments from Personal Taxation

4.40 Israel has operated a scheme whereby cost of

living increments to wages and salaries have been exempted

from personal taxation. The precise details of the Israel

scheme will be described below in Chapter V. For

expositional purposes, it is assumed here that cost of

living increments take the form of proportionate increases

in net nominal incomes at a rate equal to the rate of

inflation. Initially it is further assumed that all net

nominal incomes adjust fully and instantaneously to the rate

of inflation. This assumption will be relaxed subsequently.

4.41 Given the above assumptions, exemption of cost

of living increments from personal taxation restores the

initial distribution of the tax burden. However, this

result is not achieved by way of restoration of the initial

levels of average tax rates on each real income level.

Under such a scheme, real tax rates will decline. The

reason is that, while taxpayers' incomes have been reckoned

in real terms, their tax liabilities have not. The

Israel-type scheme may be compared with an income

deflation scheme, where tax liabilities calculated in terms

132

of the base year tax schedule are not reflated so as to be

expressed in current price terms. Exemption of cost of

living increments implies continually declining average tax

rates on each level of real income, so long as the rate of

inflation remains positive. Such a result is not required

on equity grounds nor will it maintain aggregate personal

tax revenues. As the Committee has noted previously,

conventional personal tax indexation schemes do not exempt

cost of living increments from personal taxation. The

effect of such schemes is to tax cost of living increments

at a marginal tax rate equal to the legislated average tax

rate on each real income level.

4.42 It remains to relax the assumption that all net

nominal incomes adjust fully and instantaneously to the rate

of inflation. If nominal incomes do not adjust at all to

inflation, then the adjustment scheme disappears; the

redistributive effects follow those described in Chapter

III. Likewise if nominal incomes adjust only partially,

such an adjustment scheme only partially offsets the

redistributive effects. Personal tax adjustment for the

effects of inflation is forthcoming only to the extent that

income earners are successful in obtaining full income

compensation for the effects of inflation. One of the

advantages of conventional personal tax indexation schemes

is that they do provide some tax relief for those taxpayers

whose real net incomes decline during periods of inflation.

These taxpayers are likely to be those in the weakest

133

bargaining positions. An adjustment scheme which exempts

cost of living increments is therefore likely to have

discriminatory effects. It is not obvious that such a

scheme will be successful in achieving the equity objectives

of personal tax indexation.

The Scope of Personal Tax Indexation

4.43 So far the Committee has examined alternative

methods of personal tax indexation and the possibility of

using an index based on incomes rather than prices. In the

following sections of the Report, consideration is directed

to the possible scope of the indexation procedures, with

special reference to deductions, bracket limits and the

possibility of departing from the chosen index.

Indexation of Deductions

4.44 As discussed in Chapter III, horizontal equity

between taxpayers with differing family characteristics is

mainly achieved through dependant deductions. The interplay

of inflation and an unchanged personal tax schedule leads to

a redistribution of the tax burden between different

dependant categories of taxpayers, with the large family

taxpayer category being most adversely affected. Such a

redistribution distorts the horizontal equity judgments

contained in the legislated tax schedule. On equity grounds

there is therefore a clear case for indexing dependant

deductions.

4.45 But the Taxation Review Committee and others

have pointed out that not all concessional deductions have

horizontal equity as their rationale:

134

'There are two main reasons in principle why in one form or another such concessions may be considered necessary ... some are introduced for purposes of equity. But they can also be given for efficiency reasons: to encourage individuals to adjust their expenditure in various ways, because increases in expenditure on particular items are held to be socially or economically desirable ...............

[Contributions to superannuation funds and life insurance policies probably come under this head and so perhaps .. [does the deduction] .. for education.*1

This view seems to be supported by the Australian Treasury,

which finds non-dependant deductions in general to be

· . 2

1 difficult to justify from a horizontal equity view point.

4.46 The combination of inflation and an unchanged

personal tax schedule results in a redistribution of the tax

burden which is adverse to taxpayers with levels of

non-dependant deductions initially near or above the upper

limit. Inflation erodes the real value of these deductions

in the same manner as it erodes the real value of dependant

deductions. However, the important point is that such

redistributions do not appear to provide the equity

violations that are present in the case of dependant

deductions, because non-dependant deductions are not

provided with a view to horizontal equity. Therefore the

case for indexing these limits on equity grounds does not

appear to be strong.

4.47 This does not necessarily mean that such limits

should not be indexed. There may still be a case for

indexing them on efficiency grounds. Indeed it may be 1

1 Full Report, para. 12.19.

2 Personal Income Tax - Personal Allowances, op. cit., p. 12.

135

plausibly argued that, if the legislated real value of a

non-dependant deduction limit is considered appropriate at

the time of legislation then, ceteris paribus, it is not

likely to be appropriate several years later, assuming an

unchanged nominal value and continuing inflation.

4.48 Even if it is considered that the real value of

some deduction limits should decline, it is unlikely that

inflation will provide the exact reduction that is required.

A more certain form of adjustment is explicitly to reduce

the limit to the real value deemed appropriate to the

current circumstances. It seems logical that, after the

limit has been explicitly adjusted to its appropriate real

value, this real value should be maintained so long as

circumstances render it appropriate. Such a result is

achieved by indexation of deduction limits.

4.49 Whilst failure to index non-dependant deduction

limits may not give rise to significant equity violations, a

case exists on logical grounds for these limits to be

included in any indexation scheme. The Committee has noted,

however, that several countries currently employing personal

tax indexation schemes have not extended indexation to

non-dependant deduction limits.

Indexation of Taxable Income Bracket Limits

4.50 All countries currently employing personal tax

indexation schemes apply indexation to all taxable income

bracket limits, thereby maintaining the vertical equity of

the personal tax burden explicitly determined by the

136

political process. It has sometimes been argued that

indexation should be confined to taxable income brackets up

to the level of some income norm, such as average weekly

earnings. Such a proposal is incompatible with the

objectives of personal tax indexation. All countries

currently employing indexation schemes also include the

minimum level of taxable income in the items indexed.

Extent of Adjustment for Inflation

4.51 Another issue relevant to the scope of

indexation is whether the factor used for adjusting the tax

schedule should depart from the index chosen for purposes of

the adjustment.* There are two forms of departure embodied

in the legislation of some countries currently employing

personal tax indexation schemes:

(a) the adjustment factor may be calculated as some

proportion of the movement in the chosen index;

and

(b) the adjustment factor may be set at zero if

movements in the chosen index do not exceed a

specified percentage. 1

1 The issue of adjusting an index of prices for the effects of discretionary changes in indirect taxation and subsidies, and for changes in the terms of trade, is discussed below. The discussion in this section concerns the departure of the personal tax indexation factor from

the price index, adjusted or not.

137

4.52 Regarding the first form of departure, the

Netherlands scheme contains a provision whereby the Minister

of Finance has the discretionary power to allow between 80

to 100 per cent of the change in the chosen price index to

be reflected in the factor used for tax schedule adjustment.

4.53 The two major considerations which appeared to

influence the inclusion of such a provision were:

(a) the yield from other taxes may not adapt

sufficiently to inflation to enable the growth

in real public expenditure to continue, and

increases in the rates of these other taxes

usually require legislation; and

(b) a 100 per cent adjustment may, at times,

conflict with other policy objectives.

4.54 It is certainly true that the yield of other

taxes may be extremely insensitive to inflation. Specific

taxes (i.e. taxes levied as fixed nominal amounts per unit

of quantity)constitute the most obvious example. Failure

to effect a discretionary upward adjustment to a specific

tax during a period of inflation means that the real value

of the specific tax declines. A likely but not necessary

result is that real specific tax revenues decline. In order

to maintain real specific tax revenues during periods of

inflation, discretionary increases in these taxes may

therefore be required. In some countries (such as the

United States and West Germany) the required changes in

legislation may involve a long and drawn-out process. Such

138

a situation does not prevail in Australia. Under existing

practice, increases in specific duties become effective from

the time of their announcement, and the subsequent

legislation is backdated to the time of announcement.

Automatic Indexation Versus Discretionary Adjustment

4.55 The experience during the past five years or so

of virtually every country in the Organisation for Economic

Co-operation and Development, including Australia, confirms

that during relatively rapid inflation the issue is not

whether to adjust the personal tax schedule, but the manner

in which the adjustment is to be effected. In particular

the question is whether adjustment of the tax schedule for

the effects of inflation should be legislated for in a

manner that ensures that it occurs automatically each year,

or whether it should be left to the government of the day to

make discretionary adjustments from time to time. In this

connection, the Taxation Review Committee has commented:

'Given that the income tax schedule should be adjusted regularly during periods of inflation, the question arises whether the adjustment should be an automatic one based on a formal statutory indexing procedure or merely discretionary.12

4.56 The use of the terms automatic and

discretionary may appear to suggest that the two approaches

are mutually exclusive, or that automatic indexation 1 2

1 See K. Messere, 'The Impact of Inflation on Tax Structures', Paper presented to the Barcelona Conference of the International Institute for Public Finance, September 1973.

2 Full Report, para 14.47.

139

necessarily requires a government to legislate out of

existence its right to effect appropriate discretionary

adjustments to the tax schedule. It therefore needs to be

emphasised that personal tax indexation implies no such

thing, either in principle (as the above discussion of

objectives indicates) or in practice (as the description of

country experiences below will make clear). Nevertheless,

some critics of personal tax indexation have, knowingly or

unknowingly, seized on this confusion to portray automatic

indexation schemes as placing governments in a strait-jacket

as regards personal taxation.

4.57 The distinction between automatic and

discretionary adjustments for inflation depends on the

existence of legislative provisions whereby the tax schedule

is automatically indexed on a regular, specified basis in

accordance with movements in a specified index. Such

provisions may be contrasted with what may be termed

'outline provisions', such as exist in France and

Switzerland. In France, for example, Article 15 of the

Budget Act 1968 contains the following provision: * 1 1

'If the price index ... rises by more than 5 per cent from one year to another, Parliament shall make proposals for adjusting income tax rates to this trend.'

In Switzerland, as a result of the Federal Decision of

11 March 1971 on the future management of Federal finances,

Article 41 of the Federal Constitution was amended to read

as follows:

140

1 From time to time action shall be taken to offset the effects of the progressive taxation of the incomes of natural persons.1

Such provisions provide a formal recognition of the fact

that the combination of inflation and personal progressive

taxation can give rise to certain problems; but do no more

than that. The point is not simply that such provisions

provide no indication of the amounts, methods and provisions

for adjustment, but that they do not establish a commitment

to automatic and regular adjustment for inflation. Hence

such outline provisions seem to be more in the nature of

discretionary adjustments.

4.58 Legislative provisions set out the amounts,

methods and provisions for adjustment, and state that such

adjustments will be made automatically on a regular basis.

For example, the Canadian legislation specifies the taxable

income brackets, the deductions to be adjusted, the index to

be used as the basis for adjustment, and the method of

calculation of the adjustment factor from the chosen index.

It also states that the relevant limits 'shall be adjusted

annually' by an amount equal to the product of base year

limits and the adjustment factor.1

4.59 In an ultimate but very real sense, there can

never be fully automatic indexation, as the experience of

the Netherlands indicates; in 1974 that country suspended

1 Canadian Income Tax Act 1973, Section 117.1(4), Annual Adjustment of Deductions and Other Amounts.

141

the adjustment mechanism. The Netherlands legislative

provisions for personal tax indexation are as comprehensive

and automatic as those for Canada described above, and

indeed as the provisions of all countries employing

automatic personal tax indexation schemes. The automatic

nature of such provisions does not change the fact that

ultimately a government, through Parliament, can exercise

the right to suspend or change the law if it sees fit to do

so.1 Viewed in this light, there can never be such a thing

as fully automatic indexation. No legislative provisions

can remove this ultimate power of governments, nor do they

aim to do so. But the availability of such an option does

not render automatic provisions for personal tax indexation

irrelevant or unimportant. The existence of such provisions

ensures that failure to adjust the personal tax schedule for

the effects of inflation in any given year is an explicit

public decision requiring explicit justification. This is

not so in the case of a system involving discretionary

adjustment.

4.60 In essence, the choice between automatic and

discretionary adjustment depends on this distinction.

Automatic adjustment involves an undertaking that inflation

will not be allowed automatically to increase the real tax

1 Non-adjustment may be viewed as indexation plus additional discretionary adjustments that precisely offset the adjustment for inflation.

142

burden beyond the level explicitly decided upon by political

consensus and agreed to by the political process. It

further involves the undertaking that changes in that burden

will be subjected to the 'proper Government, parliamentary

and public scrutiny in the context of their cost and overall

effect', which the Coombs Task Force found to be necessary

and desirable in the field of government expenditures.* In

this sense, automatic indexation involves a greater

accountability on the part of governments to taxpayers.

4.61 The following discussion assumes that, during a

period of continuing high inflation, the question is not

whether to adjust the personal tax schedule for the effects

of inflation, but how to adjust. For purposes of the

discussion, it is assumed that over the longer term revenue

yields are equal under an indexed system and a system of

discretionary adjustment.

4.62 The delay between inflation and adjustment of

the personal income tax system tends to be longer and more

erratic when discretionary adjustment methods are used. If

this is the case, discretionary adjustment is likely to have

less of a moderating influence on trade union attitudes to 2

wage negotiations than automatic adjustment. Automatic

adjustment also tends to minimise the need for the large 1 2

1 Review of the Continuing Expenditure Policies of the Previous Government, Australian Government Publishing Service, Canberra, 1973, p. 19.

2 But see the contrary view expressed by Mr. G. Polites on p. 101 above.

143

infrequent adjustments which are often associated with

systems of discretionary adjustment. Automatic adjustment

may be viewed as providing a more gradual, smoother process

of adjustment.

4.63 The governmental decision-making process may be

facilitated when a prior and specific commitment exists to

make adjustments on a regular basis and within the framework

of specific legislation. A system of automatic adjustment

provides a government with information about the share of

the real resources flowing to the public sector on the basis

of its legislated personal tax policies. If the government

determines its expenditure policies on the basis of revenues

resulting from an unadjusted tax schedule, its claims over

resources may be inconsistent v/ith long-term balance between

the public and private sectors, and large discretionary

adjustments may be required in the future to offset the

effects of inflation.

4.64 The Committee recognises that there can be no

such thing as a full automatic personal tax indexation

scheme. That point notwithstanding, it believes that any

legislative provisions which are less automatic than those

existing in Canada and the other countries discussed below

are equivalent to a rejection of personal tax indexation

schemes.

4.65 The objectives of automatic indexation may be

reconciled with the exercise of ultimate government

responsibility for taxation decisions by combining

144

provisions for automatic adjustment with annual (or even

more frequent) discretionary changes in the level of

taxation and with regular reviews of the rate structure and

personal concessions. Such a procedure was proposed in a

submission which the Committee received from The Taxation

Institute of Australia, which proposed that indexation

should provide an annual two-stage adjustment, involving:

"(i) the automatic adjustment of tax rate structure and concessional deductions based on the inflation factor; and

(ii) the amendment of those automatic adjustments in accordance with Government policy."

The Implications of Time Lags

4.66 Time lags may have important implications for

personal tax indexation schemes. Two types of time lags may

be distinguished:

(a) a lag between the current rate of inflation and

the rate of inflation used for indexation; and

(b) a lag between the accrual of tax liability and

the payment of tax liability.

Such timing differences may be important determinants of the

extent to which personal tax indexation schemes meet their

professed aims.

The Time Lag Between the Current Rate of Inflation and the Rate of Inflation Used for Indexation

4.67 The most common type of tax indexation scheme

involves adjustment of taxable income bracket limits and

deductions at the start of a given tax year in line with the

rate of inflation experienced during the previous tax year.

145

It has been a distinguishing characteristic of such schemes

that no adjustment has been forthcoming during the first

year of operation of the schemes. A recurring pattern has

been for a government to introduce a new tax schedule at the

start of a given tax year, along with a commitment to adjust

such a schedule for inflation in the manner described above.

The first adjustment to the tax schedule then comes at the

beginning of the following tax year. That is, no adjustment

is made for the inflation induced distortions that occur

during the course of the first operative year of the

schemes. The changes in tax rates and the redistribution of

tax burdens are effected as though there was no scheme in

operation.

4.68 It should be noted, however, that this is not a

phenomenon peculiar to the first year of the scheme. The

effect of the scheme is to restore the tax rates on each

level of real income as specified in the initial tax

schedule, for each dependant category, at only one point in

time, that is at the start of each tax year. Any positive

rate of inflation during the course of the tax year

generates increases in real tax rates for all taxpayers.

The simple and seemingly unimportant expedient of adjusting

according to a lagged rate of inflation, combined with the

absence of any adjustment when the scheme is first

introduced, results in an indexation scheme which falls

somewhat short of correcting the distortions which result

from the interplay between inflation and progressive

taxation.

146

4.69 This is not to say that such a scheme is

valueless from the point of view of taxpayers. By restoring

the initial real rate structure at the start of each tax

year, distortions operate from that time each year rather

than accumulating as they do under an unindexed tax

schedule. Take, for example, a situation where the rate of

inflation is relatively constant for a number of years.

Under an unindexed tax system, the tax rate on any given

real income level increases continually and diverges further

and further from the real tax rate specified in the initial

tax schedule. Under an indexation scheme of the type

described above, this divergence is constant each year

rather than cumulative as in the unadjusted case. Within

the context of a constant rate of inflation, such an

indexation scheme therefore has the effect of preserving the

real rate structure which emerges from the interplay between

inflation and progressive taxation during the first year of

the scheme.

4.70 There are four possible solutions to the

problems involved in the lagged adjustment procedure

outlined above. Two involve adjustment procedures which

attempt to index on the basis of the current rate of

inflation; the remaining two retain the use of a lagged

inflation rate, but involve additional adjustments. The

four possible solutions are:

147

(a) first year adjustment;

(b) adjustment of assessed liability;

(c) forecast rate adjustment; and

(d) continuous adjustment.

As the subsequent discussion will make clear, an indexation

scheme may combine features from each of these solutions.

First Year Adjustment

4.71 Some lagged adjustment problems may be

ameliorated if an adjustment is effected as soon as the

scheme is introduced, according to the rate of inflation

experienced in the tax year prior to the introduction of tax

indexation. Assume that the government has decided upon a

new rate schedule which it proposes to introduce and to

insulate from the effects of inflation. The implication of

a first year adjustment is that the new rate schedule itself

would never actually he legislated. What would be

legislated is a nominal rate schedule which would preserve

the real tax rates implicit in the desired nev; schedule, on

the assumption that the rate of inflation during the first

tax year of the indexation scheme equals the rate of

inflation of the previous tax year.

4.72 It should be emphasised that this adjustment

procedure does not avoid the increase in real tax rates

during the course of the tax year which is a feature of the

lagged adjustment scheme discussed above, if it is assumed

that the rate of inflation remains positive throughout the

tax year. However, on the assumption that the inflation

148

rate remains relatively constant over time, such a procedure

ensures that real tax rates for the tax year taken as a

whole remain relatively constant over time. This is an

important difference between the first year adjustment

procedure and the lagged adjustment procedure discussed

earlier. Indeed, when the inflation rate is constant over

time, this procedure is equivalent to adjustment on the

basis of the current rate of inflation.

4.73 However, when the rate of inflation is

fluctuating over time, no scheme of lagged indexation

ensures that real tax rates are maintained in any given tax

year, or even over a number of tax years taken together.

The variations in real tax rates depend on the manner in

which the inflation rate is fluctuating.

4.74 The objection to lagged indexation in

conditions of fluctuating rates of inflation is not only

that it fails to provide adjustment for current inflationary

conditions, but also that only by coincidence does it

provide appropriate adjustment in subsequent periods. The

following 'example illustrates this point.

4.75 Assume that a 5 per cent annual rate of

inflation prevails, that in one tax year the rate increases

to 20 per cent, and that subsequently the 5 per cent rate is

restored. For purposes of illustration, a hypothetical

single taxpayer is considered, who earns a constant real

annual income of $8,000 and is entitled to no deductions.

The tax schedule assumed to be in operation is that

operative in income year 1974-75. So long as the inflation

149

rate is constant at 5 per cent, lagged indexation ensures

that the legislated tax rate is maintained each year at

22.75 per cent. In the tax year when inflation increases to

20 per cent, the average tax rate increases to 25.91 per

cent, because the tax schedule for that year has been

adjusted in line with the 5 per cent rate of inflation

prevailing in the previous year.

4.76 The lagged indexation scheme has thus provided

inadequate adjustment in the current year. The schedule for

tiie following year is adjusted by 20 per cent. Because the

inflation rate has been reduced to 5 per cent again, it may

seem that in this year real tax rates will fall below their

initially legislated levels, and hence compensate taxpayers

for their increased burden in the previous year. However,

this is not the case. The average tax rate borne by the

notional taxpayer in the latest tax year is again 22.75 per

cent - the legislated tax rate on a real income of $8,000

for a single taxpayer with no dependants. The taxpayer

receives no compensation at all for the increased tax burden

borne during the year of 20 per cent inflation.

4.77 The explanation for this result is as follows.

Whether real tax rates in a given tax year are above or

below their initially legislated levels depends on whether

the cumulative percentage increase in the price level

exceeds or falls short of the cumulative percentage increase

in taxable income bracket limits and deductions. The base

150

point for both accumulations is the date at which the

indexation scheme is introduced.. Λ comparison between the

inflation rate and the tax schedule adjustment rate for a

single tax year provides information as to how real tax

rates will compare with the previous year. But the

comparison provides no information as to how those rates

compare with the legislated rates. In the above example,

what the 20 per cent tax schedule adjustment achieved was to

bring the two cumulative rates back into equality, thereby

restoring the legislated tax rates. On the assumptions that

were made in the example, lagged indexation worked to the

disadvantage of the taxpayer. But on different assumptions

regarding changes in the rate of inflation, government

revenue may suffer from lagged indexation.

4.70 In the Appendix to this Chapter, changes in

average tax rates under a lagged indexation scheme are shown

for two hypothetical taxpayers, on the basis of eight

different assumptions about changes in the rate of

inflation.

4.79 The major conclusions which the Committee draws

from that exercise are as follows:

(a) Under conditions of continually accelerating

inflation, real tax rates continually increase;

under conditions of continually decelerating

inflation, real tax rates continually decrease

(cases (a) and (b) in the Appendix).

151

(b) If inflation accelerates and subsequently

stabilises at a higher rate than prevailed

initially, real tax rates remain permanently

above their legislated levels; the converse

holds under conditions of decelerating

inflation (cases (c) and (d)).

(c) If inflation accelerates and subsequently

resumes its initial rate, real tax rates resume

their legislated levels. However, no

compensation will be forthcoming for the

increase in real tax rates experienced during

the period of acceleration of inflation. The

converse applies in the case of decelerating

inflation (cases (e) and (f)) .

(d) If inflation accelerates and subsequently

stabilises at a rate below the initial rate,

real tax rates initially increase and then fall

below their legislated levels; the converse

holds in the case of decelerating inflation

(cases (g) and (n)).

4.80 The foregoing cases are illustrative, each

representing a highly simplified inflation assumption. It

is not expected that any one case provides an accurate

description of actual inflationary experience. The path of

inflation in the real world is certainly more complex,

combining ingredients found in each of the cases discussed.

152

Nevertheless, the illustration demonstrates that the

apparently innocuous expedient of indexing according to the

lagged, rather than the current, rate of inflation may

vitiate the efficacy with which indexation neutralises the

impact of inflation on real tax rates. The extent to which

such a result occurs depends crucially on the magnitude of

actual fluctuations in the rate of inflation.

4.81 In an environment of high and fluctuating rates

of inflation, lagged indexation may make only a modest

contribution towards achieving relative stability of real

tax rates. However, in a period of relatively moderate

inflation with no persistent trend towards accelerating or

decelerating inflation over the longer term, real tax rate

changes resulting from inflation are not likely to be

substantial. Nor should they give rise to any significant

violation of the equity objective of indexation schemes.

Adjustment of Assessed Liability

4.82 A solution to some of the problems of lagged

adjustment may be found in a two-stage adjustment, whereby

tax payments during the income year are adjusted in

accordance with a lagged index, and the final assessment of

tax liability is made on the basis of a current index for

the year. A scheme of this kind has particular significance

for Ρ.Λ.Υ.Ε. and provisional taxpayers. The final

adjustment for P.A.Y.E. taxpayers may thus be made through

tax refunds. Tax refunds may be adjusted at the close of

153

the tax year to compensate for the increase in tax rates

which occurs during the course of the tax year under lagged

indexation. The refunds are calculated with reference to

the tax schedule to be operative in the forthcoming tax

year, which will have been adjusted in line with the rate of

inflation experienced during the tax year just completed.

The refund may be calculated as the difference between the

tax liability calculated according to this adjusted tax

schedule and the tax payments actually withheld. A refund

based on this numerical difference may not be completely

adequate, because of changes in the purchasing power of

money during the tax year. The taxpayer receives his refund

in end of tax year dollars rather than in dollars of periods

throughout the tax year (as is the case under a system of

continuous adjustment). The actual rate of inflation is

clearly an important determinant of the extent to which this

point assumes significance.

4.83 A scheme of adjustment of this kind is likely

to involve an increase in administrative costs for the

Commissioner of Taxation and an increase in compliance costs

for the taxpayer. The procedure may also be criticised on

the ground that it will result in a substantial injection of

liquidity into the economy at the tim'e when refunds are

made. Such a situation already exists in Australia, but the

size of the tax refunds under the two-stage indexation

scheme would be larger, the extent of the increase depending

on the magnitude of the inflation rate.

154

4.84 Another possible disadvantage centres on the

importance of the so-called 'tax push1 as a factor

contributing to inflation. Put very briefly, the hypothesis

is that trade unions bargain on a disposable income basis.

It has been noted above that proponents of indexing argue

that tax indexation, by increasing disposable incomes

relative to incomes under an unindexed tax system, may

exercise a moderating influence on wage demands. If tax

indexation takes the form of refunds granted after the close

of the tax year, real tax rates increase during the course of

the tax year and, in the event that gross wage and salary

increases are just sufficient to match the rate of ,

inflation, real disposable incomes decline. After the

payment of refunds has taken place, real tax rates for the

preceding tax year have been maintained. It is difficult to

judge whether trade unions are likely to respond in the same

way to an end of year refund system as to a system whereby

adjustment is more prompt and more direct. It does seem

possible, however, that an individual taxpayer's conception

of his tax burden (and of changes in that burden) is

obtained from the tax slip in his pay envelope rather than

from an end of year calculation. The latter requires a

comparison between total tax withheld during a tax year and

the amount of any refund after the close of the tax year.

If this is in fact the situation, the introduction of a tax

indexation scheme which makes provision for adjustments to

refunds may make only a modest contribution to the

moderation of wage demands.

155

4.85 A system of adjusting tax liability may be

combined with a first year adjustment of the type described

above. Such a combination permits a much smaller proportion

of the total adjustment for inflation to be effected through

the tax refund mechanism. Under a combination of first year

adjustment and tax liability adjustment, tax refunds need to

be adjusted only to compensate for any divergence between

the rate used for tax schedule adjustment in a given tax

year and the actual rate of inflation in that same tax year.

When the inflation rate is constant over time, there is

therefore no necessity for any adjustment to be made to tax

refunds.

4.86 The reduction in the importance of the tax

refund adjustment may appear to alleviate some of the

problems of the system of tax liability adjustment. But by

combining tax refund adjustment with first year adjustment,

a potential problem arises that may be of concern to the

Commissioner of Taxation. Under the basic tax refund scheme

that has been described, P.A.Y.E. taxpayers may be expected

generally to be eligible for refunds. The scheme will

involve additional tax payments from the taxpayer only if

the inflation rate becomes negative. By combining tax

refund adjustment with first year adjustment, however,

additional tax payments will be required from the taxpayer

if the inflation rate decelerates over time. This may be

less of a problem for systems where over-withholding occurs.

156

If over-withholding is significant, any additional tax

assessment may be met from P.A.Y.E. deductions, thereby

making it unnecessary to approach the taxpayer for the

additional amount.

4.87 The Committee has concluded that adjustment of

assessed liability is better viewed as a complement to first

year adjustment, rather than as an alternative.

Forecast Inflation Rate Adjustment

4.88 Another possible solution is to adjust taxable

income bracket limits and deductions at the commencement of

the tax year in line with the forecast rate of inflation for

that year. If inflation forecasting is perfect, the scheme

is equivalent to adjustment according to the current rate of

inflation. If inflation forecasting uses the previous

year's actual inflation rate as the forecast rate, the

scheme is equivalent to a lagged indexation scheme. The

reliability of inflation forecasting may lie somewhere

between these two extremes.

4.89 Under a system of forecast inflation rate

adjustment, if the forecast rate of inflation is less than

the actual inflation rate, real tax rates increase. Real

tax rates fall if the forecast rate is higher than the

actual rate. Any discrepancy between actual and forecast

rates of inflation may be dealt with by adjusting tax

refunds at the close of the tax year in the same way as has

been described in the preceding section. If inflation

157

forecasting is reasonably accurate, the required adjustment

to tax refunds may not be substantial. But if the forecast

rate significantly exceeds the actual rate, the same

potential problem arises as under the refund scheme. That

is to say, additional tax payments may be required from

taxpayers.

4.90 Governments may have qualms about using the

forecast rate of inflation as the basis of adjustment,

because to do so they must announce their own expectations

about the course of inflation during the forthcoming year.

In order not to stimulate inflationary expectations and

thereby exacerbate the inflation, there may be a temptation

for a government to use an adjustment rate lower than the

forecast rate. However, this may not be a satisfactory

option for the following reason. If the rate used for

adjustment in one tax year is less than the actual inflation

rate, then the adjustment for the following year needs to

equal the forecast inflation rate for the coming tax year

plus the discrepancy between the actual inflation rate and

the rate used for adjustment in the preceding year. Again

there is a possibility that excessive inflationary

expectations will be generated.

4.91 If adjustment is to be made according to the

forecast rate of inflation, the Committee has concluded that

the adjustment needs to be accompanied by arrangements for

adjustment of assessed liability if the actual inflationary

experience is significantly different from that forecast.

158

Without such a provision, it is possible for a substantial

discretionary element to enter into the adjustment for

inflation. From the point of view of taxpayers, one of the

major advantages of tax indexation is that the adjustment

for the effect of inflation is full, automatic and not at

the discretion of the government of the day.

Continuous Adjustment

4.92 If inflation is positive throughout a given tax

year, an unavoidable feature of the indexation schemes

discussed so far (which all rely on an adjustment at the

commencement of the tax year, supplemented possibly by a

second adjustment after the close of the year) is that real

tax rates increase continuously during the course of that

year. If the rate of inflation increases sharply during the

tax year such an increase may be substantial, and such

schemes are powerless to provide appropriate adjustment at

that time.

4.93 Increases in real tax rates during the tax year

may be avoided by making adjustments during the course of

the year. In practice, adjustments can be only as

continuous as the availability of price data permits. There

are other constraints on the frequency of intra-tax year

adjustments, the most important being the administrative

task of printing and distributing new tax tables. (This

assumes that new tax rates cannot apply until such tables

are distributed.)

159

4.94 The feasibility of quarterly adjustment depends

crucially on these administrative questions. If new tax

rates cannot operate until new tax tables are issued, and if

a period of say, six weeks, is necessary for the printing

and distribution of new tax tables, then adjustment for

inflation during the September quarter cannot commence until

the beginning of December. Similarly, adjustment for the

December quarter cannot commence until the start of March;

and for the March quarter, until the start of June.

Adjustment for inflation in the June quarter may be handled

by an adjustment to assessed liability and tax refunds. If

the length of the administrative lag is of the order of two

months (say, three weeks for the price index plus six weeks

for the preparation of the tax tables), a feasible

continuous adjustment procedure may involve a mid-year

adjustment plus an adjustment of tax refunds following the

close of the tax year. A procedure along these lines was

recommended in some submissions received by the Committee.

The Law Council of Australia thus proposed six-monthly

adjustments to operate from 1 December and 1 June each year

on the basis of price movements to 30 September and 31 March

respectively.

4.95 If the printing and distribution of new tax

tables is subject to long delays and if the administrative

costs of such an exercise are high, it may be possible to

change the design of the tables to make them more amenable

to prompt adjustment.

160

4.96 Continuous adjustment may be criticised on the

ground that the authorities do not know in advance the tax

schedule that they will use during a given tax year. Such a

situation, it may be argued, can create intolerable problems

from the point of view of economic management, because no

firm estimate can be made of personal tax receipts for the

forthcoming year. In fact, it is not likely to be difficult

to estimate aggregate personal tax receipts under a system

of continuous adjustment. In an unindexed tax structure,

the estimate is obtained by applying an estimate of the

elasticity of the personal tax structure to the estimated

percentage increase in nominal incomes. The elasticity is 2

if it is estimated that every one per cent change in

aggregate nominal incomes results in a two per cent change

in aggregate nominal tax receipts. To estimate aggregate

tax receipts under continuous adjustment it is necessary to

partition the estimate of the increase in nominal incomes

into real and inflationary components. On the assumption

that inflation adjustment is more or less instantaneous, an

elasticity of 1 applies to the inflationary component. On

the assumption that the underlying elasticity of the tax

system is unchanged following indexation, the former

elasticity of 2 is applied to the real component of the

nominal income increase. For example, if a 22.5 per cent

nominal income increase represents a 2.5 per cent real

income component and a 20 per cent inflationary component,

161

the estimated increase in nominal tax revenues equals

approximately 25 per cent (2.5 per cent X 2) + (20.0 per

cent X 1). Therefore, a policy of continuous adjustment

does not necessarily mean that the taxation authorities are

working in a situation of greater uncertainty.

4.97 Indeed, it may be argued that a policy of

continuous adjustment may actually improve the prospects for

effective demand management. Λ major O.E.C.D. report on

fiscal policy commented:

'In general, relatively little use has been made of administrative possibilities to vary tax rates for stabilization purposes within budget years.'-1 -The report recommended that:

'To increase the effectiveness and timeliness of discretionary action, ... collection systems should be readily adaptable to quid; changes in tax rates at any time during the year.'1 2

4.90 The administrative machinery necessary to

effect intra-tax year adjustments for inflation may permit

personal taxation to be used as an instrument of

demand-management policy with much more flexibility than has

so far been the case.

4.99 The case for continuous adjustment depends upon

a judgment about the administrative costs of such a scheme

relative to its advantages in terns of equity and the

1 Fiscal Policy for a Balanced Economy, O.E.C.D., Paris, December 1968, p. 121.

2 Ibid., pp. 163-4.

162

possibilities it provides for more effective demand

management. An important determinant of the equity loss

associated with the lag in adjustment is the rate of

inflation itself. Consideration may therefore be given to

the possibility of making intra-tax year adjustments

conditional. If, for example, the rate of inflation exceeds

x per cent, adjustments may be made during the course of the

tax year; if the rate is less than x per cent, adjustments

may be deferred until the close of the tax year.

The Time Lag Between Accrual and Payment of Tax Liability

4.100 Before the Committee examines this issue, it is

necessary to consider the way in which the rate of inflation

is measured. Income is a flow per period of time, the

relevant period for the purpose of personal taxation usually

being taken as one year. To measure changes in nominal

income, it is therefore necessary to compare the flow of

aggregate nominal income between one year and the next. For

the purpose of calculating inflation adjustment coefficients

for personal taxation, the rate of inflation must be

measured on a comparable basis. When the inflation rate is

constant through time, it is possible to be indifferent as

to whether it is measured on an annual or on an end of year

basis. When the inflation rate is fluctuating, however,

adjustment on an end of year basis gives rise to misleading

results. In a period of accelerating inflation, adjustment

on the basis of end of year price levels leads to

over-correction; when inflation is decelerating, the

converse is true.

163

4.101 Attention nay now be directed to the

implications, for inflation adjustment schemes, of a system

of tax collection in which there is no withholding of tax

instalments. _ For simplicity, it is assumed that the annual

tax liability is discharged by a single payment at the close

of the tax year. The most obvious implication of such a

system is that the tax schedule can be adjusted in line with

the rate of inflation in the tax year for which liabilities

are assessed. Since tax liabilities and tax payments are

both reckoned at the close of the tax year, there is no

necessity to forecast the rate of inflation or to make

continuous adjustments to the tax schedule throughout the

year. By comparison with a withholding tax system, under a

non-withholding system there is a divergence between annual

nominal tax rates and real tax rates (if a positive rate of

inflation is assumed). The reason for such a divergence is

the lack of synchronisation between the accrual of tax

liabilities and the payment of tax liabilities.

4.102 The nominal tax rate calculation involves a

comparison of dollars of different time periods. nominal

tax liabilities represent end of year dollars, while annual

nominal incomes reflect dollars of different periods

throughout the year. If the rate of inflation is positive 1

1 This statement assumes that tax liability accrues at the time income is received. In strict economic terms, tax liability accrues at the time when income is generated.

164

throughout the year. If the rate of inflation is positive

throughout the year, the nominal tax rate is greater than

the real tax rate,

4.103 An inflation adjustment scheme based on the

annual rate of inflation preserves the nominal tax rates of

the initial tax year, irrespective of how the rate of

inflation changes in subsequent years. If the rate of

inflation is constant through time, such a scheme also

maintains the real rates prevailing in the initial tax year.

This is not the case if the rate of inflation fluctuates

through time. If the rate of inflation accelerates, for

example, the inflation adjustment scheme does not prevent a

decline in real tax rates over those prevailing in the

initial year.

4.104 Where the inflation adjustment scheme takes the

form of altering exemptions and bracket limits, the

following adjustment procedure ensures that the real rate

structure of the initial year will be maintained. First,

the exemptions and brackets must be adjusted in line with

the rate of inflation measured on an annual basis. This

adjustment restores the initial distribution of the tax

burden. Then the tax liability calculated on the basis of

this schedule must be multiplied by the factor

( 1 + D )

( 1 + d )

where D represents the rate of inflation measured on an end

of year basis and d represents the annual rate of inflation.

This adjustment provides an egui-proportional change in tax

165

liabilities and ensures that the real value of tax payments

is maintained. When inflation is accelerating this

adjustment factor is in excess of unity; when inflation is

decelerating, it is less than unity. It is not logical

simply to adjust the tax schedule on the basis of the end of

year inflation rate. Such an adjustment distorts the

distribution of the tax burden and fails to maintain the

real value of tax payments. When inflation is accelerating

the real value of such payments declines; decelerating

inflation produces a converse result.

4.105 Where the inflation adjustment scheme is of the

income deflation variety, the correct adjustment procedure

involves the application of different inflation rates. For

the purpose of deflating nominal gross incomes, the

appropriate deflator is the rate of inflation measured on an

annual basis. For the purpose of reflating tax liabilities,

however, the appropriate rate of inflation is that measured

on an end of year basis, for it is this rate which

appropriately measures the decline in the value of money as

between tax payment dates.

Choice of a Price Index

4.106 It remains to consider the issue of the

appropriate price index to be used as the basis for

adjustment of the personal tax schedule. In the first

section, the Committee briefly considers the choice between

an index of consumer prices and an index of general prices.

166

The following sections examine the case for adjusting the

chosen index for the effects of discretionary changes in

indirect taxation, and for changes in the terms of trade,

respectively. The Committee then examines the case for

multiple price indexes.

Consumer Prices Versus General Prices

4.107 Except for Denmark (which now uses an earnings

index), all countries which currently adjust their personal

tax schedules automatically for the effects of inflation

measure inflation by reference to an index of consumer

prices. The rationale for this appears to be quite

straightforward. Personal tax indexation schemes aim to

prevent inflation from generating a redistribution of the

tax burden between different real income levels and

different dependant categories of taxpayers. From the point

of view of taxpayers, real income represents their command

over real goods and services for personal use, the relevant

goods and services being those which enter their consumption

expenditures. The use of a more widely based index such as

the Gross National Expenditure (G.N.E.) deflator may give

perverse results, due to the fact that it contains the

deflator for government expenditures. If, for example, the

prices of goods and services comprising government

expenditures increase at a more rapid rate than those

comprising consumer expenditures, the reduction in personal

tax revenues which results from indexing on the basis of the

G.N.E. deflator is greater than if indexing is on the basis

167

of an index of consumer prices. The more rapid the relative

rise in the price of government purchases, the greater is

the decrease in personal tax revenues. Clearly, such a

result is the opposite of that required. The G.N.E.

deflator net of the government expenditure component also

seems to be less satisfactory than an index of consumer

prices, because it includes changes in the prices of capital

goods. These are directly relevant to the real income of

taxpayers only to the extent that they affect the prices of

consumption goods and services. Hence, the preferred index

is one that measures changes in the prices of consumption

goods and services.

Adjustment for Indirect Taxation

4.108 In Denmark, between 1969 and 1974 adjustment of

the personal tax schedule was based on the cost of living

index. This is a different index from the consumer price

index, because it excludes the direct price effects of

discretionary changes in indirect taxation and subsidies.

The cost of living index was constructed for use in the

context of wage indexation, which has operated in Denmark

since 1945. The Netherlands also adjusts its personal tax

schedule on the basis of an index that excludes the effects

of indirect taxes and subsidies on prices. In Canada, where

tax indexation has been introduced most recently, the

consumer price index is not adjusted for changes in indirect

taxes or subsidies.

168

4.109 The following discussion will avoid the

difficult problem of deciding what publicly levied charges

may appropriately be regarded as constituting indirect

taxation. It is also assumed, rather heroically, that the

extent and timing of consumer price responses to

discretionary indirect tax changes are known.

4.110 There are two related but distinct arguments in

favour of removing the price effects of discretionary

changes in indirect taxation from the index used for tax

indexation. The first is based on equity considerations,

while the other depends on resource allocation

considerations. The equity argument stated quite simply is

that there is a qualitative difference between a price rise

reflecting, say, general excess demand, and a price rise

caused by an increase in indirect tax. It is argued that

the latter case involves a quid pro quo for the consumer

which is missing in the former case. The quid pro quo is

the increase in the quantity or quality of publicly supplied

goods or services. This argument is valid even if indirect

taxes are increased for stabilisation purposes and the

resultant increase in tax revenue is frozen; economic

stabilisation policy is itself an important public service

of benefit to the community at large.

4.Ill The resource allocation argument is that, if

personal disposable incomes are increased promptly in line with

consumer prices (including the price effects of indirect tax

changes), personal taxpayers are effectively avoiding the

tax and the required real resource transfer to the public

sector is frustrated.

169

4.112 These arguments will now be considered in

detail. Let it be assumed that the personal tax schedule is

indexed according to the Consumer Price Index adjusted to

exclude the price effects of discretionary changes in

indirect taxation. Further assume that nominal wages and

salaries do not respond to the price movements induced by

indirect tax changes (this assumption is relaxed

subsequently). In the case of indirect tax increases,

indexation on such a basis involves a redistribution of the

personal tax burden between different real income levels,

with the tax rate on every level of real income increasing

as real incomes rise. It also involves a redistribution of

the tax burden between different dependant categories, the

large family category being most adversely affected. These

arbitrary redistributions occur irrespective of the source

of inflation. The redistributions are equivalent to those

that are forthcoming if the actual rate of inflation is

equal to the discrepancy between the unadjusted and adjusted

inflation rates, and the tax schedule is unindexed. In the

case of indirect tax decreases (if it is assumed that these

too are reflected in consumer prices), opposite

redistributions occur, the tax rate on each level of real

income decreasing with increases in incomes for each

dependant category. Personal tax indexation according to an

adjusted price index thus ensures that increases in the

burden of one form of taxation (indirect taxation)

automatically, and at the same time, result in increases in

170

the burden of another form of taxation (direct taxation).

Similarly, it ensures that decreases in indirect taxation

automatically generate decreases in the burden of direct

taxation. An unavoidable link is established between

changes in the burden of the two forms of taxation.

4.113 On equity grounds, such a link does not appear

to be required if money incomes do not respond to price

movements induced by indirect tax changes. In the case of

decreased indirect taxation, for example, the taxpayer

receives an increase in real income as a result of reduced

consumer prices, and he also receives a de facto decrease in

his personal tax burden in that this real income increase

has been effectively exempted from personal taxation. The

quid pro quo element, in this case for a presumed reduction

in the supply of public goods and services, seems to be met

by the absence of a downward adjustment of wages and

salaries in response to the price falls induced by indirect

tax reductions. To exempt this real income increase from

personal taxation seems not only generous, but unnecessary.

It is not clear why a personal tax system should tax real

income increases from all sources except those arising from

changes in indirect taxation and, similarly, provide partial

relief for reductions in real income arising from all

sources except those arising from indirect tax increases.

4.114 It has been argued that use of an unadjusted

index gives an implicit allowance for indirect taxation

which is of greatest benefit to high income taxpayers; that

171

is, to those taxpayers subject to higher marginal rates of

tax. However, as the analysis of the impact of inflation on

tax burdens demonstrated, failure to adjust the tax schedule

for the effects of inflation, from any source, results in a

redistribution of the tax burden between low income

taxpayers and high income taxpayers. Indexation on the

basis of an unadjusted price index prevents such a

redistribution from taking place. The fact that persons

with incomes not subject to tax receive no tax reduction to

offset the increase in indirect taxes comes about as a

result of the basic structure of the personal tax system.

It is not a problem caused by the price index used for

personal tax indexation, nor is it amenable to solution

through modification of indexation procedures.

4.115 What indexation according to an unadjusted

price index does achieve is to free taxpayers with the

lowest incomes from a positive tax liability, in the event

that their real incomes decline as a result of indirect tax

increases. Equity considerations thus appear to require

indexation on the basis of an unadjusted price index.

4.116 On resource allocation grounds, however, there

is a strong case for adjusting the index. Indirect tax

changes aim to secure a given transfer of resources

between the private and public sectors, and indexation of

personal taxation on the basis of an unadjusted price index

tends partially to offset the required transfer. In the

case of indirect tax decreases, the transfer of real

172

resources is likely to be partially offset by a relatively

greater increase in the aggregate personal tax ratio than

would occur if an adjusted price index were used. In the

case of indirect tax increases, the real resource transfer

is likely to be partially offset by a relatively greater

decrease in the aggregate personal tax ratio.

4.117 There is a real question here, however. If the

above argument is valid, it is not clear why it should be

confined to indirect taxation as conventionally defined.

Exactly the same argument may be applied to any changes in,

say, company taxation which are passed on in the form of

higher prices. Indeed, the logical extension of the

argument is that the component of total inflation, which

comes about as a result of government policies designed to

shift resources from the private sector to the public

sector, should not be recognised in the index used for

adjusting the tax schedule. This would exclude from the

index not only price movements attributable to changes in

all forms of taxation, but also any price increases

generated by increased government borrowing or by increases

in the money supply generated to finance budget deficits.

Most policies aimed at shifting resources from the private

to the public sector have inflationary implications; it

seems arbitrary to single out indirect taxation and ignore

all other instruments used for this purpose. It can, of

course, be argued that the contribution of changes in

indirect taxation to the rate of inflation is more direct

173

and more easily measurable than is the case with the other

instruments. The fact seems to be that there has been very

little empirical investigation on the incidence of any of

the major taxes in Australia.

4.118 Even if the argument is confined to indirect

taxation, however, its force depends on the extent to which

nominal incomes rise because of the tax increases and on the

reason for levying indirect taxes. If the reason for

choosing indirect taxation as the instrument for the

resource transfer is to change the mix of the various taxes,

the purpose will be achieved more effectively if personal

taxation is indexed according to an unadjusted price index.

4.119 If personal tax indexation is based on an

unadjusted price index, the assumption that nominal wages

and salaries do not adjust to price changes caused by

indirect tax increases does not necessarily imply that the

aggregate personal tax ratio will decline between one tax

year and the next. Even if nominal wages and salaries fail

to respond to price increases, real wages and salaries may

still increase as a result of productivity increases or

other factors inducing real wage and salary growth. So long

as real wages and salaries increase, the aggregate personal

tax ratio will increase under a system of tax indexation

based on an unadjusted price index.

4.120 In the case of indirect tax increases, personal

tax revenues will be lower when indexation is based on an

unadjusted price index than when the index is adjusted for

174

indirect tax changes. But the shortfall in direct tax

revenue with an unadjusted index may be partly compensated

by a second round increase in indirect taxation. When

indexation is based on an unadjusted index (and if it is

assumed that there are no additional discretionary

adjustments to the personal tax schedule), real disposable

incomes will be higher, thus tending to increase consumption

and the base for indirect taxation.

4.121 It remains to examine the implications of

relaxing the assumption that nominal wages and salaries do

not adjust to the price effects of indirect tax changes.

Let it be assumed instead that all wages and salaries adjust

fully and promptly to such price effects. As in the

previous case, indexing according to an unadjusted price

index ensures that the legislated tax rates on each level of

real income, for each taxpayer category, are maintained. In

the case of indirect tax increases, the aggregate personal

tax ratio is higher than in the non-wage adjustment case,

because the same tax rates are being applied to a larger

real income base. However, the most important implication

of this assumption is that the increase in indirect taxation

is effectively avoided by wage and salary earners, "he

burden of the increase falls on those whose incomes fail to

adjust, not only to the inflation generated directly by the

increased indirect taxation, but also to the subsequent

175

inflation which may result from the wage and salary

adjustment.

4.122 Relative to the unadjusted indexation case,

indexation on the basis of a price index net of the price

effects of indirect tax changes does not increase the flow

of real resources through the indirect tax system. On the

contrary, it tends to reduce such a flow by reducing real

disposable incomes. (It is again assumed that there are no

additional discretionary adjustments.) The use of an

adjusted index provides a higher real resource flow through

the personal tax system, but only by invoking the arbitrary

tax burden redistributions which personal tax indexation

aims to prevent. If it is the case that wage and salary

earners are able to obtain full and prompt compensation for

price increases due to indirect tax increases, then indirect

taxes are an inefficient instrument for the purpose of

transferring resources from the private to the public

sector. In such circumstances, other instruments appear

preferable, either increases in other forms of taxation

(including the possibility of explicit adjustments in the

rates of personal taxation) or increases in government

borrowing from the public. Nevertheless, the options

available may be severely limited if they themselves

accentuate inflationary pressures through wage-push. 1

1 The converse is true in the case of reductions in indirect taxes because ceteris paribus such reductions assist in decreasing the rate of inflation.

176

4.123 The case for adjusting the index on grounds of

resource allocation is more or less compelling depending on

whether nominal incomes increase to a greater or lesser

extent than the increases in indirect taxation. If wages

and salaries do not adjust to price changes induced by

changes in indirect taxation, then the required real

resource transfer occurs, and it occurs through the chosen

instrument of indirect taxation when indexation is based on

an unadjusted Consumer Price Index. If wages and salaries

do adjust to such price changes, then serious doubt is cast

on the efficacy of indirect taxation as an instrument for

effecting real resource transfers. However, if such

transfers are required, it is desirable to use an adjusted

index.

Adjustment for Changes in the Terms of Trade

4.124 At the time personal tax indexation was

introduced in the Netherlands, there was some discussion

about the relationship between the consumer price index and

changes in real income, the main difficulty being seen as

the effect of the terms of trade on domestic price levels.

It was felt that, to the extent that the price index

reflected changes in the terms of trade, indexation could

result in adjustment for changes in real incomes as well as

for price changes. No adjustment for the terms of trade was

177

incorporated into the index used for adjusting the personal

tax schedule, partly because of the difficulty in isolating

the effect of changes in the terms of trade on the domestic

price index.

4.125 In order to conclude whether there are any

grounds other than impracticability for ignoring the

influence of changes in the terms of trade, it is helpful

first to examine the way in which changes in external prices

influence the consumer price index; and then to consider

the relationship between external price changes and changes

in real income.

4.126 Changes in import prices may affect the

consumer price level in two ways. As well as the direct (or

'content1) effect of the change in import prices, there may

also be an indirect (or 1 competitive*) effect, whereby the

change in import prices induces changes in the prices of

competitive domestically produced goods. In the case of

export price changes, only the indirect effect applies. An

increase in export prices may thus induce increases in the

prices of exportables consumed domestically.

4.127 If the relationship between external price

changes and changes in real income is considered, an

increase in import prices relative to export prices (that

178

is, an adverse movement in the terms of trade) means that,

ceteris paribus, the economy's command over real goods and

services diminishes, that is to say aggregate real income

declines. Similarly, an increase in export prices relative

to import prices increases aggregate real income. External

price changes thus have a direct influence on aggregate

domestic real income.

4.128 This is not so when the price level changes as

a result of internal factors. Domestically generated

inflation has no direct effect on aggregate real income.

Rising prices for domestically produced goods and services

have their counterpart in monetary returns to domestic

factors of production, so that rising prices of this type

necessarily mean rising money incomes to wage and salary

earners or to profit recipients. As discussed above,

external price changes may exert an indirect influence on

domestic price changes. But even though the domestic price

changes come about as a response to the external price

changes, they are properly characterised as domestically

generated inflation, because they have no direct effect on

aggregate real income.

4.129 Thus, changes in the terms of trade affect the

consumer price index. These price influences are

qualitatively different from the remaining price influences

on the domestic price index. The former are associated

directly with changes in aggregate real income, whereas the

179

latter are not. The essential question is whether it is

appropriate to use the consumer price index as a deflator in

the calculation of real income. On the one hand, a consumer

price index which reflects movements in the terms of trade

may be said to measure changes in real income as well as

price changes. On the other, it may be argued that the

direct effect of a rise in import prices on the consumer

price index is as much a reflection of a fall in purchasing

power as the effect of a rise in the index emanating from

any other source. The fact that the rise in import prices

is associated with an adverse movement in the terms of trade

(and, under certain circumstances, with a decline in

aggregate real income) does not reduce the logic of the

indexation procedure. This still needs to reflect changes

in purchasing power in the hands of the consumer, as

measured by a consumer price index inclusive of terms of

trade effects. Movements in aggregate real incomes are

relevant to personal tax indexation schemes of the type

currently operating in Denmark, whereby adjustment is made

on the basis of changes in annual earnings. Under such

schemes, adjustment is made for both inflation (to the

extent that nominal incomes adjust fully to inflation) and

real income growth. But movements in aggregate real incomes

have no direct relevance to an indexation scheme designed to

insulate the system only from the effects of inflation.

4.130 If the index used for adjustment is less than

the actual rate of price increase (as is the case if the

180

consumer price index is adjusted for any adverse movement in

the terms of trade arising from increased import prices),

then arbitrary redistributions of the tax burden take place

just as if the actual rate of inflation is equal to the

discrepancy between the two rates, and the tax schedule is

unindexed. An increase in import prices may, in certain

circumstances, require that the economy suffer a decline in

real living standards. In the context of wage indexation,

for instance, this fact may imply that nominal wages cannot

be fully adjusted to compensate for the increase in import

prices. (This issue is discussed in more detail below.)

However, it is not necessary from the point of view of tax

equity to require that falls in real income arising from

increased import prices are automatically accompanied by an

increase in real personal tax rates, and by a redistribution

of the tax burden as between different real income levels

and different dependant categories.

4.131 Another argument has been advanced in favour of

removing the effects of changes in the terms of trade from

the index used for adjustment. This is based on revenue

considerations:

"... changes in the terms of trade (as for example are occasioned by a rise in import prices) which reduce the real level of income of the country would be reflected in the price index used for automatic adjustment purposes occasioning reductions in income tax collections. The revenue requirements of the government are, however, unlikely to be reduced in such circumstances and such an outcome, necessitating other action to finance expenditure, would be perverse".1

1 Personal Income Tax: The Rate Scale, op. cit., p. 18

181

4.132 However, any fall in real incomes as a result

of an adverse movement in the terms of trade may be more

than offset by a rise in real incomes from other causes.

The real level of income can therefore still increase as

between one year and the next, despite an adverse movement

in the terms of trade. Indeed, such has often been the

situation in Australia during the last twenty years. So

long as aggregate real incomes increase between one year and

the next (or more precisely so long as there is a rise in

the component of aggregate real income which constitutes the

base for personal taxation), then real personal income tax

collections between one year and the next also increase.

Moreover, they increase at a proportionate rate in excess of

the increase in aggregate real personal incomes (that is,

the aggregate personal tax ratio increases), even if

indexation is based on an unadjusted index.

4.133 The Treasury statement also implies that the

whole of the burden of adjustment to the adverse movement in

the terms of trade should be borne by the private sector,

rather than shared between the public and private sectors.

Such an argument may be defended on the grounds that a

social preference has been expressed through the ballot box

for a given level of publicly supplied goods and services.

It can be argued with equal validity, however, that what has

been expressed is a preference for a given relative size of

the public sector. If this is the case, then a decline in

aggregate real income requires some decline in the real

182

expenditure levels of both the public and private sectors.

Taxpayers as consumers also have revenue requirements and

expenditure levels which they no doubt desire to see

preserved. There seems to be nothing in the democratic

process which makes public expenditures sacrosanct in the

face of declining real income for the economy as a whole.

This is not to deny that, as a practical matter, it may be

difficult to effect significant changes in public

expenditure levels in the short run. But that is a

different proposition from the assertion that, in principle,

public expenditure levels should not bear any of the burden

of adjustment.

4.134 Even if the adverse movement in the terms of

trade is associated with an absolute reduction in aggregate

real income, and even if it is decided that pre-existing

public expenditure levels are to be maintained, it does not

necessarily follow that personal tax indexation should be on

the basis of an index adjusted for changes in the terms of

trade. For if the major rationale of personal tax

indexation is accepted, the use of such an index is an

inequitable means of raising the additional required

revenue. Indexation on the basis of an unadjusted index

does not preclude the use of personal taxation as the means

of raising the additional revenue. It simply means that if

personal taxation is to be the chosen instrument (rather

than increases in other forms of taxation, or increased

borrowing from the public, or some combination of these

183

options), then explicit adjustments in personal tax rates

are required.

4.135 The foregoing discussion does not deny the

possibility that real income changes in the economy as a

whole may result in changes in preferences concerning the

size or the distribution of the personal tax burden.

However, the Committee is not persuaded that partial

adjustment for inflation will provide the desired changes.

Multiple Versus Single Price Indexes

4.136 Proposals have been made for personal tax

indexation to be based on several price indexes, each

reflecting consumer price changes weighted in accordance

with the consumption pattern of a different group of income

earners. Such a proposal assumes that a well-defined

relationship exists between consumption patterns and income

levels. It also presumes that, to the extent that such a

relationship exists, the rates of change in the prices of

the different bundles of consumer goods and services diverge

significantly from each other. There is some evidence

available to support the validity of the first proposition

for Australia, but no evidence in support of the second

proposition. Even if it is assumed that both propositions

are valid, there are economic and administrative objections

to the use of differentiated price indexes. The use of such

indexes may potentially undermine the allocative role of

changes in relative prices, by a virtual underwriting of the

initial expenditure patterns of each income group. There

184

appears to be nothing about these patterns which requires

them to be preserved in the face of changing relative

prices. Further, the task of collecting and updating data

on consumption patterns by income groups is likely to be a

formidable one, scarcely justifiable for the purposes of

tax indexation only. Differentiated price indexes may also

be expected to complicate the whole personal tax system.

For example, carried to its logical conclusion the

application of differential price indexes requires the

nominal values of deductions to be different for each income

group. The use of differentiated price indexes seems to

constitute an unnecessary complication for personal tax

indexation.

Conclusions Regarding Choice of Price Index

4.137 The Committee concludes this discussion by

distinguishing between two possible uses of a consumer price

index:

(a) as a measure of changes in the real purchasing

power of a dollar in the hands of the consumer;

and

(b) as an index for the adjustment of nominal

incomes.

For the former use, the cause of the changes in the index is

completely irrelevant. For the second use this is not the

case. If nominal incomes adjust to an increase in the index

caused by discretionary increases in indirect taxation, then

185

the tax has been avoided. It is also illogical to adjust

nominal incomes in line with increases in the index

resulting from adverse movements in the terms of trade

because, ceteris paribus, the maintenance of pre-existing

real income levels is not sustainable.

4.138 The major aim of personal tax indexation

schemes is to maintain the legislated distribution of the

tax burden between different real income levels and

different dependant categories. Such schemes require a

price index which measures the real purchasing power of a

dollar in the hands of a consumer. For this purpose the

source of changes in the consumer price index is irrelevant,

and an unadjusted consumer price index should be used for

the indexation.

4.139 Within the context of adjustment for the

effects of indirect taxation, it may be argued that an

unadjusted index is inappropriate if resources are to be

shifted from the public to the private sector. It may be

argued that the appropriate measure is not the consumer's

command over real goods and services for personal use, but

rather his command over real goods and services both

privately and publicly supplied. If this view is accepted,

however, the whole issue of tax rates becomes unimportant.

It does not matter how tax rates are levied or changed,

because a taxpayer's real income, in the sense defined

above, remains unaltered even if his tax rate doubles

186

overnight. All that alters is the mix of publicly supplied

goods and services relative to the privately supplied goods

and services which the taxpayer can command. It is not

possible to determine how the benefits of government

expenditures are distributed among the community. Even if,

as a result of the removal of indirect tax effects from the

index, those who suffer the greatest increase in their tax

burdens can be shown to receive the greatest benefit from

increased government expenditures, this does not justify the

use of the adjusted index. Such a justification must rely

on the proposition that personal tax burdens are allocated

according to the benefit principle, so that those who enjoy

the greatest benefits from government expenditure bear the

largest personal tax burdens. Contemporary progressive

personal tax systems explicitly reject such an approach.

4.140 A possible objection to the earlier argument is

that nominal incomes may not respond in accordance with

economic requirements. In the real world, for example, wage

earners may receive compensation for the price effects of

discretionary tax changes and adverse movements in the terms

of trade. The question then arises as to whether adjustment

of the price index used for personal tax indexation is an

appropriate second-best solution to this problem. If the

major rationale for personal tax indexation is accepted,

such a solution is inconsistent. This is not to say that

the personal tax system is an inappropriate instrument

through which to achieve the required adjustments. The

187

proposition is simply that low income, large family, tax

units should not bear a disproportionate share of the

required overall adjustment, as will be the case if the rate

used for indexation of the personal tax schedule is less

than the actual rate of price increase. A solution

consistent with the equity objective of personal tax

indexation is to index on the basis of an unadjusted index

and to effect an equi-proportionate increase in all

statutory marginal tax rates. In this way, the required

revenue can be obtained without any inflation-induced

redistribution of the tax burden between different real

income levels and different dependant categories of

taxpayers.

4.141 If, however, wage indexation is to accompany

personal tax indexation, it may be considered desirable that

the same index be used for both purposes. Whether the

consumer price index should be adjusted for changes in

indirect taxes under these circumstances depends on the

weight attached to the view which the Australian Treasury

expressed in its submission:

"... real problems would certainly arise unless the index used for tax indexation - it is taken for granted here that it would be based on the consumer price index - were adjusted to eliminate the effects of

increases in indirect taxes (as it should, since such taxes are designed to tax the consumers of the items concerned rather than employers). The significant point for the present discussion is that if the index used for the purposes of wage indexation did not eliminate the effects of indirect taxes, any increase

in indirect tax rates intended to replace revenue lost by tax indexation would increase the price index, and

188

consequently the level of wages. In turn, through the operation of the tax indexation system, this would make it necessary to raise indirect taxes further, pushing the index and the wage level up further, and so on. Additional inflationary pressures would be built into

the system. The core of the problem is that if the institutional framework includes both wage indexation related to a price index which reflects indirect taxes and tax indexation, the real after-tax income of wage and salary earners is beyond fiscal policy influence without discretionary changes in income tax rates".

4.142 This argument needs to be placed alongside the

view that removal of indirect taxes from the index to be

used for wage indexation could have far-reaching

implications on the state of industrial relations. All of

the central trade union organisations are strongly committed

to the inclusion of indirect taxes in the price index used

to adjust wages. Consequently, any attempt to adjust the

consumer price index for indirect tax changes is likely to

increase industrial disputation.

189

APPENDIX TO CHAPTER IV

LAGGED INDEXATION AND REAL TAX RATES

Several hypothetical inflation

situations are depicted below in order to illustrate some

implications of lagged indexation operating within an

environment of fluctuating inflation rates. Changes in

average tax rates confronting the hypothetical taxpayer

described on page 148 are shown for each situation as well as

for a taxpayer with a dependent spouse and two dependent

children at the same real income level. If indexation is

based on the current rate of inflation, the average tax rate

for the single taxpayer remains unchanged in each tax year at

22.75 per cent. It is 18.17 per cent for the married

taxpayer. In each of the cases below the indexation scheme

is assumed to commence in Year 1.

(a) continually accelerating inflation: real tax rates

continually increases

Year

0 1 2 3 4

Inflation Rate (%) 5 10 15 20 25

Average Tax Rate (%) - single 23.90 24.95 25.91 26.79

- married 19.35 20.42 21.54 22.60

190

(b) continually decelerating inflation : real tax rates

continually decrease;

Year

0 1 2 3 4

Inflation Rate (%) 25 20 15 10 5

Average Tax Rate (%) - single 21.86 20.90 19.85 18.95

- married 17.22 16.31 15.33 14.35

(c) accelerating inflation stabilising at a higher rate;

real tax rates increase during the period of

acceleration, and remain permanently above their

legislated levels once inflation has stabilised at the

higher rate:

Year

0 1 2 3 4

Inflation Rate (%) 5 10 15 15 15

Average Tax Rate (%) - single 23.90 24.95 24.95 24.95

- married 19.35 20.42 20.42 20.42

(d) decelerating inflation stabilising at a lower rate:

real tax rates decrease during the period of

deceleration, and remain permanently below their

legislated levels once inflation has stabilised at the

lower rate:

Year

0 1 2 3 4

Inflation Rate (%) 15 10 5 5 5

Average Rate (%) - single 21.78 20.73 20.73 20.73

- married 17.14 16.15 16.15 16.15

191

(e) accelerating inflation resuming initial rate; real tax

rates increase during the period of acceleration, then

resume their legislated levels once inflation resumes

its initial rate:

Year

0 1 2 3 4

Inflation Rate (%) 5 10 15 5 5

Average Tax Rate (%) - single 23.90 24.95 22.75 22.75

- married 19.35 20.42 18.17 18.17

(f) decelerating inflation resuming initial rate: real

rates decrease during deceleration, then resume their

legislated levels:

Year

0 1 2 3 4

Inflation Rate (%) 15 10 5 15 15

Average Tax Rate (%) - single 21.78 20.91 22.75 22.75

- married 17.14 16.1b 18,17 18.17

(g) accelerating inflation followed by lower stable rate:

real rates increase during acceleration, and then remain

permanently below their legislated levels as long as the

lower inflation rate persists:

Year

0 1 2 3 4

Inflation Rate (%) 5 10 15 5 5

Average Tax Rate (%) - single 23.90 24.95 22.13 22.13

- married 19.35 20.42 17.46 17.46

192

(h) decelerating inflation followed by higher stable rate;

real rates decrease during deceleration, then remain

permanently above their legislated levels as long as

the higher inflation rate persists:

Year

0 1 2 3 4

Inflation Rate (%) 15 10 5 20 20

Average Tax Rate (%) - single 21.78 20.91 23.80 23.80

- married 17.14 16.15 19,25 19.25

193

V INDEXATION SCHEMES IN OTHER COUNTRIES

5.1 This Chapter surveys the experience of various

countries which have introduced inflation adjustment schemes

for personal taxation. While a variety of schemes is

employed, the most common type involves adjustment of

taxable income bracket limits and deduction limits by

reference to a consumer price index. Not surprisingly, the

introduction of the schemes usually followed an increase in

the rate of inflation. Of the eleven countries included in

this survey, seven have introduced the schemes within the

past decade. As for the remaining countries, two have

traditionally experienced high rates of inflation.

5.2 For purposes of the following discussion

countries are grouped according to the following types of

price or income adjustment used as the basis of indexation:

(a) adjustment by reference to a consumer price or

a cost of living index;

(b) adjustment by reference to changes in average

earnings;

(c) adjustment by reference to changes in nominal

incomes; and

(d) exemption of cost of living wage increments.

Inflation Adjustment

5.3 The following countries have introduced

straight inflation adjustments based on a consumer price or

cost of living index.

194

5.4 Denmark. In 1969, Denmark introduced an

inflation adjustment scheme for personal taxation.^ The law

provided that the single person's deduction limit, the

married person1s deduction limit and the taxable income

bracket limits be adjusted by three per cent for each four

points by which the cost of living index moved in relation 2

to the level of that index in January 1969. The cost of

living index was the consumer price index net of the price

effects of indirect taxes and government subsidies. The

maximum amount specified for wives' earned income allowance

was not subject to inflation adjustment.

5.5 Two points may be noted with respect to the

calculation of the adjustment factor. First, the increase

in the index was measured with respect to a specified base

date. This meant that if, for example, two successive

annual three-point increases in that index were recorded,

adjustment would be forthcoming in the second period. This

may be contrasted with a procedure whereby adjustment is

made only if the increase in the index exceeds a specified

amount within a given period, usually twelve months. In the

latter situation, two successive three-point increases would

result in no adjustment if a four-point rise in the index

was required in a single year. Secondly, the Danish law

Denmark, Law No. 330 of 18 June 1969.

There is no deduction for dependent children in Danish personal taxation. However, tax-free family allowances are provided.

2

195

provided for proportionate increases in deductions and

bracket limits in response to increases in the absolute

number of points in the cost of living index, rather than to

proportionate increases in the index. Such a procedure

would result in some overcorrection when the absolute level

of the index was above 133, and undercorrection when the

index was below this amount."*"

5.6 In 1972 the base of the index was changed to

make January 1971 equal to 100. The lav; relating to

personal tax indexation was amended so that taxable income

bracket limits and specified deduction limits were increased

by 3h per cent for each full three-points change in the

index in relation to the figure 90. Danish tax law contains

a provision which seems to facilitate changes in tax rates

that are neutral with respect to the distribution of the

personal tax burden. The 1969 tax legislation established

that the marginal tax rates applicable to each taxable

income bracket are to be regarded as basic. Each year the

percentage at which these basic rates are to apply must be

specified. In 1970, for example, the rates were specified

to be 95 per cent of the basic rates and since that year the

rates have been fixed at 91 per cent. This means that if

full inflation adjustment implies an unacceptable reduction

in tax revenues, the Government need not suspend or modify

the inflation adjustment scheme. It can implement the

1 In January 1969, the cost of living index stood at 131.

196

scheme fully and increase the percentage at which the basic

tax rates are to apply. In this way, inflation-induced

distortions in the distribution of the personal tax burden

may be eliminated, and the required aggregate personal tax

ratio achieved. Of course, such an option is open to other

countries as well, but the Danish tax legislation seems

particularly well suited to the implementation of such a

two-stage adjustment procedure.*1 In February 1974, Denmark

substituted an earnings index for the price index which was

previously used for indexation purposes. The new law is

described in paragraphs 5.35 and 5.36.

5.7 The Netherlands. In 1971, the Netherlands

established an inflation adjustment scheme for personal 2

taxation which became operative in January 1972. Until

1973, the Netherlands tax law did not contain an explicit

tax schedule with taxable income brackets and accompanying

marginal rates. Nor were allowances for dependants set down

as specified amounts. Rather, the tax law provided that

income be taxed in accordance with tax tables issued from

time to time. These tables set out the amount of tax

payable at given levels of taxable income by single persons,

married persons, and persons with varying numbers of 3 children.

Sweden, and 22 of the 25 Swiss cantons, also have established such basic rates in their tax legislation.

The Netherlands, Public Law No. 259 (23 April 1971) Staatsblad 259, ppT 640-41. " ~

Taxable income was equal to gross income minus deductions such as pension payments, social security payments, interest expense, wives' earned income allowance, and age and disablement deductions.

3

197

5.8 The inflation adjustment took the form of a

"tax-table correction factor", calculated as the ratio of

(a) the average consumer price index during the 18th to the

7th month preceding the tax year, to (b) the average

consumer price index during the 30th to the 19th month

preceding the tax year. The consumer price index used for

this calculation was adjusted to remove the effect of

changes in indirect taxes and government subsidies.

5.9 An adjusted tax table was derived by applying

the correction factor to the taxable income levels and

amounts of tax appearing in the existing tax table. If the

argument about indirect taxes is ignored, such a procedure

maintained the average tax rate on all real taxable income

levels for all dependant categories.

5.10 The legislation also provided for the

correction factor to be applied to those deductions from

gross income that were specified as fixed nominal amounts;

namely, wives' earned income allowance, and age and

disablement deductions. If all deductions were of this

form, the scheme would ensure that the average tax rate on

all real gross income levels for all taxpayer categories was

maintained. All deductions were not of this form, but to

the extent that the payments and expenses comprising the

remaining deductions increased at a rate equal to the rate

of inflation, the same result would be achieved.

5.11 The legislation provided that the factor

actually used for correction could be fixed by the Minister

198

as a proportion up to 20 per cent below the correction

factor based on the price indexes. When the scheme was

first implemented in January 1972, full use was made of this

provision by reducing the correction factor by 20 per cent.

The ratio of the price indexes equalled 1.057, while the tax

table was adjusted by the application of a factor equal to

1.046.* Two reasons were given for this downward

adjustment. First, no measures had been taken to prevent a

fall in the real yield of several specific taxes (in

particular, excise duties and the motor vehicle tax) due to

inflation. Second, the Government was of the opinion that

full inflation adjustment would have conflicted with other

policy measures designed to curb a threatened wage-price

spiral.

5.12 The full 20 per cent downward adjustment of the

correction factor was also made for 1973, the Government

arguing that the revenue loss resulting from full downward

adjustment would have been difficult to meet from 2

alternative revenue sources. The tax structure for 1973

was amende'd, and the tax table replaced by the more

conventional form of taxable income brackets with 3

accompanying marginal tax rates. Personal allowances and 1

1 The Netherlands, Minister of Finance, Order B71/19821, October 20, 1971.

2 The Netherlands, Minister of Finance, Order B72/22207, September 18, 1972.

3 The Netherlands, Staatsblad 613, November 16, 1972.

199

allowances for dependants were also specified as absolute

amounts. The adjusted correction factor was applied to

these taxable income bracket limits and dependant

allowances.

5.13 For 1974, the adjustment scheme was suspended.

Had the scheme been implemented, allowances and bracket

limits would have increased by 8.3 per cent. In order to

provide some relief for lower income groups, personal

allowances and allowances for dependants were increased by 5

per cent. At the same time, however, the nominal width of

the first taxable income bracket was reduced by an amount

equal to the increase in the allowance for a married couple

without children. For 1975, the adjustment scheme was

reactivated, and the maximum downward adjustment to the

correction factor was again implemented.

5.14 Luxembourg. Formal provisions for automatic

inflation adjustment of the personal tax schedule were

incorporated in the new income tax law introduced by

Luxembourg at the end of 1967.* However, explicit

adjustments for inflation had been implemented in 1965 and

1966. The legislation provided for the tax schedule for the

following tax year to be adjusted whenever the consumer

price index for the first six months of the current tax year

increased by at least 5 per cent over the corresponding

period of the previous year. The method of adjustment was

not specified. However, it has taken the form of deduction

limit and bracket limit adjustment.

1 Income Tax Law of 4 December 1967, Article 125.

200

5.15 Had the Luxembourg authorities adhered strictly

to the legislative provisions, only one adjustment would

have been forthcoming between 1968 and 1974. In fact, four

adjustments were made during this period. In 1970 and 1972,

adjustments were made on the basis of the increase in the

consumer price index in the first six months of the previous

tax year over its corresponsing value two years earlier. In

1973 another adjustment was made even though the rate of

inflation was below the 5 per cent figure stipulated in the

legislation. The 5 per cent inflation threshold provision

has thus not proved as costly to the taxpayer as the

legislation implies.

5.16 Swiss Cantons. The tax legislation of several

Swiss Cantons contains provisions authorising the

governments to make adjustments for the effects of

inflation. The nature of these provisions varies between

the different Cantons, as does the degree to which such

provisions have been implemented.

5.17 An inflation adjustment scheme of the income

deflation variety exists in the Swiss Canton of Basel-Land.1

Taxable income is expressed in terms of base-year (1953)

prices. The tax rate on deflated taxable income is

determined by reference to the base-year tax schedule. The

rate so determined is then applied to taxable income

European Taxation, Switzerland, Section B. Tax tables for individuals, Canton of Basel-Land, No. 5, May 1973.

201

5.19 The 1961 income tax legislation of the Canton

of Solothurn contained a provision empowering the Cantonal

Council to effect "appropriate adjustments" to exemptions

and allowances if the cost of living index increased by more

than ten points after January 1962.* However, exemptions

and allowances were unchanged from 1962 to 1970, during

which time the cost of living index rose by 33 per cent.^

They were increased by 24 per cent in 1971, and by a further

5 per cent in 1972. Taxable income bracket limits were

unchanged throughout the decade.

5.20 The provisions for inflation adjustment

contained in the tax legislation of the Canton of Graubunden

are more comprehensive than those of Solothurn, in that

provision is made for adjustment of all nominal amounts

contained in the statute. However, adjustment has been

similarly infrequent. Between 1965 and 1973, only a single

adjustment of 10 per cent was implemented, compared with an

increase in the consumer price index of 46 per cent over the

same period.^

Law of 29 January 1961, on Direct Cantonal and Communal taxes, Article 43, Section 2.

International Financial Statistics, various issues.

Tax Law of 21 June 1964, Article 16.

International Financial Statistics, various issues.

2

4

202

5.21 The 1966 tax law of the Canton of Aargau

provided for adjustment of taxable income bracket limits if

the cost of living index changed "very considerably" after

January 1967.^ No adjustment was made from that time until

1970, while the cost of living index increased by 14 per

cent. In 1970, the adjustment provision in the tax

legislation was extended to include exemptions and 2 allowances. In 1971, exemptions and allowances were 3 increased substantially, albeit at widely varying rates.

Taxable income bracket limits were changed as well, but in a

manner suggesting a restructuring of the schedule rather

than an adjustment for inflation.

5.22 The actual process of adjustment for the last

three Swiss Cantons discussed above reveals a pattern of

discretionary changes rather than automatic inflation

adjustment of the personal tax schedule.

5.23 Canada. In 1973, the Canadian Government

introduced proposals to index the personal income tax system

from the commencement of the 1974 tax year (which is the

Law of 17 May 1966, relating to direct Cantonal and Local Taxes, Article 34.

Amending Law of 10 November 1970, relating to direct Cantonal and Local Taxes.

For instance, the child allowance was increased by 67 per cent, the dependant allowance was increased by 25 per cent, the housekeeper allowance by 50 per cent.

203

calendar year).^ The bracket limits and major exemptions

were made subject to adjustment for inflation. The

adjustment factor for a particular tax year is calculated as

the ratio of the average unadjusted consumer price index for

the 12 month period ending 30 September before that tax year

to the corresponding average for the 12 month period ending

30 September 1972. This adjustment factor is applied to the

values of the bracket limits and exemptions operative in

1973. The implied lag between the inflation rate used in

calculating the adjustment factor and the rate of inflation

during the relevant tax year is 15 months. Indexing is

asymmetric in the sense that, if the price level actually

declines, there will be no downward adjustment of bracket

limits and exemptions.

5.24 In announcing the Government's decision to

introduce indexation in his Budget Speech on 19 February

1973, the Minister of Finance (the Hon. J.N. Turner) made

the following statement:

"Beginning in 1974, I propose to introduce the following system. First, in each year an inflation factor would be determined based upon the increase in the Consumer Price Index in an immediately preceding period. Second, in each year the principal exemptions would be increased by this inflation factor. This would include the basic exemption, the marital

exemption, the two exemptions for dependants, and the exemptions for the aged and the blind and the disabled. Third, every year each of the brackets of taxable income would be adjusted upwards by the inflation

factor.

1 The proposals were introduced in the Canadian Budget Speech, 19 February 1973. The income tax law was amended by Bill C-193, Section 15, 1973.

204

For example, if in a particular year, the inflation factor was determined to be 4 per cent, then the principal exemptions would each be increased by 4 per cent. Similarly, each bracket of taxable income would be adjusted upwards by the same percentage. Thus, the

first bracket of taxable income, which is taxed this year at 15 per cent, would be raised from $500 to $520. The next bracket, which would be subject to an 18 per cent rate, would commence at $520 and would extend to

$1,040, and so on right through the tax schedule.

The indexing of rates and exemptions will produce a tax liability which will no longer erode a person's purchasing power as a result of inflation interacting with the progressive tax system. A person will no longer pay tax at a higher marginal rate simply because inflation swept him up into a higher tax bracket. For a person on a fixed income, the result of indexing would be to reduce his taxes each year if prices rise.

Members may ask why delay implementation of this indexing proposal until next year? There are two reasons. First, the income tax reductions and increased exemptions I have already announced for this year are far larger in magnitude than would be the effect of this indexing system if applied in 1973. Second, and more important, this proposal is a major

innovation in tax philosophy and practice. It is not complex, but it will take some time for people and governments to adjust to it. For these reasons, I have concluded that it should come into effect only next year.

Mr. Speaker, a final comment on income taxes. I believe that this proposal for indexing the personal income tax puts Canada in the vanguard of countries with advanced tax systems. I suggest that this new

system will be recognized everywhere as a bold and sensitive response to a rather fundamental tax problem. With the introduction of this change, Canada will join a very select group of countries which have eliminated

the hidden revenues accruing to governments through the effect of inflation on a progressive tax system."

5.25 In 1974, the first year in which indexation

applied, tax exemptions and bracket limits were raised by

6.6 per cent, while the 1975 adjustment of 10.1 per cent

increased exemptions and limits to a level 17.4 per cent

above that prevailing in 1973, the last year prior to

205

indexation. One effect of indexation was to remove from the

rolls about 175,000 taxpayers in 1974, and about 225,000

taxpayers in 1975.

5.26 As has been noted, the Canadian indexation was

restricted to personal exemptions and tax brackets. The

standard medical and charitable deduction of $100 was not

indexed, nor were the maximum dollar deduction for employee

expenses and the limits on contributions to pension and

retirement savings plans.

5.27 One complication of tax indexation in Canada

resulted from the fact that all Provinces except Quebec had

tax collection agreements with the Federal Government and

were affected by the reduction in revenue yields. Quebec

did not introduce indexation. An Ontario Government study

published in January 1974 recorded the following major

findings in relation to the budgetary and other implications

of indexation: *"

(a) The revenue loss for Ontario was estimated at 4

per cent of the Provincial personal income tax

yield in 1974, rising to 20 per cent by 1980 on

the assumption of sustained inflation of 6 per

cent p.a. Experience in other Provinces was

expected to be similar, with low income 1

1 The Dynamic Impact of Indexing the Personal Income Tax, op. ext., pp. v—8 .

206

Provinces recording relatively greater losses.

The Federal revenue loss was estimated to be

proportionately similar to that of Ontario.

(b) "Under the indexing system adopted by the

federal government, the two principal

criticisms of the concept of indexing appear to

have been met. First, the system applies to

all income whatever its source. Second,

preliminary simulation experiments indicate

that indexing need not reduce the stabilizing

properties of the income tax system. By

applying indexing with a lag, taxpayers are

compensated for past inflation, thereby

preserving the current response of revenue

flows to the current level of inflation.

(c) The effect of indexing was "to lower the curve

of tax incidence over the entire spectrum of

incomes. The largest percentage reductions in

tax occur in the bottom income brackets, but

the largest absolute tax savings go to

. -2

high-mcome tax payers.

^ Ibid., p.14.

2 Ibid, p.8

207

5.28 Chile. In 1954 Chile introduced provisions

whereby several important items of the income tax law were

defined in terms of basic salaries.^" Chilean tax law

contains two main income taxes: the scheduler tax and the

global complementary tax. The scheduler tax is levied at

various flat rates according to the different sources of

income. The global tax is progressive and is levied on

income from all sources. Exemptions and allowances for both

taxes are defined as proportions of the basic annual salary.

The same unit is used to define the bracket limits of the

global complementary tax. The basic annual salary

applicable for tax purposes is that fixed by law and

operative at the end of the year for which tax returns are

filed.

5.29 The basic salary varies between regions and

occupations. The income tax law does not specify which

salary is applicable for tax purposes, but it has been

suggested that it is that of industry and commerce employees 2 in the district of Santiago. An essential determinant of

the efficacy of Chile's inflation adjustment scheme is the

extent to which this basic salary keeps pace with the rate

of inflation. In 1961, a law was introduced stipulating

that the basic salary be adjusted annually in accordance

Law No. 11575 of 1954, amending the Income Tax Law established by Decree 2106 of 27 March 1946.

Roberto Poblete, Impuestos a la Renta Vigentes en 1970, Divulgacion Tributaria, No. 2 0 , Santiago, February 1570, p.7.

2

208

with the rise in the consumer price index over the preceding

twelve months.·*"

5.30 Originally, the global complementary tax in

Chile was not collected on a withholding basis. Income tax

returns were due shortly after the close of the tax year,

and the taxpayer was required to pay one-third of the tax

due with the tax return and the balance in two equal

instalments, which were generally due by the end of the

seventh and tenth months following the close of the tax

year. Deferred tax payments were adjusted by 100 per cent

of the increase in consumer prices which occurred during the

tax year, this increase being measured on an end of year

basis. Such a procedure raised no problems so long as the

rate of inflation was not fluctuating through time.

However, if the rate of inflation was tending to accelerate,

as it did in Chile after 1967, this procedure was not

adequate to preserve the real value of tax payments.

5.31 Toward the end of 1972, new tax laws were

enacted to meet this problem. The global complementary tax

was changed so that tax would be withheld at source and paid

to the government authorities within eighteen days from the

month when it was earned. The penalty for late payment was

a 5 per cent surtax on the tax due plus 3 per cent per month

Chile, Law No. 14688, 21 October 1961. Such adjustments apply to all public sector employees, and non-unionised employees in the private sector.

1

209

of total tax due. Whether this penalty is sufficient to

remove any incentive to defer tax payments depends to an

important extent upon the rate of inflation.

5.32 Brazil. In 1961, Brazil introduced a scheme

similar to that operating in Chile. Personal exemptions and

taxable income bracket limits were fixed as multiples of the

minimum wage. The minimum wage was changed by government

decree each year roughly in accordance with the rate of 2 inflation, so that the exemption and bracket limits were

automatically adjusted for inflation. However, during 1964

the real value of the minimum wage declined, resulting in

increased tax burdens at all levels of real income. In

November 1964, the law was changed so that exemptions and

bracket limits were defined in terms of conventional 3

monetary units instead of multiples of the minimum wage.

The law provided for exemptions and bracket limits to be

subject to adjustment in proportion to movements in the

general price index, whenever this index registered an

Law No. 3898 of 19 May 1961.

For contrasting views on this point, see Carl S. Shoup, The Tax System of Brazil, a report to the Getulio Vargas Foundation, Rio de Janeiro, 1965, especially page I-A-l and appendix; and Keith S. Rosenn, "Adaptations of the

Brazilian Income Tax to Inflation", Stanford Law Review, Volume 21, especially p.92. Shoup bases his comparison on the cost of living index, while Rosenn uses the wholesale price index.

3

Law No. 4506 of 30 November 1964.

210

increase of 10 per cent or more in any one calendar year, or

of 15 per cent or more over any three consecutive years.

Until 1972, the proportionate adjustment of exemptions and

bracket limits was in close accordance with the measured

rate of inflation. But in 1972 and 1973 there was a

significant departure from previous practice. In these

years, only the dependant allowances and the top taxable

income bracket limit were adjusted in line with the rate of

inflation. Other taxable income bracket limits were

increased at substantially higher proportionate rates, the

rate being highest for the lower taxable income brackets.

In effect, a discretionary adjustment to the rate structure

was thus superimposed on to the inflation adjustment.

5.33 Uruguay. Amendments made to the income tax law

of Uruguay in 1967 included provision for adjustment of the

personal exemption and dependant allowances in line with the

rate of inflation.* However, this provision ensured

adjustment of the taxable income brackets as well, because

the brackets were expressed as multiples of the personal

exemption. The index to be used for adjustment was the cost

of living index. The first adjustment was made for 1968, on

the basis of the variation in this index during 1967. In

1969, the multiples defining the top two brackets were

altered, but have remained unchanged since that time. The * 5

Law No. 12804 of 30 November 1960, as amended by Law No. 1363*7 of 21 December 1967, Diario Official No. 177T3— o2r“ 5 January 1968, Article 41.

211

lag between the rate of inflation used for adjustment and

the current rate of inflation was reduced at the end of

1972. A law was passed stipulating that the index used for

adjustment was to be based on changes in the cost of living

index between 1 October of the previous tax year and

30 September of the current year, rather than on changes in

the preceding year taken as a whole.^

5.34 Argentina. In 1972, Argentina introduced a

system of inflation adjustment covering exemptions and

deductions, but not income bracket limits.^ The first

adjustment was made in 1973. At the end of 1973, however,

major changes in the tax system were introduced and the

income tax law was completely redrafted. The inflation

adjustment provisions of the 1972 legislation were retained,

although adjustment of the new exemptions and deductions was

not due before 1975.

Average Earnings Adjustment

5.35 As noted in paragraph 5.6, in September 1974

the Danish Parliament established a new tax schedule,

operative from the start of 1975. Personal deductions and

taxable income bracket limits were to be adjusted on the

basis of movements in the index of hourly earnings of

industrial workers. The new tax law provided that:

Law No. 14100 of 29 December 1972, Article 40.

Law 20046, 28 December 1972.

212

"The taxable income shall be regulated according to the Danish Bureau of Statistics index for average hourly wages for industrial workers, using as its basis 1972 = 100. The regulation shall be based upon the hourly wage index for the month of March in the year before the tax year in question. Later revisions of

the wage index shall not be taken into account. The taxable income limits shall be increased or decreased by 2.1 per cent for each full three points change in the price index in relation to the figure 141.9. The figure thus arrived at shall be rounded off upwards to the nearest figure divisible by 100."·*·

5.36 The Committee was told that the reason for the

change was that Danish taxes were very high and that wages

during recent years had risen faster than prices. It was

deemed fairer to wage and salary earners to use the average

hourly wage index than a price index for purposes of

indexation. The effect of indexing limits by 2.1 per cent

for each increase of 3 percentage points on a base of 141.9,

and of rounding, is to provide a rather more than

proportionate adjustment to the tax schedule.

Nominal Income Adjustment

5.37 In 1966, Iceland introduced a law providing for

deductions and bracket limits to be adjusted (upwards or 2

downwards) each year in accordance with a tax index. No

indication was given of the basis of calculation of the

index, but adjustments for the taxable income years 1965 to

1967 conformed fairly closely to movements in nominal

Law No. 54 of 6 February 1974.

Act No. 37, 1966 (Provisional Law). After approval by the Althing, this became Act No. 14, 1967.

213

incomes. However, in 1968 and 1969 real incomes in Iceland

fell. In these circumstances, adjustment on the same basis

as previously would have involved increases in tax rates on

all levels of real income. The Government made no

adjustments in these years. Adjustment was resumed in 1970,

but until 1973 was consistently less than that implied by

changes in nominal income.

Exemption of Cost of Living Wage Increments

5.38 Israel tax legislation has long contained a

provision whereby the inflationary component of wage and

salary increases may, at the discretion of the Minister of

Finance, be exempted from personal taxation.^" The

inflationary component of wage and salary increases is

readily identifiable in Israel, because cost of living

allowances are explicitly negotiated between the Histadrut

(the General Federation of Labour) and the Manufacturers'

Association.2

Income Tax Ordinance (New Version), 1 November 1972, Part III, Article 2, Section 10(a). Such a provision existed in the original tax legislation. In late 1964, the exemption for the accumulated cost of living

allowance to that date was abolished, but increments to the allowance continued to be exempt.

The Committee has been advised that in March 1975 the Israel Government accepted recommendations from the Commission of Enquiry into Taxation to make the cost of living allowance subject to taxation and to index tax

scales by refernece to a price index. The Committee does not have details of the proposed new arrangements.

214

5.39 If all incomes adjust completely to the rate of

inflation, such a scheme contains the property that tax

rates on all levels of real income decline continuously so

long as the rate of inflation remains positive. For a

variety of reasons, such a result has not come about in

Israel. Before discussing these reasons, however, the

Committee notes an important difference of principle between

the Israel scheme and a scheme involving income deflation

without a subsequent reflation of tax liabilities. Under

the latter type of scheme, the inflation adjustment is

automatically available to all taxpayers, regardless of

actual changes in a taxpayer's nominal income.

5.40 Under the Israel scheme, tax relief is obtained

only to the extent that the taxpayer actually receives a

cost of living allowance. A taxpayer who fails to receive

such an allowance enjoys no tax relief. If a taxpayer's

nominal income remains unchanged during inflation (that is,

if his real income declines), he continues to bear the same

tax rate as he did prior to inflation, when he enjoyed a

higher real income. One advantage of conventional inflation

adjustment schemes is that they do provide some tax relief

to those taxpayers whose real incomes decline during periods

of inflation. This feature of the Israel scheme may not be

particularly significant in quantitative terras, because the

Histadrut covers over 90 per cent of employees.

Nevertheless, it is necessary to bear it in mind in

examining the design of inflation adjustment schemes for

personal taxation.

215

5.41 There are two basic reasons why the Israel

scheme has not resulted in a continual decrease in the tax

rate on each level of real income. The first concerns

variations in the application of the cost of living

adjustment according to the level of income. The second

concerns the relationship between the cost of living

adjustment factor and the current rate of inflation, as

measured by the consumer price index.

5.42 The cost of living allowance takes the form of

a fixed proportion of income, up to a specified maximum

level of income. Beyond this maximum the allowance is a

fixed absolute amount, implying decreasing proportionate

adjustments for higher levels of incomes. The quantitative

significance of this restriction depends on the level of the

maximum income subject to the allowance, relative to the

distribution of income among taxpayers. Between 1960 and

1963, the maximum was IE500 per month (equals $A61 at

current exchange rates). It was increased to IE700 per

month (equals $A86) at the beginning of 1964 and remained at

that level until July 1974. To the extent that such a

maximum was considered appropriate in 1964, it was unlikely

to be so a decade later. In 1964, for example, average

monthly wages per employee stood at IE793 (equals $A97); and

by 1973 average monthly wages were I£l,125 (equals $A138).

This implies that, throughout the period from 1964 to 1974,

a diminishing proportion of taxpayers was receiving full

216

compensation for inflation through the cost of living

allowance. In July 1974, the maximum income limit was

increased to ΙΕΙ,ΟΟΟ (equals $A123), still significantly

below average wages.

5.43 The second reason why the Israel scheme has not

resulted in continually declining tax rates lies in a

divergence between the cost of living adjustment factor and

the current rate of inflation as measured by the consumer

price index (CPI). There are three factors contributing to

such a divergence:

(a) lags in the CPI used;

(b) adjustments to the CPI; and

(c) departures of the cost of living adjustment

factor from this lagged, adjusted, CPI.

Adjustment has always been based on the rate of inflation

experienced in a previous period, rather than on the current

rate of inflation. The length of the lag has varied

considerably. During the 1950s, adjustments were made four

times a year. During the first half of the 1960s, they were

made twice a year; and from 1965 until 1972 (a period of

relatively moderate inflation), the cost of living allowance

was reviewed only once a year. In 1973, however, with

inflation running at an annual rate in excess of 20 per

cent, two adjustments were made. In the first seven months

of 1974, in the face of accelerating inflation, three

separate adjustments were made. It thus appears that,

during the past decade, a positive relationship has existed

217

between the rate of inflation and the frequency of

adjustment to the cost of living allowance.

5.44 Further, adjustment has never been based

directly on the consumer price index. Throughout the

period, the index used in negotiations has been net of the

housing services item. This index has tended to increase

more slowly than the unadjusted CPI. Between 1960 and 1971

the unadjusted CPI thus increased by 110 per cent compared

with 88 per cent for the index net of housing services.1

Secondly, the consumer price index has had to increase by at

least 3 per cent before any increment to the cost of living

allowance is negotiable. Thirdly, the index used for

adjustment has at times been modified to exclude the price

effects of other stabilisation measures. In calculating the

cost of living increment at the beginning of 1971, for

example, the parties agreed to eliminate the price rise

attributable to an import levy imposed in August 1970.

However, the cost of living agreement concluded at the

beginning of 1972 did not attempt to sterilise the price

influence of the August 1971 devaluation of the Israel

pound.

5.45 It must also be emphasised that, even when

account has been taken of the divergences between the actual

See Y. Manzly, "Price Changes in the Consumption Baskets of Various Income Groups in Israel", Bank of Israel Economic Review, April 1974, pp.35-55.

218

rate of inflation and the index used for adjustment, the

cost of living increments have borne only a fairly rough

correspondence to this index. At the start of 1973, for

example, the percentage increment to the cost of living

allowance was in excess of the 1972 rate of inflation; while

the increment at the start of 1974 was below the 1973

inflation rate. Furthermore, during periods of depressed

economic activity, such as prevailed in 1966 and 1967, cost

of living increments were waived altogether.

5.46 Over the period from 1966 to 1973, the net

result of these divergences was for cost of living

adjustments to be substantially below the rate of inflation

as measured by the CPI. If 1966 is taken as the base year,

inflation for the period as a whole equalled 71 per cent,

whereas cost of living increases equalled only 47 per cent.^"

This substantial divergence may have been one contributing

factor to the three large cost of living increments sought

and obtained in 1974: 14.8 per cent in January, 6.0 per

cent in Febraury and 20.0 per cent in July.

5.47 The final question concerns the extent to which

the Israel form of inflation adjustment for personal

taxation may be viewed as part of an incomes policy. In

countries with more conventional forms of inflation

Data on cost of living allowances may be found in The Bank of Israel Annual Report, various issues. Data on prices were obtained from Israel Central Bureau of Statistics, Monthly Bulletin of Statistics, various

issues.

219

adjustment of personal income tax, the schemes have often

been viewed as an undertaking on the part of governments not

to increase real tax rates in return for some moderation on

the part of unions in negotiating increases in nominal

wages. It is difficult to place the Israel scheme within

this same perspective. To the extent that the unions are

prepared to forgo full adjustment of nominal wages to the

inflation rate, they are at the same time forgoing full

adjustment of personal taxation to the rate of inflation.

In such a situation there is no trade-off between tax relief

and wage increases; in order to secure tax relief, an

increase in nominal wages must first be obtained. To the

extent that inflation adjustment schemes are considered to

be an important ingredient of incomes policies, the Israel

model does not appear to be ideal.

| ί

221

VI CHOICE OF METHODS AND PRICE INDEXES : RECOMMENDED PROCEDURES

6.1 In this Chapter, the Committee considers the

most appropriate form of personal tax indexation for

Australia. In the first sections, attention is directed to

the appropriate form, scope, and automaticity of personal

tax indexation. The choice of price index is then

considered, and the remaining sections analyse the

implications of the scheme for P.A.Y.E. and provisional

taxpayers.

The Form and Scope of Personal Tax Indexation

6.2 The Committee has concluded that adjustment of

taxable income bracket limits and deduction limits is a more

satisfactory form of indexation procedure than deflation of

net income. Adjustment of taxable income bracket limits and

deduction limits is likely to be more easily understood and

less costly than a scheme involving deflation of net income.

Such an adjustment procedure also tends to be more

compatible with discretionary tax changes, because income

deflation requires reference back to a base year tax

schedule.

Bracket Limits

6.3 Insofar as the scope of personal tax indexation

is concerned, the Committee believes that any indexation

scheme should apply to all taxable income bracket limits so

that legislated vertical equity prescriptions are preserved.

To do otherwise would be to change the progressivity of the

222

rate schedule in a way that is contrary to the objectives of

personal tax indexation. Required changes in the

distribution of the tax burden may still be achieved through

discretionary action.

6.4 In recommending that indexation be applied to

all taxable income brackets, the Committee is recommending

that the minimum level of taxable income be indexed also.

Only in that way can persons with real incomes of less than

$1,040 continue to be exempt from tax.

6.5 It may be true that large numbers of taxpayers

with taxable incomes in the vicinity of the minimum taxable

income are supplementing the incomes of themselves or their

families (e.g., pensioners or working wives engaging in

part-time or casual work, students working in vacation, or

school leavers earning higher rates for only a few months of

their first year of employment). But this fact is not

relevant to the issue of indexing the minimum level of

taxable income. Vertical equity with respect to relative

tax burdens on different levels of real taxable income is

one important reflection of legislated vertical equity

prescriptions. The issue of second incomes referred to

above is relevant to the issue of the appropriate definition

of income for tax purposes, or of the appropriate tax unit.

However, indexation is not the appropriate instrument to

correct fundamental deficiencies in the tax law.

Nevertheless, the Committee agrees with the Treasury

submission that the shading-in range of income above the

223

minimum level of taxable income should not be indexed. This

is necessary to keep the range of income covered by the

shading-in range short and simple.

Dependant Deductions

6.6 The Committee also believes that indexation

should be extended to all dependant deduction limits, so as

to maintain the legislated horizontal equity prescriptions.

The same conclusion has been reached in respect of the

rebate for low income families introduced in the 1974-75

Budget; this rebate is an alternative instrument to achieve

horizontal equity. Under the current form of the rebate,

indexation of dependant deductions will ensure automatic

indexation of the rebate. Indexation of taxable income

bracket limits will ensure that the rebate continues to

apply to those real income ranges for which it is intended.

Non-Dependant Deduction Limits

6.7 The issue of indexing the upper limits of

non-dependant deductions is less straightforward. As

discussed in Chapter IV, some of these deductions are

difficult to justify in terms of horizontal equity. The

Australian Treasury has discussed the life insurance and

superannuation payment deduction in the following terms;

Originally its aim seemed to be that of encouraging people to make some provision for their retirement, or to provide security for themselves or their dependants against some form of risks. This view of the purpose of the deductions would appear to be accurate, particularly because the payments eligible for deduction cannot be considered as reducing capacity to pay tax ...1

1 Personal Income Tax - Personal Allowances, op. cit., p. 20.

224

This view of the deduction for life insurance and

superannuation payments was endorsed by the Coombs Task

Force.^ The Treasury's remarks concerning the education

expenses deduction are in a similar vein:

'... the rationale for the deduction of education expenses might not be to achieve equity in the tax system, but instead to subsidise a particular form of expenditure on the part of taxpayers, presumably because of what may be held to be the resulting benefits'.2

There appears to be a reasonable consensus that the

deductions mentioned above aim to subsidise certain forms of

expenditure deemed to be socially desirable. Any rationale

in terms of promoting horizontal equity is not obvious.

6.8 The argument for indexing the deduction limits

(of $1,200 for life insurance, etc., and $150 for education

expenses) is that, if these limits were appropriate at the

time of legislation then, ceteris paribus, they are not

likely to be appropriate at a later time, under conditions

of unchanged nominal values and continuing inflation. But

the Treasury and the Coombs Task Force have pointed out

that, in the case of the deductions being discussed, the

ceteris paribus condition has not held in recent years.

Government initiatives during this period have created an

environment within which it may be appropriate that the real

values of the deduction limits should decline. The

* R e v i e w o f t h e C o n t i n u i n g E x p e n d i t u r e P o l i c i e s o f t h e

P r e v i o u s G o v e r n m e n t , op. c i t ., pp. 2 3 7 - 3 8 .

2 O p . c i t . , p. 19.

225

Committee does not wish to question the validity of such a

proposition. However, it is not obvious to the Committee

why the required decline in the real value of deduction

limits should be precisely produced by the effects of

inflation. If the Government wishes to adjust the value of

the concessions, the Committee believes that it should do so

by explicitly adjusting the limits downwards to whatever

real values are deemed to be appropriate to current

circumstances. This was the way in which the education

expenses deduction limit was adjusted in the 1974-75 Budget.

When the limits have been explicitly adjusted to their

appropriate real values, the Committee believes that it

would be logical for these values to be maintained so long

as no further policy change is deemed desirable. Such a

result may be achieved by indexation of the deduction

limits.

6.9 The same basic proposition holds in the case of

the deduction for rates and land tax. A deduction is

provided for rates and land taxes paid by the taxpayer for

which he is personally liable on non-income producing

property subject to a maximum limit of $300. The Coombs

Task Force Report argued that the deduction was an anomaly 1 and should be abolished, a proposition accepted in full by 2 both the Australian Treasury and the Taxation Review

3

Committee. To allow inflation to erode the real value of

^ Review of the Continuing Expenditure Policies of the Previous Government, op. cit., pp« 271-72.

2

Personal Income Tax - Personal Allowances, op. cit., pp. 23-4.

3 Full Report, para. 7.54.

226

this deduction limit may be a convenient method of reducing

the impact of such an anomaly, but it is likely to be an

extremely inefficient method of doing so:

'The introduction of such a high limit in relationship to the normal level of payments of rates and land tax is unlikely to result in any significant reduction in the revenue cost of the concession in later years - although it should, if maintained, serve to exert some brake upon any growth of the cost to revenue resulting

from continuing inflation pushing up the general level of the deduction.'-*·

If the Government accepts the arguments of the three sets of

advisers cited above, the deduction should be abolished. If

the Government wishes to phase the real value of the

deduction out gradually, it seems preferable to do so

explicitly by discretionary adjustments rather than by way

of reliance on the highly uncertain instrument of inflation.

If the Government believes the current real value of the

deduction limit to be appropriate, then logically it should

include that deduction limit among those to be indexed.

6.10 The Committee feels that, while failure to

index non-dependant deduction limits is not likely to give

rise to significant equity violations, a case exists on

logical grounds for these limits to be included in any

indexation scheme. It is relevant to note, however, that

several countries currently employing personal tax

indexation schemes have not extended indexation to

non-dependant deduction limits.

1 Personal Income Tax - Personal Allowances, op. cit., page 23.

227

Other Deductions and Amounts Fixed in Nominal Terms

6.11 There is a miscellany of deductions and other

items in the tax legislation which are limited to amounts

defined in nominal terms. As a general principle, the

Committee recommends that these amounts be indexed to

maintain their real value over time. However, as a matter

of prudent policy it may be convenient, at the time of

introduction of a scheme of indexation, to examine the

rationale and the need for the continued existence of these

provisions. Their relevance and adequacy in terms of

present day values may then be reassessed, as a basis for

allowing indexation to maintain their real value in future

periods of time.

6.12 A list of the references to nominal values* in

the Income Tax Assessment Act, The Income Tax (Rates) Act

and the Regulations is provided in Appendix 1 to this

Chapter. The Committee has considered each of the listed

references, and it has indicated in the Appendix whether or

not it recommends indexation for that reference. Some of

the items are expressed in terms of very small amounts, e.g.

deductibility of charitable gifts of $2 or more. The

Committee does not recommend indexation of such items even

though they may otherwise qualify on logical grounds. As

has been mentioned earlier, however, it would be appropriate

to review the amounts concerned at regular intervals.

1 Other than penalties.

228

6.13 In the Treasury's submission, specific

reference was made to the following, in addition to those

items already discussed and in respect of which

recommendations have already been made: funeral expenses;

housing mortgage interest income limitations; zone and

overseas service allowances; living away from home

allowance; aged persons rebate; relief from property

income surcharge; and the limits of the primary production

averaging provisions.

6.14 The Committee's recommendations on the

indexation of these items follows;

Item

Funeral Expenses (up to $100 per dependant)

Housing mortgage interest deduction (the percentage of interest payments which can be claimed as a deduction diminishes from 100 per cent to zero as joint net income of taxpayer and spouse increases from

$4,000 to $14,000)

Zone allowance and overseas service allowance

Committee's Recommendation

Index

Index

Index

Living away from home allowance Index

Aged persons rebate (this is a transitional measure to be phased out as a package of measures, including taxation of pensions _ and phasing out of means test, is introduced) Do not index

Relief from property income surcharge Index

Limits of $8,000 to $16,000 on Index if present

income eligible for averaging for system is retained primary producer following report

of Industries Assistance Commission

229

Automaticity of Indexation

6.15 The Committee is strongly of the opinion that,

under any indexation scheme that may be introduced,

adjustment should be automatic in the sense that the term

was used in Chapter IV. It recognises that there can never

be fully automatic indexation because governments must

retain the right to make discretionary adjustments, but it

believes that such adjustments should be made as explicit

public decisions requiring explicit justification.

6.16 The Committee further believes that the factor

used for adjusting the personal tax schedule should not

diverge from movements in the chosen index. The reason for

this is based on the same considerations which appear to

have led Canada to reject any divergence:

'Before the finally adopted procedures were settled upon, consideration was given to the possibility of varying the indexation factor at the discretion of the Minister of Finance ... This approach was viewed as being incompatible with the underlying philosophy of

indexation which argues that if tax increases are necessary - either to finance expanded expenditures or for counter-cyclical reasons - they are to be enacted explicitly, and are not obtained surreptitiously by means of a hidden 'inflation tax'. It was not,

therefore, adopted.11

J.R. Allan, D.A. Dodge and S.N. Poddar, 'Indexing the Personal Income Tax: A Federal Perspective', Canadian Tax Journal, July-August 1974, p. 358. The authors are public servants in the Tax Division of the Canadian

Department of Finance. It is stated that the article reflects their own views, and not necessarily those of the Department.

230

The Recommended Price Index

6.17 The Committee has concluded that an index of

consumer prices is the appropriate index for tax schedule

adjustment, and now considers the suitability of available

indexes which measure changes in the prices of consumption

goods and services.

6.18 The currently available indexes in Australia

are the Consumer Price Index (CPI) and the Private Final

Consumption Expenditure Deflator (CED). The CPI provides a

measure of movements in retail prices of goods and services

constituting a large proportion of the expenditure of urban

wage-earner households. It is a quarterly, fixed

expenditure weight index, available three weeks after the

close of each quarter and not subject to revision. The

weights are changed approximately every five years, the most

recent change occurring in December 1973.

6.19 Whereas the CPI is specifically designed to be

a quarterly price index, the CED is not and, indeed, is not

even published explicitly. It is calculated by dividing the

current pr-ice estimate of private final consumption

expenditure by the constant price estimate. Being a ratio

of these two estimates, the CED reflects any deficiencies in

either estimate or inconsistencies between them. The CED is

significantly more comprehensive than the CPI except in

respect of housing. The CED contains an imputed rent

component, whereas the CPI includes local government charges

and house prices. Quantity weights are, of course, not

231

fixed in the CED, so that the influence of any change in the

consumption mix is reflected along with the change in

prices. The deflator is subject to revision, and the

initial estimate is not available until two months after the

close of the quarter.

6.20 Whether the wider coverage of the CED as

compared with the CPI can be equated with superior coverage

depends on the use to which the chosen index is to be put.

If a measure is required of price changes associated with a

particular expenditure pattern (say, the most common

expenditure pattern prevailing in the economy) then wider

coverage cannot be equated with superior coverage. If,

however, a measure is required of price changes in

consumption goods and services generally, then wider

coverage may be taken to imply superior coverage. It is

apposite to recall the discussion in Chapter IV concerning

the use of multiple price indices as opposed to a single

price index. It was argued there that a single general

price index is to be preferred on the ground that this

preserves the allocative role of relative price changes.

That argument is no less relevant in this context, and

indicates that the wider coverage of the CED is a point in

its favour.

6.21 Further, in general it may be expected that a

fixed expenditure weight index will tend to indicate a

rather higher rate of change in prices than a non-fixed

weight index. This follows from the fact that,

232

ceteris paribus, an increase in the relative price of a

commodity will tend to result in a decrease in the quantity

consumed of that commodity. A non-fixed weight index

identifies this decrease in the quantity consumed, and hence

the weights attaching to those commodities undergoing

relative price increases tend to decline.

6.22 In its submission, the Australian Council of

Trade Unions (A.C.T.U.) rejected this proposition:

"The argument that a decrease in the quantity consumed of an item whose price is increasing faster than the average will necessarily decrease the weighting of the item in the Consumer Price Index, is fallacious. The weight of the item will only be reduced if the

percentage of consumer expenditure on the item falls over the period concerned. Thus one has to take into account the increase in price of the goods, the changing quantity consumed and the change in consumption expenditure."

As an empirical fact, it may not be the case that those

goods experiencing an increase in relative price decline as

a percentage of consumption expenditure. But such an

empirical fact does not render the proposition of Paragraph

6.21 fallacious. The important point is that the

ceteris paribus condition may not be fulfilled. If real

income growth is occurring, and if it is true that those

goods or services susceptible to relative price increases

also tend to have the higher income elasticities of demand,

then it may be the case that such goods or services do not

decline as a percentage of consumption expenditure.

6.23 However, the lag in the availability of the CED

is in any case a serious drawback from the point of view

233

of its use for personal tax indexation. If P.A.Y.E.

deductions are to be adjusted at the commencement of October

each year (as is suggested below), the deflator for the

March quarter would be the latest available estimate which

could be incorporated into the rate used for indexation.

This is because of the six week time lag required for the

printing and distribution of new P.A.Y.E. deduction

schedules. This implies a time lag averaging fifteen months

between the actual rate of inflation and the rate of

inflation upon which indexation is based. The fact that the

CED is subject to revision is also likely to give rise to

complications in its use for purposes of indexation.

6.24 The Committee believes that an important

advantage of the CPI is that its use may facilitate public

understanding of personal tax indexation. The A.C.T.U.

argued:

"The A.C.T.U. is strongly of the opinion that the Consumer Price Index is well known and accepted by the Australian public as a measure of inflation. This acceptance in itself renders the use of the Consumer Price Index as a tax index sensible and desirable."

6.25 It should be noted that the two indexes have in

the past moved in close consonance. If 1962-63 is used as a

base year for both indexes, the 1973-74 value of the CPI

equalled 163.3, while the value of the CED was 163.1. On a

quarterly basis, the correspondence is rather less close

(see Appendix 2 and Appendix 3 to this Chapter).

6.26 The Committee has concluded that, on balance,

the arguments above tend to favour use of the CPI. For

reasons discussed in Chapter IV, the Committee sees some

234

merit in adjusting the CPI for the effects of changes in

indirect taxation, but is sceptical about the desirability

of adjustments on account of changes in the terms of trade.

However, the Committee was informed by the Australian Bureau

of Statistics that to separate out the effects of all

indirect taxes on the CPI would call for a formula which

would involve arbitrary assumptions, the making of which the

Bureau sees as outside its sphere.

Lagged Adjustment

6.27 The Committee has concluded that it is feasible

and desirable for indexation to be based on an annual

average index lagged by one year. The index used for

purposes of adjustment in a particular income year

(commencing 1 July) would therefore be calculated as the

average increase in the CPI index in the four quarters of

the previous income year (ending with the June quarter) over

the average for the four quarters of the preceding income

year. The proposed adaptation of P.A.Y.E. arrangements to

such a system is considered below, along with the effect of

indexation on provisional taxpayers.

6.28 The recommended scheme thus follows the lines

of the Canadian scheme, except that the Committee believes

that it is possible in Australia to reduce the time lag from

15 months to 12 months, without complicating the basic

indexation scheme or interfering with other institutional

and budgetary arrangements.

235

6.29 After reviewing the various methods of

achieving perfect or unlagged indexation, the Committee is

not convinced that the benefits to be derived from such

schemes outweigh the additional complexity which they entail

for the tax administration, employers and taxpayers. The

Committee has noted that indexation schemes in other

countries are invariably lagged, and believes that if rates

of inflation do not become excessive, some lag in the

adjustment of income tax rate schedules will be readily

accepted by the Australian public. The Committee believes

that the crucial factor in public acceptance of any scheme

of indexation is the stated undertaking that rates of

taxation will be reduced automatically to offset the effects

of continuing inflation, and that the existence of a time

lag is a secondary consideration.

6.30 It was argued in some submissions that an

adjustment lag of a year or more is too great, and the

Committee does not rule out the possibility of more frequent

changes. But because the basic income tax period is one

year and because frequent changes in tax rates pose problems

for the administration and the taxpaying public alike, the

Committee believes that it would be prudent for any scheme

of automatic indexation to be first introduced on an annual

basis. If, as a result of a rapid acceleration in the rate

of inflation at some future time, it should be considered

desirable to make more frequent adjustments, experience in

operating an annual scheme will provide a sound framework

for a system of half-yearly or quarterly adjustments.

234

merit in adjusting the CPI for the effects of changes in

indirect taxation, but is sceptical about the desirability

of adjustments on account of changes in the terms of trade.

However, the Committee was informed by the Australian Bureau

of Statistics that to separate out the effects of all

indirect taxes on the CPI would call for a formula which

would involve arbitrary assumptions, the making of which the

Bureau sees as outside its sphere.

lagged Adjustment

6.27 The Committee has concluded that it is feasible

and desirable for indexation to be based on an annual

average index lagged by one year. The index used for

purposes of adjustment in a particular income year

(commencing 1 July) would therefore be calculated as the

average increase in the CPI index in the four quarters of

the previous income year (ending with the June quarter) over

the average for the four quarters of the preceding income

year. The proposed adaptation of P.A.Y.E. arrangements to

such a system is considered below, along with the effect of

indexation on provisional taxpayers.

6.28 The recommended scheme thus follows the lines

of the Canadian scheme, except that the Committee believes

that it is possible in Australia to reduce the time lag from

15 months to 12 months, without complicating the basic

indexation scheme or interfering with other institutional

and budgetary arrangements.

235

6.29 After reviewing the various methods of

achieving perfect or unlagged indexation, the Committee is

not convinced that the benefits to be derived from such

schemes outweigh the additional complexity which they entail

for the tax administration, employers and taxpayers. The

Committee has noted that indexation schemes in other

countries are invariably lagged, and believes that if rates

of inflation do not become excessive, some lag in the

adjustment of income tax rate schedules will be readily

accepted by the Australian public. The Committee believes

that the crucial factor in public acceptance of any scheme

of indexation is the stated undertaking that rates of

taxation will be reduced automatically to offset the effects

of continuing inflation, and that the existence of a time

lag is a secondary consideration.

6.30 It was argued in some submissions that an

adjustment lag of a year or more is too great, and the

Committee does not rule out the possibility of more frequent

changes. But because the basic income tax period is one

year and because frequent changes in tax rates pose problems

for the administration and the taxpaying public alike, the

Committee believes that it would be prudent for any scheme

of automatic indexation to be first introduced on an annual

basis. If, as a result of a rapid acceleration in the rate

of inflation at some future time, it should be considered

desirable to make more frequent adjustments, experience in

operating an annual scheme will provide a sound framework

for a system of half-yearly or quarterly adjustments.

236

Adjustment of P.A.Y.E. Schedules

6.31 The Committee has sought to recommend a scheme

which i s :

(a) equitable to the taxpayer;

(b) administratively feasible; and

(c) easily integrated with existing government

budgetary procedures.

6.32 To meet these objectives, the Committee favours

a scheme whereby a single annual adjustment is made to the

income tax schedule, becoming effective in the P.A.Y.E.

schedules from 1 October. As has been noted above, this

adjustment should be based on the rate of inflation

experienced in the previous income year. In order to

minimise the time period before the benefits of tax

indexation are received by wage and salary earners, the

adjusted P.A.Y.E. schedule introduced on 1 October should be

designed to reduce, to the extent that is consistent with

efficient tax administration, the over-withholding of income

tax that would otherwise result (because the adjustments had

not been made at the beginning of the income year). This

reflects the Committee's view that adjustment of tax refunds

at the close of the tax year is not the most efficient means

of reducing a taxpayer's liability to income tax in a given

1

year.

^ The Committee recognises that adjustment by means of P.A.Y.E. instalment deductions rather than by end of year refunds would add to the revenue cost of indexation in the initial year of introduction of the scheme. However, that problem is a transitional one inherent in any adjustment of the P.A.Y.E. schedule which has the effect of reducing over-withholding of personal income tax

liabilities.

237

6.33 A single annual adjustment was preferred to

more frequent adjustments on several grounds. First, there

is a very real administrative problem involved in the

printing and distribution of some 30 million income tax

return forms. This task takes, on average, about six

months. If there was to be an adjustment for inflation

within the final six months of the income year, some

information (such as the annual value of dependant

deductions) could not be included on tax return forms.

Rectification of this could imply significant increases in

compliance costs for taxpayers and in administrative costs

for the tax authorities. Secondly, some weight was given to

the fact that more frequent adjustments may make it more

difficult to estimate personal tax receipts at the time of

the government's budget deliberations. For reasons

discussed in Chapter IV, the increased uncertainty attaching

to such estimates may not be as substantial as may first be

supposed. But some increase in uncertainty was regarded as

being likely, and the Committee felt that this would not be

helpful to the government in its conduct of efficient

stabilisation policy.

6.34 An adjustment to P.A.Y.E. schedules on

1 October rather than at the commencement of the income year

was felt to be preferable on two main grounds. First, as

the Committee has consistently emphasised throughout this

Report, personal tax indexation is not viewed as being

concerned with the overall size of the aggregate personal

tax burden. That decision is properly determined by

238

reference to the government's expenditure and stabilisation

requirements, and is obviously an extremely important

component of the government's budget deliberations.

6.35 The Committee was of the opinion that it is

neither desirable nor necessary to have one indexation

adjustment of the P.A.Y.E. tax schedule at the start of the

income year to take account of inflation, followed by a

subsequent adjustment three months later to take account of

any discretionary changes introduced at the time of the

annual budget. It was felt that such a separation would

involve increased administrative costs and have a confusing

effect on the taxpaying public, especially if discretionary

changes were to be made in the Budget. Under the

Committee's proposed procedure, both the indexation rate

adjustment and any discretionary adjustments will be

announced simultaneously in the Budget. Integration of the

two adjustments is also consistent with the Committee's

opinion that indexation should be accompanied by frequent

reviews of the personal tax schedule, and that significant

changes in the aggregate size of the personal tax burden may

give rise to changes in attitudes regarding the appropriate

distribution of the personal tax burden.

6.36 A second reason for making the indexed

adjustment of P.A.Y.E. schedules effective from 1 October

was to permit the use of the June quarter inflation rate in

the rate used for adjustment. This will reduce the average

lag between the current rate of inflation and the rate used

239

for adjustment of the tax schedule to twelve months, rather

than fifteen months as would be necessary if P.A.Y.E.

schedules were adjusted at the start of the income year.

6.37 In its submission, the Australian Treasury

argued that the index used for adjustment should be

calculated on the basis of the price index up to March

quarter rather than the June quarter because, using the June

quarter index:

'... the Budget decision-making process would be carried through on the basis of revenue forecasts which would be rougher than those which are possible under present arrangements. The reason is that the price

index for the June quarter would not be known until the second half of July; by that time (and even without allowing for the time thereafter required to rework the revenue calculations) Budget processes would be well advanced and would have been carried out on the basis of best guesses about the June quarter price change.1

6.38 However, the Treasury does acknowledge the

drawback involved with use of the March index, namely that

it would involve a further shift towards a scheme that:

'... would not give precise and immediate effect to the idea behind tax indexation: cancelling the detriment from inflation of taxable incomes with the benefit of indexation of the scale*.

6.39 In the view of the Treasury, the first drawback

outweighs the second. The Committee takes a contrary view.

The budget decision-making process already involves an

estimate of the inflation rate in the June quarter, in order

to estimate tax receipts in the closing income year and tax

refunds in the forthcoming income year. Even a quite wide

240

range of feasible assumptions regarding the June quarter

index will provide only very minor changes in the factor

used for adjustment of the personal tax schedules. This is

because the June quarter index provides only one out of the

eight observations used in the calculation of the factor

used for adjustment. Thus it is difficult to see that use

of the June quarter index will provide a significant problem

for the budget decision-making process.

6.40 As has been noted above, the Committee

recommends that the annual tax rates implied by the adjusted

October schedule be achieved by way of instalment deductions

rather than through an adjustment of tax refunds after the

close of the income year. The major factor underlying this

recommendation lies in the undesirable features of

over-withholding, partly with respect to stabilisation and

partly with respect to equity (as pointed out below in the

discussion of provisional taxation).

6.41 On the question of stabilisation, the Taxation

Review Committee has observed:

"the rapid growth of end-of-year refunds, mainly in the months of July, August and September, is leading to more pronounced seasonal movements in the economy's liquidity -^movements involving costs for the whole

community".

If the tax refund was also required to cover

over-withholding occurring under indexation during the first

three months of the income year, this would serve to

1

Full Report, para. 22.93

241

exaggerate such liquidity movements. It would also lengthen

the lag involved in compensating the taxpayer for the

effects of inflation.

Provisional Taxation

6.42 The Committee recommends that personal tax

indexation be applied to provisional taxpayers annually at

the time their tax liabilities are assessed. In the light

of this recommendation, this section considers the effect of

indexation on taxpayers subject to provisional tax. After

providing a brief outline of the current system of

provisional taxation, the Committee considers how the system

operates in an inflationary environment and examines the

effect of indexation on provisional taxpayers. It should be

noted that, in 1973-74, provisional taxpayers contributed

almost 23 per cent of the total net income tax on

individuals.

The Provisional Taxation System

6.43 Provisional tax applies to individuals who

derive income from sources other than wages or salaries, and

involves an interim payment by such taxpayers during the

financial year in anticipation of the assessment of tax

after the close of the year. This interim payment is

normally calculated on the basis of income derived by the

taxpayer during the preceding tax year. The tax rates of

the current tax year are applied to this income base to

determine the amount of the interim payment. This interim

payment is not due before 31 March of the income year to

which it relates. The difference between the assessed

242

liability and provisional tax for the previous year is paid

at the same time. Where there is no salary or wage income,

the way in which the provisional tax system operates may be

illustrated by a simple example. Assume that:

(a) provisional tax paid in 1973-74 in

respect of 1973-74 income is $2,600;

(b) tax finally assessed in 1974-75 on

1973- 74 income is $2,840;

(c) the provisional tax payable in

1974- 75 in respect of 1974-75

income (assuming no change in

rates of tax) is $2,840.

6.44 On these assumptions, tax payable is calculated

as follows:

$

Tax finally assessed on 1973-74 income 2,840

less Provisional tax already paid in

respect of 1973-74 income 2,600

Balance of tax payable on 1973-74 income 240

Add Provisional tax payable in respect

of 1974-75 2,840

Total tax payable in 1974-75 3,080

Published figures reveal that more than half of the 1.4

million assessments issued to provisional taxpayers in

1973-74, based on 1972-73 income, were due for payment after

the end of the first week in April 1974, and more than a

third were due for payment in May-June 1974 and later. Much

and

243

the same pattern held in the case of provisional taxpayers

who, in 1972-73, paid provisional tax which fell short of

the amount subsequently assessed for that year. In the

subsequent analysis it is therefore assumed that the actual

payment of provisional tax is made in April of each income

year, as is any shortfall between assessed tax and

provisional tax for the preceding income year.

Provisional Taxation and Inflation

6.45 The following analysis aims to show how the

relationship between a P.A.Y.E. taxpayer and a provisional

taxpayer, who have equal real gross incomes, is changed

within an inflationary environment relative to a situation

of price stability. It is convenient to make the following

simplifying assumptions:

(a) both taxpayers have a dependent spouse and two

dependent children, and receive constant real

gross incomes of $8,000 per annum, real income

being measured in terms of dollars of the month

immediately preceding what will be referred to

below as Year 1;

(b) both taxpayers receive their annual incomes in

equal monthly instalments; and

(c) the tax schedule (introduced on 1 January 1975)

remains unchanged over time.

6.46 At the outset, the Committee makes a

distinction between nominal average tax rates and real

244

average tax rates. The nominal average tax rate refers to

total tax payments in current dollars divided by total gross

income measured in the same terms. The real average tax

rate is the same calculation with the nominal amounts

converted to a given base period. In an environment of

complete price stability, real and nominal rates are, of

course, equal. Within an inflationary environment, the two

rates are equal under a current withholding tax system, such

as the P.A.Y.E. system. The reason the equality holds under

such a system is that income is received, and tax payments

discharged, in dollars of the same time periods throughout

the income year. This situation is to be contrasted with a

non-current withholding tax system, such as the provisional

tax system. Income is received in terms of dollars of

different time periods throughout the income year, whilst

the tax payment is discharged in terms of dollars of a

single time period within the tax year. In converting

income and tax payments into real terms, different deflators

are therefore applicable, and the real tax rate is likely to

diverge from the nominal tax rate.

6.47 A simple example may help to illustrate this

point. Consider the experience of the hypothetical P.A.Y.E.

taxpayer referred to above during 1975-76, if it is assumed

that the rate of inflation is running at a rate of 20 per

cent spread evenly over the course of the year. It is

assumed that real income may be reckoned in terms of dollars

of the month of June 1975. The annual nominal income in

245

1975-76 corresponding to an annual real income of $8,000

equals $8,842. Under the P.A.Y.E. system (if the 1974-75

tax schedule is assumed to be in operation), annual nominal

tax payments equal $1,825, implying an annual nominal and

real average tax rate of 20.6 per cent.

6.48 This outcome may be compared with that for an

equivalent taxpayer under a hypothetical non-current

withholding system, whereby a single annual tax payment is

made in April of the tax year. (Assume for simplicity that

the taxpayer's annual nominal income has been accurately

estimated by April.)

6.49 Under such a hypothetical system, the nominal

annual tax payment is the same as under the P.A.Y.E. system,

that is $1,825. However, the real value of this tax payment

is less than the real value under the P.A.Y.E. system,

because the payment has been made in depreciated April

dollars rather than in dollars of each month of the year.

The real value of the tax payment equals $1,568. Therefore

the real tax rate equals 19.6 per cent and is less than the

real rate under the P.A.Y.E. system.

6.50 Appendix 4 to this Chapter sets out the

differences between nominal and real tax liabilities of a

provisional taxpayer, and compares them with those of an

equivalent P.A.Y.E. taxpayer under the assumptions specified

above. Due to the delay in tax payments, real and nominal

average tax rates diverge for the provisional taxpayer, real

rates being less than nominal rates as Table VI-1 shows.

246

TABLE VI-1

Nominal and Heal Average Tax Rates -Provisional Taxpayer (a)

Year Average Tax Rate

Nominal Real

% %

1 18.42 17.49

2 23.05 21.89

3 27.67 26.27

4 31.83 30.22

5 35.80 33.99

(a) Constant real income of $8,000, taxpayer with dependent spouse and two dependent children, 20 per cent rate of inflation.

6.51 However, even the nominal tax rates borne by

the provisional taxpayer are below those borne by an

equivalent P.A.Y.E. taxpayer, as Table VI-2 shows.

TABLE VI-2

Nominal Average Tax Rates - P.A.Y.E, Taxpayer and Provisional Taxpayer (a)

Year Average Tax Rate

P.A.Y.E. Taxpayer Provisional Taxpayer % %

1 20.64 18.42

2 25.20 23.05

3 29.60 27.67

4 33.81 31.83

5

(a)

37.75

See footnote to Table VI-1.

35.80

6.52 The provisional taxpayer is paying tax based on

the nominal income level of the previous year, rather than

of the current year. Of course, he must eventually pay tax

on the difference between these two nominal amounts.

247

However, this tax becomes payable only with a significant

time lag. Thus the provisional taxpayer gains both by

deferral of his tax payment and by the lagging of the

nominal income base for the purpose of calculating his tax

liability. Under conditions of rapid inflation, the current

provisional tax system appears to confer substantial

benefits on provisional taxpayers relative to P.A.Y.E.

taxpayers.

6.53 It should be noted that the preceding tables

take no account of the interest that the provisional

taxpayer can earn on his postponed tax liability. Nor do

they take account of the substantial over-withholding of tax

instalments that most P.A.Y.E. taxpayers are subject to.

The main scale of instalment deductions used by employers

does allow for dependant deductions and incorporates some

recognition of average other concessional deductions.

However, in general the result is that total tax instalment

deductions significantly exceed the amount of final tax

payable. In 1973-74, for example, it was estimated that

aggregate tax instalment deductions were almost 20 per cent

in excess of aggregate P.A.Y.E. tax liabilities. This

phenomenon has implications for both personal tax equity and

stabilisation policy.

Indexation and Provisional Taxation

6.54 The following discussion considers the effects

of indexation on the relative tax liabilities of the

P.A.Y.E. taxpayer and the provisional taxpayer referred to

248

in Appendix 4 to this Chapter. In the case of the

hypothetical P.A.Y.E. taxpayer, the effect of indexation is

to maintain the legislated average tax rate (18.17 per cent)

throughout the five year period. Nominal tax liabilities

increase in line with the rate of inflation, thereby

resulting in a maintenance of real tax liabilities (see

Appendix 4).

6.55 In the case of the provisional taxpayer,

indexation does nothing to alter the divergence between

nominal and real tax rates which arose in the unindexed

system. This is because of the lack of synchronisation

between the accrual and payment of tax liabilities. Neither

does indexation alter the lower nominal average tax rate

borne by the provisional taxpayer relative to the P.A.Y.E.

taxpayer, which is due to the lagged income base used for

calculating provisional tax liabilities. Table VI-3

summarises the average tax rates borne by the hypothetical

P.A.Y.E. and provisional taxpayers under an indexed system.

TABLE VI-3

Average Tax Rates - P.A.Y.E. Taxpayer and Provisional Taxpayer (a)

Year * 1

P.A.Y.E. Taxpayer Nominal and ReaT %

1 18.17

2 18.17

3 18.17

4 18.17

5 18.17

Average Tax Rates Provisional Taxpayer Nominal Real

% %

17.12 16.25

17.12 16.25

17.12 16.25

17.12 16.25

17.12 16.25

(a) See footnote to Table VI-1.

249

Indexation cannot offset the relative advantage enjoyed by

the provisional taxpayer, because such advantage derives

from basic features of the provisional tax arrangements. No

doubt the present basis of provisional tax assessment will

be reviewed in the light of the recommendations of the

Taxation Review Committee.

Conclusion

6.56 The Committee believes that the arrangements

which have been proposed in this Chapter will, if

implemented, adequately satisfy the equity objectives of

indexation. They will also be relatively simple to operate,

easily understood and fully consistent with the continued

use of the personal tax system as a flexible instrument of

government policy. The implications of adopting the

proposed scheme are examined in the next Chapter.

251

APPENDIX 1 TO CHAPTER VI

REFERENCES IN NOMINAL VALUES IN THE INCOME TAX LEGISLATION, AND THE COMMITTEE'S RECOMMENTATIONS REGARDING INDEXATION

INCOME TAX ASSESSMENT ACT

Section Item Nominal

Amount £

Recommendation re Indexation

23AB(b) U.N. Services -

Living Allowances 2.00 No

23AB(7) Deduction - Taxpayer performing services for U.N. 540.00 Yes

51A Living away from

home allowances

2.00 5.00 7.00

No

64A(3) Legal Expenses -

Allowable deduction where not deductible under Section 51 50.00 Yes

67(3) Expenses of

Borrowing 100.00 Yes

72 Rates and Taxes on

Residence 300.00 Yes

73 Subscriptions to

Associations 42.00 Yes

78 Gifts 2.00 No

79A Zone Allowances -

Zone A

Zone B

540.00 90.00 Yes

79B Service in Overseas

Localities Allowance 540.00 Yes

82AAE Contributions (by

employers) to Superannuation Funds 400.00 Yes

252

Section Item Nominal Recommendation

Amount re Indexation

82B Deductions for

Dependants etc. 364.00

260.00 208.00 Yes

8 2D Limitation of

Dependant1s Income 130.00 Yes

82G Funeral Expenses 100.00 Yes

82H Life Assurance

Premiums 1,200.00 Yes

82 J Education Expenses 150.00 Yes

82JAA Self Education

Expenses 150.00 Yes

82KC Interest on Home

Loans

100.00 4,000.00 Yes

158AC Averaging of

Incomes

8,000.00 16,000.00 Yes

158C Abnormal Incomes 1,000.00 Yes

159A Drought Bonds 50.00

100.00 No

160AA Rebate of Tax -

Low income Families

Not Specified

Yes

188 Fee - Reference

to Board of Review 2.00 No

221C Value of Sustenance

& Accommodation Value for Tax Instalment purposes 2.00 No

2 21C Living Away from Home

Allowances - Value for Tax Instalment purposes

2.00

7.00 No

253

Section

221YC

251J

251L

265

Item Nominal

Amount $

Amount subject to provisional tax where provisional tax not paid in previous year 1,040.00

Fee - Registration of Tax Agents 2.00

Exemption from Registration of Tax Agents 40.00

Hearings - Applications for relief from 200.00

payment of tax 2,000.00

Income Tax (Rates) Act

5(3) Income not subject 416.00

to Tax 1,040.00

7 Tax Limitations 416.00

on Certain 425.00

Incomes 1.040.00

1.061.00

8 Surcharge on Income

from Property 5,000.00

9 Aged Persons Rebate 3,284.00

130.00 0.25 - 1.

10 Non Profit 416.00

Companies - 1,664.00

Taxable Income 1,830.00

11 Minimum Debits or

Refunds 0.20

Recommendation re Indexation-

Yes

No

No

No

Yes

Yes

Yes

No

No

No

Schedule 1 Rates of Tax -

Income Brackets

1, 000.00 40,000.00 Yes

Schedule 2 Rates of Tax - 16,000.00

Average Incomes 6,020.00

36,725.00

Yes

254

Section Item Nominal

Amount $

Schedule 3 Rates of Tax - .

Notional Incomes 1.00

Schedule 6 Income from Property - Phasing In 5,500.00

Schedule 7 Rates of Tax -Certain Companies 10,000.00

Income Tax Regulations

Regulation 4B Minimum Values - 0.15, 0.2

Wine & Spirit Stocks & 0.60

5(3) Minimum Values - 0.40

Natural Increase 2.00

- Livestock 0.50

54 Rates of Instalment 226.55

Deductions 500.00

54DA Deductions - 10.40

Zones A, B etc. 0.25

26.00 1.75 0.05

66 Fee - Medical 2.10

Examination 2.50

Third Instalment Deduction Schedule Scale

Fourth Housing Loan Interest Schedule Deduction Scale

Recommendation re Indexation-

No

Yes

Yes

No

No

Yes

No

No

Yes

Yes

255

APPENDIX 2 TO CHAPTER VI

CONSUMER PRICE INDEX AND PRIVATE FINAL CONSUMPTION EXPENDITURE DEFLATOR ANNUAL LEVELS AND PERCENTAGE INCREASES 1963-64 TO 1973-74 (BASE 1962-63 = 100.0)

CPI PFCED

Level Change Level Change

% % % %

1962-63 100.0 - 100.0 -

1963-64 100.9 0.9 101.7 1.7

1964-65 104.7 3.8 105.1 3.3

1965-66 108.5 3.6 108.4 3.2

1966-67 111.4 2.7 111.8 3.1

1967-68 115.1 3.3 115.4 3.2

1968-69 118.1 2.6 118.6 2.8

1969-70 121.9 3.2 123.0 3.7

1970-71 127.7 4.8 130.4 6.0

1971-72 136.4 6.8 138.2 6.0

1972-73 144.6 6.0 145.4 5.2

1973-74 163.3 12.9 163.1 12.2

Source; Australian Bureau of Statistics; Index - December Quarter 1974; Consumer Australian

Price

National Accounts - National Income and Expenditure 1^72-7^; Quarterly Estimates of National Income and Expenditure September Quarter 1974 - Preliminary Statement.

257

CONSUMER PRICE INDEX AND PRIVATE FINAL CONSUMPTION EXPENDITURE DEFLATOR, QUARTERLY PERCENTAGE INCREASES DECEMBER 1962 TO JUNE 1974

APPENDIX 3 ΤΟ CHAPTER VI

CPI CED CPI CED

Dec 62 0.11 0.79 Dec 68 1.05 0.86

Mar 63 0.11 0.11 Mar 69 0.66 0.85

June 63 0.33 0.45 June 69 0.75 0.47

Sept 63 0.11 0.44 Sept 69 0.56 0.75

Dec 63 -0.11 0.11 Dec 69 0.83 1.39

Mar 64 0.67 0.44 Mar 7 0 1.01 1.28

June 64 0.99 1.32 June 70 1.28 0.81

Sept 64 1.09 0.76 Sept 70 0.63 1.34

Dec 64 1.19 0.97 Dec 70 1.88 0.85

Mar 65 0.75 0.75 Mar 71 1.05 2.08

June 65 0.85 0.64 June 71 1.74 1.70

Sept 65 1.16 1.05 Sept 71 1.88 1.09

Dec 65 1.25 0.83 Dec 71 2.35 1.32

Mar 66 0.10 0.52 Mar 72 0.98 1.55

June 66 0.82 0.72 June 72 0.89 1.20

Sept 66 0.41 0.82 Sept 72 1.37 1.43

Dec 66 1.01 0.91 Dec 72 1.19 0.31

Mar 67 0.30 0.60 Mar 73 2.11 1.64

June 67 1.20 0.90 June 73 3.30 2.38

Sept 67 1.38 1.38 Sept 73 3.64 3.67

Dec 67 0.29 0.00 Dec 73 3.58 2.60

Mar 68 0.39 0.68 Mar 74 2.42 2.68

June 68 0.77 0.97 June 74 4.05 4.25

Sept 68 0.38 0.58

Source: As for Appendix 2, plus earlier issues of documents. the same

259

APPENDIX 4 TO CHAPTER VI

COMPARISON OF AVERAGE TAX RATES FOR P.A.Y.E. TAXPAYER AND PROVISIONAL TAXPAYER - 20% CONSTANT RATE OF INFLATION

P.A.Y.E. Taxpayer - Unindexed Tax Schedule

Year Nominal P.A.Y.E. Tax Liability Average Tax

(1)

Income Level (2)

Nominal

(3)

Real (a)

(4)

Rate

(5)

$ $ $ %

-1 6141 779 1014 12.63

0 7369 1204 1307 16.34

1 8843 1825 1651 20.64

2 10611 2674 2016 25.20

3 12733 3769 2368 29.60

4 15280 5166 2705 33.81

5 18336 6922 3020 37.75

(a) Equals $8000 x average tax rate

260

Provisional Taxpayer - Unindexed Tax Schedule

Year Provisional Tax Liability Average Tax Rate

(a)

Nominal

(b)

Real

(c)

Nominal

(d)

Real

(1) (2) (3) (4) (5)

$ $ % %

1 1629 1399 18.42 17.49

2 2446 1751 23.05 21.89

3 3523 2102 27.67 26.27

4 4863 2418 31.83 30.22

5 6564 2719 35.80 33.99

(a) The total tax payable by the provisional taxpayer in year one equals tax finally assessed on income in year zero ($1204) plus the difference between this amount and provisional tax already paid in respect of year

zero income. Provisional tax paid in respect of year zero income equals tax finally assessed on income in year minus one ($779). Hence total tax payable in year one equals $1204 plus ($1204 - 779) equals

$1629.

(b) Real total tax payable equals nominal tax times 100 divided by the price index prevailing in April of each year. The April values are:

Year No. 1 116.41

2 139.69

3 167.63

4 201.16

5 241.39

Equals column (2) of Table Table 1. 2 divided by column (2) of

(d) Equals column (3) of Table 2 divided by $8000.

261

P.A.Y.E. Taxpayer - Indexed Tax Schedule

Year P.A.Y.E. Tax Liability Average Tax

Nominal Real Rate

$ $ %

1 1607 1454 18.17

2 1928 1454 18.17

3 2314 1454 18.17

4 2777 1454 18.17

5 3332 1454 18.17

Provisional Taxpayer - Indexed Tax Schedule

Year Provisional Tax Liability Average Tax Rate

Nominal Real Nominal Real

$ $ % %

1 1514 1300 17.12 16.25

2 1816 1300 17.12 16.25

3 2180 1300 17.12 16.25

4 2615 1300 17.12 16.25

5 3139 1300 17.12 16.25

263

VII IMPLICATIONS OF PERSONAL TAX INDEXATION

7.1 In this Chapter, the Committee examines some possible

implications of adopting the indexation scheme proposed in

Chapter VI. After reviewing equity implications, the

Committee considers revenue implications, possible effects

on the allocation of resources and the implications of the

scheme for macroeconomic stability.

The Equity Implications of Personal Tax Indexation

7.2 In the following section, the Committee

discusses equity in relation to the personal tax system,

before considering implications for the tax system as a

whole and the possibility that indexation may result in

disadvantages elsewhere in the economy.

Personal Tax Equity

7.3 The Committee believes that there is virtually

no dispute about whether real income provides a better

measure of capacity to pay taxes than does nominal income.

There is some dispute, however, about whether personal tax

indexation is progressive. The dispute derives from the

fact that, while indexation provides relief to taxpayers at

all levels of income, the extent of the relief varies in a

complex fashion according to the level of income. This

section considers the relief which indexation provides to

taxpayers at different levels of income.

7.4 Table VII - 1 sets out the tax savings which

would accrue to a single taxpayer from indexation in

1975-76, at several real income levels, if the rate of

264

TABLE VII - I

Tax Saying as a Consequence of Indexation In 1975-76 : 20 pier cent Inflation! Single Taxpayers (a)

Real Net Tax Liability Income Level

Tax Saving as Consequence of Indexation

(1)

Without Indexation (2)

With Indexation (3)

Absolute Amount (4)

Percentage Reduction (5)

$ $ $ $ %

2,000 136 96 40 29.41

3,000 340 264 76 22.35

4,000 628 504 124 19.75

5,000 1,000 816 184 18.40

6,000 1,468 1,200 268 18.26

7,000 2,012 1,656 356 17.69

7,500 2,300 1,920 380 16.52

8,000 2,588 2,184 404 15.61

9,000 3,196 2,760 436 13.64

10,000 3,820 3,336 484 12.67

12,000 5,140 4,584 556 10.82

15,000 7,220 6,564 656 9.09

20,000 10,980 10,104 876 7.98

30,000 18,660 17,784 876 4.69

50,000 34,620 33,504 1,116 3.22

100,000 74,820 73,704 1,116 1.49

(a) 1974-75 rate scale; no concessional deductions

265

inflation was 20 per cent and indexation was based on the

same rate. Column (4) sets out the absolute tax saving

while column (5) sets out the tax saving as a percentage of

the tax which otherwise would be payable, that is, as a

percentage of the tax which would be payable in the absence

of indexing. It will be seen that the absolute amount of

tax saving from indexation is greater the higher the real net

income level. However, column (5) shows that, in percentage

terms, the tax saving falls continuously as the level of

real net income increases.

7.5 The difficulty of evaluating benefits from

indexation does not derive from the differing patterns

suggested by absolute and relative tax savings. There

appears to be general agreement that relative tax savings

are the relevant magnitudes.

7.6 It has thus been argued, in relation to criticism

that indexation favours the rich, that;

" [In] endeavouring to assess the equity or progressivity of indexing from the behaviour of the absolute dollar amounts, this criticism is on extremely shaky ground. The simple, hypothetical tax

structure shown below should serve to make this quite evident. Taxable Amount Effective

Income of Tax Tax Rate

$ 1,000 $ 100 10%

$ 10,000 $ 500 5%

$100,000 $1,000 1%

An examination of the dollar tax liabilities yielded by this structure may suggest that it is progressive, but it is patently obvious, when the liabilities are considered in relative terms, that it

is in fact grossly regressive. Whatever the criterion for judging the equity of indexing, it is clear that the judgment ought not to be predicated on a naive comparison of dollar tax savings at different

income levels.

266

The relative information provided by ... (percentage tax savings) ... would appear to be more useful for judging the equity of ... indexing ... This measure

clearly suggests that indexing is a progressive adjustment to the tax system, for the relative tax , saving falls continuously as taxable income rises."1

7.7 It will be recalled from the discussion in

Chapter III that the view of equity adopted by the Taxation

Review Committee, and indeed by the public finance

literature in general, is based on relative tax totals,

rather than on the. tax totals themselves. In order to

assess the equity implications of indexation, it is

therefore necessary to look at relative tax totals.

Indexation restores the relative tax totals at each real

net income level for each dependant category, thereby

restoring the legislated horizontal and vertical equity

prescriptions.

7.8 The Committee notes that the foregoing analysis

is deficient in one important respect. To compare the

distributional results of two personal tax structures, it

is essential that the two tax structures provide the same

aggregate real tax yield. This requirement has long been 2

recognised in the literature of public finance. Failure

to do so means that the effects of the personal tax change

are compounded with other effects attributable to a change 1 2

1 J.R. Allan, D.A. Dodge and S.N. Poddar, 1 Indexing the Personal Income Tax: A Federal Perspective', Canadian Tax Journal, July/August 1974, pp.360-361.

2 See, for example, Richard A. Musgrave, The Theory of Public Finance, McGraw-Hill, New York, 1959, pp. 212-213.

267

revenues or indebtedness. A more relevant standard of

comparison is between an unindexed personal tax structure

and an indexed structure accompanied by a proportionate tax

surcharge (of the type levied by Australian Governments

frequently in the past) such that the yields of the two

structures are identical.

7.9 Table VII-2 compares, on the stated

assumptions, an unindexed structure with an indexed tax

structure accompanied by an across-the-board tax surcharge

of 10 per cent. ■ * " It will be seen that the ranking of

percentage changes in tax liability, as a result of

indexing, remains unaltered. The confusion about the

equity implications of indexation arises from concentration

on disposable income changes rather than on relative tax

liability changes. The argument that the effect of

inflation on progressive personal taxation cannot be

considered inequitable is based on the fact that inflation

tends to result in greater reductions in real disposable

income at the upper (but not the top) income levels.

Indexation unaccompanied by additional discretionary

adjustments results in the restoration of the initial real 1

1 This may be a little low. Given a 20 per cent rate of increase in nominal incomes, indexation plus a 10 per cent surcharge is likely to increase aggregate nominal tax revenues by approximately 32 per cent. The same proportionate increase would be forthcoming under an

unindexed tax schedule if the elasticity equalled 1.6. The estimated elasticity of the 1974-75 schedule in that year was 2.1. The appropriate figure would be smaller for 1975-76, but is unlikely to fall as far as 1.6.

However, this does not affect the qualitative conclusions reached above.

268

T A B L E V I I - 2

T a x C h a n g e a s a C o n s e q u e n c e o f I n d e x a t i o n

A c c o m p a n i e d b y a 1 0 p e r c e n t T a x S u r c h a r g e (a)

Real Net Income Level

Tax Liability Tax Change

Consequence Indexation

as a

of

Without With Absolute Percentage

Indexation Indexation Amount Change

(1) (?) (3) (4) (5)

$ $ $ $ %

2,000 136.0 105.6 - 30.4 - 22.35

3,000 340.0 290.4 - 49.6 - 14.59

4,000 628.0 554.4 - 73.6 - 11.72

5,000 1,000.0 897.6 -102.4 - 10.24

6,000 1,468.0 1,320.0 -148.0 - 10.08

7,000 2,012.0 1,821.6 -190.4 - 9.46

7,500 2,300.0 2,112.0 -188.0 - 8.17

8,000 2,588.0 2,402.4 -185.6 - 7.17

9,000 3,196.0 3,036.0 -160.0 - 5.01

10,000 3,820.0 3,669.6 -150.4 - 3.94

12,000 5,140.0 5,042.4 - 97.6 - 1.90

15,000 7,220.0 7,220.4 0.4 0.01

20,000 10,980.0 11,114.4 134.4 1.22

30,000 18,660.0 19,562.4 902.4 4.84

50,000 34,620.0 36,854.4 2,234.4 6.45

100,000 74,820.0 81,074.4 6,254.4 8.36

(a) A s s u m p t i o n s as f o r T a b l e V I I - 1

269

disposable income level associated with each initial level

of net income. Hence, on the basis of this argument,

indexation benefits upper income groups more than it

benefits lower income groups.

7.10 On the basis of the same assumptions as were

used in Tables VII-1 and VTI-2, Table VII-3 sets out the

proportionate increase in real disposable income, for

various real net income levels, which results from

indexing. The Table confirms that the proportionate

increase in real disposable income tends to vary inversely

with the initial level of net income.

7.11 However, again it is necessary to impose the

equal tax yield requirement in comparing the two personal

tax structures. Table VII-4 sets out the real disposable

income implications of the two personal tax structures

considered above; namely an unindexed structure compared

with an indexed structure accompanied by a 10 per cent tax

surcharge. Unlike the relative tax liabilities case, the

rankings do change when a relevant standard of comparison

is assumed. It will be seen that the following pattern now

emerges. The proportionate change in real disposable

income as a consequence of indexation (accompanied by a 10

per cent tax surcharge) is positive at lower income levels

and negative at upper income levels. The largest

proportionate increases tend to be in the vicinity of

average earnings. Hence the Committee agrees with the

assessment made of the Canadian indexation scheme, namely;

270

TABLE VII-3

Real Disposable Income Changes as a Consequence of Indexation in 1975-76 : 20 per cent Inflation: Single Taxpayers (a)

Real Net Real Disposable Income Percentage Increase in Income Real Disposable Income

Level as Consequence of

Indexation

W i t h o u t W i t h

Indexation Indexation

$ $ $ %

2,000 1,887 1,920 1.75

3,000 2,717 2,780 2.32

4,000 3,477 3,580 2.96

5,000 4,167 4,320 3.67

6,000 4,777 5,000 4.67

7,000 5,323 5,620 5.58

7,500 5,583 5,900 5.68

8,000 5,843 6,180 5.77

9,000 6,337 6,700 5.73

10,000 6,817 7,220 5.91

12,000 7,717 8,180 6.00

15,000 8,983 9,530 6.09

20,000 10,850 11,580 6.73

30,000 14,450 15,180 5.05

50,000 21,150 22,080 4.40

100,000 37,650 38,580 2.47

(a) 1974-75 rate scale, no concessional deductions

271

T A B L E V I I - 4

R e a l D i s p o s a b l e I n c o m e C h a n g e s a s a

C o n s e q u e n c e o f I n d e x a t i o n A c c o m p a n i e d b y a

10 p e r c e n t T a x S u r c h a r g e (al

Real Net Real Disposable Income Percentage Change in Income Real Disposable Income

as Consequence of Indexation

Without Indexation With Indexation

$ $ $ %

2,000 1,887 1,912 1.32

3,000 2,717 2,758 1.51

4,000 3,477 3,538 1.75

5,000 4,167 4,252 2.04

6,000 4,777 4,900 2.57

7,000 5,323 5,482 2.99

7,500 5,583 5,740 2.81

8,000 5,843 5,998 2.65

9,000 6,337 6,470 2.10

10,000 6,817 6,942 1.83

12,000 7,717 7,798 1.05

15,000 8,983 8,983 0.00

20,000 10,850 10,738 - 1.03

30,000 14,450 13,698 - 5.20

50,000 21,150 19,288 - 8.80

100,000 37,650 32,438 -13.84

(a) Assumptions as for Table VII-3.

2 72

1 Both criteria - ... taxes payable and ...

disposable income - indicate that indexation is progressive ... It is thus apparent that when a theoretically appropriate comparison is made, indexation is revealed as being an unambiguously progressive measure.11

The Equity of the Total Tax System

7.12 It is the view of the Committee that personal

tax indexation will undoubtedly improve the equity of the

personal tax system. However the Committee is mindful of

the fact that it is necessary to consider whether personal

tax indexation will improve the equity of the tax system

in toto. In the first place, it may be argued that to

correct one part of the tax system for the inequitable

effects of inflation, while leaving the rest of the tax

system subject to the effects of inflation, may itself be

regarded as inequitable. The second half of this Report

deals with the problems raised for business taxation by

inflation and makes recommendations in that regard. As for

indirect taxation, inflation raises no obvious equity

problems, except to the extent that the declining real

value of specific duties may be viewed as raising such

problems. It is certainly true that some of the inequities

associated with inflation and personal taxation are present

also with other forms of progressive taxation, such as

estate and gift duties. However given the weight of

personal income taxation relative to estate and gift duties

in total taxation, failure to index estate and gift duty

1 J.R. Allan, D.A. Dodge and S.N. Poddar, op. cit., p. 362

273

rate scales can scarcely be said to involve inequity on a

scale that would outweigh the equity gains resulting from

personal tax indexation.

7.13 Consistent with its philosophy, however, the

Committee believes that the principles underlying

indexation of personal income tax can be extended

throughout the whole tax system. Inflation serves to

reduce the effective rates in real terms of specific taxes

defined in nominal terms;it also alters the progressivety

of taxes levied by means of progressive rate schedules.

Taxes levied at flat rates, with no exemptions or

deductions defined in nominal terms, are unaffected by

inflation. Ad valorem sales taxes generally fall into this

category.

7.14 Representations were received by the Committee

from individuals and organisations to the effect that it

should recommend adjustment to the rate structure and the

levels of deductions (or exemptions) of other forms of

taxation, particularly estate duties, in inflationary

periods. Estate duties have been the subject of detailed

examination by the Taxation Review Committee and there

appears to be no need for this Committee to make

recommendations about changes in that form of taxation.

But the Committee records its view that the general

principles of indexation which it has described in relation

to personal income taxation may be applied to estate duties

274

and other forms of progressive taxation so as to avoid

unintended increases in the burdens of such taxation as a

result of inflation.

7.15 There is one point not to the taxpayer's

advantage which is commonly overlooked in discussions of

taxation policy. All increases in specific taxes defined

in nominal terms are generally classed as discretionary

adjustments, even though such action is necessary to

maintain the real value of those taxes in inflationary

periods. By contrast, the dollar amounts of ad valorem

taxes increase automatically with inflation. If the

general principles stated above are accepted for taxes with

progressive rate schedules, it is appropriate also for

specific taxes to be indexed to maintain their real values

in inflationary periods.

7.16 A different criticism of personal tax indexation

is that it necessarily involves increased indirect

taxation, and that the inequities associated with increased

indirect taxation need to be weighed against the equity

gains resulting from personal tax indexation. The

Committee does not agree with this view. In the first

place, as has been consistently emphasised throughout this

Report, personal tax indexation does not necessarily

involve any decrease in the role of the personal income tax

relative to its role in an unindexed system. Personal tax

indexation is completely compatible with the view that

275

personal income taxation is the most equitable form of

taxation and should play a large and growing role.

Indexation aims to improve the equity of personal income

taxation.

7.17 Further, to the extent that increases in

indirect taxation are considered necessary, the equity

implications cannot be considered in isolation from the

rest of the taxation system or from the pattern of

government expenditure. In recommending a shift towards

indirect taxation, the Taxation Review Committee emphasised

this point:

1 In considering any individual tax, account must be taken of its place in the tax structure as a whole. If a broad-based tax covering food and clothing introduces an element of regressivety, that element can be counter balanced by increasing the progressivity of other taxes in the system. The Committee is satisfied that, either by special measures by way of transfer payments or by other more

progressive taxes, or by a combination of both, the progressivity of the structure as a whole can be maintained or adjusted to the required degree.11

7.18 Personal tax indexation is also sometimes

criticised on the ground that it is likely to be adopted at

the expense of more fundamental and urgent tax reforms. It

is argued that required tax reforms can only be implemented

in a situation where the tax burden is, in general,

reduced. Because personal tax indexation also implies that

tax burdens will be lower than under an unindexed system.

1 Full Report, para. 27.23.

276

the two types of reform are likely to imply unacceptable

reductions in aggregate revenues. Thus the two types of

reform are said to be, in reality, substitutes.

7.19 The Committee is well aware that the Australian

Treasury and the Taxation Review Committee have exposed

many unsatisfactory features of the current personal tax

system, and have recommended substantial reforms.

Nevertheless, this Committee does not accept the conclusion

of the previous paragraph as valid in a long run context.

Personal tax reform and personal tax indexation are most

sensibly viewed as complements rather than substitutes.

For one thing, the Committee is not convinced that tax

reforms can only be achieved under conditions of decreasing

taxation. The overall recommendations of the Taxation

Review Committee have been made within the constraints of

that Committee's terms of reference which specified,

inter alia, that a sufficient flow of revenue to the

government must be maintained. In the case of Canada, it

is not true that it was necessary to implement tax reforms

within the context of a declining tax burden. If anything,

the converse appears to be true:

'It is an easy but greatly confusing mistake to compound the effects of the tax reform proposals with the effect of the proposed tax increase ... [The] tax increase proposed by the White Paper may well be the largest peace-time tax increase ever proposed by a Canadian government. The effects of such a tax increase should not be confused with the effects of

tax reform,11

1 John Bossons, 'The Impact of Tax Rates on the Effect of Tax Reform', Report of Proceedings of Twenty-Second Tax Conference, Canadian Tax foundation, Toronto, 1970, p 39. The White Paper referred to is Proposals for Tax Reform, Canadian House of Commons, NovelnbeS T, Γ9ο5Γ.

277

7.20 Further, as emphasised elsewhere in this

Report, personal tax indexation does not necessarily imply

a decreased flow of revenue relative to a non-indexed

personal tax structure. That depends very much on the

extent of the discretionary action which otherwise would have

been taken. The major aim of tax reform is to increase the

equity of the tax system while maintaining an adequate flow

of revenue to the government. So far as personal taxation

is concerned, the equity prescriptions of the reformed tax

system will be rapidly and substantially altered if there

is a combination of rapid inflation and an unindexed

personal tax system. Many of the beneficial effects of the

reforms will, in such circumstances, be very short-lived

indeed. For these reasons the Committee regards personal

tax reform and personal tax indexation as being

complementary in nature.

Equity and the Economy

7.21 A final equitable objection to personal tax

indexation is concerned with its partial effects. It is

thus said that adoption of tax indexation, in isolation

from other forms of indexation (such as indexation of

incomes and money claims generally), compensates one group

in society for the effects of inflation, while leaving

other groups uncompensated. In this manner, it is argued,

personal tax indexation may actually increase the

inequities involved with the redistributive effects of

278

inflation. This argument is an example of the so-called

theory of 1 second-best1 in economics, which involves the

proposition, stated simply, that removal of one

imperfection in a generally imperfect world does not

necessarily imply that the world becomes less imperfect.

On the contrary, the world may become more imperfect,

7·22 To examine this argument in any detail raises

issues beyond the scope of this Report. Nevertheless, for

the following reasons the Committee has concluded that the

argument is not a compelling one with regard to personal

tax indexation:

(a) Despite considerable discussion about the effects of

inflation on the redistribution of income, very

little empirical investigation has accompanied such

discussion. The few studies that have been made for

developed economies have all reached the same

conclusion; this is that the effects of inflation on

the pre-tax distribution of income are exceedingly

modest.·*· The Committee concedes that most of the

empirical work relates to the United States during

periods when the rate of inflation was moderate, and

that the degree of aggregation in most studies is

1 See, for example: William D. Nordhaus, 1 The Effects of Inflation on the Distribution of Economic Welfare', Journal of Money, Credit, and Banking, February 1973; E.C. Budd and D.F. Seiders, 'The Impact of Inflation on the Distribution of Income and Wealth', The American Economic Review, May 1971.

279

high. Nevertheless, it remains true that existing

empirical evidence fails to confirm substantial

redistributive effects.

(b) Economic theory supports the foregoing empirical

findings:

'economic theory suggests ... that the institutional mechanisms of a society based on freedom of choice and competition will, if the system of contract is reasonably flexible and inflation not too erratic, act to bring about

the elimination of major inflationary injustices. If one is to find genuine economic costs of inflation, therefore, one must look for costs that cannot or will not be eliminated by the processes of competitive contract

adjustment.'1

(c) Even if subsequent research were to reveal that

significant income redistributions take place during

inflationary periods, these redistributions will not

necessarily all be inequitable. For example, suppose

that research shows that inflation produces a

significant redistribution of income from creditors

to debtors; and suppose further that creditors tend

to be rich and that debtors tend to be poor. Could

such a redistribution be held to be unambiguously

inequitable?

(d) Even if substantial redistributions were found to

occur which could be regarded as unambiguously

inequitable, the nature of these redistributions may 1

1 Harry G. Johnson, 'Inflation and the Monetarist Controversy', North-Holland Publishing Company, Amsterdam, 1972, p. 24.

280

be such as to render them not amenable to remedial

government action.

7.23 The impact of inflation on personal taxation,

on the other hand, has been seen to have the following

effects, each of which may be contrasted with one of the

foregoing four propositions:

(a) The redistributive effects are demonstrably

substantial. This conclusion holds not only

for rapid rates of inflation but also for

moderate rates if the personal tax schedule

remains unchanged for a number of years.

(b) The very nature of the redistribution does not

render it amenable to elimination by the

process of competitive contract adjustment.

(c) The redistributive effects are demonstrably

inequitable.

(d) The nature of these redistributions renders

them amenable to elimination by government

action. Indeed this is virtually the only form

of action which can appropriately offset the

redistributions.

7.24 The preceding discussion suggests that the

combination of inflation and an unchanged personal tax

schedule may well provide the most quantitatively

significant, redistributive effect of inflation. This

substantial masked redistribution can be offset with

281

substantial precision by a personal tax indexation scheme.

The Committee therefore regards it as inconceivable that an

unindexed personal tax system can form part of a more

equitable economic system than a system which contains an

indexed personal tax structure.

7.25 The Committee concludes that, regardless of

whether equity is viewed in terms of the personal tax

system, the total tax system or the economy as a whole,

indexation of the personal tax schedule is likely to

enhance equity. Valid objections to personal tax

indexation must lie in the implications of such schemes for

economic and social objectives other than those directly

relating to equity.

Implications of Indexation for Personal Tax Revenues

7.26 As emphasised in earlier Chapters, personal tax

indexation does not imply any reduction in the role of

personal taxation in the total tax structure. Those who

argue otherwise need to demonstrate:

(a) that the personal tax schedule is likely to

remain largely unaltered in times of rapid

inflation; and

(b) that personal tax indexation precludes

additional discretionary adjustments to the tax

schedule.

Both these propositions have already been scrutinised in

some detail and have been found wanting in important

respects

282

7.27 With these issues in mind, the Committee now

gives a brief summary of its estimates of the revenue losses

likely to be associated with indexation. The estimates are

presented in greater detail in the Appendix to this Chapter.

W o sets of estimates were constructed for the Committee by

the Commissioner of Taxation. The first considered the

revenue implications of indexing the 1968-69 personal tax

schedule during the period from 1969-70 to 1973-74. The

exercise was carried out assuming indexation on the basis of

both the current and a lagged rate of inflation (as defined

in the Appendix). For reasons explained in the Appendix, it

is not possible to compare these revenue estimates with

actual tax collections during the period from 1969-70 to

1973-74. Therefore the standard of comparison for the

indexed revenues is the revenues which would have been

forthcoming over the same period had the 1968-69 unindexed

tax schedule been maintained, where those revenues are

estimated on a basis consistent with the indexed revenues.

The Commissioner of Taxation was not able to provide revenue

estimates that incorporated indexation of non-dependant

deduction limits. However, separate estimates were provided

of the revenue implications of indexing taxable income

bracket limits only, and indexing bracket limits plus

dependant deduction limits (referred to as partial and full

indexation respectively hereafter).

283

7.28 Table VII-5 below shows the proportionate

reduction in aggregate personal tax revenues as a result of

indexation. It must be borne in mind that these

proportionate reductions are calculated with respect to

revenues that would have been forthcoming under an unchanged

tax schedule, and not with actual revenues between 1969-70

and 1973-74. Had the latter comparison been possible the

proportionate reductions would have been substantially

smaller because of the significant downward discretionary

adjustments to personal tax rates in both 1970-71 and

1972-73."^ The Table should be interpreted in the light of

the assumptions recorded in the Appendix.

TABLE VII-5

Percentage Reduction in Aggregate Personal Tax Revenues under Indexation 1

Income Year , Current Indexation Lagged Indexation

Partial Full Partial Full

% % % %

19G9-70 2.23 2.58 1.79 2.05

1970-71 5.35 6.15 3.58 4.35

1971-72 9.49 10.83 6.49 7.39

1972-73 12.68 14.31 10.16 11.48

1973-74 18.62 20.68 12.54 13.91

7.29 There are three results which should be

especially noted. First, the major source of revenue loss

is taxable income bracket indexation . The additional

revenue loss as a result of dependant deduction limit

indexation is modest. Secondly, the revenue loss is

1 A comparison of this type appears below in the discussion of the stabilisation implications of indexation.

284

substantially smaller in the case of lagged indexation than

under current indexation, reflecting the tendency for

inflation to accelerate over the period. Thirdly, as Table

VII-6 below indicates, the aggregate personal tax ratio

(total personal taxation divided by total net income)

increases from year to year even in the full current

indexation case. This reflects the growth in aggregate real

net incomes during the period.

TABLE VII-6

Aggregate Personal Tax Ratios With and Without "indexation

income Year

Current Indexation Lagged Indexation No Indexation

Partial Full Partial Full

% % % % . %

1969-70 14.49 14.44 14.56 14.52 14.82

1970-71 15.10 14.97 15.35 15.26 15.95

1971-72 15.46 15.23 15.97 15.82 27.08

1972-73 17.44 17.12 17.95 17.68 19.98

1973-74 19.41 18.92 20.85 20.53 23.85

7.30 The second set of estimates comprises

projections over the period 1975-76 to 1979-80. The

projections assume that the 1974-75 personal tax schedule

is indexed in line with the rate of inflation lagged one

year from the start of the 1975-76 income year. Three

annual rates of inflation are assumed to prevail throughout

the five year period: 10 per cent, 15 per cent, and 20 per

cent. In each case, it is assumed that the tax schedule is

235

adjusted at the beginning of 1975-76 on the basis of a 15

per cent inflation rate in 1974-75. The large number of

simplifying assumptions that were necessary for this purely

hypothetical exercise is detailed in the Appendix to this

Chapter. The standard of comparison in each case is an

unaltered tax schedule, which, for reasons discussed below,

is completely unrealistic.

7.31 Table VII-7 shows the proportionate reduction

in personal tax revenues under an indexed system relative to

an unindexed system. Tables VII-8 and VII-9 indicate the

aggregate personal tax ratios in each situation.

7.32 As is to be expected, the proportionate

decreases in aggregate personal tax revenues are extremely

large. However, they are not worthy of detailed

consideration, because of the unrealistic nature of the

assumption that an unchanged tax schedule is a sensible

standard of comparison. The degree of abstraction in the

estimates is indicated by the fact that the assumed

retention of 1974-75 rates in 1979-80, in a situation in

which the annual rate of inflation had been 20 per cent,

would result in the average rate of tax on taxpayers in the

modal income group increasing from less than 15 per cent to

more than 35 per cent.

286

TABLE V I 1 -7

Projected Percentage fteducatton in Aggregate Personal Tax Revenues under Indexation

Income Year

1 0# I n f l a t i o n 1 5* I n f l a t i o n 2 0# I n f l a t i o n

P a r t i a l

In d e x atio n

F u l l

ln d e x a tio n

P a r t i a l

1ndexation

F u l l

In d e x atio n

P a r t i a l

Ind e xatio n

F u l l

Indexation

t % t t t i

1 9 / 5 -7 6 1 1 . 2 11.7 10.9 1 1.7 10.8 11.8

1976-77 1 7.6 1 8 . 5 19.8 21.1 21.7 2 3.2

1977-78 22.3 2 4 . 1 26.5 2 8 . 4 30.1 31 .8

1978-79 2 7.5 2 8 . 8 3 2.5 3 4 . 2 36.3 3 8 . 3

1979-8Ο 31.3 32.8 37.1 3 8 . 9 4 1 . 1 4 3 . 2

TABLE VI I - 8

Pro ie c t e d Anorenate P erson al Tax R a t i o s Assumino

an Unchanoed Pe rson a l Tax Schedule

income Year 1 0# I n f l a t i o n 1 5# I n f l a t i o n 2 0# I n f l a t i o n

% t - *

1975-76 1 9.7 2 0.5 21.1

1976-77 2 1 . 8 2 3 . 4 25.Ο

1977-78 2 4 . 0 26.4 2 8 . 8

1978-79 2 6.2 29.3 3 2 . 4

1979-80 2 8 . 4 3 2 . 2 3 3 - 9

TABLE VI I- 9

Pro iented Aaoreoate Personal Tax Rat ί c js Under Indexation

Income Year

1 0# I n f l a t i o n 15# I n f l a t i o n 2 0# I n f l a t i o n

P a rt i a l 1ndexation

F u l l

Ind e xatio n

P a r t i a l

1ndexation

F u l l

In d e x a tί on

P a r t i a l

1ndexatton

F u l l

Inde xatio n

t t i t t f

1975-76 17.48 1 7 - 3 8 1 8 . 2 2 1 8 . 0 6 1 8 . 9 4 1 8 . 7 3

1976-77 17.99 1 7 . 7 8 1 8 - 7 7 1 8 . 4 8 1 9 - 5 3 19.16

1977-78 1 8 . 4 8 1 8 . 2 1 1 9 - 3 1 1 8 . 9 0 2 0 . 0 8 1 9 . 5 7

1978-79 18.98 1 8 . 6 2 1 9 . 8 2 1 9 . 3 2 20.62 1 9 . 9 9

1979-80 19.47 1 9 - 0 4 20.32 1 9 . 7 4 21 .17 2 0 . 4 4

287

7.33 The projections are consistent with two

self-evident propositions which do not require such

exercises for their validation, namely:

(a) an unchanged nominal tax schedule is not an

appropriate standard of comparison against

which to measure the revenue losses from

indexation, under conditions of inflation at

rates anything like those currently being

experienced; and

(b) in a growing economy, the aggregate personal

tax ratio will increase inexorably, even under

conditions of perfect indexation and no

additional discretionary tax schedule changes.

7.34 The Committee recognises that, because there is

an inherent tendency for the public sector in all mixed

economies to grow at a faster rate than the private sector,

it is desirable for the tax system to generate revenue

growth at a faster rate than the growth in gross domestic

product. But it emphasises that, under the system of

personal tax indexation which it has recommended, such

revenue growth will be obtained through the combined effects

of lagged indexation and real income growth.

Implications of Personal Tax Indexation for the Tax Mix

7.35 Because personal tax indexation does not imply

any decrease in the role of personal taxation in the total

tax structure, it follows that indexation has no obvious

implications for the tax mix.

288

7.36 Having said that, the Committee recalls the

recommendation of the Taxation Review Committee to the

effect that the tax mix be changed, away from the current

heavy reliance on income taxation towards a greater reliance

on indirect taxation. To the extent that this is a desired

outcome, personal tax indexation is not inconsistent with

such an aim, although personal tax indexation per se cannot

be expected to bring about the required change. As has been

noted, even a perfect indexation scheme will not prevent an

inexorable increase in the aggregate personal tax ratio in

the context of a growing economy.

7.37 While reduced reliance on direct taxation is

very likely to imply an increased reliance on indirect

taxation, it is worth noting that this is not a necessary

outcome. In this connection, the Taxation Review Committee

commented:

"in some countries government capital expenditure is financed almost exclusively from borrowing, leaving taxes to cope with current needs. In Australia, however, a sizeable fraction of government investment

is met from taxation. Were this fraction to be lowered and the fraction represented by borrowing correspondingly raised, the pressure for increasing taxation would be that much relieved."!

The scope for significant increases in the volume of

Australian Government borrowing from the public is

inordinately difficult to gauge. There has been a

significant increase in the private sector savings ratio in

recent years. However, this may be more indicative of a 1

1 Full Report, para. 1.8, and Treasury Taxation Paper No. 13, Summary of Issues, op. cit.

289

response to the generally accelerating rate of inflation

than of a sustained long term trend. If the savings ratio

does return to traditional levels (which are relatively high

by international standards), increased Australian Government

domestic borrowing may need to be at the expense of State or

semi-government borrowing, or corporate borrowing. The

achievement of a sustainable increase in the private sector

savings ratio may well require significant increases in real

interest rates. Under current inflationary conditions, this

in turn implies high nominal rates. Of course, such

increasing interest rates themselves may be expected to have

inflationary implications. However, even if this once

provided a reason for limiting the use of such an

instrument, it no longer necessarily does so. In

contemporary developed economies all instruments capable of

achieving a real resource transfer from the private to the

public sector have inflationary implications, personal

taxation included.

7.38 Personal tax indexation thus appears to have no

obvious implications for the tax mix. Adoption of

indexation would not conflict with the recommendations of

the Taxation Review Committee and the Australian Treasury

regarding the appropriate mix of taxes.

Implications of Personal Tax Indexation for Resource Allocation

7.39 The Committee now turns to an examination of

the resource allocation effects of tax indexation, with

special reference to balance between the public and private

sectors, and to resource allocation effects within the

private sector.

290

Resource Allocation Between the Public and Private Sectors

7.40 The preceding discussion has suggested that

personal tax indexation does not necessarily imply a

diminished role for personal taxation, either in relative or

in absolute terms. It may seem, therefore, that personal

tax indexation is without implications for the allocation of

resources between the private and the public sectors. While

adoption of a personal tax indexation scheme does not imply

a reduced role for personal taxation relative to an

unindexed personal tax system, the required process of

adjustment is different under the two systems. Proponents

of personal tax indexation schemes have suggested that the

process of adjustment under such schemes is likely to result

in an improvement in the efficiency of the government

expenditure decision-making process. Under an indexed

system, incremental government expenditures demanding

revenues in excess of those produced by real income growth

require explicit discretionary tax rate increases. The

argument is that, in these circumstances, new government

expenditure projects and pre-existing government expenditure

projects are likely to be subject to greater Parliamentary

and public scrutiny, with a consequential improvement in the

efficiency of government decisions.

7.41 This proposition is, by its very nature,

incapable of verifiable proof. But it does presume that

there is significant scope for improvement in the

determination of expenditure policies. A major study of

291

government expenditure in Canada suggested that all Western

political and administrative systems are characterised by a

'slow steady increase in the size of existing programs, the failure of old programs ever to die off completely, and the steady introduction of new programs ... this process results in a steady creeping upward of

government expenditure beyond the level "required" by expansion of the population served and similar objective changes in the expenditure base.'l

Part of this phenomenon was explained in terms of bureaucratic

decision-making processes. Part of the explanation was

considered to flow from the budgetary process, which is

necessarily fragmented and incremental. Thus the budget

tends not to be considered as a whole so as systematically

to determine priorities or relate its component parts to

each other. Another part of any explanation may involve the

process of executive government and the large number of

spending departments relative to the single department

responsible for revenue raising (the Treasury).

7.42 Information about the efficiency of government

expenditure decisions is difficult to obtain. In 1973 the

Coombs Task Force, which had been established to scrutinise

expenditure programs, reported on a wide range of continuing

policies which, it said, changed circumstances had rendered

questionable. The Task Force also identified a number of

government expenditure programs which it considered

difficult to justify even at the time of their inception: 1

1 Richard M. Bird, The Growth of Government Spending in Canada, Canadian Tax Foundation, Toronto, 1970, p. 133.

292

1 Attention was given to the apparent effectiveness of the programs for the purposes to which they were originally directed. A number of programs appeared hard to justify in the light of the apparent results over a period of years. Thus, some programs have been accepted without adequate cost/benefit study or even where such studies were clearly unfavourable.

Subsequent results have justified scepticism about them and underlined the need for more critical examination of such programs in the future.'1

7.43 This quotation referred specifically to water

conservation programs, but the same basic conclusions

emerged from the Task Force's examination of other

government expenditures. The Task Force suggested that:

1 The processes of review ... could with advantage be continued and progressively cover the whole range of government action. It would be valuable if such reviews provided the material for widespread debate about the principles and other considerations underlying government decisions.'2

7.44 In a similar vein, the Task Force Report

emphasised the real need to clarify and simplify various

measures of government assistance, '... so that they can be

subjected to proper Government, parliamentary and public 3

scrutiny in the context of their cost and overall effect*.

7.45 The Task Force Report indicates that

substantial scope exists for an improvement in the

efficiency of the government expenditure decision-making

process. The findings do not, of course, prove that the

existence of an unindexed personal tax schedule contributed

in any way to such a situation. However, commonsense

suggests that the presence of an indexed personal tax 1

1 0£. cit., p. 5.

2 Ibid., p . 6.

3 Ibid., p. 19

293

schedule may have changed the climate in which government

expenditure decisions were taken. To the extent that this

may have influenced the government expenditure

decision-making process, it could only have operated in one

direction, with a tendency to improve efficiency. Consider

the situation where, under an indexed tax system, a

government is examining a proposed new expenditure project

which, all other things equal, will necessitate explicit tax

rate increases. It seems at least arguable that such a

situation will stimulate closer scrutiny of earlier

expenditure decisions, to ascertain whether they remain

appropriate and to determine fresh priorities in the light

of the proposed new project. To the extent that explicit

tax rate increases are decided upon following such scrutiny,

it seems likely that the incremental project will have been

subjected to the greater 'Government, parliamentary, and

public scrutiny in the context of its cost and overall

effect', which the Coombs Task Force found so necessary and

lacking.

7.46 The Committee believes that the introduction of

a personal tax indexation scheme would make a substantial

contribution towards the elimination of two types of fiscal

illusion, each of which tends to encourage inefficiency in

government expenditure decision-making. The Taxation Review

Committee expressed the view that there exists a fiscal

illusion on the part of the public at large:

294

which leads people to believe that what we receive from the Government comes from some supra-human Santa Claus from whose bottomless sack ever more can be produced without charge to ourselves* 1.1

The same basic point has been made elsewhere, along with the

hypothesis that the illusion has been fostered by the

practice of departing from balanced budgets which had its

origin in the Keynesian revolution:

1 The idea that money can be created by government action, if not fully understood, is nevertheless accepted as a fact of life. But it also illustrates most vividly the view of government as the miracle-doer ... with this psychology, it is a small and comprehensible step to the belief that if the government is unwilling to do something it is not because it cannot "afford" it, but because it does not believe that something is worth doing.'1

7.47 The second type of fiscal illusion which

personal tax indexation would help to eradicate concerns an

illusion that may be applicable to decision-makers

themselves. As Mr. G. Brennan said in a study paper

prepared for the Committee:

'Where the automatic increase in income tax revenue comes about through a mixture of real and purely inflationary increases in money income, political decision-makers may themselves suffer from the illusion that a greater proportion of the revenue represents real income increases than is in fact the case. If such an illusion prevails, there may well be a systematic tendency for automatic revenue increases to be spent in expanding the relative size of the public

sector. It is this sort of illusion, rather than taxpayer illusion, that is likely to imply a significantly higher level of public spending than would otherwise prevail.1

1 Full Report, para. 5.5.

1 Irving Friedman, Inflation - A Worldwide Disaster, Hamish Hamilton, London, 1973, pp. 29-30.

295

7.48 Having regard to the inflationary experience of

recent times, the Committee finds it difficult to

underestimate the potential importance of this problem. It

is estimated that aggregate personal income tax revenues in

1974-75 will be approximately double the level prevailing in

1972-73, despite substantial tax cuts within this period.

The natural growth of personal incomes will provide another

doubling inside two years. With rates of increase of this

magnitude in what is by far the major government revenue

source, decision-makers may perhaps be forgiven for

believing that the revenue constraints on government

expenditure are not restrictive.

7.49 The Committee therefore believes that the

introduction of a personal tax indexation scheme will make a

positive contribution towards improving the efficiency of

the government decision-making process. It will do this by

subjecting incremental government expenditures to greater

government, parliamentary and public scrutiny, and by

helping to ensure that all government decisions are made

within a framework of expenditure priorities and a balancing

of spending decisions against explicit revenue-raising

decisions. Personal tax indexation does not necessarily

imply a smaller public sector than will otherwise prevail,

but the Committee believes that it does imply a more efficient

and more responsive public sector.

296

Resource Allocation Within the Private Sector

7.50 If additional discretionary personal tax

adjustments accompany indexation, it is impossible to say

anything useful about the effects of personal tax indexation

on the allocation of resources within the private sector.

Obviously, the results depend on the nature of the

additional discretionary adjustments. Even if there are no

discretionary adjustments, it is difficult to arrive at

anything but extremely tentative conclusions. Insofar as

incentives to work are concerned, for example, indexation

will tend to lower average and marginal tax rates relative

to an unindexed situation. This will produce an income

effect encouraging less work effort and a substitution

effect encouraging greater work effort. On a priori

grounds, the net influence on work effort is therefore

indeterminate.^

7.51 Indexation de facto reduces marginal tax rates

by taxing purely nominal income increases at a marginal rate

equal to the initial average tax rate on any given real

income level. However, this effect is achieved by reducing

the average tax rate at the time the tax schedule is

adjusted. It may be that individual perceptions of

indexation involve cognizance only of the income effect,

thereby suggesting that the net effect will be to reduce

work effort. If discretionary adjustments accompanying 1

1 For a discussion of the relevant issues, see R.C. Gates, "The Effect of Taxation on Incentives", in J. Dixon (ed.), The Public Sector, Penguin Books, Sydney, 1972, pp. 210-262.

297

indexation take the form of egui-proportionate increases in

marginal rates, also, this implies an increase in marginal

rates relative to average rates and a net effect in the

direction of less work effort. It is difficult to estimate

tile importance which should be attached to these

conclusions. Much empirical work has failed to discover

whether personal tax rates have a significant influence on

work incentives. Indeed, the Taxation Review Committee did

not consider the issue to be a significant one in respect of

decisions concerning the progressivity of the rate scale:

1... in general the Committee is doubtful whether, within the kinds of limit that need to be considered seriously, changes in the progressivity of the tax scale would have important effects upon work

incentives1.1

7.52 In the absence of empirical information, the

Committee may nevertheless be permitted to advance a

commonsense view. It considers that personal income tax

indexation is likely to be conducive to greater work effort

than a tax system which relies solely on discretionary tax

reductions to prevent effective rates of tax from increasing

as a result of inflation. If indexation removes the fiscal

illusion presently surrounding effective increases in rates

of income tax, rational decisions will need to be made

regarding the extent to which increases in effective rates

of personal income tax are possible in the changed 1

1 Full Report, para. 4.25.

298

circumstances. A judgment about the effects of income

taxation on incentives will be a major factor in those

decisions.

7.53 Similar considerations to those discussed above

apply in relation to the impact of indexation on incentives

to avoid personal taxation. In the absence of additional

discretionary adjustments, an indexed system will

effectively involve reduced marginal tax rates, although

this result may not be fully perceived. If additional

discretionary adjustments take the form of

equi-proportionate increases in marginal rates of tax,

incentives to tax avoidance may actually increase. In view

of this possibility, the Committee welcomes the Taxation

Review Committee's statement that it 1 has been concerned in

various of its recommendations in this report to limit the

scope for tax avoidance1.^

Implications of Personal Tax Indexation for Macroeconomic Stability ‘

7.54 In the remaining sections of this Chapter, the

Committee examines the implications of personal tax

indexation for macroeconomic stability, with special

reference to its likely effects on automatic stabilising

tendencies and on the rate of inflation.

1 Ibid., para. 14.31.

299

Effects on the Built-In Stability of the Economy

7.55 The Report of the Canadian Royal Commission on

Taxation, while it emphasised that real rather than nominal

income was the appropriate base for income taxation,

nevertheless did not feel able to recommend automatic

indexation:

'... no attempt should be made to adjust the tax structure automatically for changes in the purchasing power of money. To develop a tax system that taxed only increases in "real" purchasing power would

irreparably damage the built-in stability of the system'.1

Although Canada has since adopted automatic indexation for

personal taxation, it is too soon to assess whether it has

adversely affected the built-in stability of the system.

However, several studies conducted in Canada on this issue

have failed to confirm the conclusion of the Royal

Commission, at least so far as indexation of personal

taxation alone is concerned. 1

1 Report of the Royal Commission on Taxation, Queen's Printer, Ottawa, 1966, Volume 2, p. 3 Π

300

7.56 A study by Bossons and Wilson explored the

implications of indexing the personal tax schedule by means

of a series of simulations of the Canadian economy, using

the University of Toronto's Quarterly Forecasting Model.1

The economy was subjected to an expansionary shock in the

form of a $500 million increase in exports, apportioned

equally throughout the four quarters of 1965. The response

of the economy to this shock was then traced over subsequent

time periods extending through to the fourth quarter of

1969. Bossons and Wilson compared the response of the

economy to the shock under an indexed personal tax schedule

with the response under an unindexed schedule. In brief,

their conclusions were that indexation would have produced

both a smoother path of real output movements and a higher

level of real output for the period taken as a whole. The

rate of inflation proved to be somewhat higher as a result of o

tax indexation, but the increase was exceedingly modest.

7.57 A similar exercise has been carried out for the

Australian economy with the aid of the econometric model

developed by the Australian Treasury and the Australian 1 2

1 J. Bossons and T.A. Wilson, 'Adjusting Tax Rates for Inflation', Canadian Tax Journal, Vol XXI, No. 3, May-June 1973.

2 These results were confirmed by a study undertaken within the Research Department of the Bank of Canada using the RDX2 econometric model of the Canadian economy. See D. Stephenson, 'A Quantitative Assessment of the Proposal to Index the Personal Income Tax for Price Changes', unpublished research paper, September 10, 1973.

301

Bureau of Statistics (referred to subsequently as the

Treasury - A.B.S. model).* It was assumed that personal tax

indexation was introduced at the start of the 1966-67 income

year. The factor used for adjustment was the annual rate of

increase in consumer prices, as measured by the implicit

final consumption expenditure deflator, the March quarter of

the previous income year providing the final observation for

that calculation. That is, the average lag between the

current rate of inflation and the rate of inflation used for

adjusting the tax schedule was fifteen months, as in the

Canadian indexation scheme. The simulations were run over

the period from 1966-67 to 1973-74. It was assumed that the

1965-66 schedule, indexed on the basis described above, was

maintained throughout the period. Before describing the

different responses of the indexed and unindexed systems to

a series of shocks, it is of interest to compare the two

"control" solutions in the absence of shocks. That is to

say, the model's depiction of the economy as it actually was

during the period from 1966-67 to 1973-74 is compared with

the model's depiction of what the economy would have been

like during the same period in the presence of an indexed

personal tax system. 1

1 The Committee is grateful to the Australian Treasury and to the Australian Bureau of Statistics for the use of their model and for their substantial technical assistance. The interpretative views expressed in this Report do not necessarily represent the views of either institution.

302

7.58 The Actual Economy and the Indexed Economy.

A comparison of the two control solutions suggests that, if

personal tax indexation had operated during the period from

1966-67 to 1973-74, there would have been a mild stimulus to

real activity, a modest decrease in total tax revenues, and

virtually no change in the behaviour of prices. Table

VII-10 shows the absolute increase in real gross non-farm

product und3r the indexed system.

TABLE VII-10

Absolute Increase in Heal Gross Non-Farm Product Relative to Control

Year jjM

1966-67 16.3

1967-68 50.3

1968-69 86.8

1969-70 99.4

1970-71 45.7

1971-72 98.0

1972-73 91.1

1973-74 68.5

In percentage terms these increases are modest. In 1968-69,

1969-70, 1971-72 and 1972-73 the increases represent an

increase of approximately 0.4 per cent; and the increase is

approximately 0.2 per cent for each of the remaining years

(except for the first year of indexation when the increase

is less than .1 of 1 per cent).

7.59 The decline in total tax revenues is also

modest. Table VII-11 sets out the decline in personal tax

revenues under the indexed system relative to the unindexed

system, in both absolute and percentage terms.

303

TABLE VII-11

Decline in Personal Tax Revenues Relative to Control·

Year Absolute Decrease

$m

Percentage Decrease %

1966-67 40.4 2.3

1967-68 84.0 4.2

1968-69 144.5 6.2

1969-70 215.8 7.9

1970-71 69.1 2.3

1971-72 276.3 7.6

1972-73 13.0 0.3

1973-74 202.6 3.9

The reductions are modest for two main reasons. First,

there were significant downward discretionary adjustments to

personal tax rates in both 1970-71 and 1972-73. In 1970-71,

therefore, the difference between actual personal tax

revenues and those forthcoming under an indexed system was

only $69.lm; and in 1972-73 it was only $13.0m. Secondly,

the general level of economic activity is somewhat higher

under the indexed system, thereby serving to generate

increased personal tax revenues.

7.60 It should also be noted that the absolute

decreases overstate the decline in total tax revenues,

because the increased activity under the indexed system

serves to increase revenues from indirect taxation. Table

VII-12 sets out the absolute increase in indirect tax

revenues (for both the Australian Government and State

governments) under the indexed system.

304

TABLE VII-12

Increase in Indirect Taxes Relative to Control

Year $m

1966- 67 4.7

1967- 68 14.9

1968- 69 29.4

1969- 70 43.6

1970- 71 34.0

1971- 72 47.2

1972- 73 43.9

1973- 74 52.0

7.61 In 1972-73, the sum of personal taxation and

indirect taxation under the indexed system is thus actually

greater than under the unindexed system. Company taxation

is excluded from the estimates but, because the gross

operating surplus of companies is virtually identical in the

indexed and unindexed cases, this omission is unlikely to be

important.

7.62 It remains to consider the impact of indexation

on the rate of inflation. Table VII-13 sets out the annual

rate of increase in the consumption deflator under the

indexed and unindexed systems. It will be seen that the

differences are negligible.

TABLE VII-13

Annual Rate of Increase in Co~nsumption Deflator

Year Unindexed System Indexed System

% «

1966-67 3.1 3.1

1967-68 3.2 3.2

1968-69 2.8 2.8

1969-70 3.7 3.8

1970-71 6.1 6.2

1971-72 6.0 6.0

1972-73 5.3 5.3

1973-74 11.2 11.2

305

It should be added that government expenditure is largely

exogenous to the model. Since tax revenues are, in general,

somewhat lower under the indexed system, this implies some

increase in the budget deficit. This increase in turn is

reflected in an increase in the rate of growth of the money

supply under the indexed system. Table VII-14 sets out the

annual rates of increase in the money supply under both

systems. The higher rates of increase under the indexed

system reflect both the increase in the budget deficit and

the generally higher level of activity.

TABLE VII-14 .

Annual Rate of Increase in the Volume of Money

Year Unindexed System

%

Indexed System %

1966-67 8.1 8.3

1967-68 8.8 9.2

1968-69 9.1 9.6

1969-70 10.1 10.7

1970-71 7.8 8.0

1971-72 11.5 11.8

1972-73 23.2 23.3

1973-74 20.8 20.5

7.63 As was indicated earlier, these differences

are not sufficient to produce any visible difference in

the rate of inflation. However, it should be remembered

that the transmission mechanisms in the model between the

real and the monetary sectors are fairly rudimentary. The

results should be interpreted with this deficiency in

mind.

1 Defined as trading and savings bank deposits, plus notes and coin in the hands of the public, plus shareholders1 funds and unsecured borrowings of permanent building societies.

306

7.64 The Stabilisation Properties of the Two Systems

It has come to be recognised that the automatic

stabilisation properties of an economy depend, not on the

impact or equilibrium values of various 1 automatic

stabilisers' (such as the personal tax system), but rather

on the ability of the instruments to assist in stabilising

an interdependent economic system subject to shocks. To

help the Committee understand now an indexed personal tax

system may have affected the built-in stability of the

Australian economy during the period from 1966-67 to

1973-74, the control solutions for the indexed system and

the unindexed system were subjected to the same shock and

their responses compared. The shock took the form of a $50

million increase in exports in each quarter of 1965-66.

7.65 The responses of the two systems are virtually

indentical. Not only is the pattern of responses virtually

the same, but so too are the magnitudes of the deviations of

key endogenous variables (such as real non-farm product and

the consumption expenditure deflator) from their respective

control solutions. Table VII-15 sets out the absolute

deviations of real non-farm gross product from their

respective control values for the indexed and unindexed

system. Tables VII-16 and VII-17 set out the same

information for consumer prices and personal tax revenues

respectively.

307

TABLE VII-15

Deviation of Real Non-farm GrossProduct from Control

Year Unindexed System Indexed System

$m $m

1966- 67 11.0 11.6

1967- 68 -65.9 -64.6

1968- 69 -29.8 -27.3

1969- 70 30.5 33.4

1970- 71 16.4 16.7

1971- 72 -21.6 -20.5

1972- 73 -28.3 -25.7

1973- 74 0.8 4.8

TABLE VII-16

Deviation of Consumption Expenditure Deflator from Control(a)

Year Unindexed System Indexed System

1966-67 0.3 0.3

1967-68 0.2 0.2

1968-69 0.2 0.2

1969-70 0.2 0.2

1970-71 0.3 0.3

1971-72 0.3 0.3

1972-73 0.3 0.3

1973-74 0.3 0.3

(a) Change in index points. That is, in 1973-74 the consumption expenditure deflator was 0.3 index points above its control value under both systems. In the unindexed system, the control value was equal to 144.

and the simulated value equal to 145.0.

TABLE VII -17

Deviation of Personal Tax Revenues from Control

Year Unindexed System Indexed System

$m $m

1966-67 12.9 11.7

1967-68 3.5 -0.1

1968-69 5.0 1.2

1969-70 13.5 9.5

1970-71 17.1 13.4

1971-72 15.3 8.8

1972-73 12.7 6.4

1973-74 19.3 11.8

308

7.66 Tne simulations did provide some support for

the hypothesis that tne real activity response to a given

shock leads the wage and price response.

7.67 Furtner simulations were carried out in order

to test the sensitivity of the foregoing results to both the

timing of the shock and the form of the indexation scheme.

The same shock was introduced in 1968-69, which was a year

of lower activity tnan 1965-66. The qualitative results

described above were unchanged, except to tne extent that a

rather greater real output response emerged under both

systems, and a slightly smaller price response. The same

shock introduced in 1970-71, and in 1972-73, confirmed the

conclusions of the original simulation exercise.

7.68 Finally, simulations were conducted assuming a

quarterly personal tax indexation scheme. The process of

more rapid adjustment did provide a somewhat stronger

stimulus to real activity and prices. However, the built-in

stabilising properties of the system remained unchanged.

The Committee has concluded that these results suggest that,

on the basis of past economic relationships as depicted by

tiie Treasury - n.b.H. econometric model, tne introduction of

a lagged indexation scheme for personal taxation would have

had little impact on the ouilt-in stability of the

Australian economy.

309

7.69 In order to test the extent to which these

results were peculiar to the Treasury - A.B.S. econometric

model, a similar exercise was carried out using the

econometric model developed by the Reserve Bank of

Australia.1 The exercise assumed that the 1966-67 personal

tax schedule was indexed over the period from 1967-68 to

1972-73. Under the two control solutions, there is again in

general a mild stimulus to real activity and no discernible

change in the rate of inflation under the indexed system,

relative to the unindexed system. The Reserve Bank model

suggests that personal tax revenues under the indexed system

would have been higher in 1970-71 and 1972-73 than actual

personal tax revenues in these years.

7.70 In order to test the stabilisation properties

of the indexed system, the control solutions for both

systems were subjected to a shock taking the form of an

increase in real government spending of $200 million per

quarter in each of the four quarters of 1968-69. The

dynamic responses under both systems were very similar.

These results confirm the conclusion of the Treasury -

A.B.S. model that personal tax indexation over the period

from 1967-68 to 1972-73 would not have weakened the

automatic stabilising characteristics of the personal tax

system, relative to the non-indexed system with periodic tax

cuts.

1 The Committee is grateful to Mr. J.F. Henderson of the Reserve Bank of Australia for his submission, which contained the analysis described in the text. The views expressed do not necessarily reflect those of the Reserve

Bank of Australia.

310

7.71 The limitations of the foregoing analyses

should be noted, especially with regard to the way in which

these results are relevant to the possible introduction of

personal tax indexation in some future period. The main

limitations are as follows:

(a) The analyses have been carried for an

historical period, whereas the important issue

is the likely effects of indexation in some

future period. To the extent that conditions

in the Australian economy change, the two

econometric models employed above, which use

estimates in an historical period, may be less

applicable and less able to capture the

stabilisation responses of the subsequent

period. It is a property of non-linear models

that responses both to structural changes (such

as personal tax indexation) and to shocks in

the system are dependent upon the initial

conditions prevailing and the time path of the

economy.

(b) In applying the indexation proposals to the

models, it has been assumed that other

behavioural responses embodied in the structure

of the models (for example, wage bargaining,

government spending and other policies)

remain unaffected. To the extent that an

indexation scheme has effects on the economy, a

chain of reactions to these effects may result

311

which are not necessarily captured in the

models. However the simulation technique has

the advantage that it can be replicated under

any specified assumptions.

(c) The results are obviously particular to the

models being used.

(d) The analyses have examined only two types of

indexation formula. It may be that with other

variants of indexation, the results could

suggest other than minimal effects.

7.72 Caution should therefore be used in attempting

to translate the foregoing results into statements about the

likely effects of personal tax indexation in general on the

future Australian economy.

Effects on the Rate of Inflation

7.73 The results of the econometric exercises

described in the preceding section suggest, inter alia, that

introduction of a personal tax indexation scheme would have

had little impact on the rate of inflation in the Australian

economy. These conclusions are consistent with the results

of similar exercises conducted for the Canadian economy.

They also appear to be consistent with casual empiricism,

based on observations of the rate of inflation in those

developed economies which have adopted personal tax

indexation schemes. This latter point notwithstanding, it

may be objected that existing econometric models are

ill-equipped to accurately depict the likely influence of

indexation on the rate of inflation. In particular, it may

312

be argued that existing wage equations in econometric models

do not adequately reflect recent developments regarding wage

bargaining in terms of disposable income. They may also be

unable to take account of various psychological changes that

could accompany the introduction of personal tax indexation.

Finally, the econometric results may not be considered

relevant to current circumstances. This section considers

each of these arguments in turn.

7.74 The Committee first considers the likely impact

of personal tax indexation on gross wage settlements. In

the absence of additional discretionary adjustments,

indexation would serve to reduce the disposable income

multiplier. Under an indexed rate scale in 1975-76, for

example, the average wage earner would only need to obtain a

28.5 per cent increase in gross earnings to achieve a 5 per

cent increase in real disposable income, rather than a 39.3

per cent increase under an unindexed scale. If indexation

were to be accompanied by an equi-proportionate increase in

marginal tax rates, the impact on gross wage increases in

aggregate cannot be clearly established. Such an adjustment

would tend to reduce the disposable income multiplier for

income levels below average earnings and increase it for

income levels above average earnings, relative to the

unindexed situation.

7.75 It has been implicitly assumed that disposable

income bargaining is directed towards the achievement of a

given proportionate increase in real disposable incomes.

313

This calculation involves consideration of both the marginal

rate payable on the initial income level and the initial

average tax rate. However, it is sometimes suggested that

employees are far more aware of their marginal than their

average tax rate, especially within the context of wage

negotiations. If this is the case, then personal tax

indexation may have only a modest effect on gross wage

claims. This is because, in the short run at least,

indexation may not alter the marginal tax rates faced by

given income levels. As mentioned earlier, indexation

de facto reduces marginal tax rates by taxing purely nominal

income increases at a marginal rate equal to the initial

average tax rate. But this effect is achieved by providing

a reduction in the average tax rate at the time the tax

schedule is adjusted. Whether this de facto reduction in

marginal tax rates is likely to be reflected in gross income

claims is extremely difficult to know.

7.76 It has also been suggested that tax indexation

would act to reduce the great uncertainty which surrounds

the wage negotiation process in periods of rapid inflation.

Rapid inflation per se creates substantial uncertainty about

the claim over real goods and services which a given nominal

disposable income will provide in the future. Wage

indexation has been proposed as one means of reducing this

uncertainty. However, an unindexed personal tax schedule

introduces another uncertain variable into the process.

314

Wage indexation of actual wage rates will preserve real

gross earnings; but real disposable earnings will remain at

the mercy of the interplay of inflation and an unindexed tax

schedule. There exists a substantial body of literature,

both theoretical and empirical, which demonstrates how an

environment of risk and uncertainty serves to increase the

required rate of return on capital. It does not seem

unrealistic to suggest that the same conclusions may well be

relevant to the required wage return to labour.

7.77 In tiiis connection, the Committee has noted the

view which the Department of Labor put forward in its

submission about the relevance of this 1 tax expectations'

effect;

"... at tiie time the increases were granted in 1974, builders' laborers, construction carpenters and fitters were faced with the prospect of having more than one-third of their award increase absorbed by higher

taxation. While subsequent adjustments to the income tax schedule have reduced this proportion, the important point is that at the time of the negotiations the only plausible basis on which the various unions and their members could proceed was on the assumption that the 1973-74 income tax schedule would remain the operative one. In the absence of a commitment to regular and automatic adjustments of the tax scale, the unions could not be expected to do otherwise."

As has been repeatedly emphasised, personal tax indexation

does not rule out the possibility of subsequent

discretionary adjustments. Nevertheless, a commitment to

automatic personal tax indexation does alter the most

reasonable expectation regarding subsequent rates of

personal taxation to one of constant real tax rates, rather

than one of increasing real tax rates as under the present

system.

315

7.78 Personal tax indexation provides guarantees to

taxpayers against the unlegislated increases in personal tax

rates that inflation produces. The Committee believes that

personal tax indexation may be viewed as a social contract

between the government and the taxpaying public, whereby it

is agreed that increases in personal tax rates will not be

determined by the rate of inflation. To the extent that

increases in personal tax rates are required for the

purposes of government, they will be the explicit outcome of

the political process and will be subjected to the proper

government, parliamentary, and public scrutiny. The

Committee has found overwhelming support, from all sections

of the Australian community, for such a guarantee.

7.79 Except for submissions from the Australian

Treasury (which did not express a view), the Metal Trades

Industry Association of Australia, the Central Industrial

Secretariat and one or two private individuals, the

submissions received by the Committee all expressed support

for the concept of automatic personal income tax indexation.

Among those supporting indexation were:

(a) trade union and professional organisations,

including the A.C.T.U., Council of Commonwealth

Public Service Organisations, Australian

Council of Salaried and Professional

Associations, Professional Officers

Association - Commonwealth Public Service, and

Council of Professional Associations;

industry associations, including the Australian

Farmers Federation, the Australian Woolgrowers1

and Graziers' Council, the Queensland Cane

Growers' Council, the United Farmers and

Woolgrowers' Association of New South Wales,

the Australian Bankers' Association, the

Australian Chamber of Commerce, the Australian

Retailers' Association, the Associated Chambers

of Manufactures of Australia, the Australian

Industries Development Association, the Life

Offices Association of Australia, and the

Australian Mining Industry Council;

many large and small companies, including the

Broken Hill Proprietary Company Ltd., Conzinc

Riotinto of Australia Ltd., CSR Ltd. and ICI

Australia Ltd.;

professional bodies, including the Institute of

Chartered Accountants in Australia, the

Australian Society of Accountants, the Taxation

Institute of Australia, the Law Council of

Australia and the Institute of Directors; and

Australian and State Governments, departments

or agencies, including the Australian

Government Department of Labor and Immigration,

the Department of Manufacturing Industry, the

National Small Business Bureau, the State of

Tasmania, and the Economic Intelligence Unit of

the State of South Australia.

317

7.80 The Committee believes that rarely will such

wide-ranging support be found in the Australian community

for a general principle affecting public policy. Those

supporting tax indexation appear to have recognised that the

guarantee which is implied in such a scheme does not involve

a promise on the part of the government to maintain real tax

rates for all time. It is for this reason that the

Committee is not persuaded of the force of one objection put

forward by the Australian Treasury to personal tax

indexation. The Treasury acknowleged that personal tax

indexation can be accompanied by additional discretionary

adjustments, involving upward adjustments of marginal tax

rates or more basic changes in the tax system. However, it

argued that additional discretionary adjustments could

involve difficulties, particularly in the early years of tax

indexation:

"... if indexation were introduced as part of a broad strategy involving, inter alia, wages policy - indeed, in that latter circumstance, there could be charges of reneging."

But the Committee repeats its views that the community

perception of the guarantee provided by personal tax

indexation appears to be, not tnat real tax rates will be

maintained, but rather that any increases in personal tax

rates will be explicitly legislated by Parliament.

7.81 Insofar as macroeconomic stability generally is

concerned, it is necessary for the Committee to discuss the

following argument which was raised in the Australian

Treasury submission:

318

"... the three following policy possibilities do not add up to a viable whole:

(1) a maintained or increased role for the public sector; and

(2) reduced emphasis on personal income tax; and

(3) reduced emphasis on, or failure to increase, indirect taxation.

All three are put forward in public debate, but taken together and abstracting from the current recessionary situation, they are so self-evidently a recipe for greater dependence on deficit finance and an explosively inflationary situation that the point is not laboured further."

7.82 The Committee accepts this proposition,"1 ' but

does not believe that it provides a basis for rejecting

personal tax indexation. First, as has been repeatedly

emphasised throughout this Report, personal tax indexation

does not imply reduced emphasis on personal income tax. It

has been observed that, even in the absence of additional

discretionary adjustments, the aggregate personal tax ratio

under indexation will increase continuously in a growing

economy. Personal taxation will remain the most elastic of

all major forms of taxation, and will constitute an

increasing proportion of total taxation. Furthermore,

neither the principle nor the practice of tax indexation

precludes the possibility of additional discretionary

adjustments.

1 Although it might wish to record some minor caveats. One of these was alluded to in the Treasury submission, namely the overall state of aggregate demand. The proposition also abstracts from other revenue sources (such as other

forms of taxation) and from government borrowing from the public. The Committee cannot discuss these caveats in detail, but believes them to be insufficiently important to make the basic proposition invalid.

319

7.83 Secondly, there seems to be no obvious

mechanism by which personal tax indexation will lead to a

reduced emphasis on indirect taxation. Personal tax

indexation, on the basis of a price index unadjusted for the

effects of indirect tax changes, will do nothing to generate

a reduced emphasis on indirect taxation. As mentioned

in Chapter IV, however, where wage indexation and tax

indexation involve the use of an unadjusted CPI index,

indirect tax increases are likely to be ineffective as a

means of switching resources from the private to the public

sector.

7.84 Finally, the Committee shares the general

expectation that tne relative role of the public sector will

continue to increase in the future. The Committee believes

that this result will occur with or without personal tax

indexation. Many submissions have argued that indexation

would produce a climate favourable to a somewhat more

moderate rate of growth of the relative size of public

sector. The Committee is not unsympathetic to this

argument, but it is not convinced that the impact would

necessarily be quantitatively large.

7.85 There remain two related but distinct arguments

concerning the possible impact of personal tax indexation on

the rate of inflation. The first argument concerns the

psychological reaction of the public to the introduction of

personal tax indexation. It has been suggested by some that

the introduction of such a scheme may produce a general

impression that the government expects that inflation will

320

continue and, therefore, that indexation may induce

scepticism as to the effectiveness of anti-inflationary

measures. Consequently, it has been argued, inflationary

expectations will increase, and the expectations may be

self-fulfilling.

7.86 The second argument concentrates on the

psychological reaction of governments to the introduction of

personal tax indexation. It has been suggested that the

introduction of such a scheme may make governments believe

that it is less urgent to control inflation, because they

will know that the personal taxpayer is more or less immune

from the detrimental effects of inflation. Governments may

believe that a fall in the value of money has been made

more tolerable.

7.87 Both of these arguments have been raised mainly

within the context of proposals to introduce indexation

throughout the whole economy (for example, by indexing wages,

interest rates and money claims in both the private and

public sectors, all taxes and government transfer payments),

and seem more relevant to such a situation.^- The Committee

recognises that the arguments become relevant if personal

tax indexation is likely to lead to economy wide indexation.

However, there is no evidence to support such a view, at

least in developed countries. Personal tax indexation is

present in countries where there is no indexation of other

1 For such a proposal, see Milton Friedman, 1 Monetary Correction1, Occasional Paper 41, Institute of Economic Affairs, London, 1974.

321

taxes or of other transactions. Similarly adjustment of

company incomes for tax purposes may be found in countries

without personal tax indexation. Some countries have

personal tax indexation without wage indexation, and

vice-versa."*" Indexation of one element in the economic

system does not appear to have led to a philosophical

commitment towards economy-wide indexation in developed

economies.

7.88 This fact notwithstanding, is it likely that

personal tax indexation alone will generate the responses

discussed above? As an empirical observation, it may be

noted that those developed countries which have adopted

personal tax indexation schemes do not appear to have

suffered higher rates of inflation following indexation than

the rates experienced in comparable economies. Indexation

may imply that the government is pessimistic about the

prospects of a return to price stability. But if this is

so, indexation will only confirm an economic reality which

must be known to the government and the public alike. 1

1 For a confirmation of this point, see S.A.B. Page and Sandra Trollope, 'An International Survey of Indexing and Its Effects', National Institute Economic Review, No. 70, November 1974, pp. 46-60.

322

7.89 Further, the Committee believes that personal

tax indexation alone is unlikely to generate a complacent

attitude (or a more complacent attitude than may have

previously existed) toward inflation on the part of the

government. Personal tax indexation may remove one source

of discontent with respect to inflation. But attitudes

towards inflation reflect social as well as economic 1 considerations. Apart from the fact that personal tax

indexation will remove only one (albeit an important)

redistributive effect of inflation, inflation is likely to

remain socially unpopular and therefore politically

unpopular. It is therefore unlikely that personal tax

indexation will result in an indifference on the part of

governments towards inflation.

7.90 The Committee has concluded that the adoption

of a personal tax indexation scheme is unlikely to impair

the stabilising properties of the personal tax system, or

lead to a higher rate of inflation than would otherwise be

experienced. 1

1 See in particular Harry G. Johnson, Inflation and the Monetarist Controversy, North-Holland Publishing Company, Amsterdam, 1972, pp. 22-23.

323

APPENDIX TO CHAPTER VII

REVENUE ESTIMATES OF PERSONAL TAX INDEXATION

The Commissioner of Taxation provided the

Committee with two sets of revenue estimates relating to

personal tax indexation. This Appendix sets out the major

features of these estimates.

1. Historical Series 1969-70 to 1973-74

These estimates compare the personal tax

revenues that would have been forthcoming assuming that:

(a) the 1968-69 personal tax schedule (including

the per cent surcharge) had been maintained

over the period 1969-70 to 1973-74; and

(b) the 1968-69 personal tax schedule (including

the surcharge) had been indexed over this

period, according to both the current and

lagged rates of inflation.

The current rate of inflation is measured as

the percentage average annual increase in the Consumer Price

Index. The lagged rate of inflation is equal to the

percentage average annual increase in the Consumer Price

Index in the previous year, the March quarter providing the

last observation for that calculation. That is, the lagged

indexation factor for 1969-70 is based on the average value

of the Consumer Price Index between the June quarter of 1968

and the March quarter of 1969, divided by the average value

between the June quarter of 1967 and the March quarter of

1968. Table VII-A sets out the indexation factors

calculated on this basis for the current and lagged

indexation cases.

324

TABLE VII-A

Personal Tax Indexation Factors

Income Year Current Indexation % Lagged Indexation %

1969- 70 3.21 2.56

1970- 71 4.75 2.99

1971- 72 6.81 4.34

1972- 73 6.04 6.61

1973- 74 12.94 5.52

Because inflation was tending to accelerate throughout this

period, the lagged indexation factors are, in general,

significantly below the current indexation factors.

Before presenting the results of the estimates,

several deficiencies should be made clear. The basic method

of estimation was to calculate tax yields on the assumption

that all taxpayers in each income range have a taxable

income equal to the mean in each range. This assumption is

common to both the indexed and unindexed estimates, and the

error in the difference between these understated results

may be safely ignored. Complete tabulated data on the

pre-tax distribution of income for the 1972-73 and 1973-74

income years were not available at the time the estimates

were prepared. For these income years, the 1971-72 pre-tax

distribution of income was inflated in line with the

aggregate proportionate change in pre-tax income. That is,

it was assumed that the pre-tax distribution of income

remained unchanged between 1971-72 and 1973-74. Further,

the effect of the income-averaging provisions for primary

producers could not be incorporated into the estimates.

Finally, basic data were not available to permit estimates

of the revenue costs of indexing non-dependant deduction

325

limits. It is the opinion of the Commissioner that, for

income years 1969-70 to 1971-72 at least, the effect on

revenue costs of ignoring them is insignificant.

The Commissioner did provide an estimate of the

revenue cost of increasing the upper limits of the education

deductions, life insurance and superannuation, and rates and

taxes, deductions, assuming a 10 per cent increase in the

1974-75 limits based on 1971-72 income year levels of

deductions. The estimates are as follows:

Deduction: Revenue Loss

?m

Life Insurance and Superannuation Payments 6.9 Education Expenses 3.4

Rates and Taxes 1.1

Table VII—B sets out the revenue shortfall

under indexation relative to the unindexed schedule.

Partial indexation refers to indexation of taxable income

bracket limits only. Full indexation refers to taxable

income bracket limit and dependant deduction limit

indexation.

TABLE VII-B

Revenue Cost Estimates of Personal Tax Indexation $ million

Current Indexation Lagged Indexation Income Year

Partial Full Partial Full

1969-70 62 72 49 57

1970-71 178 205 126 145

1971-72 381 435 260 297

1972-73 666 752 534 603

1973-74 1428 1586 962 1067

326

These figures in themselves are not very illuminating. A

more meaningful method of presentation is to express the

amounts in terms of the percentage reduction in aggregate

personal tax revenues as a result of indexation (see Table

VII-C).

TABLE VII-C

Percentage Reduction in Aggregate Personal Tax Revenues %

Current Indexation Lagged Indexation Income Year

Partial Full Partial Full

1969-70 2.29 2.67 1.83 2.10

1970-71 5.47 6.30 3.67 4.46

1971-72 9.73 11.10 6.65 7.57

1972-73 12.68 14.31 10.16 11.48

1973-74 18.62 20.68 12.54 13.91

There are three results of interest in these

historical estimates. First, the major source of revenue

loss is taxable income bracket indexation. The additional

revenue loss as a result of dependant deduction limit

indexation is extremely modest. Secondly, the revenue loss

is substantially smaller in the case of lagged indexation

than under current indexation, reflecting the tendency for

inflation to accelerate over the period. Thirdly, as Table

VII-D below indicates, the aggregate personal tax ratio

(total personal taxation divided by total net income)

increases from year to year even in the full current

indexation case, reflecting the growth in aggregate real net

incomes during the period.

327

TABLE VII-D

Aggregate Personal Tax Ratios - (-%)

Current Indexation Lagged Indexation No Indexation

Income Year

Partial Full Partial Full

1969-70 14.49 14.44 14.56 14.52 14.82

1970-71 15.10 14.97 15.35 15.26 15.9 5

1971-72 15.46 15.23 15.9 7 15.82 17.08

1972-73 17.44 17.12 17.95 17.68 19.9 8

1973-74 19.41 18.92 20.85 20.53 23.85

2. Projections : 1975-76 to 1979-80

Three sets of projections were carried out by

the Commissioner. The projections assume that the 1974-75

personal tax schedule is indexed in line with the rate of

inflation lagged one year from the start of the 1975-76

income year. The projections run over a period of five

years. Three annual rates of inflation are assumed to

prevail throughout the five-year period: 10 per cent, 15

per cent, and 20 per cent. In each case it is assumed that

the tax schedule is adjusted at the start of 1975-76 on the

basis of a 15 per cent inflation rate in 1974-75. The

standard of comparison in each case is with an unaltered tax

schedule.

The following assumptions are included in the

estimates:

(a) the rate of growth of productivity equals 2.5

per cent per annum;

(b) the rate of growth of the taxpaying population

equals 2.0 per cent per annum;

328

(c) the estimated 1974-75 pre-tax distribution of

income (in itself a fairly tentative

hypothetical projection) is maintained

throughout the five year period.

The working assumptions underlying constancy in

income distribution are:

(a) that all base period nominal incomes adjust

fully and instantaneously to both the rate of

inflation and the rate of productivity growth;

and

(b) that the increase in the taxpaying population

is spread evenly over the base period taxpayer

distribution.

It is scarcely necessary to emphasise that these assumptions

are in no possible way predictions of an actual outcome in

future years. They are a series of mechanical assumptions

used to conduct a purely hypothetical exercise.

Table VII-E below shows the absolute reduction

in personal tax revenues under an indexed system relative to

an unadjusted system. Table VII-F expresses the same

information in terms of percentage reductions.

TABLE VII-E

Revenue Cost Estimates of Pers'onal Tax Indexation $ million

10% Inflation 15% Inflation 20% Inflation

Income Year

Partial Index­ ation

Full Index­ ation

Partial Index­ ation

Full Index­ ation

Partial Index­ ation

Full Index­ ation

1975-76 995 1042 1058 1132 1132 1235

1976-77 1995 2100 2643 2809 3356 3586

1977-78 3288 3451 4850 5128 6708 7099

1978-79 4942 5192 7859 8267 11471 12086

1979-80 7020 7357 11833 12409 18074 18974

329

TABLE VII-F

Percentage Reduction in Aggregate Personal Tax Revenues Per Cent

10% Inflation 15% Inflation 20% Inflation

Income Year

Partial Index­ ation

Full Index­ ation

Partial Index­ ation

Full Index­ ation

Partial Index­ ation

Full Index­ ation

1975-76 11.2 11.7 10.9 11.7 10.8 11.8

1976-77 17.6 18.5 19.8 21.1 21.7 23.2

1977-78 22.9 24.1 26.9 28.4 30.1 31.8

1978-79 27.5 28.8 32.5 34.2 36.3 38.3

1979-80 31.3 32.8 37.1 38.9 41.1 43.2

The revenue losses implied by the above tables are, as may

be expected, massive. They are scarcely worthy of

consideration, because of the totally unrealistic nature of

the assumption that an unchanged tax schedule is a sensible

standard of comparison under conditions of double digit

rates of inflation. Table VII-G below shows estimated

aggregate personal tax receipts for each inflation rate,

assuming an unchanged personal tax schedule.

TABLE VII-G

Aggregate Personal Tax Receipts Assuming 3X1 Unchanged Personal Tax Schedule $ million

Income Year 10% Inflation 15% Inflation 20% Inflation

1975-76 8727 9484 10274

1976-77 10911 12799 14848

1977-78 13519 17010 21017

1978-79 16630 22312 29165

1979-80 20311 28905 39812

Even an annual rate of inflation of 10 per cent, which may

be assumed to be relatively modest in the light of current

inflationary experience, generates a massive increase in

aggregate personal tax revenues.

330

In case it is thought that a comparison of

absolute amounts is misleading, aggregate personal tax

ratios are shown below in Table VII-H.

TABLE VII-H

Aggregate Personal Tax Ratios Assuming an Unchanged Personal Tax Schedule %

Income Year 10% Inflation 15% Inflation 20% Infl

1975-76 19.7 20.5 21.2

1976-77 21.8 23.4 25.0

1977-78 24.0 26.4 28.8

1978-79 26.2 29.3 32.4

1979-80 28.4 32.2 33.9

Tables VII-I and VII-J below indicate

aggregate personal tax revenues and aggregate personal tax

ratios respectively for the indexed situations. The

aggregate personal tax ratios increase continuously from

year to year, reflecting the assumed real income growth.

TABLE i / I ) - )

$m

Income Year 1 0$ I n f l a t i o n 1 5$ I n f l a t i o n 2 0? I n f l a t i o n

Dependants ded u ctio ns Unindexed Indexed Unindexed 1ndexed Unindexed Indexed

1975-76 7,907 7,s6o 8,616 8 , 5 4 2 9,347 9,245

1 9 7 6 - 7 7 9,356 9 ,2 5 2 10,673 1 0 , 5 0 7 12,0 92 11,862

1 9 7 7 - 7 8 11,058 1 0 ,8 95 13,201 1 2 , 9 2 3 15,5 96 15,2 06

1 9 7 8 - 7 9 13,053 1 2,809 16,291 1 5 , 8 8 4 20,099 1 9 , 4 8 4

19 7 9 - 8 0 15, 405 15,0 67 2 0 , 0 8 1 1 9 , 5 0 5 25,882 2 4 , 8 9 2

T A B L E VI I - J

Ag gre gate .P e rs o n a l Tax R a t i o s , Assumi no In d e x a ti

Income Year 10? I n f l a t i o n 1 5^ I n f l a t i o n 20? f n f l a t i o n

Dependants d e d u c tio n s Unindexed Indexed Unindexed 1ndexed Unindexed Indexed

1975-76 17.43 17.35 1 8 . 2 2 18.06 18.94 18.73

1976-77 17.99 1 7.7 3 1 8 . 7 7 1 8 . 4 8 1 9 . 5 3 19.16

1977-78 1 8 . 4 8 1 8 . 2 1 1 9 - 3 1 1 8 . 9 0 2 0 . 0 8 19.57

1978-79 1 8.98 1 8 . 6 2 1 9 . 8 2 19.32 20.62 19.99

19 7 9 - 8 0 1 9 . 4 7 1 3 . 0 4 2 0 - 3 2 19.74 21.17 2 0 . 4 4

331

These projections represent a mechanical

exercise which is completely hypothetical. The projections

are consistent with two self-evident propositions, which do

not require such exercises for their validation, namely:

(a) that an unchanged nominal tax schedule is not

an appropriate standard of comparison against

which to measure the revenue losses from

indexation given inflation at rates anything

like those being currently experienced; and

(b) that in a growing economy, the aggregate

personal tax ratio will increase inexorably

even given perfect indexation and no additional

discretionary tax schedule changes.

PART TWO

TAXATION PAID BY COMPANIES AND OTHER ENTERPRISES

335

VIII EFFECTS OF INFLATION ON TAXATION OF COMPANIES AND OTHER ENTERPRISES

8.1 Although both of the Committee's terms of

reference are concerned with possible distortions in the tax

system resulting from inflation, the effects of inflation on

taxation differ as between persons and business enterprises.

This is because persons (in their private capacity) are

concerned mainly with the way in which inflation changes

their effective rates of tax; to the extent that they

derive income from non-business sources, their incomes are

usually automatically expressed in terms of current prices

and thus provide a reasonable measure of their capacity to

pay. Business enterprises, on the other hand, are concerned

mainly with the way in which inflation, by changing the

prices in which different items of their revenues and

expenses are measured, changes their effective tax base.

8.2 This comparison must be qualified by noting

that persons, in their capacity as proprietors of

unincorporated businesses, may be subject to both

influences; and that, although company tax is now generally

levied at a flat rate, certain companies pay a reduced rate

of tax on the first $10,000 of their taxable incomes (which

the Committee has recommended should be indexed in the same

way as the personal income tax rate structure). But in this

Part of the Report, the Committee addresses itself to the

336

problems which are common to all business enterprises,

whether incorporated or unincorporated. These problems are

concerned almost exclusively with the definition of taxable

income, that is with the definition of the tax base.

The Historical Cost Basis of Business Taxation

8.3 Income tax is levied on companies and

unincorporated business enterprises very largely on the

basis of a conventional measure of business income which we

describe as accounting profit. Accounting profit is

derived from a system of recording business transactions

which we describe as historical cost (or historical record)

accounting. The chief distinguishing characteristic of this

system is that, as far as possible, transactions are

recorded in terms of the actual market prices of the

transactions.

8.4 In comparing a firm's revenues and expenses for

the purpose of establishing its periodic profit, this means

that some items of revenue and expense may be expressed in

different prices from those used to measure other items,

depending on when the different transactions take place. In

a particular income period, most items of revenue and some

expenses (e.g. wages and salaries) are valued in terms of

the prices of the period, because the transactions take

place in that period. But other items of expense, in

particular those associated with using stocks or fixed

assets in the process of generating income, may be expressed

in terms of the prices of a past period.

337

8.5 Accounting profit thus measures the difference

between revenues and expenses all expressed in terms of

their original prices, although this may effectively mean

that revenues expressed in current prices are being compared

with expenses expressed in a mixture of current and past

prices. Because the concept of taxable income is

essentially based on the accounting profit concept, it also

reflects these differences.

8.6 Methods of valuing trading stocks and

depreciation under existing tax law are described in Chapter

IX. In later Chapters, the Committee explores the

possibility of using other income concepts for tax purposes.

The purpose of this Chapter is to examine the effects of

imposing business taxation on a measure of income calculated

in the conventional way that has been described, that is on

accounting profit.

8.7 At the outset, the Committee records its view

that there is nothing inherently right or wrong, or true or

false, about the use of any particular income concept for

tax purposes. This viewpoint will be repeated in later

Chapters, because many of the submissions which the

Committee received seemed to be based on an unacceptable

premise that there was but one, universally valid, concept

of income (even though there was much disagreement about the

nature of that concept).

8.8 The Committee has not been swayed by arguments

that the conventional measure of accounting profit

338

incorporates unreal, or fictitious, or illusory, or paper

profits and is therefore inappropriate for tax purposes.

These statements by themselves throw little light on the

suitability of conventional profit as a measure of the tax

base. Likewise, the Committee does not accept the

assertion, which was frequently made, that in times of

inflation historical cost accounting procedures overstate

profit or cause profit to fall. Because profit is defined

in a particular way does not mean that it is overstated.

What the assertion probably means is that profit as

conventionally determined is higher than it would be if all

revenues and expenses were expressed in similar prices. But

this tells us nothing about the suitability of the

conventional profit concept for tax purposes.

The Effects of Existing Tax Arrangements: An Historical

Cost Model

8.9 The Committee believes that this can only be

assessed by reference to the effects which flow from the

particular definition of taxable income which is adopted,

having regard not only to its effects on business

enterprises but also to its implications for the rest of the

economy. These effects need to be evaluated by reference to

specified criteria, and as already noted the Committee

follows the Taxation Review Committee in regarding equity,

simplicity, efficiency, and flexibility for purposes of

economic stabilisation or management, as being of special

339

significance for this purpose. These criteria are discussed

in relation to business income taxation generally in Chapter

XI, but in the present context it may be noted that the

Committee attaches particular importance to one over-riding

test which it believes any tax system must meet. This test

is the compatibility of the tax system with the maintenance

of financial stability in the business sector, with

continuity of business investment and operations, in short

with business survival.

8.10 There is both theoretical and empirical

evidence that the existing tax system is not meeting this

test under current conditions of rapid inflation. A simple

historical cost accounting model is used in Appendix A to

demonstrate the effect, on a firm's financial stability and

profitability, of a combination of conventional profit

measurement procedures, income distribution policies based

on those procedures, and rising prices. It will be seen

that if profit is regarded as distributable income, and

fully paid out as tax and dividends, one or more of a number

of the following consequences ensue:

(a) the firm must increase the profit mark-up (or

rate of return) on its historical costs

(without further increasing its profit

distribution through taxes or dividends); or

(b) the firm must increase its indebtedness in

order to maintain its profit distribution and

continue operating at the same level of

activity; or

340

(c) the firm must raise fresh capital? or

(d) the firm must reduce the scale of its

operations, and thus its future profitability,

by running down the volume of its trading

assets.

8.11 The only other options available to the firm

are to increase its efficiency or to reduce the amounts of

its profit distribution. If prices rise continuously over

time, the effective options available to the firm are

continuously to raise additional finance (through borrowing,

capital-raising or retention of additional profits achieved

through continuously rising profit mark-ups and prices), or

continuously to reduce the scale of its operations,

eventually to the point of extinction. In a period of

slowly rising prices, it is possible for the firm to adapt

by using one or a combination of the different options, but

in a period of rapid inflation there are limits to the

extent to which any can be used.

8.12 These limits are set by:

(a) constraints on the firm's ability to

continuously raise prices relative to

historical costs, which are imposed by such

factors as official price restraint or consumer

resistance;

341

(b) constraints on the firm's ability to continue

borrowing or raising fresh capital to maintain

operating capacity, which are imposed by the

flow of funds through the capital market and

the attitude of creditors and investors to the

firm's gearing;

(c) restrictions on the firm's ability to

continuously reduce its profit distribution,

which are set by dividend distribution

requirements in the case of private companies

and, ultimately, by the level of after-tax

profits available for distribution; and

(d) constraints on the firm's ability to wind down

the scale of its operations, which are set by

falling profitability and, ultimately, by the

liquidation of the business itself.

The Significance of Taxation in Relation to Financial

Stability

8.13 Unless it is feasible for a firm to

continuously raise fresh capital to maintain the scale of

its operations, when the rate of inflation passes a critical

level it ceases to be a viable economic unit; this is

because it will have to either increase its indebtedness to

the point of financial collapse or reduce the scale of its

operations to the point of liquidation.

342

8.14 The Committee does not believe that, under the

postulated conditions of rapid inflation, the continuous

injection of fresh capital is itself a practicable

alternative. This is because the choice of tax base itself

becomes a crucial factor in determining whether fresh

capital contributions can be justified.

8.15 On the basis of an elaborate computer model

which he developed to record the transactions of

hypothetical companies under stated assumptions, a

submission from Mr. O.F. Roach demonstrated among other

things that:

(a) the tax payable itself may exceed the profit

that can be distributed without increasing

indebtedness or reducing the scale of

operations, when the rate of inflation reaches

a certain level;

(b) this position holds in some years even when

selling prices are determined realistically by

reference to current prices, but that where the

selling price is fixed on too low a basis the

eventual outcome is company failure;

(c) it is necessary to reject the argument that the

rising prices of a firm's assets mean that it

is growing and that there should therefore be a

fresh subscription of capital. "In this

example there is no growth of physical

production, the growth is merely that of

increasing money values. If a continuing

343

subscription of capital were made it is merely

a subsidy of the selling price and does not

reduce the proportion of borrowed funds.

Furthermore, as far as the shareholders are

concerned their net receipts from the company

are dividends less [capital contributions] and

the dividends are subject to tax. Once

[capital contributions exceed] the dividends

which remain after tax, the shares have little

value. In other words the subscription of

fresh capital in this situation (of constant

real production) is not a solution."

8.16 The Committee recognises that the basis on

which tax is levied is only one of the factors responsible

for the problems which have been noted in the preceding

discussion. If the firm is to remain viable, it must

maintain pricing and profit distribution policies which are

consistent with long-run financial stability and the

maintenance of its scale of operations. But if the rate of

inflation becomes sufficiently severe in relation to the

rate of tax and the rate of return it is able to achieve on

its trading assets, the tax base itself becomes a factor of

critical importance.

8.17 It is necessary to emphasise this because, in

some submissions which the Committee received, it was argued

that the financial problems which have been described would

344

not arise, even if the present basis of taxation was

retained, provided firms reacted appropriately to their

changing circumstances. Thus Professor R.J. Chambers

argued:

"It is said that firms are forced to increase their borrowing in order to maintain working capital and meet taxes at the present level. But if their assets have gone up in value there is a broader equity base for borrowing than before, and on a proper accounting there would be no necessary defection from the relation between debt and equity stipulated in lenders'

contracts and trust deeds. (There may, of course, appear to be such a defection if companies do not place proper current valuations on assets.)"

8.18 In its submission, the Australian Treasury

emphasised the importance of the firm's pricing policy in

maintaining its financial position. Contrasting the

position of a hypothetical business under conditions of

stable and rising prices, the Treasury argued that:

"If the first effect of inflation on the business was on its costs, the owners could not continue to draw income at the same rate as before and also replace stocks unless the business put up its prices when the increase in costs occurred. Even if the business's costs and prices did not rise as other prices rose, the real income drawn by its owners would fall unless they put up their own prices. It must be emphasized that

these consequences would occur even if there were no such thing as tax on business income - inflation itself squeezes the cash flow available for distribution to the owners as real income and for replacement of stocks, and the cash flow can only be made up' (productivity' Improvements apart) by the business adjusting its selling price or raising more capital. If, as is not uncommon, there is a tightening of monetary and credit controls in a time of inflation, that can add to the difficulties businesses face in meeting their additional needs for working capital. Again this would apply even if there were no taxes. ·

In short, there are many factors which can squeeze a business's working capital during a period of inflation but evidence of serious squeezing is not evidence that the tax basis is at fault." (Emphasis in original)

345

8.19 The Committee does not disagree with the

Treasury argument that business enterprises would face

financial problems in times of inflation even if there were

no income tax, and that they need to respond to these

problems by adjusting their own policies. But it does not

follow that, if they do respond in the way suggested, the

existing basis of taxation presents no problem. If the rate

of inflation is sufficiently severe, in the long run a firm

can only survive if its prices, taxes and profit

distributions are all related to the costs of replacing its

assets. Although the Committee accepts that the whole

burden of inflation adjustment cannot be thrown on the tax

system, it is equally true that the whole burden of

adjustment cannot be imposed on the policies of the firm

itself.

8.20 This may be illustrated by reference to the

Treasury's example of a firm which held stocks at the

beginning of the income period which it had purchased for

$100, and which sold those stocks for $120 and replaced them

at the same time for $120. The Treasury argument implies

that there is no problem if the firm adjusts its selling

price to reflect the increase in the cost of replacing the

stocks. But suppose that tax is levied at 50 per cent of

accounting profit. If the firm increased its selling price

to $140 so as to maintain its absolute margin of $20, its

tax liability on an accounting profit of $40 would be $20;

it would still need to use the whole of its after-tax

accounting profit ($20) to finance the higher cost of

346

holding the stocks. If the rate of inflation exceeded its

normal rate of return, even the retention of the whole of

its after-tax accounting profit would not provide sufficient

funds to maintain the scale of its operations. The firm is

thus in the unstable financial position that has been

described in earlier paragraphs, even though it has adjusted

its own policies as proposed by the Treasury.

8.21 On the basis of the foregoing figures, if the

firm were to finance the increased cost of holding stocks

($20) from retained profits, pay a dividend equal to its

pre-inflation return ($10), and pay tax at the rate of 50

per cent on its accounting profit, it would need to charge a

price of $160. The increase in price over the pre-inflation

price would thus be double that required on the basis of the

increase necessary to finance the higher cost of holding the

stocks and to maintain the pre-inflation tax and dividend.

Even if it were possible for the firm to sell its goods on

this basis, the explosive inflationary consequences of such

a situation are obvious. In effect the level of tax would

be three times its pre-inflation level, of which two-thirds

would be reflected directly in higher prices charged by the

firm. The Committee concludes that the choice of tax base

is indeed a critical factor in determining the ability of

business enterprises to withstand the effects of rapid

inflation

347

Trends in the Financial Stability of Companies

8.22 The effects of inflation on the financial

stability of business enterprises may be illustrated by

reference to both aggregate data for the whole economy and

the problems which have been raised in submissions received

from individual firms.

8.23 In The Australian Economic Review for the 3rd

Quarter 1974, the Melbourne Institute of Applied Economic

and Social Research related its estimates of the higher

replacement costs of assets absorbed into expense by

Australian companies over the years 1969-70 to 1974-75

(estimated) to their profits and profit distributions. The

higher replacement costs are what the Committee describes as

income valuation adjustments in later Chapters, and

represent the higher prices of stocks entering costs (stock

appreciation) and the higher costs of depreciation on fixed

assets, measured by reference to the current replacement

costs of the assets concerned. The Institute's figures for

profit, profit distribution and stock appreciation for the

years 1969-70 to 1973-74 were derived from offical estimates

of the Australian Bureau of Statistics, but the 1974-75

estimates and the replacement cost depreciation figures were

estimated by the Institute and, because of data limitations,

must be regarded as speculative. The estimates are set out 1

1 Similar estimates for earlier years (1945-46 to 1952-53) were made in R.L. Mathews and J. McB. Grant, Inflation and Company Finance, Law Book Co., Sydney, 1956.

348

349

in a rearranged form in Table VIII-1. It will be seen that,

although the level of undistributed profits increased during

most of the years to 1973-74, the estimated income valuation

adjustments increased more rapidly and were absorbing

virtually the whole of undistributed profits by 1973-74. On

the basis of its estimates, the Institute concluded that in

1974-75 Australian companies would face serious liquidity

problems in financing the holding of assets at their higher

replacement prices.

8.24 Changes in company profitability and finance

reflect the state of the economy and the efficiency of

business enterprises as well as the effects of inflation and

taxation. The Committee has endeavoured to assemble

information about the financial effects associated with the

holding of inventories, providing trade credit and financing

the replacement of capital equipment under recent

inflationary conditions.

8.25 Table VIII-2 presents figures on company income

obtained by the Committee from the Australian Bureau of

Statistics. These show that during recent years an

increasing proportion of company income has been required to

finance stock appreciation (described by the Bureau as the

stock valuation adjustment), and that company tax has

represented a steadily increasing proportion of company

income net of the stock valuation adjustment. The Bureau

does not make any valuation adjustment in respect of

depreciation.

350

Table VIII-2

Australian Company Income and Distribution

1969-70 1970-71 1971-72 1972-73 1973-74(a)

(1) Company income $m 3,355 3,428 3,653 4,466 5,342

(2) Stock valuation adjustment $m 192 333 478 521 989

(3) (2) as % of (1) 5.7 9.7 13.1 11.7 18.5

(4) Adjusted company income $m 3,163 3,095 3,175 3,945 4,353

(5) (4) as % of (1) 94.3 90.3 86.9 88.3 81.5

(6) Income tax payable $m . 1,455 1,477 1,562 2,012 2,448(b)

(7) (6) as % of (4) 46.0 47.7 49.2 51.0 56.2

(8) Dividends $m 755 766 814 963 983(b)

(9) (8) as % of (4) 23.9 24.8 25.6 24.4 22.6

(10) Undistributed income $m 953 852 799 970 922

(11) (10) as % of (4) 30.1 27.5 25.2 24.6 21.2

(a) Preliminary (b) Working Estimates

Source: Figures supplied by Australian Bureau of Statistics

8.26 The income tax figures reflect changes in rates

of tax (see Table VIII-3 for data on company tax rate

changes since 1950) and the removal or reduction of certain

concessions, such as investment and export incentive

allowances, during this period. Table VIII-4 provides data

on the taxable income of companies and income tax paid in

the income tax years 1963-64 to 1972-73. The rebatable

dividends relate to dividends received from other companies

on which a rebate is allowed under the Income Tax

Assessment Act. It will be seen that the ratio of net tax

payable to taxable income less rebatable dividends has

increased from 38.9 per cent in 1963-64 to 44.0 per cent in

1972-73

25.0 20.0 25.0 22.5 25.0 27.5 30.0 32.5 37.5 45.0 45.0

35.0(d) 30.0(d) 35.0(d) 32.5(d) 35.0(d) 37.5(d) 40.0(d) 42.5(d) 42.5(d) 45.0 45.0

1968 to 1969

40.0 45.0

1970

42.5 47.5

47.5 47.5

1973 1974

47.5 45.0 47.5 45.0

30.0 40.0

40.0 45.0

35.0 45.0

35.0 45.0

35.0 35.0

32.5 42.5

42.5 47.5

37.5 47.5

37.5 47.5

37.5 42.5

47.5 47.5

42.5 47.5

42.5 47.5

37.5 37.5

47.5 45.0 47.5 45.0

47.5 45.0 47.5 45.0

42.5 42.5 47.5 45.0

42.5 42.5 47.5 45.0

37.5 37.5 37.5 37.5

(a) Includes Super tax of 10c in the $, (b) Further tax of 20c in the $ on undistributed income also payable. (c) Further tax at shareholders' rates payable on undistributed income. (d) Further tax of 50c in the $ on undistributed income also payable.

Ratio of Net Tax to Taxable Income Less Rebatable

Dividends

$'000 $'000 $'000 $'000 %

1963-64 2,374,329 535,883 1,838,446 715,938 30.15

1964-65 2,752,212 729,959 2,022,253 787,099 28.60

1965-66 2,667,844 637,898 2,029,946 786,925 29.50

1966-67 2,789,932 641,766 2,148,166 832,582 29.84

1967-68 3,195,553 742,243 2,453,310 1,010,357 31.62

1968-69 3,639,307 818,309 2,820,998 1,157,375 31.64

1969-70 4,196,521 902,859 3,293,662 1,425,555 23.97

1970-71 4,381,730 1,073,098 3,308,632 1,453,116 33.16

1971-72 4,788,353 1,273,505 3,514,848 1,547,756 32.32

1972-73(a) 5,662,037 (b) (b) 1,978,168 34.94

%

38.94

38.92

38.77

38.76

41,18

41.03

43.28

43.92

44.03

(b)

Notes: (a) Preliminary (b) Not Available

Source: Data supplied by Taxation Office

353

8.27 Table VIII-5 presents data provided by the

Taxation Office on the opening value of company inventories,

annual depreciation allowances and the written down value of

depreciable plant and equipment for the income tax years

1963-64 to 1972-73. More recent data published by the

Statistician for all private enterprises indicate that, at

the end of the quarter ended December 1974, the book value

of stocks for selected industry groups was $13,613 million,

compared with $10,080 million at the same time a year

earlier. However, not all of that increase of $3,533

million was represented by increases in the unit price of

inventories; the Australian Bureau of Statistics has

provided a separate estimate of the valuation adjustment for

stocks (stock appreciation due to price rises) of $1,836

million. Data on the total amount of the inventory

valuation adjustment for earlier years are provided in Table

VIII-6 .

8.28 The task of financing the holding of an

increase in the value of inventories o^ $1,836 million, due

to price rises alone, obviously poses severe problems for

companies in a period of declining profitability.

8.29 Recent estimates in the United Kingdom and the

United States of America show a similar tendency for

companies to face increasing financial problems. In the

United Kingdom, Professor A.J. Merrett and Mr. A. Sykes

referred to Central Statistical Office estimates which

showed that, although profits of industrial and commercial

companies had more than doubled between 1963 and 1973, after

354

Table VIII-5

Opening Value of Company Inventories, Annual Depreciation Allowances and Written-down Value of Depreciable .Plant and Equipment, 1963-64 to 1972!—7 3

Year Opening Value Annual

Written-down

of Inventories Depreciation Allowances Value of Depreciable Plant

and Equipment

$'000 $'000 $'000

1963-64 3,649,889 541,453

3,423,098

1964-65 4,109,085 623,948

3,880,300

1965-66 4,676,344 725,927

4,410,036

1966-67 5,006,184 814,943

4,919,578

1967-63 5,393,634 919,414

5,545,992

1968-69 5,723,376 1,012,641

5,898,212

1969-70 6,333,893 1,147,244

7,017,007

1970-71 7,190,078 1,238,433

7,178,917

1971-72 7,802,349 1,391,509

7,943,783

1972-73(a) 8,180,987 1,470,536

Notes: (a) Preliminary (b) Not available.

(b)

Source: Supplied by Taxation Office.

355

Table VIII-6

Stock Valuation Adjustment, 1962-63 to 1973-74 § million

Year Private

Non-farm

Farm and Miscellaneous Total

1962-63 15 33 48

1963-64 23 16 39

1964-65 110 -28 82

1965-66 89 28 117

1966-67 117 -17 100

1967-68 134 4 138

1968-69 144 -18 126

1969-70 214 -21 193

1970-71 373 2 375

1971-72 523 72 595

1972-73 572 165 737

1973-74 1,106 -34 1,072

Sources; Figures supplied by the Australian Bureau of Statistics.

356

allowing for increases in replacement costs, interest,

preference dividends and taxes, the adjusted net of tax

profits available for ordinary dividends had fallen to

little more than one-third of their 1963 level. The 2

estimates are reproduced in Table VIII-7.

Table VIII-7

Profits of U.IC. Industrial and Commercial Companies 1963 to

$ million

1963 1972 1973

Gross profits Replacement depreciation Stock appreciation

4,561 (1,006) (140)

7,981 (2,353) (1,105)

10,284 (2,732) (2,516)

Profits pre-tax Interest and pref. dividends 3,415 (529)

4,523 (1,483)

5,036 (2,372)

Net profit Tax

2,886 (627)

3,040 (1,600)

2,664 (1,839)

Net of tax profits 2,259 1,440 825

Source: Central Statistical Office.

8.30 It was no doubt for this reason that the

Chancellor of the Exchequer (Mr. D. Healey) introduced tax

relief measures in the November 1974 Budget (subsequently

extended and applied to unincorporated businesses in the

April 1975 Budget) which he described in the following

terms: 1 2

1 'The Real Crisis Now Facing Britain's Industry', The Financial Times, 30 September, 1974.

2 Estimates for earlier years were made in G.C. Harcourt, Dissertation submitted for the Ph.D. degree, 'The Finance of Investment, Taxation, Depreciation, and Retained Profits in Selected United Kingdom Industries,

1949-53', Cambridge University, 1959.

357

"The financing problems of traders who replace their trading stock in times of inflation are very serious. They would be aggravated if tax had to be paid on profits calculated in terms of the traditional methods

of stock valuation. My Autumn proposals therefore gave relief for the abnormal inflationary element in the stock valuation, a relief which added some E800 million to company resources. And I then gave a pledge that

some similar relief would be given again this year."

The form of the tax relief is described in Chapter XIII,

8.31 The Committee also noted evidence of the

effects of inflation on company finance in the U.S.A. In

1970, it was estimated that inventory and depreciation

valuation adjustments accounted for 30.35 per cent of

reported after-tax profits.^ More recent estimates were made

by the Morgan Guaranty Trust Company and reported as

follows:

"The economists at our bank have done extensive work on the effect of ... inventory profits and under depreciation ... on corporate earnings, and what they have found helps explain the condition of our capital markets. In each of the last four years, more than 20

per cent of the total profits from domestic sources reported by nonfinancial corporations in the United States represented either inventory profits or underdepreciation in terms of replacement costs. In 1973 these essentially unreal components accounted for more than 30 per cent of the reported profit total. The percentage will be substantially higher this year. " 2

8.32 Evidence that the problem that has been noted

is world-wide is illustrated by the following description in

a recent report on Taxation Policy and Inflation prepared by 1 2

1 S. Fabricant, Journal of Accountancy, December 1971.

2 S.R. Callaway, 'Considerations Affecting Investment Decisions and Capital Formation', Paper Given to Symposium held in Brussels, October 1974.

358

the Commission on Taxation of the International Chamber of

Commerce and adopted by the Chamber1s Executive Committee:*

"An absolute shortage of finance may of course emerge in any event through inability of the business to raise its prices to the necessary level due to market forces or governmental price controls. In an attempt to remedy the shortage of finance the burden may be

shifted by, for example, reducing dividends to shareholders, or using currently retained profits otherwise available for expansion, or by borrowing money. But the choice is not always available, given

the tendency of some governments to place restrictions on access to credit and to reduce distributable profits by raising corporation tax rates. In the end, however, mounting inflation can destroy all means of sustaining

or transferring the burden of financing. The residual solution of borrowing ceases to be available as its level relative to proprietor's or shareholders funds passes the point at which loans are secure. This point may be reached quickly or only after some time according to the initial gearing of the capital employed in the business.

The particular concern of this Commission is the shortage of funds occasioned by tax systems which fail to allow a business to retain in full that part of sales proceeds needed to maintain business operations, so far as that need is occasioned by a fall in the value of money. If industry is enabled to maintain its production capacity it will also be enabled to maintain levels of employment and production. If the level of production is maintained, the revenues of governments from both direct and indirect taxes can be maintained thus serving the interests of governments as well."

Responses by Individual Firms

8.33 Submissions received from individual firms

indicated that they have responded to the financial problems

of inflation in each of the ways that was described above,

that is by raising profit margins and prices, by increasing

indebtedness, by raising fresh capital, by reducing profit

distributions and by reducing the scale of operations. The * 1 6

Taxation Policy and Inflation, Document No. 180/143 Rev., 16 December ti?4, Paris, 1974. 1

359

submissions also indicated that firms were becoming

increasingly subject to the kinds of constraints which were

discussed, in particular constraints on price increases, on

increasing their gearing, on raising additional funds in the

capital market and on reducing dividends (the private

company distribution requirements were especially mentioned

in this regard).

8.34 Some evidence of the effect of price changes on

the cost of holding inventories and plant and equipment was

provided by individual companies in their submissions. One

large manufacturing company indicated that, on the most

recent figures available covering a six-month period in

1974, the unit prices of its stocks had increased by 22 per

cent p.a. Another large manufacturing company estimated

that in 1974 the average unit prices of its stocks increased

by 44 per cent, representing an appreciation in stock values

over the year, excluding the effects of quantity changes,

equal to 62 per cent of the company's taxable income. The

same company estimated that depreciation allowed for tax

purposes fell short by 36 per cent (or 18 per cent of

taxable income) of the depreciation that the company would

have needed to charge on the basis of the current

replacement cost of its assets. Together these valuation

adjustments represented 79.8 per cent of the company's

taxable income.

360

8.35 A firm which processes precious metals recorded

a net profit before tax of $1.6 million in 1974, of which

$1.2 million reflected a 'metal market margin' or "the

increase in price of the precious metal components of our

sales from the time the metal was purchased and entered the

pipeline until it emerged in the form of completed products

and was sold". The firm claimed that, because the metal

market margin was reflected in the increased cost of holding

the stocks it needed to conduct its operations, it could

only be realised by liquidating the stocks, that is by going

out of business. The remaining profit which became

available in cash was $0.4 million, and this compared with a

tax liability on the total profit of $0.7 million. The firm

therefore needed to increase its indebtedness and raise

fresh capital to finance the increased cost of holding

stocks; unsecured bank loans thus increased by $1.3 million

although this was partly offset by increases in trade

debtors of $0.8 million. New capital issues also raised

$1.0 million.

8.36 Two large companies which developed their own

indexes of construction costs estimated that replacement

costs had changed since 1966-67 as follows (comparative

figures are provided for the Australian Bureau of Statistics

Implicit Price Deflator for Private Gross Fixed Capital

Expenditure - All Other):

361

Table VIII-8

Replacement Cost Indexes

1966-67 =

Implicit Deflator Private Gross Fixed Capital Expenditure

100

Company A

Company B

1966-67 100.0 10 0 100

1967-68 10 2.1 103 102.3

1968-69 10 5.6 106 107.6

1969-70 109.7 111 115.1

1970-71 117.1 117 121.5

1971-72 125.3 127 130.2

1972-73 129.8 134 136.4

1973-74 138.0 150 149.3

1974-75 N.A. 186 N.A.

8.37 A transport company provided the following

figures to illustrate the extent to which depreciation

provisions as presently allowed fell short of replacement

cost after allowing for trade-in values. In response to a

question from the Committee as to whether the figures

reflected changes in quality, capacity or productivity, the

company replied that it had taken care 'to ensure that the

vehicles selected as examples were both representative of

our fleet range, and were also instances in which like was

replaced with like, i.e. the capacity and performance of the

replacement vehicles were comparable with those of the

original equipment'. The figures relate to vehicles which

were originally purchased in 1967 and 1969 and which were

replaced late in 1974:

362

Item Original Cost Replacement Cost Gross After Trade-In (A)

Total Depreciation Written Off (B)

B A

$ Date $ l £ %

Utility 2,059 1969 3,042 2,392 1,235 51.6

5 Ton Tray 4,945 1967 7,370 7,120 4,945 69.5

8 Ton Tray

6,000 lb.

9,052 1967 15,468 14,718 9,052 61.5

Fork Lift 15 Ton 8,586 1967 13,358 12,458 8,586 68.9

Prime Mover 39 Ton Prime 6,500 1967 11,380 10,880 6,500 59.7

Mover 27,450 1969 37,973 35,473 27,450 77.4

8.38 The Australian Road Transport Federation

presented figures obtained from the N.S.W. Department of

Education, relating to five different classifications of

omnibus, which recorded changes in the capital costs of

buses during the years 1970 to 1975 inclusive. These showed

that in five years the capital cost of a comparable new bus

increased by amounts ranging from 76.9 per cent for the

class recording the lowest increase, to 121.9 per cent for

the class recording the highest increase.

8.39 A company illustrated the effect of inflation

on its financial position by showing that, during the year

ending 30 June 1974, it had to raise an additional $148,000

to hold the same volume of stocks and debtors at the end of

the year as at the beginning. But of its net profit before

tax of $161,000, its tax liability was $84,000 and it paid

out $44,000 in dividends. This left only $33,000 in

undistributed profits to finance the increased cost of

financing assets of $148,000. The company claimed that, in

363

order to avoid this deterioration in its financial position,

it would have needed to increase its prices to a level 18

per cent above its actual prices for 1974, and that this was

not possible because of depressed market conditions.

8.40 A firm of manufacturing stationers and printers

claimed that it could only meet its tax liabilities in

1973-74 by running down its working capital, and that to

prevent this deterioration in its financial position it

would have been obliged to increase its retail selling

prices by about 10 per cent above their actual level. The

firm submitted that:

"The current system taxes the real return on manufacturing and on stock holding more harshly than it taxes the returns on other forms of investment, such as holding land. Thus, when it is forced to disinvest,

the company will cut back real stock and machinery more than proportionately, reducing employment below what it would have been reduced to if the rate of return on manufacturing and stock holding had not been taxed

discriminately."

8.41 Other companies or organisations referred to a

tendency for firms to defer replacement in an attempt to

avoid the financial problems resulting from rising

replacement costs, with detrimental effects on efficiency

and productivity. The Heavy Engineering Manufacturers’

Association thus commented as follows:

"One of the problems in our industry is to justify the heavy cost of replacing machine tools at the end of their economic life and as a result there is a strong tendency to hang on to them until they are physically worn out."

364

8.42 The financial dilemma facing private companies

as a result of rapid inflation was illustrated by a door

manufacturing company, which in 1974 made an adjustment of

$50,000 to its historical cost depreciation allowances to

provide for the current replacement cost of its plant, and

which estimated that additional funds of $184,000 were

needed to maintain the same level of working capital (trade

debtors and stocks, less trade creditors). For the year

1973-74, the firm recorded a net profit before tax of

$334,000 after allowing for depreciation on a current cost

basis; it estimated its financial requirements as follows:

Profit (after current cost depreciation) Company tax Required dividend distribution Cash deficiency Additional working capital

required to maintain level of operations Funds required

$

334,000

214.000 131.000 345,000 11,Util)

184,000 l95,00ti

The company considered that the only alternatives available

to the business were to contract the level of operations by

the equivalent of $2 0 0 , 0 0 0 p.a. (which would mean that the

organisation would ultimately die), or to achieve a pre-tax

profit of 41 per cent on sales, which was impossible (of the

required pre-tax profit of $1,225,000 on sales of

$3,000,000, $551,000 would be paid in tax, $142,000 would be

required to meet expenses not allowed for tax purposes and

$337,000 would be the required profit distribution).

365

8.43 Many other submissions referred to the effect

of distribution requirements on the financial position of

private companies and co-operatives. A group of private

companies engaged in the motor vehicle industry thus claimed

that the retention allowances of 50 per cent at present

permitted under the Act were only sufficient to finance the

business if the inflation rate did not exceed 7 per cent

p.a. It presented detailed calculations to support its

claim that, at an inflation rate of 20 per cent, it was

necessary for 73 per cent of taxable income to be retained

to finance the same volume of business at the higher prices.

8.44 The Retail Traders' Association of New South

Wales, after discussing the problem which arises when

audited profits are substantially less than taxable income

and when private company distribution requirements are

related to taxable income, illustrated the problem by

reference to two member companies, which in 1974 reported

the following:

Company A Company B 5 $

Audited net profit (before tax) 203,795 85,740 Taxable income 235,571 264,198

Tax 101,435 N.A.

Sufficient distribution 82,113 183,548 121,287 Retention 52,02?

Stock (end of year) ~?10,2l5~ 1,508,766

The reason for the differences between audited profit and

taxable income were not disclosed, but the submission

referred generally to rates of depreciation on plant,

depreciation on buildings, provisions for long-service

leave, holiday leave and sick leave, depreciation on

buildings, legal expenses and lease premiums.

366

Equity Effects

8.45 Judgments about the equity effects of the

existing system of business taxation will reflect the view

which is taken about whether it is fair for some taxpayers

to be taxed on incomes which are wholly expressed in current

prices, while other taxpayers are taxed on incomes

calculated partly by reference to expenses expressed in the

prices of past periods.

8.46 The distribution of the total tax burden

between business enterprises and other taxpayers, and the

distribution of taxes among business enterprises themselves,

will differ significantly depending on whether business

profits for taxation purposes reflect historical prices or

current prices. Under the existing system, taxpayers

holding stocks and equipment for income-producing purposes

pay relatively more tax during a period of inflation, while

other taxpayers pay relatively less tax, than they would do

if the income tax base was uniformly measured by reference

to current prices (and tax rates were increased to offset

the consequential diminution of the tax base). There are

some grounds for arguing that the present basis of taxation

is inequitable to the extent that it places at a

disadvantage, relative to all other taxpayers, enterprises

which are required to use stocks and depreciable assets for

the purpose of generating taxable income.

8.47 But the Committee recognises that views about

equity inevitably reflect value judgments, and it agrees

367

with the Australian Treasury that it is not possible to

judge the equity of one part of the taxation system in

isolation. Differences in income tax rates affecting

different taxpayers obviously have a bearing on the overall

equity of the taxation system, as do the particular

arrangements which are made for taxing companies and their

shareholders (including, for example, the distribution

requirements affecting private companies), the granting of

special concessions to sectional groups, the exemption of

certain categories of income (and capital gains) from the

income tax base, and the existence of differential

opportunities for the avoidance of tax.

8.48 The treatment of capital gains poses special

problems in the design of any taxation system. It will be

argued in Chapter XIV, however, that the effective exemption

of most capital gains from taxation makes it more difficult

to justify, on equity grounds, the existing system of taxing

gains associated with the holding of stocks and equipment

during a period of rising prices. The appropriate tax

treatment of purchasing-power gains and losses, associated

with the holding of money claims (monetary assets and

liabilities) is another issue which is taken up in later

Chapters.

Incidence of Company Tax

8.49 One of the difficulties which the Committee

faced in framing this Report has been the need to make

implicit or explicit assumptions about the incidence of

368

company tax. To the extent that company tax is shifted

either forward to consumers of goods and services produced

by companies or backwards in the fora of reduced payments to

factors of production used in producing company products,

the taxation of profits on an historical cost basis will not

have the equity effects described above or the resource

allocation effects considered below.

8.50 If the burden of company tax is fully shifted

to consumers, the tax is equivalent to an indirect tax

levied at varying rates on consumers, depending on the ratio

of taxable profits to sales for individual companies.

Because of its highly discriminatory nature, the continued

existence of an indirect tax of such a type would be

difficult to support by reference to conventional notions of

a neutral distribution of the tax burden.

8.51 Unfortunately, there is no agreed view on the

incidence of this form of taxation.^" The Committee has

proceeded on the assumption that, although companies may

attempt to shift the incidence of company tax, in practice

they are only likely to be partially, if at all, successful

in doing so. The determining factors will be the overall

macro-economic situation and the nature of the competition

faced by individual firms in their product and factor

markets. Firms facing little or no competition either from

imports or from other domestic producers are the exception

rather than the rule in the Australian economy. Even

" See, for example, Treasury Taxation Paper No. 9, Company Income Tax Systems, Canberra, 1974, pp. 16-18.

369

monopolists face competition from substitutes and cannot

exercise monopoly power in factor markets. The Committee

therefore believes that taxes on companies and other

business enterprises are at least partially paid by the

owners of those enterprises.

Effects on Resource Allocation

8.52 The resource allocation effects of existing

taxation arrangements in periods of rapid inflation are

significant and readily identified. It has been noted above

that firms may not be able to continue in business without

significant injections of new funds which, because of higher

gearing ratios or reduced ability to service dividends, will

be more difficult to obtain from capital markets. The firms

which will suffer most are those with depreciable plant and

equipment or inventories which must be replaced at

progressively higher prices as the inflation proceeds.

8.53 Because labour costs are expressed in current

prices and are fully deductible as expenses of earning

taxable income, while only the historical costs of using

depreciable assets and inventories are deductible, inflation

may be expected to influence firms to choose less capital

intensive techniques of production. The effective exemption

of most capital gains from taxation is likely to bias

investment decisions towards investment in those assets

which appreciate in value, such as land and buildings. More

370

generally, there is a presumption that the existing basis of

taxation reacts against business saving which in turn tends

to generate financial instability and reduce the level of

business investment.

8.54 In the long run, any reduction in business

investment may be expected to have detrimental effects on

the whole economy. Some reduction in the overall level of

inventories held by firms may be consistent with an

improvement in economic efficiency, but in the long run the

holding of inventories and capital investment in depreciable

plant and equipment are both essential if the supply of

goods and services is to be maintained and expanded. Where

rates of inflation are high, the long run may not be very

long, because reduced investment may force firms into

inefficient methods of production, for example by making

them use obsolete equipment with resulting higher costs and

reduced productivity. The seriousness of these effects will

depend on the rate of inflation and the nature of the assets

owned by individual firms. The Committee has already noted

the difficulties to which trading and manufacturing

companies have directed attention in their submissions.

8.55 Existing taxation arrangements affect

macro-economic stability partly through demand effects and

partly through price effects. To the extent that taxation

reduces business saving and increases business indebtedness,

there is a tendency towards financial instability and a

reduction in the level of investment activity (and business

371

activity generally). To the extent that taxation based on

conventional measures of profit induces business enterprises

to raise prices beyond the levels otherwise necessary to

achieve adequate rates of return, there is a tendency

towards price instability and inflation.

373

IX EXISTING METHODS OF STOCK VALUATION AND DEPRECIATION FOR TAXATION PURPOSES

9.1 At the Committee's request, the Australian

Taxation Office prepared a paper outlining, for the

information of the Committee, the statutory provisions of

the income tax law relating to the valuation of trading

stock and the allowance of deductions for depreciation, and

explaining the way in which these provisions are applied in

practice. This paper has been used extensively in the

following description of the existing legislation and its

interpretation.

Valuation of Trading Stock

9.2 Trading stock is defined in s .6 of the Income

Tax Assessment Act to include anything produced,

manufactured, acquired or purchased for purposes of

manufacture, sale or exchange, and also to include live

stock. From the wide terms of the definition, it is evident

that trading stock would include shares, debentures and

other securities and interests in land, where the taxpayer

is in fact carrying on a business of trading in such items

of property. Because separate treatment is accorded the

valuation of live stock and other trading stock for income

tax purposes, these categories of stock are discussed

separately.

Trading Stock other Than Live Stock

9.3 The basis on which trading stock (other than

live stock) may be valued is governed by s.31 of the Income

Tax Assessment Act. The section provides that the value of

374

e a c h a r t i c l e o f t r a d i n g s t o c k t o b e t a k e n i n t o a c c o u n t a t

t h e e n d o f t h e y e a r o f i n c o m e is, a t t h e o p t i o n o f t h e

t a x p a y e r , i t s c o s t p r i c e , m a r k e t s e l l i n g v a l u e o r t h e p r i c e

a t w h i c h i t c a n b e r e p l a c e d . T h e C o m m i s s i o n e r o f T a x a t i o n

is a u t h o r i s e d b y t h e s e c t i o n t o a p p r o v e a l o w e r b a s i s o f

v a l u a t i o n w h e r e s p e c i a l c i r c u m s t a n c e s , i n c l u d i n g s t o c k

o b s o l e s c e n c e , e x i s t . I n l a r g e b u s i n e s s e s i t is a p r a c t i c a l

i m p o s s i b i l i t y t o t r a c e t h e v a l u e o f e a c h a r t i c l e o f s t o c k .

W h i l e t h e v i e w is t a k e n t h a t , i n s t r i c t l a w , e a c h i n d i v i d u a l

i t e m o f s t o c k o n h a n d a t t h e e n d o f a n i n c o m e y e a r is

r e q u i r e d t o b e v a l u e d i n a c c o r d a n c e w i t h t h e b a s i s s e l e c t e d

b y t h e t a x p a y e r , i t is a c c e p t e d t h a t , i n p r a c t i c e , m a n y

t a x p a y e r s a r e a b l e t o d o n o m o r e t h a n m a k e a r e a s o n a b l e

e s t i m a t e o f t h e v a l u e o f t h e c l o s i n g s t o c k . T h e r e is

n e c e s s a r i l y a n e l e m e n t o f f l e x i b i l i t y i n t h e a c t u a l

v a l u a t i o n m e t h o d u s e d t o m a k e t h e e s t i m a t e .

9 . 4 T h e r e is, o f c o u r s e , a v a r i e t y o f m e t h o d s u s e d

b y a c c o u n t a n t s , a d m i t t e d l y o f t e n f o r d i f f e r e n t p u r p o s e s , t o

d e t e r m i n e t h e v a l u e o f t r a d i n g s t o c k . T h i s is p a r t i c u l a r l y

so i n r e l a t i o n t o t h e c o s t b a s i s o f v a l u a t i o n . T h e

C o m m i s s i o n e r o f T a x a t i o n i n f o r m e d t h e C o m m i t t e e t h a t w h e t h e r

o r n o t a p a r t i c u l a r m e t h o d p r o d u c e s a n a p p r o p r i a t e v a l u e f o r

i n c o m e t a x p u r p o s e s h a s t o b e j u d g e d a c c o r d i n g t o w h e t h e r o r

n o t i t c a n b e s e e n t o p r o d u c e a v a l u e r e a s o n a b l y

r e p r e s e n t a t i v e o f t h e s u m o f t h e a c t u a l v a l u e s o f e a c h

a r t i c l e o f s t o c k o n h a n d , c o n s i s t e n t w i t h t h e p a r t i c u l a r

b a s i s (i.e. c o s t p r i c e , m a r k e t s e l l i n g v a l u e o r r e p l a c e m e n t

p r i c e ) s e l e c t e d b y t h e t a x p a y e r .

375

Cost Price

9.5 In terms of the income tax law, "cost price”

includes the elements normally comprising cost price on

ordinary commercial concepts, i.e. the cost of the stock to

the taxpayer together with charges such as freight,

insurance and duty, incurred in getting it into its existing

condition and bringing it to the place where it is "on

hand". Any of several accounting concepts may be employed

by taxpayers to ascertain the cost price of total stock on

hand. Where actual identified cost is not a practical

proposition, either average cost or First-in-first-out

(FIFO) can generally be accepted by the Commissioner as

being sufficiently representative of actual cost. The

Last-in-first-out (LIFO) valuation method is not accepted by

the Commissioner as complying with the statutory

requirements of the income tax law unless, of course, the

method is in accord with true cost in the circumstances of a

particular business. With the retail inventory method of

valuation, goods in stock are marked at their retail selling

prices and the total stock value is reduced by the

percentage mark-up to arrive at the cost of goods on hand.

As long as there is an appropriate adjustment in respect

of any stock marked down due to falling market values, the

basis is generally accepted by the Commissioner as

appropriate for income tax purposes.

376

9.6 When applied to manufactured trading stock for

which no price is paid, including unfinished goods and other

work in progress, cost price is taken to embrace all costs

reasonably attributable to the production of the trading

stock. The Commissioner expressed the view that the

so-called variable (or direct) cost method of valuation does

not satisfy the requirements of the Australian income tax

law because it does not bring an appropriate share of

factory overheads, as well as the direct manufacturing cost,

into the valuation. In practice, the Commissioner does not

generally require overhead costs to be dissected in any

great detail. As a general rule, expenses related to

selling, finance and, in the ordinary course of events,

storage, are not regarded as costs of production entering

into the cost price valuation.

Market Selling Value

9.7 Market selling value represents the current

value of an article of trading stock in the taxpayer's

selling market. It is best evidenced by the price that the

taxpayer is prepared to accept on a sale of the article in

the ordinary course of his business on balancing date. It

is thus an estimate of what price the article might

ultimately be sold for. The Commissioner advised that

relatively few taxpayers would select a general market

selling basis of valuation of stock except in special

circumstances, e.g. where valuation on a cost basis would

have given a loss or where the market selling value would

377

enlarge the net profit figure so as to enable a previous

year's loss to be recouped for income tax purposes, rather

than being time-barred. Where market selling value is

selected and applied by the taxpayer on the basis of a bona

fide and reasonable estimate, there is seldom any dispute

between the Commissioner and the taxpayer concerned. The

Australian Taxation Office accepts that adjustments can be

made to the market selling value to allow for such factors

as customary trading discounts, but not for selling expenses

that would be allowed as deductions in the year in which

they are actually incurred.

Replacement Price

9.8 In terms of the law, this basis is interpreted

as referring to the amount that the taxpayer would have to

pay in his buying market in order to replace a substantially

identical article in his stock on the last day of the

accounting period. As with cost price and market selling

value, the valuation of stock by reference to its

replacement price is a matter of fact. A valuation that is

capable of objective support would seldom result in

disagreement between the taxpayer and the Commissioner.

Special Circumstances

9.9 A lower value than would be obtained under any

of the three bases mentioned above may be applied to trading

stock where special circumstances exist. The provision for

this basis was inserted in the income tax law in 1963

378

following the recommendations of the Ligertwood Committee.

Where the Commissioner is satisfied that, by reason of

obsolescence or other special circumstances relating to

particular trading stock, the value to be taken into account

at the end of the year of income should be less than the

lowest value obtainable under the preceding alternatives,

that lower value may be determined by the Commissioner.

This basis of valuation applies only in special

circumstances, where the other three alternatives are all

either inapplicable or inappropriate.

Live Stock

9.10 By s.32 of the Income Tax Assessment Act, the

value of live stock to be taken into account at the end of

the year of income is, at the option of the taxpayer, its

cost price or market selling value. Where no option is

exercised, the value is taken into account by reference to

cost price. That section authorises the Commissioner to

accept some other basis of valuation for the whole or part

of a taxpayer's live stock where it is established that the

adoption of that basis is justified by reference to the

circumstances of the particular case.

Cost Price Valuation

9.11 Where the taxpayer can identify all or part of

his live stock on hand at the end of the year of income, he

may value the live stock on the basis of actual cost; that

is, by reference to the cost at which it was purchased or

379

valued at the beginning of the year. In the case of natural

increase he may select a value, pursuant to s.34 of the

Income Tax Assessment Act, of not less than the following

prescribed minimum values:

Sheep $0.40

Cattle $2.00

Horses $2.00

Pigs $0.50

Where the taxpayer has not selected a value in excess of the

minimum values, the prescribed values are applied. Once a

value has been used for natural increase of a particular

class of live stock, that value continues to be applied in

subsequent years unless, with the leave of the Commissioner,

the taxpayer selects another value not less than the

prescribed minimum value.

9.12 The minimum values are applied in the great

majority of cases. They have remained unchanged in the law

since 1936 and provide obvious advantages to taxpayers by

providing lower statutory cost prices them would be

determined under current circumstances. In practice, it is

most unusual for primary producers to be able to value live

stock on hand by reference to actual identified cost. As a

general rule the value of closing stock is based on average

cost.

Market Selling Value

9.13 The alternative method of valuation of live

stock is market selling value. The same rules apply in

380

assessing market selling value of live stock as are applied

in relation to trading stock generally. Once live stock has

been taken into account on a particular basis of valuation,

s. 33 of the Income Tax Assessment Act requires the taxpayer

to continue to use that basis unless he obtains the

Commissioner's leave to change it. In practice, this

provision is seldom invoked since most primary producers are

on a cost basis of valuation. The special circumstance

provisions of s.32 of the Income Tax Assessment Act are

applied in special cases in which an average cost basis

would be unsatisfactory (e.g. as where a primary producer

has valuable stud animals among his live stock).

Trading Stock Account

9.14 Section 28 of the Income Tax Assessment Act

requires a taxpayer carrying on a business to ascertain the

value of all trading stock on hand both at the beginning and

at the end of each year of income, whether or not he has a

taxable income. The section provides that, where the

closing value of all stock on hand is greater than the

opening value of all stock in relation to that year of

income, the excess is to be included as assessable income.

In the reverse situation the excess of the opening value

over the closing value is an allowable deduction. Section

29 of the Income Tax Assessment Act provides that the value

of live stock and the value of each article of other trading

stock is to be taken into account at the beginning of the

381

year of income at the value it was brought to account for

income tax purposes at the end of the year of income

immediately preceding.

Winemakers' Trading Stock

9.15 From 1953 until 1973, S.31A of the Income Tax

Assessment Act provided winemakers with a concessional basis

of valuation for their trading stock on hand. The

provision, which over-rode the general trading stock

provisions, permitted a winemaker to elect to value his

stock at a figure not less than that ascertained by

reference to prescribed minimum values as follows:

Class of trading stock Prescribed unit Minimum value

Unfortified wines

Fortified wines

Brandy

Grape spirit

Liquid gallon 15Φ

Liquid gallon 25Φ

Proof gallon 60Φ

Proof gallon 60Φ

The closing valuation of the stock would also take account

of any amount allowed as a deduction in respect of excise

duty paid in respect of the stock on hand. The 1973-74

Budget amendments repealed the section, thus bringing to an

end the concessional basis of valuation of winemakers'

stocks. To cushion the effect of bringing the cash value of

stocks on hand up to a true cost figure as at 30 June 1974,

a phasing-in period of five years was provided. For each of

the five income years ended 30 June 1974 to 1978 inclusive,

382

one-fifth of the difference between the s.31 and 31A Income

Tax Assessment Act values as at 30 June 1974 is to be

included as assessable income.

The Operation of the Trading Stock Provisions

9.16 In order to measure income for tax purposes it

is necessary to determine a single, and objectively

demonstrable, profit from the year's operations. Thus,

rather than base liability to taxation on a flexible

conception of net profit determined according to 1 generally

accepted accounting principles1, which as yet do not

necessarily provide such a result, income tax is based on a

statutory conception of taxable income.

9.17 In determining the results of a business for

income tax purposes, these statutory provisions contain all

the elements of the conventional trading account, but each

element is separately defined in provisions which have to be

interpreted according to the legal provisions of statutory

interpretation. 'Generally accepted accounting principles'

are not specifically concerned with the constituent elements

in the calculation of taxable income. It is in this context

that the provisions relating to the valuation of trading

stock were designed. These provisions provide flexibility,

but with a legal standard to fall back on. The Commissioner

said that a method of valuing trading stock which accords

with the best accounting practice can generally be brought

within the scope of these provisions where the practice has

the basic objective of obtaining a definitive total

valuation of trading stock on hand.

383

Depreciation ; The General Scheme

9.18 Section 54 of the Income Tax Assessment Act

provides that deductions for depreciation are allowable in

respect of plant or articles owned by a taxpayer and used by

him during the year of income for the purpose of producing

assessable income; or in respect of plant or articles

which, although not actually used for the purpose of

producing assessable income during the year, were installed

ready for use for that purpose during the year of income and

were held in reserve by the taxpayer. The section also

gives an extended meaning to the word 'plant*. Section 55

of the Income Tax Assessment Act provides that the general

method of arriving at the rate of depreciation on a unit of

property is for the Commissioner of Taxation to make an

estimate of the effective life of the unit on the assumption

that it is maintained in reasonably good order and

condition. A basic rate of depreciation is then set such

that the cost of the unit is written off over its effective

life.

9.19 The Income Tax Assessment Act provides

alternative methods by which deductions for depreciation may

then be calculated. Under s.56 of the Income Tax Assessment

Act, the diminishing value method, under which depreciation

allowances are based upon a percentage of the depreciated

value of property, automatically applies unless the taxpayer

exercises his option to adopt the prime cost method. A rate

of one and one-half times the basic rate referred to above

384

is applied to the depreciated value of the property under

this method. Under the alternative method, the prime cost

method, deductions are based each year upon a percentage of

the cost of the property such that an annual deduction,

equal to the basic rate, is allowed until the property has

been fully written off, or the property has been disposed

of, lost or destroyed.

9.20 The option to adopt the prime cost method is

authorised by s.56(1)(b) of the Income Tax Assessment Act and

may be exercised in respect of either the whole of the

taxpayer's depreciable property or new depreciable property

of that year only. An option, once made, will generally

apply to that plant in assessments for subsequent years

unless the method is changed with the leave of the

Commissioner under s.57 of the Income Tax Assessment Act.

Once the method of depreciation has been settled, the rate

on a particular item of plant can be ascertained by

reference to the published list of standard rates contained

in Income Tax Order No 1217. These rates have been compiled

by the Commissioner to avoid the need for a separate enquiry

to be made in each case in which depreciation is claimed on

a new item of plant. Where plant is owned and used, or

installed ready for use and held in reserve, during a part

of the income year only a proportional allowance may be made

for depreciation. Similarly, a proportional allowance is

made under s.61 of the Income Tax Assessment Act, where

plant is used only partly for the production of assessable

income

385

9.21 A system of balancing adjustments applies where

depreciable property is disposed of, lost or destroyed.

Under s.59 of the Income Tax Assessment Act, where the

consideration receivable in respect of the property is less

than the depreciated value, the deficiency is deductible

from assessable income as a balancing allowance in the year

in which the disposal, loss or destruction occurs.

Conversely, where the consideration exceeds the depreciated

value, the excess (to an extent not greater than the

depreciation allowed or allowable on the property) is

brought to account as a balancing charge. This charge may

either be included in the assessable income of the year

concerned, or, if the taxpayer requests, set off against the

cost or depreciated value of other depreciable property.

9.22 Schedules A and B in the Appendix to this

Chapter provide practical examples of the operation of these

provisions. It is necessary, however, to amplify a number

of the terms used in the preceding general outline of the

scheme, with particular reference to practical

inte rpretation.

The Meaning of 'Plant and Articles'

9.23 For property to be subject to depreciation it

must qualify as 'plant' or 'articles'. These terms are not

defined in the Act and as such they have been given a wide

interpretation based on their normal usage. Further,

s.54(2) of the Income Tax Assessment Act expands the meaning

386

of plant for the purpose of depreciation allowances. Thus,

depreciable plant includes animals used as beasts of burden

or working beasts in a business other than primary

production, machinery implements, utensils and rolling stock

and structural improvements of certain primary producers.

The structural improvements which are deemed to be plant for

depreciation purposes are those which:

(a) are situated on land used for the purposes of

agricultural, pastoral or forest operations; or

(b) are used wholly and exclusively for the purpose

of pearling operations and are situated at or

in the vicinity of a port or harbour from which

those operations are conducted.

9.24 The term 'agriculture' has been interpreted to

include horticulture, viticulture, afforestation and all

pursuits dealing with the cultivation of soil. Poultry

farming has also been accepted as an agricultural pursuit.

The concession extends to dams (but not earth tanks), bores,

wells, woolsheds, stables and similar structural

improvements and also to accommodation provided for

employees, tenants and sharefarmers, but does not extend to

improvements used by the taxpayer for his own residential or

domestic purposes.

9.25 Section 54(2) of the Income Tax Assessment Act

also includes in the definition of 'plant' for depreciation

purposes, plumbing fixtures and fittings forming part of the

toilet accommodation and washing facilities provided by am

387

employer principally for his employees or for use in

child-minding facilities made available for the employees'

children. The fixtures and fittings to which the allowance

has been extended includes wall and floor tiling and pavings

and internal partitions as well as plumbing and sewerage

piping.

Standard Rates of Depreciation

9.26 As mentioned previously, standard rates of

depreciation based on the estimated effective life of items

of depreciable property are published in Income Tax Order

1217 (1974 Revision). Overall rates of depreciation have

also, in a number of cases, been determined to cover groups

of units of plant and a fair average fixed for the group.

These rates assume plant of average type, maintained in

reasonably good order and used under normal working

conditions for that plant.

9.27 It would be open to a taxpayer to demonstrate

that the rate published in that Order is not applicable to

his particular item of plant as, for example, where it

operates in unusually adverse conditions. The Commissioner

advised that, while applications for higher rates of

depreciation are not accepted without substantial evidence,

experience suggests that taxpayers with valid claims have no

difficulties in establishing their claims for increased

rates. He said that appeals against the application of the

standard rates of depreciation are practically unknown and

388

that this indicates the extent to which they are accepted as

adequate by taxpayers generally. But the Committee notes

that several submissions which it received questioned the

adequacy of the rates. In determining the rate of

depreciation applicable to a particular item of plant the

income tax law does not permit the general prospect of

obsolescence to be taken into account. On the other hand,

the Commissioner is guided by any tangible evidence of

experience in relation to the scrappage of plant in making

his estimate of the effective life of plant. To this extent

obsolescence due to gradual and persistent technological

change is taken into account in fixing rates of

depreciation. Premature or unforeseen obsolescence is,

however, a matter which defies reasonable prediction. Any

legislative attempt to provide for this kind of obsolescence

could not remove it from the area of pure guesswork. It

would have to be an overall allowance made in respect of all

plant regardless of circumstances and would be given for

possible, but not necessarily probable, obsolescence.

Cost and Depreciated Value of Property Owned by the Taxpayer

9.28 Generally speaking, the cost of property for

the purposes of depreciation allowances is the amount paid

or value given for the property. The costs of transporting

and installing plant or machinery or of dismantling and

relocating the plant are also regarded as part of the total

389

capital cost on which depreciation is allowed. However, the

cost of minor removals and re-arrangements may be claimed as

an outright deduction in the year incurred.

9.29 Depreciation is allowed on property owned by

the taxpayer. Where a taxpayer acquires plant or articles

by hire purchase it is settled practice to treat the

hire-purchaser as the owner and allow deductions to him for

depreciation on that property. Cost in these circumstances

is accepted as either the amount for which the goods could

be purchased for cash, or, alternatively, an amount equal to

the sum of the cash price and the amount added under the

hire purchase agreement for interest or hiring charges. If

the former method is adopted a deduction is allowed in each

year of income for the interest or hiring charges for that

year. If the latter method is adopted by the taxpayer,

these costs are included in the cost price subject to

depreciation.

9.30 As mentioned previously, the depreciated value

at any time of a unit of property is its cost less the total

depreciation deductions allowed or allowable up to that time

in respect of that unit. However, s.60 requires that a

person who acquires any property in respect of which

depreciation has been allowed or is allowable is not

entitled to any greater deduction for depreciation than

would have been allowed to the person from whom the property

was acquired if that person had retained it. This is

subject to the proviso that a person acquiring a unit of

390

property which has been depreciated in the assessments of

another taxpayer is to be allowed depreciation on the sum of

its depreciated value plus any balancing charge which has

been included in the assessable income of the vendor or

offset in the vendor's assessments against the cost of other

depreciable property held by him. Alternatively in

appropriate circumstances (as in an arm's length situation),

the Commissioner may authorise the allowance to the

purchaser of depreciation based on the full purchase price.

The cost or depreciated value of property may also be

reduced to the extent that a taxpayer exercises his option

under s.59 of the Income Tax Assessment Act to set off any

balancing charge realised on the disposal of another item of

depreciable property. Some aspects of the general scheme

outlined above have been varied where Parliament has

determined that certain classes of expenditure should be

afforded concessional treatment, often as an incentive to

particular investment. These are briefly outlined below.

Plant and Equipment Used to Provide Amenities and Other Facilities for Employees

9.31 Section 55(2) of the Income Tax Assessment Act

provides a special rate of depreciation of 33-1/3 per cent

on certain classes of amenities provided by an employer for

his employees, including plant and equipment used in employee

dining rooms, mess rooms and cafeterias; and fixtures and

fittings provided in locker rooms, change rooms, rest rooms,

391

casualty wards, recreation rooms and the like, including

plumbing fixtures and fittings. The concession was extended

in 1974 to include depreciation of certain facilities

provided for the care of children of employees.

Plant and Machinery Used for Purposes of Scientific Research Only

9.32 Section 73A(5) of the Income Tax Assessment Act

specifically provides a standard rate of depreciation of

33-1/3 per cent per annum on plant and machinery owned and

used by a taxpayer only for the purpose of scientific

research. Section 73A(2) of the Income Tax Assessment Act

provides that expenditure of a capital nature on buildings

used only for scientific research related to the business of

the taxpayer is allowable by three equal annual instalments,

commencing in the year in which the building is first used

for the purpose of scientific research. Normally buildings

(other than those used in mining or primary production

businesses) are depreciable only to the extent that they

form integral parts of, or take on the nature of, plant (and

do not merely provide a convenient setting for the business

operations).

Depreciation on General Mining Plant and Equipment

9.33 Special deductions for allowable capital

expenditure incurred by a mining enterprise, including plant

and equipment in carrying on prescribed mining operations,

are deductible over the estimated life of the mine, subject

392

to a maximum life for deduction purposes of twenty-five

years. The life of the mine is estimated in relation to

each succeeding year of income. The taxpayer also has the

right to elect to claim ordinary depreciation allowances in

respect of that plant.

Primary Producers - Improvements to Land

9.34 Section 75A of the Income Tax Assessment Act/

which applies to the income year ended 30 June 1974 and

subsequent years, authorises a deduction over a ten-year

period for capital expenditure on improvements of a

non-structural kind made to land on which the taxpayer

carries on a primary production business in Australia or

Papua New Guinea. Previously, these outgoings, and some

others of a structural kind (e.g. some fencing expenditures

or the cost of buildings used to store grain, hay or fodder)

were immediately deductible under s.75 or 76 of the Income

Tax Assessment Act.

9.35 The more important capital expenditures subject

to ten-year write-off for income tax purposes under s.75A of

the Income Tax Assessment Act are:

(a) eradication of vegetable and animal pests;

(b) draining of land;

(c) excavation of earth tanks and the construction

of irrigation channels;

(d) the erection of fences as an erosion-control

measure

Accelerated Depreciation

9.36 On 9 December 1974 the then Treasurer, the

Hon. Frank Crean, Μ . P ., announced that in view of the

present depressed state of the private sector the Government

had decided to provide a stimulus to new investment by the

introduction of a scheme of accelerated depreciation. Under

the proposed scheme a taxpayer may, if he so wishes, claim

deductions for depreciation in respect of certain plant and

equipment, at twice the rate determined by the Commissioner

as set out in Income Tax Order 1217. Accelerated

depreciation will apply to new plant and equipment first

used or installed ready for use on or after 1 July 1974 and

before 1 July 1975. The accelerated rate will apply until

the property has been fully written off, disposed of, lost

or destroyed.

9.37 The scheme will apply to new plant and

equipment for use by taxpayers both in the manufacturing and

primary production sectors. Those classes of plant and

equipment which will attract eligibility for accelerated

depreciation will be those to which the previously abolished

investment allowances applied. Broadly speaking, eligible

property will consist of the majority of new manufacturing

and primary production plant. The major exceptions are

structural improvements, road vehicles, household furniture

and appliances, and hand and loose tools and plant subject to

statutory depreciation rates.

394

The Basis of Operation

9.38 As with the valuation of stock the allowance of

depreciation is based on statutory provisions aimed at

allowing a deduction for a definitive cost of producing

assessable income. Depreciation for income tax purposes is

thus a process of allocation whereby the original total cost

to the taxpayer is apportioned over the income years in

which the service potential is used up or lost. It has been

noted that in circumstances where a particular incentive is

regarded as worthwhile, the period over which the cost is

written off has been shortened. However, as with all costs,

the deduction available to a taxpayer is equal to the actual

cost incurred.

9.39 As with other costs, the depreciation rates do

not allow for contingencies. As mentioned in relation to

the question of premature or unforeseen obsolescence, any

general allowance for a possible event would entail a degree

of guesswork, calculated though it may be, and would

necessarily take the form of an overall allowance in respect

of all plant. Any such overall allowance, while possibly

true in the general, will not necessarily be accurate in

relation to a particular item. Contingencies which do

eventuate are taken into account in relation to depreciation

in ascertaining the balancing adjustment on disposal of the

plant.

395

APPENDIX TO CHAPTER IX

SCHEDULE A

M E T H O D O F C A L C U L A T IN G D E P R E C IA T IO N O N T H E D IM IN IS H IN G V A LU E M E T H O D P l a n t ‘A’— Basic R ate 5 per cent— one and one-half times Basic R ate = 7 i p e r cent

P l a n t ‘B’— Basic R ate 10 per cent— one and one-half times Basic R ate = 15 p e r cent

O riginal cost of plant— 1 J u l y .........................................

F irst y e ar’s d e p r e c i a t i o n .........................................

D epreciated value a t beginning of second year . .

Second year’s d e p r e c i a t i o n .........................................

D epreciated value a t beginning of th ird year . .

U nit o f P la n t ‘A ’ sold on 1 July— $

O riginal c o s t .................................................1,000

F irst year’s depreciation . . . . 75

~ 925

Second year’s depreciation . . . . 69

D epreciated value a t 1 July . . . 856

Sale price .................................................946

B alancing charge . . . . . . 90

W ritten request m ade under Section 5 9 (2 a.) th a t

the am ount of the balancing charge be applied to reduce the depreciated value of plant 4A’ a t begin­ ning o f the year o f incom e . . . D educt

D educt depreciated value of plant sold . . .

Third year’s depreciation

P lant ‘A ’ Plant ‘B’

D epreciated value at beginning of fo urth year Plant sold on 1 July— ϋ

O riginal cost . . .

First year’s depreciation .

Second year’s depreciation

T hird year’s depreciation

D epreciated value a t 1 July Sale prices . . . .

Loss deductible under section 59 (1.) . . .

$ $

400 600

30 90

370 510

28 77

342 433

26 65

3 Ϊ6 368

250 548

66*

B alancing charge included in

assessable incom e under sec­ tion 59 (2.) as w ritten request u n d e r section 59 (2a). not

m a d e .........................................................180

D educt depreciated values o f plant sold . . .

F o u rth year’s d e p r e c i a t i o n ........................................

D epreciated value a t beginning of fifth year . .

A dditional plant purchased a t beginning of fifth y e a r .................................................................................

Fifth year’s d e p r e c i a t i o n ................................

D e p r e c i a t e d value a t beginning of sixth year .

Plant ‘A ’ 74 per cent P lant ‘B* 15 per cent

Loss on Sale

Total D eprecia­ tion Allowance

$ $ $ $

8,000 5,000

600 750 1,350

7,400 4,250

555 638 1,193

6,845 3,612 ·· ··

90

6,755 856 ..

5,899 442 542 984

5,457 3,070

316 368

5,141 2,702

386 405 *66 857

4,755 2,297 ■·

1,100 700

5,855 439

2,997 449 888

5.416 2,548 .. ·â– 

396

SCHEDULE B

M E T H O D S O F C A L C U L A T IN G D E P R E C IA T IO N O N T H E P R IM E C O ST M E T H O D B A SIC R A T E O F D E P R E C IA T IO N — 15 p er cent

T otal D eprecia-

Allowance

O riginal C ost— 1 J u l y .........................................................

F irst year’s d e p re c ia tio n .................................................

A dditional plant purchased a t beginning of second y e a r ..................................................................................

Second year’s d e p r e c i a t i o n .........................................

T hird year’s depreciation . . . . . .

A dditional plant purchased a t beginning of fourth year . . . . .................................................

$

P lant sold on 1 July— O riginal cost . . 1,500

L e s s 3 years depreciation a t 15 p e r cent p er a n n u m ............................................................ 675

D epreciated value a t 1 July . . . . 825

Sale price .........................................................................1,225

Balancing c h a r g e ............................................400

W ritten request m ade under section 5 9 (2a.) that

balancing charge be applied to reduce, fo r the

purpose of calculating depreciation allow able, the cost of plant purchased D educt

D educt depreciated value of p lan t sold . . .

F o u rth year’s depreciation . . . . . . .

(♦Original cost $9,000 less cost of p lan t sold $1,500 = $7,500— 15 p er cent o f $7,500

= $1,125)

F ifth year’s depreciation

P lan t sold on 1 July . . . . . . . .

tB alancing charge included in excess of $1,880, is the am ount by which the actual cost, $4,000, exceeds the depreciated value, $2,520, i.e. $3,480. The

am ount $1,480 is included in the assessable income under section 59 (2.) unless a w ritten request is

m ade under section 59 (2a. ) Sixth year’s d e p r e c i a t i o n .................................................

P lant sold on 1 Ju ly . . .

Loss deductible— Section 59 (1.)

Seventh year’s depreciation .

Seventh year’s depreciation . .

$ $ $ $

9,000 1,350 1,350

7,650

600

1,350 90 1,440

6,300 510

1,350 90 1,440

4,950 420

4,000

400

825 .. ..

4,125 420 3,600

*1,125 90 540 1,755

3,000 330 3,060

1,125 90 540 1,755

1,875 240 2,520

4,400 ..

Excess 1 1,880

1,125 90 1,215

750 150

.. 100

50 50

750 750

N il Nil N il

397

X INCOME AND CAPITAL MAINTENANCE CONCEPTS

10.1 Throughout this Report, the Committee has based

its recommendations on the assumption that the existing tax

system should be taken as given, except to the extent that

there is considered to be a need for changes in order to

correct the distorting effects of inflation. The Committee

has been conscious of the fact that a general review of the

Australian Government's taxation system has recently been

undertaken by the Taxation Review Committee and that the

recommendations of that Committee will be the subject of

separate examination.

Business Income

10.2 In keeping with its general approach, the

Committee has assumed that company tax will continue to be

based on some measure of business income, although the

possibility of a change to a cash flow or transactions base

is briefly considered below. Even if company tax was to be

imposed on a base other than income, the problem of defining

business income for tax purposes would presumably remain,

because of the need to include the income of unincorporated

enterprises in the assessable income of persons. Likewise,

even if steps were to be taken to assess all company income

in the hands of shareholders, or to partially impute company

tax to shareholders along lines considered by the Taxation

Review Committee, it would continue to be necessary to

measure company income for tax purposes.

1

Preliminary Report, pp. 84-94

398

10.3 Although, in a very general sense, both business

income and personal income may be defined in terms of the

accretion of economic power over resources, the concept of

business income differs in some respects from the concept of

personal income. The latter is usually defined in terms of

the goods and services (or the satisfactions which flow from

those goods and services) which may be consumed during a

period while remaining as well off at the end of the period

as at the beginning,* or more simply as the amounts which may

be consumed during the period while maintaining capital

intact. Business enterprises, on the other hand, are

producers of goods and services and are incapable of engaging

in final consumption. Only persons - acting individually or

collectively - can enjoy the satisfactions which flow from

the consumption of goods and services. This means that

business income cannot be defined in terms of the amounts

that may be consumed while remaining as well off at the end

of the period as at the beginning. Instead the concept needs

to have regard to the amounts that may be distributed by a

business enterprise so as to leave the business as well off

at the end of the period as at the beginning.

The widely quoted definition of Sir John Hicks, by referring to expectations, makes it clear that there is a subjective element in the concept of income: Ά man's income (is) the maximum value which he can consume during a week, and still expect to be as well off at the end of the week as he was

at the beginning.1 J.R. Hicks, Value and Capital, Clarendon Press, Oxford, 1939, p. 1?2.

399

10.4 There is another distinction between personal

income and business income, in that in the case of the former

only the persons to whom the income is attributed can decide

the extent to which the possible exercise of their

consumption rights in a period will leave them as well off at

the end of the period as at the beginning. In the case of

business enterprises - especially companies - ownership may

be divorced from management and there may be a conflict

between the views of owners and managers as to the amounts

that may safely be distributed without making the businesses

worse off. The shareholders of a company may be expected to

interpret distribution possibilities by reference to the need

to maintain the value of their own claims on the company's

resources (their net worth), while managers are more likely

to be interested in maintaining the worth of the whole

company, viewed as a separate entity. Expressed in another

way, proprietors may be said to be interested mainly in the

net assets of the company (proprietorship funds less

liabilities), while managers are concerned with the total

assets of the company, irrespective of how those assets are

financed.

10.5 It may thus be necessary to distinguish between

a proprietorship view of income and a management or entity

view in defining business income as the amount that may be

distributed while maintaining intact the capital of the

business. There are other problems associated with the

400

concepts of income and capital maintenance, involving the

pricing or valuation systems which may be used to record

transactions or measure income and wealth, when for any

reason prices change over time.

Valuation Systems

10.6 Four kinds of valuation systems may be

distinguished, based respectively on the actual market prices

of transactions (historical prices), the current prices of

equivalent transactions (current prices), and either the

historical or the current prices of equivalent transactions

expressed in terms of constant purchasing power (constant

prices). The first of these valuation systems is closest to

the one which traditionally has been used in Australia and

other Western countries for purposes of business accounting

and income measurement, although it should be noted that

tnere are some departures from historical prices as a result

of arbitrary valuation rules (such as the so-called cost or

market rule of stock valuation and accelerated depreciation

methods). The income concept associated with this valuation

system is usually described as accounting profit.

10.7 Current prices differ from historical prices

mainly in respect of assets which are purchased by a business

in one income period and used in the process of earning

income in a subsequent period. Of overwhelming importance

for income measurement purposes are two items specifically

mentioned in the Committee's terms of reference for this

401

inquiry, namely stocks purchased in the previous income

period and used to generate income in the current period

(described as opening stocks) and depreciation on fixed

assets (representing an allocation of the cost of the fixed

assets purchased in earlier periods and used to generate

income in the current period). If income is to be expressed

in terms of current prices, adjustments must be made to the

prices of opening stocks and depreciation to convert them to

current prices. Other expenses which are incurred in the

process of earning income (such as labour costs), and the

revenues which give rise to the income, are usually

automatically expressed in terms of the prices of the current

income period. If prices change over time, current prices in

one income period will naturally differ from current prices

in another period. Income expressed in terms of current

prices may be described as current income.

10.8 Income may be expressed in terms of constant

prices over a sequence of income periods, by adjusting income

elements in each period by a price level index intended to

measure changes in the purchasing power of money since a

base period. It is obvious, however, that different constant

price measures will be achieved depending on whether income

elements expressed in historical prices or income elements

expressed in current prices are deflated by the purchasing

power index. This is a matter of some importance because, as

will be seen below, there are different approaches to

402

accounting measurement, and hence to income determination,

based on the different constant price concepts of income. In

terms of logic, it seems to the Committee that income in

constant prices needs to be determined on the basis of

adjustments to current price data, but this is not the

approach that many accountants recommend be adopted as the

basis for expressing income in terms of constant prices.

Where historical price data have been adjusted by means of a

purchasing power index, the resulting income concept is

usually called current purchasing power (or C.P.P.) profit.

Where current price data have been indexed in the same way,

the resulting concept may be described as constant purchasing

power income.

10.9 Although the measurement of income in terms of

constant prices is sometimes described as the indexation of

income, it will be clear that the resulting income concept is

different from the concept of personal income which, it has

been suggested in Part One of this Report, may appropriately

be associated with some form of indexation for tax purposes.

This is because personal incomes continue to be expressed in

terms of current prices in order to assess tax liability;

personal tax indexation is intended merely to remove any

distortions arising from the application of a progressive

rate structure to increases in money incomes which do not

reflect increases in real incomes. The business income

concept which is closest to the income concept associated

with personal tax indexation is income expressed in terms of

403

current prices, that is current income, from which the

distortions associated with the use of different prices to

measure comparable revenue and expense items have been

removed.

10.10 Although it has been useful, in discussing

personal incomes, to contrast money incomes (by which is

meant incomes expressed in current prices) with real incomes

(by which is meant incomes expressed in constant prices), the

Committee believes that it is more appropriate to discuss

business income concepts in terms of a distinction between

historical prices, current prices and constant prices. The

distinction between money incomes and real incomes which was

made in many submissions which the Committee received is

lacking in precision. All business incomes accruing from

market transactions may be regarded as money incomes,

irrespective of the prices in which they are expressed, and

no concept of business income can be regarded as real in the

sense that its adoption will produce a measure of income free

of value judgments and other measurement constraints. No

matter how it is defined, business income remains at least

partly a subjective concept and the notion of real income is

a contradiction in terms.

10.11 The distinction that has been made between

current prices and constant prices is important in the

context of this inquiry, because it is equivalent to another

distinction which is of some significance in examining

404

different income concepts. This is the distinction between

relative price changes and changes in the general price

level. Inflation is usually defined in terms of changes in

prices generally, as measured by an index of general

purchasing power. It is thus possible, on the one hand, for

inflation to occur without any changes in the relative prices

of different goods and services, that is for all prices to

increase in equal proportions. It is likewise possible, on

the other hand, for relative price changes to occur in the

absence of inflation, that is for increases in some prices to

offset falls in other prices to the extent necessary to

prevent any change in the purchasing power index. Despite

these possibilities, however, it is likely that changes in

relative prices will normally be associated with changes in

the general price level. The concept of income which is

adopted by business enterprises in ordering their activities

will depend on the relevance they attach to the different

kinds of price movements in relation to their investment,

operating and distribution policies.

10.12 A final distinction is sometimes made between

different kinds of income concepts depending on whether they

are expressed in terms of flows over time or changes in a

stock position between two points of time. Income may thus

be defined in terms of economic transactions that take place

within a specified income period, for example as the surplus

of revenues over expenses incurred in earning those revenues;

405

or, alternatively, in terms of the accumulation of wealth

between the beginning and end of the income period, for

example as the increase in net assets or net worth. To the

extent that income is conceived as being the accretion of

economic power and defined as the accumulation of wealth or

net worth, the two concepts are of course the same. It is

rather in relation to their measurement processes that the

possibility of divergence exists.

10.13 The foregoing discussion may be summarised by

concluding that differences in income concepts depend partly

on differing interpretations of what it is that has been

accumulated during an income period and is therefore

available for distribution, and of how that accumulation is

to be measured, and partly on differing interpretations of

the capital maintenance concept as it affects the extent of

the possible distribution.

10.14 In the light of the distinctions that have been

made, four accounting measurement systems may be contrasted,

each corresponding to one of the business income concepts and

designed to provide a measure of that concept. These are:

(1) Historical cost (or historical record)

accounting, in which all prices are expressed in

historical prices. The associated income

concept (accounting profit) is measured by

comparing revenues expressed in historical

prices with expenses also expressed in

historical prices. Under this system, capital

406

maintenance is interpreted as the maintenance of

proprietorship capital in terms of historical

prices? that is, it is the original money value

of proprietorship capital which is required to

be maintained intact.

(2) Current value (or current cost) accounting, in

which all prices are expressed in current

prices. The associated income concept (current

income) is measured by comparing revenues

expressed in current prices with expenses also

expressed in current prices. Under current value

accounting, capital maintenance is interpreted

as the maintenance of entity capital in current

prices; that is, the firm's total capital is

required to be maintained intact in terms of its

command over assets expressed in current values.

(3) Current purchasing power (or general price

level) accounting, in which historical price

data are adjusted by means of a purchasing power

index. The associated income concept (C.P.P.

profit) is the sum of two components. The first

is measured by deflating individual revenue and

expense items, as originally expressed in

historical prices, by reference to changes in

the purchasing power index since the

transactions originally took place. The second

component of C.P.P. profit is the purchasing

power gain (or loss) associated with the holding

of net liabilities (or net monetary assets, that

is monetary assets less liabilities) through the

income period; this purchasing power gain (or

loss) is calculated by applying the change in

the purchasing power index to the net liability

(or net asset) holding. Under C.P.P.

accounting, proprietorship capital is required

to be maintained intact in terms of historical

prices adjusted by a purchasing power index.

Capital maintenance is thus interpreted as the

maintenance of proprietorship capital in terms

of general purchasing power; that is, it is the

original money value of proprietorship capital,

adjusted for changes in the general price level,

which is required to be maintained intact.

Relative price level (or constant purchasing

power) accounting, in which current price data

are adjusted by means of a purchasing power

index. The associated income concept (profit

adjusted for relative price changes) is the sum

of three components. The first is measured by

current income calculated in the same way as

under current value accounting. The second is

the gain during the income period from holding

assets, the current values of which have

increased during the period. The third

component (a negative component if prices are

408

rising) is the purchasing power loss on

proprietorship capital or net assets which is

associated with a rise in the general price

level (a purchasing power gain if prices are

falling). Capital maintenance under relative

price change accounting is interpreted in the

same way as under C.P.P. accounting; that is,

proprietorship capital is required to be

maintained intact in terms of historical prices

adjusted by a purchasing power index; that is,

in terms of general purchasing power.

10.15 The Committee has examined these accounting

measurement systems, and their related income and capital

maintenance concepts, with a view to determining their

relevance with respect to the problem of recommending an

appropriate basis for the taxation of business income. In

the following sections of this Chapter, each system is

described in greater detail and explained by reference to a

simple algebraical model.^

For a detailed comparison of the different systems, see A.D. Barton, The Anatomy of Accounting, University of Queensland Press, Brisbane, 1975, Chapters 21-25, and R.L. Mathews, The Accounting Framework, Cheshire, Melbourne, 1971, Chapters 6-9. The following analysis

also draws on a study paper which Professor Barton prepared for the Committee.

409

Historical Cost (or Historical Record) Accounting

10.16 Under this approach, all transactions are

recorded in terms of their original or historical prices.

Periodic income (accounting profit) is measured by recording

both revenues and expenses in terms of their original

transaction prices. Where assets purchased in past periods,

such as fixed assets or stocks, are used to generate profit,

an appropriate share of their historical cost is charged

against revenue as part of the process of profit measurement.

Expressed in another way, accounting profit is equal to the

gain in net assets over the period, where assets are valued in

terms of historical prices. The revenue from sales of goods

and services is associated with an inflow of assets (cash and

other financial assets), while the incurring of expenses is

associated with an outflow of cash, an increase in

liabilities (for credit purchases) or a reduction in

non-monetary assets (reflecting the use of services embodied

in stocks and fixed assets).

10.17 The process of charging expenses against

revenue to determine accounting profit is one of recovering,

from revenues, the resources used in terms of their

historical money values. It follows that, if the whole of

accounting profit is distributed, the original money value of

proprietorship capital is maintained intact; proprietors

thus have the same number of dollars invested in the business

at the end of the income period as at the beginning.

410

simple balance sheet and income equations as follows:

Μ + N = P (1)

h h h

and R - E = Y (2)

h h h

where M = net monetary assets (financial assets less

liabilities)

N = non-monetary assets (stocks and fixed assets)

P = proprietorship capital

R = revenue from sales

E = expenses

Y = income

and the subscript h represents the basis of valuation

(historical prices).

10.19 Because Y, is associated with an increase in net A

assets and augments proprietorship capital, it provides a link

between the income statement and balance sheet as follows:

Y = (Μ + N ) - (Μ — N ) = P - P (3)

h 1 1 0 0 1 0

where the subscripts 0 and 1 represent balance sheet values

(expressed in historical prices) at the beginning and the end

of the income period, respectively.

10.20 Accounting profit is thus represented by the

growth in net assets (expressed in historical prices) during

the income period, assuming that there is no change in

proprietorship capital (additional investment or

withdrawals). This growth results from the excess of

10.18 Historical cost accounting may be represented by

411

revenues over expenses. All balance sheet items, and all

income transactions, are valued in terms of their historical

prices. The income which may be distributed under this

system (Y^) permits capital to be maintained on the basis of

the terms M Q - NQ = PQ in Equation (3).

Current Value Accounting^

10.21 In a comprehensive system of current value

accounting, all revenue and expense transactions and all

balance sheet items are recorded in current prices. The

current value concept of income (current income) is then

measured as the excess of revenues in current prices over

expenses also expressed in current prices. By contrast with

historical cost accounting, under which revenues and expenses

are recorded on the basis of values established by actual

market transactions, current value accounting clearly poses a

more difficult valuation problem. This problem may be

alleviated by maintaining an historical cost accounting

system as the basic recording system, in which all

transactions are originally recorded in historical prices,

and making a limited number of valuation adjustments to

convert historical cost values in the income statement and

balance sheet to current values. 1

1 For detailed expositions of systems of current value accounting, see R.S. Gynther, Accounting for Price-Level Changes: Theory and Procedures, Pergamon Press, Oxford, 1$66; and E.O. Edwards and P.W. Bell, The Theory and Measurement of Business Income, University of California

Press, Berkeley, 1 ^ 4 ^ See also Professor Gynther's paper on 'Capital Maintenance, Price Changes and Profit Determination, The Accounting Review, October 1970.

412

10.22 This approach is made possible by the fact that,

in a particular income period, revenue and most expense

transactions are automatically expressed in terms of current

prices of the period. It is therefore only necessary to make

income valuation adjustments in respect of those items of

expense which relate to assets valued in prices of past

periods, in particular stocks and fixed assets. If current

prices exceed historical prices, current income may thus be

calculated as accounting profit minus a cost of sales

valuation adjustment and a depreciation valuation adjustment.

The size of the adjustments depends on the relationship

between current values and historical values, which also

determines whether tney are positive or negative. Current

values are calculated on the basis of either the current

replacement costs or the net realisable (or market selling)

values of the assets concerned. If it is intended to replace

assets as they are used to generate revenues, current

replacement cost is an appropriate measure of current value;

if it is not intended so to replace assets, market selling

value is indicative of current value.

10.23 In the balance sheet, it is likewise necessary

to revalue only those assets which have current values that

are different from their historical values. Both the income

valuation adjustments and the asset valuation adjustments are

reflected in the balance sheet by revaluation reserves, which

augment the capital originally contributed by proprietors and

413

thus make it possible for proprietorship capital to be

maintained intact in terms of the current values of the

firm's assets.

10.24 Current value accounting may be illustrated by

reference to balance sheet and income equations similar to

the equations which were used to illustrate the historical

cost accounting system (see Equations (1) to (3) above).

Assume that, at the beginning of the income year, the balance

sheet is represented by Μ + N = P, all expressed in current

prices at that time. Then first assume that there are no

revenue or expense transactions during the period, but that

the current value of N increases by q (where q represents a

proportionate increase in the current replacement cost of W)

during the income period. The balance sheet at the end of

the income period then takes the following form:

M + N(1 + q) = P + hq (4)

That is to say, the balance sheet value of non-monetary

assets N has been adjusted in line with the proportionate

increase in the current replacement cost of the assets q, and

proprietorship capital has been augmented by the asset

revaluation reserve Nq. Althougn Nq represents an increase

in value, it is not normally treated as income in a current

value accounting system.

10.25 If it is now assumed that the non-monetary

assets are stocks which are sold during the income period,

current income may be measured as follows:

R - E = Y

c c c

where tile subscript c denotes current value.

(5)

414

10.26 If Equation (5) is compared with Equation (2),

it will be seen that R^ = R_, (because revenue in historical

prices is the same as revenue in current values). However,

Ec exceeds E^ by the amount of the current value adjustment,

that is by the amount by which the current value of the

stocks sold exceeds their historical cost at the time of the

sale. If this income valuation adjustment is denoted by the

symbol Qy , then Ec = E^ + Q^. If, as noted above, R^ = Rc ,

it follows that

Yo - \ - ®h + V - Yh - Qy <6>

That is, current income Yc is equal to accounting profit Y^

less the income valuation adjustment Q^.

10.27 It remains to consider the relationship between

the balance sheet valuation adjustment N in Equation (4) and

the income valuation adjustment Q in Equation (6).

10.28 Where non-monetary assets are sold and replaced

during an income period, the change in the current value of

the assets N between the beginning and end of the income

period is represented by two valuation adjustments, the

income valuation adjustment Q and an asset valuation

adjustment Q&. The income valuation adjustment Q reflects

the price change up to the time when the assets are sold and

replaced, and the asset valuation adjustment Qq reflects the

price change on the assets held from that time until the end

of the income period. Q is converted into 0, by the act of a y

415

sale. At the end of an income period in which assets have

been sold and replaced, and all current income has been

distributed, the balance sheet equation may be expressed as

follows:

M + N(1 + q) = P + Q + Q (7)

y a

10.29 It may be noted that the equation Ng =

holds for stocks irrespective of the number of times the

stocks turn over during the income period. It is clear from

Equation (7) that, even if the whole of current income is

distributed, the firm's augmented proprietorship capital

P + Q„ + Q = is able to finance the holding of the non-monetary y a assets at their higher current values. It is for this reason

that current value accounting is sometimes said to maintain

the productive capacity of the firm in a period of changing

prices.

10.30 The income valuation and asset valuation

adjustments are sometimes described as realised and

unrealised holding gains respectively, because they represent

increases in the value of assets (above their historical

cost) which result from holding the assets during a period of

rising prices. The unrealised holding gain is the gain that

accrues on the asset up to the time of sale; it is converted

into a realised holding gain by the act of sale, when the

asset is absorbed into cost. Although the unrealised holding

gain (or asset valuation adjustment) reflects an unrealised

price change while the realised holding gain (or income

416

valuation adjustment) reflects a gain from sale, both gains

are locked into the current value of stocks which continue to

be held at the end of the income period and can only be

released by a fall in prices or a running down of assets in

physical terms.

10.31 The effect of the valuation adjustments (or

holding gains) taken together is to ensure that items in the

current value income statement are revalued in terms of

current prices of the income period, while the current value

balance sheet is revalued in terms of current prices at the

end of the income period. Where an approximate method of

calculating the valuation adjustments is used, the objective

must be to measure current income in terms of average current

prices of the income period, centred on the middle of the

period if transactions take place throughout the period, and

to measure balance sheet values in terms of prices at the end

of the period.

Current Purchasing Power (or General Price Level)^ Accounting

10.32 Under this system, financial statements (income

statement and balance sheet) prepared on the basis of

This system is described in: Accounting Research Study No. 6, Reporting the Financial Effects of Price-Level Changes, American institute of Certified Public Accountants, New York, 1963; Statement of the Accounting Principles Board No. 3, Financial Statements Restated for General Price-Level Changes, American Institute of Certified Public Accountants, New York, 1969; Exposure Draft of the Financial Accounting Standards Board, Financial Reports in Units of General Purchasing Power, American Institute of Certified Public Accountants, New York, 1974; Provisional Statement of Accounting Practice No. 7, Accounting for Changes in the Purchasing Power of Money, Institute of Chartered Accountants in England and Wales, London, 1974; and Preliminary Exposure Draft, Accounting for Changes in the Purchasing Power of Money, Australian Accounting Standards Committee, Sydney, 1974.

417

historical cost accounting are adjusted for changes in the

general price level (or purchasing power of money) since the

transactions represented in the financial statements were

originally recorded. By contrast with current value

accounting (which records the valuation adjustments and the

associated revaluation reserves in the books of account),

C.P.P. accounting is usually restricted to the preparation

of supplementary financial statements outside the books of

account.

10.33 Insofar as the balance sheet is concerned,

non-monetary assets are revalued in terms of changes in the

general price level (as measured by a purchasing power index)

between the time the assets were acquired and the date of the

balance sheet. Monetary items (financial assets and

liabilities) are not revalued because their contractual value

remains fixed in terms of their original money amounts.

Instead a purchasing power gain (or loss) is recognised in

respect of the holding of liabilities (or financial assets)

and taken into account as an adjustment to the profit, which

is also adjusted for price level changes affecting revenues

and expenses.

10.34 C.P.P. accounting may be illustrated by

reference to the same symbols as those used in earlier

examples. It is assumed that the general price level

increases proportionately by p between the beginning and end

of the income period and, initially, that there

are no revenue and expense transactions during the income

418

period. The balance sheet Μ + N = P may then be revalued at

the end of the income period by applying an adjustment factor

(1 + p) to each item:

Μ (1 + p) + N (1 + p) = P(1 + p) (8)

10.35 But because the value of M remains fixed in

terms of the original contractual obligations entered into

with debtors or creditors, it is more meaningful to express

Equation (8) in a different form by transposing Mp to the

right-hand side:

M + N(1 + p) = P(1 + p) - Mp (9)

The term M then represents net monetary assets in terms of

purchasing power at the end of the income period, while

N(1 + p) is the restated value of non-monetary assets on the

same basis.

10.36 In the income statement, all revenue and expense

items are revalued in terms of their purchasing power

equivalents at the end of the income period (not, as in

current value accounting, in prices during the period). From

the difference between revenues and expenses revalued on this

basis is deducted (or added) the purchasing power loss (or

gain) on net monetary items to arrive at C.P.P. profit:

C.P.P. profit may therefore be represented thus:

Y = R - E - ML (10)

g g g p

where the subscript g denotes a general price level adjusted

basis of valuation. Revenue and expense transactions will be

reflected in Equation (9) by changes in M and N, but if

C.P.P. profit (after allowing for the purchasing power loss

419

Mp) is fully distributed the restated proprietorship capital

P(1 + p) will still command the same general purchasing power

at the end of the income period as at the beginning. This

result is achieved, in effect, by increasing assets through

income transactions to the extent necessary to offset the

purchasing power loss Mp. Under the C.P.P. approach, capital

maintenance thus means preserving the general purchasing

power of proprietorship capital. Because it is the historical

value of proprietorship capital which is preserved in terms

of general purchasing power, it follows that proprietorship

capital will not necessarily continue to command the same

volume of non-monetary assets at the end of the income

period, if the prices of those assets have changed at rates

which differ from the proportionate change in the general

price level.

10.37 Although C.P.P. profit may be derived by

reference to historical profit adjusted for general price

level changes and the purchasing power loss (or gain) on net

monetary items, conceptually it may be regarded as the change

in the general purchasing power of proprietorship capital

between the beginning and end of the income period, assuming

that there have been no additions or withdrawals of capital

during the period.

420

Relative Price Level Accounting 1

10.38 This approach effectively combines a current

value system with a C.P.P. system. Income is the sum of

three components. The first is defined as the difference

between revenues and expenses expressed in current prices,

and is thus equivalent to the current value concept of

income. The second component of income is represented by the

changes in current value, or holding gains or losses, on

non-monetary assets; by contrast with current value

accounting, these are regarded not as valuation adjustments

but as income available for distribution. The third

component of relative price level income is represented by

the purchasing power loss (or gain) on proprietorship capital

or net assets which results from the fact that the purchasing

power of capital changes as the general price level rises (or

falls) .

1 See R.J. Chambers, Accounting Evaluation and Economic Behavior, Prentice Hall, Englewood Cliffs, 1966, for a system based on this approach. Professor Chambers incorporates in his system current values based on so-called current cash equivalents (or current realisable values), whereby holding gains and losses are recognised continuously throughout the income period. See also R.J. Chambers, 1 Second Thoughts on Continuously Contemporary Accounting', Abacus, September 1970. See also Edwards and Bell, op.cit., for an illustration of relative price level accountrng.

421

10.39 The effect of the third component is to adopt a

capital maintenance requirement that is the same as that used

under C.P.P. accounting. Income is thus not attributed to

the firm until the general purchasing power of proprietorship

capital is seen to be preserved, and proprietorship capital

is maintained intact in the sense of its command over general

purchasing power rather than its command over the assets

actually held by the firm.

10.40 Symbolically, income Yr under this approach may

thus be calculated as follows:

Yr = Rc - Ec + Nq - pp (11)

Because P = W + i4, it follows that liquation (11) may be

restated as follows:

Yr = hc - Ec + N(q - p) - M (12)

The three components of relative price level income are thus

seen to be: (a) current income (Rc - Ec); '(b) the relative

holding gain on non-monetary assets reflecting the extent to

which the rate of increase in the current values of the

assets (q) has exceeded the rate of increase in the general

price level (p); and (c) the purchasing power loss on net

monetary assets (M^).

10.41 If the firm's balance sheet at the beginning of

the income period is given by P = M + «, and income from

trading activities is ignored, the balance sheet at tne end

of the income period may incorporate the valuation

adjustments in the following way:

Μ + N (1 + q) = P (1 + p) + h (q “ p) - Mp (13)

422

10.42 It will be seen that the distribution of

N(q - p) - Mp as income would require net assets to be

reduced by a similar amount, with the following effect on the

balance sheet:

M + N(1 + q) - M(q - p) + Mp = P (1 + p) (14)

It may be seen from Equation (14) that proprietorship

capital commands the same general purchasing power at the

end of the income period as at the beginning. But if

N(q - p) is not equal to Mp, then P (1 + p) does not command

the same quantity of the kinds of assets which are actually

held by the firm as P did at the beginning of the income

period.

423

XI THE TAX BASE : CRITERIA FOR BUSINESS TAXATION

11.1 Whether business income is regarded as a

desirable - or even as a satisfactory - base for the

taxation of companies and unincorporated businesses will

depend on the view that is taken about the capacity of

business enterprises to pay tax. This in turn is likely to

depend on the incidence of business taxation - about which

our knowledge is remarkably limited - and on the choice of

tax criteria, of which those discussed by the Taxation

Review Committee are accepted by the Committee as being of

special relevance. These are equity, simplicity,

efficiency, and flexibility for purposes of economic

management.^

Business and Taxation Concepts of Income

11.2 It will be clear from the preceding Chapter,

however, that there are widely divergent views about the

concept of business income. These differences of viewpoint

exist not only among academic accountants and members of the

accounting profession who are chiefly responsible for the

design and operation of accounting measurement systems, but

also among members of the business community.

11.3 For financial reporting purposes, the

predominant system in Australia and other Western countries

is still the historical cost accounting system, modified in

a number of respects by means of somewhat arbitrary 1

1 Preliminary Report, Chapter 3.

424

valuation adjustments to the historical values of stocks,

depreciation and fixed assets. But there are signs that

this position is changing. To an important extent, the

changes are a direct consequence of the rate of inflation.

Rapid inflation makes historical values diverge increasingly

from current values or C.P.P. values, and prevents

accounting records and financial statements from conveying

information which must be considered relevant and necessary

for business policy decisions and financial decisions by

shareholders, investors, creditors, trade unions,

administrative tribunals and other government agencies.

11.4 Evidence placed before the Committee indicated

that some companies in Australia have begun to base their

accounting systems on a current value, C.P.P. or relative

price level accounting approach, and that the main

professional bodies (the Institute of Chartered Accountants

in Australia and the Australian Society of Accountants) are

considering the possibility of recommending the adoption of

either C.P.P. accounting or current value accounting.1

The adoption of C.P.P. accounting by means of the

presentation of supplementary financial statements has been

recommended by the main professional bodies in the United

Kingdom (the Institute of Chartered Accountants in England 1

1 An Exposure Draft has already been issued on C.P.P. accounting by the Australian Accounting Standards Committee of the two bodies (Accounting for Changes in the Purchasing Power of Money, op. cit.), and an alternative exposure draft on current value accounting is presently under consideration by the Committee.

425

and Wales)1 and the United States of America (the American

Institute of Certified Public Accountants).2

11·5 Which approach is eventually adopted for

business accounting purposes will no doubt depend on the

relevance of the different information systems to the

problems of business. Meanwhile, it seems clear to the

Committee that proposed changes in the taxation system

cannot be based on an assumption that there is universal

agreement about what constitutes business income.

11*6 Although it has long been recognised that there

are administrative advantages in relating the tax base to

the measure of income which is used for ordinary business

purposes, this has not prevented important differences from

developing between taxable income and the measure of income

that is derived by reference to generally accepted

accounting principles. Because the purposes of business

taxation are different from the purposes of income

measurement for financial reporting and management purposes,

the Committee accepts that there may be good reasons for

such divergences. In the course of its inquiry, it has

received numerous submissions proposing the removal of some

of these differences, involving notably depreciation on

1 Provisional Statement of Accounting Practice No. 7, Accounting for Changes in the Purchasing Power of Money, op. cit.

2 Statement of the Accounting Principles Board No. 3, Financial Statements Restated for General Price-Level Changes, op. cit.

426

commercial and industrial buildings, provision for

employees' long service leave pay, holiday pay and sick

leave, provision for doubtful debts and provision for

inflation-increased superannuation or retirement

allowances.

11.7 In examining these submissions, the Committee

has taken the view that its terms of reference restrict it

to a consideration of problems which have been caused by

inflation and which would not exist in the absence of

inflation; it has not accepted the argument that it should

propose changes to the tax system merely because problems

have been accentuated by inflation. It has taken this view

partly because it has not been possible in the time

available to examine the detailed issues involved, and

partly because it would not in any case have been possible

to consider the issues except within the context of an

overall framework for the tax system. The Committee is

conscious that responsibility for this broader task has been

entrusted to the Taxation Review Committee, but recognises

that inflation has greatly exacerbated these problems.

A Pragmatic Approach

11.8 The Committee's views about the appropriate

summarised as requiring a pragmatic approach to the 1

1 Submissions on this topic were received, for example, from the Institute of Directors in Australia, the Taxation Institute of Australia, the Associated Chambers of Manufactures of Australia and numerous individual enterprises.

427

definition of income. Conceptually, there is room for

argument about what constitutes income for either business

or taxation purposes, and the concept which is adopted for

any particular purpose must be related to the objectives

which it is sought to achieve in relation to that purpose.

This means that the Committee does not accept that there is

any measure of income which can be called 'true profit' or

'true income' and which, it is implied, should be used as a

definitive measure of the tax base. Conversely, the

Committee does not accept the proposition, advanced in many

submissions which it received, that it is necessarily wrong

in principle for so-called 'fictitious profits', 'unreal

profits', 'paper profits' or 'stock profits' to be included

in the tax base.

11.9 In its submission, the Australian Treasury

concluded that "while the matter is complex, it is difficult

to see that there is any special flaw in the way taxation is

levied on businesses or that it involves taxation of more

than true money income. A change in the way profit is

calculated for income tax purposes would seem rather to

involve a 'concession* which would create, rather than

correct, a departure from taxation on true money profit."

For the reasons given above, the Committee does not accept

the view that there is a concept of 'true money profit',

which has universal validity as the tax base and which must

never be departed from. As the Treasury pointed out

elsewhere in its submission, the choice of an income concept

428

for purposes of business taxation must take into account not

only the effects on business which flow from the use of that

concept, but also the need to maintain equity in the tax

system as a whole.

11.10 For similar reasons, it is not sufficient to

argue, as several submissions did, that taxation based on an

historical cost concept of accounting profit is

inappropriate because it may involve an element of capital

taxation. Governments consciously tax capital in all kinds

of ways, and the fact that a particular form of taxation

involves a tax on capital is not itself a sufficient reason

for rejecting it.

11.11 Nevertheless, the Committee does not believe

that any business tax - income or capital - should have

unintended results. Nor should it be imposed on such a

base, or at such a rate, as to make it impossible for the

taxpaying firms to generate income on a stable and

continuing basis. Even from the narrow perspective of

maintaining the Government's own revenue yields, such a

policy must obviously be self-defeating in the long run.

But from the wider viewpoint of the ability of business

enterprises to continue operating, investing and employing

labour and other resources, the effects of such confiscatory

taxation are likely to be disastrous.

The Test of Business Survival

11.12 Without wishing to over-dramatise the

situation, the Committee believes that the taxing,

accounting and pricing policies which have traditionally

429

been adopted in relation to business enterprises, when

combined with the rates of inflation which have recently

been experienced in Australia, are incompatible with the

continued existence of the private sector. As has been

noted in Chapter VIII, if accounting, pricing and taxing

policies are all based on historical cost accounting

measures and if inflation proceeds at a rate of 15 or 20 per

cent p.a., there are relatively few options available to a

firm and none is capable of providing a final solution to

tne problem. The options are continuously to improve

efficiency, continuously to increase profit mark-ups and

prices relative to historical costs, steadily to reduce

profit distributions to proprietors (eventually to the point

of extinction), continuously to increase indebtedness or

inject fresh capital into the firm in order to maintain the

scale of its operations, or steadily to reduce the scale of

operations (eventually to the point of liquidation).

11.13 The significance of the rate of inflation is

that firms can adapt to modest price changes by adopting one

or other (or a combination) of these policies, but that this

power of adaptation disappears when the rate of inflation

passes a critical point (which the Committee judges is well

below the present rate). Certainly it is not possible (even

if it were considered desirable) for many firms continuously

to increase profit margins in an economy experiencing

recession as well as inflation, nor is it possible

430

continuously to raise additional finance (through profit

retention, borrowing or new capital raising) under

conditions of a depressed capital market. This leaves the

liquidation of firms as the most likely eventual outcome -

indeed it must be regarded as the inevitable outcome - if

significant changes are not made in accounting, business and

taxing policies. There is evidence that most firms have

begun to experience the difficulties of adapting to rapid

inflation by the means which have been described, that many

have reached the limits of adaptation and, indeed, that some

have already succumbed.

11.14 In making this gloomy assessment of the

situation, the Committee emphasises that it is not asserting

that changes in the basis of taxation will, by themselves,

restore the capacity of business enterprises to operate

effectively and continuously. Changes in business policy

will also be necessary, at least to the extent that firms

are not already adopting rate of return, pricing and

distribution policies which will ensure their continued

profitability and existence. But the Committee believes

that changes in the basis of business taxation, while not a

sufficient condition for the restoration of business

stability, must be regarded as a necessary condition.

11.15 The problem is not merely an Australian

problem. The Australian Council of the International

Chamber of Commerce (ICC) presented a report to the

Committee which had been prepared by the Chamber's

Commission on Taxation and endorsed by its Executive

431

Committee. This report suggested that:

"...the fall in the value of money which has already been witnessed has imposed severe strains on the capacity of both the public and private sectors to maintain, much less improve upon, past levels of production. Continuing inflation at an increasing rate

threatens the whole basis of national standards of living by bringing about a collapse of the organisational framework within which employment, technology, enterprise and capital are brought

together."

The Chamber concluded that:

"The dangers of a shortage of funds in the private sector of many national economies threaten a severe decline in productive capacity and employment with disastrous secondary consequences for world trade and

investment. It is against this background that ICC requests governments to re-examine urgently the adequacy and appropriateness of their taxation policies in relation to profits in a world of mounting inflation."

The Committee has noted elsewhere the action that has been

taken in the United Kingdom in response to the problem,

including the appointment of the Committee on accounting for

inflation (the Sandilands Committee).

11.16 It will be clear from the discussion in Chapter

X that there is room for genuine disagreement about the

appropriate tax base for purposes of business taxation. But

there is one over-riding criterion which must be met before

any consideration can be given to the other criteria of equity,

simplicity etc. - which need to be taken into account in

devising tax policies. This is the need to ensure that

there is no provision built into the tax system itself which

will prevent firms from maintaining long-run financial

432

stability and continuity of investment and operations. The

ultimate test of a business tax system is thus its

compatibility with business survival itself.

11.17 The discussion so far has been concerned with

the tax base. It may be thought that, as an alternative to

changes in the tax base, business prosperity and survival

may be facilitated by reductions in the rate of company and

other income taxes. Indeed several submissions have argued

for rate reductions, or for rate reductions as well as

changes in the tax base.

11.18 Although the Committee recognises that changes

in the rates of business taxation need to take place from

time to time for all kinds of policy reasons, it does not

regard a reduction in the rate of company (or other

business) tax, while retaining the existing tax base, as an

effective alternative means of dealing with the problem that

has been described. This is because the equity and

efficiency of the tax system depend on a definition of the

tax base which is related to the capacity of individual

firms to pay tax. If the tax base is not designed to yield

such a distribution of the burden, the effects of rate

changes must be arbitrary and will not necessarily achieve

the desired result of enabling firms to remain in business.

Tax Criteria

11.19 If there is to be any substantial change in the

basis of business taxation, there are obvious implications

for the equity of the tax system, both within the business

433

sector and in relation to other taxpayers. There are also

implications for the allocation of resources, again both

within the business sector and in the economy as a whole.

If the business revenue base were to be reduced following a

more restrictive definition of income, while tax rates were

to remain unchanged, certain consequences would follow.

Either tax yields would be reduced (with a consequent

diversion of resources from the public to the private sector

or, if government spending were to continue unabated, witn

an increase in inflationary pressures), or personal and

other taxpayers would be required to make good the revenue

shortfall.

11.20 However, it will be shown below that a more

restrictive definition of the tax base does not necessarily

imply a diminution in the revenue base or a reduction in tax

yields; there may be offsetting increases in the revenue

base, as a result of changes outside the taxation system.

The Committee believes that it is possible, through the tax

system, to encourage such changes and thereby limit the loss

of revenue and the consequent repercussions for other

taxpayers. Proposals to this end follow the Committee's

recommendations for changes in the basis of business

taxation.

11.21 In evaluating the various proposals which have

been made for changing the business tax system, the

Committee has had regard to a number of other criteria

which, provided the basic test of compatibility with

business survival has been met, it considers important.

434

These are the criteria adopted by the Taxation Review

Committee, namely equity, simplicity, efficiency and

flexibility for purposes of economic management. Equity is

concerned with the distribution of the tax burden among

different taxpayers. An important aspect of equity is

associated with the aim of achieving simplicity in the tax

system; this is the problem of limiting opportunities for

tax avoidance. Simplicity is also linked with

practicability. The Committee has judged that, if proposed

changes in the tax system are too complicated or too

difficult for the Commissioner of Taxation to administer and

control, or too costly for taxpayers to comply with, they

must be judged to be impracticable.

11.22 Efficiency is concerned with the effects of

taxation on the generation of incomes and wealth (through

incentives to produce, save, take risks or invest) and on

the allocation of resources among competing uses (including

balance between the public and the private sectors).

Flexibility is concerned with the effects of taxation on

price, income and balance of payments stability. Insofar as

inflation is concerned, taxation may be either a cause or a

consequence, and in considering the effects of inflation on

taxation it is also necessary to consider the possibility of

moderating inflation through the adoption of appropriate tax

policies.

435

Conolusion

11.23 The Committee's views on the business tax base

and on tax criteria may thus be summarised as follows:

(a) There is a need for a change in the tax base,

in concert with other changes in management

accounting and business policies, to prevent

the winding down of business activity which

will otherwise be the inevitable consequence of

inflation.

(b) The over-riding criterion in the selection of

the tax base must be its compatibility with

long-run business stability and continuity of

existence.

(c) Only when that requirement has been met can

consideration be given to other tax criteria -

equity, simplicity, efficiency and flexibility

- which the Committee considers to be

important.

(d) As far as possible, any change in the tax base

needs to be accompanied by action designed to

limit loss of tax revenue and preserve the

equity and efficiency of the overall tax

system.

437

XII ALTERNATIVE APPROACHES TO BUSINESS INCOME TAXATION

12.1 Submissions received by the Committee were

invariably directed towards reducing the impact of inflation

on the taxation of companies and other business enterprises.

To this end, four types of changes in the tax base or in

methods of taxation were proposed, corresponding to the four

kinds of income concepts and accounting measurement systems

described in earlier Chapters. The proposed changes may be

summarised in terms of one of the following alternatives:

(1) Modifications to the historical cost basis of

business taxation, while retaining the essential

characteristics of historical cost accounting for tax

purposes and continuing to use a modified version of

accounting profit as the measure of taxable income.

(2) The substitution of some form of current value

accounting for historical cost accounting as the basis of

business taxation, and the adoption of current income (or

some variant thereof) as the measure of taxable income.

(3) The adoption of C.P.P. accounting as the basis

of business taxation, and the adoption of adjusted C.P.P.

profit (or some variant thereof) as the measure of taxable

income.

(4) The adoption of relative price level accounting

as the basis of business taxation, and the use of the

associated income concept as the measure of taxable income.

438

12.2 In the following sections of this Chapter,

proposals in each category are described and evaluated by

reference to their possible advantages and limitations. In

addition to the test of compatibility with business

survival, the Committee's evaluation has had regard to the

questions of equity, simplicity, efficiency and flexibility

which were discussed briefly in the preceding Chapter.

Modifications to the Historical Cost Concept of Profit

12.3 Under this heading, the most important

recommendations received by the Committee related to:

(a) recognition of the last-in-first-out (LIFO)

method of accounting for stocks or the

associated base stock method;

(b) the use of accelerated or flexible depreciation

methods, or investment allowances;

(c) full deduction against assessable income, in

the year of acquisition, of the costs of

acquiring trading stocks, plant and equipment;

(d) acceptance of periodic revaluation of assets as

a basis for calculating depreciation allowances

for tax purposes.

12.4 A manufacturing company also suggested that a

more equitable system than the LIFO basis of accounting for

stocks would be that "of a tiered system of taxation, i.e. a

rate of tax on trading profits and a lower rate on 1paper

profits' arising from inflationary factors". The proposed

439

differentiation of profits is analogous in some respects to

proposals considered below under the heading of current

value accounting, but implies a lesser departure from

historical cost accounting.

12.5 Some submissions were also received advocating

the use of so-called variable or direct costing methods of

accounting for fixed manufacturing overheads as an

alternative to the so-called absorption costing methods

which have traditionally been used. Variable costing

involves the charging of fixed manufacturing overheads to

income periods rather than to products, with the result that

stocks are valued on the basis of variable costs only. The

relationship between accounting profit calculated on an

absorption costing basis and profit calculated on a variable

costing basis depends on the relationship between production

and sales.

12.6 The Broken Hill Proprietary Company Ltd., in

addition to recommending acceptance of the LIFO method of

stock valuation (or, as an alternative, a deduction from

income based on the application of an index to opening stock

values), thus made the following proposal:

"We recommend that an option be given to vary the basis of cost used in valuing inventory for income tax purposes without the disadvantage of adjustment to taxable income by the Commissioner. Currently, where a

taxpayer wishes to eliminate fixed costs from 'cost1 for inventory valuations, i.e. to change from an absorption costing basis to a direct cost basis in

determining the cost of goods sold or in inventories for income tax purposes, an adjustment is made by the Commissioner which effectively disallows as a deduction

440

the expense to be excluded from inventory valuation. Under our proposal fixed costs would be deducted in the year they are incurred in arriving at taxable income irrespective of whether absorption costing or direct costing is adopted for accounting purposes."

12.7 The Committee does not consider that this

question relates directly to the problems on which it has

been asked to report, and it therefore makes no

recommendation in respect of the proposal.

12.8 Most submissions favouring LIFO accounting for

stocks or accelerated depreciation regarded them as

second-best solutions, which it was suggested should be

accepted pending general acceptance of preferred solutions

involving the adoption of current value or C.P.P.

accounting. Thus the Australian Retailers' Association, in

recommending the introduction of C.P.P. accounting, made

the following observation: "As such a system of indexed

accounting (even if only for taxation purposes) would take

some time to implement we also call for some measures which

are designed to give the corporate sector immediate relief."

These measures included 'a switch to the LIFO method of

inventory valuation1 and 1 introduction of accelerated

depreciation rates'.

12.9 Similarly, the Australian Industries

Development Association, in recommending that the Committee

recognise the validity of current value accounting,

suggested interim action including acceptance of LIFO as an

additional option in accounting for stocks, deductions for

441

what the Association called stock inflation allowances and

depreciation inflation allowances based on a purchasing

power index, investment allowances, and acceptance of "tax

depreciation rates determined by the taxpayer and as used in

preparing published accounts". The Association also

suggested that the tax system should "allow for the

inflation effect on the profit gained through the sale of a

capital item purchased for resale at a profit". In the

absence of a capital gains tax, such capital items may be

regarded as trading stocks and dealt with in the manner

proposed by the Committee in later Chapters of this Report.

The other recommendations of the Association may also be

considered in the context of the discussion in later

Chapters, but the Committee notes in passing that it does

not accept the proposal that the different kinds of stock

and depreciation allowances should be regarded as cumulative

rather than as options.

12.10 The professional accountancy bodies, which for

reasons discussed below have long had reservations about the

use of LIFO for accounting purposes, have proposed that LIFO

be permitted for taxation purposes as an immediate measure.

The submission made on behalf of the Australian Society of

Accountants and the Institute of Chartered Accountants in

Australia by the Joint Taxation Committee of the Australian

Accounting Research Foundation thus reached the following

conclusion:

442

”... the accountancy profession generally, both within Australia and overseas, whilst recognising the inadequacies of historically based accounts, has not yet resolved the complex technical problems surrounding the seemingly simple aim of stating accounts in real terms ...

At this stage, ... the Committee feels that it can only suggest some form of compromise solution which will at least move toward correcting the taxation disadvantages

inherent in historical cost measurement of stocks (and also of depreciation on non-current assets)."

12.11 The Joint Committee indicated that among the

compromises it considered were interim tax concessions for

increases in the value of stocks along the lines of the

provisions adopted in the United Kingdom in November 1974

(these concessions are discussed below), depreciation based

on revalorisation or revaluation of plant and equipment

(also discussed below) and special (i.e. accelerated)

depreciation allowances. Insofar as stock valuation was

concerned, the Joint Committee came to the view that; "...

while it prefers and would urge the adoption in financial

reporting of replacement cost or current value accounting,

as a relatively simple method of recognising and giving

immediate relief for the problems it has discussed it would

suggest that the LIFO method of inventory valuation should

be permitted as an alternative method of stock valuation for

the purposes of the Income Tax Assessment Act".

443

Last-in-first-out (LIFO) Accounting for Stocks^-12.12 Under the LIFO method of stock valuation it is

assumed that, for purposes of valuing the cost of stocks

sold or used in production during an income period (and also

of valuing stocks remaining unsold or unused at the end of

the period), the stocks which are sold or used are those

which have been most recently acquired. The LIFO method is

thus a pricing assumption which has no regard to the actual

movement of stocks; the assumption has obvious relevance

to the problem of profit measurement and balance sheet

valuation when the unit prices of stocks are changing over

time.

12.13 LIFO may be contrasted with the

first-in-first-out (FIFO) method of stock valuation, which

assumes that stocks are sold or used in the order in which

they have been acquired; that is, the oldest stocks are

assumed to be sold or used first. Another pricing approach

involves the use of average cost, whereby it is assumed that

all stocks are pooled whenever fresh acquisitions are made

and that their weighted average cost may be used as the

basis of costing sales or issues. Business enterprises also

use other bases of stock valuation, such as identified cost,

standard cost and the retail inventory method, but these are

In examining the LIFO method of stock valuation, the Committee was greatly assisted by two papers presented with submissions: Arthur Andersen & Co., The Last-In, First-Out (LIFO) Method for Valuing Inventories, August

1974; and Price Waterhouse & Co., LIFO Revisited: Accounting for Income Tax Considerations of a change to LIFO Costing for Inventories, December 1974.

444

not directly relevant to the problems being considered by

the Committee and are not discussed further. In the context

of this discussion, it may be noted that the FIFO and

average cost methods are permissible for tax purposes in

Australia but that the LIFO method is not (see Chapter IX).

12.14 The significance of the alternative assumptions

is that, provided stock levels do not fall, LIFO results in

stocks being absorbed into cost at prices which are close to

the current costs of replacing the stocks. When prices are

rising, the recorded cost of stocks sold or used is thus

higher under LIFO than under FIFO, and reported profit is

lower. The balance sheet value of unsold stocks is lower

under LIFO than under FIFO, and if prices and stock levels

rise continuously over a period the LIFO value will

increasingly diverge from the current cost of acquisition.

When prices are falling, LIFO cost is lower than under FIFO,

while reported profit and the balance sheet value are

higher. Average cost gives intermediate values in each

case.

12.15 On the basis of postulated changes in prices

and stock levels, the relationships between alternative

pricing methods are analysed, and compared with current

value methods of accounting for stocks, in Appendix C.

It will be seen that, if stock levels fall, the

relationships become more complicated, and LIFO costs may

exceed FIFO costs, even when prices are rising.

445

12.16 Advantages of LIFO. The main advantage of LIFO

is that it is relatively successful in matching current

costs against current revenues, and thus helps to overcome

one of the major disadvantages of historical cost (FIFO)

accounting. As a corollary, if the lower reported profit is

used as the tax base and as the basis for determining

dividend distributions or profit withdrawals, the lower

distributions relative to the FIFO method improve the cash

flow position and thus help to finance the higher cost of

holding stocks. LIFO thus helps to establish a reasonable

measure of distributable profit.

12.17 As a variant of historical cost accounting,

LIFO also has the advantage of being compatible with the

existing system of recording transactions. The method is

understood in some other countries, for example the U.S.A.,

the Netherlands, Italy and Japan, and is administered in

those countries within well established rules. The

Committee received many submissions from companies, some of

them international companies with experience of LIFO

accounting, recommending that it be permitted for tax

purposes. Dow Chemical (Australia) Ltd. thus provided an

outline of a system of LIFO accounting, based on the

so-called dollar-value method described below, which it was

considering adopting for management purposes. The Company's

submission included the following observations:

446

"Whilst the results of our first exercise in accounting for inflation are unpalatable and disturbing for management, the logic appears to bear out and support the necessity for such a method. It further highlights that, without some relief from taxation upon unrealisable - but reported - taxable profits, a

liquidity problem will develop.

Attached is a brief outline of the method ... Whilst the method at first reading may appear to be a difficult process, our practical experience is that the exercise is no more complicated than many other normal

and accepted accounting procedures."

12.18 It is usually regarded as a disadvantage that,

when stock levels fa'll, the LIFO profit figure tends to be

higher than the FIFO figure. But for purposes of business

taxation this may appropriately be considered an advantage.

As shown in Appendix c, LIFO tends to bring back into

profits (and hence the tax base if taxable income is based

on LIFO profit) implicit reserves which are no longer needed

to finance the holding of stocks (to the extent that the

level of stocks has fallen). The LIFO method thus tends to

adjust profits automatically in the direction which seems

appropriate for taxation purpose, if increases in current

costs are considered to justify tax deferment but not

permanent tax exemption. As Appendix C shows, however, the

use of LIFO in practice is likely to raise complications

which may make this apparent advantage illusory, unless the

complicated so-called dollar-value LIFO method (which is

described below) is adopted.

12.19 Disadvantages of LIFO. One of the main

disadvantages of LIFO is that balance sheet values may

diverge increasingly from the current costs of acquiring

stocks. It should be noted, however, that it is possible to

447

adapt the LIFO method in such a way as to record historical

(FIFO) or current values in the balance sheet. Such a

procedure, involving the recording of both LIFO and FIFO

stock values and the creation of revaluation reserves, was

described in the submission from Dow Chemical (Australia)

Ltd. The difficulty with this appraoch is that, while it

may go some way to achieving the same result in financial

statements as the current value methods examined below, it

is much more complicated to apply and is still subject to

the other disadvantages of LIFO noted below.

12.20 Unless a consistent basis of valuation is used

in both the income statement and balance sheet, or the

difference is specifically noted, the statements are

difficult to interpret. The capricious behaviour of LIFO

values under certain conditions makes it difficult to assess

the extent to which LIFO profits may be regarded as

distributable without weakening the firm's financial

position, and throws doubt on the inter-firm equity of using

such profits as the measure of the tax base. Evidence

presented to the Committee suggested that it would be

difficult to apply LIFO in all industries, thus throwing

further doubt on the overall equity of the method.

12.21 Because LIFO costs only approximate current

costs when stock levels are not falling, the manner and

timing of the introduction of LIFO for tax purposes would

need to be carefully considered if disadvantageous results

were not to be achieved from the point of view of those

448

advocating the use of LIFO. This is a matter of some

importance at the present time in Australia, because the

evidence suggests that the level of stocks has been building

up quite significantly during 1973-74 and 1974-75, and it is

possible that the economy may move into the downward phase

of the stock cycle. The possibility of downward price

movements must also be considered. In the event of

recession, LIFO profits and taxes would tend to rise, thus

behaving perversely. The Committee does not accept the

assertion, made in one submission opposing the use of LIFO,

that LIFO costs would necessarily be lower, and taxable

profits higher, in the year in which LIFO was introduced for

tax purposes. It would in any case be necessary to protect

the revenue by requiring opening stocks in the year of

introduction, as well as acquisitions during the year, to be

accounted for on a LIFO basis.

12.22 The Committee has noted that the United States

Internal Revenue Code (subject to some minor exceptions)

permits LIFO to be used and where it is used requires its

adoption for both tax and financial reporting purposes.

12.23 if separate LIFO records are maintained for

each line of stpck by what is described as the

'specific-goods' method, difficult problems of stock

management result whenever, for reasons of technological

change, fashion or shifts in consumer preferences, changes

need to take place in the composition of stocks. This is

because the use of LIFO results in higher recorded profits

whenever one line of stock is eliminated in favour of

449

another, with the result that either LIFO may fail to

achieve its intended result with respect to inventory costs

and recorded profits considered as a whole, or there will be

undesirable resource allocation effects to the extent that

existing stock lines are locked into inventories as firms

seek to avoid the inflation of their profit figures for tax

purposes.

12.24 In order to help overcome this problem, an

alternative method of LIFO accounting is permitted for tax

purposes in the U.S.A., known as the 1 dollar-value' method.

Dollar-value LIFO was described by Price Waterhouse & Co. in

the following terms:

"The dollar-value method uses dollars at a base year price level instead of quantities of specific goods as the unit of measurement. Under the dollar-value method, it is possible to include in a single pool the

entire inventory investment of a 'natural business unit'. Unless created merely because of differences in geographical locations, existence of the following would 'be important in determining whether a natural

business unit exists: (1 ) the natural business divisions used for internal management purposes, (2 ) the existence of separate and distinct production facilities and processes, and (3) the maintenance of

separate profit and loss records with respect to separate operations.

It may be that all of the inventory of some corporations can be placed in a single pool by electing the dollar-value, natural business unit method of valuation. If so, this method offers the greatest protection from loss of LIFO benefits by reason of

liquidation of or increment in certain pools and is less subject to criticism of distortion of financial results which can arise with multiple pools.

The dollar-value method assumes that all items within a pool are homogeneous. End of year inventory in a pool, expressed in terms of base—year cost, is compared with beginning of year inventory expressed in terms of base-year cost. If there is an increment, the LIFO value of the layer is determined by multiplying such

increment by the price change index for the year, which is the ratio of total current year cost of the pool to the total base-year cost of the pool.

450

The [U.S.] income tax regulations refer to three methods for computing the 'base-year* and 'current-year' costs of a dollar-value inventory pool. These are: (1) double-extension, (2) index, and (3)

link-chain.

Under the double-extension method, each item in the closing inventory is extended at base-year unit cost and current-year unit cost. The ratio of the total current-year costs to the total base-year cost determines the price index for the year which is applied to any increment in base dollars to value the LIFO layer.

The total 'current-year cost' of items making up a pool may be determined by reference to: (1 ) most recent purchases, (2 ) earliest acquisitions during the year, (3) average cost of purchase or production during the year, or (4) any other proper method which, in the opinion of the Commissioner, clearly reflects income.

The index method may be used where the use of the double-extension method is impractical because of technological changes, the extensive variety of items, or extreme fluctuations in the variety of items in the pool. The regulations state that the index may be computed by either double-extending a 'representative portion' of the inventory in a pool or by use of 'other

sound and consistent statistical methods'.

... Under the link-chain method, either all or a representative portion of the items in closing inventory are double-extended at current-year costs and at beginning of the year costs. An index is developed which is multiplied by the cumulative index at the end of the preceding year to get the index relationship of current year costs to base-year costs."1

12.25 The dollar-value method thus assumes that all

stocks in a so-called natural business unit may be regarded

as forming a homogeneous pool, changes in the prices of

which are calculated by reference to an index compiled for

the purpose. However, it will be clear that the

dollar-value method of stock valuation is very complicated

because of the need to record stocks in terms of different

1 LIFO Revisited, op. cit., pp. 15-17

451

price layers. It is also subject to all the problems of

compiling an appropriate index and, as the composition of

stocks changes over time, it becomes increasingly difficult

to relate current prices to the prices of base-year stocks.

12.26 These problems result from the fact that the

price adjustment under LIFO is determined by reference to a

comparison between the prices of closing stocks and the

diverging prices of stocks acquired in the base period.

These complications may be avoided under the current value

methods of accounting for stocks examined below. Appendix C

shows that the objectives of LIFO accounting may be achieved

more easily and with greater certainty by making stock

valuation adjustments directly. For the reasons which have

been discussed, the Committee regards LIFO as an inferior

alternative to the procedure which it subsequently

recommends.

Base Stock Method of Stock Valuation

12.27 The Committee also considered the base stock

method as a possible method of stock valuation. The base

stock method, which is closely related to the LIFO method,

also seeks to absorb stocks into cost on the basis of

current costs while maintaining a base stock priced at

original cost. The base stock level is determined by

reference to the expected normal operations of the business;

the value of the base stock effectively remains constant

while the value of stocks charged to sale or production is

related to current acquisition costs. The method suffers

from most of the disadvantages of LIFO which have been

452

discussed above, and is difficult to operate when stock

levels fluctuate or where the composition of stock lines

changes. It is therefore impracticable for most industries.

A variant of the base stock method was recommended for

optional use by the United Kingdom Royal Commission on the

Taxation of Profits and Income which reported in 1955, but

the recommendation was not adopted.

Accelerated Depreciation and Investment Allowances

12.28 Although depreciation allowances for accounting

and tax purposes are usually based on the historical cost of

the assets concerned, the amounts charged against revenues

in particular income periods are not closely related to the

estimated economic lives of the assets (allowing for

expected obsolescence as well as wear and tear) or to the

estimated pattern of service flows. The use of arbitrary

rates of depreciation, and of alternative methods of

charging depreciation, serves to emphasise the arbitrary

character of the charges which are made.

12.29 It has been noted that two general depreciation

methods are permitted under the Income Tax Assessment Act,

known as the prime cost and the diminishing value method

respectively. The depreciation rate under the diminishing

value method (which applies automatically unless the

taxpayer exercises an option to use the prime cost method)

is one and one-half times the basic rate calculated on the

prime cost basis. Under the diminishing value method, the

rate is applied to the depreciated value at the beginning of

each income period, whereas under the prime cost method the

453

rate is applied to the initial cost. The prime cost method

thus involves a fixed charge during each income period,

while the diminishing value method produces a reducing

charge which is higher than the prime cost charge would be

in the early years of an asset's life and lower in later

years.

12.30 The diminishing value method of charging

depreciation may thus be regarded as a form of accelerated

depreciation, whereby the time pattern of depreciation

charges is varied in order to speed up the process of cost

recovery. In Australia, more rapid write-off than is

possible under the diminishing value or prime cost methods

has sometimes been permitted for tax purposes on a number of

different bases under specified circumstances, as follows:

(1) Initial depreciation allowances of 20 per cent

or 40 per cent of the cost of manufacturing plant, in

addition to the ordinary depreciation allowances, in the

year in which the plant was installed. These were granted

at the taxpayer's option between 1 July 1945 and 30 June

1951, the higher rate applying for the last two years.

(2) Special depreciation allowances for particular

industries or for plant and equipment used for specified

purposes. Special allowances were available to primary

producers at the rate of 20 per cent p.a., for plant and

equipment acquired or structural improvements completed

between 1 July 1951 and 21 August 1973. As noted in Chapter

IX, plant used to provide amenities for employees, and plant

and buildings used only for scientific research, may be

454

written off at the rate of 33 1/3 per cent p.a. prime cost

basis, or 50 per cent p.a. diminishing value basis. Special

provisions in relation to depreciation also apply to mining

plant and equipment.

(3) Double depreciation allowances on new plant and

equipment installed by manufacturers or primary producers.

The double allowances, which may be claimed at the

taxpayer's option until the assets are fully written off,

apply to most items of depreciable plant used by

manufacturers and primary producers first used, or installed

ready for use, between 1 July 1974 and 1 July 1975 (see

Chapter IX).

(4) Full or 100 per cent depreciation in the year

of expenditure on non-structural improvements (completed

after 30 June 1951) and some structural improvements such as

fencing (completed after 30 June 1958) by primary producers.

This provision ceased to apply to expenditure incurred after

21 August 1973, when a ten-year write-off period was

substituted for expenditure on non-structural improvements.

Full write-off is also permitted on replacement of certain

kinds of assets, e.g. loose manufacturing tools.

12.31 Submissions received by the Committee from

primary producers sought the restoration of those

accelerated depreciation allowances which were abolished

after 21 August 1973, while manufacturers and primary

producers both sought the extension of the double

depreciation allowances beyond 1 July 1975. Other

submissions argued for the general adoption of 100 per cent

depreciation or free (or flexible) depreciation. Under free

455

depreciation, firms may choose their own rates of

depreciation up to 100 per cent write-off in the year of

acquisition. Approval was also sought for the optional use

of the so-called sum-of-the-years-digits method as an

alternative to the prime cost and diminishing value methods.

Under this method, the amount of the original cost written

off each year is a fraction, the numerator of which is given

by the number of years of the asset's life still remaining

at the beginning of the income year, while the denominator

is given by the sum of these numbers for every year of the

asset's life. Thus an asset with an estimated life of three

years would be depreciable on the basis of = h of its

original cost in the first year, 3 +5 +χ = 1 of the cost in

the second year, and = ■g· of the cost in the third

year.

12.32 Other submissions claimed that the rates

determined by the Commissioner of Taxation in Income Tax

Order 1217 needed to be increased because they did not allow

adequately for obsolescence. Two submissions referred to an

international comparison of depreciation allowances on

machinery and equipment which the American Iron and Steel

Institute made in February 1974, in which the capital

recovery periods permitted for taxation purposes in

different countries were contrasted as follows:1

1 Similar figures were presented by Mr. B.K. Sanden, a partner of Price Waterhouse & Co., in evidence to U.S. Senate Committee on Finance, Hearings on Tax Increase Proposals in 1974 (see also Chapter XIII).

456

12.33

United Kingdom 1 year

Canada 2 years

Sweden 5 years

Netherlands 5 years

Italy 6 years

Switzerland 8 years

France 8 years

Western Germany 9 years

Belgium 10 years

Luxembourg 10 years

Japan 11 years

United States pre-1971 assets 13 years United States post-1971 assets 10% years

The Committee cannot provide figures for

Australia which are strictly comparable with these figures,

because it does not have available a precise breakdown of

the assets included in the international comparison.

Nevertheless, a perusal of Income Tax Order 1217 suggests

that a representative cost recovery period for Australia is

about 10 years, with annual depreciation rates of 10 per

cent on a prime cost basis or 15 per cent using the

diminishing value option. For income year 1974-75, the

accelerated depreciation provisions, which apply to most new

plant and equipment of manufacturers and primary producers,

double these percentage amounts and approximately halve the

life of the assets. Figures of this order indicate that,

except while the accelerated depreciation provisions apply,

rates of depreciation in Australia are significantly lower

than those in many other countries.

12.34 Indeed by comparison with the United Kingdom

and Canada, even with accelerated rates of depreciation the

Australian rates of depreciation are low. While this may

reflect different government priorities towards private

investment, the Committee notes the differences because

457

higher rates of depreciation provide one policy option

whereby a government may modify the effects of rapid

inflation on the pattern and level of investment.

12.35 Accelerated depreciation methods do not depart

from the original cost of an asset as the basis of

allocation to time periods. It is merely the time pattern

of the depreciation charges which differs from that of prime

cost or diminishing value depreciation. From the taxpayer's

point of view, the deferment of tax which results from his

ability to claim higher depreciation in the earlier years of

an asset's life is equivalent to an interest-free loan. But

although accelerated depreciation does not provide any

permanent tax saving in respect of an individual asset, it

may do so where a firm has a stock of assets which is

balanced or growing.1

12.36 Other submissions received by the Committee

argued for the re-introduction of investment allowances,

which take the form of a subsidy or remission of tax rather

than a mere deferment. In Australia investment allowances

were given on new plant acquired by manufacturers between

7 February 1962 and 3 February 1971, or between 13 February

1972 and 21 August 1973; and by primary producers between

14 August 1963 and 21 August 1973. The allowances took the

form of deductions from assessable income of 20 per cent of

1 See A.D. Barton, 'Company Income Tax and Interperiod Allocation', Abacus, September 1970.

458

the capital expenditures incurred in acquiring and

installing plant; it is not clear why the subsidies took

the form of deductions from income, which made the extent of

the subsidy vary with the taxpayer's marginal rate of tax,

rather than of tax rebates.

12.37 The use of accelerated depreciation and

investment allowances has usually been directed towards

stimulating the size and direction of investment activity in

the manufacturing and primary producing sectors of the

economy. The allowances have not usually been justified by

reference to the problems of inflation, because although

they may provide some tax relief during a period of rising

prices they do not systematically allow for the effects of

price changes on measures of cost and income.

12.38 The effect of accelerated depreciation and

investment allowances on the distribution of business taxes

among different firms may be analysed by comparing tax

reductions using these methods with equivalent tax

reductions based on the use of some form of current value

accounting. It can be shown that the two policies differ

significantly in their effects on the profitability and

viability of individual firms. Accelerated depreciation and

investment allowances usually relate only to new investment,

whereas current value adjustments are usually intended to >

relate to existing plant and equipment as well as to new

assets."*" This means that firms not undertaking 1

1 It is suggested in Chapter XV, however, that in the process of transition to a system of current value adjustments there may be a case for phasing in the adjustments by applying them only to new assets.

459

significant new investment in relation to their existing

assets are likely to benefit little if at all from

accelerated depreciation or investment allowances. Rapidly

growing firms or those with assets of relatively short life

thus stand to be the major beneficiaries of such allowances

if they become a permanent feature of the tax system.^

12.39 If it is assumed that the price level is stable

or only changing slowly, investment allowances differ from

accelerated depreciation allowances in providing larger

benefits to firms investing in short-lived assets which are

frequently replaced. This results because investment

allowances are additional to the depreciation allowances

which may be claimed on the basis of the historical cost of

the asset. The more frequently the asset is replaced, the

greater is the benefit to the firm. Governments can, but

seldom do, compensate for this distortion in the pattern of

investment decisions by varying the rate of investment

allowance with the length of life of the depreciable asset.

12.40 By contrast, accelerated depreciation

allowances provide greatest benefit (again in the case where

price levels are relatively stable) to firms investing in

long-lived assets which are written off over a long period

of time. The discounted present value of the stream of tax

savings, assuming for simplicity of argument unchanged rates

That qualification is necessary because an investor in a slowly growing firm may fortuitously replace a major item of capital equipment with a long life in any given year and receive a substantial benefit from accelerated

depreciation or investment allowances. Such a firm may not, however, necessarily be a major beneficiary in the long run, for reasons outlined in the following text.

460

of tax over time, is increased for any given rate of return

on investment the shorter the time period over which the tax

savings are realised. The compression in the time period

over which depreciation allowances may be claimed is thus

greater for assets with relatively long lives and the

benefits to the business enterprises investing in those

assets correspondingly greater.

12.41 Free (or flexible) or 100 per cent

depreciation, in particular, may be expected to provide a

strong incentive for investment in assets with relatively

long lives. As for investment allowances the government

can, at the cost of great complexity, taper the rate of

acceleration with the life of assets. But in practice the

application of accelerated allowances to specified lists of

assets is usually the only device used to minimise the

distortions in the pattern of allowances.

12.42 When the assumption of a relatively stable

price level is relaxed, the preceding arguments must be

modified somewhat because the distorting effects of rapid

rates of inflation on the pattern of investment must also be

examined. For present purposes, the most important effect

is the disincentive to investment in assets with long lives,

which results from the reduced present value in real terms

of a future stream of tax allowances determined by reference

to a stream of historical cost depreciation allowances.

1 That assumption may be relaxed by introducing lengthy theoretical abstract argumentation, which is however of little relevance in the present context.

461

12.43 It follows that the biases in the pattern of

investment which accelerated depreciation allowances tend to

produce in a stable price level setting act in the opposite

direction to the effects of rapid inflation on the pattern

of investment. The real value of any stream of historical

cost depreciation allowances increases directly with the

rate of write-off. For the effect of accelerated

depreciation allowances on the pattern of investment to be

neutral in its effects on investment decisions, the benefits

of the acceleration in the receipt of the tax deductions

must be precisely equal to the costs associated with basing

deductions on historical depreciation costs rather than

current costs. The break-even point depends on the rates of

interest and inflation assumed in the calculation.

12.44 Full initial depreciation in the year of

purchase, or free depreciation, is non-neutral in its

effects on the pattern of investment decisions. It

eliminates, or reduces to insignificant amounts, the cost of

depreciation allowances determined on an historical cost

basis, irrespective of the level of inflation. This is

because historical cost does not differ significantly from

current replacement cost in the first year of an asset's

life, unless very high rates of inflation indeed are

assumed. But firms still receive the benefits of the

acceleration through their tax deductions. In effect, they

are able to claim depreciation allowances on the basis of

current values in advance of the time when assets are used

to generate taxable revenues.

462

12.45 By contrast, investment allowances cannot

compensate for the effects of rapid inflation. This is

because of their inherent bias in favour of short-term

investment; rapid inflation only serves to reinforce that

bias. It is possible to conceive of some mix of policies,

such as accelerated depreciation allowances combined with

investment allowances, designed to reduce the distorting

effects of the tax system on the pattern of investment. For

example the bias which full or free depreciation imparts to

investment in long-lived assets may be partially offset by

an investment allowance which favours investment in assets

with relatively short lives. But that option still leaves

the overall neutrality of the tax system (in its effects on

investment decisions) as a matter of chance, with the

outcome dependent on the inflation rate.

12.46 The Committee concludes that accelerated

depreciation and investment allowances do not provide a

systematic means of countering the effects of inflation on

taxation paid by business enterprises. It believes that

action needs to be taken to deal with this problem

explicitly, rather than as a by-product of policies which

have been designed to achieve other objectives. Accelerated

depreciation and investment allowances are appropriate

policy options for a government which wishes to influence

the level or the pattern of private investment, and in some

circumstances (such as in the case of free or flexible

depreciation) they may facilitate the matching of revenues

463

with expenses expressed in prices of the same period. While

the Committee does not regard accelerated depreciation and

investment allowances as preferred options for countering

the effects of inflation, their widespread use may explain

why few countries have felt obliged to implement

comprehensive inflation adjustment mechanisms in relation to

depreciation. ■ * "

12.47 Although depreciation rates allowed under

Income Tax Order 1217 are not directly related to the

question of accelerated depreciation, the Committee believes

that the adequacy of the rates should be regularly reviewed

to ensure that proper account is taken of the effects of

obsolescence and technological change. It would also

facilitate the adoption of the Committee's later

recommendations if the number of categories of depreciable

assets was .substantially reduced and the rate schedule

specified rates in multiples of, say, 5 per cent for the

prime cost method. Having regard to the arbitrary nature of

tax allowances for depreciation, the Committee believes that

the use of prime cost rates of 2% per cent and diminishing

value rates of 3 3/4 per cent conveys an impression of

spurious accuracy, and that the work of both taxpayers and

For analyses of the effectiveness of different kinds of tax allowances in stimulating investment, see G.C. Harcourt: 'Investment and Initial Allowances as Fiscal Devices', The Australian Accountant, September

1962; and 'Investment - Decision Criteria, Investment Incentives and the Choice of Technique', Economic Journal, March 1968. .

464

the Taxation Office will be eased considerably by a

simplification of the rate structure.

Cash Flow Concepts of Income

12.48 Although it is similar to the proposal that has

been discussed above under the category of full initial or

100 per cent depreciation allowances, the Committee has

examined separately a proposal made by Professor F.K. Wright

because it involves what is essentially a different concept

of income (and thus of the tax base), which is close to a

cash flow concept.

12.49 Professor Wright argued that the existing tax

law is inequitable and inefficient, because it

"discriminates unfairly against capital intensive industries

and against long-term investment". This is because outlays

for wages and other current expenses are tax-deductible in

the year in which they are incurred whereas deductions for

outlays on stocks and equipment are deferred, perhaps for

many years. Professor Wright suggested that investment

decisions are also distorted as a result of the interaction

of existing tax law and the decision criteria used by firms

in planning investment."*" He therefore proposed that the

whole cost of capital expenditure on plant and equipment,

and the whole cost of stock purchases, be allowed as

deductions in the year in which the assets are acquired.

Adoption of these simple tax reforms, he argued, "would

1 See J.W. Bennett and G.C. Harcourt, 'Taxation and Business Surplus', The Economic Record, August 1960

465

largely eliminate the effect of inflation on company

taxation: for the tax rebate would be received in dollars

of almost the same vintage as those spent on the item to

which the rebate is related".

12.50 By allowing deductions for stocks and plant on

the basis of cash outlays rather than on the basis of

periodic allocations of those outlays, Professor Wright's

proposal would replace the measure of income which is

currently used for tax purposes by a measure which tended to

reflect cash flows. This is because, except for the

recognition of revenues and expenses accruing through

accounts receivable and accounts payable, the process of

income determination would reflect cash receipts and cash

payments.

12.51 It should be noted in passing that if the

payroll tax· (which already exists in the States) were added

to Professor Wright's proposed method of taxing business

enterprises, the combined system would have a close affinity

to a consumption-type value-added tax. The case for a

value-added tax was considered by the Taxation Review

Committee in its Preliminary Report and that Committee

concluded that it is 'the most appropriate type of

broad-based tax on goods and services’ .^ But a

combination of a value-added tax, an income tax based on a

cash-flow concept and a payroll tax would seem more

difficult to justify. 1

1 Preliminary Report, op. cit., para. 12.39.

466

12.52 An important advantage of Professor Wright's

system would be its simplicity: most of the difficult

problems of income measurement would disappear and it would

merely be necessary to record cash transactions and changes

in indebtedness in order to establish the basis of tax

liability. Professor Wright indicated that, under his

proposed system, the proceeds of sale of plant and

equipment, or of part of a business as a going concern,

would be included in taxable income. By blurring the

distinction between income and capital, this would mean that

what are now tax-exempt capital gains would be subject to

taxation, and Professor Wright recognised that this might

pose problems of equity under circumstances where long-term

capital gains are not subject to taxation.

12.53 Other problems identified by Professor Wright

included:

(a) the possibility that taxpayers might try to

reduce their tax liability in a given year by

acquiring assets just before balance date; and

(b) the costs to government revenue of introducing

a system of full deductibility for new asset

acquisitions while it was still necessary to

permit deductions by way of depreciation

allowances and cost of goods sold in respect of

assets acquired before the change to the new

system. He suggested that it might be possible

to overcome the latter problem by restricting

467

the full deductibility of capital expenditures

to replacements, but recognised that it would

be administratively difficult to distinguish

between replacement and expansion investment. ^

12.54 The Committee sees two main difficulties in

Professor Wright's proposal, in addition to those which he

himself discussed. The first is the same problem which was

discussed in the preceding section in relation to 100 per

cent depreciation. Full deductibility of the cost of assets

in the year of acquisition is not neutral in its effects on

the pattern of investment; it tends to favour long-lived

assets. Secondly, although it is true that full

deductibility ensures that expenditures on assets are

deducted from assessable income on the basis of their

current costs, this secures an advantage for the taxpayer

only at the expense of government revenue (and by

implication other taxpayers). This is because most of the

revenues which the assets generate will not be brought into

assessable income until future income years. The time

relationship between deductible expenses and assessable

The same problem of distinguishing between replacement and expansion investment would arise under a scheme suggested to the Committee by Mr. G.T. Webb. Mr. Webb

proposed that depreciation be allowed for tax purposes at the rate of 5 per cent p.a. on the prime cost of all existing plant, that all proceeds from sale of replaced plant be exempt from tax and that expenditure on

replacement in excess of the original cost be fully deductible in the year of replacement. Mr. Webb made other proposals to encourage modernisation of plant and additional investment, including up to 100 per cent write-off of capital expenditures under certain

circumstances.

468

income is therefore distorted in favour of the taxpayer,

just as the present system may be said to distort the time

relationship in favour of government revenue. If overall

equity is to be achieved, it is necessary to match allowable

deductions and assessable income on a basis which gives

neither taxpayer nor government revenue any timing

advantage.

12.55 Professor Wright proposed an alternative

approach, involving a variant of the relative price level

method of assessing holding gains and losses on stocks, if

his main proposal was unacceptable. This suggestion is

considered below. He also suggested that, if 100 per cent

initial depreciation allowances or full deductibility of

replacement expenditure was unacceptable, consideration

should be given to a highly accelerated method of tax

depreciation (such as sum-of-the-years-digits).^ This

could be accompanied by an investment allowance to prevent

discrimination against capital intensive and long-term

investments. The problems with this approach have been

discussed 'in the preceding section.

Revaluation (or Revalorisation) of Fixed Assets

12.56 The Joint Taxation Committee of the Australian

Society of Accountants and the Institute of Chartered

1 Professor Wright referred to evidence that sum-of-the- years-digits reflects the service pattern of many assets better than conventional depreciation methods do.

469

Accountants in Australia suggested, as a possible interim

measure pending the general acceptance of current value

accounting, the revaluation or revalorisation of plant and

equipment. "Under such a method the historical cost of

plant and equipment would be adjusted annually by a suitable

index, and depreciation charges would be allowed for tax

purposes on the adjusted amount."

12.57 Since the end of World War II, one of the main

responses of Australian companies to inflation has been the

periodic but irregular revaluation of fixed assets. The

revaluations have usually been confined to land and

buildings, which except to the extent that they constitute

plant do not qualify for depreciation deductions against

assessable income. But whereas occasional revaluations of

this kind may be regarded as variations of historical cost

accounting, annual revaluations of the kind proposed by the

Joint Taxation Committee of the two accounting bodies may

more conveniently be regarded as current value or C.P.P.

adjustments. They therefore fall within the framework of

discussion of subsequent sections.

Current Value Adjustments

12.58 Submissions received by the Committee proposing

current value adjustments to the tax base may be classified

into three groups on the basis of the items proposed for

adjustment, three groups on the basis of proposed concepts

of current value, and two groups on the basis of the

proposed methods of adjustment.

470

12.59 The following suggestions were made with

respect to items proposed for adjustment in the process of

deriving a measure of current income to be used for tax

purposes:

(a) only stocks, and plant and equipment, should be

subject to adjustment;

(b) stocks, and plant and equipment, should be

subject to current value adjustments, but in

addition purchasing power losses and gains on

all monetary items should be brought into the

calculation of current income; and

(c) stocks, and plant and equipment, should be

subject to current value adjustments, and in

addition purchasing power gains and losses on

monetary assets and short-term liabilities

should be brought into the calculation of

current income (that is, no purchasing power

gain should be imputed in respect of long-term

liabilities).

12.6 0 Insofar as proposed concepts cf current value

are concerned, again three possibilities were distinguished:

(a) the use of either current replacement cost or

net realisable value, depending on which

concept is considered relevant to the

particular circumstances of the firm at the

time the adjustment is made;

471

(b) the use of current replacement cost,

established by reference to the current cost of

replacing assets which are capable of

performing equivalent services to those of the

assets being revalued; and

(c) the use of replacement cost, established by

reference not only to the current cost of

replacing assets but having regard also to the

shortfall of revaluation reserves provided by

valuation adjustments in earlier years when the

current replacement cost of the assets (and

hence the size of the adjustments) was lower

than in the current year.

12.61 Two methods of adjustment were proposed:

(a) adjustment by reference to the actual

transactions of individual firms; and

(b) adjustment by reference to an index of changes

in current values.

12.62 It will be convenient to consider these

proposals in the context of a general discussion on the

possible use of current value adjustments for tax purposes.

Support for the adoption of some form of current value

adjustments and the use of some form of current value

concept of taxable income came from:

the Joint Taxation Committee of the Australian

Accounting Research Foundation (whose

submission was prepared on behalf of the

Australian Society of Accountants and the

Institute of chartered Accountants in

Australia);

some firms of professional accountants;

primary industry groups, including the

Australian Farmers’ Federation, the Australian

Woolgrowers' and Graziers1 Council, the

Queensland Cane Growers' Council, the

Australian Sugar Producers Association Ltd. and

the Australian Timber Producers Council;

the Australian Chemical Industry Council and a

number of manufacturing companies, some of

which (such as the Broken Ilill Proprietary

Company Ltd. and Philips Industries Holdings

Ltd.) are already wholly or partially applying

current value accounting methods for internal

management and financial reporting purposes;

the Australian Chamber of Commerce and, in

respect of depreciation on plant and equipment,

the Life Offices Association of Australia;

the Institute of Directors in Australia;

Australian and State government departments and

agencies, including the Federal Department of

Manufacturing Industry and the Economic

473

Intelligence Unit of the South Australian

Premier's Department? and

(h) several academic accountants and economists.

12.63 As has been noted earlier, several of the

proponents of a current value approach have suggested that,

pending the general acceptance of such an approach,

short-term measures such as LIFO and accelerated,

depreciation should be introduced. Others have argued for

the adoption of current value principles while proposing

that adjustments be made by reference to a general price

level index, thereby combining some of the features of

current value accounting and C.P.P. accounting.

12.64 Advantages of a Current Value Concept of

Taxable Income. The general case for a current value

concept of taxable income is based on its effects on capital

maintenance, profitability and financial stability. It will

be seen from Appendix A that, under current value

accounting, capital is maintained in the sense that the

firm's funds are supplemented, as a result of the

revaluation adjustments, to the extent that is necessary to

finance the higher cost of holding assets when their current

values increase. This means that its operating capacity,

defined as its ability to generate future output, is

preserved, and the potential continuity of the firm is

assured.

474

12.65 A further advantage results from the fact that

the firm* s profitability in current value terms can be

preserved by an appropriate combination of current value

accounting and pricing policies. The illustration in

Appendix A demonstrates that a combination of current value

accounting and replacement cost pricing makes it possible

for the firm's tax and dividend base to be preserved in

current value terms, so that tax and dividend distributions

do not necessarily differ from the amounts which would be

distributed under a system of historical cost accounting and

historical cost pricing. It follows from the capital

maintenance concept that the firm's financial stability is

not impaired by increases in the current values of its

assets, because the valuation adjustments finance the higher

costs of holding the assets without the need to resort to

additional borrowing from outside creditors.

12.66 The use of some form of current value concept

of taxable income also has important advantages from the

viewpoint of equity, efficiency and flexibility. All firms

are treated equitably for tax purposes when they are taxed

on a measure of income which has been universally based on

revenues and expenses all expressed in terms of current

prices of the income period. The basis of valuation of

current income is also consistent with the basis of

valuation of the incomes of other taxpayers, such as wage

and salary earners, whose incomes are automatically

expressed in current prices of the income period. A tax

475

system based on a current value concept of taxable income

does not discriminate between capital-intensive and

labour-intensive firms, or between firms with different

asset structures, or between firms subject to a high rate of

increase in the prices of stocks and plant and those subject

to a low rate of price increase, or between old and new

firms, because the physical assets and costs of all firms

are valued in terms of the same prices. The possibility

that it may discriminate between firms with different

financial (that is, debt/equity) structures is examined

below.

12.67 Because current value measures of income and

wealth are more likely than other measures to provide

information that is relevant to efficient operating and

investment policies of firms, there is a presumption that

greater efficiency is likely to be achieved in the private

sector when cost, income and asset measurement are based on

the current value approach. The proper evaluation by

managers, proprietors, investors, or creditors of a firm's

performance needs to have regard to the relationship between

its current income and the current value of the funds (or

assets) which it employs. A firm's pricing policies need to

have regard to its current costs. Its income distribution

through taxes and dividends needs to be related to its

current income. The resource allocation advantages of the

current value approach were summarised by

476

Professor A.D. Barton, in a paper prepared for the

Committee, in the following words:

"The measures of current profit performance, current financial position and rates of return on investment are more meaningful than those given by [other] systems, and this is vital information to management and investors. Furthermore reliable interfirm comparisons of these magnitudes can be made. Use of the system helps to maintain the firm's existing productive capacity and hence its role as a going

concern. The system should promote efficiency of operations and regular adaptation of operating techniques to changing factor market conditions. Current replacement costs measure the prevailing market supply prices of productive factors and these are relevant for determining the most efficient current techniques of production. Current replacement cost

accounting provides management with useful information for pricing and output decisions, asset purchase decisions and company takeover decisions, all of which are areas of prime managerial importance."

12.68 It is more difficult to assess the balance of

advantage with respect to flexibility of the tax system and

the effective management of the economy. On the one hand,

it has been argued that current value accounting is less

likely than historical cost accounting to give rise to

optimistic expectations about profitability when prices are

rising, or to pessimistic expectations when prices are

falling, with the result that firms are less likely to

engage in destabilising investment activity. More important

as a stabilising factor, however, is likely to be the

greater business saving which is generated by a combination

of current value accounting and replacement cost pricing in

a period of rising prices.

477

12.69 On the other hand, the effect of combining

current value accounting with replacement cost pricing

could be to raise prices during boom periods, thereby

seemingly intensifying pressures. But the higher prices

will normally cut back consumption expenditures to the

extent necessary to support the continued deployment of

business resources. Provided the increased revenues are

saved by businesses (by remaining insulated in revaluation

reserves), pressures on demand will be reduced in a manner

similar to that which results from an increase in indirect

taxation that is not accompanied by an increase in

government spending.

12.70 But the main reason for believing that a

current value concept of taxable income is likely to operate

as a stabilising force is that, without such a concept, the

continuation of the rapid rates of inflation which have

recently been experienced in Australia is likely to force

more and more business enterprises into liquidation. The

financial instability that results from inadequate company

saving and excessive borrowing in a period of rapidly rising

prices threatens the equilibrium of the whole economic

system.

12.71 Disadvantages of a Current Value Concept of

Taxable Income. Several issues raised during discussions

which the Committee organised concerned apparent

disadvantages of current value concepts which, on closer

examination, were difficult to substantiate. Some of the

arguments about equity involved value judgments about the

478

extent to which it is equitable to permit firms with

long-lived or more valuable assets, or assets subject to

more rapid price changes, greater valuation adjustments than

firms with short-lived or less valuable assets, or assets

subject to less rapid price changes. These are essentially

arguments about whether it is appropriate to revalue all

financial statement items in terms of current prices, and

thus depend on the validity of the general case for current

value accounting.

12.72 Other, related, criticisms of current value

accounting are concerned with what is said to be its

tendency to require continued replacement of the assets held

by a firm and to discourage redeployment of resources when

circumstances justify changes in the nature of a firm's

economic activities. It is argued that, to the extent that

current value accounting, pricing and taxing policies

insulate firms from the effects of specific price changes

affecting their operations, they are discouraged from

adapting to the changing requirements of the economy. This

argument is based on an assumption that firms subject to

rapid increases in replacement costs are somehow less

efficient than those subject to less rapid increases, and

that it is inequitable and inefficient for the consumer

(through higher prices) and the government and other

taxpayers (through lower taxes) to subsidise this

inefficiency.

479

12.73 These arguments, which are usually advanced by

those who prefer C.P.P. adjustments to current value

adjustments, seem to the Committee to be based on

misconceptions about the reason for current value

adjustments and about what it is that they are designed to

achieve. In the first place, the fact that one industry

faces higher replacement prices than another, in respect of

the assets which it uses to generate income, tells us

nothing about the relative efficiency of the two industries.

The relative prices reflect conditions in the supplying

industries and not in the industries acquiring the assets.

This is not to deny that, if the latter industries are to

operate efficiently, they must be ready to adapt when their

relative costs change. It may be argued, for example, that

greater efficiency will be achieved if industries using oil

as a source of power switch to other fuels when the price of

oil rises relative to other fuels.

12.74 However, the use of a system of current value

accounting, pricing and taxing will not prevent such

substitutions from taking place. Indeed, the higher selling

prices which may be associated with an increase in

replacement costs will induce a response from consumers and

indicate whether or not they are prepared to pay the higher

prices. If they are so prepared, the current value

adjustments are necessary to ensure that the industry is

able to continue supplying them. If the consumers are not

480

prepared to pay the higher prices, the industry will need to

switch to other sources of supply or to other products. The

efficient allocation of resources thus depends on responses

by firms to the interaction of the forces of supply and

demand, and not merely on their responses to changes in the

prices charged by suppliers. There can be no presumption

that efficiency requires the elimination of all relative

price changes.

12.75 The other misconception about current value

adjustments is that they are said to prevent the firm from

adapting to changes in replacement costs by requiring

continued replacement of the assets subject to the

adjustments. There is no presumption about replacement,

because current value adjustments are merely intended to

make it possible for firms to continue operating in the same

industry if they should wish to do so. The resources which

they commit to particular forms of activity become freely

available for other uses whenever a replacement decision

needs to be made. Because the current value adjustments

relate to the particular assets which are held at the time

the adjustments are made, the effect of the adjustments is

to permit the level of activity to be maintained in terms of

those assets.

12.76 Whether the management of the firm decides to

replace the assets or switch to some other line of business

will depend on its iudgment about the relative profitability

of the alternative courses of action, a judgment that needs

481

to be based on the opportunity cost of the alternatives as

measured by the current values of the assets concerned. If

a decision is made not to replace the assets, it will be

because the expected net returns from continued investment

in those assets are judged to be insufficient, having regard

to the costs of replacement, relative to other investment

opportunities. As a result of this decision, the measure of

current value will cease to be replacement cost and will

become net realisable value. The size of the valuation

adjustments, and whether they are positive or negative, will

thus reflect the changes which are taking place in the

deployment of the firm's assets. The current value

adjustments neither lock the firm into particular assets (or

forms of economic activity) nor confer financial benefits on

the firm which do not reflect the particular composition of

its asset holdings at the time the adjustments are made. As

the firm's asset structure (or the nature of its economic

activity) changes, so the valuation adjustments adapt to the

new asset grouping in order to ensure that the scale of

activity may be maintained in relation to the current

deployment of the firm's assets.

12.77 In its submission, the Australian Treasury

claimed that an historical cost measure of profit for tax

purposes was preferable to a current value measure for

another reason. Arguing that it is equitable for all gains

to be taxed, that is for historical cost to be used as the

basis of calculating taxable income, the Treasury referred

to the problem of achieving equity as between continuing and

482

t e r m i n a t i n g b u s i n e s s . B y r e f e r e n c e t o a n a r i t h m e t i c a l

e x a m p l e , i t s h o w e d t h a t " t h e h i s t o r i c a l c o s t b a s i s

d e t e r m i n e s p r o f i t o f a c o n t i n u i n g b u s i n e s s a c c o r d i n g t o t h e

s a m e r u l e s a s w o u l d a p p l y t o a t e r m i n a t i n g o p e r a t i o n t o

w h i c h s e c t i o n 2 6 ( a ) ^ m i g h t a p p l y - t h e p r o c e e d s o f c o m p l e t e d

s a l e s a r e m a t c h e d a g a i n s t t h e a c t u a l c o s t o f t h e g o o d s s o l d .

T h e c o n t i n u i n g b u s i n e s s a l s o g e a r s u p t o r e p e a t t h e

o p e r a t i o n , b u t t r a n s a c t i o n s r e l a t e d t o t h a t a r e n o t t a k e n

i n t o a c c o u n t i n c a l c u l a t i o n o f p r o f i t u n t i l a l a t e r y e a r

w h e n s a l e s a r e c o m p l e t e d - i n t h e m e a n t i m e t h e y a r e t r e a t e d ,

i n e f f e c t , a s c a p i t a l o u t l a y s . "

1 2 . 7 8 T h e T r e a s u r y w e n t o n t o i m p l y t h a t c u r r e n t

v a l u e a c c o u n t i n g n e c e s s a r i l y r e s u l t s i n u n e q u a l t a x

t r e a t m e n t as b e t w e e n t e r m i n a t i n g a n d c o n t i n u i n g b u s i n e s s e s ,

w i t h t h e f o r m e r b e i n g t a x e d o n a n h i s t o r i c a l c o s t b a s i s a n d

t h e l a t t e r b e i n g a b l e t o c l a i m t h e i n c r e a s e i n c u r r e n t

r e p l a c e m e n t c o s t as a d e d u c t i o n f o r t a x p u r p o s e s . I t

t h e r e f o r e a s k e d :

" S h o u l d t h e r e t h e n b e a n y d i f f e r e n c e i n t h e t a x a b l e

p r o f i t i n t h e t e r m i n a t i n g a n d t h e c o n t i n u o u s c a s e s ?

C o m p l e t e d s a l e s a n d t h e t r a n s a c t i o n s l e a d i n g u p t o t h e m

a r e i d e n t i c a l i n t h e t w o c a s e s . D o e s t h e f a c t t h a t t h e

c o n t i n u i n g b u s i n e s s h a s t o g e a r u p t o r e p e a t t h e

o p e r a t i o n j u s t i f y r e c k o n i n g t r u e p r o f i t (and tax) a t a

l o w e r f i g u r e i n i t s c a s e ? "

1 2 . 7 9 T h e T r e a s u r y s u b m i s s i o n c o n t i n u e d :

* S e c t i o n 26( a ) o f t h e I n c o m e T a x A s s e s s m e n t A c t s p e c i f i e s

t h a t a s s e s s a b l e i n c o m e s h a l l i n c l u d e ' p r o f i t a r i s i n g f r o m

t h e s a l e b y t h e t a x p a y e r o f a n y p r o p e r t y a c q u i r e d b y h i m

f o r t h e p u r p o s e o f p r o f i t - m a k i n g b y s a l e , o r f r o m t h e

c a r r y i n g o n o r c a r r y i n g o u t o f a n y p r o f i t - m a k i n g

u n d e r t a k i n g o r s c h e m e 1.

483

"An affirmative answer to that question would imply that the gearing up process ... itself entails a loss. The proposition seems untenable, as it would logically have to apply also to a new business which had got no

further by the end of the year than acquiring stock.

If it is argued that the answer to the question is in the negative, it appears that in order to regard the true profit of the continuing business as less than [the profit determined on an historical cost basis] one must logically apply the same conclusion to the

terminating operation ..."

12.80 The Treasury's argument seems to be based on

the assumption that discontinuities exist in relation to

continuing businesses that do not exist in relation to

terminating businesses, and that the effect of these

discontinuities is to enable only continuing businesses to

take advantage of current value adjustments for tax

purposes.

12.81 It does not necessarily follow that only

continuing businesses can take advantage of current value

adjustments. In principle, a system of current value

accounting requires current costs to be determined at the

time of each sales transaction. If tax was to be based on

current income calculated on such a basis, terminating

businesses as well as continuing businesses would obtain the

advantage of any cost of sales adjustment. It may be that,

for reasons which the Committee discusses elsewhere, a

system of current value taxation would need to be based on

simplifying procedures which did have the effect of

introducing discontinuities of the kind assumed by the

Treasury. This would happen, for example, if taxable income

were to be adjusted only by reference to the change in

484

prices in an income period as it affected opening stocks. A

terminating business which had no opening stocks in an

income period would not be eligible for a valuation

adjustment and would therefore appear to be worse off than a

continuing business (unless it could arrange its affairs so

as to buy goods in one income period and sell them in the

succeeding period).

12.82 But this is not a necessary result of adopting

a current value tax base; it depends on the particular

arrangements which are made for assessing tax liability.

The equity of current value accounting, as between

continuing and terminating businesses, also depends on what

arrangements are made for taxing the revaluation reserves

(or holding gains) when stocks held by a continuing business

fall or are finally liquidated. If transfers are made from

the revaluation reserves back to taxable income under these

circumstances, as logic would seem to require (and as the

Treasury suggested as necessary in a later part of its

submission), the continuing business will effectively pay

tax on the- holding gains at the time the stocks fall or are

liquidated. The only advantage it will have over the

terminating business will then be the relatively longer

deferment of tax which it has been able to achieve, an

advantage which may be justified by the fact that it is a

continuing business.

485

12.83 The foregoing discussion may be illustrated by

a simple arithmetical example, in which one firm engages in

two separate sets of transactions; while another firm

engages in the same transactions as part of a continuing

business activity, and liquidates the business after the

second set of transactions. Suppose that the transactions

are as follows:

Terminating Business Continuing 1st Trans- 2nd Trans- Business Income action action Statement

$ $ $

Sales 12 5 150 275

Historical cost 75 100 175

Accounting profit Current cost To 50 Too

adjustment 25 25 50

Current income is T 50

12.84 It will be seen that, if either historical cost

profit or current income is used as the tax base, both

businesses will record the same income and be subject to the

same tax. Likewise, if the revaluation reserves are

required to be brought back into taxable income when stocks

are liquidated, both businesses will pay the same tax. Even

if there are discontinuities as a result of the particular

adjustment procedures which are adopted, so that the

terminating business effectively pays tax on its accounting

profit while the continuing business pays tax on its current

income, the two firms are still treated consistently

provided the revaluation reserves are taxed when stocks fall

or are liquidated. The Treasury argument is therefore

inconclusive, and does not demonstrate that accounting

486

p r o f i t i s a m o r e e q u i t a b l e m e a s u r e o f t h e t a x b a s e as

b e t w e e n t h e t w o t y p e s o f f i r m s . A l t h o u g h i t i s n e c e s s a r y t o

e n s u r e , i n a n y t a x s y s t e m , t h a t c h a n g e s i n t h e f o r m o f

b u s i n e s s o r g a n i s a t i o n c a n n o t b e u s e d f o r p u r p o s e s c£ t a x

a v o i d a n c e a n d t h u s s u b v e r t t h e s y s t e m , t h e C o m m i t t e e i n a n y

c a s e b e l i e v e s t h a t t h e t a x a t i o n o f b u s i n e s s e n t e r p r i s e s m u s t

b e b a s e d o n a p r e m i s e t h a t m o s t e n t e r p r i s e s a r e c o n t i n u i n g

e n t i t i e s .

1 2 . 8 5 A l t h o u g h t h e C o m m i t t e e h a s r e j e c t e d s o m e o f t h e

f o r e g o i n g a r g u m e n t s a g a i n s t c u r r e n t v a l u e a c c o u n t i n g , i t

n e v e r t h e l e s s s e e s t h r e e m a j o r l i m i t a t i o n s o r w e a k n e s s e s i n

t h e c u r r e n t v a l u e a p p r o a c h a s i t a f f e c t s t h e b a s i s o f

b u s i n e s s t a x a t i o n . T h e f i r s t l i m i t a t i o n h a s i t s o r i g i n i n

b o t h c o n c e p t u a l a n d p r a c t i c a l i s s u e s t h a t a r e a s s o c i a t e d

w i t h t h e c a p i t a l m a i n t e n a n c e c o n c e p t w h i c h u n d e r l i e s c u r r e n t

v a l u e a c c o u n t i n g . T h e s e c o n d l i m i t a t i o n r e s u l t s f r o m t h e

a b s e n c e o f a n y g e n e r a l s y s t e m o f t a x i n g c a p i t a l g a i n s . T h e

t h i r d l i m i t a t i o n s t e m s f r o m t h e p r o b l e m s w h i c h a r e l i k e l y t o

b e e n c o u n t e r e d i n i m p l e m e n t i n g c u r r e n t v a l u e a d j u s t m e n t s f o r

t a x p u r p o s e s , i n t h e a b s e n c e o f a n y g e n e r a l a d o p t i o n o f t h e

c u r r e n t v a l u e a p p r o a c h f o r o r d i n a r y b u s i n e s s p u r p o s e s .

1 2 . 8 6 T h e e f f e c t o f t h e c u r r e n t v a l u e c o n c e p t o f

c a p i t a l m a i n t e n a n c e i s t o e n a b l e t h e w h o l e c o s t o f i n c r e a s e s

i n t h e c u r r e n t v a l u e o f n o n - m o n e t a r y a s s e t s t o b e f i n a n c e d

t h r o u g h r e v a l u a t i o n r e s e r v e s . N o w t h e r e v a l u a t i o n r e s e r v e s

r e p r e s e n t a d d i t i o n s t o p r o p r i e t o r s h i p c a p i t a l , w h i c h

e f f e c t i v e l y i n c r e a s e t h e r e s i d u a l e q u i t y o f p r o p r i e t o r s at

487

l e a s t w h i l e t h e a s s e t s c o n t i n u e t o b e h e l d a n d w h i l e t h e i r

c u r r e n t v a l u e s c o n t i n u e t o i n c r e a s e . I f t h e r e v a l u a t i o n

r e s e r v e s a r e c o n s i d e r e d t o b e t a x a b l e i n t h e e v e n t o f

r e d u c t i o n s i n t h e p h y s i c a l l e v e l o f a s s e t h o l d i n g s o r f a l l s

i n c u r r e n t v a l u e , a s l o g i c w o u l d s e e m t o r e q u i r e , p o r t i o n o f

t h e r e s e r v e s m a y b e r e g a r d e d as b e i n g i n t h e n a t u r e o f a

d e f e r r e d t a x l i a b i l i t y . B u t e v e n u n d e r t h e s e c i r c u m s t a n c e s

t h e r e s i d u a l e q u i t y o f p r o p r i e t o r s m a y i n c r e a s e , r e l a t i v e t o

t h e c l a i m s o f o u t s i d e c r e d i t o r s , a s a r e s u l t o f t h e c u r r e n t

v a l u e a d j u s t m e n t s .

1 2 . 8 7 I t is s h o w n i n A p p e n d i x A t h a t t h e r e s u l t i n g

i m p r o v e m e n t i n a f i rm* s g e a r i n g m e a n s t h a t i t s f i n a n c i a l

p o s i t i o n h a s n o t m e r e l y b e e n m a i n t a i n e d , b u t h a s a c t u a l l y

i m p r o v e d as a r e s u l t o f t h e c u r r e n t v a l u e a d j u s t m e n t s . T h e

p r a c t i c a l s i g n i f i c a n c e o f t h i s r e s u l t m a y b e i l l u s t r a t e d b y

a s s u m i n g t h a t t h e c u r r e n t v a l u e s o f a f i r m ' s a s s e t s , w h i c h

w e r e i n i t i a l l y f i n a n c e d h a l f b y p r o p r i e t o r s h i p c a p i t a l a n d

h a l f b y d e b t , i n c r e a s e r a p i d l y o v e r a c o n s i d e r a b l e n u m b e r o f

y e a r s . B y t h e e n d o f t h e p e r i o d , t h e d e b t f i n a n c e w i l l b e

t h e s a m e i n m o n e y a m o u n t , b u t a s a r e s u l t o f t h e v a l u a t i o n

a d j u s t m e n t s t h e r e w i l l h a v e b e e n an o v e r w h e l m i n g i n c r e a s e i n

t h e p r o p o r t i o n o f t h e firm* s a s s e t s f i n a n c e d b y

p r o p r i e t o r s h i p . T h e r e c a n b e n o q u e s t i o n t h a t , as a r e s u l t

o f t h i s c h a n g e i n i t s g e a r i n g , t h e f i r m h a s i m p r o v e d its

p o s i t i o n . T h e i m p l i c a t i o n i s t h a t t h e v a l u a t i o n a d j u s t m e n t s

h a v e b e e n e x c e s s i v e a n d s h o u l d b e r e d u c e d t o t h e e x t e n t

488

necessary to enable the firm merely to maintain its

position. Appendix A shows how this might be done.

1 2 . 8 8 A n o t h e r w a y o f l o o k i n g a t t h e s a m e p r o b l e m w a s

s u g g e s t e d i n a n u m b e r o f s u b m i s s i o n s r e c e i v e d b y t h e

C o m m i t t e e , w h i c h a r g u e d t h a t i t i s n e c e s s a r y t o s u p p l e m e n t

c u r r e n t v a l u e a d j u s t m e n t s b y a d j u s t m e n t s d e s i g n e d t o e n s u r e

t h a t t h e i n c o m e m e a s u r e a l s o r e f l e c t s p u r c h a s i n g - p o w e r g a i n s

o n l i a b i l i t i e s a n d p u r c h a s i n g - p o w e r l o s s e s o n m o n e t a r y

a s s e t s . P r o f e s s o r R . S . G y n t h e r , w h o a r g u e d t h a t i n

a c c o u n t i n g f o r c h a n g i n g p r i c e s t h e m a i n t h i n g t o c o n s i d e r is

c a p i t a l m a i n t e n a n c e a n d n o t s h o r t - t e r m a s s e t v a l u a t i o n

m e t h o d s o r d e p r e c i a t i o n m e t h o d s o r r e v e n u e r e c o g n i t i o n

m e t h o d s , s u g g e s t e d t h a t t h e p u r c h a s i n g - p o w e r a d j u s t m e n t s

s h o u l d b e r e s t r i c t e d t o s h o r t - t e r m l i a b i l i t i e s a n d m o n e t a r y

a s s e t s . O n t h i s e n t i t y v i e w , t h e c a p i t a l w h i c h n e e d s t o b e

m a i n t a i n e d i n c l u d e s t h e f i r m ' s l o n g - t e r m l i a b i l i t i e s as w e l l

as i t s p r o p r i e t o r s h i p c a p i t a l . 1

1 2 . 8 9 F r o m t h e p o i n t o f v i e w o f d e c i d i n g o n a n

a p p r o p r i a t e c o n c e p t o f i n c o m e f o r t a x p u r p o s e s , t h e

C o m m i t t e e a g r e e s t h a t i t i s n o t p o s s i b l e t o e v a l u a t e c h a n g e s

i n a f i r m ' s f i n a n c i a l p o s i t i o n , a n d b y i m p l i c a t i o n it s

c a p a c i t y t o p a y t a x , w i t h o u t r e f e r e n c e t o i t s n e t

i n d e b t e d n e s s i n r e l a t i o n t o o u t s i d e c r e d i t o r s a n d d e b t o r s .

I f a f i r m f i n a n c e s a n a s s e t c o s t i n g $ 1 0 b y m e a n s o f i t s o w n

c a p i t a l , $5, a n d b o r r o w i n g f r o m a c r e d i t o r , $5, a n d t h e r e i s

R . S . G y n t h e r , ' T h e T r e a t m e n t o f B o r r o w i n g s w h e n

A c c o u n t i n g f o r C h a n g i n g P r i c e s ' , T h e A c c o u n t a n t , 12 J u l y ,

1 9 7 3 , pp. 4 8 - 5 0 .

489

subsequently a general price increase (affecting all goods

and services) of 20 per cent, it is impossible to argue that

the firm's financial position can only be maintained if

there is a valuation adjustment, and an increase in

proprietorship funds through a revaluation reserve, of $2.

Partly offsetting this effect is the purchasing-power gain

of $1 on its liabilities. A reduction in the firm's taxable

income of $2 would therefore leave the firm in a position of

relative financial advantage. From the viewpoint of the

proprietors of the firm, this advantage would accrue whether

the liability was a short-term or a long-term liability.

12.90 But while the Committee accepts that there is a

strong case for offsetting purchasing-power gains on

monetary items against (or adding purchasing-power losses

to) current value adjustments, it sees problems in equity in

introducing partial purchasing-power adjustments into the

tax system when non-monetary items are not subject to

similar adjustments, and when there is no general system of

capital gains taxation. The issue here is whether it is

equitable to take account of some capital gains resulting

from changes in the purchasing power of money when most

other capital gains are ignored for tax purposes.

12.91 The absence of a comprehensive system of

capital gains taxation exposes a second weakness of the

current value approach to the measurement of taxable income.

If an asset is purchased for $10 and sold for $15, it is

arguable that a gain of $5 has occurred even if, at the time

490

o f t h e s a l e , t h e r e p l a c e m e n t c o s t o f t h e a s s e t h a s i n c r e a s e d

t o $ 1 2 . T h e t o t a l g a i n m a y b e d i v i d e d i n t o t w o c o m p o n e n t s ,

an o p e r a t i n g g a i n o f $ 3 ( $ 1 5 - $ 1 2 ) a n d a h o l d i n g g a i n o f $2

($ 1 2 - $ 1 0 ) . T h e e f f e c t o f t h e c u r r e n t v a l u e a d j u s t m e n t i s t o

d e f e r t h e r e c o g n i t i o n o f t h e h o l d i n g g a i n a s i n c o m e . I f t h e

a s s e t c o n t i n u e s t o b e h e l d , h o w e v e r , i n t h e a b s e n c e o f a

c a p i t a l g a i n s t a x i t m a y n e v e r b e b r o u g h t t o a c c o u n t f o r t a x

p u r p o s e s .

1 2 . 9 2 T h e r e l a t i o n s h i p b e t w e e n c a p i t a l g a i n s , h o l d i n g

g a i n s a n d p u r c h a s i n g - p o w e r g a i n s a n d l o s s e s i s c o n s i d e r e d i n

C h a p t e r X I V , a l o n g w i t h t h e g e n e r a l q u e s t i o n w h e t h e r , a n d i f

s o u n d e r w h a t c i r c u m s t a n c e s , h o l d i n g g a i n s r e s u l t i n g f r o m

c u r r e n t v a l u a t i o n a d j u s t m e n t s s h o u l d s u b s e q u e n t l y b e s u b j e c t

to tax. M e a n w h i l e , t h e C o m m i t t e e r e c o r d s i t s v i e w t h a t t h e

a b s e n c e o f a c a p i t a l g a i n s t a x w e a k e n s t h e c a s e f o r t h e

a d o p t i o n o f a c u r r e n t v a l u e c o n c e p t o f t a x a b l e i n c o m e .

1 2 . 9 3 T h e o t h e r l i m i t a t i o n o f c u r r e n t v a l u e

a c c o u n t i n g f o r t a x p u r p o s e s i s c o n c e r n e d w i t h m e t h o d s o f

i m p l e m e n t a t i o n . H e r e a g a i n t h e p r a c t i c a l p r o b l e m o f

d e v i s i n g a n a p p r o p r i a t e m e t h o d o f a d j u s t m e n t i s l i n k e d w i t h

t h e c o n c e p t u a l p r o b l e m o f d e t e r m i n i n g w h a t i s the

a p p r o p r i a t e c o n c e p t o f c u r r e n t v a l u e f o r t a x p u r p o s e s . A s

n o t e d a b o v e , c u r r e n t v a l u e m a y b e i n t e r p r e t e d b y r e f e r e n c e

t o t h r e e c o n c e p t s , n a m e l y t h e n e t r e a l i s a b l e v a l u e o f an

a s s e t , i t s c u r r e n t r e p l a c e m e n t c o s t at t h e t i m e t h e i n c o m e

v a l u a t i o n a d j u s t m e n t i s m a d e o r i t s r e p l a c e m e n t c o s t at t h e

491

t i m e o f r e p l a c e m e n t . T h e v a l u a t i o n a d j u s t m e n t a n d t h e

m e a s u r e o f c u r r e n t i n c o m e w i l l d e p e n d o n w h i c h c o n c e p t is

c o n s i d e r e d s u i t a b l e f o r t a x p u r p o s e s .

1 2 . 9 4 M a n y s u b m i s s i o n s a r g u e d f o r t h e a d o p t i o n o f

r e p l a c e m e n t c o s t a s t h e a p p r o p r i a t e m e a s u r e o f c u r r e n t

v a l u e , w i t h o u t i n d i c a t i n g w h i c h c o n c e p t o f r e p l a c e m e n t c o s t

w a s p r e f e r r e d . B u t s o m e s u b m i s s i o n s a r g u e d s p e c i f i c a l l y i n

f a v o u r o f a c o n c e p t o f a d j u s t e d r e p l a c e m e n t c o s t , u n d e r

w h i c h v a l u a t i o n a d j u s t m e n t s w o u l d h a v e r e g a r d t o r e p l a c e m e n t

c o s t a t t h e t i m e o f r e p l a c e m e n t r a t h e r t h a n a t t h e t i m e t h e

i n c o m e v a l u a t i o n a d j u s t m e n t s w e r e m a d e .

1 2 . 9 5 T h e p r o b l e m m a y b e i l l u s t r a t e d b y r e f e r e n c e to

a m a c h i n e w h i c h o r i g i n a l l y c o s t $ 1 0 0 a n d i s t o b e

d e p r e c i a t e d o v e r t w o y e a r s a t t h e r a t e o f $ 5 0 p . a . C u r r e n t

r e p l a c e m e n t c o s t i n c r e a s e s i n t h e f i r s t y e a r b y 2 0 p e r c e n t

a n d a g a i n i n t h e s e c o n d y e a r b y 20 p e r c e n t , a c o m p o u n d e d

i n c r e a s e o f 44 p e r c e n t o v e r t h e t w o - y e a r p e r i o d . I f a

d e p r e c i a t i o n v a l u a t i o n a d j u s t m e n t is m a d e e a c h y e a r o n t h e

b a s i s o f t h e m a c h i n e ' s c u r r e n t r e p l a c e m e n t c o s t a t t h e t i m e

o f t h e a d j u s t m e n t , t h e a m o u n t o f t h e a d j u s t m e n t w i l l b e $1 0

i n t h e f i r s t y e a r a n d $ 2 2 i n t h e s e c o n d y e a r . As a r e s u l t ,

r e v a l u a t i o n r e s e r v e s o f $3 2 w i l l b e a c c u m u l a t e d d u r i n g t h e

t w o y e a r s w h i c h , w h e n a d d e d t o t h e a m o u n t s r e c o u p e d f r o m

o r d i n a r y d e p r e c i a t i o n ( $ 1 0 0 ) , w i l l p r o v i d e $ 1 3 2 t o w a r d s

r e p l a c e m e n t . B u t b e c a u s e t h e r e p l a c e m e n t c o s t o f t h e a s s e t

i s $ 1 4 4 , t h e r e i s a s h o r t f a l l o f $12. T h i s a m o u n t , i t w a s

a r g u e d i n s o m e s u b m i s s i o n s , s h o u l d b e t h e s u b j e c t o f an

492

a d d i t i o n a l v a l u a t i o n a d j u s t m e n t , t h e r e b y f u r t h e r r e d u c i n g

t a x a b l e i n c o m e .

1 2 . 9 6 T h e r e a r e s e v e r a l r e a s o n s w h y t h e C o m m i t t e e

r e j e c t s t h e a r g u m e n t u n d e r l y i n g t h i s a p p r o a c h t o t h e

m e a s u r e m e n t o f v a l u a t i o n a d j u s t m e n t s a n d t a x a b l e i n c o m e . I t

is b a s e d o n a n u n a c c e p t a b l e n o t i o n t h a t t h e m e a s u r e o f

i n c o m e m u s t n e c e s s a r i l y b e l i n k e d w i t h t h e p r o v i s i o n o f

f u n d s t o r e p l a c e i n d i v i d u a l a s s e t s , r a t h e r t h a n w i t h t h e

m a i n t e n a n c e o f o p e r a t i n g c a p a c i t y . B u t i n a n y c a s e i t is

l i k e l y t o r e s u l t i n d o u b l e c o u n t i n g , b e c a u s e i t i g n o r e s t h e

e a r n i n g c a p a c i t y o f t h e f u n d s r e p r e s e n t e d b y t h e f i r s t

y e a r ' s d e p r e c i a t i o n a l l o w a n c e s ($50) a n d r e v a l u a t i o n

r e s e r v e s ($10). If , f o r e x a m p l e , t h e s e f u n d s a r e i n v e s t e d

i n a s s e t s s u b j e c t t o t h e s a m e r a t e o f p r i c e i n c r e a s e s a s t h e

m a c h i n e ( n a m e l y , 20 p e r c e n t ) , t h e r e s u l t i n g e a r n i n g s o f $ 1 2

w i l l m a k e g o o d t h e s h o r t f a l l i n r e p l a c e m e n t c o s t . T h i s

r e s u l t w i l l b e a c h i e v e d i f t h e f i r m h a s a b a l a n c e d s t o c k o f

m a c h i n e s , i n t h e e x a m p l e t w o m a c h i n e s , o n e o f w h i c h n e e d s

r e p l a c i n g e a c h y e a r . D e p r e c i a t i o n b a s e d o n c u r r e n t

r e p l a c e m e n t c o s t i n t h e f i r s t y e a r , $ 5 0 + t h e d e p r e c i a t i o n

v a l u a t i o n a d j u s t m e n t $ 1 0 f o r e a c h m a c h i n e ( t h a t is, $ 6 0 x 2

= $ 1 2 0 ) , w i l l b e s u f f i c i e n t t o f i n a n c e t h e r e p l a c e m e n t o f

t h e f i r s t m a c h i n e , w h i l e c u r r e n t c o s t d e p r e c i a t i o n i n t h e

s e c o n d y e a r (($50 + $22) x 2 = $144) w i l l s i m i l a r l y f i n a n c e

t h e r e p l a c e m e n t o f t h e s e c o n d m a c h i n e .

493

12.97 Where the stock of machines is growing over

time (because the firm is expanding), current-cost

depreciation on all machines currently held may exceed the

current cost of replacing those machines purchased some

years previously. The financial problem posed by rising

replacement costs may then be regarded as having been

alleviated by the expansion in the stock of machines.

12.98 Turning now to the question of the choice

between current replacement cost and net realisable value,

it has been suggested above that, conceptually, current

replacement cost provides a measure of an asset's current

value so long as management intends to continue to use and

replace the asset, but that net realisable value is the

appropriate concept if replacement is not intended. For

taxation purposes, it may be sufficient to use current

replacement cost as the basis of valuation adjustments

under normal circumstances, whilst retaining the present

provision in the tax law whereby firms have the option of

using market selling value. Appendix D shows that there are

no measurement or taxation problems in calculating cost of

sales valuation adjustments by reference to changes in the

prices of stocks as valued for ordinary taxation purposes.

12.99 Professor R.J. Chambers has argued that

non-monetary assets should always be valued at net

realisable (or market selling) prices. Under his system of

'continuously contemporary accounting', the other aspects of

which are examined in greater detail below, holding gains

494

a n d l o s s e s a r e r e c o g n i s e d a s s o o n a s c h a n g e s i n s e l l i n g

v a l u e o c c u r a n d a r e t r e a t e d a s d i s t r i b u t a b l e i n c o m e

( s u b j e c t , l i k e m o n e t a r y a s s e t s , t o a d j u s t m e n t f o r c h a n g e s i n

t h e p u r c h a s i n g p o w e r o f m o n e y ) w i t h o u t a p p l y i n g a

r e a l i s a t i o n t e s t . T h e C o m m i t t e e a c c e p t s t h a t k n o w l e d g e o f

t h e n e t r e a l i s a b l e v a l u e o f a s s e t s is v i t a l t o e f f i c i e n t

d e c i s i o n m a k i n g w i t h i n t h e f i r m , b u t i t d o e s n o t a c c e p t t h a t

t h i s i s t h e o n l y i n f o r m a t i o n w h i c h is n e e d e d b y m a n a g e r s ,

p r o p r i e t o r s , i n v e s t o r s a n d c r e d i t o r s . W h e t h e r n e t

r e a l i s a b l e v a l u e o r c u r r e n t r e p l a c e m e n t c o s t is t h e

a p p r o p r i a t e m e a s u r e o f c u r r e n t v a l u e d e p e n d s o n w h e t h e r

c o n t i n u e d r e p l a c e m e n t o f t h e a s s e t s is j u d g e d b y m a n a g e m e n t

t o b e e c o n o m i c a l l y j u s t i f i e d , w h i c h w i l l d e p e n d i n t u r n o n

r e l a t i o n s h i p b e t w e e n c u r r e n t r e p l a c e m e n t c o s t a n d t h e

d i s c o u n t e d v a l u e o f e x p e c t e d f u t u r e r e t u r n s .

1 2 . 1 0 0 T h e p r o b l e m is n o t m e r e l y o n e o f a s c e r t a i n i n g

n e t r e a l i s a b l e v a l u e s . A s P r o f e s s o r C h a m b e r s a r g u e d i n h i s

s u b m i s s i o n :

" T h e r e a r e ... b e t t e r a p p r o x i m a t i o n s t o m a r k e t p r i c e s i n

t h e c a s e o f m o s t a s s e t s t h a n t h e h i s t o r i c a l c o s t

f i g u r e s n o w i n use. I n v e n t o r y p r i c e s s h o u l d n o t b e

d i f f i c u l t t o d e t e r m i n e as t h e ' l o w e r o f c o s t a n d

m a r k e t * r u l e a l r e a d y e n t a i l s t h a t m a r k e t p r i c e s s h o u l d

b e k n o w n . A n n u a l v a l u a t i o n s b y e x p e r t v a l u e r s a r e n o t

n e c e s s a r y f o r p l a n t , l a n d a n d b u i l d i n g s a n d s i m i l a r

a s s e t s , t h o u g h t h e y m a y b e c h e c k e d i n t h i s w a y

o c c a s i o n a l l y . W h a t is r e q u i r e d is t h e b e s t

a p p r o x i m a t i o n ? i t is c e r t a i n l y n o t d i f f i c u l t t o o b t a i n

b e t t e r a p p r o x i m a t i o n s t o m a r k e t p r i c e s t h a n o r i g i n a l

c o s t s o r a n y a r i t h m e t i c a l o p e r a t i o n o n o r i g i n a l c o s t s .

Q u o t e d h o l d i n g s o f s e c u r i t i e s a r e e a s i l y p r i c e d . A n d

s h a r e s i n s u b s i d i a r i e s w h i c h a r e n o t q u o t e d m a y b e

r e p r e s e n t e d b y t h e h o l d e r ' s p r o p o r t i o n o f t h e n e t

a s s e t s a s c o m p u t e d b y r e f e r e n c e t o t h e m o n e y

e q u i v a l e n t s o f a s s e t s .

495

I n a n y c a s e a p p r o x i m a t i o n s t o m a r k e t s e l l i n g p r i c e s

s h o u l d b e a c c e p t a b l e f o r t a x p u r p o s e s , s i n c e i f t h e

a p p r o x i m a t i o n i n a n y y e a r is i n e r r o r , o n e w a y o r t h e

o t h e r , t h e f o l l o w i n g y e a r w i l l b e a r t h e c o n s e q u e n c e o f

i t b e c a u s e a n e w a p p r o x i m a t i o n t o m a r k e t p r i c e s m u s t

t h e n b e o b t a i n e d . H i e m e t h o d i s f r e e o f t h e

c a r r y - f o r w a r d o f o u t o f d a t e f i g u r e s w h i c h is

c h a r a c t e r i s t i c o f p r e s e n t a c c o u n t i n g . T h e r e v e n u e w i l l

n o t s u f f e r f r o m t h e s e a p p r o x i m a t i o n s . "

1 2 . 1 0 1 T h e C o m m i t t e e d o e s n o t d i s m i s s t h e p r o b l e m o f

o b t a i n i n g r e l i a b l e i n f o r m a t i o n a b o u t n e t r e a l i s a b l e v a l u e s

o f a s s e t s ( o t h e r t h a n s t o c k s a n d q u o t e d s e c u r i t i e s ) . B u t

i t s m a i n o b j e c t i o n t o t h e e x c l u s i v e u s e o f n e t r e a l i s a b l e

v a l u e as t h e b a s i s o f c u r r e n t v a l u a t i o n is t h a t n e t

r e a l i s a b l e v a l u e i s n o t a r e l e v a n t i n d i c a t o r o f a n a s s e t ' s

w o r t h t o t h e f i r m if, o n t h e b a s i s o f t h e r e p l a c e m e n t

d e c i s i o n d e s c r i b e d a b o v e , i t w i l l c o n t i n u e t o b e u s e d (or

sold) a n d r e p l a c e d r a t h e r t h a n s o l d a n d n o t r e p l a c e d . A t a x

b a s e r e f l e c t i n g t h i s c o n c e p t o f c u r r e n t v a l u e w o u l d n o t , i n

t h e C o m m i t t e e ' s j u d g m e n t , b e e q u i t a b l e as b e t w e e n d i f f e r e n t

f i r m s , f o r e x a m p l e a s b e t w e e n o l d a n d n e w f i r m s o r b e t w e e n

f i r m s w i t h a h e a v y i n v e s t m e n t i n s p e c i a l i s e d p l a n t a n d

e q u i p m e n t ( a n d a c o r r e s p o n d i n g l y l o w r e a l i s a b l e v a l u e ) a n d

f i r m s w i t h r e a d i l y r e a l i s a b l e a s s e t s ( s u c h a s m e r c h a n t s

w h o s e a s s e t s c o n s i s t m a i n l y o f s t o c k s ) .

1 2 . 1 0 2 T h e f i n a l p r o b l e m i n i m p l e m e n t i n g a c u r r e n t

v a l u a t i o n a p p r o a c h t o t h e m e a s u r e m e n t o f t a x a b l e i n c o m e

c o n c e r n s t h e m e t h o d o f m a k i n g i n c o m e v a l u a t i o n a d j u s t m e n t s .

T h e m e a s u r e m e n t o f c u r r e n t i n c o m e r e q u i r e s c o s t o f s a l e s a n d

d e p r e c i a t i o n to b e v a l u e d i n t e r m s o f c u r r e n t p r i c e s . O n e

496

i s s u e i s w h e t h e r c u r r e n t c o s t s a r e t o b e d e t e r m i n e d a n d

r e c o r d e d a s t r a m s a c t i o n s t a k e p l a c e o r w h e t h e r v a l u a t i o n

a d j u s t m e n t s a r e t o b e m a d e o n l y a t t h e e n d o f t h e i n c o m e

p e r i o d . T h e p r o b l e m h e r e is t h a t t h e C o m m i t t e e o b v i o u s l y

c a n n o t a s s u m e t h a t f i r m s a r e a l r e a d y u s i n g c u r r e n t v a l u e

a c c o u n t i n g f o r t h e i r o w n p u r p o s e s , s o t h a t i f i t is t o be

u s e d f o r t a x p u r p o s e s i t w o u l d s e e m n e c e s s a r y t o d e v i s e a

m e t h o d o f a d j u s t i n g i n c o m e m e a s u r e s d e r i v e d i n a c c o r d a n c e

w i t h e x i s t i n g h i s t o r i c a l c o s t a c c o u n t i n g p r a c t i c e s . I t is

t h e n n e c e s s a r y t o a s k w h e t h e r s u c h a d j u s t m e n t s c a n b e m a d e

b y r e f e r e n c e t o t h e a c t u a l e x p e r i e n c e o f i n d i v i d u a l f i r m s ,

o r w h e t h e r i t w i l l b e n e c e s s a r y t o r e q u i r e f i r m s t o u s e

i n d e x e s p u b l i s h e d f o r t h i s p u r p o s e (by t h e A u s t r a l i a n B u r e a u

o f S t a t i s t i c s o r t h e C o m m i s s i o n e r o f T a x a t i o n ) .

1 2 . 1 0 3 A g a i n t h e p r o b l e m is p a r t l y a d m i n i s t r a t i v e a n d

p a r t l y c o n c e p t u a l . T h e a d m i n i s t r a t i v e p r o b l e m is t o e n s u r e

t h a t t h e C o m m i s s i o n e r o f T a x a t i o n h a s s u f f i c i e n t c o n t r o l

o v e r t h e a d j u s t m e n t s c l a i m e d f o r t a x p u r p o s e s , s o t h a t t h e

a d j u s t m e n t p r o c e d u r e s w i l l n o t o p e n u p f r e s h o p p o r t u n i t i e s

f o r t a x a v o i d a n c e o r t a x e v a s i o n a n d t h e r e b y e r o d e t h e

e q u i t y a n d e f f i c i e n c y o f t h e t a x s y s t e m . T h e r e is a l s o a

p r o b l e m o f e n s u r i n g t h a t a d j u s t m e n t p r o c e d u r e s a r e

r e l a t i v e l y s i m p l e f r o m t h e p o i n t o f v i e w o f t a x p a y e r

c o m p l i a n c e . T h i s m e a n s , a m o n g o t h e r t h i n g s , t h a t t h e y m u s t

b e c a p a b l e o f b e i n g a p p l i e d t o u n i n c o r p o r a t e d e n t e r p r i s e s ,

w h i c h m a y b e r e l a t i v e l y l a c k i n g i n a c c o u n t i n g a n d m a n a g e r i a l

s k i l l s , a s w e l l as t o l a r g e c o m p a n i e s w h i c h c a n e a s i l y

497

command such skills.

12.104 The conceptual problem in relation to current

replacement cost is to determine what current replacement

cost means under circumstances when identical assets are not

available for replacement, because of such factors as

fashion changes, changes in technology affecting the plant

itself, its inputs or its products, changes in capacity

affecting unit costs of production, or productivity changes

resulting from other causes. The theoretical answer must be

that the current replacement of an asset must be measured by

reference to the current cost of acquiring assets capable of

providing the same goods and services as those being

provided by the assets being revalued, but this answer

obviously leaves room for substantial measurement problems

where the nature of assets is changing in the ways described

above.

12.105 The problem arises in a more acute form in

relation to plant and equipment than in relation to stocks.

This is partly because fixed assets are used over a longer

period than the ordinary stock cycle, so that it is usually

more difficult to identify assets on currently available

price lists which are comparable with assets previously

acquired but currently in use. It is also because plant or

equipment is more complex than an individual stock item;

this means that its current replacement cost can be affected

not only by such factors as technological changes in its own

design, but also by changes in relation to its inputs and

498

o u t p u t s . T h e p r o b l e m o f m e a s u r i n g c u r r e n t r e p l a c e m e n t c o s t

is i n t e n s i f i e d w h e n f i r m s c o n s t r u c t t h e i r o w n p l a n t a n d

m a c h i n e r y . I f , f o r e x a m p l e , t h e r e a r e d i f f e r e n c e s o v e r t i m e

i n t h e d e g r e e o f u t i l i s a t i o n o f f i x e d o v e r h e a d s , t h e s e

d i f f e r e n c e s m a y b e r e f l e c t e d r a t h e r a r b i t r a r i l y i n t h e

c o n s t r u c t i o n c o s t a n d h e n c e i n t h e m e a s u r e o f c u r r e n t

r e p l a c e m e n t c o s t .

1 2 . 1 0 6 T h e C o m m i t t e e w r o t e t o a n u m b e r o f c o m p a n i e s

w h i c h , i n a d v o c a t i n g t h e u s e o f c u r r e n t r e p l a c e m e n t c o s t

a d j u s t m e n t s a s p a r t o f t h e p r o c e s s o f d e t e r m i n i n g t a x a b l e

i n c o m e , i n d i c a t e d t h a t t h e y m a d e s u c h a d j u s t m e n t s f o r t h e i r

o w n m a n a g e r i a l o r f i n a n c i a l r e p o r t i n g p u r p o s e s . I n

p a r t i c u l a r , t h e C o m m i t t e e s o u g h t c l a r i f i c a t i o n as t o w h e t h e r

t h e p r o b l e m s d i s c u s s e d i n t h e p r e c e d i n g p a r a g r a p h w e r e

a l l o w e d f o r i n s o m e w a y i n d e t e r m i n i n g c u r r e n t r e p l a c e m e n t

c o s t , a n d i f s o h o w . T h e r e s p o n s e s i n d i c a t e d t h at, a l t h o u g h

t h e c o m p a n i e s c o n c e r n e d d i d g e n e r a l l y e n d e a v o u r t o a l l o w

s y s t e m a t i c a l l y f o r t h e d i f f e r e n t f a c t o r s w h i c h w e r e

d i s t i n g u i s h e d , t h e i r p r o c e d u r e s w o u l d n o t b e c a p a b l e o f

b e i n g g e n e r a l l y a p p l i e d i n a m a n n e r w h i c h w o u l d e n a b l e t h e

C o m m i s s i o n e r o f T a x a t i o n t o v e r i f y t h e c a l c u l a t i o n s a n d

t h e r e b y c o n t r o l t h e v a l u a t i o n a d j u s t m e n t s c l a i m e d f o r t a x

p u r p o s e s .

1 2 . 1 0 7 I t w a s n o d o u b t p a r t l y f o r t h i s r e a s o n t h a t o n e

c o m p a n y , t h e B r o k e n H i l l P r o p r i e t a r y C o m p a n y L t d . , d e c i d e d

n o t t o r e c o m m e n d t h e a d o p t i o n f o r t a x p u r p o s e s o f t h e

499

depreciation method which it uses for its own accounting

purposes. The Company's method was described in its

submission as follows:

"Briefly stated the current policy provides for a charge against revenue based on the current replacement cost of the fixed assets employed. It is calculated by applying appropriate percentages, based on the expected total economic life of the assets, to the estimated current replacement costs. Asset lives are reviewed at regular intervals and the appropriate percentage rate

is determined on the basis of the total economic life of the asset, the total economic life representing the expired life to date and an estimate of the anticipated remaining future life. Commencing in 1969 the charge against profits for the use of fixed assets has been designated 'fixed asset utilisation' and has been

allocated as between 1depreciation1 and 'fixed asset value adjustment*. The amount allocated to 'depreciation' is calculated by applying the rate appropriate to the assessed future asset life to the written down book value of the asset and only this

amount is deducted from the book value of fixed assets, whilst the amount allocated to 'fixed asset value adjustment' is the remainder and represents that part of the charge against profits which relates to the

excess of the replacement value over the book value of the asset and this part appears in the balance sheet as 'fixed asset value adjustment'."

12.108 The Company's submission went on to say:

"... at first sight it would seem appropriate that we should recommend to the Committee of Inquiry that [B.H.P.'s] policy should be accepted in principle for income tax purposes also. If the policy was adopted in toto it would mean that the deduction allowable to the

taxpayer would be based on the current replacement value of the asset in question, the current replacement value being determined by the taxpayer by a method to

be agreed with the Commissioner which could include reference to a published Government index. It would also mean that the deduction would be calculated in the first instance having regard to extensions to this life

from time to time where the taxpayer is able to establish that the asset will have an operating life in excess of that set by the Commissioner ...

However, because introduction for taxation purposes of the concept of extending the lives of assets may result in continuing and increasing taxation deductions it must be accepted that a method similar to the Company's

500

a c c o u n t i n g m e t h o d c o u l d e n c o u r a g e m i s d i r e c t e d (or

d i s t o r t t h e p a t t e r n of) i n v e s t m e n t f o r t h e f o l l o w i n g

r e a s o n s . T h e f i r m , h a v i n g m a i n t a i n e d t h e n e c e s s a r y

c a p a c i t y f o r t h e e m p l o y m e n t o f e c o n o m i c r e s o u r c e s ,

w o u l d t e n d t o e x p a n d o u t p u t i n t o o t h e r a r e a s o f

a c t i v i t y a t t h e e x p e n s e o f u p d a t i n g c u r r e n t f a c i l i t i e s

t o i m p r o v e p r o d u c t i v i t y . W i t h c r e d i t a l r e a d y b e i n g

r e c e i v e d b y m e a n s o f t h e t a x s a v i n g s o n p l a n t

c o n t i n u i n g i n s e r v i c e , t h e f i r m r e a l l y h a s n o i n c e n t i v e

t o i n c u r e x p e n d i t u r e o n r e p l a c e m e n t e q u i p m e n t t o o b t a i n

a s i m i l a r t a x d e d u c t i o n f o r n e w p l a n t ; c o s t s a v i n g s i n

o t h e r a r e a s w o u l d a c c o r d i n g l y n e e d t o b e s i g n i f i c a n t t o

o f f s e t t h i s t a x c r e d i t . ”

1 2 . 1 0 9 T h i s a r g u m e n t l e d t h e C o m p a n y t o c o n c l u d e t h a t

i t s m e t h o d w a s u n s u i t a b l e f o r t a x p u r p o s e s , a l t h o u g h i t

r e m a i n e d v a l i d f o r t h e C o m p a n y ’s o w n p u r p o s e s .

1 2 . 1 1 0 A n o t h e r C o m p a n y w h i c h b a s e s i t s a c c o u n t i n g a n d

r e p o r t i n g p r o c e d u r e s o n c u r r e n t v a l u e s , P h i l i p s I n d u s t r i e s

H o l d i n g s L t d . , a l s o s a w d i f f i c u l t i e s i n a p p l y i n g i t s

a p p r o a c h f o r t a x p u r p o s e s . I n d i s c u s s i n g i t s t r e a t m e n t o f

s t o c k s , t h e C o m p a n y s a i d ;

" W h i l s t w e d o n o t m a k e a v a l u a t i o n a d j u s t m e n t f o r e a c h

t r a n s a c t i o n , w e r e g u l a r l y r e v a l u e t h e i t e m s o f t h e

s t o c k d u r i n g t h e c o u r s e o f t h e y e a r a s t h e p r i c e l e v e l

o f t h e i n p u t v a r i e s s i g n i f i c a n t l y f r o m t h e e l e m e n t s

m a k i n g u p t h e s t a n d a r d p r i c e .

O u r a p p r o a c h , s o f a r a s t h i s s u b m i s s i o n i s c o n c e r n e d ,

w o u l d b e to c o n t i n u e t o f o l l o w t h e p r a c t i c e o f v a l u i n g

s t o c k a t r e p l a c e m e n t v a l u e a n d to s e e k a s b e i n g e x e m p t

f r o m t a x t h e i n c r e a s e t o t h e v a l u a t i o n a d j u s t m e n t

r e s e r v e , i n s o f a r a s i t a p p l i e s t o s t o c k s .

A s t h e r e a r e r e l a t i v e l y f e w c o m p a n i e s w h o f o l l o w t h i s

m e t h o d , i t m a y w e l l b e t h a t t h e r e m a y n o t b e s u f f i c i e n t

r e p r e s e n t a t i o n s a l o n g t h i s l i n e t o a r g u e f o r t h i s

o p t i o n t o b e i n c l u d e d . I n t h i s c a s e , w e w o u l d s u p p o r t

a n a r g u m e n t f o r t h e ' l a s t - i n , f i r s t - o u t ' m e t h o d o f

v a l u a t i o n b e i n g a d d e d t o t h e p r e s e n t o p t i o n s f o r

v a l u i n g s t o c k . "

1 2 . 1 1 1 A f t e r a d v o c a t i n g t h a t r e p l a c e m e n t c o s t

d e p r e c i a t i o n b e a l l o w e d f o r t a x p u r p o s e s , P h i l i p s c o m m e n t e d :

501

"As it is likely that the Government would wish to set an upper limit on such increases in the depreciation, we believe this could be achieved by adopting the most relevant implicit deflator index or the G.N.P. deflator

index as the basis of either determining the increase of the depreciation, which would be an allowable deduction, or setting the limit of the depreciation actually booked which is acceptable as a deduction for

income tax purposes."

12.112 In the light of its investigation of the

problem, the Committee has concluded that it is practicable,

from the viewpoint of both the Commissioner of Taxation and

the individual taxpayer, to calculate current value

adjustments in relation to stocks by reference to price

changes affecting a firm's own inventories. It was

suggested in submissions that this may be done by:

(a) revaluing opening stocks in terms of the actual

prices of closing stocks and calculating the

valuation adjustment as the difference between

opening stocks valued at historical prices and

opening stocks valued at the prices of closing

stocks;

(b) revaluing both opening and closing stocks at

the actual prices of stocks held at the middle

of the income period, and calculating the

valuation adjustment as the sum of (i) the

difference between historical and revalued

prices of opening stocks, and (ii) the

difference between revalued and historical

prices of closing stocks; and

502

(c) b y r e v a l u i n g s t o c k s b y r e f e r e n c e t o a n i n d e x

(or i n d e x e s ) a n d c a l c u l a t i n g t h e a d j u s t m e n t in

a c c o r d a n c e w i t h (a) o r ( b ) .

1 2 , 1 1 3 I n s o f a r a s d e p r e c i a t i o n i s c o n c e r n e d , h o w e v e r ,

t h e C o m m i t t e e b e l i e v e s t h a t t h e c a l c u l a t i o n o f c u r r e n t

r e p l a c e m e n t c o s t f o r t a x p u r p o s e s c a n o n l y b e m a d e b y

r e f e r e n c e t o a p u b l i s h e d i n d e x o r i n d e x e s . T h e d e p r e c i a t i o n

v a l u a t i o n a d j u s t m e n t w o u l d t h e n b e c a l c u l a t e d a s t h e

d i f f e r e n c e b e t w e e n h i s t o r i c a l c o s t d e p r e c i a t i o n a n d c u r r e n t

v a l u e d e p r e c i a t i o n , t h e l a t t e r b e i n g m e a s u r e d b y m u l t i p l y i n g

h i s t o r i c a l c o s t d e p r e c i a t i o n b y t h e r a t i o o f t h e c u r r e n t

i n d e x o f c u r r e n t r e p l a c e m e n t c o s t t o t h e i n d e x in t h e y e a r

o f p u r c h a s e o f t h e a s s e t .

1 2 . 1 1 4 D e s p i t e t h e p r o b l e m s w h i c h h a v e b e e n d i s c u s s e d ,

t h e C o m m i t t e e s e e s v i r t u e s i n t h e c u r r e n t v a l u e c o n c e p t o f

t a x a b l e i n c o m e and, i n C h a p t e r X I V , e x p l o r e s w a y s a n d m e a n s

o f o v e r c o m i n g o r m i t i g a t i n g t h e d i f f i c u l t i e s a n d o f a d a p t i n g

t h e t a x s y s t e m t o t h e r e q u i r e m e n t s o f s u c h a c o n c e p t .

C . P . P . P r o f i t a s t h e M e a s u r e o f T a x a b l e I n c o m e

1 2 . 1 1 5 T h e C o m m i t t e e r e c e i v e d s e v e r a l s u b m i s s i o n s

a d v o c a t i n g t h e u s e o f c u r r e n t p u r c h a s i n g p o w e r (C.P.P.)

p r o f i t a s t h e m e a s u r e o f t a x a b l e i n c o m e . A s h a s b e e n n o t e d

in C h a p t e r X , t h e f u l l a p p l i c a t i o n o f t h e C . P . P . a c c o u n t i n g

a p p r o a c h i n v o l v e s t h e c a l c u l a t i o n o f p r o f i t a s t h e s u m o f

t w o c o m p o n e n t s . T h e f i r s t o f t h e s e i s m e a s u r e d b y a d j u s t i n g

a l l i n c o m e s t a t e m e n t i t e m s , a s o r i g i n a l l y e x p r e s s e d in

503

h i s t o r i c a l p r i c e s , i n a c c o r d a n c e w i t h c h a n g e s in a

p u r c h a s i n g p o w e r i n d e x s i n c e t h e t r a n s a c t i o n s o r i g i n a l l y

t o o k p l a c e . T h e s e c o n d c o m p o n e n t o f C . P . P . p r o f i t i s th e

p u r c h a s i n g p o w e r g a i n (or l o s s ) a s s o c i a t e d w i t h h o l d i n g

l i a b i l i t i e s (or m o n e t a r y a s s e t s ) t h r o u g h t h e i n c o m e p e r i o d .

1 2 . 1 1 6 S o m e s u b m i s s i o n s r e c o m m e n d e d t h e f u l l a d o p t i o n

o f C . P . P . p r o f i t a s t h e t a x b a s e , in l i n e w i t h

r e c o m m e n d a t i o n s o f o v e r s e a s p r o f e s s i o n a l a c c o u n t a n c y b o d i e s

o r t h e P r e l i m i n a r y E x p o s u r e D r a f t o n C . P . P . a c c o u n t i n g

p u b l i s h e d b y t h e A u s t r a l i a n A c c o u n t i n g S t a n d a r d s C o m m i t t e e

o f t h e A u s t r a l i a n S o c i e t y o f A c c o u n t a n t s a n d t h e I n s t i t u t e

o f C h a r t e r e d A c c o u n t a n t s in Australia.''" S o m e a c c o u n t a n t s

r e c o m m e n d e d v a r i a t i o n s i n t h e m e t h o d o f c a l c u l a t i n g a n d

r e p o r t i n g o n C . P . P . p r o f i t w h i c h w o u l d a c h i e v e t h e s a m e

r e s u l t a s t h a t r e c o m m e n d e d b y t h e p r o f e s s i o n a l b o d i e s , b u t

b y a s o m e w h a t d i f f e r e n t r o u t e .

1 2 . 1 1 7 M r . A . R . M u t t o n t h u s a r g u e d t h a t p r o f i t c a n b e

m e a s u r e d m o r e e a s i l y b y r e f e r e n c e t o c h a n g e s in t h e a d j u s t e d

v a l u e o f p r o p r i e t o r s h i p f u n d s in t h e b a l a n c e s h e e t , t h a n b y

r e f e r e n c e t o t h e a d j u s t m e n t o f i n c o m e s t a t e m e n t i t e m s :

" T h e c l e a r e s t , q u i c k e s t a n d m o s t r e l i a b l e w a y o f

a s c e r t a i n i n g p r o f i t f o r a p e r i o d is t h r o u g h t h e

m o v e m e n t o f p r o p r i e t o r s * f u n d s s h o w n o n t h e b a l a n c e

s h e e t . F o r e x a m p l e : 1

1 A c c o u n t i n g fo r C h a n g e s in t h e P u r c h a s i n g P o w e r o f M o n e y ,

o p . c i t .

504

$

P r o p r i e t o r s ' f u n d s a t 30 J u n e 1 9 X 1 w h o l l y

r e p r e s e n t e d b y d o l l a r s o f t h a t d a t e ( b e c a u s e

e v e r y a s s e t a n d e v e r y l i a b i l i t y is s t a t e d i n

d o l l a r s o f t h a t d a t e ) 100

I n c r e a s e i n t h e X Y Z I n d e x o f p r i c e s d u r i n g

y e a r e n d e d 30 J u n e 1 9 X 2 15%

A d j u s t m e n t a r i s i n g f r o m a p p l i c a t i o n o f t h a t

p e r c e n t a g e t o p r o p r i e t o r s ' f u n d s - 15% o f 1 0 0 15

P r o p r i e t o r s ' f u n d s a t 30 J u n e 1 9 X 1 e x p r e s s e d

i n d o l l a r s o f 30 J u n e 1 9 X 2 p u r c h a s i n g p o w e r 115

P r o p r i e t o r s ' f u n d s a t 30 J u n e 1 9 X 2 w h o l l y

r e p r e s e n t e d b y d o l l a r s o f t h a t d a t e (a g a i n

b e c a u s e e v e r y a s s e t a n d e v e r y l i a b i l i t y is

s t a t e d i n d o l l a r s o f t h a t date) 12 2

I n c r e a s e i n p r o p r i e t o r s ' f u n d s f o r t h e y e a r

( w h i c h is t h e p r o f i t f o r t h e y e a r e x p r e s s e d

i n 30 J u n e 1 9 X 2 d o l l a r s ) ___7

(If a n y f r e s h f u n d s w e r e i n t r o d u c e d d u r i n g t h e y e a r t h e

p r o f i t w o u l d b e l e s s b y t h a t a m o u n t . I f a n y i n t e r i m

d r a w i n g s w e r e m a d e b y t h e p r o p r i e t o r t h e p r o f i t w o u l d

b e h i g h e r b y t h a t a m o u n t . ) ”

1 2 . 1 1 8 I n t h e i r s u b m i s s i o n , P r i c e W a t e r h o u s e & Co .

r e f e r r e d t o t h e c o m p l e x i t y o f t h e c a l c u l a t i o n s n e c e s s a r y t o

c a l c u l a t e C . P . P . p r o f i t , a n d a s k e d : "If, t o a c h i e v e e q u i t y ,

w e m u s t r e f l e c t t h e f u l l s e t o f a d j u s t m e n t s a n d c o m p a n i e s

a r e n o t i n t h e h a b i t o f p r e p a r i n g s u c h f i g u r e s , is t h e r e a

p r a c t i c a l s h o r t c u t w h i c h w i l l a c h i e v e t h e n e c e s s a r y

r e s u l t ? " P r i c e W a t e r h o u s e b e l i e v e d t h a t t h e f o l l o w i n g

a p p r o a c h w o u l d p r o v i d e s u c h a s o l u t i o n :

" T o a r r i v e a t a d j u s t e d t a x a b l e i n c o m e , i n p r i n c i p l e ,

o n l y t w o a d j u s t m e n t s a r e r e q u i r e d . T h e s e a r e f o r t h e

a d d i t i o n a l d e p r e c i a t i o n b a s e d o n r e s t a t e d c o s t s a n d t h e

r e c o g n i t i o n o f t h e g a i n o r l o s s o n m o n e t a r y i t e m s a n d

i n v e n t o r y .

505

W e h a v e p r e p a r e d a s i m p l e c a s e s t u d y o f a c o m p a n y ' s

t r a d i n g f o r o n e y e a r ... T h e s t a t e m e n t o f t a x a b l e

i n c o m e b a s e d o n t h e s e a c c o u n t s w o u l d be:

N e t p r o f i t f o r y e a r p e r h i s t o r i c a l a c c o u n t s

w h i c h , f o r t h e p u r p o s e o f t h e e x a m p l e , is

a s s u m e d t o b e i d e n t i c a l w i t h t h e t a x a b l e

i n c o m e

A d d D e p r e c i a t i o n p e r h i s t o r i c a l a c c o u n t s

P r o f i t o n s a l e o f f i x e d a s s e t s i n e n d o f

y e a r t e r m s (see c o m m e n t (a) b e l o w )

G a i n o n n e t m o n e t a r y l i a b i l i t i e s a n d

i n v e n t o r y ( s e e c o m m e n t (b) b e l o w )

D e d u c t D e p r e c i a t i o n o n r e s t a t e d f i g u r e s (see

c o m m e n t (a) b e l o w ) 1 , 4 6 1

L o s s o n n e t m o n e t a r y a s s e t s a n d

i n v e n t o r y -

P r o f i t o n s a l e o f f i x e d a s s e t s p e r

h i s t o r i c a l a c c o u n t s ( s e e c o m m e n t

(b) b e l o w ) 400 1 , 8 6 1

T a x a b l e i n c o m e a s a d j u s t e d $619

T h e a b o v e t a x a b l e i n c o m e a s a d j u s t e d w o u l d b e t h e

f i g u r e o n w h i c h c o m p a n y t a x w o u l d b e l e v i e d a n d t h e

c a l c u l a t i o n o f s u f f i c i e n t d i s t r i b u t i o n f o r p r i v a t e

c o m p a n i e s b a s e d .

(a) D e p r e c i a t i o n a l l o w a n c e s a r e c a l c u l a t e d a t r a t e s

s i m i l a r t o t h o s e s e t o u t i n t h e p r e s e n t s c h e d u l e o f

d e p r e c i a t i o n r a t e s o n t h e h i s t o r i c a l c o s t s o f t h e f i x e d

a s s e t s r e s t a t e d i n c u r r e n t t e r m s b y t h e a p p l i c a t i o n o f

t h e c o n s u m e r p r i c e i n d e x ... I n a d d i t i o n , t h e g a i n o r

l o s s o n s a l e o f d e p r e c i a b l e a s s e t s w o u l d b e

r e c a l c u l a t e d ...

(b) W e c o n s i d e r i t is i n c o r r e c t t o a d j u s t i n v e n t o r y

w i t h o u t , a t t h e s a m e tim e , a d j u s t i n g n e t m o n e t a r y i t e m s

b e c a u s e o f t h e n a t u r e o f t h e b u s i n e s s c y c l e ...

W e t h e r e f o r e , r e c o m m e n d f o r p u r p o s e s o f t a x a t i o n t h a t

i n v e n t o r y b e r e g a r d e d as p a r t o f a n e t m o n e t a r y a s s e t

o r l i a b i l i t y g r o u p a n d a b l a n k e t a d j u s t m e n t b e m a d e f o r

t h i s i t em. W e w o u l d s u g g e s t t h e c a l c u l a t i o n b e m a d e o n

a s t a n d a r d f o r m , s i m i l a r to a s o u r c e a n d a p p l i c a t i o n o f

f u n d s s t a t e m e n t ..."

1 , 3 0 0

1,100

35

____45

2 , 4 8 0

506

1 2 . 1 1 9 O t h e r s u b m i s s i o n s r e c e i v e d b y t h e C o m m i t t e e

r e c o m m e n d e d p a r t i a l a d o p t i o n o f t h e C . P . P . a p p r o a c h , w h e r e b y

p u r c h a s i n g p o w e r a d j u s t m e n t s w o u l d b e m a d e o n l y t o c o s t o f

s a l e s ( i n r e s p e c t o f s t o c k s ) a n d d e p r e c i a t i o n , b u t n o t t o

m o n e t a r y i t e m s . T h e f o l l o w i n g o r g a n i s a t i o n s p r o p o s e d t h i s

a p p r o a c h :

(a) t h e A s s o c i a t e d C h a m b e r s o f M a n u f a c t u r e s o f

A u s t r a l i a ;

(b) M e t a l T r a d e s I n d u s t r y A s s o c i a t i o n o f A u s t r a l i a ;

(c) A u s t r a l i a n M i n i n g I n d u s t r y C o u n c i l ;

(d) A u s t r a l i a n B a n k e r s ' A s s o c i a t i o n ;

(e) C o o p e r s & L y b r a n d ;

(f) t h e T a s m a n i a n S t a t e T r e a s u r y , i n a s u b m i s s i o n

e n d o r s e d b y t h e T a s m a n i a n G o v e r n m e n t .

1 2 . 1 2 0 T h e A s s o c i a t e d C h a m b e r s o f M a n u f a c t u r e s o f

A u s t r a l i a ( A . C . M . A . ), a f t e r n o t i n g t h a t t h e r e a r e d i f f e r e n t

v i e w s a b o u t t h e m o s t e f f e c t i v e m e t h o d s o f a c c o u n t i n g f o r t h e

e f f e c t s o f i n f l a t i o n , w e n t o n t o s u g g e s t :

"A t t h i s s t a g e i t a p p e a r s t h a t t h e m o s t a p p r o p r i a t e a n d

s t r a i g h t f o r w a r d w a y o f m e a s u r i n g t h i s f o r t h e p u r p o s e

o f t a x r a t i n g is b y a p p l y i n g a n a p p r o p r i a t e i n d e x t o

t h e n o n m o n e t a r y f i g u r e s s h o w n i n h i s t o r i c a l l y b a s e d

a c c o u n t s . T h i s w o u l d b e d o n e t o c o n v e r t f i x e d a s s e t s

a n d s t o c k s e x p r e s s e d i n h i s t o r i c t e r m s , i n t o d o l l a r s o f

c u r r e n t p u r c h a s i n g p o w e r a n d u n i f o r m v a l u e . T h i s

s u g g e s t i o n is e m b o d i e d i n t h e m e t h o d o f C u r r e n t

P u r c h a s i n g P o w e r a c c o u n t i n g w h i c h h a s b e e n p r o m u l g a t e d

b y t h e I n s t i t u t e o f C h a r t e r e d A c c o u n t a n t s o f E n g l a n d

a n d W a l e s i n i t s S t a t e m e n t o f S t a n d a r d A c c o u n t i n g

P r i n c i p l e N o . 7 a n d p u t f o r w a r d f o r c o n s i d e r a t i o n a n d

c o m m e n t b y t h e I n s t i t u t e o f C h a r t e r e d A c c o u n t a n t s i n

A u s t r a l i a i n i t s p r e l i m i n a r y e x p o s u r e d r a f t d a t e d

D e c e m b e r , 1974.

507

T h i s m e t h o d o f m e a s u r i n g a n d r e c o r d i n g i n f l a t i o n is n o t

n e c e s s a r i l y t h e m o s t a p p r o p r i a t e t o b e u s e d f o r all

p u r p o s e s . N o r m a y it b e t h e m e t h o d w h i c h i s f i n a l l y

a d o p t e d w h e n t h e m a t t e r h a s b e e n f u l l y c a n v a s s e d an d

t h e v a r i o u s m e t h o d s c u r r e n t l y p r o p o s e d h a v e b e e n t e s t e d

a n d e v a l u a t e d ..."

1 2 . 1 2 1 U n d e r t h e A . C . M . A . p r o p o s a l , t a x a b l e i n c o m e

w o u l d b e a d j u s t e d b y (a) " t h e u p d a t i n g o f o p e n i n g s t o c k s to

t h e i r c u r r e n t p u r c h a s i n g p o w e r v a l u e a t t h e y e a r e n d b y

r e f e r e n c e t o t h e g r o s s d o m e s t i c p r o d u c t i m p l i c i t p r i c e

d e f l a t o r o r s o m e o t h e r a p p r o p r i a t e i n d e x " , a n d (b) b a s i n g

t h e d e p r e c i a t i o n c h a r g e ( c a l c u l a t e d b y r e f e r e n c e t o

h i s t o r i c a l c o s t ) o n t h e v a l u e o f f i x e d a s s e t s a d j u s t e d to

c u r r e n t d o l l a r s b y t h e a p p l i c a t i o n o f a p p r o p r i a t e p r i c e

i n d e x e s .

1 2 . 1 2 2 T h e A . C . M . A . s u b m i s s i o n p r e s e n t e d e s t i m a t e s o f

t h e s t o c k a n d d e p r e c i a t i o n a d j u s t m e n t s c a l c u l a t e d o n t h i s

b a s i s f o r r e s i d e n t a n d n o n - r e s i d e n t p u b l i c a n d p r i v a t e

m a n u f a c t u r i n g c o m p a n i e s ( t axable) f o r t h e y e a r s 1 9 6 4 - 6 5 to

1 9 7 3 - 7 4 . T h e e s t i m a t e s w e r e b a s e d o n T a x a t i o n S t a t i s t i c s of

t h e C o m m i s s i o n e r o f T a x a t i o n a n d t h e A u s t r a l i a n B u r e a u of

S t a t i s t i c s G r o s s D o m e s t i c P r o d u c t I m p l i c i t P r i c e D e f l a t o r .

B e c a u s e h i s t o r i c a l c o s t f i g u r e s w e r e n o t a v a i l a b l e for

1 9 7 2 - 7 3 a n d 1 9 7 3 - 7 4 , t h e e s t i m a t e s f o r t h o s e y e a r s w e r e

b a s e d o n a v e r a g e f i g u r e s f o r t h e p r e v i o u s e i g h t y e a r s . The

e s t i m a t e s a r e s u m m a r i s e d in T a b l e X I I - 1 .

1 2 . 1 2 3 I n a l e t t e r c o n t a i n i n g t h e f o l l o w i n g r e q u e s t ,

t h e C o m m i t t e e a s k e d A . C . M . A . f o r i t s r e a s o n s f o r i n d e x i n g

o n l y s t o c k s a n d d e p r e c i a t i o n :

1973-74

301.9 176.6 487.5 993.7

48.1

57.7 41.5 99.2 2(j57§·

37.3

509

"Although your proposal seems to be based on the current purchasing power approach to income measurement which has been suggested by some of the accounting bodies, you will be aware that this approach also involves the

inclusion in income of purchasing-power gains on monetary liabilities less purchasing-power losses on monetary assets. Proponents of this approach would argue, for example, that to the extent that

purchasing-power losses on non-monetary assets have been offset by purchasing-power gains on liabilities, there has been no diminution in CPP profit. The Committee would be interested to know whether ACMA considers that the adoption of the full CPP approach would be appropriate for taxation purposes. If, as your submissions seem to suggest, ACMA believes that purchasing-power adjustments should be restricted to non-monetary items only, we would be interested to have the Chambers' views on why purchasing-power adjustments

should not also be made in respect of monetary items."

12.124 The reply from A.C.M.A. referred, among other

things, to a recent published report about an English

company which had recorded a profit of £33.4 million

calculated on the conventional basis and a C.P.P. adjusted

profit of £100.9 million, the difference being largely

attributable to purchasing-power gains imputed on the

company's substantial liabilities:

"this latter instance appears to us to be the reductio ad absurdum of the idea of applying an index to the net financial position of a company - it would have involved taxing the company on a net monetary gain on

its borrowings, which clearly would have forced it into receivership. If this contention was accepted, one would have the ridiculous situation of a company, with no conventional profit, having to pay tax on the

notional profit on its borrowings, resulting from inflation, and then, in order to pay the tax, having to borrow more money on which further tax will be payable the following year. It is quite ludicrous that this

situation, which would compound the liquidity problems of the taxpayer, should be allowed to arise."

510

12.125 After giving a number of other reasons for

opposing the inclusion in taxable income of purchasing-power

adjustments on monetary items, A.C.M.A. concluded:

"We believe that, as far as manufacturers are concerned, to impose a tax on the hidden and unrealised gains resulting from the indexation of liabilities would cut right across any measures which your Committee might recommend by way of adjustments to stock values and depreciation charges, to mitigate the effect of tax on inflated profits. Even if a unit of plant is financed completely out of borrowings, there is a disadvantage in real terms to the entity if it has to borrow a greater amount at the end of the asset's working life merely to replace it. A continuing entity should be able to provide for these increased costs out of its operations. It should not be forced to additional capital raising or borrowing merely to replace existing assets."

12.126 Although the Committee agrees with these views

insofar as they point to general disadvantages of the C.P.P.

approach, it has difficulty in accepting the argument that

purchasing-power adjustments should only be applied in such

a way as to reduce taxable income, irrespective of whether

purchasing-power gains or losses have accrued on other

financial statement items. It is one of the chief merits of

C.P.P. accounting that it requires a comprehensive

revaluation of all items in a firm's financial statements in

terms of purchasing-power changes; the selection of only

some items for adjustment will destroy the internal logic of

the system.

12.127 In the following sections, the Committee

evaluates the advantages and disadvantages of using the full

C.P.P. measure of profit for tax purposes.

511

12.128 Advantages of C.P.P. Profit as a Measure of

Taxable Income. Because it is based on historical cost data

adjusted for changes in the general price level, C.P.P.

accounting has the same advantages and limitations as

historical cost accounting, plus an important additional

advantage in that it allows for the effects of general

inflation. As has been noted above, the C.P.P. approach is

a comprehensive and systematic one which takes account of

price-level changes affecting all income statement and

balance sheet items.

12.129 One of the main advantages of using C.P.P.

profit as a measure of taxable income would be the relative

simplicity of the adjustment procedures and the relative

ease with which the Commissioner of Taxation would be able

to verify the results. Because the index to be applied

would be prepared and published by government agencies, the

opportunities for taxpayers to manipulate the adjustments so

as to evade tax would be minimised. However, it is possible

to over-emphasise the simplicity of the C.P.P. approach.

The calculations which need to be made to adjust all items

in the income statement and balance sheet are quite complex

in the case of a firm engaging in many transactions and

recording balance sheet items with many different

acquisition dates.^ Simplified approaches (such as the one

suggested by Mr. A.R. Mutton and described above) are 1

1 See, for example, Exposure Draft No. 7 of the Australian Accounting Standards Committee, op, cit.

512

essentially different methods of presenting the results and

still need to be backed up by large numbers of detailed

calculations and adequate supportive data, for example

information about acquisition dates of assets. Large

companies would find little difficulty in complying with a

need to calculate C.P.P. profit, but small firms would

undoubtedly need to extend their accounting systems and rely

to a greater extent than at present on professional

accounting advice. As with current value accounting, there

would undoubtedly be a problem in attempting to prescribe,

for tax purposes, an income concept based on an accounting

system that was not in general operation.

12.130 Another advantage claimed for C.P.P.

accounting, one which has important equity implications with

respect to business taxes, is that C.P.P. financial

statements are statistically more reliable and more

consistent for purposes of inter-temporal and inter-firm

comparisons, because they have been expressed in terms of a

uniform instead of a fluctuating monetary unit.

12.131 In its submission, the Broken Hill Proprietary

Company Ltd. referred to the following statement by

Professor W.A. Paton as illustrative of the kind of problem

which income adjustments are intended to alleviate:

"With respect to such assets as materials and supplies, relatively short-lived, the difference between revenue dollars and the applicable cost dollars may not be very substantial where inflation is proceeding at a slow or moderate pace. In the case of resources expected to

remain in use for periods ranging from, say, five years to a half-century however, a condition may develop in

513

which the dollars in which the assets were initially stated are not even a close relative of the current 'dollars' being used in reporting sales of product and the cost of current services, taxes, and some of the other important expenses. In this situation, a matching of old dollars of cost with new dollars of

revenue results is a sheer misstatement. What is required is a conversion of the recorded long dollars - the underlying raw data - into the prevailing short dollars by the application of an appropriate index. Certainly a business is not breaking even if a current dollar of revenue is matched with a dollar of plant cost incurred 20 years ago or more. Here is one of the

serious sore spots in current accounting practice. The failure to grapple with this problem (except in a few scattered cases) has resulted in substantial understatement of the cost of plant capacity consumed, overstatement of the amount of periodic net earnings, and gross over-statement of the earning rate on property employed, throughout the past quarter-century. In the field of the public utilities, where a massive investment in relatively long-lived plant is generally required, misstatements of this character have been very substantial.1,1

12.132 A view of depreciation similar to that expressed

by Professor Paton is implicit in the C.P.P. approach. A

dollar deduction from taxable income in the current period is.

ceteris paribus, of less value than a dollar tax deduction

allowed at some time in past.

12.133 More generally it was argued, in a submission

received from Mr. J.W. Wilson, that:

"One of the merits of accounting on a GPP basis is that all companies have deductions in terms of dollars of the same dates. This eliminates the problem which exists with conventional accounting that, for otherwise

identical companies, the size of depreciation and other deductions is dependent on the date of acquisition of the relevant assets. For example, the firm with relatively older assets will, under inflation, have a

smaller depreciation charge than a firm with younger, and hence more expensive, assets." 1

1 See William A. Paton, "Inflation-Measurement, Impact Culprits", Financial 'Executive, December 1972, p. 46

514

12.134 But although Mr. Wilson considered that a

C.P.P. tax concept would have this equitable advantage, he

concluded that there were likely to be offsetting

disadvantages which threw doubt on the desirability of

adopting C.P.P. profit as the tax base, at least until the

long-term consequences of such a policy were clearer. These

disadvantages were: first, that taxes levied on C.P.P.

profits may bear less relationship to the capacity of

business enterprises to pay taxes? and second, that the

long-term growth of the economy may be reduced by a smaller

allocation of capital to capital-intensive, growth

industries. The Committee's evaluation of these and other

possible disadvantages follows.

12.135 Disadvantages of C.P.P. Profit as a Measure of

Taxable Income. The argument advanced by Mr. Wilson,

that taxes levied on a C.P.P. profit base are less likely to

reflect capacity to pay, is based on the view that capacity

to pay taxes is better reflected by a cash flow concept of

income than an accrual concept. "Price-level accounting is

based on accrual concepts of profit, arising from a desire

to maintain the long term purchasing power of shareholders'

wealth, and not on cash flows. C.P.P. profits are less

related to cash flows than are conventional profits and

consequently C.P.P. profits conflict to a greater extent

with the principle of capacity to pay." The Committee has

considered arguments for and against a cash flow concept of

income in an earlier section.

515

12.136 The other argument advanced by Mr. Wilson

against C.P.P. accounting for tax purposes is concerned with

resource allocation effects, with special reference to the

consequences for economic growth of making it more difficult

for capital-intensive firms with high growth rates to obtain

funds in the capital market. Mr. Wilson’s argument runs as

follows:

"One objective of the taxation system should be the encouragement of resources into capital-intensive industries with high growth rates. These industries demand large quantities of capital which normally cannot be raised from the limited Australian market for equity funds. Inevitably, therefore, these industries are financed by a relatively large proportion of borrowings rather than equity capital. A number of

large Australian mining companies are good examples of this point. Another reason for the emphasis on loan capital in some growth industries is the high risk

involved in the industry. Where the assets are saleable and suitable as security it is often possible to obtain loan funds for risk industries although substantial equity capital is not available.

As previously discussed, highly geared companies tend, under price-level accounting, to make gains on borrowed moneys which would be subject to tax if CPP profits were the tax base. The imposition of these taxes would act as a disincentive to firms and investors in these

capital-intensive areas. The effective cost of new and old borrowed moneys would be considerably increased under conditions of inflation.

On the basis of this theoretical reasoning it appears likely that basing taxes on CPP profits would have implications for the allocation of resources."

12.137 Other submissions (see, for example, the

A.C.M.A. letter cited above) have pointed to the problems

which result from imputing purchasing-power gains to highly

geared firms. These submissions have argued that high

gearing increases risk as well as profitability, and that

the taxation of the purchasing-power gains would ignore the

516

risk factor. This argument has also been used to justify

the exclusion of long-term liabilities from the calculation

of purchasing-power gains. It is necessary to be careful

about these arguments, because the implication of the C.P.P.

approach is that increases in the purchasing-power

equivalents of proprietorship funds (resulting from

increases in the purchasing power of non-monetary assets)

reduce the effective gearing of the firm and thereby make it

possible for firms to borrow more, to the extent necessary

to finance dividend distributions and taxation based on

C.P.P. profits, without thereby raising the gearing above

its initial level. But the Coiranittee finds it difficult to

believe that action of this kind would not, in present

circumstances, create chaos in the capital market and make

it difficult for many firms with high gearing ratios to

continue operating. If, as Professor R.S. Gynther and

others have argued on the basis of an entity theory of the

firm, long-term liabilities need to be regarded as permanent

funds which differ from proprietorship capital only in the

nature of their rights and obligations, there may in any

case be sound conceptual reasons for excluding such

liabilities from the calculation of purchasing-power gains.

12.138 Other resource-allocation disadvantages of

using a C.P.P. profit concept flow from the irrelevance of

C.P.P.-adjusted data for investment, pricing and other

policies. The adjusted values have no meaning in relation

to the decisions that have to be taken by firms. When a

517

firm first commences business, its funds can be regarded as

representing general purchasing power. At that time its

assets, mainly cash, are uncommitted and may be used for an

infinite variety of uses. But once the firm's funds are

invested in specific assets and it engages in particular

kinds of economic activity, this condition no longer holds.

Some items in the accounts are no longer recorded in terms

of their current worth to the firm; there is no longer a

consistent basis of valuation having regard to the purposes

for which information about values is likely to be required.

Moreover, the fact that most operating assets are, to a

large extent, specific to the firm means that they cannot

even notionally be regarded as representing general

purchasing power. C.P.P.-adjusted data, like historical

cost data, are therefore largely irrelevant as a guide to

the resource allocation decisions of the firm, just as

comparisons between firms cannot be meaningfully made on the

basis of such data. C.P.P. profits cannot be related to

C.P.P. measures of funds employed in order to test

profitability and efficiency, and therefore provide an

unsatisfactory measure of a firm's taxable capacity.^

12.139 Another major disadvantage in using a C.P.P.

profit concept for tax purposes is concerned with the equity

of bringing purchasing-power gains and losses into the tax

base when most other capital gains, whether realised or 1

1 See R.S. Gynther, 'Why Use General Purchasing Power?', Accounting and Business Research, Spring, 1974, for a further discussion of these issues.

518

unrealised, are effectively exempt from tax. The Committee

finds it difficult to believe that there would be a general

acceptance in the business community of the drastic shifts

in the distribution of the tax burden which would result

from adoption of C.P.P, profit as the tax base, or that such

a shift would be justified under present circumstances.

Some companies which proposed the use of C.P.P. profit for

tax purposes were apparently not aware that, in their own

particular cases, this would involve them in higher tax

liabilities because of the extent of their liabilities.

Others, as has been noted, proposed that the C.P.P. approach

be only partially applied, by excluding all monetary assets

and liabilities. Such action would avoid the problem of

redistributing taxes within the business sector only by

changing the distribution between business and other taxes.

12.140 The likely extent of the shifts in profits and

taxes which would follow the adoption of C.P.P. accounting

has been indicated in a number of empirical studies in

Australia and other countries.

12.141 In a private circular which was made available

to the Committee with the author's consent, a Sydney

stockbroker (Mr. J.M. Bowyer) in September 1974 recorded the

results of an exercise in which he attempted to make C.P.P.

adjustments, on the basis of the Exposure Draft of the

Institute of Chartered Accountants in England and Wales, to

the published financial statements of 50 listed Australian

companies. Of these, it was estimated that 14 companies

519

would have recorded higher C.P.P. profits than reported

profits, the highest increase above reported profit being 74

per cent, while 36 companies would have recorded lower

C.P.P, profits, the largest reduction being 183 per cent

below reported profit. On average, C.P.P. profit was 18 per

cent lower than reported profit. C.P.P. profits exceeded

reported profits when net gains on monetary items were

greater than negative adjustments on non-monetary items.

Firms in the property, retail, mining and transport

industries would often have recorded higher C.P.P. profits,

while most manufacturing, pastoral and finance firms would

have recorded lower C.P.P. profits.

12.142 A more elaborate English study·*" of 137 quoted

companies suggested that 104 companies, or 76 per cent of

the total, would have recorded lower C.P.P. profits than

reported profits in 1971-72, while 33 or 24 per cent would

have recorded higher C.P.P. profits. For 39 companies,

purchasing-power gains on long-term liabilities were the

most important cause of the difference between the two

measures of profit. Gains or losses on short-term monetary

items were the most important factor contributing to the

difference for 18 companies, purchasing-power losses on

stocks for 48 companies, purchasing-power losses on 1

1 'The Impact of Inflation on the Stock Markets', Accountancy, March 1973, by R.S. Cutler and C.A. Westwick.

520

depreciation for 34 companies, and other Profit and Loss

Account items for one company. Manufacturing companies

tended to record lower C.P.P. profits than conventional

accounting profits; the C.P.P. profits of electricals were

188 per cent below their conventional accounting profits,

while those of shipping were 106 per cent below, motors 71

per cent below and textiles 65 per cent below. Companies in

the services and property sectors tended to record higher

C.P.P. adjusted profits than conventional profits; the

industries affected were breweries (20 per cent above),

entertainment and catering (35 per cent), insurance (78 per

cent) and property (228 per cent).

12.143 It is necessary to be cautious in interpreting

the results of such exercises, because outside investigators

do not have all the data (for example, with respect to the

age distribution of assets and liabilities) necessary to

make reliable estimates. But there seems little reason to

doubt the general conclusion that the distribution of C.P.P.

profits differs substantially from the distribution of

profits calculated on a conventional basis. This conclusion

is reinforced by the audited financial statements of ten

British companies which reported in 1973 or 1974 on both a

conventional and a C.P.P. basis. It will be seen from Table

XII-2 that seven of these companies recorded lower C.P.P.

profits while the remaining three recorded higher profits,

in some cases significantly so. In each case the

adjustments were made in accordance with the Exposure Draft

Table XII-2

Historical basis profit

Depreciation adjustment

Historical and C.P.P. Profits - Ten British Companies 1973-74

E million

British Currys Distillers Edgar Rank Printing Ltd. Co. Ltd. Allen Organis- Industries House Staveley Trafalgar Trust Tube Wedgwood Corpora­ tion

5.17

Stock adjustment -1.17

- 1.12

Gain (loss) on net short-term

Gain on long-term liabilities

Gain (loss) on

Adjustments to other items

C.P.P. profit

3.23 67.07

& Co. tion

1.57 24.67

Ltd.

2.90

Houses Invest-

Invest- Forte ments ments Ltd.

19.57 22.96 33.67 4.24

-0.84 -17.40

-0.27 - 3.29

-0.42 -2.68

-0.22 -3.16

-1.08

-0.74

-7.89

-3.53

-0.57 ) ) ) 0.40

1.69 0.12 -2.8 9

2.16 ) 12.00 0.39 15.98

0.10 0.00 - 0.01 0.57

- - -4.13 - -

4.57 2.52 56.74 1.45 32.4 9

) )

) 1.41 )

) )

-0.30

42 o 04

1.27

-9=23 -0.74

- 2.33 -3.89 -0=62

11.44 7.51 ) ) ) 0.16

-0.65 )

0.24

-1.36

2.19 51.46 32.07 26.05 3.28

S o u r c e : Published r e p o r t s .

522

of the Institute of Chartered Accountants in England and

Wales. .

12.144 The final disadvantage of a C.P.P. profit

concept is concerned with its implications for distributable

income and capital maintenance; this is especially

significant in relation to the problem of establishing the

tax base. It will be seen from the example in Appendix A

that, although C.P.P. accounting may be said to maintain

proprietorship capital in one sense, namely its historical

value adjusted for changes in the general price level (or in

general purchasing power), the actual deployment of the

firm's assets since the capital was originally contributed

has made this achievement irrelevant.

12.145 If money claims are ignored, where the prices

of assets actually held by the firm increase at faster rates

than the general price level, the full distribution of

C.P.P. profit means that additional funds must be raised to

finance the higher cost of holding the same physical level

of assets. As in the case of historical cost accounting,

capital maintenance cannot be said to have been achieved in

the sense that the firm's operating capacity has been

preserved. The full distribution of the C.P.P. concept of

income, that is to say, does not leave the firm as well off

in terms of its capacity to generate future income.

12.146 On the other hand, if the prices of the firm's

assets increase less rapidly than the general price level

(and money claims are ignored), the resulting C.P.P. profit

523

will be less than the amount than can be safely distributed

whilst maintaining the firm's operating capacity and its

capacity to earn future income. Therefore the C.P.P. profit

concept does not meet the basic test of ensuring continuity

of business operations, and tax levied by reference to such

a concept will produce windfall gains for some firms while

making it necessary for others to raise additional funds to

maintain the level of their operations.

12.147 The Committee has concluded that the

disadvantages of C.P.P. profit which have been discussed

make it unsuitable for tax purposes. Nevertheless, there

are certain features of C.P.P. accounting which the

Committee would like to see incorporated in any tax system

designed to insulate business enterprises from the

consequences of inflation. These include the advantages for

tax administration, from the point of view of objectivity

and reliability, of basing valuation adjustments on

published price indexes where the effects of price changes

on a firm's actual transactions are difficult to establish.

The other aspect of C.P.P. accounting that is relevant to

the requirements of an inflation-adjusted tax system is its

recognition that there are gains from inflation as well as

losses, and that it is necessary to offset the gains against

the losses in striking an overall balance.

A Relative Price Level Concept of Taxable Income

12.148 In a submission to the Committee,

Professor R.J. Chambers proposed a method of calculating

524

taxable income which is based on his system of 1continuously

contemporary accounting', which as has been noted above

incorporates the relative price level approach to accounting

measurement based upon the use of net realisable value

(called by Professor Chambers current money equivalents or

current cash equivalents) as the sole measure of current

value. His implementation rules were summarised as folloivs:

"(i) Assets would be valued each year at the best possible approximation to their current money equivalents ...

(ii) Net income would be calculated thus:

Sales and other revenues $

Deduct Opening inventory (at opening money equivalents) Purchases, wage costs and other payments Less Closing inventory (at closing

money equivalents) Sub total $

Net revenues $

Add Price variations of assets upwards while held

Deduct Price variations of assets downwards while held (which includes depreciation)

Deduct Capital maintenance adjustment Sub total of adjustments £_

Net income $

(iii) Alternatively net income could be derived by simple adjustments made to the conventionally calculated net profit. The net revenue figure shown in (ii) would be adjusted for the differences between the book values and the opening money equivalents of the opening inventory, and the differences between the book values and the closing money equivalents of the closing

inventory. The items shown as 'price variation' in (ii) would be adjusted also to take account of the

525

differences between changes in book values and changes in the current money equivalents of assets. The capital maintenance adjustment would be calculated in the usual way by reference to the opening net assets

figure based on the then current money equivalents of assets and the intervening change in the general price index."

12.149 As has been noted in an earlier section,

Professor F.K. Wright suggested, as an alternative to his

proposal for the full deduction of cash outlays on plant and

stocks in the year of acquisition, a variant of the relative

price level approach to be applied to inventories only.

This was intended to revalue the stock element in cost of

sales by reference to the change in current value (current

replacement cost or net realisable value) during the income

period relative to the change in a general price level.

Professor Wright described the procedure as follows:

"Greater equity would be achieved if taxpayers who abandon the historic-cost basis of inventory valuation were taxed only on the *real' gain or loss from revaluation, calculated in accordance with an index

published by the Taxation Department and based, perhaps, on a broad consumer price index.

The following example is intended to illustrate the above proposal.

Opening value of inventory item (replacement cost or net realisable value at beginning of period) $100

Closing value of item (replacement cost or net realisable value at end of period) $110

Index at beginning of period 120

Index at end of period 138

Opening value of item restated in end-of-period dollars

= $100 . 138/120 = $115; hence 'real loss' on holding the inventory item = $5

526

T h i s l o s s w o u l d b e d e d u c t i b l e i n t h e s a m e w a y a s l o s s e s

f r o m h o l d i n g c a s h , b o n d s , e t c .

In effect, the taxpayer would be allowed to restate his opening inventory in end-of-period dollars without being liable to pay tax on the 'gain' associated with this restatement. To prevent the use of this concession for tax-dodging, it should be available only to taxpayers who have opted to abandon historic cost as a basis of inventory valuation; such taxpayers would still be free to choose between replacement cost and net realisable value.”

12.150 Advantages of a Relative Price Level Concept of

Taxable Income. The relative price level system is an

internally consistent, comprehensive and informative system.

Because it superimposes general price level adjustments on

value-data which have themselves been consistently valued by

means of current valuation adjustments, it avoids the

problems of irrelevance and unreality which result from the

application of a general price level index to historical

cost data. The analysis of the differential effects of

general and specific price changes provides useful

information for both managers and investors.

12.151 In his submission, Professor Chambers claimed

the following advantages for his system.

"The method of adjustment proposed and the net income which it yields, being realistic and consistent with real flows and accruals of general purchasing power, are deemed to be conducive to improvement in respect of the efficiency of business, and in the equity of the tax system. Because in the process of calculation changes in the prices of specific assets and classes of assets come directly under notice and because the effects of the change in the general purchasing power of money are made explicit, business firms will be able

to see to what extent the net income of a year is due to or affected by trading operations, shifts in the structure of prices and shifts in the purchasing power of money. It seems likely therefore that decisions on growth, expansion, changes in the composition of

527

business, and so on, can be more realiably made than where these different factors are indiscriminately mixed in the reported results. Achieved rates of return would be more realistic both because of the

calculation of income and because the denominator, net assets, is in up to date terms and comparable with other actual or possible investments of funds. The

inclusion of increments in the money equivalents of all assets in the calculation of taxable income would tend to reduce speculative activity in pursuit of so-called capital gains, tending in this respect to greater stability of prices. The results of the accounting process, being more realistic, would provide improved bases for all negotiations, speculations, calculations

and comparisons made as between parties with conflicting interests (e.g. in the wages and prices tribunals). And improved bases for the consideration of all problems arising in the management of the affairs of the economy as a whole insofar as they have

financial aspects."

12.152 Disadvantages of a Relative Price Level Concept

of Taxable Income. Despite such advantages, the Committee

does not believe that the adoption of a concept of taxable

income based on relative price changes - especially one

which recognises unrealised gains and losses as they accrue

- is practicable or desirable under present circumstances.

It is too sophisticated and complex to be suitable for tax

purposes in the absence of its widespread use for general

accounting purposes. Although it combines some of the

advantages of current value and C.P.P. accounting, it also

suffers from some of the limitations of both systems.

12.153 It is difficult to reconcile a system of

business accounting, which is based on recognition of

holding gains and losses and on the application of a

purchasing-power deflator, with a system of'personal

taxation which lacks a satisfactory procedure for taxing

528

most forms of capital gains and which in any case does not

adjust income by reference to purchasing-power changes.

12.154 Because the general price level concept of

income is based on the same capital maintenance concept as

the C.P.P. approach, it likewise may fail to meet the test of

preserving productive capacity and of ensuring continuity in

business operations. It will be seen from Appendix A that

the full distribution of income calculated on the basis of

relative price changes may still leave the firm in financial

difficulty. Whether it will do so will depend partly on the

relationship between the rate of increase in the current

values of the firm's assets and the rate of increase in the

general price level, and partly on the relationship between

the relative holding gain or loss on non-monetary assets and

the purchasing-power adjustment on monetary items.

12.155 If, as in the example, there is a holding gain

on non-monetary items (resulting from an increase in current

values relative to the general price level) which outweighs

any net purchasing-power loss, full distribution of income

will make it impossible for the firm to maintain its scale

of operations without introducing additional funds.

Inflation has thus contributed to a potentially unstable

situation. On the other hand, if the general price level

has increased more rapidly than current values, and the

resulting holding loss outweighs any purchasing-power gain,

the price-level adjusted measure of proprietorship capital

will exceed the amount needed to maintain its level of

529

activity, and it will be possible for it to expand its scale

of operations or reduce its liabilities.

12.156 These problems result partly from the

requirement that proprietorship capital be maintained only

in terms of general purchasing power, and partly from the

nature of the income concept. It is difficult to attach a

meaning to the maintenance, in terms of general purchasing

power, of a firm's proprietorship capital as it existed at

the beginning of the period. The purchasing power available

at that time was not used to buy the goods and services

included in the regimen of the general price level index,

but was instead allocated to the purchase of the goods and

services actually used by the firm in its operations.

Likewise, the income concept mixes up operating income

resulting from trading activities, gains resulting from the

holding of .assets and the effects of changes in the general

price level. The distribution of the last two items as

income, through taxation and dividends, can affect its

capacity to generate future income.

12.157 Although, as a result of these considerations,

the Committee has concluded that the relative price level

concept of income is inappropriate as a basis for taxation,

there are again elements of the concept which it would like

to incorporate in any changes which are made in the business

tax system. In particular, the Committee believes that it

is important to recognise that inflation may produce gains

as well as losses for a firm, and that it is unrealistic to

expect the taxation system to recognise only the losses.

531

XIII PRACTICES IN OTHER COUNTRIES

13.1 The Committee was fortunate in having access to

a miscellany of information about the practices of other

countries in relation to the taxation of business income in

inflationary periods. The sources of that information

include internal working documents of the Organisation for

Economic Co-operation and Development and the International

Monetary Fund, information obtained for the Committee by

representatives of the Australian Government in overseas

countries, references contained in individual submissions,

published articles and information supplied by Price

Waterhouse & Co. from its comprehensive files on the

subject. The Committee records its appreciation of the

assistance received from these various sources, which

because of the nature of the following survey it has not

always been able to identify by specific references.

13.2 In order to facilitate the discussion in later

Chapters, the widely differing practices in various

countries have been categorised, albeit imperfectly, in

accordance with the following groupings identified in

earlier Chaptersi

(a) taxation based on variations of historical cost

accounting measures;

(b) taxation based on the partial adoption of

current value measures; and

532

(c) taxation based on the use of a generalised

C.P.P. approach.

So far as the Committee is aware, no country follows the

relative price change approach in its taxation arrangements.

Variations of Historical Cost Accounting

13.3 By far the largest number of countries base

their taxation systems on historical cost accounting

measures of incomes or on minor variations of those

measures. Common variations include investment incentives

and accelerated depreciation allowances in respect of

depreciable assets, but in all such cases not separately

identified these variations continue to use the original

cost of the assets as the amount to be allocated.

13.4 The effect of investment allowances and

accelerated depreciation provisions in a number of

industrial countries has been summarised in a table which

has already been referred to in Chapter XII. This has been

taken from the statement submitted by Mr. B. Kenneth Sanden,

Partner, Price Waterhouse & Co. to the Committee on Finance,

United States Senate on 22 January 1974, at its hearings on

tax increase proposals. The table, which is reproduced as

Table XIII-1 below, contrasts cost recovery allowances for

industrial machinery and equipment in leading industrial

countries with similar allowances in the United States. The

capital cost recoveries for each of the foreign countries

were computed on the assumption that the investment

qualifies for any special allowances, investment credits,

533

grants or deductions generally permitted. The deductions in

the United States were determined using the double declining

balance method without regard to the limited first year

allowance for small business. The figures provided are

supported by detailed footnotes which indicate the

complexity of the comparisons undertaken by Mr. Sanden.

These footnotes do however provide some indication of the

practices in various countries and they themselves are of

considerable interest. The Committee has been advised that

the U.S. investment credit, which takes the form of a direct

rebate of tax liability related to the value of specified

new investment, was increased from 7 per cent to 10 per cent

on 29 March 1975. The higher rate is to apply on purchased

assets placed in service after 21 January 1975 and before

1 January 1977, when it will revert to 7 per cent. On

constructed assets, the new rate applies to the portion

constructed between the relevant dates, but provision has

been made for the credit to be taken progressively on the

basis of progress payments for constructed assets. In

correspondence with the Committee, Mobil Oil Australia

calculated that the new rate was equivalent to a 20.8 per

cent allowance on the cost of the asset at the U.S. company

tax rate of 48 per cent (See Note (26) in Table XIII-1).

Effective cost recovery allowances for U.S. enterprises will

be increased accordingly. Some related information in

regard to Australia is set out in paragraph 12.33.

534

TABLE XIII-1

Comparison of Cost Recovery Allowances in Selected Industrial Countries

Representative cost recovery periods (years)

United Kingdom 1

Canada

2 (6)

Netherlands

5 (10)(17)

Sweden

5 d8)

Italy

6 d0)

Switzerland

8 <2)

i i 6-2/3(2)(19)

France CO

Q

CO

W. Germany

9 (20)

Belgium 1 0 (2)

Luxembourg i o (2)

Japan

l i d 3)

" n (14)

United States , „ (2)

1962 Law (23) 13' 1

1969 Law (24) 1 3 (2)

1971 Law (25) 10-1/2(2)(2?)

Aggregate cost recovery allowances (percentage of cost of assets) (1)______

First taxable year

First 3 taxable years

First 7 taxable years

100.0 100.0 100.0

50.0 100.0 100.0

10.0 50.0 100.0

60.0 (3) 95.7 130.0

20.0 (11) 65.0<12) 100.0

12.5 50.8 84.4

15.0 58.4 90.0

31.3 67.5 94.9(9)

16.7<21> 49.6 88.8<22>

20.0(3) (4)48.8 89.0 (5)

28.0<16> 60.4 94.4

34.5 (15) 56.9 81.4

37.1 63.9 88.1

21.7(26) 47.9 80.1

7.7 33.9 66.1

23.5<26> 54.7 83.5

535

F O O T N O T E S

(1) It is common practice in many countries, prior to investment in fixed assets therein, for investors to agree with the tax authorities as to a rate of depreciation and other benefits available. Such agreements would, in many cases, have the effect of

substantially increasing the cost recovery allowances presented in the table above.

(2) Double declining balance method.

(3) Full year allowance in first taxable year.

(4) Although not considered, installation costs allowed as current deduction which reduces recoverable base cost.

(5) Method changed to straight line in fifth taxable year. Straight line rate applied to original cost for fifth, sixth and seventh taxable years.

(6) Effective 8 May 1972 machinery and equipment acquired for manufacturing or processing of goods in Canada can be written off over two years (50% per year). Proposed Law subject to approval of Parliament.

(7) 250% declining balance method.

(8) Although not considered, effect is given to multiple shift operations by reducing service life of assets used under shift conditions.

(9) Method changed to straight line in sixth taxable year.

(10) Straight line method.

(11) Includes additional foreshortened allowance of 15%.

(12) Includes additional foreshortened allowances of 15%, 15% and 10% in first, second, and third taxable years respectively.

(13) Modified double declining balance method; 18.9% per Japanese Government rate table, salvage built into rate.

(14) Depreciation in addition to ordinary depreciation in (13) above is allowed to give effect to multiple shift operations. Depreciation multiplied by factor of 1.28 gives effect to 8 hours of daily average excess usage of an item of machinery and equipment.

536

(15) Includes special first year allowance of 25%; allowance reduces recoverable base cost in second and succeeding taxable years.

(16) Includes 18% allowance equivalent of 9% investment credit at effective 50% income tax rate; credit does not reduce recoverable base cost.

(17) Depreciation periods are fixed by agreement. With multiple shift operations, a five year life is normal.

(18) Modified declining balance method - 30% rate plus additional 30% allowance in first taxable year (such additional allowance does not reduce recoverable cost); accumulated cost recovery may not be less than 20% of cost for each year asset is in service.

(19) Normal life of 8 years reduced to 6-2/3 years to reflect multiple shift operations.

(20) The average cost recovery period for machinery and equipment in Western Germany is 8 to 10 years to which additional allowances are permitted for multiple shift operations; 25% of allowance for two shift operations and 50% of allowance for three shift operations. Allowances may be further increased when plant is located in certain areas such as Berlin, areas bordering on iron curtain countries, and undeveloped areas.

The above table sets forth cost recovery allowances based on an average cost recovery period of 9 years. The double declining balance method is used. A 25% additional allowance for two shift operations is taken into account beginning with the fi th year when the method is changed to straight line. The corporate

depreciation rate thus computed is slightly over the maximum 20% rate permitted on a declining balance method to reflect that;

(A) The straight line method produces more depreciation than does the double declining balance method for certain short-lived assets; and

(B) Items of machinery and equipment costing under U.S. $200 can be expensed.

(21) Full year allowance in first taxable year for assets acquired in first half of such year; half year allowance for assets acquired in second half.

(22) Method changed to straight line in fifth taxable year. See (20) above.

537

(23) With investment credit but without accelerated depreciation.

(24) Without either investment credit or accelerated depreciation.

(25) With both investment credit and accelerated depreciation.

(26) Includes 14% allowance equivalent to 7% investment credit at effective 30% income tax rate. Credit does not reduce recoverable base cost.

(27) 13 year recovery period reduced by 20% and rounded to nearest one-half year. Double declining balance method.

Sourcei Statement by Mr. B. Kenneth Sanden, Price Waterhouse & Co. to U.S. Senate Committee on Finance, Hearings on Tax Increase Proposal 22 January, 1974, included with his consent.

13.5 There are also significant differences in the

taxation treatment of inventories in different countries.

Again practices are usually based on historical cost

accounting practices. In the United States, for example,

s.471 of the Internal Revenue Code indicates that inventory

values must be those "conforming as nearly as may be to the

best accounting practice in the trade or business and as

most clearly reflecting the income". Section 472, however,

permits inventories to be valued on the last-in-first-out

(LIFO) method. The Committee has been advised that, at

least until the recent acceleration in rates of inflation in

the U.S.A., the use of LIFO was not widespread. One reason

for this was the stipulation that LIFO inventory valuations

for tax purposes must also be used in financial statements

538

to shareholders and in credit applications. Companies

wishing to maximise reported profits to maintain stock

market standing or credit ratings were therefore reluctant

to adopt a LIFO valuation basis for taxation purposes.

13.6 Firms in Italy, Japan and the Netherlands are

also permitted to use the LIFO method of valuation, but that

option is not available in most other countries which the

Committee studied.

Cash Flow Concept of Income

13.7 During recent years, the United Kingdom has

moved substantially in the direction of adopting a cash flow

concept of income for taxation purposes. Since 1972, firms

have been permitted to write off 100 per cent of the cost of

depreciable assets in the year of acquisition, and in the

November 1974 Budget companies were permitted to write off

the full cost of the increase in stock values in the 1973-74

income period, subject to a deduction of 10 per cent of

trading income for the period.

13.8 In his Budget Speech, the Chancellor of the

Exchequer (Mr. D, Healey) explained the new arrangements

relating to stocks as follows:

"I am persuaded that industry needs a substantial immediate improvement of its liquidity through the deferment of tax on that part of the profit which corresponds to the abnormal increase in the value of stock and work in progress. I therefore propose that for tax purposes companies should have the right to reduce the closing valuation of their stocks and work in progress for the accounting period which ended

in the financial year 1973/74 - on which their current tax bills are based - by an amount by which the increase in the book value of stocks and work in

539

progress exceeds 10 per cent of the trading profits of the business in the same accounting year. In other words the maximum profit represented by the increase in the value of stocks on which tax will be payable this

year will be limited to 10 per cent of the trading profit. The figure of 10 per cent was chosen because it broadly corresponds to the proportion of profits which is attributable to the increase in the value of

stocks for an average of companies in a normal year.

Since the closing stock of one accounting period normally becomes the opening stock for the next period, this adjustment means a postponement of tax liability, and not an exemption. If no further steps were taken, the tax forgone this year would

automatically be clawed back in the following year. But this is of course not in contemplation. Indeed, the need for deferring tax in 1975/76 on abnormal stock appreciation arising in the present year's profits is

likely to be even greater.

For practical reasons, we cannot immediately deal with the whole range of companies and the immediate relief will be confined to those who have a closing stock of at least £25,000. For the same

reason, it is not possible to include individual traders or partnerships in this emergency relief. However, I intend next year's relief to extend to all

traders, whether companies or unincorporated businesses. In deciding how that further relief is to apply to those traders who, for practical reasons, will not benefit from my present proposals, I will take into

account the fact that their relief will cover 2 years' trading and that they will have had to wait a year for it. This is a bankable assurance and should be treated as such."

13.9 In its notes on the Finance Bill which was

introduced to give effect to this proposal, the Board of

Inland Revenue commented as follows on the reasons for the

relief:

"In times of rapid inflation, firms which have to hold relatively large amounts of stock face liquidity problems, which are made worse because they have to pay tax on profits which are tied up in the

increased cost of stock replacement. These problems would exist even if there were no tax; but tax makes the situation worse.

540

In computing the trader's profits for any year, normal accountancy principles require the cost of his stock at the beginning of a year to come in as a debit (deduction) and that of stock at the end of a year to come in as a credit (addition). This means that his profit for the year is computed on what he has sold; what is not sold (his stock) is in effect excluded from the account and he gets tax relief for its cost as and when he sells it. In other words he pays tax on his

total profits whether he holds them in the form of cash or has turned them into an increased amount of stock.

In times of rising prices, however, the value of the stock at the end of a year may be much greater than that at the beginning even though the volume is unchanged; and as the company sells the stock it will have to pay more to replace it. The company has to

find the cash to meet this rising cost as. well as the tax on the profits. It will of course get relief from tax in respect of its stock purchases when it sells that stock, normally in the following year; but meantime it has a cash flow problem.

The rate of inflation this year led to widespread pressure before the Budget for relief for the cost of stock."

13.10 The Chancellor referred in his Budget Speech to

the Committee on Accounting for Inflation which the

Government had established under the Chairmanship of

Mr. F. Sandilands to consider, inter alia, 'whether, and if

so how, company accounts should allow for changes

(including relative changes) in costs and prices', taking

into account among other things 'any implications for the

taxation of the profits and capital gains of companies, the

assumption being that the share of the total direct tax

burden borne by the company sector remains unchanged *.

13.11 By the time of the April 1975 Budget, the

Sandilands Committee had not reported, but in that Budget

the relief on stocks was extended to a second year and made

541

applicable to all businesses for the whole two-year period.

As with the relief announced in November, any reduction in

the closing stock figure at the end of the second year will

be reflected by a reduction in opening stock in the

following year, so that the relief represents a deferment

rather than a permanent reduction of tax. The Chancellor

had already indicated that the basis of business taxation

will be reviewed in the light of the Sandilands Committee's

recommendations.

13.12 The Committee has noted that securities were

excluded from the definition of trading stock for purposes

of the stock relief announced in the November 1974 Budget,

and land held as an investment was excluded as a result of

the April 1975 Budget.

Partial Adoption of Current Value Measures

13.13 Stocks. Other countries have moved some way

towards the adoption of a current value tax base, by

permitting stock valuation on a basis which results in a cost

of sales figure for taxation purposes that is closer to

current cost. In Mexico and Argentina, for example, firms

may be permitted with specific approval to value closing

stocks at opening prices. As noted elsewhere, this is

equivalent to a one-year deferral of tax liability, because

the closing prices of one year become the opening prices of

the following year.

13.14 In Sweden, inventories are valued on a first-in

first-out basis, subject to a general rule that book values

will be used for tax purposes. However, firms are given the

542

option of establishing non-taxable inventory reserves up to

maximum legally prescribed ratios of the closing stock

values. The maximum percentages prescribed are 100 per cent

for compulsory storage inventories governed by governmental

regulations and 60 per cent for other inventories. Amounts

added to reserves are cumulative from year to year, but

cannot exceed the prescribed maximum. In practice, reserves

set aside in one year are written back in the following year,

but the firm then has the option of creating new reserves

up to the prescribed maximum. The main rule governing

inventory valuation is supplemented by two other rules.

13.15 The first of these is the rule of "comparable

value". If the value of the inventory at the end of a

corporation's fiscal year, at cost or market and after

deducting obsolete or unsaleable items, is less than the

average of the value of the inventory at the close of the two

prior years (this average value is called the "comparable

value"), the corporation may write its inventory down by 60

per cent of that comparable value, rather than by 60 per cent

of the value at the end of the income year in question.

13.16 The second supplementary rule relates to the

valuation of raw materials or staple commodities in the

inventory. The corporation has an option to value these

assets at the lowest market price in effect during the income

year or in any of the nine previous years, and then to reduce

that figure by 30 per cent to give an inventory valuation

equal to 70 per cent of the ten-year low. If the corporation

543

chooses to value raw materials or staple commodities in this

way, it may not also take advantage of the rule of

"comparable value" outlined above.^

13.17 Similar rules apply to the creation of

non-taxable inventory reserves in Norway and Denmark, though

a maximum ratio of 30 per cent of the closing value of

inventories is prescribed for the reserves in Denmark. The

Committee understands that Norway does not specify a maximum

percentage by law and that the actual ratio is subject to

negotiation between individual firms and the tax authorities.

The Committee has been advised that companies have 2

established reserves in the 20-30 per cent range. In

Iceland, stock values may be reduced for tax purposes by a

maximum rate of 7h per cent p.a. until a maximum level of 30

per cent has been reached.

13.18 In West Germany, taxable income may be reduced by

creating an inventory valuation reserve in any year in which the

market price of inventories increases by more than ten per cent.

However, the reserves are calculated in such a way that only the

appreciation in valuation of inventories in excess of that 10 per 1

1 Information provided by the Swedish Ministry of Finance to the Australian Ambassador in Sweden.

2 The Committee acknowledges the assistance of Mobil Oil Australia Limited in providing, in correspondence arising out of its submission, detailed information on the working of the inventory reserves in France, West

Germany, Norway, Sweden and Denmark.

544

cent figure is eligible for this treatment. Definition of

market price of inventories must be negotiated with the

authorities. The reserve is computed for separate inventory

groups as follows:

Closing PriceQ-£110%^ofeOpenin£ JPrx^e χ closing Inventory

Thus, if the price of one inventory group has risen from

100 to 150 then 40 of the closing inventory value for that

group may be taken as reserve for tax purposes. Once

established, this reserve may be maintained for six years

irrespective of subsequent upward or downward movements in

prices or volumes. After six years, the reserve must be

returned to taxable income, but firms may elect to bring the

reserve to account for tax purposes at an earlier date if

they so choose.

13.19 It is of some relevance to compare the method

of limiting the relief in West Germany with the form of the

temporary relief recently provided in the United Kingdom.

Apart from the fact that the German scheme is for a deferral

of tax liability for a period of up to six years, the

limitation of the size of the valuation adjustment is based

exclusively on the change in price of inventories over the

income period, any increases in price above 10 per cent

being allowed for. By contrast, the United Kingdom

adjustment does not distinguish between a change in the value

of inventories which results solely from inflation and a

change which results from stock accumulation; instead it

545

limits the adjustment by reference to the firm's

profitability. However, both schemes are of greater benefit

to firms experiencing greater than average increases in the

prices of items included in their inventories. The ceiling

on the reserves in Sweden, Denmark and Germany indicates

that these countries have considered it desirable to set an

upper limit to the valuation adjustments which are reflected

in variations of tax liability.

13.20 In its 1959 tax reform France permitted a

deduction from taxable income of increases in inventory

prices exceeding 10 per cent. The French system is similar

to that of West Germany. A special arrangement applies for

raw materials purchased on world markets. For these

materials, the inventory valuation reserve is based on

average levels of stocks over a three-year period, and on

price indexes for various materials published by a government

agency. Mobil Oil Australia described the arrangements for

the oil industry in the following way:

"For the oil industry, the price index is based on quoted prices of Oklahoma/Kansas crude oils, and their movements since 1945-47. The procedure is as follows:

(a) The initial base inventory is established by averaging year end volumes for three years. After three years, this base inventory may be increased providing that, firstly, the average

inventory over three years is at least 20% higher than the preceding base and secondly, that each year's inventory is at least 10% higher. If these conditions cannot be met, then one must wait until one has a three year period that does meet the conditions.

(b) The base inventory is valued on a normal book basis, (usually FIFO or average costs).

546

(b) The base inventory is valued on a normal book basis, (usually FIFO or average costs).

(c) Inventory Reserve is calculated by applying a factor to the base inventory calculated in (b).

(d) The factor is calculated by reference to movement in price index as follows:

Assume that the index was 2 in 1945-47 and is now 10.

Factor = 1 - 2

IF

This equals .8, so an Inventory Reserve of 80% of the base inventory value may be set up.

(e) The reserve is adjusted annually for movements in price index and every three years or more for changes in tax inventory volumes. The reserve must be reduced if prices or base volumes go down."

13.21 From the preceding summary of the arrangements

made by several countries to permit inventory valuation

adjustments for tax purposes, it is apparent that at least

some elements of a current value philosophy have entered into

the taxation system of those countries.

13.22 Depreciation. There are fewer examples of

current value depreciation in overseas countries but Iceland,

in addition to normal straight line and accelerated

depreciation, allows what is called 'indirect' depreciation:

"In case of general inflation in acquisition costs of movable and immovable assets during any given tax year, there is allowed as an indirect depreciation an annually fixed percentage of normal depreciation used

for those assets in that year. This indirect depreciation has no effect on depreciated book value of the assets."1

1 Taxes in Iceland 1974, Director of Internal Revenue Reykjavik, 1974, (provided through the Australian Ambassador in Sweden).

547

Iceland also allowed revaluation of depreciable assets at the

end of 1968 and 1970 to be reflected in higher depreciation

charges.

13.23 In addition to the inventory valuation reserves

previously described, Sweden has made provision for the

determination of "reserves for future investment".

13.24 These reserves, which were first permitted in

1938, are additional to accelerated depreciation and

investment allowances. The investment reserve provisions

were not intended to deal with the problems of inflation, but

in inflationary periods they can facilitate the financing of

asset replacement. The Swedish Ministry of Finance through

the Australian Ambassador in Stockholm has provided the

following information about these reserves to the Committee:

"Corporations reporting income from business are permitted to set aside, in their own discretion, up to 40 per cent of their pre-tax profits as a reserve for future investment. Amounts so allocated to an

investment reserve are deductible from taxable income for purposes of both national and local income taxes.

In all cases, however, 46 per cent of the amount so allocated to an investment reserve must be deposited to the corporation account in the Riksbank, the Bank of Sweden. This account bears no interest; on the other hand, the rate of the deposits required (46 per cent of the sum allocated to the reserve) is lower than the rate of tax that would be payable (about 54.5 per cent for national and local taxes together, at current rates on the profits in question if they were not allocated to a reserve for future investment.

After the 46 per cent deposit has been made, the balance of the reserve (54 per cent) remains in the hands of the corporation as part of its working capital, like any other sum deductible as a non-cash

charge against income (depreciation, for example). There is no ceiling on the total amount which a

548

reserve may reach or on the number of years in which an allocation to the reserve may be made„ In all cases whether an allocation to a reserve shall be made, and the amount of such an allocation, are in the discretion of the corporation; no government

permission is required.

Control over the use of the reserve in such a way as to obtain the maximum tax benefit is in the hands of the government, however. In the past, authority over the use of investment reserves was largely vested in the Labor Market Board, an independent government agency with major responsibility for employment matters. But because of the special importance of investment reserves to the national economy, 1963 amendments to the law gave primary authority over their use to the government rather than the Board. Co-operation between the government and the Board has raised no problem, however. The 1963 legislation also permitted transfers of investment reserves between parent and subsidiary corporation and between two subsidiaries of a common parent.

The investment reserves system is widely used by Swedish industry. By the beginning of 1970, more than 3,200 corporations had established reserves for future investment. The total balance in those reserves, available for future investment under government authorisation, was approximately SKr 3,600,000,000

(equals approximately $A680 million at current exchange rates). During the tax years 1968 and 1969, sums allocated to reserves for future investment amounted to SKr 908,000,000 and SKr 1,023,000,000 respectively; sums withdrawn from the reserves for utilization totalled Skr 1,421,000,000 and SKr 730,400,000 respectively in those years.

The government (or the Board, to the extent authority is delegated to it) may authorize a corporation to use all or part of its investment reserve for one of the purposes allowed by the governing law whenever, in the government's opinion the country's economic and employment situation so warrants. Under the law, the

authorities may even direct a corporation to use all or part of its investment reserve for one of those purposes (in fact no such direction has ever been issued).

The purposes for which an investment reserve may be used include the construction of buildings, the acquisition of new machinery and equipment, the manufacture of goods for inventory and the

549

development of mineral deposits. To aid regional development, the 1963 amendments stressed the use of reserves for investment in areas suffering declines in population. In special circumstances, a Swedish firm doing business abroad either directly or through a

subsidiary, may be permitted to use its reserve to promote the sale of Swedish goods abroad.

W h e n an i n v e s t m e n t r e s e r v e is u s e d for o ne of t hese

p u r p o s e s w i t h g o v e r n m e n t p e r m i s s i o n , the a m o u n t so

used is n o t r e s t o r e d to t a x a b l e income. To the e x t e n t

an a s s e t o r an e x p e n s e has b e e n c h a r g e d to an

i n v e s t m e n t r e serve, ho w e v e r , it is n o t a l s o s u bject to

d e p r e c i a t i o n o r d e d u c t i o n . S i n c e the a m o u n t in the

re s e r v e has a l r e a d y b e e n d e d u c t e d f r o m t a x a b l e income,

d o u b l e d e d u c t i o n s are t h e r e b y avoided.

As an i n d u c e m e n t to the use o f i n v e s t m e n t reserves,

how e v e r , t here is an e x c e p t i o n to the rule ag a i n s t

d o u b l e d e d u c t i o n in the c ase o f r e i n v e s t m e n t r e s u l t i n g

f rom a "g e n e r a l r e l e a s e " of r e s e r v e s (see b e l o w ) . A

c o r p o r a t i o n u s i n g an i n v e s t m e n t r e s e r v e w ith

g o v e r n m e n t p e r m i s s i o n r e c e i v e s a s p e c i a l a d d i t i o n a l " i n v e s t m e n t d e d u c t i o n ” : it m a y d e d u c t f r o m taxable

income 10 p e r c e n t of the a m o u n t of the re s e r v e s so

used. If, o n t h e o t h e r hand, a r e s e r v e is u s e d

w i t h o u t g o v e r n m e n t p e r m i s s i o n , the a m o u n t involved, plus a p e n a l t y e q u a l to 10 p e r c ent o f t hat amount,

m u s t b e a d d e d to t a x a b l e i n c o m e ."

13.25 R e v a l u a t i o n . A t v a r i o u s t imes in the past,

e s p e c i a l l y in t h e i n f l a t i o n a r y a f t e r m a t h of W o r l d W a r II in

E u r o p e , m a n y c o u n t r i e s p e r m i t t e d r e v a l u a t i o n for t a xation

p u r p o s e s of some or all o f t h e a s s e t s and l i a b i l i t i e s

i n c l u d e d in c o m p a n y b a l a n c e s h e e t s . The C o m m i t t e e has been

a d v i s e d of t he f o l l o w i n g a r r a n g e m e n t s in v a r i o u s European,

A s i a n a n d L a t i n A m e r i c a n c o u n t r i e s .

13.26 A major objective of the revaluation of

non-monetary business assets in many countries was to adjust

taxable income to help finance replacement of plant and

expansion of activities. The revaluations were irregular

550

and usually followed periods of sustained inflation. At

various times, revaluations took place in the following

countries: Austria, Belgium, France, Germany, Iceland,

Italy, Netherlands, Spain, Israel, Indonesia, Japan, Korea,

Argentina, Bolivia, Chile, Colombia, Mexico, Peru and

Uruguay. The types of assets covered by the revaluations

varied but usually included physical assets and inventories.

The revaluation reserves were generally non-taxable, but of

the European countries France and Spain charged special low

rates of tax on the reserves. Attitudes varied as to whether

the reserves were distributable.

13.27 Only in rare cases, such as the revaluation

following the German currency reform of 1948, were

liabilities also included in the revaluation adjustments.

The methods of revaluation also varied widely from country to

country. Usually price indexes of various types, commonly

wholesale price indexes, were prescribed as the co-efficients

to be used for revaluation purposes. In most cases assets

were revalued directly, but in others the co-efficients were

applied to depreciation allowances. In several countries,

including Belgium, Germany and the Netherlands, individual

firms were able to make their own appraisals within specified

limits. In Germany, the post-war capital levy provided some

protection to the government against artificially high

revaluation. Some countries limited the revaluation of

assets for any one firm to a specified percentage limit.

551

13.28 The Committee believes that the history of

adjustments in other countries - especially their extent and

frequency - is indicative of the general inadequacy of the

conventional tax base in periods of rapid inflation.

Current Purchasing Power (C.P.P.) Adjustments

13.29 To the Committee’s knowledge, the taxation

systems of only two countries, Brazil and Chile, are based on

accounting procedures described in this Report as the C.P.P.

approach. In Part One of this Report, it was observed that,

because of the high rates of inflation which are endemic to

most Latin American countries, the tax systems of many of

those countries have adapted to inflation on a continuing

basis. Under conditions of rapid inflation, historical costs

soon become irrelevant and businesses could not survive if

they were to be taxed on incomes calculated by reference to

those costs.

13.30 What has evolved in Brazil, and to a lesser

extent in Chile, has been the systematic and continuous

adjustment of balance sheets and profit and loss statements

for tax purposes. It should be noted that the tax systems

of both countries, which are poorer and less developed than

Australia, cannot be readily compared with the Australian

tax system. Incomes are commonly taxed on a scheduler

rather than on a global basis, the administration and

structure of the tax laws are more discriminatory, and the

standard of taxpayer compliance differs markedly from that

in Australia. In particular, tax evasion is said to be a

major problem.

552

13.31 The tax systems in both countries reflect the

view that the effects of inflation on both the assets and

liabilities of business firms should be taken into account

in determining income subject to tax. Because of

administrative problems and revenue needs, neither country

has fully adopted the C.P.P. approach. Description of the

Chilean system is complicated by the fact that partial

revaluations periodically supplement the legislated

permanent adjustment scheme. At the end of each fiscal year

the accounts are adjusted by reference to the change in the

consumer price index (CPI) during the year, but the

adjustments which are applied to fixed assets are different

from those applied to other assets. The fixed asset

adjustments fully reflect the change in the CPI, while the

adjustment for other assets is limited to 20 per cent of

taxable profits in that year. This restriction is applied

for revenue reasons. The total amount of adjustment (after

allowing for revaluation of liabilities, also by reference

to the CPI), cannot be distributed as dividends or used in

any operation not connected with the business. The periodic

revaluations of assets are required because of the limits on

the revaluation of assets (other than fixed assets) to 20

per cent of taxable profits.

13.32 Taxation adjustments in Brazil are part of a

general system of 'monetary correction1, or indexation,

intended to eliminate economic distortions resulting from

prolonged and rapid inflation. .Monetary correction has been

553

defined as "the periodical and automatic adjustment of

certain assets pursuant to an indexing which translates the

inflation rate" . Since 1964, it has been progressively

applied to Treasury Bonds, unpaid taxes, depreciation,

working capital, real estate profits, capital market

transactions, loans and interest charges, rents, retirement

allowances, charges for public utility services, salaries,

taxation and exchange rates.

13.33 Insofar as business taxation is concerned, the

Brazil adjustment scheme has three aspects, concerned

respectively with the revaluation of fixed assets, the

revaluation of working capital and adjustments in respect of

liabilities which are index linked.

13.34 Fixed assets are revalued by reference to

their historical costs. The index used to revalue assets is

the wholesale price index and revaluation co-efficients are

prescribed annually. The following indexes were prescribed

for the 1974 revaluation of fixed assets:

1 S p e e c h b y P rime M i n i s t e r Simonsen, a c o p y of w h i c h was

f o r w a r d e d to the C o m m i t t e e by the A u s t r a l i a n A m b a s s a d o r

in Brasilia.

554

Year of Acquisition Index

1938 1,148.78

1939 1,086.67

1940 1,024.44

1941 931.40

1942 755.47

1943 652.02

1944 569.20

1945 486.39

1946 424.31

1947 393.23

1948 372.57

1949 341.46

1950 300.08

1951 248.35

1952 227.68

1953 196.68

1954 155.22

1955 134.51

1956 113.84

1957 103.51

1958 87.96

1959 64.14

1960 48.68

1961 35.19

1962 22.76

1963 10.33

1964 5.94

1965 4.67

1966 3.42

1967 2.79

1968 2.28

1969 1.87

1970 1.58

1971 1.31

1972 1.13

1973 1.00

13.35 The co-efficient for investment undertaken in

1963 was thus approximately ten times the size of the

co-efficient in 1973. The divergence between historical

costs and adjusted prices in earlier years is even more

striking. The Committee notes that, in the case of assets

with long lives, co-efficients are required for many years if

the system has been in operation for a period of time or if

555

it is made retrospective from the date of introduction. A

limitation on the value of the adjustments for other working

capital to 20 per cent of taxable profits, which had

previously been applied in Brazil as in Chile, was removed in

1974.

13.36 As has been noted, financial transactions are

generally indexed in Brazil. Indexed transactions in

monetary assets and liabilities are excluded from the general

profit adjustment scheme so as to avoid duplication of

benefits that would otherwise result. The actual provisions

of the law are complex, but the size of any revaluation of

working capital is reduced by any net gains that firms may

make on account of monetary corrections.

557

XIV INCOME VALUATION ADJUSTMENTS: RECOMMENDED PROCEDURES

14.1 Before proceeding to describe its proposed

procedures for dealing with the problems which have been

discussed in earlier Chapters, the Committee wishes to

emphasise that its recommendations with respect to business

taxation represent a pragmatic approach which is designed to

alleviate a serious situation. They are thus based on a

judgment that substantial changes in the taxation system are

necessary to counteract the severe financial strains which

the interaction of rapid inflation and conventional

accounting, pricing and taxing policies are imposing on

business enterprises and which, we believe, are placing many

firms at risk. But the Committee considers that it is

easier to identify the problems than it is to recommend

solutions. Indeed, it must be clear that no ideal solution

can be recommended among the options available and within

the constraints imposed by a rapidly growing public sector,

growing government deficits, demands for tax reductions in

other fields of taxation (including the proposals for

personal tax indexation discussed in Part One of this

Report), continuing inflationary pressures and a relatively

depressed private sector.

14.2 Although political judgments will ultimately

determine the mix of policies which are necessary to deal

with these problems, it is the Committee's own judgment that

a high priority will need to be given to the task of

558

alleviating the insidious effects of inflation on business

stability and growth. We recognise that the proposals we

make below will, if adopted, involve significant changes to

the tax system, and will involve substantial reductions in

business taxation, at least initially, at a time when the

Government's Budget is already under pressure from other

directions. But these remedies have been necessitated by an

unprecedented threat to the survival capacity of many firms,

which can be expected to operate profitably except for their

inability to deal with the financial effects of inflation.

14.3 As has been indicated in earlier sections of

the Report, this threat to survival has been induced by an

acceleration in the rate of inflation beyond the capacity of

most firms to adapt through changes in their own policies.

If the rate of inflation exceeds a critical level - and in

the Committee's judgment this level has already been passed

in Australia - there is no way in which most firms can

respond adequately through their own policies, so long as

they are required to pay taxes on profits as conventionally

determined at rates approaching 50 per cent. Changes in

taxation policy are therefore a necessary condition for

business survival.

14.4 The Committee emphasises, however, that tax

changes alone will not restore financial stability in the

business sector. Business enterprises themselves must adapt

their management accounting practices and business policies

to the realities of the economic environment in which they

559

find themselves. To counteract the undesirable effects of

inflation, firms may therefore need to amend their present

policies.

14.5 The Committee's conclusions reflect the view

that there is a major problem in reconciling the

Government's aims for the public sector with the task of

restoring equilibrium to the private sector. But we also

see great difficulty in achieving the objectives of taxation

policy - equity, efficiency, simplicity, etc. - within the

framework of a less than perfect existing system. No doubt

changes will be made to the tax system as a result of the

wide-ranging review of taxation policy which has been

undertaken by the Taxation Review Committee. But for

purposes of this Report, it has been necessary to take the

existing system as given, except insofar as we have seen a

need for it to be adapted to deal with problems of

inflation. The consequence of this is that we have been

forced repeatedly to recommend compromise procedures in

order to minimise the extent to which improvements in one

part of the tax system may result in deterioration

elsewhere.

14.6 We are conscious that, in so doing, we have

been forced to make our own value judgments about equity and

the other objectives of tax policy to a greater extent than

is desirable in a report of this kind. In examining

possible policy options, we have thus been conscious of the

need to trade off one objective for another by recognising,

560

for example, that greater equity in one part of the system

can only be achieved at the cost of less equity (or

efficiency, or simplicity) in another part.

14.7 The Committee also records that there is little

empirical evidence about how the proposed procedures are

likely to work in practice. The position is therefore in

marked contrast to the problem which faced the Committee in

relation to personal tax indexation. Insofar as business

taxes are concerned, not only was the Committee asked in

submissions to recommend tax policies based on accounting

practices which, with minor exceptions, are not yet in

existence. It also had the task of evaluating the extensive

literature on alternative accounting theories, on which

there is still little agreement among either academic or

professional accountants, without having access to any

substantial body of empirical observations of the practical

working of the theories.

14.8 The experience of other countries also proved

of limited assistance to the Committee. As has been

observed in the previous Chapter, only in some of the Latin

American countries has any comprehensive system of

inflation-adjusted taxation been introduced, and only in a

few European countries have tentative steps been taken

towards developing a tax system which incorporates current

value adjustments to income. European and North American

countries have responded to the problems of inflation mainly

by making adjustments to the historical cost method of

calculating income for tax purposes.

561

14·9 Because of the uncertainty about the possible

effects of alternative procedures, the Committee has felt

obliged to frame its recommendations in such a way as will

permit the proposed changes to be phased in gradually,

without introducing unnecessarily complex, drastic and

irreversible changes. Such an approach will also have the

effect of enabling the loss of revenue to be controlled, of

minimising the problem of administering the proposed changes

effectively, and of avoiding as far as possible unexpected

loopholes for tax avoidance or evasion.

14.10 The recommendations which follow are therefore

based on the Committee's judgment, not that they provide any

kind of ideal solution to the problems that have been

discussed, but rather that they are more likely than any

alternative procedures to achieve the objectives of tax

policy and at the same time restore stability and confidence

to the business sector.

I n c o m e V a l u a t i o n A d j u s t m e n t s

14.11 T h e C o m m i t t e e h as c o n c l u d e d that a m o d i f i e d

c o n c e p t o f t a x a b l e income, b a s e d on the cu r r e n t v alue

c o n c e p t of in c o m e , s h o u l d b e i n t r o d u c e d for p u r p o s e s of

b u s i n e s s t a x a t i o n (that is, f or the t a x a t i o n o f b o t h

c o m p a n i e s and u n i n c o r p o r a t e d e n t e r p r i s e s ) . O n l y such a

c oncept, t he C o m m i t t e e b e l i e v e s , is c o m p a t i b l e w i t h l o ng-run

f i n a n c i a l s t a b i l i t y o f the b u s i n e s s s e c t o r u n d e r c o n d i t i o n s

of r a p i d i n flation. B e c a u s e the c o n c e p t is b a s e d on a

m e a s u r e m e n t s y s t e m in w h i c h all items of revenue and e x p e n s e

562

are valued in terms of current prices, the distorting effect

of price changes is removed and equity is achieved between

different classes of taxpayers, both within the business

sector and in relation to other taxpaying sectors. The use

of current values is a necessary condition for efficient

resource allocation decisions by business, so that the

adoption of a current value tax base is consistent with the

efficiency goal of tax policy. Tax collections based on the

proposed concept can be controlled by the revenue

authorities so as to ensure taxpayer compliance, limit

revenue losses and generally provide for the effective

management of the economy.

14.12 In order to adapt the existing concept of

taxable income to a current value concept, basically only

two simple valuation adjustments need to be made. These the

Committee will describe as the cost of sales valuation (or

stock appreciation) adjustment and the depreciation

valuation adjustment. The Income Tax Assessment Act will

need to be amended to allow the two adjustments as

deductions from assessable income. Some consequential

amendments will need to be made to other sections of the Act

to reflect the changed concept of taxable income. But most

provisions of the existing legislation may be retained, for

example the alternative bases of valuation of trading stock

(s. 31) and of calculating depreciation (s. 56). The

intention is that taxable income will be calculated, as far

as possible, in accordance with existing provisions and that

563

the two valuation adjustments will take the form of

allowable deductions additional to those which have been

allowed under existing legislation. In relation to the

proposed stock appreciation adjustment, it may be necessary

for the Commissioner to consider whether legislative or

merely administrative action is necessary where taxpayers

are affected by s. 38 to s. 42 inclusive (relating to business

carried on partly in and partly out of Australia) and s. 136

(relating to Australian business controlled abroad) of the

Income Tax Assessment Act.

14.13 The Committee intends that taxable income as

modified by the adjustments will continue to be the basis

for calculating the distributable income and retention

allowances of private companies under s. 103. This will

permit private companies to retain the amounts represented

by the valuation adjustments without incurring additional

tax, and thereby to avoid the adverse financial effects

which were noted in Chapter VIII.

14.14 Because the amounts represented by the

allowable deductions for the cost of sales valuation

adjustment may need to become taxable under certain

conditions discussed below, the Committee recommends that

they be designated as non-distributable as dividends or

other proprietorship withdrawals unless tax is paid on the

amounts concerned. The deductions will therefore need to be

accumulated year by year on taxpayers' returns as possible

future assessable income. The amounts so accumulated in the

564

tax records will correspond to the revaluation reserves

which business enterprises will establish in their

accounting records as an offset to the income valuation

adjustments. These reserves may include what are

effectively deferred tax liabilities and it may be desirable

for companies, if not unincorporated businesses, to

designate an appropriate portion of the reserves

accordingly. The Committee recommends that the depreciation

valuation adjustment be treated differently from the cost

of sales valuation adjustment, so that it results in a

permanent deferment of tax (see paragraph 14.58 below).

14.15 Where the valuation adjustments contribute to a

net loss as defined under s. 80 of the Act, that is where

the allowable deductions (other than concessional

deductions) exceed assessable income less net exempt income,

it is the Committee's intention that the loss be permitted

to be carried forward and allowed as a deduction against the

assessable income of future years in accordance with the

provisions of s. 80.

14.16 As discussed in a later section, other

amendments to the Act may be necessary to specify offsetting

adjustments in respect of inflation gains at the time the

valuation adjustments are made, or in the case of the cost

of sales adjustment to ensure that transfers are made back

to assessable income if the physical level of the revalued

stocks is reduced. If prices of the revalued stocks fall in

565

a subsequent year of income, the revaluation adjustments

made in that year will have the effect of increasing

assessable (and thus taxable) income. Assessable income

will need to be defined accordingly.

14.17 A final question in relation to allowable

deductions on the income valuation adjustments is whether

they should be obligatory or available at the taxpayer's

option. It was suggested in one submission that this option

should be available to taxpayers, because prices might fall

and they would then be required to add the amounts

represented by valuation adjustments to their assessable

income.

14.18 Although the Committee recognises that

increases in taxable income resulting from falling prices

of stocks may have perverse effects in a time of general

recession, it emphasises that its recommended procedures are

intended to adjust all taxable incomes so that they are

measured in terms of current prices, thus changing the tax

base to a consistent basis of valuation. The logic of the

situation thus demands that, if cost of sales valuation

adjustments are to be allowed as deductions when prices are

rising, they should also be added to assessable income when

prices are falling. It may be desirable to leave taxpayers

with an initial option as to whether to claim the cost of

sales valuation adjustments as deductions, but once they

have elected to do so they should be required to continue to

make adjustments in future years, whether the adjustments

566

are positive or negative. If, for reasons of economic

management, the Government decides to reduce company taxes

under conditions of falling prices, it should do so by

reducing tax rates rather than by allowing taxpayers to

determine their own tax base.

Cost of Sales Valuation (or Stock Appreciation) Adjustment

14.19 The Committee considered four suggested methods

of making a cost of sales valuation adjustment:

(a) Calculation of the adjustment as the difference

between opening stocks valued at their actual

prices and opening stocks valued at the same

prices as closing stocks, using actual stock

schedules and price lists as the basis of the

calculation. It should be noted that it is the

prices of closing stocks and not prices at the

end of the income period which are relevant for

purposes of the adjustment. Only on this basis

will the cost of stocks entering cost of sales

be centred squarely on the income period, so

that revenues and expenses will both be

expressed in current prices of the period. The

effect of calculating the cost of sales

adjustment on opening stocks only is to ignore

any stock appreciation on quantity changes

during the year.

(b) Calculation of the adjustment as the sum of (i)

the difference between opening stocks valued at

their actual prices and opening stocks valued

567

at the prices of stocks held at the middle of

the income period, and (ii) the difference

between closing stocks valued at the prices of

stocks held in the middle of the income period

and closing stocks at their actual prices.

Again the calculation is made by reference to

actual stock schedules and actual price lists.

The effect of revaluing both opening and

closing stocks is to calculate the stock

appreciation on average stocks held during the

period.

(c) Calculation of the adjustment as under (a) or

(b) but using a published index as the measure

of price change instead of the firm's actual

price lists. The application of price indexes

to both opening and closing stock values is the

method used in the Australian National

Accounts, which seek to establish a value for

the increase in stocks at current prices as

part of the process of deriving estimates of

national accounting aggregates at constant

prices. The method adopted in the Australian

National Accounts "seeks to estimate first the

increase in stocks at average current prices.

For this purpose, the opening and closing stock

book values are revalued at the average current

prices for the period by means of price

indexes, and the difference between these two

568

levels is taken as an estimate of the increase

in stocks at average current prices ... The

stock valuation adjustment is obtained as the

difference between the increase in the book

value of stocks and the corresponding increase

in stocks at average current prices of the

period.Il" 1 "

(d) Calculation of the adjustments on a quarterly,

monthly or even a transactions basis, giving

individual business enterprises the option to

choose which method they will adopt.

14.20 The Committee considered that although (d)

would theoretically give more accurate results, it was too

complicated and would involve too many calculations to be

considered feasible from the viewpoint of most taxpayers.

In any case, it would present too many problems of tax

administration. Except in special cases described below,

(c) was also rejected by the Committee because it would

represent an unnecessary departure from revaluation in terms

of the current prices of assets actually held by firms. The

Committee's inquiries have confirmed that it would be

relatively simple for all firms to revalue their opening

stock schedules in terms of the prices of closing stocks, or

to revalue both opening and closing stocks in terms of the

prices of stocks held in the middle of the income period.

1 Australian Bureau of Statistics, Australian National Accounts»: National Income and Expenditure-1973^717 Canberra, 1974, p. 18.

569

14·21 These two methods of calculating the cost of

sales valuation adjustment have been contrasted in Appendix

B in order to compare the results obtained under differing

assumptions of price and quantity changes. Both methods are

compatible with procedures for calculating amounts to be

transferred from reserves to assessable income when stock

levels fall, but it will be seen that approximations are

involved because of the difficulty of measuring stock

movements directly. The problem is similar to the one

described in the Australian National Accounts:

"In principle, physical changes in stocks should be directly valued at prices current at the time the changes take place, which could in practice be taken as approximately the average current prices of each period; this would maintain consistency with the basis of valuation adopted for all transactions

recorded in the national accounts. However, since the primary sources from which statistics of stock changes are obtained are the accounting records of enterprises

and authorities, the estimates of increase in stocks at current prices must be derived indirectly from estimates of the changes in book values of stocks, and are therefore an approximation to the desired basis."

14.22 The Committee has decided that the greater

accuracy which results from the revaluation of both opening

and closing stocks is not sufficient to compensate for the

greater work involved. It has been particularly mindful of

the difficulties which small business firms would face in

making two sets of calculations instead of one. The

Committee therefore recommends that the cost of sales

valuation adjustment be calculated by reference to opening

stocks only, so as to equal the difference between opening

stocks valued at their actual prices and opening stocks

valued at the same prices as closing stocks. When the

volume of stocks and prices are both rising, the fact that

stock appreciation is not recorded on stock accumulation

during the income period operates to the taxpayer's

disadvantage. The reverse is true when the level of stocks

is falling; because it appears that stock levels may fall

in Australia during the immediate future the Committee makes

suggestions below which are designed to protect the revenue

during this period.

14.23 The Committee lays particular stress on the

simplicity of the proposed adjustments and the relative ease

with which they may be applied. Because so many submissions

recommended the adoption of LIFO accounting for stocks, it

is worth while pointing out that the proposed cost of sales

valuation adjustments will be much easier to apply in

practice because they involve fewer calculations and the

maintenance of less complicated records (especially in

relation to the dollar-value method, which must be regarded

as the LIFO method which would usually need to be adopted in

practice for reasons given in Chapter XII above).

14.24 The practicability of the proposed arrangements

was discussed in the following terms by Mr. B.H. Pascoe, a

partner of Fell and Starkey, Chartered Accountants, in a

letter received by the Committee following one of the

seminars in which he had participated:

571

".... many of the suggested methods for arriving at net profit or taxable income would not necessarily be appropriate for use by all business entities and, although the philosophy might be fine for

arriving at a reasonable net profit figure for management or reporting purposes, are not necessarily appropriate for arriving at the figure on which a cash contribution to government revenue should be made. It

therefore seems to me that it will be necessary to make any changes in the area which the average business man will understand and can be readily applied by both those business men and the taxation assessors.

One matter which the Committee raised towards the end of the meeting referred to a possible method of adjustment for trading stocks. This method involved the revaluation of opening stocks using closing stock values. The Committee inquired whether it was

considered to be a practical method for general use. My immediate thought was that the method was practical and readily applicable to all levels of business taxpayers. Obviously it is somewhat arbitrary but I

find it very difficult to think of any method which will not suffer from that defect and still be practicable. It has always seemed to me that the basic concern in inflationary times is the severe drain

on liquidity where increasing amounts are required to finance trading stock and debtors. Any proposed system to alleviate the liquidity problem in respect of trading stock needs to take into account the increases in stock levels as opposed to valuations. It seems to me that the proposal of revaluing opening stock at

closing values automatically takes care of that problem. The restatement of opening stock values would take care of increases in those values but still leave an increase in taxable income where increased levels of

stocks are held because of expansion."

14.25 Appendix C demonstrates that the proposed stock

revaluation method provides a much more accurate measure of

the current value concept of income than LIFO, while

avoiding the capricious effects produced by LIFO in the

downward phase of the stock cycle.

14.26 In some submissions, it was suggested that the

cost of sales valuation adjustment could be calculated by

revaluing closing stock at the prices of opening stocks. The

Committee accepts this as another possibility with effects

572

similar to LIFO, although it notes that the proposal was

accompanied in two submissions by a suggestion that the

revalued closing stocks should become the basis of opening

stock values in the following year. Thus Dunlop Australia

Ltd. said:

"If it is accepted that the inherent time lag involved in the pricing process should be recognised in the tax structure perhaps the simplest and administratively most feasible solution would be to permit the valuation of closing stock at the end of a tax period to be based on stock costs at the beginning of that period. In a period of inflation this would defer into the following tax period any profit arising from appreciation in stock values, and would result only in the deferral of tax liability on that profit

for one year. If there were no inflation in any period no deferral of tax liability would occur."

14.27 Because this method would result in the tax

saving on closing stocks in one year being followed by an

additional tax liability in respect of the same stocks in

the following year, any tax advantage in relation to the

stock appreciation over a number of years of continuously

increasing prices would not be cumulative. In a period of

rapid inflation the Committee therefore believes that this

method would not provide sufficient relief to business

enterprises in respect of the problems which have been

examined.

14.28 In revaluing opening stocks by reference to the

prices of closing stocks, a problem may arise when, for such

reasons as changes in fashion or technology, items of

opening stock no longer appear in the closing inventory.

Possible ways of dealing with this problem include:

573

(a) Permitting a firm to calculate the stock

appreciation on discontinued lines by reference

to the average stock appreciation on all other

stocks, calculated by applying to the opening

value of discontinued lines the ratio of stock

appreciation to opening stock values of the

other stocks. To prevent manipulation, this

method should not be permitted where

discontinued stocks account for a large

proportion of opening stocks, say more than 10

per cent of the total value of opening stocks.

(b) Applying a published price index to the opening

value of the discontinued stocks.

14.29 In its discussions with the Australian Bureau

of Statistics, the Committee was informed that the existing

wholesale price indexes do not appear to be the most

suitable indexes for the purpose of calculating a cost of

sales valuation adjustment in those limited circumstances

where an index is required. It was suggested that two new

wholesale price indexes currently being developed by the

Bureau, for (a) articles produced by manufacturing

industries and (b) materials used in manufacturing

industries respectively, would be more suitable. It would

be possible to use the index for articles produced by

manufacturing industries (all groups), for manufacturers’

finished stocks and for stocks held for resale by other

enterprises; and the index for materials used in

574

manufacturing industries (all groups) would be the most

suitable index for manufacturers' stocks of materials and

work in process. Until those indexes are available, an

existing wholesale price index could be used. It is

expected that both indexes, which will be published on a

monthly basis, will be available before the end of 1975.

The indexes to be used for purposes of the taxation

adjustment would need to be published by the Commissioner,

using say the average of the last three months for each

income year. The Committee recommends that this method

should only be permitted where discontinued stocks account

for more than 10 per cent of the value of opening stocks.

14.30 The Committee does not believe that the

uncertainties introduced into the income measurement

process as a result of the cost of sales valuation

adjustment are greater than are implicit in existing

taxation arrangements for stock valuation. Stocks may

already be valued by reference to replacement price or

market selling value, the Taxation Commissioner's control

being effectively exercised by a requirement that closing

values in one year be the same as opening values in the

following year. The Committee therefore wished to ensure

that the effects of applying cost of sales valuation

adjustments to the stock values adopted by taxpayers would

not create measurement problems or present opportunities for

tax avoidance or evasion, either where a consistent basis of

valuation is used from year to year or where the basis of

valuation is changed from year to year. The result of this

exercise is set out in Appendix D, which draws the following

conclusions:

(a) The effect of the cost of sales valuation

adjustment is to smooth out the effects of

changing bases of valuation on taxable income.

In effect, all changes in stock values are

ignored in calculating taxable income, which is

thereby measured solely as the difference

between sales revenue and the current cost of

sales.

(b) Although the current value concept of income

(that is, the proposed concept of taxable

income) is not affected by the changes in the

basis of valuation, the relationship between

the size of the conventional profit and the

cost of sales valuation adjustment changes

according to the different combinations of

valuation bases used in valuing opening and

closing stocks.

14.31 It thus seems to the Committee that there are

no measurement or tax avoidance problems inherent in

measuring the cost of sales valuation adjustment by

reference to changes in the prices of stocks as they are

actually valued for ordinary taxation purposes.

576

14.32 There is, however, one possible source of tax

evasion which would need to be closed off if the Committee's

recommendations on stock valuation were to be put into

effect. This concerns the possibility that firms would, in

the year the stock valuation adjustments were introduced,

artificially value their previous year's closing stocks.

The best way to prevent tax evasion would be to introduce

the valuation adjustments after firms have already recorded

closing stock values for the previous year in their tax

returns. The adjustments could thus be introduced in

respect of the income year 1974-75 on the basis of closing

stock values which have already been recorded in returns for

1973-74.

14.33 The Committee has considered the question

whether the cost of sales valuation adjustments should be

available to taxpayers in respect of all classes of trading

stock as defined in the Income Tax Assessment Act. This

problem is discussed in greater detail in Chapter XV, but it

may be noted here that the Committee does not believe that

valuation adjustments should be permitted in respect of

live stock (to which special provisions relate) or land,

securities and other assets which lend themselves to

speculative activities.

577

Depreciation Valuation Adjustment

14.34 The Committee considered two methods of

calculating depreciation valuation adjustments:

(a) What may be described as the 'perpetual inventory'

method, whereby two perpetual inventories of plant and

equipment are maintained in terms of the opening

balance of the stock of assets at their depreciated

value, additions, disposals, depreciation charges and

the closing balance of the stock of assets. One

inventory records these items on the basis of their

historical values, while the other records current

values. After revaluing historical cost figures for

each year's transactions to establish current values,

the closing balance at current values is revalued in

accordance with the change in current values between

that year and the following year (as measured by an

appropriate index) to establish the opening balance for

the latter year. The ratio of the current value of the

opening stock of assets to their historical value is

then applied to historical cost depreciation in order

to calculate depreciation at current value. The

procedure is described in greater detail in Appendix E,

which uses current replacement cost as the measure of

current value.

(b) What may be described as the 'age co-efficient' method,

whereby depreciation charges on plant and equipment are

classified in accordance with the age structure of the

assets to which they relate, and a separate

578

co-efficient is applied to the historical depreciation

charges in respect of each year's asset purchases in

order to revalue depreciation in terms of current

replacement cost. For the purpose of these

calculations, the firm needs to maintain an asset

register in which historical cost depreciation charges

are related to a classification of assets on the basis

of years of purchase. The current replacement cost

co-efficient needs to be derived from a published index

of replacement costs. The procedure is described in

greater detail in Appendix E.

14.35 If depreciation valuation adjustments were to

be applied for tax purposes under a comprehensive current

value system of measuring taxable income, separate action

would need to be taken to calculate the allowable deduction

under S. 59(1) and (2) when plant and machinery was disposed

of. In particular, the allowable deduction under s. 59(1)

and (2) would need to be calculated by reference to the

revalued depreciated value. Suppose, for example, that an

asset which cost $1,000 and was depreciated at $400 p.a. for

two years was sold for $300 at the end of that period. The

replacement cost co-efficient was 1.25 for the first year's

depreciation and 1.5 for the second. Under existing

legislation, the taxpayer would be required to include the

difference between the consideration and the depreciated

value ($300-$200=$100) in his assessable income, thereby

reducing the effective depreciation allowances claimed to

$400 in the first year and $300 in the second. This would

579

partly offset the effect of the valuation adjustments ($100

in the first year and $200 in the second year). But by

applying the co-efficient of 1.5 to the depreciated value of

$200, the amount to be brought into assessable income would

be reduced to zero (consideration of $300 minus revalued

depreciated value of $300). If the proceeds from disposal

were $400 instead of $300, it would be appropriate for the

excess amount of $100 to be included in assessable income as

an adjustment to current value depreciation. Likewise, if

the proceeds were only $100, it would be appropriate for the

deficiency of $100 to be allowed as an additional deduction.

However, this problem will not arise under the scheme which

is later recommended by the Committee, and the existing

provisions under s. 59(1) and (2) may therefore continue to

apply.

14.36 It will be seen from Appendix E that the

perpetual inventory method provides a convenient procedure

for calculating changes in the stock of plant and equipment,

if information about such changes is needed to measure

valuation adjustments which have the effect of increasing

assessable income when the stock of assets is reduced. On

the other hand, the co-efficient method provides the most

accurate measure of current replacement cost depreciation

when the prime cost basis is used.

14.37 The Committee recommends that the co-efficient

method be used because of its applicability to both

depreciation methods. If it is desired to measure the

change in the stock of assets for the purpose of adding

580

depreciation valuation adjustments to assessable income when

the stock is reduced, this may be done under the

co-efficient method as follows. The sum of the previous

year's closing depreciated historical value of assets and

depreciation revaluation reserves may be revalued by

reference to the change in co-efficients, and the result

compared with the corresponding sum at the end of the

current year.

14.38 There are several problems which need to be

discussed in relation to the calculation of the depreciation

valuation adjustment. One concerns the use of an index.

For reasons given in Chapter XII, the Committee has decided

that it is not possible to permit individual firms to

calculate current replacement cost on the basis of their own

experience with replacement prices, at least until current

value accounting becomes widely practised by firms for their

own internal managerial and external reporting purposes.

Technological, capacity and quality changes make it

difficult to measure current replacement cost. When an.

asset is not likely to be replaced by an identical asset, it

has been noted that its current replacement cost needs to be

measured by the current cost of an asset performing the same

services. But changes in replacement cost reflect

productivity, capacity and quality changes as well as price

changes, and it is difficult to separate the different

elements

581

14.39 For these reasons, the Committee has decided

that current replacement cost needs to be measured by

reference to an index published by the Taxation Commissioner

or the Australian Bureau of Statistics. The Committee

recognises that this represents an aberration from current

value to the firm, but regards it as a necessary condition

if effective control over the depreciation valuation

adjustment is to be exercised by the Commissioner. The

effect of applying the index to the firm's actual asset

structure will help to ensure that the valuation adjustment

is at least partly based on the transactions of the firm.

The resulting tax concept of depreciation is referred to

subsequently as 'indexed depreciation'. The choice of index

is considered below.

14.40 There is also a question about the time period

to be used for purposes of the index. Because depreciation

charges are centred on the middle of the tax year, the index

should be compiled either as an average of the four quarters

or on a mid-year basis. The former would be preferable in

principle but would involve a delay in date of publication.

If the co-efficient method of indexing depreciation is used,

the correct result will be achieved provided the index is

centred on the middle of the income period. Although the

perpetual inventory method of calculating current

replacement costs calculates replacement cost by reference

to end of year asset balances, the carry-forward of asset

balances and all transactions affecting the assets

(purchases, disposals and depreciation) may notionally be

582

regarded as occurring on 31 December each year in respect of

the fiscal year 1 July - 30 June. The revaluation for

purposes of calculating current replacement cost may then be

assumed to occur at the same date. Under either method,

firms with a balance date other than 30 June toould present a

problem but separate co-efficients could be published for

these if the problem was regarded as significant. The

question of timing is also considered more specifically

below.

14.41 A further problem concerns the extent to which

past changes in current replacement prices are to be

recognised when indexed depreciation adjustments are first

introduced. In the illustration in Appendix E, it has been

assumed that price changes prior to Year 1 may be ignored.

This assumption could be varied by calculating replacement

cost co-efficients for a number of past years and permitting

firms to apply these to the existing stock of assets in

accordance with their age classification. It would be more

difficult to apply the indexed depreciation adjustment

retrospectively if the perpetual inventory method were to be

used. But in any case, it will be suggested below that,

because of the revenue effects which are likely to be

generated, there are strong practical arguments for phasing

in indexed depreciation adjustments gradually by ignoring

price changes prior to the year of introduction. The

Committee favours such an approach.

583

14.42 It is assumed that quarterly instalments of

company tax will not complicate the task of allowing the

indexed depreciation adjustment in relation to the income

year in which the payments are made, because any adjustment

would be made after the normal taxable income for the year

has been calculated.

Choice of Index

14.43 Assistance was sought from the Australian

Bureau of Statistics as to whether any existing price

indexes or implicit indexes are generally available and

suitable for use in determining indexed depreciation

adjustments. Even though it was not judged practicable for

individual enterprises to be permitted to use their own

replacement cost experience, the possibility of using

several general indexes for specific classes of depreciable

assets was discussed with the Bureau. As a result of that

discussion, the Committee concluded that the practical

difficulties of proceding in this way were such as to rule

out the use, in the foreseeable future, of more than one

index of changes in the prices of depreciable assets.

14.44 These difficulties included: the limited range

of specific price indexes of the required type; the wide

variations in the rate of price change as measured by the

separate indexes which do exist; and the difficulty of

matching the regimen of the separate specific indexes to the

assets owned by individual firms, which may range over many

industries and types of assets. The Committee therefore

concluded that the implicit Gross National Expenditure price

deflator, for the 'all other' category of private gross

fixed capital expenditure, would be the most suitable single

index for use in calculating indexed depreciation

allowances.

14.45 That implicit price index, which is usually

available on a quarterly basis, covers items of private

fixed capital expenditure except for dwellings and other

building and construction expenditures. The Committee was

informed by the Bureau that, unlike some other implicit

price deflators,^ the construction of the index does not

involve the use of changes in the prices of labour inputs

and that productivity changes are therefore systematically

allowed for in its construction. This is a matter of some

importance, because an index which did not allow for

productivity changes would overstate the extent of the price

changes which it purported to measure.

14.46 However, the index is of a Paasche (current

weighted) type which uses as weights the investment

expenditures in the current period, and it is subject to

revision when national accounting aggregates are changed.

There is also a delay of between 8 and 10 weeks in its

availability after the end of the quarterly period to which

it relates. While these two considerations raise certain 1

5 84

1 see The Meaning and Measurement of Economic Growth, Supplement to the Treasury Information Bulletin, November 1964, especially pp. 12-13.

585

problems, the Committee does not believe that they

invalidate the use of the index for the purpose of

calculating indexed depreciation adjustments. After

co-efficients have been prescribed by the Australian

Taxation Office in accordance with the index, the Committee

recommends that revisions to the index be ignored. Such

revisions will be fully reflected in the co-efficients

published for later periods. Because the revisions may be

both positive or negative, the expectation is that in the

long term neither the taxpayer nor the revenue would on

balance benefit because of revisions.

14.47 It would be desirable for the indexation

co-efficients to be used in a given income year to. be

published by the Taxation Office before the end of income

year to which they relate. That could be achieved by using,

as the basis of the co-efficients, the change in average

value of the index for the December and March quarters from

the average value of the index for the same quarters in

earlier years. The price changes would then be centred on

the mid-points of the respective income years.* 1

1 That result would be appropriate for firms with June 30 balance dates in order to reflect the average purchase date of capital equipment during the income year. The Commissioner of Taxation may, however, wish

to publish different price co-efficients centred on earlier dates for firms with balancing dates significantly different from June 30.

586

Income Valuation Adjustments as Assessable Income

14.48 The Committee has given considerable thought to

the problem whether income valuation adjustments, which were

allowed as deductions when levels of assets and prices were

rising, should be brought back into assessable income (by

means of positive valuation adjustments) to the extent that

the level of assets is subsequently reduced. Except where

the level of assets falls temporarily for reasons beyond the

taxpayer's control, there would seem to be good reasons for

adopting such a provision. The reason for the income

valuation adjustments is to enable a firm to maintain the

scale of its operations without having to raise additional

funds to finance the higher cost of holding assets; the

revaluation reserves which are created as a result of the

adjustments in effect provide the funds for this purpose.

But if the firm's assets are subsequently run down and the

scale of its operations is reduced, the need for the

reserves disappears and it is appropriate that transfers be

made back into income, to the extent of the reduction in the

volume of assets that has taken place.

14.49 Looked at in this way, the initial income

valuation adjustments may be regarded as a deferment of tax

rather than as a tax rebate. In order to ensure that this

deferment does not open up opportunities for tax avoidance

or tax evasion, careful thought must be given to the

treatment of the revaluation reserves which result from the

income valuation adjustments.

587

14.50 The Committee has identified the following as

possible courses of action in relation to the revaluation

reserves which have thereby been created. It emphasises

that the procedures listed are not necessarily mutually

exclusive. It may be noted that the Committee recommends

that none of these procedures be applied to the proposed

indexed depreciation valuation adjustment, which for the

reasons given in para. 14.58 the Committee recommends be

treated as a permanent (and non-accountable) deferment of

tax. The Committee is therefore recommending, in effect,

that the options should be considered only in relation to

the cost of sales valuation adjustment and revaluation

reserve.

(1) Restrictions on Distribution

14.51 The revaluation reserves, representing the

accumulated valuation adjustments allowed as deductions,

could be treated as non-distributable reserves by the

taxpayer. In order to prevent such a provision from being

thwarted by the sale of a company which has been allowed

deductions in respect of income valuation adjustments, the

revaluation reserves would need to become fully taxable (by

including valuation adjustments in assessable income) if

there is a change in the beneficial ownership of the

company. This restriction could be applied in the following

way. In the case of companies the revaluation reserves

would need to be brought back into assessable income (a) if

the company ceased business, (b) if the business was sold,

(c) if control of the company changed within the meaning of

588

s. 80 of the Income Tax Assessment Act, or (d) if it was

placed in liquidation. On the happening of any one of these

events, the deferred tax would become an actual liability

unless permission were expressly given for a roll over. For

unincorporated enterprises, the disgorging of the reserves

into assessable income could be required upon sale or other

disposal of the business or upon the death of the

proprietor, but perhaps a more liberal attitude towards roll

over may be permitted in these circumstances. In the case

of death, for example, one option would be to permit

retention of the reserves in the business provided ownership

devolved upon a spouse or dependent children; another would

be to ignore revaluation reserves of less than $10,000.

(2) Additions to Assessable Income on Reduction in Asset Holdings

14.52 A reduction in the current value of assets

between the beginning and end of the income period could be

accompanied by the inclusion of appropriate valuation

adjustments in assessable income, the amounts of the

adjustments being calculated in accordance with the

procedures described in paragraph 14.16 and Appendixes B, C,

D and E.

14.53 In particular, this procedure would involve

a transfer from the revaluation reserve to assessable income,

by way of a positive valuation adjustment, of an amount

calculated as follows. The ratio of (a) the reduction in

assets during the income period (net of any valuation

adjustment during the period) to (b) the value of assets at

the beginning of the period would be applied to (c) the

589

accumulated value of the revaluation reserves at the

beginning of the period.

(3) Taxation of Reserves

14.54 The revaluation reserves could themselves be

regarded as taxable under certain circumstances. The

Committee understands that in some overseas countries a

low-rated tax, in the nature of an irregular capital levy,

has sometimes been imposed on reserves that have been

created as a result of adjustments to the tax base similar

to those being proposed by the Committee.

(4) Time Limit

14.55 A time limit could be imposed on the deferment

of tax resulting from the income valuation adjustments. It

has already been observed that some submissions recommended

that the deferment in respect of the cost of sales valuation

adjustment be limited to one year, by making the adjustment

to closing stocks and requiring a lower opening stock value

(and hence a higher taxable income) in the following year.

Mexico and Argentina provide this concession. As was also

noted in Chapter XIII, West Germany permits inventory

valuation reserves to be maintained for six years after

their creation, after which they must be transferred back to

taxable income.

(5) Limits on Value of Reserves

14.56 Although such action limits the creation of

revaluation reserves rather than restricts their

availability, it is worth mentioning in the present context

590

the possibility of limiting revaluation reserves to a

specified proportion of closing stock values or to some

other prescribed maximum. It has been observed that some

European countries permit firms to establish non-taxable

inventory reserves up to a maximum proportion of closing

stock values.

14.57 Recommendations on Transfers from Reserves. The

Committee recommends that cost of sales revaluation reserves

should be subject to restrictions on distribution. Further,

reductions in the current value of stocks should be

accompanied by transfers from revaluation reserves to

assessable income in the manner described in para. 14.52,

while giving the Commissioner of Taxation the power at his

discretion to waive the provision in a particular income

period if he is satisfied that the reduction in current

value is a temporary one which has occurred for reasons

outside the taxpayer's control. The Committee does not

recommend that cost of sales revaluation reserves normally

be regarded as taxable (through a capital levy), or subject

to any time limit, or limited to a maximum value. To place

a time limit on the tax deferment or to limit the maximum

value of the reserves would be to assume that the effects

of inflation are finite rather than continuous and

cumulative so long as the inflation lasts. In Chapter XVI,

however, the possibility is discussed of limiting the

amount of the cost of sales valuation adjustment in any

income period.

i

591

14.58 In the case of indexed depreciation valuation

adjustments, the Committee recommends that these should be

regarded as giving rise to a permanent deferment of tax, and

therefore as subject to none of the procedures described

in paras. 14.51 to 14.56. The Committee's reasons for

treating depreciation valuation adjustments differently

from cost of sales valuation adjustments are as follows:

(a) Except in the unlikely event that the stock of plant

and equipment is perfectly balanced, fluctuations in

current values will take place from year to year that

reflect leads and lags in depreciation allowances and

replacement. Under these circumstances, the

complicated task of measuring the adjustments from

year to year may be regarded as being unnecessary.

(b) The fact that profits from the sale or disposal of

plant and equipment are not normally taxed either as

income or as capital gains limits the opportunity for

tax avoidance in relation to such assets. Any trading

in plant and equipment normally used by the firm in the

production of assessable income should be readily

apparent to the Commissioner.

(c) Allowable deductions in respect of depreciation are in

any case arbitrarily determined, and efficiency in

investment decisions is likely to be encouraged if

firms are able to allocate their resources among

different classes of assets at their discretion.

592

Holding Gains, Capital Gains and Purchasing-Power Adjustments

14.59 The final issue to which the Committee draws

attention is the important question whether allowance should

be made for purchasing-power gains and losses on monetary

items, to offset or supplement the income valuation

adjustments on stocks and plant and equipment. This question

cannot be resolved without giving some consideration to the

nature of the income valuation adjustments, which the

Committee has noted may be regarded as holding gains and

losses, and establishing their relationship to other capital

gains and losses and purchasing-power gains and losses.

Holding Gains

14.60 It has been noted that, where the prices of a

firm's non-monetary assets (stocks and fixed assets) are

changing over time, for example so that it costs more to

replace them as they are sold or used up in the processes of

production and sale, the conventional measure of accounting

profit may be analysed into two parts. The first measures

the difference between revenue and expenses, including in

expenses the current cost of the non-monetary assets embodied

in the goods or services which are sold, that is the current

cost of the stocks which are used up or sold and the current

cost of depreciation expense. This component of profit is

called current income or current operating profit. The

second element of profit reflects the difference between the

current cost and the historical cost of the stock and

depreciation elements. This difference has been treated by

593

the Committee as a valuation adjustment for the purpose of

measuring current income, but if positive it may also be

regarded as a holding gain, that is a gain which is derived

by continuing to replace and thus hold assets as sales take

place. (A holding loss is incurred if historical cost

exceeds current cost.)

14.61 The nature of the distinction between operating

profits and holding gains may be illustrated by reference to

a simple example. A merchant buys a table for $10, and later

sells the table for $15, replacing it on the same day at a

cost of $12. If he is to continue to trade in tables

indefinitely, he is likely to regard his distributable profit

as being only $3, because the other $2 profit is needed to

replace the table. His accounting profit of $5 may thus be

regarded as containing two elements, a current operating

profit of $3 which can be distributed without affecting the

merchant's capacity to trade, and a holding gain of $2 which

is embodied in the higher cost of the table held for future

sale. Because it is not distributable unless the merchant

decides to cease trading, the holding gain is in the nature

of a capital gain rather than an element of income. It is

sometimes called a realised holding gain, because it is

derived from the revenue earned from sale.

14.62 By contrast, an unrealised holding gain occurs

when the current cost rises above the historical cost of

assets which are waiting to be used in the production

processes or which are awaiting sale. If, in the case of the

foregoing illustration, the cost of replacing the table

594

purchased for $12 subsequently rises to $15 but it remains

unsold, the merchant may be said to have derived an

unrealised holding gain of $3. If the table is then sold for

$20 and replaced, the unrealised gain is converted by the act

of sale into a realised holding gain of $3, and the

accounting profit of $8 (sales revenue of $20 less the

historical cost of $12) may again be divided into a current

operating profit ($20 less $15, or $5) and a realised holding

gain (of $3).

14.63 It is important to note the distinction between

realised holding gains and distributable income. If trading

activity is to continue, the realised holding gain becomes

locked into the non-monetary assets needed for purposes of

future trading and is not available for distribution as

income. It is therefore analogous to a capital gain, which

cannot be safely distributed until it is decided to cease

trading by not replacing the asset when it is sold. Although

the concept of realised and unrealised holding gains has been

illustrated by reference to an item of trading stock, the

same kinds of gains occur as a result of changes in the

prices of manufacturing stocks and fixed assets used for

purposes of production and sale.

14.64 The relationship of holding gains to other kinds

of capital gains is important in relation to company taxation

and the taxation of business enterprises generally, and is

considered in the following section.

595

Capital Gains

14.65 Conceptually, seven types of capital gains may

be distinguished (in each case the gains may be negative):

(a) holding gains on non-monetary assets which are

realised by the sale of goods or services (gains

associated with changes in the value of stocks

included in cost of sales and with changes in

the value of depreciation of fixed assets);

(b) unrealised gains from holding non-monetary

assets (associated with changes in the value of

stocks and fixed assets);

(c) realised gains from the sale of capital assets

(for example, profits from the sale of land or a

business enterprise);

(d) unrealised gains from holding capital assets;

(e) realised gains from the sale of securities;

(f) unrealised gains from holding securities;

(g) purchasing power gains associated with holding

liabilities or assets in a time of changes in

the general price level.

14.66 The distinction between the different groups is

not always clear-cut. Thus fixed assets are operating assets

until they are sold, when they might be regarded as capital

assets; in effect the act of selling a fixed asset converts

an unrealised holding gain under (b) into a realised capital

gain under (c). Similarly, as has been noted, the act of

selling trading stock converts an unrealised holding gain

under (b) into a realised holding gain under (a).

596

14.67 There is an important distinction between the

first six classes of capital gain and the seventh. Each of

the first six kinds of capital gain reflects a difference in

value which is measured by reference to the market

transactions in which the holder of the assets or liabilities

actually engages. The market value may be determined by

reference to a buying price (sometimes called an entry value)

or a selling price

the market price of the assets or liabilities which are

actually held or sold which is relevant to the determination

of the capital gain. But the seventh type of capital gain,

which becomes a capital loss if it relates to assets which

are held during a time of rising prices, is in the nature of

a hypothetical gain which is measured by reference to changes

in a general price level index. This has been statistically

conpiled to indicate, by reference to changes in the prices

of a particular collection of goods and services, how

purchasing power in general has been changing, and its

relevance to individuals or firms will depend on the extent

to which the assets they hold, or the transactions they

engage in, approximate those which are included in the

regimen used for the general index.

14.68 It should be noted that purchasing power gains

and losses are associated with the holding of all assets and

liabilities and not merely, as sometimes seems to be assumed,

with the holding of money claims (or what the Committee has

597

called monetary assets and liabilities). There is, however,

a difference between monetary assets and liabilities which do

not yield dividends or interest and other kinds of monetary

assets and liabilities, in that the former are subject only

to general purchasing power gains or losses, whereas the

latter are also subject to gains or losses resulting from

changes in the market prices of the assets and liabilities

which are actually held (that is, gains in categories (e) or

(f) above).

14.69 In Australia, it is only realised holding gains

under (a) which are subject to income tax, except for

realised gains (under (c) and (e)) on assets which are sold

within 12 months of acquisition or acquired for resale at a

profit. In many other countries, all realised gains under

(c) and (e) are taxed separately from income. In the 1974-75

Budget, the Australian Government announced its intention to

introduce a similar capital gains tax, but that decision has

since been revoked. For the ordinary business enterprise, it

therefore remains true that the only form of capital gain

which is generally subject to income taxation is the realised

holding gain on operating assets. Any discussion about the

equity of the existing system should not lose sight of this

fact. The assets concerned are the operating assets on which

the productive capacity of the economy depends, and it is not

clear why they should be singled out as the only assets which

are generally subjected to a capital gains tax and, moreover,

taxed at income tax rates.

598

Tax Indexation and Adjustment Concepts

14.70 The Committee has noted that alternative

approaches to the taxation of income and capital gains

depend on the concepts of income and capital gains

themselves. The current purchasing power (CPP) approach to

income measurement regards it as appropriate to include all

holding gains in the income tax base, but seeks an adjustment

to taxable income in respect of purchasing-power losses and

gains on all of the enterprise's assets and liabilities.

That is, taxable income is adjusted for all losses and gains

under (g). Because the firm's assets exceed its liabilities

by the amount of its proprietorship capital, this approach

implies an adjustment to the firm's taxable income for the

purchasing-power loss on its net assets. The negative

adjustment for this purchasing-power loss does not bear any

relation to the realised holding gain identified under (a).

Whether it is higher or lower than the holding gain will

depend partly on the relationship between changes in the

prices of the firm's non-monetary assets and changes in the

general price level, and partly on the relationship between

the firm's non-monetary assets on the one hand and its

monetary assets and liabilities on the other. But the

purchasing-power adjustment to taxable income in effect

removes a hypothetical capital loss from the tax base whilst

treating realised holding gains as taxable.

599

14.71 Those who favour a relative price change

approach to income measurement usually argue that holding

gains only occur to the extent that prices of the firm*s

assets increase more rapidly than the general price level.

In their view, distributable (and taxable) income includes

holding gains only to the extent that they reflect this

relative price change, and needs to be determined after

taking into account purchasing-power losses on monetary

assets and purchasing-power gains on liabilities. Taxable

income thus effectively includes realised holding gains

under (a), subject to a negative adjustment for the

purchasing-power loss on both non-monetary assets and net

financial assets. Again the hypothetical capital loss on

net assets has been excluded from taxable income but the

realised holding gain on non-monetary assets continues to be

subject to taxation.

14.72 The current value approach to income measurement

treats only current income (or current operating profit) as

distributable or taxable income. Realised holding gains are

thus excluded from the tax base, at least until such time as

they cease to be needed to finance the holding of

non-monetary assets as a result of the assets being sold and

not replaced. Variants of the current value approach involve

the inclusion in distributable and taxable income of

purchasing-power losses and gains on monetary assets and

600

liabilities, or on monetary assets and short-term

liabilities. Such variants reintroduce differential

treatment for different kinds of capital gain, in this case

purchasing-power losses and gains on monetary assets and

liabilities and, if the objective is to tax all kinds of

capital gains consistently, their rationale is by no means

clear.

14.73 The holding of dividend-yielding or

interest-bearing securities raises similar kinds of problems

to those associated with the holding of non-monetary assets.

Changes in interest rates and other factors may cause

changes in the prices of the securities, leading to capital

gains or losses under categories (e) and (f) above, and

purchasing-power gains and losses may affect the real worth

of the capital gains and the dividends or interest earned on

the securities. If the combined effect of capital losses

and purchasing-power losses exceeds the dividends or

interest received, the real tax base may be negative. Under

these circumstances, a tax system which ignores capital

losses and purchasing power losses, and taxes only dividend

or interest income, is essentially taxing not income but

wealth.

14.74 Long-term stability in the capital market can

only be achieved if lenders achieve a net positive return on

funds which they make available to borrowers, and if

borrowers incur a net positive cost. If securities are to

be inflation-proofed, the value of equity shares must

601

therefore be protected by preventing the capital erosion

effects which result from conventional accounting and

pricing policies, and the value of interest-bearing

securities needs to be protected by maintaining interest

income at a level which ensures that the securities yield

positive returns. The question of interest indexation, like

that of wage indexation, lies outside this Committee's terms

of reference, and the only question which needs to be

resolved by the Committee is whether some form of tax

indexation needs to be applied in the absence of any scheme

of general indexation of incomes. One submission received

by the Committee (from Price Waterhouse & Co.) suggested

that interest receipts should only be subject to taxation,

and interest payments should only be deductible for tax

purposes, to the extent that the rate of interest received

or paid exceeds the rate of inflation as measured by an

index of general purchasing power.

14.75 But so long as capital gains generally are not

taxed, there seems to be no case for introducing

purchasing-power adjustments, either generally or partially

in relation to particular kinds of assets. Purchasing-power

adjustments also need to be considered in relation to the

taxation of other incomes. Such adjustments have the effect

of converting current incomes into constant values, and it

is not clear why some incomes need to be converted to

constant values for tax purposes while others, for example

602

wages and salaries, continue to be taxed on the basis of

their current values.

14.76 If realised capital gains under (a), (c) and

(e) were all subject to taxation, there might be a case for

indexing the capital gains by recognising the associated

purchasing power losses and gains. Even then, it is

considered that realised holding gains on non-monetary

assets would need to be given special tax treatment, whereby

tax would be deferred until the assets ceased to be replaced

and the gains were capable of being effectively distributed.

In the absence of any general system of capital gains

taxation, however, consistency and equity would seem to be

best achieved by making no provision for tax indexation to

allow for purchasing-power losses and gains.

14.77 The Committee therefore concludes that:

(a) there is an analogy between the financial

problem which results from the holding of

stocks and fixed assets during a period of

rising prices, and the purchasing power loss

which results from the holding of monetary

assets;

(b) there may be a case for indexing interest

receipts and payments for tax purposes, by

limiting assessable receipts and deductible

payments to the amounts by which the rate of

interest received or paid exceeds the rate of

inflation as measured by a general

purchasing-power index;

603

(c) so long as capital gains or losses generally

are not taxed there seems to be no case for

taxing purchasing power gains or losses which

result from the holding of financial assets and

liabilities.

14.78 The Committee is in some doubt as to whether

the question of tax indexation of interest receipts and

payments falls within the Committee's terms of reference,

although it believes that it comes within the general phrase

of the second reference: "To examine the effects of rapid

inflation on taxation paid by companies and other

enterprises But whether or not it is appropriate

for the Committee to make any recommendations on this

matter, it is an issue that needs to be discussed as part of

the problem of ensuring that the recommendations are

internally consistent.

14.79 However, there seem to be two reasons why the

general tax indexation of interest receipts and payments

cannot be regarded as feasible at the present time:

(a) Tax indexation of interest transactions cannot

correct inflation-induced distortions in the

capital market unless it is accompanied by

indexation of financial claims and interest

transactions relating to those claims.

(b) In the absence of interest indexation, the

reduction in the tax base which would result

from tax indexation of interest receipts and

604

payments would be far too great to be

acceptable in the light of the revenue effects

likely to result from the other changes which

are being proposed in personal and business

taxes. The main reason for this is that

interest receipts are generally subject to

taxation, but interest payments are deductible

only to the extent that they are incurred in

the production of assessable income (except for

deductible mortgage interest payments). At

present rates of