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I. Taxation Review Committee




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1. Chapter 1 The need for Tax Reform

I. Reasons for a Review

1.1. There are a number of distinguishable, though overlapping, reasons why a broad review of the Australian tax system is timely.

1.2. There has been nothing approaching such a review since two Royal Commissions on Taxation, the Warren Kerr Commission (1921–23) and the Ferguson Commission (1932–34), reported. Several Commonwealth Committees on Taxation were set up in the 1950s—the Spooner Committee (1950–54), the Hulme Committee (1954–55) and the Ligertwood Committee (1959–61)—but each was restricted by its terms of reference to aspects of income tax. Even if, as is not the case, the Australian system were generally agreed to be as satisfactory as any tax system is ever admitted to be, a periodic thorough inspection would be as wise a precaution in this area of affairs as in any other.

1.3. Many of the key features of the present tax system were introduced in the 1930s and 1940s for good short-term reasons connected with the Depression and World War II, without much thought to their longer-run implications. This is true, for instance, of the adoption of sales tax in 1930, of the discontinuance in 1940 of company tax rebate on dividends to individuals, and of the introduction in 1941 of payroll tax (now under the control of the States) and Federal gift duty. Three decades or more later it is reasonable to examine the permanent consequences of these changes as well as to take stock of the piecemeal accumulation of minor changes that have since occurred. The present Australian fiscal legislation is best viewed more as an historical growth than as a system in the sense of a deliberately conceived and integrated structure in which every part has a defined role to play. The Anglo-Saxon tradition is to adapt slowly; but a periodical re-examination of the logic of what has grown up remains appropriate.

1.4. The wide range of tax structures to be found in countries with economic, social and political systems not unlike Australia's, to which reference is again made in Chapter 2, points to a variety of experiences from which much can obviously be learned, whether as precept or warning. If one wishes to choose between foreign models there are indeed many from which to make a selection. Stimulating too, though somewhat intimidating, is the long row of reports and studies produced overseas in the last few years, notably the six volumes and thirty accompanying studies of the Canadian Royal Commission on Taxation (Carter Commission, 1966), the report of New Zealand's Taxation Review Committee (Ross Committee, 1967), the several reports of the Commission of Enquiry into Fiscal and Monetary Policy in South Africa (Franzsen Commission, 1969–70), a series of Green and White Papers and Select Committee reports on various tax changes under consideration in the United Kingdom, and the many volumes of evidence submitted to the 1969 and 1973 Congressional hearings on tax reform in the United States.

1.5. Of more immediately pressing significance is the increasing discontent with the existing system. A decade ago four economists from Australian universities published a book entitled Taxation in Australia: Agenda for Reform, under the auspices of the Social Science Research Council. Their study, though traversing much that the present report has to cover, attracted little public attention. The 600 or so submissions


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received by the Committee reveal a less ready acceptance of the existing system. While few of these submissions discuss taxation in the broad, and many deal with quite small points of detail, collectively they reveal widespread and lively criticism. No doubt the impact of a rapid rate of inflation and the upward trend in government spending with its accompanying increases in the overall level of taxation partly account for this shift in public attitudes, but there is certainly revealed also the existence of a number of anomalies and inequities, many very real, in the tax system we now have.

1.6. The two factors just mentioned—inflation and the rising trend of government expenditure—provide further reasons for the urgency of a radical discussion of tax reform. The Australian tax structure was not designed for, and is still not adapted to, an economy in the throes of inflation. The implications of inflation warrant separate detailed examination and discussion is postponed to Chapter 6. Present comment is directed to the other factor—the increase in government spending.

1.7. A great part of the sharply rising totals of government expenditure, referred to again in Chapter 2 where statistics are given, can be explained by the rising unit costs of normal government expenditure of all kinds and the increase in population. But not of course all, since expenditure has also been increasing as a proportion of gross national product. The existence of this trend, and its likely future, are an important factor in tax policy.

1.8. The Committee's terms of reference instruct it to have regard to ‘the need to ensure a flow of revenue sufficient to meet the revenue requirements of the Commonwealth’. This may be taken to exclude from this report any substantial discussion of the relative place of taxation and borrowing in the overall public finances of Australia. But it may be noted that 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. However, whether such a further lowering would be practicable over the years ahead is not something the Committee is competent to judge, involving as it does issues of economic policy and monetary management that go beyond its terms of reference. But the point deserves to be noted.

1.9. Even if rather more borrowing is resorted to, it is virtually certain that government spending will continue to increase as a percentage of gross national product. This has recently been happening in Europe and appears to be nearly universal: the varying political complexions of governments, it would seem, do no more than cause some dispersion in the speed of the growth.

1.10. In Australia, as summary figures in Chapter 2 serve to remind us, both the main overall categories of public expenditure—on goods and services involving a shift in real resources from the private to the government sector, and on transfer payments chiefly in the form of cash social service grants—have been gradually, if not quite steadily, rising as a proportion of gross national product for many years. They will do so again in the current financial year, and it is reasonable to assume that the upward trend will continue over the next few years. The Committee is aware that a number of commissions and inquiries are at work or have recently made recommendations in such fields as the relief of poverty, national superannuation, compensation for injury, illness or disability, and resource matters, all of whose findings are likely to invite consideration of measures that will make very large demands upon public revenue. It is


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conscious that it has to recommend a structure of taxation capable of meeting present and future revenue needs.

II. Committee's Approach

1.11. In presenting its findings, the Committee could adopt one of two approaches. Either it could go through the provisions of the legislation as it now stands, stating its immediate and long-term proposals about the revision of each Act, explaining in some detail its suggestions for additional legislation, and letting the broad picture of the implications of the whole set of reforms emerge gradually; or it could first settle the broad outline of the kind of tax system it would like to see established eventually and work back from that to the changes in the present system that would have to be made before that long-term aim could be realised.

1.12. The second approach has been adopted as the Committee believes that this will prove the more useful procedure. There are some detailed areas of tax legislation that the Committee has not fully explored. It is also, of course, uninformed of many of the short-term pressures and constraints under which the Australian Government must labour, as all governments must always labour. If it advanced precise proposals for immediate adoption, and especially if it gave them exact numerical content, many would be likely to turn out, in the event, to be untimely. In matters of taxation, committees of inquiry are ill-advised to offer neat time-tables and precise rates or quantities. Moreover, and above all, when a tax system becomes somewhat ossified and somewhat incoherent as has the Australian, and when rather sweeping reforms are under consideration, much public discussion and understanding are essential before large changes can be attempted. Structural reforms will inevitably take some years to implement, rate changes have to be made gradually as the circumstances of the day permit, and transitional problems of much intricacy have to be solved at every point. A proper appreciation of the ultimate aims of what is being proposed requires a presentation that in the first place is in terms of general principles rather than legal or quantitative detail. Strategy comes before tactics.

1.13. Hence in this report the Committee will reach its conclusions by first discussing the long-term aims of tax reform of a general but not, it is hoped, unduly abstract kind. This will occupy Chapters 3–5, after a brief descriptive survey in the next chapter. Chapter 3 will examine the competing criteria of merit for individual taxes and tax systems; Chapter 4 will describe and debate the issues surrounding the central problem of the right progressivity of the tax system as a whole; Chapter 5 will outline the prime options of direction for long-term reform from which, in the Committee's view, a choice needs to be made, and state the Committee's own preference. Inflation has major implications both for long-term reform and for immediate tax revision, and these will be identified and discussed in Chapter 6. Then a succession of chapters will examine existing and possible taxes with respect to some changes that should be made as soon as possible, to others that would have to be effected gradually if the Committee's recommended strategy were to prove acceptable. In the final chapter, a brief restatement of the matters covered in the earlier chapters is presented.

1.14. By its terms of reference the Committee's attention is confined to the taxes imposed by the Australian Government and it has not therefore closely examined the taxes levied by other authorities in this country. It has, however, taken these taxes into account when viewing the tax system as a whole and will need at a number of points to mention particular areas where the several tax systems crucially impinge on one another.




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1.15. One further point. In a review that touches on basic issues about what society wants and does not want its taxation system to do, the Committee must be deliberately tentative in those of its recommendations whose merit turns upon social and political judgments about which there can never be one right answer. It should not pretend to replace the political process or suggest the exact compromises that may have to be made. At the same time it should hope to clarify the factual basis upon which these value judgments ought to be founded, and to draw attention to gaps in the information when these are particularly important.




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2. Chapter 2 The Australian Tax System in Perspective

2.1. This report concerns the future of the tax system rather than its past, but it is helpful in considering what lies ahead to have some slight perspective on what has gone before. It is the Australian system being examined and not overseas ones, but a greater awareness of the possibilities of change is provoked if the Australian system is compared with those of other prosperous countries with kindred political and social institutions. This chapter therefore provides short descriptive accounts of these matters, designed merely as background.

I. Historical Perspective

2.2 In 1973–74 the various governments in Australia between them raised over $13,750 million in taxes. The figure had been gradually, though not continuously, climbing to this total ever since Federation, with the increase in population, in money income per head, and in the range of government activities. Some salient statistics, revealing among other things the lasting impact two major wars have had on the level and pattern of taxes and on the Australian Government's share of them, are given in Table 2.A.

TABLE 2.A: TAX REVENUE: SELECTED YEARS SINCE 1901–02 ($ million)

                           
1901–02   1909–10   1919–20   1928–29   1938–39   1949–50   1959–60   1966–67   1973–74  
Income tax— 
Australian Government  21  20  24  559  1,339  2,724  7,523 
State and local governments  12  32  60 
Total  33  52  84  559  1,339  2,724  7,523 
Other domestic taxes— 
Australian Government  22  34  66  300  1,011  1,493  2,810 
State and local governments  12  25  64  72  146  523  967  2,830 
Total  12  16  47  98  138  446  1,534  2,460  5,640 
Tariff revenue  15  19  23  59  62  155  168  275  605 
Total taxes  28  38  103  209  284  1,160  3,041  5,459  13,768 
Tax per adult ($)  13  15  33  54  62  216  479  758  1,655 
(a) 
note note  

2.3. These figures can be better understood, and be more readily acceptable to those who pay taxes, if they are related to the growth of the economy as a whole, as reflected in estimates of gross national product, and to a broad classification of the


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multifarious uses made of tax revenue. Statistics for the more distant past are not, however, readily available. In rough terms, the total taxes as a proportion of gross national product have risen from 6 per cent in the initial years of Federation, to 9 per cent in the early 1920s, 16 per cent by the end of the 1930s, and 24 per cent at the height of World War II. More trustworthy estimates are available for less distant years and these, with some figures for the main uses of taxation, have been assembled in Table 2.B. They show that while taxes remained a fairly stable proportion of gross national product during the 1950s—at around 22–23 per cent, the proportion was only a little lower than the wartime peak—they have recently been gaining ground and now correspond to over 27.5 per cent of gross national product. Government spending presents a similar picture.

TABLE 2.B: TAXATION AND ITS USES: ALL LEVELS OF GOVERNMENT SELECTED YEARS SINCE 1949–50

                           
1949–50   1954–55   1959–60   1964–65   1969–70   1973–74  
$ million 
Total taxation  1,160  2,184  3,041  4,622  7,722  13,768 
Uses— 
Current goods and services  426  941  1,323  2,066  3,677  6,869 
Transfer payments(a)  520  811  1,230  1,872  2,900  4,978 
Contribution to government investment(b)  214  432  488  684  1,145  1,921 
Percentage 
Percentage of gross national product(c)— 
Taxation  22.8  22.8  22.2  23.6  25.9  27.7 
Government expenditure on goods and services (current and capital)  16.6  18.9  18.5  20.0  21.6  21.5 
Total government expenditure (including transfer payments)  26.8  27.4  27.5  29.6  31.4  31.5 
Contribution of taxation to government investment as per cent of government investment (d)  51.0  49.6  40.2  36.9  41.6  50.0 
note note  

2.4. One of the key issues examined in this report concerns the tax mix. Recent trends for the principal taxes levied by the Australian Government are summarised in Table 2.C. Undoubtedly the most striking feature of this table is the mounting importance of personal income tax. In 1973–74 just over half of the Australian Government's tax revenue derived from personal income tax and the figure is expected to be close to 55 per cent in 1974–75, whereas scarcely a dozen years ago personal income tax accounted for little more than a third of revenue.




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TABLE 2.C: AUSTRALIAN GOVERNMENT TAXES: SELECTED YEARS SINCE 1949–50

                                                     
(a) 
1949–50   1954–55   1959–60   1964–65   1969–70   1973–74   1974–75  
$ million 
Income tax— 
Persons  392  720  884  1,569  2,855  5,490  7,966 
Companies  167  343  455  722  1,187  2,033  2,566 
559  1,063  1,339  2,291  4,042  7,523  10,532 
Estate and gift duty  14  22  32  49  80  76  77 
Customs duties  155  202  168  268  414  605  770 
Excise duties  132  286  504  631  939  1,555  1,765 
Sales tax  85  201  328  363  569  969  1,105 
Payroll tax(b)  45  83  110  150  230  12 
Other(c)  24  17  37  67  106  202  258 
Total  1,014  1,874  2,518  3,819  6,380  10,938  14,519 
Percentage of total taxes 
Income tax— 
Persons  38.7  38.4  35.1  41.1  44.7  50.2  54.9 
Companies  16.5  18.3  18.1  18.9  18.6  18.6  17.7 
55.1  56.7  53.2  60.0  63.4  68.8  72.5 
Estate and gift duty  1.4  1.2  1.3  1.3  1.3  0.7  0.5 
Customs duties  15.3  10.8  6.7  7.0  6.5  5.5  5.3 
Excise duties  13.0  15.3  20.0  16.5  14.7  14.2  12.2 
Sales tax  8.4  10.7  13.0  9.5  8.9  8.9  7.6 
Payroll tax(b)  4.4  4.4  4.4  3.9  3.6  0.1  0.1 
Other(c)  2.4  0.9  1.5  1.8  1.7  1.8  1.8 
Total  100.0  100.0  100.0  100.0  100.0  100.0  100.0 
note note  

2.5. The complexity of the Australian tax system is one of the matters to which the Committee is expected to address itself. The simple facts of the numbers of taxpayers involved with income tax are given in Table 2.D: particularly significant is the very rapid growth in the proportion of adult females subject to income tax and in the numbers of partnerships and private companies. Some other facts are worth noting too. More than 80 amending Acts have altered or been added to the principal Income Tax Assessment Act since it first came into operation in 1936; as a result the 1936–1973 Act now extends to 526 pages, six times its original length. Practitioners' textbooks explaining the operation of the Act are today printed in four or more volumes instead of one. In 1973–74 a total of 54,401 objections were lodged against income tax assessments, 350 cases transmitted to Boards of Review, and 31 taxation appeals (mostly income tax cases) decided by the High Court or State Supreme Courts. The several Acts covering Federal estate and gift duty occupy nearly 60 pages, while the sales tax legislation is covered in 220 pages. Significant changes have been made in sales tax exemptions since 1936, with the result that the publication containing relevant sales tax rulings now runs to over 700 pages. The handbook,


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Commonwealth Sales Tax, has been expanded in length to give rulings and explanations of the application of the sales tax laws to new manufacturing processes. While all this may be necessary, it deserves continuous review.

TABLE 2.D: NUMBERS OF TAXPAYERS, RESIDENT AND NON-RESIDENT, ASSESSED FOR INCOME TAX: SELECTED INCOME YEARS SINCE 1954–55

                               
1954–55   1964–65   1971–72  
Individuals— 
Male (million)  2.7  3.2  3.6 
per cent of adult males (a)  90  93  91 
Female (million)  1.0  1.5  2.1 
per cent of adult females (a)  34  43  51 
Total (million)  3.7  4.6  5.7 
per cent of adults (a)  63  67  71 
’000  ’000  ’000 
Partnerships  155  301  413 
Trusts  65  108  113 
Companies: (b)— 
Private (c)  23  55  87 
Public  11  10 
Total (d)  31  71  105 
note note  

II. International Perspective

2.6. In almost any field of human endeavour international comparisons are difficult to make and liable to be misleading. The area of taxation is no exception. Fortunately, however, international organisations nowadays have large and expert staffs making such comparisons and over the last few years the Organisation for Economic Co-operation and Development (OECD) has been assembling an impressive range of tax statistics covering all twenty-four member countries. The statistics for Australia, which joined OECD in 1971, have been recast in a form comparable with that of most of the countries with which it is interesting to make comparison. The latest document, Revenue Statistics of OECD Member Countries 1965–71, provides a rich hoard of information some of which is summarised in Table 2.E for the earliest and latest years available. The figures are necessarily a little out of date.

2.7. It will be seen that Australia is lightly taxed by international standards, 26.6 per cent of gross national product being taken in tax in 1971 compared with the OECD average of 31.8 per cent. The picture changes somewhat if social security contributions are excluded from the comparison, as Australia is the only country represented in Table 2.E without a separate social security contribution. But, being compulsory levies and a substitute for higher taxation, such contributions should probably not be excluded, unless that fraction of Australian taxation spent on social security is also excluded. However, social security finance is a complex issue on which more will be said in Chapter 13.

2.8. Whether the comparison is made with or without social security contributions, one thing is apparent: the tendency for taxes to rise as a fraction of gross national product, noted already in relation to Australia, is a world-wide phenomenon. In all the countries shown in the table that might be described as modern welfare states,


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taxes (including social security contributions) now account for a third or more of gross national product.

2.9. Table 2.E illustrates the considerable diversity of tax patterns. It is particularly noticeable that, by international reckoning, Australian income tax (especially on companies) is a heavy impost. So too are the miscellaneous levies grouped under ‘other taxes’, a fact to be explained not by any peculiarity of the Australian Government's own tax system but by the very large measure of reliance by State and local governments on stamp duties, property taxes and (in more recent years) payroll tax. By contrast, taxes on goods and services feature less prominently than they do in many countries and, as mentioned already, social security contributions fail to feature at all. In one major respect—the shift towards personal income tax—Australian experience since 1965 parallels the trend of events overseas. On the other hand, the share of company tax has not been diminishing in this country in the way that it has been elsewhere.

TABLE 2.E: INTERNATIONAL TAX COMPARISONS: OECD COUNTRIES, 1965 AND 1971

                                           
Percentage of total taxes  
Taxes on goods and services   Income tax: persons   Income tax: companies   Social security contributions   Other taxes (a)  Total taxes as percentage of gross national product  
1965— 
Australia  34.3  33.9  15.6  16.2  23.9 
Average of 22 OECD countries(b)  36.7  24.7  8.5  20.4  9.7  27.7 
1971— 
Selected OECD 
courntries— 
Australia  31.6  36.9  16.6  14.9  26.6 
Canada  33.0  33.9  10.2  8.2  14.7  32.3 
France  35.5  10.1  5.8  41.9  6.7  35.6 
Germany  29.7  26.9  4.5  33.8  5.1  34.5 
Italy  36.9  11.7  6.9  37.9  6.6  30.9 
Japan  22.3  24.0  18.8  20.0  14.9  20.1 
Netherlands  26.7  27.2  7.0  35.6  3.5  42.2 
Sweden  31.7  43.1  3.6  18.0  3.6  41.8 
United Kingdom  28.9  33.2  7.8  14.1  16.0  35.7 
United States  20.2  33.7  10.4  20.7  15.0  27.8 
Average of 22 OECD 
countries(b)  33.9  26.9  7.3  22.7  9.1  31.8 
Australia's ranking  15th  4th  2nd  22nd  5th  16th 
note note  

2.10. Even these very summary figures show the Australian tax system to be somewhat untypical. It is revealed as still more so when one looks behind these broad categories to the exact kinds of taxes they contain. What Table 2.E does not reveal, for example, is that in many countries a broad-based value-added tax is the major domestic levy on goods and services, whereas Australia mainly relies on excise duties and wholesale sales tax which weigh heavily upon only a restricted range of goods and services. Again, unlike Australia, at least nine OECD countries impose an annual wealth tax, and the United Kingdom and Ireland are proposing to do so; on the other


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hand Australia has never levied a wealth tax. Also Australia is somewhat unusual in employing the ‘separate’ or ‘classical’ system of taxing companies and, until now, in not imposing capital gains tax.

2.11. Another feature of overseas experience, naturally not reflected in simple statistical tables, deserves special mention. Tax systems in many overseas countries have been drastically changing in recent years and are still under active debate. In the United States, for example, earned income has been given relief in the form of a reduction in top marginal rates of tax. In Canada, capital gains tax has been introduced, significant changes in company tax have been made and personal income tax rates are now being indexed for inflation. In the United Kingdom, much too has recently happened or is being contemplated in the fields of capital gains and development gains taxes, company tax, taxation of goods and services, taxation of capital transfers, and wealth tax. Among recent developments elsewhere are Sweden's partial abandonment of the family as the taxpaying unit under income tax, a change in the form of company tax in West Germany, New Zealand's property speculation tax, and proposed new capital taxes for Ireland. Thus the tax reformer in Australia does not need to feel deprived of possibilities to explore.




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3. Chapter 3 Criteria for Tax Systems

3.1. The Committee's task raises a number of issues of broad principle which are reviewed in this and the next two chapters. The present chapter begins with an interpretation and amplification of the terms of reference. These are not only broad in scope, but so general in language that some interpretation is necessary to clarify discussion.

I. Terms of Reference and their Interpretation

3.2. Throughout and repeatedly in the terms of reference the phrase ‘taxation system’ is used. This way of regarding a collection of administratively distinct taxes is of fundamental importance. In a complex modern economy where government expenditure is at a high level it is impossible to raise all the revenue needed from any single tax. Each tax will have its own distinct merits and defects when judged by the various criteria commonly applied to taxation. When several taxes are used they have to be seen as supplementing each other and their interactions—and sometimes their conflicts—have to be reckoned with. Whatever their individual characteristics it is their combined impact that must primarily concern the policy-maker. The complete set has therefore to be looked at as an integrated whole, even though before this can be done it is necessary to examine the parts that have to be linked together.

3.3. The Committee is directed to carry out its review of the existing taxation system ‘in the light of the need to ensure a flow of revenue sufficient to meet the revenue requirements of the Commonwealth’. It was with this phrase in mind that the Committee, while drawing attention in paragraph 1.8 to the fiscal importance of the division between taxation and borrowing in the finance of government investment, refrained from offering views of its own on the merits of existing policies about this matter. It would certainly have lightened the load of the Committee's work if this proviso could have been taken to debar any discussion whatever of public expenditure. However, for at least two reasons this is impracticable.

3.4. Firstly, where tax stops and expenditure starts is often unclear. A tax concession to a particular area of spending in the private sector can as well be looked upon as an expenditure of revenue as a failure to collect it, and it is often an issue of importance to tax policy whether such concealed subsidies should not better be given overtly. Still more important is the point that cash transfers to individuals, the whole class of social service payments of every kind, are inextricably bound up with the equity of the taxation system. The Committee certainly does not regard itself as qualified to advise upon the details of the social services, and is aware of other inquiries at work in this area. But some consideration of cash grants, taxable or otherwise, is essential in the design of an optimal tax system. They constitute a fiscal technique to which some attention will be given later, especially in chapters 12 and 13.

3.5. These problems aside, however, once revenue requirements are set there is no scope at all for reducing total taxation: the two are simply the same thing. By this phrase in its terms of reference the Committee is prohibited from suggesting any general set of measures that would necessarily reduce total taxation below revenue needs. The Committee is uninformed, and could not have been informed, of exact future requirements. Any proposal that, explicitly or implicitly, entails a reduction of


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present taxation in any particular area has to be matched with proposals that, explicitly or implicitly, approve increases in others. Though the great bulk of the submissions received by the Committee very naturally contain suggestions for lowering present taxation in particular areas, it has been the Committee's task in assessing the arguments offered to ask where the taxation forgone could be recouped more fairly, more simply and more efficiently. Only in Chapter 6, in the context of inflation control, has the Committee sought to refer to tax cuts in a somewhat wider setting.

3.6. The first of the more positive commands in the terms of reference bids the Committee to consider the effects of the taxation system ‘upon the social, economic and business organisation of the community’. This is a phrase with multiple connotations. It is probably helpful to separate these out and attach them to other rather more specific injunctions which follow. Thus, the Committee is to consider the effects of the system upon the ‘economic and efficient use of the resources of Australia’, the desirability that there should be a ‘fair distribution of the burden of taxation’, and that revenue-raising be ‘by means that are not unduly complex and do not involve the public or the administration in undue difficulty, inconvenience or expense’. For brevity, these aims may be referred to as efficiency, fairness and simplicity. However, each of the three when one seeks to define it closely proves to embrace several distinct qualities, and these qualities may conflict with each other in particular applications. Furthermore, each of the ‘big three’ criteria will often, in some respects, conflict with the others. In deciding the best overall tax system and in deciding between alternative provisions in particular taxes, the policy-maker comes repeatedly up against choices between simplicity and efficiency, or fairness and simplicity or fairness and efficiency. These are perhaps the hardest choices he has to make, or invite others to make. Hence it is convenient to give here fuller discussion of the meanings of these simple-seeming terms.

Fairness

3.7. As a quality of a tax or a tax system everyone demands fairness, or equity (the terms will be used interchangeably). But, in tax matters as in law and ethics, it is an ideal exceedingly difficult to define and harder still to measure. It is customary to distinguish the two dimensions of ‘horizontal’ and ‘vertical’ equity: the notions that it is fair that persons in the same situation should be equally treated, and those in different situations differently treated, with those more favourably placed being required to pay more. Both expressions will have to be frequently employed in this report. They reflect the ‘ability to pay’ principle and as such tend to embody the idea that taxation is no more nor less than a sacrifice. As the Committee will record later, this is an idea that needs qualification if it is not to mislead. An alternative principle used in much recent academic discussion is that of ‘benefit’, which relates taxes to the benefits individuals are estimated to receive from government-provided goods and services. Except in a small number of cases where taxes take the form of fees or prices for the direct use of publicly-provided services by particular individuals (e.g. postal facilities), this principle is prohibitively hard to apply. In any case it abstracts altogether from notions of fairness, or implicitly embodies an interpretation of ability to pay that may not be socially acceptable. Hence the Committee argues in this report in terms of ability to pay, though the benefit principle has its place in the discussion of the Australian-origin income of non-residents (Chapter 17) and the taxation of goods and services (Chapter 27).

3.8. When we say that persons in equal situations should pay the same tax we probably say so because we think of the tax as a sacrifice levied upon some kind of private


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‘economic well-being’. But the ‘economic well-being’ is a sequence of barely describable psychological states of a thoroughly immeasurable kind. For purposes of practical discussion and decision-making, both the ‘sacrifice’ by way of tax and the ‘well-being’ upon which the tax is levied have to be measured in money terms. Many of the most difficult questions in tax policy stem from the arbitrariness and convention that must be accepted when making this leap from the immeasurable to the measurable, from levels of ‘well-being’ to the choice and exact definition of the tax base.

3.9. It is usually taken for granted that the best available measure of an individual's ‘well-being’ is his income. The ‘burden of taxation’ is thought of primarily in terms of the proportion of a man's income that goes in paying taxes, whether they be taxes levied formally on that income or indirectly by elements of tax in the price of the goods and services he buys. Horizontal equity is then taken to require that two persons with the same income pay the same taxes (at least in the first place and ‘other things being equal’), while vertical equity would require that, of two individuals with different incomes, the one with the larger should pay more by some correct amount.

3.10. Even when income is so regarded, there remain very great difficulties in finding an exact and workable definition of it for tax purposes, as the length of the Income Tax Assessment Act and its frequent amendment testify. The most important of these difficulties are surveyed in later chapters. There is evidently some discrepancy between the legal approach to this problem, which seeks to extend and refine the everyday meaning of ‘income’, and the more abstract approach adopted by many economists which generates a very much wider meaning.

3.11. A further problem arises over the question of the appropriate unit for tax purposes. Many would argue, for example, that in a family the ‘economic well-being’ of individual members is likely to be measured better either by the average or by the total income of the family members than by their separate incomes. Whether or not this is so is an extremely vexed question and is discussed in Chapter 10.

3.12. Irrespective of whether individual or family income is accepted as the appropriate starting-point, it is recognised that this cannot be the end of the matter. Further argument is required before it can be concluded that two individuals should pay identical taxes simply 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 (for example, sex, race, religion, and many other personal characteristics), but others (such as health and size of family) are widely felt to be very relevant indeed. But to decide which differences are which, and how much allowance for such things should be given in calculating tax liabilities must involve much nice judgment and many decisions of an arbitrary kind. The main problems are examined in Chapter 12.

3.13. Yet other problems arise because taxes are, in most cases, calculated and levied on the basis of annual magnitudes. This is of course necessary for the administration of the public sector, but the period of a year is arbitrary from the viewpoint of fairness. Those with incomes that vary from year to year will over several years pay more tax under a progressive system than others earning the same total income in an even stream. This aspect of a very fundamental issue is widely recognised, and opportunities for ‘averaging’ are already provided for some groups for whom fluctuations are especially marked and unavoidable. But the deeper issues that arise here are not often thought about in explicit terms. In the Committee's view most people would agree on reflection that fairness mainly requires that taxation be the same for


  ― 14 ―
individuals whose total ‘well-beings’ are likely to be the same over their whole lifetimes and that too much importance should not be attached to temporal differences in the way ‘well-being’ is distributed, by choice or necessity, over adult years. Indeed, more than a single lifetime is relevant when the fairness of taxation upon an individual's capacity to do his duty to his heirs is considered. This lifetime perspective is not, of course, a practicable basis for taxation, but it has its implications for the structure of an inevitably annual system.

3.14. The custom of using income as the tax base is not inconsistent with this lifetime view of things. Over any short period, say a year, an individual's consumption undoubtedly reflects his ‘economic well-being’ better than does income. A man can, by consuming out of past savings or by borrowing against future income, achieve levels of ‘economic well-being’ much greater than his current income. For many, over a lifetime, total income and total consumption will be the same. In this sense, lifetime income will be a fairly good measure of an individual's ‘well-being’, whichever base is felt to be the fairer.

3.15. But a tax on income is not at all the same as a tax on consumption, even in lifetime terms. When a tax is levied on income, it falls on savings as well as consumption; and when income is earned from those savings in later years, that income too is taxed. This means that the effective tax rate imposed on consumption which is postponed is greater than the rate imposed on current consumption: income tax falls more heavily than consumption taxes on those who prefer to save a high proportion of their incomes and do more of their consumption later in their lives. But individuals may save for reasons other than to supplement consumption in later years: because they wish to bequeath to their heirs, or because the process of accumulating wealth yields ‘satisfactions’ which contribute to ‘well-being’ directly (and independently of any income wealth may bring in). Such motives for saving will be more significant at the upper end of the income scale; but certainly at the bottom end people will primarily save in order that they may consume more in future years (specifically in their old age). For the latter persons, taxation based on consumption is probably fairer than income taxation because it does not discriminate between individuals according to how they spread their consumption over their lifetimes. Higher up, horizontal equity may well be held to require not only taxation of income but taxation of capital as well, and this quite apart from any desire to make the system fairer in a vertical sense.

3.16. Questions of equity are complicated by inflation, as is so much else. The discussion of equity starts from the idea that taxation is a sacrifice of ‘real’ private satisfactions (however much this may be offset by the satisfactions that public expenditure may simultaneously create). But taxes have to be levied in money terms. In the case of incomes from current effort, the distinction may not much matter since incomes and prices may go up simultaneously and tax rates can be adjusted to maintain the same underlying rate structure. However, a serious difficulty arises with property incomes. The real value and the real return on assets with variable money returns may indeed be maintained by rises in their money capital value and their money returns. But the real return on fixed-interest assets declines and their real capital values fall; until redemption is near, their money capital values also fall. With an income tax this latter fall is inadequately reflected in the tax liability. There is a consequent inequity of a horizontal kind; and since fixed-interest securities are often the main financial assets of lower income groups, there may be vertical inequities too. These inequities do not arise so conspicuously—if at all—under consumption taxation.




  ― 15 ―

3.17. There are good reasons, therefore, why consumption might be preferred to income as the primary index of ability to pay. Some economists, notably Lord Kaldor, have found the reasons sufficiently compelling to justify abandoning personal income tax altogether and substituting a progressive expenditure tax. The Committee is not prepared to go this far, recognising as it does that an expenditure tax would probably be even more difficult to administer than personal income tax. But the philosophy underlying an expenditure tax has much to recommend it, and the Committee has allowed itself to be influenced by this philosophy in certain of its proposals, including those bearing on the tax treatment of income-protection insurance premiums (Chapter 7), investment income (Chapter 9), and superannuation and life insurance (Chapter 21).

3.18 The issues just mentioned relate primarily to horizontal equity. Problems of an equally intractable kind arise with vertical equity. Indeed, establishing the ‘right’ degree of progressivity by reference to the criterion of equity is so fundamental to tax policy, as regards both the set of taxes to be chosen and their rates, that it will need to be explored at length in the next chapter.

Simplicity

3.19 After equity, simplicity is perhaps the next most universally sought after of qualities in individual taxes and tax systems as a whole: like fairness it is a word that, in this context, points to a complex of ideas.

3.20 Two of these are explicitly stated in the Committee's terms of reference. A tax will be called simple, relatively to others, if for each dollar raised by it the cost of official administration is small, and if the ‘compliance costs’, the costs in money and effort of all kinds to the taxpayer, are also small. These two ideas are of course connected, and add up to much the same as the ancient canon of certainty. Both costs will be the less if assessor and assessed can each establish with certainty what is due: uncertainty entails the costs of consultation with experts and sometimes the yet greater costs of litigation. Both kinds of cost are increased, and certainty is endangered, when a tax, whether in the interests of equity or of efficiency, requires the drawing of fine distinctions between what is and what is not liable, and when these distinctions involve such uncertain ideas as ‘purpose’ or ‘value to the recipient’. Then the legal definitions get longer and longer and beyond the comprehension of those untrained in the law, and the relevant facts in particular cases become more and more disputable.

3.21. Two further aspects of simplicity require specific mention here. First, when (as is often unavoidable) a quite complex operation is needed before the administrators can make the assessment or the taxpayer can ascertain his liability, it is desirable that the tax be such that the taxpayer, for private purposes unconnected with tax, already needs to perform such operations. A tax on company income may be fairly regarded as a simple tax if the company already calculates its income or profits on the same or very similar basis. A tax on personal income is not a simple tax if it be so structured that many taxpayers who would not otherwise wish (or without hired help be able) to keep accounts at all, have to preserve many records and learn sophisticated accounting. The point, though obvious, is often forgotten.

3.22. A second observation is perhaps even more obvious and even more frequently forgotten. The fewer, per million dollars raised, are the individuals or organisations from whom tax is collected the simpler is a taxation system. The sheikdom that can raise all the revenue it requires (and maybe much more) from a single tax on a single oil company has what is unquestionably the simplest tax system of all.




  ― 16 ―

Efficiency

3.23. The ‘economic and efficient’ use of national resources is of course a longstanding and by now almost conventional objective of public policy: the phrase was long central to the terms of reference of the Tariff Board and is now in those of the Industries Assistance Commission.

3.24. Narrowly interpreted, efficiency requires that the resources available for public use be as nearly as possible equal to the resources withdrawn from the private sector: that is, that the process by which resources are transferred involve minimal ‘waste’. One example of such waste has already been mentioned in the context of simplicity objectives: the cost of administering and complying with the tax law is a ‘deadweight’ cost to the community and ought to be minimised. Waste can however also arise where the tax system is such as to encourage individuals to substitute things they value less for things they value more, or business to continue to use or to substitute productive processes that are technically less efficient for productive processes that are more efficient. In so far as it can be presumed that, left to their own devices, individuals will spend their incomes wisely, and business will choose the most efficient means of production, the minimisation of waste requires that the tax system should not influence individual and business choices. This is the requirement that the tax system should be neutral. Thus the tax system should not interfere with the manner in which an individual spends his income by changing the relative prices of the goods he buys; it should not alter the relative rewards of the different types of work between which he has to choose, or the relative attractions of work and leisure, or the relative returns from different modes of investment; it should not alter the relative attractiveness of different types of business organisation, or the relative prices of productive resources; and it should not discriminate between different types of production.

3.25. But it cannot always be presumed that consumers will spend their incomes wisely; and even when they do, consumers and producers alike may fail to take adequate account of the effects that their activities have on others, of what economists have come to call ‘externalities’. The efficiency of the use of available resources can sometimes be improved by departures from neutrality, by government interventions to alter what would otherwise have been the outcome of private market operations. There are many such interventions by government through, for instance, tariffs, subsidies, monetary control and marketing organisations. But the tax system is an alternative instrument. Tax concessions may aim at increasing the output or consumption of goods and services the government wants to encourage. Similarly, taxes can be used to discourage the output, or increase the prices to consumers, of commodities whose unrestricted production or consumption might otherwise have harmful effects, for example on health or urban development. Taxes can also be employed to charge the users of facilities, such as roads, on the use of which it is otherwise difficult to impose a price. Discriminatory taxes of these kinds will here be called ‘efficiency taxes’.

3.26. The Committee is persuaded that neutrality should be the general aim when efficiency is under consideration. Departures should be made only in a deliberate and explicit way for proven, explicit and quantified purposes and after it had been shown that other approaches (such as regulation and subsidy) are likely to be less effective for the end chosen. In the Committee's view, when there are circumstances warranting encouragement for a field of activity by means of a reduction in tax, any such


  ― 17 ―
reductions should be granted only for a specified purpose and a limited period, thereby ensuring periodical review.

Other Objectives

3.27. Equity, simplicity and efficiency seem to the Committee the three dominant tests of merit for individual taxes and for the tax system as a whole. There are others, however. In particular, flexibility in the taxation system is a characteristic of obvious importance to economic management. Economic management or ‘stabilisation’ requires, firstly, that there be at least some taxes in the total package the rates of which can be easily raised or lowered in the light of short-run fluctuations in the level of economic activity. Secondly, it requires that these taxes be such as to operate very quickly in altering revenue yields and influencing individuals’ and firms' behaviour. Thirdly, in so far as smaller rate changes are politically more acceptable than larger ones (particularly when rate increases are called for), the taxes available should have as large an impact as possible on the level of economic activity per dollar of revenue change.

3.28. Economic growth is another objective that, in the view of some, should be deliberately and distinctly pursued in taxation policy. As a general purpose of public economic policy it has, of course, been long accepted as important, though its interpretation can be the subject of much controversy. In the context of taxation its encouragement is often taken as implying that the overall level of taxation should be kept lower than it would be otherwise—a prescription upon which its terms of reference make the Committee unable to comment. It is also however taken to indicate that, in the interests of greater investment, savings should certainly not be discouraged under the tax system and perhaps even be taxed less than considerations of equity and neutrality alone would suggest. This is an argument that will need mention in the next chapter in connection with the general question of progressivity.

II. Appraisal of Particular Taxes

3.29. It is convenient next to appraise the main kinds of tax that already exist in or might be introduced into Australia, by reference to these dominant criteria. They are all taxes that will have to be surveyed in more detail later, but a short summary here will help towards a preliminary discussion in the next section of alternative kinds of tax system.

3.30. Personal income tax. If income can be accepted as the primary feature in comparisons between the ability to pay of individuals, it follows that, if the problems of definition and information-collection can be solved, a personal income tax is an admirable vehicle for fairness. An almost limitless range of provisions for horizontal equity can be introduced into it. Any degree of progressivity can be enacted. It is indeed the only tax currently in the tax system that is capable of raising large revenues and into the structure of which a refined set of progressive provisions can be incorporated. To the extent, however, that consumption represents a superior measure of ‘economic well-being’, at least for some income groups, it might still be less fair than a progressive consumption tax, were such a thing practicable. But on the whole personal income tax scores highly in terms of equity.

3.31. By contrast, and again comparing it only with potentially large taxes, it must rank lowest for simplicity. Complexity is introduced when many allowances are believed to be called for by horizontal equity; and more when, with a highly progressive scale, measures have to be taken to prevent or control the transfer of incomes from


  ― 18 ―
persons in high tax ranges to those lower down. As a main revenue-raiser it must fall on almost every person with income, many of whom have little taste for or skill at form-filling and many of whom, but for income tax, would have no need to keep financial records. The definition of what taxable income is to include is a matter of the greatest difficulty. It is a tax on which the administrators must perpetually compromise between the expense and intrusiveness of a rigorous administration and the losses of revenue suffered when administration is comfortably trustful. It is one too that presents the largest number of citizens with annual temptations to evade and avoid and to suspect misbehaviour in others.

3.32. As regards resource efficiency, personal income can certainly be made the vehicle for deliberate non-neutralities. Considered as a neutral tax, faults can be found with it. Since it must, in large measure, be a tax on the proceeds of work, it is not neutral between work and not working though it shares this defect with almost every tax. Nor, as noted already, is any general tax on income neutral between current consumption and savings. This makes the income tax rather discouraging to growth.

3.33. Company income tax. This is a most difficult tax to appraise, especially with respect to equity, not least because in this area the international aspects of tax are of the highest importance. Equity is essentially a matter of comparative justice between individuals. Any tax on corporations may (or may not) be fair to its owners, its employees or the purchasers of its products; but it cannot be said either to be fair or unfair to the corporation as such. When the tax is held to fall upon the income rights of the proprietors, its fairness will turn upon whether the sum paid is equal to what would be paid were the income in question simply added to the other income of these individual proprietors. Neither in Australia nor elsewhere is this in fact often the case.

3.34. For simplicity it will rate higher than personal income tax. The problem of ascertaining the income of a company is, in principle, no different than in the case of personal income, but the necessary accounting procedures are likely to be, if anything, more readily available, more fully required already for the company's own purposes. Furthermore, though the vast majority of companies are not large, in Australia as elsewhere a comparatively small number among them produce the bulk of the substantial revenue this tax yields.

3.35. The efficiency of company income tax is also hard to judge. It is adaptable to deliberate non-neutralities—almost too conveniently so. But even when neutrality is sought there are ways in which it will probably fail: there is likely to be some discrimination between companies and other types of legal organisation.

3.36. Capital gains taxes. The pros and cons of capital gains taxes are discussed at some length in Chapter 23. The fundamental case for such a tax rests upon equity. It is almost universally agreed that capital gains (when ‘real’ and not simply the result of inflation) are so closely akin to income in its everyday sense that equity requires that they be taxed if income is. By the test of fairness, therefore, a capital gains tax has merit, in principle, as a supplement to personal income tax. On the other hand it must be a tax of great complexity, and efforts to bring it within the bounds of administrative practicability must lead to some evaporation of its equitable advantages. It is a tax not without attractions in terms of resource efficiency. When capital gains are untaxed but income gains are, investments in the kinds of asset on which the returns come (or can be arranged to come) in the form of capital appreciation will be made relatively the more profitable. A misallocation of resources is therefore likely which the tax serves to correct.




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3.37. Estate and gift duties. These taxes may be taken together, since (as will be argued in Chapter 24) they lead into a tangle of inequities and avoidances without even the merit of producing large revenues unless they be integrated and tightly administered. As a supplement to income tax—or even to a consumption tax—an estate duty ranks high for equity. It taxes those assets the income from which could only with difficulty be ‘imputed’ for income tax purposes. It can also bear specifically upon inherited wealth if equity is believed to require a special levy upon it.

3.38. Estates and gift duties, and such variants as inheritance and accession duties, must however be very complex taxes. They cause less continuous trouble to those concerned than annual taxes—and this gains one good mark for simplicity—but their provisions need to be elaborate. However, if it be possible to confine them to large fortunes, they will be simple in the sense of not affecting the majority of the population. They need not be inimical to resources efficiency. They inevitably contain a nonneutrality in terms of their discouragement of accumulation for the benefit of heirs, in the same way as a progressive income tax may contain a more general discouragement to savings. But in both cases the conflict is between distinct ultimate ends and has to be resolved by judgment.

3.39. Wealth taxes. Wealth taxes are discussed in Chapter 26. Here they can be briefly disposed of. They have some of the advantages of estate and gift duties in terms of equity and all their disadvantages in terms of simplicity—and more, since they will be so much more frequently levied.

3.40. Taxes on goods and services. A distinction must be made here between ‘narrow-based’ taxes falling upon only a few consumption goods and services (even though they be ones that absorb quite a significant proportion of total expenditure) and ‘broad-based’ taxes levied on very large ranges of goods and services even if not quite all consumption. The Australian sales and excise taxes are an obvious example of the former category; the British and Continental value-added taxes belong to the latter. They are described in Chapter 27.

3.41. Narrow-based taxes rank badly for equity. They discriminate between persons with the same incomes but different tastes. It may perhaps be desirable to levy a heavier burden on the smoker and the drinker than on other people but if so it will be on the grounds of efficiency rather than equity and even then it has to be remembered that the real sacrifice may well be borne by the families of those on whom it is intended to lay the impost. Nor can such taxes be made in any way effectively progressive in terms either of consumption or income. They are however taxes of extreme simplicity. Exceptionally few enterprises have the legal responsibility for payment; they will have the machinery for calculating their liability as part of their normal activities; generally their assessment can quickly be settled with the official administration. In terms of resource efficiency it is obvious that these are non-neutral taxes. They rank well for efficiency only when they are deliberately tailored to fit some desired non-neutrality, and they can be made fees for particular government services rather than taxes required for general revenue.

3.42. Various forms of broad-based taxes are discussed in Chapter 27. The choice between them chiefly turns on points of technical detail. What is more relevant here are the qualities such taxes have when at high uniform level and when very widely based.

3.43. A broad-based tax serves horizontal equity by not discriminating between savings and consumption; but by itself it cannot be adapted to the varying situations of


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individuals. Nor is it, by itself, suitable for vertical equity. It is essentially a proportionate consumption tax, and actually regressive as a tax on income since the proportion of consumption to income normally falls as income increases. It stands high by the test of simplicity, certainly far higher than personal income tax when both are compared as major revenue-raisers. Whatever its form it would be levied on far fewer persons or enterprises. A much higher proportion of them would have little difficulty with the paper work, much of which would be only a small addition to ordinary commercial recording. This latter advantage would be greatly diminished if the rate were not uniform. Such taxes certainly have problems of definition at their edges, even though uniformity within the boundary avoids them there, and the higher the rate the more acute they will be. However, it seems unlikely that these would ever reach the scale of those encountered in income tax. A broad-based tax at a uniform rate is inherently neutral within its ambit. Were all savings made solely for the purpose of savers’ own future consumption, it would also be neutral between consumption and savings; but to the extent that other motives enter into savings, this would not be so.

3.44. Grants. As noted earlier in this chapter cash grants by the State need to be brought into the overall assessment of taxation systems. As will become clearer in Chapter 12 they provide an alternative to concessional deductions in the personal income tax as a technique for achieving horizontal equity. Most social service grants to the needy may also be quite naturally viewed as instruments of vertical equity at the lower end of the income scale. Whether taxed or not they will, when at a flat rate, somewhat increase the net progressivity of the tax system. Since they will constitute an ever smaller proportion of the incomes of their recipients as one moves up the income scale, they serve to make the distribution of income less unequal. They are also, when free of means test, simple since their eligibility is determined by such tests as age, parenthood, sickness, unemployment. In general too they are neutral. Unless the benefits are very large it is unlikely that child endowment could be much of an incentive to parenthood or that well-administered sickness or unemployment benefits increase the incidence of illness or unemployment to any significant extent.

III. Alternative Tax Systems

3.45. This brief survey is a reminder that when any body of advisers is invited to formulate proposals for improving the taxation system, ‘either by way of making changes in the present system, abolishing any existing form of taxation or introducing new forms of taxation’, a singularly wide range of options is laid open for review. To raise a given revenue any of a great many permutations and combinations of distinct taxes can be used, and when one combination has been selected their relative weights can be varied and the choice of detailed provisions in each is enormous. There are legions of taxation systems to choose from when the problem is considered in a longterm context.

3.46. The short assessments just given of the principal taxes among which the choice lies assist in the classification of the options. It becomes evident that different systems or ‘tax packages’ will serve the different aims of equity, simplicity and efficiency to differing extents. Because there are unavoidable conflicts between these aims, it is essential to assess their extent, and to arrive at the preferred system after a conscious effort to weigh, or give relative values to, these ultimate aims.

3.47. In general it does not appear that, in practice, the conflict between simplicity and efficiency need be very great. Certainly when the latter can be interpreted as


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mainly requiring neutrality, reliance upon a very simple tax, a broad-based tax at uniform rates on all goods and services used in consumption, would produce a taxation system that was simple and efficient. Though efficiency may undoubtedly require additional special taxes for special purposes it need not require many if policy instruments other than taxation are also being actively directed to this aim.

3.48. The potential conflict between the ideals of simplicity and equity, by contrast, is apparently very great indeed. The taxes most obviously adapted to the requirements of equity, those technically capable of being adapted to vary the levy upon individuals in accordance with a multitude of differences in their situations considered relevant to equity, are the most complex of taxes: income tax, capital gains tax, gift and estate duties, wealth tax. Hence it appears that a country may have a simple and efficient taxation system or an equitable one but not both.

3.49. The dilemma is not however so stark as that, for two reasons. One is that, as has just been noticed, quite simple measures on the side of expenditure can to some extent be used to offset the inequities created by the indiscriminate impact of simple taxes. The other is more important yet. A great deal turns upon the precise quantitative interpretation that is put upon the ideal of vertical equity and how the application of this quantitative judgment works out in the particular circumstances of the economy being considered. These are quite cardinal issues in the consideration of taxation policy, and they will be examined at length in the next chapter. When that discussion is completed it will be possible to return in Chapter 5 to the problem of defining the alternative types of tax system that are there for Australia's choice.




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4. Chapter 4 The Problem of Progressivity

4.1. The question of the proper degree of progressivity, of the extent to which a fair distribution of the burden of taxation requires that taxes should increase more than proportionally as one moves up the income scale, is perhaps the most difficult of all the basic issues in taxation policy.

4.2. To begin with, some general remarks may be offered about the phrase ‘burden of taxation’. It is frequently used, but it is misleading. It may have had some descriptive validity in pre-democratic days (and in some undemocratic countries today) when taxes supported government activities from which most taxpayers received no obvious benefit and which indeed may have been damaging to many of them. But the implication that all the taxes a citizen pays constitute a straight diminution of his welfare, that he gets nothing noticeable back from them, is not true of any advanced democratic society. Many of the public activities financed from taxation are prerequisites to the functioning of the private economy, and many of them are conducted by the State because by any reckoning the State is the most efficient instrument available. If they were not done at all, or left to private enterprise, everyone would be a great deal worse off than they are. To call such payments a ‘burden’ is to encourage confusion and prejudice. Also, much present taxation is one side only of a continuing process of removing money from people's pockets at one stage of their lives and returning it to them at another when it is more urgently needed. Again, scarcely a ‘burden’.

4.3. The belief that taxes as a whole are a burden has more rational origins in the normal human resentment at compulsion, and in the fact that, though few of us evaluate all that we get from paying them, all of us know of some government expenditure that we believe to be useless and wasteful. Nevertheless the phrase is an unhappy one and misleading especially in the discussion of progressivity. The central and sensitive question here 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 properly about the differences between the totals rather than about the totals themselves. Even then the problem is best seen as one of the role of the tax system among the whole complex of policies by which the modern State affects the distribution and the size of the community's income and property. Thus regarded, the problem loses its false air of simplicity but it can then be approached in a more constructive fashion.

4.4. A succession of three groups of questions has to be posed:

  • (a) What are the present facts of the distribution of income between persons and families in Australia (i) gross, and (ii) net of all taxes and social service payments? In other words, taking the tax system as a whole and allowing for cash transfers from the State, who pays what? In particular, how progressive apparently is the present Australian system? These are statistical questions.
  • (b) Supposing that the situation revealed by (a) suggests a need to consider changes in the distribution of income that are unlikely to occur naturally in the evolution of society on existing policies, how far are alterations in the tax system capable of bringing them about, and to what extent should tax rather than other public policies be adapted to the ends preferred? These are substantially problems in economic analysis.



  •   ― 24 ―
    (c) Granted that the tax system is one of the necessary and, at least to some extent, effective instruments for distributional objectives, what in fact should these objectives be? This is clearly a question going far beyond the statistical and the economic into the realms of the social, political, ethical.

4.5. In the three sections of this chapter these issues will be examined in turn. Advance warnings are, unhappily, necessary. The discussion of the statistical questions will be far from providing an adequate account of the basic facts: such facts are, at present, not available. It is hoped here to go some way in a part of the analysis that might have been expected to be the easiest, but the welter of myths existing in this area cannot yet be wholly dispelled. Similarly in the examination of the second question, to which it might also be expected that an agreed expert answer could be assembled, no such answer exists. Here, too, it is necessary to end up with best estimates from which many will dissent. The third question is one to which even in principle there is no hope of attaining any scientifically demonstrable answer, and it would be foolish to pretend otherwise.

I. The Statistical Situation

4.6. Any description of the taxes actually paid by some millions of taxpayers must consist of broad generalisations. Since income is the magnitude to which most of us first look in comparing the position of individuals and families, it would be convenient to be able to classify individuals into income groups and present for each group the average of all taxes paid by members of that group. Then from further information about the family situation and other particulars of individuals, it would be desirable to go on to present a summary picture of the average taxes paid by family groups of different size and composition, again classified by income. It is lamentable that estimates of the former kind cannot be made from the data available in Australia, and that the only source from which estimates of the latter kind can be developed is largely out of date and deficient in other ways. The extensive sample survey of family income and expenditure now being conducted by the Australian Bureau of Statistics may begin, in a year or two, to give results on which greater confidence can be placed. Meanwhile the Committee can only argue from ‘best guesses’.

4.7. A large array of statistics is inevitably generated in the administration of income tax, and in the annual volume Taxation Statistics a selection of the data is presented to the Australian Parliament by the Commissioner of Taxation, analysed in a variety of informative ways. These are, perhaps, the figures most inquirers turn to when considering the distribution of taxation, if only because they are virtually the only official ones available. Table 4.A, which presents a summary regrouping of data from the latest Taxation Statistics, reveals something of the distribution of individual net income as defined for statistical purposes—broadly, income less expenses of deriving income—and of average personal income tax paid by individuals in the income ranges indicated. But such information hardly serves as a basis for a general discussion of taxation policy. For example, it includes in the lower income ranges many persons who were unemployed for part of the year and omits many others who were not required to lodge returns; it excludes some income from trusts; it also excludes the undistributed income of companies and the bulk of social service grants; and of course such light as it throws on the distribution of taxation is confined to personal income tax, only about 40 per cent of total taxation. To use the Commissioner's figures in the present analysis would therefore be entirely misleading.




  ― 25 ―

TABLE 4.A: INCOME TAX: INDIVIDUALS, 1971–72 INCOME YEAR

                 
Number of taxpayers  
Grade of net income   Male   Female   Total   Net income   Net tax   Average rate of tax on net income  
’000  per cent  ’000  per cent  ’000  per cent  $m  per cent  $m  per cent  per cent 
0–2,999  849  23.4  1,418  68.7  2,268  39.8  4,124  18.1  338  9.4  8.2 
3,000–5,999  1,980  54.6  553  26.8  2,533  44.5  10,860  47.6  1,459  40.7  13.4 
6,000–9,999  642  17.7  75  3.6  716  12.6  5,255  23.0  970  27.1  18.5 
10,000+  155  4.3  20  1.0  175  3.1  2,589  11.3  817  22.8  31.5 
Total  3,626  100.0  2,065  100.0  5,691  100.0  22,827  100.0  3,584  100.0  15.7 
note  

4.8. For a fuller picture of tax distribution it is necessary to rely upon estimates originally based on the material contained in the Australian Survey of Consumer Expenditures and Finances, which was conducted in 1966–68 by Professors Drane, Edwards and Gates. This ‘Macquarie survey’ is a mine of information for students of social affairs and contains vital tax data unavailable elsewhere. Though it suffers from statistical defects fully acknowledged by its authors, is now somewhat dated and will be superseded before long, the Committee has found it, and the work done upon it on the Committee's behalf, indispensible.note

4.9. Figures in the Macquarie survey were collected on a household basis: indeed, with so much expenditure being shared, they could only have been collected on that basis if the results were to be meaningful. Taxes paid in cash are readily identifiable, but not taxes on goods and services paid indirectly: the latter have had to be estimated from expenditure information. To complete the picture company incomes, and the taxes on these incomes, have had to be assigned to particular income groups; so too have estate and gift duties. Thus in such an exercise a great many assumptions of a largely arbitrary kind have had to be made. No one, least of all the statisticians making them, would say otherwise. But if sets of alternative assumptions are made, each in its way reasonably plausible, it is at least possible to see how far the overall results differ and, when they mostly reveal much the same pattern, to attach some credence to the broad picture (if not the exact set of figures) that emerges. Over a hundred alternatives have been explored on the Committee's behalf and the patterns revealed are not in fact widely spread. One resulting estimate is shown in Table 4.B.

4.10. Though Table 4.B has to be interpreted cautiously, especially as regards the details of particular taxes, it suggests an overall distribution of taxation rather different from what most people would probably expect. Taxation, it seems, is quite sharply regressive at the lower end of the household income scale, nearly proportional in a wide middle band, and progressive only at higher levels. Indirect taxes are chiefly responsible for the large difference between this sequence and the progressivity apparently displayed in Table 4.A. (The surprising figure for company income tax paid by households with the smallest incomes is to be explained by the disproportionate number of elderly persons on low incomes living off investments.)




  ― 26 ―

TABLE 4.B: TAXES AS A PROPORTION OF INCOME, 1966–67

                           
Australian Government taxes  
Income range(a)  Personal income tax   Company income tax   Estate and gift duties   Indirect taxes   Total   State government taxes   Local government taxes   Total taxes  
$ per annum  per cent  per cent  per cent  per cent  per cent  per cent  per cent  per cent 
0–1,449  11.5  18.9  30.4  5.6  4.9  40.9 
1,450–2,899  2.9  7.2  13.0  23.1  4.1  2.8  30.0 
2,900–4,349  7.8  3.4  11.6  22.7  3.8  2.1  28.6 
4,350–5,799  9.4  1.9  9.9  21.2  3.3  1.7  26.3 
5,800–7,249  10.3  2.9  9.0  22.1  3.0  1.5  26.7 
7,250–8,699  11.1  2.5  8.6  22.2  2.9  1.4  26.5 
8,700–10,149  11.9  1.7  7.5  21.1  3.0  1.2  25.3 
10,150–13,049  13.2  3.1  7.4  23.7  3.3  1.2  28.2 
13,050–17,399  15.8  9.5  0.9  8.0  34.2  5.4  1.3  40.9 
17,400+  17.0  13.3  3.3  6.8  40.4  7.0  1.0  48.4 
note note  

4.11. However, as an account of the apparent impact of public finance upon households, these estimates represent only one side of the picture. The impact of transfers received from the government sector by way of age pensions, child endowment, sickness benefits and the like is ignored. Not surprisingly, these cash grants are heavily concentrated upon those families with small original incomes, and their inclusion substantially alters the overall result. The necessary calculations can be made in only a very rough and ready way, but some results are shown in Table 4.C. The importance of including transfers is apparent. When taxes and grants are considered together, progressivity is restored at the lower extremity of income distribution, but the system remains proportional in the middle range—a point of some importance in the Committee's argument. Despite the shortcomings of these estimates and the conceptual problems involved in constructing and interpreting ‘tax burden’ tables, the Committee is prepared to accept the validity of this conclusion as a broad statement of the apparent impact of the current tax-transfer system.

TABLE 4.C: DISTRIBUTION OF TAXES AND TRANSFERS ACROSS RANGE OF NET-OF-TRANSFER INCOMES, 1966–67 (a)

                             
1   2   3   4   5   6   7   8  
Income range   Original income   Transfers received   Total income (2 + 3)  Tax rate   Taxes (5×4)  Net taxes (6 - 3)  Net taxes as fraction of original income (7÷2) 
$ per annum  per cent  per cent 
0–1,449  194  1,417  1,611  41  661  -756  -390 
1,450–2,899  2,195  447  2,642  30  793  346  16 
2,900–4,349  3,679  283  3,962  29  1,149  866  24 
4,350–5,799  5,008  226  5,234  26  1,361  1,135  23 
5,800–7,249  6,412  232  6,644  27  1,794  1,562  24 
7,250–8,699  7,853  228  8,081  27  2,182  1,954  25 
8,700–10,149  9,368  189  9,557  25  2,389  2,200  23 
10,150–11,599  10,778  229  11,007  28  3,082  2,853  26 
11,600–13,049  12,142  207  12,349  28  3,458  3,251  27 
13,050–15,949  14,407  286  14,693  35  5,143  4,857  34 
15,950+  23,947  310  24,257  45  10,916  10,606  44 
note note  




  ― 27 ―

4.12. Even with grants included, the picture is far from complete, since no account is taken of government expenditure on goods and services and of the distribution of the benefits of such expenditure between families. Many of the benefits of direct government spending would, by any reckoning, be very unequally distributed, and at least in certain areas like education rather more heavily concentrated in the bottom half of the income scale. But ultimately there is no way of apportioning the benefits of public spending that is not completely arbitrary, and it seems best therefore to focus only on the tax-transfer operations of the budget.

4.13. It is impossible to assess the practicability, let alone the desirability, of any substantial alteration in the incidence of total taxation and grants without regard to the number of persons and families within each income range. Given that taxation in an advanced economy may have to be of the order of one-third of national income, it is simply not arithmetically feasible to secure a major part of it from the highest income groups if the great bulk of income is earned by those in the middle and lower ranges. Some estimates of family income distribution drawn from the Macquarie survey, and from a valuable pilot survey conducted by the Australian Bureau of Statistics in 1968–69, are shown in Table 4.D. They suggest that the top fifth of families in the second half of the 1960s received about 40 per cent of total income, the bottom fifth something less than 10 per cent, and the remaining three-fifths over 50 per cent—a very substantial bunching. It needs, however, to be borne in mind that high rates of tax at the top require reasonably high rates in the middle as well, if marginal tax rates are never to reach excessive heights: reducing the tax paid on income within the range from $8000 to $10,000, for example, necessarily reduces the tax paid on that slice of income from those whose incomes lie above $10,000. If the treatment lower down the scale is too generous, then the required revenue cannot be obtained without pushing marginal rates applying on upper incomes to extreme levels. It is the joint operation of revenue requirements and the constraint that marginal rates of tax be reasonable that compels the weight of tax in lower and middle income ranges to be significant.

TABLE 4.D: DISTRIBUTION OF ANNUAL INCOME, 1966–67 AND 1968–69 SURVEYS (Cumulative percentages)

                         
1966–67(a)  1968–69(b) 
Percentage of surveyed families   Percentage of income excluding transfers   Percentage of income including transfers   Percentage of income including transfers and imputed rent   Percentage of income  
10  0.1  2.4  2.9  2.2 
20  2.9  6.4  7.3  6.8 
30  9.2  12.8  13.8  12.8 
40  16.6  20.1  21.2  19.7 
50  25.2  28.5  29.6  28.2 
60  35.0  38.0  39.1  37.5 
70  46.1  48.7  49.8  48.1 
80  59.0  61.1  62.1  60.3 
90  74.6  75.9  76.7  75.2 
100  100.0  100.0  100.0  100.0 
note  




  ― 28 ―

4.14. These are annual figures and it is of the greatest importance in the present context to avoid being misled by them. It is tempting with annual statistics to argue as if families in each income group are there all their lives, which of course is not the case. Almost everybody's income starts, on entry to the work force, at a much lower level than it reaches later in working life and falls on retirement. Almost anyone, too, may have years of exceptionally low income during a normal working career because of sickness, unemployment or even extended holidays. Moreover, the figures in Table 4.E, drawn from the Australian Bureau of Statistics survey of 1968–69, reveal a further significant fact: the lifetime pattern of earnings varies greatly according to occupational level, at least in so far as this level is indicated by educational attainment.

TABLE 4.E: AVERAGE ANNUAL INCOME OF FULL-TIME MALE WORKERS, BY EDUCATIONAL ATTAINMENT AND AGE GROUP, 1968–69 PILOT SURVEY ($)

                       
Age group (years)  
Educational attainment   15–24   25–34   35–44   45–54   55 and over   All age groups  
University degree  (a)  6,940  8,910  10,320  8,920  8,170 
Non-degree tertiary  3,430  5,180  6,600  6,360  7,150  5,940 
Technician level  3,200  4,470  5,410  5,620  5,010  4,970 
Trade level  3,270  4,030  4,270  4,120  3,620  3,950 
Matriculation only  2,840  4,460  4,940  5,120  5,650  4,320 
Left school at: 
17  2,640  3,970  4,530  4,360  5,010  3,750 
16  2,290  3,750  4,380  4,630  4,210  3,510 
14 or 15  2,320  3,440  3,810  3,770  3,600  3,420 
note note  

4.15 The implication is clear that were it possible to ascertain the distribution of Australian income in terms not of annual income but of the probable average lifetime income of persons now alive, such a distribution would (after eliminating the effects of general economic progress) be considerably more bunched than any annual figures. The great majority of individuals in the lower intervals of annual distribution (the sick, unemployed, aged) would move into higher income groups; equally, many of those towards the top on the basis of annual statistics (persons at the temporary peak of their careers or old enough to have incomes from their own savings and from inheritances) would move into lower groups. There would be far fewer very rich and far fewer very poor; the bulk of the population would be even more concentrated in the middle ranges.




  ― 29 ―

4.16 It would have been desirable to round off this section with some arithmetical calculations showing the alternative patterns of progressivity in the overall taxation system consistent with a given total revenue. But available information on the distribution of income, even on an annual basis, is unfortunately too dated and too sketchy for such working estimates as the Committee has been able to make to deserve reproduction. A few brief observations of a qualitative nature must suffice:

  • (a) By manipulating rates on existing taxes and widening their bases, by their tighter administration, and by such new levies as a tax on capital gains, it would certainly be possible to raise more revenue from those at the top end of the income and wealth scale, were this considered desirable.
  • (b) The number of persons in those groups is so small that the additional revenue would inevitably be very modest in relation to total revenue requirements.
  • (c) Revenue needs are now so great, and the underlying distribution of income is so concentrated in the middle ranges, that the bulk of revenue must come, in one way or another, from those ranges.
  • (d) Within the middle ranges there is certainly scope for more or less progressivity in marginal and average rates as opposed to the near-proportionality now apparently exhibited, but the degree of variation practicable is much less than is often supposed.

II. Tax and Non-Tax Policies in Redistribution

4.17. Even if the current distribution of income after tax were known more accurately than it is and were judged to be satisfactory, it would still of course be necessary to discuss whether the existing tax structure is contributing to the result in as simple and efficient a way it could. But if it may be assumed that society desires eventually to achieve a more equal distribution, it becomes necessary explicitly to discuss the relative effectiveness of the policy instruments available. Of these the taxation system is by no means the only one actually or potentially employable in Australia, and it is probably less all-powerful than appears at first sight. There is thus a very real problem in finding the right mixture, the most efficient balance, between the various kinds of instruments that are or can be brought into use. Hence the Committee cannot reach recommendations about the tax system without referring briefly to the other policies available, though any detailed examination of them would involve an unwarrantably wide interpretation of its terms of reference.

4.18. It is evident that were the government to possess effective and wide-ranging controls over all earned incomes and all payments for rights in land and industrial property and financial assets (rents, dividends, interest, etc.), it would thereby have a dominant control of the distribution of income. The equity objective of taxation would largely become superfluous except as regards the distribution of property income between persons as determined by the initial and evolving distribution of ownership of the property itself. The tax system could be operated instead primarily with the objectives of simplicity and efficiency in mind. Such control over incomes may effectively be the situation in totalitarian economies and they can have very simple tax systems. While it is here assumed that control to this extent will never exist in this country, it is worth recording that in so far as, within Australia's political framework, government or other public agencies have some direct influence upon the


  ― 30 ―
evolution of relative gross incomes, the redistributional tasks of the tax system can be to that extent lightened.

4.19. Policies towards monopoly and restrictive practices of all kinds are plainly relevant. The distortions of the market tackled by such policies usually, though not always, tend to increase inequality.

4.20. Policies towards land-tenure and urban development, even though primarily directed towards the achievement of decent urban conditions in the right places, may have important implications in one area of great difficulty for tax policy, that of capital gains from transactions in land.

4.21. Much social service expenditure, for example on health and counselling of one kind or another, even when not involving direct cash transfers is evidently important in preventing extremes of poverty.

4.22. Finally, and perhaps of the greatest general significance, there is the State's part in determining the amount and influencing the composition of education, general and technical and professional. At the lower end of the scale some persistent poverty can be attributed to failures at the level of elementary education. Higher up the scale much of the difference in earned incomes certainly derives from the scarcity of skills that are costly in time and money to acquire. This is a large issue, and not without many intricacies, but the point must be made that in the long term education policy is a powerful weapon in the pursuit of greater equality in incomes—perhaps indeed the most powerful available in a democratic community.

4.23. To return now to the use of taxation as a redistributive measure, one remark should be made at the outset. When contemplating any table showing the distribution of income gross, the taxes paid and grants received at each level, and the resulting distribution net, it is tempting to suppose that simply by altering taxes and grants an exactly equal alteration can be made in after-tax incomes, i.e. that the gross distribution can be taken as something fixed and upon which one may operate at pleasure. This, of course, is a mistake. A change in the tax pattern will in general have an effect upon both the size and the distribution of gross incomes, and the final result to net incomes will be affected by this interdependence, or rather by the combined outcome of a whole set of interdependencies. Some judgments about those tangled and still controversial issues must be offered.

4.24. It is important to distinguish between the initial effect of a change in the progressivity of the rate structure and the permanent effects. Obviously a large change coming suddenly is liable to have sharp impact effects which may or may not last and which may even be reversed. In this part of the analysis it is necessary to consider only the more permanent steady differences that might be made to gross and net incomes by more or less progressive tax structures, after any initial reactions to alterations in the present structure had worked themselves out. The case of an increase in progressivity via personal income tax can be taken by way of illustration. Three types of permanent reaction have to be considered: upon work effort, upon savings, and upon gross income claims.

4.25. Few issues have been more elaborately argued at the theoretical level or more inconclusively tested empirically (or are more difficult to test) than the effects of varying tax levels upon the individual's choice of work against leisure. It is generally held that a high marginal rate of tax will limit the desire to work, but the real question is whether the effect will be large or negligible. It need not be doubted that a marginal rate of 80 per cent or more, imposed on the marginal earned income of a man who


  ― 31 ―
can live comfortably on a few hours' work, will inhibit him from working longer unless he has an exceptional delight in the kind of work he is doing. But within the range, more relevant to practical discussion, of say 40 to 70 per cent, the matter is problematical. It is evident on all sides that most well-to-do people now earning incomes that are taxed towards the top end of the scale do work hard and long and it may be judged that pride and interest in their work are dominant reasons for this. The effects of tax rates may well be small. At the lower income levels the consequences of medium and high marginal tax rates are perhaps much more mixed, and very much more dependent on personal and job characteristics. Hence 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 incentives.

4.26. Any progressive tax system must to some extent be inimical to savings. This follows from the familiar fact that within the working-age groups the proportion of income saved, generally speaking, increases with income. But the precise sensitivity of savings to tax rates on any permanent basis is extremely hard to judge, and the difficulty is compounded in inflationary conditions when the volume and pattern of savings are likely to be dominated by varying expectations about potential returns, real and monetary, and about the stability of income. It is also to be remembered that in the industrial sector (the needs of which are often in mind when the importance of saving to growth is being emphasised) much investment is internally financed and its productivity may be determined as much by its quality as its quantity. The Committee regards incentives to save, as it regards incentives to work, as important but not crucial factors in deciding whether the tax system should be made rather more or rather less progressive.

4.27. A still more enigmatic problem is that of the connection between the progressivity of tax rates and the occupational and hierarchical spread of gross incomes. In conditions such as those of Australia at present and in the foreseeable future, where a high proportion of incomes from effort is in one way or another collectively determined with considerations of ‘fair relativities’ very much to the fore in the debate, it is at least theoretically conceivable that any attempt to compress (or expand) established differentials in real income may be defeated by countervailing adjustments in gross incomes. This would be so if it were relativities net of tax that were involved in ideas about fair shares, and market forces were no obstacle.

4.28. It is a reasonable inference from the very frank specification of ‘fringe benefits’ which takes place in the recruitment of senior staff in many areas of the economy, that in that range levels of real income net of tax are a prime factor in settling remuneration. At other levels the matter is not so clear. Taxation is not overtly considered by the Arbitration Commission. But facts that will be relevant to the intensity of emotion behind a dispute do not need to be explicitly stated to enter the minds of negotiators. The notion of taxes as a burden may be misleading but it has a deep hold. When an increased wage, arrived at by either a Court award or direct negotiation, proves disappointing when received in the pay packet with tax deducted, consequences to the next claim may be expected. Explicit bargaining in ‘real’ terms, net of tax, is spreading overseas and the higher the general level of taxation becomes the more probable it is that it will come to Australia, more especially as, with continuing inflation, everyone is becoming used to thinking in ‘real’ terms. The matter is further considered in Chapter 6.




  ― 32 ―

4.29. There are limitations on the possible extent of such tax-offsetting income adjustments. As the relative prices of the services of those who secure an upward shift of gross income increase, it will be to the interest of their purchasers to economise and to change techniques so as to use more of other, now relatively cheaper, factors of production. But this may not always be possible, even in the long run, and the power of interest groups may be such as to hamper it when it is.

4.30. The kinship is obvious between the argument here and the questions of relative shares (and inconsistent group claims about them) that are central to the debate on the causes of the inflation now endemic in western economies. There seems unfortunately to be as little hope of agreed conclusions in this debate as in the wider one.

4.31. It is about the relationship between taxation and earned incomes that these doubts principally arise. Taxes on property income can be expected to prove more or less progressive in accordance with the rate structure. So can estate and gift duties, if adequately tightened up, and so too would a wealth tax if technically feasible. Hence the Committee does not come quite to the conclusion that the distributions of income net of tax and of property are not significantly amenable to tax policy when all repercussions are taken into account. It does however believe that the distributions are by no means so readily malleable as may appear at first sight.

III. The Distributional Objective

4.32. Even if it had been possible to provide an accurate and precise account of the distributions of income, gross and net of taxation, and even if the potentialities for changing them in any desired direction by means of the taxation system were assessable in a far more clear-cut way than they are, it would still be a problem of the utmost difficulty to decide how much should be done. It is however implied in the Committee's terms of reference and must be broached, though with all the diffidence that befits a non-political Committee offering views on problems that are essentially and acutely political.

4.33. To start with some simple generalities. If asked what the government should do about the distribution of income and property and how taxes should be used in doing it, it seems likely that nearly everyone would agree on certain vague propositions: that taxes should be related to ability to pay, that they should be used to assist the aged, the unemployed, the sick, the economically weak, and those burdened with the upkeep of large families; that while poverty exists some limits should be put upon the passage of growing accumulations of wealth from generation to generation. They would agree, on the other hand, that part at least of the extra rewards given by the market to those who work especially hard or have rare abilities should certainly stay with them. But if pressed to translate such merely qualitative statements into quantitative terms—to indicate the actual level of grants to those requiring help, to specify tax rates and so forth—plainly a welter of divergent answers would be elicited, even from intelligent respondents doing their best to give practicable figures. It is apposite to consider the principal explanations that might be discovered for this variety.

4.34. There would in the first place be the most widespread ignorance of the statistical facts of the present situation (and of the trends in it) and in consequence all kinds of inconsistent myths and legends and distorted views would be honestly believed. Secondly there would be, among most of those questioned, much ignorance also of the qualitative nature of the lives of people socially remote from themselves. Not


  ― 33 ―
many of the well-to-do know what it is to be very poor, and most of us may have strange ideas of the daily lives of the very rich. Finally, and quite separately, there would be the widest divergences in the extent to which people in fact cared very much what happened to the rest of the population, in the extent of their mutual sympathy, in the extent of their exclusive self-interest or group loyalties, in their willingness, in the last resort, to pay up for the good of others.

4.35. It is reasonably to be supposed that were the first kind of ignorance remedied there would be a reduction in the spread of opinions about distribution policy. Such too might be the consequence of remedying the less tangible ignorance that surely exists under the second head. But even then, residually, there would remain the variations in social and political attitudes last mentioned as a cause of different views on this basic issue of social justice. Such variations stem ultimately from the moral—or if you will, immoral—beliefs of individual citizens, which may indeed change over the generations but which are of a kind not amenable to alteration by the expression of ‘expert’ views. It is by reason of the inevitability of these variations that distributional policies must be decided in the political process and cannot be determined on any impartial, scientific, objective basis. But it does not follow that, were ignorance remedied, the dispersion of basic political attitudes would be so great as to make a reasonably settled policy unattainable. Some extreme views will doubtless always persist in small minorities. More importantly, whatever objective is currently being pursued, many may want more done and many less. But the differences among the moderate majority may be, quantitatively, of no great magnitude, no greater than can be accommodated by changes in tax rates, without changes in the whole structure.

4.36. Australia has a very homogeneous society, both economically and socially. It is sometimes abused for over-valuing material well-being, perhaps because it is a country with a very high standard of living, but it is predominantly tolerant and individualistic. Most Australians are self-reliant and indisposed to believe that there exists any kind of exact social scale in which they have their own precise place, still less to identify such a scale and their own place in it by reference to their own and their neighbours' income or wealth. Hence it seems to the Committee that some such near-consensus as that just suggested may exist here, behind and below, so to speak, the existing ignorances and myths and despite Australia's tradition of vigorous language in political debate. In recommending a direction of reform in the Australian tax system it is one of the Committee's tasks to attempt to define in general terms what this underlying national unity suggests for fiscal policy.

4.37. In the Committee's judgment there will be almost universal agreement that, overall, taxation should be progressive at the upper end of the scales of income and wealth, and that at the other extreme proverty and threats of poverty reflecting situations of special need should be relieved of taxation or assisted by social service payments. But it is convinced that there will neverthless long remain debate and disagreement about the exact extent to which it is economically safe, administratively feasible, and socially justifiable to push taxation at these higher levels and to assist poverty and need.

4.38. At the same time and quite consistently with this recognition of sharp disagreements about the extremes, the Committee's belief is that over the middle band of income and wealth, the band in which the great majority of them spend their lives, most Australians will accept as fair and convenient an approximately proportional taxation system. When the estimates are made as best they can, that appears to be the


  ― 34 ―
quantitative outcome of the present system, and the Committee sees no reason to depart from it.




  ― 35 ―

5. Chapter 5 The goals of Tax Reform

5.1. When the analyses of the previous two chapters are drawn together it is possible to provide some general discussion of the options open to Australia in the reform of its tax system, and to state, in broad terms, the direction of change recommended by the Committee.

I. The Options

5.2. It will be helpful first to distinguish two quite opposite destinations towards which, if so desired, it might be possible to work. Each would be consistent with whatever level of revenue-raising from time to time may be decided upon. For reasons to be noted neither can be recommended, but both are worth describing briefly as the extremes between which a range of more satisfactory possible destinations can be imagined.

5.3. Were simplicity and efficiency the only objectives, one might aim at a system overwhelmingly dependent for revenue upon a single broad-based tax on goods and services set at a very high rate, with some simple additional taxes on, for example, alcoholic drinks, tobacco, and motoring to serve the specific interventions in the private market needed for efficiency purposes. At the same time simple grants to meet the most obvious differences in individual needs—child endowment, age pensions, sickness and unemployment benefits—would deal, without much administrative complexity, with the most serious problem of equity at the bottom end of the scale. There would be no income or capital taxes at all.

5.4. If this be called the ultra-simple extreme, its polar opposite might be called the ultra-complex. The latter would be a system relying overwhelmingly for its revenue upon an income tax, buttressed in its operation by a capital gains tax and capital taxes, whether estate and gift duties or a wealth tax or even both. Again some efficiency taxes could be incorporated. There would be no place for any broad-based tax on goods and services: the income tax could be put at any desired level. The same set of grants would be included whether separately means-tested or made fully taxable; concessional deductions from income tax would be freely used. It would be a system thoroughly adaptable to the expression of very refined notions of progressivity, involving minute adjustments of relative tax liability from the bottom to the top of the scales of income and wealth, and allowing, if so desired, a very sharp rate of progressivity.

5.5. Certainly the ultra-simple system would have in full measure the attractions of simplicity. Very few individuals would directly pay taxes, and they and the enterprises on whom the task would chiefly fall would probably be able to handle the accounting without difficulty. Taxes in fact would become as nearly invisible as possible, though everybody would of course know of the level of the broad-based consumption tax. Indeed, taxes might be almost too invisible. There would be a reinforcement of that misunderstanding, already with us, 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. (In a report rendered to a Treasurer it is unnecessary to argue that this myth is troublesome to the right conduct of public finances.) This system too would admirably serve the end of economic growth. With no income tax and no capital tax restraining the savings of the


  ― 36 ―
well-to-do, there would be no direct limit on accumulation and inheritance. But this, of course, would be the mere obverse of the fault that would certainly make it wholly unacceptable. The grants would make it a progressive system at the bottom of the scale, but towards the top it would become actually regressive. It would grossly offend universally accepted interpretations of the aim of equity.

5.6. The ultra-complex extreme would have to be rejected for opposite reasons. It would be even more complicated than the system we have now. Everyone would be annually involved in completing elaborate returns. With total income tax higher than at present, the problems of willing compliance would be exacerbated. The costs of enforcement, both monetary and in terms of bureaucratic intrusion into private affairs, would rise. If the one system was drawn towards the Scylla of the fallacy of Santa Claus, this would fall into the Charybdis of the burden fallacy.

5.7. Between these plainly unacceptable extremes a narrower band of alternatives can be imagined between which more serious debate is possible. The cardinal objection to the ultra-simple system, that of its regressivity at high levels of income and wealth, would be largely met by the inclusion of an income tax and a capital tax with high minimum exemption limits that effectively confined their impact to the upper end of the scales of income and wealth, perhaps with measures to improve their coverage of capital gains. The simple though now taxable grants would still deal with vertical and horizontal equity at the other end; the broad-based tax would still secure no more than a simple proportionality to consumption in the middle range; simplicity would only be sacrificed in the interests of equity at the top where, however the dividing line were placed, only a minority of the population would be found. Correspondingly, the prime fault of the ultra-complex system would be quite substantially relieved if a broad-based tax at a moderate level were added to it, combined with some efficiency taxes, and the proceeds used to increase grants (in compensation for the rise in prices) and to reduce the rates and simplify the structure of personal income tax. As long-term possibilities for a permanent structure neither of these less extreme systems, which might be dubbed the simple and the complex, could reasonably be dismissed out of hand.

5.8. It will at once be noticed that in these alternatives the list of taxes is the same. Where they differ is in the relative weights given in each to the taxes they comprise. When one imagines these weights being changed to exhibit a whole series of intermediate alternatives, one comes upon a continuum. Moving along this continuum from the complex end, the rate of the broad-based tax rises as also do grants, while the income tax is reduced in rate and coverage. Conversely, travelling from the simple end the rate of broad-based tax falls, grants fall, and income tax rises. Efficiency (in the sense of neutrality modified by some specific taxes for specific purposes) is unaffected, but simplicity varies.

5.9. The analysis of Chapter 3 points thus far. That of Chapter 4 enables the Committee to take a further step. Even in a system quite far towards the simple end of the range it is possible by varying the rates of the income and capital taxes to express a greater or less desire to be progressive at the top end of the distribution, and to improve progressivity via grants at the opposite end of the scale. Also, by variation of the rate of the broad-based tax these grants can be raised or lowered at will, to the advantage or disadvantage of those at the bottom (as well as to the advantage or disadvantage of the average level of intra-lifetime transfers for everyone). Thus provided that approximately proportional taxes are accepted as fair in the middle range,


  ― 37 ―
a simple system can serve greater or less public ambitions for redistribution at the extremes.

5.10. The analysis in Chapter 4 of such factual information as the Committee has been able to gather suggested two tentative conclusions of prime importance. First, it would appear that when all taxes are taken into account the Australian tax system is already approximately proportional in the middle ranges, though (when grants are reckoned in) progressive at the lower end and, through the impact of personal and company income tax and estate duty, progressive again at high levels. Second, it would also appear that the distribution of income is such that, accepting the need for substantial grants at the bottom end of the scale and significant progressivity at the top, there is not very much scope for change in the progressivity of the tax system in the middle range. Furthermore it was suggested in the later part of that discussion that something like proportionality in the middle range was socially acceptable in Australia, and that the spread of socio-political views chiefly concerned the extent to which those in need should be assisted through grants and the higher groups taxed more than proportionately.

5.11. If these tentative judgments of fact and value be correct, it follows that a tax system towards the simple end of the spectrum just described would suit the facts and values of the Australian community. The Committee therefore recommends such a system as the long-term target to which Australia should work and would favour a general strategy of tax reform which worked towards it.

II. Immediate and Long-Term Perspectives

5.12. There is of course a world of difference between establishing a long-term target in general and abstract terms and achieving it. Indeed on the way to it much may happen to cast doubt upon the continuing validity of the underlying factual and social judgments.

5.13. Currently, as the Committee sees it, the Australian tax system contains sufficient internal incoherences for the term ‘system’ to be somewhat of a euphemism. As will be argued later, the income tax, both personal and company, on which major dependence is now placed, has considerable defects that require remedy; the lack until now of a capital gains tax is seriously inequitable and renders the system less progressive than was probably intended; estate and gift duties are very faulty as capital taxes; and the existing sales tax and excise duties are defective as efficiency taxes. A number of reforms to deal with these immediate deficiencies will be proposed in later chapters, together with the introduction of a broad-based consumption tax.

5.14. In the immediate result the Committee's recommendations would, it hopes, give Australia a more systematic body of taxation, and one that would be more efficient and equitable. But it would be very much at the complex end of the spectrum just described, and it is questionable whether it could be claimed to be, overall, simpler than the present system especially since two new taxes are proposed. On the other hand, if the Committee's full proposals were accepted it could be argued that at least the complexity of the still dominant income tax would be alleviated and there would be simplifications in the area of estate and gift duties.




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5.15. The major opportunities for simplification, in the Committee's judgment, inevitably lie further ahead. Some might be gained quite soon. As and when the Australian taxpayer becomes accustomed to a broad-based tax, it should be quickly practicable (above all if the co-operation of those concerned with the fixing of wages and salaries was forthcoming) to reduce marginal and average rates of income tax by progressively raising the level of the broad-based tax. Thereby great gains in terms of reduction of evasion and avoidance and costs of compliance could be achieved, and the effect upon incentives to work and save might also be favourable. But beyond that lie the further goals of gradually replacing the existing means-tested social service transfers by a simpler system of taxable grants and of raising the exemption level of income taxation so that at length such grants were only taxed in the hands of a minority. Were it ever possible to reach that situation Australia would indeed have attained the simplest taxation of any advanced country. But its eventual practicability would depend crucially upon future trends in the level of grants, in the numbers eligible, in the spread of incomes before tax and in the way social attitudes to this spread change as average real incomes rise. The Committee would by no means wish to suggest that much progress to these ultimate goals can be made in the years just ahead. Perhaps they would always prove impracticable. But the Committee would not wish to exclude them from the eventual ideal of a tax system appropriate to a rich democratic and socially egalitarian country.

5.16. The discussion of this chapter has deliberately been kept at a very general level and, correspondingly, has had to be somewhat vague. In later chapters particular taxes will be examined in greater detail and more concrete content given to the Committee's proposals.




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6. Chapter 6 Inflation and Tax Reform

6.1. The Committee, which began its task of formulating advice in October 1972, has had to do so against the background of an economy in the throes of a continuing serious inflation—inflation at a rate which, at the time this report is presented, threatens to be far beyond anything contemplated during the initial stages of the Committee's deliberations. The rate has increased noticeably since the compilation of the Committee's preliminary report which was completed at the end of May 1974.

6.2. In the period from 1954–55 to 1968–69, the annual rate of increase in consumer prices—customarily treated as the main index of inflation—averaged 2.6 per cent; but over the last five years the annual rate of increase, taking the figures from one June quarter to the next, has sharply accelerated in the following manner:

             
Percent 
1969–70  3.7 
1970–71  5.4 
1971–72  6.2 
1972–73  8.0 
1973–74  14.4 
note  

6.3. Inflation on the present scale is gravely disturbing. It produces arbitrary changes in the distribution of income and wealth, favouring borrowers at the expense of lenders, the working population at the expense of the retired, and more powerful pressure groups at the expense of less powerful ones. It distorts the composition of production as people seek, not the commodities they most want for consumption and the level and pattern of savings most suited to their real needs, but rather what will give them the best hedge against inflation. It creates uncertainty and frustration over the whole range of the community, and leads to serious breakdown in commercial confidence and great industrial unrest. It may cause balance of payments difficulties. And once the rise in prices is at all rapid, the new threat emerges of further acceleration, leading if unchecked to hyper-inflation and to the undermining of the whole economic and social fabric.

6.4. There can be no denying, too, that tax arrangements are capable of intensifying or moderating the pace of inflation. In its proposals on tax reform, compiled within its terms of reference of 1972 and spelled out in later chapters of this report, the Committee has given only modest attention to the impact of taxes on inflation. For one thing, tax measures on their own are hardly likely to remove inflation, and it is not within the Committee's competence to pass judgment on policies outside the immediate field of taxation. Furthermore, effective action to deal with inflation may require at least temporary adjustment to the overall level of taxation, and the Committee by its terms of reference is instructed to ‘ensure a flow of revenue sufficient to meet the revenue requirements of the Commonwealth’. Also the role of taxes in the inflation process is a matter of much controversy and uncertainty: any recommendations would thus have to be somewhat tentative. But with inflation running at an


  ― 40 ―
exceptionally high rate and threatening to become a permanent feature of the Australian economy, the Committee might justly be criticised for seeming to be out of touch with reality if it failed to make observations on tax policy in relation to inflation, more especially in view of the variety of anti-inflation schemes now being canvassed that assign a somewhat novel role to the tax system. Section I of this chapter is intended to forestall such criticism.

6.5. Just as taxation has a bearing on the rate of inflation, so inflation impinges on the tax system in important respects, furnishing both grounds for a measure of tax reform and, since it is reasonable to suppose that an undesirable rate of inflation is going to persist for some time, complicating the task of devising reforms that will still be relevant years from now. Some of the main ways in which inflation impinges on the tax system are outlined in Section II of this chapter; the manner in which the Committee has sought to allow for inflation will be explained in later chapters when particular taxes are being reviewed.

6.6. Before proceeding to Section I, brief reference should be made to a further way in which inflation has affected the drafting of this report. With prices rising at rapid but unpredictable speed, it becomes correspondingly more difficult to estimate tax yields a year or two ahead, let alone yields four of five years hence which may prove to be the earliest that at least some of the Committee's recommendations can be implemented. That the Government now has difficulty forecasting revenue accurately even 12 months in advance is fairly apparent when actual tax receipts in 1973–74 are compared with estimates published in August 1973: for instance, sales tax brought in 9.0 per cent more revenue than anticipated and the pay-as-you-earn component of personal income tax 7.6 per cent more. Understandably, therefore, the Committee has not sought to be precise about the revenue implications of its various tax recommendations. Nor, in most cases, has it attempted to attach particular money values to levels of proposed concessions, rebates and the like, except by the way of indicating rough orders of magnitude and then only on the basis of today's prices.

I. Taxes and Inflation Control

6.7. The causes of inflation are complex and incompletely understood. But broadly two schools of thought can be distinguished, commonly labelled demand-pull and cost-push.

6.8. The former school looks to the behaviour of individuals and groups in the face of excess demand for goods and services over available supply, a rapid expansion in the volume of money, and expectations of changes in prices and earnings. It is recognised too that inflation may stem in part from international factors, and a number of channels by which rising prices may be transmitted from country to country have come to be identified: for example, by overseas demand raising exporters’ incomes or a balance of payments surplus causing the domestic money supply to expand. In general, the emergence of excess demand is considered to be the prime initiating factor, though inflation may continue after excess demand has been eliminated and perhaps even been replaced by a short-fall in demand accompanied by unemployment—what has come to be known as stagflation. Inflation persists because the pursuit of income claims in response to price increases that have already occurred establishes a wage-price spiral which is liable to continue as long as monetary conditions permit, reinforced in some measure no doubt by wage-fixing practices inside and outside the arbitration system. The spiral tends to be accompanied by greater strike activity as wage earners exploit their market power to press their income claims.


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To control inflation, according to the demand-pull school, the various sections of the community must be induced to alter their behaviour, which can be done by manipulating such conventional economic variables as the money supply, interest rates, the exchange rate, taxes and government spending.

6.9. The second school would acknowledge that the economic factors referred to in the last paragraph may at times be important, but argues that the underlying cause of inflation is more deep-seated and relates to a basic social struggle over the distribution of national income. Unions, firms and other groups use their economic and political power to try to protect or improve their share of national income, inflation of the cost-push variety being the means by which conflicting income claims find expression. The process is self-sustaining because governments have a strong political commitment to full employment and are therefore prepared to let the money supply expand to accommodate the income claims. This school also accepts that, to control inflation, behaviour must be changed, but the emphasis is less on manipulating conventional economic variables as on fundamental institutional and social reorganisation.

6.10. The explanations of both schools are undoubtedly important for an understanding of the inflationary process and it is misleading to polarise them. The first school points to the tendency for expenditure plans to exceed the capacity of the economy to satisfy them and sees rising prices as the inevitable consequence. The second school focuses on the conflict about income shares and sees rising money incomes as the manifestation of this struggle.

6.11. This latter view may help account for the long-term upward movement in the price level in the post-war period, but a more immediate explanation for the upsurge of inflation in Australia since 1970, and particularly after 1972, would seem to lie in the excessive growth in money supply, the pressure of demand on available resources and the build up of inflationary expectations. These tendencies can be traced to both international and domestic sources. The rapid growth of international reserves contributed in no small degree to the 26 per cent increase in money supply during 1972–73, while the steep rise in world commodity prices has obviously had a signficant influence on the growth of Australian prices and incomes. On the domestic front the easy monetary conditions of 1972–73 and early 1973–74 added to the growth of money supply and strengthened the demand for factors of production and final commodities. Budgetary policy was strongly expansionary throughout 1972–73 and only very slightly less so during 1973–74. Under these circumstances expectations of continuing and accelerating inflation led employers and employees to use their market power to maintain or increase their share of national income. The severest wage-price spiral since the wool-boom days of the early 1950s was thereby established.

6.12. It is fairly apparent that a reduction in the rate of inflation is only possible if individuals and groups in society can be induced to modify their behaviour. This is as much a political and social problem as an economic one, requiring common agreement about the extent to which the policy objectives of full employment, appropriate use of resources and a fair distribution of national income should be compromised for the sake of greater price stability. Conflicts inevitably arise in establishing satisfactory compromises, but until they are resolved an underlying inflationary trend seems unavoidable. Moreover, even if consensus about policy objectives can be achieved, there is still likely to be dispute over the means of ensuring that behaviour is consistent with the objectives chosen.




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6.13. Tax increases have traditionally been viewed as one of a number of policies for inclusion in a program to combat inflation. Increases in personal income tax reduced disposable incomes, thereby easing the pressure on resources caused by excessive spending in the private sector. Increases in indirect taxes tend to be shifted forward in varying degrees, producing once-and-for-all increases in the price level; but higher prices involve a cut in real spending power and in this sense such taxes are demand-reducing and therefore, in the absence of corresponding wage increases, anti-inflationary. It is conventionally assumed, when tax increases are to be used in a program to combat inflation, that any additional tax revenue is not in fact spent by the government.

6.14. Recent trends of events have called these views into question. It may be unduly optimistic to assume that government spending will be kept in check as taxes increase. Given the political commitment to full employment and pressures on governments to fulfil electoral promises, increases in tax revenue may have the effect, at least indirectly, of boosting government spending with the result that community spending is not in fact reduced. Such commitments and promises, morever, make it unlikely that tight monetary policies will be pursued for any length of time. In these circumstances the conventional assumptions may no longer be appropriate: there now seems to be a distinct possibility that personal income tax will in some degree be shifted too, and once-and-for-all price increases associated with tax shifting in general will become cumulative.

6.15. For a number of reasons personal income tax may be a somewhat weaker anti-inflationary device than used to be thought. To the extent that employees, in formulating their wage claims, anticipate the extra income tax that higher wages will attract, personal income tax may contribute in fairly direct fashion to the wage-price spiral. For if attempts to shift the tax through correspondingly higher wage claims prove successful and employers seek to recover their higher expenses by passing on additional labour costs (including those unavoidable costs accompanying a larger wages bill, such as payroll tax, workers’ compensation insurance premiums, and holiday and long-service leave costs), then commodity prices must rise as long as the money supply is allowed to expand. Workers, in deciding their wage demands, appear increasingly to be recognising the fact that personal income tax not only bites heavily into additional income but, because of the graduated rate schedule, does so with mounting severity the greater the additional income. It is understandable, in these circumstances, that employees should set their wage claims as high as possible, knowing as they do that the real value of their extra pay is going to be eroded not only by the rising prices but also by heavier taxation. Paradoxically, though, the more successful the work force as a whole in securing large wage increases, the more is the real value of extra pay liable to be eaten into by higher marginal tax rates.

6.16. The point is illustrated in Table 6.A. A 25 per cent increase in 1974–75 in the income of the average earner (row 1), if accompanied by similar increases throughout the work force and by a 2.5 per cent growth in national productivity, will mean a rise in consumer prices of the order of 22 per cent. The increase in pre-tax real income will thus be modest (row 2), being confined to growth in productivity. However, because of the considerable expansion in money income, tax payable will rise sharply in the context of an unadjusted rate schedule (rows 3 and 6). Were the 1973–74 schedule still functioning, the real value of the average earner's take-home pay would actually decline (row 5); indeed, had the 1974–75 schedule applied in both years, the decline would be somewhat greater (row 8).




  ― 43 ―

TABLE 6.A: EFFECT OF RISING MONEY INCOMES AND AN UNALTERED PROGRESSIVE INCOME TAX SCHEDULE

                         
1973–74   1974–75   Change 1973–74 to 1974–75  
Per cent 
1.  Average earnings per employed adult male unit  6,136  7,670  +25.0 
2.  Value of average earnings at 1973–74 prices (a)  6,136  6,289  +2.5 
1973–74 rate schedule and dependant allowance provisions  
3.  Tax payable (b)  761  1,202  +58.0 
4.  Take-home pay  5,375  6,468  +20.3 
5.  Value of take-home pay at 1973–74 prices (a)  5,375  5,302  -1.4 
1974–75 rate schedule and dependant allowance provisions  
6.  Tax payable (b)  455  922  +102.6 
7.  Take-home pay  5,681  6,748  +18.8 
8.  Value of take-home pay at 1973–74 prices (a)  5,681  5,531  -2.6 
note  

6.17. It is thus all too clear that tailoring wage demands to allow for the additional tax liability that higher incomes involve, if attempted by all employees, must be self-defeating in the absence of adjustments to the rate schedule or of the acceptance of lower profit margins by business. Nevertheless, particular sections of the work force, viewed in isolation, may be perfectly rational in seeking to maximise their wage demands; for if they are only modest in their demands, while other sections are not, they face the prospect of being made even worse off both absolutely and in relation to the rest of the work force. In the outcome, such inflationary pressures as already exist in the economy tend to be reinforced. Resistance to paying heavier taxation merges with the more basic struggle, adverted to in paragraph 6.9, between different groups in society each seeking a larger share of national income and reacting to the claims of others for a larger share.

6.18. This view of the contribution of personal income tax to the wage-price spiral has intuitive appeal and is beginning to gain many adherents. Empirical studies have yet to establish conclusively that there is a close relationship between changes in income tax, changes in wages, and changes in the general price level: investigations in the United Kingdom and Canada point to a relationship, but the research there is in its early stages and the findings are necessarily tentative. However, the wide publicity now being given to theories of inflation that attach importance to the passing on of personal income tax may in time serve to confirm such theories by bringing home more forcibly to income earners just how significant a bearing high and progressive rates of income tax have on the real value of take-home pay.

6.19. Doubts of other kinds have also been expressed about the efficacy of personal income tax as an anti-inflation device. Exactly how far work effort is inhibited by personal income tax is a matter of conjecture, but to the extent that it is it may tend to accentuate inflation by curbing the supply of goods at a time when demand is rising strongly. The issue is particularly important in relation to overtime work: it was concern on this account that led New Zealand, in 1974, to introduce a special rebate of tax on overtime earnings.




  ― 44 ―

6.20. There is the further point that if unions are now increasingly bargaining in net of tax terms, high and graduated rates of personal income tax may mean greater industrial unrest and strike action as workers attempt to achieve their wage demands, which again will be reflected in the supply of goods coming on the market as well as in the cost of producing them. Strong claims have been made, on the basis of United Kingdom data, for the existence of a relationship between strike activity and taxes.

6.21. Finally, the demand-reducing effects of personal income tax may be weaker than often thought. An increase in personal income tax expected to be only short-lived may do little to restrain personal consumption spending. To the extent that personal consumption depends upon ‘permanent’ rather than current income, the effect of a temporary increase in rates of personal income tax will be to reduce saving rather than consumption. A counter-cyclical increase in personal income tax may thus be ineffective in restricting demand precisely because it is seen to be a temporary stabilising measure. Moreover, in so far as personal income tax reduces the reward for saving and acts as an inducement to consume now rather than later, its efficacy in curbing demand may be further weakened.

6.22. In the conventional view, company tax reduces demand, and hence inflationary pressure, by diminishing company savings and the income of shareholders and thus reducing the rate of spending in both corporate and household sectors. To the extent that tax is shifted forward to consumers, the spending of companies and their shareholders will be less affected, but purchasers of the company's output will find their disposable incomes reduced in real terms. In the latter case, however, raising company tax is likely to exacerbate the wage-price spiral unless the offsetting demand-reducing effects are substantial.

6.23. It has been customary to argue that increases in rates of indirect tax are passed on as once-and-for-all increases in prices and constitute a deflationary measure because of the accompanying decline in the real spending power of consumers. However, the deflationary impact on the demand side may prove weaker than the initial effect on the general price level; furthermore, the price level effect may become embodied in expectations and hence in income claims. In these circumstances the tax increase will lead to cumulative shifting—forward to consumers through firms raising their prices and backward to firms through employees raising their income claims. Like other taxes, therefore, it is by no means certain that an increase in indirect taxation will be effective in reducing inflation; indeed, it could make things worse in some situations. Payroll tax is particularly open to criticism on this account, directly tied as the levy is to the size of an employer's wages bill.

6.24. Understandably, therefore, the view is now being widely canvassed that stabilisation policy in a period of severe inflation should feature tax cuts rather than tax increases, and the Committee can see some merit in this. Tax cuts, if accompanied by appropriate action in such other areas of policy as government spending, money supply, the exchange rate, tariffs and surveillance of prices and incomes, may have at least three attractions:

  • (a) Once inflation becomes at all rapid, the appropriate setting of monetary and exchange rate policies and levels of government spending is likely to be associated with long delays before the effects are seen in a reduction of inflation. Tax cuts may fulfil the useful function of breaking into the wage-price


      ― 45 ―
    spiral and thus of shortening the time-lag involved in applying other more conventional policies.
  • (b) Tax cuts in effect represent a reduction in the income claims of the government sector, which is one of the major groups involved in the struggle over income shares.
  • (c) Tax cuts can be made to serve as a quid pro quo for trade union agreement to moderate wage claims. Employing taxes as part of a ‘social compact’ of this kind inevitably merges with the broader issue, now also attracting much attention, of using the tax system to implement some form of income and prices policy. This warrants closer examination.

6.25. Incomes and prices policies have found favour with many overseas countries, at one time or another, as a means of coping with inflation, though the results have been disappointing especially in the longer-term context. These policies usually involve the setting of guidelines for the growth of national and individual prices and incomes, and the adoption of devices to induce employers and employees to behave in a manner consistent with those guidelines. The inducement devices vary considerably, from moral suasion at the one extreme to legal compulsion at the other. In most countries the central government has had the power to pass legislation to regulate prices and incomes directly, but this is not the case in Australia and perhaps goes some way to explaining why, at least in peacetime, such policies have never been tried here. Lately, however, a number of proposals have been put forward for using the Australian tax system to induce employers and employees to formulate their income claims in conformity with certain national guidelines. This is not the place to debate the merits and shortcomings of incomes and prices policies generally; but it is not inappropriate to comment on particular tax arrangements designed to put pressure on management and labour to behave in certain ways.

6.26. Most of the suggestions in this area involve employing company tax to stiffen the back of the corporate sector in wage negotiations with employees. They include raising the basic company tax rate to, say, 60 per cent and then providing a rebate of perhaps 20 per cent for all companies holding wage increases within prescribed limits; leaving the basic rate unaltered but providing tax relief to firms that keep their wage increases down; and the denial of wage payments, in excess of some norm, as a tax deduction. More sophisticated proposals involve tapering the tax rebates or penalties. An excess profits tax has been canvassed too. Outside the company tax field there has been some support for a penalty rate of personal income tax on all increases in income in excess of a prescribed figure. One suggestion goes so far as setting the penalty rate at 100 per cent.

6.27. There may be constitutional obstacles to tax-penalty schemes of these kinds. Under section 51(ii) of the Constitution, the Commonwealth Parliament has power to make laws ‘with respect to taxation’. It is open to argument that a law purporting to impose differential rates of tax on employers according to their policy on wages or seeking to confiscate wage rises above a certain norm by imposing a marginal tax rate of 100 per cent would not be a law ‘with respect to taxation’ but one imposing wage control.

6.28. As well as constitutional problems, substantial tax shifting might occur, which would defeat the whole purpose of such measures. Indeed, unless the tax penalties were carefully designed, and effective price controls to apply, price might rise even faster than otherwise in circumstances where firms were readily able to shift taxes forward because of the buoyant state of the market and were anxious to avoid becoming


  ― 46 ―
embroiled in protracted industrial disputes. The ability to shift tax penalties is likely to vary markedly in different parts of the economy depending, for example, on the degree of competition from overseas suppliers or from domestic producers not subject to the penalty provisions. Such penalties might therefore prove highly inequitable, even as between firms exposed to penalties.

6.29. The use of the company tax system to restrain wage increases has further shortcomings. It might encourage some companies to assume partnership or trust status to avoid penalties. It might encourage others to change their method of operation, relying more heavily on sub-contractors instead of on their own employees. It could undermine many soundly-based production bonus schemes. It would make it extremely difficult for firms to estimate the effects of the coming into operation of major items of new equipment or the launching of additional products. There would be formidable administrative problems for employers and endless and unproductive argument on the exercise of the many discretions the Commissioner would need to be given to ensure that the scheme will function with some semblance of equity for all taxpayers.

6.30. It is extremely doubtful whether an excess profits tax aimed at inhibiting firms from pushing up their prices would achieve its purpose; it might simply weaken their resolve to hold down costs. Moreover, the problems to be faced in designing a scheme that would be both equitable and administratively feasible are daunting indeed. They were examined in some detail by the Spooner Committee which, in 1950, was asked to look at methods of giving effect to the government's decision, subsequently abandoned, to impose an excess profits tax as an anti-inflation measure.

6.31. There are also likely to be thorny problems in employing a penalty rate of personal income tax to curb wage claims. Persons working overtime or taking on second jobs or securing promotions would have to be accorded special treatment if the system was to be fair and work effort not to be unduly discouraged. Special consideration would also have to be given to persons with fluctuating incomes and to those entering the work force for the first time. There would be a strong inducement to understate income or attribute it to someone else, making the administration of the scheme even more burdensome for the Commissioner. Industrial unrest might intensify.

6.32. In the Committee's view tax penalties of the kinds outlined above are not a feasible proposition. Constitutional difficulties aside, effectively administering such penalties poses many awkward problems and there is no reasonable prospect that the rate of inflation would be held in check.

6.33. As already indicated, however, the Committee is not unsympathetic, in certain circumstances, to employing the opposite technique of tax cuts as part of a properly integrated program to halt inflation. It is particularly relevant in this regard to note the possible introduction soon of a scheme of wage indexation, intended to eliminate the insecurity and uncertainty employees feel about levels of real income and to establish an orderly basis for wage negotiations focusing on changes in productivity. A similar scheme, involving quarterly adjustments of wages by reference to changes in a price index, operated for many years in this country; it was abandoned in 1953 because it was thought to be inflationary.

6.34. The Committee is not in a position to judge the likely impact that the reintroduction of wage indexation would have on the pace of inflation: much would obviously depend on whether incomes were indexed on a percentage basis or in flat terms and on whatever other concurrent measures were taken. But if nothing were done to


  ― 47 ―
counteract price increases already in the pipeline or to moderate wage claims currently under negotiation, wage indexation would almost certainly make inflation worse. This is where tax cuts could perhaps play one useful role. They might serve to reduce the impact on the consumer price index of wage and price increases already in the pipeline, especially if concentrated on excise duties, sales tax and payroll tax which have a fairly immediate impact on the consumer price index. However, any moderating effect that tax cuts might have on the consumer price index, and hence on those wage increases directly tied to consumer prices, would count for little in the longer run if wage indexation failed to exert some downward pressure on wage claims in excess of increases in the cost of living and improvements in productivity. Hence a second function of tax cuts might be to foster a climate more conducive to wage restraint. Thus in so far as employees are increasingly seeking to protect the real value of their take-home pay from the eroding effects of a progressive income tax by bargaining in net-of-tax terms, one might hope that cuts in personal income tax rates would cause employees to moderate their wage demands. But it would be asking too much of the tax system to shore up a wage indexation scheme that was poorly conceived and badly timed.

6.35. In Section II of this chapter, and later in Chapter 14, attention is drawn to the need in times of inflation to adjust tax rates frequently when, in such cases as personal income tax and death duties, rate schedules are progressive. While the case for doing this, at least as far as personal income tax is concerned, may in some measure be to curb wage demands and thus assist in restraining inflation, the main object is to counteract the arbitrary and inequitable restructuring of tax schedules that inflation inevitably produces. In this main object the adjustment may be seen as an attempt not so much to control inflation as to make it more comfortable to live with. In Section II and later chapters attention is also drawn to the way inflation upsets the measurement of the base upon which a tax is levied, and suggestions are put forward for overcoming this problem. These suggestions, too, may be seen as measures to make inflation more comfortable to live with. They are partial expressions of a policy which, in its widest operation, would extend far beyond the tax system and include linking the number of dollars to be delivered on a contract—whether a wage contract, a sale or loan contract, or a pension entitlement—to changes in some specified price index. The Committee is not competent to determine the feasibility of comprehensive indexing along these lines. It would, however, reject the inference sometimes drawn that if a wide enough range of measures is taken to accommodate personal and business circumstances to rising prices, inflation no longer presents problems. Many problems would in fact remain—not least the prospect that inflation may be allowed to accelerate. The community's top priority, in the view of the Committee, must be to reduce inflation.

II. Effects of Inflation on Taxes

6.36. Whatever views are held about the impact of the tax system on inflation, there can be no question that inflation in its turn exerts a powerful influence on the character of the tax system which must be explicitly allowed for in any program of tax reform. This influence manifests itself in a variety of ways. They may conveniently be dealt with under the three headings of tax payment, tax drift and tax base.




  ― 48 ―

Tax Payment

6.37. With inflation, any appreciable delay between tax liability and actual tax payment may produce a not insignificant reduction in the real burden of tax: tax is, in effect, paid in depreciated currency. Unless such delays can be exploited by all taxpayers, inequities will occur. There is of course always an advantage in postponing tax payments as long as possible, but the advantage may be greater with inflation. Expressed another way, any delay in paying tax confers a benefit on the taxpayer unless a realistic rate of interest is charged on the postponed amount; and since nominal interest rates tend to be higher in times of inflation, the advantage of delaying payment is correspondingly greater. For example, present arrangements for paying company tax involve a noticeable time-lag, and the Committee has recommendations to make in this regard in Chapter 22.

6.38. The other side of the coin, where taxpayers find themselves disadvantaged through initially paying too much tax, is perhaps best illustrated by the system of instalment deductions under personal income tax. Most wage and salary earners are obliged to make interest-free loans to the government by way of excessive instalment deductions which are not paid back until after the end of the financial year. In a time of rapid inflation, as at present, both the size of these loans and the rates of interest taxpayers are forgoing by not having the money themselves, tend to rise sharply. This too is discussed in Chapter 22.

Tax Drift

6.39. Where a tax is levied at progressive rates or involves exemptions and deductions that remain unchanged in money terms over a period of years, substantial increases in prices and incomes have the effect of increasing tax receipts particularly rapidly. One important implication of this phenomenon, perhaps best described as ‘tax drift’, is the possible impetus it gives to inflation as wage earners find it necessary to pitch their income demands ever higher in a vain effort to compensate for the larger tax bite. Some of its other implications must also be considered.

Total Tax Receipts

6.40 In so far as tax drift applies to a major segment of the tax system, as in fact it does, it is inevitable that tax receipts will rise in relation to gross national product. As the statistics in Chapter 2 indicate, revenue from taxation has increased from 22.2 per cent of gross national product in 1959–60 to 27.7 per cent in 1973–74—in absolute terms an increase from $3,041 million to $13,768 million. 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. 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. But such illusions are unlikely to persist. People are already coming to realise that though their incomes before tax may be rising as fast or faster than prices, their incomes after tax are rising less than they had expected.

Tax Mix

6.41. Since tax drift mainly concerns personal income tax, a further effect of inflation is to increase the proportion of tax revenue attributable to income tax. As recently as 1963–64 personal income tax raised only $1,271 million, or some 32 per cent of all tax revenue; ten years later, in 1973–74, the figure had reached $5,490 million, which is nearly 40 per cent of tax revenue and puts Australia almost at the top among OECD


  ― 49 ―
countries in terms of reliance on personal income tax. It is the Committee's view, already expounded in Chapter 5, that less, not more, reliance should be placed on personal income tax.

Income Tax Rates

6.42 Even were the present trend towards greater reliance on personal income tax thought to be in the right direction, it is unlikely that inflation is achieving the restructuring at the right pace and in the right way. It especially has to be borne in mind that the drift associated with personal income tax does not operate uniformly over the whole income range. The Committee has received numerous submissions on this point and it deserves close examination.

6.43. The 1973–74 rate schedule, now superseded, was a modified version of the one introduced in 1954–55 which, apart from a special levy or rebate in certain years as part of counter-cyclical policy, remained unaltered until 1970–71. In that year, as Table 6.B reveals, reductions of approximately 10 per cent in tax payable on taxable incomes up to $10,000 were made, while reductions in tax payable above that level progressively declined to 4.4 per cent at $20,000 and zero at $32,000. The rate scale was again adjusted in 1972–73 to provide an overall reduction of about 10 per cent in total tax collections but the adjustment was so arranged that the percentage reduction in tax payable decreased as income rose.

TABLE 6.B: PERSONAL RATE SCHEDULE: MARGINAL TAX RATES(a)

                                                                 
Taxable Income   1954–55   1970–71(b)  1973–74   Taxable Income   1974–75(c) 
per cent  per cent  per cent  per cent 
0–200  0.4  0.3  0.2 
201–300  1.3  1.2  0.8 
301–400  2.9  2.7  2.4 
401–500  4.6  4.1  3.8  0–1,000  1.0 
501–600  6.3  5.5  4.9 
601–800  8.3  7.4  6.5 
801–1,000  10.8  9.7  8.2 
1,001–1,200  12.5  11.3  9.8 
1,201–1,400  14.2  12.8  11.3 
1,401–1,600  15.8  14.3  12.7  1,001–2,000  7.0 
1,601–1,800  17.5  15.8  14.1 
1,801–2,000  19.2  17.3  15.4 
2,001–2,400  21.7  19.5  17.2 
2,401–2,800  24.6  22.1  19.6  2,001–3,000  14.0 
2,801–3,200  27.1  24.4  22.0 
3,201–3,600  29.6  26.7  24.4  3,001–4,000  20.0 
3,601–4,000  32.1  28.8  26.8 
4,001–4,800  35.4  31.9  30.3  4,001–5,000  26.0 
4,801–5,600  38.3  34.5  33.3 
5,601–6,400  41.3  37.0  35.7  5,001–6,000  32.0 
6,401–7,200  43.8  39.4  37.9  6,001–7,000  38.0 
7,201–8,000  46.3  41.7  39.9  7,001–8,000  44.0 
8,001–8,800  48.8  43.9  41.8  8,001–10,000  48.0 
8,801–10,000  51.7  46.5  44.1 
10,001–12,000  55.0  50.6  48.2  10,001–12,000  52.0 
12,001–16,000  57.9  56.4  54.6  12,001–16,000  55.0 
16,001–20,000  60.4  62.4  60.3  16,001–20,000  60.0 
20,001–32,000  63.3  66.7  64.0 
32,001–40,000  66.7  66.7  64.0  20,001–40,000  64.0 
40,001 and over  66.7  66.7  66.7  40,001 and over  67.0 
note  




  ― 50 ―

6.44. These changes were partly designed to meet the criticism that in periods of inflation when money incomes are rising rapidly the continued use of the same progressive scale, defined as such scales conventionally are on the basis of money income, produces substantial increases in the ‘burden’ of tax as reflected in average rates of tax.

6.45. The simplest way of depicting this increasing ‘burden’—a burden which, it ought to be stressed, derives ultimately not from inflation but from government spending increasing at a faster rate than gross national product—is to compare the average tax payable in different years on the same ‘real’ income, i.e. on an income which remains unchanged when the inflation component is removed. A set of such real incomes is assembled in Table 6.C. As a comparison of column 6 with column 2 indicates, average rates of tax in 1973–74 were somewhat higher than in 1954–55 at all levels of real income, notwithstanding the cuts made in 1970–71 and 1972–73. In terms of the percentage increase in average rates of tax (columns 4 and 7), the taxpayers whose position has changed most by comparison with their predecessors in 1954–55 are those at the bottom of the scale.

TABLE 6.C: EFFECTS OF INFLATION ON ‘REAL’ INCOME RATE SCHEDULE

                                 
1954–55   1969–70(a)  1973–74   1974–75(b) 
Taxable income (constant real size 1973–74 prices)   Average tax rate   Average tax rate   Increase in average tax rate since 1954–55   Reduction in after-tax income as a result of increase in average tax rate since 1954–55   Average tax rate   Increase in average tax rate since 1954–55   Reduction in after-tax income as a result of increase in average tax rate since 1954–55   Average tax rate   Increase in average tax rate since 1954–55   Reduction in after-tax income as a result of increase in average tax rate since 1954–55  
1   2   3   4   5   6   7   8   9   10   11  
Per cent  Per cent  Per cent  Per cent  Per cent  Per cent  Per cent  Per cent  Per cent  Per cent 
1,500  3.7  6.1  64.9  2.4  6.4  73.0  2.8  3.7  ..(c)  (0.1)(d) 
2,000  5.4  8.1  50.0  2.8  8.4  55.6  3.2  5.7  5.6  0.2 
3,000  8.3  11.8  42.2  3.8  12.0  44.6  4.1  9.4  13.3  1.3 
4,000  10.7  15.0  40.2  4.8  15.2  42.1  5.0  13.1  22.4  2.6 
6,000  15.2  20.6  35.5  6.4  21.0  38.2  6.9  20.4  34.2  6.2 
8,000  19.0  25.0  31.6  7.5  25.3  33.2  7.8  27.0  42.1  9.9 
12,000  25.3  32.0  26.5  9.0  32.1  26.9  9.2  35.7  41.1  13.9 
16,000  30.1  37.4  24.3  10.5  37.7  25.2  10.9  41.4  37.5  16.1 
20,000  34.2  41.5  21.3  11.1  42.2  23.4  12.2  45.8  33.9  17.5 
30,000  41.8  48.0  14.8  10.7  49.5  18.4  13.3  51.8  23.9  17.3 
50,000  49.7  54.6  9.9  9.7  55.8  12.3  12.2  57.7  16.1  15.9 
100,000  57.8  60.7  5.0  6.8  61.3  6.1  8.3  62.4  8.0  10.9 
note note  

6.46. A more satisfactory indicator of the change in tax liability resulting from inflation is the percentage reduction in disposable income (i.e. income after tax) resulting from the change in average rates of tax. This variable is shown in columns 5 and 8 of Table 6.C and, except at high levels, presents the contrary impression to columns 4 and 7. Up to a certain income level 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 does taxable


  ― 51 ―
income. As a result, even though average rates of tax may increase to a greater extent in the lower income ranges, the net effect of inflation as one moves up the income scale is intitially to reduce disposable income after tax by increasing percentage amounts. This reflects the fact that at low incomes, where income tax is a small proportion of income, even a large percentage increase in tax takes only a small part of income. Eventually this trend is reversed. At very high levels the percentage reduction in disposable income, for a given rate change, is considerable.

6.47. It follows that criticisms based on percentage increases in the average rates of taxation claiming that the change in tax liability as a result of inflation is inversely related to taxable income are too simplistic. The changes in the distribution of tax liability as a result of inflation are much more complex than this: all taxpayers face increases in average rates of tax and the disposable incomes of taxpayers with higher taxable incomes are in many cases reduced proportionately more than the disposable incomes of those with lower taxable incomes. Much of the confusion about the distributional effects of changes in the effective rates of income tax as a result of inflation can be attributed to the application of an inappropriate summary measure to what is essentially a complex problem. If anything the pattern of changes in after-tax income as inflation proceeds lends support to a view that people well up the income scale, but not at the top, are relatively hardest hit.

6.48. The 1974–75 rate schedule, summarised in Table 6.B and described more fully at the beginning of Chapter 14, will moderate the effects referred to above only to a limited extent. Average rates of tax have been cut on taxable incomes up to $50,000, the reduction being fairly substantial on taxable incomes below $8,000 but no more than a gesture on taxable incomes above $12,000. Nevertheless, rapid inflation will soon offset these tax advantages, particularly for persons with taxable incomes between $5,500 and $11,000 who now face the prospect of paying noticeably higher marginal rates on any additional income they earn. It is impossible to tell how much tax real incomes of various sizes will attract in 1974–75: it depends on how quickly prices rise in 1974–75. However, Table 6.C has been extended to include figures for 1974–75 showing the tax implications for various levels of real income on the assumption that prices in 1974–75 are 20 per cent higher than in 1973–74. A comparison of the last three columns of the table with those for 1973–74 suggests that, as far as the tax schedule alone is concerned, all real incomes above about $7,000 (in 1973–74 prices) will face heavier income tax in 1974–75 than in 1973–74. Moreover, should a capital gains tax apply in 1974–75, requiring the inclusion in income of half of any realised capital gains, the taxable incomes of some individuals are going to rise rather faster than otherwise and thus accentuate the tax drift.

6.49. If inflation continues at anything like its present rate, it will be a matter of only two or three years before even the average wage earner finds himself paying taxes at marginal rates of 50 per cent or more. In 1954–55, as Table 6.D reveals, the average male wage earner claiming no deductions was subject to marginal tax at 17.5 per cent. In 1973–74 the marginal tax of his counterpart had risen to 35.7 per cent; and in 1974–75, if average earnings increase in the current year by the extremely conservative estimate of 20 per cent, the figure will be as high as 44.0 per cent. Admittedly, as the final column in the table makes clear, the increase in average earnings over the years is only partly due to inflation: growth in real incomes has also occurred. But as the final column indicates too, increases in average earnings in very recent years predominantly reflect inflation: thus, as much as 79 per cent of the $858 addition to average earnings in 1973–74 was matched by higher prices, the largest percentage for many years.




  ― 52 ―

TABLE 6.D: TAX ON AVERAGE EARNINGS PER EMPLOYED MALE UNIT, 1954–55 TO 1973–74(a)

                                             
Year   Average earnings   Total tax   Average tax rate   Marginal tax rate   Inflation component of increase in average earnings(b) 
$ per annum  per cent  per cent  per cent 
1954–55  1,799  173  9.7  17.5 
1955–56  1,924  197  10.3  19.2  59 
1956–57  2,012  215  10.7  21.7  (h) 
1957–58  2,070  227  11.0  21.7  34 
1958–59  2,132  241  11.3  21.7  53 
1959–60(c)  2,304  264  11.5  20.6  31 
1960–61  2,413  302  12.5  24.6  87 
1961–62(c)  2,475  301  12.2  23.4  19 
1962–63(c)  2,543  317  12.5  23.4 
1963–64(c)  2,678  349  13.0  23.4  17 
1964–65  2,876  418  14.5  27.1  51 
1965–66(d)  3,011  466  15.5  27.8  77 
1966–67(d)  3,219  554  17.2  30.3  39 
1967–68(d)  3,406  580  17.0  30.3  57 
1968–69(d)  3,661  659  18.0  32.9  35 
1969–70(d)  3,968  760  19.2  32.9  38 
1970–71(e)  4,410  828  18.8  32.7  43 
1971–72(f)  4,836  986  20.4  36.0  70 
1972–73(g)  5,278  1,009  19.1  33.3  66 
1973–74  6,136  1,308  21.3  35.7  79 
note  

6.50. Evidence of a different kind pointing to the same conclusion is presented in Table 6.E. In less than a decade the percentage of taxpayers with net incomes above $6,000 has risen from 4 per cent to nearly 16 per cent. Even within the space of a single year, according to the 1970–71 and 1971–72 figures, the change is striking—and will certainly prove yet more striking in 1972–73 and 1973–74 when statistics for those years become available.

TABLE 6.E: PERCENTAGE OF INDIVIDUAL TAXPAYERS WITH NET INCOME IN EXCESS OF $3,000, $6,000 AND $10,000

             
1963–64   1970–71   1971–72  
Net income (a) in excess of   Males   Total   Males   Total   Males   Total  
$ per annum  per cent  per cent  per cent  per cent  per cent  per cent 
3,000  32.0  24.8  71.6  54.1  76.6  60.2 
6,000  4.9  4.0  16.1  11.5  22.0  15.7 
10,000  1.4  1.1  3.1  2.3  4.3  3.1 
note  

6.51. If the rate schedule is to be protected from the distorting and eroding effects of inflation, whether on grounds of fairness or to induce people to moderate their demand for higher incomes, it will need to be adjusted more comprehensively than was done in 1974–75. To ensure that the percentage of taxable income going in tax is properly cushioned against inflation at all income levels, the width of marginal tax brackets must be increased regularly in line with changes in the general price level. Frequent adjustment of the rate schedule and the manner in which it might be done are considered at greater length in Chapter 14.




  ― 53 ―

Concessional Allowances

6.52. Another aspect of tax drift relates to the complaint that adjustments to dependant allowances under personal income tax have not kept pace with inflation and that, in consequence, the real value of these allowances has been seriously eroded.

6.53. That this is a valid complaint may be illustrated in terms of a taxpayer with wholly dependent wife and two dependent children. In 1954–55 such a taxpayer would have qualified for a $520 deduction from net income for his dependants. Had the size of the deduction been fully adjusted for inflation, it would by 1973–74 have amounted to $1,030—almost exactly twice the earlier figure, the consumer price index having practically doubled in the meantime. In actual fact, the deduction in 1973–74 was $832, only 80.8 per cent of what it would have been if fully hedged against inflation. Table 6.F shows, for selected net incomes, how in 1973–74 a taxpayer with wife and two children was penalised by the deduction being $832 rather than $1,030.

TABLE 6.F: DEDUCTIONS FOR DEPENDANTS 1973–74: EFFECT OF FAILURE TO ADJUST FULLY FOR INFLATION

                           
Tax as proportion of net income, assuming  
Net income   $832 deduction(a)  $1,030 deduction(b)  Additional tax saving if deduction $1,030 rather than $832  
per cent  per cent 
2,500  4.8  3.7  26 
3,000  6.6  5.4  32 
4,000  9.9  8.8  43 
6,000  16.2  15.1  66 
8,000  21.2  20.2  75 
12,000  28.8  28.0  96 
16,000  34.9  34.2  108 
20,000  39.7  39.1  119 
30,000  47.7  47.3  126 
50,000  54.7  54.5  132 
note  

6.54. The extent to which the dependant allowance for wife and two children, after adjusting for inflation, has fallen short of the 1954–55 allowance varies considerably from year to year depending on the size and timing of increases in allowances and the rate of inflation. This is apparent from the first column in Table 6.G. Since the late 1950s, however, there has invariably been a substantial short-fall, even in 1967–68 and 1972–73 when dependant allowances were adjusted. Moreover, because inflation has been so severe recently, the short-fall in 1973–74 was almost as great as it has ever been.

6.55. It is clear from the remaining columns of Table 6.G that the several categories of dependant allowances have been affected differently. In 1973–74 the spouse allowance was 70.7 per cent of the adjusted 1954–55 figure, the first-child allowance 84.3 per cent, while the allowance for other children was fully adjusted for inflation. In 1957–58, 1967–68 and 1972–73, all three categories were raised by identical amounts ($26 on the first two occasions and $52 on the last); but since the spouse allowance was the largest to start with and the other-children allowance the smallest, the percentage increases in allowances have inevitably been greatest for other children and least for spouse.




  ― 54 ―

TABLE 6.G: VALUE OF DEPENDANT ALLOWANCES, 1955–56 TO 1973–74, AS PERCENTAGE OF INFLATION-HEDGED 1954–55 ALLOWANCES

                                             
Percentage of inflation-hedged 1954–55 allowances  
Year   Spouse + 2 children   Spouse   First child   Other children  
per cent  per cent  per cent  per cent 
1955–56  96.1  96.1  96.1  96.1 
1956–57  90.8  90.8  90.8  90.8 
1957–58(a)  103.4  98.9  104.9  112.4 
1958–59  101.8  97.4  103.3  110.6 
1959–60  99.3  95.0  100.7  108.0 
1960–61  95.4  91.3  96.8  103.7 
1961–62  95.0  90.9  96.3  103.3 
1962–63  94.8  90.7  96.1  103.0 
1963–64  93.9  89.9  95.3  102.1 
1964–65  90.5  86.6  91.8  98.4 
1965–66  87.4  83.6  88.7  95.0 
1966–67  85.1  81.4  86.3  92.5 
1967–68(a)  93.1  86.0  95.5  107.4 
1968–69  90.8  83.8  93.1  104.7 
1969–70  87.9  81.2  90.2  101.4 
1970–71  83.9  77.5  86.1  96.8 
1971–72  78.6  72.5  80.6  90.7 
1972–73(a)  91.2  79.8  95.0  114.0 
1973–74  80.8  70.7  84.3  101.0 
note  

6.56. However, the erosion of the real value of the amount deductible from net income must not be confused with the erosion of the real value of tax saving resulting from deductions. As individuals are pushed into higher marginal tax brackets because of inflation, a dependent deduction of given size means larger tax saving in money terms—perhaps larger in real terms too. At the same time, the more fully are tax schedules adjusted for inflation, the lower still will be the real value of tax savings associated with dependant deductions of given size. It is thus important, if tax schedules are going to be regularly altered, to adjust dependant allowances regularly too—more important, indeed, than if tax rates are not so altered.

6.57. The link between the level of tax rates and the tax saving involved in concessions for dependants would vanish were such concessions to be given as tax rebates rather than as deductions from taxable income. It is thus significant that a special rebate of tax was in fact introduced in the 1974–75 Budget aimed at increasing the value of dependant allowances for persons at the lower end of the income scale. In future a taxpayer whose income is sufficiently low that the tax saving through claiming dependant deductions would be less than 40 per cent of the amount deductible will attract a rebate of tax to bring the tax saving up to 40 per cent. This means that a taxpayer on a marginal rate of, say, 32 per cent who, in the normal course of events, would save $266 in tax as a result of the present $832 concessional deduction for wife and two children, will now also receive a rebate of $66 to lift the tax saving to $332 (40 per cent of $832).

6.58. The rebate will compensate those families most in need for at least some of the recent inflation-induced decline in the value of dependant allowances. It will also tend to cushion the value of dependant allowances, for such families, from the effect of tax cuts—including the cuts introduced in 1974–75 when the rebate comes into effect. But it means that as money incomes continue to expand with inflation, the element of tax saving from moving into a higher tax bracket and thus being able to


  ― 55 ―
claim deductions against higher marginal tax will disappear for persons on low incomes.

6.59. The eroding effect of inflation has been less conspicuous with other concessional deductions since the amount deductible is not restricted in the same way as dependant allowances. Some of these other deductions are open-ended; and in the case of one of the main ones that is not—life insurance and superannuation contributions—the maximum limit has gone up faster than inflation: in 1973–74 the real value of the maximum deduction of $1,200 was 50 per cent greater than in 1954–55, though it is true that the real value of this maximum deduction has fallen by nearly 30 per cent since being raised to $1,200 in 1967–68. What was said in paragraph 6.56 applies to these other deductions too: because the concessions are in the form of deductions from taxable income, the real value of the tax saving has in some measure been protected by taxpayers being pushed into higher tax brackets where the deductions are worth more, and would have been protected even further had tax rates not been cut in 1970–71, 1972–73 and 1974–75.

Estate and gift duties

6.60. Like personal income tax, Federal estate and gift duties are progressive levies. In the absence of offsetting adjustments to the rate scale and to the size of exemptions, duties will bite into estates and gifts with ever increasing severity as rising prices cause money values to become inflated.

6.61. The point is illustrated for estate duty in Table 6.H, though in very oversimplified fashion. No account is taken of death duties levied by the States, which are allowed as a deduction from the value of the estate in computing Federal duty; attention is confined to estates passing wholly to close relatives and unconnected with primary production; and the figures do not reflect the concessional treatment of the matrimonial home introduced in 1974.

TABLE 6.H: AVERAGE RATE OF FEDERAL ESTATE DUTY, 1954–55 AND 1973–74 (a)

                             
Average rate of duty  
1954–55   1973–74  
Value of estate at 1973–74 prices (b)  If no change in rate scale or exemptions since 1954–55   Actual   Change between 1954–55 and 1973–74 (actual)  
1   2   3   4  
Per cent  Per cent  Per cent  Per cent 
20,000  (c)  2.0  0.0  -100.0 
50,000  2.4  7.0  0.8  -66.7 
75,000  5.4  9.5  3.7  -31.5 
100,000  7.0  12.0  7.1  -1.4 
150,000  9.6  17.0  14.4  +50.0 
200,000  12.1  22.0  22.0  +81.8 
300,000  17.1  26.2  26.2  +53.2 
500,000  26.0  26.7  26.7  +2.7 
1,000,000  26.7  27.9  27.9  +4.5 
note  




  ― 56 ―

6.62. As can be seen by comparing columns 1 and 2 of Table 6.H, had no adjustments of any kind been made to the rate scale or to exemptions since 1954–55, average rates of Federal duty on estates of the same real value would by 1973–74 have been higher right across the board; though in the case of very large fortunes already attracting maximum or near-maximum duties as far back as 1954–55, the increase would have been modest.

6.63. While the 1954–55 rate scale still applies—indeed it was introduced as long ago as 1940—the level of exemptions has been adjusted on two occasions: with estates passing wholly to close relatives, the maximum exemption was raised in 1963 from $10,000 to $20,000, and in 1972 from $20,000 to $40,000. These are sizeable increases that more than compensate for inflation; but the exemptions are vanishing ones conferring no benefit on estates above a certain value (currently $20,000 in the case of estates passing wholly to close relatives). It is thus possible, on the basis of columns 1, 3 and 4 of Table 6.H, to identify three categories of estates:

  • (a) Smaller estates, up to a value approaching $100,000 at today's prices, are now in fact burdened with proportionately less duty than in 1954–55 because of more generous exemptions.
  • (b) In the case of very large fortunes (in excess of say $500,000 at today's prices), the fraction going in duty has not been noticeably affected by inflation: in these upper reaches the rate of duty is virtually proportional.
  • (c) The estates to be hit hardest by inflation are those in the $150,000–$300,000 range (at today's prices), being too large to benefit greatly, if at all, from more generous exemptions, yet low enough to attract higher rates of duty as money values rise.

6.64. If the burden of death duties on all estates, and not merely on smaller ones, is to be cushioned against inflation, it is clearly not enough to adjust vanishing exemptions as was done in 1963 and 1972: the rate brackets themselves must be adjusted for rising prices and, if inflation is rapid, must be adjusted quite frequently. Recommendations are made along these lines in Chapter 24 in the context of an integrated estate and gift duty.

Tax Base

6.65. Even in a regime of proportional tax rates or of regularly adjusted progressive schedules, there are still major problems in times of inflation in establishing just what is the proper tax base to which tax rates should apply.

6.66. One of the most important of these problems concerns business income. The effect of inflation on the measurement of business income, more especially for companies engaged in manufacture, has been the subject of intense discussion within the accounting profession and among business management generally for many years now; it has also featured prominently in submissions to the Committee. The fundamental problem is that in periods of inflation profits determined on the basis of conventional historical accounting methods do not reflect ‘true’ profits, which are materially lower. These same methods, when employed in arriving at net income for income tax purposes, can lead to business income being taxed more heavily than intended. When this occurs, the viability of business suffers, ‘true’ retained profits are reduced to below the level needed for continuing operations, and organisations are forced to seek new investment funds which are likely to prove difficult and costly to obtain in a period of tight liquidity.




  ― 57 ―

6.67. For many years certain larger businesses have sought to take some account of inflation in their financial accounts: in arriving at their profits they have deducted charges for the use of their fixed assets calculated by reference to their replacement values and not their historical cost. Also some countries permit methods of valuing trading stocks which allow for the effect of rising prices on profits and on net income for taxation purposes. It is generally agreed that there is urgent need to reconsider financial and tax accounting procedures in periods of high inflation. This is a crucial problem and one for which no generally acceptable solution is currently available. More will be said about it in Chapter 8.

6.68. A further effect of inflation is to highlight the concern felt by many that capital gains should be brought to tax, since such gains become extremely obvious to everyone in periods of rising prices. But inflation also makes the devising of a way of taxing capital gains that much more difficult. If capital gains are made taxable without adequate recognition of the fact that in a period of inflation a considerable proportion of such gains are not ‘real’ but simply an aspect of the change in the general price level, a large element of capital levy will be involved which may not be intended. Table 6.I illustrates just how heavily a 30 per cent capital gains tax that makes no allowance for changes in the value of money will bite into an asset whose money value has merely risen in step with inflation and whose real value has thus remained unaltered. Yet there are major problems, conceptual and practical, in devising a capital gains tax that takes proper account of the distinction between ‘real’ and ‘fictitious’ gains. In the eyes of some, these problems are sufficiently daunting to make it highly inadvisable to consider introducing such a tax during a period of serious inflation. The Committee generally agrees with this view.

TABLE 6.I: EFFECT OF IMPOSING 30 PER CENT CAPITAL GAINS TAX WHERE CAPITAL APPRECIATES AT SAME RATE AS INFLATION

               
Tax as percentage of realised value of asset, (a) where annual rate of increase in general price level is  
Number of years before asset is realised   5 per cent   10 per cent   15 per cent   20 per cent  
1.4  2.7  3.9  5.0 
2.8  5.2  7.3  9.2 
6.5  11.4  15.1  17.9 
10  11.6  18.4  22.6  25.2 
20  18.7  25.6  28.2  29.1 
note  

6.69. Inflation also has implications for the taxation of income from property, particularly fixed-interest income. When prices are rising but interest rates are held down, the real return on fixed-interest assets declines and the real capital value falls too. This raises problems in establishing an equitable tax base that are closely related to the appropriate treatment of business income and capital gains. These problems are briefly considered in Chapter 9.

6.70. What taxing of business income, capital gains and property income have in common that creates special problems in a time of inflation is the necessity of having to compare values of items of property in different years when the unit of measurement—money—has itself altered in value. Similar kinds of problems arise in relation to the integration of money amounts established at different times and will


  ― 58 ―
need to be considered in appropriate context in later chapters of this report. For example, a decline in the value of money means that business losses are worth less later when applied as an offset to income: indeed, most tax provisions for income spreading, of which loss carry-forward is but one, lose much of their conventional rationale in a period of rapid inflation. Again, a decline in the value of money means that gifts made at different times by the one person cannot be regarded as equivalent. The Committee has had to take special account of this in its proposals for an integrated estate and gift duty.

6.71. Where a tax is levied on a base significant components of which do not regularly enter the market and thus require special valuation, inflation poses added problems since values will quickly date. Thus one reason for the Committee's rejection of a wealth tax, as explained in Chapter 26, is the formidable administrative burden and cost to the taxpayer that would be involved in regularly revaluing such assets as freehold property and the inequities that would arise if regular revaluation were not in fact undertaken.

Need for Further Investigation

6.72. The variety of distorting and confusing ways in which inflation impinges on the tax system considerably complicates the task of tax reform. The setting up recently of an independent panel to inquire into the effects of rapid inflation on personal and company taxation payments is some indication of the concern felt by the Government in this regard. While the Committee has had inflation very much in mind in formulating its recommendations in later chapters, it acknowledges the need for intensive study of the implications of inflation for the tax system beyond what it has been possible to attempt in this report.




  ― 59 ―

7. Chapter 7 Income Tax: The Base

7.1. ‘Income’, as the starting-point for the formal legal structure of income taxation of persons, companies and other entities, is surrounded with problems of definition. The aims of this chapter are to clarify these, to suggest a logical framework into which some of the problems discussed in this and later chapters can be fitted, and to deal with specific issues of definition of general relevance. Specific issues relating peculiarly to business and professional income, and to employment income and investment income are dealt with separately in later chapters.

I. Problems of Definition

7.2. In the language of the present law, income tax is levied on ‘taxable income’, which is income in the meaning of the law (other than exempt income) derived during a period, normally one year, less (i) expenses in deriving that income and (ii) a number of other deductions reflecting equity considerations and particular social and economic policies. The phrase ‘net income’ is here adopted to refer to income less the first of these deductions, but before the second are subtracted.

The Concept of Income

7.3. The legal meaning of income is drawn very largely from judicial decisions— many of them borrowed from the United Kingdom—extended and refined by specific provisions. The primary characteristic of the tax law's approach has been to express what the word may be taken to mean in ordinary English usage. Some basic notions underlie the meaning. One of these is the idea of gains (in some contexts a receipt, in others a profit) from the carrying on of organised activity—an employment, a business or profession, or a business deal—directed to the making of gains. Another is the idea of gains derived from property which leave the property intact—a fruit of the tree as distinct from the tree itself. A third is the idea of compensation which substitutes for gains that would have been income. A fourth is the idea of gains periodically received. None of the ideas is sharp in its outlines, least of all the third and fourth. Thus compensation which substitutes for gains that would have been income must be distinguished from compensation for an asset that would have produced such gains. Gains periodically received must be distinguished from receipts of a fixed sum by instalments.

7.4. For analysis in terms of economic principles in which theory comes first and practicalities are wrestled with later, economists have sought a primary definition of income in any period that is a measure of the flow of an individual's actual and potential satisfactions. One of the most thorough-going efforts to this end is that associated with the American economist Henry Simons whose Personal Income Taxation, published in 1938, has had great influence in academic debate. That formulation centres upon ‘increases in economic power’ to command satisfactions.

7.5 The economists' definition would in general include in income all of the gains that the law includes: salary and wages; profits from a business or profession or business deal; interest, rent, dividends; compensation for income; and periodical receipts. But it also covers a great many gains that would probably not be reckoned as income in ordinary English usage, and have not been brought in, or have been brought in


  ― 60 ―
only to a very limited extent, by judicial and legislative extensions and refinements of that usage. The comprehensive tax base would include:

  • (a) capital gains: gains from the realisation of property, when the realisation is not an aspect of the carrying on of a business or a profession, or the carrying out of a business deal;
  • (b) bequests and gifts received;
  • (c) lottery and casual gambling winnings;
  • (d) retirement benefits and compensation for loss of office;
  • (e) compensation for physical injury to person received in a lump sum or for injury to reputation; and
  • (f) non-money income.

Some comment on each of these is called for.

7.6. Except to a limited extent resulting from the provisions of sections 26 (a) and 26AAA of the Income Tax Assessment Act, which define the base to include gains from the sale of property acquired for the purpose of profit-making by sale and gains made within a period of twelve months, capital gains (as defined in paragraph 7.5) are not included in the present base, though the introduction of a tax on such gains has been announced. The Committee's recommendations for the taxing of capital gains are set out in Chapter 23.

7.7 The present base does not include bequests and gifts received except where the receipt is one of a number received periodically, for example an annuity, or where, in the case of a gift, it is included as salary or wages or as a business gain or a gain from a profession. In Chapter 24 the Committee rejects the possible extension of the income tax base to include all bequests and gifts and proposes the continued taxation of property the subject of bequests and gifts on a separate basis.

7.8. Lottery and casual gambling winnings are not infrequently described as ‘windfall gains’, though the phrase has no very precise meaning. It suggests gains that are more or less unexpected. A quality of unexpectedness also belongs to some capital gains, but the Committee takes the view that this is not an argument for freeing capital gains from tax. However, taxing lottery and casual gambling winnings raises awkward problems, some of them administrative, others concerned with the deductions that should be allowed. There would be difficulties of enforcing the law with respect to casual gambling winnings. The problems associated with the allowance of deductions may be illustrated by asking how one would deal with the coins fed into a poker-machine. The Committee has no proposal to extend the tax base to include lottery and casual gambling winnings.

7.9. Retirement benefits and compensation for loss of office which are not periodically received are by an express provision included in the present base only to the extent of 5 per cent of the amounts involved. Were it not for this provision, a retirement benefit would be wholly included as a gain from an employment, while compensation for loss of office received in a lump sum—sometimes called a ‘golden handshake’—would be wholly excluded. Such compensation might be treated as embodying a capital gain if the notion of ‘property’ for the purpose of bringing capital gains to tax were broadened to include an office. Alternatively, it might be regarded as a substitute for salary which would have been earned and thus income. If any change is to be made in the existing law there is much to be said for treating retirement benefits and compensation for loss of office in identical fashion. Moreover,


  ― 61 ―
the best way of dealing with these receipts depends quite crucially on how the tax law treats superannuation benefits and life insurance proceeds, and the matter is further considered in Chapter 21.

7.10. Compensation for physical injury to person received in a lump sum or for injury to reputation is not at present included in the income base. In theory the compensation could be regarded as embodying a capital gain if the notion of property were made wide enough to extend to human capital. It would, however, be impossible to identify the gain, since the cost of acquiring human capital cannot readily be ascertained. Some of the compensation may be in respect of income already lost and in respect of a loss of capacity to earn income in the future, in which cases it could be regarded as a substitute for the income that would have been earned. To this extent, at least, it might be thought appropriate to include it in the base. If compensation is received in the form of periodical payments, it will be income as received, whether given for lost income or some other aspect of the taxpayer's loss. These matters are further considered in paragraphs 7.34–7.41.

7.11. The major item of non-money income currently omitted from the income base is imputed rent of the owner-occupied home. This omission is discussed later in paragraphs 7.42–7.57. But houses are not the only form of property that may yield flows of satisfaction to which imputed income might be attached. Works of art and consumer durables in general are other obvious examples. Inclusion in the tax base of imputed income from these latter items of property would of course involve great administrative problems, and is not proposed.

7.12. Goods produced for one's own consumption or services performed for oneself are currently excluded from the income base. Whatever the case in economic theory for their taxation, it would be administratively impracticable and the Committee has no proposals to change the present position.

7.13. Other instances of non-money income that would be included in the comprehensive tax base may be found in the fringe benefits an employee receives from his employer. The gain may be in the form of goods received, services received, relief from an obligation that would ordinarily have been incurred or valuable rights.

7.14. The general rule of the income tax law is that a gain must be valued by reference to the amount of money that could be obtained for it. On this principle of valuation, a made-to-measure suit is likely to be valued at the price it would bring as a second-hand suit. A service one receives from another, such as the use of a motor-car or a residence available only to oneself or free holiday travel as an airline employee, has no value. Similarly the relief from the payment of interest enjoyed by a person who has an interest-free loan has no value; nor has a person's right to take up shares in a company, if not assignable, unless there is a way in which he can make the benefit of the right available to somebody else.

7.15. This general rule is, however, qualified in important respects by section 26 (e) of the Act, but only in relation to income gains that are rewards for services rendered. This provision substitutes ‘the value to the taxpayer’ for the test of value under the general rule. The special rule certainly limits the tax-planning possibilities opened up by the general provision, but its operation is not entirely clear. It has not prevented the offering and accepting of fringe benefits in substitution for cash, under employment contracts. Some of these benefits are certainly taxed; but to the extent that they are valued for income tax purposes below what would be paid for them in cash outside the income-producing relationship, the equity of the tax system is seriously affected.




  ― 62 ―

There may be a form of collusion between employer and employee by their splitting the saving of tax that attends a full deduction to the employer of the cost of providing the benefit and a lesser amount being included in the income of the employee. There is, however, no easy solution to the problem of making adequate provision. In many instances, the fringe benefit is so interwoven with the normal performance of the services for which the fringe benefit is a reward that the element of gain may be very difficult to identify. The commonplace illustration is the use of a motor-car for both employment and personal purposes. The question of the taxation of fringe benefits is explored in Chapter 9.

Deduction of Expenses

Expenses Incurred in Deriving Income

7.16. Besides questions of what should or should not be included in income, a host of problems arise over the identification and measurement of the expenses incurred in deriving income that have to be deducted before a figure for net income is reached. It is common to both the existing tax law and to the theory of a comprehensive tax base that such deductions be made.

7.17. A prime problem here is to achieve a practical application of the distinction between an expense in deriving income (which gives rise to a deduction) and consumption expenditure (which should not unless by some special concessional provision). Some expenses, such as for entertainment and travel discussed in Chapter 9, often involve elements of both. Drawing the distinction becomes very subtle when, for example, equipment is used which, in its luxuriousness, exceeds the commercial needs of business: as, for example, when an expensive car is employed where a more modest vehicle would serve just as well.

7.18. Very important areas of controversy arise over costs of travel to and from work and child-minding expenses. These are not now regarded as expenses of deriving income, though it is often argued that they should be. They are further examined in paragraphs 7.58–7.75. Extended to its logical conclusion, the argument leads to a notion of expense in deriving income that would include almost all personal expenditure, even that on food and clothing, in which event the income tax base would largely disappear.

7.19. Expenses in deriving income include the depreciation or amortisation of investment expenditure on assets that deteriorate through use. Issues that arise in relation to the deduction of this expenditure are considered in Chapter 8.

7.20. Certain expenses that would not usually be thought of as consumption expenditure or investment expenditure on non-deteriorating assets are denied deduction. Examples are the cost of moving business operations or of moving home to a new place of work: the cost does not relate wholly to current income, and there is no obvious asset to which depreciation might be applied. These expenses are considered in Chapters 8 and 9.

Other Deductible Expenses

7.21. From ‘net income’ as the term is used here the tax law authorises a whole series of further deductions before the taxable income is reached to which the prescribed rate scale is applied and liability determined. These are generally known as concessional deductions and for the most part are so called in the Act. They include dependant allowances, medical and education expenses, zone allowances, life


  ― 63 ―
insurance and superannuation premiums, and gifts to charities. They primarily reflect considerations of equity as well as particular social and economic policies. They are discussed in Chapters 12, 21 and 25.

Exempt Income

7.22. The income base is qualified by a number of express exemptions. Some of these are aspects of the taxation of foreign income and of the income of non-resident taxpayers dealt with in Chapter 17. Others may accord special treatment to particular industries and activities and are discussed in Chapters 19, 20 and 25. Questions of equity are raised by the exemption of child endowment and some scholarships and pensions. The possible inclusion in the tax base of child endowment, scholarships and pensions, where they are grants by government, is considered in Chapters 12 and 13. Receipts of alimony are usually exempt. As a correlative of this there is no deduction for their payment: the equity of this arrangement is discussed in Chapter 10.

Annual Accounting

7.23. The income tax base, like the comprehensive tax base, relates to a selected period. For the income tax base the period of account is normally one year and is referred to as the year of income.

7.24. Where the income is that of an individual and the rate structure is progressive, any unevenness, or bunching, of the amounts of income derived in different years will result in more tax being payable than would be the case if a longer period of account were adopted. The present law has some provisions directed to overcoming the consequences of bunching. Averaging of income is allowed to primary producers and special provisions having a similar effect apply to authors and inventors. These illustrations of averaging are examined in Chapters 14 and 18. There would be administrative and compliance costs in the wider application of averaging: the wider application of averaging is considered in Chapter 14.

7.25. A strict application of annual accounting would work unfairly where a loss has been suffered for a year. Subject to some limitations, the present law allows a loss in one year to be applied to reduce net income of a later year, though not the net income of an earlier year. The treatment of losses is analysed in Chapters 8 and 16.

7.26. Under a system of annual accounting the timing of an income gain or expense in deriving income will affect the amount of net income. The questions, in the language of the law, are when an income gain is ‘derived’ and when an expense is ‘incurred’. Derivation and incurring, in turn, depend on the method of accounting, cash or accruals, held appropriate to the income. Broadly, cash accounting involves actual receipt and actual payment. Accruals accounting involves entitlement to receive and obligation to pay. There are problems as to what is a sufficient right to receive or a sufficient obligation to pay under the accruals method, for example whether a provision for long-service leave in the accounts of a business is an expense. These matters are considered in Chapter 8.

Income of Particular Industries and Activities

7.27. The present law contains a number of special provisions that affect net income arising from the conduct of particular industries and activities or the tax payable in relation to them; and the operation of the general provisions poses special problems in relation to these and other industries and activities. In certain instances, incentives


  ― 64 ―
are given through exemption of income receipts and favourable treatment of expenses. Various industries and activities, including primary production, mining, superannuation and life insurance, and general insurance, are examined individually in a series of later chapters.

Income Moving Through Intermediaries

7.28. The determination of net income as explained in this chapter is the primary step in ascertaining the amount of income on which tax is levied, whether the income is that of an individual, a trust estate, a partnership or a company.

7.29. A trust estate has income and may be a taxable entity distinct from its beneficiary. Where there is a beneficiary presently entitled to the income, the income is taxed to the beneficiary; though where the beneficiary is a child, the tax may in effect be paid for him by the trustee. Where, however, there is no beneficiary presently entitled, the income is taxed to the trustee as if it were the income of an individual or, in some circumstances, at a special rate of 50 per cent.

7.30. A partnership has income but the income is treated as income of its members in accordance with their interests in the partnership. A partnership is not a taxable entity distinct from its members.

7.31. The taxation of trusts and partnerships is considered in Chapter 15.

7.32. The income of a company is taxed to the company and is taxed again to shareholders when distributed to them. This system is examined in Chapter 16.

International Aspects

7.33. In general, the bases of Australia's jurisdiction to tax income are residence of the taxpayer and source of the income. Foreign-source income of a non-resident is beyond that jurisdiction. International aspects are referred to in a number of chapters, more especially in Chapter 15 in relation to trusts and partnerships, Chapter 16 in relation to companies, and Chapter 17 where issues of general application are considered.

II. Specific Issues

Compensation for Physical Injury to the Person

7.34. Compensation in a lump sum for personal injury is not included in income. The compensation is a composite receipt of a number of elements. These may include income already lost as a result of the injury, capacity to earn income in the future, pain and suffering and diminished expectation of life. Except perhaps for the first, none of the elements has an income character, whether by virtue of the ordinary usage of the word or the specific provision in section 26 (j) dealing with receipts by way of insurance or indemnity. Compensation for income already lost is income, but it is arguable that there is no such element in the compensation receipt: so far as the amount of compensation takes account of income already lost, this is only for the purpose of determining the amount of the loss of capacity to earn that resulted from the injury. The resolution of the question is, for the present, unlikely, because of the difficulties placed by the present law in the way of dissecting or apportioning composite receipts. These difficulties are considered later in paragraphs 7.101–7.102.




  ― 65 ―

7.35. So long as compensation received in a lump sum for personal injury is not included in income, the amount of compensation given by the Courts in personal injury cases will continue to be calculated on the basis that what has been lost as a result of the impairment of capacity to earn is the present value of what would have been earned less the present value of the tax that would have been paid on that amount. This results from the application of the principle in Gourley's Case.note The Court in applying the principle must estimate the deductions and concessions likely to have been available to the injured person and, presumably, what he might have done by way of tax planning to minimise his tax liability. The principle is sometimes criticised on the ground that the person who caused the injury receives a benefit at the expense of all other taxpayers who must make up the loss to revenue. The Committee does not see the matter in these terms, involving as they do notions of ensuring a full penalty for his wrongs on the person who caused the injury which, in the conditions of compulsory insurance of motor vehicle and industrial accident liabilities, are inappropriate. However, the Committee does not regard the application of the principle as sufficient in itself to justify the exemption of lump-sum receipts from tax. It is not intended as a substitute for tax: it is rather a consequence of the absence of tax. Moreover, the application of the principle cannot be precise even when a case comes to trial. There is no way of assessing the significance of the principle in out-of-Court settlements.

7.36. Where compensation for personal injury is received in a series of periodical payments, the amounts received are included in income without regard to whether they are for lost earnings, for loss of earning capacity or for pain and suffering. Thus periodical payments of workers’ compensation are included in income. There are, therefore, important tax implications in the recent proposal of the Committee of Inquiry into Compensation and Rehabilitation in Australia, that injury and sickness compensation be universally paid in periodical amounts. The Bill currently before Parliament preserves to some extent the system of lump-sum awards, but their role in compensation for physical injury has been significantly reduced.

7.37. The continuing exclusion from income of compensation for physical injury must rest primarily on the importance of the element of non-economic loss reflected in the compensation. Whatever the theory of the comprehensive tax base may suggest, it would be a significant departure from accepted ideas to include in income amounts received which are in respect of physical suffering and disability as distinct from being for the reduced capacity of a person to earn which may attend that suffering and disability.

7.38. If it were sought to separate the element of compensation for non-economic loss and to tax the remainder, this could only be done by some arbitrary apportionment. The award of damages by a Court or the award of a lump sum under workers’ compensation will not show the breakdown; and a lump sum payable under an accident insurance policy is expressed simply as an amount of money.

7.39. The taxing of that part of the compensation apportioned to the element representing a substitute for income would lead, in the case of compensation assessed by a Court or tribunal, to a considerable increase in the level of awards. Gourley's Case would no longer apply and awards would be made on predictions about the gross income of the injured person.




  ― 66 ―

[?] Committee for these reasons does not propose any change in the present [?] tax receipts of compensation for physical injury.

Compensation for Injury to Reputation

[?] compensation for injury to reputation is also a composite receipt covering a [?] of elements. Some of these are concerned with income that would have been [?] with the feelings of the person injured. The compensation is invariably in the form of a lump sum. In the Committee's view there is no ground for distinguishing such compensation from compensation for injury to the person, and it proposes that it too be excluded from income.

Imputed Rent of the Owner-Occupied Home

7.42. At present one very large item of non-money income—imputed rent of the owner-occupied home—is omitted from the income base and thereby escapes tax altogether. This has not always been so. In the earliest years of Federal income tax, from 1915 to 1923, 5 per cent of the capital value of an owner-occupied residence was included in assessable income; deductions were allowed against this amount for expenses by way of repairs, rates and land taxes, and mortgage interest. In 1923, however, the provision for including imputed rent was discontinued; repairs and mortgage interest became non-deductible, but the owner-occupier was still permitted a tax deduction for rates and land taxes. This remains the situation today, with two qualifications. In 1973 a ceiling of $300 was placed on the amount of rates and land taxes an owner-occupier might deduct, and the deduction was henceforth to be confined to a principal place of residence. More recently a scheme has been introduced, restricted to home-purchasers in the lower and middle income ranges, making some portion of interest paid on home loans tax deductible. Where the combined actual income of husband and wife is $4,000 or less, the whole of interest paid on a principal residence is deductible. On incomes above $4,000 the deduction is reduced by 1 per cent for each $100 of the excess, disappearing altogether when income reaches $14,000.

7.43. Only a few countries, including West Germany and Sweden, treat the rental value of the taxpayer's own home as income for tax purposes. In West Germany, for example, the basis of valuation varies between one-family homes and other types of housing. For one-family homes, 3 or 3½ per cent of the assessed value is used (depending on the date of erection) to determine the rental value; for other types of housing, a rental value is established by comparison with the market rental value of dwellings of equivalent standard. Deductions are allowed for mortgage interest, taxes on real property, depreciation, repairs and maintenance, and insurance.

7.44. The arguments for imputation merit some consideration though, as will appear, the Committee does not propose to recommend that imputed rent be taxed. A substantial inequity between home-owners and tenants is involved under the present Australian system. And though a case can perhaps be made for treating home-ownership specially favourably on the grounds that widespread ownership is socially desirable and good housing benefits the whole community, it is questionable whether exempting imputed rent is an appropriate way of encouraging home-ownership. For one thing, low-income tenants are exluded from the benefits of non-imputation; for another, home-purchasers may in fact be made worse off because of the higher prices they must pay for their homes in the face of greater public demand for housing.

7.45. If imputed rent is to be taxed, the amount subject to tax can be calculated in one of two ways:




  ― 67 ―

  • (a) The first way involves the determination of the gross rental value of the home. From this repairs, depreciation, and local rates are deducted to arrive at a figure representing net rental value. A further deduction of interest on money borrowed and invested in the home is then made in order to establish the net rental of the owner's equity. This is the amount subject to tax.
  • (b) The second way avoids some of the complexities of the first, though, in the result, it involves elements of arbitrariness. A percentage of the capital value of the home is assumed to be the net rental value. Interest on money borrowed is then deducted and the residual is the amount subject to tax.

Whichever method is adopted there is the prospect, especially when borrowing has been made at a high interest rate, that the imputed rent will be a negative figure.

7.46. However the calculation is done the taxing of imputed rent is open to two major criticisms, one concerned with hardship for some taxpayers, the other with administration.

7.47. Where the owner's equity in his home is substantial, a considerable amount of non-cash income could well be involved. In times of high interest rates, annual imputed rent on a house with a capital value of $40,000 may amount to $4,000. If this is added to a retired person's investment income of, say, $6,000 and the total amount of $10,000 is taxed, hardship may result. The inclusion of imputed income in the income tax base will, it is true, make possible some reduction in rates of tax, but the reduction may not be enough to obviate hardship in many cases. One could visualise similar difficulties arising for other classes of taxpayers: for example, a widow with young children may have been left the family home, now freed of mortgage by the proceeds of an insurance policy taken out by her husband, but she may have only modest cash income and few other assets.

7.48. Employee taxpayers with imputed rent, whose employment income is subject to the system of collecting tax by instalment, would not be as conscious of the hardship if the taxing of imputed rent were keyed in some way into the instalment system. There will be administrative problems in doing this; but if it were not done and employees had to pay tax on assessments, the system of collecting tax by instalments would be seriously weakened.

7.49. The adoption of the second way of calculating imputed rent avoids some administrative difficulties at the cost of a certain degree of arbitrariness. But the difficulties inhering in the determination of capital value in the second way are no less than the difficulties of determining gross rental value in the first. Both ways involve defining and applying principles for determining whether money borrowed has been invested in the home.

7.50. Either way poses administrative problems in that it creates a demand for valuation services, a need for a verifiable record of valuation that the taxpayer may quote in his tax return, and a mechanism by which the taxpayer may contest that valuation. The existing State valuation services throughout Australia provide valuation information on a variety of bases. But the information collected is not always relevant or consistent. In New South Wales, for example, the Valuer-General values only the unimproved capital value of residential land: the provision of both improved capital value and assessed annual value was discontinued in 1973. By contrast, the Victorian system employs both net annual value and unimproved capital value. A further problem is the revision of valuations over time—not necessarily annually—to ensure they reflect current market values.




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7.51. If the first way of calculating imputed rent is preferred, there would be administrative problems in regard to depreciation allowances and repairs. The problems of depreciation allowances and deductions for repairs are considered in wider context in Chapter 8.

7.52. Difficult problems arise when interest, to be deductible, must be shown to be related to a particular kind of income. Taxing imputed rent would multiply the occasions when these problems have to be resolved. The availability of a deduction of interest would open up avenues of tax planning for the well-advised who will consolidate their debts into the borrowing for home finance.

7.53. The Committee recognises the arguments for including imputed rent in the tax base; but having regard especially to the administrative difficulties it is not prepared to recommend a change in the law to this end.

7.54. The Committee does however propose that the deduction for rates and land taxes, now limited by amendments in 1973, be further reduced and eventually abolished. It is a relic of the time when imputed rent was included in the income tax base. No doubt the availability of the deduction is of some financial benefit to local governments in providing an indirect form of Federal financial assistance. However, the Australian Government is already making direct grants to local governments, and any revenue difficulties for these governments arising from the abolition of the deduction could be dealt with by extending such grants.

7.55. The Committee also proposes that the recently introduced deduction of interest on home loans be discontinued. Allowing such a deduction accentuates the inequity resulting from the failure to tax imputed rent. There is, indeed, some irony in this: the reason given in paragraph 7.52 for not taxing imputed rent is the complexity involved in the allowing of a deduction for interest on a home loan and the opportunities for tax planning to which it gives rise.

7.56. If the deduction for rates and land taxes were abolished, some of the tax advantage owner-occupiers have over tenants would disappear. The advantage might be reduced still further if a deduction were allowed to tenants for some part of the rent they pay. The allowance of such a deduction would be novel: so far as the Committee is aware, a concession of this kind is available only in Columbia. Because of the limit on deductibility, the advantage would generally remain with the owner-occupier; though where because of interest payments imputed rent is a negative amount, the advantage would move to the tenant.

7.57. The Committee has not explored in detail the administrative feasibility of a rent deduction but considers it worthy of serious examination. The amount of the rent deduction would seek to express the net rent element in what is paid by the taxpayer. It would be necessary of course to proceed by way of allowing a fraction of the rent paid, since the taxpayer would not be in a position to know the expenses incurred by the landlord. A ceiling would need to be placed on the amount deductible, perhaps related to the number of persons dependent on the taxpayer and living with him: the Committee would not wish to encourage the over-consumption of housing further than may be inherent in the continued exemption of imputed rent. There would, it is true, be difficulty in separating out a payment for rent in a composite payment for provision of rent and services: for example, where the accommodation is a serviced flat or where lodging and board are involved. However, the ceiling on the amount deductible might justify ignoring the element of service.




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Cost of Travel to and from Work

7.58. The present law, in general, denies a deduction of expenses of travel between home and work. In some circumstances, however, costs of travelling between home and work are regarded as expenses in deriving income and thus deductible. The principle applied in these circumstances requires that the home be in some sense a base of income-earning operations so that the travel can be regarded as travel between bases of operation. The application of the principle is not always clear and consistent, more especially where the bases of operation are aspects of different income-earning activities: the taxpayer may conduct his own business at home and also travel to a base of operations where he is an employee. The application of the principle is obscure where the taxpayer is, for example, a building worker: it is inappropriate to speak of him as having a base of income-earning operations, since his place of work may vary from day to day. The application of the principle may at times appear generous to the self-employed taxpayer where, for instance, he uses his own car in his business or profession. If the denial of a general deduction is to continue, a stricter definition and application of the law as to those costs of travelling between home and work which are to be regarded as expenses in deriving income would seem to be indicated.

7.59. In denying a deduction of expenses of travelling between home and work, the present law treats them as a form of consumption. Arguably they ought not to be so treated, since they are a prerequisite to the earning of income. But the same could be said of many other expenses whose deduction is currently denied, such as outlay on basic food, clothing and shelter. In the Committee's view a general deduction for expenses of travelling between home and work can only be justified as a concession.

7.60. A general deduction is denied in the United Kingdom and other English-speaking countries. There is however a deduction of general application but limited in several respects in a number of European countries. In Sweden, for example, the expenses are deductible where the taxpayer lives more than 2 kilometres from his place of work. The deduction for the most part covers only the cost of the cheapest means of transportation. A person who drives a car may deduct the cost of a bus or train fare; but should the saving in time resulting from the use of his car be more than 1½ hours a day, a deduction for the actual costs of operating the car is allowed.

7.61. The case for giving a concessional deduction in this area of consumption rests on the circumstances that the incidence of such expenditure, unlike expenditure on basic necessities, varies noticeably between individuals in a way that cannot be wholly explained by personal preference. For some taxpayers, admittedly, there may be a fairly clear choice between more expensive housing plus modest travel expenses and less expensive housing plus considerable travel expenses. But this would be far from generally true.

7.62. Variation in the incidence of travel expenses may arise:

  • (a) because one taxpayer has to meet his own expenses of travel while another has the means of travel provided for him by his employer; or
  • (b) because one taxpayer faces high costs of travel while another does not: the former may live a considerable distance from his place of work, or may be forced to use expensive means of transport because public transport is not available at all or not available when he has to travel (e.g. a shift worker), or may require special means of transport because he is disabled.

7.63. The Committee acknowledges the horizontal inequities that may thus arise. In the case of (a) there is clearly also a vertical inequity in that those receiving the benefit


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of free travel are likely to be concentrated in the higher income groups. But in this instance the inequities will disappear if the Committee's recommendations on the taxing of fringe benefits are implemented. It might be claimed that there is a vertical inequity in relation to (b) because lower income earners tend to live further from their places of work than those with higher incomes. It is doubtful, however, if such a claim can be substantiated. The case for a general deduction must therefore rest on the horizontal inequity involved in some taxpayers having heavier travel costs than others.

7.64. If a general deduction were allowed, some control would obviously need to be imposed on the amount deductible so as to deny a deduction of extravagant expenditure, for example on a chauffeur-driven limousine. One possibility would be to limit the deduction to expenses in fact incurred in using public transport. This might have a collateral advantage for State and local government finances but would lead to a new set of inequities—between taxpayers who are in a position to use public transport and taxpayers who are not. A way of overcoming this problem would be to allow expenses of other modes of travel where public transport is not available but to limit the deduction to some notional amount that might be thought reasonable in the circumstances. There would of course be administrative problems in fixing such notional amounts, and an inevitable element of arbitrariness. Other administrative problems would be involved in assessing the expenses of the private transport adopted—most often a motor vehicle in respect of which running costs and depreciation would be claimed. In some instances there would be a claim of a composite deduction, involving both private and public transportation, for example where a car is used to reach the nearest railway station. If it were thought that the concession should be extended to those using private transport when public transport is available, the administrative problems associated with assessing the expenses of private transport would be multiplied.

7.65. In the Committee's view the administrative costs of allowing the deduction outweigh any possible equity advantages, and accordingly it does not recommend that a deduction be allowed for costs of travel to and from work. There are special situations, however, for which some other provision might have to be made. Thus under the present sales tax law, tax concessions are available to a disabled person who incurs special expenses by having to use his own car to travel to work. If the continuance of such a concession is not thought appropriate under the value-added tax recommended by the Committee, an alternative form of subsidy—if necessary a direct grant—could be employed. Other special situations, such as the shift worker or the person called on to work in an area remote from any form of public transport, will already have been mitigated to the extent that wages include a loading for time or location of work.

Child-Minding Expenses

7.66. Other illustrations of expenses which, while not expenses of deriving income, are peculiarly prerequisites to the earning of income may be found in relation to child-minding. There are circumstances where a parent in order to be free to go to work must arrange for the minding of children.

7.67. Under the present law child-minding expenses as such are not deductible. Section 82D involves a related concession. It allows a deduction of $364 when, during the year of income, a housekeeper is engaged wholly in keeping house for a taxpayer and in caring for a dependant of the taxpayer where that dependant is (i) a child of the taxpayer, under 16 years of age; or (ii) any other child under 16, or an invalid relative (narrowly defined), for whom a dependant deduction can be claimed; or (iii) a spouse who is an invalid. A deduction is allowed to a married taxpayer only where the


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housekeeper is engaged in caring for a spouse in receipt of the invalid pension, except in special circumstances. The Commissioner has a discretionary power to determine these special circumstances. If, for example, a wife has deserted her husband and the husband has engaged a housekeeper who keeps house and also cares for his dependent children, the circumstances will be sufficient for the Commissioner to exercise his discretion and allow the deduction. On the other hand, where a husband and wife both work and engage a full-time housekeeper to care for their dependent children, the Commissioner has taken the view that there are not sufficient grounds to justify a deduction for the housekeeper. It thus appears that while the section may incidentally give a concession in a case where child-minding is a prerequisite to the earning of income, it is not specifically directed to that situation.

7.68. Some countries have provisions that are so directed. For instance, child-minding expenses are deductible in the United States under certain conditions. The main requirement is that the child-minding expenses are necessary for the taxpayer to be employed or to seek employment. The child must be a dependant under 15 years of age for whom the taxpayer is entitled to claim a dependency exemption or, if the dependant is over that age, he must be physically or mentally disabled. The deduction is available to a taxpayer who is raising a child alone, for whatever reason. It is also available to married couples where both are gainfully employed or seeking such employment or where one spouse is disabled. The maximum deduction is $400 per month; however, for services provided outside the home—in a creche, for example— the maximum is $200 per month for one child, $300 for two children, and $400 for three or more children. The deduction is reduced by 50 cents for each dollar of the taxpayer's gross income in excess of $18,000. Expenses are not deductible if paid to a relation of the taxpayer.

7.69. In the Committee's view there should be some concession in the law, not because of any policy of encouraging persons with responsibilities to children to seek employment, but in order that those who are employed, whether through choice or necessity, might be assisted in meeting the costs of discharging the responsibilities of caring for children when the services of others must be employed. The need for a concession will be the less if the government provides child-minding facilities directly by way of free or subsidised creches and the like. It cannot be anticipated, however, that such facilities will ever be universally available. The need will be the less, too, if generous child-endowment grants are made. But such grants will favour all parents and not provide specially for those who must incur the expenses of child-minding.

7.70. The Committee recommends that the concession be available to a married couple both of whom are working, to a married couple where one works and the other is an invalid, and to the head of a one-parent household who works. A number of other questions arise as to the scope of the concession. These relate to the nature of a qualifying expense, the amount of expense that may be recognised in respect of each child, the age at which the concession ceases, the scaling down of the expense where the earning of income is on a part-time basis or extends to only part of the year, and the protection of the Revenue when the expense involves payment to a relative.

7.71. Where the child-minding is incidental to the provision of education, there is no need to give a concession if there is an appropriate concession available for expenses of education. The question then arises as to the correlation between the child-minding expense concession and the education expense concession. The Committee has, in paragraphs 12.32–12.34, proposed that the present concession for education expenses in respect of dependants be related only to a taxpayer's expenses by way of fees for


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tuition, be limited by a ceiling of $600 in respect of each dependant, and involve a tax rebate rather than a deduction from income. In the Committee's view the child-minding expense concession ought to be framed as an extension of the education expense concession. Its function is to give a tax concession in respect of the expenses of the pre-school and out-of-school care of a child which a taxpayer is by his employment precluded from providing himself.

7.72. If the child-minding expense concession is framed as an extension of the education expense concession, it follows that the limit of $600 will cover both education and child-minding expenses in respect of the same child where both kinds of expenses are incurred.

7.73. The age at which a child ceases to attract the concession might be set at 14 years. The scaling down will need examination: where a parent is employed for only part of the year, some scaling down would seem to be called for. Where the person to whom the payment is made is a relative, protection of the Revenue will require provisions of the kind at present applied generally to payments between associated persons (section 65).

7.74. In the Committee's view, in line with its thinking on the education expense concession, the function of the concession proposed should be seen as assistance in meeting special costs of discharging parental responsibilities. The concession should seek to give similar assistance to all taxpayers concerned, whatever their position on the income scale. The expense should therefore be the subject of a rebate of tax at a rate which, like the education rebate, might be set at 40 per cent. This means that somebody incurring $600 in child-minding expenses which qualify for concessional treatment will save $240 in tax.

7.75. There will be need of some provision to determine the correlation between the child-minding concession and the related concession, discussed in paragraph 7.67, provided by section 82D in the case of a housekeeper. An appropriate provision would require that where that concession is given in circumstances involving the care of a child, it be available only as an alternative to the child-minding concession.

Expenses of Income-Earning Activities Carried on at Home

7.76. Considerable administrative difficulties have arisen under the present law in regard to expenses associated with an income-earning activity which is in some degree carried on at the taxpayer's residence. Such expenses are deductible under the general provision allowing deduction of expenses in deriving income.

7.77. The present law, though by no means settled, would appear to draw a distinction between overhead expenses, such as interest and repairs to the residence or rent, and expenses directly connected with the income-earning activity, such as light, heating and depreciation on furniture. In regard to the former, the allowance of a proportion of the overheads requires that the room in which the income-earning activity is conducted should have been used in a manner that could not be described as a domestic use: ‘A study does not cease to be part of a taxpayer's home because it is used by the taxpayer for the pursuit of activities from which he earns his income’.note If the study were to be held to change its character from domestic to non-domestic when it is used for such activities, one would have to concede that a bedroom ceases to be part of a home because the taxpayer solves his most difficult business problems in bed. The Committee is conscious of the need to draw a line that involves an objective test and is as determinate as possible. There is a distinction, it is true, between a barrister who prepares a brief for the next day in his study and a lecturer who reads the latest literature. But the barrister will on occasions read the latest literature and the lecturer may be preparing a lecture for the next day. A test in terms of the activities pursued in the room is unmanageable. The non-domestic-use test appears to the Committee to be the appropriate one.




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7.78. Under the latter test, a room devoted to an artist's studio or to a carpenter's workshop will attract a deduction for overheads. So too will a doctor's surgery. If it is thought that there might be doubt in any of these cases, the Act should expressly define non-domestic use.

7.79. In a case such as the doctor's surgery, the allowance could be justified on the ground that the room is used in a way that involves contact with the public. The Committee would, however, prefer the test to depend wholly on non-domestic use. The mere fact that a taxpayer occasionally sees patients, clients or customers at home should not attract the deduction. But where a room is set aside for such contacts, the use will clearly be non-domestic.

7.80. The observations in the last paragraph raise an issue whether exclusive non-domestic use of a room is necessary to attract the deduction. In the Committee's view a test in terms of exclusive use is appropriate. However, the Commissioner should be given a discretion to disregard minor use of the room for a domestic purpose.

7.81. Expenses more directly connected with the earning of income may, under the present law, be deductible even though no part of the home is devoted to a non-domestic use. Expenditure in providing light and heating exclusively for the taxpayer while he is engaged in work from which he derives incomes is, it seems, deductible. Depreciation on domestic furniture, carpets and curtains in a room where the taxpayer engages in work is allowed, subject to apportionment where the room is also used for other purposes. In the Committee's view these principles are unmanageable. The deductibility of expenses for light and heating and depreciation on items of ordinary domestic equipment should be determined by the same principle as applies to overheads. Deduction should be allowed only where the expenses relate to the deriving of income in a room exclusively devoted to a non-domestic use.

7.82. The deductibility of depreciation on items that are not ordinary items of domestic equipment (for example, a typewriter or a filing-cabinet or, more obviously, a lathe), the current expenses associated with such items (for example, electricity charges) and also the expenses associated with the use of a telephone should be left to the operation of the general provision unaffected by the special provisions proposed by the Committee.

7.83. The carrying out of the Committee's proposals will require some statutory amendments to displace, in regard to direct expenses, the interpretation of the general provision. The Committee suggests that the opportunity be taken not only to do this, but to establish a special code which will settle the law in this area in a form that will overcome the present uncertainties.




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Subscriptions to Trade and Professional Associations

7.84. The present law contains a special provision (section 73) in regard to subscriptions to trade and professional associations, which draws a distinction between a taxpayer carrying on a business and an employed person. The former may deduct the subscription, without limit on the amount, when membership of the association to which the sum is paid is a pre-condition of the taxpayer carrying on the business.

7.85. The employed person, and a taxpayer carrying on a business whose subscription is not a pre-condition, is entitled to a deduction limited to $42 of any periodical subscriptions paid by him in respect of his membership of any trade, business or professional association. There is a further provision under which an amount greater than $42 in respect of one subscription may be allowed, if the subscription is made to an association that incurs expenses in carrying out any activity on behalf of its members where those expenses would be deductible by the member if incurred by him directly.

7.86. Subscriptions that do not fall within the special provision relating to subscriptions may nonetheless be deductible under the general provision in regard to expenses in deriving income. Deduction under the general provision, while not limited in amount, may in other respects be narrower in its operation.

7.87. The special provision has the advantage of determinateness and, subject to the recommendation made below, should be retained. In cases where the subscription is less than $42, the test will be simply whether the payment has been made to a trade, business or professional association. On the other hand, there is some prospect that what is really private expenditure may attract a deduction: the association may offer some of the amenities of a club. Hence there may be need to protect the Revenue by a more restrictive definition of a qualifying association.

7.88. The limit of $42 may, with a fall in the value of money, be thought to have become too restrictive. That limit, it is true, can be exceeded in the circumstances described above; but except in the case of a taxpayer carrying on a business who is compelled to be a member, the calculation of the amount deductible involves a measure of complexity where the claim exceeds $42. An increase in the present ceiling of $42 is therefore recommended.

Income-Protection Insurance Premiums

7.89. Section 82H of the Act allows a deduction of amounts paid by a taxpayer as premiums for insurance against sickness of, or against personal injury or accident to, the taxpayer or his spouse or child. The amount of the deduction under the section is limited in that the total sum deductible for premiums and payments of the various kinds referred to in the section may not exceed $1,200. These premiums and payments include life insurance premiums and payments made to a superannuation scheme.

7.90. The question has been raised, in cases before Boards of Review, whether a premium for insurance against sickness or accident of the kind referred to in the section may not be deductible as an expense in deriving income. If it is so deductible, there will of course be no limit on the amount that may be deducted. The principles applicable in determining whether an insurance premium is deductible as an expense in deriving income are by no means clear. In some circumstances an expense directed to protecting a capital asset is deductible, though Australian judicial authorities in this respect are less helpful to the taxpayer than United Kingdom authorities. The question to be resolved is whether the expense, even though it relates to a capital asset, is a


  ― 75 ―
‘working expense’. An insurance premium of the kind now considered could be regarded as a working expense of protecting human capital, in this context the capacity to earn income. There seems, however, to be no basis for an assumption that the deductibility of the premium depends under the present law on whether the form of compensation is a lump sum, which will probably not be income, or periodical receipts, which certainly will be.

7.91. Two consequences flow from these views of the operation of the law as to expenses in deriving income. First, it may be easier for a self-employed person to obtain the deduction of the premium. Secondly, there is a prospect of asymmetry in that while a deduction is allowable for the premium a receipt of compensation in a lump sum under the present law may not be income.

7.92. The first consequence involves what might be considered an unfair discrimination between the self-employed and the employee. The second may be thought to involve an unacceptable cost to Revenue.

7.93. The Committee's proposals in relation to deduction under section 82H are dealt with in Chapter 21. Apart from any concession that may be available under provisions replacing section 82H, the Committee considers that there should be a further specific provision allowing a deduction in circumstances outside the concession. The specific provision should in its terms exclude the operation of the general deduction for expenses in deriving income in relation to premiums on income-protection insurance policies. The premium on such a policy should be made deductible, without limit on its amount, only if the policy provides that the compensation will be paid in periodical amounts during sickness or disability. A sum received in commutation of periodical payments under the policy should be expressly made assessable income.

7.94. To the extent that the new section goes further in allowing a deduction than the general deduction now provides, it will involve a concession that calls for justification. In Chapter 21 the Committee offers, as justification for the deduction of contributions to a superannuation fund, that it is reasonable to allow the postponement of tax on income when expenditure of that income has been demonstrably deferred, provided there is some assurance that it will be brought to tax at a later time. The same justification may be offered for the deductibility of premiums under the Committee's present proposal.

7.95. It will be seen in Chapter 21 that the Committee proposes limits on the deductibility of contributions to a superannuation fund. There might seem, then, to be justification for restricting the amount of the deduction under the provision now proposed by the Committee. However, the availability of insurance will act as a brake. Underwriting practices already set limits on the total cover that an insured person may have: in many cases he will, for example, already be covered to a degree by a superannuation scheme of which he is a member. In the circumstances the Committee does not propose any limit on the deductibility of the premium. Were some limit imposed, there would be a case for allowing a deduction of excess premiums against receipts of compensation under the policy. This would introduce awkward administrative problems.

7.96. Consideration must also be given to payments to sickness and accident funds and to friendly societies that provide benefits by way of periodical payments on the incapacity of a member through sickness or accident. Where the benefits are provided exclusively on a periodical basis, payments and benefits should be given similar treatment to that proposed for income-protection insurance policies.




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Self-Education Expenses

7.97. Expenses of self-education are in some circumstances deductible as expenses incurred in deriving income. Though the judicial authorities are not always reconcilable, they suggest a distinction between, on the one hand, the expenses of education undertaken primarily for the purpose of entering on an income-earning activity or a substantial increase in standing in an existing income-earning activity (which are non-deductible) and, on the other, the expenses of maintaining knowledge or skill required for an existing income-earning activity or improving such knowledge or skill (which are deductible). There is an obvious grey area between the two: a doctor who takes a higher degree to enable him to practise as a specialist may be denied a deduction; an employee who undertakes studies to qualify for promotion may not. Expenses that do not relate to any income-earning activity—the pursuit of a general education or a hobby—are not deductible. They are regarded as consumption.

7.98. Those expenses denied deduction as expenses of deriving income because they relate to entry on an income-earning activity or substantial increase in standing could, in principle, be treated as costs of acquiring capital and as generating deductions by way of amortisation against income of the activity in future years. There are, however, no provisions that allow this treatment.

7.99. In 1972 a new section (section 82JAA) allowing a deduction was inserted in the Act intended to cover some of those expenses that are not of a consumption character but are denied deduction as expenses of deriving income because they are undertaken for the purpose of entering on an income-earning activity or a substantial increase in standing. The deduction is limited to expenses for fees, books and equipment in connection with a course of education provided by a school, college, university or other place of education. There is a ceiling on the amount deductible, and the deduction is reduced by any amount allowed under the provisions of section 82J, which relates to education expenses of dependants. Recently the ceiling under both section 82JAA and section 82J was reduced from $400 to $150.

7.100. Reference has already been made to the Committee's recommendations in regard to the education expense deduction for dependants. Under those proposals the ceiling on the concession would be raised to $600 and become a rebate of tax; also, the expenses involved would be confined to fees for tuition. In the Committee's view the self-education expense concession should be retained, with a limit of $400, and it should remain a deduction rather than become a rebate of tax. It is, in effect, the allowance, as a current deduction, of expenses which would in principle be deductible as capital costs subject to amortisation, but which are more conveniently treated in this way. The range of deductible expenses is already narrower than under the existing deduction for education expenses of dependants; the Committee therefore does not propose a reduction in the range of qualifying expenses as it does in relation to the concession for dependants’ education. To avoid double allowance of the self-education expense deduction and the proposed rebate for dependants' education, there should be provisions of the kind at present appearing in section 82JAA(3).

Dissection and Apportionment of Composite Receipts and Outgoings

7.101. An issue of general application arises when a receipt is composed of a number of elements, some of an income character and some not. In certain circumstances, not clearly defined in the legal authorities, the composite receipts may be dissected or apportioned so as to determine what part of the receipt is income. Dissection


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would appear to require that there has been some acceptance by the taxpayer in the course of the transaction of an amount as referable to the income item. Apportionment, it is said, is appropriate where the amount referable to the income item is ascertainable by calculation, but not, it seems, where the calculation involves a distribution of the receipt between items on the basis of a valuation of each item. The law as it stands might be thought to encourage practices in the settlement of claims to compensation and, in some cases, in the disposal of assets that will defeat the Revenue. Section 36 (relating to trading stock) and section 59 (relating to depreciable property) offer some protection, but more general provisions allowing apportionment on the basis of values would strengthen the law. Even when the parties have made a dissection of the composite amount, the Revenue may still need protection: it should not be open to the parties to make a dissection that is contrary to what would be a fair apportionment, so as to bring about a favourable tax result.

7.102. A similar issue arises when the taxpayer has paid an amount in part for a purpose that would attract deduction as an expense in gaining income and in part for a purpose that would not. The words of the general provision (section 51) purport to allow a dissection or apportionment. An outgoing is allowable ‘to the extent to which’ it is incurred in deriving income. But it is not clear in what circumstances a dissection or apportionment may be made. According to the authorities, it is only when a purpose other than the gaining of income is evident on the face of a transaction that it is proper to deny a deduction for that part of an outgoing incurred for this purpose. Where the transaction is a contract, it must be a part of the contractual arrangement ‘that … some advantage not … related to the production of assessable income was gained’. The words quoted are from the judgment of the Privy Council in a New Zealand appeal,note but would be thought as well to be a correct statement of the Australian law. The Committee would not wish to make the test of deductibility depend on the subjective purpose of the taxpayer. On the other hand, the character of a transaction should not depend exclusively on its form. It should be expressly provided that the character of a payment may be inferred from all the circumstances of the transaction and, where that character is in part a payment for a purpose which is not the gaining of income, an apportioned amount will be denied deduction. Such apportionment should be made ‘as the facts … may seem to make just’. The words quoted are from a High Court judgment:note they might be made the basis of the drafting of the proposed provision.




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8. Chapter 8 Income Tax: Issues Related to Business and Professional Income

8.1. The broad concepts of income and expenses in deriving income have been dealt with in Chapter 7. These concepts apply in the determination of net income from business and professional activities irrespective of the form in which these activities are conducted, whether as individuals or through trusts, partnerships, or companies. In this chapter, the numerous particular problems which arise in ascertaining the net income of a business or profession are considered.

8.2. The first and overriding principle, in the Committee's view, is that income tax should be levied on true profits flowing from the business or professional activity during its whole period of operations. If this is not achieved the rates of tax, be they progressive as for individuals or proportionate as for companies, become meaningless and misleading as an indication of the weight of tax. The true after-tax profits remaining and available for maintenance or expansion of the activity cease to be readily apparent and become distorted. Further, meaningful international comparison of the incidence of tax on business operations is made very difficult and the results are subject to qualifications which often cannot be quantified. Additionally, if the base is not true profits, ostensible concessions or incentives in specific areas may in fact be excessive or alternatively of less value than the figures suggest.

8.3. The Committee has received, as have previous committees charged with inquiries into income tax, numerous submissions on the ascertainment of net incomes of businesses and professions. Many of the matters now raised have been previously ventilated and pressed without result, some even as far back as the Spooner Committee in the early 1950s. Others have been considered not only by that committee but also by the Hulme Committee (1954–55) and the Ligertwood Committee (1959–61).

8.4. Most submissions point to the failure of income tax legislation to allow deductions for expenses which, under normal commercial practice, are deducted in arriving at profits before income taxation. In some cases a deduction for the expense is not available for income tax purposes; in others it is available in an accounting period other than that in which it is normally charged using generally accepted accounting principles. In the end result, the profits subject to tax tend to be higher than those determined for commercial purposes.

8.5. A further factor, to which brief reference has already been made in Chapter 6, is the overstatement of net income as a result of inflation, and claims for more equitable treatment on this score increase as the pace of inflation quickens. When the rates of income tax were very much less than they are at present, the consequences of net incomes determined by reference to the income tax legislation being higher than profits before tax arrived at on a commercial basis were not as severe. The overstatement of net income arising from inflation, taken with this increase in rates of tax, is giving rise to growing concern and disquiet.

8.6. It has again been proposed that the overstatement of net income arising from business activities would be avoided if the Income Tax Assessment Act were to be amended to provide that, subject to certain specific provisions, net income for tax purposes should be the profits determined on a commercial basis by applying generally accepted accounting principles.




  ― 80 ―

8.7. At first blush such a scheme may appear to have attractions, but these fade on closer examination. There has, it is true, been considerable progress in recent years towards the acceptance, by companies particularly, of authoritative statements on accounting principles which should be followed in arriving at disclosed profits. However, it is clear that many instances remain within the authoritative standards where alternative procedures continue to be available, and in many types of business organisation the standards accepted generally by the larger publicly-listed companies have yet to be attained.

8.8. In addition, to place the basis for determination of net income on which taxes are to be levied outside the jurisdiction of the revenue-raising authority could not be seriously considered in Australia and has not been adopted, to the Committee's knowledge, in any other country. The proper approach therefore must be to seek to narrow, as far as is possible, the differences between net income as determined under the revenue legislation and as determined by commercial standards.

8.9. The division adopted in this chapter is to deal in Section I with problems which arise in determining the accounting method—cash or accruals—to be followed in computing net income. Section II discusses the appropriateness of the general approach of the Australian law to arriving at net income when the accruals method of tax accounting applies. Attention is drawn to the failure of the law to ensure that, except to a limited extent, matching items of income and expense are brought to account in the same tax year.

8.10. Section III examines a number of the instances of costs or outgoings which are not deductible for income tax purposes in the same accounting period as that in which they fall to be treated as an expense by a business. These instances include provisions or accruals for employee benefits (long-service leave, holiday pay and sick pay) and provisions for product warranties and doubtful debts.

8.11. Section IV deals with allowances for depreciation and amortisation of fixed assets. Special consideration is given to depreciation of buildings, a subject raised in numerous submissions.

8.12. The special provisions of the Act relating to the valuation of trading stock are examined in Section V, as are also possible extensions of their scope. Section VI is concerned with the offsetting of losses arising in one income year against net income of other years. The existing restrictions on the recoupment of losses have important implications for the overriding principle that income tax should be levied on profits of the whole period of operations of a business.

8.13. Section VII takes up the important subject of the overstatement of net income flowing from the effects of inflation on business income and discusses briefly some of the measures being advanced to arrive at real profits and net income in periods of high inflation.

8.14. Section VIII is concerned with the treatment for tax purposes of a number of costs of business operation, including expenditure on repairs, anti-pollution expenses, and travelling and entertainment expenses.

8.15. This chapter is concerned with the treatment of business and professional income generally. The treatment of several particular industries—mining and primary production, for example—and the special provisions which at present apply in those fields of activity are considered in later chapters.




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I. Cash or Accruals Basis

8.16. Income tax law recognises two accounting bases, cash and accruals, for the determination of net income, which broadly correspond with the cash and accruals bases in financial accounting. What is included in ‘income derived’ and in ‘outgoings incurred’ will depend on the basis of tax accounting which is held to apply. If it is the cash basis, income is not derived until an amount has been received: it is not enough that it is receivable. Similarly, an outgoing is not incurred until there has been a payment: it is not enough that the outgoing is payable. On the other hand, where the accruals basis applies, income is derived when an amount is, in the language used in the cases interpreting the law, ‘due’, even though it has not been received and is not immediately receivable. There is an outgoing incurred if there is a ‘definitive commitment’ to pay, even though payment has not been made and there is no immediate liability to pay.

8.17. Accruals tax accounting differs from accruals financial accounting in ways which are considered in some detail in subsequent sections of the chapter. In theory, both seek to strike a balance for an accounting period between income earned and the costs and expenses incurred in relation thereto which will reflect the true result whether it be a profit or a loss. Cash tax accounting, on the other hand, is concerned with little more than striking the net result of a balance of receipts and payments.

8.18. It would seem to follow, as a matter of general principle, that all businesses and professions should be required to return their net incomes on the basis of accruals accounting. It has been recognised, however, that for some professions and small businesses a cash basis is more appropriate. This may be because most of the income generated flows from the taxpayer's personal labour or effort, because receivables and payables are modest and do not differ greatly in amount, because stock held is small, or because the taxpayer is unlikely to keep the more sophisticated records which will be necessary if he is to return on an accruals basis. The choice of cash rather than accruals in these instances will make little difference to the amount of net income in a tax period; yet the simplicity of the tax system for the taxpayer concerned is so much greater.

8.19. The Committee believes that a cash basis should continue to be available to a large proportion of those currently using it. To impose more sophisticated accounting would have little effect on net income but would add greatly to the compliance costs of those involved in a change from their existing method. The factors detailed in paragraph 8.18 may well be a better guide to the drawing of a dividing line than a general classification based on type of business or professional activity. The fact that most of the income from a business or profession is generated by the taxpayer's own effort might be made the dominant test. This would embrace the majority of doctors, dentists and barristers, as well as many other sole practitioners and small professional partnerships; it would also cover sole traders in the service industries.

8.20. Where the activity includes the employment of tradesmen or professional staff together with supporting administrative staff, the use of a cash basis is clearly inappropriate. In these instances, it is rarely employed in settling interests between partners or in arriving at an appropriate price for the sale of a business. Here, an accruals basis, which brings to account amounts owing and sums payable and a value for work in progress, if any, is needed to assess net income.




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8.21. Where the business is carried on by a company, the need to lodge returns on an accruals basis should not impose any added burden as company legislation requires the maintenance of full accounting records.

8.22. The Committee believes that the use of the accruals basis of accounting should be the general rule in computing the net income of a business or professional activity. Exceptions ought to be specified in the Act or Regulations. The definition of the exceptions should be founded on the extent to which the net income reflects the payment for the individual taxpayer's personal efforts, the scale of operations, the normal level of debts due, debts payable, work in progress and stock in trade. Businesses conducted through a company (except where the company is merely acting as a trustee) should use the accruals basis. No restriction should be placed on any taxpayer adopting an accruals basis if he chooses to do so even though he may qualify for cash-basis treatment.

8.23. The adoption of this general rule will impose a requirement for additional accounting on many taxpayers. However, side-benefit should flow in the way of improved management of the business. And in the event of a broad-based indirect tax being imposed, such as a value-added tax as recommended by the Committee, many small businesses will in any case need to lift the standard of their accounting.

8.24. The question remains as to the special provisions needed to cope with the switch from a cash to an accruals basis, which may arise from a change in law to give effect to the Committee's recommendation or because of an election by a taxpayer to adopt an accruals basis under that law. In most instances the use of the cash basis will have resulted in a lower net income and the accumulated understatement may be a substantial figure for some taxpayers. When many professional firms were required to change from a cash basis to the present quasi-accruals one several years ago following a Court decision, the Commissioner ruled that, in computing net income of the first year under the accruals method, a deduction was to be allowed for the value of debts due to the firm, and a deduction was not allowable for amounts owing to creditors for expenses, as at the commencement of that year. The Committee believes this precedent ought to be followed. It should be provided that a deduction will be allowed in the year of change for the value of debts due and stock in trade, and deduction denied for trade liabilities, as at the commencement of the year, subject to the change to the accruals basis being made prior to a specified date.

8.25. Where a change is made after the specified date, the accumulated understatement of net income should not escape tax. However, it would not be equitable, where progressive rates of income tax apply, to seek to tax the whole of the accumulated income omitted in the year following the change. To do so would also result in serious liquidity problems for most taxpayers. Accordingly, the Committee recommends that when a taxpayer after the specified date is required to or elects to change from a cash to an accruals basis, the total of net income previously excluded from tax at the commencement of the year of change should be included in his taxable income in the succeeding five to ten years, the actual period depending on the amount involved. A minimum adjustment to income of a succeeding year of $1,000 should be fair in most cases.

8.26. Where the entity changing its basis is a partnership, it will be the interest of each partner in the total net income omitted which will need to be adjusted in the way indicated. A subsequent change in a partner's interest in the partnership should have no effect on his liability to tax on his proportion of the omitted income: its value will


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normally be reflected in the true worth of his interest in the total net assets of the partnership, whichever tax basis is being used.

II. Accruals Tax Accounting and Financial Accounting

8.27. Many submissions claim that accruals tax accounting under the Australian law is too rigid. It is said that in determining the net income of a business, tax law should take as its starting-point the results of the business for the period determined by generally accepted principles of financial accounting. Tax law should then require adjustments to the results where a particular rule of tax accounting has no parallel in financial accounting, or where the principle of financial accounting that has been adopted differs from the rule of tax accounting.

8.28. The approach suggested would lessen the rigidity of tax accounting only if financial accounting is more flexible in the choices it offers and adjustments are not required by tax accounting. In the Committee's view flexibility in this sense is desirable in some contexts. However, it is for the tax law to define the choices. The law could not resign its function of determining the base of income tax in favour of the professional bodies and business or trade organisations which play a large part in formulating generally accepted principles of financial accounting.

8.29. The criticism of the rigidity of the existing law may be stated in another way. Accruals tax accounting, it is claimed with real justification in some respects, is much less effective than financial accounting in striking a balance which reflects the true profit or loss of a business activity. To the extent that this is true, the Committee would agree that tax accounting rules should adopt the financial accounting principles. However, a difference between a rule of tax accounting and a rule of financial accounting can be no more than a valid reason for re-examining the rule of tax accounting. It cannot dictate a change in the tax rule.

8.30. The change in approach that is being sought would in any case involve a radical redrafting of the existing law and this should not be contemplated if the purpose of the change can be achieved without it. Old law is, to this extent at least, good law. Overseas experience suggests that a major redrafting of the law would not significantly reduce the complexities of the tax.

8.31. The differences between tax accounting and financial accounting can be overstated. Some of the early pronouncements in legal authorities that tax law is not concerned with the profits from transactions, except where there is some express provision, are contradicted by the treatment the law accords to contracts extending over several years. It has been decided that a charge made to a client of a business, even though it be received, should not be treated as income until the services for which it is the reward have been performed: this is a tax recognition of a principle of financial accounting. The provisions of the Act in regard to the allowance of depreciation and accounting for trading stock are intended to ensure that net income of a business for an accounting period reflects the profits of that business for the same period.

8.32. Attention has tended to focus on those differences between accruals tax accounting and financial accounting that lead to net income being overstated, which is what happens when a deduction for income tax purposes is deferred until an expense is paid while for financial purposes it is brought to account as it accrues. On occasions, however, the law allows a deduction in the year in which the cost or outgoing is met even though, in the particular case, the cost clearly refers to or is connected with an


  ― 84 ―
item of income to be derived in a later year. Thus, for example, interest is generally available as a deduction in the year in which it accrues, irrespective of the fact that it may relate to cost of establishing a new industrial complex in course of erection or to development land held for resale. Under financial accounting principles, interest paid in these circumstances will frequently be added to the cost of the asset concerned. A finance institution may in its financial accounts accrue interest on fixed-interest securities; but it is permitted to exclude such amounts from tax accounting on the grounds that the income has not in fact been received. A grazier may purchase a quantity of superphosphate just prior to the end of a financial year and become entitled to deduct the cost from his net income, even though the whole benefit from his expenditure will not fall to be included in his net income until a subsequent period.

8.33. Differences between accruals tax accounting and financial accounting which increase net income subject to tax sometimes arise from legal authority limiting the meaning of a cost or outgoing incurred in deriving income so that an anticipated expense or an expense subject to some contingency is not allowed as a deduction. Into this category fall accruing costs of employee benefits such as long-service leave and the extension of depreciation allowances to allow for obsolescence of fixed assets. These are examined in detail later in this chapter, as also are several differences of a permanent nature such as depreciation of buildings.

8.34. There is one other difference operating in favour of the taxpayer which must be mentioned because of its fairly general application. It relates to the failure to take to account the value of work in progress in certain professional activities. The professions mainly concerned are those of solicitors, accountants and architects. In those cases where a large staff is employed, the costs incurred in any year will frequently relate in substantial degree to services rendered which have not been billed by the end of the year. Work in progress and unrendered charges and costs may constitute the largest asset of the business and its existence needs to be taken to account to arrive at profits for financial accounting purposes. There is little reason why it should not be similarly taken into account in reaching net income.

8.35. Clearly it is not practicable to seek to eliminate every difference currently arising or to correct the lack of symmetry in every business transaction. Some of the differences spill over to the taxation of income outside the business area. For example, the deduction allowed a finance company for interest accrued but unpaid on debenture loans would require each debenture-holder to include in his net income accrued interest as at the end of a tax year if symmetry were to be achieved. This obviously is not feasible.

8.36. However, several of the differences referred to in this section appear to call for legislative action.

Holding Charges

8.37. The Committee recommends that holding charges (in the form of interest, rates, land tax, etc.) on land held for resale, being akin to trading stock, should not be allowable as a deduction to the extent that the charges relate to land held at the end of an income year. The charges so excluded would form part of the value of trading stock.

Work in Progress

8.38. The fact that professional firms do not bring to account the value of work in progress or unrendered charges, except where the work performed at a year end has


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given rise to a recoverable debt, results in their net income being computed on a quasi-accruals method.

8.39. One result is that net income tends to be understated under normal conditions when activities are increasing and costs rising. An associated problem is the considerable room for dispute as to whether the services performed or work carried out at the year end have in fact given rise to a recoverable debt the value of which needs to be included in net income of that year.

8.40. Those professional firms which base their charges to clients on time incurred on the assignment by principals and staff now maintain records from which the value of work in progress is computed at regular intervals for purposes of internal management. There are probably many other firms, however, which do not now find it necessary to keep these additional records. Accordingly, to require all professional persons or firms to bring to account a value for work in progress in determining net income would be onerous and add significantly to administrative costs for at least some taxpayers. But there seems no good reason why a professional person or firm should be debarred from computing net income on a full accruals basis as a matter of choice.

8.41. The Committee recommends that professional persons or firms, whether incorporated or not, be given the right to elect to take account of the value at cost of work in progress at the beginning and end of an income year.

8.42. The Committee proposes that the principle set out in paragraph 8.24 relating to changes prior to a specified date should apply to an election to bring in work in progress.

8.43. This procedure will, it is true, result in the opening value of work in progress escaping tax. But the change in basis for treating work in progress for those firms which elect will tend in most instances to increase their net income and the taxes payable without lifting the cash flow of profits available to taxpayers. Also the change will tend to increase annual taxation revenue, despite the failure to tax the opening value of work in progress.

8.44. Where a firm makes an election to bring in work in progress after the specified date, it is proposed that the opening value of work in progress should fall to be taxed by the spreading procedure, outlined in paragraph 8.25, to be applied when a taxpayer changes from a cash to an accruals basis.

Tax on Basis of Financial Accounting Principles

8.45. While the decision in the Arthur Murray Casenote has led to a more factual approach to the determination of income of a year, there remain elements of rigidity in the present law. This rigidity has already been referred to, as has also the claim that on occasions accruals tax accounting fails to arrive at a balance reflecting the true result from a business activity.

8.46. While the Committee rejects the proposal that net income be computed using generally accepted accounting principles, it acknowledges that it might well be in the interests of both the Revenue and taxpayers if the Act were more flexible in its requirements both as to computation of gross income and as to deductions for related expenses. In practice, flexibility has been given by administrative decision of the Commissioner and his officers.




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8.47. The Committee feels it would be desirable for the Commissioner to have statutory authority to compute the net income from a business activity using one or more of the generally accepted accounting principles approved by recognised Australian professional accounting bodies, where the taxpayer so requests and the Commissioner is of opinion that to do so would be reasonable having regard to all the circumstances.

III. Provisions and Accrued Expenses

8.48. It is under the general heading of provisions and accrued expenses that the major differences arise between net income and results determined under financial accounting: the latter takes to account numerous provisions and accruals that need to be made to match income and expenses which have been incurred or are anticipated in earning that income. These additional charges made against financial results include accrued employee benefits such as long-service leave and holiday pay, provisions necessary to reduce debts receivable to their anticipated realisable value (doubtful debts), and provisions for product warranties and for known contingencies.

8.49. The principle basic to the general deductions section of the Act (now section 51) since its introduction in 1915 is that deductions are allowable for outgoings incurred. But these do not necessarily include provisions for future expenditure.

8.50. One objection raised to relaxing this general deduction provision to eliminate some of the differences which now exist is that the bases of the estimates of provisions and accruals are suspect and tend to err in the taxpayer's favour. This objection may be valid in the case of certain provisions, for example doubtful debts and product warranties. It has no real force, however, in relation to an employee's vested right to long-service leave and holiday pay, where his entitlement is fixed by a governing statute or an industrial award.

Long-service Leave and Holiday Pay

8.51. Both long-service leave and holiday pay are regulated for all employees by either legislation or industrial agreement. There is considerable uniformity in the legislation and awards as to the circumstances in which the leave is payable. The variations between legislation and awards are concerned mainly with the rate at which leave is accumulated and paid. So while the leave requirements are not identical throughout Australia, they are nonetheless uniform to a substantial degree.

8.52. Table 8.A summarises what are understood to be the minimum periods of service to qualify for long-service leave under current State legislation or Federal awards and weeks of leave granted.

8.53. From inquiries made by the Committee it appears that most major employers of labour, and many smaller employers, have established provisions to cover the liability for long-service leave, the liability usually being determined on the basis of the employee's current salary. Inquiries also show that many employers start to make provision after the employee has completed five years' service. Since legislation and industrial awards govern the accrual for long-service leave and require detailed records to be kept of each individual's entitlement to long-service leave, calculation of the provision is made reasonably simple.




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TABLE 8.A: LONG-SERVICE LEAVE ENTITLEMENT

             
N.S.W.  Vic.  Qld  S.A.  W.A.  Tas.  Federal 
1. First entitlement, where entitlement flows principally from termination by the employer or sickness, death or domestic reasons of the employee (years of service)  10  10  10  10 
2. First entitlement, where termination by employee (years of service)  10  15  10  15  15  15 
3. Entitlement vests absolutely (years of service)  15  15  15  10  15  15  15 
4. Amount of leave after entitlement vests absolutely (weeks of leave)  13  13  13  13  13  13  13 
5. Record of entitlement of each employee required to be kept  Yes  Yes  Yes  Yes  Yes  Yes  Yes 
note note  

8.54. The Spooner and Ligertwood Committees, which examined this question, both recommended that provisions for long-service leave be allowable deductions. They had different views, however, on procedure for deductions. The Spooner Committee recommended that a deduction be allowed for the taxpayer's estimate, while the Ligertwood Committee favoured allowing the deduction for employees with ten or more years' service.

8.55. The Committee agrees in principle with the recommendations of its predecessors and accepts the equity of the claim made in numerous submissions that a deduction should be allowed for the value of long-service leave entitlements which have accrued to employees at the end of a financial period. The difficulty lies in determining the entitlement to be used in calculating the figure and the transitional safeguards to be provided to protect the Revenue. There are no reliable figures on the probable total value of employees' long-service leave entitlements accrued in the private business sector, but the figure probably exceeds $1,500 million. Clearly a reduction of taxable income of this order in one financial year could not be contemplated. Transitional arrangements are obviously called for.

8.56. As Table 8.A shows, an employee working under New South Wales legislation and having his services terminated by his employer is entitled to a pro rata payment of long-service leave if he has completed five years' service, though the more general requirement in Australia is that he must have completed ten years' service to qualify. Where, on the other hand, an employee takes the initiative in terminating his service, he need have served for only seven years under South Australian legislation but more generally for fifteen years. In deciding which entitlement should be accrued, most employers and their advisers would feel that the dominant factor should be the period of service after which the employer would be required to make a payment to an employee in the event of his services being terminated by the employer. To omit to make any provision until an entitlement vested absolutely (in the vast majority of cases after fifteen years' service) would be to fail to match income with costs related to that income.




  ― 88 ―

8.57. The Committee believes that, at the very least, a deduction should be allowed for the total amount, at each year end, of the employees' entitlements to long-service leave which have vested absolutely. This limited deduction would not, however, eliminate the failure to match income with expenditure. Accordingly, the Committee recommends that, subject to transitional provisions, a deduction be allowable for the total amount of employees' entitlements at each year end, calculated according to each employee's entitlement should his services have been terminated by his employer at that date, but only to the extent that a deduction in respect thereof has not been allowed against a taxpayer's income of a prior year. Transitional provisions are considered later.

8.58. An argument commonly made against the kind of proposal being put forward here is that a deduction for a provision calculated by reference to payments in a future year is liable to be excessive unless the provision is calculated by discounting the future payments to their present value. In the Committee's view this discounting is unnecessary. The failure to discount will be offset in part by the calculation of the provision on the basis of the present wages of the employee and not his anticipated remuneration when leave is taken. In most instances promotion and award increases will have lifted his current wages when he takes his leave. For example, a man who at 30 June 1974 had completed ten years' service and whose gross wages at that date were $120 per week would have accrued long-service leave of 8 ? weeks—in money terms, $1,040. If, at 30 June 1975, his gross wage rises to $150 per week—a not unlikely occurrence—the value of his long-service leave accrued at this later date will be $1,430, an increase of 37.3 per cent in one year.

8.59. The rights of employees to receive and the liability of their employer to meet holiday pay appear to be more certain and uniform than the conditions relating to long-service leave. Except in the case of some casual workers where a holiday pay loading is incorporated in weekly rates of pay, legislation requires an employee to be granted paid holidays, now generally at the rate of four weeks' leave for each complete year of service, and payment in cash of a pro rata sum in the event of his ceasing employment at any time. Employment for even one day carries an entitlement to pro rata holiday pay.

8.60. From an employer's viewpoint, the cost of meeting the liability for holiday pay of staff is just as much a cost of labour as the wages or salaries paid regularly. Here too the relevant legislation imposes a requirement to maintain records disclosing the holiday pay entitlement of all employees on an individual basis.

8.61. The Ligertwood Committee concluded that a deduction for accrued holiday pay was not warranted, mainly it seems because of the relatively small sums of money involved. Since it reported in 1961, however, legislation has extended the benefit considerably. Amongst other things, the benefit has increased from two weeks for each year of service to four weeks, and in most cases there is currently a loading of 17½ per cent. The accrued liabilities of employers is now quite a substantial sum and it has become general practice to take the liability to account in computing financial results.

8.62. This Committee has not been able to locate any reliable statistics on the total estimated value, at a given date, of the accrued holiday pay liability of the private business sector. But the figure may well exceed 50 per cent of the total liability for accrued long-service leave.

8.63. The Committee recommends that, after a transitional period aimed at easing the impact on income tax revenue, a deduction be allowed for the total amount at


  ― 89 ―
each year end of the accrued liability for holiday pay entitlements of employees, calculated according to their vested rights under industrial awards or other legislation. In practice, the deduction allowable from the net income of a year would be limited to the increase in the accrued liability at the year end over the figure at the commencement of that year: a decrease in the liability would result in net income of that year being increased to offset the deduction claimed for holiday pay actually met and forming a component of wages and salaries paid in that income year.

8.64. The need for a transitional period for the implementation of the Committee's recommendations in respect of long-service leave and holiday pay has already been referred to. Of the various alternative courses open, it appears that a gradual introduction of allowances over a period of ten years would be the most appropriate. It is therefore recommended that, in the first year of change, the deduction allowable be restricted to 10 per cent of the accrued liability for each benefit, determined as previously recommended, and at the end of the second year to 20 per cent, and so on. It is further recommended that the right to obtain a deduction for these accruals be subject to an election by the taxpayer. For example, a taxpayer may, through omission or having regard to the smallness of his accrued liability for one of these benefits, elect not to claim a deduction for his accrued liability until, say, the third year of the transitional period. The law should provide that in that year he is entitled to a deduction for the full 30 per cent of his total accrued liability and, if further postponement occurs, to the higher percentages applicable to the following years until he becomes entitled to the full 100 per cent allowance against his net income for the tenth year. A taxpayer who does not elect to claim a deduction for his accrued liability should continue to be entitled to a deduction for the actual payments made in each income year.

8.65. Transitional arrangements along the lines suggested would cushion the impact on income tax revenue arising from allowing deductions for these business costs— costs which clearly should be taken to account to arrive at true net income for a tax accounting period. Special provisions will be needed to ensure that no undue benefit is received by either the vendor or purchaser of a business which changes hands.

Other Provisions for Liabilities

8.66. A number of submissions have been received requesting allowance of a deduction for provisions for other liabilities made in arriving at commercial profits. Firstly, there is the matter of the provision for a liability arising under a warranty given when a product is sold: for example, a manufacturer may undertake to replace defective parts for a specific period. The major difficulty in the case of provisions for warranty is in determining, in objective fashion, what constitutes a reasonable provision at any year end.

8.67. Several years ago income tax legislation in the United States was amended to allow a deduction for a provision for product warranties. However, the amounts claimed in the first year of operation proved so high and the effect on revenue so great that the deduction had to be abandoned, with retroactive effect. Because of the difficulty of assessing a reasonable provision for any business at each year end, the Committee does not favour an amendment of the law in respect of provisions for warranties. This is in line with the recommendation of the Ligertwood Committee.

8.68. The second liability or contingency for which a deduction has been sought concerns a possible loss under an impending law suit. The legal proceedings may not be resolved for several years and the decision may give rise to a substantial loss. Here too the impossibility of making any objective assessment of the amount that might be


  ― 90 ―
claimed as an appropriate provision appears to the Committee sufficient reason for not allowing a deduction.

Provision for Doubtful Debts

8.69. Another difference between tax and financial treatment frequently arises in the case of provision for doubtful debts. Business prudence normally demands that adequate provision be made for doubtful debts in determining the results of any period. In addition Australian company legislation requires directors to take reasonable steps to ensure that adequate provision is made for losses which may arise in the recovery of debts owing at the end of a financial period. However, income tax law permits a deduction only for bad debts written off. The amount of provision necessary to provide for doubtful debts is a matter of judgment, experience with bad debt differing from one industry to another and from year to year.

8.70. It would be possible for the law to prescribe limits, varying from industry to industry, as to the amount of a provision which might be deducted. But inconsistencies could hardly be avoided, and there would inevitably be arguments as to what proportion of the outstanding debts of a company operating in several fields related to each industry classification. For these reasons the Committee does not recommend that a provision for doubtful debts be allowed as a deduction.

IV. Depreciation and Amortisation of Fixed Assets

8.71. If the cost of a fixed asset used to produce income is not fairly spread over the period of use, by allowing deductions each year, the tax base will be distorted by the failure to match expenses with income. Criticisms of the present law relate to the unfairness of the spreading for those assets for which the law does allow depreciation and to the absence of any deduction for certain other fixed assets, principally buildings. In addition allowances have been sought for certain expenditure which, though not wholly falling within the usual definition of fixed assets, is nonetheless of a capital nature. This includes costs of acquiring know-how, of company formation and issues of shares, of feasibility studies; it also includes some expenses of moving the site of business operations. The denial of depreciation deductions to a taxpayer who has incurred expenditure on an asset he does not own—for example, improvements to leasehold property—also has been criticised.

8.72. The depreciation provisions of the Act were examined both by the Spooner Committee and, in rather more detail, by the Commonwealth Committee on Rates of Depreciation (the Hulme Committee). The terms of reference of the Ligertwood Committee did not extend to the matters dealt with by the Hulme Committee; but it examined the lease provisions of the Act, including the question of allowances for expenditure by a lessee on improvements to leasehold property.

8.73. Many of the matters raised in submissions are identical with those brought to the attention of the earlier committees, particularly the Hulme Committee: for despite the recommendation of these committees that allowances be available for the recoupment of the cost of certain assets of a capital nature, the law has remained unchanged. Consequently, the differences between net income and accounting profits which arise in relation to depreciation and amortisation continue. In the years that have elapsed since the recommendations of the Hulme Committee, the grounds for the criticism of the differences in treatment have not weakened; rather, they have been strengthened by technological progress and by the now almost general acceptance by business that


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failure to provide adequate depreciation for buildings results in overstatement of profits. The omission to tax capital gains, particularly on land, which it might be thought has mitigated to a degree the absence of depreciation allowances for buildings is now proposed to be rectified.

8.74. The discussion which follows is arranged under four broad categories of assets in respect of which changes in the law are sought. These are plant and equipment, buildings, leasehold improvements and other assets and costs. The questions which arise are considered in relation to the recoupment of the historical cost: the extent to which regard should also be paid to the increased cost of replacement due to inflation is briefly mentioned in Section VII. The special provisions applying to primary production and to the mining and petroleum industries are considered in Chapters 18 and 19.

Plant and Equipment

8.75. Practically all units of property classified in financial accounting as fixed assets and in respect of which depreciation is at present allowed fall under the broad heading of plant and equipment.

8.76. The annual percentage rate of depreciation allowable in respect of each unit of property is determined by the Commissioner on the basis of the estimated effective life of the asset, assuming it is maintained in reasonably good order and condition, and an annual percentage allowance is fixed accordingly. Standard rates of depreciation are determined by the Commissioner in respect of various types of assets. The standard rates make no allowance for obsolescence. Although the Commissioner may allow a variation from the standard rates where special circumstances or conditions relating to a particular unit of property justify such a variation, his determination, it seems, must be made on the physical life of the asset. Australia is one of the few countries which does not have regard for obsolescence in determining rates of depreciation.

8.77. The Hulme Committee considered whether it was practicable and desirable, in determining annual rates of depreciation, to take obsolesence into account and reached the view that it should be recognised as a relevant and material factor. It added, however, that the method of making an allowance for obsolescence and the degree of the allowance had given it some difficulty and concluded that the only feasible approach was to introduce a degree of flexibility by allowing the taxpayer choice of a rate of depreciation within a band of rates.

8.78. The need to make due allowance for the factor of obsolescence has again been pressed in many submissions to the present Committee, including a number from particular industries in which, owing to the speed of technological advances, the matter is of major concern. Where the period of the estimated effective life of any equipment proves, in practice, to have been excessive, a deduction for the cost not covered by allowances in prior years is available when the equipment is scrapped or abandoned. However, this defers a deduction and does not give an even spread of the recoupment of the capital cost over the effective life of the equipment.

8.79. Complaints about the inflexibility of the standard rates continue, though it may well be that a proportion of these are not soundly based. The Commissioner and his officers permit variation from the standard rates where a taxpayer produces satisfactory evidence that, in his particular case, the specified standard rate is inadequate.


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Submissions rarely record whether an application has in fact been made for permission to adopt higher than standard rates.

8.80. The essential feature of rates of depreciation is that they are estimates of effective working lives. The allowances flowing from them are in reality estimates also and not precise figures of the portion of an asset's cost relating to a year of income. Considerable clerical recording and effort are frequently involved in computing depreciation allowances, particularly in manufacturing industries, due to the differing rates to be applied to the separate units of property. The clerical effort in checking or reviewing the computations by Departmental officers is also heavy. One method of reducing this would be the adoption of a composite rate to be applied to all depreciable fixed assets of a business, other than motor vehicles and buildings. This method recognises the futility of incurring clerical costs in performing precise calculations of allowances for various categories of property attracting different rates, when approximately the same total allowance can be determined by simple and less expensive procedures and the result under either approach is in any event only an estimate.

8.81. The Committee recommends that the schedules of standard rates of depreciation incorporate composite depreciation rates for specified industries which may be adopted, in lieu of standard rates, for all depreciable assets other than those excluded in fixing the composite rate. It further recommends that, in fixing the composite rate for a particular industry, a loading be added to take account of obsolescence.

Buildings

8.82. The Act allows deductions for depreciation of ‘plant’ used for income-producing purposes but, with certain limited exceptions, not for depreciation of ‘buildings’. The exceptions are income-producing buildings forming an integral part of plant; buildings used only for scientific research related to the business of the taxpayer; structural improvements on land used for the purpose of agricultural or pastoral pursuits; and buildings erected by mining enterprises as part of the development of a mining property.

8.83. One argument that has been used to support the present situation is that land and buildings appreciate in value rather than depreciate. The Hulme Committee, in observing that the Commonwealth income tax law did not allow depreciation on buildings, stated that the reasons which appeared to have previously weighed against the granting of such an allowance were those to be found in the following extract from the Report of the Ferguson Commission (1932-34):

‘We received many requests that depreciation should be allowed in all cases. There are many buildings, however, which with repairs and maintenance, all of which are of course allowed as deductions, will last for hundreds of years. There is the further consideration that many substantial buildings in good localities have not depreciated in value—on the contrary the property as a whole has appreciated owing to an increase in values of the sites on which the buildings stand … We recommend that depreciation on buildings be restricted to buildings forming an integral part of plant …’

8.84. The Hulme Committee reported that in none of the matters which came before it had it encountered more widespread representation, or more unanimity of opinion, than that an allowance should be given for depreciation of buildings. It


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recommended that depreciation be allowed in respect of the cost of all income-producing buildings but drew attention to the practical problems of including existing buildings.

8.85. It recommended that existing buildings be included where, if depreciation using the prime cost method had been available at the time the building was constructed, there would still be some portion of the construction cost unrecouped. However, to overcome the problem of ascertaining the actual construction costs of older buildings, it devised a complex scheme for calculating the cost of existing buildings where actual construction costs were not known. Construction costs of buildings erected between 1939 and 1955 (the year in which the recommendations were made) could, it was thought, be ascertained. It was proposed that buildings erected before 1939, which tended to be more standardised than are buildings erected today, should be given a deemed cost of construction calculated by applying a standard cost for that type of building in 1939 to the building's internal floor area and then relating the result to an index of relative levels of building costs in earlier years. Since the rates of depreciation suggested for brick, stone or concrete buildings assumed a normal life of sixty-seven years, the existing buildings (in 1955) which would still have qualified for depreciation could have been constructed as long ago as 1888.

8.86. Depreciation on industrial and commercial buildings used in the production of income is allowed in many overseas countries including Belgium, Canada, Italy, Japan, Netherlands, New Zealand, South Africa, Sweden, the United States, and West Germany. The United Kingdom is an exception, the deduction being limited to industrial buildings. However, the Millard Tucker Committee on the Taxation of Trading Profits (1951) and the Royal Commission on the Taxation of Profits and Income (1955) both recommended that the depreciation allowance be extended to include commercial buildings.

8.87. In reaching this conclusion, the second of these United Kingdom inquiries reported:

‘380. No doubt commercial buildings involve an ultimate wastage of capital in the same way as industrial buildings do. From that point of view there is no reason to distinguish between them. But we recognise that there are other arguments to be considered. There is an argument that any allowance for capital that is lost in the using up of a fixed asset is anomalous in an income tax system which refrains from treating as taxable a realised capital surplus. This unbalanced treatment, for long confined to plant and machinery, has now been extended to cover other types of assets, in order to stimulate capital investment of a kind desirable in the national interest. It is only in the new context of shortages and high prices combined with a wider range of assets to which capital allowances apply that the anomaly of principle could be of any material importance. But in that context it is not impossible that what is right for industrial buildings is wrong for commercial buildings.

381. The Board are opposed to this recommendation. We summarise their reasons:

  • (1) Commercial buildings last a very long time; they are not nearly as much subject to obsolescence as factories are.
  • (2) Over very long periods they tend to appreciate rather than depreciate in value, so that if allowances were given they would very often have to be withdrawn when a sale took place.
  • (3) At the present time there is no economic importance in stimulating the construction of commercial buildings.
  • (4) The proposal would involve drawing a line between commercial buildings and dwelling-houses that would inevitably be regarded as unsatisfactory, particularly in the common case of the house over the shop. Complicated provisions would, moreover, be required to deal with changes of user.



  •   ― 94 ―
  • (5) The proposal would add considerably to the work of the Department.

382. Although these arguments must be taken into account we do not believe that in the long run they can be decisive. So far as they are not concerned with administration they amount to saying that businesses would not find it worth while to claim the allowance, or that there would be no economic reason for a Chancellor to implement the recommendation. That may well be so, and we should agree to this extent that we do not regard a change from the present system as in any sense an urgent requirement. But we could find no fiscal justification for distinguishing between commercial and industrial buildings and we think both should get the allowance. Accordingly, we endorse the recommendation of the first Tucker Committee.’

8.88. The Institute of Chartered Accountants in Australia and the Australian Society of Accountants, in a joint statement, ‘Depreciation of Non-current Assets’, issued in April 1974, recommended as follows:

‘Buildings. For the purposes of calculating depreciation, the historical cost of a freehold property (or other value substituted for historical cost in the accounting records) should be apportioned between the land itself and the building(s) erected on the land. The resultant depreciable amount attributable to the building(s) should be written off as an expense by means of periodical depreciation charges over the estimated useful life (lives) of the building(s).’

8.89. The experience of this Committee is very similar to that reported by the Hulme Committee and referred to in paragraph 8.84. Numerous submissions have been received which are unanimous in condemning the present restriction of the allowances to buildings to the extent that they form integral parts of manufacturing plant. The representatives of various kinds of business have urged that at least their own particular class of buildings should qualify for relief.

8.90. The basic arguments in favour of allowing depreciation on buildings as a taxation deduction stem from a recognition that a material asset has a finite useful life which may be shorter than the physical life of the asset. All buildings and other structures on land are just as subject to the need for eventual replacement as is working plant, and with the rapid rate of technological change the effective working life of these items is becoming shorter. This fact is reflected in a practical manner in the continual demolition of existing buildings to make room for new ones, usually of increased capacity and more suitably designed for modern conditions.

8.91. The argument which persuaded the Ferguson Commission to recommend against an allowance for building depreciation—that any loss in value of a building tends to be offset by appreciation in the value of land—has, in general, long since been rejected. A further argument—that the imposition of a capital gains tax on profits arising from the realisation of real property is a necessary counterpart to the allowance of building depreciation—has also been rejected. The reasons for the rejection of both these arguments were stated in the Hulme Committee report and have been dealt with at some length in pronouncements by the major professional accounting bodies in Australia and overseas. The principal reason is that they overlook the fact that buildings are consumed and replaced in the course of business operations unrelated in any way to changes in the value of the underlying land. Many business activities are conducted on land owned for very long periods. Rarely is industry carried on efficiently in buildings erected more than fifty years previously. Commercial buildings of the same vintage originally used for offices or accommodation are seldom now suitable for that purpose without expenditure of a capital nature on reconstruction.




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8.92. In the Committee's view allowances for depreciation of buildings are called for. Their introduction, however, raises certain problems:

  • (a) For what classes of building should depreciation be allowed?
  • (b) Should all buildings be included or only those completed after a certain date or after the proposal is introduced?
  • (c) How should changes in the ownership of depreciating buildings subject to depreciation be treated?
  • (d) How should the demolition and destruction or damage of buildings be treated?
  • (e) Is a phasing-in period necessary to cushion the effect on tax revenue?

8.93. Classes of buildings which should qualify. The Committee sees no valid reason for excluding particular classes of buildings from the allowances and therefore recommends that depreciation be allowable in respect of all income-producing buildings whether they be industrial or commercial. In this context commercial would include residential accommodation. While the case for allowances may be stronger for industrial buildings, which generally have a shorter effective life than other buildings, and possibly also for accommodation buildings such as hotels and motels for the same reason, allowances are justified whenever a building is used in producing income. Moreover, real difficulties would arise in identifying industrial buildings if the allowances were confined to such buildings, or in identifying accommodation buildings if allowances extended only to industrial and accommodation buildings.

8.94. The inclusion of existing buildings. Some restriction on the scope of buildings entitled to allowances, related to time of erection, would seem to be inescapable. The broad alternatives are to give allowances in relation to (i) all existing buildings, together with all new buildings and additions to buildings; or (ii) buildings and additions erected after a specified day (say 1960); or (iii) buildings and additions erected after a very recent date (say 1974). The problems involved in giving allowances in respect of all existing buildings are immense, especially when it is proposed that all income-producing buildings should qualify. On the other hand, the restriction of the allowance to relatively new structures must give rise to inequity: for example, a rented house finished in 1975 would qualify but one next door completed in 1973 would not. The exclusion of existing buildings would also distort the property market.

8.95. Choosing between the alternatives is not easy. The major reason why nothing has been done in this area for so long, despite the recommendations of earlier committees, is probably the administrative difficulties associated with the proposals that have been made. Hence, administrative feasibility must be the major consideration, even though some inequities may result. The Committee therefore recommends that all buildings which were completed, and were used or were available for use, in the production of assessable income after 30 June 1974 (referred to hereafter as the ‘qualifying date’) and any additions to buildings where the additions were completed and used or available for use after that date, should qualify for depreciation. The rates should be based on their estimated effective lives as determined by the Commissioner. Contractual completion date rather than cost incurred to a specified date should be more readily ascertainable in the case of most buildings and a modestly retrospective date, coinciding with the end of a fiscal year, is proposed.

8.96. There will be formidable problems in determining the apportionment of the cost of a building to individual home units, own-your-own units and strata titles to property. An official study will be needed to work out special provisions for these


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cases, and initially it may be appropriate to defer granting allowances for buildings to which the title is held in one of those forms.

8.97. There is evidence in the published reports of a number of public companies that some taxpayers hold the view that because of the purpose for which a property is held, the value attributed to a building, or some other reason, depreciation of the building does not need recognition. There could be little merit in introducing a difference between tax accounting and financial accounting in these instances. In some overseas countries certain allowances are available only to the extent that the costs concerned have been recognised in a taxpayer's financial records. A similar provision might well be appropriate in relation to allowances for building depreciation proposed by the Committee, at least in respect of companies.

8.98. Treatment on change of ownership. The segregation of the proceeds of the sale of a building from the proceeds of the sale of the land on which it is erected gives rise to special difficulty. This was recognised by the Hulme Committee in its proposal that there be no balancing charge in respect of depreciation on the sale of a building, but not, however, in its proposal that there be a balancing allowance on such a sale.

8.99. In the view of this Committee, the difficulty of ensuring a fair and realistic segregation, within the proceeds from the sale of a property, of that part of those proceeds applicable to a building dictates that there be neither a balancing charge nor a balancing allowance. Segregation within sale proceeds would give rise to added complications if it were necessary to dissect further the sum allocated to buildings, so as to identify that part of the sum applicable to a building erected prior to the qualifying date and that part applicable to additions to it made subsequently.

8.100. Accordingly, the Committee recommends that in the event of the disposal of a building, the new owner should be entitled to depreciation on the basis that he succeeds to the unrecouped amount of the original cost of the structure. His annual allowances would be in accordance with the depreciation schedule for that property applying at the date of purchase. The purchase price of the property would be irrelevant in regard to depreciation allowances, the sale proceeds of the building being deemed to be its written-down value. Where there has been non-income-producing use in any year, the written-down value will have been reduced by a ‘notional’ depreciation allowance in that year.

8.101. Implicit in these proposals is the principle that all proceeds received on the sale of a property which are in excess of the written-down value of the building must represent the value of the land on which the building stands. The total of depreciation previously allowed to the vendor will, however, diminish the cost base of property for capital gains tax purposes. Where property is sold for less than the written-down value of the building—an unlikely event, no doubt—the assumption that the building was sold for its written-down value is of course contradicted by the facts, and there may be a case in this circumstance for the application of a balancing allowance. The buyer would be treated as having acquired the building at the price he paid for the property. If this is not done, the seller will be allowed only a capital loss in respect of what should be an income deduction.

8.102. It should be noted that these proposals are not intended to vary the present treatment of depreciation of buildings under the special provisions of the Act relating to mining, petroleum, primary production and forestry operations.

8.103. Demolition and damage. There would need to be exceptions, in the case of demolition or damage to a depreciated building, to the general rule that balancing


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adjustments are not made. Problems of segregating amounts received between land and buildings would not arise here (though segregation would need to be made between a building erected prior to the qualifying date and additions made subsequently). In the case of demolition or destruction, the difference between the written-down value of the building and the salvage or insurance proceeds would be allowed as a deduction in the year of demolition. If the proceeds exceeded the written-down value, the excess, up to the sum of the depreciation deductions previously allowed to the taxpayer, would be a balancing charge. Any amount of the excess not then treated as a balancing charge would reduce the cost base of the land for purposes of capital gains tax, unless the taxpayer elected to apply it in reduction of the cost of a building erected in replacement. Where there is only partial damage, any insurance recoveries would be offset against the cost of any restoration not deductible as a repair. Any amount not so absorbed would be treated as a balancing charge to the extent of depreciation previously allowed to the taxpayer and thereafter applied to reduce the cost base of the property for purposes of capital gains tax. Insurance recoveries in respect of restoration amounting to repair are income under existing law and the repair cost deductible. Balancing deductions would not be allowed, since depreciation will continue to be available on the original schedule.

8.104. Effect on revenue. The loss of tax revenue that would result if income-producing buildings were to qualify for allowances has been a major factor in postponing the introduction of such allowances. But this factor should not be permitted to override the correction of an inequity in the form of an overstatement of net income by a large body of taxpayers. Some phasing-in of the allowances is nevertheless called for. If, contrary to the Committee's proposal, a major portion of existing buildings were to qualify, phasing-in could be achieved by commencing with a low rate which would increase to a realistic figure over a period of five to ten years. A phasing-in is automatically achieved under the Committee's proposal that the allowances be restricted to buildings completed after the qualifying date.

Leasehold Improvements

8.105. Brief reference is made in Section VIII to leases in general. Here discussion is limited to leasehold improvements carried out by a taxpayer at his own expense in connection with his business activities and for which an allowance, either by way of depreciation or amortisation, is not available. A number of submissions have been received on this point.

8.106. A taxpayer sometimes has no option but to incur costs in erecting buildings on leasehold, and it has been claimed that an allowance should be available which recoups the costs over a reasonable period. Buildings erected at an airport by an airline to service passengers, cargo and aircraft are one example.

8.107. The Ligertwood Committee made a series of recommendations relating to a deduction for part of the cost of improvements carried out by a lessee on leased property used for the production of assessable income and for the inclusion of an equivalent sum in the assessable income of the lessor. The effect of these recommendations would have been to allow the lessee a deduction, spread over the period of the lease subsequent to making the improvements, of an amount agreed by the parties as being the estimated residual value of the improvements at the end of the term of the lease. There would have been corresponding inclusions in the assessable income of the lessor. However, that Committee was mainly concerned with overcoming the abuse of the then provisions of Division 4 of Part III of the Act. The recommendations of the Ligertwood Committee were not acted upon but the abuses were ended by the


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termination in 1964 of the operation of Division 4 in respect of new improvements. Whatever merit there may have been in the recommendations of the Ligertwood Committee they do not seem to be appropriate in the context of the general allowance of depreciation on buildings which this Committee recommends.

8.108. At least when the lessee has erected the building at his own expense on Crown land or on land of a public authority or a body not subject to taxation, it would be reasonable to deem him to be the owner of the building in question and to provide that he should receive the depreciation allowances. However, this approach would exclude any allowance to a lessee where the leasehold improvements have been carried out on privately owned land and accordingly may be thought to be unduly restrictive.

8.109. The Committee recommends that, for the purpose of allowances for depreciation of buildings, a lessee should be deemed to be the owner of any leasehold improvements carried out at his own expense if he uses the property for income-producing purposes. He should be entitled, during the period of his possession as lessee, to allowances to recover the costs he has incurred at the same rate as would apply to equivalent expenditure by the owner. It is not proposed that on his ceasing to have possession as a lessee he should obtain a balancing allowance as to do so would possibly open the way for abuse of the allowance. The treatment of any unrecouped cost for capital gains tax purposes would be a matter of detail of that legislation.

Other Assets and Costs of a Capital Nature

8.110. The existing law has been criticised for its failure to make allowances available for the cost of assets not falling within the ambit of the depreciation provisions and for the costs of a capital nature incurred in business operation but having limited enduring value. The items include costs of acquiring know-how and trade rights, some expenses of moving the site of operations, feasibility studies and costs of capital-raising.

8.111. With the introduction of capital gains tax, thought would need to be given to whether some of these costs should qualify for amortisation allowances, similar to those available to primary producers under section 75A (paragraphs 18.23–18.25). Alternatively, losses arising from expenditure of this nature could be made to fall within the definition of capital losses for capital gains tax purposes, though there would often be problems in fixing the time when losses of this nature are to be treated as having been incurred.

8.112. The Committee is inclined to the view that at least some of these costs could be conveniently dealt with by a provision similar to section 75A, which would make the costs allowable, over a period of years, against income.

V. Trading Stock

8.113. The matching of income and expense, which is necessary if net income is to reflect a ‘true’ profit from business operations, requires a method of deferring costs which relate to stock held at the close of a year of income. The present method is set down in the provisions of the Act in respect of trading stock. If net income is to reflect ‘true’ profits, there is also a need for provisions by which an anticipated loss of the sale of stock may be brought to account. This, too, is met by the trading stock provisions. Those provisions have a third function: they make possible the anticipation of a profit by writing up the value of stock to its market selling value. This anticipation, though not related to the determination of a ‘true’ profit of a year of income, makes


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possible a spreading of income of a number of years. In this function the trading stock provisions act to support the loss carry-forward provisions and, in the case of individual primary producer taxpayers, to support any provisions relating to the averaging of incomes.

8.114. Trading stock is defined in the Act as including anything produced, manufactured, acquired or purchased for purposes of manufacture, sale or exchange and also includes livestock (section 6 (1) ). Other provisions relating to trading stock include the following:

  • (a) A taxpayer carrying on any business is to bring to account the value of his trading stock on hand as at the beginning and the end of each year of income in order to ascertain his taxable income (section 28).
  • (b) The value of the stock at the beginning of a year is the value ascertained under the Act at the end of the previous year (section 29).
  • (c) The value of each item of stock, other than livestock, on hand at the end of the year may be, at the option of the taxpayer, its ‘cost price or market selling value or the price at which it can be replaced’ (section 31 (1) ). The latter terms are not defined in the Act. A fourth basis of valuation applies where the taxpayer, on application, satisfies the Commissioner that, by reason of obsolescence or any other special circumstances (e.g., slow turnover items), a value other than one provided by section 31 (1) is appropriate for that item.
  • (d) Disposals of trading stock otherwise than in the ordinary course of business are to be brought to account at the market value of the trading stock on the date of disposal (section 36).
  • (e) A notional disposal at market value is deemed to occur where, for any reason, there is a change in ownership of or the interests of persons in trading stock (but specifically including change by reason of formation, dissolution or variation of a partnership) and one or more persons who owned or had an interest in the stock before the change has a continuing ownership interest after the change. There is relief from this requirement, if the parties so request, where a person or persons having an interest in the partnership before the change have at least a 25 per cent interest after the change (section 36A).
  • (f) A market valuation of trading stock applies on devolution of trading stock on death of a taxpayer; but relief is again given where the trustee of the estate and the beneficiaries (if any) agree and give notice that the valuation should be on the basis of a continuing business (section 37).

8.115. A number of aspects of the trading stock provisions call for consideration. These relate to the assets to which the provisions might apply, the methods of valuing trading stock and of identifying stock which remain on hand at the end of a year of income, and the operation of those provisions which in some circumstances will deem a disposition of trading stock to have been made at market value.

Definition of Trading Stock

8.116. The present definition of trading stock is giving rise to difficulty in determining whether it embraces several classes of assets which are on occasions dealt with as stock in hand for financial accounting purposes. The assets in question generally fall into one of three groups:

  • (a) land held for resale;



  •   ― 100 ―
    (b) plant spares and consumable stores;
  • (c) shares, debentures and similar assets.

8.117. Land held for resale. In defining trading stock section 6 (1) uses the expression ‘anything …’ and sections 29 and 31 refer to ‘each article’ of trading stock. The question arises, whether land is to be regarded as trading stock. Opinion is divided, though it is understood that in practice the Commissioner treats land purchased by a dealer in land as trading stock. If land does not fall within the definition of trading stock, disposals by a land dealer other than in the ordinary course of business would not have to be valued at market value (section 36). Such a disposal would include, for example, a gift of land by a taxpayer, who might otherwise have been assessable on the sale of the land, to his wife. Where real property is held for resale by a taxpayer who is engaged in a business of trading in real property, the asset should, in the Committee's view, be treated for income tax purposes as trading stock and the definition should be amended to give this result.

8.118. Plant spares and consumable stores. The problem of plant spares held in stock for future use is of a different nature. The items do not fall within the present definition of trading stock as they are not acquired or manufactured for the purpose of sale. In addition, they are not articles depreciable as ‘plant’ because they are not ‘installed ready for use’. Thus while the cost of items actually used in repairs during the income year are deductible, any loss on sale or scrapping of spare parts for which the taxpayer has no use is a capital loss and not deductible. Consumable stores such as oils, lubricants, protective clothing, cleaning materials, etc., which are used in manufacture but do not form part of the finished product also do not constitute trading stock for the purposes of the Act: they may be deductible in full in the year of purchase. In this regard the taxation treatment differs from the accounting treatment where such stock have a significant value. The Committee recommends that provision be inserted in the Act which will permit supplies on hand, including plant spares, to be treated on the same basis as trading stock.

8.119. Shares, debentures and similar assets. Another area of doubt is whether the definition of trading stock extends to shares, debentures and similar assets. This question was considered by the Ligertwood Committee which proposed that the definition should not be extended to include such assets: to do so would permit the deduction of unrealised losses on some of them without regard to unrealised gains on others.

8.120. A decision of the High Court in 1971 has substantially resolved this question in relation to shares,note but the Committee believes the position of all these assets needs clarification.

8.121. There are circumstances where the profits on sale of property may be assessable income, even though the taxpayer is not classified as a dealer in such property and the property is not within the definition of trading stock. An example is where the varying of investments and turning them to account is an essential feature of the business: it has been held that the profit on realisation of portfolio investments by banks, life insurance companies and some investment trusts is assessable income under section 25 of the Act. In the Committee's view these assets should be treated as trading stock if they are to be subject to income tax. If they are not treated as trading stock, these profits should be subject to capital gains tax.




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8.122. The Committee sees merit in the point raised by the Ligertwood Committee, referred to in paragraph 8.119. When shares, debentures and similar assets are treated as trading stock for income tax purposes, the basis of valuation elected under the trading stock provisions should be applied not to individual assets but to all assets falling within a particular class: for example, to all debentures or to all shares.

Methods of Valuing Trading Stock

8.123. The valuation of trading stock is discussed here in the context of general business. The special provisions of the Act in respect of livestock are dealt with separately in Chapter 18.

8.124. Under the present provisions of the Act each article of trading stock may, at the option of the taxpayer, be valued at its cost price or market selling value or the price at which it can be replaced. There is also provision for valuing trading stock at a lower figure where the taxpayer requests this and the Commissioner can be satisfied that, due to obsolescence or other special circumstances, a lower value is more appropriate.

8.125. The terms ‘cost price’, ‘market selling value’ and ‘the price at which it can be replaced’ are not defined in the Act and have been the subject of litigation and discussion over the years. It is therefore proposed to consider each term separately and the problems associated with it.

8.126. Cost price. Cost is regarded as identifiable or historical cost and the elements which make up cost are:

  • (a) The purchase price of goods and, in the case of manufactured stock, materials used in manufacture.
  • (b) Direct expenditure incurred in bringing the stock into its existing condition and location.
  • (c) Depending upon the circumstances, indirect or overhead expenditure attributable to the stock.

In large businesses it is often either impossible or impracticable for the actual cost of each article of stock on hand to be ascertained. This is recognised by both the accounting profession and the Revenue, and certain methods or formulae have been devised which produce an estimate of the cost of trading stock. These include:

  • (i) First-in-first-out (FIFO).
  • (ii) Average cost.
  • (iii) Standard cost.
  • (iv) Adjusted selling value.
  • (v) Last-in-first-out (LIFO).
  • (vi) Base stock.

The accounting literature on stock valuation is extensive, and it is not therefore proposed to describe each of these methods in detail.

8.127. The Revenue does not accept the LIFO and base stock methods, and, understandably, accepts standard costs only where the standards are reviewed regularly to equate with current prices.




  ― 102 ―

8.128. The major area of disagreement between the taxpayer and the Revenue as regards valuation at cost is the extent and nature of overhead expenses which need to be included in the cost of manufactured products and items in process of manufacture. Other problems include the meaning of ‘cost’ in special situations: for example, in relation to imported goods when foreign exchange rates change in the interval between purchase and payment; in relation to second-hand cars when discount on a new car is given by higher trade-in on a second-hand car (recently solved but only by Commissioner's compromise); and in relation to by-products. These problems arise out of the many possible interpretations of ‘cost’ when applied to different businesses.

8.129. In practice there is quite often disagreement of a technical nature regarding costs to be included. Because of the variety of methods of valuation applicable to particular types of businesses, it would not be possible to lay down statutory definitions. This was the view reached by the Spooner and Ligertwood Committees, and also by the Carter Commission in Canada.

8.130. A number of submissions have drawn attention to the difficulties currently being experienced in valuing stocks at cost figures acceptable for income tax purposes. These are some of the points which have been raised:

  • (a) There is some inconsistency in the rulings given by departmental officers as to the extent that overheads are to be included in determining cost.
  • (b) The appropriate method of calculating manufacturing cost depends on the nature of the business.
  • (c) The valuation of trading stock which is in accordance with accepted accounting standards consistently applied should be acceptable for tax purposes.

8.131. Generally the Commissioner requires, when the basis of valuation of a taxpayer's stock comes under review, that cost be determined on a full absorption basis that takes to account all production overhead expenses whether they be fixed or variable. However, it seems that many taxpayers for both financial accounting and tax purposes use a direct cost basis which allows only for production overheads varying according to volume of production. Direct costing excludes a value for many overhead costs normally brought to account on a full absorption cost basis. When the basis adopted is consistently applied from year to year in the case of a continuing business, the effect of the method used on net income of a year is not usually significant.

8.132. Having regard to the many and varying factors which need to be given due weight in determining the appropriate method for arriving at cost, particularly of manufactured stock, the consistent application of a generally accepted method of valuation may well be an adequate test of the reasonableness of the value. It would be most undesirable, from an efficiency viewpoint, were a large body of taxpayers to find it necessary to value their stock on two different bases, one for financial accounting and the other for tax accounting.

8.133. The Committee makes no recommendations for amendment of the present provisions relating to the valuation of trading stock at cost. It believes, however, that many taxpayers in business would benefit were the Commissioner to publish information dealing with the interpretation and operation of the law on stock valuation. This should help to remove some of the uncertainty that now exists.

8.134. It would be helpful if there were a requirement that where the valuation of trading stock has an important bearing on the determination of net income, taxpayers should disclose their methods of valuation and whether or not the method has been


  ― 103 ―
consistently applied. This raises the question of special provisions to cope with situations where taxpayers decide it is necessary or appropriate to vary their method of valuation.

8.135. Where a taxpayer changes his method, it has been the practice to require that the new method be also applied to valuation of stock at the commencement of the year of income. Where this results in opening stocks being valued at below the closing value of the previous year, the taxpayer loses a deduction for the amount by which the opening stock value in the year of change is decreased. The Committee recommends that special provision be made so that differences such as these arising from a change in method of valuation will be spread and brought to account over a period of, say, five years. A somewhat similar recommendation has been made in respect of a change in the basis of taxation from cash to accruals (paragraph 8.25).

8.136. Market selling value. By market selling value is meant the price at which the item could be expected to be sold in the market in which the trade of selling by the taxpayer is conducted. It contemplates a sale in the ordinary course of business and not a forced sale. No allowance is made for a possible fall in market price in the future, even when such an eventuality is reasonably anticipated.

8.137. Market selling value ceased to be an acceptable method of stock valuation for financial accounting purposes many years ago when it was replaced by the concept of valuation at ‘net realisable value’, provided it is less than cost. Net realisable value has been defined as the price at which it is estimated that the stock can be realised in the normal course of business, either in its existing condition or as embodied in the product normally sold, after allowing for expenditure to be incurred before and in the process of disposal. In estimating this price, regard is to be had to excess and obsolete stocks, the trend of the market and the prospects of disposal.

8.138. The main ground for rejecting net realisable value as a basis for tax treatment is that it involves estimates which would be difficult for the Revenue to confirm. However, the problems in this area should be no greater than currently apply in computing net income under the accruals method (for example, in estimating the liability of a general insurance company for outstanding claims). The Committee therefore recommends that the Act be amended to substitute net realisable value for market value as one of the alternative bases of valuation of trading stock.

8.139. Replacement price. Replacement price means the price at which the taxpayer can buy the goods on the last day of the year of income. This basis appears to be a satisfactory alternative and the Committee believes it should be retained.

Disposal of Trading Stock

8.140. A number of problems are occurring in the operation of the special provisions of the Act dealing with the disposal of trading stock otherwise than in the ordinary course of business. Where a taxpayer disposes, whether by sale, gift or in some other way, of trading stock which is an asset of his business activity and the disposal is not made in the ordinary course of that business, the value of the asset so disposed of is included in his assessable income at its market value (section 36).

8.141. This provision extends to disposal of trading stock flowing from a change in ownership or of interests following the formation, dissolution or variation of interests of a partnership; but the parties concerned may elect that it shall not apply if the persons holding not less than a 25 per cent interest prior to the change continue to have an interest of not less than 25 per cent after the change has been implemented. Where


  ― 104 ―
the parties so elect, the value of the trading stock shall be the figure at which it would have been valued if no disposal had occurred and the year of income had ended on the date of the change (section 36A).

8.142. The major weaknesses in the existing provisions appear to flow from the limitation of their application to assets of a business carried on by the taxpayer.

8.143. For example, a taxpayer who may, on disposal of property, have been liable under section 26 (a) may gift the property to another person. Section 36 will not apply, as the taxpayer was not carrying on a business of which the property was an asset. The other party will not be taxable on the profits on disposal of the property as, having acquired the property as a recipient of an unsolicited and unencumbered gift, he could not be said to have acquired it for resale at a profit.

8.144. The Committee believes that an additional provision is necessary to extend the requirement for bringing to account as assessable income the market value of any asset disposed of, where the profit on disposition is subject to tax and the asset disposed of was not included in the assets of a business carried on by the taxpayer. A new provision modelled on the existing subsection (4) of section 26AAA would be worth considering.

8.145. It is desirable that there be two exceptions, available at the election of the taxpayer, to the general rule that, on disposal otherwise than in the ordinary course of business, trading stock and other assets should be valued at market price. Firstly, the rule should not apply to transfers of assets between companies forming part of a company group. Secondly, it should not apply when assets are transferred in the course of an amalgamation, reconstruction or merger of one or more companies.

8.146. Consideration also needs to be given to the devolution at death of assets other than trading stock and from which any profit realised prior to death of the taxpayer would have fallen to be taxed. Under the present law trading stock must, on the death of a taxpayer, be brought to account at its market value (section 37); there is a proviso, however, by which the trustees and beneficiaries may give notice of their agreement to the Commissioner that the value of trading stock forming part of the business assets of the deceased shall be their value determined on the basis that the deceased had not died, with the result that any difference between tax value and market value is not brought to account for tax as at the date of death (section 37). This proviso is of considerable assistance to the beneficiaries of a deceased taxpayer who had been carrying on primary production and valuing livestock at average cost values. In the Committee's view, the proviso should be retained.

8.147. The question arises whether there should be a provision, equivalent to section 37, which will bring about a deemed realisation at death for income tax purposes in the case of an asset of the kind referred to in paragraph 8.144, i.e., an asset whose disposition will generate a taxable profit but which is not an asset of a business carried on by the taxpayer. It would be somewhat illogical if there were no provision to this effect when, under the Committee's recommendations, there will be a deemed realisation of other assets at death for capital gains tax purposes.

8.148. The difficulties arising from the operation of the special provision (section 36A) relating to changes in interests of partnerships carrying on business and with assets which include trading stock, growing crops, etc. are somewhat different.




  ― 105 ―

8.149. Section 36A was introduced into the Act in 1952 following a recommendation of the Spooner Committee. The basic rationale was to avoid the inequitable taxation of unrealised profits which arose from the application of section 36 where there was a continuity of interest in the members of a partnership following a variation, dissolution, etc. of an old partnership. Unfortunately it seems that in addition to correcting the old inequity, section 36A, as at present worded, has also created a ready means of income-splitting.

8.150. For instance, a sole trader disposing of livestock, having a market value far higher than its average cost value as used for income tax purposes, to a family partnership would, but for section 36A, be required to bring the disposal to account at the then market value of the stock. Where the sole trader holds a substantial interest in the new partnership, it is reasonable that he should not be called upon to pay tax on a profit largely unrealised. However, by a two-stage arrangement it has been found possible to transfer the whole interest in the stock to a family partnership or family company without incurring tax on the excess of market value over income tax value. By this method the tax liability on the excess can be transferred from a person paying a high marginal rate of personal income tax to other members of the family paying at lower marginal rates when the profit is realised in the normal course of business.

8.151. The Committee recommends that the principles adopted in New Zealand income tax legislation in relation to the disposition of an interest in trading stock be embodied in the Australian law. In New Zealand the following wording is inserted after sections of the Act dealing with disposals of the entirety of trading stock:

‘The foregoing provisions of this subsection shall with necessary modifications apply in any case where a share or interest in any trading stock is sold or otherwise disposed of by any taxpayer.’

A taxpayer disposing of a share or interest in trading stock is required to bring to account his share of the market value of trading stock so sold or transferred. The purchaser or transferee of the interest is deemed to have purchased the share of the trading stock at the same market value. Problems which might otherwise arise of assessing continuing partners in a partnership on profits which have not been realised are overcome by permitting their interest in trading stock on hand at the balance date following the acquisition to be valued on the same basis as would have applied had there been no change in the constitution of the partnership.

8.152. The following is an example illustrating the operation of the New Zealand principles. A, a grazier, operating as a sole trader enters into partnership with B on 31 August 1973, each having a half-interest in partnership profits and capital. A transfers to the new partnership his livestock which had an average cost value of $10,000 and a market value of $16,000. The provisions operate as follows:

  • (a) A brings to account his disposal of livestock to the new partnership at market value: $16,000.
  • (b) The partnership brings to account its opening livestock at 31 August 1973 at the same figure: $16,000.
  • (c) At the end of the income year, 30 June 1974, the partnership is entitled to value its closing livestock at what would have been A's average cost had he carried on the business for the full year.
  • (d) The result may be summarised as follows. A's income for the year includes the full profit of $6,000 on the disposal of the partnership. However, his share of partnership income is reduced by the loss on writing down livestock from


      ― 106 ―
    its market value to his average cost, which virtually eliminates any unrealised profit on livestock flowing from his continuing half-interest in it. B's share of partnership profits is also reduced by the writing down of the value of livestock He obtains a deduction for the full cost of his interest in this asset of the new partnership.

8.153. The adoption of provisions based on those in force in New Zealand should eliminate a major weakness in the existing provisions. It is appreciated that this new approach will permit a deferral of income arising from the reduction from market value to average cost, for example in respect of B's income in the illustration above. However, any loss to Revenue on this count should be largely offset by tax payable on the profit realised on the interest in trading stock disposed of, which currently is being largely deferred by the operation of section 36A.

8.154. Where a share or interest devolves by the death of a taxpayer, the principles of the present section 37 of the Act considered in paragraph 8.146 should apply.

VI. Recoupment of Losses

8.155. The overriding principle that income tax should be levied on ‘true’ profits from a business during the whole period of its operation is an administratively impossible ideal. Annual tax accounting is clearly necessary if tax is not to be indefinitely deferred and the flow of revenue made uneven. Where a loss is suffered in one year, some expression of the overriding principle will be achieved if the loss is carried forward and applied against income of subsequent years. Carry-forward of losses is allowed by the present law for seven years, and, in the case of primary producers, for an indefinite period. But a full expression of the overriding principle would only be achieved if losses could be indefinitely carried back to earlier years and applied against the income of those years, generating tax refunds to the taxpayer. A workable tax system requires that an assessment must at some time be treated as final: the physical problem of record-keeping is the ultimate control.

Carry-back of Losses

8.156. For many years carry-back of losses has been permitted in a number of overseas countries. In the United States losses may be carried back for three years; in Canada, the Netherlands and the United Kingdom (in effect) for one year. Currently there is no provision for carry-back of losses in New Zealand, France, West Germany or Sweden. In some countries special rules apply on cessation of business operations: in Sweden and the United Kingdom there is provision for carry-back of losses in these circumstances for two and three years respectively.

8.157. Carry-back of losses was considered by the Spooner Committee and again by the Ligertwood Committee. Many submissions requesting an amendment to the Act to permit losses to be dealt with in this way have been made to the present Committee. The Spooner Committee, while acknowledging that loss carry-back had much to commend it, foresaw formidable practical difficulties and recommended against amending the Act. These difficulties were principally the problem of collecting adequate tax revenue in periods of depressed incomes, the prevention of the early finality of assessment due to the increase in amended assessments of prior years resulting from the operation of carry-back provisions, and the inherent complications


  ― 107 ―
of amended assessment of private companies and trust estates. The Ligertwood Committee agreed with the findings of the Spooner Committee and again rejected the proposal that carry-back of losses be permitted.

8.158. In the years following the reports of these two committees it seems that the problems of business arising from the absence of any carry-back provisions for losses have increased and this view is supported by the submissions received. To some extent the difficulties flow from the inability to obtain deductions for accrued employee benefits such as long-service leave and holiday pay. In the income year in which a business activity ceases, the profits of that income year are frequently insufficient to meet the deductions which become available from the payment of employee benefits. In addition, an anomalous situation can arise in respect of private companies. For example, a private company may incur a profit for, say, the year ending 30 June 1973, which will give rise to a liability for undistributed profits tax if a sufficient distribution of that profit is not made prior to 30 April 1974. Suppose now that the company incurs heavy losses in the year to 30 June 1974 which make the payment of a dividend imprudent and in breach of company legislation. From a practical viewpoint the company has no profits available to distribute. However, it incurs a liability for undistributed profits tax at the flat rate of 50 per cent because it has failed to make a sufficient distribution of its profits for the year ended 30 June 1973. The Act takes no cognisance of the fact that the company is incapable of paying a dividend.

8.159. The Committee's recommendations relating to a deduction for accrued employee benefits will overcome some of the problems arising from the absence of provisions for carry-back of loss, but as a result of the phasing-in proposals it will be some years before a full deduction is available. The recommendation in Chapter 16 on transfer of losses between companies will in some instances also assist in the recoupment of losses.

8.160. The difficulties foreseen by the earlier committees do not appear to be sufficiently formidable to justify the continued absence of any loss carry-back. Loss carry-back will, it is true, involve some dislocation to Revenue; but this dislocation should be comparatively minor having regard to the total revenue from taxation now flowing to the Australian Government. The degree of lack of finality in assessment depends largely on the period for which losses may be carried back: a short carry-back period should not cause undue administrative difficulty.

8.161. Apart from ensuring much greater regard for the overriding principle that the tax base should reflect ‘true’ profits, carry-back has advantages in terms both of the cash-flow of business and of government economic management. The refund of tax which will result from the operation of loss carry-back should provide a business with cash funds at a time when they are most needed. Also where a downturn in the fortunes of the business coincides with a general business recession, the cash funds will provide a source of spending which should assist in stimulating economic recovery.

8.162. The absence of any provisions for carry-back of losses is partly responsible for the practice, described in paragraph 16.142, of selling the shares of ‘loss-companies’. The Committee, in Chapter 16, expresses its agreement with the measures that have been adopted to control this practice. The proposal to allow a carry-back of losses, in removing the unfairness which the practice sought to overcome, strengthens the case for the measures directed against the sale of loss companies.




  ― 108 ―

8.163. The Committee recommends that the law allow a carry-back of losses for all taxpayers other than trust estates and it believes that a period of two years should not cause undue administrative problems. It does not favour these carry-back provisions being made available to trust estates: to do so would require lengthy and complicated special provisions to ensure that the benefit of any loss carried back was in fact received by persons entitled to the benefit.

Carry-forward of Losses

8.164. Currently the Act restricts the allowance of losses to those incurred by a taxpayer in the seven years following the year of income (section 80(2)). There is one exception to this general rule in that primary producers may carry losses forward indefinitely (sections 80AA to 80 AC).

8.165. As a result of representations made to it, the Spooner Committee considered the question of the removal of the seven-year limit and made a qualified recommendation in favour of the indefinite carry-forward of losses. The qualifications were, firstly, that a deduction would not be allowed for a loss incurred in a year of income prior to the year of income ended 30 June 1944; and secondly, that a taxpayer claiming a loss incurred more than seven years before the year of income should be required to establish the amount of any loss and also establish that it had not been allowed as a deduction from assessable income in any intervening year or been offset by exempt income. The point was also considered by the Ligertwood Committee, which dismissed the issue with the brief comment: ‘No evidence was presented to us that the seven year period is generally inequitable or inadequate, and in the absence of cogent reasons to the contrary, we consider the period of seven years now provided should be retained.’

8.166. Overseas practice varies considerably. In the United Kingdom, South Africa and New Zealand losses may be carried forward without restriction; Norway permits ten-year carry-forward, the Netherlands and Sweden six-year; Canada, France, West Germany and the United States allow a five-year period. According to the Carter Commission, the existing five-year period applying in Canada was insufficient for new businesses that required long periods to develop and a liberal carry-forward of losses was essential to overcome limitations of the annual period of measurement. It therefore recommended that losses be allowed to be carried forward indefinitely.

8.167. Numerous submissions have been received by this Committee requesting either that there should be an indefinite carry-forward period or alternatively the existing period should be extended to ten years or more. One reason given was that in the chemical, mining and other capital-intensive industries losses incurred during establishment years and in times of continuous expansion frequently cannot be recouped within the present limited period of seven years. Another reason was that the trend to larger manufacturing operations, combined with the development of new products and processes, are having the effect of extending the period of initial losses. Closely related is the claim by general insurance companies that in providing the greatly increased total covers required in a growth economy and in an economy experiencing heavy inflation, insurance companies stand to incur substantial losses which require periods in excess of seven years to recoup.

8.168. The Committee recommends that the Act be amended to permit all taxpayers to carry losses forward indefinitely. In implementing this change, it should be provided that losses qualifying for allowance on the indefinite basis be limited to losses incurred subsequent to a date seven years prior to the first year of application.




  ― 109 ―

Exempt Income

8.169. The present law requires that in calculating both the amount of a loss available for carry-forward and the income against which a loss may be applied, exempt income must be brought to account. Bringing to account exempt income in this way has been criticised on the ground that it partly neutralises the concession intended to be given by the exemption.

8.170. In one situation the exemption of income is given not by way of concession but as a means of preventing double taxation of income. There is a general provision whereby income derived from a foreign source which is taxed in the country of source is exempt from Australian tax. The provision is considered in Chapter 17. Bringing this income to account in applying the provisions in regard to carry-forward of losses could be seen as, in effect, taxing the same income a second time without any allowance for the tax already paid. If, of course, the income has only been subject to modest taxation abroad, there may be thought to be reason why it should not be relieved from taxation in Australia; but the loss carry-forward provisions do not differentiate in terms of the amount of tax paid abroad.

8.171. In Chapter 17 the Committee has proposed that the method of preventing double taxation of foreign-source income be replaced by a system under which the Australian resident brings that income to tax but receives credit for the foreign tax. If this system is adopted there can of course be no objection to the income being brought to account in the operation of the loss carry-forward provisions. And the new system will overcome another criticism of the existing system. A loss which has been suffered in operations that would have generated a tax liability abroad had they been profitable, is not available for application against income subject to Australian tax. The existing system thus requires a foreign profit to be brought to account in the operation of loss carry-forward but not a foreign loss. The system proposed by the Committee will allow the bringing in of a foreign loss.

Effect of Dividend Income

8.172. One further point remains to be dealt with. It concerns the provisions of the Act aimed at preventing the double taxation of dividends flowing through intermediate companies. The Act provides (section 46) that a rebate of company tax is allowable in respect of dividends received by one company from another. The section generally operates to render dividends received by one company from another virtually free of tax in the hands of the receiving company. However, the dividends received form part of the net income of the receiving company; and in the event of the receiving company incurring a trading loss, this loss is applied against dividend income and is not available for deduction against trading profits of other periods.

8.173. There are two ways in which the result may be viewed, both of which suggest that the tax payable by the company is excessive. The first view is that to the extent to which the loss is offset against dividend income, the dividends ultimately bear double taxation. The second view is that to the extent to which the losses are so offset, no allowance in made for that proportion of the loss in computing company tax and in fact the loss is never recouped.

8.174. The Committee believes that it ought to be a fundamental principle of company tax that dividends flowing through intermediate companies should not incur double taxation and, further, that the full benefit of trading losses should be available for offsetting against other trading profits. Accordingly, it recommends that in computing the recoupment of losses of companies, amounts representing dividends


  ― 110 ―
received from other companies should be excluded from the net income of the relevant years. There would continue, of course, to be need to counter dividend-stripping opportunities.

VII. Implications of Inflation for Business Income

8.175. In the earlier sections of this chapter the discussion has been mainly concerned with the differences which arise between net income and financial accounting profits, both determined using historical cost methods of accounting. In Chapter 6 brief reference has been made to the effect of inflation on business income and the need for the effect to be recognised in levying taxes, particularly in periods when inflation is severe. A number of submissions have requested that the tax law permit depreciation allowances to be based on replacement cost in lieu of historical cost and trading stocks to be valued using bases not now acceptable to the Revenue.

8.176. It is increasingly being recognised, that conventional accounting methods fail to take account of the increased costs of replacement of fixed assets and fail too to exclude stock appreciation in computing profits which form the basis of net income and reported financial results.

8.177. The extent to which conventional accounting methods overstate profits by failing to have regard to depreciation at replacement cost and stock appreciation in periods of high inflation is very significant. On the basis of figures issued by the Commonwealth Statistician for stock appreciation and its own estimate of depreciation at replacement cost, the University of Melbourne's Institute of Applied Economic and Social Research has recently estimated that when allowance is made for these two factors profits before tax of non-finance companies for the year 1973–74 drop from $4,325 million to $2,953 million. Since company tax is assessed on the higher figure, the rate of such tax is in effect equivalent to 66 per cent of the lower figure.

8.178. Accounting methods for adjusting business profits for inflation were discussed in Germany in that country's period of high inflation after the World War I. It was subsequently examined spasmodically in other countries but received increased attention in the early 1950s when the rate of inflation became a worldwide problem.

8.179. Since then, the professional accounting bodies in Canada, the United Kingdom, the United States and Australia have devoted considerable attention to finding an acceptable alternative to historical cost accounting. In June 1969 the Accounting Principles Board of the American Institute of Certified Public Accountants issued a statement entitled ‘Financial Statements Restated for General Price-Level Changes’, which explained the theory and practice of general price level restatement. It sought the presentation of restated accounts as a means of conveying supplementary information not available in historical accounts.

8.180. Early in 1972 the Confederation of British Industry appointed a committee on inflation and accounts under the chairmanship of Sir David Barron. This committee issued an interim report in January 1973 and a final report in September 1973. The following extract from the final report is worth noting:

‘The work of the Committee in the six months since the interim report was published has only strengthened its opinion that financial statements should be adjusted to take account of inflation… The longer present historical accounting alone is continued the more will companies and the public be deceiving themselves. The continued erosion of real capital and company earnings while inflation continues at its present pace will almost certainly lead to more critical difficulties to be faced eventually. The Committee attaches great


  ― 111 ―
importance to moving as quickly as possible consistent with allowing sufficient time for the process of education’.

8.181. It is understood that neither the United States nor the Canadian professional accounting bodies have made positive recommendations to date. In January 1973 the Institute of Chartered Accountants in England and Wales, in conjunction with other United Kingdom accounting bodies, issued a draft statement entitled ‘Accounting for Changes in the Purchasing Power of Money’. It proposed that historical cost accounts be restated in terms of pounds of current purchasing power and that the restated accounts be issued as a supplementary statement attached to the conventional financial statements. In May 1974 the draft was adopted as a provisional statement of standard accounting practice.

8.182. In December 1974 the Institute of Chartered Accountants in Australia, together with the Australian Society of Accountants, issued a draft of an accounting standard entitled ‘A Method of Accounting for Changes in the Purchasing Power of Money’, which was almost identical with the provisional standard recommended by the United Kingdom accounting bodies. In issuing the draft, the Australian bodies did not recommend the United Kingdom method of adjusting profits and financial statements for the effects of inflation. Rather, it was published as an initial step in arriving at an acceptable solution.

8.183. A cardinal problem involves tax adjustments to be made where a significant portion of the capital employed in an enterprise is financed by medium-or long-term borrowings. An approach which concentrates on the need of the business entity to make adequate provision from profits for costs of replacement and for stock appreciation will tend to ignore the gains arising from the repayment of borrowings in money which has fallen in value. On the other hand, an approach which concentrates on the interests of the holders of equity capital will have regard also to those gains.

8.184. There appears to have been a tendency for revenue authorities in most countries to remain aloof from the efforts to find an alternative to conventional accounting methods which will produce ‘true’ profits in periods of high inflation. Nevertheless, some concern has recently been shown in the United Kingdom with the appointment in early 1974 of the Committee on Accounting for Inflation (Sandilands Committee) which has not yet issued its report.

8.185. Some recognition of the problems facing business in times of inflation has been given in a number of countries by the introduction of special allowances in respect of depreciation of fixed assets, though frequently these allowances have been employed primarily as a tool of economic management. The allowances vary in form: in some instances as investment allowances in the year the asset is acquired, in addition to normal depreciation allowances; in other instances in the form of substantial initial depreciation allowances. In the United Kingdom, for example, a taxpayer may claim 100 per cent of the cost of new plant installed.

8.186. For some time now, the need to retain sufficient profits to assist in financing the higher costs of replacing fixed assets has been acknowledged by many of the larger industrial organisations. Some have carried out revaluations of their assets at regular intervals, substituted the higher values for the historical cost values and thereafter provided for depreciation on the written-up figures. However, a tax deduction is not available for the additional depreciation thus set aside in computing financial accounting results. Others have calculated the estimated additional depreciation needed on a replacement values basis and have taken this further sum into account


  ― 112 ―
when considering profits available for distribution to shareholders. However, many businesses have largely ignored the problem, with the result that no account has been taken of the increased costs of replacement.

8.187. With inflation at high levels, the effect of stock appreciation forming part of profits falling to be taxed and the related problem of providing funds to finance the increased value of stocks are now matters of major concern. The need to have regard to stock appreciation in computing taxable income has recently been recognised in the United Kingdom where, in November 1974, a special measure was proposed. Broadly, where the increase in value of trading stock and work in progress during the financial year 1974–75 exceeds 10 per cent of a company's profit, the company is permitted to reduce the value of these assets at the close of the year so that the increase in trading stock does not exceed 10 per cent of profits. The measure is confined to companies and to instances where the increase in stocks exceeds £20,000. It results in a deferment of the tax payable on the amount by which the year end stocks are reduced. It is not as yet clear when the deferred tax will fall due for payment, but industry has been assured that it will not be payable in the subsequent income year.

8.188. In the United States where the LIFO method of valuing trading stocks is permitted, it seems that a growing number of companies are adopting this alternative basis which tends to restrict the extent to which stock appreciation arising from inflation forms part of current profits.

8.189. In Australia, at least until very recently, there have been virtually no measures to alleviate either the impact of tax or the pressure on business for finance in the current period of rapid inflation. However, in December 1974 the Australian Government announced the appointment of an independent panel to conduct an inquiry into inflation and taxation and to report by May 1975. The panel's second term of reference is:

‘To examine the effects of rapid inflation on taxation paid by companies and other enterprises and in particular: (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’.

8.190. A further measure proposed is the introduction of a new depreciation allowance which doubles the depreciation deduction for the current financial year in respect of new plant installed in manufacturing and certain other industries. However, this special allowance is very much less than that available in most overseas countries.

8.191. Further action to bring net income for tax purposes closer to ‘true’ profits in periods of high inflation is now urgent. In view of the inconclusiveness of endeavours by business and the accounting profession to find an acceptable alternative for conventional accounting despite considerable research and exposure of the issues involved, it would be unduly optimistic to expect that the problem will shortly be solved by a change in accounting procedures. In any case, new methods are unlikely to meet the circumstances of the whole range of business activity: though acceptable to many businesses, they may prove to be inappropriate for use in computing net income for tax purposes.




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8.192. In the circumstances the appropriate course would appear to be the adoption of measures which operate on a broad scale and which recognise to a degree the overstatement of net income currently occurring. Policies which merely result in a deferment of tax, such as the United Kingdom provision in respect of trading stock and the granting of initial allowances in respect of depreciation on new fixed assets, though helpful, will not be as effective as policies which are more lasting or permanently reduce taxes payable on business income. Measures of the latter type include reductions in rates of income tax, a LIFO method of stock valuation and investment allowances in respect of fixed assets.

8.193. In view of the appointment of the special panel and the detailed studies of which it will have the benefit, this Committee makes no recommendations as to steps which might now be taken. It stresses, however, the urgency of the need for action.

VIII. Sundry Costs Of Business Operation

8.194. This section discusses the treatment for taxation purposes of a number of costs in conducting business, all of which involve matters raised in submissions.

Lease Transactions

8.195. Division 4 of Part III of the Act contains special provisions dealing with premiums received in relation to the grant, assignment or surrender of a lease and improvements erected by lessees on leased property. However, the application of these provisions was restricted in 1964 and they are no longer generally available. A number of submissions have sought the reintroduction of provisions similar to Division 4 along lines recommended by the Ligertwood Committee.

8.196. In Section IV the Committee has made recommendations for the allowance of depreciation on buildings, including a tentative proposal in relation to allowances in respect of leasehold improvements carried out at a lessee's expense.

8.197. With the introduction of capital gains tax some changes in the law will be necessary in respect of lease transactions generally. Until such time as the Government's proposals in relation to leases under the capital gains tax legislation are known, it would be inappropriate for this Committee to attempt to make detailed recommendations in this area. Clearly the income tax provisions must be blended with those relating to capital gains tax.

Expenditure on Repairs to Income-producing Property

8.198. Two aspects in relation to repair expenditure have been raised. The first relates to what are generally termed initial repairs, being repairs carried out shortly after the acquisition of property. The second refers to the widely accepted practice by business of treating replacement purchases of plant and small tools, of relatively low value, as repair expenditure rather than as items falling to be dealt with by way of depreciation.

8.199. In the case of repairs carried out shortly after the acquisition of property, usually to buildings and to other structural improvements, the practice has developed, in line with a number of legal decisions, of disallowing a deduction for this expenditure where it is apparent that the repairs were necessary at the time of purchase, the general theory being that this would normally be reflected in the purchase price. This practice has been criticised on the ground that it causes administrative difficulties in the case of minor repairs and some inequity.




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8.200. The Committee believes it would be in the interests of taxpayers and the Revenue if a somewhat more flexible approach could be followed, though it is aware that if its recommendations for building depreciation are adopted, some of the complaints will tend to weaken: at present if an allowance is denied for building repairs no deduction is available. The Committee recommends that deductions be allowed for costs of repairs incurred shortly after acquisition, where the expenditure relates to normal maintenance such as painting and minor building repairs. It agrees that major structural repairs, such as the replacement of roof cladding, carried out in the initial period of ownership should continue to be treated as forming, in effect, part of the cost of the property. This is an area in which the issue of guidelines or public information bulletins would be of assistance to taxpayers and their agents.

8.201. A more flexible approach would also be desirable in relation to purchases of plant and tools of small value. Many large business organisations attempt to lessen clerical costs by writing off, in the year of purchase, minor items of plant and maintenance equipment as it is purchased. It is usual to follow this practice of write-off, subject to a limit of, say, $200 for any one item. By so doing, the need for detailed recording of the asset in depreciation schedules is avoided. The Committee recommends that the Commissioner give favourable consideration to requests of taxpayers to be allowed to deal with minor items of a capital nature in this way, within the statutory authority that it is proposed he be given in paragraph 8.47.

Professional Libraries

8.202. A number of requests have been received, mainly from professional bodies, persons and partnerships, for a more realistic deduction for expenditure incurred in respect of the purchase of textbooks and other publications of a professional nature. While a deduction is normally allowable in respect of a subscription to a journal or to a professional body which sometimes carries with it the right to receive periodical publications, other publications, purchased frequently at considerable cost, are deemed to be assets subject to depreciation at the rate of 5 per cent on a fixed instalment basis or 7½ per cent on the reducing balance method. The submissions on this subject complain that these rates are far too low.

8.203. Textbooks and digests are the necessary ‘tools of trade’ of the professional person. New editions are constantly being published as advances in professional knowledge and methods make existing texts redundant. In the legal profession continual changes in the law brought about by the enactment of statutes and decisions of the Courts have a similar effect. The effective useful life of library texts is therefore limited. In order to cope with these continual changes, modern technical publishing, particularly in the field of law, now often takes the form of loose-leaf services. These are regularly updated by revision sheets which supersede existing parts of the service as they become redundant. The Committee understands that the cost of updating sheets is treated by the Commissioner, in the same way as professional journals, as a revenue expense. This treatment seems reasonable. An ancillary feature of the present provisions for professional library depreciation is the administrative problems of recording depreciation and accounting for disposals and their related balancing adjustments.

8.204. Two methods of simplifying the recoupment of capital expenditure on professional libraries warrant consideration. Texts costing less than, say, $40 could be treated as a revenue expense to be written off in the year of purchase, and the rates of depreciation on other texts might be reviewed in the light of the present limited useful life of publications. Alternatively, the rate of depreciation could be set at a realistic


  ― 115 ―
level, say 20 per cent per annum, calculated on the reducing balance method for the whole library; additions would be added to the written down value of the library at cost while the sale proceeds, if any, of disposals would be deducted from the written-down balance. Where the sales proceeds in any year exceed the written-down balance plus additions in the year, a balancing charge would need to be made. Otherwise balancing allowances or charges would automatically be added to or deducted from the written-down balance. This effective absorption of balancing adjustments removes the need to maintain continued records of the cost of individual texts. The Committee prefers the second method since it simplifies the clerical task of keeping depreciation records and prevents any abuse of an arbitrary limit for any one text.

Travelling and Entertainment Expenses

8.205. Reference has been made in Chapter 7 to the interpretation given to the general deduction section (section 51) of the Act. It is there recommended that an apportioned amount of an outgoing should be denied deduction where it can be inferred from all the circumstances that the character of the outgoing is in part a payment for a purpose which is not the gaining of income. It is not intended, however, that merely because an outgoing such as travelling and entertainment expenses might be said to be extravagant, some part of it must be denied deduction. The proposition asserted in the authorities that the law does not enable the Commissioner to say how much a taxpayer should spend in the gaining of income will continue to be valid. The Committee would not favour provisions, of the kind included in the Canadian law, which would give the Commissioner power to disallow a deduction if he considers that the expenditure involved is unreasonable.

8.206. It may nonetheless be appropriate for the law to specify particular items of expenditure which are likely to involve substantial elements University private consumption by the proprietors of a business and deny them deduction. Recent amendments to the Act deny, for example, deductions of some expenditure on yachts and expenditure on club subscriptions.

Anti-pollution and Ecological Expenditures

8.207. A number of submissions have been received seeking special deductions in respect of expenditure to reduce pollution and to preserve the ecology. Sometimes the expenditure is incurred to prevent pollution of the atmosphere, on other occasions pollution of the soil, streams and ocean, and in yet others to prevent destruction of the environment by its physical alteration. The expenditure may be incurred to comply with legislation, or solely because of the moral obligation of business to avoid inconvenience to the public. The Committee's attention has been drawn to provisions in the United States which allow expenditure of this type to be recouped over five years, and to a similar allowance available in New Zealand.

8.208. The costs are incurred over the broad spectrum of the manufacturing industry and very often in activities connected with mining and other extractive industries. On occasions the costs by way of special equipment, enlarged chimney stacks and treatment of effluent are substantial. Clearly, expenditure in this area warrants encouragement, and special allowances for costs of this kind might be thought justified. However, as what is sought involves an incentive, the Committee merely draws attention to the fact that a number of submissions have been received seeking concessional treatment in this area.




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IX. Conclusion

8.209. Many of the recommendations made in the chapter are intended to eliminate differences between tax accounting and financial accounting and in general to bring them into closer relationship. None of the recommendations involve concessions to business but merely give tax recognition to the fact that the expenses involved are incurred in earning business income.

8.210. Further differences between net income and financial profit will no doubt arise in the course of time as business operations change. A continuing concern with differences between tax accounting and financial accounting should be one of the main areas of responsibility of the independent standing committee on taxation proposed by the Committee in paragraph 22.63.

8.211. Attention is drawn to the Committee's recommendations in Chapter 18 in relation to the restriction of deductions for certain losses incurred in primary production activities. There it is proposed that a deduction be disallowed for a loss where the activity is not being carried on with a view to profit or where there is no reasonable expectation of a profit being achieved. Consideration should be given to the introduction of a provision along similar lines which would have application to business generally, or at least to a number of specific areas in addition to primary production. Motor racing, fishing and the search for minerals might be examples.

8.212. The Committee has not given special consideration to the peculiar problems of small businesses, whether they be problems of income tax, estate duty or other taxes. Shortly after its appointment it accepted a proposal from the Department of Economics at the University of Newcastle that it provide funds for a special survey of the effect of taxation on small businesses in Australia—a survey forming part of a broader investigation into small businesses. This survey was not completed in time for full consideration by the Committee; it is one of the studies listed at the end of this report which the authors have agreed may be published.




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9. Chapter 9 Income Tax: Issues Related to Employment and Investment Income

I. Employment Income

9.1. Chapter 7 contains a discussion of a number of matters which, though not confined to persons deriving employment income, are clearly of interest to them. These include the deductibility of expenses of travel to and from work, child-minding expenses, subscriptions to trade and professional associations, and self-education expenses. The present section of this chapter is concerned with further issues related exclusively to employment income. Most notable among these is fringe benefits. Some attention is also given to salary and wage adjustments, travel and removal expenses, payments to obtain release from employment contracts, and a standard deduction for miscellaneous employment expenses.

Fringe Benefits

9.2. The phrase ‘fringe benefits’ is intended to refer to any benefit, other than salary and wages, derived from an employment. The benefit usually takes the form of non-money income, such as the use of a company car or a home provided by the employer. Sometimes, however, it involves cash, as when a portion of an expense allowance remains unspent, or a cash prize or gift is received from an employer.

9.3. Reference was made in paragraphs 7.13–7.15 to the problems of bringing fringe benefits to tax when they take the form of non-money income. Some further elaboration of these problems is necessary, and also of the related problems of fringe benefits by way of cash. The provision of the Income Tax Assessment Act most relevant to the present discussion is section 26 (e), which requires the inclusion in the taxpayer's income of ‘the value to the taxpayer of all allowances, gratuities, compensations, benefits, bonuses and premiums allowed, given or granted to him in respect of, or for or in relation directly or indirectly to, any employment of or services rendered by him, whether so allowed, given or granted in money, goods, land, meals, sustenance, the use of premises or quarters or otherwise …’.

9.4. A number of matters call for examination. The first concerns the adequacy of the present law to cover all those benefits that it is thought should be included in income. Thus it is doubtful whether the law is adequate to cover the case where the benefit is given, not to the employee, but to a member of his family. There is also a question of how far it is proper to treat as benefits the amenities enjoyed by an employee which are inherent in the performance of his services. In addition, the method of valuing a benefit prescribed by the present law may not be appropriate.

9.5. Secondly, it is proposed to consider the kinds of benefits that would, at least in theory, be within the operation of the amended law and to make observations on how far rules might be laid down that could be applied in the general run of cases to identify benefits and fix their values.

9.6. Thirdly, whether the benefit is one presently subject to tax, or will come within the ambit of reformed provisions, it is necessary to consider the possibility of integrating the taxation of benefits with the system of tax instalment deductions from salary and wages.




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Adequacy of Present Law

9.7. Section 26 (e) is concerned with benefits ‘allowed, given or granted’ to the taxpayer, in the present context the employee. It is not uncommon for the employee to be rewarded in some respects by benefits given to members of his family: for example, air travel provided for them by his airline employer, or education expenses in respect of his children paid directly by his employer. It might be possible to argue that the employee receives a benefit in the saving of expense he would otherwise have incurred. And, in some cases, it will be possible to construe the facts so that section 19 applies: that section would include in the income of the employee an amount that has been ‘dealt with’ by the employer ‘on behalf’ of the employee or as the employee ‘directs’. In the Committee's view it is nonetheless necessary, in order that all situations be clearly covered, to provide generally in section 26 (e) that a benefit arising from the employment relationship enjoyed by a member of the employee's family be deemed to be a benefit derived by the employee.

9.8. Another question is whether the section extends in any respect to benefits that are inherent in the performance of the employee's services. In some cases a benefit is a necessary consequence of performing employment duties: for example, attractive office accommodation or the entertainment enjoyed when attending official functions. It may be argued that where the working conditions of employees of one firm are so much more attractive than those of employees of another firm, the benefit of the more favourable conditions should be brought to tax; or, alternatively, that any remuneration reflecting the less attractive environment in which the second group of employees works should be exempt from tax. While the Committee recognises the force of this argument, it believes that law framed in either of the alternative ways would not be feasible to administer.

9.9. Where the benefit relates only in part to the carrying out of the employment duties, in the sense that it is only in part a necessary consequence, the Committee considers that an appropriate part of the benefit should continue to be brought to tax. Identifying the benefit which is a necessary consequence will always be a matter of judgment. Take, for instance, employer-subsidised housing, which may be a flat in an office building provided for a caretaker who lives in it with his family, or a prestige house provided for a business executive who is expected to entertain clients at home, or a house made available to the local manager of a country branch of a business. In each case the question must be one of how far the employee's use of the house serves his employer's purpose.

9.10. The Committee recommends that section 26 (e) be amended so as to ensure that, even though a benefit is inherent in the carrying out of employment duties, it should be brought to tax except so far as its derivation is a necessary consequence of the performing of those duties.

9.11. Another legal issue relates to the interpretation of the words ‘value to the taxpayer’ in section 26 (e). The intention in the use of these words is clearly to displace the general principle of the income tax law that a benefit must be valued by reference to the amount of money that could be obtained for it. On this principle of valuation, the use of a motor vehicle or a residence available only to the employee has no value; the relief from the payment of interest enjoyed by a person who has an interest-free loan also has no value. But the precise method of valuation required by the words ‘value to the taxpayer’ is unsettled. In the Committee's view the meaning to be given to the words should be what it would cost the employee to provide the taxable benefit for himself.




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9.12. It may be contended that the interpretation thus proposed would be too harsh: that it would, for example, require the full rental value of the caretaker's house, in the illustration given in paragraph 9.9, to be brought to tax. It would be made clear in the amended section, however, that the benefit being valued does not include that element which is a necessary consequence of carrying out the employee's duties.

9.13. The employee will in some circumstances be able to argue that the benefit he might have provided for himself would have been something more modest than the benefit he has derived. The argument would be relevant to determining the element of benefit that ought to be brought to tax but not to valuation. An executive should be able to say that he occupies a home which is too large and too expensive for his needs and tastes because his company requires him to live there in the company's interests. But he should not be able to say that a benefit he is free to refuse, for example an expensive car provided exclusively for his private use, is beyond his needs and tastes.

Kinds of Benefits

9.14. Assuming that the law has been amended in the ways proposed by the Committee, issues both of identification and of valuation will arise in relation to various kinds of benefits. These are explored in the following paragraphs. While the legal obligation always rests on the employee to include a benefit in his return of income, there is a question of what the Commissioner should do as a matter of administration to establish rules of identification and valuation. Possible rules of these kinds are also considered in the following paragraphs.

9.15. Housing. Many of the problems of identifying and valuing the benefit from employer-provided housing have already been raised in the illustrations of the caretaker's flat and the business executive's house. Where housing is not in a remote area, the Commissioner should be able to frame rules of identification and valuation, and these ought to be made public. (Such rules would not preclude the taxpayer from establishing that he is entitled to different treatment.) In particular classes of situations, for example a vice-chancellor's house on university grounds, the rules of identification could prescribe certain fractions as taxable benefits. The rules of valuation might provide for the adoption of either a percentage of the capital value as determined by a valuation authority or a rental value of comparable accommodation. Any rent paid by the employee would of course be subtracted.

9.16. Problems of identification of a more especially intractable kind arise when the housing has been provided by the employer at a remote location, such as a mine site: some recognition should be given to the fact that while he remains in the employer's service the employee has no real choice of housing. Problems of valuation may also be acute. It would, presumably, be inappropriate to determine value on the basis of what the house cost the employer, which may be a very high figure because of the location; on the other hand, sale price in a remote area might give too low a figure. There is unlikely to be any market in the area by which to determine a rental value. It may not be possible to frame rules: identification and valuation would have to be settled by negotiations between the employer, or an employee organisation, and the Commissioner.

9.17. Board and lodging. Where the benefit is board and lodging, the same questions arise as for housing and the same recommendations are appropriate. But one further point is worth noting. Section 51A, considered later in paragraphs 9.60–9.62, allows a deduction against a living-away-from-home allowance in circumstances where an employee may be said to be required by his employment duties to establish a temporary home away from his normal place of residence. Arguably, there should


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not be held to be a benefit from board and lodging to the extent that the employee, had he received an allowance, would have been entitled to a deduction under section 51A.

9.18. Use of motor vehicles. The use of a motor vehicle provided by the employer is a common fringe benefit. In principle the value of any private use of such a vehicle should be brought to tax. Private use would include travel to and from work except in those circumstances, explored in paragraph 7.58, where such costs, if incurred by the employee, would be deductible outgoings.

9.19. The Commissioner should establish rules for valuation based either on the annual depreciation of the vehicle and running costs referable to the amount of private use or on some assumed rate per kilometer applied to the distance travelled in private use.

9.20. Provisions have recently been inserted in the Act requiring the inclusion in the employee's income of a minimum amount in respect of the private use of a motor vehicle. These provisions may make unnecessary the calculations contemplated in the preceding paragraphs in the not uncommon case where private use is restricted to travel to and from work and occasional week-end travel. Where the vehicle has an original cost of $6,000, the minimum amount will be $720 in a year of income, assuming that the vehicle is available to the employee for private use for some part of each day of the year of income. It will be proportionally less if the vehicle is available for only a part of the year. The new provisions are complex and it is too early to gauge how well they will work. The Committee is aware of criticisms that the legislation is likely to operate unfairly in some cases but has not sought submissions in this regard.

9.21. Goods or services supplied at a discount. It is not uncommon for an employee to be permitted to purchase goods from his employer at a discounted price. The amounts of the discounts vary widely. It might be thought appropriate to regard an excessive discount as a benefit if what is excessive could be fairly determined. One difficulty is that the retail price by reference to which the excessiveness of the discount would need to be calculated tends, in competitive business conditions, itself to vary noticeably. Another is the problem of relating the treatment of the employee in a retail store receiving discounts against retail prices with the treatment of an employee of a wholesaler who receives discounts against wholesale prices. Ascertaining that an employee has received a discount and, indeed, ensuring that the employee keeps a record of such discounts would present great difficulties.

9.22. In the Committee's view it would not be practical for the Commissioner to frame rules in regard to benefits arising from discounts. In a particular case, say a motor vehicle sold at a very substantial discount, it is open to the Commissioner to tax the employee on the undoubted benefit he receives.

9.23. Discounts may also be provided in respect of services supplied to an employee, or services may be supplied without charge. Similar problems to those already considered in regard to goods apply in bringing to tax benefits of these kinds. In the Committee's view it would not be feasible to devise rules for general application. However, there is a case for applying rules to particular industries where expensive services may be provided to employees at a sizeable discount. An obvious example is the airline industry, where substantial fare discounts are given in respect of travel by an employee or members of his family.

9.24. As already conceded, there will be circumstances where the facts and amounts of discounts are unlikely to be known, even to the employee himself. This is especially


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so when the employer incurs a loss in providing meals in a canteen for his staff. In this case any tax consequence could only be brought about by denying a deduction to the employer, and the Committee would not recommend this. A dining-room restricted to a small group of business executives might be thought to be different from a staff canteen and warrant a more or less arbitrary apportionment of benefits among the business executives concerned.

9.25. Low-interest loans. The practice has existed for many years of granting low-interest loans to employees, primarily for house purchase. This is another conspicuous fringe benefit. In the Committee's view the benefit arising from a loan of this kind should be brought to tax whenever it is derived from the employment relationship. It should not be brought to tax when the making of the loan is solely an act of charity on the employer's part.

9.26. A loan may have been made for a term, at a rate of interest that cannot be varied, at a time when commercial rates were low. Where the rate of interest was not less than the commercial rate, there would not appear to be any benefit to the employee in a later year if, in the meanwhile, commercial rates have risen significantly. Where, however, the rate of interest was less than the commercial rate at the time the loan was made, it could be argued that some benefit is involved. Yet it would not necessarily be appropriate to regard the benefit as the difference between the loan rate and whatever happens to be the commercial rate in the relevant year of income. In the case of a loan at a rate that cannot be varied, the amount of benefit should probably be restricted to the difference between the loan rate and the commercial rate at the time the loan was made. On the other hand, where the loan rate is variable in the power of the lender, it might indeed be appropriate to treat as a taxable benefit the difference between the loan rate in fact charged and the commercial rate in a particular year.

9.27. Implicit in these propositions is a notion of a commercial rate of interest. Commercial rates tend to vary not only by reference to general financial conditions but also with the kind of loan. It would be necessary in framing a rule to fix some single arbitrary rate—one would think a low rate—to apply in all cases where an examination of individual loans is not made.

9.28. The committee recommends that rules be framed, at least as a beginning, in terms of a single ‘commercial rate’ set for each year by reference to the minimum rate charged by savings banks for long-term housing loans.

9.29. Prizes and gifts. Prizes as work incentives are given by some firms. The value of the prize is income of the employee and should be included in his return, though there is a case on administrative grounds for excluding prizes of small value.

9.30. Gifts may be looked at differently where they are in the nature of recognition of the personal esteem in which the employee is held by his employer. There is scope in the legal authorities for the view that gifts of this kind are not income, but this view would be restricted to cases such as the traditional gold watch.

9.31. Stock options and share purchase schemes. Until recently, the operation of section 26 (3) 26 (e) that the value of rights which an employee acquired under an employee stock option scheme or share purchase scheme should be brought to tax at the time those rights first arose. The valuing of rights arising under these schemes provided to be inordinately difficult and the employee who paid or was liable to pay tax felt aggrieved on occasions when the rights, in line with the value of the shares on the market, fell substantially in value.




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9.32. Provisions have recently been inserted in the Act displacing the operation of section 26 (e). Under these provisions the time of derivation of income under a share option or share purchase scheme will be the time when the option is exercised or shares are transferred to the employee. The benefit will be the amount by which the value of the shares acquired exceeds the consideration the employee has given for them. In the Committee's view this approach is the correct one. Comment on the detail of these proposals is not attempted in this report.

9.33. Goods and services supplied by others and paid for directly by the employer. A wide range of goods and services may be supplied to employees and paid for directly by their employer. It may be helpful to consider some typical situations.

9.34. Where the expense met by the employer relates to the education of the employee's children, there is a simple case of a benefit that should be brought to tax. However, a difficulty arises in regard to the operation of the tax concession for education expenses: that concession is available to the employee only in respect of an expense he himself incurs. Administratively it may be convenient to treat the direct payment by the employer as involving no benefit to the extent that it is within the amount of the concession.

9.35. Where the employer meets the costs of the employee's education, for example in a trade or professional course, an employer purpose is being served. In this case it is possible to conclude that there is no taxable benefit to the employee, in which event there is a prospect of discrimination between one employee whose employer finances his education and another whose employer does not. In some instances, expenses met by the employee will be deductible as employment expenses, and in regard to such expenses discrimination could not arise. But where the employee who meets his own expenses must rely on section 82JAA—the self-education deduction section—such discrimination seems unavoidable where the expenses exceed the limit imposed by that section. The employer's purpose may in some cases be remote: for example, where the course is not related to the employer's business. In such a situation a taxable benefit should arise, except so far as the employee would have been entitled to a deduction under section 82JAA.

9.36. The employer may meet directly the travel and entertainment expenses of his employee: the availability of credit cards facilitates this. The tax consequences of direct payment by the employer should not be different from the consequences considered in paragraphs 9.40–9.42 where the employee pays from an allowance given him by the employer or is reimbursed by the employer.

9.37. The expenses of attending a conference may relate, at least in part, to a benefit that is not simply the necessary consequence of the carrying out of employment duties. The same is true of some club subscriptions paid by the employer.

9.38. In the case of the club subscription a further issue arises. It is provided in legislation recently enacted that certain kinds of expenditure, not thought to serve clear business needs, will be denied deduction whoever incurs them, and notwithstanding their relevance to the earning of income. The fact that the employer is denied a deduction should not preclude the identifying of a taxable benefit derived by the employee.

9.39. If an employee benefit is to be identified and valued, it will be essential for employers to maintain adequate records showing the purpose and detail of the expenses. In the United States the law requires a substantial degree of detailed recording of the precise nature of travel and entertainment expenditure and the vouching of such expenditure. The Committee recommends that similar provisions be included in the


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Australian law. In the absence of such recording and vouching, deduction for travel and entertainment expenditure should be denied. The recording of entertainment expenditure would, for example, require specification of the date, place and description of the entertainment, the business purpose of the entertainment and details of the persons being entertained. It would be necessary to set some limit on the amount of any individual expenditure below which vouching would not be required.

9.40. Allowances made available to employees for travel and entertainment expenses. Where an employee is given an allowance which relates to travel, entertainment and similar expenses that do not involve any taxable benefit, or is reimbursed such expenses, there are no tax consequences for the employee unless, in the case of an allowance, some part of it fails to be spent in this way. There may, however, be elements of taxable benefit in the travel and entertainment.

9.41. Over recent years there has been an increasing tendency for employers, in both the private and public sector, to pay their senior staff annual expense allowances of a fixed sum to cover entertainment and other expenses incurred in the performance of their duties. Provided the amount is considered reasonable by the Commissioner, it has become normal procedure to view the allowance as having been fully expended without requiring the employee to substantiate his claim. In many instances the amount of the allowance has been negotiated by employers with the Commissioner. It is rare to treat such allowances in this way in overseas countries. It causes administrative problems in negotiating the amount with the Commissioner—inconsistencies are unavoidable—and it is open to abuses which are difficult to police.

9.42. The Committee recommends that the law should require detailed recording and vouching of expenses met from travel and entertainment allowances and similar expenses reimbursed by the employer. The recording and vouching should be the same as is proposed in regard to travel and entertainment paid directly by an employer. Any part of the allowance or reimbursement not matched by recording and vouching would be treated as a benefit derived by the employee. Some concession in regard to the recording and vouching required might be allowed in respect of the cost of meals and accommodation where an employee is travelling. The Commissioner might set a per diem figure, and recording and vouching of the costs of meals and accommodation would be dispensed with where the allowance or reimbursement given by the employer does not exceed this figure. The employee would nonetheless have to record other details.

Tax Instalment Deductions

9.43. Except in cases where an employer provides sustenance and use of quarters, the present law does not require that the calculation of tax instalment deductions take account of non-cash fringe benefits derived by an employee. The amounts attributed to sustenance and use of quarters for purposes of tax instalment deductions may, in any event, be less than their real value. The value of these benefits, and also cash allowances, are shown on the group certificate, but other non-cash benefits are not.

9.44. A fully effective system of taxing fringe benefits would require that all such benefits be included in the amount upon which tax instalment deductions are calculated and be shown in the group certificate in respect of an employee. Such a system is clearly out of the question. It would be unreasonable, for example, to expect the employer to calculate the cash value to each employee of discounts allowed to him.




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9.45. However, the Committee favours imposing much wider statutory obligations on employers to disclose fringe benefits in group certificates and to make tax instalment deductions from salary and wages in respect of fringe benefits given to employees. The obligation to disclose should extend to all fringe benefits of which the employee has knowledge. The requirement to make tax instalment deductions should at least apply to regular benefits such as the use of a motor vehicle, housing, board and lodging, low-interest loans and cash allowances. It would always be open to the employee to include in his return an amount different from the value assigned to the benefit by the employer and to substantiate this amount. The Commissioner of course would not be bound by either the employer's or the employee's valuation.

Other Issues

Salary and Wage Adjustments

9.46. It is not uncommon for an employee to receive an amount of wages relating to a period of employment during an earlier year: a wage increase may have been made retrospective to a date in the previous year of income. Less frequently, an employee will receive wages in advance: he may be paid a sum, say in June, for a period of long-service leave he is about to take. The consequence of the cash method of tax accounting applying to employment income is that the wages are taxed in the year of receipt without regard to the period of employment to which they relate. Because of the progressive rate structure, this usually results in greater tax than would have been payable had the wages been received at the time of the employment to which they relate.

9.47. In Chapter 8 it was assumed that in determining the income of a business or profession for tax purposes, efforts should be made to relate receipts to the year of income to which they properly belong. The Committee sees force in the argument that the same should be done for employment income.

9.48. However, the administrative costs in reopening earlier returns, and in deferring the inclusion in other cases to later returns, would be very considerable. They might be mitigated if a lower limit were set on the amount which could be taken into the other return, but this would introduce elements of inequity. Because of the wider marginal tax brackets now obtaining, the number of cases where there will be a significant tax disadvantage is not likely to be very great. In some circumstances, the income equalisation scheme proposed in Chapter 14 will assist the employee to defer the inclusion of an amount to a later return.

9.49. On the balance of considerations, the Committee feels that no change in the existing position is warranted.

Travel and Removal Expenses

9.50. In Chapter 7 the appropriate treatment of fares to and from work was considered, and the Committee recommended against extending the law to allow these fares to be deducted. However, it was also explained that expenses of travel between two places of work within an employment are properly allowable as deductions. Where an employee travels within an employment to a place of work away from his normal base, his own travel expenses are deductible whether the movement is necessary for some temporary purpose or involves an employment in the new place of work for a more permanent purpose. Where the purpose is temporary, his travel expenses will include accommodation and sustenance expenses in the new place of work, but where the purpose is more permanent this will not normally be so. In the case of travel for a more permanent purpose, a question arises whether the travel expenses of his family and the expenses of removal of his home are deductible. When a person


  ― 125 ―
accepts a new employment involving his moving to another city, there will be a question of the deductibility of his own expenses of travel and also of the expenses of travel of his family and removal of his home. There are, in addition, two marginal situations requiring separate examination, one concerned with living away from home and the other with study leave.

9.51. Travel within employment for a temporary purpose. Travel expenses, including in this case accommodation and sustenance, are deductible by the employee as expenses in deriving income. Where the employee can be said to act on his employer's behalf in incurring the expenses, it is appropriate to treat any allowance or reimbursement provided by the employer as not being the employee's income and any amounts paid by the employee as not being deductible by him. The general practice would be to treat expense allowances and reimbursements in this way. If the employer himself meets the expenses directly, there will be no income derived by the employee.

9.52. There is ordinarily no question of deductibility of the expenses the employee may choose to incur in having his wife or other members of his family travel with him. These expenses are private. The expenses of a member of his family are only deductible in the unusual case where the role of that member is essential for the performance of the employment. If the employee receives a sum of money from his employer in respect of the expenses of his family, this is included in his income.

9.53. Travel and removal expenses within an employment for a more permanent purpose. The travel expenses of the employee are deductible: these expenses ordinarily include accommodation and sustenance expenses, though this is not the case if he may be said to have established a home at the new place of work. Where the expenses are the subject of an allowance or reimbursement or are met directly by the employer, there is again ground for the view that the employee is not entitled to any deduction and does not derive any income. The deductibility of the travel expenses of members of his family and of removal expenses raises a somewhat different issue. An employee who is required to move to a new place of work where he will have to stay for any length of time may fairly claim that these expenses are not private but are incurred in deriving income. In this case, however, it would appear that the expenses are not deductible.

9.54. Where the employer meets family travel and removal expenses, either directly or by giving an allowance or reimbursement, there is a question of how the amount involved should be treated. It is at least arguable that the amount is not income of the employee. It appears to be the Commissioner's practice to treat such an amount in this way, provided it does not exceed the actual expenses and those expenses are reasonable.

9.55. In the result there would appear to be an unfair discrimination between an employee whose employer is prepared to meet the expenses and another whose employer is not. To overcome the unfairness it would be necessary to provide that the reasonable expenses incurred by the employee will be deductible where he is required by his employer to move to a new place of work.

9.56. In the Committee's view the law and practice assumed in paragraph 9.54 should be confirmed. Where the employer meets the reasonable removal costs of an employee, no amount should be included in the employee's income. Where the employee who is required to move meets his own reasonable expenses, he should be entitled to a deduction for those expenses.




  ― 126 ―

9.57. Travel and removal expenses to take up a new employment. The expenses of seeking new employment are currently not deductible: they are akin to the expenses of exploring the possibility of undertaking new business operations. The denial of a deduction, to a person who is unemployed, of expenses in seeking a job may appear unfair. However, the difficulties in defining the expenses to be allowed rule out the possibility of giving a deduction. If the Commonwealth Employment Service provides financial assistance to meet the expenses of seeking a job, this assistance should be excluded from income.

9.58. The expenses of taking up a new employment are, it seems, not deductible. In the view of the Committee, the treatment in paragraph 9.54 should apply in respect to any amount provided by the new employer to cover those expenses.

9.59. Treating a reasonable amount provided by the employer in respect of these expenses as non-taxable could in this case, even more than in the previous one of movement within an employment, be justified as contributing to greater mobility of labour.

9.60. Living away from home. Since 1945 there have been express provisions in section 51A allowing a limited deduction to an employee in receipt of a living-away-from-home allowance, i.e. an allowance paid to him for the additional expenditure he is obliged to incur in meeting living costs in a place of employment away from his home. The deduction is limited to what the Commissioner considers reasonable, but in general it may not be more than the amount by which the allowance exceeds two dollars. Two dollars is supposed to represent the amount by which his permanent household expenses would be increased were he at home; but clearly, with a decline in the value of money, theory and reality have parted company.

9.61. This deduction does not fit comfortably into any of the situations already considered. In its terms it is intended to cover expenses in deriving income not deductible under the general provisions of the Act. Some element of permanence in being away from home seems to be contemplated, so that the expenses would not necessarily be in the nature of travel expenses in the sense of those words in paragraph 9.53. Travel expenses, deductible under the general provisions, include accommodation and sustenance expenses only when the taxpayer has not established a home in the new place of work. Provided there is an establishment elsewhere which the employee may claim to be his home, there is a prospect of his being permitted deductions against a living-away-from-home allowance even though, in a sense, he has a home in the place where he works.

9.62. The distinction between travel expenses deductible under the general provisions and the expenses to which section 51A applies is not readily apparent. Having regard to the nominal character of two dollars at today's prices, very little turns on whether a deduction is classified as the one or the other. If the sum is increased to a more realistic figure, the classification will become of some consequence. In the Committee's view, section 51A should be regarded as a special provision appropriate to the case of an employee who, because of the limited time he spends in any one place of work or the remoteness of the place of work, does not move his principal home to his place of work.

9.63. Study leave expenses. Another situation that does not fit comfortably into any of those dealt with in paragraphs 9.51–9.59 is that of a person, most often on the staff of a university, who goes abroad on study leave in the course of his employment. The leave may be of varying length, quite commonly twelve months. It is not unusual for


  ― 127 ―
the employee to be given allowances by his university intended to cover his own fares and those of his family and extra costs associated with his going abroad.

9.64. The practice of the Commissioner, it would appear, is to treat the employee as a person travelling within his employment for a temporary purpose. He is allowed to deduct his own fares and his accommodation and sustenance expenses; any allowances he receives from his university are taxed as income.

9.65. This practice seems to the Committee appropriate where the employee goes abroad for only a short period of leave. It does not appear appropriate, however, when an extended period of leave is involved, say four months or more. It would not be thought fair in this case to disregard the necessity for the employee to be accompanied by his wife and dependent children. Yet this appears to be the consequence of the Commissioner's practice. Even though an allowance has been given by the university intended to cover the fares of members of the employee's family, these expenses are not deductible. Moreover, where the employee has taken members of his family with him and has established a temporary home abroad, he may find himself limited in the amount of the deduction for his own accommodation and living expenses he will be allowed: the Commissioner will attribute a substantial proportion of the expenses of the temporary home to the members of his family who have accompanied him.

9.66. In the Committee's view, the amount of a reasonable allowance provided by the employer to cover the fares of the employee, his wife and dependent children, and the extra expenses which fall on the employee in undertaking the study leave and are met by way of a per diem allowance, should not be included in his income when an extended period of leave is involved.

Payments to Obtain Release from Employment Contracts

9.67. It is not uncommon for scholarships and cadetships under which a person undertakes some form of training to provide that he must enter or continue in the employment of the organisation giving him the scholarship or cadetship for a period of years after completing his training. If he does not fulfil this condition, he may be required to pay an amount to the organisation to obtain his release. Under the present law there does not appear to be any basis on which a deduction of an amount so paid might be claimed: it would be regarded as a capital cost of obtaining freedom of action to enter on other employment.

9.68. There is a general principle appropriate at least to business income that moneys received are not income if, under the terms of the receipt, there are outstanding conditions yet to be fulfilled; the moneys will become income only as the conditions are fulfilled. If this principle were applied to moneys received under the scholarship or cadetship, it would bring about a result somewhat different from a deduction of the amount paid to obtain release. Receipts under the scholarship or cadetship would cease to be taxed as received but would become income during the years of service following training, and this would mean a bunching of income which would not be welcomed by the former trainee. The Committee would not, in any event, favour the application of such a principle in the present context.

9.69. If the law is to make any allowance in respect of payment under an employment contract, it will have to be by way of a special provision permitting a deduction of the whole or some part of the payment at the time it is made. However, the Committee does not favour such special provisions.




  ― 128 ―

Standard Deduction

9.70. A number of employment expenses of relatively minor significance for the vast majority of taxpayers are deductible under the general provisions of the Act. These largely relate to tools of trade, special clothing and its maintenance, and professional, technical and trade journals. The administration of the law in this regard involves considerable compliance and administrative costs which might be thought disproportionate to the revenue involved. Some taxpayers who are unaware of the available deductions or are unwilling to submit to the tedium of record-keeping do not obtain deductions to which they are entitled. Claims for deductions put the Commissioner to considerable trouble in verifying the amount of claims and whether they qualify.

9.71. In some countries, for example Canada and New Zealand, a standard deduction in respect of these items is given. The deduction, usually of modest amount, is allowed without proof of actual expenses and any further deduction is denied. In Canada's case the amount is 3 per cent of employment income up to a maximum of $150. There is considerable merit in this approach, though it must cause injustice to some taxpayers for whom the expenses are of more than minor significance. Both Canada and New Zealand have found it necessary to treat some classes of taxpayers more generously.

9.72. Were the Canadian and New Zealand approach adopted, it is likely that some occupations would seek to be excluded. It might be more realistic, therefore, to provide that the standard deduction be available but not obligatory: a taxpayer would still be allowed to itemise his claims. If a taxpayer chose to itemise, he would not be subject to the money limit on deductibility. At least some saving in compliance and administrative costs would be achieved.

9.73. The Committee recommends that an optional standard deduction against employment income be available. The amount of the deduction might be set, as in Canada, at $150 or 3 per cent of employment income, whichever is less. It will be necessary to specify the kinds of claims the standard deduction is intended to cover in addition to those listed in paragraph 9.70. The Committee does not contemplate that the standard deduction, if taken, would preclude the allowance of separate deductions for such expenses as subscriptions to trade and professional associations.

II. Investment Income

9.74. Ownership of property can give rise to various forms of investment (or property) income, notably rent, interest, dividends and capital gains. Their tax treatment is analysed in a number of places in this report. Imputed rent from owner-occupied dwellings is dealt with in Chapter 7, dividend income in Chapter 16, income from investment in superannuation and life assurance in Chapter 21, and capital gains in Chapter 23. A further aspect, the levying of a special surcharge on property income, is considered in Chapter 14 and there rejected. An issue not taken up in Chapter 14, however, is whether there are grounds not merely for rejecting the surcharge but for actually granting concessional treatment to investment income. This is the issue considered here.

9.75. One possible justification for concessional treatment is to encourage saving, either in general or in particular forms. In Chapter 21 the Committee has commented on the objective as justifying special treatment of superannuation funds and life insurance.




  ― 129 ―

9.76. A second possible justification for concessional treatment is that consumption may be thought a better indicator than income of ability to pay tax. If this is accepted, it follows that imposing an income tax, including tax on income from savings, is horizontally inequitable because individuals are treated differently according to how they spread consumption over their lifetime, the effective rate of tax on postponed consumption being greater than the rate on current consumption. Given the retention of income tax, however, the consumption approach suggests a need to give relief to income saved as distinct from relief to income from saving, and it is this philosophy that underpins much of the discussion on superannuation and life insurance in Chapter 21.

9.77. As already pointed out in Chapter 3 and 6, conventional procedures for establishing income subject to tax under conditions of inflation can result in ‘illusory’ rather than ‘real’ gains being brought to tax. This leads to inequities of a horizontal kind, and perhaps vertical inequities too. The Committee discusses the problem for recipients of business income in Chapter 8, and its proposals in regard to capital gains are spelled out in Chapter 23.

9.78. In times of inflation, recipients of interest income, too, face the prospect of being taxed on ‘illusory’ gains. This is particularly noticeable when interest rates lag behind the rate of inflation, in which case tax is imposed on what are in reality negative gains. For this reason the Committee considers that some form of concessional treatment should be provided for taxpayers in receipt of interest income.

9.79. One means of providing concessions would be the broad-brush approach of indexing all monetary debts. This is a radical proposal, raising issues beyond the Committee's terms of reference. Were a move to be made in this direction, the initiative would have to come from the government, which might as a first step issue indexed bonds.

9.80. An alternative approach would be to make ad hoc adjustments to the income tax base. Canada has recently introduced legislation to this end. In computing taxable income, an individual in Canada may deduct interest income from securities such as bank and trust company deposits, mortgages and bonds. The deduction is limited to the lesser of (a) $1,000 or (b) the taxpayer's interest income for the year minus the amount, if any, deducted by him in computing his income on account of interest paid on borrowed money for the purpose of earning income from a business or property. New Zealand also has tax concessions for persons receiving interest income, and these have recently been extended. An exemption is given of $100 of interest from any source; in addition, $200 of savings bank interest is exempt. There is also a special exemption of $500 in respect of savings certificates and national development bonds. In the short run at least, ad hoc adjustments such as these appear to be the most appropriate.

9.81. If legislation were to be introduced along these lines, the following general principles should be followed:

  • (a) The deduction should be available for interest income on as wide a range of securities as possible to avoid introducing new distortions into the capital market. Consideration might be given to making the deduction available in respect of dividends on preference shares which carry no rights to capital beyond the amounts subscribed.
  • (b) The deduction should be limited to net interest in the sense of interest received less interest that is deductible, whether as costs of deriving income or by a virtue of a concessional deduction provision.



  •   ― 130 ―
    (c) The deduction should be limited in amount and be personal to the individual taxpayer.




  ― 131 ―

10. Chapter 10 Personal Income Tax : The Taxpaying Unit

note

10.1. A fundamental characteristic of any system of personal income taxation must be the ‘unit’ chosen for taxation. It can be the individual, or the married couple, or the family, with ‘family’ narrowly or widely defined.

10.2. From the beginning, personal income tax in Australia has been based on individual incomes; along with Canada and New Zealand, Australia is one of the few countries still making this selection. This is not, of course, to assert that in our tax system (or in others with this basic unit) no regard whatever is paid to the family situation of the individual taxpayer. There are allowances for various dependants and numerous concessional deductions applying not only to the taxpayer's expenditure upon himself but also to that made on behalf of family members. It is, however, true that the allowances provided are generally rather small in relation to the total expenditure that the individual will normally make upon his or her family.

10.3. The problem of whether the individual unit system is appropriate or not has been put to the Committee in many submissions and in two main ways. Some have tackled it directly, arguing that the total income of the family is the proper indicator of ability to pay, and that the manner in which that income happens to be divided among the individuals concerned is irrelevant.

10.4. Others have raised the same problem rather less directly. Since under the individual system with a progressive rate scale, family tax will be minimised when incomes are equally divided, it is plainly to the tax advantage of families to rearrange their affairs so as to permit them to return equal or nearly equal incomes. They take measures to this effect, perhaps of a kind they would not take for any other reason. In fact, some people—for example, those in business or with substantial property incomes—can rearrange their affairs to this end fairly readily, and have been doing so in increasing numbers in recent years: other people, wage and salary earners in particular, cannot. The latter naturally have a grievance of the ‘horizontal inequity’ kind and denounce ‘income splitting’ in sharply pejorative terms. But it is often not clear whether their complaint is that others can, or that they themselves cannot, so rearrange their affairs. If the latter (whether or not they have thought the matter through), they are in effect espousing the cause of family unit taxation. If the former, they would seem to be arguing that some ways of arranging division of income are acceptable while others are not—that existing law, in sanctioning the latter, draws the dividing line in the wrong place.

I. Overseas Experience

10.5. Over the years, the general issue of the taxpaying unit has been dealt with in overseas countries in a wide and changing variety of ways which to a large extent have been influenced by the history of the legal systems of the particular countries concerned. Several examples may be described.

10.6. In 1799 upon initial introduction into the United Kingdom of an income tax, a husband and wife constituted one taxpaying unit because the English common law, unlike the laws of many parts of Europe, rejected the doctrine of community of property between husband and wife on marriage and regarded the legal personality of the


  ― 132 ―
wife as merging in that of her husband so that in law they became one person. While in course of time the growth of equitable doctrines modified to some extent the operation of the common law, for a long period this made no practical difference as, in an action to recover the tax levied in respect of the income of a wife living with her husband, he was a necessary party. It was not until towards the end of the nineteenth century that the married women's property legislation began to effect a separation at law between the wife's property and income and her husband's rights thereto. This separation was not finally completed until 1935 but, in the removal of these restrictions upon a married woman's property rights, the income tax legislation did not march in company with the laws of property. It was not until 1950 that the married woman ceased to be classified for the purposes of the income tax legislation as an ‘incapacitated person’ along with infants and various categories of mental defectives. Although from time to time full aggregation of the wife's income with her husband was in some respects departed from, the Income and Corporation Taxes Act 1970 still deems the income of a married woman living with her husband to be his income and not hers. In 1914 the husband was given the right to require separate assessment of their respective incomes and in 1918 provision was made for either husband or wife to make a similar election but, in general, separate assessment did not make the parties liable to pay less tax.

10.7. Originally the separate incomes of husband and wife were added together and this income was taxed as if it were the sole income of one taxpayer. Ultimately concessional deductions were allowed as some means of recognising differences in taxable capacity of different taxpaying units—in addition to deductions for dependent children. The United Kingdom allows personal deductions which vary according to marital status. If the wife works, a special wife's earned income allowance is also provided in the form of a deduction from taxable income additional to the personal deduction. Since 1971, married couples have been provided, where husband and wife jointly elect, with a limited option of submitting separate income tax returns. Under this option, tax is calculated as if all the income other than the wife's earned income were the husband's, so that for tax purposes the husband receives only the single person's personal deduction, and the wife is taxed as a single person on her earned income, with the single person's personal deduction only. The wife's earned income relief is not available under this option and the allowances for children must be claimed against the husband's income. The new option is described in the following terms in a reference document submitted to the OECD by the United Kingdom Government:

‘Whether this [the new option] will reduce the total tax bill of a married couple will depend upon their personal circumstances; but as a general rule it will not unless their combined income exceeds £6,900, and may not do so even then’.

10.8. In the United States there is another system that can be traced to a legal background of property and income rights. After an earlier abortive attempt to levy an income tax, Congress was given constitutional power in 1913 to impose an Income Tax Act. However, the law with regard to the property and incomes of spouses was not, and still is not, uniform throughout the United States. In eight States, which prior to their accession to the Union had been under the influence of the European community property legal system, property acquired by a husband and wife after marriage is presently regarded as owned by them in community and in equal shares and the income from such property is divisible equally between them. Each of these States has different rules to distinguish between separate income and community income but generally all earned income is community income. All property acquired by either


  ― 133 ―
spouse before marriage is his or her separate property and property acquired thereafter is their community property. Income tax returns in these eight States may be filed jointly or separately. In the separate return, half the community income is shown and, in addition, the separate income. Usually the filing of a joint return will result in a tax saving to both spouses. In the remaining States, where there is no community property law, the spouses may file a joint return and this even though one spouse has no income or deductions. Generally the filing of a joint return will result in the saving of tax for the married couple because of the tax rates applicable to the joint return or optional tax tables, the latter being available where the joint return shows an adjusted gross income from all sources of less than $10,000. The presence in the Union of a number of community property States has no doubt influenced the course of taxation in the remaining States in an attempt to achieve some uniformity in the mode of taxing spouses.

10.9. The split-income provisions, when initially enacted in 1948, gave the couple the option of filing a joint return under a tax rate schedule that provided tax brackets twice as wide as those applying to single people. This in effect resulted in the same taxation burden as if each spouse was taxed separately on half their combined income. Compared with the Australian system, it had much the same effect as legally allowing all married couples to put themselves in the position of those practising what here might be regarded as income-splitting abuses. This rather peculiar, though temporary, arrangement was an outcome of the previous history. However, as the result of criticism of this system by single persons, the rate schedules were changed in 1969 to ensure that in no event did the liability of a single person exceed by more than 20 per cent that of a married couple with the same taxable income. A new head-of-household classification was also introduced to meet the cases of unmarried persons with family responsibilities, providing for rates that fall midway between those of single and married persons. It is now possible for two single persons with equal incomes who are living together to pay less tax than a married couple with the same total income, a situation that was not possible under the pre-1969 legislation which incorporated an underlying tax bias in favour of marriage.

10.10. South Africa is a country which, through the influence of its connection with Roman-Dutch law, has a community property legal system. For taxation purposes the income of a woman, married and with or without community property, living with her husband, is deemed to be income accrued to her husband and in such case the husband makes the return and is liable for the tax. If, in the income return of the husband, there is any income earned by the wife not in association with her husband, for example not in a husband-wife partnership or in a private company in which both are interested, the husband is allowed a deduction of R.500 or the actual amount of earned income if it be less than that figure. Either husband or wife may make application to the Secretary for Inland Revenue for the right to submit a separate return and a separate return may be lodged if he considers it to be desirable. The Secretary himself may also require the making of a separate return. However, the total tax payable on the separate assessments must not be less than the total tax payable by the husband alone had the wife's income been assessed as his. In South Africa a married man's liability to tax is on a much more favourable basis than that of other persons. He enjoys lower rates of taxation. He is also entitled to a much higher primary abatement (deduction) in addition to the earned income deduction and to more advantageous medical deductions.

10.11. While the rule of aggregating the incomes of husband and wife is found in other European countries, the unit of taxation is sometimes the family. Thus, in


  ― 134 ―
France not only are the incomes of husband and wife aggregated but also the incomes of children are included in the income of the family unit. Allowance for differences in the composition of families and differences in family size are then made, not by way of deduction but instead by means of a method commonly called the ‘quotient system’. The aggregate income is divided into parts according to the number of adult persons and children in the family and tax is charged separately on each part. For this purpose a child is counted as one-half and an adult as one part. Thus a married couple with two dependent children pays three times the tax of a single person with one-third of the joint family income. This system may provide a more generous treatment of married couples, especially those in higher tax brackets with children, than either the United Kingdom or the Australian system.

10.12. The present United States system is similar in many respects to the Carter Commission proposal for reform in Canada which after lengthy discussion was not accepted by the Canadian Government. This plan provided separate rate schedules for single persons and married couples but also included the incomes of dependent children in family income subject to tax. Dependant allowances were to be granted in recognition of differences in family circumstances; however, unlike the quotient system described above, the variation in tax liability between single persons and families was to be achieved by means of the different rate schedule. But Canada preferred to tax husbands and wives as individual persons.

10.13. Mention should also be made of a recent change in Sweden which reverted from a system that taxed the combined income of husbands and wives (and of single persons living together) to one that now taxes the earned income of wives separately. Property income is still taxed in the hands of the husband as before. A stated purpose of the change was to remove the disincentives for married women to work inherent in the previous system.

II. Review of Possible Reform

10.14. With so many overseas models, old and new, to choose between, and so many compromises that could be devised, it is necessary to make a systematic review of the arguments before coming to conclusions.

10.15. Broadly there are three directions that reform could take: (i) Australia could stay with its present basis of compulsory individual taxation; (ii) it could go over to a compulsory family unit basis; or (iii) it could retain the individual basis but provide families with the option of taxation on a family unit basis if both spouses so elect.

10.16. The Committee is agreed that the second course, the adoption of a compulsory family unit basis, must be rejected on grounds of general social principle. The right to be taxed as an individual has always been accorded in Australia. At a time when women are playing an ever greater role in the economic and other affairs of society, the withdrawal of this right would certainly be regarded as a retrograde step. And objections would come not only from women: men too might take exception to a universal and compulsory commingling of their tax affairs with those of their wives. This would, in the Committee's view, make a change in this direction politically unacceptable irrespective of whether married women (or married men) paid more or less tax after the change than they do now: social attitudes to the separate status of the sexes, rather than purely economic considerations, are involved here.




  ― 135 ―

10.17. The choice therefore lies between leaving the existing basis of individual taxation unaltered (with or without measures to handle income splitting) and adding an option for married couples to be taxed on some newly devised family unit basis if they elect to do so. The choice, naturally, cannot be resolved until a number of issues about the new basis are settled, but the general argument for family unit taxation can be considered first.

10.18. The proponents of the family as the tax unit rest their case mainly on a proposition about the normal attitudes and practices of married couples in spending and enjoying the fruits of their incomes. It is argued that, however separate, legally and practically, the sources of their two incomes, in practice married couples largely share or pool their expenditure. Much is jointly consumed: one house, one lounge suite, one television set, one refrigerator and (to a diminishing extent) one car suffices. Whichever spouse made the purchase, both enjoy the benefits, and even the purely personal expenditure of each gives the other pleasure. On this view of the matter, it is the total income of the pair that determines their ability to pay rather than the way the total is formally divided between them: it is wrong that families should pay more tax the more unequally their total income is divided, at any rate to the extent shown in Table 10.A.

TABLE 10.A.: TAXES PAID BY EQUAL-INCOME FAMILIES: EXISTING SYSTEM (a)

                                 
Total family income   Husband   Wife   Total tax payable  
6,000  5,000  1,000  680 
6,000  4,000  2,000  500 
6,000  3,000  3,000  440 
6,000  2,000  4,000  500 
10,000  8,000  2,000  1,900 
10,000  7,000  3,000  1,600 
10,000  5,000  5,000  1,360 
10,000  3,000  7,000  1,600 
10,000  1,000  9,000  2,300 
20,000  19,000  1,000  7,830 
20,000  15,000  5,000  6,150 
20,000  10,000  10,000  5,560 
20,000  8,000  12,000  5,640 
20,000  4,000  16,000  6,440 
note  

10.19. It must be agreed that this argument has force. But even those who use it will certainly concede that a high degree of sharing of this kind is by no means universal. In some marriages, and not by any means only unhappy ones, almost completely separate patterns of spending and enjoyment may be the rule. Between the extremes a whole range of intermediate arrangements will be found. At the one extreme a family unit basis would give the fair result, at the other the existing individual basis would. The compulsory family unit would be unfair to some; the compulsory individual unit is unfair to others. A graded set of alternatives being self-evidently impracticable, to give a choice between two bases is at least better than to give none. The Committee agrees with this conclusion; the difficulties lie in settling the details.

Questions Arising over the Taxation of Family Units

10.20. The first question of detail under a family unit system is the rate scale to be used. Under the British system the same scale as for single persons is applied to the


  ― 136 ―
aggregate income of the married couple (though with qualifications in the form of allowances to moderate the extreme severity of the result). If this be called ‘pure aggregation’, then ‘pure averaging’ might be the term for the system introduced in the United States in 1948, when a schedule with tax brackets twice as wide as those for single persons was adopted for those electing family treatment. This, as noticed, gave the same arithmetical result as if each spouse was taxed separately on half their combined income.

10.21. In terms of economic equity between married and single persons, neither of these very simple solutions to a difficult issue commends itself. Pure aggregation produces the same result as the current Australian individual basis in the special case of one spouse having no income (apart from the effect of the modest dependent spouse allowances). But it would increase the tax paid by the pair in almost any case where both spouses have significant incomes. They would then pay more tax than if they had elected to be taxed as individuals, and the amount by which that tax would increase would be the greater the more equal were their separate incomes. An election system with this rate would ensure no elections. Pure averaging, by contrast, would mean that election saved tax for all married couples except those who happened to have equal incomes. The tax each paid would in no way reflect the additional capacity to pay inherent in the notion of shared enjoyment. Everyone would have a financial inducement to elect, including perhaps those whose relationship was more fairly described as, and felt to be, economically quite separate: the tax result would be the same as if all couples achieved complete income-splitting. The loss of revenue would be so great as to entail, if the income tax revenue were to be maintained, a severe increase in tax on single persons (and those married couples who resisted the tax inducement to represent themselves as a sharing unit). It was for this reason that the pure averaging provisions of the United States tax were abandoned in 1969.

10.22. It is inherent in the equity arguments for an elective family unit system that there should be a distinct family rate somewhere between the extremes of pure averaging and pure aggregation. The former is undoubtedly too kind to electing pairs, too unkind to single persons and couples who require individual treatment; the latter undoubtedly too harsh on electing pairs, too kind to single persons and those who accept individual treatment. The choice of family rate relative to the individual rate is therefore one of nice judgment.

10.23. A further question that has to be dealt with under a family system is the treatment of dependent wives. There are here two distinguishable situations: (i) when the wife's dependence is primarily due to her looking after small children rather than going to work; and (ii) when, without children, she simply prefers to take no paid work (or can obtain none). In the present Australian income tax system they are treated alike. As regards (i), married couples who both work often feel that, because their child-minding and their housework involve more strain than for families where the wife is at home, they are unfairly treated at present. Under a family unit system this situation could be handled by an earned income allowance for the second working spouse. As regards (ii), under the present system the family in which the wife stays at home may feel over-taxed relative to the family in which both spouses work and receive the same total income, since the dependent spouse allowance is small and the wife will almost certainly be contributing domestic services of value even though they are unmeasurable. But under a family unit system with a rate near the pure averaging end of the range, the situation might be reversed. Examining this problem, the Canadian Royal Commission on the Status of Women (1970) was tempted to propose the abolition of any allowance for dependent wives without dependent children,


  ― 137 ―
but concluded against this recommendation because it felt there were inadequate employment opportunities for married women of working age in many places and it was concerned also for the position of elderly wives. The future of the dependent spouse allowance in Australia is further discussed in Chapter 12.

10.24. The treatment of children in a family unit system also requires thought. It is implicit in the concept of a family unit that the income of children is part of that of the family as a whole. Certainly when living at home children have full use of the common equipment of the family and may properly be said to share in much parental expenditure. Considerable scope for tax avoidance would remain if any property income they derived, whether the property came to them by parental gift or otherwise, were left to be wholly taxed on an individual basis. This matter is dealt with in Chapter 11. Income being accumulated in a trust estate to which a child is contingently entitled must also be considered. Indeed there might be income so accumulating to which husband or wife is contingently entitled. These matters are taken up in Chapter 15.

10.25. Concessional deductions for dependent children, and the associated issue of child endowment, appear to be unaffected in principle by the possible adoption, or rejection, of a family unit system and their discussion can be left over to Chapter 12. This would not be so, however, if the French version of the system were selected. That variant, summarised in paragraph 10.11, provides, as there remarked, extremely generous treatment for parents with children and seems to be expressly designed to encourage a high birth rate. The Committee presumes that this is not an objective of Australian Government policy and would therefore not recommend a quotient system.

Individual Taxation with an Election System

10.26. The provision of the option to be taxed on a family unit basis would not reduce the necessity, which the Committee regards as urgent, to remedy tax avoidance by income-splitting within a family which has not exercised the option. It would be necessary, at the least, to deny the tax effects of tax-avoidance transfers of income by parents to children. Furthermore, spouses who were taxed as individuals and who had incomes of unequal magnitude would still have an incentive to make tax-avoidance transfers of income to enable more equal incomes to be returned for taxation purposes. By choosing to be taxed as individuals they would have asserted a claim to behave, in their financial dealings, as if they were at arm's length, and it would be important to ensure that this relationship was reflected in their tax liability. Measures directed against income-splitting are proposed in Chapter 11. Consideration must also be given to the accumulation in a trust estate of income to which a member of a family is contingently entitled. This matter is considered in Chapter 15.

Restrictions upon the Right of Election

10.27. During the decades over which a marriage will normally last, the absolute and relative incomes of husband and wife will usually change. There will be years in which to be taxed as a unit would be more advantageous financially, others when separate individual taxation would reduce their tax liability. To provide married couples with an unrestricted right to move in and out of family unit taxation whenever it would save them money to do so would be perilous to the Revenue and inequitable between married persons and single, whether they be bachelors, spinsters, widowers or widows. The proposal to institute an option for taxation as a family unit is not put forward as a mode of reducing taxes for married persons (or raising them for the


  ― 138 ―
single); it is, rather, designed to provide a fairer allocation of personal income tax between persons, and in particular between families with different practices and attitudes towards the expenditure of their separate incomes. Some restriction on the right to elect and to cancel past election therefore seems to be imperative.

10.28. Such a restriction would not be easy to define and administer. Provisions for cancelling an election would of course be necessary in the event of formal separation or divorce. In addition it might be provided that married persons who do not elect for family unit treatment within some defined period after the option becomes available or after their marriage may elect thereafter only upon the fulfilment of a condition that guards the revenue from any misuse of the option to elect. Thus the condition might require the payment of the additional tax that the spouses would have paid had they elected in the immediately preceding years.

De Facto Relationships

10.29. Where any provision of the present law depends on a marriage relationship, a formal marriage is necessary, although in some circumstances an illegitimate or adopted child may qualify as a dependant. The Committee is conscious of the change in social attitudes that could lessen the significance of formal marriage. An extension of the law so that the status of ‘spouse’ would include a partner in a de facto relationship would, in the Committee's view, be desirable if it were possible to define such a relationship in a manner that would not pose undue problems of interpretation and application. The Committee has, however, concluded that it is not possible to define the relationship in a satisfactory way. One context in which proof of the relationship will be important is the election of family unit treatment. The restrictions on the election could not be conveniently applied. Thus the requirement that an election must be made within a stipulated time after marriage would pose the problem of establishing the commencement of the relationship. The claim for a concession for a dependent spouse made in a previous return would assist; but no such claim would have been made where, because both had income, no tax advantage could have been obtained. Another context is the application of provisions against income-splitting. The Commissioner could not enforce the law in regard to a de facto relationship without what might be thought to be an unacceptable invasion of privacy.

Separated or Divorced Spouses

10.30. The present law (section 23 (1)) exempts income received by way of periodical payments in the nature of alimony or maintenance, by a woman from her husband or former husband. There is a proviso denying the exemption where the husband or former husband has, for the purpose of making such payments, divested himself of any income-producing assets, or diverted from himself income upon which he would otherwise be liable to tax. The husband is not allowed a deduction of the payments made to his wife or former wife.

10.31. In some countries the wife or former wife is taxed on the alimony or maintenance receipts and the husband is allowed a deduction of the payments. A system of this kind was proposed in Australia in 1942 but was rejected by the government of the day largely on the ground that a taxpayer who was separated or divorced from his wife would have been placed in a more advantageous position than a taxpayer who was not. The system, in effect, involves an income split, which would not be open to the latter.

10.32. The Committee would consider it appropriate to allow a husband a deduction for alimony or maintenance payments, whether or not divorced from his wife,


  ― 139 ―
provided there are safeguards against connivance to exploit the potential tax advantages and that the payments are taxed as the income of the wife or former wife. Already the law, in effect, allows a split of income between husband and wife where for the purpose of making payments to his wife the husband has divested himself of income-producing assets or diverted from himself income upon which he would otherwise be liable to tax. As explained in paragraph 11.45 section 102B (4) protects such a split of income from the operation of the short-term assignment provisions. The policy reflected in section 102B (4) should, in the view of the Committee, extend to allow a deduction of the payment where the husband is not in a position to divert income to his wife.

A Proposal for Public Examination

10.33. The provisions of a regime for family unit taxation as an optional alternative to the existing individual basis would be a large departure for Australia, requiring substantial public discussion. The Committee has not suggested a rate scale if only because in this report, given the separate necessity to consider the existing scale and the variety of other proposals being made, no precise figures would be helpful. In any case, statistics of family incomes, and their distribution between individual members, would be required to calculate the effect on revenue. But the Committee emphasises the importance of the choice of scale, and the need, when one is proposed, to explain its effects on families in different situations and its relation to the individual tax scale, in a readily comprehensible manner. The Committee is persuaded of the equity arguments for providing an option that recognises the reality of one large category of family relationship better than does the individual basis, and therefore recommends that the Government prepare a detailed scheme for an elective family unit system for public examination.




  ― 140 ―

Reservation to Chapter 10: Personal Income Tax: The Taxpaying Unit

In paragraphs 7.5–7.33 of its preliminary report (now paragraphs 10.1-10.28 of the full report) the Committee discussed matters concerning the ‘unit’ to be chosen for income taxation, namely, the individual, the married couple, the family, with ‘family’ narrowly or widely defined. After reference to overseas systems of taxation, the difficulties inherent in an elective system for joint returns, and the problems of an appropriate rate scale, the Committee concluded in paragraph 7.34 of its preliminary report: ‘The Committee is persuaded of the equity arguments for providing an option that recognises the reality of one large category of family relationship better than does the individual relationship, and therefore recommends that the government prepare a detailed scheme for an elective family unit system for public examination.’ The ‘large category of family relationship’ was not defined by the Committee and in what sense its ‘reality’ existed for taxation purposes was not specified. This conclusion has been carried over into the full report (see paragraph 10.33) and it is to this that I wish to make a reservation.

The Committee has not overlooked the use of the family relationship for the prevention of income-splitting between the family members (including children) and the avoidance of death duties and has made detailed recommendations elsewhere in this full report (which time did not allow for in the preliminary report) to prevent the exploitation of the procedures which have been employed to these ends. As I have endeavoured to make clear in a paper titled ‘Aggregation of Incomes of Husband and Wife’ which accompanies this full report, the aggregation of the separate incomes of husband and wife never originated as a means of inhibiting schemes for income tax avoidance; and the propriety of aggregation should be considered quite apart from the activities of those who seek to abuse the taxation system for the reasons which I have set forth in the paper above referred to.

Upon much further consideration than I was able to give in the very limited time which was available in getting out the ‘broad brush’ preliminary report, I am firmly convinced that the Committee's conclusion is unsatisfactory and should not have been made. In the paper referred to above I have discussed in some detail the historical basis of the aggregation of the incomes of husband and wife in the United Kingdom and the United States and have pointed out that in Australia, with the exception of a very brief period in the early income taxation period in Tasmania, Australian taxation systems of income tax have consistently rejected the aggregation of the respective incomes of the spouses. I have also opposed their aggregation on the grounds of unfairness and for a number of other reasons which appear in the paper.

I have also observed that the recent Canadian Royal Commission on the Status of Women (1967-70) found against such an aggregation of incomes but recommended an optional system for a joint return which would result in a tax advantage for those married couples who elected to be taxed jointly.

Before the inevitable expenses of any public examination of a detailed scheme for an elective unit system should be seriously contemplated, it seems to me that a rate system for the taxation of the aggregated incomes of husbands and wives and its


  ― 141 ―
consequences both to the taxpayers and to the Revenue would have to be given close consideration. In all taxation systems which embody an optional system of aggregation for the taxation of husbands and wives, everything hinges upon the rate scale and a special rate scale is sometimes devised for optional use. The word ‘elective’ presupposes a choice for the taxpayers not only between the individual and the joint return and assessment but also between different rate scales which could produce monetary results which are, on the one hand, advantageous to the taxpayers and, on the other, disadvantageous to the Revenue.

If a rate system were constructed so as to result in both spouses paying a higher total amount of tax than they do under an individual unit base, this would be not only an unacceptable approach in Australia but also one which, for reasons which I have given, is unjustifiable. If it were to result in the payment of less tax than otherwise would be recoverable if each spouse were individually taxed, naturally it would meet with wide acceptance on the part of the taxpayers but at the same time would bring about a substantial loss to the Revenue. If it were at all possible to ensure that the tax upon the aggregated incomes would not bear more heavily upon each of the taxpayers, husband and wife, than the existing individual unit system, an eventuality which would lead to a great deal of complexity for both the administration and the taxpayers alike, then the change from the existing system would be an expensive exercise in futility.

In my opinion, in the world of today a married woman should be treated both under the general law and in the taxation system as an individual in her own right and, in relation to the income which is both morally and legally her own, she should pay no more and no less tax than if she were a single person.

For these reasons I have come to the conclusion that a public examination of the kind recommended in the preliminary report—and repeated in the full report—should not be embarked upon.

K. W. Asprey




  ― 143 ―

11. Chapter 11 Income-Splitting

note

11.1. The phrase ‘tax evasion’ describes an act in contravention of the law whereby a person who derives a taxable income either pays no tax or pays less tax than he would otherwise be bound to pay. Tax evasion includes the failure to make a return of taxable income or the failure to disclose in a return the true amount of income derived. Leaving aside the cases where a person parts with some portion of his income under the dictate of some particular legal or moral obligation, ‘tax avoidance’, on the other hand, usually connotes an act within the law whereby income, which would otherwise be taxed at a rate applicable to the taxpayer who but for that act would have derived it, is distributed to another person or between a number of other persons who do not provide a bona fide and fully adequate consideration; in the result the total tax payable in respect of that income is less than it would have been had no part of the income been distributed and the whole been taxed as the income of that taxpayer. The act which distributes an amount of income for the purpose of achieving that result is usually described as ‘income-splitting’.

11.2. Generally speaking, as salaries and wages cannot be made the subject of income-splitting, the opportunity by that means to order one's affairs so as to reduce the amount of tax otherwise payable is not equally available to all taxpayers. This is inequitable to the taxpayers who do not have that opportunity. A progressive taxation system that seeks to bring to charge the income of each individual upon an ascending scale of tax rates should operate fairly as between all taxpayers and should tax each person upon the amount of income that was truly and realistically his to receive. Fairness to the whole body of taxpayers demands that this principle should have a full application, for the loss to the Revenue in the reduction of taxation effected by income-splitting must be recouped from those who are unable to practise it. Therefore, it behoves the revenue laws to correct the inequity and restore the efficiency and balance of the taxation system.

11.3. Income-splitting is almost universally confined to family relatives: husband and wife, father and child, grandfather and grandchild and so forth. When the word ‘relative’ is mentioned in this chapter, it is intended that it should bear the meaning ascribed to ‘relative’ in section 6 (1) of the Income Tax Assessment Act. The means by which it is accomplished are most frequently to be seen in partnerships, alienation of income, trusts, private company arrangements, loans, gifts and employer and employee relationships. The current legislation contains a number of sections designed to inhibit some forms of income-splitting; but these have proved to be ineffective in the sense that they leave large areas untouched, and it is necessary that the use of other measures be explored.

11.4. One suggestion to this end has been the adoption, in place of the individual as the unit of taxation, of a family unit which could be comprised of a husband and wife or husband, wife and children. For the reasons given in Chapter 10, the Committee has rejected the compulsory aggregation of family incomes; and in the present context it would not attain its objective where children had reached a given age and in circumstances where the income distribution was effected to children who had ceased to reside in the household of their parents. This chapter proceeds on the footing that any proposal for a family unit basis of taxing income is not being implemented.




  ― 144 ―

11.5. In some other countries, legislation has been enacted for the purpose, amongst other things, of preventing income-splitting. These are sections framed in such extremely wide and general terms and in language so vague and imprecise that interpretation becomes very difficult. This inevitably leads to inconsistency in their application, with the consequence that liability to taxation becomes to a great degree uncertain and causes dissatisfaction to both the taxpayers and the administration. It has been well said that in fiscal legislation, when the choice lies between general provisions and provisions identifying with precision the kind of transaction which is to be struck at and prescribing with corresponding precision the consequences which are to follow, the second course ought to be chosen. The Committee rejects the adoption of general legislation of the type referred to. In so far as it is possible to do so, it prefers to deal with the different areas in which income-splitting is practised by less sweeping means.

11.6. It is, however, not always possible to enact legislation to cope with tax avoidance in language that fulfils the ideals of simplicity and precision. Firstly, most provisions of a taxation statute have an application to so many sets of circumstances of infinite variety that to attain an adequate coverage of all of them necessitates the employment of wording that is correspondingly extensive. Secondly, the ingenuity and complexity of the procedures to be found in the many and varied schemes of tax avoidance compel the use of measures that are sufficiently wide to counter them, and precision usually sits uncomfortably with width of expression. Thirdly, it must also be recognised that in framing legislation sufficiently all-embracing to deter tax avoidance, there is always the danger of penalising those who have a genuine reason for entering into a bona fide transaction which, if carried out by others, has the objective that ought to be prevented. There is frequently such a very fine line to be drawn between the transaction which offends and the one which merits no condemnation that clear definition in statutory terms cannot always be satisfactorily achieved. In some instances recourse must be had to an administrative discretion as the only practical instrument available to obviate an unjust result. To set forth in detail in the statute all the circumstances and factors that would regulate the discretion's exercise is clearly out of the question. Some guidelines there may be but, as with a judicial discretion, to confine it within rigid limits is in effect to destroy the discretion and to legislate in its place for a number of particular cases the full complement of which could never possibly be foreseen. The safeguard against error in the exercise of the discretion lies in the availability of a satisfactory procedure for its review.

11.7. Before proceeding to discuss the various procedures by which income-splitting may be effected, it is convenient to point out that all transactions between family relatives do not fall within that description. Some may be voluntarily and reasonably entered into in response to a legal or moral obligation and others may be executed in compliance with a Court order. Others again may result from the desire to carry into effect a mutual enterprise or dealing which by its very terms is stamped as genuine and free from criticism as an income-splitting device. The last-mentioned serves to emphasise the importance of what the law describes as ‘valuable consideration’, which for present purposes may be said to be the value received by a person in return for parting with some part of his income to another. Valuable consideration may consist of money or money's worth. For example, if a husband were to take his wife into partnership and the income she receives from the partnership is truly commensurate with the services she renders, or if one relative purchases from another some income-producing asset at a price reflecting its true value, no question of income-splitting arises, since such transactions or others like them are entered into on the same basis as


  ― 145 ―
strangers, acting at arm's length, would do. On the other hand, there are those arrangements between relatives under which income arising from the employment of assets owned by one person, or from the exercise by that person of personal skills or business ability, is established wholly or in part as the income of a relative: in reality there is a gift of this income. There are also those cases—inter-family gifts of capital—where assets producing income are the subject of transfer between relatives without adequate valuable consideration.

11.8. In general the Committee has approached this question in terms of three principles. Firstly, minor children are in a special category and tax advantages that might otherwise flow from diversion of income to them should be denied, by taxing their income at a rate based on parental income. Secondly, husband and wife are a category of relatives requiring special consideration separately from other relatives. But while income arising from arrangements resulting in gifts of income, as referred to in the preceding paragraph, should be assessed at a rate of tax based on notionally aggregated incomes, the Committee, on balance, considers that income arising from gifts of capital between spouses should be assessed in the normal way to the spouse actually deriving the income. And thirdly, there should be denial of income-splitting advantages under arrangements resulting in gifts of income in the case of other relatives; in these cases, however, as with husbands and wives, there should be no assessment on a notionally aggregated basis of income arising from gifts of capital. These matters are considered in more detail in the following paragraphs. The position in relation to minors is first examined; various means of income-splitting between spouses and with other relatives are then dealt with under several headings.

Income-splitting and Minor Children

11.9. It would be possible to deal with income-splitting between parents and minor children, i.e. children under 18 years of age, in much the same fashion as is being proposed in relation to income-splitting between other relatives. In the Committee's view, however, it is appropriate that their incomes should in general be taxed at rates that take account of the amount of income of their parents. It is proposed therefore that the unearned income of a minor child be taxed at a rate determined by notionally adding his income to the income of the parent with the higher income. The income thus notionally added would, for the purpose of ascertaining the tax on it, be regarded as the top slice of the parent's income with the amount added. Where there is more than one child involved, the total income of the children would be added for this purpose and the resulting additional tax then spread amongst the respective children on the basis of their incomes.

11.10. As a method of dealing with income-splitting, the proposal would have a wider application than measures specifically directed to that end would be likely to have. Thus unearned income of a minor child derived under a trust established by the will of a deceased grandfather would be taxed by reference to the amount of his parent's income.

11.11. The existing provisions of the Act (section 102 (1) (b)) relating to a trust created by a parent for his minor children would be unnecessary. Those provisions have, in any event, been shown to be defective in a number of respects. It seems that they have no application where the trust is created by some person other than the parent and the parent later vests assets in the trust. They are defective, too, in not requiring that amounts under all such trusts for the same minor child, and incomes under trusts for several minor children, be added in one calculation to the income of the parent in order to determine the rate of tax to be applied to the amounts.




  ― 146 ―

11.12. A number of detailed aspects of the Committee's proposal require consideration. The Committee has, in framing what follows, derived assistance from the model of the provisions of the United Kingdom Income Tax Act relating to ‘Aggregation of Income—Parent and Child’.

11.13. The system should apply only to income of a minor child who is unmarried and is not working in some occupation in an arm's length arrangement. The system is based on a view that it is appropriate to determine the ability of a child to pay tax on his income, by reference to the ability to pay tax of those on whom he normally depends for support.

11.14. The system will not apply to arm's length earned income derived by a minor child, since this would operate as a disincentive to work effort. But it should apply to earned income from transactions not at arm's length. For the purposes of the operation of the system, the latter income should be treated as income from property (or investment income). A minimum amount of such income might be specified which would not be taxed under the system. The purpose of this exclusion would be to limit compliance and administrative costs.

11.15. The United Kingdom legislation makes an exception of income derived from the investment of compensation for personal injuries and some similar amounts. The Committee considers that a similar exception should be adopted in Australia. There should also be provisions excluding the operation of the system when the child has a disability and is resident in an institution. There may be a case for other exclusions, for example where some grave and permanent incapacity is involved calling for special care for the child. The Committee would propose a general provision giving the Commissioner a discretion to relieve income from the operation of the system where he is of opinion that to tax the income at the parent's rate would cause unreasonable hardship.

Income from Gifts of Capital

11.16. There are difficulties in the way of dealing with income-splitting in the area of gifts. Where one person becomes the legal owner of an asset as the result of a gift from another, that asset may be income producing, may be incapable of producing income, or may not have been producing income when given but is capable of producing income when put to another use. Subject to such exemption or reliefs as the gift duty legislation may allow, gift duty will be payable on the capital value of the asset. Its value may be reflected in the income it produces or is capable of producing. If the subject-matter of the gift is cash, its value for gift duty purposes will be the amount given. But a gift of cash may not have effected any split of the donor's income: it may have been paid out of a credit balance in the donor's bank account. On the other hand, the donor may have sold an income-producing asset (a parcel of shares) or an asset not producing income (his own residence) or one not capable of producing income (jewellery) in order to obtain the cash to give. Ordinarily, in the latter two cases, there would again be no split of the donor's income. These are some only of the aspects of a gift when looked at in the hands of the donor and before he parts with it to a donee.

11.17. The asset when transferred into the possession and ownership of the donee may in turn be given to a third party, sold for a price above or below its value, mortgaged, exchanged, consumed, rendered non-income yielding or made to yield an income greater or less than that obtained by the donor when it was his property. The form and character of the asset may be materially changed by the labor of the donee


  ― 147 ―
himself or by the expenditure of his own moneys. By that expenditure the donee may have effected a reduction of his own income. It is unnecessary to list further illustrations. Enough has been said to indicate that the form, character and value of the subject-matter of the gift in the ownership of the donee in a great many instances will be markedly different to the features it exhibited in the ownership of the donor. More importantly, there is no necessary correspondence between either the income-producing qualities of the asset or the income it in fact produces in the ownership of the donor and donee.

11.18. If the donor owns a valuable work of art from which he derives only his own personal enjoyment and makes it the subject of a gift, it would not be a practical course to impute an income to the donor or the donee for the purpose of exacting an income tax from the donee, as the pleasure obtained from its ownership will vary with the personality of the owner and the use to which he puts it. In the genuine case of a gift of non-income-producing assets there is no income splitting by the donor. If the donee converts such assets into income-producing investments or sells them and invests the proceeds so as to produce an income, in either case the net income proceeds will normally be taxed in the usual way by taking into account the deductions allowable in respect of the production of that income.

11.19. The outright gift of income-producing property which confers upon the donee as its absolute owner the unfettered right to do with it as he wishes presents problems which are difficult to resolve in a manner that is both practical and equitable. If the donor splits his income by giving to the donee an income-producing asset, its income proceeds, whilst the asset remains intact in the donee's hands in the form given to him, could be identified and taxed at a rate equal to the rate of tax that would have been payable by the donor had those proceeds been included in his assessable income. The same objective of income-splitting could be achieved if the donor were to realise an income-producing asset and give the cash proceeds, or a non-income-producing asset aquired with those proceeds, to the donee who thereupon invested the cash proceeds, or the proceeds of the realisation of the asset gifted, in an asset that produced income for him. Whatever course be pursued, the subject-matter of the gift—the asset in specie or the cash—will have borne its appropriate gift duty. Difficulties for income taxation are to be met with in each case. For example, the donee may realise the income-producing or the non-income-producing asset given to him in specie and out of the net proceeds now mixed with his own funds in his bank account may take another investment, or by his own exertions or expenditures the donee may alter the income characteristics of the asset he has retained. Similar problems can be envisaged where the gift takes the form of the cash proceeds.

11.20. In those circumstances the onus should, perhaps, rest on the donee to satisfy the Commissioner either that there is no income derived by him which is attributable to the subject-matter of the gift or that, of the income he does derive from an investment constituted in part by his own funds and in part either by the proceeds of the realisation of the asset originally given or the gift in the form of the cash proceeds, so much is attributable to the subject-matter of the gift to be taxed as if it were the income of the donor, and so much is attributable to his own labours or expenditures.

11.21. A statutory alternative would be to adopt as the income of the donee attributable to the gift an amount determined by applying a rate per cent, say a rate equal to the ruling bank overdraft rate, to the amount of the gift or to some part of it that could reasonably be regarded as producing income. This alternative would be available for adoption by the donee where he found major difficulties in determining the income


  ― 148 ―
actually attributable to the gift or by the Commissioner where he is not satisfied with the basis of determination of a lower figure put forward by the donee.

11.22. The view might be taken that, despite the difficulties outlined above, there should be a notional aggregation of the income, arising to a donee from capital transferred by way of gift, with the income of the donor for assessment of tax. This view could enlist greater support where the donor and donee are husband and wife, because such transfers commonly have saving of income tax as their objective and because in practice some married couples pool their incomes for joint spending. These aspects are considered in more detail in Chapter 10 dealing with the taxing of family units.

11.23. An alternative view is that where a gift of capital has been made by one person to another, including a gift between married couples, the Revenue should be satisfied by payment of any gift duty liability; and income arising from the gift, in the hands of the donee, should be taxed to the donee in the normal way. This view is supported on the grounds of the major difficulties, to both taxpayers and the Commissioner, in satisfactorily identifying, in the hands of the donee, the capital constituting the gift and the income flowing from it, referred to earlier in paragraph 11.19. These difficulties would increase with the passing of time subsequent to the making of the gift and the need to identify further income arising from the investment of earlier income produced by the capital the subject of the gift.

11.24. The Committee, on balance, favours the latter view and accordingly recommends that income derived by a donee from capital received as a gift should in all cases be assessed to income tax in the hands of the donee in the normal manner.

Partnerships, Inter Vivos Trusts and Arrangements Achieving Similar Income-sharing Results

11.25. Under this heading the Committee considers in some detail income-sharing between relatives by means of a partnership, puts forward proposals for denial of tax advantages from income-splitting by this means, and then goes on to apply the principle of those proposals to trusts and other arrangements achieving generally similar income-sharing results. The other arrangements include those under which a business may be in the ownership of one or more persons but the operational skills, work effort and capital are supplied or in part supplied by a relative of the owner or owners in a manner which is not at arm's length; the ownership of income-producing assets is vested in one or more persons and the financing of the purchase has been by interest-free loans by a relative; and substantial property is leased to a relative, at a token rent, to enable the relative to derive the substantial rents from the sub-lessees.

11.26. In considering these income-sharing arrangements, it is necessary to have in mind that the Committee in Chapter 15 recommends a basis of assessment of income of an inter vivos trust to which no beneficiary is presently entitled. Attention here can thus be confined to the taxation treatment of income flowing from such a trust to a beneficiary in circumstances where the beneficiary is assessable on that income. It is also necessary to have in mind the recommendation earlier in this chapter that income of unmarried minors should be assessed at a rate based on parental income, and the recommendation that income arising from assets transferred between married couples, and others, by way of gift should be taxed to the donee in the normal manner.

11.27. As in most taxation systems, the partnership in Australia, though required to make a return, is not taxed as a single entity (section 91). As set out in more detail in


  ― 149 ―
Chapter 15, the partners themselves are taxed in separate assessments and their assessable incomes include their individual interests in the net income of the partnership (section 92). The only measure directed against income-splitting by the use of a partnership is section 94. That section provides that a partner who does not have the real and effective control and disposal of his share of the partnership income is taxed, unless the Commissioner by reason of special circumstances is of the opinion that it would be unreasonable, at a rate of not less than 50 per cent on that share of income (section 94). For this purpose a direct or indirect share of partnership income of a taxpayer under 16 years of age, as reduced by any amount genuinely attributable to remuneration for services rendered, is uncontrolled partnership income.

11.28. The Ferguson Commission (1932-34) recommended that the administration should not be concerned with the purpose for which a partnership is formed or with the relationship of the partners. The only test to be applied ought to be whether the partnership is bona fide or fictitious, and the partnership should be regarded as bona fide if each partner is the real owner of his share of the capital and profits of the partnership. In many instances, the result in practice of such a test is that the mere production of a partnership agreement meets the test and in almost any occupation provides a partner, frequently a wife or child, regardless of qualifications and despite the performance of services of a very minor nature, with a legal entitlement to a substantial share of the partnership profits. The test propounded by the Ferguson Commission is satisfied and the partners are taxed in accordance with section 92, but the reality of the situation is that the income of the effective owner and operator of the business or profession is split.

11.29. With the greatest respect to the Ferguson Commission, the Committee is unable to agree with its recommendation. The taxation treatment of a family partnership should not depend simply on the existence of a document which, as a matter of form, satisfies the requirements of the law of partnership but which readily presents itself as a vehicle for income-splitting by distributing the profits in arbitrarily determined proportions to relatives whose services (if any) in the partnership activities and/or whose capital or property contributions are not commensurate with the remuneration or share of profits received. The privacy attaching to an inter-familial contract is of itself sufficient to cast an onus upon relatives of displacing the possibility that the transaction they have entered upon is the product of a tax avoidance scheme. This is in keeping with the well-established principle that, where the relevant facts are solely within the keeping of one party, very little is required to change the onus relating to their disclosure. The fact that the partnership comprises family members requires that disclosure. The Commissioner is entitled to be made aware of the whole of the facts surrounding the formation of the partnership.

11.30. The whole of these facts are not necessarily established by the partnership agreement itself. Also relevant are the facts relating to the operation and control of the business, the manner in which its capital and property have been provided, and the relationship between the services performed and the capital and property provided by each of the partners and the remuneration each receives by way of salary and profit-sharing. Neither section 161 (1) of the Act nor Regulations 13 and 14 are sufficient in this regard. The Commissioner should be supplied, in a form accompanying the return of partnership income for the relevant year, with the appropriate information to enable him to be satisfied that the partnership is bona fide and that the individual interests of each partner in the partnership income, when measured in relation to his business or professional activities in the partnership and his provision of


  ― 150 ―
capital and property, are such as would reasonably be determined upon in all the circumstances by parties acting at arm's length. If the Commissioner was not so satisfied as to the share of any partner or some part thereof, that share or that part of the share should be taxed at a deterrent rate. Where an assessment was objected to, the issue for determination on appeal would not simply be, as it is at present, whether a partnership existed but whether the distribution of its income to each of its members was genuinely commensurate with their contributions of capital and property and their services to the partnership or whether the partnership agreement was merely a cloak for tax avoidance. The bona fide partnership would have no difficulty in resolving this issue in its favour. However, if the reality of the situation were otherwise, it should be apparent that the partners would be faced with the difficulty of proving the truth of the statements accompanying the return of income as to their respective roles and activities and their provision of capital and property in order to discharge the onus that lies upon them to displace the assessment. For this purpose the provision of capital and property to a partnership would not only include funds and assets overtly contributed as partnership capital. It would also extend to property, including loan moneys made available for use in the partnership business without recompense or on favourable terms, and any other benefit given or granted to the partnership by one or more partners but not by all partners according to their shares, such as land, livestock, plant, goodwill, etc. owned by one partner but used by the partnership without realistic recompense.

11.31. The determination of the amount of any share of partnership income to be taxed at a deterrent rate in accordance with what is set out above should also apply as the base figure for determining any liability to gift duty. Paragraphs 24.A54-24.A64 and 24.A67 deal with these questions for gift duty purposes. Thus, where in an equal partnership between a husband and his wife deriving income of $15,000 the Commissioner determines that $5,000 of the $7,500 allocated share of the wife is to be subject to a deterrent rate, that figure of $5,000 would be the base figure for gift duty purposes. As stated in paragraph 24.A105, that amount less the income tax payable on it would be treated as a gift.

11.32. Inter vivos trusts—trusts created by the creator or settlor of the trust during his lifetime—are frequently resorted to by a taxpayer to bring about a sharing of income with those of his relatives who are beneficiaries. In fact it is true to say that an inter vivos trust, where the income of the trust is distributed to the beneficiaries and becomes assessable to tax in their hands, can achieve the same purpose and result as the family partnership considered above. In the view of the Committee, distributions of income from trusts of this kind should be accorded the same tax treatment as distributions from family partnerships. Thus the Commissioner would be required to examine the whole of the facts surrounding the setting up of the trust and its operation and control. This examination would disclose whether the shares of income as allocated to beneficiaries, when measured in relation to their beneficial interest in capital and property of the trust and their business and/or professional contributions to the production of the trust income, are such as would reasonably be determined upon in all the circumstances by parties acting at arm's length. To the extent that the Commissioner could not be so satisfied, income or a part of income distributed would be subject to a deterrent rate of tax.

11.33. In relation to the other arrangements achieving income-sharing mentioned in paragraph 11.25, the Committee recommends the same treatment as for partnerships and inter vivos trusts. Thus, in the case of a business owned by one person and conducted and financed by a relative, including a spouse, the Commissioner would be


  ― 151 ―
enabled, in effect, to treat the business as a partnership between the relatives involved. Where the incomes derived by each relative could not be supported on the arm's length tests set out previously, the deterrent rate of assessment would apply. The same results would follow where the ownership of assets or property and certain leasing arrangements have been established and operated on bases not in accord with the arm's length test.

Excessive Payments for Services or Benefits

11.34. A common method of income-splitting is the payment by one relative to another of sums for services rendered or in respect of some benefit received and the amount of the payment exceeds what would normally, in an arm's length transaction, be expected to be paid for those services or that benefit. Payments of this kind are encountered in the relationship of employer and employee, hire of equipment, rent of premises and interest on money lent. Partnerships and private companies are areas frequently used for this purpose. The relationship of the person performing the services or affording the benefit to the person making the payment would, if the quantum of the payment were reasonably commensurate with the nature of the services or benefit, be an irrelevant consideration and the payment would be an allowable deduction under section 51 of the Act as an outgoing in gaining or producing the assessable income of the relative making the payment. Section 65 of the Act provides that a payment to an ‘associated person’ or a liability incurred to make such a payment shall be allowable as a deduction only to the extent to which, in the opinion of the Commissioner, it is reasonable. Section 65, broadly speaking, defines an ‘associated person’ as including relatives (as defined in section 6 (1)) of a taxpayer, partnerships in which relatives are involved, and relatives of partners in a partnership making a payment, as well as members of a company and beneficiaries in a trust, and relatives of these people, where a company or a trust is a partner. Provisions are included in the section to cover the position of the recipient of a disallowed payment and also to cover an amount not allowable as a deduction in a partnership in which a private company is a partner. These are of some unavoidable complexity.

11.35. Section 109 of the Act is designed to prevent income-splitting by a private company where excessive payments are made or credited to persons who are or have been its shareholders or directors or their relatives for services rendered or by way of an allowance, gratuity or compensation upon retirement from or termination of office or employment. The amount allowable as a deduction shall not exceed an amount which, in the opinion of the Commissioner, is reasonable.

11.36. The Committee is of the opinion that the principles of sections 65 and 109 are to be supported but that, as they now stand, these sections are not sufficiently wide in their coverage. There are basically four types of taxation entities that need to be considered in the context of income-splitting by the means envisaged in sections 65 and 109: an individual taxpayer, a partnership, a trust estate and a private company. The Committee recommends that the principles of sections 65 and 109 should apply to all payments flowing from any one of these entities to another entity in such circumstances that the payment, or part of the payment, can enure directly or indirectly for the benefit of the payer or a member or director of the payer or for the benefit of a relative of such a payer or member or director of a payer. For this purpose a settlor or deemed settlor and a beneficiary of a trust estate are to be included in the term ‘member’ in relation to a trust estate of which they are a settlor, deemed settlor or beneficiary.




  ― 152 ―

Alienation of Income

11.37. Alienation of income for short periods is dealt with in Division 6A of Part III of the Act. Generally speaking, a taxpayer is legally entitled to transfer to another, through an inter vivos transaction, the right to receive income from assets owned by the taxpayer without transferring the property in those assets to that other person. Where a taxpayer makes such a transfer for a period of less than seven years, by section 102B, the income transferred will be included in his assessable income from other sources. Sections 434 to 436 of the United Kingdom Income and Corporation Taxes Act 1970 contain provisions with the same objective as Division 6A of the Act, but the period is six years in place of seven. Where family income-splitting is to be prohibited, there appears to be no reason why a much longer period could not be selected—indeed, any period which by the form of the alienation did not transgress the provisions of the general law.

Family Companies

11.38. The private company when it is controlled by relatives is one of the most fruitful fields for income-splitting. For the purposes of the Act, a private company is defined as a company that is not a public company (see sections 6 (1), 103A), and it is the company that falls into one of the various categories set forth in the statute which for income taxation purposes constitutes a public company. Not every company classified for income taxation purposes as a private company is used as a medium for tax avoidance. The private company of the ‘family company’ kind is the usual vehicle employed to attain that objective. Private companies that are not family companies may attract the provisions of section 109 (see paragraphs 11.35–11.36 above), but most frequently it is the private company controlled by relatives in which income-splitting is practised. A family company, in the present context, is a private company controlled directly or indirectly by relatives either by means of a preponderance of its shares or the voting rights attached to them or to classes of them or by means of any other rights conferred by the Articles of Association, whether the person to exercise those rights be a shareholder or simply the holder of some office in the company, or by agreement or covenant. The number of relatives who possess that control is irrelevant: the relevant fact is the control.

11.39. One type of transaction which may constitute an income-splitting device by means of a family company can be seen in the acquisition of shares by a relative of the family which (i) entitle the holder to a share in the distribution of the company's profits disproportionate to the amount of capital subscribed by him, or (ii) enable those in control of the company to declare dividends in respect of his shares without distributing dividends to other shareholders, or (iii) enable those in control to declare differential dividends to selected shareholders. By these means it becomes possible to regulate the income levels of the various relatives associated with the company in addition to those activities struck at by section 109. It is not necessary, of course, for shareholders in a family company to subscribe substantial sums by way of capital in order to be capable of exercising the contemplated control or to be in a position to benefit from its exercise. It is not uncommon for the proprietor of a prosperous unincorporated business to sell his business to a family company in exchange for shares of a class which, however numerous they may be, will not necessarily return to their owner a share of the company's profits bearing any realistic relation to the amount of capital represented by them. The bulk of the profits will be divided amongst relatives whose shareholdings are nominal, so that the moneys required to take up those shares can be provided by them out of their own funds or by some friend of the family. The variations in the schemes that have been adopted to secure the income-splitting objective


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are multiple and further description of them would serve no useful purpose. But they all have one characteristic feature. The transactions carried out between the relatives themselves and between them and the company, in conjunction with the structure of the company itself, constitute a ‘settlement’ or an ‘arrangement’ of their affairs which it would be impossible to say that business people acting at arm's length in the investment of their own funds and contemplating for that purpose a bona fide commercial transaction would enter upon.

11.40. Apart from definitions of the word for some special statutory purpose, generally speaking a ‘settlement’ may be said to be created by or consist of any transaction operating or contributing to effect a disposition of property, whether real or personal, by means of one or a number of instruments with the intention that the property, whatever its form, may be enjoyed by others. Where other persons join in the transaction at some point in order to benefit or to be capable of benefiting from the property, either in pursuance of some legally enforceable agreement or of some informal understanding with others (including a family company) engaged in the transaction the scheme regarded as a whole may be termed an ‘arrangement’ whereby the income to be derived from the property can be parcelled out amongst those designed to be its putative beneficiaries.

11.41. In the Committee's view, income-splitting by means of settlements or arrangements of this nature effected through the medium of family companies should be prevented. Where the Commissioner is of the opinion that any such settlement or arrangement was effected by means and created rights or obligations that business people acting at arm's length in a bona fide commercial transaction of that nature would not be likely to adopt, he should be enabled at his discretion to tax the dividend income paid or credited to any shareholder at a deterrent rate: for example, at a rate that would have been payable had such shareholder been paid or credited with all the profits distributed by way of dividend in the relevant year of income. Gift duty could also be involved in these cases. The amount determined as subject to the deterrent income tax rate would be the base for the levy of gift duty (see paragraphs 24.A70–24.A90).

Section 260

11.42. The parent of section 260 appears to be section 82 of the New Zealand Land and Income Tax Assessment Act 1900 which, apart from the addition in 1936 to the Australian section of the words ‘as against the Commissioner’ and certain other immaterial differences in wording, is the pattern of the Australian section. The counterpart of section 260 was section 108 of the New Zealand Land and Income Tax Act 1954 as amended by section 16 of the Land and Income Tax Amendment (No. 2) Act 1968. The New Zealand section 108 has been recently repealed and replaced by a section in very wide-reaching terms but is itself now intended to be the subject of further amendment. The present New Zealand section 108 would be susceptible to the type of criticism referred to in paragraph 11.5. Although in a shortened form to section 260, both that section and the former New Zealand section 108 have the same objective and both have been the subject of considerable judicial criticism and frequent differences of judicial opinion as to their application. As with the New Zealand section, the Revenue has endeavoured to apply section 260, sometimes successfully and sometimes unsuccessfully, to transactions where it has been contended that the feature of income-splitting is involved. The section has been interpreted as meaning that not every transaction having as one of its ingredients some tax-saving feature is caught by its provisions and that, if a bona fide business transaction can be carried


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through in one of two ways, one involving less liability to tax than the other, the section is not to be applied merely because the way involving less tax is chosen. For the section to have an application, it has been held, it must be able to be shown that it was implemented in that particular way so as to avoid tax; if the transaction is capable of explanation as an ordinary business or family dealing without necessarily being labelled as a means of avoiding tax, the section cannot be applied to the transaction. If tax avoidance is an inessential or incidential feature of the arrangements that may well serve to indicate that the arrangement cannot necessarily be described as a means of avoiding tax (see the various observations collected in Hollyock's Case note).

11.43. It cannot be denied that this test for the section's operation lacks precision and that in many instances there will be strongly opposing points of view as to the necessity of applying the label. Further, as it has been held that section 260 is an annihilating provision—that it operates to destroy but not to supply and contains no power to rectify a transaction or to substitute something new in its place—the consequences which may follow from its application also create many difficulties. A number of these problems are referred to in the dissenting judgments of Lord Donovan in Peate's Case note and Mangin's Case note. The section provides ample room for uncertainty and for dissatisfaction on the part of the Revenue and the taxpayer alike and has been said to be long overdue for reform.note

11.44. The Committee is of the opinion that the criticisms of section 260 to which reference has been made should be heeded and the section be amended to reflect the following principles. If any arrangement had or was calculated to result directly or indirectly in the type of tax advantage described in the lettered sub-clauses of the section, the Commissioner should have the right to disregard it for taxation purposes, unless the arrangement was an ordinary business transaction creating rights or obligations that would normally be created between business people dealing at arm's length in a transaction of the nature in question and effected by means normally employed in such a transaction, or was made in the ordinary course of making or changing an investment, or was a bona fide arrangement of a person's or a family's affairs, and the Commissioner was satisfied that the arrangement was not entered into solely or primarily for the purpose of obtaining the tax advantage or that one of its main objectives was to obtain the tax advantage. If the Commissioner did disregard the transaction, he should be empowered to assess any person deriving income under or consequent upon the arrangement to income tax at a deterrent rate: for example, at a rate equal to the maximum marginal rate or at a rate declared by Parliament for the purposes of the section. Where the Commissioner acted upon this section, he should supply any persons affected with his reasons for doing so. It should be made possible to obtain the Commissioner's ruling upon proposals for any such arrangement in order to prevent a transaction being irrevocably entered into with the consequences, amongst others, of expensive litigation. For this purpose the system of advance rulings by the Commissioner, proposed by the Committee in Chapter 22, would be available to taxpayers and their advisers.

Distributions of Income under a Legal Obligation

11.45. A husband has an obligation imposed under the general law to maintain his wife, and a father has a similar obligation in respect of his infant children. Such obligations are presently the subject of certain relief in the nature of concessional deductions from assessable income (see section 82B) and are discussed elsewhere in this report. No question of income-splitting arises in connection with payments made in discharge of these obligations. In certain circumstances a husband may transfer a right to receive income from property or income-producing property itself to his wife or to his former wife pursuant to the order of a Court, in which case the income would be taxable in the hands of the wife and would not be exempt income under section 23 (1). Section 102B (4) exempts the transfer by a husband or former husband of a right to receive income from property for the purpose of alimony or maintenance from the alienation of income provisions of section 102B, whether made in compliance with a Court order or not, and the income in question is not taxable as income of the husband. The Committee is of the opinion that, where the right to receive income or income-producing property is, by virtue of a Court order, transferred to a wife or former wife or to the children or to a trustee for her or the children, by the husband or father, the measures against income-splitting in this chapter should not apply.




  ― 155 ―

Distributions of Income under a Moral Obligation

11.46. Distributions of income under a moral obligation fall into two classes. Firstly, there are cases in which, without the intervention of a Court, the impact of a strong moral obligation will induce a person to make some enduring provision for a relative by the creation of a trust of some part of his income-producing property or by some kindred means. It is impossible to catalogue all the types of instances where particular circumstances may raise the need for the implementation of a transaction of this nature. It will for the present suffice to be reminded of those cases in which grave and permanent incapacity calls for some special institutional care upon a stable income basis. In the Committee's view, the Commissioner should have a discretion to relieve transactions of this class from the provisions of the Act which otherwise would be attracted to them where he is of the opinion that to impose them would create unreasonable hardship. Secondly, there are the transfers of income-producing property to charitable institutions. Such transfers to selected charitable institutions should not be categorised as income-splitting.

Retrospectivity

11.47. The provisions that have been suggested to overcome the problems for the Revenue of income-splitting have, of necessity, a wide application. If they are adopted, the consequences of their infringement will be, in many cases, to impose a heavy burden of taxation upon those who fall within their purview. For a long period of years there has been no legislation in the Australian taxation system comparable to what is now being proposed. Accordingly, taxpayers have been lawfully enabled and entitled to order their affairs so that the tax for which they become liable was less than it otherwise would have been. The arrangements they made and the documents they executed breached no provision of the law. A great many of these transactions have been long acted upon and the rights and obligations of third parties, who were not the instigators of these schemes, have been regulated and affected by them, and it would not be unreasonable to suppose that in a great many cases what has been done is irrevocable.

11.48. There is a well-established, fundamental and sound principle that legislation, especially fiscal legislation, should not have a retrospective operation. That which was


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lawfully done should not, after the completion of the act by which it was done, be made unlawful and subjected to a penalty. There is a strong presumption against retrospectivity because it manifestly shocks one's sense of justice.note It is, for example, because of this principle that section 437 (2) of the United Kingdom Income and Corporation Taxes Act 1970 is framed not to affect an irrevocable settlement made before 22 April 1936, which was the date when section 21 of the Finance Act 1936 came into operation and introduced for the first time provisions similar to those now appearing in the current legislation. In the opinion of the Committee, it will be proper, therefore, to safeguard any legislation that may be introduced on the lines discussed in this chapter from the vice of retrospectivity penalising any bona fide transaction where the rights and obligations of the parties are involved irrevocable.




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Reservation to Chapter 11: Income-Splitting

My reservations relate, in the first place, to the chapter's explanation of the principle that measures directed against transfers of income should serve. The descriptions given in the chapter of unacceptable ‘income-splitting’ transactions fail to identify any such principle except a notion that a course of action is ‘tax avoidance’, and therefore unacceptable, if it is undertaken solely or primarily for the purpose of reducing income tax liability. In my view such a notion is not a satisfactory explanation nor, where it is adopted as such, is it a workable test of the operation of measures intended to deal with transfers of income.

It is true that this notion is at the basis of the interpretation of section 260 of the Act. But, in that context, it has led to the development of a question-begging distinction between cases where a taxpayer is said to have a ‘choice’ to pursue a course of action which will reduce his tax and cases where he has not. And the drawing of an inference of purpose to reduce tax is unpredictable. A gift of property by a husband to his wife is as much open to the construction that he has moved by love for her as it is open to the construction that it was done to reduce tax on the income produced by the property given.

A principle requiring the defeat of a transfer of income to a person, most likely a spouse, who may be expected to share the enjoyment of the income with the transferor may have some merit as the basis of measures directed against transfers of income, though the appropriate measures would, of course, have a significantly narrower operation than those proposed by the Committee. This principle might be seen as some expression of the philosophy of family unit taxation discussed in Chapter 10. It would be said that the transferor's ability to pay tax should be determined not only by reference to income he himself has derived, but also by reference to income derived by others who may be expected to share that income with him. The income transferred should be taxed to him or taxed at a rate determined by reference to his income.

Clearly the expression given to the family unit philosophy by the principle would be very limited. That philosophy assumes that the ability of an individual to pay tax should reflect not only the benefits he may expect from the expenditure of income by others, but also the benefits he confers on others by sharing his income with them. It requires an aggregation of the incomes of those who share expenditures, and the taxing of that aggregated income at a rate which reflects the fact that the aggregated income supports more than one individual. And the principle would apply only when the shared income had been the subject of transfer. The principle cannot give effect to the philosophy where the shared income enjoyed by one spouse is income derived from property which the other has inherited from a third party.

Moreover, there are very significant practical limitations on how far measures giving effect to the principle can go. Any attempt, otherwise than by the most arbitrary rules, to identify as income transferred income which flows from the investment of money transferred or from property transferred is clearly an impossible undertaking. There may have been movements of money and other property, sometimes in both directions, between husband and wife over a period of years and dealings with that money or other property.




  ― 158 ―

The imperfections and inadequacies of measures against transfers of income as an expression of family unit philosophy suggest that what is really called for is the explicit application of family unit taxation. The Committee has rejected compulsory family unit taxation. I appreciate that it is unlikely to be politically acceptable, though those who would reject it on the ground that it denigrates the status of women curiously assert, at the same time, that a widow should be treated as having been an equal partner in the acquisition of assets which her husband owned at his death. An elective system of family unit taxation could not, however, be said to denigrate the status of women, and it ought to be politically feasible. It should not be too costly to Revenue, nor would it be unfair to unmarried individuals, if the rate structure were carefully framed to offer a limited advantage, over a lifetime, to most married couples, compared with the lifetime operation of individual unit taxation.

An elective system of family unit taxation would not make measures against transfers of income between husband and wife wholly inappropriate, but it would then be possible to give a satisfactory explanation of the limited measures which practical considerations would allow. Husband and wife who did not elect would be taken to have asserted that family unit philosophy had no application to them because the financial affairs of each were wholly separate from the other's. Transfers of current income made without consideration between husband and wife contradict the assertion of separateness and those who have not elected family unit taxation should not be allowed by such transfers to gain a tax advantage over those who have. The possible tax advantage that they could gain would, in any event, be significantly less than they could gain under an exclusively individual unit system. Put in another way, elective family unit taxation gives some of the advantages to be gained by transfers of income but gives it to all those who elect, whether or not there are techniques of transfer of income open to them.

I accept that, so long as family unit taxation is not applied, or is not available on an elective basis, what can be done should be done to prevent an individual gaining a tax advantage by transferring income in whose enjoyment he continues to share. The opportunities to transfer income which property law and the tests of derivation in tax law afford are unevenly distributed between taxpayers. They are readily available to taxpayers in business and to taxpayers who have substantial property incomes but not to wage and salary earners. Nonetheless, my acceptance of measures to defeat transfers is tempered by the fact that the divisions of income between husband and wife which occur as a result of the good fortune of inheritance or gifts from third parties continue to give tax advantages. It is tempered too by the fact that defeat of the principal technique of transfer of income—outright gift of capital—is beyond the limits of effective legal action.

Having regard to my understanding of their function and what I consider to be administratively feasible, the measures against transfers of income which I think appropriate will have a narrower operation than those proposed by the Committee. The measures would be limited to transfers of income between husband and wife. There are other cases, it is true, where a person who transfers income may be expected to share in the expenditure of the income transferred: a son may transfer income to his aged parent who lives with him. But these other cases are not a serious threat to the equity of the tax system. The measures would not attempt to deal with the income flowing from the investment of money or from other property which has been the subject of an outright transfer. The problems involved are quite unmanageable even if the attempt is confined to income flowing from capital transfers. And there is no


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reason in logic why the attempt should not extend to income flowing from the investment of income currently transferred, for example, through a partnership.

The measures should be limited to transfers of income made without full consideration. Where full consideration is given for a transfer there will be an offsetting transfer of income which cannot fairly be ignored, though, in the interests of administrative feasibility, an offsetting transfer involved in a less than full consideration will have to be ignored. Division 6A of Part III, referred to in paragraph 11.37, in its present terms, applies to transfers of income whether or not consideration has been given. I think that its operation should be qualified so that it applies only when there is a transfer for less than full consideration. I would, in any case, limit its operation to transfers of income between husband and wife. The principle expressed in Division 6A is not easily discovered. It applies notwithstanding that there has been a transfer for full consideration, whether or not the transfer was between persons who share the enjoyment of income and whatever might be thought to have been the purpose of the transfer.

I have a number of reservations in regard to the detail of the measures proposed by the Committee. The proposals are not fully integrated, as I think they should be, with the proposals in Appendix A to Chapter 24 as to the operation of gift duty in relation to gifts of income. The references to taxing income transferred at ‘a deterrent rate’, for example in paragraph 11.30, seem to me to be inappropriate. The income transferred should either be taxed to the transferor as if it were his income, or, preferably, be taxed to the transferee at a rate determined by reference to a notional addition to the income of the transferor.

The assumption in paragraphs 11.34–11.36 that sections 65 and 109 are designed to prevent ‘income-splitting’ seems to me to be open to question. While they will in some circumstances defeat transfers of income, their basic purpose is to deny deductions in respect of payments which are not in fact made in the deriving of income. Without such measures tax might be imposed on an amount less than the true net income of a business and, to this extent, income might escape tax altogether. I agree that there is need for such measures and that they should have a wider operation than they have at present.

The proposals made in paragraphs 11.42–11.44 in regard to section 260 do not have my support. I do not agree that they will overcome the uncertainty and dissatisfaction associated with the operation of the section. The proposed express exclusions of ordinary business transactions and bona fide arrangements of a family's affairs have already been written into the section by judicial interpretation. And the Commissioner's proposed powers to tax any person deriving income consequent upon the arrangement at ‘a deterrent rate’, are too wide. In any case it is my view that section 260 has no place in the Act. Any general provision directed against courses of action described only as ‘tax avoidance’ involves an abdication of Parliament's responsibility to formulate and inform the taxpayer of the principles intended to be expressed in the tax law.

I concur in the proposal to tax the unearned income of a minor child at a rate determined by reference to his parent's incomes. I think it should be made explicit that this is an adoption of the philosophy of family unit taxation. The child's ability to pay tax on his income reflects the fact that he shares in the expenditure of the income of those on whom he is dependent for support. However, as an expression of that philosophy, the proposal in paragraph 11.9, in my opinion, goes too far. It is not appropriate to tax the income of a minor child at a rate which takes account not only of


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the incomes of his parents but also the incomes of other minor children of the same parents.

R. W. Parsons




  ― 161 ―

Reservation to Chapter 11: Income Splitting

While I am in full agreement with the need to strengthen the income tax law to reduce the loss of revenue from income splitting, I have a number of reservations on the proposals set out in Chapter 11.

I concur with the view of Professor Parsons that the proposals in this chapter are not adequately integrated with the proposals in appendix A to Chapter 24 as to the operation of gift duty in relation to gifts of income. As paragraph 11.1 states, income splitting devices invariably involve the distribution of income to a person who has not provided an adequate consideration for the amount received. The appendix to Chapter 24 contains detailed procedures for identifying and quantifying gifts of this type together with proposals that such gifts should be brought within the ambit of the proposed integrated estate and gift duty. The principal objective of Chapter 11 should be to suggest clear and certain provisions for the method to be followed in taxing income which has been identified as a gift by the operation of provisions which match those proposed in relation to the estate and gift duty.

I support the proposal in paragraph 11.9 that the unearned income of a minor child should be taxed at a rate determined by reference to his parents’ income. However I concur with the reservation of Professor Parsons that it is not appropriate to tax such income of a minor child at a rate which takes to account not only the income of his parents but also the incomes of other minor children of the same parents.

I do not support the proposal made in various paragraphs of the chapter, that income identified as having been unreasonably diverted to others should be taxed at ‘a deterrent rate’. I concur with the view expressed by Professor Parsons that it is only income diverted to a spouse which need be subject to special taxing measures. In these cases, the tax payable should be such as would have been paid had the income in fact been received by the spouse who has made or is deemed to have made the gift. In cases of other than minor children and a spouse the diverted income should be taxed in the normal way and the sole deterrent to income splitting procedures should be the imposition of gift duty as proposed in Chapter 24.

I reject as impracticable the proposal in paragraph 11.32 that the allocation of income between the beneficiaries of a trust, other than a trust established by will, should fall to be reviewed by the Commissioner in the same way as is proposed in the chapter in respect of allocations of income by a family partnership. The tests proposed in paragraph 11.32 that the Commissioner should apply, such as beneficial interest in capital and property of the trust, business and professional contributions to the production of trust income and the arm's length concept have no place in a review of the distribution of trust income made by a trustee in accordance with the provisions of the trust document, particularly in the case of a discretionary trust. There may well be grounds for empowering the Commissioner to identify partnership income or income of a company flowing through a trust to a spouse to determine tax payable on this income but such a provision should be limited to these instances only. The Committee's proposals in relation to taxing of income of minor children, the imposition of tax at maximum marginal rates on income accumulated by a trustee and the widening of the base of estate and gift duty should adequately protect the Revenue in cases where trusts are used to spread or divert income.




  ― 162 ―

Finally, I do not support the proposed amendment to section 260 of the Act as proposed in paragraph 11.44. I believe it will increase the present uncertainty of the application of this section and is contrary to the Committee's view expressed in paragraph 11.5 of the chapter. I make no suggestion as to the action which should be taken to heed criticisms of this section of the Act as no acceptable proposal, in my view, has emerged from the Committee's researches and discussions in this area.

K. Wood




  ― 163 ―

12. Chapter 12 Personal Income Tax: Dependant Allowances and Other Concessional Deductions

12.1 Fairness between persons who differ from one another in the level of their income involves questions of rate structure to be examined in Chapter 14. Fairness between persons who differ from one another in other relevant respects has to be achieved by alternative means, the chief of which might be concessional deductions as is the case today. Statistical information about the size and composition of these concessional deductions, for the income year 1971–72, is summarised in Table 12.A.

TABLE 12.A: DEDUCTIONS ALLOWED BY RANGE OF NET INCOME, 1971–72

           
Average deduction claimed for  
Income range   Proportion of taxpayers   Average net income   Dependants   Medical and hospital benefits fund payments   Net medical (a)   Rates and land taxes (b)   Life insurance and superannuation payments   Education (b)   Other (c)   Total (d)  
Per cent 
417–1,999  21.9  1,255  23  15  28  22  26  127 
2,000–2,999  18.0  2,506  77  30  54  20  57  20  42  300 
3,000–3,999  18.6  3,493  174  47  76  41  102  40  60  540 
4,000–5,999  25.9  4,858  302  69  105  74  190