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17. Chapter 14 Personal Income Tax: Rate Structure
14.1 The personal income tax scale in Australia, as set out in the Income Tax Act 1974, has a number of basic characteristics:
- (a) The scale is progressive, with increasing marginal rates specified for successive intervals of income, from 1 per cent on the initial $1,000 of taxable income to 67 per cent on income in excess of $40,000.
- (b) The progression is achieved using a series of taxable income steps—fourteen in all—which are subject to progressively higher marginal rates. These are shown in Table 14.A. (Marginal rates in earlier years are set out in Table 6.B.)
- (c) A surcharge is payable on property income where a property owner's taxable income exceeds $5,000. Subject to shading-in provisions on taxable incomes between $5,000 and $5,500, the rate of surcharge is 10 per cent of the average rate of tax on all taxable income.
- (d) Taxable incomes of individuals up to $1,040 are wholly exempted from tax, but incomes above this figure attract tax on the initial $1,040. To obviate what on the present scale would be a tax of $12.80 on the 1,041st dollar earned—a marginal rate of 1,270 per cent—a shading-in clause limits the tax payable on incomes between $1,040 and $1,061 to not more than 66 per cent of the excess of taxable income above $1,040. In other words, the effective marginal rate is zero up to $1,040,66 per cent from there to $1,061, 7 per cent on the next $939, and then on up, as indicated in Table 14.A, until a rate of approximately two-thirds is reached again at $40,000.
14.2. This tax scale, introduced as recently as November 1974 in place of the revised scale announced in the 1974–75 Budget, differs in significant respects from the scale applying in 1972–73 and 1973–74 at the time the Committee was receiving submissions and beginning to marshall its thoughts on tax reform. The rate schedule of those earlier years had come in for criticism for:
- (a) being unnecessarily complicated;
- (b) failing to differentiate between income from personal exertion and income from property;
- (c) not discriminating in the right degree between high and low incomes;
- (d) being too infrequently adjusted for inflation; and
- (e) making insufficient provision for the inequity that may arise where individuals have fluctuating incomes.
Each of these criticisms warrants examination, having regard among other things to the latest restructuring of the rate scale.
I. Complexity of Rate Scale
14.3 In its preliminary report the Committee, addressing itself to the situation as it was in 1973–74, drew attention to the fact that Australia's rate scale, with its twenty-nine marginal steps, was by international standards, exceptionally complicated. As Table 14.A indicates, the United Kingdom employs only ten marginal steps, Canada thirteen, and New Zealand nineteen; the United States employs seventeen, but has eight more for very large investment incomes, mostly well beyond the point at which the Australian scale stops. Two particular aspects of these overseas scales, closely related to their lesser number of steps, were noted in the preliminary report:
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| Australia (b) | Per cent | United Kingdom (c) | Per cent | United States of America (d) | Per cent | Canada | Per cent | New Zealand | Per cent |
| $A | £ | $US | $Can | $NZ | |||||
| 0–1,000 | 1 | 0–4,500 | 33 | 0–500 | 14 | 0–500 | 12 | 0–500 | 18.0 |
| 1,000–2,000 | 7 | 4,500–5,000 | 38 | 500–1,000 | 15 | 500–1,000 | 18 | 500–1,000 | 18.5 |
| 2,000–3,000 | 14 | 5,000–6,000 | 43 | 1,000–1,500 | 16 | 1,000–2,000 | 19 | 1,000–2,000 | 19.0 |
| 3,000–4,000 | 20 | 6,000–7,000 | 48 | 1,500–2,000 | 17 | 2,000–3,000 | 20 | 2,000–2,500 | 22.5 |
| 4,000–5,000 | 26 | 7,000–8,000 | 53 | 2,000–4,000 | 19 | 3,000–5,000 | 21 | 2,500–3,000 | 26.5 |
| 5,000–6,000 | 32 | 8,000–10,000 | 58 | 4,000–6,000 | 21 | 5,000–7,000 | 23 | 3,000–3,500 | 28.5 |
| 6,000–7,000 | 38 | 10,000–12,000 | 63 | 6,000–8,000 | 24 | 7,000–9,000 | 25 | 3,500–4,000 | 32.0 |
| 7,000–8,000 | 44 | 12,000–15,000 | 68 | 8,000–10,000 | 25 | 9,000–11,000 | 27 | 4,000–4,500 | 34.5 |
| 8,000–10,000 | 48 | 15,000–20,000 | 73 | 10,000–12,000 | 27 | 11,000–14,000 | 31 | 4,500–5,000 | 36.0 |
| 10,000–12,000 | 52 | 20,000+ | 83 | 12,000–14,000 | 29 | 14,000–24,000 | 35 | 5,000–5,500 | 39.0 |
| 12,000–16,000 | 55 | 14,000–16,000 | 31 | 24,000–39,000 | 39 | 5,500–6,000 | 41.5 | ||
| 16,000–20,000 | 60 | 16,000–18,000 | 34 | 39,000–60,000 | 43 | 6,000–6,500 | 44.5 | ||
| 20,000–40,000 | 64 | 18,000–20,000 | 36 | 60,000+ | 47 | 6,500–7,000 | 46.0 | ||
| 40,000+ | 67 | 20,000–22,000 | 38 | 7,000–8,000 | 47.0 | ||||
| 22,000–26,000 | 40 | 8,000–9,000 | 48.0 | ||||||
| 26,000–32,000 | 45 | 9,000–10,000 | 48.5 | ||||||
| 32,000+ | 50 | 10,000–11,000 | 49.0 | ||||||
| 11,000–12,000 | 49.5 | ||||||||
| 12,000+ | 50.0 | ||||||||
| note |
― 185 ―
- (a) Rates of tax on the early steps are substantially higher than in the Australian scale. The outstanding example is the United Kingdom where the height of the initial step was until recently 30 per cent and has now been lifted to 33 per cent. Australia's initial step was only 0.2 per cent in 1973–74 and earlier years; it has now been raised to 1 per cent.
- (b) There are noticeably fewer, and hence correspondingly much wider, steps over the bottom ranges of income than under the Australian system. Again the United Kingdom stands out, with an initial step extending over the first £4,500 of taxable income. In contrast, twenty of the twenty-nine steps featuring in the Australian rate scale until 1974–75 occurred below a taxable income of $6,000, encompassing the bulk of taxpayers; the number of steps below $6,000 has now been sharply cut back to six.
14.4. The sole defence known to the Committee for the large number of steps that has been traditional in the Australian scale is that it provides a nearly continuously graduated set of rates, and is thus capable of moving nearly continuously with the size of income and hence also with ability to pay, if this in turn be supposed to be continuously related to income. But as has been emphasised in earlier chapters, ‘ability to pay’ in the vertical equity sense is not a quantifiable concept bearing an exact relationship with income. With wider steps average rates would still rise with income, and this is the prime requirement for vertical equity. To require that the average should rise smoothly is to try to be precise about something that is essentially imprecise.
14.5. It could not seriously be argued that as many as twenty-nine marginal steps were ever necessary for practical fairness. So many steps only confuse taxpayers. They lead to inchoate fears of ‘moving into a higher tax bracket’ whenever income increases. They add to the complexity of tax calculations, whether for the taxpayer or the administration. Experience suggests that they make changes in rates difficult to introduce. Indeed if, as the Committee proposes, the share of income tax revenue be gradually reduced as a broad-based consumption tax is built up, simplification of the scale by a further reduction in the number of the steps on the fourteen applying in 1974–75 would be desirable.
II. Surcharge on Property Income
14.6. There is one respect in which the Australian rate scale in the recent past has, for all its proliferation of steps, tended to be simpler than those applying in the United States and United Kingdom. In those countries, and in others, income from property (or investment income) is subject to heavier tax than income from personal exertion. The United States distinguishes between the two forms of income by limiting the maximum marginal rate of tax on personal exertion income to 50 per cent, even though the nominal rate schedule extends as high as 70 per cent. Property income of persons in the relevant ranges of income is thus subject to higher rates of tax than the maximum rate on personal exertion income. Until 1973 the United Kingdom provided for a deduction of an earned income allowance of two-ninths of personal exertion income up to £4,005 and of 15 per cent of income in excess of that figure. Under the unified income and surtax arrangements now operating, the earned income allowance has been abandoned and a surcharge imposed on investment income. At one stage Canada imposed a special 4 per cent tax on investment income from all sources. In 1961, however, it was withdrawn from investment income from domestic sources.
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14.7. For many years a distinction was also drawn in the Australian legislation between personal exertion and property income, both as to rates of tax and as to the level of general exemption from tax. Property income was subject to higher rates of tax until 1953, but the lower level of exemptions was removed in the 1930s. The abolition of the differential rate of tax in 1952 was no doubt influenced by the Spooner Committee which had drawn attention in the previous year to the low revenue yield in relation to the complexity involved and the irksomeness of the differential where taxpayers with personal exertion income also had a small amount of property income. However, the differential was reintroduced in 1974–75 in the manner described in paragraph 14.1.
14.8. A long-standing argument for treating income from personal exertion more kindly is its greater ‘precariousness’, having regard to the fact that such income is confined to the period of a person's working life and its continuity may be interrupted by sickness or unemployment. However, much property income is precarious too: losses on investments are by no means an unusual occurrence. In any case, government assistance by way of age pensions and sickness and unemployment benefits now affords considerable protection to those who depend heavily on personal exertion income.
14.9. It is also sometimes said that acquiring income through personal exertion involves greater effort than acquiring property income. But assertions of this kind overlook the fact that a taxpayer's property income may derive from his own saving out of earlier years’ personal exertion income: it would clearly not be feasible to distinguish between property income according to source of investment funds and to confine any property surcharge to income from inherited wealth. So far as the point is that income from personal exertion involves a greater variety of expenses than income from property and many of these expenses may be inadequately reflected in the tax deductions allowable, this is a matter to be corrected by a liberalisation of deductions.
14.10. A surcharge on property income has been proposed, too, as a way of moderating income inequalities, the assumption being that persons on high incomes derive a greater proportion of their income from property than do persons on low incomes. At best, however, this will be so only in a broad statistical sense. There are, after all, many individuals of quite modest means, especially retired folk, for whom interest, dividends or rents are the chief component of income: the relief proposed for low incomes in the Government's recent surcharge is recognition of this. In any case, such vertical redistribution as a surcharge on property income achieves tends to be at the cost of serious horizontal inequities. It is difficult to see why, where there is no relief from surcharge, a retired couple living off their past savings should be asked to pay more tax than members of the work force earning the equivalent income.
14.11. The case for differential treatment has also been argued in terms of the special advantages property confers on its owner over and above any income it produces, particularly in providing a reserve of spending power. Those advantages, it is sometimes held, should be taxed through an annual levy on wealth. For reasons to be explained in Chapter 26, the Committee rejects a wealth tax, and a surcharge on property income might be thought to be a suitable proxy. But this the Committee would not accept. As pointed out in Chapter 3, the income tax system already contains an in-built bias against saving, reducing the ratio at which future consumption can be substituted for present consumption. And an additional bias against certain forms of property income is introduced by inflation, a feature also referred to earlier.
14.12. The Committee sees a number of problems in imposing a surcharge on investment income. Taxpayers are not divided
neatly into two mutually exclusive categories, those receiving income from personal exertion and those receiving income
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from property. Most property owners, except perhaps the retired, also receive personal exertion income even
though many wage earners may have little if any property income. This raises difficult questions, foreshadowed in
paragraph 14.10, when it comes to trying to accommodate a differential rate structure to an overall tax system designed to
be fair. Should somebody with investment income of, say, $5,000 and no other income be subject to the same additional tax
burden as somebody else with $5,000 investment income and a substantial amount of income from personal exertion?
Alternatively, as under the present Australian scheme, should persons with the same total income but different components
of personal exertion and investment income be subject to the same rate of surcharge on the investment component of their
income? Whichever approach is followed, serious inequities and anomalies are bound to arise.
14.13. The administrative difficulties of levying a special tax on property income or of providing an earned income relief are substantial. When taxpayers are dealing at arm's length with employers, few problems are likely to arise in determining what constitutes salary and wages. But in many situations, especially those involving private companies and small unincorporated businesses, there may be considerable scope for substituting the payment of salary and wages for the payment of investment income. In the case of unincorporated enterprises, such as farms, further awkward problems arise in determining the income from the ownership of, as distinct from the employment in, an unincorporated enterprise. It may be possible to apply distinctions for administering the law, but if such distinctions involve many arbitrary elements, as they inevitably must when it comes to drawing a line between what is a return for labour effort and what is a return on investment, inequities will occur and opportunities are opened up for tax planning. No set of tax reform proposals that takes equity and simplicity seriously can really contemplate these types of arrangements.
14.14. The Committee therefore recommends that the present surcharge on property income be abolished at the earliest opportunity.
| Income range (net income) | Proportion of taxpayers | Proportion of taxable income | Mean taxable income | Average tax rate | Proportion of income tax receipts | |
| (a) | (b) | |||||
| $ | per cent | per cent | $ | per cent | per cent | per cent |
| 0–999 | 7.2 | 1.5 | 671 | 0.3 | 0.3 | 0.3 |
| 1,000–1,999 | 14.6 | 6.0 | 1,353 | 6.3 | 7.0 | 2.2 |
| 2,000–2,999 | 18.0 | 11.9 | 2,206 | 9.7 | 11.0 | 6.9 |
| 3,000–3,999 | 18.6 | 16.5 | 2,953 | 11.8 | 14.0 | 12.2 |
| 4,000–4,999 | 15.8 | 17.3 | 3,645 | 13.5 | 16.6 | 15.1 |
| 5,000–5,999 | 10.1 | 13.3 | 4,385 | 15.3 | 19.0 | 13.4 |
| 6,000–6,999 | 5.9 | 9.1 | 5,140 | 16.9 | 21.2 | 10.3 |
| 7,000–7,999 | 3.4 | 6.1 | 5,924 | 18.5 | 23.2 | 7.5 |
| 8,000–9,999 | 3.2 | 6.9 | 7,041 | 20.6 | 25.8 | 9.3 |
| 10,000–14,999 | 2.2 | 6.3 | 9,597 | 25.2 | 30.9 | 10.3 |
| 15,000–19,999 | 0.5 | 2.3 | 14,368 | 32.5 | 38.4 | 4.6 |
| 20,000–29,999 | 0.3 | 1.7 | 20.689 | 40.7 | 46.5 | 4.1 |
| 30,000 + | 0.1 | 1.3 | 40,551 | 52.8 | 57.7 | 3.8 |
| 100.0 | 100.0 | 100.0 | ||||
| note note |
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III. Shape of Rate Scale
14.15. From submissions to the Committee it is evident that the shape of the rate scale, so far as it determines how much more tax a high income bears than a low, is a subject on which the community holds strong but differing opinions. The appropriate degree of progression in the rate scale of personal income tax is a subordinate aspect of the question of the degree of progressivity proper to the tax structure as a whole. As the analysis of Chapters 3–5 suggested, preoccupation with the progressivity of income tax obscures the realities of the problem. The discussion of progressivity requires an appreciation, virtually impossible on the basis of present statistics, of the impact of all taxes, and not merely of one of them. This becomes a consideration of increasing importance with the imposition of capital gains tax, the restructuring of company tax and estate and gift duties, and the introduction of a broad-based consumption tax—in other words, all the measures later proposed in this report. Underlying the implications for progressivity of the measures taken—or not taken—in these areas are the trends in revenue requirements, the evolution of expenditure policies, and the basic developments in the economy over the years.
14.16 Some consideration of the present rate scale is nonetheless called for. Table 14.B may conveniently serve as a starting-point to identify three ranges of net income:
- (a) The low range, up to an income of, say, $3,000. In 1971–72, 39.8 per cent of taxpayers fell within this range, providing 9.4 per cent of total revenue from personal income tax. Because of continued inflation and recent changes in tax rates, the corresponding percentages are likely to be noticeably lower in 1974–75.
- (b) The high range, above an income of, say, $20,000. Only 0.4 per cent of taxpayers fell within this range in 1971–72, but they accounted for 7.9 per cent of total revenue. Somewhat higher percentages may be anticipated in 1974–75.
- (c) The intermediate range between the two extremities, encompassing the majority of taxpayers (59.8 per cent) in 1971–72 and supplying the bulk of tax revenue (82.7 per cent). A higher percentage of taxpayers is likely to come within this range in 1974–75, but the percentage contribution to revenue may not be greatly different from what it was in 1971–72.
Low Range
14.17. One of the first questions of detail to settle in any analysis of the income tax scale is the level of the initial step. At present this step, at 1 per cent, is effectively abolished, except in a few cases, by the exemption of the first $1,040 of taxable income, so that up to this level there is a marginal (and average) rate of zero. After the shading-in arrangements already described, a marginal rate of 7 per cent resumes at $1,061 where the average rate is 1.3 per cent. As noted, in the United Kingdom system the initial marginal rate now stands at 33 per cent. The contrast is striking.
14.18. The most important advantage of an initial step of some magnitude is not that it raises much tax from the taxpayers whose total income is confined within this step; it is rather that a sizeable minimum average rate is thereby struck for all higher incomes. Without a significant rate on the lower steps, much higher marginal rates than otherwise must be imposed further up the income scale if substantial revenue is to be raised from the later income brackets with their greater numbers.
14.19. On the other hand, it may seem quite wrong and vertically inequitable to impose any significant income tax on
very low incomes, and this points to a near-zero rate on such incomes, whatever the unwelcome implications for
marginal rates higher up. In discussion of tax matters it is often suggested that this dilemma can be escaped
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by one or other of two devices. First, a universal personal allowance can be provided, as a deduction
from taxable income, tax only being paid on what remains: as indicated in a footnote to Table 14.A, the United
Kingdom, the United States and Canada provide for a universal personal allowance. Or, secondly, a non-reimbursable tax
rebate can be given cancelling out the tax that would otherwise be paid at these levels: New Zealand has recently
introduced a rebate along these lines. But these are in fact exactly equivalent to making the first step a zero-rate
one; and they mostly serve to conceal the abrupt rise in the effective marginal rate when, at the point of exhaustion
of the allowance or the rebate, the marginal rate of the tax scale begins to be effective. Universal tax allowances or
non-reimbursable tax rebates are merely techniques for altering the actual progressivity of the tax scale. It seems
altogether simpler and less confusing to determine the progressivity of the income tax on its merits in the one
obvious place: in the scale. The issue of the amount of tax to be levied on low incomes should not be obscured by
artificialities.
14.20. It seems essential to the Committee that decisions about the level of the first step, and the general shape of the rate scale for low income earners, should be made in the light of some clear understanding of the kinds of people it is who have these very low taxable incomes. That information is currently not available. But it is reasonable to suppose that they are persons who are realising capital or receiving exempt incomes from social services benefits or scholarships, or have been working part-time or for only part of the year. And many others may be a statistical illusion arising from a person with more than one job preferring to appear as two persons to the Commissioner. At a time when the minimum wage is over $4,000 a year, it is clear that few could in fact survive on these lower incomes if the latter were a true measure of available resources for essential consumption.
14.21. The Committee would not recommend any increase in the exemption limit above the present figure of $1,040. Moreover, it sees considerable merit in an initial marginal step rather higher than at present and extending further up the income scale. The initial step might be set at 20 per cent. In view of the fact that a marginal rate of 20 per cent now applies on increments of taxable incomes between $3,000 and $4,000, this would mean a first step extending up to a taxable income of $4,000. (The band of taxable income above $1,040 over which there must be shading-in would, of course, have to be rather wider than at present.)
14.22. An increase in the height and width of the initial marginal step in the manner suggested would in itself involve a substantial increase in tax revenue, since the higher marginal rates on initial income would apply to all taxpayers. It would be important to ensure that additional revenue was used, as far as possible, to protect the living standards of specific categories of taxpayers in the low range and at the bottom end of the intermediate range, notably those with families or dependent on social service benefits. This will be especially necessary if, in line with what was recommended in the previous chapter, social service benefits, including child endowment, are made taxable.
14.23. In paragraph 12.6 the Committee has recommended that the dependent spouse allowance be converted to a rebate, which might be set at $300. However, if an initial marginal rate of 20 per cent is introduced, as is proposed here, the spouse rebate will need to be of the order of $600 to ensure that a married person on a taxable income of $4,000 pays no more tax than at present.
14.24. The proposals in paragraphs 14.21–14.23 are addressed to the more immediate future. The Committee has indicated,
however, that as a long-run objective it favours placing less reliance on personal income tax. It might therefore be
possible to
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visualise an initial marginal rate on taxable incomes up to $4,000, fixed in the first
instance at 20 per cent, being in time gradually reduced. Indeed, there would be considerable merit, if a simpler tax
system is to be achieved, in at some stage zero-rating the initial marginal step, so that persons on low incomes pay
no income tax at all and persons on high incomes are exempt from tax on the initial increments of income. It would
then of course be necessary, as has been indicated earlier, to rely exclusively on taxable grants to assist low-income
families.
High Range
14.25. It is sometimes argued that there is considerable scope for redistributing the income tax burden from the lower to the higher income groups. That is to say, tax reductions on lower incomes could be financed by tax increases on higher incomes. However, from the data of the distribution of the tax burden by grade of net income summarised in Table 14.B, it is readily apparent just how little scope there is for such redistribution. The 0.4 per cent of taxpayers in 1971–72 with net incomes in excess of $20,000 received only 3.0 per cent of taxable income, contributing 7.9 per cent of total tax collected. Given that the average rate of tax on a taxable income of $20,000 was over 40 per cent, further significant increases in revenue could not have been obtained from taxpayers in that range. An increase to 75 per cent in the average tax liability of a taxpayer on $20,000 would have left him with after-tax income of $5,000 and involved a near 100 per cent marginal tax rate. Such a change for all taxpayers with taxable incomes in excess of $20,000 would have added only about 3.5 per cent to total revenue, and then only if the taxpayers concerned had continued to earn the same income as before—a dubious assumption given the confiscatory marginal tax involved.
14.26. Hence in establishing what the maximum income tax rate should be, factors other than simply contribution to revenue must be the chief concern. As already indicated in paragraph 14.15, the question of the income tax scale inevitably merges with the wider issue of the progressivity of the tax system as a whole and the character of other taxes in the system. Within a narrower compass, considerations of some relevance in fixing the top rates of personal income tax include the relationship between the systems of personal and company income taxes, the effect of taxation on incentives to work and save, and the incentives provided by high rates of taxation for tax avoidance and evasion.
14.27. As is pointed out in Chapter 16, there may be some advantage in linking the maximum rates of personal and company income tax. This was, for example, a key element of the proposal of the Carter Commission for full integration of personal and company income tax, and West Germany is considering a scheme to link the maximum marginal rates of both taxes. Such a link affords a means of limiting the purely tax advantages of retaining undistributed profits in the hands of companies: the tax burden on undistributed profits would equal the top marginal rate of income tax and for most taxpayers this rate of tax would exceed the rate of personal income tax. Such a relationship, however, involves setting the maximum rate of tax applied to all personal income in the light of considerations relevant only to dividend income, which might easily lead to inappropriate results.
14.28. In fixing the maximum marginal rate of tax, as well as in framing the rate scale lower down, some account must
be taken of possible effects on the incentive to work. A taxpayer's incentive to work is affected by both the ‘income’
and ‘substitution’ effects of income tax. Because income tax reduces a taxpayer's net of tax income, he will to that
extent have an incentive to increase his work effort to recoup at
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least some of the income taken in tax.
The extent of this income effect will be determined by the taxpayer's average rate of tax: the higher the average
rate, the greater will be the influence of the income effect. However, the substitution effect works in the other
direction. The effect of income tax is also to reduce the return from additional work effort, and the higher the
marginal rate of tax the greater will be the incentive to reduce work effort and substitute leisure in view of the
increased relative attractiveness of leisure.
14.29. Economic theory is thus inconclusive as to whether high rates of income tax adversely affect incentives to work. Commonsense reasoning suggests that the higher are marginal rates of tax in relationship to average rates the more is the substitution effect likely to outweigh the income effect; but psychological and sociological forces obviously play a major role in determining the work ethics of particular individuals, while the ability of taxpayers to vary the number of hours they work may be limited by such factors as the length of the miniumum working week or the state of demand in the labour market. It is little wonder that empirical evidence on the effects of income tax on incentives to work has tended to be inconclusive and of hardly any guidance to policy-makers.
14.30. The implications of income tax for personal saving are clearer, for here the substitution and income effects tend to reinforce each other. High marginal rates of income tax encourage the substitution of immediate consumption for saving; high average rates, especially at the upper end of the income scale where saving features more prominently, mean lower disposable incomes and hence less opportunity to save. But it must not be overlooked that a large part of saving today is undertaken in the business sector and by government; and the Committee has already expressed the view in Chapter 4 that incentives to save, like incentives to work, are important but not crucial in deciding how progressive the tax system ought to be.
14.31. What it is possible to be rather more certain about is the encouragement high marginal rates of income tax give to avoidance and evasion. The large number of professional people who own farms is not necessarily a reflection of a love of the land: tax considerations often loom large. High marginal rates of income tax substantially increase the reward from an activity of this kind, and attempts to avoid the workings of the law pose serious problems for the equitable administration of the tax system. As far as loopholes in the legislation or in the administration of the law are concerned, a frequent criticism of the tax system raised in many countries with high rates of taxation is that the tax system is steeply progressive only in form and that in substance many wealthy taxpayers are able to avoid the full effects of the progressive rate schedule. The Committee has been concerned in various of its recommendations in this report to limit the scope for tax avoidance.
14.32. Evasion of the law raises separate though to a large extent interrelated issues. Taxpayer compliance is an essential feature of the administration of a comprehensive income tax levied on a large number of taxpayers; and while evasion will always be a problem for tax administration, the problems can be expected to be more severe the lower the willingness of the public to accept that the tax system is a fair and equitable one. Except in special situations such as war-time, a high burden of income tax is unlikely to be favourably received by the population at large. This is a factor of considerable practical relevance to the design of a progressive rate schedule and explains in some measure why the Carter Commission in Canada and tax authorities elsewhere have been attracted by the prospect of a maximum marginal rate of 50 per cent.
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14.33. The Committee, too, sees advantages in top marginal rates of tax lower than at present. As a first step it might be possible, in the more immediate future, to lift the points on the income scale, in the top range, where the highest marginal rates start applying: for example, the 64 per cent rate could cut in at a taxable income of $40,000 instead of the present $20,000, and the 67 per cent rate at $80,000 instead of $40,000. But in line with the Committee's view that more reliance should be placed on the taxation of goods and services and less on personal income tax, a reduction in the maximum marginal rate to the region of 50 per cent would be thought an appropriate long-term target.
Intermediate range
14.34. A significant feature of the intermediate range, which encompasses the majority of taxpayers and provides the bulk of revenue, is the high marginal rates of tax applying over the greater part of the range. Thus by the time taxable income reaches $8,000, the marginal rate is already 48 per cent, and by the time it reaches $12,000 the rate is as high as 55 per cent.
14.35. It follows that any attempt to raise substantial additional revenue from this range, if unaccompanied by increases in marginal rates in the low range, would necessarily involve lifting marginal rates over a wide section of the intermediate range to excessively high levels. For example, 10 per cent more income tax revenue, secured exclusively from net incomes in excess of $10,000, would, on the basis of 1971–72 figures, have meant an increase in average tax rates of the order of 50 per cent and a rather steeper increase in marginal tax rates. Instead of paying at a marginal rate of 48 per cent, an individual on a taxable income of $10,000 would have been subjected to tax at a rate of over 80 per cent on each extra dollar he earned.
14.36. Recent restructuring of the rate scale to relieve the tax burden on the low range, and on the bottom end of the intermediate range, has brought the issue into sharp focus. As Table 14.C reveals, taxable incomes between about $5,500 and $11,000 now face significantly higher marginal tax rates than in 1973–74: indeed, on a taxable income of $7,000 the increase is more than 16 per cent.
| 1973–74 | 1974–75 | |||||
| Taxable income | Average tax rate | Marginal tax rate | Average tax rate | Marginal tax rate | Change in marginal tax rate between 1973–74 and 1974–75 | |
| Percentage | ||||||
| $ | per cent | per cent | per cent | per cent | points | per cent |
| 1,500 | 6.4 | 12.7 | 3.0 | 7.0 | -5.7 | -44.9 |
| 2,000 | 8.4 | 17.2 | 4.0 | 14.0 | -3.2 | -18.6 |
| 3,000 | 12.0 | 22.0 | 7.3 | 20.0 | -2.0 | -9.1 |
| 4,000 | 15.2 | 30.3 | 10.5 | 26.0 | -4.3 | -14.2 |
| 5,000 | 18.3 | 33.3 | 13.6 | 32.0 | -1.3 | -3.9 |
| 6,000 | 21.0 | 35.7 | 16.7 | 38.0 | +2.3 | +6.4 |
| 7,000 | 23.3 | 37.9 | 19.7 | 44.0 | +6.1 | +16.1 |
| 8,000 | 25.3 | 41.8 | 22.8 | 48.0 | +6.2 | +14.8 |
| 10,000 | 28.9 | 48.2 | 27.8 | 52.0 | +3.8 | +10.8 |
| 12,000 | 32.1 | 54.6 | 31.8 | 55.0 | +0.4 | +0.7 |
| 16,000 | 37.7 | 60.3 | 37.6 | 60.0 | -0.3 | -0.5 |
| 20,000 | 42.2 | 64.0 | 42.1 | 64.0 | 0.0 | 0.0 |
| 40,000 | 53.1 | 66.7 | 53.1 | 67.0 | +0.3 | +0.5 |
― 193 ―
14.37. The upward adjustment of marginal tax rates in this latest restructuring has a number of disturbing implications. It may well inhibit work effort in view of the fact that, for many taxpayers, higher marginal rates have been accompanied by lower average rates: for such taxpayers both the income and substitution effects referred to in paragraph 14.28 will exert a depressing effect on work effort. Moreover, to the extent that marginal tax rates are built into claims for higher incomes in the manner discussed in Chapter 6, increases in marginal rates over much of the intermediate range will tend to foster more rapid inflation. Finally, raising marginal rates to higher levels may encourage avoidance and evasion among a larger circle of taxpayers.
14.38. It was in some degree because of its concern to keep marginal rates in the intermediate range as low as possible that the Committee in earlier paragraphs proposed a higher and wider initial marginal rate bracket and some modification of marginal rates in the high range. These measures will permit wider tax brackets and less steeply rising marginal rates over the intermediate range. Any long-run shift towards less reliance on income tax will facilitate further moves in this direction.
14.39. As indicated in Chapter 6, it is taxpayers in the intermediate range, especially in the top half of the range, who have suffered most from the unplanned restructuring of tax liability produced by inflation. In the next section the question of adjusting the rate schedule for the effects of inflation is examined more closely.
IV. Frequency of Adjustment
14.40. The restructuring of the rate scale in 1974–75 has provided a measure of immediate tax relief for lower wage and salary earners, notably those with large families. However, it has provided no relief to those persons in the upper intermediate range particularly hard hit by what was earlier described as tax drift. Moreover, if inflation continues unabated, it will be only a short time—perhaps no more than a year or two—before income earners lower down the scale are subject to higher average rates of income tax than before the latest restructuring.
14.41. The extent of the change over the last twenty years in effective average rates of tax at various levels of real income has already been described in Chapter 6, illustrated with relevant statistics. Notwithstanding the reductions in 1970–71 and 1972–73, average rates of tax at all levels of real income, except the very highest, were significantly greater in 1973–74 than in 1954–55. It is thus hardly surprising that there has been so much complaint recently of heavier tax burdens.
14.42. The general increase in average tax rates over the past twenty years has been accompanied by a change in the distribution of income tax liability. Two aspects of this change were noted in Chapter 6. First, inflation has narrowed the width of tax brackets in real terms and altered the tax liability of individuals depending on the marginal rate applicable in the region of their taxable income. The resulting change in the distribution of tax liabilities has been arbitrary and it would be fortuitous indeed if it corresponded exactly with government intentions. Secondly, dependant allowances have been eroded. To the extent that dependant allowances have failed to keep pace with inflation, the income earner with a larger family has become worse off in relation to somebody with the same income but a smaller family or no family at all. Here, too, the redistribution of tax liabilities has not been deliberately sought, and again it would be surprising if it reflected the wishes of government.
― 194 ―
14.43. The Committee is therefore sympathetic to the view, now being widely canvassed, that the rate schedule and concessional allowances require more frequent adjustment in times of inflation. But there are several important questions to be answered: Should adjustment extend to the component of rising money incomes reflecting growth in real incomes, or should it be confined simply to the inflation component? Should the adjustment be statutory or a matter of discretion? What is the appropriate adjustment procedure?
Purpose of adjustment
14.44. It is sometimes argued that the rate schedule should be adjusted for the effects not only of inflation but also of increasing real incomes, implying that once an income tax structure has been established the burden of tax should remain constant over time at each point on the income scale. The radical implications of such a policy may be brought home forcibly by pointing out that the average rate of income tax for the taxpayer with an income equivalent to average weekly earnings would have remained approximately 5 per cent, taking 1954–55 as the starting-point.
14.45. The view that the rate schedule should be adjusted for the effects of changes in real incomes cannot, however, be ignored altogether. Even if there were no inflation, the use of an unchanged rate scale over an extended period would, in a growing economy, eventually result in all taxpayers being subject to the highest marginal rate of income tax.
14.46. Nevertheless, the problems arising from increases in real incomes are less immediate and obvious than those attributable to inflation because the effect of increases in rates of tax stemming solely from inflation is to reduce a taxpayer's real income net of tax whereas those increases in rates reflecting rising real income serve only to reduce the rate of increase of real after-tax income. It thus seems to the Committee appropriate that any policy to adjust the rate scale more regularly to compensate for the effects of rising money incomes on the level and pattern of income tax liability should concentrate on the inflation element.
Statutory or Discretionary?
14.47. Given that the income tax schedule should be adjusted more regularly during periods of inflation, the question arises whether the adjustment should be an automatic one based on a formal statutory indexing procedure or merely discretionary.
14.48. The effect of an automatic adjustment mechanism would be to maintain a constant average rate of tax on any given level of real income, and income tax collections in real terms would increase only with increases in real income and the number of taxpayers in the economy. Since the income tax rate schedule is progressive, income tax collections would in these circumstances still rise more rapidly than gross national product, but not to anywhere near the same extent as would be the case if no automatic adjustments were made. On the assumption that expenditure commitments and corresponding revenue requirements of the government are determined in the light of factors other than growth in revenue, a government that permitted rates of income tax to be adjusted automatically to offset the effect of inflation could more frequently expect to face situations where the anticipated growth in revenue was insufficient to finance the desired level of expenditures.
― 195 ―
14.49. In a regime of statutory tax adjustments, a government that was unwilling to introduce discretionary increases in income tax rates would have to meet a short-fall of revenue by cutting back on expenditure. Some of the proponents of the statutory adjustment see the possibility of such an outcome as one of the strongest arguments for automatic procedures. They argue, in effect, that because inflation causes an automatic increase in revenue so long as rates are unaltered, restraints upon the disproportionate growth of government expenditure are diminished, financial discipline is relaxed and the public sector is encouraged to grow too fast. The implicit assumption here is that government and the electorate are insufficiently aware of the alternative possibility of reducing tax rates and in some way fail correctly to estimate the relative attractions to the community of lowering taxes or increasing real expenditure. While it must certainly be agreed that in a complex dynamic economy with a large public sector and many social services, wise choices between the ever-changing options are difficult to make, there nevertheless appears to be a growing awareness throughout the community that the option of lowering taxes does in fact exist and can be made effective through political pressure on the government.
14.50. A formal indexation of income tax scales might be a convenient administrative device if government spending in money terms were rising at the same rate as total national expenditure. In such a situation the automatic tendency of average rates of tax to increase with rising incomes would require regular tax cuts to obviate excessive budget surpluses of a deflationary kind, and the indexation would do much to ensure these cuts being automatically achieved. Even then there would be some complications in finding a statutory formula that took account of other taxes whose yields would be changing in other ways, and more in finding an appropriate index for the purpose.
14.51. Reality, however, is less stable than the conditions just assumed. As noted in Chapters 1 and 2, the share of the government sector in the national economy has been rising in recent years, and this trend may well continue. Hence even if the initial pattern of the rate structure were accepted as fair, and to be preserved, indexation of income tax rates would not simplify the government's decision-making process. It would do little more than make annual decisions about the mode in which additional finance was to be collected more difficult to explain. The new rates would appear as adjustments to what they would otherwise have been rather than to what they had been the year before. Such a measure might also have a confusing effect upon public opinion if, in line with the Committee's general approach, taxation of goods and services were increasing and the income tax scale being separately adjusted for this also.
14.52. The Committee is not persuaded of the need for statutory indexing: unless preceded by restructuring of rates
along the lines suggested earlier in this chapter, it would only serve to perpetuate the unsatisfactory features of
the present rate schedule. The Committee accepts, however, that in a period of inflation the rate schedule requires
more frequent adjustment. As an aid to regular review and informed debate, it would recommend that a statement be
attached to the Budget Papers each year showing how the rate structure would appear in the current year were rates to
be fully indexed for changes in the price level over the previous year. There would, of course, be problems in
choosing an appropriate price index and of deciding whether or not to allow for the effects on the index of changes in
rates of indirect tax. In the absence of
― 196 ―
any new official index, the present consumer price index might
have to be employed— preferably, the Committee would think, with the effects of discretionary changes in indirect
taxes removed.
Adjustment Procedure
14.53. Regular adjustment of the tax schedule for inflation, whether statutory or discretionary, involves the choice of an appropriate adjustment procedure. There are several possibilities:
- (a) The three-step procedure of converting current year income to its equivalent in base year prices, calculating tax liability at base year rates, and re-expressing this liability in current year prices.
- (b) The widening of marginal tax brackets by reference to price increases since an earlier period.
- (c) The adjustment of tax rates by reference to price increases since an earlier period.
Methods (a) and (b) can be readily extended to apply to concessional allowances.
14.54. To the Committee's knowledge no country with statutory indexing has yet adopted method (a). However, a number of countries have implemented variants of method (b). Canada, for example, has recently joined Denmark in linking tax rates and income brackets to adjust the income tax rate schedule automatically for inflation. In the Netherlands there is a statutory link, subject to certain discretionary modifications: in both 1971 and 1972, the Netherlands reduced the size of the automatic adjustment index by the prescribed maximum limit of 20 per cent; in 1973 it decided not to apply the automatic adjustment mechanism but to increase exemptions by 5 per cent instead. These actions were taken on demand management grounds and with the revenue needs of the government in mind. In Iceland there is provision for exemptions and brackets of taxable income to be adjusted annually according to a ‘tax index’. Statutory adjustment procedures have also been applied in Brazil and Chile where inflation has featured prominently for many years.
14.55. Method (c) has been used in Sweden, where income tax law provides for rate adjustments to offset inflation but with an element of discretion reserved to the government.
14.56. The basic idea underlying each method is to provide a mechanism preventing individuals moving into higher tax brackets simply because of inflation. Method (a) can be dismissed as unnecessarily complicated: method (b) achieves the same results in much simpler fashion. The choice therefore lies between methods (b) and (c).
14.57. Method (b) has the merit that it reduces the burden of taxation at all levels of income. By stretching each step in the marginal rate schedule over wider ranges of money income, it reduces the steepness of the progression in marginal rates throughout the schedule, relative to money incomes, while maintaining the same steepness relative to real incomes. To do otherwise involves changes over time in the distribution of tax payments between taxpayers with different levels of real income, which is not the object sought in adjusting the rate schedule for inflation.
14.58. It follows that method (c), which adjusts for inflation by changing rates of tax rather than width of tax
brackets, will alter the distribution over time of the tax burden on different levels of real income: levels of real
income at which the adjusted
― 197 ―
rates of taxation apply tend to be compressed by inflation, causing the
progressivity of the rate schedule to change. For this reason method (c) is inferior to method (b).
14.59. Whether statutory indexing is adopted or, as the Committee would prefer, regular review and frequent discretionary changes, there can be little question that method (b) is the technically appropriate way of correcting for inflation. It was not the way actually employed in 1974–75, suggesting that the latest restructuring of the rate scale was not intended simply to compensate for the effects of inflation but was in fact designed to achieve more basic changes in income distribution.
V. Income-Averaging
14.60. Income tax law generally adopts an annual accounting period for the purpose of assessing tax liability. The employment of an annual period creates a number of problems, particularly for individuals with an unstable income who may, over a number of years, find themselves paying more tax than other individuals whose income is the same in aggregate but is earned in a steadier stream. This is illustrated in Table 14.D for a three-year period on the basis of the 1974–75 rate schedule.
| Taxpayer A | Taxpayer B | |||
| Year | Taxable income | Tax payable | Taxable income | Tax payable |
| $ | $ | $ | $ | |
| 1 | 4,000 | 420 | 7,333 | 1,527 |
| 2 | 11,000 | 3,300 | 7,333 | 1,527 |
| 3 | 7,000 | 1,380 | 7,333 | 1,527 |
| 22,000 | 5,100 | 22,000 | 4,581 | |
14.61. The imposition of heavier taxes on recipients of fluctuating incomes tends to give rise to a special type of horizontal inequity, sometimes referred to as period inequity. Though period inequity is chiefly identified with a progressive rate structure, it may also be present under a regime of proportional rates as with company tax. When income instability is sufficiently great to result in profits in some years and losses in others, period inequity will occur as long as provisions for carry-forward or carry-back of losses are inadequate. Recommendations on the treatment of losses have been dealt with in Chapter 8. Attention is confined here to a consideration of measures to alleviate the period inequity to which individuals may be subject as a result of progressive income tax.
The Existing Law
14.62. Existing income tax law contains provisions that may be utilised by some classes of individuals to reduce their tax liability when income fluctuates. These provisions fall broadly under three headings: primary producer averaging; drought bonds; and measures to spread exceptional income (sometimes referred to as ‘anti-bunching’ provisions). On a wide interpretation, each of these could be described as averaging; but to avoid confusion the term ‘averaging’ will be confined to those procedures involving the calculation of tax liability by reference to the average of an individual's income over a number of years.
14.63. The system of primary producer averaging provides for taxable income of the current year
to be assessed at the rate applicable to the average income of the five years up to and including the current year.
(If, for example, a primary producer has
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an income stream as shown in Table 14.E, 1974–75 tax liability
would be determined by applying to $5,600 the rate of 4.35 per cent referable to $2,068.) Where primary producers have
average or taxable incomes over $16,000, the application of averaging is limited. Special rules exist for determining
the first year to be taken into account in calculating average income, and there are also provisions to deal with
producers whose income is permanently reduced. There are limitations on withdrawing from or re-entering the scheme.
For the purpose of averaging, a primary producer is a taxpayer who carries on a business of primary production; but it
does not have to be his principal activity or constitute his chief source of income. Averaging is available to
beneficiaries presently entitled to a share of income in a trust estate deriving income from a business of primary
production.
| Income year | Taxable income |
| $ | |
| 1970–71 | 450 |
| 1971–72 | 550 |
| 1972–73 | 1,040 |
| 1973–74 | 2,700 |
| 1974–75 | 5,600 |
| 10,340 | |
| note note note note |
14.64. The drought bond scheme is a means by which certain primary producers can postpone tax payments and take steps to spread their incomes. Individuals who derive at least 90 per cent of their gross farm receipts from raising sheep or beef cattle are permitted to deduct from assessable income expenditure on the purchase of government securities issued under the Loan (Drought Bonds) Act of 1969. The deduction is limited to $50,000, and it may not exceed 20 per cent of sheep and beef cattle receipts for the year of income. If the bonds are redeemed due to drought, fire or flood, an amount equal to the deduction is included in assessable income in the redemption year. Redemption for any other reason results in a cancellation of the tax saving, but the individual may have derived a benefit from the deferred payment of tax.
14.65. In addition, the present legislation contains a variety of specific anti-bunching measures designed to reduce the extra tax burden on individuals receiving certain types of lumpy income. The provisions applicable to primary producers, discussed in Chapter 18, include the allowance of a tax rebate when an abnormal profit from the disposal of livestock in the course of putting an end to a business adversely affects the size of the average income calculated for averaging purposes; spreading of insurance recovery on livestock and trees; postponement of assessment of the proceeds of a second wool clip; spreading of income from the forced disposal of livestock; election to treat proceeds of a forced disposal of livestock as a reduction of outgoings otherwise allowable for the cost of replacement stock; and the spreading of compensation for death or compulsory destruction of livestock.
14.66. Other anti-bunching provisions allow the application of concessional rates of tax to specified kinds of income.
Under certain circumstances the taxable income, including abnormal income, of authors and inventors is taxed at the
rate appropriate
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to the individual's normal income plus one-third of abnormal income. The concessional
rate is not available automatically but must be applied for by the taxpayer. A concessional rate of tax is also
available to taxpayers who, upon ceasing business, receive abnormal income from the disposal of plant.
Alternatives to the Existing Law
14.67. The provisions outlined above have been widely criticised. Some favour their extension to provide relief for a wider range of taxpayers. Others advocate moving in the opposite direction: they see the relief as providing an unfair advantage to those who are eligible, particularly under present inflationary conditions. The various alternatives need to be examined.
Averaging
14.68. The instability of primary production is widely acknowledged: much was made of the fact in the recent Green Paper, The Principles of Rural Policy in Australia. A Discussion Paper (1974). Such factors as seasonal conditions and the character of the market are responsible for this instability, not the tax system; but tax arrangements may nevertheless serve to cushion the impact on primary producers’ incomes. It has been traditional in Australia to recognise this in the legislation, primary producer averaging having existed since 1921. The Committee would not wish to interfere with long-accepted principles by denying averaging to this group; however, it has reservations about the operation of the existing system.
14.69. While individuals other than primary producers can have unstable incomes too, and between 1921 and 1937 the system of primary producer averaging was available to all taxpayers except companies, the introduction today of a system of averaging involving all taxpayers would present considerable problems. It would not be easy to integrate general averaging with the present PAYE system; calculating tax liability would be more complicated; taxpayers would be much less certain of their tax commitments; and, to the extent that income fluctuation is due to inflation, the introduction of averaging for all might run counter to the objects sought by frequent adjustment of the rate scale. On balance, the Committee remains unconvinced that the possible gains in terms of equity would outweigh the costs and it does not recommend the introduction of averaging for taxpayers who are not primary producers. Alternative arrangements should go some way towards alleviating the problems associated with other fluctuating incomes. They include widening the income tax brackets, discussed earlier in this chapter; changes in methods of tax accounting, referred to in Chapter 8; and the introduction of an income equalisation scheme considered below.
14.70. While the Committee favours the retention of income averaging for primary producers, it recognises that the present system has a number of major shortcomings. When income turns down the effect may be harsh: tax payable in the downturn year is generally greater than it would be in the absence of averaging. Taxpayers must accept this or opt out of the scheme if the law allows. On the other hand, when incomes are rising, the system is very generous. This provides considerable incentive for individuals to enter primary production in a small way to gain the advantages associated with averaging applied to their whole income. The $16,000 limit serves to some extent as a deterrent, but the figure is necessarily arbitrary and discriminates against the genuine primary producer whose average income exceeds the limit but is still liable to fluctuation.
― 200 ―
14.71. One alternative to the present system would be cumulative averaging, which is based on the principle that total taxes paid over the averaging period should be equal to the total taxes that would have been paid had the income been received in equal amounts over that period. Tax liability in the current year is computed by multiplying the cumulative average income by the tax rate applicable in each year of the averaging period, adding the separate calculations, and then subtracting the total taxes already paid. The period for averaging may be lifetime or something shorter. Cumulative averaging is extremely difficult to administer and is not favoured by the Committee.
14.72. Another alternative is block averaging. Taxes are paid annually in the normal way on the basis of current income and current rates. At the end of a block of years, income earned for the period is aggregated and allocated to each year of the block in equal amounts. Tax liability for each year is re-calculated on the basis of the rates applying to that year and then summed. This is compared with the taxes actually paid and a debit or a refund may result on the assessment for the fifth year. Block averaging is currently available in Canada on an elective basis to individuals whose chief source of income is farming or fishing. Although administratively feasible, it suffers from two major drawbacks that have led the Committee to reject it. First, relief is delayed: the taxpayer must wait a long time—in the Canadian case five years—before a refund is received. Second, if the rate structure is adjusted regularly for inflation, certain anomalies arise: a taxpayer may actually incur a greater tax liability with averaging than without it.
14.73. A further alternative is the marginal adjustment scheme put forward in the Green Paper on rural policy referred to in paragraph 14.68. Like the current system of primary producer averaging, it is based on the moving average principle. Tax liability on current year income is equal to (a) tax payable on the moving average income of the five years up to and including the current year, (b) plus or minus tax payable on an adjustment factor, which is equal to the difference between current year income and the moving average income multiplied by the marginal rate applicable to the moving average income. When current year income is above the moving average income, the adjustment factor is positive; and when current income is below the average, it is negative. This scheme has one major feature not present in the current averaging system. When income falls less tax would be paid than at present and when income rises tax liability would be greater. There is therefore a general tendency for fluctuations in after-tax incomes to be reduced, whereas the effect of the present system is just the opposite. The marginal adjustment scheme thus warrants serious consideration. However, it has one serious drawback. The rate scale is structured so that marginal tax rates rise in steps, rather than continuously. Hence, under the marginal adjustment scheme a small difference in income can be associated with a comparatively large difference in tax liability. Table 14.F illustrates the position, over a five-year period, of two taxpayers with almost identical income streams. On the basis of the 1974-75 rate schedule, a $6 difference in income in the fifth year results in a $43 difference in tax liability for that year. The only way this boundary anomaly could be avoided is to replace the present stepped marginal rates with continuously rising rates. But this would introduce additional complexities into the rate structure and run counter to the Committee's proposals in Section I of this chapter.
― 201 ―
| Year | Income stream A | Income stream B |
| $ | $ | |
| 1 | 10,000 | 10,000 |
| 2 | 9,000 | 9,000 |
| 3 | 6,000 | 6,000 |
| 4 | 14,000 | 14,000 |
| 5 | 10,995 | 11,001 |
| (i) Moving average | 9,999 | 10,000 |
| (ii) Excess of income in year 5 over moving average | 996 | 1,001 |
| (iii) Marginal rate of tax in relation to moving average | (48 per cent) | (52 per cent) |
| (iv) Tax liability on year 5 income: | ||
| Tax on moving average income | 2,779 | 2,780 |
| Tax on excess (ii) at marginal rate (iii) | 478 | 520 |
| Tax payable | 3,257 | 3,300 |
14.74. The United States system is a further alternative. It is available to all taxpayers whose current year income is in excess of their average ‘base period income’, but only where the excess is greater than $US3,000. It is based on the moving average principle and in effect stretches the rate brackets for income in excess of the base period moving average. The steps for computing current year tax liability are as follows:
- (1) Compute ‘base period income’ by determining the average income of the previous four years and multiplying by 120 per cent.
- (2) Subtract ‘base period income’ from current year income. The difference constitutes ‘excess income’: as long as it exceeds $US3,000, this excess amount will be subject to averaging.
- (3) Compute tax liability on an amount of income equal to the ‘base period income’ plus one-fifth of ‘excess income’.
- (4) Compute tax liability on ‘base period income’.
- (5) Compute tax liability on ‘excess income’; it is equal to tax liability in step 3 minus tax liability in step 4 multiplied by 5.
- (6) Compute tax liability for current year: it is equal to tax payable on ‘base period income’ (step 4) plus tax payable on ‘excess income’ (step 5).
Assuming 1974-75 Australian rates, a current year income of $13,000 and prior year incomes of $4,000, $11,000, $7,000 and $8,000, the amount of tax payable would be calculated as follows:
Step 1: ‘Base period income’:
$4,000 + $11,000 + $7,000 + $8,000 = $30,000 ÷ 4 = $7,500
$7,500 × 120 per cent = $9,000.
Step 2: ‘Excess income’:
$13,000 - $9,000 = $4,000; therefore averaging applies.
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Step 3: Tax on $9,800 (i.e. $9,000 + one-fifth of $4,000) = $2,684.
Step 4: Tax on ‘base period income’ of $9,000 = $2,300.
Step 5: Tax on ‘excess income’ of $4,000: ($2,684 - $2,300) × 5 = $1,920.
Step 6: Tax liability on current year income:
| $ | |
| Tax on ‘base period income’ of $9,000 (step 4) | = 2,300 |
| Tax on ‘excess income’ of $4,000 (step 5) | = 1,920 |
| 4,220 | |
| Tax liability on current year income without averaging | = 4,370 |
14.75. Canada has recently adopted a general averaging system similar to that of the United States. Eligibility depends upon current year income exceeding both 110 per cent of the income of the immediately preceding year and 120 per cent of the average of the incomes of the four preceding years.
14.76. The United States/Canadian schemes tend to reduce tax liability when income is rising, but not to the same extent as the present Australian system. On the other hand, tax liability is not raised when income is falling. Admittedly, no reduction in tax liability occurs: averaging simply does not apply. The United States/Canadian schemes therefore suffer to some extent from the same basic weakness as the present Australian system, but the instability of after-tax income is not as great. Furthermore, the eligibility tests go some way to excluding those taxpayers whose income instability is caused purely by inflation. On the other hand, the basic United States/Canadian calculation is probably more difficult for the taxpayer to comprehend than the Australian in the general run of cases.
14.77. The choice would therefore seem to lie between retaining the present system which involves substantial tax saving when income is rising but heavier taxes when income is falling, and substituting a United States/Canadian-type scheme which provides less advantage when income rises but no disadvantage when it falls. The Committee is particularly anxious that tax disadvantage when income falls be minimised and that the arbitrary limit of $16,000 be removed. It would therefore propose that the present system be changed. This might be done by allowing primary producers to opt out of the present scheme whenever income falls, but a provision of this kind would be far too generous. The Committee therefore recommends that a United States-type averaging system be available to Australian primary producers. The basic qualification for the proposed system would be that current year income exceeds a figure equal to, say, 120 per cent of the average taxable income of the preceding four years. Averaging would apply to the difference between current year income and 120 per cent of the average income of the preceding four years. This would operate as follows:
Determination of Qualification:
| $ | |
| Current year income | 6,500 |
| Average of income of previous four years ($3,000, $3,500, $4,500, $5,000) | 4,000 |
| 120 per cent of $4,000 is $4,800. As current year income of $6,500 exceeds $4,800, the qualification is met | |
|
― 203 ― Calculation of tax liability (1974-75 rates) |
|
| Tax on $4,800 ($4,000 × 120 per cent) | 628 |
| Tax on ‘excess income’: | |
| $ | |
| $6,500 less $4,800 | = 1,700 |
| $1,700÷5 | = 340 |
| $ | |
| Tax on $5,140 ($4,800 + $340) | = 725 |
| Less tax on $4,800 | = 628 |
| 97 | |
| Tax on $1,700 ‘excess’ (5 × $97) | 485 |
| Tax payable | 1,113 |
| Tax on $6,500 without averaging | 1,190 |
| Tax on $6,500 with present primary producer averaging | 794 |
It will be noted from the above example that, when income is rising, the proposed averaging system is not as favourable to a taxpayer in the lower income range as the present system. If it were considered appropriate for a higher concession to be given, a lower qualifying percentage could be adopted. Thus, had 110 per cent been employed as the qualifying percentage rather than 120 per cent, tax liability in the example given would have been $1,069 instead of $1,113. Further illustrations of the proposed averaging system are included in Appendix A to this chapter.
14.78. Steps would have to be taken to ensure that average years took effect only when the taxpayer had actually commenced as an income earner. There would also need to be built-in safeguards to eliminate, as average years, periods of nonresidence, years when no assessable income is derived, and years when the taxpayer fails to qualify because of the eligibility test discussed in the next paragraph.
14.79. There is the further problem of confining the operation to ‘genuine’ primary producers. Under present law any taxpayer carrying on a business of primary production is eligible for averaging. This allows persons making nominal investment in primary production—for example, students contributing small amounts of capital to a primary producer trust estate—to take advantage of the provisions and secure tax savings that can be quite substantial. The Committee considers that such advantages should not be available and that a more stringent test of eligibility should be applied. There are a number of possibilities. Averaging could be confined to taxpayers whose chief occupation is primary production; however, this would exclude persons who derive wage or salary income but also farm properties. Averaging could be applied to primary production income only; however, this involves the problem of establishing a fine dividing line between sources of income, something to be avoided if possible. The most appropriate test is the Canadian one that applies block averaging to those persons whose ‘chief source of income’ is from farming or fishing. If the taxpayer has two or more sources of income, it is a question of fact which is the chief source during the period concerned: the yardstick is the period as a whole, not each individual year. Although there will always be borderline cases, this test would deny averaging to many persons now taking advantage of the Australian provisions who are involved in only minimal activity of primary production. The Committee therefore recommends that the Canadian ‘chief source of income’ test be adopted to determine who is entitled to primary producer averaging.
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Income Equalisation Scheme
14.80. An alternative way of dealing with the problems of fluctuating incomes is by means of an income equalisation scheme. A scheme of this kind permits individuals to spread income at their own discretion by lodging deposits with the government in a particular year, the amount deposited being deductible from that years taxable income. When the deposit is later withdrawn, the amount is added to taxable income in that year.
14.81. New Zealand, which has no averaging for primary producers, operates a scheme of this type, confined to primary producers. Its main features include:
- (a) Deposits of up to 100 per cent of taxable income from primary production in any one year may be made with the taxation authorities up to six months after the end of the taxation year.
- (b) The minimum period of deposit is one year and the maximum five.
- (c) No interest is paid on deposits.
- (d) Withdrawals cannot be taxed at a greater rate than the tax saved when deposited.
Canada has what amounts to an income equalisation scheme under which persons can purchase income-averaging annuities when specified types of income are received. The Australian drought bonds, described in paragraph 14.64, are another variant. However, these drought bonds have not been extensively used, and some of their provisions have afforded opportunities for tax avoidance.
14.82. The concept of an income equalisation scheme is sound: it would be particularly helpful as a smoothing device for taxpayers receiving large amounts of income sporadically; and it would also provide an alternative to hasty expenditures undertaken near the end of the tax year to reduce taxable income. The basic problem with such schemes is that deposits must be made in cash: taxpayers may not have the necessary liquidity, and even when they have they may be reluctant to tie up funds for twelve months or more. Nevertheless, the Committee sees an income equalisation scheme as a potentially useful supplement to primary producer averaging and recommends that the drought bond provisions be replaced by an income equalisation scheme modelled on New Zealand lines. The treatment would differ in a number of respects from the New Zealand scheme: deposits would be limited to a proportion of the net income, not exceeding taxable income; deposits could only be made up to one month after the end of the taxation year or prior to the lodgement of a return, whichever was the earlier; and interest would be paid on deposits at a rate equal to, say, half the medium-term bond rate. The scheme would be available on election to all primary producers, not just those involved in sheep and beef cattle raising.
14.83. Though the proposal that averaging be extended to other taxpayers has been rejected, the Committee acknowledges that present anti-bunching measures do not adequately cope with the taxation problems of non-primary producers with unstable incomes. Some form of spreading provisions should be available to all taxpayers, and the income equalisation scheme suggested for primary producers might appropriately be called upon to fulfil this role. The Committee therefore recommends that the income equalisation scheme be available to all individual taxpayers. Authors and others, eligible for anti-bunching concessional rates outlined in paragraph 14.66, would be required to choose: it is not envisaged that they would be able to take advantage, in the one year, of both the income equalisation scheme and the antibunching provisions.
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Anti-bunching Measures
14.84. The current anti-bunching provisions are designed to cope with the problems of recipients of specific types of lumpy income. The Committee, elsewhere in this report, recommends that these provisions be retained and in some respects extended. For example, in Chapter 23 spreading provisions for capital gains are proposed, and in Chapter 21 there are recommendations for dealing with lump-sum receipts by an employee or self-employed person on retirement.
14.85. Anti-bunching measures need to be considered in conjunction with the averaging proposals and the income equalisation scheme to ensure that unwarranted tax savings do not flow to some taxpayers. The case for anti-bunching measures is weakened when averaging exists. However, it is traditional for primary producers to be eligible for both, and the Committee does not propose to alter this, though with the change in the method of averaging for primary producers it will be necessary to look at the present anti-bunching measures available to primary producers to ensure that there is no conflict.
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Chapter 14: Appendix A: Tax Payable Under Alternative Systems: 1974-75 Rates
| Tax payable | |||
| Income stream | Without averaging | Present averaging | Proposed averaging |
| $ | $ | $ | $ |
| Example 1: Prior year incomes: 2,000, 2,500, 3,000, 3,500 | |||
| 4,000 | 420 | 292 | 420 |
| 4,500 | 550 | 410 | 525 |
| 5,000 | 680 | 525 | 680 |
| 5,500 | 840 | 671 | 840 |
| 6,000 | 1,000 | 816 | 1,000 |
| 8,000 | 1,820 | 1,288 | 1,759 |
| 10,000 | 2,780 | 1,940 | 2,699 |
| 8,090 | 5,942 | 7,923 | |
| Example 2: Prior year incomes: 12,000, 11,000, 10,000, 9,000 | |||
| 9,000 | 2,300 | 2,538 | 2,300 |
| 12,000 | 3,820 | 3,384 | 3,820 |
| 8,000 | 1,820 | 2,152 | 1,820 |
| 6,000 | 1,000 | 1,500 | 1,000 |
| 9,000 | 2,300 | 2,250 | 2,300 |
| 5,000 | 680 | 1,135 | 680 |
| 3,000 | 220 | 519 | 220 |
| 12,140 | 13,478 | 12,140 | |
| Example 3: Prior year incomes: 11,000 11,000, 10,000, 9,000 | |||
| 8,000 | 1,820 | 2,184 | 1,820 |
| 7,000 | 1,380 | 1,785 | 1,380 |
| 6,000 | 1,000 | 1,362 | 1,000 |
| 5,000 | 680 | 985 | 680 |
| 7,000 | 1,380 | 1,302 | 1,380 |
| 9,000 | 2,300 | 1,719 | 2,260 |
| 12,000 | 3,820 | 2,664 | 3,738 |
| 12,380 | 12,001 | 12,258 | |