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.


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 

  ― 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.


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 ―


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 

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.


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 

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.


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 

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 ―


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 

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.


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 

  ― 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.


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 

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

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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.