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.

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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.