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.

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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.

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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

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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

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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.