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.