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.
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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.
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| 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.