Taxing real income

TAXING REAL INCOME

The 'benchmark' income tax base offering minimal impact on investment decisions discussed in the framework papers is all about nominal - not real - income. Investment decisions remain unaffected under this benchmark by annual nominal income being taxed everywhere in an even-handed fashion. Nevertheless, with inflation present, taxing annual nominal income reduces taxpayers' command over real consumption with associated wealth effects.

Taxing real, rather than nominal, economic income is achieved by incorporating in the tax base annual real changes in value of assets and liabilities - rather than their annual nominal changes.

Most importantly, however, investment neutrality may be achieved by either taxing annual nominal economic income everywhere or taxing annual real economic income everywhere. Investment decisions will be distorted if the features of nominal and real income taxation are mixed - for example, real capital gains included in a tax base which incorporates symmetrical treatment of nominal interest. Attempts at comprehensive real income taxation are rare; mixing up features of nominal and real income tax bases is not uncommon.

Like the achievement of investment neutrality by taxing nominal economic income, investment neutrality under the taxation of real economic income stems from before-tax income being reduced by the tax in the same proportion as the tax reduces the before-tax discount rate used for evaluating asset/liability value and investment viability. Crucially, however, the proportional reduction differs between the two neutral income tax regimes: under the nominal regime, simply the investor's tax rate ; under the real regime, the investor's tax rate times the ratio of the difference between the before-tax discount rate and the inflation rate to the before-tax discount rate - see Mayo (1984), Appendix 1.

The differing proportional reduction in the before-tax discount rate stems directly from the very different impact of nominal or real income taxation on interest costs of investment debt financing - or, equivalently with equity financing, the impact on the opportunity cost of tying money up in tangible investments. Thus, it is the nominal or real income tax treatment of debt that specifies whether the income associated with the cash flows from physical assets needs to be taxed on a nominal or real basis to achieve neutral investment outcomes.

REAL INCOME TAX BASE

Figure 44 summarises the real income tax base offering tax collections with limited effects on investment decisions. The real economic income tax base includes the real annual change in value of assets and liabilities along with the usual recurrent receipts and costs. Real, rather than nominal, change in value is included on the assumption that - unlike virtually all income tax systems around the world - real, and not nominal, interest income is included symmetrically in the income tax base (real non-private interest payments deductible and interest receipts assessable).

Including real changes in value of assets and liabilities in the tax base requires amounts equal to the values of the assets/liabilities at the start of the year times the general inflation rate to be included in the tax base (as an extra deduction for assets and an extra assessable amount for liabilities) - as discussed in Mayo (1984) and Australian Government (1985), Chapter 18. Thus, for debt, incorporation of real, rather than nominal, interest in the tax base requires – in a mechanical sense – the value of debt at the start of a year times the general rate of inflation to be added to the tax base (as a deduction if the debt is an asset producing assessable interest receipts or as an assessable amount if the debt is a liability requiring deductible interest payment to be made).

With this change from nominal to real debt, Figure 45 illustrates the changed relationship between pre-tax and post-tax investment returns. Only the real part of the investor’s 10% return from alternative investments in financial markets, manufacturing activities, primary production, mining, etc would be taxed at the investor’s tax rate. With 3% inflation say, only the real 7% would be taxed, reducing the 10% pre-tax return to 6.71% for a 47% taxpayer - ie 7% x (1 - 0.47) plus the 3% inflationary component. The 32.9% reduction from 10% pre-tax to 6.71% post-tax matches the proportional reduction in the 10% pre-tax discount rate under real income taxation - ie the investor's tax rate (0.47) times the ratio of the difference between the pre-tax return and the inflation rate (0.1 - 0.03) to pre-tax return or 0.47x(0.1-0.03)/0.1 to give 0.329 - as shown in Mayo (1984), Appendix 1. Similarly, for a 30% taxpayer the 10% pre-tax return would be reduced by 21% to 7.9%.

Investors' returns - neutral real income tax base

In sum, achieving neutral investment outcomes under real income taxation requires that all real economic income (notably changes in real values of assets/liabilities) be included in tax assessments in the year it arises.

In a year when the income is positive (real economic profit occurring), tax is paid at the investor's tax rate.
Symmetrically, in a year when the income is negative (real economic loss occurring because of, say, high recurrent costs or losses in the real value of assets), the achievement of investment neutrality requires that tax savings are made equal to the loss times the investor's tax rate - ie 'full loss offset'. Conceptually, these tax savings would be realised in all circumstances by tax refunds from the tax authorities but, in practice, would be expected to be generally restricted to circumstances where the investor has other income against which to write-off the annual losses.

EXAMPLE OF REAL INCOME TAXATION

The following example uses an investment in a tangible depreciating asset to illustrate the taxing of real investment income. Related references are made to tangible appreciating assets and financial assets. The snapshots of the depreciating asset investment are from the MyProject computer package, which allows analysis of real income taxation. Taxation of the investment with declining balance depreciation allowed when there is no inflation is shown first and then, after inflation is introduced, taxation with either declining balance or nominal economic depreciation allowed is shown before the introduction of real economic income taxation.

Declining balance depreciation with no inflation

A marginal depreciating tangible asset that costs the investor $1000 at the start of Year 1 is shown in Table 4. Its value (and its net receipts stream) declines at 15% per year. The investor sells it at the end of Year 5 for $443.7. Before tax, the asset’s net receipts steam and sale price discount to the start of Year 1 to $1000 using a discount rate of 10% pa (the going interest rate from financial markets). The before-tax net present value (NPV) of the asset is therefore zero. Risk aside, the asset is marginal before tax. The 10% pa it returns is the same as the going interest rate.

Depreciating asset with declining balance depreciation

Depreciation for income tax purposes, applied to the $1000 purchase price, is allowed at 15% per year on a declining balance basis. The per year depreciation allowances therefore match the annual decline in asset value. Moreover, there are sufficient net receipts each year to fully absorb available depreciation deductions. Nominal interest is included in the income tax base.

The features of the taxation situation in this example are consistent with the benchmark nominal income tax base. With the investor facing a 46% tax rate, the 10% pre-tax return is reduced to 5.4% pa after tax and the NPV of the investment remains zero (with discounting at 5.4% pa). Risk aside, the investment remains marginal after tax. The 5.4% pa return is the same as the after-tax return that the investor could get from financial markets.

Thus, with depreciating tangible assets in the absence of inflation, if the percentage declining balance depreciation applied to a particular asset matches the asset's annual percentage loss in value, the tax outcome is equivalent to that from the benchmark nominal economic income tax base. The asset's decline in value might derive from physical deterioration resulting in lower net receipts from say either reduced revenues, higher maintenance costs or both. This rate of decline before inflation would have to be estimated indirectly from technical effective life determination or directly from non-inflationary value data for the type of asset involved.

Declining balance depreciation with inflation

Now assume that inflation occurs at 8% per annum with a consequent lift in the going interest rate from 10% to 15%. Thus, the rate of decline in value of the $1000 asset is now only 8.2% - ie (1-s)(1+i)-1, where s is the rate of decline before inflation and i is the rate of inflation. Nevertheless, declining balance depreciation continues to be applied at 15% pa. The result is summarised in Table 5.

Depreciating asset with db depreciation and inflation

After inflation with 15% declining balance depreciation still applying, the after-tax rate of return is 8.55% pa and the NPV is $14.8. The investor could do better than the 8.1% pa after tax from financial markets - ie 15% reduced by the investor's 46% tax rate. The investment has been shifted from marginal to above the margin and depreciating assets with different rates of decline before inflation would be differentially affected - see Mayo (1984), Table 1.

Nominal economic depreciation with inflation

Table 6 shows the effect of replacing declining balance depreciation with nominal economic depreciation under these conditions of 8% inflation and 15% interest rates. In Table 6, annual change in asset value is obtained from the difference between the present value of future net receipts and sale value at the start and end of each year. This produces economic depreciation allowances declining at 8.2% pa reflecting the asset's 15% decline in value before inflation but then subject to 8% inflation. Thus, as before inflation, the asset has a zero NPV before and after tax and the 15% pa before-tax return from investing in the asset is reduced in proportion to the investor’s 46% tax rate to 8.1% pa, the after-tax return that the investor could get from the financial market. The nominal effective tax rate is 46%, the same as the investor’s statutory tax rate. The investment, marginal before tax, remains so after tax.

Depreciating asset with economic depreciation

Table 5 shows that, under inflation, rates of historical cost declining balance depreciation will be too high if set on the basis of an asset type's rate of value decline in the absence of inflation. Table 6 then shows how estimates of the rate of value decline of under inflationary conditions may be obtained from (1-s)(1+i)-1 where s is the rate of decline before inflation and i is the rate of inflation. As noted previously, the rate of decline before inflation would have to be estimated indirectly from technical effective life determination or directly from non-inflationary value data for the type of asset involved. Thus, if K is the tax (depreciated) value of an asset at the start of a year, the estimate of economic depreciation (positive for value decline, reflecting the net amount to be deducted for tax purposes, and negative for value increase, reflecting the amount to be added to tax assessments) for that year, D, is:

D = K - K(1 + (1-s)(1+i) - 1)

That is,

D = K - K(1 - s)(1 +i)

Or,

D = s.K - i(1 - s)K (1)

Equation (1) shows that economic depreciation in a year may be estimated by applying to the tax (depreciated) value at end of previous year (ie asset cost less allowed economic depreciation to date), first, the rate of value decline without inflation, s, and, secondly, the inflationary adjustment, i(1 - s). Alternatively, if levels of inflation are expected to be within a reasonably narrow band, rates of value decline for different depreciating assets could be estimated under those inflationary circumstances either directly from value data or from effective life determination.

Conceptually, equation (1) could also form the basis of estimating annual accrued gains of appreciating tangible assets - most notably land - as a basis for including those accrued gains in tax assessments - with s then being an estimated negative rate of value decline (ie reflecting increasing asset value) for the particular asset type involved. Given the uncertainty over future increases in value of land in different locations, however, s would likely be set at zero leaving simply the inflationary component to be taxed on accrual. More realistically, were accrued capital gains on land to be included in tax assessments generally, direct annual valuation would often be possible as would comparisons with actual recent sales of similar property. Annual estimates of property values are often already required for state government land taxes.

In relation to financial assets, market values of ownership interests in listed entities (like companies and trusts) would be known. Good estimates of market value of ownership interests in unlisted entities would often be possible. For other financial assets/liabilities, value is known or good estimates of value can often be obtained from associated cash flows.

Real economic depreciation with inflation

Table 7 shows the effect of moving from nominal to real economic depreciation. In addition to nominal economic depreciation, the annual loss in real value of the asset (value at start of year times inflation over the year) is allowed for tax purposes. That additional allowance is shown in the 'No-prof royals' column of the table.

Depreciating asset with real economic depreciation

As in the nominal economic depreciation case of Table 6, the NPV of the asset is zero before and after tax and its return is 15% pa before tax, reducing to 11.78% pa after tax (consistent with pre-tax and post-tax going interest rates). 11.78% is the after-tax real interest rate for the investor from financial markets – ie with 8% inflation only the real 7% of the 15% interest rate is taxed at the investor’s 46%, reducing the 15% interest rate by 3.22%. The after-tax NPV is zero with discounting at this 11.78% rate. The investment, marginal before tax, remains marginal after tax - see Mayo (1984), top half Table 2.

For depreciating tangible assets, allowing real economic tax depreciation means that, beyond nominal economic depreciation (or estimates of annual change in value) being allowed, an additional deduction would be allowed equal to the tax value at the start of the year times the rate of inflation over the year. Thus, to the estimated annual change in nominal value of an asset in equation (1) would be added the income tax deduction, iK, resulting in the annual estimate of real economic depreciation of:

D (real) = s.K - i(1 - s)K + i.K

That is,

D (real) = s(1 + i)K (2)

Despite the simplicity of equation (2) in showing total annual deductions (if positive) or assessable amounts (if negative), the additional annual allowance, iK, would not be used in determining the tax value of the asset at any time (including when the asset is sold). The effect of the additional capital allowance is to maintain the indifference of the entrepreneur between investing in an asset which is marginal before tax and investing in the financial market when only the real component of interest the alternative financial investment is taxable.

The same extra allowance (tax value at start of tax year times the general rate of inflation) would apply to other assets (and extra assessable amount to liabilities) beyond tangible depreciating assets; such as, financials (for debt, the adjustment ensures the symmetrical treatment of real interest), appreciating assets and trading stock.

COMMENT

Some of the practical issues involved in a general shift from an essentially nominal income tax system to one centered on the taxing of real income are canvassed in Australian Government (1985), Chapter 18 - where particular complexities were identified in relation to the application of a real income tax base to financial institutions and to financial assets and liabilities more generally.

In considering the possibility of a move from a nominal to a real tax base, issues such as the extra complications plus narrower tax base and consequent higher tax rates necessarily associated with a real tax base would need to be weighed against the alternative of keeping inflation low (consistent with the modus operandi of many central banks) and seeking investment neutrality via a less complicated nominal income tax base. Moreover, general acceptance and understanding of a nominal economic income taxation - with its inclusion of annual accrued gains in value mirroring the inclusion of annual accrued losses (like plant depreciation) - would seem to be a necessary precursor to the general implementation of real economic income taxation.