Why We Should Abolish The Income – Capital Distinction

Much of the present tax system was designed in an era of physical industry and service and is not well suited to the modern intellectual property based environment.

The past 20 years of “tax reform” has mostly been tweaking existing systems, rather than creating innovations.  Given that we are faced with a present period of such rapid changes it seems to me to be appropriate to have substantial changes in more than just technology that we use, but also the societal ecosystem that it exists in.

One change that is (accidentally) a step towards a possible radical shake up of the tax system was the centrepiece of the recent Australian Federal Budget was the ability to immediately claim a deduction for the entire value of an asset, for all but the largest companies.  For the layman this may seem like a strange rule: couldn’t a business already claim a deduction for business related expenses?  The answer is that items of a capital nature can at best depreciate over their “effective life”, generating deductions spread out over a number of years. 

Under the immediate asset write off a business that spends $1M on a bank vault gets to deduct that $1M spent from their assessable income in the present year, instead of depreciating the bank vault over its effective life (which is 100 years) and therefore only getting (depending on the method of depreciation) say, a $10K deduction each of the next 100 years.  We can therefore see the attractiveness of the write off to stimulate investment and asset purchases by businesses.

Why The Write Off Creates Distortion

Let’s assume some round numbers for an example: a 25% tax rate, a 5 year effective life, a 5 year loan (lets ignore interest to keep simple figures) and a $100K asset purchased.  Ordinarily the asset would be depreciated at $20K pa (using a straight line method of depreciation).  In order to match cash flow with tax deductions a reasonable decision might be to finance the purchase with a loan over 5 years with capital repaid of $20K per annum.  There could be a $5K tax saving over each of the 5 years.

Under the instant asset write off there is a $100K deduction in the first year, and the full $25K tax saving in that first year.  If the asset was financed, the business would only need to pay $20K in order to get a $25K tax deduction an extremely attractive outcome.

Of course, the business still has to pay off the asset over the remaining 4 years or have a “balancing adjustment” (deemed income) if it disposes of the asset for more than its written down value (i.e. more than nil).

There is a distortion because business will be incentivised to alter its structuring decisions based on the tax outcomes.

What We Should Have Instead?

If we abolished the distinction between Income and Capital, tax would be paid on the difference between cash inflows and outflows.

Therefore, in the above example there would be cash inflow of $100K from the loans and outflows of $100K from the purchase of the asset.  Therefore, nil tax, but also nil deductions against other income.  Given that there is a loan and acquisition of an asset this seems the correct outcome to me.

Therefore, a business would be taxed on the amount that it did not spend each year.  Such an environment is, from the point of view of poacher-turned-gamekeeper, much more difficult to create artificial tax outcomes in.  The only way to pay less tax is to have less money, which seems to me to be quite reasonable.

Theoretically a business that spends all money that it receives could avoid paying tax indefinitely.  But such a business would be investing and growing (assuming it is managed well) for the benefit of some future generation.

There would need to be a distinction between private (personal) expenditure and business expenditure, but such a distinction is well established.  Therefore, if a business owner wishes to take money out of the business for personal expenditure, then that amount will be taxable as it is intended to be at present (but is not always).

What Would Change?

The abolition of the distinction between Income and Capital would be a tax reform that has far reaching changes, well beyond the extensive simplification of tax affairs that it would bring (indeed even what constitutes income and what constitutes capital is still the subject of litigation).  One change would be in investment structuring.  At present the classic investment dichotomy is between debt, for which interest paid thereon is a deductible expense, and equity, for which the dividends paid is not deductible.  Debt is supposed to have fixed payments, and equity payments that are variable with the profits of the business.  For profitable companies there is a tax incentive to be funded by tax deductible debt, rather than equity.  However, from a business risk perspective having fixed interest repayments creates problems if there is a downturn in trade.  At present there is a semi-solution for some businesses to have hybrid securities such as redeemable preference shares or convertible notes.  However, if there was no distinction between Income and Capital the character of the payments (debt or equity) would not matter.  Businesses and their investors would consider purely commercial matters.

There would need to be changes to tax rates, probably to a lower flat rate. What exactly that rate is would depend on spending. This is not a discussion about the spending side; I am just exploring better ways to collect the money to be spent however that is determined.

Although this is a very radical proposal, given the rapid rate of technological change surely we need our tax system to catch up?

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