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In general life, we commonly say “don’t judge a book by its cover”. In doing so, we are acknowledging that the form of something will not necessarily reflect its substance. In fiscal policy analysis, the concept of a tax expenditure is one example of this ‘substance over form’ approach.

The tax expenditure concept recognises that a government may, in substance, “spend” public money by not imposing tax when it should otherwise have done so. For example, there is no difference in substance between raising $100 in tax from a person and then paying a $100 grant to that person, as compared to simply not raising the $100 tax in the first place. In both cases, the person – and the government – end up in the same economic position.

Challenges in identifying tax expenditures

For over thirty years, the Australian government has identified tax expenditures and estimated their cost as part of its fiscal management. Over this time, several challenges have been encountered in applying the tax expenditure concept to fiscal decision making. One challenge is to determine the basis upon which tax expenditures ought to be identified. For this purpose, the definition of a tax expenditure currently adopted by the Australian Treasury states that a tax expenditure exists when “the actual tax treatment of an activity or class of taxpayer differs from the benchmark tax treatment.”

The benchmark tax treatment in a tax expenditure report states what ought to be taxed. In the current Tax Expenditures Statement, the Australian Treasury identifies a benchmark for each Commonwealth tax. For example, the benchmark income tax, is based upon a well-known concept of economic income:

“The starting point for defining the income tax benchmark is the Schanz-Haig-Simons (SHS) definition of income. Under this definition, income is equal to the increase in an entity’s economic wealth (stock of assets) between two points in time plus the entity’s consumption in that period. Consumption includes all expenditures except those incurred in earning or producing income.”

From this starting point, the Australian Treasury details specific aspects of the income tax benchmark by, for example, excluding unrealised capital gains from the income tax benchmark.

The reference to the “actual tax treatment” in the Australian Treasury’s definition of a tax expenditure suggests that substance should prevail over form. This indicates that any form of departure from the benchmark tax system must be reported as a tax expenditure.

Substance over form principle requires reporting of all departures

A rigorous application of the substance over form approach would acknowledge that tax expenditures may exist in different forms. One form of tax expenditure is a legislative rule expressly creating a departure from the benchmark taxation system. A second form of tax expenditure is the absence of a legislative rule imposing tax in circumstances where the benchmark taxation system would impose tax. A third form of tax expenditure exists where a government does not in fact apply a tax law that follows the benchmark tax treatment.

In all of these forms the economic substance is the same – public money is “spent” by not imposing tax in the first place where the tax expenditure benchmark indicates that tax ought to have been imposed.

The Australian Treasury restricts its reporting of tax expenditures to expressly legislated departures from the benchmark. Such expressly legislated rules typically take the form of exemptions, deductions, offsets, concessional tax rates and deferrals of tax liability. So, for example, the first tax expenditure reported in the Tax Expenditures Statement deals with the legislative rule specifically allowing an income tax deduction for expenses incurred by candidates seeking election to political office.

When we acknowledge the substance over form principle underlying the tax expenditure concept, we should also recognise that Australian tax expenditure reporting could be improved by applying that principle consistently to all the forms by which tax expenditures arise. This would mean that Australian tax expenditure reporting ought to identify departures from the benchmark even if those departures do not arise from an express legislative rule.

A departure from the benchmark taxation system could arise from judicial or administrative interpretation of the law. For example, without any error of law, a court of law may interpret “grey law” in a manner that departs from the benchmark taxation system. Such a judicial approach may not be overruled by legislation.

Similarly, the Australian Taxation Office may decide not to enforce the law by issuing a taxation ruling, settling a tax dispute or by issuing a “letter of comfort” to a taxpayer with respect to the Tax Office approach to applying the law. Such administrative practice may be defensible, as a matter of law or pragmatic tax administration. Yet, such practice may also give rise to a departure from the benchmark taxation system, even though there is no legislative rule specifically creating that departure.

As a matter of substance, there is no difference between expressly exempting something from taxation in line with the benchmark tax treatment, as compared to the taxation system ignoring that subject of taxation altogether. An example is wealth transfers from deceased estates or in the form of gifts. These are typically accepted to be a form of economic income within the Schanz-Haig-Simons concept of income adopted by the Australian Treasury in its definition of the income tax benchmark (see above), and therefore the Australian benchmark tax system should include taxation of such wealth transfers.

In Australia, since the abolition of the federal estate and gift tax in 1981, there is no express legislative rule imposing taxation upon deceased estates and gifts, and nor is there a general rule expressly exempting such transfers from taxation. The absence of taxation of these transfers should be recorded as tax expenditures relative to the benchmark.

A substantive approach would improve fiscal management

Adopting a substance over form approach in identifying a broader range of tax expenditures would promote the purposes of the Australian Treasury’s tax expenditure statement in several ways. One of those purposes is to strengthen Commonwealth fiscal management, by providing a true report of the fiscal impacts of public policy decisions. Another purpose is to enhance the transparency of government decision making, so that elected representatives may be held accountable for their policy decisions which impact upon a government’s fiscal position.

First, expanding tax expenditure reporting to include all departures from the benchmark tax system would promote fulfilment of these purposes by focusing the Australian community’s attention upon the way that the taxation law applies in practice, rather than assuming that the law in the books accurately reflects the practical operation of the law. The government and the community may then be better placed to decide whether the law should be changed or whether additional resources should be devoted to applying the law as it stands on the statute book.

Second, the purposes of tax expenditure reporting would be promoted by acknowledging that legislative omission, such as the absence of estate and gift taxes, can give rise to a tax expenditure. Such acknowledgement would encourage public consideration of options open to the government in strengthening the existing tax base or in altering the mix of taxes deployed to meet the government’s policy objectives.

Third, the purposes of tax expenditure reporting would be promoted by applying the substance over form approach to classification of existing legislative rules. Recognition of substance over form would focus attention upon the operation of legislative rules, rather than focusing upon the existence of particular legislative words (for instance, “exemption”, “concession”) within those legislative rules.

Finally, consistent application of the definition of tax expenditure adopted by the Australian Treasury, along the lines sketched here, would enhance the integrity of Australian fiscal management, and thereby enhance public confidence in Australia’s fiscal institutions.

The benefits of expanding Australian tax expenditure reporting are substantial. Of course, these benefits must be weighed against the costs of expanding the scope of the tax expenditure report. Unfortunately, this cost/benefit analysis has not been undertaken to date. That assessment would best be undertaken by commissioning a public inquiry undertaken by an appropriate parliamentary committee.

 

For more on tax expenditure management, see M. Burton and K Sadiq, Tax Expenditure Management: A Critical Assessment, Cambridge University Press, 2013. This article is based on Mark Burton, ‘Extending the Tax Expenditure Concept in Australia’, https://papers.ssrn.com/sol3/papers.cfm?abstract_id=3215630

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This article has 1 comment

  1. Tax expenditures are never fully documented at state or federal level, nor are the reasons for granting them. Governments need to be more transparent and accountable in this area.

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