The optimal use by farmers of the income equalisation scheme

Abstract

A progressive income tax penalises those taxpayers with a fluctuating income (for example, farmers), as compared with those on a stable income with the same average. However there are various methods of smoothing taxable income and hence reducing average tax payments. One such scheme is the Income Equalisation Scheme which was proposed by the Taxation Working Party of the Agricultural Development Conference in 1965 and was subsequently adopted by the Government. Under this scheme a farmer can deposit up to a quarter of his income from one year in the Income Equalisation Fund. He must withdraw a deposit within five years, adding the withdrawal to his income for that year. However, using the Income Equalisation Scheme has an opportunity cost, an opportunity foregone elsewhere. The funds deposited with the Government earn no interest. A thousand dollars deposited in the Fund for a year could have reduced a farmer’s overdraft with his bank by that amount, saving him about $75, In deciding how best to use the Income Equalisation Scheme to smooth taxable incomes, the tax saving gain from a smoother income must be balanced against the opportunity cost of storing the income in the Equalisation Fund. This paper describes a method for farmers and their advisers for making optimal use of the Income Equalisation Scheme. Optimal is defined as the maximisation of the present value of post-tax incomes. However readers should be aware that the scheme is of little value in reducing tax payments unless the farmer’s income is highly variable. In presenting the method which involves dynamic programming, the mathematics has been put in appendices so that the paper can be followed by those not skilled in mathematical techniques. The paper is divided into four sections. Firstly, a method of estimating farm income variability is given. Secondly, a method is presented for estimating the extra tax paid because of a fluctuating income. Thirdly, the results of using the Income Equalisation Scheme on historical incomes from Lincoln College's Ashley Dene farm are discussed. Finally, the rules for making optimal use of the Income Equalisation Scheme under realistic circumstances are presented.