The effect of taxation method on post-tax income variability

McArthur, A. T. G.
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Income variability is one of the serious disadvantages of farming. It makes it difficult to organize farm development wisely and upsets the farm family's standard of living. In the past there have been boom years when farmers have spent wastefully to prevent windfall gains being lost to the farm in taxation. In years of low farm income it may be difficult to carry on a development plan started in better times and thus not exploit past investment. Moreover few farming families have the liquid reserves to see them over bad seasons and it is customary for banks and stock and station agents to carry their clients over bad seasons. Farmers have to "draw their horns in" too. Development ceases, holidays are foregone, and teenage children may be brought home from boarding school following a difficult season. In the past New Zealand agricultural policy has aimed to reduce the fluctuations in farm income. The guaranteed price for butterfat and the floor price for wool are examples of policy aimed at reducing price fluctuations and the drought relief scheme is an example ameliorating the results of technical uncertainty. The Income Tax Assessment Act of 1957 which introduced the pay-as-you-earn method of paying income tax encourages a system which increases rather than decreases the variation in post-tax income a reversal of previous policy. The Act provided for provisional and terminal taxation. Terminal taxation is the difference between the provisional tax paid in the previous year and the tax which should have been paid. This annual square up, which can be a refund of an overpayment or a demand for underpayment, adds extra variation to a farmer's post-tax income compared with the method of tax assessment before 1957. The Tax Department and accountants encourage farmers to base, provisional tax on the previous year's income and this, in conjunction with terminal tax, results in three years' income having an influence post-tax income as will be explained later. While farmers and other businessmen are well aware of the adverse effects on post-tax income variation of provisional and terminal tax, the author has, not found any quantitative investigational work done in this field. Consequently this paper describes the provisions for paying tax under the existing taxation legislation in New Zealand and outlines some alternative methods. The use of the standard deviation as a measure of income variability is described. Then follows a case study in which the implications of these taxation methods are evaluated using pre-tax incomes from Lincoln College's Ashley Dene farm over a 16 year period. Finally, general analytical methods are developed for calculating the variance of post-tax income. These methods treat pre-tax income as a random variable. This makes it possible to predict the standard deviation of post-tax income under a wide range of conditions and to draw more general conclusions than is possible from a case study.
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