Chapter 61 - Income Tax is not Income Tax

One assumes that Income Tax is a tax on income, but this turns out to be incorrect for businesses. The issue is the way that Income Tax is calculated. It turns out that the calculations for Income Tax are the same calculations that would be used to calculate profit. For an individual, the person pays Income Tax on the income received. For a business, Income Tax is not the income that the business removes to feed and keep the family. For the business the Income Tax is calculated. The calculation used is the calculation that one would use to calculate the profit of the business. The significance of this is that much of the money that a business spends is on assets and trading stock. Neither of these are edible. The expenditure is not recorded as an expense but as a fixed asset or trading stock. If a business wishes to expand, it is likely to buy a new piece of equipment such as large coffee roasting machine for $10 000. The tax department does not allow the business to reduce its income by $10 000. It demands that it depreciates the equipment over say ten years. It allows $1000 depreciation expense each year for ten years. Neither is any consideration given for the loss in value of the money over ten years. Expanding businesses get harsh treatment under the Income tax regime. Let us not care for the business owner. We should care for the business owner. It is the business owners that grow our food, deliver our food, house, and entertain us. One item missing from the list is that these businesses employ us. If we hamper their expansion, we do the nation and the citizens a disservice. We need these businesses to expand to feed and employ us.

A simple definition is: “Depreciation is the fall in the value of an asset over the assets useful life.”

Other definitions might be:

“Economic depreciation is the annual change in the value of an asset owned by the business as they age or become obsolete.”

Assets depreciate due to wear and tear or obsolescence.

“Depreciation is the systematic reduction in the recorded value of a fixed asset.”

Examples of fixed assets that can be depreciated include: furniture, computers, cars, shelving, printers, trucks, buses, and general business equipment. There is usually a floor level below which deduction of the purchase cost is considered an immediate deduction.

Depreciation expense reduces the book ‘written down’ value of an asset. The calculation is done annually by bookkeepers and accountants. A skate rink skimming machine might cost $1000 and be depreciated over ten years. Under what is called ‘straight line depreciation’, the asset at the end of one year can charge a ‘depreciation expense’ of $100 giving the asset a ‘written down’ value of $900. $100 is charged as an expense to the business and the asset has a value of $900 in the business balance sheet. In the second year, another ‘depreciation expense’ of $100 is deducted giving the asset a ‘written down’ value of $800.

The effect of depreciation on the economy is little studied. When a business wishes to expand, it would commonly buy some new equipment. This would generally come out of the earnings of the business. To the business owner, the business has reduced income for the year. What is strange about depreciation is that the money spent purchasing the machinery is not deductible like most expenses. The expense is classed as the purchase of an asset. I often word this as: “You cannot eat wheelnuts.” Although accounting only seems to excite accountants, you need to understand the effect this has on a nation’s economy.

I shall give you a story: A butcher makes a profit of $30 000 in the year. At a tax rate of 33%, he will pay $10 000 in tax. This leaves $20 000 to feed the family. He is a popular butcher and toward the end of the year, our enterprising butcher decides to expand by purchasing a sausage making machine for $10 000. This is taken from his income. He now has only $10 000 to feed his family. He can’t claim the deduction because the sausage machine is classed as an asset of the business. We have a strange situation where Income Tax is called Income Tax even though it is not Income Tax. The business owner has an after-tax income of $10 000. He made a profit of $30 000 and the tax office took $10 000. The tax office claims that his income was $30 000 even though he spent $10 000 on a sausage machine. What the government is calculating is the profit of the business. In ten years time, the business may still not have claimed the expense of the sausage machine. This is very unkind to a small business.

There is another bad butcher in the district who is slowly losing business. He made a profit of $30 000 and paid $10 000 in Income Tax. He also sold some equipment for $10 000 that was fully depreciated. He had to pay tax on the sale of the equipment. He has an income of $20000 plus the $10000 from equipment sales less $3300 tax.

Hopefully, you might see that the tax system is punishing expanding businesses and being kind on businesses that are downsizing.

Whether you understood my ramblings or not, the net effect is to damage and discourage business expansion and employment whilst overtaxing the real incomes of business owners and entrepreneurs. In economic terms, it might be worded: “The depreciation of assets causes delayed cost recovery, increases the tax burden on investment, inhibits capital formation, stymies employment, and penalizes owners of businesses.”

I felt this when I was running my bus company. I was always short of money if I was expanding. Turnover often increased by fifty percent in a year. Technically the business was doing well. Calculated profit and money available to live on were two different things. I thought accountants to be a bunch of looneys.

Since the early 1980s, the government may have recognized that modification of depreciation can be used to stimulate the economy. The method involves a modification to the method of calculating depreciation. The modified method is called ‘accelerated depreciation’ where a greater proportion can be claimed in the earlier years. If a small business is using expensive equipment, such as airplanes, the depreciation rate is critical to the operation of the business. Allowing businesses to deduct their expenses earlier boosts the economy. If a business is keen to expand, it needs money and fresh equipment, but the tax office takes more off them, preventing them from expanding. The enthusiastic business purchases equipment with real money. It now has less money in the bank. It cannot claim the expense of purchasing the equipment until years into the future. If it bought the equipment toward the end of a tax year, it cannot claim any deduction at all from that year’s tax. It has to wait a full year before it can claim even a small part of the expense. Under such scenario, the only businesses that are going to expand are the ones that ignore the silly rules. Don’t think too ill of a small business for doing this because the business that ignores this stupidity, grow to be a bigger business paying more tax which then employs people that pay more tax.

In general term, Income Tax has a large negative effect on the economy. Depreciation just happens to be a nasty imposition on top of a nasty imposition. Depreciation magnifies the economy destroying nature of Income Tax. Income Tax does a good job of destroying the economy. Depreciation helps Income Tax to destroy the economy faster. Depreciation changes Income Tax into a Profit Tax. Depreciation makes you pay Income Tax before you receive income. In my opinion, depreciation is the worst creation ever by a tax department to damage the tax collecting ability of the tax department. Depreciation imposes a penalty on any business expansion.

It is better to tax in a manner that does not harm economic growth. If growth is damaged, tax revenue falls. There is little point in increasing tax parameters if the result is a fall in tax revenue. Depreciation is one of those components of Income Tax that stymies tax collection by resisting the growth of the economy.

Businesses should be allowed to report the value of their assets to any schedule they choose. Depreciation rules have been set to standardize the calculation methods without considering what is best for the economy. The expected lives for accountants is different to the tax collection requirements of the government and the tax office. Accountants like to revalue the assets for internal calculations so that revenue for a specific asset is balanced against the cost of owning the asset. Thus they prefer to use realistic asset values. The accountants want to calculate the realistic profit of the company. Unfortunately, the tax office classes this as income. What is needed is a double calculation. One is income the other is profit. A business that uses income to expand is going to produce greater tax in the future and should not be punished for trying to do so. There is a little more to it than allowing businesses to decide their own depreciation rate. Income for tax purposes should ignore the accountant’s depreciation schedules used to calculate profit. Income for tax purposes is all income less all expenses. The tax department will collect slightly less tax from expanding businesses but will collect significantly more when the business expands. It will also collect increased tax from the fresh employees. The tax department will bring in more tax by being a little gentler on their customers. The tax office could even give additional discounts to expanding business and reap even more tax. If you think about it logically and imagine that you inherit a nation. If your aim is to pull as much tax as possible, you need first to make sure that they are all vibrant and not impeded from doing business. The last thing you would want to do is to take money from them that prevents them from making money. Banks do a pretty good job of destroying business by ceasing to lend money. We don’t need a tax department that pulls so much out of circulation that it throttles business. For similar reasons, they only take one pint of blood at a time. If they took much more, you would not come back next time. You probably wouldn’t get as far as the exit door.

This graph was constructed for another purpose, but it does show that if there is more money circulating, the tax revenue rises. If the volume of money circulating falls, the tax revenue falls:

A graph of the change in Circulating Money in the USA and its effect on tax revenue. Andy Chalkley. Creative Commons Attribute

I give you this example. I purchase a motorcoach for $1 000 000 and depreciate it using straight line depreciation over ten years. My depreciation is $100 000 per year. If the motorcoach works 250 days a year, I get $400 per day in depreciation cost. The motorcoach needs to earn in excess of $400 to cover the cost of ownership. The bean counters tend to get this a little wrong. The motorcoach needs to earn in excess of $400 per day on average. If there is no other work, it can still go out and earn only a $200 contribution to depreciation. A $200 contribution is better than no contribution. If for example, some evening work arrives, then it may earn more than the annual depreciation requirement. Pricing only needs to be such that it earns at least $100 000 to cover depreciation during the year. Now we get a little trickier. The motorcoach looks magnificent during its first few years. It needs to cover a higher proportion of the depreciation expense in its first few years. Accelerated depreciation is closer to this situation. If you believe that half of the expense of the vehicle needs to be covered in the first two years, we have a different calculation. Depreciation for the first two years is $500 000. This is to be collected over 500 working days. The result is $1000 in depreciation per day. If you price the motorcoach to gain $1000 per day to cover depreciation, you will likely get underpriced by a rival company. At times it is better to ignore the bean counters and simply maximize the takings of the fresh motorcoach. It may do cheaper work in the evenings and weekends but overall it is pulling better income because of higher utilization.

The depreciation rate used for internal calculations does not need to match the depreciation calculations used by the tax department. The income calculation as used to pay tax need not be the same as the internally calculated profit.

The accountants and economists often call income and profit the same thing. They are different. Income is what you remove from the business to live on. Profit is income plus a calculation for the value of the assets. The selling value of the business is not taken into account and rightly so. The assets that have calculated values may have different market values. A new car loses perhaps fifteen percent of its value on the first day of use. We do not charge fifteen percent of its value for the first day of use.

Australia’s Temporary Respite on Depreciation.

Laws were passed that allow small businesses to claim an immediate deduction for depreciable assets that cost less than $20 000. This will temporarily raise the threshold of $1,000. It applies for the period 12 May 2015 until 30 June 2017. This means that a small business will be able to claim an immediate deduction for the cost of each and every depreciating asset that they purchase for less than $20,000.[1] This is a great help to expanding businesses who would normally be hampered from expansion because they spent money that would otherwise have been classed as income. They opted to expand their business and suffered for the consequence by being punished by delayed deductibility of the expense. The delayed deductibility hampers the expansion of business. If it is a small business, it encourages expanding businesses to go to the money lenders. If it is a company, it encourages the company to part with ownership of the company by selling its body in the form of shares.

Depreciation and Property

Another anomaly occurs with property. This is also an asset that can be purchased by a business. This asset tends to rise in value rather than fall. Strangely, assets that fall in value have a calculated depreciation, but assets that rise in value are exempt. Tax is paid at the time of sale. If the sale is deferred indefinitely, the tax is deferred indefinitely. Speculators tend to buy land and property, and very conveniently their appreciating asset is not assessed by straight line appreciation or accelerated appreciation. Sometimes the income tax at the time of sale is massively reduced by calling it ‘Capital Gains Tax’. An excuse is given that it is impractical to revalue the assets each year. Businesses need to pay more tax so wealthy individuals can make speculative capital gains on land and property without paying tax.

Depreciation and Inflation

Inflation degrades the value of money. It is partially offset by interest. Occasionally the economy undergoes increased inflation. Under a tax depreciation scheme, the money value of the depreciation falls as the years go by. Because the tax deduction for an asset is delayed for many years, the business loses money on the arrangement. The depreciation is like a loan to the government and the government will give you the tax back in future years. However, no allowance is made for the interest or the loss in value of the money the government owes. This adds to the destructive nature of depreciation. An expanding business not only gets its expenses deducted it doesn’t even get the full value. This can even lead to the bizarre situation where businesses are paying tax when they are actually losing money.

New Businesses and Depreciation

New businesses need to buy significant quantities of new equipment. The business has just started and the owners are ‘learning the ropes’. Income will be small in the first year. The deduction for equipment will be less valuable in the first year. There is no smoothing to iron out jumps in income from year to year. This is not a good way to treat the new businesses that are so valuable to the economy. In reality, no business would survive if it stuck to the rules. Thankfully they bend the rules and play cat and mouse with the tax department. Thankfully, small business slips a bit of money out from the till so that they have something to live on without the tax office sending them into an impossible debt situation or causing the collapse of the business. Many businesses fail in the first few years of operation. Tax unfriendly arrangements and lack of assistance contribute to this. New businesses need financial assistance, not financial punishment. Local councils should assist with mentors that have retired from similar businesses.

Inventory

No deduction is available for inventory. Money spent on fresh stock is not considered to be an expense for tax purposes. Inventory is an expense to a business at the time of purchase and becomes an inventory asset until sold. A better tax treatment is to treat inventory as an expense at the time of purchase for tax purposes. When the item is sold, the full sale price is treated as income.

I shall try to give you an example. A person borrows $50 000 to start a corner store. He buys $50 000 in stock and purchases top-up stock during the year to the value of $50 000. Interest is $5000. Rent is $10 000. He sells half the stock during the year for $80 000. His gross profit is $30000. Profit is $15 000. He pays tax on $15 000 even though he has spent out $100 000 during the year on stock plus interest of $5000 plus rent of $10 000 whilst receiving $80 000 in income. He should pay no tax because his outgoings are greater than incomings. The taxation arrangements almost ensure that any business that sticks to the rules is permanently in debt to the moneylenders.

Government

The government prefers to receive its tax revenue as soon as possible. The problem with taking it from depreciation is that it stymies the growth of businesses. If these hurdles are remedied, growth of the economy would be significant. Further economic gain would occur by lowering income tax rates for businesses and individuals and putting the tax load on less damaging areas. Land should be appropriately taxed in the form of a Land Tax and when purchased as an investment. Sales Tax should be reduced or replaced with an all-encompassing very small Transactions Tax. This graph is controversial but it does indicate that there is a possibility that increased tax rates can decrease tax revenue. Decreased tax rates can increase revenue.

A graph of change in tax rate and its effect on tax revenue. Data:OECDstat. Andy Chalkley. Creative Commons Attribute
Moneylenders

The nature of the punitive depreciation arrangements and the treatment of inventory means that expanding businesses are short of money and need to scurry to the moneylenders. Thus the money lender makes money from expanding and profitable businesses whilst at the same time putting a brake on the real economy and encouraging money to move from the productive real economy to the unproductive area of Hoarded Money. If the expanding business is a company, the entity is encouraged to sell ownership through share issues to obtain the funds to expand. The share owners then take a portion of all productive businesses without the day to day stress of operating the business. The money to purchase such shares tends to come from the idle money in society owned by those who have accumulated ‘more money than they can spend’.

The same issue occurs with inventory. A business needs to purchase stock which becomes part of its inventory. To the business, this is an expense. For tax purposes, it is not treated as an expense but is treated as an asset. No deduction is allowed for the purchase of stock. The tax office is taxing income for individuals but is taxing profit for business. If an individual starts a small shop, the stock purchased is not deductible. If he purchases $100 000 of stock during the first year and sells half of it during the year for $80 000, he has made a profit of $30 000. He pays Income Tax of $10 000. He has spent $100 000 and received $80 000. He has no money on which to live. Yet he still had to pay tax. For tax purposes, inventory should be considered an expense. Income Tax should be a tax on the income that the business owner takes for his family’s upkeep. Income for tax purposes should be equal to money in less money out.