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Economic effects of income-tax law on investments in Australian agriculture
With particular reference to new and emerging industriesby Rick Lacey, Alistair Watson, John Crase
January 2006
RIRDC Publication No 05/078 RIRDC Project No AWT-1A
Risk and the action of income tax as a vehicle for the shifting of risk and reward between the individual and the state is the key causal link of interest. Risk sharing arises from the deductibility of losses from the development of a project against income earned elsewhere by that taxpayer.
This attribute of income taxation was first noted in the academic literature by Domar and Musgrave (1944) along with the proposition that (with full deductibility of losses) demand for risky assets would increase with higher rates of income tax. The policy importance of this depends on the efficiency of the market for risk.
This study contends that significant elements of market failure remain in the market for risk and hence this attribute of income taxation may be beneficial in addressing potential under-investment in riskier investments. A range of factors including long gestation periods, volatility of commodity markets and erratic seasonal conditions mean that investment in rural industries tends to be more risky. This is all the more so for investments involving a higher degree of innovation (e.g. a novel product or method of production).
Agricultural industries are predominantly family businesses — most commonly sole traders and partnerships. While this is not the case in forestry and some specialised areas of agriculture, the overall rural asset base is predominantly owned and managed by small family businesses.
Accordingly, the major stream of investment is that arising from this class of business.
In this context, the potential impact of Division 35 of the Income Tax Assessment Act (ITAA) is of concern.
Introduced on 1 July 2000, Division 35 imposed new conditions governing the circumstances under which individuals could claim tax losses from one activity against income earned elsewhere.
This study, in common with a number of others, raises some concerns with this aspect of taxation law — from the perspective of both economic efficiency and equity.
From an efficiency point of view, it appears likely that this provision will have a negative impact on innovation in new and emerging industries and in farm diversification.
Quantitative analysis of this aspect of the taxation system is limited by lack of data, although the availability of data would only partially illuminate the issue; Some ideas and investments are not progressed because of Division 35 The extent to which current rural businesses are not complying with Division 35 in the compilation of their taxation returns — as they incorrectly believe that it does not apply to them.
(For example, is their farm one business or a collection of separate businesses for the purpose of the Act — and if the latter, is each of these businesses passing the tests proscribed by Division 35?) This study argues that the current situation is problematic and that changes are required. The key questions are: What was the scale of the revenue loss to Treasury from the description of consumption spending as investment under the rules that existed before Division 35? If that loss was such as to justify tightening in this area, can a system be devised that provides Treasury with effective protection of the revenue but is less potentially distortionary and inequitable? We suggest that a focus on output rather than the current rules pertaining to real and working capital employed is likely to be more productive. The example of the concept used by the Australian Bureau of Statistics (ABS) and the Australian Bureau of Agricultural and Resource Economics (ABARE) of the Estimated Value of Agricultural Operations (EVAO) is noted.
Managed Investment Schemes (MIS) have been a high profile source of investment in rural industries. In recent years, these are believed to have accounted for around $300 million per annum of investment in rural industries — mostly in forestry, viticulture/wine, olives and almonds. While a minor source of investment in the total picture, MIS have been important in the development of some industries — notably blue gum forestry and olives.
MIS have at times been a contentious area of investment. The policy context of MIS is outlined at length, including the actions of the ATO against ‘Budplan’ type schemes and the resulting Senate Economics Reference Committee Inquiry into Mass Marketed Tax Effective Schemes and Investor Protection.
It is clear that a number of important problems remain in the area of MIS. We contend that economic analysis — particularly that related to the economics of information and market failure arising from particular attributes of information — is being under-utilised in the development of policy and government action in this area.
While there has been some controversy surrounding MIS, they have several benefits that should not be ignored. MIS spread risks over large number of investors and, because tax deductibility of losses is allowed, share the risks between investors and the state. This encourages more investment in higher risk areas, redressing to some extent potential under-investment from failure in the market for risk.
Pooling of investment funds is most beneficial in those agricultural industries where scale is necessary to achieve low cost production.
The intention of this report is not to condemn MIS but to suggest improvements in the way MIS are operated and regulated.
Along with other studies, our analysis suggests that the MIS sector (but not all MIS) continues to perform poorly with respect to realistic or actual rates of return versus projected rates. There are limited rights for investors. Issues arising from the large number and small economic size of the retail investor population, and those arising from asymmetric information, dominate the economics of MIS.
Typically, the agent (the
MIS promoter–manager) takes little risk whereas the principal (the investor)
is exposed to market and production risks — and in many situations has
no ownership of the underlying assets, simply a beneficial right to income
for a period. This outcome is related to:
The approach of the authors
is that creating more markets for information and advice will make markets
for MIS and investment advice more competitive.
It should be straightforward to devise reporting systems that accumulate data on the performance of MIS and advisors and make this available to the public. This is particularly so since the ATO is already collecting significant data on schemes for the purpose of its Product Rulings.
The real point is the need for government institutions to try to create foundations for a competitive market rather than trying to solve the problem through administrative or procedural devices.
In this regard, there are some problems with the ASIC approach to providing market information, as outlined in our discussion in Section 3 of guidelines issued in September 2002 and published as Policy Statement 170, Prospective Financial Information.
We suggest four broad approaches
to the problems of MIS:
The current superannuation
tax regime is one tax product offered by Treasury/ATO, but is highly restrictive
in its application.
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