18 January 2011

Switching To Current-Year Basis Of Tax Assessment: Who Benefits?

As budget time approaches, tax consultants and economists are reviving the suggestion to switch from the preceding-year basis of income tax assessment to the current-year basis of income tax assessment.

Features of the preceding-year basis

Tax is assessed and paid in the year next following the year in which the income is earned.  For example, income earned in calendar 2009 is assessed and paid in 2010.

It allows taxpayers to defer paying tax for one year.

It is less difficult and less costly for taxpayers, especially when the business climate is volatile.

It is claimed to be particularly hard on the newly retrenched and those who have just suffered pay cuts.  However, this is not an inherent defect of the preceding-year basis.  It is due to some people's aversion to thinking about their tax liability.  Therefore they do not, or do not adequately, set aside funds for tax on their income as they earn it; they prefer to pay the current year's tax with next year's income.  Thus, they encounter difficulties when they are retrenched, suffer pay cuts or retire.

Features of the current-year basis

Tax is paid in the year in which the income is earned.  For example, income earned in calendar 2009 is assessed and paid in 2009.  Since the actual income earned in any year is not known until the end of that year, the tax assessment is not finalised until the following year; however, much of the tax would have been paid during the year.

It offers macroeconomic benefits, with income tax being an automatic economic stabiliser.

It is being used by many countries.

It increases compliance costs.

What happens when a country switches from preceding-year basis to current-year basis?

When a country switches from a preceding-year basis of assessment to a current-year basis of assessment, the country will collect two years' worth of taxes in a single year (the transition year).

Individuals will claim that they have difficulty paying two years' taxes in a single year, although (as explained above), they themselves created the difficulty.  They should have set aside funds for taxes on income as it is earned, instead looking to the following year's income for funds to pay the preceding year's tax.

A possible solution may be to allow individuals to stagger the preceding year's tax over a period of, for example, five years.

Another solution may be to waive the preceding year's tax.  As countries operate on the basis (or assumption) of carrying on forever, the cost to the country is negligible.

From a macroeconomic perspective, waiving one year's tax seems right.  Otherwise, if individuals pay tax on the current year's income plus part or the whole of the preceding year's tax in one year, the government's budget surplus will swell and it will drain liquidity from the system.

Obviously, the high income earners salivate at the possible waiver of part or the whole of the preceding year's tax.

But the employed who do not earn enough to pay any income tax, housewives and retirees will not benefit.

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