The Mathews Report on Business Taxation:Reply

The Mathews Report on Business Taxation: Reply*

RUSSELL MATHEWS Australian National University,

Canberra, ACT 2600

Income Measurement Models Because Part Two of the Report of the Committee

of inquiry into Inflation and Taxation‘ was concerned with the taxation of business income, it would have been easier to discuss Dr Swan’s criticisms (Swan, 1978) of tha’Report if, instead of concentrating on the Committee’s two final recommendations on business taxation, they had been related to the four basic income measurement models or valuation systems which were considered by the Committee.z These were described as:

(a) Historical cost (or historical record) accounting, in which: all prices are expressed in

*The author records his thanks to Professor A. D. Barton for his comments on an earlier draft of this paper. [Editors’ note: publication of this Reply has been substantially delayed in order that it may appear in the same issue as the following Rejoinder.]

‘Injation and Taxation: Reporr o/ Committee of Inquiry into Inflation and Taxation, Chairman, R. L. Mathews, AGPS, Canberra, 1975 (hereinafter referred to as Repori).

There are very few references to the body of the Report in Swan’s paper, and one of these (13) is inaccurate in the definition of capital maintenance attributed to the Committee.. Whereas Swan asserts that the Committee defined the phrase ‘as well off as ‘the maintenance of the existing capital in physical terms so that theenterprise has command over existing assets expressed in current values’, the Committee’s actual words were: ‘Under current value accounting, capital maintenance is interpreted as the maintenance of entity capital in current prices; that is, the firm’s total capital is required to be maintained intact in terms of its command over assets expressed in current values.’ In fact, the Committee went to considerable pains to point out that the current value concept does nor require physical capital maintenance, but is concerned only with the maintenance of operating capacity. See, for example, Report, pp. 478-81, 492.

historical prices; income is measured by comparing revenues and costs expressed in historical prices; and capital maintenance is interpreted as the maintenance of proprietorship capital in terms of historical prices. (b) Current value (or current cost) accounting,

in which: all prices are expressed in terms ofcurrent values (current replacement costs or net realizable values); income is measured by comparing revenues and costs expressed in current prices; and capital maintename is interpreted as the maintenance of entity capital in current prices.

(c) Current purchasing power (or general price level) accounting, in which: historical cost data are adjusted by means of a purchasing power or general price level index; income is measured as the sum of (i) historical cost revenues less expenses both adjusted for general price level changes and (ii) a purchasing power gain or loss from holding liabilities less monetary assets; and capital maintenance is interpreted as the maintenance of proprietorship capital in terms of general purchasing power.

(d) Relative price level accounting, in which: current price data are adjusted by means of a purchasing power or general price level index; income is measured as the sum of (i) current income calculated as in (b) above, (ii) the gain during the income period from holding assets which have increased in terms of current values, and (iii) the purchasing power loss (a negative item if prices are rising) on proprietorship capital or net assets which is associated with a rise in the general price level; and capital maintenance is interpreted (as in (c) above) as the maintenance of proprietorship capital in terms of general purchasing power.

Subject to variations in the form of arbitrary cost allocations and valuation adjustments, historical cost accounting is the income measurement system

26 I

262 THE ECONOMIC RECORD SEPT.

generally used by business enterprises and taxation authorities in Australia and other Western countries. During the 25 years before the Committee’s inquiry in 1975, current purchasing power accounting had come to be widely advocated by accountants as a means of adjusting accounting data for price changes, but since 1975 there has been a reversal of this approach in favour of current value accounting.

A system of current value accounting, involving valuation adjustments for inventories and depreciation designed to record all national accounting data in terms of current prices, has long been used by economists for purposes of national income accounting, while the constant price level estimates produced for national accounting purposes have some affinity with the fourth income measurement model which the Committee described as relative price level accounting. (However, in national accounting systems implicit price deflators based on a variety of indexes replace uniform adjustments to current value data based on a general price level index.) Another variant of the relative price level accounting approach has been developed by erofessor R. J. Chambers under the description of- ‘continuously contemporary accounting’. The distinguishing feature of this approach is the use of net realizable value (called by Chambers current cash equivalents) as the measure of current value for purpose of making price variation adjustments. Professor Chambers’ capital maintenance concept is the same as that adopted in general price level accounting and other relative price level accounting models.

The Committee was far from dogmatic in evaluating the different income measurement models which it considered. After noting that each of the income measurement models incorporates a consistent basis of valuation, the Committee considered both their advantages and disadvantages before making recommendations based on the current value approach. The only substantial criticism by Swan of the Committee’s recommendations, to the effect that ‘firms are compensated for price increases on their entire stock of physical assets with no account taken of financial liabilities in the form of debt finance’, was not only anticipated by the Committee but formed the basis of an exhaustive study, in both the text and in Appendices to the Report, of the limitations of adopting a current value basis of business

The Australian National Accounts make adjustments only for changes in inventory values.

taxation (Report , pp. 486-90, Appendix A, Appendix F).

Capital Gearing and the Distinction between Enterprise and Proprietorship Income

The problem noted by Swan was seen by the Committee to result from the fact that the current value concept of capital maintenance would enable the whole cost of increases in the current value of non-monetary assets to be financed through the revaluation reserves which would be created under this approach. This meant that the firm’s gearing, defined as the ratio of proprietorship funds to net liabilities, would improve as a result of the current value adjustments. The Committee showed how this might be countered by reducing the valuation adjustments (and increasing taxable income) by the amount of the implied gain on liabilities, which would then be augmented by additional borrowing of an equivalent amount. This suggestion has since been taken further by the Richardson Committee in New Zealand (Richardson Report, 1976, Chapter IS), by the present author in a paper contrasting the work of the two Committees (Mathews, 1977), and by a sub-committee of the United Kingdom Accounting Standards Committee (Hyde Report, 1977):

Briefly, the proposal as formulated by the Hyde Committee is for a gearing adjustment to be credited to distributable (and taxable) income in theevent that total liabilities exceed total monetary assets. The gearing adjustment would be calculated as follows:

where IVA ( L - M A ) / { ( L - M A ) + OE]

L = average total liabilities M A = average total monetary assets OE = average owners’ equity,

including revaluation reserves IVA = total income valuation

adjustments (that is, cost of sales and depreciation valuation adjustments) in the income period.

If total monetary assets exceed total liabilities, an amount equal to z ( M A - L) would be charged against revenue as a gearing adjustment in the measurement of income, where: is the change in an appropriate price level index in the income period. Alternatively and consistently with the current value approach, the gearing adjustment on net monetary assets could be measured by reference to

See also R. h4a and R. L. Mathews (1979).

1980 MATHEWS REPORT ON BUSINESS TAXATION 263

the current price changes on non-monetary assets, as given by the proportion of income valuation adjustments to the average current value of non- monetary assets (Mathews, 1977, p. 92).

The introduction of a gearing adjustment would give effect to the important distinction made by the Richardson Committee between the current cost operating profit of the enterprise (based wholly on current values) and what it called profit attributable to the owners. The gearing adjustment would prevent proprietorship equity from increasing through income valuation adjustments that fail to recognize the offsetting gains which result from financing assets through debt.

Criteria for Tax Reform As well as arguing that the Committee’s Report

is ‘not based on any meaningful criteria’, Swan has criticized its approach as being ‘ad hoc rather than systematic’: ‘Piece-meal refom’ is offered whereas a comprehensive approach is required’ (1978, pp. I , 13). This is to ignore the whole of the conceptual discussion and to confuse the Committee’s specific recommendations with the underlying approach to income measurement on which those recommendations were based.

It is difficult to see how what Swan calls a comprehensive approach could be applied sensibly to a taxation system which already embodies all kinds of special provisions that have influenced the income distribution, capital raising and resource allocation decisions of business enterprises. Swan’s own proposals, as he himself notes, are based on a partial equilibrium model which ‘abstracts entirely from risk and uncertainty’ and which also ignores ‘the general equilibrium . consequences which would arise from changes in the tax system including changes in tax rates’ (1978, p. 2). This is to assume that the proposals embodied in Swan’s system can be evaluated without reference to the existing system or to their overall effects on the economy.

By contrast, the Committee argued (Report, pp. 337, 338) that ‘there is nothing inherently right or wrong, or true or false, about the use of any particular income concept for tax purposes’, but that the definition of taxable income which is adopted must have regard ‘not only to its effects on business enterprises but also to its implications for the rest of the economy’. After noting that these effects need to be evaluated by reference to criteria of equi ty , simplicity, efficiency and the requirements of economic management, the

Committee indicated (Report, p. 339) that it attached particular importance to one over-riding test which any tax system must meet. This was the compatibility of taxation arrangements ‘with the maintenance of financial stability in the business sector, with continuity of business investment and operations, in short with business survival’.

Swan has argued (1978, pp. 1-2, 13) that the Committee’s criterion of business survival and financial stability does not support any change from the ‘current taxation system based on historical cost accounting, and indeed that one merely finds in the Report ‘an emotional crusade in which “business survival” has replaced the holy grail’.

Far from relying on emotion, the Committee demonstrated by reference to u priori reasoning, algebraical models, arithmetical examples and empirical evidence from the submissions it had received that the existing system threatened financial stability under the then prevailing conditions of very rapid inflation.

Pricing Policy and Business Liquidity Swan has asserted (1978, p. 8) that there is no

financial problem in times of inflation provided firms adopt appropriate pricing policies and that, in any case, observations over a long past history of inflation d o not provide support for the proposition that ‘the (capital market is incapable of financing higher asset values’.

The notion that, under conditions of rapid inflation, a liquidity or cash flow problem is inherent in a system of historical cost accounting, pricing and taxing was central to the Committee’s argument, and i t is not possible to rebut i t by asserting that the problem can be overcome by raising fresh capital. ’The two questions which must be asked are, first, whether a n adequate supply of capital is available and, second, whether it is worth while for firms caught in the liquidity trap to raise additional capital even if i t should be available on reasonable terms. Swan’s answer to the first question is that the ‘depressed state of the share market in 1975 at the time the Report was written can perhaps be best accounted for by the credit squeeze and factors other than the tax system’ (1978, p. 8).

However, fa r f rom being a temporary phenomenon, the depressed state of the capital market has been a continuing problem in Australia and those other Western countries which have experienced high rai.es of inflation during recent years. A more plausible explanation of the


unwillingness of investors t o contribute funds to the Australian business sector-and of the economic malaise in the Western world generally- is the one advanced by the Committee. This is the unsatisfactory performance of business enterprises when incomes and funds employed are measured in terms of current values.

Swan is not justified in criticizing the Committee’s argument that the capital market will not be willing to supply additional funds merely to finance higher holding costs of assets. ‘The flaw in this reasoning lies in the failure to consider the possibility that the alternative return which investors could get elsewhere may indeed be even more negative’ (Swan, 1978, pp. 8-9). The flaw is in Swan’s own reasoning. This is because he has calculated what he calls the real rate of return on government bonds by reference to an inflation adjustment measured by the rate of increase in consumer prices, without making a similar adjustment in respect of the return on investment in non-monetary assets. The income valuation adjustments proposed by the Committee in respect of the latter do not convert the resulting income concept into the equivalent of Swan’s real income, but merely convert it into a current value concept equivalent to the actual interest return on government bonds, which is automatically expressed in current prices. A second adjustment must be made to both income measures if allowance is to be made for changes in consumer prices or the generalized purchasing power of the return on the two kinds of investment. Investors have switched from ordinary shares to fixed- interest securities, and the share market has remained relatively depressed during the recent period of high inflation, precisely because the effective return on fixed-interest securities has been higher for the negative return lower) than that on shares.

Even if funds are available to finance the holding of assets a t higher prices, the question must be asked whether it is sensible for business enterprises to raise additional finance solely for the purpose of meeting taxation and dividend payments while merely maintaining operating capacity. Even if there were n o risks involved in operating business enterprises, businessmen can hardly be expected to stay in business if fresh capital has to be raised to cover tax and dividend payments. Swan’s prescription is tantamount to telling businessmen that they can overcome their cash flow problem by increasing their cash flow.

The problem is illustrated in Table 1 in Swan’s

paper, albeit in an exaggerated form because of the peculiar incope concept (based on the concept he calls economic depreciation which is examined below) which is implicit in both his Proposition 1A and Proposition 2A.S Before the firm can begin to earn revenues in excess of those necessary to cover his definition of user cost in the absence of taxes, it must issue new shares well in excess of taxable income under both Proposition IA and 2A. The Committee showed that, even under the less extreme requirements of a system of historical cost accounting, pricing and taxing, if the rate of inflation is high enough then additional capital has to be raised not only to maintain operating capacity but also t o meet tax liabilities. The result is a negative cash flow and a negative after-tax return to shareholders in terms of incomes and proprietorship funds measured in current values. Long before this point is reached, businessmen may be expected to conclude that continued operation is not worth the risks involved.

Like the Commonwealth Treasury in its submission to the Committee, Swan again sees an easy solution to the problem. The firm simply needs to increase profit mark-ups and prices to enable the higher costs of holding assets to be financed from retained earnings: ‘Closer study reveals, however, that survival is threatened, not by the tax system as one is led to believe, but by an unaccountable decline in the effective profit mark-up used in an illustrative example’ (Swan, 1978, p. 13).

This statement and Swan’s earlier discussion (p. 8) of the example referred to d o not fairly represent the Committee’s position, since i t repeatedly emphasized the need for price adjustments as well as changes in accounting, taxation and income distribution arrangements6 The particular example to which Swan referred, which was contained in Appendix A of the Reporf, was part of a comprehensive review of the financing

Swan (1978, p. I I). The figures in Table 1 must be treated with caution. Not only are discount periods mixed up so that investment outlays ( I t ) and new shares issues are both recorded in the wrong rows, but there is a conceptual confusion between depreciation and retained earnings as well as numerous errors in the figures for Proposition 1A and Proposition 2A. The shortcomings of the Table in relation to the Committee’s proposals are discussed below.

“Major references in the Committee’s Reporr to the need for appropriate pricing and rate of return policies include pp. 345, 474-7, 629, Appendix A and Appendix G.


options available to a firm under the conditions of historical cost accounting, taxing and pricing postulated by the Committee. In considering each of these options in turn, there was a clear assumption that the others were held constant only for the purpose of analysis. One of the options was expressly stated to be a combination of the other possible policies, which were identified as continuously increasing profit mark-ups on historical cost, reducing profit distributions, improving efficiency, injecting fresh capital or running down operating capacity. The Committee considered the constraints operating to limit the effectiveness of each of these options. Insofar as the use of retained profits (reduced profit distributions) was concerned, it showed that in the absence of other changes and if taxes were related to profits determined on an historical record accounting basis, the option was available ‘only up to the point where the rate of increase in replacement costs reaches ( 1 - t ) times the rate ofreturn on the assets, where t is the rate of tax’. If the rate of tax is 50 per cent and the pre-tax rate of return is 30 per cent as in the example, only half the return is available to finance the higher cost of holding stocks, and if replacement cost rises by more than 15 per cent ‘the additional cost must be financed by other means’ (Report, p. 659).

The point made by the Committee is incontrovertible. Swan’s attempt to counter it by reference to what he calls the firm’s real pre-tax rate of return i = rg, [ I - c) (1 + g,)r * is irrelevant to the Committee’s argument, since the financing problem facing the firm depends on the rate of price increase of its inventories (h , in Swan’s terminology) and not on the rate of increase in consumer prices g,.

It will also be observed that the Committee expressly noted that, if the replacer,ient cost of the inventories rises by more than (1 - t ) times the profit mark-up, the additional cost must be financed by means other than retained profits. Far from ignoring effective profit mark-ups as Swan has claimed, the Committee considered pricing policy as one of the financing options which the firm must consider. In the same Appendix to which Swan has referred, the Committee showed that ‘if selling prices were to be determined in such a,way as to achieve the same absolute profit mark-up on current replacement cost of sales as was achieved on historical cost of sales. . . and if tax was to be based on current income instead of accounting profit’, both the tax and dividend base would be preserved, there would be no reduction in the tax

yield, and the ability of the firm to generate income would be preserved ‘as a result of the combination of current value accounting and current value pricing policies’ (Report, p. 664). The Committee thus emphasized the need to combine current value accounting, taxing and distribution policies with current value pricing policies.

In arguing that there is no financing problem provided firms adopt appropriate pricing policies, Swan followed the Commonwealth Treasury in its submission to the Committee but ignored the Committee’s consideration and rejection of the Treasury’s argument.

The Committee showed, by reference to the Treasury’s own arithmetical example, just how unreal and potentially destabilizing was the Treasury’s proposal that prices should be adjusted to reflect increases in replacement costs while retaining historical ccpt accounting and taxation policies. On the figures postulated by the Treasury (the replacement of stocks which had originally cost $100 for $120 at the same time as they are sold for $120), the firm would need to charge a price of $160 to finance the higher cost of the stocks from retained profits (SZO), pay a dividend equal to the pre-inflation return ( S I O ) and pay tax at the rate of 50 per cent on its accounting profit ($30 tax on a profit of f60). In the Committee’s words (Report, p. 346):

The increase in price over the pre-inflation price would thus be double that required on the basis of the increase necessary to finance the higher cost of holding the stocks and to maintain the pre-inflation tax and dividend. Even if it were possible for the firm to sell its goods on this basis, the explosive inflationary consequences of such a situation are obvious. In effect the level of tax would be three times its pre-inflation level, of which two-thirds would be reflected directly in higher prices charged by the firm. The suggestion that appropriate pricing policy

will solve the firm’s financing problems without any adjustment in accounting or taxing policies must therefore be rejected.

Egui,!y and EBciency Swan’s final criticisms of the Committee’s

proposals (1978, p. 2) were that ‘they measure up very poorly against more conventional criteria such as equity and efficiency’. The Committee’s evaluation of both i.he equity and efficiency aspects of its proposals w,3s dominated by its view that


these criteria can only be satisfied if ail incomes- those of business enterprises, rentiers and wage and salary earners-are measured in terms ofconsistent prices. In circumstances where some incomes are automatically measured in terms of current prices (e.g., rentiers and wage and salary earners), while others are measured in terms of a mixture of current and historical prices, the Committee considered that equity and efficiency could only be served by means of valuation adjustments designed to express all incomes in terms of equivalent current prices.

Questions of equity in relation to a taxation system necessarily involve value judgements, which should have regard not only to proposals for change but also to the distribution effects of existing arrangements. The Committee’s proposals for adjusting the revenue base for purposes of business taxation certainly should not be considered in isolation from the proposals which it made at the same time for indexing tax schedules for purposes of personal income taxation.

Insofar as the efficiency criterion is concerned, the Committee’s position was simply that decisions relating to the consumption of assets for taxation purposes, like other resource allocation decisions, should be based only on the current worth of the assets. The amounts paid for the assets at some earlier time are quite irrelevant for purposes of resource allocation decisions, whether those amounts are unadjusted as in historical cost accounting or adjusted in accordance with either of the two sets of propositions advanced by Swan.

Finally, Swan’s criticisms of the Committee’s proposals fall down because the criticisms are based on the assertion that only his two sets of propositions are optimal in an efficiency sense, in that the tax system is neutral with respect to investment decisions. The tax treatment of interest, whether the nominal rate r, as in Swan’s first set of propositions or his so-called real interest rate it = ( r , - g,) (1 + g,)-l, is not an appropriate criterion by which to evaluate the tax treatment of business income.

Essentially this is for the reasons given above. Nominal interest receipts are automatically expressed in current prices and the tax treatment of business income is not comparable to that of interest receipts unless it also is expressed in current prices. An adjustment to the nominal interest rate to allow for the rate of increase in consumer prices, as suggested by Swan under his second set of propositions, does not provide a remedy. If such an adjustment is to be made to nominal interest rates,

to maintain comparability a similar adjustment needs to be made to business income after it has been converted into current income by means of current value adjustments. The resulting measure of income will then reflect the relative price change approach described by the committee.

In any case, the existing tax system cannot be regarded as neutral as between interest and business income when so many provisions in the Income Tax Assessment Act differentiate between the two forms of income. One needs merely to point to such policies as the deductibility of interest as a cost for taxation purposes; the taxation of company income in the hands of both companies and, insofar as dividends are concerned, shareholders; the special tax treatment of private companies; averaging provisions for certain kinds of business income; the arbitrary tax treatment of trading stocks and depreciation; and the use of various kinds of tax incentives such as investment allowances.

The irrelevance of Swan’scriteria for purposes of assessing the Committee’s proposals may be illustrated by reference to his Table 1, in which he purports to demonstrate that the net present value of the return to equity holders under the Committee’s proposals is substantially higher than under his Propositions 1A (economicdepreciation) and 2A (economic depreciation plus a capital maintenance adjustment based on the change in consumer prices). The need which Swan sees for new share issues under the Committee’s proposal arises only because Swan has applied the inappropriate pricing policy Lle has assumed for purposes of evaluating Propositions 1A and 2A. He has also applied the inappropriate discount rate of 8 per cent (11, = 0.08) to the cash flow generated by the Committee’s proposals. But if revenues each year are set at a level which will merely cover interest payments and current value depreciation, the value of the asset at the end of Year 5 will be recorded at $1244.2, which needs to be discounted by reference to the annual rate of increase in the asset (h,= 0.2) to arrive at a net present value for the entity of 5500 at the beginning of Year 1. That is to say, under the Committee’s proposal the firm is not regarded as having earned any income until i t has maintained the current value of the asset (or its equivalent in t e r n of operating capacity). If a firm merely holds an operating asset through a period of rising buying prices, in the Committee’s view it is not to be regarded as being better off simply because the price of the asset has appreciated, or as subject to a liability for taxation and dividend

1980 MAMEWS REPORT ON BUSINESS TAXATION 267

distributions which can only be financed by raising fresh capital.

SwanS Income Measurement Models So much for the defence of the Committee’s

proposals. It remains to consider Swan’s own proposals, which among other things are based on his concept of economic depreciation. He describes this as the change in the money value of the asset, defined as D,= [&(I + h , ) - h,] K, where a,= the physical deterioration of an asset K, during t and h, = the rate of price increase of K t during t .

The first thing to be said about Swan’s economic depreciation is that it is not strictly either an economic concept or a depreciation concept. It is not an economic concept because it is based on the historical cost of the asset, and it is not a depreciation concept because it does not simply measure the cost of using the asset but also incorporates the price appreciation on the asset itself,sothatD,= V,- V , + I where V,is themarket value of a unit of Kt at 1.’ This means that his measure of depreciation for a unit of K, is given as the sum of two components, current cost depreciation based on the current value of the asset [a positive element Y,(6,( 1 + hJ)] and the whole of the price appreciation that has occurred on the asset itself (a negative element- Y,hr) . Because current cost depreciation is itself equal to historical cost depreciation (V16,) plus an income valuation adjustment ( V,Sh,), Swan’s so-called economic depreciation may be identified, in terms of the terminology discussed earlier in this paper and used by the Committee, as being equa! to historical cost depreciation plus a depreciation valuation adjustment (or realized holding gain) minus an asset valuation adjustment (or unrealized holding gain).

If depreciation is to be measured in this way for tax purposes, the allowance for historical cost depreciation would be offset by the inclusion in assesaable income of the price appreciation or unrealized holding gain which has occurred during

‘Swan confuses time periods with points of time and thus incorrectly refers to the beginning of t in his definition. In the following section, Swan’s notation is followed but the subscript t should strictly not be used for revenue, cost or income valuation adjustments occurring over a period. Swan also confuses units (Kl) and values (V,) of assets in his definitions of depreciation and cost of sales by including Kt in the definitions rather than Kt V,. Numbers of assets cannot be included as values in cost equations.

the period on the depreciated value of the asset (V,h, - V,S,h,) = Vthr( 1 - Si).

The taxing of unrealized holding gains resulting from price changes affecting depreciable assets held by business enterprises would have drastic implications for the tax system and serious consequences for the economy. Why should such unrealized gains (which are valuation adjustments and not real gains) be included in the assessable income of business enterprises when even most realized capital gains escape taxation and the taxation of unrealized capital gains has generally been accepted as admirlistratively impracticable? If unrealized holding gains on depreciable assets were to be taxed in the hands of business enterprises, the same principle would need to be extended to other forms of assets and other classes of taxpayers, such as farmers in respect of unrealized gains on farm properties, rentiers in respect of unrealized gains on property and securities, and persons in respect of the annual unrealized increase in the value of both their real and personal property (such as houses, land, furniture and motor cars). Quite apart from the valuation problems and the potential this would provide for a massive taxpayer revolt, it is difficult to conceive of any action which would be more damaging to the Australian economy and its competitive position than the inclusion in taxable income of the unrealized appreciation which has occurred on the depreciable assets held by business enterprises.

Although Swan seems to treat his Proposition IB, which defines cost of sales as the change in the market value of stocks plus purchasess, as symmetrical to his Proposition IA, this is not so because his concept of cost of sales does not include any allowance for unrealized holding gains on inventories. He has noted that if the turnover ratio of sales to stock is greater than or equal to unity, his Proposition 1 B coincides exactly with the historic cost based taxation s y ~ t e m . ~ But because of his failure to distinguish between periods and points of time, Swan has not allowed for any price variation on stocks purchased during an accounting period and held until the end of the period. Neither does his system, in either Proposition 1 B or Proposition 2B, resemble

a Swan (1978, p. 3). Swan presumably ifleans purchases minus the increase in value of stocks.

9The condition stated by Swan on p. 4 is a turnover ratio of unity, but in the light of the discussion on p. 2 this needs to be interpreted as a turnover ratio greater than or equal to unity.


Professor R. C. Chambers’ so-called continuously contemporary accounting (CoCoA) system, because the latter requires price variations on stocks to be recorded as they occur, and in effect brings unrealized gains on stocks into income only at the time the stocks are purchased or as price variations occur while they are held, and not at the time stocks are sold. Thus whereas Chambers’ system is symmetrical as between its treatment of fixed assets and stocks, and depreciation and cost of sales, Swan’s is not.

The effect of taxing unrealized gains, which has been criticized above, would be moderated as a result of the capital maintenance adjustment which Swan proposes as part of his Propositions 2A and 2B. However, i t is difficult to see what rationale exists for measuring income by reference to charges for depreciation which incorporate changes in the realizable value of fixed assets and charges for cost of sales based on the historical cost of stocks, both of which are subject to a. ‘capital maintenance adjustment based on the change in consumer prices. In terms of the income measurement models described by the Committee, Swan is proposing not a relative price change approach in which income is measured in currenf value terms and subsequently adjusted by reference to general price level changes, but rather a hybrid system which measures income by reference to a mixture of changes in realizable value (in respect of depreciation on fixed assets) and historical cost (in respect of cost of sales), followed by a capital maintenance adjustment.

That is to say, Swan is proposing a Chambers- type system insofar as depreciation is concerned and a current purchasing power approach in respect of cost of sales, and his Propositions 2A and 2B are therefore subject to the disadvantages of both systems. If he were to make his two propositions symmetrical by adopting a Chambers-type CoCoA system for both fixed assets and stockslO, the disadvantages that were noted above in relation to Proposition 1A and IB would be multiplied. In particular, the taxation system would involve the assessment of unrealized gains associated with the holding of stocks as well as fixed assets. Quite apart from the administrative

lo In his submission to the Committee, Chambers showed how his system could be adapted for tax purposes (Report, pp. 524-5). For an evaluation of Chambers’ income measure as a basis for business taxation, see Report, pp. 495,527-9. The author has since extensively reviewed the CoCoA system in R. Ma and R. Mathews ( I 979).

problems of determining the realizable values of stocks for taxation purposes, such a system would have seriously disrupting effects on the stability of business enterprises and of the Australian economy.

If, on the other hand, the CPP approach were to be adopted in relation to stocks, to that extent the disadvantages which the Committee noted in respect of that approach would ensue (Reporr, pp. 514-23).

Finally, Swan’s assertions (1978, p. 14) that the ‘tax revenue loss from the company sector would be considerably less’ under his proposals than under those of the Committee, and that his system of indexing both business and interest income ‘would have roughly the same cost to consolidated revenue as the Mathews proposals’, may be contrasted with the detailed estimates which the Committee made of the revenue implications of its proposals and its suggestions for implementation procedures which would limit their cost to revenue. In particular, Swan’s proposals cannot be costed without making allowance for their effects on the revenue base.

Conclusion: The Future of the Mathews CommitteeS Proposals

Despite the Fraser government’s announcement that it would implement the main recommendations of the Mathews Committee over a period of three years, that period has now elapsed without such action being taken. Not only will the so-called stock valuation adjustment not be extended beyond its existing 50 per cent nor will a depreciation valuation adjustment be introduced, but the government has indicated its intention to abolish the existing stock valuation adjustment. Its decision in 1976 to grant investment allowances was in any case incompatible with the introduction of a depreciation valuation adjustment as recommended by the Committee.

The reduction in the rate of inflation has, at least temporarily, reduced the urgency of valuation adjustments for tax purposes and, although progress has been made by the accountancy profession tgwards the development of current value accounting standards which incorporate an appropriate treatment of monetary items, the issues are far from settled. There has been considerable resistance to the introduction of current value accounting standards from businessmen, many of whom seek valuation adjustments for tax purposes while simultaneously


opposing them for purposes of reporting business income to shareholders or investors. Incredibly, some firms have even attempted to take the stock valuation adjustment into after-tax profits and make it available for distribution as dividends.

Under these circumstances, the government can hardly be blamed for shelving further action in respect of valuation adjustments for taxation purposes, a t least until the accountancy profession and the business community can agree on standards which can be applied consistently to all three areas of accounting measurement, business policy and taxation policy. By that time the detailed proposals of the Mathews Committee will undoubtedly need to be modified in order to give effect to the changes which have occurred in the taxation system since 1975 and the refinements which are taking place in developing and obtaining consensus on appropriate income measurement systems.

REFERENCES Inflation Accounting: An Interim Recommendation by fhe

Accounring Standard:; Committee (1977), Chairman, W. Hyde, Accounting Standards Committee, London.

In& lion and Taxation: Reporr of Cornmitree of Inquiry info Inflation and Ta..ration (1975). Chairman, R. L. Mathews, AGPS, Canberra.

Ma, R. and Mathews, R. L. (1979), The Accounting Framework: A Contemporary Approach. Longman Cheshire, Melbourne.

Mathews, R. (1977). 'The Shift to Current Values: the Mathews and Richardson Reports', The Accountants' Journal, April, 85-92.

Report of the Committee of Inquiry into inflation Accounting (1976). Chairman, I. L. M. Richardson, Government Printer, Wellington.

Swan, Peter L. (1978). 'Ilhe Mathews Report on Business Taxation', Economic Record, 54, April, 1-16.

Documents

The Mathews Report on Business Taxation:Reply