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An Inflation-Proof Tax System?: Some Lessons from Israel

Author(s):
International Monetary Fund. Research Dept.
Published Date:
January 1991
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Economists have long been interested in the so-called inflation tax or the real depreciation of money holdings. In a seminal paper, Bailey (1956) studied the welfare cost of inflationary finance, and Friedman (1969) investigated the optimal inflation tax and concluded that it should be negative. These early studies tended to ignore the fact that in the real world the alternatives to an inflation tax are not nondistortionary lump-sum taxes, but rather some other distortionary taxes. Therefore, the inflation tax should be considered in a second-best framework. Later, Phelps (1973) and Helpman and Sadka (1979) investigated the optimality of inflationary finance in a second-best context, employing an optimal taxation approach.

These studies considered only one aspect of inflationary finance: the real depreciation of money holdings or the revenues from printing money (seigniorage). These revenues tend to be relatively small as a percentage of gross domestic product (GDP). For instance, in Israel such revenues have averaged about 2 percent of GDP, with an inflation rate ranging widely between 40 percent and 500 percent a year (see, for instance, Eckstein and Leiderman (1989)).1 Furthermore, as the (perfectly foreseen) inflation rate rises, real money holdings decline; and with a very high inflation rate a country may well find itself on “the wrong side of the Laffer curve.”

Tanzi (1977, 1978) identified another much more important and practical aspect of inflationary finance: the effect of inflation on the tax system.2 According to Tanzi, real tax revenue is eroded by inflation owing to the collection lag, which is “the time that elapses between a taxable event (that is, earning of income, sales of a commodity) and the time when the tax payment related to that taxable event is received by the government” (Tanzi (1978, p. 419, fn 7)). In fact, the overall revenue from inflationary finance may well be negative.

The collection lag can be shortened to lessen the effect of inflation on the tax system, but such measures are not themselves without costs. For example, the filing period for the value-added tax (VAT) in Israel was shortened from three months to one month when inflation reached the triple-digit plateau. Accordingly, during the period 1979–85, businesses had to file a VAT return and pay the tax collected to the Government every month, thereby increasing both their bookkeeping costs and the Government’s collection costs. This is another real cost of inflation that should be added to the lists compiled by Fischer and Modigliani (1978) and Fischer (1981).

This paper emphasizes yet another aspect of the effect of inflation on the tax system: the definition of income. The traditional approach followed in macroeconomic textbooks is that with a progressive individual income tax (that is, the average tax rate increases with income), nominal income, which rises in proportion to the rate of inflation, causes nominal tax liability to rise more than in proportion to nominal income and inflation. Hence, real tax revenues increase and the progressive individual income tax serves as an automatic stabilizer. However, with full, and almost instantaneous, indexation of the income tax brackets, individual real tax liabilities no longer rise with inflation. Therefore, the effect of inflation rests primarily on the definition of business income. Since business income is defined according to nominal accounting standards, high inflation virtually destroys the income tax base in the business sector.

Many attempts have been made in the past to correct tax laws for the effects of inflation so as to re-establish a valid income tax base in the business sector during periods of inflation.3 As the early (1975–82) Israeli experience suggests, these attempts were partial and not evenhanded. Lawmakers were under pressure, first of all, to remove those effects of inflation that hurt taxpayers (for example, the taxation of inflationary capital gains). Only much later did they come to deal with the effects of inflation that played into the hands of taxpayers (for example, the tax deductibility of nominal interest payments). These “one-side-of-the-balance-sheet” adjustments tended to worsen the detrimental effect of inflation on the tax system (see also Kay (1977)).

It took several years of high inflation before a law providing comprehensive adjustment to the effects of inflation on business income was enacted in Israel in 1982. Like any tax law, it contained several serious loopholes, some of which were later closed. Also, it applied mainly to corporations and neglected most proprietorships. In the event, the effectiveness of the “Israeli solution” was never put to the test because in mid-1985, the Government introduced its stabilization program, which brought inflation down very rapidly (to a 15–20 percent range).

It is nevertheless true that during the period of high inflation (1981–85), the tax on wage earners accounted for an unusually high fraction (about 65 percent) of all income tax revenues. Today, it accounts for only 40 percent. Yet, when the rapid deceleration in inflation in 1985 succeeded in erasing the Government’s budget deficit, a significant contribution came from the automatic increase in real tax revenues caused by the sharp decline in inflation. Should not economists therefore abandon the traditional concept of the “inflation tax” in favor of the more realistic “inflation subsidy”?

The paper is organized as follows. Section I describes the main effects of inflation on business income. Section II summarizes early partial adjustments for inflation in the tax laws. Section III analyzes the main elements of the 1982 tax law that was supposed to provide a comprehensive adjustment for inflation in the definition of business income, and Section IV describes the major loopholes and exceptions in that law. Section V discusses the importance of withholding when income tax brackets are indexed and change within the same tax year. Section VI discusses some alternatives to income taxation (for example, consumption or cash flow taxation) during inflationary periods. The Appendix provides an alternative to the derivation of real income as presented in Section III.

Throughout this paper, inflation is assumed to take the form of an equiproportional increase in all prices, so that relative prices do not change. This assumption makes it possible to abstract from the question of which price index to employ in converting nominal values into real values.

I. Effects of Inflation on Taxable Business Income

Taxable income in the business sector is calculated according to standard accounting procedures, which are nominal in nature. In other words, 1 sheqel (the Israeli currency unit) is treated as 1 sheqel regardless of the date on which it was paid or received. Nominal business income (or profit) so calculated, which is the difference between revenues (or sales) and costs, is calculated by adding together sheqalim received at different dates (and having different real values) and subtracting from them sheqalim paid at different dates and having different real values. When the inflation rates are in the range of 100–500 percent a year, a beginning-of-the-year sheqel may be worth, in real terms, as much as 2 to 6 end-of-the-year sheqalim. As a result, nominal income cannot even serve as an approximation of the true, real income of a business firm in periods of high inflation rates, such as those Israel experienced during the late 1970s and the first half of the 1980s.

Inflation creates several deviations of the nominal income from true, real income. Some of these deviations or biases are negative and some are positive, but they do not offset each other. Furthermore, as I shall explain below, their incidence and magnitude are not independent of the behavior of the taxpayer. In other words, the taxpayer may take certain actions that reduce the calculated nominal income even though the real income does not change. In such a case, a higher inflation rate reduces rather than increases real tax revenues; and the tax system fails to serve as an automatic stabilizer.

The deviations or biases of real income from nominal income that are caused by inflation may be classified into five main categories as follows.

(1) Nominal capital gains on an asset have two components: an artificial or inflationary component that merely reflects an increase in the general price level of all goods and services; and a true real component that reflects the portion of the appreciation in the value of the asset that is over and above the increase in the general price level. Thus, nominal income overstates real income by the sum of the inflationary component of capital gains. For later reference, it is worth pointing out that capital gains are normally taxed upon realization, rather than on an accrual basis, so that the inflationary component of the capital gains is taxed only when the asset is sold or otherwise disposed of.

(2) Analogous to the distinction between the inflationary and real components of nominal capital gains is the distinction between the inflationary and real components of the interest rate. Thus, allowing deductibility of nominal interest accumulations causes nominal income to understate real income by the sum of the inflationary component of the interest accumulations.

At first glance, one may argue that (1) and (2) above offset each other. On the one hand, inflationary capital gains on an asset are included in taxable income but, on the other hand, the inflationary interest charges incurred for the purpose of acquiring the asset are tax deductible. This argument is invalid on two grounds. First, the purchase of an asset may be financed by equity rather than by debt. Second, capital gains are taxed upon realization, whereas interest is deductible on an accrual basis. Suppose, for instance, that a firm takes out a fully indexed loan of 100 sheqalim to be repaid after five years in order to purchase a certain asset. If the annual inflation rate is 100 percent, then the firm will be allowed to deduct from taxable income an indexation differential (that is, the inflationary component of the interest rate) of 100 sheqalim in the first year, 200 sheqalim in the second year, 400 sheqalim in the third year, and so on, even though these differentials were not actually paid before the end of the fifth year.4 The inflationary capital gains on the asset purchased, however, will not be taxed until the asset is sold.

(3) The depreciation allowance on a physical asset is calculated on the basis of the nominal (historic) cost of the asset. In this respect, nominal income overstates real income.

The above three sources for the deviation of real income from nominal income are well known and have received considerable attention. In fact, many economists have asserted that these are the only significant effects of inflation on real tax liabilities (see, for instance, Halperin and Steuerle (1988)). Many believed that in order to eliminate the effect of inflation on real tax liability in practice, it would suffice to exempt inflationary capital gains from tax, disallow tax deductibility of inflationary interest charges, and allow replacement cost depreciation (or more simply, indexation of historic cost depreciation).

This simple prescription for dealing with the effect of inflation on taxable income might well be adequate for relatively low rates of inflation, say up to 10–15 percent a year. But when the annual rate of inflation reaches the three-digit range, other, less obvious, factors come into play. The above suggested solution fails to recognize these factors and is therefore inadequate for dealing with the effects of inflation on real tax liabilities in the business sector.

When the inflation rate reaches the double-digit range on a monthly basis, two additional major factors cause nominal income to deviate significantly from real income. These factors, unlike the first three, pertain primarily to the determination of real operating income (that is, income before capital gains and long-term financing costs are taken into account). They relate to the nature of the production process, which takes place over time.

(4) Given that the production process takes place over time, output is usually sold at the end of this process, while the costs of labor and other inputs and raw materials are incurred earlier. Thus, output is sold at high (inflated) nominal prices, relative to the low nominal prices of the inputs. As a result, the nominal operating income overstates the real operating income. Naturally, the time length of the production process is short relative to the length of life of fixed assets and long-term loans. Thus, the bias in the operating income, unlike the biases caused by capital gains and interest payments, is significant only when the inflation rate is relatively high (for instance, when the annual rate climbs into the triple-digit range).

A special case of the preceding bias applies in particular to retail firms.

(5) A retail firm normally buys and pays for its merchandise before it sells the merchandise. Thus, the sales price is inflated relative to the purchase price. As a result, the nominal profit from sales includes an inflationary appreciation in the value of the merchandise. The firm is thus taxed on the inflationary appreciation of the merchandise it sells.

II. Partial Adjustments for Inflation: 1975–81

One might conclude from the preceding section that since the various deviations of nominal income from real income are not all of the same sign, then the effect of inflation on nominal taxable income, vis-à-vis real income, is ambiguous. However, such a conclusion ignores the long-run behavior response of the taxpaying firm to the effect of inflation on nominal income. In the short run, when inflation unexpectedly picks up, firms are caught by surprise and may either lose or gain from inflation. For instance, those firms that have invested heavily in fixed assets financed by debt usually gain (because, as will be recalled, capital gains are taxed upon realization, whereas interest charges are deducted on an accrual basis); those firms that have used equity capital to finance their production process usually lose. But in the longer run, firms will have taken various tax avoidance measures in order to reduce nominal taxable income. For instance, they will use less and less equity capital and invest more and more in buildings and real estate. Such a tax avoidance activity is further fueled, as will be seen below, by changes that are made in the tax laws in the wake of inflation—changes that are partial and unbalanced.

As inflation persists, lawmakers start introducing provisions in the tax laws aimed at eliminating the effect of inflation on real tax liabilities. However, the Israeli experience suggests that these provisions are generally introduced piecemeal and tend to be unbalanced. Lawmakers first yield to the public outcry of those who are hurt by inflation and grant relief against taxation of inflationary (artificial) income. Only much later do they close up the loopholes that enable taxpayers to reduce nominal taxable income much below real income.

One of the earliest provisions introduced in 1975 in the wake of the stubbornly persistent inflation was a reduction in the tax rate on the inflationary component of capital gains to 10 percent, compared to the 61 percent rate on ordinary corporate income.5 Similarly, the holders of indexed government bonds and some other bonds were exempted from tax on the inflationary component of the interest (the indexation differential) earned. Owners of bank saving deposits were also granted an exemption on the inflationary component of earned interest. Another ad hoc relief measure allowed firms to take a deduction based on the size of their (finished or unfinished) inventories. The rationale for this deduction was the need to offset artificial inflationary elements in the operating income of the firm that were related to the temporal nature of the production process.

The form all of these provisions took was what I have called “one-side-of-the-balance-sheet”—that is, they all pertained to the asset side. The liability side was initially ignored. Only later on did it become evident that it made no sense, for instance, to exempt inflationary capital gains or to tax them at a low rate, while still allowing taxpayers to deduct from ordinary income the total inflationary component of the interest incurred by them. As a result of these lopsided measures, firms increased their borrowing in order to invest in buildings, equipment, machinery, inventories, stocks, and indexed government bonds. Attempts to restrict the tax deductibility of inflationary interest charges were partial and clumsy and they failed.6

III. The Comprehensive Approach: 1982–Present

The partial adjustment measures discussed in the previous section proved to be inadequate, and after some seven years, with inflation reaching an annual rate of 140 percent, a new law was introduced in 1982. The aim was to remove in a comprehensive manner all effects of inflation on real tax liabilities. In principle, the law should have been applied to all businesses. However, since the various provisions of the law were based on the balance sheet of the firm, it was effectively confined to “big” businesses, which are usually required to provide balance sheets: namely, to corporations and some other proprietary firms (usually above a certain size).

From a theoretical point of view, the most logical method for eliminating the effects of inflation on taxable income is to evaluate each transaction in units of some stable currency (say, the European Currency Unit (ECU)), instead of nominal Israeli sheqalim. Thus, if income is calculated by subtracting costs of labor and other inputs, finance costs, and depreciation, from receipts from sales, all evaluated in ECUs, the result will indeed reflect the true, real income of the firm. However, implementing this method would be difficult and costly. As long as the Israeli sheqel remains the only legal medium of exchange, and transactions are consequently made in sheqalim, this method would require a record to be maintained of the exact date of each transaction, so that the nominal sheqalim involved in each transaction could be translated into ECUs at the current rate of exchange between the sheqel and the ECU, which varies daily in periods of high inflation.

A further drawback of this method is that standard accounting procedures calculate income not on a cash flow basis, but on an accrual basis. However, transactions take place over time; that is, some time elapses from the date on which a sale of a good or a purchase of an input is made, and the date on which cash is actually received or paid. This time lapse complicates the process of translating the sheqel value of a transaction into an ECU value. For instance, suppose that firm A sells some merchandise to firm B for 100 sheqalim. Suppose, further, that when the merchandise is shipped and an invoice is issued, the rate of exchange between the sheqel and the ECU is NIS 1 = ECU 1. Hence, at this date firm A records a sale of 100 ECUs and debits the account of firm B by 100 ECUs. Suppose also that the terms of the sale allow firm B to pay for the merchandise within 30 days, a common trade practice. Suppose, further, that after 30 days, when the payment of 100 sheqalim is actually made, the rate of exchange between the sheqel and the ECU is NIS 1.25 = ECU 1. Thus, when firm B pays its bill, its account with firm A is credited for only 80 ECUs with a balance due of 20 ECUs, which is, of course, incorrect. Hence, an additional entry in firm A’s books is required: the value of sales should be lowered by 20 ECUs and firm B’s account should be credited with the same amount.7 (An analogous entry is also needed in firm B’s books.)

Recall that the period in question was the late 1970s up to the early 1980s when the use of personal computers was not widespread, and many small businesses still did their accounting manually. It was felt then that the method of dealing with the effects of inflation on taxable income by translating the sheqel value of every transaction into units of some stable currency would be too complicated to implement in practice. Hence, an alternative, much simpler, but indirect, method was adopted.

The main features of the new comprehensive law that was enacted in 1982 are quite simple: first, calculate income in nominal terms according to standard accounting procedures; then for each of the five effects of inflation enumerated in Section I, an adjustment is introduced that either directly removes that effect or ensures that it is offset by another one or more of these effects. Income, after these adjustments, will then reflect the true, real income of the firm, evaluated at end-of-year prices.

The following describes in more detail the adjustments that are needed. Consider first, items (4) and (5) of Section I. They relate to the fact that costs (of labor inputs, raw materials, and merchandise) are paid for some time before sales receipts are cashed in. These effects inflate nominal income because revenues are evaluated at prices that are inflated relative to the prices at which costs are evaluated. But there are now two possibilities: if the costs were financed by debt, then these two effects are offset by item (2) (that is, the deductibility of inflationary interest charges); if the costs were financed by equity, then these two effects are corrected for by the following adjustment, which puts equity on a par with debt.

(i) Allow a deduction equal to an imputed inflationary interest on equity (that is, a deduction that is equal to the amount of equity times the inflation rate).

Next, consider item (1) from Section I, the inclusion of inflationary capital gains in taxable income. When inflationary interest charges—both the genuine interest on debt and an imputed interest on equity—are tax deductible on an accrual basis, then it is correct to include inflationary capital gains in taxable income. Furthermore, these inflationary gains should be included on an accrual basis. Thus, the following adjustment has to be made.

(ii) Add inflationary capital gains accruing (even if not yet realized) on all fixed and other nonmonetary assets (that is, on all assets that appreciate in nominal terms during inflation). This means adding to nominal taxable income an amount that is equal to the book value of these assets times the inflation rate; upon realization of the capital gains, only their real component is taxed.8

Notice that once inflationary interest charges on both debt and equity are deducted from taxable income, then adjustment (ii) above should be applied also to business inventories. Specifically, recall that the cost of sales is defined as beginning-of-the-year inventory, plus new purchases during the year, minus end-of-year inventory. The latter should be evaluated at end-of-year prices, so as to include in taxable income the inflationary capital gains accruing to it.

Adjustments (i) and (ii) above fully correct for items (1), (2), (4), and (5) of Section I. The following adjustment must be made to correct for item (3), which is the historic cost depreciation.

(iii) Allow a depreciation that is evaluated at end-of-year prices.

These three adjustments to nominal income make it a true representation of real income, evaluated at end-of-year prices. In practice, (i) and (ii) were combined. Since (i) calls for a deduction equaling equity times the inflation rate, while (ii) calls for an addition to income, which is equal to fixed (and some other) assets times the inflation rate, then the net effect of (i) and (ii) is to allow a net deduction that is equal to

Notice that this net deduction may well be negative. It is referred to as “the deduction for the preservation of equity,” since it could be interpreted as a deduction aimed at protecting that part of the equity not invested in “inflation-proof” assets.

An alternative way to derive this formula is to employ the definition of real income of the firm as the difference between the firm’s net worth at the end of the year and its net worth at the beginning of the year, when both are evaluated at the same prices, say, end-of-year prices (see the Appendix).

IV. Loopholes and Exceptions

The preceding section described in a schematic way the basic features of the 1982 law. However, the actual implementation of these features was complicated by the emergence of some serious practical considerations, which are described below.

Equity may vary within any one tax year, since new equity may be issued and some old equity may be retired by paying dividends. Thus, according to adjustment (i) described in Section III, the firm has to keep track of the movements of equity within the tax year in order to be able to calculate the tax deduction to which it is entitled. Beginning-of-the-year equity, for instance, will be entitled to a deduction based on the annual rate of inflation (that is, from the beginning to the end of the year), whereas a new issuance of equity will be entitled to a deduction that is based on the rate of inflation only from the date of issuance of the new equity to the end of the year.

A similar caveat applies to fixed assets (as described in adjustment (ii) in Section III). Since one usually encounters only a few changes in equity or in the stock of fixed assets within a relatively short period of one year, the calculation of the deductions from and additions to income is fairly manageable. However, this is not usually the case with business inventories, which are normally fast moving and typically include an extremely large number of items. Hence, calculating the inflationary capital gains accruing to end-of-year inventories is not feasible and has therefore not been put into practice, even though it was one of the principles embodied in the 1982 law. The effect of this deviation from the rule has been to postpone the tax on inflationary capital gains on end-of-year inventories to the next year.9 A public committee recommended in 1985 that some accounting formula could be used to calculate the average holding period of inventories and, accordingly, adjust the value of the end-of-year inventories, but this recommendation was never adopted.

Industrial Equipment and Machinery

A second exception was granted to industrial equipment and machinery. Industry in Israel has traditionally been accorded favorable treatment via the tax-subsidy system, in the belief that such assistance is essential for long-term, export-led growth.10 Until 1986, for instance, the corporate income tax rate on industrial firms was substantially lower than on nonindustrial firms. Similarly, industrial firms are exempted from a general payroll tax.

Following this tradition, the 1982 law provided for the inflationary appreciation of industrial equipment and machinery to be exempted from tax until the date of realization, so as to encourage investments in these capital assets. As a partial offset for this tax relief, depreciation allowances for industrial equipment and machinery were not indexed.

The tax relief reduced the effective tax rates on income from industrial equipment and machinery and generated an overinvestment in them. The problem was that the magnitude of the decline in the effective tax rates depended on the rate of inflation: the higher is the rate of inflation, the lower are the effective tax rates. A method for determining the magnitude of the reduction was suggested by Sadka and Zigelman (1989), who adapted standard effective tax rate formulas (see, for instance, Auerbach (1983, 1987)) to the 1982 law and concluded that the effective tax rate(ti) on the income generated by asset i is given by

where MPKi is governed by the profit-maximization condition:

and where

  • MPKi = marginal product of asset i

  • t = statutory corporate tax rate

  • Di = physical depreciation of asset i

  • r = real rate of return required by equity holders

  • Zt = real present value of the depreciation allowances for asset i

  • Ui = real present value of the “equity preservation deduction” (see preceding section).

The interpretation of the above formulas is straightforward. The effective tax rate (ti) is the rate by which the before-tax marginal return to capital (MPKiDi) exceeds the real rate of return required by equity holders (r). The firm invests up to the point where the net-of-tax marginal product of capital equals the tax-adjusted cost of capital (Di + r). The tax-adjustment parameters are related to the depreciation allowances (Zi) and the equity preservation deduction (Ui).

Employing the above formulas, Table 1 presents the effect of inflation on the effective tax rates on income from industrial equipment and machinery (for t = 52 percent, which until 1986 was the statutory tax rate, and r = 4 percent). As the annual inflation rate rises from zero to 400 percent, the effective tax rates fall by about 12–15 percentage points.

Table 1.Effect of Inflation on Effective Tax Rates on Industrial Equipment and Machinery(t = 52 percent, r = 4 percent)
Inflation Rate
Asset0 percent400 percent
General industrial equipment28.916.5
Tools27.315.4
Special industrial equipment26.414.8
Construction equipment34.720.5

A reduction in effective tax rates as a response to a higher inflation rate introduces a built-in automatic destabilizer into the tax system, against the conventional wisdom of all public finance textbooks, which advocate fiscal automatic stabilizers. Indeed, the tax relief that was granted in 1982 to industrial equipment and machinery was abolished in 1985, when inflation in Israel reached its peak. Inflationary capital gains accruing to industrial equipment and machinery became taxable, and the depreciation allowances were indexed.

Proprietorships and Self-Employed Individuals

The 1982 law covered all corporations, but largely ignored the incomes of most proprietorships and self-employed persons (for example, small businesses, brokers, law firms, plumbers, accountants, and clinics), giving rise to the third loophole. Proprietorships were only somewhat restricted with respect to the amount of interest deductions they could claim. As a result, the 1982 law essentially created two tax sectors within the business sector: one to which the law did apply, which I shall call the indexed sector (mostly corporations); and one that escaped the provisions of the law, which I shall call the nonindexed sector (mostly proprietorships and self-employed individuals).

The nonindexed sector can maneuver the timing of its cash receipts and payments so as to deflate its taxable income and reduce its real tax liability. By advancing the date of the cash receipt for a certain real revenue, one can deflate nominal revenues. Similarly, by postponing the date of the cash payment for a certain real expense, one can inflate real tax liability.

A simple example can serve to illustrate this argument. Consider an individual whose real revenues, expenses, and net income, when measured in terms of a stable currency (say, the ECU), are as follows:

RevenuesECU 250,000
Expenses– ECU 150,000
Net incomeECU 100,000

Suppose that the annual inflation rate is 100 percent, so that prices double from the beginning to the end of the year. Thus, if the rate of exchange is NIS 1 = ECU 1 at the beginning of the year, it will be NIS 2 = ECU 1 at the end of the year. Suppose further that the individual is able to advance the receipt of revenues to the beginning of the year and postpone the payment of expenses until the end of the year. The statement of nominal income will then show the following entries:

RevenuesNIS 250,000
Expenses– NIS 300,000
Net income– NIS 50,000

Thus, through a few simple maneuvers, real income can be turned into a loss for tax purposes.

Notice that the validity of the above example rests on the ability of the individual to advance cash receipts or postpone cash payments or both. However, a receipt for one agent is also payment of another agent. Therefore, there should be other agents in the above example for whom payments of expenses were advanced and receipts of revenues were postponed. Would not the incomes of these agents be inflated and their real tax liabilities increased? The answer is not necessarily, since these agents could belong to the indexed sector and their real tax liabilities would not then be affected by the manipulations described in the example. Alternatively they could belong to the nontaxable, nonprofit sector, or the public sector, or they could be foreign residents, or final consumers—in any case, their liabilities would not be affected.

V. Wage Taxation: The Role of Withholding

Unlike taxpayers in the business sector, wage earners cannot maneuver with the indexed sector in order to reduce their real tax burden because of the withholding system. This system ensures that any manipulation of the timing of cash receipts for wages earned will have little, if any, effect on real tax payment.

A simple example will serve to illustrate this point. Consider, for the sake of simplifying the arithmetic, that the tax year consists of just two months. Suppose that in the first month the income tax schedule is

Month 1
Income BracketMarginal Tax Rate
0–1,000 sheqalim0 percent
Over 1,000 sheqalim30 percent

Suppose further that prices double between the first and the second month. With full indexation of the income tax brackets (as is the case in Israel), the income tax schedule in the second month would be

Month 2
Income BracketMarginal Tax Rate
0–2,000 sheqalim0 percent
Over 2,000 sheqalim30 percent

The income tax schedule is calculated for the annual tax returns by adding up the brackets for the various months. Thus, the annual tax schedule will be

Annual Schedule
Income BracketMarginal Tax Rate
0–3,000 sheqalim0 percent
Over 3,000 sheqalim30 percent

Consider an individual who earns a steady wage income of ECU 1,500 a month. Suppose also that the rate of exchange is NIS 1 = ECU 1 in the first month, and, consequently, NIS 2 = ECU 1 in the second month. Thus, the individual earns NIS 1,500 in the first month and NIS 3,000 in the second month. In the first month, the individual will be subject to a withholding tax of (NIS 1,500 – NIS 1,000) × 30 percent = NIS 150, which is worth ECU 150. In the second month, she will be subject to a withholding tax of (NIS 3,000-NIS 2,000) × 30 percent = NIS 300, which is worth ECU 150. Altogether, an amount NIS 450, or ECU 300, is withheld at the source. When this individual files a tax return at the end of the year, she will report an annual income of NIS 4,500, on which the tax liability is (NIS 4,500 – NIS 3,000) × 30 percent = NIS 450. The latter is also the amount that was withheld, and hence she will pay no further taxes. Real tax payment is therefore ECU 300.

Now, suppose the individual advances the receipt of her wage for the second month to the first month; that is, she receives her total annual wage of ECU 3,000, or NIS 3,000, in the first month. The amount of tax withheld will then be (NIS 3,000 – NIS 1,000) × 30 percent = NIS 600, which is worth ECU 600. When she files a tax return at the end of the year, she reports an annual income of NIS 3,000, on which the tax liability is zero. Therefore, she receives a refund of NIS 600, which is now worth only ECU 300. Hence, her real tax payment is ECU 600 – ECU 300 = ECU 300. This is also exactly what she paid when her income was spread evenly over the two months.

In the above example, the individual gained nothing by maneuvering the timing of her wage receipts. Although one may be able to devise an example in which some gain could occur, nevertheless, this example serves to show how withholding substantially curtails the gains from advancing wage receipts. When a wage receipt is advanced, the tax is withheld, thereby limiting the real gain that can be realized from such a maneuver.

VI. Consumption Tax Versus Income Tax with Inflation

The income (or direct) versus consumption (or indirect) tax controversy has been discussed at length in the literature (see, for example, Atkinson (1977)). Although this controversy can be addressed from several angles,11 I shall confine the discussion here to the relative performance of these two taxes in the presence of inflation.

As was seen above, the presence of inflation poses some serious complications in the definition of business income, but the consumption tax appears to be unaffected by these difficulties. This is why many economists and policymakers argue in favor of a consumption tax in a period of high inflation. Indeed, a consumption-type VAT performed remarkably well in Israel, even during the peak inflation period of 1984–85.

However, a consumption tax is usually levied at a flat rate. In a life-cycle model, or in a Ricardian world, the present value of consumption is equal to the present value of wages. Hence, a proportional consumption tax has the same equity implications as a proportional wage tax (that is, it is not progressive). In order to make the consumption tax more progressive, one could exempt from tax some necessities (such as food products, for example) and impose a higher tax rate on luxuries.12 This is indeed the practice followed in many European Community countries with respect to the VAT. Yet, it is highly questionable how much progression one can achieve through a three-tier VAT system (that is, a zero rate, a standard rate, and a luxury rate).

In order to strengthen the progression capacity of the consumption tax, the tax rate has to be tied to the total consumption of the individual (in the same way as the income tax rate depends on the total income of the individual). In other words, there should be a consumption tax schedule that is applied to the total consumption of each individual or household. Each individual would have to report her total consumption, which could only be done accurately by subtracting real personal saving from real personal income. For a typical wage earner, it presumably would not be difficult to calculate real personal income—real interest income, dividends, and real capital gains would be added to the wage income to yield real personal income. The corporate income tax would no longer be needed and would be abolished. But a self-employed individual or an owner of a small business (unincorporated) would still need to calculate real business income. Thus with this group of taxpayers, we are back to square one: how to define real business income in a period of high inflation. In addition, the problem arises of how to calculate real personal savings (that is, the real increase in net (of debt) wealth). A progressive consumption tax therefore is not necessarily an easy alternative to the progressive income tax in a period of high inflation.

Another alternative to the business income tax is a business cash flow tax (see King (1987)). This is a tax on the net cash flow a company receives from its real economic activities.13 It differs from the income tax, in that it grants immediate expensing (100 percent first-year depreciation allowances) to all forms of investments. This feature gives the cash flow tax an administrative advantage, since its implementation does not require a calculation of “true” or “economic” depreciation upon which to base depreciation allowances. After analyzing the positive implications of the cash flow tax for the efficiency of resource allocation, King (1987, p. 379) concluded: “It is attractive for a further reason, namely that the base of the tax requires no adjustment for inflation, and hence that the complicated indexation provisions for depreciation, for example, required under alternative corporate tax systems are unnecessary with a cash flow tax. … The tax eliminates the necessity of calculating ‘economic profit.’ Hence, there is no need to construct a true measure of depreciation or to make any adjustment for the effects of inflation.”

Obviously, with a cash flow tax that grants immediate expensing, the need for indexation provisions for depreciation vanishes. However, with a high inflation rate, other adjustments for inflation still need to be made in the tax base. When the inflation rate is sufficiently high (say, in the triple-digit range), the cumulative price increase within any single tax year, from the first months to the last months, is quite substantial. In such a case, one cannot simply subtract cash outflows from cash inflows in order to calculate the annual net cash flow of the firm, if the cash inflows were received at different points in time than the cash outflows were paid, even though both flows occurred within the same tax year. Thus, cash flows have to be indexed in calculating the annual net cash flow of the firm. Alternatively, the tax period can be shortened from one year to one month. (In fact, the idea of a cash flow tax on a monthly basis was briefly considered in Israel in 1984, but the time was not yet ripe for such a tax “revolution.”) A big advantage of the cash flow tax in this respect is that, unlike the income tax, it does not require the calculation of depreciation allowances or a complicated evaluation of business inventories (especially inventories of unfinished goods in the production process). Hence, a monthly cash flow tax would not be excessively costly to administer.

However, the monthly net cash flow of the firm varies considerably over time; often, it may be negative. (For example, one would certainly expect a negative net cash flow in a month in which the firm makes a major investment.) Therefore, it is essential for the smooth functioning of the monthly cash flow tax either to grant a full tax rebate in case the net cash flow is negative or to allow net negative cash flows to be carried forward with full indexation and real interest.

The cash flow tax deserves serious consideration as an alternative to the business income tax. In addition to its “fiscal neutrality” advantage over the standard income tax, it may also perform more effectively in a period of high inflation.

APPENDIX Alternate Derivation of Real Income

In Section III the real income of the firm, evaluated at end-of-year prices, was shown to be equal to nominal income adjusted by the formula given on p. 144, “the deduction for the preservation of equity,” and by an indexation differential on depreciation. This Appendix provides an alternative, but equivalent, definition of real income via the balance sheet of the firm.

If no new equity is issued within the tax year and no dividends are distributed, then the real change in the firm’s net worth is equal to its real income. Thus, real income, evaluated at end-of-year prices, is equal to end-of-year net worth, evaluated at end-of-year prices, less beginning-of-the-year net worth, also evaluated at end-of-year prices.

If the firm neither purchases nor sells any fixed asset during the year, then its nominal balance sheets at the beginning and the end of the year will typically appear as follows (a “0” subscript stands for the beginning of the year and a “1” subscript stands for the end of the year).

Beginning of the Year
AssetsEquity and Liabilities
FAE
NNA0L0
End of the Year
AssetsEquity and Liabilities
FA – DE
NNAiNI
L1

where

  • FA = fixed assets at historic (that is, beginning-of-the-year) prices

  • NNA = net nominal (nonindexed) assets. These may include, for example, cash, checking accounts, and balances due from clients (less balances due to suppliers)

  • E = equity at historic prices

  • L = long-term indexed liabilities at current prices

  • NI = nominal income

  • D = depreciation at historic prices.

Notice that

and

Suppose that the price level rises from the beginning to the end of the year at the rate π. Then, the beginning-of-the-year net worth of the firm, evaluated at end-of-year prices is

Similarly, the end-of-the-year net worth of the firm, evaluated at end-of-the-year prices is

Hence, the real income of the firm, evaluated at end-of-year prices is obtained by subtracting (3) from (4):

Employing (1) and (2), equation (5) reduces to

Rearranging terms, equation (6) becomes

Notice that (E – FA)π is the deduction for the preservation of equity that is given by the formula in Section III. The term Dπ is the indexation differential on depreciation. Thus, equation (7) suggests that real income is indeed equal to nominal income, adjusted by the deduction for the preservation of equity and by an indexation differential on depreciation. A similar formula is proposed by Harberger (1988), but he understated the difficulties involved in the evaluation of business inventories, especially unfinished goods in the production process (see also equation (9) in Tanzi (1981)).

REFERENCES

    AtkinsonAnthony B.“Optimal Taxation and the Direct versus Indirect Tax Controversy,”Canadian Journal of EconomicsVol. 10 (November1977) pp. 590606.

    AtkinsonAnthony B. and AgnarSandmo“Welfare Implications of the Taxation of Savings,”Economic JournalVol. 90 (September1980) pp. 52949.

    AuerbachAlan J.“Taxation, Corporate Financial Policy and the Cost of Capital,”Journal of Economic LiteratureVol. 21 (September1983) pp. 90540.

    AuerbachAlan J.“Corporate Taxation in the United States” in Economic Policy in Theory and Practiceed. byAssafRazin and EfraimSadka (London: Macmillan1987).

    BaileyMartin J.“The Welfare Cost of Inflationary Finance,”Journal of Political EconomyVol. 64 (April1956) pp. 93110.

    BalcerYves and EfraimSadka“Budget Share and Optimal Commodity Taxes Without Computation,”Economics LettersVol. 7No. 3 (1981) pp. 26571.

    Casanegra de Jantscher Milka“Taxing Business Profits during Inflation: The Latin American Experience,”International Tax Journal (1976) pp. 12846.

    DeatonAngus S.“Equity, Efficiency, and the Structure of Indirect Taxation,”Journal of Public EconomicsVol. 8 (December1977) pp. 299312.

    EcksteinZvi and LeonardoLeiderman“Estimating an Intertemporal Model of Consumption, Money Demand, and Seigniorage” (unpublished; Foerder Institute for Economic Research, Tel Aviv University1989).

    FischerStanley“Towards an Understanding of the Costs of Inflation: II,”Carnegie-Rochester Series on Public PolicyVol. 15 (1981) pp. 542.

    FischerStanley“Seigniorage and the Case for a National Money,”Journal of Political EconomyVol. 90 (April1982) pp. 295313.

    FischerStanley and FrancoModigliani“Towards an Understanding of the Real Effects and Costs of Inflation,”Weltwirtschaftliches Arciv 114No. 4 (1978) pp. 81033.

    FriedmanMilton“The Optimal Quantity of Money” in his The Optimum Quantity of Money: and Other Essays (Chicago: Aldine Publishing Co.1969).

    HalperinDaniel and EugeneSteuerle“Indexing the Tax System for Inflation” in Uneasy Compromise: Problems of a Hybrid Income-Consumption Taxed. byHenryJ. AaronHarveyGalper and JosephA. Pechman (Washington: The Brookings Institution1988).

    HarbergerArnold C.“Comments on Indexing the Tax System for Inflation,”in Uneasy Compromise: Problems of a Hybrid Income-Consumption Taxed. byHenryJ. AaronHarveyGalper and JosephA. Pechman (Washington: The Brookings Institution1988) pp. 38083.

    HelpmanElhanan and EfraimSadka“Optimal Financing of the Government’s Budget: Taxes, Bonds or Money,”American Economic ReviewVol. 69(1) (March1979) pp. 15260.

    KayJ.A.“Inflation Accounting—A Review Article,”The Economic JournalVol. 87 (June1977) pp. 30011.

    KingMervyn A.“The Cash Flow Corporate Income Tax” in The Effects of Taxation on Capital Accumulationed. byMartinS. FeldsteinUniversity of Chicago Press1987.

    OliveraJulio H.G.“Money, Prices and Fiscal Lags: A Note on the Dynamics of Inflation,”Quarterly Review Banca Nazionale del LavoroVol. 20 (September1967) pp. 25867.

    PhelpsEdmund S.“Inflation in the Theory of Public Finance,”Swedish Journal of EconomicsVol. 75 (March1973) pp. 6782.

    SadkaEfraim and AviZigelman“Income Taxation in the Industrial Sector” Economic Quarterly (1990).

    SadkaEfraim and AviZigelman“Inflation and Effective Tax Rates in the Industrial Sector,”Bank of Israel Economic ReviewVol. 64 (1990) pp. 7182.

    TanziVito“Inflation, Lags in Collection, and the Real Value of Tax Revenue,”Staff PapersInternational Monetary FundVol. 24 (March1977) pp. 15467.

    TanziVito“Inflation, Real Tax Revenue, and the Case for Inflationary Finance: Theory with an Application to Argentina,”International Monetary FundStaff PapersVol. 25 (September1978) pp. 41751.

    TanziVito“Inflation Accounting and the Taxation of Capital Gains of Business Enterprises” in Reforms of Tax Systems: Proceedings of the 35th Congress of the International Institute of Public Financeed. byKarlW. Roskamp and FrancescoForte (Detroit: Wayne State University Press1981).

See also Fischer (1982) for a study of other countries where the inflation tax revenues seem a bit higher.

Tanzi (1977) credits Olivera (1967) for first contemplating the possibility that inflation may lead to a decline in real tax revenues.

See Casanegra de Jantscher (1976) for a description of the early Latin American experience.

These indexation differentials, which are tax deductible for the borrower, would, in principle, be taxable income for the lender. However, in the Israeli case, where major segments of the capital market are effectively nationalized, the lender is very often the Government itself, so there would be no taxable lender that would pay the tax that the borrower saved.

It is worth noting that the Israeli tax laws are generally very generous with respect to capital gains accruing to individuals, even when they are real gains. For instance, securities traded on the stock exchange are exempted, as is residential housing (even if not owner-occupied) under some (not significantly restrictive) conditions.

These restrictions applied to interest charges that could be attributed to the financing of tax-exempt government bonds and other securities.

This example could be further complicated by supposing that firm B’s payment is made by check, which takes a few more days to clear.

Notice that in view of the adjustments to income discussed in this section, dividends represent real income.

It should be pointed out that using the last-in-first-out (LIFO) method (rather than the first-in-first-out (FIFO) method) for evaluating end-of-year inventories would only increase the disparity, because the LIFO method deflates rather than inflates the monetary value of end-of-year inventories.

Of course, most academic economists in Israel do not approve of favorable treatment for one sector of the economy.

Atkinson and Sandmo (1980), for example, point out that the income tax causes both intra- and intertemporal distortions, whereas the consumption tax causes only intertemporal distortions—the so-called double-taxation-of-savings argument.

For the theoretical foundation of this result see Deaton (1977) and Balcer and Sadka (1981).

In order for the cash flow tax to have the same effect as the consumption tax, interest payments should still qualify as a deduction if interest income is taxed at the individual level; otherwise, the firm and the individual will be using different rates of discount—the firm’s rate of discount will be the pretax rate of interest, while the individual’s discount rate will be the after-tax rate of interest. Such a divergence between the firm’s rate and the individual’s rate causes an intertemporal inefficiency of resource allocation.

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