Australia's Future Tax System

Final Report: Detailed Analysis

Chapter A: Personal taxation

A1. Personal income tax

A1–2 Income from work and deductions

Key points

A broad definition of taxable income is both fair and efficient. Income from work should be taxed on a more consistent basis, whether it comes from wages and salaries, fringe benefits or superannuation contributions. Tax exemptions should not apply to income from work.

Fringe benefits that are readily valued and attributable to individual employees should be taxed in the hands of employees. To ease compliance costs for employers, valuation and apportionment methodologies should be simplified, and the scope of fringe benefits streamlined.

Arrangements to prevent the transfer or alienation of income arising from work are important to the integrity of the tax system, and should be improved.

Earned income that is subject to taxation should continue to be net of the costs required to earn that income, although those costs should be more tightly defined as those necessary to producing the income. A standard deduction should be introduced to cover work-related expenses and the costs of managing tax affairs for most taxpayers, although individuals with high expenses should continue to be able to claim all expenses with full substantiation.

The consistent taxation of income from work is fundamental to a fair and efficient tax system, ensuring that people with the same level of earned income are treated similarly, regardless of how they are paid, their occupation, or their employment status. Treating different forms of earned income in a similar way for tax purposes avoids creating incentives for people to structure their income purely for the sake of minimising their tax.

For employees, remuneration comprises three main elements:

  • wages and salaries, which are generally taxed according to the personal income tax rates scale, although some forms of wages and salary are tax-exempt;
  • employer superannuation contributions, which are included in the taxable income of the fund, and are subject to 15 per cent tax; and
  • fringe benefits (non-cash benefits in the form of free or discounted goods and services provided by an employer to an employee), which are taxed in the employer's hands at the top marginal tax rate. In 2007–08, around 1.5 million employees received fringe benefits, such as cars and housing.

For self-employed people, some profits from their self-employment or business also represent labour income.

Some forms of income are neither from work nor from savings — most notably transfer payments. Income support and supplementary payments replace or supplement wage and salary income.

The costs associated with producing income are deductible for tax purposes. For employees, this takes the form of a deduction for work-related expenses; for self-employed people, a deduction for expenses necessarily incurred in operating a business. The costs of managing tax affairs are claimed by large numbers of people with earned income, as well as those with savings and investment income. Other allowable deductions include gifts to deductible gift recipients.

Various kinds of income are exempt from tax. Some of these are income from work, including certain forms of foreign and Defence force income. Some are not directly from work but have similar characteristics. These include superannuation benefits from a taxed source for people aged 60 or more, government transfer payments (of which some but not all are exempt), and government scholarships. Others are unlike work income, such as one-off bonuses from government and lump sum damages payments.

Principles

All income from work should be taxed consistently. This includes wages and salaries, fringe benefits (where they are a direct substitute for salary and wages), employer superannuation contributions, and the returns from self-employment.

Tax exemptions should not apply to income from work.

Employee income

Employee income most commonly takes the form of wages and salary, which are taxed through the personal income tax rates scale. A general principle of the income tax system is that amounts derived from employment or as a reward for services should be taxable. However, some forms of income from work are specifically exempted from tax, giving rise to inequities between taxpayers.

Wage and salary tax exemptions

Wages and salary are generally subject to the personal income tax rates scale. However, some income from work is exempt from tax, giving rise to horizontal inequities between employees.

Employment-related exempt payments

Genuine redundancy payments, foreign termination payments and certain payments from approved early retirement schemes are exempt from income tax.

The tax free arrangements for termination payments affect horizontal equity, as individuals with the same total income have different tax liabilities and different entitlements for means tested government assistance. The subjective definitions for redundancy payments and certain payments from approved early retirement schemes also complicate the income tax law. The exemption of these payments is inconsistent with the tax treatment of other forms of work income. The definitions used to determine whether a termination payment qualifies for an exemption are opaque and subjective.

Foreign income and income of foreign residents

The worldwide income of Australian residents and the Australian-source income of foreign residents is generally taxable, subject to the obligations set out in Australia's bilateral tax treaties and other international agreements.

As a general rule, payments in respect of employment or that are rewards for service are treated as taxable income. However, an exemption applies to some payments to foreign experts and officials for service or advice they provide in Australia, or work they undertake in relation to certain Australian government projects.

Exempting payments for work on some overseas projects or for expert foreign advice creates horizontal inequities between individuals and is contrary to basic income tax principles. Exempting some payments for foreign employment from tax also has a cost to revenue. The revenue forgone as a result of the exemption of income of individuals employed on certain overseas projects is estimated at $520 million in 2008–09.

Defence and disciplined force payments

Members of disciplined forces such as the Australian Defence Force and the Australian Federal Police may receive taxation concessions on their income depending on the location of their duty and period of service. Defence force members serving on 'warlike' operations receive a full income tax exemption for pay and allowances earned while on deployment. Members serving on 'non-warlike' operations receive an exemption of pay and allowances earned while engaged in foreign service for a continuous period of not less than 91 days. Australian Federal Police deployed on International Deployment Group missions who are subject to Commander orders also receive this exemption. Further, supplementary remuneration for Defence force personnel such as deployment allowance and separation allowance are exempt from income tax.

The cost to revenue of exempting pay and allowances of Defence force personnel deployed on 'warlike' service is estimated at $120 million in 2008–09. The cost of the exemption for part-time Defence reservist pay and allowances is estimated at $40 million in 2008–09. Delivering these benefits as outlays would involve minimal net cost to the budget.

Finding

Wages and salary are generally taxed according to the personal income tax rates scale, but concessions apply to income in the form of superannuation and fringe benefits. A number of forms of remuneration from work are exempt from tax.

Reform directions — tax all forms of wages and salary consistently with minimal exemptions

Recommendation 8

All forms of wages and salary for Australian resident taxpayers should be taxable on an equivalent basis and without exemptions.

  1. Private education payments provided in respect of employment or as an incentive to undertake employment and employment-related payments should be assessed as income and taxed at marginal tax rates.
  2. The broad exemptions for foreign employment income should be removed and such income should be taxed at marginal tax rates.
  3. Defence and disciplined forces payments should be taxable and direct remuneration increased for affected personnel.

A simple and fair system would treat all forms of employee remuneration and related amounts in the same way, upholding the basic income tax rule that amounts derived from employment or as a reward for services are taxable. Pay and allowances for individuals working on government-approved overseas projects would be taxable in accordance with this principle. Pay and allowances of Defence and disciplined forces would also be taxed, with compensation provided through increases in direct remuneration.

All private education payments provided in respect of employment or as an incentive to undertake particular employment (such as bonded scholarships) should be taxable. However, government payments that are similar in nature to income support, such as scholarships or bursaries paid to a full-time student at a school, college or university, should be exempt from tax. This would align the tax treatment of these payments with that of income support. Taxing forms of remuneration that are currently exempt from tax may require employers and other bodies to make higher payments or individuals may receive lower disposable income.

Foreign-source employment income derived by an Australian resident and Australian-source employment income derived by a foreign resident should be taxable irrespective of whether the income is incurred on work for government or private entities, or for particular purposes. The tax status of payments for employment should not depend on whether the employer is government or non-government. If appropriate, compensation may be provided through direct remuneration.

Other exemptions from tax

A tax exemption is appropriate in some circumstances, although not for income from work. An exemption may be justified when payments are one-off in nature and not related to income-producing activities, such as compensation payments and personal injury awards, and government grants and one-off payments. An exemption may also be justified where double taxation would otherwise apply.

Superannuation contributions

Compulsory superannuation contributions are included in the taxable income of the fund, which is subject to 15 per cent tax. This concession means that there are distinct advantages to taking income in the form of superannuation, and these advantages are greater the higher the income of the recipient. The taxation arrangements for superannuation are discussed in detail in Section A2.

Fringe benefits

Fringe benefits tax (FBT) was introduced in 1986 and applies where non-cash benefits are provided by an employer to an employee — such as through the provision of free or discounted goods and services. In most cases, fringe benefits are provided as a substitute for salary and wages; however, in some cases, they are incidental to an individual's employment.

Table A1–3 shows the major categories of fringe benefits, which were collectively valued at $7.2 billion in 2007–08. The value of fringe benefits has risen sharply in recent years, particularly in relation to car parking benefits, housing benefits, and living away from home allowances.

Table A1–3: Taxable value of fringe benefits by type, 2007–08(a)

Type of fringe benefit Value ($m)
Expense payment(b) 3,827.9
Car benefit  
– statutory formula 1,624.3
– operating cost 147.3
Car parking 213.3
Property 147.9
Meal entertainment 416.2
Housing benefit 303.0
Living away from home allowance 90.6
Entertainment 43.3
Loan fringe benefit 28.1
Debt waiver 19.6
Board 5.4
Airline transport 1.8
Residual 319.3
TOTAL BENEFITS(c) 7,188.1
  1. Total FBT payable was $3,772 million in 2007–08.
  2. Expense payments arise where an employer reimburses an employee for expenses they incur, or pays a third party to meet expenses incurred by an employee. In either case, the expenses may be business expenses or private expenses, or a combination of the two.
  3. Totals may not add due to rounding.

Source: ATO (2009).

As Table A1–4 shows, Australia's fringe benefits tax system is complex, like those of many other countries. There are, however, some differences in the way in which Australia taxes fringe benefits. While the FBT system has the same broad tax base as other countries, it relies on a higher number of statutory valuation rules and a greater number of concessions and exemptions. The complexity of Australia's FBT system is exacerbated by the taxation of fringe benefits in the hands of employers, which has required the introduction of a large number of supplementary rules to ensure that fringe benefits are factored into means tests in the tax and transfer systems.

Table A1–4: International approaches to the taxation of fringe benefits

  Australia Canada Denmark Ireland Japan Netherlands New Zealand Spain Switzerland UK US
Incidence Employer Employee Employee Employee Employee Employee Employer Employee Employee Employee Employee
Valuation principles

Statutory rules and some use of market valuation

Fair market value

Statutory rules apply to certain fringe benefits such as cars, loans and housing

Market value

Statutory rules apply to certain fringe benefits such as cars, loans and housing

Cash equivalent value for benefits convertible into cash

Cost to the employer for benefits not convertible into cash

Statutory rules apply to certain fringe benefits such as cars, loans and housing

Cost to the employer

However, certain fringe benefits are valued using statutory rules

Economic value

However, certain fringe benefits are valued using statutory rules

Statutory rules are applied for four major classes of benefits

There is also a category of unclassified benefits where market value is applied to determine taxable value

Market value

Statutory rules apply to certain fringe benefits such as cars, loans and housing

Either cost to employer or market value

However, specific valuation rules exist for particular benefits such as cars and loans

Cash equivalent value (or cost to the employer)

Statutory rules apply to certain fringe benefits such as cars, loans and housing

For low-income employees benefits are valued at actual cash sale value

Fair market value

Base Broad Broad Broad Broad Broad Broad Broad Broad Broad Broad Broad
Concessions and exemptions Exemptions and concessions narrow base considerably Exemptions and concessions narrow base considerably Few exemptions and concessions apply Few exemptions and concessions apply Few exemptions and concessions apply Few exemptions and concessions apply Few exemptions and concessions apply Few exemptions and concessions apply Few exemptions and concessions apply Exemptions and concessions narrow base considerably Exemptions and concessions narrow base considerably

In looking at the FBT system, the Review has considered narrowing the fringe benefits tax base and instead denying deductions for employers. While this approach would be simpler, it would also give rise to significant integrity and equity issues.

There is scope to reform the legal incidence of FBT, valuation methodologies and concessions and exemptions in a way that would reduce compliance costs for employers and employees and would deliver greater neutrality in the treatment of cash and non-cash remuneration.

Legal incidence

Most OECD countries either tax fringe benefits in the hands of employees, or align fringe benefits taxation with the employee's personal income tax rate.

In Australia, FBT is paid by employers (including government employers) at the top personal income tax rate plus the Medicare levy (currently 46.5 per cent), irrespective of the income of the employee receiving the fringe benefit. Submissions express concern that the application of the top marginal rate is inequitable, as employees ultimately bear the economic incidence of FBT. In 2007–08, less than 12 per cent of employees with reportable fringe benefits were in the top marginal tax bracket (even accounting for the value of their fringe benefits).

The value of reportable fringe benefits is included on an employee's payment summary on a 'grossed-up' basis — that is, the value of the fringe benefit is increased to reflect the value of income tax (at the top personal rate) that would be paid if the fringe benefit were purchased out of the employee's after-tax income.

Means tests in the tax system generally take account of the grossed-up value of fringe benefits; however, as Box A1–1 indicates, means tested transfers generally reflect the net or 'cash' value of fringe benefits (with the exception of the income test to assess child support liability).

Box A1–1: Fringe benefits and transfer payments

The 2006–07 Budget announced that the grossed-up value of fringe benefits would be included in the means test for family assistance payments from 1 July 2008. The Government reversed this measure on 19 June 2008, citing concerns over the implications for employees in the not-for-profit (NFP) sector.

As many NFP organisations are eligible for FBT concessions, employees in the NFP sector are more likely to receive their income as fringe benefits. Further, these employees often receive lower wages (and are hence taxed at lower rates) given the charitable nature of their work.

This issue was explicitly referred to the Review for consideration.

Finding

The current FBT arrangements are inequitable as they apply the top marginal tax rate regardless of the income of the recipient employee.

Valuation and reporting arrangements

The current approach to valuing fringe benefits is to use market value in some cases, complemented by a large number of statutory valuation methodologies. Submissions from business have expressed concern that these methodologies are highly complex, particularly in relation to meal entertainment. One submission claimed that a business meal can potentially be valued in 39 different ways for FBT purposes.

In some cases, any one of a number of methodologies may be used to value a single benefit. Generally, all the methodologies deliver broadly similar results. For example, property fringe benefits can be assessed in five different ways, all of which seek to proxy market value. Nonetheless, anecdotal evidence suggests that employers calculate the value of a fringe benefit using all available methodologies and then choose the lowest valuation. This results in unnecessary compliance costs. Table A1–5 shows that the compliance costs for FBT are significantly larger than those for other taxes (measured in terms of the costs of compliance relative to the amount of tax paid). These compliance costs are exacerbated by the need for employers to apportion the value of shared fringe benefits between employees (such as where several employees attend a business lunch).

Table A1–5: Compliance surtax(a)

  Mean (%) Median (%)
Income tax 1.6 0.9
Payroll tax 0.7 0.2
Fringe benefits tax 7.6 4.8
Overall 2.9 1.2
  1. The compliance surtax measures the costs of compliance for each tax relative to the amount of the tax paid. For example, an organisation that incurs $2 in compliance costs for every $100 it pays in GST would face a compliance surtax of 2 per cent for GST.

Source: PricewaterhouseCoopers (2009).

Concessions and exemptions

Market value is not applied as broadly as it could be, due to the volume of fringe benefits that receive concessional or exempt treatment. Many of these concessions and exemptions have a historical basis that is no longer relevant. For example, the concession applied to the living away from home allowance has evolved to encompass expenses that are essentially private in nature. This has led to inequities in employee remuneration.

The FBT concessions and exemptions have a significant impact on the FBT base. In 2008–09, FBT concessions and exemptions were estimated at $3.3 billion (Treasury 2009), while FBT revenue collections amounted to $3.6 billion.8

Not-for-profit organisations

Fringe benefits received by employees of certain NFP organisations attract concessional FBT treatment. For example, public benevolent institutions and health promotion charities receive a $30,000 capped exemption from FBT per employee — that is, the first $30,000 of fringe benefits received by each employee is exempt from FBT. Public and not-for-profit hospitals and public ambulance services receive a $17,000 capped exemption. Meal entertainment expenses, entertainment facility leasing expenses, and car parking expenses do not count towards the caps. Anecdotal evidence suggests that the benefits of these concessions are shared between employers and employees (although the benefits are more likely to accrue to employees).

In addition, certain not-for-profit, non-government bodies are eligible for a 48 per cent rebate of FBT that would otherwise be payable. The rebate applies to the first $30,000 worth of benefits per employee and reflects the fact that these employers do not benefit from tax deductibility for the cost of fringe benefits. In general, the rebate applies to religious institutions, not-for-profit scientific or educational institutions, charitable institutions, schools, trade unions, and associations of employers or employees. The rebate also applies to not-for-profit societies, organisations, and clubs that are exempt from income tax.

Submissions to the Review have expressed concern that the FBT concessions for NFP organisations result in horizontal inequity, as they are not equally accessible by all employees. For example, one submission notes that the FBT arrangements favour nurses in public and not-for-profit hospitals, even though they provide identical or similar services to their private hospital counterparts. Public and NFP hospitals argue that the concessions have a 'profound' impact on their ability to attract and retain staff and are a highly sensitive factor in their overall remuneration strategy.

Findings

Fringe benefit valuation and apportionment methodologies impose unnecessary compliance costs on employers and have embedded high levels of concessionality in the FBT system.

Most of the existing FBT concessions and exemptions have a historical basis that is no longer relevant. This has eroded the FBT tax base.

While the FBT concessions provided to certain NFP organisations help them deliver their services, they result in horizontal inequity and undermine the perceived integrity and fairness of the tax system.

Car fringe benefits

There are two approaches for determining the taxable value of car fringe benefits, the statutory formula and the operating cost method:

  • The statutory formula applies so that the taxable value of a car fringe benefit falls as total kilometres rise. At the margin, this may create an incentive for individuals to travel additional kilometres to reduce the taxable value of their car (particularly at the points at which the statutory fraction falls — 15,000, 25,000 and 40,000 kilometres) (see Chart 1–13). This increases pollution and road congestion.
  • Under the operating cost method, the actual operating costs of a car (for example, all car expenses, depreciation, registration, and insurance) are apportioned between business use and non-business use, as determined by a log book maintained over a 12-week period. The non-business portion of the operating costs is the value of the car fringe benefit. While the operating cost method provides a more accurate valuation than the statutory formula, it imposes a high compliance burden for users with low levels of business use.

Chart A1–13: Number of vehicles by kilometres travelled

(2007–08 fringe benefits tax (FBT) year)

Chart A1-13: Number of vehicles by kilometres travelled (2007–08 fringe benefits tax (FBT) year)

Source: Based on SG fleet submission to the 2009 Review of Australia's Automotive Industry, as cited in the AFTS submission of the Federal Chamber of Automotive Industries.

Finding

The existing statutory formula for valuing car fringe benefits applies a reduced taxable value the further a vehicle is driven. At the margin, this may encourage individuals to travel unnecessary kilometres.

Reform directions — treat reportable fringe benefits like salary and wages

Recommendation 9

Fringe benefits that are readily valued and attributable to individual employees should be taxed in the hands of employees through the PAYG system. Other fringe benefits, including those incidental to an individual's employment, should remain taxed to employers at the top marginal rate (and non-reportable for employees). The scope of fringe benefits that are subject to tax should be simplified.

  1. Market value should generally be used to value fringe benefits (with an appropriate adjustment for employee contributions).
  2. The current formula for valuing car fringe benefits should be replaced with a single statutory rate of 20 per cent, regardless of the kilometres travelled.
  3. All fringe benefit tax (FBT) exemptions should be reviewed to determine their continuing appropriateness. To improve simplicity, consideration should also be given to excluding fringe benefits from tax where the costs of compliance outweigh equity and tax integrity considerations. The broad definition of fringe benefits in the FBT law could be reviewed to exclude essential workplace items such as chairs, stationery and toilets.
  4. For fringe benefits that are taxed in the hands of employers, a small de minimis threshold, below which fringe benefits are exempt from tax, should apply. The threshold could vary depending on the number of employees within an organisation.
  5. Not-for-profit entities' FBT concessions should be reconfigured (see Section B3). The FBT exemptions for members of the Defence force should be replaced with direct remuneration increases for affected personnel (see related Recommendation 8c).
Shift the legal incidence of reportable fringe benefits to employees

Fringe benefits that can readily be valued and assigned to a particular employee should be taxable in the employee's hands and reportable for transfer purposes. Other benefits that are incidental to an individual's employment or difficult to assign should be taxable to the employer at the top marginal tax rate (and be non-reportable for the employee for transfer purposes). The scope of fringe benefits that are subject to tax should be simplified.

This approach would provide a more neutral taxation of income, regardless of whether it is received as cash or fringe benefits. By removing the need for the current grossing-up process, it would also facilitate the consistent and equitable treatment of fringe benefits for means tested taxes and transfers (thereby addressing the issues raised in Box A1–1).

Under this approach, responsibility for valuing fringe benefits and including their taxable value on employee payment summaries would remain with employers. These tasks would be simplified through the proposed reforms to FBT valuation methodologies discussed below.

The transition to the new arrangements would require the renegotiation of remuneration packages for employees currently receiving fringe benefits. Collecting FBT fortnightly through the PAYG withholding schedules (rather than quarterly instalments) may require some level of smoothing to minimise fluctuations in tax payments. To facilitate these processes, a lead-in period of at least two years should be provided before any changes take effect.

Adopt greater usage of market valuation

To simplify the valuation of fringe benefits, market valuation should be more widely used.

Market value represents the amount an employee would need to spend to purchase the same fringe benefit in the market (rather than the cost to the employer of providing the benefit). For example, the cost of discounted travel supplied by a public transport provider to its employees would be measured not in terms of the marginal cost to the provider (which is almost zero), but the cost of the travel for members of the public.

Market valuation would reduce compliance costs and provide a clear outcome for employers. It would also facilitate a significant reduction in the volume of FBT legislation (around 400 pages), much of which describes valuation and apportionment methodologies.

Table A1–6 summarises the different approaches to valuation in the current system, and the proposed valuation framework.

In most cases, market value is readily identifiable (such as where an employer reimburses an employee for a holiday). However, to assist employers and ease compliance costs, market valuation could be supported through ATO guidelines. Unlike the valuation methodologies in the FBT law, the guidelines could be quickly and easily adjusted to changing circumstances. The ATO could also provide a ruling about the market value of a fringe benefit in less common cases.

Market valuation would require an appropriate adjustment to account for any employee contributions; for example, rent paid by an employee receiving a housing fringe benefit would be deducted from the market value of the benefit to determine its taxable value.

Table A1–6: Approaches to FBT valuation

Type of fringe benefit Current Proposed valuation framework
Expense payment Amount reimbursed or paid Market value(a)(b)(c)
Property Market value
Lowest selling price
Notional value
'Arms-length' purchase price
Discounted price
Housing benefit Market value
Loan fringe benefit Statutory formula
Airline transport Stand-by value of the transport (37.5 per cent of the lowest publicly advertised economy airfare for a domestic route, and 37.5 of the lowest published fare for an international route).
Residual Lowest 'arms-length' price charged to the public
Price that would reasonably be expected to be paid to receive the benefit
Operating cost or c/km method (for car motor vehicles)
Debt waiver Actual amount of debt released
(Meal) entertainment Could apply the rules applying to other categories as appropriate (giving rise to the 39 different ways of valuing meal entertainment referred to in one submission)
50/50 split method
12 week register method
Car parking Market value
Commercial parking station method
Average cost
12 week register method
Statutory value
Board Statutory formula ($2 per meal per person, or $1 if the person is aged under 12)

Car benefit

Statutory formula
Operating cost

Statutory formula(d)

  1. Subject to an integrity rule encompassing non-arms-length payments for expense payment fringe benefits.
  2. To assist employers with apportionment, substantiation rules for meal entertainment could be provided.
  3. The market value of car parking could be linked to the methodologies used by State and municipal governments for determining car parking levies.
  4. For car benefits, the operating cost method would be retained for individuals with exceptional circumstances surrounding the usage and costs of their vehicle.

Source: Fringe benefits tax: A guide for employers, ATO (2006).

Improve the operation of the statutory formula for car fringe benefits

While market valuation would be appropriate for most fringe benefits, a statutory formula for car fringe benefits should be retained to reduce compliance costs in the medium-term.

The Review has carefully considered a range of options to enhance the operation of the statutory formula, from increasing the number of gradations in the formula to basing the taxable value of a vehicle on its emissions rating. It favours replacing the statutory formula with a single statutory rate that would apply to the original cost of the car regardless of the distance travelled. This approach would provide a more neutral taxation treatment for employee remuneration by reducing the concessions available to those who can take their income as a private car benefit. It would also remove any incentive for individuals to drive unnecessary kilometres to access a lower FBT rate. Under this approach, the operating cost method would be retained.

Review the existing FBT exemptions

The existing FBT exemptions should be reviewed. Consideration should be given to exempting fringe benefits from tax where the costs of compliance outweigh equity and tax integrity considerations. The broad definition of fringe benefits in the FBT law could also be reviewed to exclude essential workplace items such as chairs, stationery and toilets.

The exemptions relating to not-for-profit organisations and the Australian Defence Force should be reconfigured.

As discussed in Section B3, all NFP FBT concessions should be phased out over 10 years, to be replaced with annual direct government funding.

The important contribution of Australians serving overseas is best recognised through direct salary and wages, rather than complex fringe benefits tax concessions and exemptions. Consistent with this principle, the existing exemptions should be replaced with direct remuneration increases for affected personnel. This would simplify the tax system, while still recognising the hardships that members face while serving in particular localities.

Introduce a single threshold for non-reportable fringe benefits

The existing FBT thresholds, encompassing the $300 exemption for minor benefits, the $1,000 exemption for in-house benefits, and the $2,000 exemption for reportable fringe benefits, should be removed.

Non-reportable fringe benefits should be subject to a small de minimis threshold, below which benefits would be exempt from tax. The threshold could vary depending on the number of employees within an organisation. It should be set at a level that encompasses minor benefits to reduce compliance costs for employers.

Income from self-employment

Income from self-employment is generally assessed on the same basis as income from employment. Aspects of the current income tax system may provide a favourable treatment to self-employment income. These include the retention of profits in a company to defer any additional personal income tax, the greater ability in practice to claim deductions for expenses (such as home office and travel expenses), and the greater ability to arrange income splitting.

Some self-employed people may also benefit from tax concessions applying to capital gains (the general 50 per cent capital gains discount), or small business capital gains (the small business capital gains tax concessions) and measures designed to reduce small business compliance costs (under the small business tax framework).

The capital gains discount and concessions can be particularly beneficial. For many business owners, their personal effort and investment of capital is rewarded through the appreciating value of their business and its assets. This is most common in businesses that can create valuable intangible assets such as business goodwill, customer lists and brand names, or other businesses with appreciating tangible assets such as land.

For these self-employed people, and their businesses, the capital gains tax arrangements provide two advantages. First, taxation is deferred until the gain is realised, and, secondly, the amount of the gain taxed on realisation is significantly discounted. As a consequence, while 100 per cent of an employee's income is generally taxed as it is earned, income from self-employment may not be taxed until later and then only in small part. For example, on the sale of goodwill that benefits from the general and active assets discounts, only 25 per cent of the gain would be taxable.

Favourable treatment of self-employment income over income from salaried employment may give rise to efficiency or equity concerns, depending on the ultimate effects of that treatment. A tax that applies only to employees' wages creates incentives for people to shift from being employees to being self-employed and operating their own business.

To the extent that the burden of a tax on employment is spread to all workers, there is an efficiency cost because the allocation of labour in the economy is biased by the tax or because compliance costs are increased by efforts to artificially characterise wages as income from self-employment. To the extent that the burden of the tax is not spread, there may be equity concerns as a self-employed person on a given income pays less tax than an employed person on the same income.

Alienation of personal services income

Specific rules target the alienation of personal services income to a partnership, trust or company. The rules are effectively aimed at personal services income (income from working) earned by people in employee-like cases (such as dependent contractors). The rules are designed to prevent income splitting and the deferral of tax. They also act to ensure that deductions relating to such alienated income are limited to those available to employees.

While these specific rules have had some effect, their scope is generally limited to employee-like cases, compliance is poor, they are complex and a good deal of uncertainty remains around their operation (Board of Taxation 2009).

For personal services income arising in other cases (as well as cases covered by the specific rules above), general provisions and anti-avoidance rules are used to limit the alienation of income attributable to the efforts or exertion of a person. This includes alienation achieved both through the interposition of an entity like a partnership or trust, and through payments to associates (such as relatives who provide some services, or the use of service trusts by professional partnerships). Enforcement of these provisions and rules can be difficult and uncertain.

Findings

Some self-employed people can benefit from a relatively favourable tax outcome compared to an employee undertaking similar work.

Current rules limit, but do not eliminate, the scope for the alienation or assignment of an individual's earned income to other people or legal entities. These rules are not fully effective, and are complex and uncertain.

Reform directions — limit the alienation of personal services income

Recommendation 10

Consideration should be given to a revised regime to prevent the alienation of personal services income that would extend to all entities earning a significant proportion of their business income from the personal services of their owner-managers, whether in employee-like or non-employee-like cases. This regime may also apply an arm's length rule to deductions arising from payments to associates to ensure deductions reflect the value of services provided.

Effective rules are required to deal with the alienation of income arising from a person's work and the possibility of income splitting or tax deferral. The ability to alienate such income undermines the individual basis of taxation and the overall progressivity of the personal income tax system. It also means that some taxpayers may be advantaged over others and poses a risk that labour and other resources will be misallocated as people move to occupations or forms of employment more suited to alienation.

A major failing with the current approach is that it attempts to distinguish between personal services income arising in employee-like cases and other personal services income, when in either case alienation or income splitting is inconsistent with the choice of the individual as the unit of taxation and with progressive income tax rates.

Consistent with an option raised in the Board of Taxation's recent post-implementation review of the alienation of personal services income rules, consideration could be given to a revised regime that would extend to all entities earning a significant part of their income from the personal services of their owner-managers, including personal services businesses (Board of Taxation 2009).

The focus would be on personal services income in general, and not on whether the income was derived by the taxpayer acting in, say, an employee-like capacity. Personal services income, as now, could be defined as income that is mainly a reward for personal exertion. Alternatively, the rules could be more explicitly aimed at closely-held entities where a set proportion of the business income of the entity arises from the efforts of owner-managers.

Such a revised regime, like the existing rules, would not apply to businesses with significant assets, as a significant proportion of the profits of such businesses include a return on investment and savings, rather than earned income.

Income splitting opportunities could also be further limited by applying an arm's length rule to deductions arising from payments to associates, to ensure deductions reflect the value of services provided.

Such approaches could provide a more effective constraint on the alienation of earned income, while simplifying the law and making administration easier (Board of Taxation 2009). It would also temper the additional incentives to alienate earned income to a company that may arise from any future reduction in the company income tax rate (see Section B1).

Deductions

Tax deductions are allowed for a range of expenses. Beyond those associated with earning income, deductions are available for the cost of managing tax affairs, and for gifts to deductible gift recipients. Deductions for deriving income from savings are discussed in the following section.

The costs of earning income

The personal income tax system allows deductions for the costs incurred in producing income. In the case of employee income, this entails the deductibility of work-related expenses, including expenses for self-education associated with earning income. For self-employed people, this entails the deductibility of expenses incurred in producing their assessable income, and expenses necessarily incurred in carrying on their business to produce income.

These deductions are consistent with the Schanz-Haig-Simons definition of income, under which income represents the increase in a person's stock of assets in a period, plus their consumption in the period (with consumption including expenditure other than that incurred in producing income). There are important equity reasons for maintaining this approach; that is, it is fair to recognise that people with the same level of income may incur different costs in earning that income.

Principle

Earned income subject to taxation should be net of the costs directly incurred in earning that income. Work-related expenses should be clearly defined as those that are necessary to produce income.

Australia's tax system is relatively generous to work expense claims

Deductions for work-related expenses (WREs) are the most common claims among employees. In 2006–07, three quarters of net taxpayers claimed WREs for items including tools of trade, equipment, technical and trade books, travel, self-education and home office costs. Under specific statutory concessions, employees are able to claim certain other WREs such as uniforms and motor vehicle costs.9

WRE claims account for around 42 per cent of the value of all deductions claimed by individuals, or around $14 billion in 2006–07 (ATO 2009). Generally, the claimable amount is not capped, and the total claimed has grown substantially over time.

Most WREs are deductible for a taxpayer in a particular income year if the expense is incurred in the course of gaining or producing their assessable income and the expense is not 'private, domestic or capital' in nature. This provides taxpayers with a broad range of deductible expenses.

Compared to Australia, a number of countries that allow deductions for WREs do so only for a very limited and carefully prescribed set of expenses (see Box A1–2). In addition, the nexus between deductible expenses and income generation is much tighter than it is in Australia.

WRE deductions are intended to improve the equity of tax treatment between those who incur costs in producing their income and those who do not. By allowing deductions for these expenses, the existing framework seeks to treat income on net terms, because net inputs vary for different income producing activities. However, it is not clear that WRE deductions are necessary to maintain this type of equity. If they were no longer available it is likely that wages would rise or that expenses would be met by employers rather than employees (for example, Baldry 1998).

Box A1–2: International comparisons of deductions for WREs

Country Deductions for work‑related expenses Scope of deductions and arrangements
Australia Yes Incurred in gaining or producing an employee’s assessable income.
Canada Limited Only deductions specifically legislated are allowed, including accounting and legal fees.
Denmark Yes Wage or salary earners can fully deduct work‑related expenses from income, after a standard deduction has been applied.
Ireland Yes — narrow Expenses incurred wholly, exclusively and necessarily in the performance of duties.
Japan Limited Specific deductions that exceed the standard deduction for employment income are allowed. Specific deductions include travelling expenses.
Netherlands Yes — narrow Most work‑related expenses are not deductible; in limited circumstances exceptions apply for transport, education and home office expenses. There is an employed person's tax credit.
New Zealand No  No deductions for work‑related expenses for employees.
Spain No Expenses relating to employment are generally not deductible. Some exceptions include trade union / professional association fees and legal expenses on termination. Other allowances and a standard deduction are available.
Switzerland Yes — narrow Necessary work‑related expenses are deductible — 3 per cent of net income with a minimum and maximum deduction.
United Kingdom Yes — narrow Most claimable expenses must be incurred wholly, exclusively and necessarily in the performance of an employee’s duties, a condition that precludes the deduction of many employment‑related expenses.
United States Limited Employees can deduct work‑related expenses subject to limits (expenses generally only deductible to the extent they exceed 2 per cent of adjusted gross income). Taxpayers have the option of claiming a standard deduction in lieu of itemising deductions.

Source: Adapted and updated from International comparison of Australia's taxes released April 2006, OECD Taxing Wages 2007–08 and International Fiscal Database Documentation.

Most WREs, including car and self-education expenses, increase with income. Generally, WRE claims follow income, although uniform expenses remain flat (see Chart A1–14).

Chart A1–14: Mean work-related expense deductions by type, 2006–07

Chart A1–14: Mean work-related expense deductions by type, 2006–07

Source: Treasury calculations based on ATO (2009).

The law for WREs is complex (supported by numerous ATO decisions, determinations and rulings). While the general principles are simple, many tax rulings, court rulings and legislative provisions underpin their application. WREs impose a compliance burden on individuals and practitioners and add to administration costs for the ATO.

Under the current framework, there are significant difficulties in correctly quantifying work-related costs, in apportioning expenses between income-earning purposes and private purposes, and in defining and claiming the deductions. These complex arrangements constitute one of the impediments to further pre-filling of tax returns and, ultimately, removing the need to complete a tax return for a large number of employees.

There is a high degree of variation in WRE claims among individuals with identical occupations and income levels. This variability could be explained by: some taxpayers over-claiming (including expenses that might be private, domestic or capital in nature), given the limited ability of the ATO to audit WREs; some taxpayers interpreting expenses that are incurred in performing their job differently from other taxpayers (raising issues of complexity and transparency in the system); and differences in employer behaviour, where some employers pay for a particular type of expense while other employers do not.

In Canada, a country with a similar tax system and administrative arrangements to Australia, it is estimated that 10 to 15 per cent of WRE claims each year are invalid. If over-claims in Australia are of a similar order, this would equate to an over-claim of between $1.4 and $2.1 billion in 2006–07. While no tax system can achieve perfect compliance, the potential magnitude of non-compliance suggests that administrative solutions alone cannot address this issue (Highfield 2009).

Findings

The scope of work-related expenses for which a tax deduction can be claimed is broad by international standards.

Deductibility for work-related expenses adds a great deal of complexity to the personal income tax system and imposes high compliance costs on taxpayers.

The scope and number of claims significantly limits opportunities for fully automating the preparation of tax returns using pre-filling.

Deductions for the cost of managing tax affairs

The costs of managing their tax affairs are deductible to all taxpayers, whether they are business taxpayers, salary or wage earners, or investors.

This deduction is important in recognising the compliance costs imposed by government on individuals, and can be seen as one of the direct costs of the tax system.

Principle

The costs of managing tax affairs should be deductible in recognition of the compliance burden the tax system imposes on individuals.

Claims for managing tax affairs reflect complexity

Individual taxpayers can deduct expenses incurred in managing their income tax affairs (including complying with legal obligations). These expenses include costs incurred in preparing an income tax return (including travel and other incidental costs), the purchase of tax reference material, and the costs of objecting or appealing against an assessment or determination made by the Commissioner of Taxation.

Of the 11.8 million individuals who lodged a tax return in 2006–07, around three quarters used a tax agent. Approximately two thirds of these, or 5.3 million individuals, claimed a deduction for the cost of managing their tax affairs, totalling over $1.4 billion. The average deduction for these expenses was $206 for employees and $740 for investors.

Finding

The costs of managing tax affairs are widely claimed by individuals, reflecting the complexity of the system.

Reform directions — costs of earning income and managing tax affairs

Recommendation 11

A standard deduction should be introduced to cover work-related expenses and the cost of managing tax affairs to simplify personal tax for most taxpayers. Taxpayers should be able to choose either to take a standard deduction or to claim actual expenses where they are above the claims threshold, with full substantiation.

Recommendation 12

There should be a tighter nexus between the deductibility of the expense and its role in producing income.

A new test that better aligns income and work-related expenses

Under the current system an expense may be deductible as long as it is sufficiently related to earning income. The necessary link is considerably looser than in other countries. The current test adds to compliance costs, makes it hard to move to pre-filled (automated) tax returns, and expands the net of allowable expenses to such an extent that is it is difficult to check that expenses conform with the law.

Requiring a tighter link between an expense and gaining income would improve clarity for taxpayers on what they can deduct and would ensure that WREs and other deductions are well-targeted.

A new test that more strictly defines deductible expenses incurred in producing income should be introduced. This test could be similar to the approach taken in the United Kingdom, where a tax deduction for WREs is only available if the employee is obliged to incur and pay the expense as holder of the employment, and if the expense is incurred wholly, exclusively and necessarily in the performance of the duties of the employment. A tighter nexus should be consistent with the fringe benefit tax arrangements, to eliminate opportunities for arbitrage.

This approach would exclude some expenses that are claimed under Australia's current arrangements: expenses that are only loosely linked to generating income, to the extent that they are so used.

Standard deduction to simplify tax arrangements

Many taxpayers face legitimate expenses that are directly related to generating their income, including business income for individuals. Recognising legitimate expenses is important to ensure that employment and business activities that involve relatively high expenses are appropriately taxed relative to those that have few expenses.

However, the current arrangements for deductions, particularly for WREs, place a considerable compliance burden on many taxpayers. To simplify individuals' interaction with the tax system and to facilitate much more pre-filling of tax returns, an automatic standard deduction should be introduced.

Taxpayers would be provided with a standard deduction as part of their pre-filled tax return, unless their claim for WREs (excluding tuition fees that should be separately deductible) and for the cost of managing their tax affairs exceeds a claims threshold and they choose to claim their actual expenses with full substantiation. The standard deduction should be the default option. Taxpayers could opt out of the standard deduction and claim higher total expenses where these are above the claims threshold (see Chart A1–15).

The standard deduction would consist of:

  • a nominal base amount available to those with labour and/or capital (non-business) income who do not elect to claim itemised expenses (WREs, including some self-education expenses, and cost of managing tax affairs) above a minimum claim threshold; and
  • a proportion of labour-related income up to a capped amount (the claims threshold).

While the increasing value of the standard deduction would reflect the fact that expense claims rise with income, the value of the tax concession should ultimately be set so as to bring most taxpayers into the standard deduction. The level of the standard deduction would need to be set with regard to changes in the requirements for expense deductions.

Taxpayers with high expenses above the claims threshold would be able to claim expenses above the claims threshold with full substantiation (and subject to the new requirements for expense deductions).

Chart A1–15: Standard deduction increases with labour-related income

Chart A1–15: Standard deduction increases with labour-related income

An alternative approach would be to allow taxpayers to identify whether they wished to claim the standard deduction, or to claim all eligible expenses that meet the new substantiation requirements.

To bring as many taxpayers into the simplified system as possible, smaller capital-related deductions (excluding interest expenses) and the cost of managing tax affairs deduction should be incorporated into the standard deduction. However, consistent with current administrative arrangements, genuine and reasonable travel allowance expenses (including accommodation, food, and drink associated with working away from their ordinary residence) would not be include in a taxpayer's assessable income (or in the standard deduction). Consideration would need to be given to the interaction of the standard deduction and the proposed capital income discount.

Depending on the rate of the standard deduction and the claims threshold, a large number of individual taxpayers would no longer need to complete a detailed tax return. This would simplify the tax return lodgement process, and alleviate the compliance burden for many taxpayers.

Refine deductibility for self-education expenses associated with earning or producing income

Education and training is an essential part of human capital development and a significant contributor to economic outcomes for all Australians. It is essential that Australians have opportunities to train and study, both to enhance their skills for their current employment and to pursue new opportunities, particularly when structural change in the economy makes re-training essential for sustainable employment.

There is a role for the deductibility of self-education expenses to encourage further education and training. Tuition fees for education related to current employment should not be included in the standard deduction. Instead, these expenses should be deductible from the first dollar, with full substantiation.

To reduce complexity for taxpayers, other deductible self-education expenses (including travel expenses and educational materials) should be included in the standard deduction.

The Review has considered whether a taxpayer should be able to deduct education and training expenses that are not related to their current employment.

Extending deductibility in this way would be costly and difficult to administer. It would be challenging and inefficient for the administrators of the tax system to differentiate between (non-deductible) leisure activities, and (deductible) training that increases human capital. This risk would be reduced by ensuring that the tuition expense must be incurred in the generation of labour income with a sufficient link to employment. For this reason, financial support for people who want to build skills unrelated to their current employment should be delivered through direct transfers, not tax deductions.

Streamline the costs of managing tax affairs deduction to facilitate automated lodgement

The deduction for the cost of managing tax affairs can be attributed to the costs associated with generating both capital and labour income. As the deduction is claimed by a large number of taxpayers, rolling it into the standard deduction would simplify the taxpayers' experience of the tax system and facilitate tax return pre-filling. People whose income is solely derived from capital should have access to the base amount of the standard deduction.

The costs of managing tax affairs should continue to be separately deductible where the taxpayer's total expenses exceed their minimum claim threshold.

Deduction for gifts

Individuals and businesses support the activities of many not-for-profit (NFP) organisations, including through volunteering time and donating goods and services. Donations of money were valued at $8.9 billion in 2004 (FaHCSIA 2005).

The decision to donate money to a NFP organisation may be motivated by a range of factors, including altruism, the possibility of material gain, family or business tradition, social affiliation, values or beliefs, and humanitarianism. Submissions suggest that donations are also influenced by the tax concessions provided to certain NFP organisations. Donations over $2 are tax deductible if they are made to a deductible gift recipient (DGR).

In 2006–07, 36.3 per cent of individuals claimed a gift or contribution to a DGR as a deduction in their income tax return. Of these individuals, 82.5 per cent donated less than 1 per cent of their total income (ATO 2009).

Assessment

Gifts are a longstanding and important source of funding for the NFP sector, and are supported through gift deductibility.

While it is unclear how gift deductibility influences the amount individuals donate, it provides several benefits. It supports pluralism by giving individuals the opportunity to direct government expenditures to their preferred causes, provides transparency in the provision of government assistance, and is an administratively simple mechanism for both donors and the ATO (although donors incur some compliance costs from the requirement to hold receipts for audit purposes).

Findings

Gifts are an important source of funding for the NFP sector.

Gift deductibility supports pluralism, and is a transparent and administratively simple mechanism.

Reform direction — retain gift deductibility for donations to deductible gift recipients

Recommendation 13

Gift deductibility should be retained, with the deductibility threshold raised from $2 to $25.

The Review has investigated options to streamline the current arrangements, including replacing gift deductibility with a flat rebate that the donor could choose to assign to the NFP organisation. This approach has been successfully adopted in other jurisdictions, including New Zealand, the United Kingdom and the United States.

While a rebate would provide several benefits (including facilitating a more timely refund, lowering compliance costs through simplifying tax returns and addressing the vertical inequity of gift deductibility), it would also give rise to several integrity issues that require further detailed consideration (for example, ensuring individuals are not able to 'double dip' by claiming the rebate for themselves and assigning the rebate to the NFP organisation). Further, the impact of removing gift deductibility on philanthropy is unclear.

Given these concerns, the Review favours retaining gift deductibility, and raising the gift deductibility threshold to $25 per recipient organisation per income year. A higher threshold would reduce the reporting burden for donors who have to retain receipts to be entitled to the tax deduction, and for DGRs that need to issue a large number of receipts for small donations.

In 2007–08, tax deductions for donations to NFP organisations were valued at $1.8 billion. Of these, $16 million were claimed by people with total donations of $25 or less.

Other deductions

Over time, governments and the community have placed a high value on certain activities and projects — including standing for political elections, making additional superannuation contributions, investing in the Australian film industry, and investing in forestry — and have encouraged investment in them through tax deductions for individual taxpayers.

Deductions for these activities, can be claimed against labour or capital income. For example, election expenses incurred by candidates for any level of government are deductible although they may not be related to current income-earning activities and therefore would not be deductible under the general deduction provisions of the tax law.

Other deductions are available for investing in the Australian film industry and in forestry managed investment schemes. The cost of insurance premiums related to the loss of income, such as income protection, sickness and accident insurance premiums, is deductible under the general deduction provisions, because the premiums relate to the earning of assessable income.

A future review of the relevance and impact of these deductions could be undertaken.


8 The ratio of concessionality to revenue collections is underestimated due to the omission of many fringe benefits from quantification in the TES (for example, in-house childcare).

9 The statutory deduction for uniforms relates to non-compulsory uniforms — compulsory uniforms are deductible under the general provision. Motor vehicle expenses are deductible under the general provision but there are special statutory rules for valuing the expense incurred.