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Taxation and the Environment

Environmental Economics Seminar Series
Department of the Environment, Sport and Territories
March 1996
ISBN 0 642 24878 8

Taxation and the Landcare Program

Deborah Peterson
Australian Bureau of Agricultural and Resource Economics

Introduction

In a recent ABARE survey of broadacre and dairy farms, more than 60 per cent of all respondents indicated that they had a significant land degradation problem on their farms. Regional patterns to the distribution of these perceived problems can be seen in Maps 1 and 2. In some areas, more than 80 per cent of farms in the region indicated they perceived a significant problem, while in other regions the percentage was much less. Overall, most respondents said the problems on their farms were getting worse.

Costs of land degradation include lost agricultural production, environmental damage, cost to infrastructure and so on. There are many estimates of these costs around, and a fair degree of uncertainty associated with them. But whatever the exact figure, the consistent story is that the magnitude is quite large.

With this in mind, ABARE was commissioned by the Department of Primary Industries and Energy to undertake an evaluation of existing land care and taxation arrangements. The review is to consider the appropriateness, efficiency and effectiveness of current provisions, and to consider alternative means of financial assistance. This forum, along with presentations at Outlook 95 and the Rural Income Taxation Forum, held recently in Perth, are means of obtaining public comment and feedback on the direction of the review.

Here I wish to focus on the tax provisions which are directly aimed at land and water problems - that is, sections 75B and 75D of the Income Tax Assessment Act (1936). The review takes a broader perspective and considers both tax and non-tax means of providing assistance.

In this talk I want to look at the role the income tax system might play in the prevention and treatment of land degradation. First, I will consider modification of the design of the land care provisions in the Income Tax Assessment Act to meet commonly accepted design criteria while also furthering land care objectives. Second, I will consider the case for specific tax measures to meet land care objectives through deviations from a 'neutral' taxation system.

In the course of this discussion, I will make some comparisons of different kinds of tax provisions - rebates, deductions, tax credits - with direct subsidies. I will not be covering non-tax options, apart from direct subsidies, but it is important not to forget that there is a range of instruments available to achieve policy goals, including direct regulation or tax penalties rather than subsidies.

Sections 75B and 75D

The current taxation provisions for land care are summarised in Box 1. Both sections 75B and 75D are provisions which essentially allow accelerated depreciation of various types of capital expenditure associated with land degradation and water management.

Section 75B covers water conservation and conveyancing. It allows deductions over three years on items such as dams, water storage tanks, bores and irrigation channels. Section 75B is clearly applicable to activities that are much broader than those associated with land care. In some circumstances these activities may be even contrary to land care objectives - for example, when an expansion of irrigation contributes to increased salinisation, or when installation of watering points results in increased stocking rates.

image: map 1

map of Proportion of farms with a perceived land degradation problem

image: map 2

Most commonly perceived land degradation problem

BOX 1 Taxation provisions for land care

MAP 2 - Most commonly perceived land degradation problem: Broadacre and dairy farms, 1992-93
Section 75B Under section 75B primary producers may deduct costs of capital expenditure (including plant and articles) over a three year period where the expenditure is incurred primarily and principally for the purpose of conserving or conveying water.

Section 75D An outright (100 per cent) deduction for expenditure on certain capital works designed to prevent or combat land degradation on rural land is permitted under section 75D. Those eligible are primary producers and other taxpayers who carry on a business (other than mining or quarrying) for the purpose of gaining or producing assessable income from the use of any rural land in Australia .

Section 75D allows immediate write-off of capital expenditure used to prevent and treat land degradation. Examples include capital expenditure on pest or weed control; planting shrubs and trees to control soil salinity; soil conservation earthworks such as contour banks; and fencing to exclude livestock from eroded areas or to separate different land classes.

Only primary producers are eligible for deductions under section 75B, but section 75D has been extended to include other taxpayers earning income from the use of rural land for purposes other than primary production, mining and quarrying. For example, horse riding schools and other rural recreational pursuits may use the provisions of section 75D. However, a car wrecker's yard may not - even if it is on rural land. That is because the use of the land and the land's rural character must be an inherent and integral part of the business.

The role of the tax system

I turn now to the role of the tax system in land care. As I mentioned earlier, I will be following a two-tiered approach here. First, I will argue that the provisions for depreciation over the economic life of structural improvements to land might be justified as more accurately reflecting Treasury's benchmark tax base, and that this element of the current tax provisions should not be viewed as concessional.

Second, I will argue that provision for depreciation faster than the economic life of the asset may be viewed as an attempt to correct some form of market failure. But I will also note that the current accelerated depreciation provisions do not do a very good job of this and that it is far from clear that the tax system is the best way to try to correct market failures.

Tax policy distinguishes between wasting and non-wasting assets. Wasting assets are those which depreciate in value as they are used. Non-wasting assets either retain their value indefinitely, or change in value as a result of changes in market forces. Land is traditionally considered a non -wasting asset.

Ideally, to accord with Treasury's accepted benchmark tax base, outgoings would be allocated to different taxation periods based on whether those outgoings have actually been used up during the assessment period. However, the general provision for depreciation in the Income Tax Assessment Act - section 54 - is very limited. It only allows depreciation for a narrow class of capital items - that is, plant and articles.

There are some statutory extensions to this provision, in particular section 54(2) which allows, among other things, depreciation of fences, dams and other structural improvements on farmland. Without such extensions, expenditure on capital items that are neither plant nor articles could not be depreciated, and hence income assessed as taxable would be larger than net economic gain.

Sections 75B and 75D can be thought of as extending the deduction for capital expenses beyond those items eligible for the depreciation deduction in section 54. Without section 75B, many of the items currently claimed under that section could be claimed under section 54, but at a slower rate. However, items involving improvements to land for the purposes of water storage, conservation or conveyancing such as laser levelling of land would not be deductible. In the absence of section 75D, fencing could be depreciated by primary producers under section 54, but over a longer time period. Expenditure on structural improvements to land for the prevention and treatment of land degradation such as filling erosion gullies could not be depreciated without section 75D. Likewise, without section 75D, capital expenditure on trees and shrubs planted primarily and principally to prevent or control land degradation could not be depreciated.

Capital expenditures on wasting assets used to produce income for which no revenue or capital deductions are allowed are known as 'black hole expenditures'. Black hole expenditures can be viewed as distortions which are inherent in the income tax system (if you accept the benchmark tax base). They have economic costs because investment items qualifying for deductions will be favoured over investments which do not qualify, thus breaching the efficiency criterion. As noted in the Draft White Paper on tax reform, any tax tends to discourage the activity on which it is imposed, hence efficiency is enhanced by adoption of a comprehensive tax base.

To the extent that sections 75B and 75D remove a black hole, you can argue that these provisions are not concessional. I am not talking here about the acceleration component of the provisions, just about provision of deductions over the economic life of the asset - or, for that matter, provision of a deduction at a rate applicable to other deductions if general acceleration is allowed.

Similarly, you could argue for removing a black hole expenditure for other taxpayers carrying on a business and for income-producing activities on non-rural land on the grounds that removing a black hole for some taxpayers and not for others also leads to a distortion of relative returns.

However, an obvious problem with such extensions and, indeed, with any proposal to remove any black hole expenditure, is the cost to revenue. Nevertheless, the point is that there is an element of sections 75B and 75D which can be argued to be not concessionary, thus Treasury's tax expenditure statements are likely to be overstated as they do not take this into account.

Off-site effects of externalities

I move now to the subsidy element of these provisions. Why provide a subsidy for land care expenditure? The usual efficiency argument for government intervention is the existence of market failure where high transaction costs or ill-defined property rights pose a barrier to collective action and where the costs of government action are likely to be exceeded by the benefits.

One frequently noted form of market failure associated with land degradation - although it is not the only one - has to do with off-site effects of externalities. Many types of land degradation problems do not recognise farm boundaries. For example, dryland salinity might be the result of previous decades of tree clearing on farms in an upper part of a catchment area. The salt-affected areas lose their vegetation cover. Then you might get stock coming in and trampling on the bare land and an erosion problem emerges. The effects may be felt by farms in the lower catchment area as well as by water users whose water has been contaminated by the soil salinity or the erosion run-off.

A recent ABARE study by Suzanne Wilson looked at the on-site versus off-site costs of dryland salinity in the Kyeamba Valley in southern NSW. Suzanne found that off-site costs, such as decline in water quality and damage to community infrastructure, amounted to 96 per cent of the total costs. In other words, a farmer contributing to a salinity problem in that area, say by clearing trees on their own property, bears only four per cent of the costs on average, while others in the vicinity bear 96 per cent of the costs.

It is important to remember that the proportion of on-site versus off-site costs varies by the type of land degradation and also by location of the property. For example, woody weeds affect a large proportion of the rangelands area, but most of the costs of woody weed invasion are borne by the individual landholder. Soil acidity is another type of land degradation which is mainly on-site rather than off-site.

The problem with deductions

The current tax arrangements do not discriminate between land degradation measures which have large off-site effects and those which have primarily on-site effects. Rather, they discriminate between taxpayers with high and low marginal tax rates. This is because the current provisions are structured as deductions. As you are aware, people with higher taxable incomes face higher marginal tax rates. The higher the marginal tax rate, the higher the benefit from the deduction.

In other words, if your marginal tax rate is 47 per cent, a tax deduction of $100 is worth $47 to you. But if your marginal tax rate is only 20 per cent, then the deduction is worth only $20. Taxpayers who do not pay any tax in the year of expenditure get no immediate benefit from the deduction. However, if the deduction adds to a loss, taxpayers can carry forward the loss and maybe get some benefit in the future if taxable income goes up again. Taxpayers whose income before any deduction is always below the tax free threshold never receive any benefit from tax deductions.

Most farmers pay tax under the income averaging scheme, where tax rates are calculated with reference to the average of current income and that of the preceding four years. With income averaging, the benefit of any tax deduction is spread over a five year period. In the broadacre sector, recent ABARE estimates indicate that around 85 per cent of broadacre family farm operators and spouses use income averaging. The proportion of broadacre family farm operators and spouses in various marginal tax brackets in 1992-93 is shown in Figure 1. These estimates assume that all farmers use income averaging.

The large majority of these individuals were estimated to be in the lower income tax brackets with lower marginal tax rates. Only about seven per cent of broadacre farmers are estimated to have had effective marginal tax rates above 35.5 per cent. Just over a quarter are estimated to have paid no tax at all in 1992-93 and thus would have obtained no immediate benefit from a deduction.

image: figure 1

Distribution of estimated marginal tax rates

The current provisions provide the greatest benefit to those in higher marginal income brackets and provide no immediate benefit for those not paying tax. As can be seen in Figure 1, the latter category encompasses a sizeable proportion of the farm population.

The key problem with using deductions to address land degradation problems is the link between the marginal tax rate and the level of benefit offered. There is no reason to presume that a land degradation problem occurring on the land of a farmer with higher taxable income has any greater external costs than the degradation problem that occurs on the land of a farmer with lower taxable income.

A further concern is that the concessionary deductions may provide incentives to treat land degradation problems which do not generate any off farm costs. The associated efficiency losses may further reduce the net benefits to society from using this form of intervention. In addition, concessionary deductions apply only to land care activities which require expenditures. They have no effect on the level of incentive to undertake the wide range of land care activities which do not involve expenditures, such as reducing stocking rates in times of drought. Activities such as these are, however, being promoted under different government initiatives such as property management planning.

Alternative solutions

Is there anything better? Within the income tax system rebates are one possibility. A rebate is a reduction in tax paid, as opposed to a reduction in taxable income. A rebate of $100 is worth $100, no matter what your marginal tax rate might be. Unlike deductions, the value of a rebate is received in the year of claiming: income averaging does not defer some of the benefit.

However, a rebate is far from perfect. People who do not pay tax, say, because of low taxable income or because of accumulated losses, get no benefit from rebates. And, unlike deductions, rebates cannot be used to add to a loss to be carried forward for use in other years. So if a rebate cannot be used in the year of expenditure, it is forfeited. It is a 'use it or lose it' situation.

In theory it might be possible to distinguish between expenditures which have high external benefits and those with low external benefits with a rebate system. But in practice you cannot go very far down that route. First, there are measurement problems. As noted earlier, the size of the external benefits varies according to the type of land degradation and the region. Second, and perhaps more importantly, the Commonwealth is constitutionally constrained against making tax laws which vary by state or by regions within states. So, for example, the tax system could not target a salinity problem specifically in Yass, but can target salinity generally.

Another option sometimes raised is that of tax credits. In the Income Tax Assessment Act tax credits are an allowance for taxes already paid by the taxpayer. For example, you might get a tax credit if you have paid foreign income tax. In general, tax credits, like rebates, cannot exceed tax payable and cannot be carried forward.

The obvious suggestion is to be to design a new instrument which has the properties of a rebate but can be carried forward. This would allow benefits independent of marginal tax rates for all eligible individuals, irrespective of whether or not they pay tax in a given year. This would also allow taxpayers currently not paying tax to receive benefits sometime in the future when they return to paying tax. Another possibility would be to allow a choice between a rebate and a deduction. One can think of various combinations. But the Treasury has fairly consistently opposed establishing new precedents in income taxation.

One problem with tax concessions are that they are less visible than direct outlays, and may therefore be less accountable. The problem of respondent burden for the revenue authorities means that they are unable to collect specific data on the use of each of the myriad concessions in the Income Tax Assessment Act. Although the Treasury has published the Tax Expenditure Statement since 1986, no detailed reporting is provided and there is no statutory requirement for this publication. Similarly, although the Australian Tax Office publishes a limited range of statistics on specific items, the coverage is far from complete. For example, some information is available on claims made under section 75D, but no information is collected on claims under section 75B.

Since tax concessions are necessarily open-ended, the government has no direct means of controlling the year to year amount of public funds spent through these concessions. This may result in unanticipated costs to revenue. The level of incentive can be varied from year to year, but only in a 'trial and error' approach.

ABARE survey data indicate that one of the main reasons why broadacre and dairy farmers with a land degradation problem do not undertake land care expenditure is cash flow constraints (see Table 1). This will not surprise those who have some farming background, but it does say something about the effectiveness of tax measures versus direct subsidies. A tax concession does not give any cash flow benefit until tax liabilities are due, which is often a year or more after the event. If cash flow problems are a major reason why farmers are not undertaking land care expenditure, then direct subsidies might be more appropriate.

An alternative to providing subsidies through the tax system is a direct subsidy. Direct subsidies can be targeted much more effectively than taxation concessions, but they require individual application, assessment and auditing and are thus more expensive to administer. The administration costs of tax concessions are relatively low: the infrastructure is already in place in the tax system to collect the taxes, an accounting system is there and no application forms or assessment panels are needed. So by using existing infrastructure, a tax concession can be delivered relatively cheaply. However, as noted earlier, the tax system is relatively poor at targeting. There is a direct trade off between the ability to target, control and account for expenditures and the costs of administration.

Deductions, rebates and credits

We used the ABARE survey data of land care expenditures claimed under section 75D in 1992-93 to compare the distributional impacts of tax deductions, rebates and credits ( Table 2). This analysis uses only one year of data and hence excludes the effect of income averaging and carry forward of losses. Average intended claims by broadacre farmers under section 75D in 1992-93 are shown in Table 2. As can be seen in this table, the size of intended claim varies by taxable income group.

Savings provided under the current provision are also shown in Table 2. Clearly taxpayers with higher taxable income receive more tax savings from the current provisions than taxpayers with lower taxable incomes.

The level of rebate analysed here - 31 per cent - was chosen to give approximately the same total amount of savings to taxpayers as indicated by intended claims under the current section 75D.

Under both section 75D and the 31 per cent rebate option, no tax savings are made in the year of expenditure by taxpayers who have taxable income less than the tax free threshold. Forfeited rebates arise when rebates exceed tax payable.

A tax credit, being an allowance for tax already paid, would provide the same savings as for a rebate (if both were set at the same level).

As can be seen from this table, the current provision clearly provides the greatest level of benefit to higher taxable income. Under a rebate or tax credit system, the level of benefit is more evenly distributed across different levels of taxable income. Deductions, rebates and credits alike offer no benefit for those not currently paying tax.

TABLE 1 - Main reason for not making expenditure on land care: broadacre and dairy industries, 1993-94p

FIGURE 1 - Distribution of estimated marginal tax rates, 199293 for broadacre family farm operators and spouses




Low cash availability
Intend to make land care related expenditure in coming years
No time, no labour
Higher priority investments
Made changes to farm management not requiring expenditure
Other

p Preliminary estimates
a Excluding farms which never had a land care problem, or had already dealt with the problem

Farms with no
expenditure
a
Per cent

50
18
11
8
2
12

Conclusions

To conclude, I emphasise the following points:

Land degradation is a serious and growing problem on much of Australia's rural land.

The provisions of sections 75B and 75D of the Income Tax Assessment Act seek to target the prevention and treatment of land degradation.

It is important to distinguish between the two aspects of these provisions: the first aspect is the provision of economic life depreciation of wasting assets; and the second is the subsidy component of the provisions.

Without 75B and 75D, capital expenditures on structural improvements to land for water conservation and storage or for prevention and treatment of land degradation could not be deducted.

Allowing depreciation over the life of the asset may be thought of as removing what would otherwise be a 'black hole' in the income tax system.

A case for accelerated depreciation may be made on the existence of large off-site effects associated with some forms of land degradation, and might be thought of in terms of providing a Pigouvian subsidy directed at correcting this market failure.

The current tax measures do not do a particularly good job of targeting this market failure. The size of the benefit from a deduction is dependent on the marginal tax rate, not on the size of the external benefit.

image: table 2

Rebates are a possibility. They are independent of the individual marginal tax rates, but they have the disadvantage of 'if you don't use, you lose it'. Rebates could be crudely tailored to the size of external benefits.

Tax concessions do not do much to help short-term cash flow problems. They are less visible and less accountable than direct subsidies and there are no direct means of control. However, against this must be set administration costs.

Optimal policy may well require a mix of solutions, rather than only one. A critical element of policy design is to ensure that the aims and goals of policy instruments are complementary rather than in conflict.

References

Commonwealth of Australia 1985, Draft White Paper on the Reform of the Australian Tax System, AGPS, Canberra, June 1985.

Douglas, R.; Peterson, D.; Kokic, P.; and Parameswaran, B. 1995, 'A note on accelerated depreciation and investment allowances', in Rural Income Taxation, Proceedings of the Rural Income Taxation Forum, Perth, 13 February 1995, Australian Tax Research Foundation Conference Series No. 15, ATRF, Sydney, pp.119-34.

Grivas, J.; Moon, L; Mues, C.; Peterson, D.; and Toussaint, E. 1995, 'The land care taxation provisions some issues', ABARE paper presented at the National Agricultural and Resource Outlook Conference, Canberra, 7 - 9 February 1995.

Wilson, S. 1993, 'Formulating cost efficient salinity management plans: a case study in Kyeamba Valley' , paper presented at the National Conference of Land Management for Dryland Salinity Control, Bendigo, Victoria, 28 September - 1 October 1993.

Peterson, D. 1995, 'Role of taxation in the prevention and treatment', paper presented at the Rural Income Taxation Forum, Perth, 13 February 1995, Australian Tax Research Foundation Conference Series No. 15, pp.103-10.

TABLE 2 Estimated tax savings under Section 75D and under a rebate provision: Average per broadacre family farm operator and spouse, 1992-93 dollars p
MAP 1 - Proportion of farms with a perceived land degradation problem: Broadacre and dairy farms, 1992-93
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