POTENTIAL EFFECTS OF SELECTED TAXATION PROVISIONS
ON THE ENVIRONMENT

Robert Douglas
Consultancy Report

 Commonwealth of Australia 2002
ISBN 		1 74037 094 5
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An appropriate citation for this paper is:
Douglas, R. 2002, Potential Effects of Selected Taxation Provisions on the Environment, Report to the Productivity Commission, Canberra.

The Productivity Commission
The Productivity Commission, an independent Commonwealth agency, is the Government’s principal review and advisory body on microeconomic policy and regulation. It conducts public inquiries and research into a broad range of economic and social issues affecting the welfare of Australians.
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Overview

Key points	
•	The design of the income tax and Goods and Services Tax regimes may influence private decisions to use land for conventional productive purposes compared to undertaking environmental management activities.
•	Some taxation arrangements may have potential impacts on the environment:
–	expenditure on certain environmental management activities is only deductible from income taxation if undertaken by a business, and this may discourage private environmental activities that are not conducted for profit;
–	the definition of ‘primary production’ generally excludes activities such as conservation of biodiversity. This may discourage primary producers from undertaking these activities if they think they are not eligible for primary producer-related tax deductions;
–	the definition of ‘Landcare’ is targeted at land degradation and generally excludes other activities, such as conservation of biodiversity. This may discourage primary producers and other natural resource-based businesses from undertaking such conservation activities as they are not eligible for ‘Landcare’ tax deductions; and
–	income taxation provisions for valuing the natural increase of livestock may encourage heavier stocking of land.
•	It is timely to explore these effects:
–	a broader-based assessment of current taxation arrangements would also need to consider net effects on taxation revenue, and the net environmental benefits from different policy responses;
–	taxation-based measures can assist environmental management, but are difficult to target to those environmental management projects with public benefits.
•	While the report makes a contribution to understanding how these taxes work, it makes no recommendations about how they might be changed.	

Overview
The income tax and Goods and Services Tax (GST) regimes and, in particular, the taxation provisions for primary producers, can have potential impacts (positive and/or negative) on the environment. This report identifies various taxation provisions that may have environmental consequences.
While the report makes a contribution to understanding how these taxes work, it makes no recommendations about how they might be changed. The report does not quantify the environmental impacts that it identifies, nor does it assess the revenue implications of any changes to tax arrangements. It also does not compare tax arrangements with alternative instruments that might be used to achieve environmental outcomes. These issues would all need to be considered as part of a broader-based assessment of the potential environmental impacts of taxation arrangements.
The primary role of the taxation system is to raise revenue to fund the general functions of government. A key objective of taxation policy is to enhance overall economic well being by increasing the efficiency of the taxation system, while promoting fairness, and continuing to raise sufficient revenue.
Taxation-based measures can be used to assist environmental management, but are difficult to target to those environmental management projects with public benefits. The consequence is that the revenue cost of taxation incentives can be high, compared to the marginal public benefits from the environmental management projects.
Tax bases and the environment
While income tax is a tax on net income derived over an assessment period, and the GST is a tax on private consumption, their tax bases have many similarities. As a rule, expenditure on the environment is not deductible from income tax, and is also subject to GST, unless it is related to the ‘earning or the production of income’ or a specific tax expenditure is introduced (such as a tax exemption, deduction or offset). As a result, the income tax and GST systems take limited account of potential impacts (positive and/or negative) of transactions on the environment. 
Tax systems are designed to tax monetary transactions and those transactions whose costs and benefits can easily be valued in monetary terms. The result is that non-monetary costs and benefits are not generally dealt with by tax systems — they are implicitly exempt from tax.
Income tax and the environment — general provisions
Expenditure on environmental activities will only be tax deductible to the extent that the activities constitute ‘a business’ — broadly defined as an activity undertaken on a regular basis with the expectation of making a financial profit. A business conducting environmental activities would be entitled to the same tax provisions as any other ordinary business, but not necessarily to the additional tax provisions available to industry sectors, such as primary production and mining.
The recent business tax reforms and changes to the tax system may impact on the environment in two main ways. First, the non-commercial loss provisions may affect the commencement of new environmental businesses. Second, the ‘small business’ capital gains tax changes may favour land use for profit compared to private environmental activities that are not conducted for profit.
If an environmental business were to receive a grant or a subsidy to carry out capital works, there may be a timing mismatch between taxing the grant as income, and allowing depreciation deductions for the expenditure. This mismatch could arise because grants or subsidies received by a business could be taxed as income in the year of receipt, while the expenditure may be depreciated over a number of years. If the expenditure had been deductible under the provisions relating to ‘Landcare’ and conveying and conserving water, different provisions would prevent the timing mismatch.
Environmental impact of tax provisions for primary producers
Landcare
The ‘Landcare’ taxation provisions provide an incentive for farming and other businesses conducted on rural land to undertake capital works to combat land degradation. ‘Landcare’ is narrowly defined, and does not cover expenditure in other environmental areas, such as the conservation of biodiversity. The ‘Landcare’ provision may provide tax deductions for eradicating or exterminating native animals as well as introduced species, and for the clearing of native vegetation and regrowth. 
Conveying and conserving water
The taxation provisions for conveying and conserving water may have variable and unintended environmental impacts. The provisions may provide assistance to primary producers to invest in technologies that allow for more intensive use of water, such as drip irrigation. However, the provisions may also provide assistance for investments in water infrastructure which may affect the environment, such as constructing irrigation dams in catchments with inadequate environmental flows.
Viticulture and horticulture
The investment incentives for horticulture and viticulture may have little environmental impact at farm level, as one agricultural activity is substituted for another (for example, a change from pastoral land use to viticulture). However, at an aggregate level, they may have a major impact on water flows in some catchments. The provisions, in combination with those for conserving and conveying water, may have partly encouraged the recent expansion in viticultural plantings. In most cases, these plantings have resulted in the substitution of irrigated activities for non-irrigated activities. As a result, there has been an increase in the number of on-farm dams designed to harvest water for irrigation purposes, with reduced flows in some catchments.
Valuation of livestock
The provisions for valuing and taxing the natural increase of livestock may lead to overstocking with potential impacts on the environment, and discourage tactical stocking rate responses to address the impacts of climate variability.
A simple case study: the impact of taxation provisions
A simple case study is used to examine the tax implications of using a farm in three different ways: exclusively for agricultural purposes; setting some land aside for private non-profit conservation purposes; and conducting an eco-business on part of the land. The case study shows that the taxation system may encourage the use of rural land for agriculture, and discourage private environmental activities that are not conducted for profit.
The aggregate impact of tax provisions for primary producers
Having examined the potential environmental impact of specific tax provisions for primary producers, there remains the question of the potential environmental impact of these provisions in aggregate.
Most of the tax provisions discussed tend to encourage investment in primary production-related activities. Some provisions, such as those relating to ‘Landcare’, conveying and conserving water, and viticulture, are explicitly designed to provide investment incentives. The tax deferrals associated with the provisions for livestock valuation, and small business capital gains tax concessions, may also provide an implicit investment incentive. 
One method of assessing if the tax system is providing investment incentives to the agricultural sector is to examine the amount of tax paid on income from agriculture.
The 1998-99 Taxation Statistics show that primary production is the only broad ‘small business’ industry grouping with negative net business income (-$354 million). In addition, primary producers who were listed in the ‘large business’ industry grouping had a net business loss of $9.6 million. Tax payers whose main source of income is other than primary production appeared to make substantial tax losses from primary production activities. The tax losses of these taxpayers may have a cyclical components associated with adverse climatic effects and commodity price cycles, but significant tax losses also occur in other tax years.
The tax losses of primary producers whose main occupation is not primary production means that there may be little net taxable income from, and hence net tax paid by, individuals involved in primary production overall. Further research may be needed to assess why little net tax appears to be paid on agricultural activities, and possible implications for the environment.

1	Introduction
In recent years, the impact of taxation arrangements on the environment and the potential use of taxation-based measures to assist environmental management have been considered by, among other bodies, Parliamentary Committees, the Commonwealth Government and environmental organisations. For example, the Commonwealth House of Representatives Standing Committee on Environment and Heritage (2001) recommended in its report Co-ordinating Catchment Management: 
Recommendation 24: The Committee recommends that the Government develop options for increasing the taxation incentives to participate in Landcare activities for landholders on low incomes.
Recommendation 25: The Committee recommends that the Government conduct a public inquiry into the disincentives for the ecologically sustainable use of Australia's landscape contained in the present taxation arrangements at all levels of government, and make recommendations for change, including costings.
The Commonwealth Government has progressively made changes to the taxation system to assist in conserving Australia’s environment and heritage. In October 2001, the Commonwealth Government further amended the tax deduction and capital gains tax (CGT) provisions of the tax law to provide additional incentives for conservation of biodiversity. The amendments provided for two types of tax concession:
•	an income tax deduction for any decrease in land value as a result of entering into a conservation covenant (provided the landowner receives no payment for entering into it); and
•	where a conservation covenant is entered into, CGT provisions will apply as if it were a sale or gift of the land.
More recently, the Australian Bush Heritage Fund, Greening Australia and Trust for Nature (Victoria), have released a discussion paper proposing a range of financial and taxation measures to encourage philanthropy to benefit the environment (Steering Group on Incentives for Private Conservation 2002).
The primary role of the taxation system is to raise revenue to fund the general functions of government. A key objective of taxation policy is to enhance overall economic well being by increasing the efficiency of the taxation system, while promoting fairness, and continuing to raise sufficient revenue.
In general, taxation provisions should neither advantage nor disadvantage one sector over another (Henry 1996). The use of taxation provisions that favour one sector or activity over another may create perverse incentives and unintended outcomes. Overall, the community may be worse off with the taxation provision, than without.
The use of taxation-based measures is one method of government intervention to assist environmental management — governments can also use market-based mechanisms and/or regulation. Taxation-based measures may provide additional support for environmental management projects where the private benefits are less than the overall cost of the project.
However, it can be difficult with taxation-based measures to target any incentive to environmental management projects with public benefits. Hence, the use of taxation measures may not be as efficient, or as cost-effective, as other approaches, such as targeted grants or regulation. At times, taxpayers may use the tax incentive for projects that will deliver the greatest private benefit, and not necessarily select projects with significant public benefits. The provision of a tax incentive for such a project would result in a ‘windfall gain’ to the taxpayer undertaking the project, when the project may have been undertaken anyway because of the private benefits. Further, the revenue cost of taxation incentives can be high compared to the marginal public benefits from the environmental management projects. In many cases, direct payments and grants can be more tightly targeted, allowing policy- makers to focus on those projects that deliver larger benefits to the community.
Just as caution needs to be exercised in considering new options for taxation incentives, so too is caution required in assessing proposals for winding back existing arrangements. The removal or reduction of specific taxation-based measures for primary producers may have positive environmental outcomes. However, an assessment of changes to the existing taxation arrangements would need to take into account the role of the taxation system, and the efficiency and effectiveness of taxation-based measures compared with other policy instruments.
1.1	Costs and benefits of inclusion of activities in the tax system
It is important to note that inclusion of an activity in the tax system (for example, primary production), has the dual impact of reducing both the net benefits received from the activity, and the net costs incurred in undertaking the activity. In effect, the tax system results in the community sharing financially both the costs and benefits of taxed activities.
If it is assumed that all the benefits and costs of an activity are financial and that there are no externalities, including an activity within the tax system will reduce the private net return from the activity if it is profitable, and increase the private net return if the costs exceed the benefits (ie reduce the private loss). The community will not only share in the gains from profitable activities, but in the losses from unprofitable activities. The corollary is that excluding an activity from the tax system will mean that the community will not share financially the costs and benefits of the activity. This may have the effect of increasing the financial costs of the untaxed activity, but it also results in untaxed benefits.
As a rule, it is undesirable for an activity to be subject to a ‘hybrid’ treatment, with either benefits being taxed with no allowance for costs, or allowing tax deductions for costs while income is exempt. Introducing a hybrid tax treatment that allows tax deductions for expenditure on improving the environment, without simultaneously attempting to tax environmental benefits, is likely to weaken the tax base.
However, few activities have exclusively financial benefits and costs, and externalities are common. Moreover, tax systems are designed to tax monetary transactions, and those transactions whose costs and benefits can easily be valued in monetary terms. The result is that non-monetary costs and benefits are not generally dealt with by tax systems — they are implicitly exempt from tax. This means that non-monetary benefits received, such as the use of a beach or the enjoyment of a vista, are not taxed. Similarly, it means that tax deductions are not allowed for expenditures that are unlikely to result in monetary gain.
Further, a large number of activities have either positive and/or negative externalities, which may result in costs and benefits to the community. Because these externalities may have no direct financial impact and may be difficult to measure, they also tend to be ignored by the tax system. 
Theoretically, it should be possible to further integrate positive and negative externalities into a tax system. From a practical viewpoint however, difficulties would exist in attempting to measure and value an externality. The administrative and compliance costs of such a system could be large, and may exceed the possible benefits. Consequently, it is probable that the tax system may not be best method of dealing with specific environmental management issues. 
1.2	Purpose of this report
The purpose of this report is to examine aspects of the income tax regime and identify provisions that may have potential impacts (positive and/or negative) on the environment. Where relevant, reference will also be made to the Goods and Services Tax (GST). The report will particularly focus on the taxation provisions for primary producers. There will also be a brief reference to the concessional application of state land taxes and local government rates to land used for primary production. This report will not attempt to quantify the potential impacts as that would involve a much larger study. 
While the report makes a contribution to understanding how these taxes work, it makes no recommendations about how they might be changed. The report does not quantify the environmental impacts that it identifies, nor does it assess the revenue implications of any changes to tax arrangements. It also does not compare tax arrangements with alternative instruments that might be used to achieve environmental outcomes. These issues would all need to be considered as part of a broader-based assessment of the potential environmental impacts of taxation arrangements.
This report complements the Productivity Commission’s paper Constraints on Private Conservation of Biodiversity (PC 2001) by providing a more detailed analysis of the tax provisions discussed in that paper. The Commission’s paper was written at a time of substantial change to the income tax system, particularly for capital gains tax (CGT) — it focussed on the tax law operating at the time it was written. One aim of this report is to update the Commission’s paper in light of the business tax reforms.
This report is divided into six chapters. Chapter 2 examines the treatment of the environment in the tax base — both the income tax and GST tax bases take limited account of potential environmental impacts (positive and/or negative). 
Chapter 3 describes the general income tax and GST provisions and their potential environmental impacts. It will be shown that environmental activities only receive tax benefits from income tax and GST when those activities are carried on by a business.
Chapter 4 examines tax provisions specific to primary producers, starting with the definitions of ‘a primary production business’ and ‘a Landcare operation’. Some environment-friendly activities undertaken by primary producers are excluded from both definitions. If the exclusion were to be applied strictly, this may provide an impediment to primary producers undertaking such activities. Other primary producer-specific tax provisions to be examined are:
•	investment incentives for conveying and conserving water;
•	investment incentives for viticulture and horticulture;
•	taxation of livestock;
•	livestock elections; and
•	GST on acquisition and sale of land.
Chapter 5 comprises a brief hypothetical case study. It examines the different tax implications that would follow from a decision to acquire two similar blocks of land, using one for primary production and the other for private conservation. The case study draws on the examples used in this report to show incentives to use land for primary production.
The final chapter examines the net amount of income tax paid on primary production income. It illustrates how taxpayers who describe their main occupation as primary production derive significant net income from primary production, but this is offset by the primary production losses of other taxpayers. It is probable that, in aggregate, individuals pay little tax a year on primary production income (after allowing for all income of trusts and partnerships to be distributed).
A Caveat. Taxation is an area where most terminology is strictly defined. As this report is aimed at a non-technical audience, the terms used are meant to take their ordinary meaning rather than that defined in a taxation provision, unless that term is italicised.

(1) (a) erecting a fence to separate different land classes on the land in accordance with an approved management plan for the land; or
     (b)	erecting a fence on the land primarily and principally for the purpose of excluding animals from an area affected by land degradation: 
	(i)	to prevent or limit extension or worsening of land degradation in the area; and
	(ii)	to help reclaim the area; or
      (c)	constructing a levee or a similar improvement on the land; or
      (d)	constructing drainage works on the land primarily and principally for the purpose of controlling salinity or assisting in drainage control; or
      (e) an operation primarily and principally for the purpose of: 
	(i)	eradicating or exterminating from the land animals that are pests; or
	(ii)	eradicating, exterminating or destroying plant growth detrimental to the land; or
	(iii) preventing or fighting land degradation (except by erecting fences on the 	land); 	or
      (f) an extension, alteration or addition to an asset described in paragraph (a), (b), (c) or (d) or an extension of an operation described in paragraph (e). 
(2) Paragraph (1)(d) does not apply to an operation draining swamp or low-lying land.
An omission from this definition is a reference to the conservation of biodiversity. The provision is more narrowly aimed at land degradation, and it is not clear that expenditure to promote biodiversity qualifies under this provision, as shown in example 6. 
Example 6: In example 3, a landowner fenced off a wetland. Would the fence be tax deductible under the ‘Landcare’ provisions? The deduction could be obtained indirectly if the landowner had an approved management plan that classified the wetland as a separate land class. However, there is no explicit provision providing tax deductions for fences erected to exclude animals from environmentally-sensitive areas.
Another issue is that paragraph (e) provides tax deductions for eradicating or exterminating native animals as well as introduced species. Furthermore, it appears that works that would merely exclude native animals from encroaching on farming activities would not qualify for a tax deduction under these provisions — see example 7.
Example 7: A landowner decides to plant a vineyard on grazing land. The landowner finds that kangaroos like grapevine leaves, and regularly strip all the leaves off the newly-planted grapevines. The landowner erects a high fence to exclude the kangaroos from the grapevines. The fence would not qualify for a tax deduction under the ‘Landcare’ provisions. However, the landowner could receive a tax deduction for capital works that eradicated or exterminated the ‘pests’.
A similar ambiguity arises with the provision relating to ‘destroying plant growth detrimental to the land’. It is possible that this provision could contribute to land clearing and removal of regrowth.
The original definition of ‘Landcare’ was written over 20 years ago, and focuses narrowly on land degradation. Consequently, many activities that may encourage biodiversity may not qualify for a tax deduction under existing provisions. Of course, any proposed change would need to be subject to a cost–benefit analysis. In addition, such a definition may be difficult to draft and administer.
Provisions for conserving and conveying water
Capital expenditure on conveying and conserving water can be deducted in three equal annual deductions of one-third of the expenditure. An alternative tax offset applied to expenditure incurred between 1 July 1997 and 30 June 2001. The tax offset of 30 per cent could be claimed over three years (eg, an offset or rebate of 10 per cent a year of the cost over three years).
The taxation provisions for conveying and conserving water may have variable and unintended environmental impacts. On the one hand, they may provide assistance to primary producers to invest in technologies that allow for more intensive use of water, such as drip irrigation. On the other hand, they also provide assistance to investments, such as the construction of irrigation dams, in catchments that have inadequate environmental flows.
Like the ‘Landcare’ provisions, the provisions for conserving water were introduced over 20 years ago. There may be a case for amending the provisions to ensure that assistance is not provided to projects that adversely affect the environment. However, as above, any definitional change may be difficult to draft and administer.
Other investment incentives
The ITAA contains several other investment incentives for capital expenditure in agriculture. Of these, the provisions relating to vineyards and horticultural plants are the most utilised. The incentives are provided by allowing tax deductions at an accelerated rate when compared to a benchmark of depreciation over an item’s effective life. 
The costs of planting grapevines can be deducted over four years from the date of planting (equivalent to a straight-line depreciation rate of 25 per cent). As grapevines can live for more than 100 years, write-off over four years is definitely accelerated. Some vineyards may have old vines; for example, the Tahbilk vineyard produces wine from grapevines planted in 1860.
The costs of establishing horticultural plants can be deducted over their estimated effective life, with the deductions commencing from the year of first commercial harvest. 
Irrigation expenses associated with establishing a vineyard or horticultural plants will normally be claimed under the provisions for conveying and conserving water (ie over three years).
These provisions may have little environmental impact at farm level, as one agricultural activity is substituted for another (for example, from pastoral land use to viticulture). However, at an aggregate level, they may have had an impact on water flows in many catchments. The provisions, in combination with those for conserving and conveying water, may have encouraged the recent expansion in viticultural plantings. In most cases, these plantings have meant the substitution of irrigated activities for non-irrigated activities. As a result, there has been an increase in the number of on-farm dams designed to harvest water for irrigation purposes. This has resulted in reduced flows in catchments. Both the New South Wales and Victorian State Governments have now regulated the construction of irrigation dams.
While the environmental impacts of these concessions are not conclusive, an important lesson is that investment incentives can potentially have negative environmental consequences which may take a number of years to manifest themselves. 
The tax savings from investment incentives
The tax provisions for ‘Landcare’, conveying and conserving water, viticulture and horticulture are designed to act as investment incentives. However, in most cases the value of incentive is not the amount of tax saved from the immediate deduction. This is because most of the expenditure would be deductible over longer periods of time under the depreciation provisions of the ITAA, as shown in example 8.
Example 8: In example 3, a landowner fenced off a wetland. Assuming the landowner was not entitled to claim an immediate tax deduction for the fence under the ‘Landcare’ provisions, the landowner could depreciate the fence.
It follows that the value of an investment incentive is the net present value (NPV) of the tax savings gained under the investment incentive compared to the NPV of the tax savings that were available under the depreciation provisions.
A further phenomenon of taxation is that providing immediate tax deductions may actually reduce the NPV of tax benefits received by individuals for larger investments. This phenomenon arises because of the progressive nature of the individual rate scale, as shown in example 9. 
Example 9: Assume a farmer who is not on the tax averaging system has a relatively constant income of $40 000 per year. The farmer undertakes a ‘Landcare’ project with a capital cost of $30 000 in the 2001 financial year.
If the cost were immediately deductible, the tax saving would be $7700. However, if the cost had been deducted over three years, the tax saving would have been $9000 ($3000 per year). At a discount rate of 10 per cent, the tax savings over three years have a NPV of $8206. The calculations become much more complex if it is assumed that the farmer is using tax averaging.
It appears that deducting the cost of assets over a three to five year period will optimise the tax benefit a farmer will receive (Douglas et al. 1995).
Investment incentives and capital gains tax
The investment incentives discussed will also affect the amount of capital gains tax paid if the land is eventually disposed of, as shown in example 10 (detailed calculations are in appendix A).
Example 10: Assume a landowner purchased a farm for $200 000, and fencing of the wetland cost $10 000. The farm is then sold some years later for $250 000. The wetland comprises 10 per cent of the farm by area. The amount of tax deductions received, and CGT paid for each of the scenarios discussed would be:
Scenario 1 — Farm used exclusively for grazing: Assuming the wetland was assumed to be a separate land class, the landowner would receive an immediate tax deduction of $10 000 when the fence was erected. The landowner may pay CGT on $12 500 when the farm is sold.
Scenario 2 — Wetland used for eco-business: As discussed earlier, the landowner would depreciate the fence, as the landowner would be ineligible to claim an immediate ‘Landcare’ deduction. Assume that when the farm is sold, the landowner has received $6000 of tax deductions, and the fence is worth $4000. The sale proceeds of $250 000 would be apportioned with $4000 allocated to the fence and $246 000 to the land. In this scenario, the landowner would have received $6000 of tax deductions for the fence and may pay CGT on $11 500 when the farm was sold.
Scenario 3 — Wetland used for private conservation purposes: As noted earlier, the landowner would not receive an income tax deduction for the cost of erecting the fence, but would be able to add the cost of the fence to the cost base of the land for CGT. In this scenario, the landowner may pay CGT on $10 000 when the farm was sold.
These scenarios illustrate that agricultural activities would be the most tax-favoured land use, and private conservation activities would be the least tax-favoured land use.
Valuation of livestock
It has been suggested that the provisions for taxing livestock may cause environmental problems by leading to overstocking, and discouraging tactical stocking rate responses to climate variability (see Douglas (1995) and Stafford-Smith et al. (2001) for further discussion of these matters). 
Livestock are defined by the ITAA to be trading stock — items held for the purpose of resale. (It is arguable that this classification is incorrect, particularly for breeding stock which may be better classified as a capital item.) There are also special tax provisions for horses, which are not discussed in this report.
The ITAA requires taxpayers to value trading stock each year at the taxpayer’s choice of cost, market or replacement values. The value of trading stock on hand at the end of a financial year is then included in the taxpayer’s assessable income for that year, with an offsetting tax deduction being allowed in the following year. The purpose of this mechanism is to ensure tax deductions relating to items of trading stock are taken in the year in which the trading stock is disposed of, not the year they are acquired.
Many taxpayers choose to value trading stock at cost, as both market and replacement values include any unrealised profits that the taxpayer may hope to achieve. Valuation at cost means that a taxpayer will pay tax on those profits only once they have been realised. On the other hand, use of market valuation would include unrealised profits in assessable income. In general, a lower valuation for trading stock will result in a short-term tax advantage.
Valuation at cost is (relatively) simple for items that a taxpayer has purchased, but is more complex for natural increase of livestock. Tax law provides that not only the direct costs (for example, feed costs) of producing the natural increase should be taken into account, but also indirect costs (such as an appropriate share of fertiliser costs). The determination of the cost of a calf or a lamb can be a complex exercise.
The ITAA has recognised these difficulties and provided that natural increase of livestock can be valued at an arbitrary cost prescribed by regulation, resulting in a significant reduction in compliance costs. Current prescribed costs are shown in table 4.3.
Table 4.3	Prescribed costs for natural increase
Species	Prescribed cost	
Cattle	$20.00	
Deer	$20.00	
Horses	$20.00	
Pigs	$12.00	
Emus	$8.00	
Sheep	$4.00	
Goats	$4.00	
Poultry	$0.35	
Source: Income Tax Regulations.
These prescribed costs are below market value for most species of livestock, in some cases substantially. This means that when the natural increase livestock are sold, a large portion of the sale price will be taxable, as shown in example 11.
Example 11: Assume a steer was born in the 2000-01 financial year. It would be included in trading stock at $20, and the owner would include this amount in assessable income for the year. If the steer were sold the following year, the owner would be assessed on the sale proceeds (say $580) less the cost value included in the previous year ($20), a net $560. It can be seen that the prescribed cost affects the allocation of income between years, but does not change the total amount of income.
To the extent that the prescribed costs are below actual cost, agriculture receives a benefit compared to other industries where actual cost is used (because a lower valuation for trading stock will result in a short-term tax advantage).
In self-replacing herds or flocks, the tax value of the herd or flock trends downward to the prescribed cost. Glau (1971) has shown that the closing value of a livestock account is a recursive relationship with a limiting value of the prescribed cost when all replacement animals are obtained from natural increase.
The tax deferral from investing in a self-replacing livestock herd can be substantial, as shown in example 12.
Example 12: Assume a landowner purchased 50 cow and calf units, a total of 100 animals, for $100 000 when purchasing a farm. After 10 years, the herd is sold for $100 000. In this unusual herd, artificial insemination is used and 50 calves are born each year, and 50 head are sold. All replacement livestock are acquired from the natural increase. While the artificial insemination assumption is unrealistic, it allows the only variable to be the different tax treatment of livestock.
The average tax value of livestock at the end of the first year is calculated using the formula.

Value of original purchase + (number of natural increase * $20)
Number purchased + number of natural increase

$100 000 +(50*$20)
100+50
Average value = $673.33 
Total tax value of closing stock = $67 333
Because the closing tax value of the livestock is less than their purchase price, the difference is a tax deduction (an increase would be assessable income). Table 4.4 shows the tax value of the landowner’s cattle for the 10 years, and the resultant adjustment to taxable income.
Table 4.4	Calculation of taxable income for livestock farmer
Year	Tax value of livestock 
$	Trading stock adjustment 
$	
0	100 000		
1	67 333	- 32 667	
2	45 555	- 21 778	
3	31 036	- 14 519	
4	21 357	- 9679	
5	14 904	- 6453	
6	10 602	- 4302	
7	7734	- 2868	
8	5822	- 1912	
9	4548	- 1274	
10	100 000	95 452	
It can be seen that the landowner received a significant tax deferral from investing in livestock. However, when the landowner realised the investment, there is a substantial tax liability.
From an environmental perspective, there are suggestions that the current method of valuing livestock may lead to land degradation for two reasons (Douglas 1995). First, economic theory suggests there is over-investment in subsidised activities. With livestock, over-investment may well lead to over-stocking, with negative environmental effects.
Second, it has been suggested that the disparity between market and tax values may lead to a ‘lock-in’ effect, and discourage tactical stocking decisions. In times of drought, there will be a reluctance to de-stock unless the livestock elections for forced disposal (discussed below) can be accessed.
These hypotheses have recently been tested by CSIRO using ‘Riskherd’ — a unique stochastic model of rangelands properties, that coupled a daily time-step model of plant growth, a soil loss model, an animal nutrition and herd dynamics model with a farm financial model with full tax specifications. The model has the capacity to ‘… analyse the degree to which a given tax instrument may promote changes in pasture state’ (see Stafford-Smith et al. 2001).
Stafford Smith et al. (2001) concluded that there would be environmental benefits, such as a reduction in soil loss and maintenance of native vegetation, from moving from the current system of valuing livestock to one which resulted in higher valuations. The ‘long-term environmental benefits could be significant, at least in cattle regions’.
Stafford Smith et al. (2001) identified transition issues, particularly the additional tax that may be levied on producers, as a major impediment to increasing taxation values for livestock. They argued that the environmental benefits of moving to an improved system of livestock taxation may justify a substantial write-off of deferred tax liabilities.
The livestock elections
The term ‘livestock elections’ is used to collectively describe several tax provisions designed to defer the taxation of income derived from abnormal disposals of livestock following drought, flood or fire.
As noted earlier, there is frequently a large disparity between the tax and market values of livestock, with the consequence that most of the proceeds from the sale of livestock are taxable. If an abnormal number of livestock is disposed of, this can lead to a ‘bunching’ of income, and large tax liabilities. If the proceeds from the disposal are required to purchase replacement livestock, the tax system prevents replacement with an equal value.
The tax law attempts to overcome this ‘bunching’ problem by allowing farmers to choose to spread the abnormal income from certain forced disposals over a longer period, so reducing the ‘period inequity’ problem. In most cases, farmers have the choice of either paying tax on 20 per cent of the abnormal income in each of the current and four succeeding years, or carrying the abnormal income forward and offsetting it against the cost of replacement livestock. This latter election has the effect of deferring tax until the replacement livestock are sold.
Table 4.5 provides a list of available elections and their effects. In some cases, choosing to use these elections may have the perverse effect of increasing overall tax liabilities. This is because a year in which a farm has suffered a fire, flood or drought is normally a low-income year, and subsequent years may have a higher income.
From an environmental perspective, livestock elections may have a positive effect by encouraging de-stocking when there is a drought. However, it is possible that they may have the perverse effect of also encouraging farmers to delay de-stocking until they are sure they will qualify for the election.
Table 4.5	Livestock elections and effects
Election and trigger	Effect	
Shearing twice in one year where the second shearing is caused by fire, flood or drought	Profit on second wool clip is deferred until subsequent year	
Forced disposal of livestock caused by fire, flood or drought	Choice of spreading income over 5 years, or deferring profit to reduce tax value of replacement livestock.	
Receipt of compensation for compulsory destruction of livestock	Choice of spreading income over 5 years, or deferring profit to reduce tax value of replacement livestock.	
Insurance recoveries of death or destruction of livestock	Choice of spreading income over 5 years	
Source: Douglas (2001).
4.4	GST provisions specific to primary production
The main GST provisions specific to agriculture that may affect the environment are those relating to the transfer of agricultural land.
Most GST regimes have provisions that allow the ‘sale of businesses as a going concern’ to be GST-free. The most probable reason for these provisions is to minimise cash flow costs on the sale of businesses, as the sale should not generate net revenue — the GST collected by the vendor being offset by the input tax credits claimed by the purchaser.
However, agricultural businesses are not usually sold as a going concern. Instead the land is sold first, and then the plant and livestock are sold separately (frequently at a clearing sale). The GST legislation provides that the sale of farmland to another intending farmer will be GST-free. The GST-free status does not apply to sales of plant or livestock.
However, the GST-free status will not apply if the farmland is purchased by a registered organisation for conservation activities. While the GST paid by the registered organisation will be refunded as an input tax credit within 3–4 months, having to pay 10 per cent more for the farm and wait for a refund can cause cash flow difficulties (see Productivity Commission (2001) for a discussion of the impact of these issues on Birds Australia).
If a farm were purchased purely for private conservation purposes by a non-registered organisation or individual, GST would be included in the purchase price.
Of course, the choice between agriculture and conservation is seldom made for whole farms, but rather is made for particular parts of farms, such as wetlands, areas of bush and wildlife corridors. This raises the question of what happens if the vendor sets aside part of the farm for private conservation, or if the purchaser intends to set aside part of the land for private conservation purposes. 
There appears to be no Australian Tax Office tax ruling on this issue. However, it is possible that the Australian Tax Office may require some form of apportionment, and require GST to be paid on the land that has been set aside/will be set aside for private conservation purposes.

5	Case study
The purpose of this simple case study is to examine the differential application of taxation to land used for both agriculture and private conservation. The case study draws on earlier examples in this report and looks at impacts on the environment from purchasing, operating and selling the farm. The tax law consequences described are based on a strict technical interpretation of the law. In practice, less strict interpretations of the law may be developed.
5.1	Scenario
A landowner purchases a grazing property that contains a wetland. The landowner believes that conservation of the wetland will be best achieved if grazing animals are excluded from it.
If the landowner purchases the farm purely for grazing, the purchase will be GST-free. If, however, part of the farm is not to be used for farming, GST must be charged on that portion. This will require apportionment of the purchase price, increasing compliance costs. If the landowner then uses the wetland for income-producing purposes, the landowner would be able to claim an input-tax credit for the GST paid. However, if the wetland were used solely for private conservation purposes, there would be no refund of the GST.
Having purchased the farm, all the landowner’s operational expenditure will be tax-deductible if this farm is used purely for grazing, or if the wetland is used for commercial purposes; for example, guided nature walks. However, if the wetland was used solely for private conservation purposes, deductions could not be claimed in respect of the wetland. The required apportionments may increase compliance costs.
The costs of fencing off the wetland will not be tax-deductible if the landowner uses the wetland solely for private conservation purposes. If the wetland is used in an environmental business, depreciation would be allowed on the fence, but it is unlikely the landowner could claim an immediate tax deduction under the ‘Landcare’ provisions.
If the wetland is used for private conservation purposes and if the landowner were to receive a grant to assist with the costs of construction of the fence, the landowner would have to pay tax on the grant immediately, while the deductions for the fence would be depreciated over several years.
In addition, use of the wetland for conservation purposes may increase local government rates, or attract Land Tax, and the land will not be eligible for concessions available to agriculture.
Further, the non-commercial loss provisions may quarantine any loss the landowner incurs if the wetland is used for commercial conservation purposes.
Finally, when the landowner sells the farm, small business capital gains tax concessions would not be available for the wetland if it had been used for non-profit conservation purposes. In addition, the landowner may not be able to sell the entire farm GST-free.
It can be seen that the taxation system, if applied strictly, would discourage the landowner from using land for private non-profit conservation purposes.

6	The aggregate impact of tax provisions for primary producers
Having examined the possible environmental impacts of specific tax provisions for primary producers, there remains the question of the possible environmental impacts of these provisions in aggregate. A key issue is the effect of the provisions on the level of investment in primary production.
Many of the tax provisions discussed may encourage investment in primary production-related activities. Some provisions, such as those relating to ‘Landcare’, conveying and conserving water, and viticulture, are explicitly designed to provide investment incentives. The tax deferrals associated with the provisions for livestock valuation, and small business capital gains tax concessions, may provide an implicit investment incentive.
One method of assessing if the tax system is providing investment incentives to the agricultural sector is to examine the amount of tax paid on income from agriculture.
Examination of the 1998-99 Taxation Statistics and the amount of taxable income derived, and tax paid, by primary producers, shows that primary production is the only broad ‘small business’ industry grouping with negative net business income (‑ 354 million). In addition, primary producers who were listed in the ‘large business’ industry grouping had a net business loss of $9.6 million.
Partnerships, trusts and companies also run primary production businesses. However, partnership and trust income is distributed in the year it is derived. When partnership and trust income and losses from primary production are included, it appears that the net taxable income derived from primary production by all individuals in 1998-99 was $672 million (see table 6.1). 
Subtracting taxable income derived from primary production by those individuals whose main activity is primary production from total taxable income from primary production for all individuals, shows taxpayers whose main occupation is not primary production appeared to make substantial tax losses from primary production activities (see table 6.1). The tax losses of these taxpayers may have a cyclical components associated with adverse climatic effects and commodity price cycles, but significant tax losses also occur in other tax years.
Table 6.1	Primary production income of taxpayers whose main occupation is not primary production
I