The Treasury

Global Navigation

Personal tools

Measuring comprehensive income

Before income can be taxed, it has to be measured. In the case of some forms of income from capital, this presents severe problems.

There are three generic measurement problems in using a comprehensive definition of income as a tax base: (i) measuring changes in asset values (property rights) when there is either no market or only a very thin market in which to observe market prices, (ii) taxing income that accrues in a period but is not realised by the owner in cash or some other liquid form of wealth and (iii) determining the income of an individual when this requires a complex adjustment or attribution or there is uncertainty. Table 3 sets out some examples of these particular problems.

Table 3 – Problems with measuring and taxing different types of income
Type of incomeProblems
Capital GainsThese should be taxed on accrual but due to problems (i) and (ii) they are almost always taxed only on realisation.  This deferral lowers effective tax rates according to duration of asset ownership and creates lock-in distortions.
ProfitsMeasuring profits correctly depends on measuring true economic depreciation but this is difficult due to problem (i).  There is also a host of problems involving the timing of the recognition of receipts and expenditures and many more arising from the capital-revenue distinction.
Imputed Rental IncomeMeasuring and taxing this form of income runs into problems (i) and (ii).  As a result, it is usually not taxed, e.g. imputed rental income arising from owner-occupied housing.
Income earned indirectly via an entityExamples are profits earned by companies on behalf of shareholders, and investment income earned by pension funds, life insurance companies, unit trusts and trusts on behalf of members, holders or beneficiaries.  These give rise to problem (ii), and problem (iii) (particularly when there is a chain of entities between the source of income and the underlying individual owner).  There can also be a problem because attribution to an individual is impossible because of uncertainty, e.g. defined-benefit pension schemes and discretionary trusts.
Income distorted by inflation

While the problem can be overcome in principle by indexation, this would involve great complexity and consequently high compliance and administrative costs. Examples are real versus nominal capital gains, real versus nominal interest receipts and payments, and depreciation allowances, when based on historic costs and inventory rules (FIFO versus LIFO)


Income from human capitalThe problem here is distinguishing between returns to raw labour and to human capital.  The former cannot be observed directly and they will vary from person to person depending on raw talent and ability.

These problems of measuring and taxing income from capital comprise a formidable list. They cause effective tax rates to differ (sometimes greatly) from the statutory tax rate. As a result, there will generally be production inefficiency with over-investment in tax-favoured projects and under-investment in tax-penalised projects. Researchers have done a large number of studies in different countries and for cross-border investments.[11] The results typically show large variations in effective marginal tax rates across investment projects.

Measuring expenditure/consumption

Even granting that the measurement and taxation of comprehensive income is extremely difficult and impossible to achieve fully, can one necessarily expect the problems to be less formidable with an expenditure base? One must be careful not to compare an imperfect but functioning income tax with an ideal, untested expenditure tax. But as Meade (1978), Kay and King (1989), Bradford (1979) and others have explained, there are good arguments for believing that the measurement and collection-of-tax problems with an expenditure base would be much less serious than for a comprehensive income base.

The easiest and most effective way to appreciate these arguments is to use them to demonstrate how an expenditure base would avoid the three central problems with measuring and taxing comprehensive income. A key characteristic of an expenditure tax is that it is possible to base almost all measurements on cash flows. This has tremendous advantages. Cash flows are relatively easy to observe and measure, so that the problem of valuation (problem (i)) is much reduced (although not solved entirely). When people are taxed on cash flows they do not face tax demands on income they have not received in cash (so problem (ii) is solved). People are not taxed on income earned on their behalf until it is distributed to them, thus solving the problems of attribution (problem (iii)). Finally, since taxes are based on cash flows at a particular point in time, there is never any need to make complicated adjustments for inflation (problem (iii)).


  • [11]For an analysis of New Zealand’s experience, see Moes (1999).
Page top