The 'Tax Simplifier' series aims to make the case for a much simpler tax code with practical recommendations for policy change on a regular basis. Blogs are published twice per week, on Monday and Thursday. Read David's previous blog on the window tax. You can follow David on Twitter @TaxSimplifier.
Profit is normally a good base for taxation, provided the rate of tax is not so high that it discourages people from earning the profit. Profit reflects taxable capacity, and taxing profit is seen as fair.
What is profit? The basic concept is that it represents the amount a businessman can withdraw from his business by the end of the year and spend without being any worse off than he was when the year began.
If profit is to be a satisfactory tax base there must be limited scope for manipulation. Modern accounting requirements for the measurement of earned profit have contributed a great deal towards this end. But for small businesses strict accounting requirements may be relaxed, and the number of tax adjustments needed to calculate their taxable profit from a basic calculation of earnings will usually be very limited.
But the tax man has to keep his eyes open! Of particular concern these days is the measurement of profits of banks and other financial concerns, particularly having regard to the introduction of International Accounting Standards. These permit, or require, the use of market valuations more often than were needed under the historic cost convention. But these valuations, applying to such matters as derivatives and future cash flows, can allow more scope for subjective judgments than we might like.
Readers of a strong nervous disposition are recommended to look at “The Law of Opposites - Illusory profits in the financial sector” written by Gordon Kerr. This hair-raising booklet shows for example how short term profits can be conjured from derivative contracts by both counter-parties! Of course any derivative contract is a zero sum game by the time it eventually expires, as one side’s gain must equal the other side’s loss. But the problem is hair-raising because the value of extant derivative contracts runs into trillions of dollars.
The accountancy profession is primarily responsible for sorting these problems. But in the meantime tax legislators must tackle the difficult issue of identifying any adjustments which are appropriate for tax purposes to the accounting profit of financial concerns.