I’ve been having an interesting chat about the arguments in favour of removing deferred tax from the consideration in the Fair Tax Mark method. Personally, I think it can seriously distort the results and thought an illustration of the principle I’m concerned about is worthwhile for review.
It appears that the argument in favour of removing deferred tax is that over an extended period of time deferred tax differences reverse anyway. That is only true for timing differences which arise and reverse in the period itself, but because of the odd Fair Tax Mark weighting, even this occurrence distorts the calculation.
Here is a fairly innocuous looking example where profit is stable and corporation tax stays at 30%. A single asset (worth £60) receives first year allowances in year 1, is depreciated in a straight line over six years. The deferred tax asset movement in year 1 reverses in full over the next five years.
The argument that the current tax rate should naturally smooth itself means that the weighted rate should still come out at 30%. The deferred tax charge would “misleadingly” smooth the effective rate to 30% in all six years and produce a weighted average of 30%.
However, disregarding deferred tax produces this:
If I’ve got the Fair Tax Method right, my understanding of the reason to remove deferred tax is correct and I’ve not made a silly error, the Fair Tax Method produces a 2% difference in rate out of nowhere.
Given that a 7% swing turns a score of 5 to 0, I would consider this to be material.
Even then, this is just theoretical, but it tests only one variable for the removal of deferred tax: the weighting by year.
But if you throw in different profits, different rates of tax, different sizes in deferred tax movements and timing differences that do not arise, or do not reverse fully, in the six year period, then you might begin to realise why I am concerned.
Also, it is not the results of the method that are the “product” of the Fair Tax Mark, it is the method itself – the method should not be susceptible to producing anomalies like this.