Staff Paper. Farm Savings Accounts: Examining Income Variability, Eligibility, and Benefits. Brent Gloy, Eddy LaDue, and Charles Cuykendall


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1 SP August 2005 Staff Paper Department of Appled Economcs and Management Cornell Unversty, Ithaca, New York USA Farm Savngs Accounts: Examnng Income Varablty, Elgblty, and Benefts Brent Gloy, Eddy LaDue, and Charles Cuykendall
2 It s the Polcy of Cornell Unversty actvely to support equalty of educatonal and employment opportunty. No person shall be dened admsson to any educatonal program or actvty or be dened employment on the bass of any legally prohbted dscrmnaton nvolvng, but not lmted to, such factors as race, color, creed, relgon, natonal or ethnc orgn, sex, age or handcap. The Unversty s commtted to the mantenance of affrmatve acton programs whch wll assure the contnuaton of such equalty of opportunty.
3 Farm Savngs Accounts: Examnng Income Varablty, Elgblty, and Benefts By Brent Gloy, Eddy LaDue, and Charles Cuykendall* Government subsdzed farm savngs accounts have ganed attenton as possble rsk management tools. These accounts encourage farmers to set asde funds n hgh ncome years to be drawn upon n low ncome years. Ths study consders two potental savngs programs, Farm and Ranch Rsk Management (FARRM) accounts and CounterCyclcal (CC) farm savngs accounts. FARRM accounts use tax deferral as the prmary ncentve for partcpaton and under CC accounts the government would match farmer deposts up to $5,000. Ths report examnes the potental benefts of these accounts for New York dary farmers. The study llustrates how the selecton of dfferent ncome to defne elgblty wll mpact the potental elgblty and benefts receved by the accounts. In partcular, f measures do not correct for changes n farm sze, the value of the accounts to commercal farmers wll be greatly reduced. Although partcpaton and beneft estmates vary by the specfc net and gross ncome measures used to defne partcpaton and allow wthdrawals, the dfferences were relatvely small. The analyss ndcates that most commercal dary farms would be elgble to buld substantal balances n the accounts. The use of net ncome measures as opposed to gross ncome measures ncreases the lkelhood that farmers wll be able to access the funds deposted n the accounts. The next sectons of the study descrbe the constructon of the farm data used to analyze the account programs. Then, the analyss of Farm and Ranch Rsk Management (FARRM) and CounterCyclcal (CC) farm savngs accounts s presented. The analyss begns by descrbng the magntude and degree of varablty n measures of net ncome and gross farm ncome. Next, the analyss consders the ablty of farmers to contrbute to FARRM and CC accounts. Fnally, the study consders the lkelhood that farmers wll be able to wthdraw funds from the accounts and provdes some very basc estmates of the potental benefts assocated wth FARRM and CC accounts. Data Preparaton and Analyss Two data sets were developed to examne ncome varablty for New York dary farms. The farm level fnancal data comes from the Cornell Dary Farm Busness Summary program. Extenson personnel workng wth farmers collect the data. All ncluded records must meet cash and equty reconclaton standards. The frst data set contans farms that had completed the fnancal summary program for each of the years 1997 to The second data set contans farms that completed the summary for each of the years 1993 to The fveyear panel contans the fnancal records of 142 dary farms and the 9year panel contans the fnancal records of 89 dary farms. * Assstant Professor, W.I. Myers Professor of Agrcultural Fnance, Emertus, and Senor Extenson Assocate, Department of Appled Economcs and Management, Cornell Unversty
4 Calculaton of Farm Income Measures Four measures of farm ncome were calculated to assess the vablty of farm savngs programs. The ncome measures were based upon ncome tax defntons. Two measures of gross ncome and two measures of net taxable ncome were calculated. The frst two measures were based upon 1040 Schedule F. The procedure for calculatng the Schedule F measures are shown n Table 1. Table 1. Calculaton of 1040 Schedule F Gross and 1040 Schedule F Net Farm Income from Dary Farm Busness Summary Records Components Descrpton Total cash recepts from farmng Cash recepts from the sale of farm products n a gven calendar year. DFBS records nclude all revenue from farm operatons.  cattle sales Sales of breedng lvestock (both purchased and rased) are ncluded n total recepts and must be subtracted to determne 1040 Schedule F gross ncome. = Schedule F Gross Farm Income Our estmate of the gross 1040 Schedule F ncome.  total cash expenses Any cash farm expenses n a gven calendar year.  real estate deprecaton Any deprecaton taken on any real estate tems n a gven calendar year.  machnery deprecaton Any deprecaton taken on machnery n a gven calendar year.  lvestock deprecaton Deprecaton on purchased lvestock. Estmated based upon cullng rates and hstorcal purchases. = Schedule F Net Farm Income Our estmate of net 1040 Schedule F ncome. Several expense and revenue components do not appear on 1040 Schedule F. In order to examne the mportance of total farm measures, two addtonal ncome measures of ncome were calculated. Agan, one gross and one net measure were calculated. Total farm gross ncome was obtaned by addng the gan or loss from the sale of lvestock (purchased and rased) to Schedule F gross farm ncome. Total farm net ncome was calculated by subtractng the 1040 Schedule F expenses from total farm gross ncome. Table 2 descrbes these calculatons and ther components. 2
5 Table 2. Calculaton of Gross and Net Taxable Farm Income from Dary Farm Busness Summary Records Components Descrpton 1040 Schedule F Gross Farm Income Our estmate of the gross 1040 Schedule F ncome. + sale of rased breedng lvestock Sale of rased breedng lvestock held more than one year. Calculated subtractng sales of purchased lvestock from total breedng lvestock sales. + gan (loss) on the sale of purchased breedng lvestock  loss on the death of purchased breedng lvestock Gan (loss) on the sale of culled, purchased lvestock. Estmated based upon cullng rates, hstorcal purchases, purchase prces, and sales prces. Loss on the sale of purchased breedng lvestock. Estmates based upon recorded death rates and hstorcal purchase prces. = Estmate of Total Farm Gross Income Estmate of gross farm ncome Schedule F expenses Cash expenses plus real estate deprecaton plus machnery deprecaton plus lvestock deprecaton. = Total Farm Net Income Our estmate of net taxable total farm ncome. Estmaton of deprecaton and gan or loss on lvestock It s mportant to note that, as the Dary Farm Busness Summary data are collected, the sale of breedng lvestock s ncluded n the total cash recepts for each farm and the expenses for rased lvestock are ncluded n the total cash expenses for each farm. In order to calculate Schedule F net ncome, t was necessary to exclude breedng lvestock ncome and estmate deprecaton on purchased lvestock. Lkewse, n order to calculate total farm net ncome t was necessary to estmate gan or loss on the sale of purchased breedng lvestock, and loss from death of purchased lvestock, as well as lvestock deprecaton. The estmaton procedure was based upon actual farm lvestock purchases and cullng rates. The estmaton was complcated because the farm busness summary only collected nformaton regardng cullng rates begnnng n The farm busness summary recorded actual purchases of lvestock for all years under consderaton. Because deprecaton on purchased lvestock n any gven year s nfluenced by purchases n prevous years, t s necessary to consder how purchases (and cullng decsons) mpact deprecaton. A smple model was developed to estmate the amount of current year deprecaton of purchased lvestock. Lvestock are consdered 5year property for deprecaton purposes. The estmaton process seeks to establsh a percentage of purchases that are deprecated and a percentage that are counted as sold or ded n each year. Table 3 shows the calculaton of these percentages under a 33% cullng rate and a death loss of 3.7%. The average cullng and death rates for each farm were estmated based upon the average cullng and death rates employed/experenced by the farm over the years Thus, t vares accordng to the actual cullng practces employed on a partcular farm. Smlarly, the death 3
6 loss was calculated accordng to the death losses experenced by the farm. Both values were necessary to determne the number of anmals remanng n any gven year. Table 3. Calculaton of Deprecaton and Death Loss on Purchased Lvestock a Year Culled (% of orgnal purchase) 33.0% 20.9% 13.2% 8.4% 5.3% 3.4% Percent of anmals lost to death (% 3.7% 2.3% 1.5% 0.9% 0.6% 0.4% of orgnal purchase) Contnued n herd (% of orgnal 63.3% 40.1% 25.4% 16.1% 10.2% 6.4% purchase) Deprecaton expense (percent of 6.3% 8.0% 5.1% 3.2% 2.0% 0.6% orgnal purchase) Death loss (% of orgnal purchase) 3.70% 2.11% 1.04% 0.47% 0.18% 0.04% Tax bass 100% 90% 70% 50% 30% 10% a Usng average death and cullng rates for all farms of 3.7 and 33 percent, respectvely, and assumng straght lne deprecaton. Deprecaton Deprecaton as a percent of purchases n any gven year s found n the 3 rd row from the bottom of Table 3. For nstance, n year one we would expect that a farm wth a 33% cullng rate and a 3.7% death loss would have deprecaton equal to 6.3% of the purchases that they made n that year. Ths amount was determned by calculatng the proporton of anmals remanng n the herd after cullng and death at the end of year one and applyng the halfyear conventon. In ths case, that would amount to 63.3% of the anmals (100%*(1 (cullng rate + death rate) )) tmes 10%. The amount of anmals remanng n the herd at the end of year two s 40.1% (100%*(1 (cullng rate + death rate)) 2 ) and these anmals receve a full 20% deprecaton n year two. Thus, 8% of the orgnal (year one) purchase s deprecated n year two and so on. Therefore, n order to calculate the deprecaton n any year t s necessary to multply purchases n the prevous 5 years by the approprate percentage. The analyss assumes that the cullng and death rates for newly purchased anmals are the same as experenced for the rest of the herd. Death loss The loss on the death of purchased anmals was calculated n a smlar fashon. Table 3 shows the calculatons for the case of an average death loss of 3.7%. The death losses for each farm were based upon the actual death losses experenced by a partcular farm over the perod Agan, the cullng rates were based upon the average of the farm. The cullng rate s necessary to determne the amount of anmals remanng n the herd. The proporton of anmals lost to death s calculated by multplyng the proporton of anmals remanng at the begnnng of the year by the death rate. For example, 2.3% of the anmals purchased n year one wll de n year two. The loss on these anmals s determned by multplyng the proporton of anmals lost to death by ther remanng tax bass at the tme of death. In our example, the dollar loss due to death n year two would amount to 2.1% of the orgnal purchase prce (death loss*tax bass) or 2.3%*0.9. Thus, n order to calculate the dollar loss due to death for a gven year, one would multply the purchases n the current and prevous fve years by the proportons n the second to last row of Table 3. 4
7 Gan or Loss on Sale In order to estmate the gan or loss on the sale of purchased breedng lvestock t was necessary to determne sale prce of the purchased lvestock. Although DFBS records nclude data on the number and dollar amounts of lvestock sales for , the number of anmals sold pror to 1999 was not collected. Ths made t necessary to estmate the value of cull lvestock sold pror to Hstorcal data on the value of replacement lvestock and value of cull dary cows was used as the bass of ths estmate (New York Agrcultural Statstcs). The hstorcal reported cull prce was multpled by the average cull weght (1230 pounds) for all DFBS cull anmals sold The average recepts per anmal were estmated by dvdng cash cattle sales by the number of cull anmals sold on each farm. Average recepts per anmal were then dvded by the average reported cull prces for the correspondng year to obtan the average weght per anmal. Ths average was used for all years. Farms that sold replacement lvestock were excluded from ths analyss. Table 4 shows the replacement prces, cull prces, and cull values for New York dary farms over the perod These results were then used to establsh a relatonshp between the purchase prce of the anmals and ther cullng sale prce. Table 4. Value of Cull and Replacement Lvestock, Replacement Value ($ s per head) Cull Prce ($/Cwt) Cull Value ($ s per head) a a Cull prce tmes 1230 pounds per anmal. Source: Agrcultural Statstcs, USDA The gan or loss on the sale of purchased lvestock was calculated by subtractng the sale prce of the lvestock from the estmated tax bass of the lvestock. Ths calculaton s relatvely complex because n any gven year anmals of dfferent ages are beng sold. The tax bass was determned by multplyng prevous purchases by the approprate tax bass percentage. For nstance, the 1998 tax bass of 1996 purchases would be 70% of 1996 purchases wth straght lne deprecaton. In order to calculate the loss on these anmals one must determne the proporton of anmals sold n Ths was accomplshed by multplyng the proporton of anmals beng culled by the orgnal 1996 purchase value. If the cullng rate was 33% and the death rate was 3.7%, approxmately 13.2% of the 1996 purchases would be sold n 1998 (Table 3). The sellng prce of these anmals was determned by multplyng the 13.2% of the 1996 purchases by the relatonshp between 1998 value of culled lvestock and the value of 1996 replacement lvestock. In ths case the cull value for 1998 was $ per head and the replacement lvestock 5
8 purchased n 1996 were valued at $1,010 per head (Table 4). Thus, the purchases n 1996 were multpled by 39.33% to determne the sales prce. Because the tax bass s 70% of the purchase prce (Table 3) and the sellng prce s 39.33% of the purchase prce, the loss s estmated as 30.67% of the 1996 purchases that were culled n Because 13.2% of the 1996 purchases were culled n 1998 (Table 3), the loss s estmated as 30.67%*13.2% or 4.04% of 1996 purchases. If the sales prce exceeds the tax bass, the loss wll be negatve, ndcatng a gan. The relatonshp between the sellng prce and the purchase prce of culled anmals wll depend on the years under consderaton. The relatonshps between purchases and sales prces for each year from 1993 to 2001 are shown n Table 5. For nstance, Table 5 shows that anmals purchased n 1998 and sold n 2001were sold for 46.8% of ther orgnal purchase prce. When nformaton was not avalable on hstorcal purchases,.e., purchases pror to 1993, the average purchases, over the maxmum number of years of data, were used Table 5. Relatonshp Between Purchase Prces of Replacement Lvestock and Sales Prces of Culled Lvestock, Sales Prce as a Percent of Orgnal Purchase Prce Year Sold Year Purchased Rased Lvestock Sales The fnal step n the estmaton of taxable ncome was to compute the rased lvestock sales, because purchased lvestock sales were ncluded wth sale of rased anmals n cash breedng lvestock sales n the orgnal data set. Ths s accomplshed by subtractng the estmated value of purchased lvestock sold from total lvestock sales. The estmate of purchased lvestock sold was calculated by multplyng the value of purchased lvestock tmes the proporton of lvestock culled n any gven year (Table 3) by the relatonshp between replacement purchase prce and cull sales prce (Table 5). For example, the amount of 1998 purchased lvestock sold n 1998 was calculated 6
9 by multplyng 1998 purchases by 33% (proporton culled) and 39.3% (relatonshp between replacement and cull prce). In order to determne the total amount of purchased lvestock sold n 1998 the same procedure was appled to purchases made from The 6.4 percent of purchased anmals remanng n the herd after the sxth year would be sold n future years and would be 100 percent gan because the tax bass s zero. These are ncluded wth the rased lvestock sales, because sale of purchased anmals only counts sales durng the frst sx years after purchase. Ths procedure correctly calculates gan, although a small part of the gan counted as the sale of rased anmals, whch would be captal gan, s really gan from the sale of purchased anmals, whch would be ordnary gan. Summary data for estmated lvestock sales and gan or loss for all farms n the sample for the most recent fve years are shown n Table 5a. The estmated annual loss on the sale of purchased lvestock s approxmately equal to the estmated deprecaton expense for purchased lvestock. Table 5a. Estmated Lvestock Sales, Gans, and Losses, 142 New York Dary Farms, Year Rased lvestock sales Purchased lvestock sales Deprecaton on purchased lvestock Death loss Loss on sale of purchased 1997 $20,735 $6,873 $6,584 $3,007 $7, $21,680 $6,683 $6,623 $2,564 $6, $24,491 $7,176 $7,195 $3,045 $8, $29,612 $8,529 $8,098 $3,577 $9, $30,552 $8,523 $8,644 $3,412 $9,588 Results The data were analyzed to assess several aspects of the proposed farm savngs account programs. These analyses focused on two specfc savngs account proposals. The proposals consdered are often referred to as farm and ranch rsk management accounts (FARRM) and farm countercyclcal savngs accounts (CC accounts). Ths secton of the report presents the results of the analyss of each type of account. The analyss focuses on addressng three broad questons for each type of account. Specfcally, we analyze: 1) the magntude and degree of varablty n measures of net ncome (FARRM) and the magntude and the degree of varablty n measures of gross farm ncome (CC accounts); 2) the ablty of farmers to contrbute to FARRM and CC accounts; and, 3) wthdrawals from and benefts obtaned by contrbutng to FARRM and CC accounts. The analyss of ncome varablty s relatvely straghtforward. An mportant dfference between FARRM and CC accounts s that they are based on dfferent measures of ncome. FARRM accounts are drven by a measure of net ncome, whle CC accounts are drven by a measure of gross farm ncome. Smlarly, the benefts for the programs dffer. The man beneft from FARRM accounts s tax deferral and possble tax exempton, whle CC accounts provde farmers a matchng government depost. Fnally, the ablty to wthdraw funds s dfferent for the accounts. Wthdrawal from FARRM accounts s not restrcted, whle wthdrawal from CC accounts s subject to shortfalls from a gross ncome target. Each of these ssues s examned n the results secton. 7
10 Analyss of FARRM Accounts The FARRM account proposal uses tax deferral as an ncentve for farmer savng. Although a varety of proposals have surfaced, the analyses n ths report follow the basc dea that farmers would be allowed to take a tax deducton of up to 20 percent of elgble farm ncome for contrbutons made to a FARRM account. Although the program specfes that a measure of net ncome wll be used to determne elgblty, the defnton s somewhat ambguous wth respect to the components ncluded n the measure. In addton, because many dary farms have substantal ncome and expenses that are ncluded on IRS form 4797, there s some nterest n examnng the mportance of the net ncome measure selected to determne elgblty. For ths reason, two alternatve measures of net farm ncome were consdered. The measures consdered used to analyze FARRM accounts are Schedule F net farm ncome (Table 1) and total farm net ncome (Table 2). FARRM Accounts: Analyss of Net Income Varablty In order to understand the potental beneft of FARRM accounts, t s mportant to examne the net ncome varablty faced by farmers. Because the mplementaton of both FARRM and CC account proposals use would rely upon tax nformaton the present study consders the varablty n measures of taxable ncome. These measures do not necessarly reflect the actual or accrual proftablty of the farms under consderaton. The frst set of analyses of FARRM Accounts consdered the magntude and extent of varablty n two measures of taxable net farm ncome, Schedule F net farm ncome (hereafter referred to as NSF ncome) and total farm net ncome (hereafter referred to as NTF ncome). Table 6 presents the means and standard devatons of several summary measures of the varablty of NSF and NTF ncome across the farms n our study. Table 6. Average Income Varablty per Farm, 142 New York Dary Farms a, Standard Measure Mean Devaton Mnmum Maxmum Total Farm Net Income Dfference Between Hghest and Lowest $131,436 $195,048 $6,631 $1,778,229 year s ncome ($ s) Largest Negatve Devaton from Mean ($ s) $68,112 $120,410 $3,184 $1,251,549 Largest Negatve Devaton from Mean (% of mean) 245% 506% 8% 3572% Schedule F Net Farm Income Dfference Between Hghest and Lowest $125,076 $190,511 $8,789 $1,778,293 year s ncome ($ s) Largest Negatve Devaton from Mean ($ s) $63,789 $117,089 $4,520 $1,242,416 Largest Negatve Devaton from Mean (% 235% 518% 15% 5247% of mean) a The statstcs reported n the table are the average across farms n = 142. For nstance, the dfference between the hghest and lowest net taxable ncome over the 5 year perod was calculated for each farm and these values were averaged. Several conclusons can be drawn from the analyss of the varablty n the two measures of net ncome. Frst, one can see that both measures of net ncome produce smlar estmates of the amount of varablty experenced by the farms n the sample. Second, the average varablty n net ncome s substantal. Over a fveyear perod the average dfference between the hghest and lowest NTF for the 142 farms was $131,436 and the standard devaton was $195,048. Ths would suggest that many farms experence dramatc changes n net ncome over a fveyear perod. 8
11 Whle the measures that utlze percentages are nfluenced by ncomes that are close to zero, they present smlar stuatons and the conclusons drawn from these measures are smlar. Specfcally, there s a substantal amount of ncome varablty over a fveyear perod and that the specfc measure NTF or NSF used as the bass for the analyss does not substantally nfluence ths concluson. We also compared the averages across farms to the averages across years. Table 7 reports the average NTF and NSF for all farms by year. The dfference between the hghest and lowest average NTF and NSF was $62,247 and $60,209, respectvely. The analyss at the ndvdual farm level ndcates that the varablty s much greater than the dfference between the average ncomes. As expected the total farm net ncome s greater than Schedule F ncome due to the ncluson of lvestock sales that are only partally offset by losses on the sale of purchased lvestock. Table 7. Average Net Taxable Income Per Year, 142 New York Dary Farms. Year NTF NSF 1997 $24,039 $13, $65,057 $53, $86,286 $73, $36,090 $19, $64,353 $46,801 The average NSF and NTF ncome over the fve year perod was also calculated for each farm. The dstrbuton of these averages shows that NSF and NTF are relatvely smlar for each farm (Fgure 1). However, t s apparent that most farms are able to generate a greater NTF than NSF. The dstrbuton also shows that the range n average ncome across farms s qute wde. Some farms generated negatve NSF and NTF ncome whle approxmately 20 farms generated average ncomes n excess of $100,000. Average Income per Farm Schedule F Net Total Farm Net Farms $200,000 $100,000 $0 $100,000 $200,000 $300,000 $400,000 $500,000 $600,000 $700,000 Fgure 1. The Cumulatve Dstrbuton of Average NTF and NSF Income by Farm, , 142 New York Dary Farms 9
12 To further nvestgate the range for NTF and NSF, the dstrbuton of the range for each varable s plotted by farm n Fgure 2. The fgure ndcates that the dstrbutons of the dfferences n NTF and NSF are hghly skewed. For 105 of the 142 farms, the dfference between the greatest and lowest NTF s less than $162,000. The fgure also llustrates the close correspondence between the two measures of net ncome. There are several factors that mght cause varaton n net ncome from year to year. These would nclude prce changes (both nput and output), varaton n producton levels and changes n farm sze. Several of the farms n the sample have experenced growth over ths tme perod. In fact the average percentage growth n herd sze over the perod was 20%. Greatest Dfference Between Hghest and Lowest Net Income per Farm Schedule F Net Total Farm Net Farms $0 $200,000 $400,000 $600,000 $800,000 $1,000,000 $1,200,000 $1,400,000 $1,600,000 $1,800,000 $2,000,000 Fgure 2. Dfferences Between the Hghest and Lowest Net Farm Income per Farm, , 142 New York Dary Farms FARRM Accounts: Analyss of Elgblty Elgblty to gan tax deferral benefts s dependent upon the farmer havng postve taxable ncome. Funds nvested n FARRM accounts are tax deductble, and thus, reduce taxes n the year of nvestment. The ncome s taxed n the year t s removed. Therefore, unless the tax rate on the funds n the year they are removed s less than n the year of the depost, the advantage s the deferral of taxes. The deferral of taxes allows the farmer to nvest the deferred taxes and earn nterest ncome (whch s taxable). The ablty to defer taxes to a tax year n whch the farm s n a lower tax bracket would result n lower taxes, creatng an ncentve for contrbuton to a FARRM account. For nstance, a farmer could contrbute to a FARRM account n a year n whch the funds would be taxed at the 27% margnal tax bracket and then wthdraw the ncome n a year where they fnd themselves n a lower tax bracket. For these reasons, the margnal tax bracket plays a crtcal role n determnng the value of FARRM accounts. The frst step n the analyss was to determne how frequently farmers actually had taxable ncome. A farmer wth a postve taxable ncome s elgble to contrbute up to 20% of ths 10
13 ncome to a FARRM account. The proporton of farmers wth a postve NSF or postve NTF vares by year (Table 8). In most years the proporton of elgble farmers s only slghtly hgher under the postve NTF rather than the postve NSF elgblty rules. The smallest proporton of farmers would qualfy n 1997 when only 63 percent had a postve NSF and 70 percent of the farmers had a postve NTF. Although well over half of the farms would be elgble to contrbute to a FARRM account, t s mportant to remember that many farms wll show a postve NSF or NTF and stll pay no taxes because of standard or temzed deductons and personal exemptons. Thus, those farms wth low ncome levels would have lttle ncentve to contrbute to FARRM accounts. In the balance of the report, references to standard deductons refer to the sum of the standard or temzed deductons and personal exemptons of the taxpayer (standard deducton). Ths analyss smply consders whether the farmer would have a postve NTF and s equvalent to assumng that nonfarm ncome would exactly offset the standard deductons avalable to the farm. It s also mportant to remember that the beneft of tax deferral and tax exempton s greater for those farms n hgher tax brackets. Both of these ssues wll be revsted n detal n the secton dealng wth estmatng the benefts of FARRM accounts. Table 8. Percent of Farmers Elgble to Contrbute to a FARRM Account Under Two Measures of Taxable Farm Income, 142 New York Dary Farms, Year Schedule F Net Farm Income Total Farm Net Income Entre Perod Analyses were also conducted to examne how frequently ndvdual farms would be able to contrbute over the fveyear perod. The results n Table 9 show the percent of farmers able to make up to 5 contrbutons to a FARRM account under the two measures of net ncome. Nearly all of the farms had a postve net ncome at some pont n the fveyear perod. However, wth an NSF trgger only 44 percent of the farms would have been elgble to contrbute to a FARRM account all fve years. In ths case usng an NTF trgger would enable 57 percent of the farms to contrbute to the account each of the fve years. These results ndcate that many farmers would fnd years when they are unable to contrbute to a FARRM account. Ths would suggest that they would want to wthdraw ncome from the accounts n these years to offset the low net ncome. Table 9. Percent of Farmers wth Income Enablng them to Contrbute to FARRM Accounts a, 142 New York Dary Farms, Number of Years Qualfed to Contrbute Schedule F Net Farm Income (% of Farmers) Total Farm Net Income (% of Farmers) a Entres n table dentfy the percent of 142 farms elgble to contrbute to FARRM Accounts. For nstance, 1 percent of the 142 farms never generated enough ncome to contrbute to a FARRM account. 11
14 The results would suggest that n any gven year we would expect nearly 80% of the farmers to be elgble to make a contrbuton usng ether an NTF or NSF trgger. However, t s mportant to remember that tax deferral and possble ncome tax reductons provde the prmary ncentve for partcpaton. Although many of the farmers have a postve NTF, standard deducton wll allow many of the farms to avod tax lablty. Producers whose NSF or NTF s close to zero are unlkely to pay ncome taxes, thereby reducng the ncentve for partcpaton. Table 10 shows the percent of farmers that would be elgble to contrbute to the FARRM accounts f NTF s reduced by the amount of the standard deducton for a marred couple flng jontly ($7,850) and two personal exemptons ($6,000) for a total deducton from net taxable farm ncome of $13,850 (year 2002). Our analyses do not consder any ncome other than farm ncome and make no allowances for deductons for state ncome tax or selfemployment taxes or other credts. After applyng these deductons, the number of farms that would have an ncentve to contrbute to the FARRM accounts falls ten percentage ponts. For nstance, n 1997, 63% of the farms were elgble to contrbute to the accounts (Table 8 and Table 10), but only 54% of the farms would have a postve NTF after standard deductons were appled. Table 10. Percent of Farmers wth Tax Lablty After Standard Deductons and Exemptons, 142 New York Dary Farms, Year Percent of Farms Entre Perod The next step n the analyss was to calculate the amount of funds elgble for depost. Agan, ths was done for both NTF and NSF trggers. In both cases, t was assumed that elgble farmers would contrbute 20 percent of ether ther NTF or NSF to the FARRM account. Ths s reasonable because the contrbuton can be wthdrawn at any tme and t allows the farmer to defer the tax for a mnmum of one year. For example, a farmer could make a depost n December of year one, or lkely up to Aprl 15 of year two, and then wthdraw the funds early n year two, or a few days after depost. Taxes are deferred for a year and only a few days of nterest are ncurred to obtan use of the funds. Deferral also opens the possblty that the farmer could reduce the tax rate (possbly to zero) on some of the deposted funds f ther taxable ncome fell n the subsequent year(s). The actual beneft of the deferral amounts to the nterest the farmer gans on the funds that would otherwse be pad to the government plus any tax exempton that the farmer s able to obtan due to fallng ncome. These ssues are covered n the secton dealng wth the benefts of the farm accounts. Over the entre perod, the average elgble depost to FARRM accounts by farms was slghtly greater under the NTF measure than under the NSF measure (Table 11). Under the 20% contrbuton rule farms would depost on average $13,382 wth a NTF trgger and $10,610 wth a NSF trgger. Dependng upon the tax bracket, ths would result n a modest amount of tax deferral. The average deposts were also calculated for each year of the tme perod to assess how 12
15 varable the deposts were from year to year. As expected the average deposts from year to year closely follow the average ncome of the farms for that year. It s clear that the NTF trgger allows the farms to defer a greater amount of ther tax lablty. In all years the amount of the contrbuton s greater than 20% of the average NTF or NSF. Ths s due to the negatve ncomes that count towards the average NTF or NSF but not toward the contrbutons. Table 11. Average Maxmum Contrbutons to FARRM Accounts per Farm by Year, 142 New York Dary Farms, Year Schedule F Net Farm Income Total Farm Net Income Entre Perod $10,610 $13, $5,975 $8, $11,901 $14, $15,710 $18, $7,902 $10, $11,560 $15,124 The fnal balances n the account wll depend upon the amount of the deposts that are wthdrawn n any gven year. The amounts of wthdrawals are dependent upon the tax benefts of the account. A later secton of the report provdes actual estmates of the wthdrawals from FARRM accounts. The next secton n the report examnes the lkelhood that a farmer wll receve tax benefts from the accounts. The margnal tax bracket s mportant n determnng the benefts of FARRM accounts. The greatest beneft from FARRM accounts occurs when farmers can contrbute n years wth a hgh tax lablty and wthdraw n years wth a reduced tax lablty. In order to assess the tax stuaton, a seres of analyses were conducted to determne the farmer s margnal tax bracket wth and wthout FARRM account contrbutons and wth and wthout standard deductons. The frst step n the analyss was to calculate the margnal tax bracket based only upon NTF. Next, the margnal tax bracket was calculated after subtractng a contrbuton to a FARRM account based upon ether NSF or NTF ncome. The results of ths analyss are reported n Table 12 for each year of the study perod. In 1997, 30% of the farmers had no tax lablty before standard deductons, 30% had no tax lablty after a contrbuton based upon NSF ncome and 30% had no tax lablty after a contrbuton based upon NTF ncome. Ths s surprsng snce one would expect the contrbutons to move some farms nto the zero tax bracket. In later years the results ndcate that addtonal farms enter the 0% tax bracket after contrbutng to FARRM accounts. The results allow one to begn to assess the movement n tax brackets caused by contrbutons to FARRM accounts. There are several mportant conclusons that flow from ths analyss. Frst, the movements created by contrbutons based upon NSF and NTF ncome are smlar. The only meanngful dfference occurs n 1997, when an addtonal 8% of the farms enter the 10% tax bracket under an NTF contrbuton and an addtonal 3% shft to ths bracket under a NSF contrbuton. Ths analyss was conducted wth constant 2002 federal ncome tax rates acknowledgng that the 10% bracket was not avalable n The second key result s that the contrbutons to FARRM accounts cause relatvely small proportons of the farmers to swtch ncome tax brackets. Further, most of ths swtchng occurs n the mddle (10% to 30%) ncome tax brackets, some occurs n the top tax brackets, and no swtchng occurs n the lowest ncome tax bracket. 13
16 Table 12. Percent of Farmers n Varous Tax Brackets Ignorng Deductons and Exemptons and Maxmum Contrbuton to FARRM Accounts Under Two Alternatve Qualfyng Income Measures, 142 New York Dary Farms, Margnal Income Tax Bracket Bass for Deposts 0% 10% 15% 27% 30% 35% 38.6% Percent of Farms, 1997 No Deposts Deposts based on Schedule F Net Income Deposts Based on Total Farm Net Income Percent of Farms, 1998 No Deposts Deposts Based on Schedule F Net ncome Deposts Based on Total Farm Net Income Percent of Farms, 1999 No Deposts Schedule F Net ncome Net Taxable Income Percent of Farms, 2000 Orgnal Schedule F Net ncome Net Taxable Income Percent of Farms, 2001 Orgnal Schedule F Net ncome Net Taxable Income If one consders the mpact of subtractng standard deductons from NTF, we would expect that the shfts n ncome tax brackets would also mpact the lower ncome tax brackets. The analyss proceeded n the same fashon wth the excepton that the amount of the standard deducton ($13,850) was subtracted from each of the ncome levels (Table 13). As expected, ncorporatng exemptons and deductons coupled wth the FARRM contrbuton results n fewer farms wth a tax lablty. The general concluson regardng the shfts caused by NTF or NSF based contrbutons does not change. Namely, both measures result n smlar changes n the proporton of farmers n each tax bracket. The greatest shft to lower tax brackets comes n the low ncome year, It s also useful to note that a much greater proporton of the farmers n the hgher ncome tax brackets are mpacted by contrbutons to the farm accounts. That s, there are fewer farms that are n the hgher brackets to begn wth and they are more lkely to change brackets as a result of contrbutng to a FARRM account than are the farmers n lower tax brackets. 14
17 Table 13. Percent of Farmers n Varous Tax Brackets Assumng Deductons and Maxmum Contrbuton to FARRM Accounts a, 142 New York Dary Farms, Margnal Income Tax Bracket Bass for Deposts 0% 10% 15% 27% 30% 35% 38.6% Percent of Farms, 1997 No Deposts Schedule F Net ncome Net Taxable Income Percent of Farms, 1998 No Deposts Schedule F Net ncome Net Taxable Income Percent of Farms, 1999 No Deposts Schedule F Net ncome Net Taxable Income Percent of Farms, 2000 No Deposts Schedule F Net ncome Net Taxable Income Percent of Farms, 2001 No Deposts Schedule F Net ncome Net Taxable Income a The analyss assumes that net taxable farm ncome s reduced by the amount of the standard deducton for marred flng jontly of $7,850 and two personal exemptons ($6,000 total). The NSF measure s only used to determne the amount of the FARRM Account contrbuton. The fnal analyss of the margnal tax brackets summarzes the percent of farmers n each margnal tax bracket over the entre perod, (Table 14). These results further llustrate the fndngs prevously presented. The ablty to contrbute to FARRM accounts tends to push farmers from the top tax brackets to lower tax brackets and the choce of NTF or NSF as the mechansm for determnng the contrbuton does not result n a sgnfcant dfference. 15
18 Table 14. Percent of Farm Incomes n Each Margnal Tax Bracket Over a FveYear Perod Assumng Dfferent Deductons and Contrbutons, a Hghest Margnal Tax Bracket 0% 10% 15% 27% 30% 35% 38.6% No standard deducton No standard deducton, FARRM based on NTF No standard deducton, FARRM based on NSF Wth standard deducton Wth standard deducton, FARRM based on NTF Wth standard deducton, FARRM based on NSF a The percentages are of 710 observatons. The observatons are for 142 farms over a fveyear perod. FARRM Accounts: Analyss Wthdrawals and Benefts To ths pont the analyses have reled on very basc assumptons. In order to estmate the wthdrawals from FARRM accounts and the benefts obtaned by depostng funds n the accounts one must make addtonal assumptons. In dong so t s useful to examne the possble motvatons and benefts that mght accrue by contrbutng to FARRM accounts. The most basc beneft obtaned by contrbutng to the account s the deferral of tax lablty for one year or more. Because the farmer must eventually wthdraw the funds, the contrbuton s a deferral unless the contrbuton s wthdrawn when the farmer s n a lower tax bracket resultng n taxaton at a lower, possbly zero, rate. The ablty to defer taxes allows the farmer to nvest funds that would ordnarly be pad to the government. The beneft of nvestng these funds can be expressed as: (1) beneft = ( balance * t )( r)( 1 t ) where beneft s the net beneft n year of deferrng taxes on the amount deposted n the account n year, balance, t s the margnal tax rate n year, and r s the rate of return earned on the deferred taxes. Ths equaton was used to estmate the beneft of deferrng taxes n any gven year. The benefts receved by nvestng deferred taxes overstate these benefts, because they do not consder any opportunty costs for the funds. For nstance, f the farm could pay down debt wth these funds, the benefts would lkely be negatve unless the rate of return n the account, r, s qute hgh. The cumulatve balance n the account was estmated by addng the maxmum contrbuton n any year to prevous year s balance and subtractng any wthdrawals from the account. (2) balance = balance 1 + contrbuton wthdrawal Therefore n order to estmate the beneft n any gven year t was necessary to estmate the wthdrawals from the accounts. The followng general relatonshp was used to estmate 16
19 wthdrawals from the accounts under the assumpton that the farmer wshed to mnmze taxes pad. (3) wthdrawal T 0 f = mn bkt bkt [( target ( ncome contrbuton adjustments )), balance ] 1 otherwse where wthdrawalt s the wthdrawal from the account n year under the tax mnmzaton assumpton, mn returns the mnmum of the arguments n brackets and bkt s the farmer s tax bracket n the current and prevous perod. In order to determne the wthdrawal t s necessary to set a target ncome measure for each year, target. In ths case the target measure was set as the hghest ncome level assocated wth the farmer s current tax bracket. For nstance, f the farmer was n the 27% tax bracket the ncome target was $112,850 (Table 15). The current tax bracket was determned by subtractng the contrbuton to the account under ether a total farm net ncome target or a schedule F net ncome rule from net taxable ncome. In other words, the tax bracket was always based on NTF, but the contrbuton to the account could be based upon 20% of ether a NTF or NSF contrbuton rule. Ths makes t possble, although unlkely, that the tax brackets could dffer dependng upon the ncome measure used to defne the maxmum contrbuton to the account. Our analyss only allowed farmers to wthdraw funds from the account f ther tax bracket fell from the prevous year. It would be possble to consder wthdrawals desgned to maxmze the current tax bracket regardless of the prevous tax bracket, but such analyses would not maxmze the potental ncome tax exempton benefts assocated wth the FARRM accounts. Table 15. The Margnal Tax Brackets (2002 year) Used as the Income Target n Tax Based Wthdrawal Models Margnal Tax Brackets Income 0% $0 10% $12,000 15% $46,700 27% $112,850 30% $171,950 35% $307, % >$307,050 In each perod, the current perod NTF or NSF reduced by current perod contrbutons and other adjustments are subtracted from the target ncome. If the value s postve the farm wthdraws the smaller of the shortfall or the balance n the account as of the prevous perod. Ths formulaton allows the farmer to reduce ncome by the amount of current perod contrbutons, but current perod wthdrawals are lmted to the amount that had been contrbuted n pror perods. Two dfferent scenaros were examned wth respect to the sze of the standard deducton allowed the farmer. These standard deductons are symbolzed wth the adjustments varable. For nstance, the base scenaro assumes no standard deductons n whch case adjustments s equal to zero. In another case, the farmer s allowed the standard deducton for marred flng jontly wth two personal exemptons and adjustments s equal to $13,
20 Three addtonal wthdrawal rules were also examned. These rules were based upon ncome targets and can be summarzed by (4). (4) wthdrawal 0 f = mn target ncome < 0 [( target ncome ), balance ] 1 otherwse In ths formulaton wthdrawals were made when ncome fell below the target measures. The wthdrawal was the lesser of the balance n the account n the prevous perod and the amount of the shortfall from the target ncome measure. Ths formulaton does not reduce ncome by the amount of the contrbuton to the account. Under ths mechansm the farmer would use the account to smooth ther ncome. Targets were defned to represent a fveyear rollng average of ncome, a one perod rollng ncome target, and a shortterm movng average ncome target. The targets were constructed for both NTF and NSF ncome. The descrptons of the targets are gven for the case of total farm net ncome. The same targets were used for the case of Schedule F net ncome. The fveyear rollng average ncome target for NTF s presented n (5). 3+ j = j NTI (5) Roll j = j = 1 and Roll j = j = 2,3, j = j NTI The one perod rollng ncome target for NTF s defned n (6). (6) Roll NTI 1, j = j j = The shortterm movng average ncome target for NTF s defned n (7) 1 + NTI1996+ = 1 (7) StAve j = j = 0,1,2, 3 1+ j j Benefts and Wthdrawals: Tax Based Wthdrawals For NTF and NSF, two basc analyses were conducted and n both we assume that the tax brackets are those for a marred couple flng jontly n The frst analyss s based upon the assumpton that the margnal tax bracket was determned based only upon the level of NTF and reduced by the amount of the contrbuton to the FARRM account (ether NTF or NSF based). Thus, n both cases the level of NTF s used to determne the margnal tax bracket. The amount of the contrbuton wll depend upon whether NTF or NSF s used as the contrbuton rule. Ths analyss s consstent wth assumng that the farmer generated enough offfarm ncome to offset any potental standard deducton. The second analyss assumed that the farmer was able to reduce NTF by the amount of the contrbuton to the FARRM account (ether NTF or NSF based) and by the standard deducton for a marred couple flng jontly ($7,850) and two personal exemptons ($6,000) for a total deducton from net taxable farm ncome of $13,
21 In the prevous secton we estmated that the average annual contrbuton to FARRM accounts would range between $10,610 and $13,382 dependng upon the net ncome measure used to defne elgblty. Thus, a typcal farm would contrbute slghtly over $50,000 to the account over a fveyear perod. One beneft of ths contrbuton s that the farmer s able to nvest the tax savngs. The aftertax earnngs on these funds are then a net beneft to the farm. In order to calculate the potental earnngs on these funds t was necessary to estmate the balances n the accounts and the aftertax rate of return. Ths estmaton requres that we also estmate the wthdrawals from the accounts. The average wthdrawals from the accounts were frst estmated assumng that farmers would only wthdraw funds when they found themselves n a lower tax bracket (see equaton (3)). The analyss proceeded by calculatng the margnal tax bracket for each farm and each year. When the tax bracket fell the farmer was allowed to wthdraw enough funds to exhaust the lower tax bracket or the balance n the account. The total wthdrawals were then calculated for each farm and averaged. The estmated average annual wthdrawals are reported n Table 16, whch shows the average annual wthdrawals per farm under varous assumptons regardng the contrbuton rule and whether or not the standard deducton was allowed. It s also mportant to note that the wthdrawals were only allowed n the 4 years after the establshment of the program (the farm could not contrbute and wthdraw the same funds n the same year). The results ndcate that on average a farm would wthdraw approxmately $4,277 when the contrbuton was based upon NTF wth no standard deducton appled. It s mportant to note the role the standard deducton plays s n determnng the tax bracket. Table 16. Average Annual Wthdrawals from FARRM Accounts per Farm wth a Tax Based Wthdrawal Rule, 142 New York Dary Farms, Depost Crteron Standard Deducton Average Wthdrawal Maxmum Wthdrawal NTF No $4,277 $148,349 NSF No $3,622 $115,746 NTF Yes $4,531 $151,811 NSF Yes $3,858 $115,746 It s useful to note that t would appear that smply relyng upon a tax based wthdrawal rule would not let the farmers wthdraw all of ther funds from the accounts. Thus, t s lkely that a 5year maxmum depost lmt would not allow farmers to wat for a drop n ther tax bracket to wthdraw all of ther funds. Ths would lmt the tax exempton beneft provded by the accounts, but would ncrease the tax deferral beneft of the accounts. The results ndcate that by gnorng the standard deducton, one generally underestmates the amount that would be wthdrawn from the account by $254 n the case of NTF and $236 n the case of NSF. The dstrbuton of average wthdrawals under the four scenaros consdered s shown n Fgure 3. Ths fgure truncates wthdrawals at $30,000. At ths pont, the wthdrawals from all but about 5 farms are captured. Ths fgure llustrates several key ponts. Frst, a large proporton of the farms make no wthdrawals from the accounts. The fewest farmers are able to wthdraw under the NSF contrbuton and wth the standard deducton (90). Ths occurs because fewer farms change tax brackets wth ths approach as the $13,850 reducton n taxable ncome places them at the top of a tax bracket and these farms are not offset by farms moved to the bottom of the tax brackets. Second, only about 10 of the farms make average wthdrawals n excess of $10,
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