THE DESTINATION-BASED CASH FLOW TAX AND VAT-TYPE OPTIONS

A rather more fundamental type of reform than we have considered so far would involve moving from the income-type taxation of businesses toward a consumption- type tax system. Consumption-type taxes—such as cash flow taxes and various forms of a VAT—all share some fundamental commonalities. A cash flow tax takes as its base the net cash flows of a firm (its cash receipts minus its cash outlays). As investment is fully deductible at the time it is undertaken (i.e., fully “expensed”), a cash flow tax is a tax on economic rents, exempting the normal return to capital. The destination-based cash flow tax (DBCFT) builds on this idea by adding a destination principle that addresses many of the cross-jurisdictional distortions of corporate taxation (Auerbach 2010; Auerbach, Devereux, and Simpson 2010).[1]

Moving to a DBCFT from the existing corporate income tax involves two major steps. The first is to transform the tax base from income to cash flow. This is accomplished by allowing deductions for all cash outflows (including the full cost of investment expenditures). The full expensing of investment eliminates distortions to the amount of investment. All cash receipts (apart from cash generated by the issuance of equity) are included in the tax base. Borrowed funds are included in the tax base, while interest payments are deductible as they constitute cash outflows. The symmetric treatment of borrowed funds and interest payments eliminates debt bias.

The second step is the introduction of the destination principle. A cash flow tax that uses a source principle may distort discrete investment and location choices, even though it fully expenses investment, because the EATR may differ across locations. In contrast, the destination principle is based on the location of consumption. It is implemented by ensuring that the DBCFT does not apply to any form of cross-border activity. Income from abroad—whether earned by a foreign affiliate or from exports—is excluded. This exclusion of foreign-related cash receipts goes considerably beyond what territorial income tax systems seek to achieve, and its conceptual basis is quite different. For a territorial income tax system, the key principle is source, and foreign- source income is exempt under certain conditions; however, income from abroad that is attributable to domestic economic activity is taxable. Under a DBCFT, the guiding principle is destination rather than source, and so what matters is the location of consumption, not the source of income. Thus, there is also no deduction for the cost of purchases made abroad. The DBCFT's stance of ignoring foreign transactions is essentially equivalent to the border adjustments made under a destination-based VAT, which ensure that the base of the VAT includes only domestic consumption.

The DBCFT would solve virtually all distortions from the corporate tax. It was noted earlier that it would not affect the amount or location of investment and that it would eliminate debt bias. There is no gain from income-shifting because the source principle has been jettisoned. Under a DBCFT, there are no tax consequences associated with repatriation. Thus, lockout will not occur, and there will be no ownership distortions. Notwithstanding the caveats raised by the analysis in section 8.2.2, it is reasonable to expect that there would be a substantial efficiency gain from the elimination of the deadweight costs associated with the (mis)allocation of workers to tax planning activity.

The only possible exceptions to this rosy scenario relate to areas where the DBCFT interacts with the personal tax system. In particular, the distortion to payout depends on the personal tax treatment of dividends and capital gains, while the distortion to the choice of organizational form depends on the personal tax treatment of pass-through business income. The adoption of a DBCFT does not, by itself, settle these issues, and the consequences with respect to these margins depend on the personal tax system with which the DBCFT is paired.

One possibility is that the current personal income tax system continues to operate. Then, some distortions, for instance to organizational form, may persist. To address issues of organizational form, Auerbach (2010) proposes extending the DBCFT to S corporations (pass-through entities that are close substitutes for C corporations), based on the number of shareholders rather than on legal form. This would reduce the distortion, and while there may be some inefficiency at the margin (for instance, firms keeping the number of shareholders above or below the threshold for application of the DBCFT), it might reasonably be expected to be localized and small.

An alternative perspective emphasizes the commonalities between the DBCFT and the VAT. The DBCFT is equivalent to a destination-based subtraction-method VAT with a deduction for payroll (Auerbach, Devereux, and Simpson 2010).[2] Thus, the DBCFT could be viewed as the business component of a subtraction-method VAT (with a deduction at the business level for wages). Value-added due to labor inputs could then be taxed at the individual level, with this individual wage tax replacing the current personal income tax. The individual tax on value-added due to labor would resemble the individual component of other subtraction-method VAT-type proposals, such as the well-known Hall and Rabushka (1995) flat tax. When paired with an individual-level tax on value-added due to labor, the DBCFT would eliminate all the distortions catalogued in section 8.2. In particular, organizational form distortions of the type discussed in section 8.2.6 will not occur because there is no personal income tax, and payout to common stockholders will also be unaffected by this tax system as there would be no personal tax on dividends or capital gains.

The DBCFT is thus clearly very attractive, in that it can solve essentially all of the inefficiencies described in section 8.2. It should be remembered, however, that this virtue is shared by VAT-type proposals such as the flat tax and by a VAT (especially a “full-replacement” VAT under which personal and corporate income taxes would be eliminated).[3] Moreover, implementing a DBCFT would raise new issues of administration and law, whereas the implementation of a VAT could draw on the extensive body of law and experience developed by about 150 countries over several decades. Thus, the introduction of a VAT or one of its variants would seem to be a policy that is worthy of serious consideration, notwithstanding its lack ofpolitical popularity and the opprobrium it attracts in the Hatch Report.[4] However, a full consideration of the ramifications of such a fundamental reform is beyond the scope of this chapter.

  • [1] Devereux and de la Feria (2014) address issues relating to the implementation of a DBCFT.Note that the DBCFT proposal formulated by Auerbach (2010) applies to financial as well asnonfinancial firms.
  • [2] VAT systems generally use either the subtraction method—which involves computing the valueof sales, subtracting the costs of inputs, and then applying the VAT rate to the result—or the credit-invoice method, which involves computing the value of sales, applying the VAT rate to the result,and then subtracting the VAT paid on inputs (which are established using the invoices providedby suppliers). These approaches are fundamentally equivalent, and tax the same base (namely, consumption). However, the credit-invoice method predominates around the world and is thought tohave various administrative advantages (Grinberg 2010).
  • [3] Note, however, that while legal form as such does not matter for VAT liability, there may be adifferent distortion to firm size around the VAT threshold. Most countries apply VAT only abovea threshold, typically defined in terms of turnover (e.g., Liu and Lockwood 2015), and firms may“bunch” below such a threshold.
  • [4] In the US political arena, a VAT is criticized primarily for two reasons—its “regressivity” relativeto the current personal income tax and its reputation as a “money machine” that is “too” efficient atraising revenue. The distributional issues are important, though it should be remembered that redistribution can be achieved via expenditures as well as revenues.
 
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