Journal Issue
Working Paper Summaries (WP/93/1 - WP/93/54)

Summary of WP/93/2: “Cash-Flow Tax”

International Monetary Fund
Published Date:
August 1993
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Conceptually, cash-flow taxation is based on consumption and is therefore neutral with respect to capital formation. The paper identifies three variants of the corporate cash-flow tax (CCFT) as follows: (1) The R--or real--base CCFT taxes net real transactions (the difference between sales and purchases of real goods and services). As opposed to a corporate income tax (CIT), it allows immediate expensing of capital outlays but not the deduction of interest payments. Interest received is not taxable. (2) The RF--or real plus financial--base CCFT, in addition, includes in its tax base nonequity financial transactions (the difference between borrowing and lending). Interest and retirement of debt are deductible, while borrowing and interest received are taxable. (3) The S--or shareholder--base CCFT taxes the net flow from the corporation to shareholders (dividends paid plus purchases of shares minus issues of new shares) and conforms closely to the interpretation that the CCFT is a “silent partnership” of the government in any investment.

The success of a CCFT, the paper argues, depends on the existing CIT structure, the structure of the corporate sector, and the relative importance of foreign investors. The CCFT’s advantages, it claims, lie primarily in the theoretical clarity of the tax base insofar as it does away with the problems of defining true economic depreciation, measuring capital gains, costing inventories, and accounting for inflation (although not in all variants of the tax).

However, the paper observes, the CCFT can give rise to problems--for example, tax-base erosion through avoidance and evasion. This, the authors argue, could be contained by carefully designing the tax code and by selecting an RF-base over the R-base CCFT, thereby including the financial sector. On the other hand, an important advantage of the R-base CCFT--nondeductibility of interest, which eliminates incentives for debt over equity financing and obviates any need for inflation adjustments for the calculation of real interest--is not shared by the RF-base variant. The S-base CCFT, while sometimes favored because it has been perceived to be administratively simpler, could, the paper contends, lead to a tax rate of over 100 percent because of the definition of the S base. Thus, the choice among variants of the CCFT is not at all clear.

Observing that international considerations turn out to be important in any future implementation of the CCFT because of the unresolved treatment of foreign tax credits under a CCFT, the paper nevertheless argues that the prevalence of excess foreign tax credits and the existence of tax-sparing arrangements would tend to dampen the negative impact of a CCFT on foreign investment. The paper concludes that the CCFT remains a theoretically attractive option with accompanying practical difficulties. However, it notes, the CCFT may prove particularly difficult to implement for a single--especially developing--country in an environment that may not necessarily accommodate its smooth and effective operation.

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