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Helpful comments from Richard Bird, Isaias Coelho, John Isaac, Michael Keen, Russell Krelove, and Peter Mullins are gratefully acknowledged. Discussions with John Isaac have been particularly valuable. The usual disclaimer applies.
The basic difference between a CFT and an accounts-based VAT is that wages are a deductible expense under the former but not under the latter. Because of its conceptual similarity to the CFT, such a VAT is not further discussed below. Surely the desirability of taxing wages at the business level would in part depend on how wages are taxed at the personal level—a subject that is not pursued in this paper.
It is perhaps worth mentioning in passing about a frequent argument by tax practitioners against the CFT (or for that matter, any tax that deviates from the conventional CIT): the possibility that it will not be regarded by countries that operate a residence-based tax system as a creditable tax, and hence may deter foreign investment. This argument is largely irrelevant (with one possible caveat) with respect to any tax that taxes only excess profits or rents. Given that normal profits are not taxed, foreign investors are unlikely to find such a tax unattractive even if it is not creditable at home, as long as the combined tax rate of home and host countries does not reached 100 percent. The one caveat concerns lumpy investments that may prevent the full exploitation of all excess profits.
The bulk of these transactions comprises distributions to shareholders, and will be so characterized as a shorthand reference in the rest of the paper. However, there are clearly other share-related transactions, such as the issuance of new shares (an inflow) and purchases of shares in other domestic corporations (an outflow)—see Table 1 for a more precise definition of different types of transactions.
Let R be the net cash inflow of real transactions, F be the net cash inflow of financial transactions, and S be the net cash outflow of share transactions. Then, R + F ≡ S, which is the well-known accounting identity. In the rest of the paper, unless stated otherwise, the labels “S” and “R+F” will be used interchangeably.
It is, for example, the business tax component of the celebrated flat-tax proposal of Hall and Rabushka (1995).
The X tax consists of the destination-based R-CFT at the business level and a progressive labor compensation (wage) tax at the personal level.
In a more complete analysis, the optimal financing mix, i.e., the value of α, would be determined endogenously by the investor’s profit-maximizing calculus. But this issue is not an essential aspect of the present paper.
One common argument against the CFT is that, due to its expensing of fixed assets, it would have a narrower tax base than the conventional CIT for this reason alone. However, accelerated depreciation and investment allowances of varying extents are often found under the latter tax, Hence, it is not at all clear a priori that, when such features exist, which tax in fact has a broader base. In a recent study, Becker and Fuest (2005) found that switching from the conventional CIT to either an R-CFT or an S-CFT in Germany would have surprisingly small revenue effects.
If the investor has no access to debt financing (i.e., α = 0), the R-CFT would duplicate the no-tax environment.
This statement is strictly true only if the S-CFT is implemented on an origin basis, as explained below.
This is conceptually the same problem that has plagued the VAT treatment of the financial sector on a transaction-by-transaction basis. For further discussions and a possible solution, is Zee (2005).
However, the S-CFT does need to distinguish between interest and dividend flows, but this requirement seems simpler to control by several orders of magnitude than the general need to separate real and financial transactions.
An origin-based R-CFT would also be effective, by default, against thin capitalization (but not transfer-pricing) problems.
For ease of presentation, it has been assumed here that transactions with residents and non-residents are completely independent and separable from each other. This is not typically the case in reality, of course. For real transactions, as when domestic inputs are used in producing exports, apportioning of the cash outflows arising from purchasing such inputs between exports and domestic sales is necessary for any destination-based tax (R-CFT or S-CFT). The same apportioning would need to apply to financial transactions under a destination-based S-CFT, as when (say) a bank uses domestic nonfinancial inputs (wages, overhead costs, etc.) to support financial transactions with non-residents. Such inputs would also have to be apportioned, such as based on the shares of cash inflows from financial transactions with residents and non-residents in the total of such inflows.
Note that if the resident borrowers are taxable entities, the loan proceeds would be taxable in their hands immediately. In this case, there would not even be a timing difference on the flow of tax revenue to the treasury.
Bradford (1998; 2004) has proposed a similar scheme (depreciation plus an allowance equal to the interest on business assets) to manage the transition from a conventional CIT to an R-CFT, and argued that such a scheme is equivalent to (for a constant tax rate) the expensing of fixed assets in present value terms. The analysis in this paper shows that this equivalence is strictly true only for marginal projects. For projects earning excess profits, expensing—which provides an advantage that goes beyond a zero METR—will always be more beneficial to investors (whether under the R-CFT or S-CFT) than any scheme requiring some sort of carry-forward with interest. The cost of the added advantage to investors provided by expensing is borne, of course, by the government, in the form of either a lower level of revenue or a higher level of revenue risks, or both.
For simplicity, it is assumed that the tax depreciation allowance given corresponds to the true economic depreciation of the fixed assets.
Of course, this begs the question why, if the taxpayer is able to borrow to finance the tax payment, he would not borrow more to finance the project itself. As noted earlier, there are probably other factors not analyzed here that would limit the extent to which the project could be leveraged by debt.
Note that, in a more general setting with multiple concurrent projects extending over multiple years, this equivalence holds only if tax credits are carried forward under either the S-CFT or R-CFT on a project-by-project basis. Moreover, the tax credits associated with each project have to be spread over the life of the project in proportion to the economic depreciation of the project’s underlying fixed assets.
A transaction-based VAT on the destination basis would zero-rate exports (thus effectively freeing exports from tax) and tax imports.