I. Introduction

As is well known, the corporate income tax (CIT) in its conventional form engenders a number of serious economic distortions, the two most notable ones being that it creates a wedge between pre- and post-tax rates of return to corporate investment, and it provides a tax-induced incentive for debt financing. Administratively, it is also a most complex tax to enforce effectively, because it requires the correct attribution of profits in a world in which there are myriad ways taxable profits could be easily disguised, transformed, deferred, shifted out of the tax jurisdiction, or otherwise evaded. Problems of transfer-pricing and thin capitalization that plague the conventional CIT are notoriously difficult to tackle satisfactorily, and, if ad hoc administrative rules are used to deal with them (such as advance pricing agreements and debt-equity ratio ceilings), such rules could well inject distortions of their own.

There has certainly been no shortage of proposals by academics and tax practitioners to reform the conventional CIT since the publication of the landmark tax reform study by the Institute for Fiscal Studies (1978)—commonly referred to as the Meade Committee study. The most notable of such proposals, which are comparatively summarized in Table 1, include: (1) the comprehensive business tax (CBIT) proposed by the U.S. Department of the Treasury (1992); (2) the CIT with an allowance for corporate equity (ACE) proposed by the Institute for Fiscal Studies (1991); (3) various versions of the cash-flow tax (CFT) proposed by the Meade Committee itself and others; and, finally, (4) various versions of the accounts-based value-added tax (VAT)—which are to varying degrees conceptual cousins of the CFT—proposed by a number of researchers either as a way of taxing corporations at the local level (e.g., the business value tax (BVT) of Bird and Mintz (2000)) or as part of a broader, fundamental tax reform program (e.g., the subtraction-method VAT (S-VAT) as a component of the so called “USA” tax as described in Seidman (1997)).² Needless to say, these proposals vary in focus and ambition, but none is completely successful in overcoming all of the conventional CIT’s problems.³ Furthermore, some introduce problems of their own.

Table 1

Alternative Proposals for Reforming the Conventional CIT

Source: Author’s compilation.

^1/As stated, the tax is viewed as an income tax (as is common). However, as explained in the text, the S-CFT can also be viewed as a consumption tax that can be implemented on either the origin or the destination principle.

^2/Asterisks denote inputs used only in the production of domestic sales. Apportioning such inputs between exports and domestic sales is required.

^3/In income taxation, the source principle refers to taxing income arising from within the relevant country. The counterpart in consumption taxation is the origin principle, which taxes the value (however defined) of goods and services produced in the relevant country.

^4/In income taxation, the residence principle refers to taxing the world-wide income of residents of the relevant country. The counterpart in consumption taxation is the destination principle, which taxes the value (however defined) of goods and services consumed in the relevant country.

^5/From the accounting identity governing inflows and outflows and the definition of accumulation of the equity base, the base of the S-CFT can be stated alternatively as P − (E¹ –E⁰). In the long run, equity accumulates at the rate of “normal” return r, i.e., E¹ = (1 + r). E⁰, so that the base of the S-CFT is identical to that of a CIT with ACE.

^6/Japan’s S-VAT (known as the consumption tax) co-exists with a conventional CIT.

Table 1

Alternative Proposals for Reforming the Conventional CIT

Legends
Real transactions			Financial transactions			Share transactions			Other variables
Cash inflows:			Cash inflows:			Cash inflows:			P = pre-tax profits
	S = total sales			B = net borrowing			H = net increase in own shares issued			= S-M- W-I-DEP [+ DF]
	ES = exported sales			DF = dividends from investment abroad			DD = dividends from domestic investment		DEP = depreciation
Cash outflows:			Cash outflows:			Cash outflows:			E0 = equity at beginning of period
	W= wages and salaries			I = net interest expenditure			D = dividends paid		E1 = equity at end of period
	K = net acquisitions of fixed assets			VF = net investment in foreign shares			VD = net investment in domestic shares			= E0+H + P + DD - T - D - VD
	M= total purchases of nonlabor, noncapital inputs			C = net increase in cash balance					T = tax payment
	IM= imported nonlabor, noncapital inputs								r = representative rate of interest
		Conventional CIT	Income-based variants						Consumption-based variants
			CBIT		CIT with ACE	S-CFT		BVT	R-CFT		S-VAT
Tax base
Accounting basis		P	P + I		P - r.E0	(D+VD) – (H+DD)1/		P + W + I	Origin basis: S - W - K - M Destination basis: 2/ S - ES - W* - K* - M* + IM*		Origin basis: S - K - M Destination basis: 2/ Z-ES-K*-M*+IM*
Economic substance		Total corporate profits (return to equity).	Total corporate income (return to debt and equity).		Corporate profits in excess of “normal” rate of return r (excess profits).	Net cash outflow in share transactions, which by accounting identity is equivalent to net cash inflow of real and financial transactions combined.		Value-added of the income type.	Net cash inflows in real transactions.		Value-added of the consumption type.
Notable deviation(s) from conventional CIT		…	Nondeductibility of net interest expenditure.		Deduction of imputed opportunity cost of equity.	Tax liability arises only upon net distribution of dividends, less net acquisition of equity shares.		Nondeductibility of wages and net interest expenditure.	Nondeductibility of net interest expenditure. Full expensing of capital purchases.		Nondeductibility of wages and net interest expenditure. Full expensing of capital purchases.
Possible treatments of international transactions
Source/origin basis 3/		Foreign-sourced profits are exempt.	Foreign-sourced income is exempt.		Foreign-sourced profits are exempt. Foreign equity investment (VF) is treated on par with domestic equity investment, with foreign-sourced dividends (DF) exempted from tax.	Foreign-sourced dividends (DF) are not counted as inflows, and foreign equity investment (VF) is not counted as an outflow. Tax base adjusted accordingly.		Foreign-sourced profits are exempt.	Exports and imports are treated on par with domestic sales and purchases.		Same as R-CFT.
Residence/destination basis 4/		World-wide profits taxed, with credits for foreign taxes paid.	World-wide income taxed, with credits for foreign taxes paid.		World-wide profits taxed, with credits for foreign taxes paid. Foreign equity investment not deducted from base for computing ACE.	Tax base is as stated. However, reduction to the tax base resulting from foreign equity investment may justify denial of standard double-tax relief.		World-wide profits are taxed, with credits for foreign taxes paid.	Proceeds from exports are excluded from computing inflows, and payments for imports are excluded from computing outflows.		Same as R-CFT.
Main merit(s)		Prevailing international practice. Generally accepted principles and conventions.	Neutrality between debt and equity finance. Effective capture of interest income in the tax base.		No tax wedge between pre- and post-tax rates of “normal” return to investment. Neutrality between debt and equity finance.	Inclusive of those found in a CIT with ACE. 5/ Administrative simplicity as only a few transactions need to be monitored.		Inclusive of those found in the CBIT. Neutrality in capital-labor mix in production. Broadness of base could allow a relatively low rate.	Inclusive of those found in a CIT with ACE. Exclusion of financial transactions greatly simplifies administration. Elimination of transfer pricing if implemented on destination basis. No border monitoring needed for source basis.		Same as R-CFT, except for having a broader base (because wages are not deductible).
Main limitation(s)		Tax wedge between pre- and post-tax rates of return to investment. Bias in favor of debt over equity finance. Source-based tax is prone to foreign tax competition. Residence-based tax does not completely mitigate foreign tax competition, due to tax deferral and profit shifting devices.	Tax wedge between pre- and post-tax rates of return to investment remains. Foreign tax competition is reduced (thin capitalization removed) but not eliminated. Complexity arising from establishing franking account necessary to track interest and dividends paid out from tax-exempt income (if dividends not taxed in the hands of recipients).		Difficulty in choosing the “right” rate r of ACE. Different treatments of corporations earning above and below “normal” profits. Narrowing of the tax base requires a higher tax rate to meet a given revenue target. Issues of foreign tax competition left unaddressed. Foreign countries may regard a CIT with ACE not an income tax and deny foreign tax credits.	Annual revenue yield could be severely limited if profits are retained rather than distributed as dividends. Form of tax is drastically different from a conventional CIT, and most likely will not be recognized as such by most countries for foreign tax credit purposes.		Inclusive of those found in the CBIT. Greater deviation from the conventional CIT than the CBIT, potentially giving rise to greater problems of its recognition as an income tax.	Form of tax is drastically different from a conventional CIT, and most likely will not be recognized as such by most countries for foreign tax credit purposes. Destination basis requires border monitoring. Source basis vulnerable to foreign tax competition (except thin capitalization).		Same as R-CFT.
Country experience(s)		Most countries.	…		Belgium (effective 2007), Brazil, and Croatia and Italy (both discontinued)..	Estonia.		As local tax in Italy and United States (Michigan).	Proposed in the United States (destination basis).		Japan. 6/

Source: Author’s compilation.

^1/As stated, the tax is viewed as an income tax (as is common). However, as explained in the text, the S-CFT can also be viewed as a consumption tax that can be implemented on either the origin or the destination principle.

^2/Asterisks denote inputs used only in the production of domestic sales. Apportioning such inputs between exports and domestic sales is required.

^3/In income taxation, the source principle refers to taxing income arising from within the relevant country. The counterpart in consumption taxation is the origin principle, which taxes the value (however defined) of goods and services produced in the relevant country.

^4/In income taxation, the residence principle refers to taxing the world-wide income of residents of the relevant country. The counterpart in consumption taxation is the destination principle, which taxes the value (however defined) of goods and services consumed in the relevant country.

^5/From the accounting identity governing inflows and outflows and the definition of accumulation of the equity base, the base of the S-CFT can be stated alternatively as P − (E¹ –E⁰). In the long run, equity accumulates at the rate of “normal” return r, i.e., E¹ = (1 + r). E⁰, so that the base of the S-CFT is identical to that of a CIT with ACE.

^6/Japan’s S-VAT (known as the consumption tax) co-exists with a conventional CIT.

View Table

Table 1

Alternative Proposals for Reforming the Conventional CIT

Legends
Real transactions			Financial transactions			Share transactions			Other variables
Cash inflows:			Cash inflows:			Cash inflows:			P = pre-tax profits
	S = total sales			B = net borrowing			H = net increase in own shares issued			= S-M- W-I-DEP [+ DF]
	ES = exported sales			DF = dividends from investment abroad			DD = dividends from domestic investment		DEP = depreciation
Cash outflows:			Cash outflows:			Cash outflows:			E0 = equity at beginning of period
	W= wages and salaries			I = net interest expenditure			D = dividends paid		E1 = equity at end of period
	K = net acquisitions of fixed assets			VF = net investment in foreign shares			VD = net investment in domestic shares			= E0+H + P + DD - T - D - VD
	M= total purchases of nonlabor, noncapital inputs			C = net increase in cash balance					T = tax payment
	IM= imported nonlabor, noncapital inputs								r = representative rate of interest
		Conventional CIT	Income-based variants						Consumption-based variants
			CBIT		CIT with ACE	S-CFT		BVT	R-CFT		S-VAT
Tax base
Accounting basis		P	P + I		P - r.E0	(D+VD) – (H+DD)1/		P + W + I	Origin basis: S - W - K - M Destination basis: 2/ S - ES - W* - K* - M* + IM*		Origin basis: S - K - M Destination basis: 2/ Z-ES-K*-M*+IM*
Economic substance		Total corporate profits (return to equity).	Total corporate income (return to debt and equity).		Corporate profits in excess of “normal” rate of return r (excess profits).	Net cash outflow in share transactions, which by accounting identity is equivalent to net cash inflow of real and financial transactions combined.		Value-added of the income type.	Net cash inflows in real transactions.		Value-added of the consumption type.
Notable deviation(s) from conventional CIT		…	Nondeductibility of net interest expenditure.		Deduction of imputed opportunity cost of equity.	Tax liability arises only upon net distribution of dividends, less net acquisition of equity shares.		Nondeductibility of wages and net interest expenditure.	Nondeductibility of net interest expenditure. Full expensing of capital purchases.		Nondeductibility of wages and net interest expenditure. Full expensing of capital purchases.
Possible treatments of international transactions
Source/origin basis 3/		Foreign-sourced profits are exempt.	Foreign-sourced income is exempt.		Foreign-sourced profits are exempt. Foreign equity investment (VF) is treated on par with domestic equity investment, with foreign-sourced dividends (DF) exempted from tax.	Foreign-sourced dividends (DF) are not counted as inflows, and foreign equity investment (VF) is not counted as an outflow. Tax base adjusted accordingly.		Foreign-sourced profits are exempt.	Exports and imports are treated on par with domestic sales and purchases.		Same as R-CFT.
Residence/destination basis 4/		World-wide profits taxed, with credits for foreign taxes paid.	World-wide income taxed, with credits for foreign taxes paid.		World-wide profits taxed, with credits for foreign taxes paid. Foreign equity investment not deducted from base for computing ACE.	Tax base is as stated. However, reduction to the tax base resulting from foreign equity investment may justify denial of standard double-tax relief.		World-wide profits are taxed, with credits for foreign taxes paid.	Proceeds from exports are excluded from computing inflows, and payments for imports are excluded from computing outflows.		Same as R-CFT.
Main merit(s)		Prevailing international practice. Generally accepted principles and conventions.	Neutrality between debt and equity finance. Effective capture of interest income in the tax base.		No tax wedge between pre- and post-tax rates of “normal” return to investment. Neutrality between debt and equity finance.	Inclusive of those found in a CIT with ACE. 5/ Administrative simplicity as only a few transactions need to be monitored.		Inclusive of those found in the CBIT. Neutrality in capital-labor mix in production. Broadness of base could allow a relatively low rate.	Inclusive of those found in a CIT with ACE. Exclusion of financial transactions greatly simplifies administration. Elimination of transfer pricing if implemented on destination basis. No border monitoring needed for source basis.		Same as R-CFT, except for having a broader base (because wages are not deductible).
Main limitation(s)		Tax wedge between pre- and post-tax rates of return to investment. Bias in favor of debt over equity finance. Source-based tax is prone to foreign tax competition. Residence-based tax does not completely mitigate foreign tax competition, due to tax deferral and profit shifting devices.	Tax wedge between pre- and post-tax rates of return to investment remains. Foreign tax competition is reduced (thin capitalization removed) but not eliminated. Complexity arising from establishing franking account necessary to track interest and dividends paid out from tax-exempt income (if dividends not taxed in the hands of recipients).		Difficulty in choosing the “right” rate r of ACE. Different treatments of corporations earning above and below “normal” profits. Narrowing of the tax base requires a higher tax rate to meet a given revenue target. Issues of foreign tax competition left unaddressed. Foreign countries may regard a CIT with ACE not an income tax and deny foreign tax credits.	Annual revenue yield could be severely limited if profits are retained rather than distributed as dividends. Form of tax is drastically different from a conventional CIT, and most likely will not be recognized as such by most countries for foreign tax credit purposes.		Inclusive of those found in the CBIT. Greater deviation from the conventional CIT than the CBIT, potentially giving rise to greater problems of its recognition as an income tax.	Form of tax is drastically different from a conventional CIT, and most likely will not be recognized as such by most countries for foreign tax credit purposes. Destination basis requires border monitoring. Source basis vulnerable to foreign tax competition (except thin capitalization).		Same as R-CFT.
Country experience(s)		Most countries.	…		Belgium (effective 2007), Brazil, and Croatia and Italy (both discontinued)..	Estonia.		As local tax in Italy and United States (Michigan).	Proposed in the United States (destination basis).		Japan. 6/

Source: Author’s compilation.

^1/As stated, the tax is viewed as an income tax (as is common). However, as explained in the text, the S-CFT can also be viewed as a consumption tax that can be implemented on either the origin or the destination principle.

^2/Asterisks denote inputs used only in the production of domestic sales. Apportioning such inputs between exports and domestic sales is required.

^3/In income taxation, the source principle refers to taxing income arising from within the relevant country. The counterpart in consumption taxation is the origin principle, which taxes the value (however defined) of goods and services produced in the relevant country.

^4/In income taxation, the residence principle refers to taxing the world-wide income of residents of the relevant country. The counterpart in consumption taxation is the destination principle, which taxes the value (however defined) of goods and services consumed in the relevant country.

^5/From the accounting identity governing inflows and outflows and the definition of accumulation of the equity base, the base of the S-CFT can be stated alternatively as P − (E¹ –E⁰). In the long run, equity accumulates at the rate of “normal” return r, i.e., E¹ = (1 + r). E⁰, so that the base of the S-CFT is identical to that of a CIT with ACE.

^6/Japan’s S-VAT (known as the consumption tax) co-exists with a conventional CIT.

By denying the tax deductibility of interest expenses, the CBIT succeeds in leveling the field between debt and equity financing by raising the cost of debt to that of equity, but only at the price of further increasing the tax burden—and hence the economic distortion—on corporate investment. In contrast, the CIT with ACE takes the opposite track by providing an allowance equal to the opportunity cost of equity capital, and thus succeeds in leveling the field between debt and equity financing by lowering the cost of equity to that of debt. In doing so, this approach produces the attractive result that only excess profits (rents) of corporations are taxed, or, equivalently, of a zero marginal effective tax rate (METR) on investment. Unfortunately, taxable profits under it must still be determined according to conventional CIT rules, thus leaving all the problems of tracking and attributing such profits associated with the conventional CIT intact.

Fortunately, however, the CIT with ACE is not the only tax that could deliver the desirable property of a zero METR. As is well known, a CFT also has this property.⁴ Following the Meade committee study, it is now conventional to refer to a CFT as having three versions: (1) a real transactions-based CFT (R-CFT)—real transactions being those associated with the sales and purchases of goods and services; (2) a combined real and financial transactions-based CFT ((R+F)-CFT)—financial transactions being those associated with lending and borrowing, as well as interest receipts and payments; and (3) share transactions-based CFT (S-CFT)—share transactions being those associated with a corporation’s equity account (see Table 1). Since, by accounting identity, the net cash inflow of real and financial transactions combined must equal to the net cash outflow of share transactions,⁵ there are only two conceptually-independent versions of a CFT (although there are genuine administrative differences among all three versions).⁶

Modern discussions of the CFT have tended to focus on the R-CFT,⁷ probably because the S-CFT is largely seen as a tax on profit distributions, and therefore susceptible to deferral at the discretion of the taxpayers. It will be argued below that this deferral problem, though real, is probably limited in practice for a number of reasons. Nevertheless, the R-CFT has recently gained added prominence through a series of influential papers by Bradford (2001; 2003; 2004), who championed its adoption on a destination basis as the business tax component of his so-called “X” tax proposal.⁸ That Bradford’s business tax idea has recently been adopted by the president’s advisory panel on federal tax reform in the United States (henceforth the U.S. tax reform panel) can only further strengthen the R-CFT’s policy acceptability as a viable option for replacing the conventional CIT.⁹

The fundamental argument being advanced in the present paper is that, while the destination-based R-CFT is without question a better tax than the conventional CIT, it is not the best reform option available. A far superior choice would in fact be the S-CFT, suitably modified to produce, in effect, a hybrid CFT. This tax, henceforth referred to as the modified S-CFT, would have all the merits of the R-CFT but not its limitations. It would, therefore, be the ideal candidate as the conventional CIT’s replacement. Before describing the nature of the modified S-CFT, provided in Section III, the comparative merits and limitations of the R-CFT and S-CFT are first discussed in the next section. Section IV concludes the paper.

II. Merits and Limitations of R-CFT and S-CFT

Both the R-CFT and the S-CFT clearly share the hallmark of any CFT: the expensing of fixed assets. However, the economic implications of removing such assets from the tax base are different under them, because of their different treatments of financial transactions. To underscore this difference, and to lay the groundwork for discussing the modified S-CFT in the Section III, the merits and limitations of these two versions of the CFT are assessed from two different perspectives: distortion on investment and administrative complexity.

A. Distortion on Investment

To bring out the comparative impacts of the R-CFT and S-CFT on investment in as transparent a manner as possible, a simple example will suffice. Consider the following stylized two-period investment project requiring the purchase of fixed assets at a cost of 1 in the first period, in return for yielding an income in the amount of (1 + ρ) in the second, after which the assets have no salvage value. For simplicity but without loss of generality, it is assumed that no other inputs are required to generate this second-period income.

The investment can be financed by either equity capital (no distinction is made between new equity and retained earnings for simplicity) or debt at the prevailing interest rate r. The opportunity cost of equity capital is clearly also r, since the investor can forego undertaking the project and invest the funds in debt instruments instead. To fix ideas, assume that the proportions of debt and equity used to finance the project is and α (1 − α), respectively, where 1 > α > 0 is a given constant.¹⁰ In a no-tax world, the project entails cash flows in the two periods given in the following table (an outflow is indicated by a minus sign).

			1st period	2nd period
Real transactions
	Purchase of fixed assets		−1	--
	Income		--	1 +ρ
		Total	−1	1 +ρ
Financial transactions
	Issuance of debt		α	--
	Debt amortization		--	−α
	Interest expense		--	−α·r
		Total		−α·(1 + r)
Total of all transactions			− (1 − α)	(1 − α) + (ρ − α·r)

View Table

			1st period	2nd period
Real transactions
	Purchase of fixed assets		−1	--
	Income		--	1 +ρ
		Total	−1	1 +ρ
Financial transactions
	Issuance of debt		α	--
	Debt amortization		--	−α
	Interest expense		--	−α·r
		Total		−α·(1 + r)
Total of all transactions			− (1 − α)	(1 − α) + (ρ − α·r)

Hence, the project requires a net outflow of cash of (1 − α) in the first period (which amount is, of course, precisely equal to the injection of equity capital), in return for a net inflow of cash of [(1 − α) + (ρ − α·r)] in the second. The first component of the second-period inflow simply recoups the first-period outflow, and the second component represents the project’s net return. The implied rate of return (v) to this project is, therefore,

$\begin{array}{lllll}& (1)& v& =& \frac{(1-\alpha )+(\rho -\alpha \cdot r)}{1-\alpha }-1\\ & & & =& \frac{\rho -r}{1-\alpha }+r.\end{array}$

Equation (1) is particularly instructive in that it shows that the rate of return v can be stated as a sum of two components: the first represents the excess of income yielded by the project over the opportunity cost of equity, while the second is the opportunity cost itself. Whenever excess profits, or rents, exist (i.e., ρ > r), v can be raised by increasing the debt proportion α. In reality, there are, of course, other factors not captured in this simple stylized example that would probably place some upper limit on the extent to which investors could rely on debt financing. In a no-tax competitive economy, one would expect projects to be undertaken to the point where ρ and r would be equalized, so that the marginal project would be characterized by ρ = r. Consider now the impact of introducing different taxes at the rate t. Purely for reference, the conventional CIT is first briefly discussed.

Conventional CIT

Under the conventional CIT, interest is a deductible expense for tax purposes and a depreciation allowance d is given for fixed assets. Note that d need not be the same as the true economic depreciation (actual physical wear and tear) of such assets. The real and financial transactions associated with the project are the same as before, except that now there are additional tax calculations involved, as summarized below.

			1st period	2nd period
Tax calculations
	Income		--	1 +ρ
	Deductible expenses
		Interest	--	−α·r
		Depreciation	--	−d
	Taxable profits		--	(ρ − α·r) + (1 − d)
	Tax		--	t·[(ρ − α·r) + (1 − d)]
Post-tax net cash flow			− (1 − α)	(1 − α) + (1 – t)·(ρ − α·r) − t·(1 − d)

View Table

			1st period	2nd period
Tax calculations
	Income		--	1 +ρ
	Deductible expenses
		Interest	--	−α·r
		Depreciation	--	−d
	Taxable profits		--	(ρ − α·r) + (1 − d)
	Tax		--	t·[(ρ − α·r) + (1 − d)]
Post-tax net cash flow			− (1 − α)	(1 − α) + (1 – t)·(ρ − α·r) − t·(1 − d)

Total net outflow of cash in the first period is unchanged from before, since there are no tax consequences to the transactions that transpired in that period under a conventional CIT, while the total net inflow of cash in the second period is now reduced by the tax liability. The implied post-tax rate of return (v_c) to the project is, therefore,

$\begin{array}{lllll}& (2)& v_C& =& \frac{(1-\alpha )+(1-t)\cdot (\rho -\alpha \cdot r)-t\cdot (1-d)}{1-\alpha }-1\\ & & & =& (1-t)\cdot \left(\frac{\rho -r}{1-\alpha }+r\right)-t\cdot \frac{1-d}{1-\alpha }.\end{array}$

Putting the term involving depreciation aside for the moment, the significance of equation (2) is clearly that the conventional CIT taxes not only the excess profits, but also the opportunity cost of (normal return to) equity capital. A comparison between equations (1) and (2) reveals that the wedge between the pre- and post-tax rates of return is simply

$\begin{array}{ccc}& (3)& v-v_C=t\cdot \left(v+\frac{1-d}{1-\alpha }\right).\end{array}$

Equation (3) highlights the importance of tax depreciation as a variable affecting the profitability of the project: its pre-tax rate of return necessarily exceeds its post-tax rate of return as long as the tax depreciation does not exceed economic depreciation, i.e., 1 ≥ d. The converse could result if d exceeds unity and is sufficiently large, as it could happen if a large tax incentive in the form of an investment allowance is given to the investor.¹¹ If tax depreciation coincides with economic depreciation, i.e., d = 1, then the tax wedge, expressed as a proportion of the pre-tax rate of return, equals precisely the tax rate: t = (v − v*)/v, which is a well-known result in the tax literature.

R-CFT

As explained earlier, the R-CFT provides expensing of fixed assets but ignores financial transactions. In the context of the above stylized investment project, debt proceeds and amortization, as well as the associated interest expense, are not part of the cash flows for tax purposes. Tax calculations under it would then be as follows.

^1/A tax preceded by a minus sign represents a tax credit.

^2/It is assumed that (1 – α – t) > 0, for otherwise there would be net-of-tax cash inflows in both periods, which is not economically meaningful.

		1st period	2nd period
Tax calculations
	Pre-tax cash flow of real transactions	−1	1 +ρ
	Tax 1/	−t	t·(1 +ρ)
Post-tax net cash flow 2/		−(1 − α − t)	(1 − α) + (ρ −α·r) − t·(1 +ρ)

^1/A tax preceded by a minus sign represents a tax credit.

^2/It is assumed that (1 – α – t) > 0, for otherwise there would be net-of-tax cash inflows in both periods, which is not economically meaningful.

View Table

		1st period	2nd period
Tax calculations
	Pre-tax cash flow of real transactions	−1	1 +ρ
	Tax 1/	−t	t·(1 +ρ)
Post-tax net cash flow 2/		−(1 − α − t)	(1 − α) + (ρ −α·r) − t·(1 +ρ)

^1/A tax preceded by a minus sign represents a tax credit.

^2/It is assumed that (1 – α – t) > 0, for otherwise there would be net-of-tax cash inflows in both periods, which is not economically meaningful.

The implied post-tax rate of return (v_R) to the project becomes:

$\begin{array}{lllll}& (4)& v_R& =& \frac{(1-\alpha )+(\rho -\alpha \cdot r)-t\cdot (1+\rho )}{1-\alpha -t}-1\\ & & & =& \frac{(1-t)\cdot (\rho -r)}{1-\alpha -t}+r.\end{array}$

Equation (4) illustrates the well-known property of the R-CFT as a tax only on excess profits; a marginal project would bear no tax burden and, therefore, the METR would be zero. A far more important implication of equation (4) is, however, that if the investor has access to debt financing (i.e., α > 0), the R-CFT could actually confer a subsidy on the project.¹² To ascertain the possible subsidy element, subtract v in equation (1)—the no-tax rate of return— from v_R in equation (4) to obtain:

$\begin{array}{ccc}& (5)& v_R-v=\frac{t\cdot \alpha \cdot (\rho -r)}{(1-\alpha -t)\cdot (1-\alpha )}>0\text{as}\rho >r.\end{array}$

Hence, for any project earning excess profits, the post-tax rate of return under the R-CFT would actually exceed the rate of return in a no-tax environment. This result comes about because the denial of interest deductibility cannot fully offset the benefit of expensing whenever the fixed assets are yielding a return in excess of the interest cost of debt. Although seldom mentioned in the literature, it is a decidedly undesirable property of the R-CFT.

In principle, the above potential subsidy element can be neutralized in a straightforward manner: instead of granting the tax credit in the first period as a result of expensing, the tax credit is simply carried forward with interest at the rate r. In other words, the net cash outflow in the first period is restored to (1 - α), while the net cash inflow in the second period is increased by [t (1 + r)]. It then follows that the post-tax rate of return in this case becomes:

$\begin{array}{ccc}& (6)& {v^{\prime }}_R=\frac{(1-t)\cdot (\rho -r)}{1-\alpha }+r.\end{array}$

Compared to the no-tax environment, it is clear from equation (6) that the R-CFT, as modified, will always impose a tax burden at the rate t on any investment with excess profits.

While excess profits are taxed under the R-CFT with the above carry-forward of tax credits with interest, there is still the well-known implication that, under it, as fixed assets are expensed, the government essentially assumes the role of a silent partner in any and all private investments, thus exposing government revenue to the same investment risks as those faced by private investors. These risks cannot be completely mitigated simply by requiring that the total net tax credits in a given period be carried forward, since in a more realistic setting with multiple and concurrent investment projects, the overall profitability of a corporation in each period is an amalgamated outcome of successful and unsuccessful projects. This aspect of the R-CFT is an inherent limitation of any version of the CFT that has the expensing feature.

S-CFT

The S-CFT is a tax on the net cash outflow from transactions associated with the shareholders’ account (e.g., distribution of profits) of a corporation. As noted earlier, by accounting identity, it is equivalent to a tax on the net cash inflow from real and financial transactions combined. Hence, the tax calculations under such a tax are as follows.

^1/It is assumed that the second-period cash inflow is actually paid out to the investor.

^2/A tax preceded by a minus sign represents a tax credit.

		1st period	2nd period
Tax calculations
	Pre-tax cash flow of all transactions 1/	− (1 − α)	(1 − α) + (ρ − α· r)
	Tax 2/	− t ·(1 − α)	T · [(1 − α) + (ρ − α · r)]
Post-tax net cash flow		− (1 − t·)·(1 − α)	(1 − t)·[(1 − α) + (ρ − α · r)]

^1/It is assumed that the second-period cash inflow is actually paid out to the investor.

^2/A tax preceded by a minus sign represents a tax credit.

View Table

		1st period	2nd period
Tax calculations
	Pre-tax cash flow of all transactions 1/	− (1 − α)	(1 − α) + (ρ − α· r)
	Tax 2/	− t ·(1 − α)	T · [(1 − α) + (ρ − α · r)]
Post-tax net cash flow		− (1 − t·)·(1 − α)	(1 − t)·[(1 − α) + (ρ − α · r)]

^1/It is assumed that the second-period cash inflow is actually paid out to the investor.

^2/A tax preceded by a minus sign represents a tax credit.

In the first period, a tax credit is granted to the investor on account of the net cash outflow, while a tax liability arises in the second period on account of the net cash inflow. As a result, the implied post-tax rate of return (v_S) to the project is:

$\begin{array}{lllll}& (7)& v_S& =& \frac{(1-t)\cdot [(1-\alpha )+(\rho -\alpha \cdot r)]}{(1-t)\cdot (1-\alpha )}-1\\ & & & =& \frac{\rho -r}{1-\alpha }+r,\end{array}$

which is identical to the rate of return in a no-tax environment (see equation (1)). Hence, the S-CFT does not affect a project’s rate of return at all—even if the investment earns excess profits. Clearly, the S-CFT not only produces a zero METR, it also produces a zero average effective tax rate. This startling but well-known result is achieved by making no differentiation in the tax treatment between real and financial transactions, and is a fundamental implication of the accounting identity that ensures that the government’s tax intake in the second period represents exactly the recouping of the first-period tax credit at the project’s pre-tax rate of return.¹³ With such a tax, therefore, the role of the government as a silent partner of the investor is brought out even more starkly than before.

Just as in the case of the R-CFT, the first-period tax credit [t · (1 − α)] available under the S-CFT could be required to be carried forward with interest at the rate r into the second period to offset the tax liability in that period. In other words, the net cash outflow in the first period is restored to (1 − α), while a tax credit in the amount of [t · (1 − α) · (1 + r)] becomes available in the second period, thus reducing the tax liability in that period to [t · (ρ − r)]. The post-tax rate of return with such a carry-forward provision is:

$\begin{array}{lllll}& (8)& {v^{\prime }}_S& =& \frac{(1-\alpha )+(\rho -\alpha \cdot r)-t\cdot (\rho -r)}{1-\alpha }-1\\ & & & =& \frac{(1-t)\cdot (\rho -r)}{1-\alpha }+r,\end{array}$

which is exactly the outcome that would have been obtained under the R-CFT with a similar carry-forward provision (see equation (6)). Hence, apart from the S-CFT’s potential deferral problem (i.e., taxpayers can delay tax payments by engaging in lending activities), which is further discussed below, the two versions of the CFT can be rendered economically identical to each other through the carrying-forward of tax credits with interest. Moreover, for the same reason noted earlier with respect to the R-CFT, this carry-forward provision would likewise not be sufficient to completely mitigate the government’s exposure to private-sector investment risks under the S-CFT. As will be shown in Section III, the modified S-CFT being proposed in this paper is able to overcome this inherent limitation of a CFT and at the same time preserve its desirable zero-METR property. Before turning to that issue, however, it is important to compare the administrative implications of the two versions of the CFT. It is here that the S-CFT has a decisive advantage over the R-CFT.

III. Nature of Modified S-CFT

The discussions in the preceding section strongly suggest that, on administrative grounds, the S-CFT is clearly superior to the R-CFT. However, the government is exposed to possibly large revenue risks under either tax, which is clearly not reassuring news to any treasury that has to fund government programs on an on-going basis and would thus prefer a relatively reliable level of revenue collection. Fortunately, this limitation could be easily overcome by modifying the design of the S-CFT. The modification involves replacing expensing of fixed assets with normal depreciation allowances—but, crucially, the undepreciated value of the fixed assets is carried forward with interest at the opportunity cost of equity capital.¹⁹ It turns out that such a procedure would in fact produce an outcome that only excess profits would be taxed. To see this in the context of the stylized two-period investment project, note that a tax liability of (t ⋅ α) now arises in the first period (due to the inflow of loan proceeds α), but a new tax deduction of (1 + r) becomes available in the second period (representing the depreciation allowance with interest).²⁰ The associated tax calculations are shown below.

		1st period	2nd period
Tax calculations
	Pre-tax cash flow of all transactions	− (1 − α)	(1 − α) + (ρ − α · r)
	Tax	t· α	t·[(1 − α) + (ρ − α · r) − (1 + r)]
Post-tax net cash flow		− [1 − (1 − t·)·α]	(1 − t)·[(1 − α) + (ρ − α · r)] + t·(1 + r)

View Table

		1st period	2nd period
Tax calculations
	Pre-tax cash flow of all transactions	− (1 − α)	(1 − α) + (ρ − α · r)
	Tax	t· α	t·[(1 − α) + (ρ − α · r) − (1 + r)]
Post-tax net cash flow		− [1 − (1 − t·)·α]	(1 − t)·[(1 − α) + (ρ − α · r)] + t·(1 + r)

The post-tax rate of return in this case is, therefore,

As is evident, the carrying-forward of the undepreciated value of fixed assets with interest at the rate r achieves the desired outcome that the tax burden only falls on excess profits as they accrue. The intuition behind this result is straightforward: the added depreciation allowance available due to the interest factor (as compared to the normal depreciation allowance without interest) means that only returns yielded by the depreciable fixed assets in excess of the interest rate would result in any taxable profits. A comparison between equation (11) with equation (8) indicates that $v_S^{*}<v_S^{\prime }$, that is, carrying forward the undepreciated value of fixed assets with interest would result in a higher tax burden than carrying forward the tax credit with interest, as long as there is issuance of debt (which has tax implications because it generates a cash inflow). However, it is also clear that this increased tax burden does not affect the normal return to equity (which remains untaxed), and hence cannot distort investment at the margin. At the same time, since fixed assets are not expensed, government revenue would no longer be exposed to private-sector investment risks.

Note that under the modified S-CFT, a taxpayer has the ability to neutralize any discrepancy between $v_S^{*}$ and ${v^{\prime }}_S$ by engaging in an appropriate series of financial transactions To achieve this, the taxpayer could simply borrow sufficient funds to cover all tax payments in the first period and repay the loan in the second period with interest at the rate r.²¹ The amount of borrowing (B) needed for this purpose is simply

in which case the tax calculations become as follows.

		1st period	2nd period
Tax calculations
	Pre-tax cash flow of all transactions	− (1 −α) + B	(1 − α) + (ρ − α · r) − B · (1 + r)
	Tax	T·(α + B)	t ·[(1 − α) + (ρ − α · r) −B · (1 + r) − (1 + r)]
Post-tax net cash flow		− (1 − α)	(1 − t)·[(1 − α) + (ρ − α·r) − B ·(1 + r)] + t·(1 + r)

View Table

		1st period	2nd period
Tax calculations
	Pre-tax cash flow of all transactions	− (1 −α) + B	(1 − α) + (ρ − α · r) − B · (1 + r)
	Tax	T·(α + B)	t ·[(1 − α) + (ρ − α · r) −B · (1 + r) − (1 + r)]
Post-tax net cash flow		− (1 − α)	(1 − t)·[(1 − α) + (ρ − α·r) − B ·(1 + r)] + t·(1 + r)

The post-tax rate of return from the above cash flows is

where use is made of equation (12). Clearly, $v_S^{**}={v^{\prime }}_S={v^{\prime }}_R$ so the impact of the modified S-CFT on private investment could be rendered the same as that of the S-CFT and R-CFT by the investor’s own voluntary actions without jeopardizing government revenue, provided that tax credits are carried forward under either of the latter two taxes.²²

The above result is actually an illustration of a crucial aspect of a CFT that includes financial transactions in the tax base. For such a tax, the taxpayer can always alter the time path (but not the present value) of tax payments through lending and borrowing. Hence, in principle, the modified S-CFT is as susceptible to the deferral problem as the S-CFT. But how serious is this problem in reality? In answering this question, it is important to bear in mind that an act of lending by one party is necessarily mirrored by an act of borrowing by another party. For the economy as a whole, such financial transactions would result in a net tax deferral only if the borrowing party is tax exempt (or in a tax-loss situation). Of course, one important class of tax-exempt borrowers would be non-residents, but even this leakage would be closed off if the tax is implemented on the destination basis. Hence, as a practical matter, the overall scope of tax deferral under either the S-CFT or modified S-CFT would seem to be limited.

The modified S-CFT, as described above, possesses the crucial zero-METR property but does not have the administrative complexity of the R-CFT in having to treat real and financial transactions differently. There are other advantages as well: by not having the expensing feature, the modified S-CFT is highly unlikely to lead to many taxpayers having negative cash-flow positions for tax purposes—a distinct likelihood under the R-CFT (somewhat less so—but still quite possible—with the S-CFT). Apart from risk considerations, the revenue stream under the R-CFT would also likely be much more volatile than that under the modified S-CFT, due to the volatility of investment over business cycles (see Becker and Fuest (2005)). Of course, the modified S-CFT does involve retreating somewhat from a conceptually pure CFT—the incorporation of the depreciation feature essentially renders it a hybrid tax on income and cash flows—but the benefits from doing so seem absolutely compelling from the standpoint of reliable revenue collection.

Transitional issues always complicate any fundamental tax reform, such as replacing the conventional CIT with a CFT. However, the modified S-CFT has significantly less transitional complications to deal with than the R-CFT. First and foremost, interest expenses would continue to be deductible under the modified S-CFT as under the conventional CIT, thus rendering any measures for transitional relief that would be highly desirable under the R-CFT all but unnecessary. Secondly, the tax treatment of fixed assets under the modified S-CFT represents only a relatively small change to that under the conventional CIT; the carrying forward of the undepreciated value of fixed assets with interest could—if desired— be applied to all such existing assets without the need to separate new from old investments. The associated revenue loss from transitioning into a modified S-CFT will be far less than transitioning into an R-CFT, since new fixed assets will not be expensed.

Of course, not all transitional issues will be absent with the modified S-CFT, such as those connected with the tax treatments of outstanding loans extended by financial institutions and of existing business inventory holdings at the time the modified S-CFT comes into effect. These issues are generically the same as those that would arise if there are tax rate changes over time. For example, the tax effect of taking out a loan would be different from the tax effect of its repayment if the applicable tax rate had changed over the life of the loan. As in all major tax reforms, administrative rules would probably be required in practice to resolve these issues. The complexity of such rules would depend on the nature of the affected assets: a simple loan arrangement may only require a relatively straightforward basis adjustment at the time of its repayment before the principal amount is added to (subtracted from) the creditor’s (debtor’s) tax base, while a more complicated financial arrangement may well call for elaborate rules that may, at best, still yield only an approximate solution. Problems associated with tax rate changes afflict all versions of the CFT to varying degrees; the basic viability of any CFT is thus ultimately predicated on the presumption of a relatively stable tax rate.

Finally, a cautionary note should be made about the modified S-CFT: because a CFT (be it the R-CFT or S-CFT) is a consumption tax in substance (due to the expensing of fixed assets), implementing it on the destination basis would be on a par with implementing a normal transaction-based VAT on the same basis—a universal practice.²³ In contrast, a modified S-CFT does not technically have the expensing feature (although it does produce the same substantive outcome as any version of the CFT). Hence, implementing the modified S-CFT on a destination basis could potentially raise a question about whether it would amount to an export subsidy. On economic grounds, it would seem that if a destination-based modified S-CFT fails the export subsidy test, so would any version of a destination-based CFT. This is certainly a compelling, but obviously untested, proposition. Of course, this uncertainty can always be removed by going to the origin basis, but then the problems of transfer pricing and thin capitalization that afflict the conventional CIT would re-surface, although such problems are never worse under a CFT than under the conventional CIT.

IV. Concluding Remarks

This paper has argued that, while replacing the conventional CIT with a CFT is unquestionably a desirable tax reform, the version of the CFT that should be adopted is not the R-CFT that seems to have received common acceptance, but a modified S-CFT that is essentially a hybrid tax on income and cash flows. The crucial limitation of the R-CFT is that it treats real and financial transactions differently, which amounts to injecting a major non-neutrality into the tax system. This non-neutrality opens the door to all sorts of administrative complexities, including the correct tax treatment of financial services provided by financial institutions and the myriad ways real transactions can be disguised as financial transactions between not necessarily related parties. The regular S-CFT does not have this limitation, but it, just like the R-CFT, has the important drawback of exposing the government to possibly large revenue risks. The modified S-CFT remedies this drawback but otherwise retains the regular S-CFT’s neutral tax treatment of real and financial transactions.

The proposed modification to the S-CFT involves replacing the expensing of fixed assets—a typical feature of a CFT—with normal depreciation allowances, but, crucially, the undepreciated value of fixed assets is carried forward with interest at the opportunity cost of equity capital. This modification produces the desirable economic outcome of a zero METR—only excess profits are taxed as they accrue so that there is no distortion to investment at the margin. Furthermore, transitional complications are far less significant with the modified S-CFT than with any version of the CFT. Hence, the modified S-CFT is clearly a superior policy choice.

Just like a CFT, the modified S-CFT can be implemented on the destination basis, and thus would be equally effective in overcoming transfer-pricing and thin capitalization problems that plague the conventional CIT. However, there is some uncertainty regarding whether a destination-based modified S-CFT—by not being a pure consumption tax—would constitute an export subsidy. Nevertheless, since the economic outcome of the modified S-CFT is substantively the same as any version of the CFT, a compelling economic case could be made that they would in fact face identical scrutiny on this as yet untested question. Implementing the modified S-CFT (or for that matter any version of the CFT) on an origin basis would render the question moot, but then transfer-pricing and thin capitalization problems would re-surface—although such problems are never worse under any version of the CFT than under the conventional CIT.