Cash-Flow Tax
  • 1 0000000404811396 Monetary Fund

The cash-flow tax has been proposed as an alternative to the corporate income tax on grounds that it would define the tax base more clearly and more simply in the face of widespread departures from the comprehensive income tax of actual practice. The cash-flow tax, and its variants, would require careful design. Simplicity may prove elusive because of anticipated administrative problems related to tax avoidance and evasion through transfer pricing, to inflation adjustments, and to incompatibility with existing international tax regimes. Thus, the tax remains theoretically attractive but difficult to implement.


The cash-flow tax has been proposed as an alternative to the corporate income tax on grounds that it would define the tax base more clearly and more simply in the face of widespread departures from the comprehensive income tax of actual practice. The cash-flow tax, and its variants, would require careful design. Simplicity may prove elusive because of anticipated administrative problems related to tax avoidance and evasion through transfer pricing, to inflation adjustments, and to incompatibility with existing international tax regimes. Thus, the tax remains theoretically attractive but difficult to implement.

This paper surveys some practical issues relating to an alternative form of corporate taxation: the cash-flow tax.1 Cash-flow taxation has long been discussed as an alternative to the taxation of income, both at the personal and the corporate levels. There has been a renewed policy interest in such proposals recently, motivated by long-standing conceptual arguments and increasingly by administrative reasons. It is argued that despite a renaissance of the comprehensive income tax as an ideal in many tax reform endeavors of the 1980s, it is only poorly approximated in the existing tax codes. Cash-flow taxation might be a viable alternative to the “uneasy compromise” (Aaron, Galper, and Pechman (1988)) of a “hybrid income-consumption tax.”

Conceptually, cash-flow taxation is based on consumption; thus, it is neutral with respect to capital formation. The practical advantages of cash-flow taxation—its definitional clarity and its simplicity of measurement—were first forcefully argued by Andrews (1974), as well as discussed in a U.S. Treasury report (1977). Perhaps they have received more interest recently as tax theorists have come to emphasize the implementation and administration of tax policy (Kay (1990), Slemrod (1990), and, for developing countries, Khalilzadeh-Shirazi and Shah (1991)). The classic Haig-Simons ideal of a comprehensive income tax, based on consumption plus net accrual of wealth, seems to be rather problematic when judged by these criteria. It has been argued that the hypothetical nature of the accrual concept tends to create complexities in the tax code, increase the burden of administration and compliance, and foster avoidance and distortion (Kay (1990), p. 67). Under these circumstances, a cash-flow tax seems a promising alternative especially at the corporate level, where equity concerns about exemption of capital income are irrelevant and where some technical problems are less salient.2

Opponents of the cash-flow tax question the superiority of its tax base on equity grounds. Also, they are usually not optimistic about the administrative advantages of the tax. Regarding the corporate sector, they decry it primarily because of implementation problems and the lack of international experience and coordination. The doubts emanate from perceived difficulties in containing tax evasion, because of transfer-pricing practices, and tax avoidance, because of intracompany leasing arrangements, as well as because the tax may not be creditable in those countries that export capital until they themselves introduce the tax. Therefore, the tax may not be compatible with the existing international tax regime. In addition, political forces that lead to the erosion of the corporate income tax (CIT) base are also likely to affect the corporate cash-flow tax (CCFT) base. Although the cash-flow tax may address some inherent shortcomings of the income tax, it is not any less vulnerable to the political pressures working to undermine the system through special provisions and targeted incentives.3

The objective of this paper is to survey some of the practical problems associated with the introduction of a CCFT—namely, its effects on revenue, the possibilities for tax avoidance and evasion, the international compatibility of the tax, and transition issues. We begin by discussing the conceptual background of the tax and pointing to some of the advantages and disadvantages that arise from its definition. We next assess the CCFT on practical grounds rather than on its conceptual merit, addressing issues that would arise in the transition to a CCFT, as well as considerations of a more general nature. Among the latter are the revenue effects arising from the CCFT's impact on investment, the often expressed preoccupations regarding increased tax avoidance and evasion, and the implications of the relatively uncoordinated cross-country tax arrangements that currently prevail. However, many of the difficulties associated with administration of the cash-flow tax are not reviewed in any detail. Finally, many middle-income developing countries, especially in Latin America, are considering the introduction of a cash-flow tax. Therefore, the paper, at several points, gives specific consideration to issues relevant for them.

I. Conceptual Elements

Conceptually, the CCFT has been discussed as a supplement to a personal expenditure tax, a personal income tax, and a value-added tax (VAT), and as a tax on economic rent. The CCFT base also varies in conception, reflecting whether real transactions or real and financial transactions are taxed. These and related issues are discussed below.

What Is a CCFT?

Although the focus seems to have shifted over time, the CCFT rests within a tradition of consumption tax proposals (Sunley (1989)). Thus, it is usually advocated first as a supplement to a personal expenditure tax (ET) that is designed (1) to withhold tax on economic rents and nonwage labor income,4 (2) to discourage evasion of the ET by individuals through business activities, and (3) to capture foreign capital income. It would also curtail the windfall capital gains accruing to shareholders if an ET were adopted.

Second, the CCFT has been discussed as a separate corporate tax alongside a personal income tax system. Such a system would fall short of the ideal consumption tax “package.” But given the difficulties of an ET, a CCFT may be a second-best alternative, correcting the administrative and economic shortcomings of the CIT (Mintz and Seade (1991), King (1986)).

Third, the CCFT was suggested, in an array of variants, as a tax on economic rent. For example, it has been recommended as an ideal resource tax (Garnaut and Clunies Ross (1983)).5

Fourth, there seems to be an argument for combining the cash-flow tax with the VAT. Thus, if a VAT is calculated using the subtraction method, the same tax return could be used to deduct wages and investment in order to compute the cash-flow tax.

The following discussion is not confined to any particular form of the CCFT. For practical purposes, the most relevant option seems to be the CCFT as a complement to a personal income tax. However, most of the points raised will be equally valid for other variants.

CCFT Tax Base

Following Meade (1978), there are three types of CCFTs:

—The R-based CCFT is one in which the tax base is net real transactions—that is, the difference between sales and purchases of real goods and services. As opposed to an income tax. the distinctive features of such a tax base are the immediate expensing of capital outlays and the nondeductibility of interest payments. At the same time, interest received is no longer taxable.

—The RF-based CCFT (real plus financial) is one that also includes nonequity financial transactions—that is, the difference between borrowing and lending. Interest and retirement of debt would be deductible, but borrowing and interest received would be taxable: RF base = (sales + borrowing + interest received)—(purchases + interest paid + debt repaid).

—The S-based CCFT taxes the net flow from the corporation to shareholders—that is, S = (dividends paid + purchases of shares—issues of new shares).6 The S base is conceptually equivalent to the RF base minus the CCFT, as can be seen from a basic accounting identity: any difference between total business inflows and outflows has to be paid out either to shareholders or as tax, RF = S + CCFT. Since taxes enter into the sources and uses-of-funds statement, the rate of the RF-based tax would be tax inclusive. The S-based rate would be tax exclusive—it could well be higher than 100 percent.

The S base was favored by Meade (1978) because it was perceived as administratively simpler. However, the conceptually equivalent RF base is closer to current tax base configurations and is therefore more commonly discussed as an alternative to the CIT. Nevertheless, an R-based CCFT system has been advocated recently by McLure (1991) and by McLure and others (1990), who suggest it as part of a simplified alternative tax, which is essentially a consumption-flow tax for business and personal taxation. McLure argues that the exclusion of financial transactions makes an R-based tax easy to administer. On the other hand, the exclusion of the financial sector from the R-based CCFT is an obvious drawback. Further, it increases the problems of transition and seems particularly prone to tax avoidance schemes, points that are elaborated upon later.

Selected Characteristics

A classic interpretation of the CCFT is that government acts as a “silent partner” in an investment (Brown (1948)). This is most clearly seen for the S base where the government sustains tax losses from the equity raised and receives revenue from the distributed earnings. Alternatively, with immediate expensing and a tax rate tc, capital outlays K produce a tax loss of teK. This can be interpreted as a reduction in the corporation’s own investment outlay, so that its effective financing becomes (1 - tc)K. If one assumes a constant tax rate, government will then share a proportion tc of all subsequent inflows. As outflows and inflows for the corporation are reduced proportionately by the “silent partnership,” the rate of return on an investment remains unaffected by taxation.

The “silent partnership” enables the government to appropriate a share of the above-normal returns that are generated in the economy. Those returns may be economic rents from entrepreneurial activity, from nonrenewable resources, or from monopoly, but can also be investors’ compensation for risks, which on average will be positive. Hence, the CCFT can also be interpreted as a tax on pure profits and on returns to risk taking (Stiglitz (1976)). For marginal projects that just cover the opportunity cost of capital, the present values of initial tax losses and of subsequent CCFT payments just offset each other.7

The marginal effective tax rate of zero is a crucial implication of the CCFT. The tax is neutral with respect to the employment of capital. In itself, the tax would not discourage any project that might have been undertaken in its absence.

From a theoretical perspective, there are a number of other attractive features of a CCFT (King (1986)):

—The exemption of marginal returns implicit in immediate expensing does not discriminate between debt and equity.8 The income tax favors debt over equity by allowing deduction of interest only. Partial integration of corporate and personal income taxation does not solve this problem as long as there is a substantial spread between marginal investor tax rates.

—Immediate expensing also ensures neutrality with respect to the rank ordering of projects. Under the income tax, any divergences between the profiles of “economic” and “tax” depreciation—which are virtually inevitable—result in positive or negative tax wedges that distort this ordering (Samuelson (1964)).

—Except for situations of hyperinflation (where even annual expensing falls short of a full deduction of real investment), the cost of capital is not affected by inflation under the CCFT.

—If the CCFT is introduced alongside a personal income tax, there is no need to integrate the two taxes. Because capital income is effectively exempt at the corporate level under the CCFT, the appropriate treatment would be the classical system under which the corporation is treated as a separate entity and no effort is made to attribute its earnings to equity holders.

—The CCFT is based on current transactions and hence avoids the timing problems of a typical income tax: expensing replaces the calculation of “true economic depreciation” as well as the need for an inflation adjustment of inventory and asset replacement values. The problem of capital gains is irrelevant.

For practical purposes, however, two critical assumptions underlying the theoretical neutrality results need to be stressed: it is assumed that tax rates are constant and that taxable inflows are always sufficient to offset expenses, so that an investment will actually produce an initial tax reduction. These points are considered next.

Rates of a neutral CCFT must not be progressive and must be stable over time. The latter, especially, may be a problem, since governments have a short-run incentive to raise rates once investors have committed themselves (King (1986)).9 An unexpected rate hike in itself will not affect the allocation of capital but only generates wind fall-tax revenue. However, the effects of a CCFT on investment activity will depend crucially on the credibility of the government’s pledge not to change rates in the future.

If inflows are insufficient to offset expenses, a cash refund for unused deductions would be required to make an ideal CCFT work. Alternatively, a provision to carry forward losses at an appropriate interest rate could be used to preserve the present value of the initial deduction. Following the silent-partner interpretation, one might also say that with a loss-carry forward provision the government’s “equity share,” tc, is effectively financed by a forced loan from the firm. For the CCFT to remain neutral, the loss then has to be carried forward at the firm’s discount rate. Timing issues obviously would sneak in through the back door if loss—carry forwards are used. Grossing them by firm-specific discount rates is hardly possible. Thus, there seems to be a clear trade-off between practical and conceptual considerations in some important aspects of the application of a CCFT.

II. Practical Considerations

While the CCFT cannot be strongly criticized for lacking theoretical foundations, it does come up against some practical hurdles. The important practical considerations for the CCFT fall into two categories: those that involve the transition phase and those that involve its general implementation.

Transition Issues

There are numerous concerns that arise during the transition from a CIT to a CCFT. First, a “cold turkey” transition would produce windfall-tax revenue by denying companies their existing depreciation allowances. On the other hand, allowing immediate expensing of remaining depreciation could adversely affect revenue. A hybrid of allowing continued depreciation might be the only practical solution. As Sunley (1989) points out, however, such “transitional” arrangements may have to last for a number of years.

Most authors (Gordon (1989), Sunley (1989)) suggest that a short-term revenue loss is likely during the transition. Various arrangements could accommodate the amortization of old investment, while new investment could generate substantial tax losses. In order to mitigate this effect, one may resort to “present value expensing” (McLure and others (1990))—that is, during the transitional period, deductions for new investments could be spread out over several years, grossed so that their present value would still equal the initial outlay. This obviously would raise the issue of using the right discount rate.

The particular choice of the CCFT base and transitional provisions would obviously affect the financial position of firms (King (1986)). Under an R-based CCFT, leveraged firms could face financial distress because interest would no longer be deductible. Yet, continued interest deductibility for old debt might be prone to manipulation. The solution, therefore, would seem to be an RF-based CCFT.

In the very short term, the tax may have undesirable announcement effects. Investment might collapse in anticipation of future expensing unless the tax can be introduced retroactively. If the prospective CCFT is RF based, firms may increase borrowing and later repay debt by raising equity. Whether retroactive enactment is possible could depend on political factors (King (1986)).

General Issues

Under a CCFT, issues such as the stability of revenue, a high possible incidence of tax avoidance and evasion, and international compatibility assume particular importance. These are addressed below.

Revenue Implications

The CIT is an important source of revenue in many developing countries. Following a bell-shaped curve, its share of GDP and total revenue

generally increase in the initial stages of development,10 so that for different income groups in developing countries the CIT makes up between 11 and 23 percent of total the revenue. In a few cases, tax CIT accounts for more than one-fourth, even more than one-half, of total revenue (Tanzi (1990)).

The revenue implications of any change in corporate taxation have to be weighed very carefully in this context—even if one were to argue that, in the long run, the CCFT is likely to foster growth through increased investment and improved capital allocation and that the government would participate in such growth. If we leave aside both the purely transitional issues and the longer-term structural and dynamic effects, what can be said about the revenue implications of the CCFT?

Smaller Tax Base? There are conflicting views about the likely differences in the size of the corporate tax base under a CIT and a CCFT. The straightforward argument against the CCFT is that full and immediate expensing seems to reduce the tax base. The government forgoes tax on the marginal returns to capital, and one would therefore expect the CCFT rate to be higher than the initial income tax rate if present-value revenue is to be sustained.11

On the other hand, proponents of the CCFT have based their case partly on the massive erosion of the tax base under the CIT (Kay (1990), King (1986)). They argue that most marginal returns escape taxation anyway. Firms find it advantageous to finance their investments through debt, as nominal interest payments are deductible. Foreign investors may choose “thin capitalization” to shield their income from host country taxation and to facilitate repatriation. Legislative rules against excessive interest deductions often are not fully effective. Firms may also avoid taxation of capital income by making use of special incentives, such as accelerated depreciation, tax arbitraging, tax-preferred activities, and investing abroad.

The traditional view of the CIT as a tax on the use of capital in the corporate sector becomes questionable. According to the “new view,” the CIT is instead a tax on immobile production opportunities in the corporate sector. The CCFT is the “logical counterpart” (Kay (1990), p. 29) of this “new view,” since it would tax the same base while eliminating the excess burden of the present system, for example, by restoring debt-equity neutrality.12

Empirical work on developed countries suggests that the CCFT and the current income tax base would not be very different in many cases. Assuming unchanged behavior on the part of firms, and ignoring transitional issues, several rough estimates of the potential yield from a CCFT in the United Kingdom, the United States, and Canada indicate that even for stable tax rates the revenue loss should not be a serious problem (King (1986), Daly, Jung, and Schweitzer (1986)). Gordon and Slemrod (1988) found that by 1983 the U.S. tax code offered so many tax arbitraging opportunities that exemption of capital income through adoption of a “pure” cash-flow tax would have increased revenue, even after transitional losses were taken into account.13

In developing countries where the corporate sector is dominated by large mineral exporters, local cartels, monopolies, and debt-financed foreign corporations, the existing CIT may also be fairly close to a pure profits tax, as the tax base consists mainly of above-normal returns.14

Mintz and Seade (1991) suggest that, in many cases, the CCFT might actually increase revenue, because existing tax codes already provide generous investment incentives. With fast write-offs and tax holidays, income taxation is similar to the CCFT.

Investment and Current Revenue. The tax yield under the CCFT would also tend to be very sensitive to investment. Under an income tax with “true economic depreciation,” gross returns and offsetting capital allowances on an investment follow the same time pattern. But, under the CCFT, taxable inflows from past investments are partly offset by the expensing of new outlays. Hence, current revenue will depend on the difference between the average rate of return and the rate of growth of the capital stock. During periods of rapid expansion—which, for instance, may follow structural adjustments in reforming socialist economies-revenue could dry up or even become negative, at least theoretically.15 In other words, revenue could drop during upswings in economic activity, making the tax procyclical.

This does not imply that revenue would be permanently postponed. In the long term, the capital stock would not, on average, grow faster than the average rate of return on it. Nevertheless, the sensitivity of revenue to investment is undesirable both in terms of fiscal liquidity and business-cycle effects. As far as the latter is concerned, the CCFT would tend to generate more revenue during the downside of a business cycle since investment would tend to be low, even as returns from earlier investments could flow into the tax base.

However, to the extent that existing tax codes have special investment incentives, such as accelerated depreciation or investment tax credits, similar problems do arise under an income tax. Because of administrative problems and collection lags, the stabilizing effects of corporate income taxation are also less clear than they appear in theory. On the whole, however, it seems that the ramifications of incentives and collection lags under the income tax should be less pronounced.

Revenue Risk, As the government assumes the “silent partner” role with full loss offset, revenue from individual projects becomes more risky—though its expected value is still positive if investors are risk averse. Still, the “silent partnership” should not cause substantial variations in total revenue as long as the independent risks of many projects can be pooled. But in the case of a small country with only a few major projects, or in the case where risks are correlated, variability of revenue may be an additional concern.16

Other Effects. Two other revenue-related points deserve mention. First, the introduction of the CCFT may require substantial improvements in the loss-offset provisions of the existing CIT. Such improvements may be costly in terms of revenue if previous loss trading between corporations was imperfect. Second, there may also be a revenue-increasing effect if the CCFT actually improves the administration of taxes on small businesses and other hard-to-tax groups.

To conclude, the revenue effect of replacing a CIT with a CCFT remains an empirical question. Whether or not a revenue-neutral CCFT would require higher rates depends on the particular income tax laws to be replaced, the value of economic rents earned in the corporate sector, and the current debt-equity compositions of corporate portfolios. Transition rules might be needed to soften any adverse revenue effect of the conversion, and such rules may have to be applied for a considerable period of time.

Tax Avoidance and Evasion

The above discussion of revenue effects excluded possible behavioral responses by corporations. However, as firms try to exploit any new “loopholes” in the CCFT, revenue could be lost and tax administration might face new challenges.

A number of new possibilities for “gaming the system” under the CCFT have been discussed in the literature (Sunley (1989), McLure and others (1990), Gordon (1989), Mintz and Seade (1991), Tait (1992)). Like any avoidance scheme, the problems are enunciated by, and based on, differences in tax rates between activities, jurisdictions, institutions or individuals, legal forms, and points in time, all of which make arbitraging profitable (Stiglitz (1988)). This section surveys some possible avoidance and evasion schemes. It also discusses the related tax-exhaustion problem, the merits of the R base versus the RF base, and some general issues.

Gaming the System. Some tax avoidance possibilities are specific to the R-based CCFT, as there is an entire class of schemes exploiting the crucial difference between taxable real flows and tax-free financial transactions (Sunley (1989)):

—Installment sales to a tax-exempt party may understate the taxable purchase price but overstate the tax-free interest component of seller financing.

—Labor, goods, and services may be sold at low prices and assets leased at low rates to a tax-exempt party, who in return would provide a low-interest loan to the employee, seller, or lessor; prearranged defaults and loan forgiveness would be extreme cases of such low-interest loans, unless they are included as imputed flows in the tax base.

—Companies using different accounting years may reduce their tax bases by increasing purchases from each other. At the end of its accounting year, company A could make large purchases from company B and vice versa. These intercompany transactions could be debt financed without tax consequences.

—To circumvent nondeductibility of interest payments, financing may be provided by a tax-exempt seller or lessor. Interest payments would be transformed into deductible leasing payments or purchases.

In order to contain these arrangements, McLure and others (1990) suggest that for tax deduction purposes, ceilings and floors may need to be imposed on interest rates.

Under both the R and RF bases, taxpayers may try to shift the tax base to an affiliated low-tax party, for instance a tax-exempt pension fund or a foreign corporation with a lower rate.17 Expensable capital outlays would be allocated to the high-tax party, and subsequent cash inflows would be directed toward the low-tax party. Such base shifting may take the form of

—transfer pricing through the purchase of inputs from the low-tax party at inflated prices, and the sale of goods at understated prices;

—low-rate leasing of capital acquired and expensed by a high-tax party to a tow-tax party; and

—selling expensed assets at understated prices to the low-tax party.18

Such schemes could be operated under the income tax as well, but the incentive for them is much more powerful under the CCFT. This is because expensing makes the present value of deductions on any asset equal to the purchase price. Under any other depreciation scheme, the present value of deductions decreases with the longevity of an asset and with the discount rate used by the corporation.19 Also, because the entire deduction is available up front under the CCFT, immediate sale of the asset at an understated price becomes much more attractive. Under an income tax, the high-tax party would have to hold on to the asset to benefit from available depreciation.

A CCFT will hence increase the incentive for tax-saving leases and for mergers between corporations with different tax rates. Foreign corporations may set up subsidiaries in the CCFT country only to take advantage of expensing, then channel inflows to a lower-rate jurisdiction.

Manipulation of reported transactions may also be an important channel of tax evasion. Companies could try to overstate asset prices upon purchase to the tax authorities. They could also buy equipment, take the deduction, and immediately resell, concealing or understating the price. These possibilities also arise under the income tax. Again, however, expensing, which grants tax savings up front, increases their attractiveness.

To counter base-shifting schemes, arm’s-length prices and rates for transactions between affiliates have to be enforced. But such monitoring is notoriously difficult. Perhaps certain types of transactions, such as leasing to foreigners or tax-exempt institutions, would need to be prohibited. If there is a system of wealth taxation, it may put some checks on the valuation of transferred assets. However, all such requirements would result in considerable complications, essentially eroding the tax’s main characteristic, simplicity, on which proponents base its attractiveness.

Some general lessons from the income tax apply even more so to the CCFT in this context. Tax treatment of activities and institutions should be uniform to reduce arbitraging opportunities. For instance, some business activities of tax-exempt institutions may be taxed. The rate structure should be flat and low to the extent possible (given revenue needs), since it determines the taxpayer’s per-dollar savings from reducing or shifting the tax base.

Tax Exhaustion and Tax Avoidance. A special case of uneven rates arises from tax exhaustion, where available deductions exceed taxable inflow. A tax-exhausted corporation has a marginal tax rate of zero, though its statutory rate may be quite high. It is unable to benefit from capital allowances.

Excess allowances (through tax losses) are likely to be much larger and more frequent under the CCFT. However, especially with an R base, whether the resulting lumpy tax profile will foster additional arbitraging and mergers largely depends on the loss-offset provisions. To the extent that such provisions ensure symmetrical treatment of profitable and loss-making corporations, profitable arbitraging would be curtailed.

Loss offsets are crucial to the CCFT in conceptual terms as well, and a refund would be the straightforward solution. Refunds may be problematic, though, in that they aggravate the problem of “hobby farms”: businesses set up solely to generate tax losses on consumptive, nonprofit-oriented activities. Rules against such abuses under the income tax would have to be carried over to the CCFT (Gordon (1989)).

If statutory provisions are insufficient, additional tax arbitraging through leases or mergers could take place. The objection against such arrangements should not be that they cost revenue; in fact they could be interpreted as a “market solution” to the tax exhaustion problem (King (1986), Stiglitz (1988)), ensuring equitable treatment of loss-making and profitable firms and preserving the investment incentive of the CCFT. But the objection is that such solutions would be inefficient, because they tend to distort economic activity through reduced competition and “parasitic tax-based industries” (Weeden (1988)). If full statutory loss-offset provisions cannot be obtained, a second-best strategy for government may be to facilitate loss trading.20

To conclude this section on tax avoidance and evasion, a summary assessment of the R and RF bases may be called for. The administrative advantage of the R base is that financial transactions can be entirely ignored. This actually reflects the basic concept of the CCFT—equal treatment of debt and equity. On the other hand, the R base is vulnerable to the above-mentioned tax avoidance schemes. With the RF base, the tax profile is less lumpy, and incentives for base shifting and evasion are reduced. However, the RF base creates an incentive to raise capital as equity and disguise payouts as interest payments, a problem that is shared under the income tax. Therefore, the existing CIT provisions to ameliorate these problems would have to be carried over to an RF-based CCFT.

International Issues

Since the CCFT is an untried tax, many legal and economic questions remain with respect to its international compatibility, especially where tax treatment of foreign investment income is concerned.

Basic Concerns, The introduction of the CCFT raises serious questions about international compatibility. These questions have legal as well as economic aspects. As the CCFT might not legally qualify as an income tax, its adoption could require the renegotiation of tax treaties. Such negotiations could take many years and hence imply considerable transactions costs and transitory arrangements. Moreover, tax treaties for many host countries offer a stability that they may not want to risk. Reforming socialist countries that ultimately want to join the European Community (EC) may find the CCFT unacceptable simply because it would not conform to the EC requirement for the CIT.21

Host countries are worried about losing existing options for “soaking up” foreign tax credits. Also, there has been an overriding concern that home countries—in particular, the United States—might not grant foreign tax credit for the CCFT and that this might discourage foreign investment. The creditability problem was the major obstacle for the adoption of CCFT proposals in Canada, Mexico, Sweden, and Colombia (Boskin and McLure (1990)).

Principles for Taxing Foreign Earned Income. Briefly recalling the basic principles applied to the taxation of foreign income (OECD (1991), Slemrod (1992), Leechor and Mintz (1991)), three regimes can be distinguished:

—Exemption: Home countries impose no tax at all on income earned abroad. This is sometimes referred to as the territorial system. Income is only taxed by the host country (source principle).

—Taxation upon accrual: Home countries reserve the right to tax worldwide income of their resident corporations (residence principle), and foreign income is taxed as it is earned. Taxation upon accrual is typically applied to foreign branches of resident corporations.

—Taxation upon repatriation: Home countries apply the residence principle. However, corporations can defer their domestic tax liability by retaining earnings abroad. Because of the time value of money, deferral reduces the effective domestic tax rate. This type of tax is typically applied to subsidiaries.

If home countries apply the residence principle, foreign income is potentially subject to double taxation in the host and home countries. Double taxation can be mitigated in different ways. First, the home country can allow deduction of taxes paid abroad. This is an efficient policy, since foreign taxes represent a social cost to the home economy. If the deduction is granted, resident corporations will equalize the aftertax foreign return to the pretax domestic return. However, this is not optimal from a global point of view, since capital exports are discriminated against. To ensure capital-export neutrality, many home countries grant a tax credit against foreign taxes paid. Corporations then equalize the pretax rate of returns. In terms of revenue, the tax credit implies that home countries bear the foreign tax burden of their resident corporations. Unless additional tax treaties impose restrictions, the host country can “soak up” these tax credits—that is, it can tax foreign investors without deterring them. However, the tax credit is usually limited to domestic tax liability (on the sum of domestic and foreign incomes), so that corporations ultimately face the higher of the (average) foreign or domestic tax rate. If the domestic rate is higher, the corporation will face the same effective tax rate at home and abroad. If the foreign rate is higher, the corporation may accumulate excess tax credits. Under a system of tax credit by source, such offsets are limited to income from a particular host country. Under the more generous worldwide system, excess tax credits may be used against tax on income from any host country. In this case the corporation actually faces the higher of the domestic and the average foreign tax rate.22

CCFT and Foreign Direct Investment. Here, two regimes can be identified.

—Exemption at home: The concerns about revenue and creditability are irrelevant for foreign investment from home countries that grant an exemption for foreign dividend income; in this case the CCFT host country will attract additional foreign investment until the pretax rate of return is equal to the after-tax rate of return in the home country.

—A creditable CCFT: What if the home country taxes foreign earnings? Let us first assume that the CCFT would be creditable. Another crucial distinction has to be made between corporations whose available tax credits are less than their domestic liability on foreign earnings (their so-called excess limit position) and those who have excess credits.

If corporations are in an excess limit position, the tax credit mechanism would wash out the effects of host country tax policy. The revenue argument against the CCFT is based on this point. While the investment incentive of the CCFT would be neutralized, revenue is forgone, simply to be picked up by the home country.

Note, however, that this argument does not hold in the presence of “tax sparing.” Under tax sparing, the home country assumes that the full tax has been paid in the foreign (host) country, in effect calculating foreign tax credit on the basis of regular foreign tax rates regardless of the actual taxes paid (on the basis of preferential treatment). This approach protects host country tax incentives. With the notable exception of the United States, many capital-exporting countries (such as Japan and the United Kingdom) have signed tax-sparing treaties with developing countries.

Note also that under a “deferral system,” retained earnings are tax exempt in the home country. The investment incentive of the CCFT may therefore remain effective. Hartman (1985) has argued that under deferral the home country tax is in fact a tax on repatriation rather than on foreign income. This “repatriation tax” is ultimately unavoidable and therefore affects neither marginal investment decisions nor decisions to retain or repatriate profits.23 Hence, a corporation considering reinvestment of funds earned abroad will compare after-tax rates of return just as it would under the source principle. A tax credit will still alleviate the overall tax burden but does not wash out the effects of host country tax policy.

The “new view” of host country tax policy under the deferral system has been criticized in the literature, however.24 The criticism does not apply to “immature” investment—investment funded at the margin by transfers from abroad, which may be predominant in many, especially ex-socialist, economies. It has also been pointed out that the formulas used for the calculation of the domestic tax are such that the investment and financing decisions of the subsidiary do affect the total liability on repatriated earnings.25

To preserve the incentive for “mature” investment but still “soak up” the foreign tax credit, the CCFT country may want to adopt a supplementary withholding tax on repatriated earnings (Sunley (1989), Mintz and Seade (1991)). Such a tax would introduce some administrative complications, because foreign corporations’ income would have to be calculated in order to distinguish dividends from the return on capital (Sunley (1989)). Also, the tax should not apply to foreign investors whose earnings are tax exempt at home. But discrimination between corporations hardly seems feasible (Slemrod (1992)). Finally, the creditability of such a tax is uncertain. It will probably depend on the creditability of the CCFT itself (McLure and others (1990), Sunley (1989)).

If corporations have excess tax credits, their foreign earnings at the margin are effectively shielded from domestic taxation. They do not trigger any additional liability in the home country. Host country tax policies therefore “matter” as they do under the source principle. Since the Tax Reform Act (TRA) of 1986, whose main feature was a reduction of U.S. statutory rates, many U.S. corporations have accumulated excess tax credits. This suggests that investment incentives of developing countries are likely to be more effective in the future, but some qualifications are in place.

Not all foreign investors are in an excess credit position. For non-U.S. multinationals the lowering of U.S. rates has meant a reduction of excess credit positions at home. Those who have excess credits are likely to adjust their behavior in order to make profitable use of them.26

In the long run, an excess credit situation may not be stable because (1) the home country, in this case the United States, may raise its tax rates since it does not collect revenue from corporations with excess tax credits; and (2) other host countries may lower their rates to attract additional investment. Host country tax competition may ultimately lead back to the usual situation, in which tax credits neutralize host country policies.

Arguments based on the excess credits of foreign investors can thus be easily overstated. “The TRA 1986 may have created a temporary disequilibrium” (Slemrod (1992), p. 13) rather than a fundamental change in the international environment for developing country tax policy.

—A noncreditable CCFT: So far, it has been assumed that the home country would grant foreign tax credit for the CCFT. Possible noncred-itability of the CCFT in home countries, however, especially in the United States, has been a major concern in countries considering the tax.

There is no clear answer in advance to the legal question of creditabil-ity. Conceptually, the CCFT is based on cash flow rather than on income, and thus seems likely to fail the “substitution test” required, for instance, by U.S. legislation. However, while the United States grants tax credit for income taxes, it also grants credit for taxes imposed “in lieu” of income taxes (Sunley (1989)). In fiscal terms, the CCFT makes home countries better off to the extent that they recover tax on marginal foreign returns. Therefore, there should be no reason for them to deny creditabil-ity (McLure (1991)).27 Also, home countries agreeing to protect host country incentives through tax sparing should be wilting to grant foreign tax credit for the CCFT (Sunley (1989)).

What if the CCFT were not creditable? Would double taxation discourage foreign investment? McLure (1991) points at three qualifications to this common argument, two of which were discussed above. First, “mature investment” may still be attracted by the CCFT because a repatriation tax does not affect rates of return at the margin. Second, corporations may have excess tax credits and therefore be back to source-based taxation at the margin. However, lasting excess credit “protection” of a noncreditable CCFT is only possible if the home country has a worldwide credit system, such that new credits may be earned in high-tax countries. If the home country grants credit only by source, excess tax credits are available only from the previous income tax regime and will be used up after some time. Third, it may be argued that a tax with a marginal effective rate of zero “even when combined with a (home country) tax on repatriated earnings is unlikely to have much disincentive effect on investment in the host country” (McLure (1991), p. 21). A noncreditable CCFT will not distort investment at the margin, because for projects just earning the opportunity cost of capital net CCFT payments will simply be zero.28

For a project earning above-normal returns, the CCFT burden that is deductible but not creditable at home will become an additional cost. To the extent that such investment is mobile, it will be discouraged by the CCFT. One may argue, though, that above-normal returns on investments in developing countries are often earned on immobile production opportunities (for example, the extraction of mineral resources or the exploitation of a local monopoly by a multinational trademark). In these cases, the noncreditability of a tax on pure profits will have no effect. Note, however, that the noncreditability of the CCFT is likely to entail the noncreditability of any supplementary withholding taxes. A noncred-itable withholding tax would clearly introduce a distortion even for marginal investment.29

III. Conclusions

The CCFT has the drawback of any untried tax innovation, simply that “no one does it” (McLure (1991), Mintz and Seade (1991)). There is no experience or administrative know-how about the possibly complex details of a transition to the CCFT, its operation, and the avoidance schemes that might emerge. No official ruling on the critical question of the creditability of the CCFT has been required so far. The uncertainty costs of experimenting with the tax may be reason enough for a developing country or an economy in transition not to implement the CCFT. The purpose of this paper, however, is to identify potential sources of problems and to understand better the conditions for a successful experiment with a CCFT. It seems clear that, depending on the existing CIT structure, the structure of the corporate sector, the relative importance of foreign investors, and the mix of countries they come from, some countries may find the CCFT less attractive than others. The key conclusions of the paper may be summarized as follows:

1. The theoretical pros of the CCFT seem clear. It can be interpreted as a “silent partnership” of the government in any investment, and as such it is generally neutral with respect to the financial and real decisions of corporations. The neutrality result has to be taken with a grain of salt as the loss-offset provisions are likely to be imperfect and some erosion of the tax base through lobbying and other political pressure is probably unavoidable. Expectations of future rate changes may also modify the results. Still, in a closed economy, the CCFT would tend to increase investment and improve the allocation of capital. On the administrative level, a tax based on observable cash flows rather than on a hypothetical concept of the accrual of income promises to be simpler and more robust (again, theoretically speaking). It would do away with the problems of defining “true economic depreciation,” measuring capital gains, costing inventories, and accounting for inflation.

2. Possible revenue effects are an important aspect of the CCFT, especially in developing countries, since the CIT to be replaced is often a major source of revenue. Revenue losses are likely during the transition period, but they need not be prohibitive if the transition is carefully designed and tax rates are appropriately adjusted. However, a more fundamental issue is that the CCFT as a tax on above-normal returns may have a significantly smaller tax base than the comprehensive CIT. With expensing, the tax base may also be more volatile. Nevertheless, the actual difference between the CCFT and CIT bases remains an empirical question, depending on the particular income tax laws to be replaced as well as on the current compositions of corporate portfolios between debt and equity. In some cases, the two bases may be fairly similar.

3. Tax-base erosion through tax avoidance and evasion may be a serious problem for the CCFT. By choosing an RF-based CCFT over an R-based one and by carefully designing the tax code, some of the CCFT schemes could probably be contained at reasonable administrative cost.30 But the large up-front deduction that results from the expensing of capital assets would create a powerful incentive for base-shifting schemes. The administrative efforts required to contain these schemes could be considerable and would involve the enforcement of arm’s-length prices, which is notoriously difficult. The “simplicity” argument for the CCFT has to be qualified accordingly.

4. Any answer to whether international considerations favor the CCFT would be complex. To the extent that host country tax policies matter, a country with the CCFT may attract additional investment. This is most clearly the case if home countries exempt the foreign earnings of their multinationals—as do many Western European countries. Other important capital-exporting countries, such as Japan, the United States, and the United Kingdom, apply the residence principle with a foreign tax credit. This system tends to neutralize host country tax policy, but not entirely. The incentive offered by the CCFT is likely to remain effective for those investors who benefit from tax sparing, which is granted by many countries but not by the United States. The CCFT is also likely to attract additional “mature” investment and investors who have excess tax credits. Recently, many U.S. corporations have accumulated such credits, although this position may not be stable in the long run.

To the extent that the effect of the CCFT is washed out by the tax credit mechanism, the host country will lose. Tax forgone on marginal returns is merely picked up by the home country. In the case where the home country denies tax credit for the CCFT, some foreign investment would be discouraged. The creditability of the CCFT is an issue related mainly to the United States, since most other developed countries either exempt foreign earnings or grant some form of tax sparing.

To conclude, at this point the CCFT remains a theoretically attractive option with some practical disadvantages. Moreover, many unanswered questions remain for its implementation by a single country—especially a developing one—in an environment that will not necessarily accommodate its smooth and effective operation.


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Parthasarathi Shome is Chief of the Tax Policy Division in the IMF’s Fiscal Affairs Department. Christian Schutte was a summer intern in 1992 in the same division when the paper was written; at the time, he was pursuing a master’s degree at the Kennedy School of Government at Harvard University. The authors would like to thank Milka Casanegra de Jantscher, Ved Gandhi, David Nellor, Emil Sunley, Vito Tanzi, and Howell Zee for many helpful comments. Remaining errors are the responsibility of the authors.


In the literature, the tax is sometimes referred to as the Brown tax, after its first classic proponent Brown (1948).


Among the problems confined to personal taxation are the treatment of consumer durables, education, and gifts and bequests. For a discussion of these and other problems of a cash flow-based personal consumption tax, see Pechman (1980).


For instance, claims have been made that the CCFT is “an alternative way to attain the objective of fiscal neutrality without a significant erosion of the tax base” (King (1986), p. 2) and that it “avoids the problem of targeted incentives; the need to pick winners and losers” (McLure (1991), p. 15).


Note here its similarity to the value-added tax, a point taken up below.


Cash flow-based rent resource taxes have actually been used for mining projects in Papua New Guinea, Tanzania, and several other developing countries (Garnaut and Clunies Ross (1983)).


Since share transactions between corporations cancel out, the aggregate S base represents the net flow from the corporate sector to shareholders.

For illustration, consider a simple two-period investment project of K— 1, which yields a pretax return of r. The present value of the CCFT payments from this project is given as

where—te is the tax benefit from initial expensing and (1 + r) is the cash inflow in the second period; i is the risk-free market rate of interest, equal to the government discount rate, so that (1 + i) is the discount factor. As can be seen, revenue is raised on the difference r—i, that is, on above-normal returns. A marginal project, with r = i, is effectively untaxed.


Financial decisions under the CCFT may still be distorted by the personal income tax—that is, if there is differential treatment of capital gains and dividend income.


This incentive is particularly strong under the CCFT because taxation consists of two separate stages: first the government contributes to an investment by granting expensing; then it collects revenue from the inflows. Defecting from initial tax rules after the first stage is more attractive than in the case of the income tax, where depreciation allowances and tax payments are calculated simultaneously over the lifetime of the project.


In industrial countries, the CIT has become relatively unimportant over time,

If total returns r constitute the tax base of the CIT, above-normal returns (r—i) form the base of the CCFT, ti and tc are the respective tax rates, and Tt and Tc are the present value of revenue under both taxes, then revenue neutrality requiring Tc - Ti implies
Thus, the re venue-neutral CCFT rate is

The right-hand expression in brackets, which is the ratio of total returns to above-normal returns, will obviously decrease for increasing r, as above-normal returns make up an increasing proportion of total returns. If the CIT allows initial expensing of a proportion a(0 ≤ a < 1), its base reduces to (r - ai): that is, the necessary rate increase will also be smaller.


A classic re interpretation of the CIT is Stiglitz (1976, p. 310): “In my interpretation of the U.S. tax system the dominant feature [of the corporation tax] is the interest deductibility provision….[The corporation tax] is partly a tax on pure profits, partly a tax on entrepreneurship and partly a return on an implicit government partnership in risk-taking. Quantitatively, I suspect that the third role is the most important.”


The strength of this argument should have declined after the 1986 tax reform.


Economic rents (such as in the cases of monopoly and mineral deposits) constitute a common tax base for the CIT and CCFT. Debt-financed corporations can shield marginal returns by deducting them as interest under the CIT. Thus, the CCFT and CIT become similar.

Assume a sequence of two-period projects. If total investment in the previous period was 1 but grows at rate g—so current investment is (1 + g)—then under the CCFT current government revenue Rr is
Contrast this with an income tax that allows expensing of proportion a. Current revenue Rt is

For a = 0 (no expensing), current revenue Ri is completely independent of g.


This argument may be an important element in the reluctance of governments to use the cash-flow base for mineral taxation.


This holds provided that international tax differentials are not washed out by tax credit mechanisms.


The problem arising from the possibility that firms may move once they have expensed an investment (Tait (1992)) could be alleviated by taxing them upon migration. Since they previously benefited from expensing, such a tax should not conflict with free international capital movement.


There is very little to be gained from shifting long-lived assets under the income tax. Think of land as the most extreme case. It is not depreciable under the income tax—but should be expensable under CCFT.

The difference between expensing and straight-line depreciation for different parameters is illustrated below. For example, an asset depreciated over ten years by a firm using a 4 percent discount rate produces a present value of deductions that is roughly 80 percent of its initial value. The CCFT always provides a 100 percent deduction.

Present Worth of Straight-Line Depreciation Deductions

(As a percent of asset’s cost)

article image
Note: Straight-line depreciation is cost divided by length of life, assuming no scrap value.


The so-called safe-harbor leases (legalization of purely tax-motivated leasing arrangements) in the United States and flow-through shares (option to pass losses on to shareholders) in Canada were controversial attempts in this direction (Daly, Jung, and Schweitzer (1986), Stiglitz (1988)).


As a consequence of growing economic integration, the coordination of capital income taxation will become even more important in the European Community. Although there are advocates of “spontaneous coordination” through increased competition of tax systems, this approach has serious problems. Rather, the European countries will want to increase managed harmonization of existing CIT systems (Tanzi and Bovenberg (1990)). A CCFT would hardly fit into this process.


Countries often do not apply one principle consistently but have special provisions for different circumstances. In general, tax exemption for foreign-source dividend income, at least that from tax-treaty countries, is provided by the following countries: Australia, Austria, Belgium, Canada, Denmark, Finland, France. Germany, Luxembourg, Netherlands, Sweden, and Switzerland.

The tax credit system for foreign dividends is used by Greece, Iceland. Ireland, Italy, Japan, New Zealand, Norway, Portugal, Spain, Turkey, the United Kingdom, and the United States. Iceland, Japan, and the United States provide worldwide tax credit; all other countries use the more restrictive credit by source (OECD (1991), p. 63).


However, it does affect the initial investment decision. Also note that the argument regarding marginal decisions not being affected should be qualified by the possibility that foreign income may never be repatriated.


Hines (1992) has a brief survey of this debate.


See Leechor and Mintz (1991) who develop a model to quantify empirically the effects of host country policy on effective tax rates and multinational investment. Using a related framework, Mintz and Tsiopoulos (1992) have estimated the incentive value of a cash-flow tax in central eastern European countries for U.S. corporations. They found that it would be reduced by about two-thirds on average.


Possibilities for such adjustments are outlined by Slemrod (1992).


The Internal Revenue Service may have a different view.


This is most clearly seen for a marginal project that uses perfect loss-carry forward. As cash inflows are just sufficient to offset the loss-carry forward, the corporation never makes any actual payment to the host country.


The effects of a noncreditable CCFT and withholding tax can be illustrated algebraically as follows:

1. The after-tax rate of return of a domestic investment is
Compare this with investment in a foreign country that has the CCFT. Domestic tax liability if foreign taxes are deductible is Td = td(rTt), where foreign taxes are Tf = tf(ri), assuming that a loss-carry forward bears interest at rate i. The after-tax rate of return on foreign investment is
and the wedge between the domestic and foreign after-tax rates of return is

If r > i, foreign CCFT payments Tf are an additional cost and hence discourage investment abroad.

2. A supplementary withholding tax with a rate of tw would increase foreign-tax liability by tw[r—tf(r—i)], where the term in brackets represents repatriated after-CCFT earnings. After a rearrangement of terms, total foreign tax liability becomes Tf = tf[(r—i)(l—tw)] + twr, and, from equation (1), the new wedge is

which is positive even for marginal investments, where r = i.

For numerical illustrations of the effects of a noncreditable CCFT, see McLure and others (1990).


This is not to say that the R-based CCFT has no advantages over the RF-based variant. After all, one attractive feature of the cash-flow tax is the nondeductibility of interest, which eliminates incentives for debt financing over equity financing and obviates any need for inflation adjustments to calculate real interest. These are properties of the R-based, rather than of the RF-based, CCFT.