Academic journal article Brookings Papers on Economic Activity

Demystifying the Destination-Based Cash-Flow Tax

Academic journal article Brookings Papers on Economic Activity

Demystifying the Destination-Based Cash-Flow Tax

Article excerpt

The destination-based cash-flow tax (DBCFT) has received considerable attention since the introduction of the House Republican tax plan (the House Blueprint) in June 2016 (Tax Reform Task Force 2016) and the November 2016 election that brought unified Republican control of the federal government. Although not new to the public finance or tax policy literature, the DBCFT was a novel idea for lawmakers, and its consideration generated a significant amount of lobbying activity, editorial commentary, and serious attention from tax specialists and the broader community of economists, many of whom had previously been unfamiliar with this approach. But the approach, its potential economic effects, and its rationale remain poorly understood.

I. What Is the DBCFT?

The DBCFT would modify the existing structure of U.S. business taxation for both domestic and international activities. With respect to the domestic side, the DBCFT would replace the income tax with a cash-flow tax, substituting depreciation allowances for immediate investment expensing and eliminating interest deductions for nonfinancial companies. On the international side, the DBCFT would replace the current "worldwide" tax system--under which the U.S. activities of U.S.- and foreign-based businesses and the foreign activities of U.S.-based businesses are subject to U.S. taxation--with a territorial system that would tax only U.S. activities, plus a border adjustment that would effectively deny a tax deduction for imported inputs and relieve export receipts from taxation. Popular discussion of the DBCFT proposal has focused almost exclusively on the latter provision, dubbing it the "border-adjustment tax," though border adjustment is only one component of the broader proposal. Yet even a cash-flow tax without a border adjustment would represent a major departure from the current tax system.

The DBCFT can also be thought of in relation to consumption taxation. It follows from the national income identity.

GDP = C + I + G + X - M,

that taxing consumption can be achieved by taxing imports and income net of exports, allowing the expensing of investment, and not taxing government purchases. Indeed, this is how value-added taxes (VATs) work in practice. In particular, VATs effectively exempt purchases of investment goods and impose a border adjustment. The border adjustment is needed to tax domestic consumption because some consumption goods are imported and some goods produced domestically are not consumed domestically.

Dividing private GDP (GDP - G) into returns to labor (W) and capital (R), the consumption tax can be broken into two pieces: a tax on returns to labor, W; plus a border-adjusted tax on business cash flows, R - I - X + M = C - W, which is the DBCFT Thus, the DBCFT is equivalent to a tax on consumption net of returns to labor, or, equivalently, to a combination of a VAT and a wage subsidy at an equal rate. The notion of separating a consumption tax into two pieces in this manner goes back to the work of Robert Hall and Alvin Rabushka (1983), who articulated how taxing wages at the individual level--rather than at the business level--allowed for progressive wage taxation (via a tax-exempt threshold) based on an individual's ability to pay. However, Hall and Rabushka (1983) envisioned the cash-flow tax component as being imposed on an origin basis--that is, without a border adjustment--and early discussions of business cash-flow taxation (for example, by the Institute for Fiscal Studies 1978) likewise did not explicitly call for a border adjustment. One might think that the difference between origin- and destination-based approaches relates primarily to the timing of tax collections, to the extent that the present value of a country's trade surpluses is zero, but this fails to account for short-run adjustment, as well as potentially important differences in incentives faced by multinational corporations. …

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