income tax would be required to report the $1,000 gain. Under the cash flow income tax, the same person would have been given a $9,000 deduction but would later be required to report a $10,000 cash flow on his or her tax return. Clearly, the second case creates a much greater incentive than does the first to report the purchase and conceal the sale. This incentive is a key reason to require complete reporting of financial transactions by financial institutions. It would also be desirable to require purchasers of financial assets to report the name of the seller of such assets along with their claims for deductions, thus facilitating cross- checks. In any event, it is clear that auditing of asset transactions would have to increase under a cash flow income tax.
The cash flow income tax, like the reforms of the annual income tax examined in the last chapter, would do away with the distortions, complexity, and inequity arising from numerous special features that clutter current tax law. In addition, however, the cash flow income tax would solve the four fundamental problems that other proposed reforms solve imperfectly, if at all: inflation effects, untaxed accruals, double taxation of corporate income, and the distortion of the choice to consume or save. Here is a recap of these points.
The distortions caused by inflation--the erosion of deductions for capital depreciation, the mismeasurement of capital gains, the misstatement of real interest income and deductions, and the understatement of cost of goods sold--all would disappear. Because all outlays for saving or investment would be fully deductible when they are made, there would be no deferred deductions to be eroded by inflation.
The cash flow income tax eliminates the need to determine when accrued gains are realized, because cash flows alone would count in determining tax liability. A savings account in which interest accrues would be treated exactly like appreciating stock. In both cases, tax would be due only when the asset is liquidated to finance consumption or when it is transferred to others. The amount a person can spend or transfer would be unaffected by the timing of the sale of an asset. Unrealized gains would not enter the tax base.
The cash flow income tax on corporations would be fully integrated with the personal cash flow tax. In contrast to current law, the two taxes