Destination-based cash flow tax Michael Devereux June 27, 2016
2 elements of proposal Cash flow tax Meade Committee: R base (real flows only), or R+F base (real + financial flows) Destination base Broadly, location of consumer Like VAT, zero-rate exports, tax imports Unlike VAT, give relief for labour costs 2
Cash flow tax: why? Tax falls on economic rent Government effectively becomes shareholder Contributes share of all costs and takes same proportion of all revenues No impact on: Prices Rates of return Scale of investment Choice of debt v equity 3
Cash flow tax: why? Simpler to administer No need to capitalise any expenditures, or to keep track of asset values Under R-base, no need to identify separately flows of debt and equity But do need to distinguish between real and financial flows And taxable losses more common 4
Alternatives to cash flow tax Allowance for corporate equity (ACE) Also a tax on economic rent Combine depreciation allowances with relief for cost of finance, including opportunity cost of equity finance Timing different, but same outcome in net present value terms Normal corporation tax Then smaller reform, but suffers from usual problems of increased cost of investment, and Incentive to use debt finance Cash flow tax element not necessary element to address cross-border issues, but helpful 5
Destination-based element Tax revenues in relatively immobile location where the consumer is Implemented like VAT - by Zero-rating exports Taxing imports But asymmetric: Tax income in place of destination Give relief for expenses in place where incurred 6
Properties of the tax (1) Reduce distortions to business decisions Scale of investment Source of finance Location of investment Like VAT, would raise prices in each location, relative to the rest of the world This would offset the gain to receiving relief at a higher tax rate, implying no location distortion 7
Properties of the tax (2) Robust to tax avoidance Internal transfers within multinational group net out Exports not taxed Imports taxed, but cost of imports is also a deduction could also simply ignore imports by registered firms Applies also to licence payments (a type of import) Under R-base, no relief for interest 8
Properties of the tax (3) No incentive for governments to compete (further) on rates Tax rate in place of economic activity would be zero So ultimate competitive move relative to existing tax systems Note that we do not usually observe competition in VAT rates 9
Properties of the tax (4) Who would bear the tax? Would expect a general rise in price level relative to rest of the world (as with a VAT) In nominal terms, this offsets the tax, so that foreign shareholders unaffected And wages would also rise by same proportion (unlike with a VAT) so domestic workers also unaffected So tax would be borne by domestic residents spending out of non-wage income 10
Implementation (1) As corporation tax (R-base) Starting with existing corporation tax: Introduce immediate expensing Abolish relief interest payments Introduce border adjustments (zero rate exports, tax imports) 11
Implementation (2) Using existing taxes Increase VAT rate Reduce rate of tax on labour income eg. National Insurance Reduce corporation tax rate Why? VAT = destination-based tax on economic rent + labour income So VAT + offsetting reduction in payroll tax = DBCFT 12
Choice between two approaches (1) Both approaches require: Ability to levy a tax in the place of sale / consumer Difficult for services and digital products Helped by co-operation eg. One Stop Shop Though only problem for purchases by consumers Imports by registered businesses could be ignored Decision on which entities subject to the tax A common threshold with VAT? Question of what rates to apply remains 13
Choice between two approaches (2) Corporation tax approach Requires new administrative structure eg. for border adjustment For individual exporting businesses, may result in taxable losses in place of economic activity. In principle, government should give relief: Perhaps through one stop shop approach, or offsetting taxable loss against other liabilities, eg. NI NB. Issue of which government keeps revenue is not central for economic efficiency 14
Choice between two approaches (3) Corporation tax approach Legal issue tax not compliant with WTO rules WTO permits border adjustments, but only where offsetting taxes or reliefs Tax on imports gives no relief for costs incurred in producing imports But costs would be relieved if product sourced domestically Note though that VAT approach is WTO compliant 15
Choice between two approaches (4) VAT approach Tax base depends on exemptions and low rates on certain goods and services Full implementation requires offsetting reduction in tax on labour May be politically difficult Or may be impossible in low income countries without well functioning tax on labour income 16
Taxing financial services (1) How can we tax economic rent earned by banks? Not done well under the VAT! Do we need Meade s R+F base? ie: Tax all financial inflows, eg. Borrowing by firm Receipt by bank of interest and capital repayments Net of all financial outflows, eg. Lending by bank Repayment by firm of interest and capital 17
Taxing financial services (2) For transactions between registered financial and nonfinancial companies, financial cash flows net out Lending by bank receives tax relief Borrowing by firm is taxed Repayment by firm receives tax relief Receipt of repayment by bank is taxed So tax on such financial transactions net out to zero can just use R base 18
Taxing financial services (3) Economic rent earned by banks from lending to registered businesses is effectively taxed in the hands of the business under an R base Need R+F base to tax economic rent earned by banks from lending to non-registered entities, eg. individuals and tax exempt entities But note ALL real costs of banks should be allowed as deduction raises question of how to implement tax if bank has permanent taxable loss 19
Taxing financial services (4) Border adjustments for financial transactions Treating the borrower as the consumer, then should tax lender and give relief to lender in the country of the borrower This nets out with the taxation of the borrower Confirming that R-based taxation is sufficient for taxing financial transactions between tax-registered businesses on a destination basis 20
Taxing natural resources Considered so far a general tax on all profit But countries may also want to tax location-specific economic rent, if that can be identified May result from general production, though hard to evaluate what is location-specific More likely to result from specific sectors in particular, natural resources Destination-based tax not appropriate for taxing natural resources So advocate a separate tax 21
Effects on revenue Differences from existing tax system (R-based version) Allow immediate expensing Do not allow interest deductions Significantly restrict profit shifting Much more difficult to shift profit to havens Implement border adjustments tax imports, not exports 22
Effects on revenue Are border adjustments a problem for revenue in low income countries? If combined with separate taxes on natural resources To see this, leaving other factors to one side, consider Balance of trade in goods and services, excluding trade in natural resources Vast majority of countries have negative trade balance, excluding trade in natural resources No evidence that lower income countries worse hit 23
Incentives for unilateral adoption Aggressive move in tax competition game Remove tax on economic activity taking place domestically Attract more inward investment at expense of countries with source-based systems Which may then follow suit Possible offsetting factor if existing tax burden partly exported to foreign shareholders Incidence of existing taxes uncertain More likely a factor for source-based tax on economic rent 24
Final thoughts Economic forces create powerful incentives to move to taxation of relatively immobile factors See consequence of this in reductions in corporation tax rates, and increases in VAT rates and taxes on labour income Without deliberate reform, this is likely to continue Reforms proposed here are consistent with these economic forces 25