The destination-based cash-flow tax (or DBCFT) at the heart of House Republicans’ “Blueprint” for tax reform has already attracted high-level attention, pro and con. Proponents and detractors are aligned, however, in one respect: the DBCFT would be a radical departure from the current corporate tax system. In this post, we provide an introduction to the key distinctions by describing what a DBCFT is in broad terms. At base, a DBCFT contains two related but distinct changes to the current U.S. corporate tax: the change to a “cash-flow” tax and the change to a “destination-based” tax.
Cash-Flow Tax. First, a cash flow tax differs from the corporate income tax in that it is a tax on net cash-flows rather than on net income. Concepts currently used in the corporate income tax, such as basis, realization, capitalization, and depreciation are all designed to measure a corporation’s economic income. A pure cash-flow tax, on the other hand, simply includes cash inflows in the tax base while allowing a deduction for cash outflows.
Cash-flow taxation is accomplished primarily by giving businesses an immediate deduction for expenditures (including for equipment, facilities and inventory). When combined with the existing deductibility of wages, businesses would be allowed to deduct all “real” cash outflows (i.e., expenditures for services and for tangible or intangible property, other than financial instruments and any financing component of otherwise “real” cash flows). A pure cash-flow tax would also reform the treatment of “financial” cash flows (as the House Republican plan begins to do with its denial of net interest expenses), but that is a topic for a later post.
As such, a cash-flow tax is not an income tax. Rather, a cash-flow tax is a form of consumption tax, similar to the Value-Added Tax (VAT) used by many other countries. Under a VAT, a business pays taxes on its revenue minus costs paid to businesses further up the supply chain. When the tax bases for all the businesses in one supply chain are summed, the total is the retail price of the good. The VAT is therefore a form of a retail sales tax, which is clearly a tax on consumption. A DBCFT is also a consumption tax; it is simply a VAT with an additional deduction for wage expenditures.
Destination-Based Tax (Border Adjustments). Second, a DBCFT imposes a tax based on the location of consumption rather than the location of production or incorporation. Currently, U.S.-incorporated companies are taxed on their worldwide income, regardless of where the income is earned or produced. A DBCFT would tax only cash inflows that originate from the United States, i.e. money from the sale of goods and services that are destined for the United States.
A DBCFT implements a destination-basis using “border adjustments.” Under a DBCFT, businesses would not include revenues from sales to overseas customers in their tax base, and they would not be allowed to deduct inputs purchased from overseas suppliers. The DBCFT thus effectively ignores cross-border transactions in calculating its tax base and eliminates the need for transfer pricing rules (one of the major benefits touted by supporters) and, potentially, many of the other complex existing tax rules for outbound investment by U.S. corporations.
Together, border adjustments and a cash-flow basis for tax render any DBCFT a tax on domestic consumption: By virtue of its nature as a cash-flow tax, a DBCFT is a tax on consumption. By excluding proceeds from non-U.S. sales, a DBCFT excludes foreign consumption from its tax base. Finally, by disallowing deductions for inputs purchased from overseas, a DBCFT captures consumption of foreign goods in the United States.
While new as a mainstream proposal for U.S. tax reform, a DBCFT has been included in proposals for business tax reform that have been circulating in academic and policy circles for decades, including a 2005 proposal by a tax reform panel established by President George W. Bush and a 2010 proposal by Professor Alan Auerbach, who remains a vocal proponent of the tax.
In future posts, we will further explore the features of a DBCFT, including the benefits of the system and potential obstacles to putting it into practice.