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Public Disclosure AuthorizedPublic Disclosure AuthorizedPublic Disclosure AuthorizedPublic Disclosure AuthorizedPolicy,Planning,and ResearchWORKINGPAPERSPublicEconomicsCountry Economics DepartmentThe World BankMay 1989WPS 189The Treatmentof CompaniesUnder Cash Flow TaxesSomeAdministrative,Transitional,and InternationalIssuesEmil M. SunleyCash flow taxes eliminatemany of the problems of the corporateincome tax, but they have significant administrative, transitional, and international problems, especially for developingcountries.The Policy. Planning. and Research Complex distribkjtesPPR Working Papers to dissemninatethe findings of work in progress and toenoourage the exchange of ideas among Bank staff and all others interested in development isstes. These papers carry the names ofthe authors. reflect only their views, and should be used and cited accordingly.The findings, interprerations, and conclusions are theauthois own. They should not be auributed to theWorld Bank, its Board of Directors,its management, or any of its menmbercountries.
Plc,Planning,and ResearchPublicEconomicsThe author begins his discussion of the cashflow tax by outlining the major administrativeand compliance issues of a cash flow tax. Thereare problems with the tax because of the numerous possibilities for gaming the system (particularly if financial flows are left out of the taxbase), the appropriate treatment of employeebenefits and business entertaimnent, and thetreatment of loss companies. In addition, thecash flow tax has the same problem as thecorporate income tax in dealing with companiesthat do not use aboveboard accounting piocedures.The paper goes on to discuss the problemsinvolved in the transition from a corporateincome tax to a cash flow tax. First, carryoverproblems arise because income deferred underthe income tax may never be taxed under thecash flow tax and income previously taxed byincome tax may be taxed a second time underthe cash flow tax. Second, changes in assetprices arise because changes in the tax law affectexpected after-tax cash flows, causing eitherwindfall gains or losses. There are ways aroundthese problems but they cause further ones.Sunley outlines these secondary problems andpossible solutions to them but concludes thatthere is no easy way to orchestrate a totallysmooth transition.The intemational aspects of imposing a cashflow tax are most troublesome. After a summary of the major intemational income tax rules,Sunley discusses how the cash flow tax treatsinbound investment, outbound investment, andexport and imports. It is likely that a cash flowtax imposed by a developing country would notbe creditable against the U.S. income tax. Inaddition, it would be difficult to provide a bordertax adjustment for a cash flow tax.The paper concludes by proposing one wayto fix up the income tax. It suggests that the taxbase be defined in terms of financial incomewith certain specific adjustments such as for depreciation and extraordinary items. The proposal is in some depth, including a simplifiedsystem of tax depreciation.This paper is a product of the Public Economics Division, Country Economics Department. Copies are available free from the World Bank, 1818 H Street NW, Washington DC 20433. Please contact Ann Bhalla, room N 10-061, extension 60359 (42pages).The PPR Working Paper Series disseminates the findings of work under way in the Bank's Pol;cy, Planning, and ResearchComplex. An objective of the series is to get these findings out quickly, even if presentations are less than fully polished.The findings, interpretaoons. and conclusions in these papers do not necessarily represent official policy of the Bank.Produced at the PPR Dissemination Center
The TreatmentSomeof CompaniesUnderAdministrative,and InternationalCashFlowTaxesTransition,IssuesbyEmil M. SunleyTable of ContentsI.Introduction1Types of Consumption Flow Taxes2A.Subtraction-Method VAT3B.Hall-Rabushk. Flat Tax and Bradford's Plan X4C.Expenditure Tax5D.Blueprints6E.Meade Commission and the Aaron/Galper ProposalsII. Outline of Corporate Cash Flow Tax10III Tax Compliance and Administration13A.Gaming the System16B.Fringe Benefits and Business Entertainment20C.Loss and Start-up Companies21IVTransition Problems21VInternational Problems25A.Inbound Investment30B.Outbound Investment33C.Exports and Imports33Appendix35Footnotes42Emil M. Sunley is Director of Tax Analysis in the Washington, D.C.office of Deloitte Haskins & Sells
A *cash flow tax", as this term is commonly used, is abroad-based consumption tax imposed on the difference betweencash receipts during the period and allowable expenses.Undera cash flow tax, capital assets are expensed, resulting in azero effective tax rate on the returns to investment.l/Thus, the tax base is consumption, not income.Unlike a salestax or the credit/invoice-method VAT, a cash flow tax is notimposed on each separate transaction.Proponents of a cash flow tax generally favor taxingconsumption over income because (1) pure consumption taxes donot distort the choice between future and present consumptionand (2) consumption taxes avoid the difficult problems ofincome measurement (e.g. rules for depreciation and
-2inventories and adjustments for inflation).They also favor acash flow tax over a transactions-based consumption taxbecause a cash flow tax can be made more progressive withrespect to the level of consumption than a sales tax or a VATeven if these taxes have multiple tax rates with lower rateson necessities and higher rates on luxuries.This paper is not an evaluati,n of whether developingcountries should impose a cash flow tax or even whether thesecountries should tax consumption instead of income.Thispaper focuses on more narrow, but important, issues raised byproposals to impose a cash flow tax on companies; namely theissues of tax administration, transition rules, and thetreatment of international capital flows.The Appendix tothis paper outlines a practical approach to depreciation andinflation accounting.The Appendix demonstrates that themeasurement problems of an income tax can be kept undercontrc.I.Tvyes of Consumption Flow TaxesConsumption taxes come in many different stripes.Some wouldbe imposed only at the company level; others only at theindividual level; and still others at both the company andindividual levels.A corporate cash flow tax is corporate
-3accompaniment to a full expenditure tax on individuals.Toset the stage we begin with a brief description of variousproposals for consumption taxes that are not transactionsbased.A.Subtraction-Method VATPossibly the simplest cash-based consumption tax would be asubtraction-method VAT.companies.This tax would be imposed only onEach company would calculate its value-added bysubtracting its purchases from its sales.The tax liabilitywould then be determined by multiplying value-added by theappropriate tax rate.A defective subtraction method VAT, called a businessactivities tax, was imposed in Michigan from 1953 to 1967.Inthe U.S. at the federal level, Senator Roth's businesstransfer tax is essentially a subtraction-method VAT.a/Therecent Canadian tax reform proposals included three optionsfor a comprehensive consumption tax.One option, wthe tax onfederal goods and services," is a subtraction-method VATconceived as basically a cash flow tax.3/
-4Subtraction-method VAT's differ in two major respects from thecredit-invoice VAT's that have been enacted by many industrialFirst, under a subtraction-methodand developing countries.tax, the tax is not imposed separately on each transaction.Second, there is no way toNo invoices are required.distinguish between taxable and exempt purchases if the taxbase is not comprehensive.Thus, if export sales are excludedfrom the tax base, and a deduction is allowed for allpurchases by the exporter, too much VAT would be "rebated" onexports when there are exemptions or exclusions at an earlierstage.A subtraction method VAT could only work with minimalexemptions.In contrast, under the credit invoice method, thetax is imposed on each transaction and the tax collected ateach stage of production or distribution is only the tentativetax because purchasers who are not final consumers are able toreduce their tax liability on sales by the amount of tax paidon purchases.The subtraction-method VAT, like other value-added taxes, isnot imposed directly on persons which limits the extent towhich this tax can be made progressive.B.Hall-Rabushka Flat Tax and Bradford's Plan XRobert Hall and Alvin Rabushka proposed a two-tier variant ofa subtraction method VATA1Under their flat tax, companieswould pay tax on the difference between sales and purchases
5from other companies, less compensation paid to employees.rhe companyIndividuals would pay tax on their compensation.tax base and the individual tax base when added together wouldequal value-added, except for any exemptions or personalallowances provided for individtials.A key feature of the Hall-Rabushka proposal was the flat taxrate for individuals and companies.The Hall-Rabushkaproposal could be made more progressive if individuals weretaxed at progressive rates. These rates, however, would onlyapply to labor income.David Bradford's Plan X is aprogressive version of the Hall-Rabushka tax.l/C.Expenditure TaxA progressive expenditure tax on families and individuals is athird type of consumption tax.One form of this tax wasproposed by Professor Nicholas Kaldor6/ in 1955 and anotherform by Professor William D. Andrews2 / in 1974.Under theKaldor proposal, families and individuals would not have tokeep track of all their consumption expenditures.Instead,they would first determine their income in much the same wayas under the current income tax.They would then subtract netsavings to get total consumption for the year.Thus, cashbalances at the beginning of the year, money borrowed, and
-6proceeds from sales of investments during the year would beincluded in the tax base while end-of-year cash balances, debtrepayments, and investments made during the year would besubtracted from the tax base.The Kaldor expenditure tax (and the Andrews proposal) wouldonly apply to families and individuals. Companies would notbe subject to the tax.If the goal is to tax consumption,there is no need to tax companies because companies do notconsume, except possibly when they provide in-kind benefits toemployees, officers or shareholders.D.BlueRrintsIn January 1977, the U.S. Treasury Department releasedBlueprints for Tax Reform,which contained outlines for acomprehensive income tax and a comprehensive consumption tax.The latter applied to families and individuals and was similarto the Kaldor and Andrews proposals.Corporations would notbe taxed, but the net receipts of an unincorporated businesswould be directly attributable to the owner.The Blueprints consumption tax was a hybrid tax in thatindividuals had a choice between a cash flow treatment ofinvestments or a tax-prepayment treatment.If an individualchose to invest through qualified accounts, payments to the
qualified account would be deductible and receipts from theaccount would be taxable.Income earned on funds invested ina qualified account would not be taxable until distributed outof the account.If, instead, the individual chose not to usea qualified account, there would be no deduction for theinvestment.Thus, the investment would be fully taxed (ortax-prepaid) when made.be exempt from tax.Income from these investments wouldIt can be shown that both the qualifiedaccount and the tax-prepayment treatments are equivalent to azero effective rate of tax on capital income.E.Meade Commission and the Aaron/Galoer ProposalsBoth the Meade Commissioni1 in 1978 and Henry Aaron andHarvey GalperIQ/ in 1985 proposed consumption taxes thatwould apply to individuals and corporations.The individualportion of the tax would be similar to the cash flow taxoutlined in Blueprints.The business component was a cashflow tax with a zero effective tax rate.The Aaron/Galper cash flow tax on business would permitinvestments to be expensed.Aaron/Galper propose (1) a tax onthe cash flow of the corporation excluding stock sales anddividend payments and other cash distributions to stockholdersand (2) a separate withholding tax on dividends, interest,rents and royalties paid to foreigners. This latter tax is
aimed at soaking up any available foreign tax credits inthe home country.In the case of unincorporated businesses,the cash flow would be computed in the same way as forincorporated businesses, but it would be attributed directlyto the owners.The Meade Commission outlined several approaches to taxingcorporations.The Commission's preferred option would be totax the net cash flow from real and financial transactions.This is similar to the Aaron/Galper proposal.The Meade Commission and the Aaron/Galper proposals wouldimpose the cash flow tax on corporations.One may well ask ifthe goal is to tax consumption, why tax corporations at all inthat people not corporations consume.One reason for taxing corporations may be the appearanceproblem.If corporations are not taxed in the consumption taxworld, individuals may view the tax system as unfair.Aaron/Galper offer three reasons for not scrapping thecorporate tax.'-/First, if corporations are not taxed,foreign investors would pay no U.S. tax on their U.S. sourceincome.Second, owners of businesses would be able to usetheir businesses to avoid personal taxes by having their
-9corporations buy personal automobiles and other goods forthem.Third, if the corporate tax is repealed, currentcorporate owners of depreciable capital would receive awindfall.The first of the reasons relates to the international aspectsof a cash flow tax and is dealt with in Section V.The secondreason is a compliance issue and is a problem for both incomeand cash flow taxes.This issue is discussed in Section III.The third reason Aaron and Galper offer is a transition issuewhich is discussed in Section IV.A final reason that has been put forward for a corporate cashflow tax is that it will raise revenue in present value termsif the cash flows are discounted at the government's borrowingrate. This is true even though the effective tax rate iszero.This present value magic comes from the company's rateof return being above the government's discount rate.Iwouldn't want to push this argument too far.Under a corporate cash flow tax, the government becomes asilent partner.The government's borrowing rate probably isnot the appropriate discount rate for discounting thegovernment's cash flows from risky corporate investments,particularly given there is a moral hazard because any privateinvestor with any project would be able to obtain matchingfunds from the government.
-II.10-Outline of a Corporate Cash Flow TaxIn the case of an expenditure or cash flow tax on individuals,it is fairly clear how the tax base is defined.The totalamount of funds at the taxpayer's disposal from all sources(wages, proprietorship income, interest, sales of investments,borrowed funds, cash at the beginning of the year, etc.) wouldbe included in the tax base and a deduction would be allowedfor all uses of funds other than for personal consumption(investments, loaned funds, and cash at the end of the year).The tax base is personal consumption.How would a cash flow tax be applied to corporations?If oneincluded funds from all sources in the tax base and subtractedall funds not expended on consumption, the tax base would bezero because corporations do not consume.Or put another way,.for a corporation the sources of funds and the uses of fundsare equal and net to zero.Aaron/Galper and the Meade Commission propose that the taxbase for the corporate cash flow tax would include financialflows other than (1) purchases or sales of corporate stock and(2) dividends and other corporate distributions paid orreceived.12/Under this approach to the cash flow tax,investments would be expensed, borrowings aridinterest incomewould be included in the tax base and interest and debtpayments would be deductible.
-11-This approach to taxing corporations makes the government apartner with the private investor.If the corporate tax rateis 20 percent, the government puts up 20 percent of the fundswhen a corporation buys assets with new equity.Thegovernment also receives 20 percent of the earnings that arenot reinvested and are otherwise available for distribution toshareholders.If the government puts up 20 percent of thefunds and receives 20 percent of the return, the effective taxrate, defined as the percentage reduction in the rate ofreturn due to the tax, is zero.There is an alternative approach to taxing businesses under acash flow tax.reversed.Under this approach the treatment of debt isBorrowings and interest income would not beincluded in the tax base and interest and debt repaymentswould not be deductible.treatment.Loans would be given tax prepaymentThis treatment leads to the R tax base discussedby the Meade Commission.This paper will consider the two main versions of corporatecash flow taxes; i.e. with and without financial flows (otherthan dividends and corporate distributions) being in the taxbase.Put another way, the paper will consider both theR F tax base discussed by Aaron/Galper and Meade as well asthe R tax base discussed by the Meade Commission alone.
-12 -Though both tax bases will be considered in this paper,including financial flows (R F) as duggested by Aaron/Galperand Meade appears to be more promising for four reasons.Iffinancial flows are not included in the tax base:--Companies that are highly leveraged on the effective dateof the new law would be disadvantaged because interestwould no longer deductible.This transition problem ledthe Meade Commission to favor the R F tax base.--Most financial institutions would have a negative taxbase.This would aggravate the problem of loss companies.At the individual level, the cash flow tax would beessentially a wage tax.Though a wage tax may beequivalent to a consumption tax, there are likely to besignificant perception problems if wages are taxed andcapital income exempt.There is also a transitionaldifference because old people have low wage income buthigh consumption.--There will be pressure on the line separating real fromfinancial transactions.For example, how shouldinstallment sales or seller-provided financing betreated?Are insurance premiums, loan guarantees, orsimilar payments financial transactions or realtranactions?Are long-term net leases installment sales?
- 13 -III.Tax Compliance and AdministrationA major difficulty with an income tax is that one must firstmeasure income in order to tax it.Though conceptually thereis widespread agreement that the income tax base beforepersonal allowances should equal consumption plus change innet worth, there are many practical problems in defining thistax base.Most of these practical problems relate to definingthe change in net worth.A pure consumption tax would eliminate many of these practicalproblems.For example, it would no longer be necessary tomeasure depreciation or amortization.Inflation adjustmentsfor depreciation, inventories, capital gains, and debt wouldnot be necessary because all the cash flows would occur in thesame year as the tax.Complex basis rules would not be neededbecause it would not be necessary to compute gain or loss onthe sale of assets.Provisions providing for nonrecognitionor deferral of gains or losses would disappear.The compliance and administration argument for a cash flowtax, particularly one that applies to companies, can beoverstated.Individuals may not need income and balancesheets, but whether or not there is an income tax, mostcompanies, except the very smallest, will need financialstatements for internal management purposes and for reports toshareholders and creditors.Foreign-controlled companies willneed to measure income to report to foreign tax authorities.
-14 -For companies that have a complete set of financialstatements, determining the cash flow tax base would bestraightforward.The statement of sources and uses of capitalcould be adjusted to pull out (1) dividends and otherdistributions paid or received, (2) sales and purchases ofstock and (3) financial cash flows, if these flows are to beexcluded.The tax base would equal net cash flow after theseadjustments.It is well known that companies may have three or four sets ofbooks:one for creditors, one for stockholders, one for thetax authorities, and one for management.This is a problemfor both an income tax and a cash flow tax.The problem canbe minimized by requiring audited financials for largercompanies, licensing accountants, pulling licenses ofaccountants who falsify statements, and imposing criminalpenalties for abetting fraud or tax evasion.By taking stepsalong these lines, the private accounting profession can bemade a partner of the tax authorities in insuring that incomeor cash flow is properly reported.Tax authorities could alsorequire financial institutions to supply the tax authoritieswith copies of any financial statements submitted withapplications for loans in excess of a certain amount.
-15-Small companies will not have either audited or unauditedfinancials.Some will operate out of a business checkbook.These companies deposit receipts at the end of each day orweek and write checks for purchases.The tax base for a cashflow tax can be determined from the bank records if they arecomplete.It is true that owners can skim cash, but this is aproblem for either the income tax or a cash flow tax.If thetax base excludes all financial transactions, it would benecessa-y to determine whether a business check was forinventory or for a financial asset.Income tax records are more difficult to construct from abusiness checkbook.established.Inventory and capital accounts must beIt can be difficult to verify that inventory wasdestroyed or stolen or to determine appropriate reserves.Smaller companies will operate out of a single personal andbusiness checkbook.Here the additional problem is separatingpersonal and business expenses, but presumably most of thesebusinesses will not be subject to the cash flow tax.The smallest companies may operate only in cash.Forcompanies that have inadequate or no records, presumptivetaxes can be used.a business license.The simplest form of a presumptive tax isStreet vendors, small retail outlets, andcottage industries can be required to purchase annual licenses.
-16 -There are a number of administrative and compliance problemsMany of these problems are at thewith a cash flow tax.individual and not the company level; e.g. treatment ofhousing and other durables; the treatment of education andtraining, withholding on periodic income payments may notapproximate final tax liability; and possible gaming of thesystem if individuals can choose between qualified accountsand tax-prepayment.The major compliance issues for a companycash flow tax are the possibilities for gaming the system, theappropriate treatment of employee benefits and businessentertainment, and the treatment of loss companies.A.Gaming the SystemGaming possibilities arise when (1) one party to a transactionis outside the system and (2) the transaction itself can beconverted from a transaction that is inside the system to onethat is outside the system.To illustrate this, consider the following example.subsidiary pays a dividend to a foreign parent.AThesubsidiary will be subject to the regular cash flow tax on thedividend because dividends are not taxable.The foreignparent in addition will be subject to the special withholdingtax on dividends paid to foreigners.If instead of paying adividend, the subsidiary pays management fees to its foreignparent, no tax will be collected because the purchase of
-17 -management services reduces the tax base of the subsidiary.Because the parent is outside the system, it would not pay taxon the management fee except in the home country (where bothmanagement fees and dividends are likely to be in the taxbase).Thus, converting a dividend into a manageme.t feeshrinks the source country's tax base.There are many similar possibilities for gaming the system,particularly if financial transactions are outside the system.1.Transfer Drices - The foreign-controlled subsidiary couldpurchase raw materials at an inflated price or sellfinished goods at a below market price in lieu of paying adividend to its foreign parent.2.Seller financina - A company buying abroad may have achoice between paying 100 now or 105 six months fromnow.The company would choose to pay 105 and in effectdeduct 5 of interest.In contrast, when a company sellsabroad, the company would want any interest paymentsseparately stated.In fact, the company will want tounderstate the true selling price and inflate the interestpayments.This all suggests that seller financing willhave to be very carefully policed if financialtransactions are outside the system and one of the partiesto the transaction is outside the system.
-3.18-Defaults and forgiveness of indebtedness - If loans areincluded in the tax base, a default or debt forgivenesswould have no tax consequences.If loans are not includedin the tax base, a default or debt forgiveness should bean imputed receipt for the borrower and an imputeddeduction for the lender.If this rule is not followedand the lender is outside the system, a default or debtforgiveriess is an extreme case of a below market rateloan.Abuse possibi4ities are widespread.For example,an exempt university could make a market rate loan to aprofessor and then forgive the principal and interest eachyear.4.Emoloyer loans - If financial transactions are outside thesystem, tax exempt institutions could remunerate exployeeswith exempt interest.Alternatively, the exemptinstitutions could compensate their employees by givingthem low interest rate loans instead of taxable wages.Inshort, employer/employee loans can convert wage incomeinto interest income.This may not be a major problem ifboth the employer and employee are in the system andsubject to about the same marginal tax rate, but it is aproblem if the employer is outside the system or if theemployee's marginal tax rate is significantly differentfrom the employer's marginal rate.
-5.19-Long-term leases - A net long-term lease may be difficultto distinguish from a purchase with seller-providedfinancing.If the lessor is an exempt taxpayer or aforeigner, leasing would permit the buyer to deduct"interest" payments.6.Different accountina years - If companies have differentaccounting years, it may be possible to game the systemthrough intercompany transactions.For instance, at theend of company A's accounting year it purchases excessmaterials from B, reducing its tax base.Next month, whencompany B's accounting year ends, it repurchases thematerial from company A plus additional excess material toartificially reduce its tax base.These traxisactionscould be financed by debt that is outside the system.Theproblem of differing fiscal years might be solved byrequiring all companies to have the same tax year.If financial transactions are inside the system; that is, thetax base is R F, there would be fewer possibilities forgaming the system because converting interest into wages orlease payments, etc. will not be a problem.One would stillneed to be concerned with converting non-deductible dividendsinto something deductible such as interest whenever thedividend recipient is outside the system.
- 20 -These examples of gaming also plague the income tax.Therules to limit gaming possibilities are a major source ofadministrative and compliance complexity.As the Appendixdemonstrates, depreciation accounting need not be a majorsource of complexity under an income tax.B.Fringe Benefits and Business EntertainmentIn general, people consume, not corporations.Corporations,however, do provide company cars for personal use and housing,medical and other insurance to their employees, officers, andshareholders.A portion of business entertainment has apersonal element.taxed.Such company provided consumption should be(Under U.S. law such consumption generally is imputedto employees or it is tested under Section 89 fordiscrimination.)It may be difficult to impute the value ofthis consumption to the employees, officers, andshareholders.An alternative would be to deny a companydeduction for these expenses.If the company tax rate ishigher than the marginal rate of most individuals, this formof consumption may be overtaxed.This would not be all bad.Another alternative would be to impose an excise tax at thecompany level.This would reach the employee benefitsprovided by companies with losses and by any tax-exemptemployer including governmental units.
-C.21 -Loss and Start-up CompaniesAaron/Galper suggest that tax losses should not be refundablebut instead should be carried forward with interest toThough the chosen rate for imputedmaintain their real value.interest may on average be the right rate, it is unlikely tobe the right rate for every taxpayer.The problem of loss companies will be magnified if financialtransactions are outside the system.For example, consider astart-up company which issues stock for 40 and borrows 60 topurchase a 100 machine.If financial transactions are leftout of the system, the tax base is -100; if financialtransactions are included, the tax base is -40.IV.Transition ProblemsThe Treasury Blueprints outlined two separate problemsrequiring transition rules:carryover anl price changes.If the corporate income tax is replaced %ith a cash flow tax,carryover problems arise because income deferred under theincome tax may never be taxed under the cash flow tax andincome previously taxed under the income tax may be taxed asecond time under the cash flow tax.Changes in asset pricesoccur because changes in the tax law affects expectedafte
It is likely that a cash flow dures. tax imposed by a developing country would not be creditable against the U.S. income tax. In The paper goes on to discuss the problems addition, it would be difficult to provide a border involved in the transition from a corporate tax adjustment for a cash flow tax. income tax to a cash flow tax. First, carryover
