The taxation of financial intermediaries has been a perennial problem for the design and administration of VATs. This has required countries around the world to resort to ad hoc solutions that are invariably inefficient and often complex. The House Republican destination-based cash flow tax, which is closely related to a VAT, could be headed down the same uncertain and haphazard path.
Even though banks, insurance companies, and other financial institutions compose a significant share of the U.S. economy, the House blueprint 
released June 24 left readers with no idea of how finance would be treated under the new plan. The proposal said only that the House Ways and Means Committee would work to develop "special rules" for these taxpayers.
This is why a January 27 paper with special emphasis on financial transactions released by the intellectual godfathers of the destination-based cash flow tax is so important. (See Alan Auerbach, Michael P. Devereux, Michael Keen, and John Vella, "Destination-Based Cash Flow Taxation," Oxford University, Said Business School, Working Paper 17/01, Jan. 27, 2017. The authors, along with Paul W. Oosterhuis and Wolfgang Schön, composed a working group chaired by Devereux that has been studying alternative methods of international corporate taxation for the last three years.) With its focus on financial transactions, the working paper provides a missing piece that is desperately needed if this new approach is going to advance.
In a nutshell, their proposed solution for computation of the cash flow tax base involving financial transactions is to ignore all financial flows (interest, premiums, principal payments, etc.) when financial institutions conduct transactions with other taxable businesses. On the other hand, treatment of financial transactions with individuals and businesses not subject to the tax would be more complicated and use a method unfamiliar to most income tax payers. This latter method would require all financial cash flows, including the disbursement of loans to borrowers and the repayment of principal to lenders, to be included in the computation of the destination cash flow base.
A Surge in Interest
The 98-page paper by Auerbach, Devereux, Keen, and Vella is an excellent and timely summary of the main issues involved in destination-based cash flow taxation. Most of these problems were only of academic interest until House Republicans released their blueprint for tax reform. Let's view some of the basics. A cash flow tax without border tax adjustments, which is similar to the business component of the Hall-Rabushka flat tax and the American Business Competitiveness Act (H.R. 4377 ) proposed by Rep. Devin Nunes, R-Calif., taxes a firm's total nonfinancial receipts less total nonfinancial outlays, including wages and salaries. The main economic gains from this approach are that it promotes capital formation by replacing depreciation with expensing and equalizes the treatment of debt and equity by disallowing interest deductions (in excess of interest income).
The inclusion of border tax adjustments adds extraordinary additional economic benefits to a conventional cash flow tax. With the repeal of the corporate tax, the exclusion of exports from the tax base and disallowance of deductions for imports transforms the taxation of U.S. corporate business from a tax on production to a tax on consumption. That means there is no U.S. tax benefit from moving jobs and factories out of the United States. On the contrary, if other countries kept their corporate taxes, no matter how low their rates, the net U.S.-foreign tax incentive would be to shift production into the United States.
Moreover, the current incentive to shift profits out of the United States would follow the same dynamic. Because the United States has a higher corporate statutory rate than most other countries, there is a tax incentive to shift profits out of the United States. If a destination-based cash flow tax replaced a corporate tax, imports and exports would be simply excluded from U.S. tax calculations, so the prices assigned to cross-border sales between related parties and the resulting location of profits would not matter for tax purposes. If other countries maintained their corporate taxes, the focus of tax planning would be to locate profits in the United States, which would become a tax haven. Many existing tax planning structures used by U.S. multinational corporations would be obsolete and require a significant overhaul.
Even though the export exclusion and lack of deductions for imports are expected by many to reduce the U.S. trade deficit -- because these border adjustments have the appearance of export subsidies and tariffs -- the authors are (like most economists) emphatic that dollar appreciation would offset the benefits of border tax adjustments. So, for example, an importer may pay considerably more tax under a destination-based cash flow system, but the before-tax cost (in dollars) of imports should offset the extra tax burden and leave after-tax profits unchanged after imposition of the tax. Recognizing that most non-economists are skeptical of this point, the authors state: "The idea that prices and/or the exchange rate will adjust so as to exactly neutralize differences in rates of destination-based cash flow tax across countries, it should be stressed, is not fanciful or arbitrary."
Two additional potentially positive aspects of destination-based cash flow taxation are its relative progressivity and simplicity. It should always be remembered that a cash flow tax is exactly equal to a VAT less a reduction in wage taxes. The reduction in wage taxes would make a destination-based cash flow tax much more progressive than a VAT, which is often subject to significant political resistance because of its regressivity. A destination-based cash flow tax may also be considered less regressive than a corporate tax, depending on one's views about the how much of the economic burden of the corporate tax is borne by labor.
Regarding simplification, on the domestic side a cash flow tax eliminates the need for depreciation rules and also the need to distinguish between different types of assets. Of even larger significance on the international side is the elimination of the need for intricate anti-base-erosion rules and complex tax planning that inevitably flourishes in response to these rules. For U.S. tax purposes, there would no longer be a need for the IRS to police the location of profit, and there would be no gain to taxpayers to artificial profit shifting.
Finally, from the practical political perspective, one tremendously attractive aspect of a destination-based cash flow tax is that border adjustment taxes are estimated to raise approximately $1 trillion over 10 years because of the large U.S. excess of imports over exports expected over the next decade. It is hard to see how Republicans in a revenue-neutral exercise can get a business tax rate in the low 20s without the large amount of base-broadening that inclusion of border tax adjustments would entail.
The Challenges Facing a Cash Flow Tax
Probably the biggest challenge to the United States replacing its corporate tax with a destination-based cash flow tax is its likely inability to pass muster with World Trade Organization rules. The source of the problem is the potential advantage to U.S. production of the deduction for domestic wages not available to imports into the United States and to goods competing with U.S. exports in foreign markets. This objection seems illogical to most economists because, as already noted, a destination-based cash flow tax is equivalent to a destination-based VAT and a reduction in payroll taxes, both of which clearly do not violate WTO rules. Although Auerbach, Devereux, Keen, and Vella are proponents of the tax, they conclude that "because WTO compliance is determined by interpretation of existing legal agreements and not by virtue of economic equivalences, it is unlikely that a destination-based cash flow tax, drafted with an integrated wage subsidy, would, if challenged, be held to be WTO compliant."
The WTO problem is only the beginning of a list of new difficulties that arise with the replacement of the U.S. corporate tax with a cash flow tax. For a destination-based cash flow tax not to interfere with the trade balance, there must be symmetric treatment of exports and imports. One implication of this is that firms with insufficient tax liability to absorb losses should receive immediate cash refunds for negative tax liability. Most observers consider the prospect of the U.S. treasury providing large amounts of cash to large, profitable multinationals politically unacceptable. Unlimited carryforwards with interest as suggested in the blueprint help, but they do not solve the problem for firms that are perpetually generating losses because a high proportion of their sales are exports. To partially alleviate the perception problem, the authors suggest that negative tax liability from a cash flow tax could be used to reduce other taxes, most notably payroll taxes, paid by multinational corporations.
An unattractive feature of a destination-based cash flow tax is the massive one-time loss in wealth to U.S. investors holding foreign assets if the dollar appreciates in value. Another disadvantage to the United States would be the inability of the U.S. government to "export" tax burdens (now achieved by the corporate tax) on foreign shareholders in U.S. corporations generating profits on production in the United States. Also fraud arising from the disguising of domestic sales as exports, common under VATs, would be a new administrative problem to the U.S. tax collectors.
Finally, another significant difficulty facing the destination-based cash flow tax (which is also a problem for VATs) is how to properly tax financial institutions. It is to this problem that Auerbach, Devereux, Keen, and Vella devote a considerable amount of attention in their new paper.
Taxing Financial Institutions
For financial institutions, a tax that excludes interest income and interest costs cannot accurately compute value added (in the case of a VAT) or excess profits (in the case of a destination-based cash flow tax) because financial institutions modify market interest rates in lieu of charging explicit fees for services. To capture excess profits of a financial institution, the computation of a destination-based cash flow tax base must be extended beyond the usual computation we have been discussing so far to include all financial as well as nonfinancial cash flows. Though this calculation more strictly adheres to the plain English meaning of a cash flow tax, this "R+F" method (short for real plus financial) is less intuitive to tax professionals and a lot more complicated than the "R" method most often used in policy discussions.
To take the simplest example, under the R+F method, in addition to the usual calculations under the R method for nonfinancial cash flows, a bank must include in its tax base all financial cash flows, including not only interest received but also repayment of principal, and must deduct loan disbursements. Conversely, the borrowing firm must include in its tax base loans received and must deduct principal as well as interest payments.
But somewhat surprisingly, the authors point out that this does not mean that for the proper implementation of a cash flow tax for financial intermediaries, the R+F method must always be used. In fact, all financial transactions between taxable businesses can retain use of the simpler R method. The authors explain that this is possible because if one takes into account both sides of the transaction, the same amount of tax is collected under the R method as under the R+F method (assuming borrower and lender pay the same tax rate). The only difference is that the statutory burden of the tax under the R method falls entirely on the borrower. So all financial transactions between taxable entities can use the simpler R method without any loss of neutrality or revenue.
Unfortunately, this is not the case for a financial institution lending to individuals or entities that are not subject to the tax. These transactions must use the R+F method to assess the proper overall amount of tax. If the R method were used in these transactions, the entire tax base would be assigned to the nontaxable entity, from which no tax could be collected. Under the R+F method, the correct destination-based cash flow tax is attributed to and paid by the lending institution.
Usually when we deal with international aspects of taxation, they are an order of magnitude more complicated than their purely domestic counterparts. That is not the case here. For cross-border financial transactions, the authors offer the same policy prescription as they do for domestic financial transactions: The simpler R method should be used for transactions between taxable businesses, but for lending to entities that do not pay the destination-based cash flow tax, the R+F method is necessary.
If Congress decides to adopt a destination-based cash flow tax, it cannot avoid the problem of devising the proper tax treatment of financial transactions. It will have to determine how the tax base will be adjusted for financial institutions and transactions with specific customers. Auerbach, Devereux, Keen, and Vella have provided one solution. Unfortunately, it seems unlikely to be quickly embraced by lawmakers on Capitol Hill, if only because of its complexity and unfamiliarity. Other related solutions to the financial transaction problem include the computation of "tax calculation accounts" in various forms that have the advantage of not requiring upfront taxation of principal amounts by borrowers. But this approach is not favored by the authors because of the potential inaccuracies from choosing the incorrect discount rate. (For more discussion of tax calculation accounts, see Peter Merrill, "VAT Treatment of the Financial Sector," The VAT Reader, Tax Analysts, 2011, pp. 163-185.
Justified Skepticism
Those who are of the view that a destination-based cash flow tax cannot be approved by Congress and the president in 2017 have good cause to be skeptical. Despite the monumental multiyear effort of the Devereux working group and despite President Trump's new seemingly relaxed attitude toward deficit reduction ("Our military is more important than a balanced budget," Trump told Sean Hannity in a January 27 interview), the complex technical details such as the treatment of financial transactions discussed here, the innumerable political squabbles that will arise as members protect their constituents' interests, and an already jam-packed congressional schedule with other major issues make timely reform of what would be the most radical change in U.S. business taxation ever a tall order.
