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An Analysis of a Cash Flow Tax for Small Business  - WP 02/27

1  Introduction

One probably insurmountable barrier to simplification of any income tax is the innate complexity of the concept of income, especially when it comes to the annual measurement of business income. A particular difficulty is that income tax calculations are inherently firm-specific, since they are based on things like the value of assets, trading stock on hand and debtors and creditors. Firm-specific record keeping is required.

In a recent submission to the Minister of Finance and Revenue, the Canterbury Manufacturers’ Association proposed a number of changes to how small businesses are taxed. A common theme of these suggestions, although not expressed as such, was that the income tax should be converted to a cash flow tax (CFT).

This paper is an investigation of whether it is both possible and desirable to change the way small businesses in New Zealand are taxed from an income tax to a CFT.

The income tax involves a complex set of calculations surrounding what is included in taxable income.[1] Complexity arises from the accrual nature of an income tax: when income and expenditure (especially expenditure on items of capital) are to be taken into account for calculating tax liabilities. A CFT, on the other hand, is much simpler, as calculations are on a “cash in, cash out” basis.

Under an income tax, the nature of payments and receipts is key in determining tax liability, as is when they occur. For example, deductions for expenditure on a capital item are spread over the life of the asset. Payments received now for services to be rendered in the future are brought to tax when the services are rendered, not when the payment is received.

Under a CFT all that matters is the amount of payments and receipts: there is no distinction between items of current expenditure or capital and payments and receipts are counted for tax purposes when they are made.

For some firms, there might not be much difference between income tax treatment and CFT. For a firm with limited amounts of capital, little externally-provided finance and small amounts of trading-stock, CFT and income tax will give approximately the same results, in terms of tax to pay. CFT is, however, much easier to understand for all firms. Compliance and administration can be better integrated with the GST system, since the GST base and the CFT base are similar (the CFT base is the GST base less wages).

Despite the simplification potential of a CFT, there appears to be only one recent example of a country replacing an existing income tax with a CFT, that being Croatia in the period 1994 to 2001. For a discussion of the Croatian experience, see Keen and King (2002).

The most likely reasons for this are the novelty of a CFT, compared with an income tax; and the transition: with an existing capital stock in place, it has proved impossible to develop a set of feasible rules to move from an income tax to a CFT. “Feasible” here means having an acceptable combination of fiscal cost, compliance costs and economic impacts. These issues are discussed in more detail below.

1.1  Outline of the paper

The remainder of this paper is arranged as follows.

Section 2 briefly outlines the economics of a CFT, compares a CFT with the income tax and describes the main types of CFT that have been proposed in the past and how they would operate at the firm level and at the level of owners and financers. In the particular context of New Zealand, this section also looks at how a CFT could be integrated with GST and PAYE for administration and compliance purposes.

Section 3 describes two apparently insurmountable barriers to the implementation of a CFT for small business: transition of existing capital into a CFT and a transition rule for when the firm ceases to be small.

Section 4 sets out some particularly difficult (but not insurmountable) issues with a CFT for small business. The first is a sustainable, non-arbitrary boundary between “small” and “big”, while the second is how to integrate a CFT with taxpayers (especially owners and funders) subject to the income tax.

Section 5 concludes with an analysis of whether a CFT for New Zealand small businesses would be desirable.

Notes

  • [1]These calculations do not just revolve around issues like whether capital gains should be taxed, but are inherent in the economic nature of an income tax.
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