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

2  Cash flow taxes[2]

This section describes the basic nature of cash flow taxes compared with other taxes and outlines the basic rules of a CFT. Further details of the economic differences between a CFT and an income tax are contained in an annex.

The best-known examples of CFTs, or variants thereof, are the proposal in 1978 by a Commission established by the UK Institute for Fiscal Studies chaired by Sir James Meade (Meade (1978)); and the “flat tax” proposals that were prominent in the United States in the early 1990’s (Hall and Rabushka (1995)). The New Zealand Treasury has looked at a CFT for New Zealand on a number of occasions, most recently in the late 1990s (see Katz (1999) and Treasury (1997)).

2.1  Overview of consumption taxes

2.1.1  The relationship of cash flow, consumption or expenditure tax to an income tax and a GST[3]

Cash flow, consumption and expenditure taxes, including GST, have in common the feature that tax is levied only at the point in time when individuals spend their money and consume what they have previously earned and saved, or, indeed, spend what they have borrowed.[4] The economic effect is that the return from savings is not taxed - removing the tax-driven incentive to consume now rather than later. Under an income tax (which by definition includes interest as income), however, the return on savings is taxed, which means that there is an economic disincentive to saving. Indeed, the difference between an income tax and a consumption tax lies entirely in the treatment of savings.[5]

Consider an example of a person who earns $1,000, saves it (at interest) for one year and then spends it. Under an income tax, they would pay tax on both the initial income and on the interest earned while spending is deferred: savings is treated as a new source of income. Under a consumption tax, the only tax impost is at the point of final consumption: interest income is exempt.

A CFT is a particular form of an expenditure or consumption tax. And a GST differs from an expenditure or consumption tax only in terms of from whom the tax is collected.[6]

The fact that direct consumption taxes are collected directly from individuals means that the tax impost can be made to vary with individual circumstances: it can have a progressive tax rate structure. This is, of course, not possible with a GST.

The following paragraphs set out these relationships in more detail. A more detailed examination of the important economic properties of income, consumption and cash flow taxes are contained in an annex.

What is an income tax?

Economists’ generally accepted notion of income is the Haig-Simons-Shranz definition:

Personal income may be defined as the algebraic sum of (1) the market value of rights exercised in consumption and (2) the change in the value of the store of property rights between the beginning and the end of the period in question.[7]

No income tax in effect anywhere in the world uses this exact definition of income, and many have significant departures from it.[8]

Under a pure income tax, the tax would be levied on the ability to consume without reducing wealth. Table 1 describes what would be taxed under a comprehensive income tax.

Table 1 – What is taxed under an income tax
For individuals

Net increase in wealth plus value of consumption (including the imputed rental value of consumer durables), or, equivalently:

Net income from labour plus net income from investments (including realized and unrealised capital gains and income in kind).

For businesses

Increase in the value of net assets (if dividend and interest payments are deductible) or, equivalently:

Increase in the value of net assets before dividend payments (if dividends are non-deductible) or, equivalently:

Net profits from trading activities plus net income from investments, including capital gains (if dividends are non-deductible).

Under a comprehensive accruals income tax, companies and other business entities would not need to be taxed except in order to save on overall compliance or transactions-costs. That is, the undistributed income of a company would be automatically included in the income of its owners. If companies are taxed, they are taxed effectively as agents for individuals. The tax on them is effectively a withholding tax on the investment income flowing to individuals (just as PAYE and FBT are withholding taxes on labour income flowing to individuals).

Real world income taxes tax companies and other legal entities separately from their owners, with varying attempts to integrate taxation at the entity and individual level.[9] There are two main reasons for taxing companies. One is an efficiency argument to do with “corporate form neutrality”, the other is about compliance costs.

If companies were not taxed, taxpayers would gain from accumulating their income in the (untaxed) corporate entity. This is because the compounding effect of the reinvestment of retained earnings escapes tax. If tax is paid when earnings are distributed, the net present value of tax is less than if the company had been taxed on an annual basis. The longer the deferral, the greater the gain.

Taxing companies directly avoids this effect, and thus ensure that taxpayers are not influenced by taxes in deciding the form in which they do business.

The compliance cost argument relates especially to large firms. It is possible to tax shareholders on the income they earn through a company by imputing the appropriate share of the income (and expenses) of the company direct to the shareholder.[10] For companies with few shareholders, the costs of doing so are probably little different than the costs of taxing the company directly and then applying the imputation system to integrate personal and company taxation. However, the greater the number of shareholders, the higher the compliance costs. So for very large entities, like publicly listed companies, the company tax/imputation system is preferable from a national perspective.

What is an expenditure tax?

Expenditure taxes all share one common feature: they do not tax savings. Direct expenditure taxes are levied on individuals and typically also on businesses as withholding agents, see Table 2.

Table 2 – What is taxed under an expenditure tax
For individualsA tax on all expenditure. This is equivalent to taxing net income from labour plus returns in excess of the government-borrowing rate on investments. Because the tax rate could be varied according to the level of expenditure, the tax could be made progressive or to vary with individual circumstances (e.g. number of dependents).
For businesses

Cash inflows less cash outflows (hence a cash flow tax or CFT), or equivalently:

Sales minus purchases of real assets and services (financial assets and related flows are generally ignored, including interest and dividend payments). An indirect expenditure tax is levied at the business level only, in effect as a final withholding tax. The GST is an example. The tax base is: sales minus purchases of real assets and services except wages. This is equivalent to the value of consumption (including imputed rental value of consumer durables) to the individual. This is also in effect a CFT.

A CFT therefore differs from an income tax in that a part of the rate of return on investment income is not taxed. This is important. A CFT is not just a simpler way of calculating tax liabilities. A most important practical implication of this difference is that to raise the same amount of revenue, a CFT must be levied at a higher statutory rate than an income tax.

Notes

  • [2]This Section is based on Katz (1999), which in turn draws heavily on Treasury (1997).
  • [3]For a more detailed description of the relationships between these various tax types, see Slemrod (1997).
  • [4]A distinction can be made between spending, which is the outlay of funds and consumption, which is the receipt of services. In many cases they are the same. The difference comes in the case of long-lived items, like household goods and, indeed, houses themselves: you spend money buying a TV today, but you consume the entertainment it provides over its life. The distinction between spending and consumption can be important when thinking about the appropriate tax treatment of long-lived assets.
  • [5]Bradford (1979): 6.
  • [6]This is the legal incidence of the tax: who is responsible for collecting the money and accounting to the revenue authority. The economic incidence relates to on whom the burden of the tax falls. For example, the legal incidence of GST in New Zealand falls on suppliers, but the economic incidence is on consumers to the extent that the introduction of GST increases consumer prices.
  • [7]The definition quoted is from Simons (1938).
  • [8]In New Zealand, for example, investments in forestry are granted CFT treatment under the “Income Tax Act”.
  • [9]In New Zealand, for large companies, integration is by way of the imputation system: companies are taxed in their own right and then, if they distribute income via dividends, allowance for company tax paid is made in the calculation of the tax liability of the shareholder.
  • [10]This system applies to partnerships in the current New Zealand tax system. While partnerships are required to file tax returns, the liability for tax falls directly on the partners.
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