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

2.2  Why do income taxes persist?

Given the complexity of the income tax and its alleged higher economic cost, why do most OECD countries use the income tax as a major source of revenue, especially as there are alternatives?

There are three main reasons a Government might want to operate an income tax as well as other taxes.

The first has to do with variability of revenue flows. Having a range of tax bases that are subject to different influences means that government revenues are less variable from year to year. For example, in New Zealand, GST flows are closely related to the increase in nominal GDP, while income tax relates to changes in employment and wage rates (for the labour income base) and business conditions (for the business base).

The other two main reasons go to equity. An income tax can be made progressive – the proportion of income paid in tax increases with income.[12] This is because it is possible, although at some cost to compliance and administration, to set tax rates that vary with the personal circumstances of the individual, like level of income or family circumstances (marital status, family size). This is not possible with indirect taxes like the GST.

The second equity issue is that an income tax is a good application of the “ability to pay” principle, whereby those with the greatest means make the greatest contribution to the state. This is not exactly the same as having a progressive tax scale. Under an income tax two people with the same income, but different spending patterns, pay the same tax. Thus, a person with high savings in any one year (and therefore a low consumption tax liability) pays the same in income tax as a person who spends all their income that year. For this reason, income is a better measure of ability to pay than consumption.[13]

Unlike indirect consumption taxes like GST, a CFT can be made progressive. Thus, proponents of such taxes have argued that a CFT is superior to an income tax in terms of its simplicity and economic efficiency, while being at least equal on equity grounds.

2.3  Types of CFT

The literature on cash flow taxes includes a number of variants on the basic theme of taxing on a “cash-in, cash-out” basis. The terminology the Meade Commission used to describe the two main variants – the “R” and “R+F” bases – has been adopted as the standard in the literature.

The “R Base” (R stands for real) involves businesses being taxed on all cash receipts arising from transactions in goods or services: financing transactions are ignored.[14] The cost of acquiring a financial asset is non-deductible and returns and amounts received on sale or redemption of financial assets are exempt.

The treatment is derived from the idea that financing transactions are simply mechanisms by which firms’ value-added is distributed to the individuals who own the financial capital with which firms purchase real assets.[15] So long as value-added has already been taxed (at the correct rate) in firms’ hands, no additional tax should be payable when their earnings are distributed. This is similar to the treatment of dividends under New Zealand’s imputation system: no additional tax is payable by shareholders on dividends paid out of tax-paid income. It is, however, different from the income tax treatment of interest, which is deductible to the payer and assessable to the payee.

The “R+F” base (F stands for financing) includes financing transactions in the tax base, again on a cash-in, cash-out basis. Under this approach, borrowers include loan principal (but not equity raised) in taxable cash income and deduct payments of interest and principal. Lenders deduct principal when they make a loan and include loan repayments – principal and interest – in taxable income.

In the case of tax on rents from assets acquired with debt finance, the effect of an R+F regime is to shift liability from the owner of the asset to the provider of the finance. Thus, the R+F base is economically different from the R base.

Take the example of a company that buys a machine in year 0 for $100. The machine generates a single cash inflow, of $120, in year 1 and is then scrapped. Under an R base tax, or if the company had used equity finance to acquire the machine, its taxable income would be simply minus $100 in year 0 and $120 in year 1. But under an R+F base tax, if the company had borrowed the machine’s full purchase cost, at an interest rate of 15%, its taxable income in the first year would be zero and $5 in the second. The financer would receive a deduction of $100 in the first year (for the out-going of the loan principal) and income of $115 (principal and interest) in the second. The effect of the R+F base is to shift liability for tax for part of value-added, $15 in this case, to lenders.

Differences between various CFT schemes primarily reflect varying treatments of financing transactions. Table 4 summarizes the traditional ways of dealing with financing transactions under different taxes on income from capital.

Table 4 – A Comparison of standard tax bases
Key characteristics Comprehensive Income Tax Value-added tax (GST) R-base business tax R + F CFT
What is taxed? All returns Above normal return Above normal return Above normal return
At what level are returns subject to tax?

At business level in respect of equity-financed investment.

For debt-financed investment, above normal return at business level, normal return at individual level.[16]

At business level

At business level in respect of value- added attributable to capital (equity and debt).

At individual level in respect of wages.

At business level for equity-financed investment.

At individual level for wages and debt-financed investment.

International trade and investment

NZ-sourced income of non-residents.

Worldwide income of residents

Destination Base (exports zero-rated, imports taxed) = value-added of goods and services consumed in NZ. Origin base (export receipts assessable, import costs deductible) = value-added on goods and services produced in N Z.

Base is smaller than R base if provider of debt outside NZ.

If real asset outside NZ and provider of debt is New Zealander, then base is bigger than R base.

Financial institutions Taxed on net income. Financial services are exempt supplies. A pure R-base tax cannot be applied to financial institutions because the price of financial services is part of interest rates. R + F base can tax financial intermediaries but requires distinction between debt and equity.

Notes

  • [12]The most common example is an income tax scale where the marginal tax rate increases with income. Another example of a “progressive” rate scale is a constant marginal tax rate combined with either a tax-free threshold or a uniform government grant. In both these cases, the average tax rate increases with income, while the marginal rate (above the threshold in that case) is constant.
  • [13]There are contrary views on this point. David Bradford, a leading US tax economist and policy adviser is of the view that the superiority of an income tax on equity grounds only applies over short periods of time. His view is that when viewed over a longer period, like a lifetime, a consumption tax is superior on equity grounds. See Bradford (1979).
  • [14]Likewise, financing transactions are ignored under a GST or VAT.
  • [15]This characterisation applies only to “pure” financing transactions. It is not correct to the extent that returns on financial instruments also embody payments for services provided by financial intermediaries.
  • [16]The taxation of normal returns at the individual (rather than the business) level arises because of the deductibility of interest to firms.
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