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

4  Seemingly insurmountable barriers to implementing a CFT

While a CFT looks significantly more desirable than an income tax, especially from a simplification point of view, analysis to date, both within Treasury and elsewhere has failed to develop a workable transition from an income tax to a CFT. The recent independent review of the New Zealand tax system (Tax Review 2001), concluded that transition issues were an apparently intractable barrier to the implementation of a CFT.[18]

4.1  Transition from an income tax to a CFT[19]

Transition refers to how to take the world from one with an income tax to one with a CFT. In many cases of tax policy, transition is not a serious issue: a date is set from which the new regime applies. With a CFT, the transition issue that appears impossible to solve is that relating to existing assets. Remember, under an income tax, income-earning assets are deductible over their economic life, while under a CFT a firm receives an immediate deduction. On disposal, proceeds from the sale of assets held on capital account are exempt from income tax, while under a CFT all proceeds are taxable.

There are three options for dealing with existing assets. The first approach is referred to as the "free entry" transition and allows firms an immediate deduction for the value of undepreciated assets. In this approach, on the implementation date, all taxpayers get an immediate tax deduction equal to the undepreciated value of their existing capital. This approach will not bankrupt any firms, but it might get close to bankrupting the government, as the fiscal cost would be huge.[20] It also entails large wealth transfers, from those without savings (who will have to pay a larger tax on labour income to finance the fiscal cost) to those with savings (who get an unanticipated increase in the after-tax rate of return on their investments). But more importantly, from an efficiency point of view, the higher tax on labour means an increase in dead-weight economic costs that will partially or wholly offset any economic gains from moving to an expenditure tax.

Bradford (1998) has proposed a variation on the “free entry” regime which does not involve an increase in other taxes to finance the transition. Under his proposal, taxpayers are allowed a deduction for the undepreciated value of existing assets on the day of introduction of the tax. Rather than grant this deduction immediately, the transition could provide a path of tax rebates or other transfers over time with the same discounted value. He suggests a payment schedule that matches the deductions they would have taken over the life of the asset, with interest. For example, if taxpayers purchased a computer worth $10,000 depreciable over three years on a straight-line basis, they would be paid $3,333 in each year, with interest added to payments in years two and three.

Bradford’s proposal is economically equivalent to the Government allowing immediate deductibility and issuing debt. Rather than borrowing on the open market, the borrowing is from the owners of the existing capital.

The second transition is known as the "cold turkey" approach and involves denying any further deductibility for existing assets – this involves a multi-billion dollar cost for firms, especially those that have borrowed to finance the purchase of assets (they would continue to have a commercial liability for the gross amount of any interest payments, but would receive no offsetting tax deductions).

Suppose you borrow $100 and buy a machine for $100 that depreciates at 20%. Income is $30 p.a., interest on debt is $10, and $20 is used to repay the principal of the loan (so that it is paid off by the time the machine ceases to be useful). Under an income tax, you expect to pay no tax ($30 income less $10 interest expense, less $20 deduction for depreciation).

A CFT is introduced soon after purchase of machine. Sale of the machine would be taxable and there is no longer an allowance for depreciation. Real income is taxable and real (as opposed to financial) expenditures are deductible. In year 1, you are taxed on $30 (at, say, 33%), leaving me $20.10. This is insufficient to pay interest and amortise the debt. After 5 years you will have a worthless machine and outstanding debt of $45.50 and will go bankrupt.

The final option involves continuing to operate an income tax for existing assets, including, and this is the key, assets sold to other taxpayers – this would significantly, if not totally, reduce the administrative and compliance cost savings of transiting to a CFT.

The necessity of applying a transition rule to assets that are bought and sold shows why only applying a CFT to new businesses is not a solution: a new company could simply purchase the assets of an existing business, and would receive cash flow treatment (immediate deductibility). That is, the free entry transition would apply.

Combinations of the three transitions are also possible. For example, free entry could be phased in over a period. With a five years transition, for example, firms would be allowed to depreciate their existing assets over five years, regardless of their economic life, with cash flow treatment applying to their new assets. Doing so, however, would require an element of the parallel systems transition, since rules would be needed to prevent firms selling their existing assets to other firms.

Treasury’s previous conclusion that it is not possible to develop a feasible transition to a CFT still seems to hold. Limiting a CFT to a subset of the economy – small businesses – reduces but does not eliminate, the problems.

4.2  Transition from CFT to income tax

Not all small businesses stay small. If small businesses are taxed under a CFT, while large businesses are taxed under an income tax, then there needs to be a set of rules to allow firms to transfer from CFT treatment to income tax treatment.

As always with issues of CFT, the complexity surrounds the ongoing treatment of assets of an enduring nature. As noted above, income tax treatment involves the depreciation of assets over their economic life, while in a CFT the full purchase price is deductible in the year of purchase (with sale proceeds being assessable on disposal).

Consider a firm that is taxed under a CFT and has an asset that is still economically valuable. The firm ceases to be small and becomes subject to the income tax. A rule would be needed to deem the asset to be fully depreciated. Conceptually, this is not difficult for assets that are simply used in the business and then disposed of when they have zero economic value. Difficulties could arise if an existing asset was improved, since depreciation would, under an income tax, be allowed on the improvements over the remaining life of the asset.

A particularly difficult issue would arise when the asset is sold, since the income tax includes the revenue/capital distinction. Thus, under an income tax, the proceeds from selling an asset that is held on capital account are not assessable, while under a CFT they are. Allowing firms to have cash flow treatment on acquisition (immediate deductibility) and income tax treatment on disposal (exemption of proceeds for assets on capital account) would leave the government with a potentially large fiscal cost. It would also be inappropriate to allow the purchasing firm (if it were subject to income tax treatment) to depreciate an asset for which deductions had already been taken under the CFT.

Any transition rule would need to avoid being a claw-back of CFT treatment. As with the transition to a CFT in a world with existing assets, it does not seem possible to develop a feasible set of rules to transit firms from a CFT to an income tax.

Notes

  • [18]See Tax Review (2001) : 106.
  • [19]While the discussion that follows relates to a transition from an income tax to a CFT, similar issues would apply to the introduction of a CFT in a world where this is no pre-existing income tax. Transition issues arise because of the existence of a capital stock, not because of the pre-existing tax system.
  • [20]In 1997, Treasury estimated that the first year cost of a “free entry” transition to be in the order of $20 billion. Compare this with total annual tax revenue at that time of around $34 billion.
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