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

5.3  The undesirability of differential treatment

Even if the issues of integration could be overcome, it is not certain that applying a CFT to part of the economy and income tax to the rest would be desirable. Because an income tax has a wider base than a CFT, applying CFT treatment to one sector of the economy (new small businesses) would considerably distort investment decisions towards such businesses. This is because the tax base of a CFT is smaller than that applying under an income tax.

To see the implications, consider the example of an individual with $10,000 to invest. They have two options: a small business to be taxed under a CFT and a large business to be taxed under an income tax. To make the differences stark, consider further that the two firms will be doing the same thing with the capital: buy an asset in year one that will produce income of $1,000 before tax and is then sold for $10,000 one year later. The pre-tax rate of return to the asset is 1000/10000, or 10%.

At a tax rate of 33%, a CFT would allow immediate deductibility in a first year, leading to a tax refund of $3,300. So the after-tax cost of buying the asset is just $6,700. In the second year, the sale of $10,000 and the income of $1,000 are also taxed at 33%, leaving $7,370 after tax. The after-tax rate of return to the asset is (7,370-6,700)/6,700 = 10%, the same as the before-tax rate of return.

In contrast, under an income tax the $10,000 purchase price is not deductible until the asset is sold. The tax is calculated in the second year at 33% of $1,000 in income plus $10,000 sales revenue minus $10,000 purchase price. The after-tax rate of return to the asset is $670 / $10,000 = 6.7%.

5.4  The revenue risk of a CFT

In its discussion of the issue of a CFT, the Tax Review raised the issue of the revenue risk that such a tax would pose to the Crown. They expressed this risk in these terms:

By allowing immediate deductibility for new investment, the government would in effect provide almost a third of the total capital to new corporate ventures (and a still larger proportion of total equity finance in ventures partially financed by debt) without exercising any control and with uncertainty over whether taxable cash flows would materialise in future years.

Experience has shown that immediate deductibility for investment outlays can create severe revenue risks, particularly when the assets for which deductions are claimed are difficult to value and are acquired from parties outside the tax base (or on lower tax rates than those claiming the deductions). Foreign firms could undertake investments in New Zealand, creating losses through their initial capital outlays, and structuring their affairs so that future cash flows were received in other jurisdictions.[23]

The risk in the first paragraph may be more of a truism than an argument against a CFT. It is true that by its very nature, a CFT involves immediate deductibility for payments that are, under an income tax, spread over the life of assets. But concomitant to that is the taxation of revenues on a cash flow basis. This seems to significantly reduce the possibility that firms could escape paying tax on their operations.

The experience with GST gives some comfort that the Review’s concerns would not eventuate. Under the GST, firms receive a refund of their input tax credits without the Government “exercising any control and with uncertainty over whether taxable cash flows would materialise in future years”, yet the GST produces sizable revenues for the Crown.

The risk in the second paragraph is real, although the experience cited is of the provision of immediate deductibility in the context of a far from comprehensive income tax. Providing CFT treatment on the expense side of the ledger, while allowing income tax treatment on the income side, does seem to involve significant risks to the Crown. But CFT treatment on both sides should not.

What would involve revenue risks is the application of a CFT to one part of the tax system, small business, with the remainder subject to an income tax. As noted under the section above on integration with the rest of the tax system, the partial application of a CFT seems to create further opportunities for escaping the income tax.

Notes

  • [23]Tax Review (2001): 106.
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