The election of Donald Trump in November has substantially increased the likelihood of major tax reform in the near future. While it is uncertain what shape such reform will take, there has been renewed interest in the so-called "Blueprint" for tax reform released by House Republicans on June 24, 2016. The Blueprint's stated aims are to promote economic growth for American business, incentivize companies to remain in the United States and greatly reduce the complexity of the current tax system. To promote these objectives, the Blueprint advocates the replacement of the current corporate income tax with what is referred to as a "destination-based cash flow tax" (the "DBCFT") at a 20% rate. Two primary concepts of the DBCFT are its move towards a cash flow tax (rather than an income tax) and its use of border adjustments. The Blueprint argues that a DBCFT would level the playing field for American business, eliminate the distortive effect of taxes on economic decision-making and reduce compliance costs through a simpler and more streamlined corporate tax code. While the Blueprint is incomplete in many respects, this memorandum offers a general overview of the DBCFT while raising several important questions that remain unanswered.
Border Adjustments
Perhaps the most controversial aspect of the DBCFT is its border adjustments provision. The proposed border adjustments are meant to level the playing field with trading partners that currently impose a value-added tax regime with border adjustments. The proposed DBCFT's border adjustments would remove imports and exports from a corporation's tax base—in other words, revenue from exports would not be taxable and no deduction would be provided for the cost of imports. As a result, the proposed DBCFT would effectively ignore cross-border transactions in calculating a business's tax base and would transform the US corporate tax system into a tax on the location of consumption rather than production.
According to the Blueprint, adding border adjustments would eliminate the existing self-imposed export penalty and import subsidy by moving to a destination-basis tax system. Although border adjustments seemingly promote exports and disfavor imports, the consensus in economic literature suggests that a DBCFT is trade-neutral. Economists point to the currency appreciation the DBCFT is expected to create as the mechanism for creating trade-neutrality. It is estimated that the DBCFT as proposed would lead to appreciation in the US dollar of approximately 25%. As a result, currency appreciation should leave foreign purchasers with 80% of their buying power for US goods (similarly, costs of imports should be reduced by 20%). The basic thinking relating to the effect of currency appreciation under the DBCFT is that taxing imports (via removal of a deduction for their cost) would reduce domestic demand for imports which, in turn, would cause fewer dollars to end up overseas. Correspondingly, exempting exports from tax would increase demand for US goods and US dollars. The relative scarcity and increased demand for the US dollar should raise its value relative to other currencies. Some economists have expressed significant concern that the US dollar would not appreciate as much as predicted, in which case the cost to consumers of imported goods could increase substantially.
One challenge to imposing border adjustments is that the World Trade Organization ("WTO") permits border adjustments upon exports only with respect to indirect taxes. In other words, border adjustments are prohibited by the WTO under an income tax regime. This prohibition appears to be a primary reason for the Blueprint's other primary concept—a move away from an income tax and towards a cash flow tax.
Cash Flow Tax
The second major pillar of the Blueprint's corporate tax reform is a move from an income tax towards a cash flow tax. A pure cash flow tax calculates a business's tax base by including cash inflows while deducting cash outflows and is meant to reflect a tax on consumption rather than income. Under the DBCFT, the amount paid for a business asset (other than land), including intangible assets, would be deducted up front, rather than incorporated in the basis of the asset. Concepts such as realization, basis, capitalization and depreciation or amortization, all of which play a role in the current corporate income tax system, would be eliminated under the plan. No attempt would be made to match the timing of income with related deductions—a general tax and accounting principle, though not always reflected in current law.
A simple numerical illustration is helpful in demonstrating the difference between an income tax and a cash flow tax. Suppose a corporation spends $100 on an asset. That asset will generate $10 a year in revenue, is depreciable at a constant rate over a period of 20 years (i.e., the asset produces depreciation deductions of $5 per year) and will be sold at the end of year five for $90. Under current law, the corporation takes a $100 basis in the asset, recognizes $5 of net income each year ($10 of revenue minus a $5 depreciation deduction) and reduces its basis in the asset by $5 a year (on account of depreciation). In year five when the asset is sold, the corporation will take into account $15 of income ($90 sale price minus $75 basis). The corporation will include a total of $40 in taxable income over the course of holding the asset.
Under a cash flow tax, the corporation will simply deduct $100 up front for the purchase (for the purpose of this example, it is assumed the corporation has sufficient revenue to offset against the deduction, otherwise the deduction will create a net operating loss (an "NOL")). The corporation will then include $10 of revenue each year as taxable income. In year five, the corporation will include year five's revenue of $10 plus the $90 of proceeds from the sale. Total taxable income remains the same under each approach.
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