## 1. Alternative Proposals for Reforming the Conventional CIT

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### I. Introduction — context and candidate reforms
- Conventional corporate income tax (CIT) generates:
  - a wedge between pre- and post-tax rates of return to corporate investment;
  - a tax-induced incentive for debt financing.
- Administrative problems highlighted:
  - attribution of profits; transfer-pricing; thin capitalization; evasion via disguising, transforming, deferring, or shifting profits.
- Notable reform proposals summarized:
  - Comprehensive business tax (CBIT) — U.S. Department of the Treasury (1992).
  - CIT with an allowance for corporate equity (ACE) — Institute for Fiscal Studies (1991).
  - Cash-flow tax (CFT) variants — R-CFT, (R+F)-CFT, S-CFT.
  - Accounts-based value-added taxes (VAT) / BVT / S-VAT variants.
- Key trade-offs among proposals:
  - CBIT: nondeductibility of net interest expenditure — levels debt/equity but raises cost of corporate investment.
  - CIT with ACE: deducts imputed opportunity cost of equity — taxes only excess profits (zero marginal effective tax rate (METR)) but still requires conventional profit determination.
  - CFTs: can achieve zero METR; administrative and distributional differences across versions.

### II. Comparative structure (from Table 1) — succinct attributes
- Tax-base distinctions (preserved):
  - Conventional CIT base: P (pre-tax profits).
  - CBIT base: P + I.
  - CIT with ACE base: P – r·E0 (D + VD) – (H + DD).
  - S-CFT / R-CFT / S-VAT: variants of net cash inflows/outflows by transaction types (real, financial, share).
- Economic-substance characterizations:
  - Conventional CIT: Total corporate profits (return to equity).
  - CBIT: Total corporate income (return to debt and equity).
  - CIT with ACE: Corporate profits in excess of “normal” rate r (excess profits).
  - S-CFT: Net cash outflow in share transactions (equivalently net cash inflow of real + financial transactions).
  - R-CFT: Net cash inflows in real transactions.
- Cross-country mentions preserved: Belgium (effective 2007), Brazil, Croatia, Italy (discontinued), Estonia, Japan.

### III. Merits and limitations of R-CFT and S-CFT

- Stylized two-period project (notation preserved):
  - Fixed asset cost 1 in period 1; income (1 + ρ) in period 2; opportunity cost of equity = r; financing proportions: α (debt) and (1 − α) (equity).
  - No-tax rate of return v (equation (1)):
    - v = 1 + (ρ − α·r)/(1 − α) = r + (ρ − r)/(1 − α)
- Conventional CIT results:
  - interest deductible; depreciation allowance d.
  - post-tax rate C v given by (2) (form and role of d preserved).
  - tax wedge between pre- and post-tax rates: equation (3).
  - if d = 1 then (v − vC)/v = t.
- R-CFT properties:
  - expensing of fixed assets; ignores financial transactions.
  - post-tax rate R v (equation (4)): zero METR for marginal projects.
  - potential subsidy when investor uses debt: equation (5) shows R v − v > 0 when ρ > r and α > 0.
  - remedy: carry forward tax credits with interest at rate r → modified post-tax rate (equation (6)) that taxes excess profits at rate t.
  - government exposed to investment risk due to expensing (volatile revenue).
- S-CFT properties:
  - tax on net cash outflow from share transactions (equivalently R + F).
  - post-tax rate S v (equation (7)) equals no-tax v: zero METR and zero average effective tax rate.
  - with carry-forward of tax credits with interest at rate r → S v′ (equation (8)), identical to R-CFT with similar carry-forward.
  - S-CFT intrinsically neutral between real and financial transactions; subject to deferral via lending/borrowing but limited in aggregate if implemented on destination basis.
- Administrative complexity — real vs financial transactions; origin vs destination:
  - R-CFT complications:
    - Converting financial sector to (R+F)-CFT often required; definition and boundaries problematic.
    - Disentangling real and financial elements in transactions is practically difficult; invites recharacterization and abuse (McLure and Zodrow (1996) discussion preserved).
  - S-CFT advantages:
    - No need to separate real and financial transactions; simpler to administer relative to R-CFT.
    - Still requires distinction between interest and dividend flows, but easier to control.
  - Border-tax adjustments:
    - Destination-based R-CFT or S-CFT ignores transactions with non-residents (exports excluded from inflows; imports excluded from outflows).
    - For S-CFT, decomposition (equations (9) and (10)) preserved: S ≡ (R_D + R*) + (B_D + B*) + (I_D + I*). Destination basis: S − R* − B* − I* ≡ R_D + B_D + I_D.
    - Residency ascertainment for financial transactions needed but feasible; destination-based S-CFT can address transfer-pricing and thin-capitalization effectively.

### IV. Nature of the modified S-CFT — design and properties
- Modification described:
  - Replace expensing with normal depreciation allowances.
  - Carry forward the undepreciated value of fixed assets with interest at the opportunity cost of equity capital r.
- Intended outcome:
  - Tax only excess profits as they accrue (zero METR) while avoiding government exposure to investment risk from expensing.
- Two-period project under modified S-CFT (expressions preserved):
  - Tax liability t·α in period 1 due to inflow of loan proceeds α; new tax deduction (1 + r) in period 2 for depreciation with interest.
  - Post-tax rate v* given by equation (11): only excess profits taxed; normal return untaxed.
- Taxpayer behavior and neutrality results:
  - Taxpayer may neutralize discrepancy between v* and S v′ by borrowing B = t·α/(1 − t) (equation (12)), producing post-tax rate v** equal to R v (equation (13)).
  - Demonstrates taxpayers can alter timing but not present value of tax payments when financial transactions included in base.
- Advantages of modified S-CFT:
  - zero METR preserved;
  - government revenue stability improved relative to R-CFT (no expensing of new assets → less volatility);
  - administrative simplicity relative to R-CFT (no separation of real vs financial transactions);
  - fewer transitional complications than R-CFT: interest remains deductible; carrying forward undepreciated value can apply to existing assets.
- Limitations and practical considerations:
  - Modified S-CFT is a hybrid retreat from pure CFT (mix of income and cash-flow features).
  - Still susceptible to deferral via lending/borrowing in aggregate only when borrowers are tax-exempt; destination basis closes much leakage to non-residents.
  - Unresolved question whether destination-based modified S-CFT would be treated as an export subsidy in trade terms; origin basis would avoid export-subsidy concern but reintroduce transfer-pricing/thin-capitalization issues.

### V. Key policy conclusion and recommendation
- Central conclusions:
  - Replacing conventional CIT with a CFT is desirable.
  - R-CFT is inferior due to non-neutrality from differentiating real vs financial transactions and associated administrative vulnerabilities.
  - Regular S-CFT is administratively superior but exposes government to revenue risk via expensing.
  - Modified S-CFT (normal depreciation + carry forward undepreciated value with interest at rate r) combines zero-METR with administrative simplicity and improved revenue reliability.
- Policy recommendation:
  - Adopt the modified S-CFT as the preferred replacement for the conventional CIT.
  - Consider destination-basis implementation to address transfer-pricing and thin-capitalization.
  - Note the unresolved question concerning export-subsidy treatment for destination-based, non-pure-consumption variants.

*Source: _wp06117 - 1. Alternative Proposals for Reforming the Conventional CIT*

### References............................................................................................... 22

### References............................................................................................... 22

### References
- References............................................................................................... 22

### Table
- Table

*Source: _wp06117 - References............................................................................................... 22*

### 1. Alternative Proposals for Reforming the Conventional CIT.............................. 4

### 1. Alternative Proposals for Reforming the Conventional CIT

### I. Introduction — context and candidate reforms
- Conventional corporate income tax (CIT) creates:
  - a wedge between pre- and post-tax rates of return to corporate investment;
  - a tax-induced incentive for debt financing.
- Administrative problems: attribution of profits; transfer-pricing; thin capitalization; evasion via disguising, transforming, deferring, or shifting profits.
- Notable reform proposals (comparatively summarized in Table 1):
  - Comprehensive business tax (CBIT) — U.S. Department of the Treasury (1992).
  - CIT with an allowance for corporate equity (ACE) — Institute for Fiscal Studies (1991).
  - Cash-flow tax (CFT) variants — Meade Committee and others: R-CFT, (R+F)-CFT, S-CFT.
  - Accounts-based value-added taxes (VAT) / BVT / S-VAT variants.
- Key trade-offs among proposals:
  - CBIT: nondeductibility of net interest expenditure — levels debt/equity but raises cost of corporate investment.
  - CIT with ACE: deducts imputed opportunity cost of equity — taxes only excess profits (zero marginal effective tax rate (METR)) but still requires conventional profit determination.
  - CFTs: can achieve zero METR; administrative and distributional differences across versions.

### II. Comparative structure (from Table 1) — succinct attributes
- Tax-base distinctions preserved as in source:
  - Conventional CIT base: P (pre-tax profits).
  - CBIT base: P + I.
  - CIT with ACE base: P – r·E0 (D + VD) – (H + DD).
  - S-CFT / R-CFT / S-VAT: variants of net cash inflows/outflows by transaction types (real, financial, share).
- Economic-substance characterizations:
  - Conventional CIT: Total corporate profits (return to equity).
  - CBIT: Total corporate income (return to debt and equity).
  - CIT with ACE: Corporate profits in excess of “normal” rate r (excess profits).
  - S-CFT: Net cash outflow in share transactions (equivalently net cash inflow of real + financial transactions).
  - R-CFT: Net cash inflows in real transactions.
- Notable cross-country mentions preserved: Belgium (effective 2007), Brazil, Croatia, Italy (discontinued), Estonia, Japan.

### III. Merits and limitations of R-CFT and S-CFT

#### A. Distortion on investment — stylized two-period project (notation preserved)
- Setup (as in source): fixed asset cost 1 in period 1; income (1 + ρ) in period 2; opportunity cost of equity = r; financing proportions: α (debt) and (1 − α) (equity).
- No-tax rate of return v (equation (1)):
  - v = 1 + (ρ − α·r)/(1 − α) = r + (ρ − r)/(1 − α)  (preserving algebraic relationships and notation).
- Conventional CIT:
  - interest deductible; depreciation allowance d.
  - post-tax rate C v given by (2) (preserve form and role of d).
  - tax wedge between pre- and post-tax rates: equation (3).
  - if d = 1 then (v − vC)/v = t (well-known result).
- R-CFT:
  - expensing of fixed assets; ignores financial transactions.
  - post-tax rate R v (equation (4)): shows zero METR for marginal projects.
  - potential subsidy when investor uses debt: equation (5) shows R v − v > 0 when ρ > r and α > 0.
  - remedy: carry forward tax credits with interest at rate r → modified post-tax rate (equation (6)) that taxes excess profits at rate t.
  - government exposed to investment risk due to expensing (volatile revenue).
- S-CFT:
  - tax on net cash outflow from share transactions (equivalently R + F).
  - post-tax rate S v (equation (7)) equals no-tax v: zero METR and zero average effective tax rate.
  - with carry-forward of tax credits with interest at rate r → S v′ (equation (8)), identical to R-CFT with similar carry-forward.
  - S-CFT intrinsically neutral between real and financial transactions; can be subject to deferral via lending/borrowing but limited in aggregate if implemented on destination basis.

#### B. Administrative complexity — real vs financial transactions; origin vs destination
- R-CFT complications:
  - Treating financial sector: must often convert certain financial institutions to (R+F)-CFT; definition and boundaries of financial institutions problematic.
  - Transactions mix: disentangling real and financial elements in transactions is practically difficult; taxpayers or financial institutions asked to separate elements invites creative interpretation or abuse.
  - Incentives to recharacterize real payments as financial (e.g., interest) for tax avoidance — significant enforcement difficulty (McLure and Zodrow (1996) discussion preserved).
- S-CFT advantages:
  - No need to separate real and financial transactions; administrative simplicity relative to R-CFT.
  - Distinction still required between interest and dividend flows, but simpler to control.
- Border-tax adjustments (origin vs destination):
  - Destination-based R-CFT or S-CFT ignores transactions with non-residents (exports excluded from inflows; imports excluded from outflows).
  - For S-CFT, decomposition (equations (9) and (10)) preserved: S ≡ (R_D + R*) + (B_D + B*) + (I_D + I*). Destination basis: S − R* − B* − I* ≡ R_D + B_D + I_D.
  - Residency ascertainment for financial transactions needed but feasible; destination-based S-CFT can address transfer-pricing and thin capitalization equally effectively.

### IV. Nature of the modified S-CFT — design and properties
- Modification: replace expensing with normal depreciation allowances, but carry forward the undepreciated value of fixed assets with interest at the opportunity cost of equity capital r.
- Intended outcome: tax only excess profits as they accrue (zero METR) while avoiding government exposure to investment risk from expensing.
- Two-period project under modified S-CFT (preserve expressions):
  - tax liability t·α in period 1 due to inflow of loan proceeds α; new tax deduction (1 + r) in period 2 for depreciation with interest.
  - post-tax rate v* given by equation (11): only excess profits taxed; normal return untaxed.
- Taxpayer may neutralize discrepancy between v* and S v′ by borrowing B = t·α/(1 − t) (equation (12)), producing post-tax rate v** equal to R v (equation (13)); demonstrates taxpayers can alter timing but not present value of tax payments when financial transactions included in base.
- Advantages of modified S-CFT:
  - zero METR preserved;
  - government revenue stability improved relative to R-CFT (no expensing of new assets → less volatility);
  - administrative simplicity relative to R-CFT (no separation of real vs financial transactions);
  - fewer transitional complications than R-CFT: interest remains deductible; carrying forward undepreciated value can apply to existing assets.
- Limitations and practical considerations:
  - modified S-CFT retreats somewhat from pure CFT (hybrid of income and cash-flow features);
  - still susceptible to deferral via lending/borrowing in aggregate only when borrowers are tax-exempt; destination basis closes much of leakage to non-residents;
  - potential uncertainty whether destination-based modified S-CFT would be treated as an export subsidy in trade terms — untested question; origin basis would avoid subsidy concern but reintroduce transfer-pricing/thin-capitalization issues.

### V. Key policy conclusion and recommendation
- Replacing conventional CIT with a CFT is desirable, but:
  - R-CFT is inferior due to major non-neutrality from differentiating real vs financial transactions and associated administrative vulnerabilities.
  - Regular S-CFT is administratively superior but exposes government to revenue risk via expensing.
  - Modified S-CFT (normal depreciation + carry forward undepreciated value with interest at rate r) combines the desirable zero-METR property with administrative simplicity and improved revenue reliability.
- Recommendation: adopt the modified S-CFT as the preferred replacement for the conventional CIT, with consideration of destination-basis implementation to address transfer-pricing and thin-capitalization, while noting the unresolved question concerning export-subsidy treatment for destination-based, non-pure-consumption variants.

*Source: _wp06117 - 1. Alternative Proposals for Reforming the Conventional CIT*

### REFERENCES

### _wp06117 - REFERENCES

### References list

- Bird, Richard M., and Jack M. Mintz, 2000, “Tax Assignment in Canada: A Modest Proposal,” in Toward a Mission Statement for Canadian Fiscal Federalism, ed. by Harvey Lazar (Kingston, Ontario: Institute of Intergovernmental Relations), pp. 263–92.

- Becker, Johannes, and Clemens  Fuest, 2005, “Does Germany Collect Revenue from Taxing the Normal Return to Capital?” Fiscal Studies, Vol. 26 (December), pp. 491–511.

- Bradford, David F., 1998, “Transition to and Tax Rate Flexibility in a Cash-Flow Type Tax,” Tax Policy and the Economy, Vol. 12, pp. 151–72.

- ———, 2001, “Blueprint for International Tax Reform,” Brooklyn Journal of International Law, Vol. 26, pp. 1449–63.

- ———, 2003, “Addressing the Transfer-Pricing Problem in an Origin-Basis X Tax,” International Tax and Public Finance, Vol. 10 (September), pp. 591–610.

- ———, 2004, The X Tax in the World Economy (Washington, DC: AEI Press).

- Devereux, Michael P., and Peter Birch Sørensen, 2005, “The Corporate Income Tax: International Trends and Options for Fundamental Reform,” paper prepared for the Working Party No. 2 of the Committee on Fiscal Affairs of the OECD (Paris: OECD).

- Hall, Robert E., and Alvin Rabushka, 1995, The Flat Tax, 2nd ed. (Stanford: Hoover Institution Press).

- Institute for Fiscal Studies, 1978, The Structure and Reform of Direct Taxation (London: George Allen and Unwin).

- ———, 1991, Equity for Companies: A Corporate Tax for the 1990s (London).

- McLure Jr., Charles E., and George Zodrow, 1996, “A Hybrid Approach to the Direct Taxation of Consumption,” in Frontiers of Tax Reform, ed. by Michael J. Boskin (Stanford: Hoover Institution Press), pp. 70–90.

- Seidman, Laurence S., 1997, The USA Tax: A Progressive Consumption Tax (Cambridge, Massachusetts: MIT Press).

- U.S. Department of the Treasury, 1992, Integration of the Individual and Corporate Tax Systems: Taxing Business Income Once (Washington, DC).

- U.S. Report of the President’s Advisory Panel on Federal Tax Reform, 2005, Simple, Fair, & Pro-Growth: Proposals to Fix America’s Tax System (Washington, DC).

- Zee, Howell H., 2005, “A New Approach to Taxing Financial Intermediation Services Under a Value-Added Tax,” National Tax Journal, Vol. 58 (March), pp. 77–91.

*Source: _wp06117 - REFERENCES*

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