Australia's Future Tax System

Final Report: Detailed Analysis

Chapter D: Taxing consumption

D1. A cash flow tax

D1–1 An alternative approach to taxing consumption

A cash flow tax can be a simple way of utilising the consumption base

There are a number of ways to impose a consumption tax, including the invoice-credit method (see Section D2 The goods and services tax), the 'additive' method (discussed in Section D4 Taxing financial services) and the 'direct subtraction' method, so called because the tax applies to cash receipts after payments (excluding payments for the labour services of employees) are subtracted.

The invoice-credit method (used for GST) is suitable when tax authorities cannot rely on cash flow financial statements to ensure tax compliance. This could be because of the many exemptions from the tax base, which mean that cash flows from different goods and services require different tax treatments. Under this approach, entities must use a formal tax invoice to substantiate tax liabilities and credits for all goods and services bought and sold, adding to compliance burdens on business. The additive method may be suitable in some cases (for example, financial services), but requires additional calculations, such as deducting a normal return to capital before taxing profit.

The direct subtraction method is the simplest and likely to be the most consistent with the needs of a modern economy, as it can run off standard business cash flow management practices. For example, where the GST relies on concepts such as 'supplies' and 'creditable acquisitions' that have no business meaning, a cash flow tax would rely on cash flow concepts already familiar to business.

The CFT is sometimes called a 'business activity tax' because it focuses on taxing entities, rather than outputs. For example, the United States Treasury (2007, pp. 19–38) has considered a direct subtraction business activity tax to replace business income taxes in the United States.

Unlike the transaction-based GST that taxes goods and services, the CFT is based on accounts. There would be no compliance need to show CFT on invoices, as this would not be needed to support a deduction (or an input tax credit under GST) for other businesses. Rather than adding up tax payable or refundable for each individual sale or acquisition (as necessary for an invoice-credit GST), a taxpayer would apply a single rate of tax to their net cash flow position (see Chart D1–1). The broader the cash flows included in the base, the simpler the tax is for those in the system.

Chart D1–1: Cash flow tax

Tax liability = tax rate (net cash flows)

Tax liability = tax rate (net cash flows)

This example shows a 10% CFT rate.

Under the CFT, taxable cash inflows would include inflows such as sales but not revenue from exports, as goods and services consumed outside Australia should not be taxed under an Australian consumption tax. Likewise, imports of goods would be taxed at the border.

Deductible cash outflows would make no distinction between capital and non-capital expenses, but would exclude cash payments related to labour remuneration (as the value of labour, unlike the value of most other inputs, would not have been subject to the tax, ensuring that there would be no bias between in-sourcing and out-sourcing labour). Similarly, no deduction would be available for imports of services (which cannot be taxed at a border).

Principle

A cash flow tax — using the direct subtraction method — can be a simple way of taxing consumption.

Financial cash flows, such as interest or taxes, would be excluded

The broadest possible consumption tax would include all cash flows, including those related to interest payments and receipts. This is described technically as a 'real plus financial', or 'R+F', tax base. This would effectively tax the value generated in all sectors of the economy, including businesses that generate revenue by charging interest rather than selling tangible goods or services.

There would be a number of benefits from levying the CFT on an R+F base. First, it would provide a more neutral form of consumption taxation — products that rely more on the value add from financial services would not enjoy a relative price advantage to other products.

While theoretically attractive, imposing an R+F-based tax on existing businesses would affect assets that have already been financed by debt. From the perspective of a lender, interest payments and repayment of principal would become taxable in the hands of the lender after the introduction of the tax but no deduction would have been provided for the original loan. To avoid this, complex transitional arrangements would be necessary and these would severely undermine the simplicity of a CFT. This problem would be widespread as nearly all entities engage in at least some purely financial transactions during their business lifecycle.

However, as most value in the economy is generated from the production of non-financial goods and services, this problem can be avoided without significantly undermining the tax base. The solution could lie in what is known as a 'real' or 'R base' cash flow tax, which involves removing cash flows associated with financial services from the taxable base. While an R base would not be as comprehensive as an R+F base, and requires a distinction to be drawn between (untaxed) financial and (taxed) non-financial cash flows, it is nevertheless an appropriate base with which to tax the non-financial sector, particularly as most of the value add in an economy can be effectively taxed by restricting the CFT to non-financial cash flows. The sale and purchase of most goods and services would be included, but payments of principal or interest would not.

To ensure a broad and neutral consumption tax base, the value add of those sectors of the economy that could not be captured using an R base cash flow tax should instead be taxed using an equivalent tax specific to financial services. Three models for taxing the consumption of financial services are outlined in Section D4 Taxing financial services.

Cash flows relating to other taxes — for example, company tax — would not be included in an R base cash flow tax, as they are financial flows. Instead, a CFT liability would be deductible for income tax, while a CFT refund would be assessable income.

Treatment of negative cash flows

If an entity's cash outlays exceeded its cash receipts, it would be in a negative net cash flow position. In this case, a cash refund should be provided. The effect of providing an immediate refund is to exempt the normal return to capital from tax (see Box D1–1), thereby ensuring that the tax only falls on consumption.

This introduces a potential revenue risk, as the government would be required to make cash payments to businesses that claim to be in a net refund position. The GST already operates on this basis, as input tax credits are refundable. However, unlike the GST, a claim for a refund under the CFT need not be supported by a tax invoice issued by a third party (although evidence of payments would still be needed).

Box D1–1: A cash flow tax does not tax the normal return to capital

The normal return to capital can be thought of as that part of the return from an investment that compensates the investor for loss of purchasing power (inflation) and for deferring consumption ('the return to waiting'). In the absence of risk, a proxy for the normal return would be the risk-free interest rate.

The value of an investment is equal to the present value of the cash flows it is expected to generate. In the case of a risk-free marginal investment — that is, one that is expected only to generate a normal return — the value of the asset would be equal to the future cash flows of the asset discounted at the risk-fee interest rate.

For example, if the risk-free interest rate were 5 per cent, an asset that generated cash flows of $4,600, $4,400 and $4,200 in years 1, 2 and 3 respectively would be worth $12,000.

If the investment were immediately expensed, as occurs under a cash flow tax, it would give rise to a negative tax liability (or tax refund) at the time of purchase. Where that investment generated future cash flows that were not reinvested, those cash flows would generate future tax liabilities. In net present value terms, no tax would be imposed on this investment.

  Year 0
$
Year 1
$
Year 2
$
Year 3
$
Cash receipts   4600 4400 4200
Cash outlays (12,000)      
Net cash flow position (12,000) 4,600 4,400 4,200
Tax due/(refundable) at 5 per cent (600) 230 220 210
Present value of tax due/(refundable) (600) 219 200 181
Net tax paid on this investment (in present value terms) 0      

If the cost of purchasing this investment were immediately expensed, it would give rise to a tax benefit at the time of purchase. Where that investment generated future cash flows that were not reinvested, taxes would be imposed on those cash flows. Overall, over the life of the investment, the effect of providing a tax benefit would be that the normal return to capital would not be taxed. That is, only above-normal returns would be taxed.

Because cash outlays on capital expenditure would be immediately deductible in full, new or growing businesses would likely be in a tax loss position in the early years, with tax liabilities arising in later years (when the business becomes profitable). They would receive an initial refund on their negative cash flow, but when they generate positive cash flows in later years they would incur a CFT liability. This is similar in effect to the government sharing the risks in the business by taking a position equivalent to a silent equity partner.

Businesses that export a significant proportion of what they produce would be expected to have a negative net cash flow for the purpose of CFT, as export sales (goods or services consumed outside Australia) would be excluded from the tax base. This means that exporters would be in a net refund position. However, this revenue loss would be balanced by taxing imports (foreign goods or services consumed inside Australia) under the CFT.

Similarly, as the CFT would exclude financial flows, businesses that provide predominantly financial services, but purchase real goods and services, would be in a net refund position under a CFT. However, coverage of the financial sector through a financial services tax (see Section D4 Taxing financial services) would ensure that the domestic consumption of financial services would still be taxed on an equivalent basis.