National Tax Journal
Vol 49 no. 3 (September 1996) pp. 487-500
CASH-FLOW TAXATION OF FINANCIAL SERVICES
CASH-FLOW TAXATION
OF FINANCIAL SERVICES
PETER R. MERRILL
EDWARDS *
*
AND CHRIS R.
Abstract - Introduction of a consumption-based tax in the United States will
require finding a method for taxing
financial intermediation services. This
paper describes the “cash-flow” method
of taxation and its application to
financial services companies. The cashflow method is used to tax certain
financial companies in the Unlimited
Savings Allowance (USA) bill introduced
by Senators Nunn and Domenici. Tax
liability estimates under the USA cashflow tax are presented for a sample of
banks, insurance companies, and
securities brokers. These results indicate
that the financial sector would likely
enjoy a substantial tax cut under the
USA tax.
Tax, introduced by Representatives
Schaefer and Tauzin.1
The drafters of these bills intend that
companies providing financial services,
such as banks, insurance companies,
and brokers, should be subject to tax.
By contrast, value-added tax (VAT)
systems typically exempt “core”
financial intermediation services.2 The
rationale for exemption is that customers implicitly pay for many financial
services through interest rate spreads,
bid-ask spreads, and other financial
margins. Exemption avoids many
difficult issues involved in measuring the
value of financial services where no
separately stated fee is charged.3
Exemption of financial services, however, causes numerous problems. For
example, financial services provided to
business customers may be subject to
overtaxation (so-called “tax cascading”)
due to nonrecoverable input taxes.4
INTRODUCTION
Several bills have been introduced to
replace the federal income tax system
with a consumption-based tax system,
including the Flat tax, introduced by
House Majority Leader Dick Armey; the
Unlimited Savings Allowance (USA) tax,
introduced by Senators Nunn and
Domenici; and the National Retail Sales
Instead of exemption, the drafters of
the USA legislation would tax most
financial services under a “cash-flow”
method of taxation.5 The cash-flow
method is not a new idea—it was
discussed as a replacement for the
income tax by the Institute of Fiscal
Studies (IFS) (1978) and the U.S.
Treasury Department (1977).
*
Economic Policy Consulting Group, Price Waterhouse LLP,
Washington National Tax Service, Washington, D.C. 20005.
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Vol 49 no. 3 (September 1996) pp. 487-500
NATIONAL TAX JOURNAL VOL. XLIX NO. 3
This paper describes the cash-flow
method of taxation, discusses some
problems with the application of the
cash-flow method to financial services,
outlines the Tax Calculation Account
(TCA) method that is being considered
by the European Commission, and sets
forth an alternative “accrual” method
for taxing financial services. In addition,
the paper presents the results of an
analysis of USA business tax liability for
a sample of banks, insurance companies, and securities brokers using the
cash-flow tax rules. The results indicate
that financial services may enjoy a
substantial tax cut under a revenueneutral consumption-based replacement
to the corporate income tax system.
the value of these services provided to
households would escape taxation
under a consumption tax that excludes
implicit FI fees from the tax base. By
contrast, the failure to tax implicit FI
fees supplied to business customers
typically will be offset by the lack of a
deduction at the customer level. These
services will be taxed at the customer
level as part of the value of goods and
services supplied by the business
customer.6
Household consumption of implicit FI
services commonly eludes taxation
under the income tax as well as under
the VAT.7 Consider a bank that pays
three percent on household savings
deposits and charges eight percent on
home mortgages. Under present law,
the bank is taxed on its spread of five
percent; however, the individual income
tax base in many cases is reduced by the
same amount, with homeowners
deducting mortgage interest payments
at an eight-percent rate and depositors
including interest income at a threepercent rate.8
MEASURING VALUE ADDED FROM
FINANCIAL SERVICES
The main problem in applying a
consumption-based tax to financial
services is the difficulty in properly
measuring value added from financial
intermediation. For financial services,
value added is given by the sum of
explicit and implicit fees less inputs
purchased from other businesses (e.g.,
telecommunications, rents, etc.):
Rearranging equation 1, implicit FI fees
can be measured as a financial
intermediary’s value added reduced by
the difference between explicit fees and
business inputs:
1
Value added = explicit fees
2
+ implicit fees – input costs.
Implicit FI fees = value added
While explicit fees, such as automatic
teller machine charges, may be easily
tallied, implicit financial intermediation
(FI) fees are hidden in interest rate
spreads and other financial margins that
provide the bulk of revenues for many
financial institutions.
– (explicit fees – inputs).
For equation 2 to be useful, however, an
operational measure of value added
must be determined for financial
intermediaries. Under the USA business
tax, the cash-flow method of taxation
generally would be used to measure
value added for FI businesses.
Unless financial institutions are required
to measure and report implicit FI fees,
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Vol 49 no. 3 (September 1996) pp. 487-500
CASH-FLOW TAXATION OF FINANCIAL SERVICES
DESCRIPTION OF THE CASH-FLOW
METHOD
Following the Meade Commission
Report, the cash-flow (CF) tax base can
be written as the sum of net real and
net financial transactions:
Under the cash-flow tax proposed by
the Meade Commission, both real and
financial business inflows are subject to
taxation, and both real and financial
business outflows are deductible.
However, amounts received in connection with equity issued by the taxpayer
are excluded (e.g., contributions to
capital), and amounts paid in connection with shares (e.g., dividends) are not
deductible. The components of the
cash-flow tax base, along the lines
conceived by the Meade Commission,
are summarized in Table 1.
3
Meade CF tax base = R + F
where R is real inflows minus real
outflows and F is financial inflows minus
financial outflows.
In contrast to the Meade Commission’s
R + F cash-flow tax, the Armey Flat tax
can be viewed as an R base tax:
2
4
Like the Armey Flat tax, but unlike the
VAT, the Meade Commission’s cash-flow
tax allows businesses to deduct employee compensation, removing labor
value added from the base of the
business tax. As proposed by the
Meade Commission, the cash-flow tax
is origin-based, i.e., amounts received
for exports of goods and services are
taxed and amounts paid for imports
are not taxed. This is in contrast to the
European VAT under which imports
are taxable and exports are free of
tax.
1
1
Transaction
Flat
2 tax base = R.
Under a pure R base tax, implicitly
charged FI services are excluded from
the tax base of financial service providers. The most recent Armey Flat tax bill
(H.R. 2060) seeks to tax implicit FI
services according to their “value”;
however, the bill provides no rules for
valuing these services and there is no
mechanism for business customers to
claim an offsetting deduction.
TABLE 1
COMPONENTS OF THE CASH-FLOW TAX BASE
Inflows (taxable)
Outflows (deductible)
Real transactions
Proceeds from the sale of goods
and services.
Amounts paid for plant, equipment,
inventory, supplies, and labor.
Financial transactions
Sale of financial assets (other than own
shares or shares of other U.S. residents);
receipt of debt repayments; borrowing of
funds; interest income; dividend income
(other than from shares of U.S.
residents); other receipts in connection
with financial instruments; receipt of
insurance premiums; and receipt of
insurance claims.
Purchase of financial assets (other
than own shares or shares of other
U.S. residents); payments to reduce
debts; interest expense; other payments in connection with financial
instruments (other than dividends
paid); payment of insurance claims;
and payment of insurance
premiums.
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Vol 49 no. 3 (September 1996) pp. 487-500
NATIONAL TAX JOURNAL VOL. XLIX NO. 3
APPLICATION OF CASH-FLOW TAX TO
FINANCIAL SERVICES
ESTIMATED TAX LIABILITY UNDER USA
CASH-FLOW TAX
The USA cash-flow tax, applicable to
certain financial intermediation businesses, includes compensation in its
base and thus is a modified version of
the Meade Commission’s cash flow tax:
For any business entity, aside from
changes in cash on hand, total cash
inflows must equal cash outflows. The
cash-flow
identify of the firm may be
3
written as
5
7
USA CF tax base = (R + W) + F = R’ + F
R+F=S+T
where W is employee compensation and
R’ denotes a compensation-inclusive R
base.
where S denotes amounts paid in
connection with own shares and
shares in other domestic corporations
minus amounts received in connection
with such shares; and T represents
net taxes paid to governmental entities.9
Using the USA cash-flow tax base to
measure value added in equation 2
above yields an operational measure of
implicit FI fees as the excess of financial
inflows over financial outflows (F base):
From equations 5 and 7, the USA cashflow tax can be calculated indirectly as
the sum of employee compensation, net
distributions to shareholders and net tax
payments:
6
Implicit FI fees = (R’ + F )
– (explicit fees – inputs)
8
= (R’ + F ) – R’= F.
USA CF tax base = R’ + F = W + S + T.
Under the cash-flow tax proposed by
the Meade Commission, all companies
would include financial inflows in the
computation of taxable income and
would deduct financial outflows. Under
this system, there is no need for FIs to
report implicit FI fees to their business
customers. Because all businesses
would be on the cash-flow method,
they would automatically deduct net
payments to financial service providers.
By contrast, the USA tax would limit
application of the cash-flow tax to
financial intermediation businesses, with
a mechanism for business customers to
recover taxes paid in connection with
implicit FI fees.
The USA cash-flow tax treats amounts
paid and received in connection with
shares of unrelated domestic companies
as part of F rather than S, so that the
S component of the USA tax is equal
to amounts paid in connection with
own shares (dividends and redemptions)
minus amounts received from the
sale of own shares (contributions to
capital).
To calculate the USA cash-flow tax from
financial statement data, it is convenient
to take advantage of another accounting identity which states that net
income equals the sum of (1) the
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Vol 49 no. 3 (September 1996) pp. 487-500
CASH-FLOW TAXATION OF FINANCIAL SERVICES
change in net worth over the accounting period and (2) net distributions to
shareholders during the period:
reported on the financial statements of
the ten largest public companies
(measured by assets) in the securities,
commercial banking, life and health
insurance, and property and casualty
insurance industries. The USA tax is
calculated as 11 percent of the USA
cash-flow tax base reduced by a credit
for the employer’s share of payroll
taxes.11
9
Y = (NW – NW–1) + S
where Y is net after-tax income and
(NW – NW–1) is end of period minus
beginning of period net worth.10
According to the sponsors, the USA
tax is estimated to collect the same
amount of revenue from the business
sector as the present income tax system.
For financial services companies,
however, we estimate that the USA
tax generally would have resulted in a
significant tax cut (Table 2). Tax liability
is reduced in each year for each industry
except property and casualty insurance
in 1992. Over the three-year period,
there is a 40-percent reduction in the
average tax liability of security brokers,
a 56-percent reduction for banks, a
57-percent reduction for life and health
insurers, and a 1-percent reduction in
the tax liability of property and casualty
insurers. Excluding 1992, the average
tax liability of the property and casualty
industry would have declined 43
percent. The anomalous results in 1992
are due to the significant downturn in
property and casualty insurance
operating income primarily caused by
the industry’s record $23 billion of
catastrophe losses that year.
From equations 8 and 9, the USA cashflow tax base can be estimated from the
financial statement as net income
increased by taxes and compensation
paid and reduced by the change in net
worth from the beginning to the end of
the tax period:
10
USA CF tax base = Y + T + W
– (NW – NW–1).
Two adjustments must be made to
measure the USA cash-flow tax
accurately. First, sales, excise, and other
“product” taxes are deductible under
the USA business tax and should not
be added back to net income in
equation 10. Second, only the domestic portion of the tax base, as
determined by formula apportionment,
is subject to tax. The apportionment
method is not specified in the USA tax
bill; for purposes of this analysis, the
domestic share of gross income reported in the consolidated financial
statement is used to apportion the tax
base.
Significant tax cuts for financial services
under a VAT are not surprising if one
considers financial services within the
context of national income accounts. In
1992, the finance and insurance sector
(depository and nondepository institutions, securities and commodity brokers,
and insurance carriers) accounted for
9.2 percent of gross domestic product
(GDP) originating in the corporate
sector, but paid 28.1 percent of corpo-
Table 2 compares USA tax liability,
estimated as if the USA tax
had been in effect over the 1992–94
period, with federal income tax liability
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NATIONAL TAX JOURNAL VOL. XLIX NO. 3
TABLE 2
TAX LIABILITY UNDER CORPORATE INCOME TAX AND USA CASH-FLOW TAX, 1992–94
(TOP TEN PUBLIC COMPANIES IN EACH FINANCIAL INDUSTRY; DOLLAR AMOUNTS IN MILLIONS)
Item
1992
1993
1994
Mean
$1,283
$2,808
$1,262
$740
$1,525
$2,655
$1,270
$586
$874
$1,668
$768
$660
$912
$1,161
$545
$581
–31.9%
–40.6%
–39.1%
–10.8%
–40.2%
–56.3%
–57.1%
–0.9%
Corporate Income Tax
Securities brokers
Commercial banks
Life and health insurers
Property and casualty insurers
$1,052
$2,269
$976
($393)
Securities brokers
Commercial banks
Life and health insurers
Property and casualty insurers
$877
$710
$498
$523
Securities brokers
Commercial banks
Life and health insurers
Property and casualty insurers
–16.6%
–68.7%
–49.0%
–233.1%a
$2,239
$2,889
$1,573
$1,412
USA Cash-Flow Tax at 11 Percent
$985
$1,105
$370
$560
Percentage Change in Tax Liability
–56.0%
–61.8%
–76.5%
–60.3%
Source: Price Waterhouse LLP calculations from SEC Form 10-K information.
a
Tax increase as a percent of negative income tax liability under present law.
rate income taxes (Table 3).12 Thus, a
revenue-neutral change in the corporate
tax base—from income to value added
—would be expected to result in a
substantial reduction in the tax liability
of the finance and insurance sector.
Conversely, one might expect that the
tax liability of nonfinancial corporations
would increase under the USA tax. This
is consistent with the findings of Merrill,
Wertz, and Shah (1995) who estimate
that the USA tax would have increased
the tax liability of nonfinancial corporations by 11 percent over the 1988–92
period.
ISSUES ARISING UNDER THE CASH-FLOW
METHOD
Treatment of Nonfinancial Businesses
The application of a cash-flow tax to
nonfinancial businesses has been
viewed as imposing an unacceptable
administrative burden as well as a strain
on liquidity due to the imposition of tax
on borrowed funds.13 To alleviate
concerns about the universal imposition
of a cash-flow tax, the USA business tax
would limit its application to financial
intermediation businesses (FIBs). This
has been referred to as a “truncated”
cash-flow method by Poddar and
English (1994). A problem that arises
under a truncated cash-flow tax is that
FI services provided to business customers would be subject to tax cascading
unless (1) a mechanism is provided for
allowing business customers to deduct
their allocable share of implicit FI fees,
or (2) these fees are excluded from the
tax base of financial services companies
(i.e., zero rating).
These results must be interpreted with
caution—they do not take into account
transition rules, adjustments that might
be made by taxpayers in response to
introduction of the USA tax system, or
changes in the U.S. economy that might
occur. Also, these results address tax
payments by financial companies rather
than the ultimate incidence of the tax
burden.
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CASH-FLOW TAXATION OF FINANCIAL SERVICES
TABLE 3
FINANCIAL SECTOR SHARE OF CORPORATE GDP AND INCOME TAXES, 1992
(DOLLAR AMOUNTS IN BILLIONS)
GDP, Corporate
Sector
Finance and insuranceb
All industries
Corporate Income Taxa
Amount
Percent of Total
Amount
$328.3
$3,571.7
9.2%
100.0%
$28.5
$101.5
Percent of Total
28.1%
100.0%
Sources: U.S. Department of Commerce, Survey of Current Business; and Internal Revenue Service, Statistics of
Income Division, Corporate Income Tax Returns, 1992.
a
Fiscal years ending on or after June 30, 1992 and before June 30, 1993.
b
Excludes insurance agents, brokers, and services.
The USA tax provides two methods for
determining implicit FI fees: (1) in the
case of lending, the borrower calculates
implicit FI fees based on tables published by the Treasury Department; and
(2) for other FI services, the FIB may
elect to allocate and report implicit FI
fees to customers. An electing FIB must
allocate implicit FI fees on a “reasonable
and consistent basis” and report to each
recipient, not later than February 15th
of each year, the amount of implicit FI
fees for the preceding calendar year.
Consistent methods of allocation are
required for business and nonbusiness
customers as well as persons who
receive and persons who pay money to
an FIB.14 Note that amounts allocated
to persons who receive money from an
FIB are not reported as implicit FI fees
and thus may not be deducted by
customers.15 The maximum amount of
implicit FI fees that may be allocated by
an FIB for a calendar year is equal to the
excess of (1) the FIB’s cash-flow tax base
over (2) explicit fees for FI services
received by the FIB.16
(2) Financial flows (e.g., interest
payments) must be allocated
between the financial and nonfinancial activities of a taxpayer
engaged in both types of activities.
(3) Implicit FI fees must be allocated
between business and nonbusiness
customers and, if reported to
business customers, must be
allocated among them.
Transition Effects
Hoffman, Poddar, and Whalley (1987)
point out that the first imposition of a
cash-flow tax, and any subsequent
change in the rate of tax, would create
windfall losses and gains with respect to
open financial transactions. For
example, loans made prior to the
introduction of a cash-flow tax would
be taxable upon repayment even
though the principal amount of the loan
would not have been deducted previously. Similarly, deposits received prior
to the date of introduction would be
deductible when paid out to depositors
even though the principal amount of
the deposit would not have been
included previously. In theory, introduction of a cash-flow tax imposes a tax on
wealth equal, in present value, to the
rate of tax times the taxpayer’s net
financial assets at the date of introduction.17 This wealth effect is equal to the
cash-flow tax that hypothetically would
While the truncated cash-flow method
addresses some of the concerns
associated with a universal cash-flow
tax, it introduces other complications:
(1) Financial intermediation businesses
must be distinguished from
nonfinancial businesses.
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NATIONAL TAX JOURNAL VOL. XLIX NO. 3
where F f equals financial inflows from
foreign residents minus financial
outflows to foreign residents. Imposition of the cash-flow tax on a destination basis, however, precludes measurement of the tax base indirectly from
financial statement information using
equation 10.
be owed if the taxpayer liquidated
immediately following the date of
introduction.
Tax Deferral Opportunities
By issuing equity and purchasing
financial assets (or reducing debt),
companies can indefinitely defer payment of tax under a cash-flow tax. The
entire corporate sector could, in theory,
defer tax by lending money to the household sector for use in purchasing corporate equity issues. While tax liability is not
reduced in present value, this is unlikely
to comfort the Treasury Department.
Mutual Companies
In mutual organizations, the customers
are also shareholders. Examples include
mutual funds, credit unions, mutual
savings and loans, mutual life insurance
companies, etc. Under a cash-flow tax,
it is necessary to separate the portion of
each payment between a mutual
organization and its owners that
represents a customer transaction as
distinct from a shareholder transaction.
This issue also arises under the income
tax.19 The USA tax treats all such
payments as customer, rather than
shareholder, transactions. From
equation 8 it can be seen that the USA
tax base for FIBs organized in mutual
form is the sum of employee compensation plus net payments to governments
(i.e., a W + T base).
The Meade Commission also anticipated
that, for example, corporation A might
issue shares to corporation B in order to
finance the purchase of B’s shares. In
this way, absent antiabuse rules, both
corporations A and B would obtain a tax
deduction with no cash inflow from
households into the corporate sector.
The Meade Commission sought to
prevent this result by denying a deduction for the purchase of shares of
domestic corporations.
International Issues
TAX CALCULATION ACCOUNT
The USA cash-flow tax generally is origin
based, in contrast to the destination
basis used for nonfinancial businesses.18
From equation 6, net implicit FI fees
received for services supplied to foreign
residents could be defined as financial
inflows from foreign residents minus
financial out- flows to foreign residents.
Thus, destin-ation-based taxation of
implicit FI services could be achieved by
deducting net implicit FI fees for services
supplied to foreign residents from the
USA tax base:
Poddar and English (1994) have
proposed a TCA method for calculating
implicit FI fees that addresses a number
of problems that arise under a truncated cash-flow tax system. The TCA
system is designed to be compatible
with a European-style VAT and currently
is being evaluated by the European
Commission. Under the TCA system,
business customers would receive
invoices from financial service providers
indicating the amount of implicit fees
for services provided and the associated
VAT paid by the financial company.
Business customers could claim an input
credit for the amount of VAT reported
paid by the financial company.
11
Implicit FI fees under destination-basis
CF tax = F – F f
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CASH-FLOW TAXATION OF FINANCIAL SERVICES
Under the standard cash-flow system,
implicit FI fees are measured as financial
inflows minus financial outflows.
Splitting financial flows into “capital”
and “income” components, the cashflow method of measuring implicit FI
fees, shown in equation 6, can be rewritten as
where i is the TCA index rate, A–1 is the
TCA balance at the end of the preceding taxable period, and u is the tax rate.
The TCA balance is determined as the
“book” value of the account, K,
multiplied by the tax rate:
14
12
A = K*u.
CF implicit FI fees = F k + F y
The book value of a customer account is
the sum of all (positive and negative)
capital transactions from the date the
account was opened:
where F k denotes financial inflows
less financial outflows on capital
account and F y denotes financial inflows
less financial outflows on current
account.
15
K = – {F k + F k–1 + F k–2 + . . .}
Under the TCA method, implicit FI fees
are calculated separately for each
customer account based on the financial
flows into and out of each account
during the taxable period. However,
the taxation of the capital component
of implicit FI fees is suspended, and
the suspended tax balance is subject to
an interest charge (or credit) at the
designated TCA index rate. This
suspension system is intended to
eliminate account-specific swings in
implicit FI fees that otherwise would
occur when large capital transactions
take place. For example, absent the
suspension system, a $1 million loan
would result in an implicit FI fee of
negative $1 million when made and an
implicit FI fee of positive $1 million
when repaid.
where a financial intermediary’s outflows are recorded as a negative
number, inflows as a positive number,
assets as a positive number, and
liabilities as a negative number.
Comparing equations 12 and 13, it can
be seen that the difference between
implicit fees measured under the cashflow and TCA tax systems is given by
16
CF implicit FI fees – TCA implicit FI fees
= F k – (i * K–1).
Discounting at the TCA index rate, i,
beginning at the date the tax is introduced, t, and ending at a terminal date,
t + n, the present value (PV) of the righthand side of equation 16 is equal to the
book value of the account at the end of
the period immediately preceding
introduction of the tax minus the
present value of the terminal book value:
The TCA measure of implicit FI fees for
an individual customer account can be
written as
13
TCA implicit FI fees = F y – (i*A–1 / u)
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17
The TCA system, however, has a
number of potential disadvantages.
First, depending on the choice of index
rate, implicit FI fees can be negative
(causing business customers to be taxed
as if supplying financial services to the
financial intermediary). Second, the
costs of making TCA calculations each
tax period for each customer account
and reporting these calculations to
business customers would be very large.
PV{F k – (i *K–1)} = Kt–1 – Kt+n(1+ i )–n.
Hence, for any customer account, the
present value of implicit FI fees under
the TCA system, discounted (at the TCA
index rate) from the date the tax is introduced until the date the book value of
the account goes to zero, is equal to the
present value of implicit FI fees under the
cash-flow method reduced by the book
value (if any) of the account immediately
preceding introduction of the tax:
ACCRUAL METHOD
Another way to address the transition
and tax deferral problems raised by a
cash-flow tax is to use what we refer to
as an “accrual consumption tax” (ACT).
The compensation-inclusive ACT base is
equal to a company’s financial statement net income increased by taxes and
compensation paid and reduced by the
imputed cost of equity capital:
18
PV{TCA implicit FI fees}
= PV{CF implicit FI fees} – Kt–1.
Thus, the TCA and cash-flow measures
of implicit FI fees generally are equal in
present value for accounts that open
after the date the tax is introduced
(because Kt–1 is zero in this case). In
situations where the book value of the
account is not zero at the date of
introduction, the present value of TCA
implicit FI fees does not include the
existing account balance, and thus
avoids the tax on wealth that otherwise
occurs when a conventional cash-flow
tax is introduced.
19
Compensation-inclusive ACT base
= Y + T + W – (rE *NW –1)
where rE is the designated cost of equity
capital, and NW –1 is the net worth at the
end of the preceding tax period. Aside
from the nondeductibility of compensation and taxes, the ACT base would be
measured using conventional income
accounting principles with one key
difference—a deduction would be
allowed for the imputed cost of equity
capital analogous to the deduction of
interest paid to bondholders. In effect,
only equity income in excess of the cost
of equity capital (i.e., economic “rents”)
would be taxable.
The TCA system solves a number of the
difficulties associated with the truncated
cash-flow method of taxation: (1) the
TCA method allows implicit FI fees to be
calculated for each tax period on a
customer-by-customer basis; (2) the TCA
method eliminates the adverse transitional effects of a pure cash flow; (3) the
TCA method eliminates tax deferral
opportunities by charging interest on
TCA balances; and (4) the TCA method
can be made consistent with a destination-basis tax.20
Comparing equations 10 and 19, it can
be seen that the difference between the
cash-flow tax and ACT is given by
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CASH-FLOW TAXATION OF FINANCIAL SERVICES
20
base in situations where a company’s
net worth is growing faster than the designated cost of equity, and conversely:
Cash-flow base – ACT base
= (rE*NW –1) – (NW – NW –1).
23
Discounting (at the designated cost of
equity capital) from the date that the tax
is introduced, t, until the date the tax is
terminated, t + n, the present value of
the term on the right-hand side of
equation 20 is equal to net worth at the
end of the period immediately preceding introduction of the tax minus the
present value of the company’s terminal
date net worth:
{ACT base > CF base} if, and only if,
{(NW – NW –1)/NW–1 > rE } .
Considering only current period tax
liabilities, rapidly growing companies
would favor the cash-flow tax base,
while more mature companies would
prefer the ACT base.
The accrual method is similar in spirit to
the method of taxing financial intermediaries proposed in Canada’s 1987
“white paper” on sales tax reform. For
financial intermediaries, the white paper
proposed a modified income tax base
with a deduction for the cost of equity
capital.21 The white paper would have
limited its version of the accrual method
to taxpayers engaged in FI activities and
would not have allowed financial
intermediaries to report implicit FI fees
to business customers. As a result, the
Canadian proposal would have resulted
in substantial cascading of tax on
business customers—one of the reasons
that the proposal was dropped.
21
PV{(rE*NW–1) – (NW – NW –1)}
= NWt–1 – NWt+n(1+ rE)–n–1.
Hence, the present value of a company’s
tax base under the ACT system,
discounted from the introduction until
the termination of tax, is equal to the
present value of the cash-flow tax base
reduced by net worth immediately
preceding introduction of the tax and
increased by the present value of net
worth at the date the tax is terminated
The ACT may be distinguished from the
so-called “addition” method VAT under
which financial intermediaries are taxed
on the sum of income plus compensation paid, as is the case in Israel. The
addition-method VAT does not allow a
deduction for the imputed cost of
equity capital and, thus, overstates value
added as compared to the ACT base.
Under the Israeli system, implicit FI fees
are not reported to, nor deducted by,
businesses’ customers. Moreover,
financial intermediaries are not permitted to recover VAT on inputs. Consequently, the Israeli system exacerbates
22
PV{ACT base} = PV{CF tax base}
– NWt–1 + NWt+n(1 + rE)–n–1.
Thus, the ACT avoids the tax on existing
wealth that effectively occurs when a
cash-flow tax is introduced, as well as
the forgiveness of tax that effectively
occurs when the tax is terminated.
From equation 20, it can be seen that,
for companies with positive net worth,
the ACT base exceeds the cash-flow tax
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Vol 49 no. 3 (September 1996) pp. 487-500
NATIONAL TAX JOURNAL VOL. XLIX NO. 3
the over-taxation of business customers
that arises under the exemption
method.
The exemption system, however, has a
number of defects including overtaxation of business customers.
The ACT solves a number of the
difficulties associated with the cash-flow
method of taxation: (1) the ACT
eliminates adverse transitional effects of
a pure cash-flow tax; and (2) the ACT
eliminates tax deferral opportunities.
These features of the ACT are similar to
the TCA method and are due to the fact
that financial flows on capital accounts
are neither included nor deducted in
computing the tax base; instead, the
capital account is charged (or credited)
with the time value of money at a
specified rate. An important advantage
of the ACT is that it relies on conventional income accounting principles and
could be applied with equal ease to
financial and nonfinancial companies.
One alternative to exemption is use of
the cash-flow method. A truncated
version of the cash-flow method is
incorporated into the Nunn–Domenici
USA business tax for purposes of taxing
certain financial intermediaries. Based
on 1992–94 financial statement data for
the ten largest public companies in the
securities, banking, life and health
insurance, and property and casualty
insurance industries, the USA business
tax is estimated to reduce tax liability
significantly compared to the present
corporate income tax.
While attractive in theory, the truncated
cash-flow method raises a number of
difficult administrative questions and
has not been adopted by any country.
One difficult issue is the allocation of FI
fees to nonfinancial businesses that is
required to avoid cascading of tax. The
TCA method, under consideration by
the European Commission, holds
promise for solving this problem, but
would impose a heavy compliance
burden on financial companies.
The ACT, however, has a number of
disadvantages. First, if the ACT is
limited to financial service companies
(i.e., truncated), tax cascading will arise
unless implicit FI fees allocable to
business customers are excluded from
the tax base (i.e., zero rating). This
would require apportionment of the
ACT base between business and
household customers using formula
apportionment methods. Second, the
ACT is inherently an origin-based tax
and would not integrate well with a
VAT. Third, implementation of the ACT
requires designation of the cost of
equity capital. Overtaxation will result if
the designated cost of equity is too low,
and conversely.
An alternative to the cash-flow
method—referred to as the ACT—also
addresses some of the problems raised
by the cash-flow tax. If limited to
financial intermediaries, however, the
accrual method would require allocation
of implicit FI fees associated with
business customers to avoid cascading
of tax. In addition, the accrual method
is inherently an origin-based tax that
could not easily accommodate border
tax adjustment.
Conclusions
Approximately 90 countries impose a
national VAT. Core financial services are
exempt in virtually all of these countries
primarily as a result of difficulties in
measuring the value of implicit FI fees.
ENDNOTES
The views expressed in this paper are those of the
authors and should not be attributed to Price
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National Tax Journal
Vol 49 no. 3 (September 1996) pp. 487-500
CASH-FLOW TAXATION OF FINANCIAL SERVICES
1
2
3
4
5
6
7
8
9
10
11
Waterhouse LLP or its clients. The authors
gratefully acknowledge helpful comments from
David Bradford, Satya Poddar, and Edith Brashares.
These bills include S. 2160, the Business Activities
Tax introduced by Senators John Danforth and
David Boren; S. 722, the USA tax introduced by
Senators Sam Nunn and Pete Domenici; H.R.
2060, the Flat tax, introduced by House Majority
Leader Dick Armey; and H.R. 3030, the National
Retail Sales Tax introduced by Representatives Dan
Schaefer and Billy Tauzin.
See Organisation for Economic Co-operation and
Development (1995).
Under the exemption system, however, it is
necessary to allocate inputs between taxable and
exempt supplies. In practice, this is a very
complicated area of VAT compliance.
The exemption system also results in only partial
taxation of household customers. The inability to
recover fully input credits may encourage financial
intermediaries to self-supply inputs (e.g., printing)
to avoid nonrecoverable VAT. The exemption system
also may put domestic financial service providers at
a competitive disadvantage as compared to foreign
financial companies that provide services to
domestic residents. See Tait (1988) and Merrill and
Adrion (1995).
Under the USA business tax, special rules would be
applicable to regulated lending institutions,
financial “pass-through” entities, and nonfinancial
businesses that self-supply financial services.
See Henderson (1988).
12
13
14
15
16
See, IFS (1978, Appendix 12.1) and Bradford
(1996).
The home mortgage interest deduction is subject
to a number of limitations and is only available to
taxpayers who itemize their deductions.
See, IFS (1978, ch. 12). Recognizing the cash-flow
identity, the Meade Commission suggested the
possibility of a tax on net distributions from
corporations to shareholders (i.e., an S-base tax),
grossed up to account for other taxes, as an
alternative to the R + F base tax.
Note that adjustments to net worth which do not
flow through the income statement must be
removed in order for this identity to hold. Such
adjustments include the foreign currency
translation adjustment and the change in market
value of securities available for sale.
The USA legislation includes a separate tax regime
for banks and other regulated lending institutions;
however, for purposes of this analysis, the cashflow tax rules are used. Federal payroll taxes are
estimated as 7.65 percent of U.S. wages and
salaries reported on financial statements. Under
the USA tax, payroll taxes are nondeductible.
Other nondeductible taxes cannot be identified
from financial statements. This analysis assumes
that the excess of present corporate income tax
17
18
19
20
21
499
payments over tax payments under the USA
business tax would be used to pay dividends (and
thus included in the USA tax base). Losses and
credits are assumed to be utilized fully in the year
in which they arise.
The Commerce Department generally estimates
value added by the financial services industries as
the sum of wages and profits.
See, Poddar and English (1994). These concerns
have, perhaps, been given too much weight in the
past. The tax on borrowed funds does not reduce
liquidity to the extent that funds are used to
finance plant, equipment, land, supplies, and other
deductible business inputs. Moreover, if imposed
on an accounts basis (like the income tax) rather
than on a transactional basis (like a VAT), the
information necessary to calculate an origin-based
cash-flow tax is currently contained in financial
statements, as shown in equation 10.
The Treasury Department would be authorized to
issue regulations governing (1) the timing of
deductions of implicit FI fees by fiscal year
taxpayers, (2) subsequent year adjustments in the
event of excess allocations, (3) advance approval of
allocation procedures, and (4) safe harbor
alternatives.
It is unclear why a business that implicitly pays a
fee to an FIB in the form of a reduction in net
receipts from a financial transaction (e.g., a bid-ask
spread on the sale of a security to a broker) should
not be able to deduct this implicit FI fee.
The bill apparently contains a drafting error.
Conceptually, implicit FI fees are equal to value
added by an FIB less receipts from explicit fee
services plus business purchases (equation 2).
Inconsistent with this formula, the bill does not
permit the cost of business purchases to be added
back in determining the cap on implicit FI fees.
See, Hoffman, Poddar, and Whalley (1987). Repeal
of the corporate income tax also could result in
windfall gains and losses.
Under the USA cash-flow tax, implicit FI fees
associated with exports are subject to tax. The
source rules for insurance premiums and claims,
however, are more consistent with destinationbasis taxation.
See Internal Revenue Code section 809 relating to
dividends paid by mutual life insurance companies.
Implicit fees can be measured on a destination
basis by excluding from TCA calculations all of the
financial flows (on capital and current account) to
and from foreign residents, consistent with
equation 11.
The white paper suggested two possible methods
for measuring the cost of equity capital: (1) the
product of the cost of equity capital and net
worth; and (2) dividends paid. Unlike the ACT, the
Canadian proposal would have adjusted income of
financial intermediaries to a cash-flow basis by
National Tax Journal
Vol 49 no. 3 (September 1996) pp. 487-500
NATIONAL TAX JOURNAL VOL. XLIX NO. 3
expensing rather than depreciating (or amortizing)
capital costs. Because undepreciated capital
expenditures increase net worth, the lack of
expensing under the ACT is offset by a larger
deduction for the cost of equity capital.
Merrill, Peter, and Harold Adrion.
“Treatment
of Financial Services Under Consumption-Based
Tax Systems.” Tax Notes 68 No. 6 (September
18, 1995): 1496–1500.
Merrill, Peter, Ken Wetz, and Shvetank Shah.
“Corporate Tax Liability under the USA and Flat
Taxes.” Tax Notes No. 12 (August 7, 1995):
741–5.
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