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W&M Subcommittee examines consumption and cash-flow based taxation

Joint Committee on Taxation, Background on Cash-Flow and Consumption-Based Approaches to Taxation, (JCX-14-16), March 18, 2016.

Consumption-based and cash-flow approaches to taxation have long been part of the tax reform debate and are perceived by some as a potential way to offset some of the costs of other reforms, such as lowering the corporate tax rate or shifting away from a worldwide system of taxation, or simply as a way to deal with budgetary shortfalls. These alternative approaches to taxation were the subject of a recent hearing held by the Ways and Means Subcommittee on Tax Policy and a report prepared by the Joint Committee on Taxation (JCT) in connection with the hearing. This article provides an overview of several specific methods of consumption-based taxation and various proposals to implement them, either as a supplement to or an alternative or replacement of, the current income-based system.

JCT report. On March 21, the JCT released a report titled “Background on Cash-Flow and Consumption-Based Approaches to Taxation” (the JCT document). The JCT document describes a number of alternative tax systems to potentially replace the current U.S. income tax system. Many of these proposals alter the tax base so that it is based on consumption, rather than income, as discussed in more detail below.

…(1) A Value Added Tax (VAT). In general, a VAT is a tax imposed and collected on the “value added” at every stage in the production and distribution process of a good or service. The JCT notes that over 140 countries have implemented a VAT, although the these countries have generally done so to supplement, rather than replace, their income tax system.

Generally speaking, the amount of value added can be thought of as the difference between the value of sales (outputs) and purchases (inputs) of a business. However, there are several methods to compute the taxable base for a VAT:

  • The credit-invoice method has been the VAT system of choice in nearly all countries that have adopted a VAT, according to the JCT report. Under the credit invoice method, a tax is imposed on a seller for all of its sales. The tax is calculated by applying the tax rate to the sales price of the good or service, and the amount of tax is generally disclosed on the sales invoice. A business credit is provided for all VAT levied on purchases of taxable goods and services (i.e., the inputs) used in the seller’s business. However, the ultimate consumer (i.e., a non-business purchaser) does not receive a credit on his or her purchases.
  • The VAT credit for inputs prevents the imposition of multiple layers of tax with respect to the total final purchase price (i.e., a “cascading” of the VAT). As a result, the net tax paid at a particular stage of production or distribution is based on the value added by that taxpayer at that stage of production or distribution. In theory, the total amount of tax paid with respect to a good or service from all levels of production and distribution should equal the sales price of the good or service to the ultimate consumer multiplied by the VAT rate.
  • In order to receive an input credit with respect to any purchase, a business purchaser is generally required to possess an invoice from a seller that contains the name of the purchaser and indicates the amount of tax collected by the seller on the sale of the input to the purchaser. At the end of a reporting period, a taxpayer may calculate its tax liability by subtracting the cumulative amount of tax stated on its purchase invoices from the cumulative amount of tax stated on its sales invoices.
  • RIA observation: The European Union and other countries have established a large body of requirements for the format of and information reflected in VAT invoices, which all parties must adhere to in order to ensure there will be no problems in the case of tax audits. In certain countries, if a valid tax invoice cannot be provided at the time of a VAT audit, a vendor may lose up to 100% of the input VAT being claimed on the invoice, even if an amended valid invoice can be provided subsequent to the audit.
  • The subtraction method VAT is also known as a business transfer tax. Under the subtraction method, value added is measured as the difference between a business’s taxable sales and its purchases of taxable goods and services from other businesses. At the end of the reporting period, a rate of tax is applied to this difference in order to determine the tax liability.
  • The subtraction method is similar to the credit-invoice method in that both methods measure value added by comparing outputs (sales) to inputs (purchases) that have borne the tax. The main difference between the subtraction method and the credit-invoice method is that, under the subtraction method, the tax rate is applied to a net amount of value added (sales less purchases), rather than to gross sales with credits for tax on gross purchases as under the credit-invoice method. The determination of the tax liability of a business under the credit invoice method relies upon the business’s sales records and purchase invoices, while the subtraction method may rely upon records that the taxpayer maintains for income tax or financial accounting purposes.
  • The JCT report states that the subtraction method may allow more flexibility in determining the amount of value added for a taxable period. For example, capital costs may be either expensed or amortized under the subtraction method. The credit-invoice method, by allowing a credit for the tax paid with respect to capital equipment in the year of purchase, effectively provides for expensing. Similar issues arise with respect to inventory valuation methods, installment sales reporting, long-term contract reporting, the treatment of bad debts, or other attempts to match the recognition of revenues or costs with a specific accounting period.
  • The addition method, like the subtraction method, attempts to measure value added with reference to existing income tax or book accounting records, rather than with reference to the sales and purchase invoices on which the credit-invoice method relies. Specifically, the addition method adds together the taxpayer’s inputs that are not purchased from other taxpayers (e.g., wages, interest, and profits) and applies a tax rate to such sum. In this regard, the addition method is a mirror image of the subtraction method in that it uses the items of production that the subtraction method ignores. It is for this reason that the subtraction and addition methods are often viewed as alternative, but essentially identical, methods of determining value added.

Policymakers may exclude certain goods, services, or classes of taxpayers from a VAT, either by providing a “zero rating” or an exemption. There may be significant differences between these two alternatives, particularly under the credit-invoice method. If a sale is zero-rated, the sale is considered a taxable transaction, but the rate of tax is zero. Sellers of zero-rated goods or services do not collect or remit any VAT on their sales of those items, but are required to register as taxpayers. In this way, sellers of zero-rated items are able to claim credits (and perhaps a refund to the extent the taxpayer does not have taxable sales) for the VAT they paid with respect to purchased goods and services.

Similarly, a seller of goods or services that is exempt (as opposed to zero-rated) is not required to collect any VAT on its sales. However, because such sellers are not required to register as taxpayers under the VAT system, they may not claim any refunds of the VAT that they may have paid on their purchases. In addition, under the credit-invoice method, purchasers of exempt goods or services are generally not allowed a credit for any VAT borne with respect to such goods or services prior to the exempt sale.

For the reasons discussed above, a VAT exemption (as opposed to a zero rating) in a credit invoice system breaks the chain between inputs and outputs along the various stages of production and distribution and may result in a cascading of the tax (i.e., total tax collected from all stages of production exceeds the retail sales price of the good times the VAT rate). Most VAT commentators prefer zero rating as a method of providing VAT relief under the credit-invoice method.

Finally, the JCT document acknowledges that the imposition of a federal-level VAT and the method used to compute the VAT may have a direct effect on revenues at the state level. However, one study exploring the Canadian experience with the VAT suggests that the introduction of a VAT in the U.S. would not create significant technical problems for either States or businesses, said the JCT document. (See Richard M. Bird, Jack M. Mintz, Thomas A. Wilson, “Coordinating Federal and Provincial Sales Taxes: Lessons from the Canadian Experience,” National Tax Journal, vol. 59, no. 4, December 2006, pp. 889-903.)

…(2) Flat taxes. A flat tax is generally any tax system with only one marginal tax rate. For example, one could construct a flat tax out of the current individual income tax by eliminating all but one marginal rate bracket and also repealing provisions, like the personal exemption phase-out and the limitation on itemized deductions, that in effect impose higher marginal rates by reducing other deductions or exclusions.

Many of the flat tax proposals that have been developed do more than simply apply one rate to the current and individual income tax base, as they redefine the base of the tax as well. There are two main approaches: a consumption base and an income base. The difference between the two is in the treatment of savings: an income-based tax includes the return to savings in the tax base, while a consumption-based tax does not.

…(3) An X-tax. An X-tax is a progressive consumption tax that consists of two primary components: (i) a flat tax on business cash flow and (ii) a graduated-rate tax on individual compensation with a top rate equal to the tax rate on business cash flow. Financial transactions are excluded from the tax base so that no tax is paid on capital gains, dividends, and receipt of interest.

With regards to cross-border transactions, the X-tax could be implemented on either a destination-basis or origin-basis. A destination-based X-tax imposes tax on goods and services in the country where they are bought, so that imports are subject to tax while exports are exempt from tax. In contrast, an origin-based X-tax imposes tax on goods and services in the country in which they are produced, so that exports are taxed while imports are exempt from tax.

…(4) A retail sales tax. A national retail sales tax (as its name implies) is a tax imposed on the retail sales (i.e., sales to final consumers) of taxable goods and services. A retail sales tax has approximately the same economic burden as a VAT. However, a retail sales tax may vary from a VAT in terms of administrability, compliance burden, and ease of implementation.

As stated in the JCT report, the choice of a retail sales tax to implement a consumption tax may be attractive because the start-up and overall compliance costs of the tax could be small compared to those for a VAT. Furthermore, implementation of a federal retail sales tax may draw on some of the experiences of state and local governments. Although tax collection and administration synergies may develop if both the federal and state governments have retail sales taxes, this does not mean that one government could or should be the tax collector for the other. However, the retail sales tax may have a number of drawbacks, and these drawbacks are worth further examination.

The March 22 public hearing. The Tax Policy Subcommittee held a public hearing on March 22 to exchange views on “Fundamental Tax Reform Proposals.” It is to be the first in a series of hearings where members of both parties will have the opportunity to share, discuss, and promote their proposals for U.S. tax reform. The next hearing is currently scheduled for April 13 and will be focused on fundamental reforms within the context of an income-based tax system.

In his opening statement, Subcommittee Chairman Boustany stated that the purpose of the hearing was to learn about proposals that would “take the tax system in a new direction, by moving away from income as the tax base and instead looking to cash-flow or consumption as a tax base that is more conducive to economic growth.”

The following representatives testified at the hearing about bills that they introduced that would, to varying degrees, implement some version of a cash-flow and/or consumption-based system:

  • Rob Woodall (R-GA) discussed his bill, H.R. 25, the FairTax Act of 2015, which would repeal all federal income, payroll, withholding, and estate and gift taxes and replace them with a 23% national sales tax on gross payments of taxable property or services (with a rebate for lower-income taxpayers). Rep. Woodall stated that most American families pay more in payroll taxes than in income taxes, and that “[i]f you really want to help working families… you have to deal with the payroll tax code.”
  • Representative Devin Nunes (R-CA) explained his bill, H.R. 4377, the American Business Competitiveness (ABC) Act of 2015, which would tax a business based on its actual cash flow instead of its income. He described his plan as ensuring that “[c]ompanies of any size, no matter how they’re organized, would pay no tax on any of their spending for personnel, equipment, property, or any other expenditure related to the operation of their business in the United States.”
  • Michael Burgess (R-TX) described his bill, H.R. 1040, the Flat Tax Act, which gives businesses and individuals the choice to be subject to a 17% flat tax and to be taxed on a cash flow basis for business activities. He described his proposal as allowing taxpayers to “fill out a simple return, and then everyone of the same income level would pay the same amount.” He also emphasized that the flat tax was elective under his bill, stating that “[i]f you like your tax, you can keep your tax.”
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