Cash-Flow Taxation of Financial Services

CASH-FLOW TAXATION OF FINANCIAL SERVICES

CASH-FLOW TAXATION OF FINANCIAL SERVICES PETER R. MERRILL * AND CHRIS R. EDWARDS *

Abstract - Introduction of a consump- Tax, introduced by Representatives tion-based tax in the United States will Schaefer and Tauzin.1 require finding a method for taxing financial intermediation services. This The drafters of these bills intend that paper describes the “cash-flow” method companies providing financial services, of taxation and its application to such as banks, insurance companies, financial services companies. The cash- and brokers, should be subject to tax. flow method is used to tax certain By contrast, value-added tax (VAT) financial companies in the Unlimited systems typically exempt “core” Savings Allowance (USA) bill introduced financial intermediation services.2 The by Senators Nunn and Domenici. Tax rationale for exemption is that custom- liability estimates under the USA cash- ers implicitly pay for many financial flow tax are presented for a sample of services through interest rate spreads, banks, insurance companies, and bid-ask spreads, and other financial securities brokers. These results indicate margins. Exemption avoids many that the financial sector would likely difficult issues involved in measuring the enjoy a substantial tax cut under the value of financial services where no USA tax. separately stated fee is charged.3

Exemption of financial services, however, causes numerous problems. For example, financial services provided to INTRODUCTION business customers may be subject to Several bills have been introduced to overtaxation (so-called “tax cascading”) replace the federal income tax system due to nonrecoverable input taxes.4 with a consumption-based tax system, Instead of exemption, the drafters of including the Flat tax, introduced by the USA legislation would tax most House Majority Leader Dick Armey; the financial services under a “cash-flow” Unlimited Savings Allowance (USA) tax, method of taxation.5 The cash-flow introduced by Senators Nunn and method is not a new idea—it was Domenici; and the National Retail Sales discussed as a replacement for the income tax by the Institute of Fiscal

*Economic Policy Consulting Group, Price Waterhouse LLP, Studies (IFS) (1978) and the U.S. Washington National Tax Service, Washington, D.C. 20005. Treasury Department (1977).

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This paper describes the cash-flow the value of these services provided to method of taxation, discusses some households would escape taxation problems with the application of the under a consumption tax that excludes cash-flow method to financial services, implicit FI fees from the tax base. By outlines the Tax Calculation Account contrast, the failure to tax implicit FI (TCA) method that is being considered fees supplied to business customers by the European Commission, and sets typically will be offset by the lack of a forth an alternative “accrual” method deduction at the customer level. These for taxing financial services. In addition, services will be taxed at the customer the paper presents the results of an level as part of the value of goods and analysis of USA business tax liability for services supplied by the business a sample of banks, insurance compa- customer.6 nies, and securities brokers using the cash-flow tax rules. The results indicate Household consumption of implicit FI that financial services may enjoy a services commonly eludes taxation substantial tax cut under a revenue- under the income tax as well as under neutral consumption-based replacement the VAT.7 Consider a bank that pays to the corporate income tax system. three percent on household savings deposits and charges eight percent on home mortgages. Under present law, MEASURING VALUE ADDED FROM the bank is taxed on its spread of five FINANCIAL SERVICES percent; however, the individual income The main problem in applying a tax base in many cases is reduced by the consumption-based tax to financial same amount, with homeowners services is the difficulty in properly deducting mortgage interest payments measuring value added from financial at an eight-percent rate and depositors intermediation. For financial services, including interest income at a three- 8 value added is given by the sum of percent rate. explicit and implicit fees less inputs purchased from other businesses (e.g., Rearranging equation 1, implicit FI fees telecommunications, rents, etc.): can be measured as a financial intermediary’s value added reduced by the difference between explicit fees and 1 business inputs:

Value added = explicit fees 2 + implicit fees – input costs. Implicit FI fees = value added While explicit fees, such as automatic – (explicit fees – inputs). teller machine charges, may be easily tallied, implicit financial intermediation (FI) fees are hidden in interest rate For equation 2 to be useful, however, an spreads and other financial margins that operational measure of value added provide the bulk of revenues for many must be determined for financial financial institutions. intermediaries. Under the USA business tax, the cash-flow method of taxation Unless financial institutions are required generally would be used to measure to measure and report implicit FI fees, value added for FI businesses.

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DESCRIPTION OF THE CASH-FLOW Following the Meade Commission METHOD Report, the cash-flow (CF) tax base can be written as the sum of net real and Under the cash-flow tax proposed by net financial transactions: the Meade Commission, both real and financial business inflows are subject to taxation, and both real and financial 3 business outflows are deductible. However, amounts received in connec- Meade CF tax base = R + F tion with equity issued by the taxpayer are excluded (e.g., contributions to where R is real inflows minus real capital), and amounts paid in connec- outflows and F is financial inflows minus tion with shares (e.g., dividends) are not financial outflows. deductible. The components of the cash-flow tax base, along the lines In contrast to the Meade Commission’s conceived by the Meade Commission, R + F cash-flow tax, the Armey Flat tax are summarized in Table 1. can be viewed as an R base tax:

2 Like the Armey Flat tax, but unlike the 4 VAT, the Meade Commission’s cash-flow tax allows businesses to deduct em- Flat2 tax base = R. ployee compensation, removing labor value added from the base of the Under a pure R base tax, implicitly business tax. As proposed by the charged FI services are excluded from Meade Commission, the cash-flow tax the tax base of financial service provid- is origin-based, i.e., amounts received ers. The most recent Armey Flat tax bill for exports of goods and services are (H.R. 2060) seeks to tax implicit FI taxed and amounts paid for imports services according to their “value”; are not taxed. This is in contrast to the however, the bill provides no rules for European VAT under which imports valuing these services and there is no are taxable and exports are free of mechanism for business customers to tax. claim an offsetting deduction. 1

1 TABLE 1 COMPONENTS OF THE CASH-FLOW TAX BASE Transaction Inflows (taxable) Outflows (deductible) Real transactions Proceeds from the sale of goods Amounts paid for plant, equipment, and services. inventory, supplies, and labor.

Financial transactions Sale of financial assets (other than own Purchase of financial assets (other shares or shares of other U.S. residents); than own shares or shares of other receipt of debt repayments; borrowing of U.S. residents); payments to reduce funds; interest income; dividend income debts; interest expense; other pay- (other than from shares of U.S. ments in connection with financial residents); other receipts in connection instruments (other than dividends with financial instruments; receipt of paid); payment of insurance claims; insurance premiums; and receipt of and payment of insurance insurance claims. premiums.

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APPLICATION OF CASH-FLOW TAX TO ESTIMATED TAX LIABILITY UNDER USA FINANCIAL SERVICES CASH-FLOW TAX The USA cash-flow tax, applicable to For any business entity, aside from certain financial intermediation busi- changes in cash on hand, total cash nesses, includes compensation in its inflows must equal cash outflows. The base and thus is a modified version of cash-flow3 identify of the firm may be the Meade Commission’s cash flow tax: written as

5 7

USA CF tax base = (R + W) + F = R’ + F R + F = S + T where W is employee compensation and where S denotes amounts paid in R’ denotes a compensation-inclusive R connection with own shares and base. shares in other domestic corporations minus amounts received in connection Using the USA cash-flow tax base to with such shares; and T represents measure value added in equation 2 net taxes paid to governmental enti- above yields an operational measure of ties.9 implicit FI fees as the excess of financial inflows over financial outflows (F base): From equations 5 and 7, the USA cash- flow tax can be calculated indirectly as the sum of employee compensation, net 6 distributions to shareholders and net tax payments: 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 The USA cash-flow tax treats amounts would include financial inflows in the paid and received in connection with computation of taxable income and shares of unrelated domestic companies would deduct financial outflows. Under as part of F rather than S, so that the this system, there is no need for FIs to S component of the USA tax is equal report implicit FI fees to their business to amounts paid in connection with customers. Because all businesses own shares (dividends and redemptions) would be on the cash-flow method, minus amounts received from the they would automatically deduct net sale of own shares (contributions to payments to financial service providers. capital). By contrast, the USA tax would limit application of the cash-flow tax to To calculate the USA cash-flow tax from financial intermediation businesses, with financial statement data, it is convenient a mechanism for business customers to to take advantage of another account- recover taxes paid in connection with ing identity which states that net implicit FI fees. income equals the sum of (1) the

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change in net worth over the account- reported on the financial statements of ing period and (2) net distributions to the ten largest public companies shareholders during the period: (measured by assets) in the securities, commercial banking, life and health insurance, and property and casualty 9 insurance industries. The USA tax is calculated as 11 percent of the USA Y = (NW – NW ) + S –1 cash-flow tax base reduced by a credit for the employer’s share of payroll where Y is net after-tax income and taxes.11

(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 From equations 8 and 9, the USA cash- amount of revenue from the business flow tax base can be estimated from the sector as the present income tax system. financial statement as net income For financial services companies, increased by taxes and compensation however, we estimate that the USA paid and reduced by the change in net tax generally would have resulted in a worth from the beginning to the end of significant tax cut (Table 2). Tax liability the tax period: is reduced in each year for each industry except property and casualty insurance in 1992. Over the three-year period, 10 there is a 40-percent reduction in the average tax liability of security brokers, USA CF tax base = Y + T + W a 56-percent reduction for banks, a 57-percent reduction for life and health – (NW – NW ). –1 insurers, and a 1-percent reduction in the tax liability of property and casualty Two adjustments must be made to insurers. Excluding 1992, the average measure the USA cash-flow tax tax liability of the property and casualty accurately. First, sales, excise, and other industry would have declined 43 “product” taxes are deductible under percent. The anomalous results in 1992 the USA business tax and should not are due to the significant downturn in be added back to net income in property and casualty insurance equation 10. Second, only the do- operating income primarily caused by mestic portion of the tax base, as the industry’s record $23 billion of determined by formula apportionment, catastrophe losses that year. is subject to tax. The apportionment method is not specified in the USA tax Significant tax cuts for financial services bill; for purposes of this analysis, the under a VAT are not surprising if one domestic share of gross income re- considers financial services within the ported in the consolidated financial context of national income accounts. In statement is used to apportion the tax 1992, the finance and insurance sector base. (depository and nondepository institutions, securities and commodity brokers, Table 2 compares USA tax liability, and insurance carriers) accounted for estimated as if the USA tax 9.2 percent of gross domestic product had been in effect over the 1992–94 (GDP) originating in the corporate period, with federal income tax liability sector, but paid 28.1 percent of corpo-

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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 Corporate Income Tax Securities brokers $1,052 $2,239 $1,283 $1,525 Commercial banks $2,269 $2,889 $2,808 $2,655 Life and health insurers $976 $1,573 $1,262 $1,270 Property and casualty insurers ($393) $1,412 $740 $586

USA Cash-Flow Tax at 11 Percent Securities brokers $877 $985 $874 $912 Commercial banks $710 $1,105 $1,668 $1,161 Life and health insurers $498 $370 $768 $545 Property and casualty insurers $523 $560 $660 $581

Percentage Change in Tax Liability Securities brokers –16.6% –56.0% –31.9% –40.2% Commercial banks –68.7% –61.8% –40.6% –56.3% Life and health insurers –49.0% –76.5% –39.1% –57.1% Property and casualty insurers –233.1%a –60.3% –10.8% –0.9% Source: Price Waterhouse LLP calculations from SEC Form 10-K information. aTax increase as a percent of negative income tax liability under present law.

rate income taxes (Table 3).12 Thus, a ISSUES ARISING UNDER THE CASH-FLOW revenue-neutral change in the corporate METHOD tax base—from income to value added —would be expected to result in a Treatment of Nonfinancial Businesses substantial reduction in the tax liability The application of a cash-flow tax to of the finance and insurance sector. nonfinancial businesses has been Conversely, one might expect that the viewed as imposing an unacceptable tax liability of nonfinancial corporations administrative burden as well as a strain would increase under the USA tax. This on liquidity due to the imposition of tax is consistent with the findings of Merrill, on borrowed funds.13 To alleviate Wertz, and Shah (1995) who estimate concerns about the universal imposition that the USA tax would have increased of a cash-flow tax, the USA business tax the tax liability of nonfinancial corpora- would limit its application to financial tions by 11 percent over the 1988–92 intermediation businesses (FIBs). This period. has been referred to as a “truncated” cash-flow method by Poddar and These results must be interpreted with English (1994). A problem that arises caution—they do not take into account under a truncated cash-flow tax is that transition rules, adjustments that might FI services provided to business custom- be made by taxpayers in response to ers would be subject to tax cascading introduction of the USA tax system, or unless (1) a mechanism is provided for changes in the U.S. economy that might allowing business customers to deduct occur. Also, these results address tax their allocable share of implicit FI fees, payments by financial companies rather or (2) these fees are excluded from the than the ultimate incidence of the tax tax base of financial services companies burden. (i.e., zero rating).

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TABLE 3 FINANCIAL SECTOR SHARE OF CORPORATE GDP AND INCOME TAXES, 1992 (DOLLAR AMOUNTS IN BILLIONS) GDP, Corporate Corporate Income Taxa Sector Amount Percent of Total Amount Percent of Total Finance and insuranceb $328.3 9.2% $28.5 28.1% All industries $3,571.7 100.0% $101.5 100.0% Sources: U.S. Department of Commerce, Survey of Current Business; and Internal Revenue Service, Statistics of Income Division, Corporate Income Tax Returns, 1992. aFiscal years ending on or after June 30, 1992 and before June 30, 1993. bExcludes insurance agents, brokers, and services.

The USA tax provides two methods for (2) Financial flows (e.g., interest determining implicit FI fees: (1) in the payments) must be allocated case of lending, the borrower calculates between the financial and nonfi- implicit FI fees based on tables pub- nancial activities of a taxpayer lished by the Treasury Department; and engaged in both types of activities. (2) for other FI services, the FIB may (3) Implicit FI fees must be allocated elect to allocate and report implicit FI between business and nonbusiness fees to customers. An electing FIB must customers and, if reported to allocate implicit FI fees on a “reasonable business customers, must be and consistent basis” and report to each allocated among them. recipient, not later than February 15th of each year, the amount of implicit FI fees for the preceding calendar year. Transition Effects Consistent methods of allocation are Hoffman, Poddar, and Whalley (1987) required for business and nonbusiness point out that the first imposition of a customers as well as persons who cash-flow tax, and any subsequent receive and persons who pay money to change in the rate of tax, would create 14 an FIB. Note that amounts allocated windfall losses and gains with respect to to persons who receive money from an open financial transactions. For FIB are not reported as implicit FI fees example, loans made prior to the and thus may not be deducted by introduction of a cash-flow tax would 15 customers. The maximum amount of be taxable upon repayment even implicit FI fees that may be allocated by though the principal amount of the loan an FIB for a calendar year is equal to the would not have been deducted previ- excess of (1) the FIB’s cash-flow tax base ously. Similarly, deposits received prior over (2) explicit fees for FI services to the date of introduction would be 16 received by the FIB. deductible when paid out to depositors even though the principal amount of While the truncated cash-flow method the deposit would not have been addresses some of the concerns included previously. In theory, introduc- associated with a universal cash-flow tion of a cash-flow tax imposes a tax on tax, it introduces other complications: wealth equal, in present value, to the rate of tax times the taxpayer’s net (1) Financial intermediation businesses financial assets at the date of introduc- must be distinguished from tion.17 This wealth effect is equal to the nonfinancial businesses. cash-flow tax that hypothetically would

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be owed if the taxpayer liquidated where F f equals financial inflows from immediately following the date of foreign residents minus financial introduction. outflows to foreign residents. Imposi- tion of the cash-flow tax on a destina- Tax Deferral Opportunities tion basis, however, precludes measure- ment of the tax base indirectly from By issuing equity and purchasing financial statement information using financial assets (or reducing debt), equation 10. companies can indefinitely defer payment of tax under a cash-flow tax. The Mutual Companies entire corporate sector could, in theory, defer tax by lending money to the house- In mutual organizations, the customers hold sector for use in purchasing corpor- are also shareholders. Examples include ate equity issues. While tax liability is not mutual funds, credit unions, mutual reduced in present value, this is unlikely savings and loans, mutual life insurance to comfort the Treasury Department. companies, etc. Under a cash-flow tax, it is necessary to separate the portion of The Meade Commission also anticipated each payment between a mutual that, for example, corporation A might organization and its owners that issue shares to corporation B in order to represents a customer transaction as finance the purchase of B’s shares. In distinct from a shareholder transaction. this way, absent antiabuse rules, both This issue also arises under the income corporations A and B would obtain a tax tax.19 The USA tax treats all such deduction with no cash inflow from payments as customer, rather than households into the corporate sector. shareholder, transactions. From The Meade Commission sought to equation 8 it can be seen that the USA prevent this result by denying a deduc- tax base for FIBs organized in mutual tion for the purchase of shares of form is the sum of employee compensa- domestic corporations. tion plus net payments to governments (i.e., a W + T base). International Issues

The USA cash-flow tax generally is origin TAX CALCULATION ACCOUNT based, in contrast to the destination Poddar and English (1994) have basis used for nonfinancial businesses.18 proposed a TCA method for calculating From equation 6, net implicit FI fees implicit FI fees that addresses a number received for services supplied to foreign of problems that arise under a trun- residents could be defined as financial cated cash-flow tax system. The TCA inflows from foreign residents minus system is designed to be compatible financial outflows to foreign residents. with a European-style VAT and currently Thus, destin-ation-based taxation of is being evaluated by the European implicit FI services could be achieved by Commission. Under the TCA system, deducting net implicit FI fees for services business customers would receive supplied to foreign residents from the invoices from financial service providers USA tax base: indicating the amount of implicit fees for services provided and the associated 11 VAT paid by the financial company. Business customers could claim an input Implicit FI fees under destination-basis credit for the amount of VAT reported CF tax = F – F f paid by the financial company.

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Under the standard cash-flow system, where i is the TCA index rate, A–1 is the implicit FI fees are measured as financial TCA balance at the end of the preced- inflows minus financial outflows. ing taxable period, and u is the tax rate. Splitting financial flows into “capital” The TCA balance is determined as the and “income” components, the cash- “book” value of the account, K, flow method of measuring implicit FI multiplied by the tax rate: fees, shown in equation 6, can be re- written as 14

12 A = K*u.

k y CF implicit FI fees = F + F The book value of a customer account is the sum of all (positive and negative) where F k denotes financial inflows capital transactions from the date the less financial outflows on capital account was opened: account and F y denotes financial inflows less financial outflows on current account. 15

K = – {F k + F k + F k + . . .} Under the TCA method, implicit FI fees –1 –2 are calculated separately for each customer account based on the financial where a financial intermediary’s outflows into and out of each account flows are recorded as a negative during the taxable period. However, number, inflows as a positive number, the taxation of the capital component assets as a positive number, and of implicit FI fees is suspended, and liabilities as a negative number. the suspended tax balance is subject to an interest charge (or credit) at the Comparing equations 12 and 13, it can designated TCA index rate. This be seen that the difference between suspension system is intended to implicit fees measured under the cash- eliminate account-specific swings in flow and TCA tax systems is given by implicit FI fees that otherwise would occur when large capital transactions take place. For example, absent the 16 suspension system, a $1 million loan would result in an implicit FI fee of CF implicit FI fees – TCA implicit FI fees negative $1 million when made and an = F k – (i*K ). implicit FI fee of positive $1 million –1 when repaid. Discounting at the TCA index rate, i, The TCA measure of implicit FI fees for beginning at the date the tax is intro- an individual customer account can be duced, t, and ending at a terminal date, written as t + n, the present value (PV) of the right- hand side of equation 16 is equal to the book value of the account at the end of 13 the period immediately preceding introduction of the tax minus the y TCA implicit FI fees = F – (i*A–1/u) present value of the terminal book value:

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17 The TCA system, however, has a number of potential disadvantages. PV{F k – (i*K )} = K – K (1+ i)–n. First, depending on the choice of index –1 t–1 t+n rate, implicit FI fees can be negative Hence, for any customer account, the (causing business customers to be taxed present value of implicit FI fees under as if supplying financial services to the the TCA system, discounted (at the TCA financial intermediary). Second, the index rate) from the date the tax is intro- costs of making TCA calculations each duced until the date the book value of tax period for each customer account the account goes to zero, is equal to the and reporting these calculations to present value of implicit FI fees under the business customers would be very large. 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 18 cash-flow tax is to use what we refer to as an “accrual consumption tax” (ACT). PV{TCA implicit FI fees} The compensation-inclusive ACT base is = PV{CF implicit FI fees} – K . equal to a company’s financial state- t–1 ment net income increased by taxes and compensation paid and reduced by the Thus, the TCA and cash-flow measures imputed cost of equity capital: of implicit FI fees generally are equal in present value for accounts that open after the date the tax is introduced 19

(because Kt–1 is zero in this case). In situations where the book value of the Compensation-inclusive ACT base account is not zero at the date of introduction, the present value of TCA = Y + T + W – (rE*NW–1) implicit FI fees does not include the existing account balance, and thus where rE is the designated cost of equity avoids the tax on wealth that otherwise capital, and NW–1 is the net worth at the occurs when a conventional cash-flow end of the preceding tax period. Aside tax is introduced. from the nondeductibility of compensation and taxes, the ACT base would be The TCA system solves a number of the measured using conventional income difficulties associated with the truncated accounting principles with one key cash-flow method of taxation: (1) the difference—a deduction would be TCA method allows implicit FI fees to be allowed for the imputed cost of equity calculated for each tax period on a capital analogous to the deduction of customer-by-customer basis; (2) the TCA interest paid to bondholders. In effect, method eliminates the adverse transi- only equity income in excess of the cost tional effects of a pure cash flow; (3) the of equity capital (i.e., economic “rents”) TCA method eliminates tax deferral would be taxable. opportunities by charging interest on TCA balances; and (4) the TCA method Comparing equations 10 and 19, it can can be made consistent with a destina- be seen that the difference between the tion-basis tax.20 cash-flow tax and ACT is given by

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20 base in situations where a company’s net worth is growing faster than the de- Cash-flow base – ACT base signated cost of equity, and conversely:

= (rE*NW–1) – (NW – NW–1). 23 Discounting (at the designated cost of equity capital) from the date that the tax {ACT base > CF base} if, and only if, is introduced, t, until the date the tax is {(NW – NW–1)/NW–1 > rE } . terminated, t + n, the present value of the term on the right-hand side of Considering only current period tax equation 20 is equal to net worth at the liabilities, rapidly growing companies end of the period immediately preced- would favor the cash-flow tax base, ing introduction of the tax minus the while more mature companies would present value of the company’s terminal prefer the ACT base. date net worth: The accrual method is similar in spirit to the method of taxing financial interme- 21 diaries proposed in Canada’s 1987 “white paper” on sales tax reform. For PV{(r *NW ) – (NW – NW )} E –1 –1 financial intermediaries, the white paper –n–1 proposed a modified income tax base = NWt–1 – NWt+n(1+ rE) . with a deduction for the cost of equity capital.21 The white paper would have Hence, the present value of a company’s limited its version of the accrual method tax base under the ACT system, to taxpayers engaged in FI activities and discounted from the introduction until would not have allowed financial the termination of tax, is equal to the intermediaries to report implicit FI fees present value of the cash-flow tax base to business customers. As a result, the reduced by net worth immediately Canadian proposal would have resulted preceding introduction of the tax and in substantial cascading of tax on increased by the present value of net business customers—one of the reasons worth at the date the tax is terminated that the proposal was dropped.

22 The ACT may be distinguished from the so-called “addition” method VAT under PV{ACT base} = PV{CF tax base} which financial intermediaries are taxed on the sum of income plus compensa- –n–1 – NWt–1 + NWt+n(1 + rE) . tion paid, as is the case in Israel. The addition-method VAT does not allow a Thus, the ACT avoids the tax on existing deduction for the imputed cost of wealth that effectively occurs when a equity capital and, thus, overstates value cash-flow tax is introduced, as well as added as compared to the ACT base. the forgiveness of tax that effectively Under the Israeli system, implicit FI fees occurs when the tax is terminated. are not reported to, nor deducted by, businesses’ customers. Moreover, From equation 20, it can be seen that, financial intermediaries are not permit- for companies with positive net worth, ted to recover VAT on inputs. Conse- the ACT base exceeds the cash-flow tax quently, the Israeli system exacerbates

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the over-taxation of business customers The exemption system, however, has a that arises under the exemption number of defects including over- method. taxation of business customers.

The ACT solves a number of the One alternative to exemption is use of difficulties associated with the cash-flow the cash-flow method. A truncated method of taxation: (1) the ACT version of the cash-flow method is eliminates adverse transitional effects of incorporated into the Nunn–Domenici a pure cash-flow tax; and (2) the ACT USA business tax for purposes of taxing eliminates tax deferral opportunities. certain financial intermediaries. Based These features of the ACT are similar to on 1992–94 financial statement data for the TCA method and are due to the fact the ten largest public companies in the that financial flows on capital accounts securities, banking, life and health are neither included nor deducted in insurance, and property and casualty computing the tax base; instead, the insurance industries, the USA business capital account is charged (or credited) tax is estimated to reduce tax liability with the time value of money at a significantly compared to the present specified rate. An important advantage corporate income tax. of the ACT is that it relies on conventional income accounting principles and While attractive in theory, the truncated could be applied with equal ease to cash-flow method raises a number of financial and nonfinancial companies. difficult administrative questions and has not been adopted by any country. The ACT, however, has a number of One difficult issue is the allocation of FI disadvantages. First, if the ACT is fees to nonfinancial businesses that is limited to financial service companies required to avoid cascading of tax. The (i.e., truncated), tax cascading will arise TCA method, under consideration by unless implicit FI fees allocable to the European Commission, holds business customers are excluded from promise for solving this problem, but the tax base (i.e., zero rating). This would impose a heavy compliance would require apportionment of the burden on financial companies. ACT base between business and household customers using formula An alternative to the cash-flow apportionment methods. Second, the method—referred to as the ACT—also ACT is inherently an origin-based tax addresses some of the problems raised and would not integrate well with a by the cash-flow tax. If limited to VAT. Third, implementation of the ACT financial intermediaries, however, the requires designation of the cost of accrual method would require allocation equity capital. Overtaxation will result if of implicit FI fees associated with the designated cost of equity is too low, business customers to avoid cascading and conversely. of tax. In addition, the accrual method is inherently an origin-based tax that Conclusions could not easily accommodate border tax adjustment. Approximately 90 countries impose a national VAT. Core financial services are exempt in virtually all of these countries ENDNOTES primarily as a result of difficulties in The views expressed in this paper are those of the measuring the value of implicit FI fees. authors and should not be attributed to Price

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Waterhouse LLP or its clients. The authors payments over tax payments under the USA gratefully acknowledge helpful comments from business tax would be used to pay dividends (and David Bradford, Satya Poddar, and Edith Brashares. thus included in the USA tax base). Losses and 1 These bills include S. 2160, the Business Activities credits are assumed to be utilized fully in the year Tax introduced by Senators John Danforth and in which they arise. David Boren; S. 722, the USA tax introduced by 12 The Commerce Department generally estimates Senators Sam Nunn and Pete Domenici; H.R. value added by the financial services industries as 2060, the Flat tax, introduced by House Majority the sum of wages and profits. Leader Dick Armey; and H.R. 3030, the National 13 See, Poddar and English (1994). These concerns Retail Sales Tax introduced by Representatives Dan have, perhaps, been given too much weight in the Schaefer and Billy Tauzin. past. The tax on borrowed funds does not reduce 2 See Organisation for Economic Co-operation and liquidity to the extent that funds are used to Development (1995). finance plant, equipment, land, supplies, and other 3 Under the exemption system, however, it is deductible business inputs. Moreover, if imposed necessary to allocate inputs between taxable and on an accounts basis (like the income tax) rather exempt supplies. In practice, this is a very than on a transactional basis (like a VAT), the complicated area of VAT compliance. information necessary to calculate an origin-based 4 The exemption system also results in only partial cash-flow tax is currently contained in financial taxation of household customers. The inability to statements, as shown in equation 10. recover fully input credits may encourage financial 14 The Treasury Department would be authorized to intermediaries to self-supply inputs (e.g., printing) issue regulations governing (1) the timing of to avoid nonrecoverable VAT. The exemption system deductions of implicit FI fees by fiscal year also may put domestic financial service providers at taxpayers, (2) subsequent year adjustments in the a competitive disadvantage as compared to foreign event of excess allocations, (3) advance approval of financial companies that provide services to allocation procedures, and (4) safe harbor domestic residents. See Tait (1988) and Merrill and alternatives. Adrion (1995). 15 It is unclear why a business that implicitly pays a 5 Under the USA business tax, special rules would be fee to an FIB in the form of a reduction in net applicable to regulated lending institutions, receipts from a financial transaction (e.g., a bid-ask financial “pass-through” entities, and nonfinancial spread on the sale of a security to a broker) should businesses that self-supply financial services. not be able to deduct this implicit FI fee. 6 See Henderson (1988). 16 The bill apparently contains a drafting error. 7 See, IFS (1978, Appendix 12.1) and Bradford Conceptually, implicit FI fees are equal to value (1996). added by an FIB less receipts from explicit fee 8 The home mortgage interest deduction is subject services plus business purchases (equation 2). to a number of limitations and is only available to Inconsistent with this formula, the bill does not taxpayers who itemize their deductions. permit the cost of business purchases to be added 9 See, IFS (1978, ch. 12). Recognizing the cash-flow back in determining the cap on implicit FI fees. identity, the Meade Commission suggested the 17 See, Hoffman, Poddar, and Whalley (1987). Repeal possibility of a tax on net distributions from of the corporate income tax also could result in corporations to shareholders (i.e., an S-base tax), windfall gains and losses. grossed up to account for other taxes, as an 18 Under the USA cash-flow tax, implicit FI fees alternative to the R + F base tax. associated with exports are subject to tax. The 10 Note that adjustments to net worth which do not source rules for insurance premiums and claims, flow through the income statement must be however, are more consistent with destination- removed in order for this identity to hold. Such basis taxation. adjustments include the foreign currency 19 See Internal Revenue Code section 809 relating to translation adjustment and the change in market dividends paid by mutual life insurance companies. value of securities available for sale. 20 Implicit fees can be measured on a destination 11 The USA legislation includes a separate tax regime basis by excluding from TCA calculations all of the for banks and other regulated lending institutions; financial flows (on capital and current account) to however, for purposes of this analysis, the cash- and from foreign residents, consistent with flow tax rules are used. Federal payroll taxes are equation 11. estimated as 7.65 percent of U.S. wages and 21 The white paper suggested two possible methods salaries reported on financial statements. Under for measuring the cost of equity capital: (1) the the USA tax, payroll taxes are nondeductible. product of the cost of equity capital and net Other nondeductible taxes cannot be identified worth; and (2) dividends paid. Unlike the ACT, the from financial statements. This analysis assumes Canadian proposal would have adjusted income of that the excess of present corporate income tax financial intermediaries to a cash-flow basis by

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expensing rather than depreciating (or amortizing) Merrill, Peter, and Harold Adrion. “Treatment capital costs. Because undepreciated capital of Financial Services Under Consumption-Based expenditures increase net worth, the lack of Tax Systems.” Tax Notes 68 No. 6 (September expensing under the ACT is offset by a larger 18, 1995): 1496–1500. deduction for the cost of equity capital. Merrill, Peter, Ken Wetz, and Shvetank Shah. “Corporate Tax Liability under the USA and Flat Taxes.” Tax Notes No. 12 (August 7, 1995): REFERENCES 741–5. Bradford, David F. “Treatment of Financial Organisation for Economic Co-operation and Services Under Income and Consumption Development. Consumption Tax Trends. Paris: Taxes.” In The Economic Effects of Fundamental OECD, 1995. Tax Reform, edited by Henry Aaron and William Poddar, Satya, and Morley English. “Taxation Gale. Washington, D.C.: The Brookings of Financial Services under a VAT: Issues and Institution, 1996 (forthcoming). Options.” Paper presented at National Tax Associ- Canadian Department of Finance. Tax Reform ation Conference on Taxation of Financial Ser- 1987: Sales Tax Reform. Ottawa: Department vices, Clearwater, FL, February 24–25, of Finance, June 18, 1987. 1994. Henderson, Yolanda K. “Financial Intermediar- Tait, Alan. Value Added Tax: International ies Under Value-Added Taxation.” New England Practice and Problems. Washington, D.C.: Economic Review (July/August, 1988): 37–50. International Monetary Fund, 1988. Hoffman, Lorey A., Satya N. Poddar, and U.S. Congress. Senate. The USA Tax of 1995. John Whalley. “Taxation of Banking Services Introduced by Senator Domenici. 104th Cong., 1st Under a Consumption Type, Destination Basis sess. 1995. S. 722. VAT.” National Tax Journal 40 No. 4 (December, U.S. Department of Treasury. Blueprints for 1987): 547–54. Basic Tax Reform. Washington, D.C.: Govern- Institute of Fiscal Studies. The Structure and ment Printing Office, January 17, 1977. Reform of Direct Taxation. London: Allen and Unwin, 1978.

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