We model the effects of consumption-type taxes which differ according to the base and location of the tax. Our model incorporates a multinational producing and selling in two countries with three sources of rent, each in a different location: a fixed basic production factor (located with initial production), mobile managerial skill, and a fixed final production factor (located with consumption). In the general case, we show that for national governments, there are trade offs in choosing between alternative taxes. In particular, a cash-flow tax on a source basis creates welfare-impairing distortions to production and consumption, but is partially incident on the owners of domestic production who may be non-resident. By contrast, a destination-based cash-flow tax does not distort behavior, but is incident only on domestic residents. In the alternative case with the returns to the fixed factors accruing to domestic residents, the only distortion from the source-based tax is through the allocation of the mobile managerial skill. In this case, the source-based tax is also incident only on domestic residents, and is dominated by an equivalent tax on a destination basis.
WP 12/14 Alan Auerbach and Michael P Devereux, Consumption and cash-flow taxes in an international setting
Research Highlight 2014
Cash-flow taxes in an international setting
One aspect of the Centre’s research agenda is to consider and analyse potentially fundamental reforms to the international tax system. This is partly in response to the problems of the existing system, and partly in response to far-reaching proposals that have been advocated, such as a formula apportionment system. This project sets up a rich theoretical economic model which can help understand the incentives created and outcomes for alternative forms of taxation. Within this framework we compare three broad structures of taxation: (i) the existing system - which economists characterise as a source-based tax; (ii) a system based on formula apportionment; and (iii) a system based on taxing income where sales are made in a similar way to VAT (though unlike VAT allowing employee costs to be deductible) – we describe this as a destination-based tax.
Within the setting of the theoretical model, the destination-based tax avoids distortions to business behaviour, since we assume that the location of sales to third parties cannot be chosen by the selling company. Such a tax would also inhibit much tax planning with respect to, for example, the location of intangible assets. These factors represent a significant advantage of a destination-based system over the other two systems. In theory, then, it would prove a better basis for international taxation if implemented in all countries.
But a significant question is whether there would be an incentive for an individual country to switch to a destination basis unilaterally. From the perspective of a single country, there is one advantage to a source-based tax – that is the effective incidence of the tax falls at least partly on shareholders; this implies that part of the burden of the tax can fall on non-residents. This is a form of “tax-exporting”, which benefits domestic residents. From a single country perspective, a switch to a destination basis would therefore require trading off the benefits of reducing distortions to economic activity against the benefits of tax exporting.