How should business profit be taxed? Some thoughts on conceptual developments during the lifetime of the IFS

This paper reviews developments since the 1970s in economic thinking about the design of taxes on business profit. It charts developments from proposals for a cash flow tax from the Meade Committee, to refinements of this in the form of an Allowance for Corporate Equity (ACEA) and levying the cash flow tax in the country of destination. It describes how the development of international trade and investment has led to ever-increasing problems in the international tax system with respect to economic efficiency, profit shifting, complexity and tax competition, and identifies why responding to these problems requires a major reform in the location of taxation. 

Developing ideas about taxing profit: a long view

Michael Devereux began his career as an economist researching in business tax in 1982, at the Institute for Fiscal Studies. As part of a special issue of the journal Fiscal Studies, to celebrate the fiftieth anniversary of the IFS, he has written a paper outlining the development of academic thinking on the taxation of profit over that period.  

Following the pioneering work of the IFS Meade Committee in 1978, economists generally thought at the time that a ‘source-based’ cash flow tax on economic rent was economically efficient and progressive. The more immediate developments in thinking at the time related to implementation – including the proposal in 1991 by the IFS Capital Taxes Committee, chaired by Malcolm Gammie, for
an allowance for corporate equity (ACE) which has similar properties to the cash flow tax.  

But further consideration of international issues in open economies cast doubt on this consensus for two related reasons. First, even a tax on economic rent can affect mutually exclusive business location decisions, as businesses choose the location with the highest posttax economic rent. Second, the narrow base of a tax on economic rent would require a relatively high statutory rate to collect a given revenue, which worsens incentives for profit shifting. Both of these key problems would be solved by developing the original Meade Committee proposal to levy taxation in the market, or destination, country: a destination-based cash flow tax (DBCFT). The key idea here is that income is taxed in the place of the customer, who is relatively immobile. Largely as a consequence, location decisions would be unaffected by the tax. Also, the location of the tax makes it much harder to shift profit. 

The promise of an economically efficient, yet progressive, tax is therefore still on the agenda. Although the DBCFT was considered in the United States in 2016/17 (and previously in 2005), the actual practice of taxing the profits of multinational companies has of course not kept up with the theory. However, the most recent developments in the OECD have been in the direction of introducing at least some element of destination-based taxation.