U.S. Corporate Tax Reform: The Merits of the DBCFT

S&P Global
Written By: John Kingston and Joaquin Cottani
S&P Global
Written By: John Kingston and Joaquin Cottani

One of the few things Republicans and Democrats agree upon is the need to reform the U.S. corporate income tax system. Among various proposals advanced by the two parties over the years, one stands out at present, both for its merits and the fact that it is the intellectual basis for the governing Republican party’s corporate tax reform overhaul: the DBCFT, which stands for “destination-based cash-flow tax.”

In its original form, the proposed tax is the brainchild of Alan J. Auerbach, a professor at the University of California, Berkeley, who first outlined it in 2010 in a paper called A Modern Corporate Tax. A modified version of this tax is a key component of the GOP’s blueprint for comprehensive tax reform in the U.S. called A Better Way, which was introduced in June 2016 by House of Representatives Speaker Paul Ryan (R-Wisconsin) and House Ways & Means Chairman Kevin Brady (R-Texas).

Interest in the DBCFT has soared since it first burst on the scene in the weeks leading up to President Donald Trump's inauguration. The purpose of this article is to explain the intellectual basis for the proposal and discuss its likely economic effects.

Key Provisions

The objective of the reform to the existing corporate income tax is threefold. First, to eliminate distortions that currently impinge on investment incentives, the favoring of debt financing over equity financing, the treatment of exports and imports, and capital repatriation. Second, to shift the tax basis solely to activities in the U.S., bringing it in line with most of the world and reducing significantly company efforts to shift activities outside the country as much as possible. Third, to reduce the statutory tax burden on incorporated and unincorporated U.S. businesses without losing tax revenue, by concurrently changing the existing structure and altering what some critics view as loopholes.

At 35% (up to as much as 39% if state taxes on business income are included), the U.S. corporate income tax rate is higher than in most other countries. The GOP blueprint plans to reduce it to 20%, more in line with the rates that prevail in the rest of the world. If this were all the reform did, it would fix some--but not all--the problems associated with the current tax.

What distortions are these? Professor Auerbach lists several:

  • The disincentive the U.S. corporate income tax rate creates for businesses to locate, invest, and produce in the U.S., which has led to the phenomenon of tax “inversions,” whereby U.S. multinational companies seek to relocate to other countries where business taxes, in particular the corporate income tax, are lower.
  • The incentives that are created for U.S.-based companies to use transfer pricing. Under the current system, companies have considerable leeway to lower their tax bills by the creative use of internal transfer pricing in accounting for their imports and exports.
  • The stretched-out depreciation schedules of the current structure do not accurately reflect the actual loss in the value of capital goods caused by technological obsolescence and other factors, which effectively increases the after-tax cost of capital.
  • And last but not least is the incentive the U.S. corporate income tax rate creates for companies to use debt financing, which results from the fact that interest payments are deductible for tax purposes while dividend payments to shareholders are not.

To remedy these problems, the DBCFT is applied to net cash flows generated by domestic transactions only. As such, it would also allow the full deductibility of investment in the same year as purchases of domestic capital goods are made; eliminate the deductibility of net interest payments and depreciation; exempt export revenues from the tax base; and tax imports of intermediate and capital goods, a provision that has been likened to a tariff. In the next section, we explain how these provisions would help remove the aforementioned distortions.

Taxonomy of Changes

For a given U.S. company, the current corporate income tax is calculated as follows:

U.S. CORPORATE INCOME TAX RATE = 0.35 * PROFIT

whereas the proposed DBCFT will be calculated as follows:

DBCFT = 0.20 * (PROFIT + NET PAID INTEREST + DEPRECIATION – INVESTMENT + IMPORTS – EXPORTS)

We can re-write the previous expression as

DBCFT = 0.20 * (PROFIT + NET PAID INTEREST + DEPRECIATION – INVESTMENT) + 0.20* (IMPORTS – EXPORTS)

This says that the DBCFT is, effectively, the sum of two levies: one on adjusted profits, where the adjustment consists of substituting the full deduction of investment expenses--which could include plant or office construction, and purchases of capital goods and equipment--for the current ability to deduct net debt interest and depreciation; and a separate “border adjustment” which accomplishes its goals by no longer allowing the exclusion of import costs from a company’s tax base, while changing the system to allow full deductibility of export revenues. This is the provision that has led some, mostly critics, to refer to the import cost inclusion into the tax base as a “tariff.”

As an example of how these changes would affect the taxes paid by U.S. businesses, let’s separate the effect of changing the tax base from that of changing the rate by assuming that the latter doesn’t fall. Also, to separate the profit-adjustment feature of the DBCFT from the border-adjustment feature, let’s first consider a firm that doesn’t export or import, as shown in Table 1.

Table 1: Firm Doesn't Export or Import

Scenario A: Firm Uses Own Capital to Invest

Year 1: New Investment Occurs Year 2: No Investment Occurs
1. Sales 1,000 1. Sales 1,000
1a. Domestic 1,000 1a. Domestic 1,000
1b. Exports - 1b. Exports -
2. Cost of Goods Sold 400 2. Cost of Goods Sold 400
2a. Domestic 400 2a. Domestic 400
2b. Imports - 2b. Imports -
3. Value Added (1-2) 600 3. Value Added (1-2) 600
4. Labor Costs 300 4. Labor Costs 300
5. Investment 1,000 5. Investment -
5a. Domestic 1,000 5a. Domestic -
5b. Imports - 5b. Imports -
6. Interest - 6. Interest -
7. Depreciation - 7. Depreciation 100
8. Profit (3-4-6-7) 300 8. Profit (3-4-6-7) 200
USCIT = 0.35*(8) 105 USCIT = 0.35*(8) 70
DBCFT = 0.35*(1a-2a-4-5a) (245) DBCFT = 0.35*(1a-2a-4-5a) 105

Scenario B: Firm Borrows to Invest

Year 1: New Investment Occurs Year 2: No Investment Occurs
1. Sales 1,000 1. Sales 1,000
1a. Domestic 1,000 1a. Domestic 1,000
1b. Exports - 1b. Exports -
2. Cost of Goods Sold 400 2. Cost of Goods Sold 400
2a. Domestic 400 2a. Domestic 400
2b. Imports - 2b. Imports -
3. Value Added (1-2) 600 3. Value Added (1-2) 600
4. Labor Costs 300 4. Labor Costs 300
5. Investment 1,000 5. Investment -
5a. Domestic 1,000 5a. Domestic -
5b. Imports - 5b. Imports -
6. Interest - 6. Interest 100
7. Depreciation - 7. Depreciation 100
8. Profit (3-4-6-7) 300 8. Profit (3-4-6-7) 100
USCIT = 0.35*(8) 105 USCIT = 0.35*(8) 35
DBCFT = 0.35*(1a-2a-4-5a) (245) DBCFT = 0.35*(1a-2a-4-5a) 105

For simplicity, we have assumed that the firm starts its operations in Year 1, which is when the initial investment is made, and doesn’t distribute dividends, pay interest or account for capital depreciation until Year 2. Two alternative scenarios are presented, A and B, which assume that the initial investment is financed using 100% equity and 100% debt, respectively.

In contrast to the current U.S. corporate income tax rate, which creates tax obligations for businesses as long as their profits are positive, the DBCFT can generate large tax credits—in other words, negative tax liabilities--in the years when investment occurs, followed by tax obligations in subsequent years. Actually, since the tax credit offsets the present value of future tax payments, the effective tax on new investment is zero regardless of whether the latter is financed using equity or debt. Compare this with the lower tax payments that result under the current U.S. corporate income tax rate when new investments are financed with debt rather than equity. This amounts to a subsidy on debt, which encourages excessive borrowing on the part of U.S. corporations.

Now consider a firm that doesn’t invest, has zero debt, and its real capital is fully depreciated. This implies that investment, interest, and depreciation are zero. We want to compare how the DBCFT performs relative to the U.S. corporate income tax rate under three alternative scenarios: one where the firm doesn’t export or import, which we call C; another where all of the intermediate inputs the firm uses are imported (D); and, finally, one in which all the sales are exports (E). These three scenarios are represented in Table 2.

Table 2: Firm Doesn't Invest, but May Export or Import B: Firm Uses Own Capital to Invest

  Scenario C:
No Exports or Imports
Scenario D:
Full Imports
Scenario E:
Full exports
1. Sales 1,000 1,000 1,000
1a. Domestic 1,000 1,000 -
1b. Exports - - 1,000
2. Cost of Goods Sold 400 400 400
2a. Domestic 400 - 400
2b. Imports - 400 -
3. Value Added (1-2) 600 600 600
4. Labor Costs 300 300 300
5. Investment - - -
5a. Domestic - - -
5b. Imports - - -
6. Interest - - -
7. Depreciation - - -
8. Profit (3-4-6-7) 300 300 300
USCIT = 0.35*(8) 105 105 105
DBCFT = 0.35*(1a-2a-4-5a) 105 245 (245)

While the U.S. corporate income tax rate generates the same tax obligation in all the cases (35% of before-tax profits), the DBCFT is responsible for significant effective tax rate dispersion. Depending on whether the firm is a net exporter or a net importer, the effective tax rate on profits is less than 35%--possibly turning negative--or more than 35%. Only if net exports are zero, the effective rate is 35%, assuming, as mentioned before, that investment, interest, and depreciation are zero. However, this analysis assumes that the nominal exchange rate is fixed, which in the case of the U.S. dollar is not true. When full exchange rate flexibility is taken into account, the conclusions change materially (See related piece on currency movements by Joaquin Cottani).

Effects on Corporate Finance and Investment

In accounting terms, the DBCFT taxes EBITDA (earnings before the deduction of interest, taxes, depreciation, and amortization) while the U.S. corporate income tax rate taxes earnings. However, it is a well-known axiom of corporate finance that investment equals the present value of expected EBITDAs, namely, the latter discounted at a break-even rate that represents the opportunity cost of capital.

Hence, the full deductibility of investment allowed by the DBCFT, coupled with the non-deductibility of interest and dividends, implies that in the long run investment is not taxed at all except for any unexpected or extraordinary profits resulting from it, which economists call rents. In other words, the DBCFT is a tax on corporate rents rather than break-even profits.

This feature of the DBCFT—that the effective long-term tax rate on investment is zero—can also exist in the current U.S. corporate income tax system. But it occurs now only if the investment is debt financed, and it does so through deductibility of interest paid on debt. By contrast, what the DBCFT does is extend the same treatment to dividends and reduce taxes upfront rather than gradually over time through depreciation. In the words of Professor Auerbach, “the government becomes a silent equity partner, sharing equally in investment costs and returns.”

Seen in this way, the DBCFT accomplishes two goals at the same time: it encourages investment and it removes the incentive to finance it using debt rather than retained profits or the issuance of shares. If accompanied as expected by a shift in the tax code from a global to a territorial basis, whereby active foreign-source income of U.S. multinationals would no longer be taxed, the reform would result in the likely repatriation of billions of dollars held by U.S. corporations abroad. There no longer would be any incentive to keep those funds outside the U.S.

Relation to the Value Added Tax

Many countries in the world that have a lower corporate income tax than the U.S. also have a value added tax (VAT), which the U.S. does not have. Despite its name, the VAT doesn’t tax value added but private consumption. Like the corporate income tax, it is contributed by firms although, as with all taxes, the final incidence is shared by businesses and consumers depending on specific market conditions.

An important characteristic of the VAT that makes it easily comparable with the DBCFT is that it allows full deductibility of investment expenses, as well as border adjustment. The latter means that imports are subject to the VAT and exporters are refunded the VAT paid on purchases of intermediate and capital goods. In terms of Tables 1 and 2, the VAT base is (3)-(5)-(1b)+(2b)+5(b), which is the same as the DBCFT base except for the fact that the latter also excludes labor costs, namely, wages and salaries inclusive of payroll taxes. As such, the DBCFT is a tax on non-wage consumption, namely, on consumption out of capital income, which makes it a progressive tax compared to the VAT (see related piece on VAT by Tatiana Lysenko).

Effects on Tax Revenue

The U.S. corporate income tax rate collects around 1.5% of GDP. Considering that corporate profits are 12% of GDP and the tax rate is 35%, this is slightly more than one third of theoretical tax revenues at full collection. On the other hand, private consumption and labor income are 68% and 55% of GDP, respectively, meaning that the potential tax base of the DBCFT (68 minus 55) is about the same as that of the current U.S. corporate income tax system. But since the DBCFT eliminates tax loopholes that exist today and are responsible for the high level of avoidance that characterizes the U.S. corporate income tax rate, it is entirely possible for the DBCFT to raise the same revenue of the U.S. corporate income tax rate despite the reduction in the tax rate from 35% to 20%. For example, the fact that imports represent 15% of U.S. GDP and exports only 12% implies that border adjustment itself would help to have 0.6% of GDP (0.2*0.03) contribute one third of the needed collection.

Differences Between the “Better-Way” and “Modern-Corporate-Tax” Proposals

As mentioned in the introduction, the A Better Way blueprint for corporate income tax reform in the U.S. proposed by Congressmen Ryan and Brady is not exactly the same as the DBCFT outlined by Professor Auerbach in his paper, A Modern Corporate Tax. The latter is a pure destination-based cash-flow tax that covers financial as well as real transactions and ignores transactions that do not occur in the U.S. Thus, sales revenues are taxable if they come from domestic sources; otherwise, they are ignored.

As for borrowing, the Auerbach plan taxes the receipts from borrowing and allows deduction of interest payments. By adopting this plan, the Auerbach proposal is true to the “cash flow” aspect of the DBCFT. Any cash flow that comes into a company, whether it’s from a sale or borrowing or other source, is subject to being taxed. But since interest is a cash flow going out the door, it becomes a deduction.

As far as the Republican proposal, it too attempts to disincentive borrowing. But it does so by not allowing the deductibility of interest payments. It does not go as far as Auerbach in counting the proceeds from borrowing as part of the tax base.

The original DBCFT, as designed by Professor Auerbach, is not only simpler than the current U.S. corporate income tax system; it is also trumps the Ryan-Brady version for simplicity. The tax base is the net of all corporate cash flows regardless of their nature. In other words, every cash receipt is taxed and every cash outlay is deductible as long as they originate in a domestic transaction. The only exception is cash raised through equity issuance.

Potential Pitfalls Going Forward

There are other potential aspects of the proposed reform. For example, since double taxation of returns to capital disappears under the DBCFT, as well as the favorable treatment of debt, is there any basis to continue a separate tax treatment for dividends and capital gains? One of the more radical corporate tax reform proposals that has been discussed would eliminate the corporate income tax completely, and allow dividends and capital gains to be taxed as straight income, thereby leading some taxpayers to face a rate of as much as 39.1%.

As any major tax reform, the shift from the U.S. corporate income tax rate to something based on the DBCFT would create transitional issues. While new investment would be effectively untaxed, existing investments would be taxed more heavily than before, especially if they are highly leveraged, as interest and depreciation deductions are eliminated. This would require that the U.S. implements the reform gradually as a way of providing relief during the transition. In his paper, Auerbach cites the phase-in of some of the key provisions of the 1986 tax reform as an example of how a transition to a DBCFT might be implemented.

Like most academic-based proposals, the Auerbach one is sure to get dissected, beaten on and kicked around. One of the most troublesome: does the allowance of the deductibility of labor costs put it at odds with World Trade Organization provisions that govern Value Added Taxes, which are similar in nature? And would the elimination of taxes on export revenues in something other than a consumption tax also run up against WTO regulations?

Still, the DBCFT’s intellectual basis remains the dominant point of discussion before a Congress that is being looked upon as one that can finally deliver upon the promise of fixing a corporate income tax system that is widely considered broken. Professor Auerbach and his plan are sure to be at the center of the debate.