VoxEU Column International trade Taxation

Understanding the destination-based approach to business taxation

The rising importance of multinational companies and the changing nature of production represents a challenge to the traditional ways that countries try to tax corporate profits. This column examines one potential policy response – a destination-based cash-flow tax – which it argues would confront the key international problems of existing tax systems. It also addresses some of the concerns arising in particular from US proposals to introduce such a tax.

The rising importance of multinational companies and the changing nature of production, in particular the growing dependence on intellectual property, represents a challenge to the traditional ways that countries try to tax corporate profits, because the concepts on which tax systems typically rely, such as corporate residence and the location of profits, have become less well defined and more responsive to cross-border tax incentives.  One clear result of the changing landscape has been intense tax competition in the form of a steady decline in headline corporate tax rates, shown in Figure 1 for the G7 countries and Ireland, a country often cited in discussions of tax competition.

Figure 1 Statutory combined corporate income tax rates for the G7 countries and Ireland, 1990–2017

Source: OECD tax database.

This decline in tax rates is all the more remarkable in having occurred in the face of calls to confront rising inequality with more progressive taxation, and has also prompted additional policy responses.  Many responses have been of a legalistic nature, trying to make existing tax systems work.  Important examples include the Obama administration’s measures to erect tighter rules against corporate inversions and the European Commission’s attempts, through its Directorate-General for Competition, to force US multinationals to pay more taxes to EU member countries with favourable tax regimes, such as Ireland, Luxembourg, and the Netherlands.  But the underlying problems of existing systems are very large, and it is hard to see such initiatives, which also include the OECD’s recent Base Erosion and Profit Shifting project, as adequate.  For example, by one recent estimate (Guvenen et al. 2017), profit shifting by US multinationals, and the associated overstatement of net US imports, accounted for more than half of the official 2012 US trade deficit.  

Moving to a destination-based cash-flow tax

An alternative approach has been to identify fundamental tax reforms that can deal more adequately with the new economic realities.  One such approach builds on the concept of business cash-flow taxation, first proposed in the late 1970s by the Meade Committee (Institute for Fiscal Studies 1978).  Originally conceived as a tax on the cash flows of domestic producers (an ‘origin-based’ tax), the cash-flow tax had many potential benefits, including eliminating the tax on normal returns to new investment, removing tax-based incentives for corporate borrowing, and eliminating the need to measure income of companies with complex business arrangements.  But this standard cash-flow tax leaves in place the pressure for international tax competition via incentives for companies to shift the location of profitable activities and reported profits to low-tax countries.  This shortcoming led to consideration of a destination-based cash-flow tax (DBCFT), which adds ‘border adjustment’ to cash-flow taxation and has the effect of basing the tax on the location of consumers rather than on the location of profits, production, or corporate residence.

As described in a series of papers, including Auerbach (2017), converting an origin-based cash-flow tax into a destination-based cash-flow involves relieving tax on export revenues and imposing tax on imports, in precisely the same manner as is done under existing value-added taxes (VATs).  The key difference from a VAT is that the DBCFT maintains the income tax deduction for wages and salaries, and thus amounts to a tax on domestic consumption not financed by labour income, in principal a much more progressive tax than the VAT.

The DBCFT confronts the key international problems of existing tax systems. 

  • First, it removes corporate residence as a determinant of tax liability, which would eliminate the incentive for corporate inversions currently being driven by the US approach of taxing the foreign-source income of its resident companies (and hence primarily a US problem). 
  • Second, because transactions with related foreign parties would be ignored by the tax system (the border adjustment offsetting any domestic tax on receipts or deduction of expenses associated with cross-border transactions), there would be no incentive to manipulate internal transfer prices to shift profits from a high-tax country, either through overstating the cost of imports from related foreign parties or by understating the value of exports. 
  • Finally, because the border adjustment would have the effect of imposing a tax based on where products are sold, rather than on where they are produced, the DBCFT would eliminate any tax on business profits generated by producing in a country that adopts it. 

Note that all of these effects of the DBCFT are independent of the tax rate adopted under the new system.  As such, it would remove the incentive to compete over tax rates.

DBCFT adoption would need to confront many technical issues, including potentially persistent tax losses on the part of exporters (whose domestic costs would be fully deductible even as their export revenues were relieved of tax), the need to deal consistently with non-corporate businesses, and constructing an appropriate tax regime for financial institutions.  While these issues are important, potential solutions exist, and it is primarily with respect to other issues that concerns have arisen, particularly after a version of the DBCFT was proposed by the Republican leadership in the US House of Representatives (Tax Reform Task Force 2016).

WTO objections

Border adjustment, as part of a VAT, is practiced around the world and is not a WTO violation.  Cuts in broad-based domestic payroll taxes are not generally considered problematic, nor are corporate tax rate reductions. However, many trade policy analysts have suggested that the DBCFT—a policy that is equivalent to the combination of these three policies, replacing corporate income taxes with a border-adjusted VAT plus a reduction in payroll taxes—may violate WTO rules and could be struck down if another country challenged it (e.g. Schön 2016).  Even though such objections lack any economic basis, concerns about a challenge may be real, particularly because adopting the DBCFT would put considerable pressure on other countries to modify their own tax systems.  If a large country like the US adopted the DBCFT, thus eliminating any tax penalty on locating profits there, this would encourage companies to move production and shift profits to the US from any countries still imposing corporate income taxes based on the location of production.

This concern is an argument for pursuing a multilateral approach to tax reform, but also for seeking ways of characterising the DBCFT that could achieve consistency with the formalistic WTO rules (e.g. Grinberg 2017).

Tax revenues

Some proponents of the DBCFT cite as an advantage the tax revenue it could generate for countries that, like the US, have large current trade deficits, because border adjustments amount to a tax on net imports.  This has provoked criticism that (1) the trade deficit might shrink immediately in response to the DBCFT; and (2) even if the trajectory of the trade deficit is unchanged, the long-run constraint on trade deficits suggests that the present value of such deficits is zero, or perhaps even negative for countries already having a negative international investment position.

The first of these criticisms ignores the fact that one wishes to compare the revenue raised under a new system to that under the old system, and therefore it is the trade deficit under current law that is relevant to calculating the impact of a border adjustment.  The second criticism ignores the fact that the constraint on a country’s ability to run trade deficits on a permanent basis is relaxed where (as suggested above to be the case for the US) a large share of the trade deficit arises from inflated net imports that in turn generate inflated related-party profits in other countries.  Such effects offset each other in a country’s current account and have no impact on its international investment position, and therefore are presumably indefinitely sustainable.

Exchange rates, trade, and asset revaluations

There is little doubt that a large border adjustment can lead to large real exchange rate responses, through some combination of nominal exchange rate appreciation and domestic price and wage increases.  Under simplifying assumptions, the Lerner symmetry theorem predicts that such responses should neutralise any effects on trade.  But there are many possible complications to the analysis, such as the responses of other countries, the perceived permanence of the tax reform, and stickiness in the pass-through mechanism relating exchange rates to relative prices.  Several papers have recently considered the possible importance of such complications.  One may hope that work in this area will progress in incorporating more of the relevant features of the DBCFT as well as its possible short-term transition provisions.

As to the asset revaluations that might occur, most obviously if a country’s currency appreciation reduces the wealth of its residents holding assets denominated in foreign currencies, one must keep in mind that such effects mirror the effective wealth reduction that occurs under adoption of a VAT, where the real value of such assets falls in terms of domestic purchasing power.  Such effects occur whether adjustment to the DBCFT is through domestic price increases or nominal exchange rate appreciation, and should not be seen as an incidental or unintended effect of the reform. 


Auerbach, A J (2017), “Demystifying the Destination-Based Cash-Flow Tax”, NBER Working Paper no. 23881, forthcoming in Brookings Papers on Economic Activity.

Grinberg, I (2017), “The House GOP Blueprint Can Be Drafted to Comply with WTO Rules”, Working paper.

Guvenen, F, R J Mataloni Jr., D G Rassier, and K J Ruhl (2017), “Offshore Profit Shifting and Domestic Productivity Measurement”, NBER Working Paper no. 23324.

Institute for Fiscal Studies (1978), The Structure and Reform of Direct Taxation, London: George Allen & Unwin.

Schön, W (2016), “Destination-Based Income Taxation and WTO Law: A Note”, in H Jochum, P Essers, M Lang, N Winkeljohann, and B Wiman (2016), Practical Problems in European and International Tax Law: Essays in Honour of Manfred Mössner, Amsterdam: International Bureau for Fiscal Documentation.

Tax Reform Task Force (2016), “A Better Way: Our Vision for a Confident America”, Washington: U.S. House of Representatives.

5,564 Reads