The Destination-Based Cash Flow Tax Remains a Strong Option for US Business Tax Reform

Few reforms in Options for Reforming America’s Tax Code 3.0: A Policymaker’s Guide to Tax Reform Trade-Offs simultaneously raise revenue and increase the size of the economy. Replacing the business income taxA tax is a mandatory payment or charge collected by local, state, and national governments from individuals or businesses to cover the costs of general government services, goods, and activities. with a destination-based cash flow tax (DBCFT) is one such option. This reform improves the tax baseThe tax base is the total amount of income, property, assets, consumption, transactions, or other economic activity subject to taxation by a tax authority. A narrow tax base is non-neutral and inefficient. A broad tax base reduces tax administration costs and allows more revenue to be raised at lower rates., reducing the business tax’s distortive effects on investment and financing decisions while also curtailing multinational profit shiftingProfit shifting is when multinational companies reduce their tax burden by moving the location of their profits from high-tax countries to low-tax jurisdictions and tax havens..

Tax Foundation estimates that this reform would grow GDP by 1.4 percent in the long run and reduce the 10-year deficit by $3.9 trillion on a dynamic basis, including interest savings.

Table 1. Replacing the Business Income Tax with a DBCFT Would Grow the Economy and Raise Tax Revenue

Note: A negative number is a decrease in the deficit.
Source: Tax Foundation General Equilibrium Model.

What Is a Destination-Based Cash Flow Tax?

A DBCFT makes three changes to the corporate income taxA corporate income tax (CIT) is levied by federal and state governments on business profits. Many companies are not subject to the CIT because they are taxed as pass-through businesses, with income reportable under the individual income tax.: immediate expensing for investment instead of depreciationDepreciation is a measurement of the “useful life” of a business asset, such as machinery or a factory, to determine the multiyear period over which the cost of that asset can be deducted from taxable income. Instead of allowing businesses to deduct the cost of investments immediately (i.e., full expensing), depreciation requires deductions to be taken over time, reducing their value and disco over time, elimination of both the deduction for interest paid and the taxation of interest received, and a border adjustment. Border adjustment can be implemented in several ways, but one approach is to deny the deduction for imported goods and services and exclude exports from taxable incomeTaxable income is the amount of income subject to tax, after deductions and exemptions. Taxable income differs from—and is less than—gross income.  .

This option also integrates the US business tax by replacing the individual income taxAn individual income tax (or personal income tax) is levied on the wages, salaries, investments, or other forms of income an individual or household earns. The U.S. imposes a progressive income tax where rates increase with income. The Federal Income Tax was established in 1913 with the ratification of the 16th Amendment. Though barely 100 years old, individual income taxes are the largest source on non-corporate business income with the same 21 percent tax collected at the entity level for corporations, eliminating the Section 199A deduction in the process. Business tax integration is not inherent to a DBCFT, but it is important to ensure neutrality across business forms. The option also eliminates general business tax credits.

These two parts—a cash flow base and a destination basis—would fix several problems with the current business tax.

Table 2. The DBCFT Is Economically Similar to a Value-Added Tax with Deductible Labor Compensation

Source: Tax Foundation research.

What Does the Cash Flow Base Fix?

The current code taxes businesses on profits they earn as well as, in some cases, the investments they make. The One Big Beautiful Bill Act removed the tax on some types of investment with permanent, immediate deductions for equipment and research, but it left out structures. Structures must be deducted across 27.5 to 39 years, except for qualified production property, which temporarily qualifies for expensing.

Because inflationInflation is when the general price of goods and services increases across the economy, reducing the purchasing power of a currency and the value of certain assets. The same paycheck covers less goods, services, and bills. It is sometimes referred to as a “hidden tax,” as it leaves taxpayers less well-off due to higher costs and “bracket creep,” while increasing the government’s spendin and the time value of money shrink the value of a deduction over time, businesses are unable to deduct the full real cost of what they build, so the business tax falls on the normal return to investment. Expensing drives most of the growth effect of a DBCFT.

The current code is also biased toward debt over equity. Under current tax law, a company that borrows deducts its interest payments, whereas a company that funds the same investment by selling equity cannot deduct its payments to equity (e.g., dividends), making debt an artificially cheaper source of financing for tax reasons alone. Ending the deduction for interest would reduce the bias by increasing the cost of debt financing, making it closer to the cost of equity financing.

What Does Destination-Based Taxation Fix?

Under the current system, corporations have incentives, and some means, to shift profits to low-tax countries from high-tax countries. For example, a company can house its patents in a Bermuda subsidiary, then have its US operation pay large fees for using them, so its US profits are shifted to Bermuda and only taxed there. Transfer pricing rules and economic substance requirements try to limit this practice; nevertheless, tens of billions of dollars in US federal tax revenue are lost due to profit shifting, although exact estimates vary widely.

The border adjustment makes the business tax destination-based and curtails profit shifting because it then taxes only a subset of income attributed to goods and services consumed in the US. Import and export transactions are ignored in the calculation of a business’ taxable income, and therefore many transactions that make profit-shifting possible would no longer be relevant for tax liabilities. Value-added taxes achieve the same result through a tax collected on imports at the border and a refund of tax on exports, and border adjustment could alternatively be implemented in a similar fashion.

Much of the controversy surrounding DBCFT proposals stems from the fact that taxing imports and exempting exports appears to look like a tariffTariffs are taxes imposed by one country on goods imported from another country. Tariffs are trade barriers that raise prices, reduce available quantities of goods and services for US businesses and consumers, and create an economic burden on foreign exporters.. But a tariff taxes imports alone to favor domestic producers, while a border adjustment taxes imports and credits exports equally.

Cheaper exports and costlier imports raise foreign demand for dollars, and the dollar appreciates until the two cancel out, leading to no effect on trade in the long run. The best evidence in favor of long-run trade neutrality comes from value-added taxes, which are border-adjusted and show no effect on trade in the long run.

How Does This Option Address Non-Corporate Businesses?

Leaving the current pass-through regime in place alongside a DBCFT applied only to corporations would invite arbitrage, because the individual income tax on business income would remain origin-based, while the corporate tax would be destination-based. For example, an exporter would prefer to organize as a corporation, because a DBCFT would then exclude its export sales from tax, while an importer would prefer to organize as a pass-through, because then the income tax would still allow a deduction for its imports.

This option applies the border adjustment at the entity level to every form of business, avoiding this problem. Specifically, this option repeals the Section 199A deduction and subjects pass-throughs to a flat 21 percent rate, which is border-adjusted. This change preserves a bias in the tax code against operating as a corporation due to the double taxationDouble taxation is when taxes are paid twice on the same dollar of income, regardless of whether that’s corporate or individual income. of corporate returns at the entity and individual levels via capital gains and dividends. That could be addressed through other reforms, such as integrating the individual and corporate tax systems through a dividend deduction.

Who Ends Up Paying a DBCFT?

A DBCFT taxes a part of consumption that is not financed by wages. Because firms deduct both investment and wages, neither the normal return to capital nor labor income remains in the base. What is left is consumption funded out of existing wealth and rents—such as returns to land, natural resources, and market power.

Replacing the corporate income tax with a DBCFT would be modestly progressive on its own, since wealthier households finance a larger share of their consumption out of non-wage income. However, this option would also replace a progressive individual income tax on pass-through income with a flat 21 percent entity-level tax. On net, the bottom quintile’s income would fall by 5.4 percent while the top 0.1 percent’s income would rise by 2.9 percent, making it more regressive than the border adjustment in isolation.

Table 3. A Corporate Border Adjustment Alone Is Modestly Progressive, While the Full Option Is Regressive

Note: Dynamic distributional estimates show how the after-tax incomes of each group of taxpayers would change due to both direct taxA direct tax is levied on individuals and organizations and is not expected to be passed on to another payer (unlike indirect taxes such as sales and excise taxes), though economic incidence can still fall upon others. Often with a direct tax, such as the individual income tax, tax rates increase as the taxpayer’s ability to pay, or financial resources, increases, resulting in what is called a p changes and indirect economic effects. Despite growing the economy, the full option reduces average after-tax incomeAfter-tax income is the net amount of income available to invest, save, or consume after federal, state, and withholding taxes have been applied—your disposable income. Companies and, to a lesser extent, individuals, make economic decisions in light of how they can best maximize their earnings. due to increased tax collections.

Source: Tax Foundation General Equilibrium Model.

What Implementation Challenges Would a DBCFT Face?

Symmetry. For a DBCFT to be genuinely neutral, it must be symmetric. If a business is taxed at the full rate on gains but is not compensated for losses, the code continues to discourage investment on the margin. Exporters can also run persistently negative liability because of the border adjustment, and neutrality again requires some sort of compensation.

Cutting refund checks to corporations is not practical, so a DBCFT would rely on loss carrybacks and carryforwards, which accrue interest to preserve neutrality. This would create an incentive for persistently unprofitable firms to merge with profitable ones. In practice, though, major exporters also import many inputs, so fewer firms may face persistent negative liability than one might expect.

Currency transition. The exchange rate adjustment that delivers trade neutrality also transfers value to dollar holders and away from those who owe dollar-denominated debt. Markets would begin pricing in the adjustment ahead of enactment as traders buy dollars, and the tax could be phased in gradually to limit the disruption.

Financial institutions. A DBCFT shares a VAT’s difficulty in measuring the base for financial intermediation. DBCFT proposals therefore usually include a separate tax regime for financial institutions.

Trade law. World Trade Organization rules distinguish direct from indirect taxes, and because a DBCFT allows a wage deduction, it would likely be treated as a direct tax—which makes exempting exports a prohibited subsidy. To get around this, lawmakers could enact a VAT paired with an equivalent employer-side payroll taxA payroll tax is a tax paid on the wages and salaries of employees to finance social insurance programs like Social Security, Medicare, and unemployment insurance. Payroll taxes are social insurance taxes that comprise 24.8 percent of combined federal, state, and local government revenue, the second largest source of that combined tax revenue. cut, reproducing the economic effects of a DBCFT while staying within the rules.

Should Lawmakers Adopt a DBCFT?

A DBCFT reduces the tax code’s penalty on investment, narrows its bias toward debt over equity, and removes much of the incentive to shift profits abroad. It raises substantial revenue while increasing long-run output—a rare combination. While lawmakers would need to iron out significant design complexities for a DBCFT to be implemented successfully, the case for a DBCFT tax base is strong, and reforming the business tax code could play a significant role in deficit reduction.

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