Transition to and Tax-Rate Flexibility in a Cash-Flow-Type Tax

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The difficulty of making a transition from an income-type to a consumption-type tax is often cited as an obstacle to such a change in policy. Put simply, the problem is the double taxation of old savings or old capital. A person who has accumulated wealth under an income tax will be hit with an extra tax on the consumption financed by that accumulation under a shift to consumption tax. Such a transition effect raises issues of equity, political feasibility, and efficiency. In the typical implementation of a consumption tax, the same sorts of transition phenomena associated with a shift from an income tax follow from any change in the rate of tax. That is, introduction of a consumption tax is the same as raising the rate of consumption tax from zero to what-ever positive rate is envisioned for the new system. Consequently, the problem of transition to a consumption tax generalizes to the problem of changing the rate of consumption tax. In this paper I consider the design of rules that render consumption taxes in the family of business cash-flow taxes immune to the incentive and incidence effects of changes in rate of tax. I show that two relatively simple approaches are available to deal with it: grandfathering the tax rate applicable to a given period's investment or substituting depreciation allowances for the usual expensing of investment, coupled with a credit for the equivalent of interest on the undepreciated investment stock. A cost of this approach is its requirement to identify true depreciation and, in the second case, the real rate of interest.