The X Tax in the World Economy
byDavid F. Bradford, Princeton University,
New York University, NBER, CESifo
CEPS Working Paper No. 93
August 2003

This paper is a synthesis of two other papers: “Blueprint for International Tax Reform,” prepared
for the Brooklyn Law School International Tax Policy Symposium, “International Tax Policy in
the New Millennium,” November 9-10, 2000, and published in Brooklyn Journal of InternationalLaw, (XXVI-4) 2001, pp. 1449-1463, and “Addressing the Transfer-Pricing Problem in an
Origin-Basis X Tax,” forthcoming in International Tax and Public Finance. I would like to thankReuven Avi-Yonah, Charles Berry, Yariv Brauner, Daniel Frisch, William Gentry, Harry
Grubert, Jim Hines, Stuart Leblang, Lawrence Lokken, Paul McDaniel, Jack Mintz, Satya
Poddar, James Poterba, Daniel Shaviro, Peter Sorensen, John Steines, David Weisbach, George
Zodrow and two anonymous referees for thoughtful comments and discussions of the issues.

Abstract
This paper explores how the tax design called the X tax could alleviate thecomplexities and avoidance opportunities plaguing the existing U.S. system for taxing
international business income. In addition to laying out the general efficiency, equity andadministrative characteristics of an X tax, the paper considers, in particular, thefundamental choice between two treatments of transborder business transactions – theorigin and destination principles. The destination-principle approach sidesteps the need
to identify arm’s length terms of transborder transactions between related business
entities – the transfer-pricing problem. This problem remains in the origin-principle
approach, which, however, presents fewer challenges of monitoring the flow of goods
and services across borders, obviates what I call the “tourism problem” whereby people
can reduce their taxes by consuming in a low-tax jurisdiction and, arguably mostimportant, avoids transition effects associated with introduction of the tax and subsequenttax rate changes that occur in the destination approach. To obtain the advantages without
the principal disadvantage, I suggest special rules for transborder transactions between
related parties that would eliminate the transfer-pricing problem in an origin-based
system.

Author address:
Woodrow Wilson School
Princeton University
Princeton, NJ 08544-1013
bradford@princeton.edu

JEL Nos. H200, H250, H870

Outline
ABSTRACT ................................................................................................................................................... IINTRODUCTION ........................................................................................................................................ 1
THE X TAX IN AN INTERNATIONAL SETTING ................................................................................ 3
BASIC X TAX STRUCTURE .......................................................................................................................... 3
EXTENSION TO AN INTERNATIONAL SETTING ............................................................................................. 5
Two General Approaches: Origin- and Destination-Based Taxes ...................................................... 6
Economic Equivalence between the Approaches: The Basics ............................................................. 7
Supernormal Returns, Measurement Issues and Transfer Pricing Problems..................................... 10
ADMINISTRATIVE PROPERTIES........................................................................................................ 17
FINANCIAL TRANSACTIONS EXCLUDED FROM THE BASE .......................................................................... 17
RESIDENCE OF FIRMS................................................................................................................................ 18
DOUBLE-TAXATION AND THE CREDITING OF FOREIGN TAXES ................................................................. 19
DOMESTIC VS. FOREIGN SOURCE .............................................................................................................. 22
SOME OTHER ISSUES THAT GO AWAY ..................................................................................................... 22
EFFICIENCY PROPERTIES................................................................................................................... 23
GENERIC EFFICIENCY FEATURES OF THIS TYPE OF TAX ........................................................................... 23
FEATURES RELATING TO THE INTERNATIONAL CONTEXT ........................................................................ 24
Neutrality With Respect To Location of Production ........................................................................... 24
Neutrality With Respect To Location of Consumption?...................................................................... 26
EQUITY ISSUES ....................................................................................................................................... 28
GENERIC DISTRIBUTIONAL FEATURES OF THIS TYPE OF TAX ................................................................... 28
SPECIFIC FEATURES OF THE INTERNATIONAL VERSION ............................................................................ 29
Inter-Nation Equity ............................................................................................................................. 29
Equity Aspects of the Tourism Problem.............................................................................................. 30
TRANSITION AND TAX RATE CHANGES OVER TIME................................................................. 31
GENERIC FEATURES OF TRANSITION TO THIS TYPE OF TAX ...................................................................... 32
The Tomato Juice Problem ................................................................................................................. 32
Using Income-Style Accounting to Avoid the Problem....................................................................... 34
SPECIFIC FEATURES OF THE INTERNATIONAL VERSION ............................................................................ 36
The Fundamental Problem of Rate Changes in a Destination Tax .................................................... 36
Coordination of Tax Systems in a Transition ..................................................................................... 40
A REMEDY FOR THE TRANSFER-PRICING PROBLEM IN AN ORIGIN-BASED X TAX ....... 41
CASH-FLOW ACCOUNTING FOR FOREIGN SUBSIDIARIES: THE DOMESTIC INSTALLMENT-SALE ANALOGY................................................................................................................................................................. 42
APPLYING THE APPROACH TO MULTINATIONAL CORPORATE FAMILY MEMBERS .................................... 43
The Use of Basis ................................................................................................................................. 45
Mark to Market? ................................................................................................................................. 47
Treatment of Loans and Transition .................................................................................................... 48
CONCLUSION........................................................................................................................................... 48
REFERENCES ........................................................................................................................................... 51

The X Tax in the World Economy
David F. Bradford*
Introduction“X tax” is the name I have given to a system intended replace the income tax on
corporations and individuals in the United States (Bradford 1986, 1996a). Like thepresent system, it is based on a combination of company and individual taxation. It
differs from the present system in two related respects that it shares with several othertax-restructuring plans: First is a tightly coordinated treatment of the tax base ofcompanies and the earnings of workers. Second, in determining the company level tax
base and in motivating the form of integration of company and worker taxation,
consumption replaces the accrual income ideal that, in principle, underlies so much of thepresent tax design.
These features make possible substantial simplification of the tax system andneutrality of taxation to decisions about how much, where and in what form to invest. It
would arguably be broadly similar to the present system in the scope it allows for
progressivity.

*

Princeton University, New York University, National Bureau of Economic Research,
CESifo. This paper is a synthesis of two other papers: "Blueprint for International Tax
Reform," prepared for the Brooklyn Law School International Tax Policy Symposium,"International Tax Policy in the New Millennium," November 9-10, 2000, and publishedin Brooklyn Journal of International Law, (XXVI-4) 2001, pp. 1449-1463, and“Addressing the Transfer-Pricing Problem in an Origin-Basis X Tax,” forthcoming inInternational Tax and Public Finance. I would like to thank Reuven Avi-Yonah, Charles
Berry, Yariv Brauner, Daniel Frisch, William Gentry, Harry Grubert, Jim Hines, Stuart
Leblang, Lawrence Lokken, Paul McDaniel, Jack Mintz, Satya Poddar, James Poterba,
Daniel Shaviro, Peter Sorensen, John Steines, David Weisbach, George Zodrow and two
anonymous referees for thoughtful comments and discussions of the issues.

2
My main object in this paper is to consider the options for incorporating into a
U.S. X tax transactions that cross national boundaries. I also consider the neutrality andequity properties of the worldwide use of national X taxes, such as might result from a
broader program to transform the international system of company taxes and their links.
In the interest of stimulating discussion and reflection the paper takes a broadbrush approach. The material represents an extension of ideas I have developed in aseries of previous publications. That my principal research focus is now elsewhere is my
excuse for the unsystematic quality of my citation of the work of others but extensive
citation of the relevant previous works of mine (many of which are collected in Bradford
2001). With apologies, I do not attempt to credit comprehensively the sources fromwhich I have learned about all of this or to which I may implicitly respond.
With the same justification, I touch lightly, if at all, on a host of importantpractical and political dimensions of the international tax dilemma. Perhaps the mostimportant matter to which I give only the briefest attention is the problem of coordination
with the tax systems of other countries that would arise if the regime of taxation
presented here were to be adopted by the United States. The transition to such a regime
would raise many questions as to its impact on other countries that did not adopt a similar
approach and, more generally, with respect to obligations under treaties coveringinternational trade and taxation. Although I suggest below that some of these problems
may be less serious than commonly assumed, no doubt I am missing many other issues,
an omission for which I beg indulgence.
A standard approach to this subject would be to lay out a set of criteria that the
proposed system should strive to fulfill – a set of questions to which the proposed system3is the answer. In the interest of moving briskly to the concrete, I propose, instead, to givethe (partially specified) answer – the X tax – and then work back through some of theimportant questions.
The X Tax in an International Setting
An X tax is a variant of the Hall-Rabushka (1995) Flat Tax, an example of what I
have called a “two-tiered consumption tax” (Bradford 1986). In the interest of making
this paper reasonably self-contained, I present here a brief description that neglects
matters such as treatment of governments, charitable contributions, and the like.
Basic X Tax Structure
An X tax consists of two components: a business tax and a compensation tax.
Under the business tax, all businesses (regardless of legal form) are liable for tax at asingle rate on the difference between proceeds from sales and purchases from otherbusinesses. (I mention a qualification to this description below.) In addition, payments
to workers are deducted. Except as they are also businesses, individuals are taxed only
under the compensation tax, the base of which consists of payments for labor services.
Unlike the business tax, the compensation tax is levied at graduated rates, with a zerobracket amount and some set of higher rates on larger amounts received, up to a top ratethat is the same as the business tax rate. In addition, there could be an earned income tax
credit, as under the current system.
Importantly for ease of administration, financial transactions are excluded fromboth business and compensation tax bases. In the ordinary case, transactions such as
borrowing and lending, issue and repurchase of stock, payment and receipt of dividends,
and the like, do not enter the calculation of the taxable base. In the helpful terminology

4of the Meade Committee (Institute for Fiscal Studies 1978), this is an R-Base (“real”
transactions, as opposed to “financial” transactions) tax. (Financial institutions present
special problems, which I neglect in this paper. For some details and some possible
solutions to those problems, see Bradford 1996b.)
The idea would be to adjust these parameters to raise the needed revenue andachieve the desired degree of progressivity of the system. This is not the context inwhich to develop what might be required to mimic the present system's progressivity. To
have something concrete in mind, however, I would guess we could approximate theprogressivity of the current U.S. income tax system with a rate of business tax of 28-30
percent, which would also be the top rate of compensation tax.
If we neglect the deduction of payments to workers, the business tax componentof this system constitutes, in the jargon of the tax trade, a value-added tax of theconsumption type, implemented by the subtraction method. This is a great help tothinking about the links among tax systems in a world of national X taxes. For, provided
the rate of tax is the same and neglecting administrative details, a value-added tax of thesubtraction type is essentially equivalent to a value-added tax of the invoice-and-credit
type, a tax institution with which there is a great deal of experience.
Under the invoice-and-credit method, the selling firm pays a tax on all sales,
noting the amount of tax on the sales invoice. A taxable firm making a purchase isallowed a credit against tax liability of the amount of tax shown on the invoice. The
effect is that a sale from one business to another gives rise to simultaneous payment oftax by the seller and equal credit against tax for the buyer. There is no net tax paid to thegovernment until the point of sale to a buyer other than a taxable firm, generally the5public. The invoice-and-credit method value-added tax thus gives rise to exactly thesame flow of revenues to the government as does a subtraction-method value-added tax
or a retail sales tax, with the proviso that the same goods and services are subject to tax at
the same rate.
The fact that an X tax allows a deduction for payments to workers (taxed
progressively via a graduated rate schedule at the individual level) and would presumably
include an earned income tax credit does not fundamentally change the story from an
economic perspective, even though it may do so from a legal perspective. The system
can be understood as a subtraction-method value-added tax, combined with a system oftransfers based on earnings for purposes of adjusting the vertical distribution of net
burdens (Bradford 1987).
Extension to an International Setting
The building blocks of an X tax are business firms. We can think of it as a tax
that consolidates transactions among some set of companies, with the base consisting of
the net flows of goods and services from that set of companies. In principle, there isconsiderable room for choice about the exact definition that places a company within or
outside the taxable circle. For present purposes, however, I imagine rules rather like theones now used to determine the liability for value-added taxes (Lokken, 2001, provides a
discussion). Given such conventions, no distinction is made between domestic andforeign companies. All companies operating in the United States, for example, aretreated alike.

6
Two General Approaches: Origin- and Destination-Based Taxes
In general, in the purely domestic context, a sale from a company to a customerthat is not another company is subject to tax, and a purchase from a customer that is notanother company is not deductible from the tax base. In the international setting,however, there are two main options for the treatment of transactions with customers("sales to abroad") and suppliers ("purchases from abroad") who are in another tax
jurisdiction. (McLure 1987; Tait 1988)
Under most value-added tax systems, no tax is charged on exports, that is, sales toabroad; imports, purchases from abroad, are subject to tax. Not charging value-added tax
on exports corresponds to excluding sales to abroad from the X-tax base (so they are notsubject to current tax). Corresponding to charging value-added tax on imports is denying
a deduction for business purchases from abroad in the X tax. (Throughout, this paper
presupposes that imports run through domestic companies. Consistent treatment of direct
imports by individual consumers, e.g., returning tourists or direct sales over the Internet
or by mail order, would call for appropriate institutional details that I leave largely
unspecified.) The result is a "destination-based" tax, the idea being that the tax is basedon the aggregate value of goods and services consumed in the country in which it islevied. Sales destined for another country are excluded from the base of the exporting
country; imports destined for a country are included in the importing country's base.
The alternative is to include in the domestic business tax base sales to abroad andto allow a deduction for purchases from abroad. The result is an "origin-based" tax, theidea being that the tax is levied on the aggregate value of goods and services produced in
the country in which it is levied.

7
Understandably, these two approaches seem very different to the lay person. In
view of the strong equivalence between these two forms of tax, however – they are
economically essentially the same – it is clear that we must be careful in basing intuitions
on the destination and origin labels. Distinctions between the two approaches
encountered in policy debates, especially regarding effects on exports, are often wrong(Feldstein and Krugman, 1990).
Economic Equivalence between the Approaches: The Basics
A numerical illustration will remind readers of the sense in which the two
approaches are economically equivalent. Suppose the world consists of two countries,
the United States and France, between which trade is currently and has in the past been
exactly balanced (so the value of goods and services exported from the one exactly
equals the value of goods and services imported in return, period by period). Bothcountries produce a basic consumption good, say corn, which sells for $1 per bushel. In
addition, computers are produced in one of the countries, say the United States, selling
for $1000 each.
In the illustrative equilibrium, 1m of the computers are sold by U.S. companies tobuyers in France for a total value of $1b. Companies in France export to U.S. companies
1b bushels of corn at $1 each. The United States has an origin-based X tax (so with noadjustment at the border) with a business tax rate of 25 percent. For purposes of this andother such exercises in this paper, we can ignore the compensation tax or assume it islevied on all earnings at the business tax rate and withheld by the companies. So thesituation is transactionally equivalent to a 25 percent value-added tax of the consumption
type.

8
Suppose in the illustrative situation computers are produced without any inputs oflabor or other materials. The tax paid by the computer sellers on their export sales is$250m and the owners of the companies get to keep $750m. The outlay of $1b for theimport of corn by relevant companies gives rise to a deduction of $1b and the resale to
U.S. customers to an inclusion of $1b for no net tax. In France, let us suppose, there isno company tax; the $1b paid for the corn is paid in turn to owners of farms, to French
workers and perhaps to the French government (in taxes on owners and workers), whotogether spend a total of $1b for the imported corn.
In the alternative case, suppose that the United States employs a destination-based
tax. That is to say, firms are allowed to exclude the export sales from their X-tax
calculations but may not deduct the amount paid to foreign suppliers for imports. The setof prices in the United States and France that we stipulated to prevail in equilibrium
under the origin-based tax cannot characterize equilibrium under the destination-based
tax. Under the former set of prices, exporting computers from the United States toFrance would be highly profitable (which is why people naturally think that a shift tosuch a tax would stimulate exports), while the U.S. importer of corn would suffer losses.
We can, however, readily specify other sets of prices that will, give rise to exactly thesame activities as we observed in the origin-based tax world.
For example, if the price level (not just the price of corn) in France were lower by
25 percent, the former equilibrium conditions would be realized. In that case, the price ofa bushel of corn in France would be $0.75, instead of $1.00. A computer would sell for$750, instead of $1000. Unspecified in the example, the nominal wage in France would
have to be lower, too, by 25 percent, so the real wage rate would be the same in the two

9situations. We know that, with these prices, the French farmers will happily supply thesame quantity of corn to the U.S. companies as in the former case, and that U.S. demandfor French (plus U.S.) corn would be the same, because $0.25 per bushel in tax is added
to the price in the destination-based system. The U.S. computer makers are happy toaccept the $750 offered by the French buyers, even though computers still sell for $1000
in the United States, since the sale is not included in the X tax base and hence yields thesame amount as a domestic sale after the $250 tax. The U.S. Treasury still collects $2.5b
in tax; owners of U.S. computer companies still get $7.5b in earnings that they can still
spend on computers and corn at the original terms.
Note that, in view of the equivalence between the outcomes in these twosituations, we would want to describe them in international trade statistics as being thesame. This would be accomplished by measuring both exports and imports, not at what
the U.S. exporter or importer receives or pays, but at their value in the U.S. market.
Under the origin-based tax system, these two are the same but in the destination-based
system, they differ by the applicable U.S. tax.
In this example, I used a lower price level in France to generate the economic
equivalence between the two tax regimes. I could as readily have used a higher pricelevel in the United States. Alternatively, some readers may find it easier to think of avariation in the exchange rate between different currencies used in the two countries,
with no difference in the general price levels between the two tax regimes. So, suppose
under the initial, origin-based situation, one dollar ($1) buys ten French francs (Ffr 10).
Computers sell for Ffr 10,000 each and corn for Ffr 10 a bushel. If, in the alternative, theUnited States has a destination-based tax, all of the real opportunities in the system are

10
the same if the exchange rate is Ffr 13.33 to the dollar (13.33 less 25 percent of 13.33
equals 10). The exporter of a computer from the United States receives Ffr 10,000,
which he exchanges for $750. Since this sale is not subject to tax, the exporter keeps thewhole amount; the after-tax result is the same as for a $1000 sale to a domestic customer.
The U.S. importer of a bushel of corn pays $.75 at the 13.33 to 1 exchange rate. Whenthe bushel is sold for $1 there is no deduction, so $.25 in tax is paid; the net proceeds justcover the cost of the import.
The point to take away from this exercise is the basic economic equivalence ofthe two approaches once in place and with the same tax rate when prices are determinedat arm’s length. The choice between these two rules for treatment of trans-border salesdoes, however, have important implications, mostly relating to transitional incidence andincentives but also relating to administrability, especially in situations with transactions
across borders among related companies.
Supernormal Returns, Measurement Issues and Transfer Pricing Problems
A key feature of the system contributing to its properties is its grounding in cashflow accounting for sales and purchases of goods and services only (with, in general,
exclusion of financial transactions from the tax base). In the standard subtraction-method
value-added tax, all that is required to calculate a firm's tax base is cash-flow information
about real transactions – sales less purchases from other businesses. It is important tonote here that, for reasons that are briefly sketched below in connection with transition in
the international context, I have come to the conclusion that a modification to thisaccounting system, to provide instead for something like conventional business income
accounting for "real" business assets (inventories, equipment, structures, land, etc.),

11
would ameliorate – in principle, eliminate – incentive and incidence effects of tax ratechanges. To keep the consumption-tax economic properties of the system, a deduction
would be provided for the current cost of capital, calculated as the product of an
appropriate interest rate and a company’s basis in real business assets (Bradford 1998).
(To be clear: No deduction is allowed for interest expense.)
Maintaining the consistency of ignoring financial transactions is important, since
the major simplifications achieved by the X tax are due to the fact that financialtransactions are excluded. This eliminates a host of intractable problems in the world offinance (Bradford 1995). For ordinary business tax accounting, it means no inclusion ofinterest or dividends received (and thus no rules to distinguish between them), no
deduction for interest paid, and myriad related changes in accounting, eliminating anequally large host of tax complexities. To mention one prominent problem that would
disappear: No special rules are required for capital gains. Business assets are taxed on a
cash-flow basis (perhaps as modified per my remarks above); transactions in financial
assets and liabilities, and associated financial flows, such as payments of dividends andinterest, are out of the base.
These administrative advantages extend to the international version of the system.
New administrative problems are, however, introduced by the border adjustment in thecase of the destination-based system. The exclusion of sales to abroad requires
monitoring methods to assure that the payments in question really come from foreignpurchasers (rather than domestic consumers). The disallowance of deduction forpurchases from abroad requires monitoring incoming travelers at the borders (since it has
the effect of subjecting imports to tax), as is done by customs inspectors at present.

12Different from import tariffs, however, is the treatment of imports by businesses; since adenial of a deduction is involved, there is no need to monitor business imports. Thismight be implemented by requiring businesses to justify deductions by providing the tax
identification numbers of suppliers; a foreign supplier would not have a U.S. tax
identification number (Lokken 2001).
The disadvantage of monitoring the border is offset by a major plus of adestination-based tax, its elimination of the transfer-pricing problem. The need to value
purchases and sales among related domestic and foreign companies is a perennial
problem in the existing income tax. The problem is greatly magnified by the evergrowing importance of intangible property in the generation of profit and the rapid
growth of intra-firm trade (Gordon and Hines 2002). Since the proceeds of a sale to aforeign customer are not in the destination-based X tax base, the price that related
partners may use to account for the transaction has no impact on the tax base. The same
holds for an import from abroad. The price does not matter because there is no
deduction.
Under the origin-based system, by contrast, there is no need to police the borders
for imports (apart from customs requirements). This property becomes especially
important when we take into account the possibility that consumers may cross borders to
do their consuming. I call this the “tourism problem," with the caveat that the term mayseem to imply it is confined to cross-border shopping on temporary excursions. It applies
as well to the situation of a U.S. individual who times consumption to take place in a
low-tax jurisdiction – for example, during retirement years – and thereby avoids the tax

13that would fall on a person who remained in the United States. The price of avoiding theneed for monitoring the borders is, however, to bring back the transfer-pricing problem.
To illustrate some of these points in our abstract international economy, we needto change the stipulated facts. We can, for example, add capital transactions – a U.S.
investor might lend $1m to a French borrower. To postpone dealing with time more
systematically, suppose the loan and repayment (without interest, because the time is so
short) occur between 8:00 am and noon of the one day in the model. Such financialtransactions are ignored in the X tax so this round trip transaction would have no tax
consequences, direct or indirect. A slightly more interesting transaction could, however,
have indirect tax consequences: The U.S. lender agrees to accept in repayment theoutcome of a $1m bet in the French stock market, which is open from 8:00 am until noon.
At noon, the financial arrangement is wound up, with the U.S. investor having made aprofit or a loss, relative to the $1m put up at 8:00 am. This result will ultimately – forillustrative purposes, I am assuming immediately – result in an increase (if the investment
is a winner) in imports to the United States from France, or a decrease (if the investment
is a loser). In a destination-based tax, the result is a change in U.S. tax revenues, since
imports are not deducted but sales to the public (which are affected) are subject to tax. In
that world, the U.S. fisc shares in the fortunes of U.S. financial investments abroad (since
they affect consumption in the United States). In the origin-based system, the changes insales to the public that result from the working out of the illustrative financial position
are matched by changes in deductions for imports, so there are no indirect tax
consequences.

14
The expected return on a financial investment will generally embody a risk
premium (which, as illustrated by insurance, could be negative). In the example, it may
be that the expected payoff to the financial investment in France (net of the invested
amount) is positive and we might say it incorporates the expectation of a “supernormal
return.” This expected supernormal return is subject to U.S. tax indirectly, if the system
is on a destination basis. It is ignored if the system is on an origin basis. There is,presumably, no policy significance to the tax difference in this case. The U.S. tax stakein the foreign investment simply compensates for the portion of the risk taken on by the
U.S. fisc. (For a discussion of the general issues involved see, for example, Kaplow
1994, Bradford 1995 or Zodrow 1995).
A different form of “supernormal return” is at issue in the classic transfer-pricing
situation. To adapt our illustration for the purpose, suppose the patent for producing thecomputers in our example is owned by a U.S. company. Since a computer sells for$1000, and all that is required to produce one is the patent right, that right will also sell
(at arm’s length) for $1000. Now, instead of having the U.S. company export computers,
suppose it exports to a French company the rights to produce 1 million computers for alicensing fee of $1000 per unit. In this fact situation, the tax consequences and exchange
rate or price level outcomes under the alternative regimes are the same as in the earlier
example of the export of computers from the United States, simply substituting U.S.
export of license rights (a “service”) for export of computers.
If the licensing transaction as described is at arm’s length, that is, between parties
with opposing interests in its terms, this example presents no fresh administrative
problems. New issues may arise, however, if, as is typical, the payoff to the licensor

15
were to take the form of a share of the profits from the sale of computers by the French
licensee, or a royalty per unit sold in the future. What I, at least, think of as theconceptually “correct” accounting for this transaction would be to value the sale oflicense rights at $1b, which is of direct tax consequence only in the origin-based system.
The subsequent actual payoff to the U.S. owner of the rights would be treated as afinancial transaction, with no direct tax consequences in either system. In the case of anuncertain return, the indirect tax consequences of the financial portion of the transaction
would be different under the origin- and destination-principle regimes, as discussed
above.
But the actual terms of the transaction may not reveal this conceptually correct
amount. Using as an alternative the cash-flows attributable to the licensing arrangement(royalties), for example, will give a different result. (If one can ignore timing issues, thetax consequences of this approach will be an economically equivalent result if thearrangement is at arm’s length.) There are no direct tax consequences, in any case, in thedestination-based system; in the origin-based system, the direct tax liability will be
proportional to the payment, of whichever form. In particular, the risky form may
include a “supernormal return” element.
Where, however, the French company is, in fact, owned by the U.S. computercompany, the licensing transaction is functionally internal to the firm, whatever may be
the legal structure of the companies. In the origin-based system, the terms of thetransaction matter. Now there are two problems. The first is converting the possibly
contingent terms of the transaction (for example, a royalty per computer) into thearguably correct equivalent certain current amount. This is no different from the same16
problem for arrangements reached at arm’s length. Much more serious, and also
sometimes described as involving supernormal returns, is determining appropriate arm’s
lengths terms, whatever their form. Since the transaction is effectively within a single
entity, its terms on the books of the two nominally separate companies are referred to as“transfer prices.” Because transfer prices need have no significance apart from their use
in determining tax or other regulatory consequences, they can and will be adjusted to
optimize those consequences. The check on this optimization in the tax context is torequire the prices, or the terms of transactions more generally, to be those that would bereached at arm’s length. If the two companies are dealing in bushels of corn, it is astraightforward matter to determine the requisite arm’s length prices. When, however,they are dealing in complex goods and services, as in the example of a license to sell aparticular form of computer, the arm’s length standard leaves a very wide range of choicefor the taxpayer companies. (Because the economic justification for ownership extending
across national borders may be synergies internal to the firm, arm’s length terms may noteven be well defined.) This is the transfer-pricing problem in tax administration.
To illustrate, suppose the U.S. parent knows that computers can be sold for $1000
but this is not a fact easily discerned by the tax authorities. The U.S. parent therefore
licenses the wholly owned French company to sell computers for a royalty of $500 per
computer, or $0.5b for the run of 1m computers in the illustrative transaction. In a
destination-based U.S. tax system, these terms are of no significance, since the sale ofservices to the foreign company are not taken into tax directly. The payoffs to suchforeign investments are, however, reflected indirectly in the tax base, when they affectimports of goods and services (which are sold in the United States subject to tax but

17
support no deduction). In the origin-based system, the royalty determines the U.S. tax
base of $0.5b in this case, compared to the $1b tax base that would have obtained underarm’s length terms. The profit obtained by the French subsidiary can then be repatriatedto the parent company as a dividend on equity, a financial transaction that is not taken
into the tax base, directly or indirectly, under the standard rules.
As the example indicates, the transfer-pricing problem is potentially more serious
under an origin-type X tax than under the current income tax because of the different
treatment of dividends. (The difference is not absolute. If the repatriation of earnings issufficiently delayed in the income tax, the tax on dividends may be effectively zero.
There may also be other ways of repatriating earnings that avoid income taxation.) The
basic device to address the transfer pricing problem that I suggest in nonstandard rules tobe described in a later section of this paper to aggregate real and financial thetransactions between parent and subsidiary (so dividends are treated as sales).
Administrative Properties
Financial Transactions Excluded from the Base
A hallmark of an X tax in a purely domestic setting is its administrative
simplicity. (For a discussion of some of the basic ideas see Bradford 1986.) The basic
framework of cash-flow accounting is central to its potential for simplification, relative tothe existing income tax. (For a discussion that highlights the importance of clarity about
the conceptual basis for the tax, see Bradford 1997b.) In the standard subtraction-method
value-added tax, all that is required to calculate a firm's base is cash-flow information –sales less purchases from other businesses. It is important to note here that, for reasonsthat are briefly sketched below in connection with transition in the international context, I18
have come to the conclusion that it is preferable to modify this accounting system, toprovide instead for something like conventional business income accounting for "real"business assets (inventories, equipment, structures, land, etc.), supplemented by adeduction for the current cost of capital (an interest rate times real business asset basis).
Such a change in the accounting rules would cut into the simplicity of the X tax businesstax base, although, I would argue, not very significantly. (For details, see Bradford
1996a, 1998.)
As has been mentioned, the really major simplifications achieved by an X tax are
due to the fact that financial transactions are excluded. In the case of businesses, thismeans no inclusion of interest or dividends received, no deduction for interest paid, and ahost of similar changes in accounting, eliminating an equally large host of tax
complexities. To mention one prominent problem that would disappear: No special rules
are required for capital gains. Business assets are taxed on a cash-flow basis (perhaps as
modified per my remarks above); transactions in financial assets and liabilities, andassociated financial flows, such as payments of dividends and interest, are out of thebase.
These administrative advantages extend to the international version of the system,
which does, however, introduce the administrative problems of border adjustment, in thecase of the destination-based system, and transfer-pricing, in the case of the origin-based
system.
Residence of Firms
The building blocks of an X tax are business firms. We can think of it as a tax
that consolidates transactions among some set of companies, with the base consisting of

19
the net flows of goods and services from that set of companies. In principle, there isconsiderable room for choice about the exact definition that places a company within orwithout the taxable circle. For present purposes, however, I imagine rules rather like theones now used to determine the liability for value-added taxes (Lokken 2001 provides a
discussion). Given such conventions, no distinction is made between domestic andforeign companies. All companies operating in the United States, for example, aretreated alike.
Double-Taxation and the Crediting of Foreign Taxes
In the present system, a country has priority in the taxation of income arising
within its borders. (For a discussion of the basic principles of the U.S. international
income tax regime, see Ault and Bradford 1990.) It is not often recognized that
underlying this principle is a distinction as to the location of income that is actually at
variance with the Haig-Simons concept of income that is the traditional motivation forincome taxation. The Haig-Simons definition relates to a person (or family): Income isthe sum of a person's consumption and increase in wealth during the year. The only
location involved would appear to be location of the person; location or source does not
attach to income as such. (Confusion on this point is reflected in the traditional emphasison the principle that income is "regardless of source," a nonsensical distinction under the
Haig-Simons definition.)
Complications arise when the concept of income is extended to a company, inwhich case distributions to owners replace consumption. (For discussion of the HaigSimons idea, including its extension to companies, see Bradford 1986.) Since a company
is owned by people, an income tax levied on the basis of a company's income presents a

20
problem of double-taxation. In the purely domestic context, this is the problem ofintegration of company (corporation) and individual income taxes. In the international
context the question is how income deemed to be that of a company located in one
country (the source country) owned by a company located in another country (the homecountry) should be taxed. To drastically simplify one of the most complex areas of tax
law, the general rule in the United States is that the parent company is liable for tax onincome of all its component companies, wherever located. The United States
acknowledges, however, the primacy of the income tax claim of the source country. To
ameliorate double taxation, the United States allows the parent company credit (up to alimit) against its U.S. income tax for foreign income taxes paid on the income of its
foreign subsidiaries.
For reasons probably related to the income and value-added "metaphors" thathave guided the development of the two types of tax, the issue of double-taxation does
not arise in the case of a tax like the company tax component of an X tax, which is to say,a value-added tax variant. To illustrate, consider the case of a French company, with noassets and no liabilities but with a scientific genius on the staff, who comes up with asoftware application immensely popular with French customers (and with no one else).
To sell it, the company prints the program on compact disks. Suppose the cost of thedisks is negligible, as is the salary of the scientific genius. The French company's
accounts are then simple: receipts from sales, a big number; outlays for production andsales, negligible; other costs, negligible; annual income, a big number.
If this company were subject to French X tax at a rate of 28%, or to a value-added
tax at the same rate, then 28% of the annual big number would be paid in tax. The same

21
would be true if it were subject to an income tax at a rate of 28%. If this company were100% owned by an American parent, the income tax that it paid would give rise to acredit in the same amount against the parent's income tax liability. But no U.S. credit
would be provided for the French value-added tax. (For U.S. income tax purposes it
would be, in effect, deductible, since earnings ultimately repatriated would be net of theFrench tax.)
The big difference between the company component of an X tax and a standard
value-added tax is the treatment of wages, which are deducted under the former and notunder the latter. On the one hand, this might motivate an argument for a foreign tax
credit for the company component of an X tax; equally, it could motivate a foreign tax
credit for a standard value-added tax, with an appropriate correction for the wages thatare a part of a company’s value-added tax base but not in an income tax base. Present
doctrines clearly exclude a credit for any part of a value-added or cash-flow tax (theUnited States will not allow credit for a foreign tax that does not include a deduction forinterest, for example) and I presume that there would be no credit generated in the UnitedStates for foreign X tax payments by a subsidiary of a U.S. parent. (I have mentioned thepresumption that there would be U.S. company entities for activities within the UnitedStates. I suppose that the tax credit situation could be complicated if the national identityof "company subject to X tax" were not unambiguous, so that more than one country
claimed X tax from the same company. As far as I know, mutually exclusive definitionsof companies characterize present value-added tax regimes, but it is a subject that may
merit further attention – see Lokken 2001.)

22
Domestic vs. Foreign Source
I comment briefly below on the neutrality advantages of the proposed/likely
treatment of foreign company income. Here I would highlight a simplification
advantage. In order to implement the present system of crediting foreign income taxes
paid (subject to a limit), a distinction is needed between domestic and foreign-source
income. As I have mentioned, the usual economic concept of income relates to a person
or family and is not naturally located other than by the location of the person. The ideaof "source" is, however, needed in the implementation of limits on the foreign tax credit.
I suspect that the ambiguity of the idea at the most fundamental level is a reason thatsourcing rules are so controversial and arcane. (For some further development of thispoint, see Ault and Bradford 1990 and Bradford 1993.) Being able to dispense with theconcern would be a significant simplification advantage for the X tax system.
Some Other Issues That Go Away
In an X-tax world, repatriation of earnings (a financial transaction) would have no
tax consequences. Deferral would be a non-issue. Subpart F rules would be unnecessary(although an analogue might be considered to address the tourism problem under adestination-based tax). Issues of interest allocation, related to the definition of source ofincome, would be gone. Financial arbitrage among taxable and tax exempt entities, suchas foreign governments, that are deployed in many tax shelter schemes would no longer
pay off. I believe the list could be greatly extended by those knowledgeable about thecurrent system.

23
Efficiency properties
Generic Efficiency Features of this Type of Tax
This is not the place to go into an extended review of the efficiency properties ofthis type of tax (see Bradford 1986). But we may in passing remind ourselves that, if the
tax rate is constant over time, it is neutral with respect to the timing of people's
consumption. This well-known property of consumption taxes with constant rate overtime has often been taken (generally, not by me) as the main ground for advocating suchtaxes as alternatives to income taxes.
An X tax provides neutrality with respect to all financial margins. For example,
there is no bias toward or against debt as opposed to equity finance of companies. Thereis no lock-in with respect to positions in financial assets, no bias toward or against
particular assets based on their different patterns of realization relative to accrual. An X
tax is neutral with respect to all real investment margins (with the important exception ofhuman capital formation). The tax has no impact on the choice among different forms ofdepreciable capital, inventory investment, intangible investment. These neutralities
would hold for a perfect accrual income tax as well, but do not hold for a practical,
realization-accounting tax, even less for a system with a classical corporation income tax.
An X tax is nonneutral with respect to labor supply. In economists' jargon, thetax puts a wedge between the social payoff to an increment of work effort and the amountreceived by the supplier of that effort. This nonneutrality is shared by all consumption
taxes and by income taxes. Under an X tax, the wedge would be zero for a worker within
the zero bracket range of the compensation tax (negative if the worker is eligible for an24earned income credit) and equal to the top rate for a worker in the top bracket range ofthe compensation tax.
Features Relating To the International Context
Neutrality With Respect To Location of Production
Under either treatment of transborder transactions, an X tax would be neutral withrespect to the location of incremental real investment of the conventional sort. This is thetype of investment that we usually think of in describing the objectives of capital export
neutrality and capital import neutrality. Consider an investment opportunity, defined bycash flows, gross of tax. Investment decisions will be based on cash flows, net of tax.
Capital export neutrality for the U.S. investors holds if an investment opportunity that is abarely breakeven proposition if it is undertaken in the United States is also a barely
breakeven proposition if it is undertaken anywhere else in the world, taking into accountthe tax consequences at each location. Capital import neutrality for investors fromdifferent countries holds if a breakeven investment project in the United States for a U.S.
investor is also a breakeven project for foreign investors. These neutralities are arguably
desirable to assure the world's capital is deployed to maximum advantage.
These properties depend, in general, on the tax systems used by all countries. For
example, an idealized system of national income taxes, with every country providing its
investors unlimited foreign tax credits, would have both sorts of neutrality everywhere. I
should stress "idealized," however. Even if it were the intent of policy makers toaccomplish this result, it would be difficult to implement with conventional income taxes.
A worldwide system of X taxes, with no cross crediting, would, however, be quite
feasible and would have the property of capital export and capital import neutrality

25
universally, without restriction as to the rate of tax in any country. This property follows
because an X tax does not put any wedge between the before- and after-tax rates of returnat the margin, at home or abroad.
Another important class of investment choices involves the location at which a
new idea is exploited. Suppose a U.S. company has an idea for a new video game. The
production cost of copies of the game is close to zero; duly licensed watermarked copies
will trade freely internationally. Where should the inventing company have the thing
produced? Since it doesn't cost anything to produce the good, taxes constitute the only
locational factor.
Once again, a numerical example may be helpful. Imagine a world in which only
the United States has a tax and it is at a rate of 20 percent, expressed on a tax-inclusive
basis, so selling something for $1.25 implies a tax liability of $0.25. Exports are
excluded from the destination-basis tax base, so competitive forces will tend to push theprice of this illustrative good to $1.00 abroad. (I neglect transportation cost.) Similarly,
a foreign-produced good that sells for $1.00 abroad will sell for $1.25 in the UnitedStates. With an origin-basis tax, there is no exclusion of the sale to abroad from thedomestic base, so competitive forces will tend to push the prices at home and abroad tothe same level, say $1.00 in this case. (The absolute price level is indeterminate in thislittle story.)
Suppose an origin basis tax applies to the illustrative problem of locating the
production of the game. Then copies of the game will sell for the same price at home andabroad; specifically, suppose each copy will sell for $100 and there is a market for 5,000
copies abroad and 5,000 copies in the United States, for a total value of sales of $1 m.

26With proper transfer pricing rules, having the game produced abroad will produce $1m inpayments from the foreign company for the rights. This will be treated as a sale by the
U.S. X tax, so the inventing company's owners net $800,000 from the game, the sameamount they would net if they produced at home and sold the copies themselves. (If, on
the other hand, through transfer price manipulation, the royalties can be understated, withthe profits returned in a form not subject to U.S. X tax, there will be a payoff to locationof production abroad.)Suppose, instead, a destination-based tax is used. Then, if the price of the gameabroad is $100 it will sell for $125 in the United States. Again, the net-of-tax proceeds
are the same, regardless of the location of production. If the thing is produced at home,the domestic sales net the company $500,000, as do the foreign sales, for a total of $1m.
It may appear that the inventor is better off under these arrangements, but that neglects
the difference in U.S. price levels in the two examples, it being 25 percent higher in thesecond case. The purchasing power of what the inventor nets is the same in both
examples.
Neutrality With Respect To Location of Consumption?
I have emphasized the economic equivalence of origin- and destination-basedtaxes. There is, however, in practice a difference between the two, owing to thedifficulty of measuring the consumption of a person of one country while physically inanother country. In international accounts, expenditure by a U.S. tourist in France istreated as an import by that person from France to the United States. If the tax systemcannot catch this expenditure, the equivalence that I described earlier between origin- anddestination-based taxes systems is not precise.

27
I refer to the incentive, under a destination-basis tax, to shop in the country withthe lowest tax rate as the "tourism problem." If the boundaries can be monitored, thisincentive is eliminated except to the extent that both the shopping and the consumption
are done in the low-tax country. Hence my name for the problem.
We can add this phenomenon to any of our illustrations above. Suppose ourconventional good is produced by labor alone. The worker gets $1.00 and the producer
breaks even by selling the good for $1.25 and paying $0.25 in tax. In terms of this good,
the worker's earnings on this deal at home are only 0.8; that is, he or she can buy just 0.8
units of the good with the wages earned in producing it. On the other hand, the worker
who goes abroad with the wages earned can buy 1 unit of the good. This is the tourism
problem. The country with the destination VAT penalizes visiting tourists and rewards
its own citizens who shop abroad.
The efficiency consequences of the tourism problem depend upon the tax rates athome and abroad and on the possibilities for substitution between consumption at home
and abroad. So in our example, the U.S. worker has no incentive to consume abroad if
the French impose a destination VAT at the same rate as does the United States.
Suppose, however, the French have no VAT but all U.S. workers like to combine
consumption at home and abroad in rigid proportions. Then the opportunity for
consumption in France has the efficiency impact of lowering the effective U.S. VAT rate,or, equivalently, the effective tax on U.S. earners but no other efficiency consequences.
More plausible in this case would be both an intertemporal and locational effect,
as workers find it in their interest to save at a higher rate while residing in the UnitedStates and then consuming the extra savings abroad in retirement. The tourism problem

28
is encountered in the U.S. tax system currently in the form of debates over an"expatriation tax." Because the U.S. system has substantial elements of accrual
accounting and because changing citizenship is a much bigger deal than changing
location of residence, the extent of the tourism problem is probably very much lower
under present U.S. law than it would be under a destination-principle X tax. Not only
would the dot-com-generation inventors of our illustrative game have an incentive to
migrate to a low-tax jurisdiction; ordinary folks with ordinary retirement incomes mightfind it worth while as well.
Equity issues
Generic Distributional Features of this Type of Tax
I have indicated above my view that an X tax is capable of implementing a wide
range of degrees of progressivity. Since, as a matter of adminstrability, the top rate ofcompensation tax is limited to the rate of business tax, and it is probably desirable, also
as a matter of enforcement, not to have too high a rate of business tax, one might argue
that the existing system is capable of imposing a heavier burden at the very high reachesof the income distribution. On the other hand, the fact that we have in the past hadcompany tax rates in the neighborhood of 50%, suggests a range of possible policies thatis not usually associated with a flat tax.
Some will probably object that there is something inherently regressive about
using a consumption, rather than an income, measure as the basis for discriminating
among taxpayers. How can a tax system that exempts "income from capital" be as
progressive as one that taxes income from capital? I will not rehearse the arguments that,starting from first principles (that is, not taking income as the right measure of ability to29
pay as a matter of definition), one is quite likely to conclude that excluding income from
capital is plausibly appealing in its own right. (See Bradford 1986 for extensive
discussion of this equity issue.) Rather I would emphasize my view that there is a
general misperception of what income from capital is. Most of what we regard asbusiness income would be subjected to tax by an X tax. (Consider the tax levied on thosecopies of the French game.) The realization is slowly spreading among those of us who
think about tax policy (it dawned on me rather late in my career), that the difference
between a well-designed income tax and just about any old consumption type tax is
entirely in the taxation of the risk-free return to wealth. I would argue that this does notamount to much in the context of the debate about the choice between systems. (It is noteasy to know how to estimate "the" risk-free rate of return. In the United States, theTreasury bill rate, corrected for inflation, averaged less than 1% per year during the 20th
century.) Most other payoffs to investment and enterprise are equally taxed or missed byboth types of tax. (For more discussion of these points, see Bradford 1996a.)
Specific Features of the International Version
Inter-Nation Equity
I think the main fresh equity issue raised by extending the X-tax to theinternational economy relates to concerns about equity among nations or "inter-nation
equity." I have always been uneasy with the notion that nations, as opposed to individual
people, have tax equity claims. It may be, however, that there is a correlation between
national welfare and the circumstances of residents of different countries that would
unify the two perspectives. Rather than tackle this question, let us consider the
implications for an X-tax regime of the traditional viewpoint that there is an ethical claim

30
by a country to revenue associated with income produced within its boundaries (with, tobe sure, a residual claim by the country of residence of the owner of that income).
It would seem to me – and I confess to being unsure whether this captures theright idea – that an origin-based X tax would satisfy the demands of the traditional view.
Basically, all business "income," as defined by the X-tax rules, would be subject to tax inthe origin country. That the income so defined excludes what amounts to the risk-freerate of return times the real wealth tied up in the enterprise seems to me a minor matter
quantitatively. I recognize that others may disagree with the quantitative assessment,
which ought to be a valid subject of analysis and discussion. If, however, the basic
premise is accepted for purposes of discussion, the further conclusion follows from theeconomic equivalence of an origin- and destination-based X tax that the latter equallysatisfies the demands of inter-nation equity. In that case, a choice between them could bemade primarily on administrative or other grounds unrelated to inter-nation equity.
Equity Aspects of the Tourism Problem
The tourism problem would be just an efficiency problem if everyone were alike.
If, however, there is a systematic difference among people classified, say, by earnings
level, tourism consumption could diminish the progressivity of an X tax system, as highearners took advantage of the option to consume their accumulations abroad. A person
earns a fortune in one country (typically, a high-tax country) and retires to anothercountry (typically, a low-tax country). If an origin-based tax is in place in the country inwhich the fortune is earned, the person will bear that tax on all of it. If a destinationbased tax is in place, the person's tax liability will be divided between the two countries
according to the rate in effect at the time and place the consumption occurs. It is not31
obvious which of these two outcome is "better," or exactly what standard of equity one
would apply. There is, however, a difference between the two systems to take into
account when choosing the preferred tax policy.
Transition and Tax Rate Changes over TimeA particularly important set of issues bearing on the choice between origin- anddestination-basis approaches, involving both allocative efficiency and equity, is raised bytransition. The obvious transition is from the existing tax regime to the X tax regime.
Since the treatment of international business in the existing income tax system isessentially on an origin basis (sales to abroad are counted in income and purchases fromabroad are deducted), it is the potential shift to a destination-based tax that poses thedistinctive problems. This, in turn, is most easily analyzed in terms of a switch from an
origin- to a destination-based X tax. This transition amounts to an increase in the tax rate
"forgiven" on exports and imposed on imports from zero (under the origin-basis tax) to
the full X tax business rate (under the destination-based tax). Furthermore, the problems
associated with this transition are repeated any time there is a change in the business X
tax rate in a destination-, but not in an origin-, based tax.
A similar phenomenon is encountered in the choice I have mentioned above
between a cash-flow business tax and an economically equivalent tax that uses income
accounting for business assets, including a separation of capital and current transactions,with an allowance of a deduction for the capital tied up replacing the immediate
expensing of capital outlays. The capital cost deduction would be determined bymultiplying the capital in the business, as measured by basis, by an appropriate rate of32interest. I think it will help understanding of the international tax problem to review thetransition issue in this purely domestic context.
Generic Features of Transition to this Type of Tax
Transition to a consumption type tax, such as the X tax, from an income type tax
with current accrual accounting, such as the existing system, raises significant issues ofincidence and efficiency. Most of those engaged in tax policy debates are familiar withthe major point: Shifting from accrual to pure cash-flow accounting imposes a one-time
tax on "old capital" or, more precisely under income tax accounting conventions,"existing basis" in the nonfinancial assets of businesses (Bradford1996a, 1998; Pearlman
1996; Hall 1996; Zodrow 2002). Whether this is fair in the context of a major tax
restructuring is debatable (Kotlikoff 1996; Shaviro 2000). It is not debatable that itpresents significant incentive problems, since taxpayers can mitigate the burden of thetransition impact, perhaps significantly, by selling their assets to increase consumption in
anticipation of the change in regimes. Both equity (accepting the premise that it is unfair
to impose such a transition burden on taxpayers) and efficiency considerations support
the adoption of the income style accounting for business activity that I briefly alluded toabove. (If all that were involved were a one-time change in the applicable X tax businesstax rate, from zero to some fixed level, the same result would be obtained with cash-flow
accounting by permitting immediate expensing of business asset basis in the new
regime.)The Tomato Juice Problem
I like to use the following numerical example to illustrate this problem oftransition from an accrual business income tax to a cash-flow business tax (Bradford

33
1996a). In that case, consider a retailer who purchases $10,000 worth of canned tomato
juice on December 31. The next day, the cash-flow business tax replaces an accrual
income tax. The retailer sells the tomato juice for an apparently break-even sum of$10,000. This sale is taken into income. Under an accrual income tax, there would be anoffsetting deduction of the $10,000 cost of goods sold, reflecting the outlays for theinventory in the previous year. But under the cash-flow tax, only current-year outlays are
deductible. So the retailer is stuck with the full amount of the tax on his inventory. The
extra tax remains, regardless of the character of the economic adjustment to the changed
regime (for example, it is unaffected if there is a general price level increase in theamount of the new tax; see Bradford 1996a).
To work out the incidence and allocational effects of the transition, we need tothink through how people would behave to avoid the burden. The traditional approach
treats the introduction of the cash-flow tax as a completely unanticipated event (Feldstein1976). In that case, the transition effect (the tax on the inventory of tomato juice) iscompletely borne by the taxpayer who happens to own the assets affected. At the otherextreme, if the introduction of the tax is anticipated far in advance, no one will be foolishenough to hold assets across the boundary of introduction of the cash-flow accounting
unless doing so is rewarded by an appropriately high real reward. In the case of thetomato juice example, presumably, businesses would hold inventory from December 31
to January 1 of the transition year only under the expectation that consumers will pay a
premium for the service provided by the retailer – as an alternative to buying their tomato
juice before the transition and storing it in their kitchen cabinets. The generic point isthat an anticipated change to the cash-flow from an income tax regime – or of an34
increase in the tax rate under a cash-flow regime – cannot in the absence of transactions
costs impose any particular tax burden on the owners of the assets subject to thetransition penalty. Instead, it will impose a tax disincentive on pre-transition investment
with returns extending into the post-transition period – driving up the pre-tax rate of
return and driving down the interest rate applicable to commitments that cross the
temporal boundary between the two regimes. There would then be a positive incentive toinvest right after the transition – driving up the interest rates for commitments extending
forward from the transition boundary. The incidence effects are those of the peculiarlytime-varying rate of tax on the return to investment, with its associated impact on
efficiency.
The incidence of an unanticipated decline in a cash-flow tax rate, and the
incentive effects of an anticipated decline in the tax rate, are simply the opposite of those
for an increase in the tax rate.
Using Income-Style Accounting to Avoid the Problem
One of the strengths of true accrual income as a tax base is its insensitivity tochanges in the rate of tax. Income tax accounting principles incorporate this idea in theirinsistence on associating income with particular years – rules that would measure income
over several years but give effect to the same discounted tax, given a constant tax rate,
are therefore generally shunned. (For an example of a system that would use such anequivalence, see Auerbach and Bradford forthcoming.)
This property can be turned to the service of a consumption-type tax by making
use of the familiar concept of basis in real assets. In practice, this would mean
maintaining something like the present system of accounting for depreciable assets and35
inventories instead of the expensing of capital outlays of the classic cash-flow
consumption-type tax. To preserve the consumption base as the effective principle, anallowance would be provided for the cost of capital deployed in the business, calculated
as the product of an appropriately chosen rate of interest and basis (Bradford 1996a,
1998). (This should not be confused with a deduction for interest paid; there would beneither taxation of nor deduction of interest payments in the system.)
The ideal of this approach, as of theoretical Haig-Simons income accounting, ismark-to-market valuation of assets. An increase in value of an asset during the year
would be added to the tax base in that year and also added to the basis of the asset,
eligible for the interest allowance and recoverable as a deduction upon disposal of theasset. Boadway and Bruce (1984) may have been the first to describe the theoreticalunderpinnings of this system, which was actually briefly put into practice in Croatia(Rose and Wiswesser 1998). Its implementation presents a number of challenges worth
closer examination that we can undertake here. Two such challenges, however, merit
mention. The first is the determination of the appropriate rate of interest to use in thecalculation of the cost of capital used in the business. The idea is that a business ownershould be indifferent between the depreciation plus interest on basis that goes with aninvestment and immediate write-off, taking due account of the possibilities that financial
markets will present to convert one form of cash flow to another. The second is thesystem’s call for information on accruing changes in asset values. This requirement haslong been recognized as an Achilles heal of the accrual income tax standard. In thisconnection it is significant that, unlike for an income tax, accuracy in the timing of
deductions is unimportant so long as the rate of tax is constant. The cost of capital36
allowance compensates for postponing deductions, and reduction of the allowance offsets
the advantage of any acceleration of deductions, relative to the mark-to-market standard,that the rules may allow. (Throughout this paper I abstract from an important aspect of
capital accounting, the need to allow for inflation in rendering comparable amounts at
different dates.)
The importance of matching the basis of assets to market value is confined toconditions of changing tax rate. To illustrate, suppose inventory with market value $100
is carried on a company’s books with a basis of $50. If the tax rate is going to increase
between the present and the next period, it is advantageous to realize now, so that the $50
excess of basis over market will be taxed at the present, rather than the next-period rate.
The opposite holds if the basis of the asset is $150, $50 over current market value. Thenit will pay to postpone realization. These accelerations and postponements translate into
systematic distortions of investment. The workability of imperfect asset accounting in
the X tax context is premised on the likelihood that tax rate changes will be relatively
slow, infrequent and hard to predict and on the fact that realizing what one might call thefundamental market value of typical business assets is not easy. (By definition, one canrealize the market value of an asset defined as what one can sell it for.)Specific Features of the International Version
The Fundamental Problem of Rate Changes in a Destination Tax
The choice between origin- and destination bases for the X tax regime raises
similar problems. We can get a feel for them by imagining what would be involved in
making a switch from an origin- to a destination-basis tax.

37
Since the issues here are all about timing, and not about production of different
goods in different countries, we can examine them in a stripped-down model with just asingle good (corn) that can be produced in either of the two countries (United States andFrance) and that can be consumed or invested in capital in either of the countries. In theexample at the beginning of the paper we took as a condition a situation of balanced
trade. Now we are interested precisely in the possibility of unbalanced trade, so we needto introduce the element of time, which I do by specifying a two-period world. As in theearlier example, we assume that there is an X tax (or subtraction-method consumption tax
on goods and services) in the United States only. Any taxes in France use some otherapproach. The U.S. tax may be of either the destination- or origin-type.
Start with an origin-basis tax, say at a rate of 25 percent; the price of corn in thetwo countries must be the same, say $1 per bushel. In France, the wage rate is also $1(some other tax is used to pay for government); in the United States the wage rate is $.75.
In the first period, the good is exported and imported in some quantities, and at the end of
the day there exist various borrowing, lending, and wealth-holding (stocks of corn)situations, some crossing the national border.
We need not go through all the details; it suffices to illustrate the problem createdby a shift in the U.S. tax from origin to destination basis between the first and second
period. Between the first and second period, shift to allow a border adjustment for the
U.S. 25 percent tax. Now, to equilibrate trade in the single commodity, the price has tochange in the United States or France. Suppose it drops in France and stays at $1 in the
United States; stocks of corn in France now sell for $.75 per bushel, instead of $1. For

38
someone planning to consume in France, this is no problem. But there is a problem for a
U.S. resident, owning a stock of corn in France but desiring to consume at home.
Thus, suppose I, a U.S. resident, own a stock of corn in France. I got my stock bysending some corn to a French consumer in the first period. In general, I will haveearned a return on my stock, so it will be more than I sent over in the first period. We
need not spell out this detail either. Before the destination tax, I could import my stock
to the United States without tax. In the new situation, when I want to bring my cornhome to the United States, I must pay a tax of $.25 per bushel, based on its U.S. market
price of $1 per bushel. So I only get to consume three quarters of what I had anticipatedat the time of my export to France.
The impact of a shift in regime from an origin to a destination basis is analyticallythe same as an increase in the rate of a desination-based tax from zero to 25 percent.
More generally, the incidence phenomenon sketched here would accompany any change
in the rate of a desination-based tax. (A drop in the rate would imply a gain for myillustrative claimant on France.) As in the analogous case of an increase in the rate of acash-flow tax in a purely domestic setting, in the international context incidence effects –gains and losses based on saving or portfolio commitments established before the policy
shift – depend on whether the change is, as in the example, completely unanticipated. If
it is completely anticipated, the incidence effects must be built into the anticipatedreturns. In the example, I would certainly not have exchanged my corn in the first period
for a claim on an equal amount of corn in France, to be redeemed (with an ordinary rateof return) in the second period. Either the actuality of a change in tax regime (or tax rate)

39
or the risk that it might happen would, in theory at least, greatly influence theinternational capital market.
An unanticipated shift from an origin-based tax to a destination-based tax would
impose a one-time tax at the X tax rate on the net claims of U.S. taxpayers on the rest of
the world. If the net claims are positive, the tax is a loss to the U.S. claimants and a gain
to the U.S. fisc. If the net claims are negative, the tax would be negative (and there
would be a cost to the U.S. fisc). Corresponding to these incidence effects would be
incentive/allocative effects to the extent the change in policy is anticipated, and there
would be ongoing incentive/allocative effects from the ongoing risk of tax rate changes.
It would be useful to know how important, quantitatively, are the incidence andefficiency effects of transition/rate changes. What one may think of as the direct impact
incidence – since it is the product of the tax rate change and the net claim on foreigners(which could be positive or negative) – is sensitive to the size of that net claim. If theforeign claims on the United States and the U.S. claims on foreigners are equal, acompletely unexpected tax change would not have U.S. tax revenue consequences (atleast in terms of present discounted value). Still, U.S. owners of claims on foreigners
would lose and foreign owners of claims on U.S. residents would gain from an increasein the tax rate/shift from origin- to destination-based tax. Furthermore, the incentive
effects of anticipated rate changes do not depend upon the balance of claims. It is hard toimage that an anticipated change from 0 to, say, 28 percent would not have quantitatively
significant impacts.
It is true that European economies have somehow made the transition todestination-based value-added taxes of 15-20 percent without obvious consequences of

40
the type I have described but it is not clear that anyone has looked for such consequences.
Furthermore, it is well known that the European value-added taxes, at least initially,
substituted for turnover taxes of broadly similar economic character. One could describe
their introduction as a rationalization of a destination-type value-added tax structure.
Consequently, without having done the hard work to assess the proposition, I would
surmise that the issue raised here is quantitatively significant.
In most of the examples I chose to look at a change from an origin- to a
destination-based tax advisedly. Since the treatment of sales and purchases of goods andservices in the U.S. income tax is today on an origin basis (business sales to foreign
customers are counted in gross income and purchases from abroad are deducted, perhaps
on a delayed basis if on capital account), adopting an origin-based X tax would
presumably have relatively small incidence and allocation effects of the sort describedabove.
Coordination of Tax Systems in a Transition
The problem of coordination between the tax system in the United States andthose of other countries in the process of a possible switch to an X tax regime presumably
will depend sensitively on the details of the system chosen by the United States (origin-,
destination-), the speed of transition and the extent to which other countries are pursuinga similar shift in tax regime. Filling in a table of alternative possibilities would take us
far beyond the broad-brush treatment that is my objective in this paper.
If, however, the process were to involve a relatively slow, phased transition into
an X tax – especially into an origin-based version – and out of the income tax in the
United States, it is not obvious that there would be particularly acute coordination issues.

41
In Bradford 1996a I describe a transition whereby the X tax is introduced as an extra
schedule in the existing income tax. A taxpayer’s liability is x percent of the otherwise
applicable X tax and (100-x) percent of the existing income tax. The percentage x would
increase from 0 to 100 over a period of years. Suppose we were to envision a six-stagetransition to an X tax with a business tax rate of 28 percent, so a four percentage point
increase in the business tax rate each time, with a stage lasting two years.
Consider what happens at the first stage. What is involved can be compared to ajump in a European VAT rates by four percentage points except that, if an origin-based X
tax is involved, much less revision in fundamental international economic relationships isinvolved. At the same time, the U.S. income tax burden would be cut by about 15
percent. Economically, it would be like a fairly modest acceleration of deprecation
allowances under the income tax. Such a back-of-the-envelope calculation does notsubstitute for more elaborate and careful analysis of a specific plan but the exercise
suggests that the stress imposed internally by a given stage in such a transition would not
be very large, even if there is no coordinated movement in the same direction by othercountries.
A Remedy for the Transfer-Pricing Problem in an Origin-Based X Tax
In view of the advantages of the origin-based approach (transition problems,
including ongoing transition problems associated with tax rate changes, much less than in
the destination-based approach; monitoring the borders not necessary; no “tourism”
problem), a method of reducing or eliminating the transfer-pricing problem would be of
considerable value. In what follows I suggest such a method. The ideas are preliminary,42and have not been subjected to the acid test of the search by clever tax advisors to gamethe proposed system. In my view, however, the approach merits close study.
Cash-Flow Accounting for Foreign Subsidiaries: The Domestic Installment-Sale
Analogy
The cross-boundary transfer-pricing problem is analogous to the problem oftaxing the domestic sale to a consumer (or a nontaxable entity) of an ordinarycommodity, say an automobile, on an installment basis. In the standard X tax accounting(as under a conventional value-added tax), interest received is not included in tax. By
bundling the sale of the car with the credit sale contract, specifying a low price on the car
but a high rate of interest on the loan, a company can keep the cash flow from the buyer
constant but convert it in part into a nontaxable form. A similar logic is at work when thecompany sells a car to its foreign subsidiary for an artificially low price. In this case thepayment in return takes the form of a financial transaction (a dividend) that is not subject
to X tax. (I use “foreign subsidiary” to stand for “related party” here. The key questionis whether transactions involve the sort of opposition of interests that we summarize inthe arm’s length characterization. Implementing the approach I am about to outline
would require a specification of these conditions.)
McLure and Zodrow (1996) regard this problem as sufficiently serious to merit
aggregating all transactions of companies, financial and real, in determining the cashflow business tax base, thereby implementing an “R+F” (“real plus financial”) company
tax, in the terminology of the Meade Committee (Institute for Fiscal Studies 1978). A
more narrowly targeted remedy in the installment sale case is to require cash-flow
treatment of the bundled transaction (Bradford 1996a,b). So if the financing is notorganized at arm’s length, the seller is taxed on all payments received for the car,43
however labeled and at whatever time. The characteristic exemption of interest in a
consumption-based tax means that the seller will be indifferent between arm’s length
terms and the bundled terms.
Once we are in this world, however, there are fresh incentives when the tax rate is
not constant. By charging a low price for the car and high interest rate on the loan, theseller can move tax base from the present into the future. If the future tax rate is lower
than the present, this is advantageous. Conversely, if the tax rate is going up in the
future, by charging an above-market price for the car and a below-market interest rate on
the loan, the seller can concentrate the tax base in the current period. Protection against
such manipulation can be implemented by a requirement that the car sales price be anarm’s length price. A possible alternative or additional requirement, that I do not pursue
here, would be arm’s length conditions on the loan that is embedded in the installment
contract. This may seem to leave us with the problem we started with. But typically the
stakes will be much lower (and with the possibility of rate changes either up or down,
gaming the system is more difficult), so the importance for tax administration of getting
the price “right” will be less.
Applying the Approach to Multinational Corporate Family Members
The case of related-party transactions across national jurisdictional boundaries inan origin-basis tax is similar to the installment-sale example in involving conversion of ataxable sale to a nontaxable financial payments. I suggest a two-part approach to thisproblem. First is bundling of the goods and services and financial flows throughaggregation of the transactions between related parties. Second, the familiar income tax

44
concept of basis is deployed to inhibit the manipulation of financial flows to exploit tax
rate changes over time.
To use the basic bundling approach of the installment sale example, when Ford
U.S. (FUS) sells motors to Ford Canada (FC), its wholly owned subsidiary, all paymentsfrom FC to FUS with respect to these engines would be taken into U.S. tax, as
representing current or deferred payment for the motors. The analysis goes through as
before, including the U.S. tax system’s stakes in getting the nonfinancial price (the priceof the motors) “right” when the tax rate is changing through time.
There is a fresh difficulty, however. It will generally not make sense to isolate asingle sale and its consequences. When FUS sells motors to FC at a below-market price,
the payoff is higher future dividends from FC to FUS, which are the result of all theoperations of the two companies, not confined to the transactions involving the motors.
The suggested remedy is to treat the entire financial relationship on a bundled basis. Any
financial transfer from FUS to FC would be deducted and any payment from FC to FUS
would be included in U.S. tax.
To illustrate, if FUS sets up FC by transferring $1b to FC, the amount would be
deducted from the U.S. tax base. When, subsequently, FC sends a dividend back to FUS,
the amount would be included in the U.S. tax base. Now suppose that FUS sells FC $1m
worth of motors for an artificial transfer price that means FUS is paid only $700k, which
is subject to U.S. tax. This reduces the FUS tax base by $300k, compared with atransaction at arm’s length. But the implication is an increase in subsequent dividends
from FC to FUS by $300k (in present value – the dividends may take place in the future).

45
With constant tax rate, the result is a wash – no gain from the manipulation of the transfer
price.
The problems that arise when the tax rate is not constant are, however, more
serious than in the case of the illustrative installment sale. By large transfers to and froma foreign sub, a U.S. parent could exploit even small year-to-year differences in the U.S.
tax rate. A possible remedy for this problem, as in the analogous domestic situation
discussed above, is to follow principles of timing underlying the existing income tax, in
which income is assigned to particular years so the taxpayer does not have a choice inthis regard.
The Use of BasisTo return to the purely domestic context, the X tax would use capitalization rules
for ordinary business assets more or less along present lines. The difference from an
income tax would be the allowance of a deduction for the normal return on basis. In theinternational context, the analogous reasoning would apply to an equity position in aforeign subsidiary. Now a transfer from parent to subsidiary gives rise, not to a current
deduction but to an addition to parent’s basis in the subsidiary. A transfer from thesubsidiary to parent – that is, a dividend – would be deducted from the parent’s basis.
The basis device with respect to transfers between parent and subsidiary protects
against essentially unlimited exploitation of tax rate variation across time. As in the
installment-sale case, there remains the potential to exploit tax rate variation via transfer
prices in the “real” domain. To illustrate: FUS sells FC $1m worth of motors for an
artificial transfer price that means FUS is paid only $700k. This reduces the FUS tax
base by $300k, compared with a transaction at arm’s length. To simplify, suppose the46interest rate is zero. Next year, FC sends home to FUS the profit of $300k made on thesale of the motors (presumably built into their assembled cars). If the tax rate is lower inthe second year than in the first, FUS gains from this set of transactions. The required
remedy is the same as in the present system, to attempt to assure the price of the motors isthe arm’s length price. The fact that the stakes in the proposed approach are in theintertemporal difference in the tax rate, not in timing (because of the interest allowanceon basis) or the entire rate, should help to make it workable.
We can check that the approach works for relations between a foreign parent andU.S. sub: Suppose Farma Switzerland (FS) sells its products through a wholly-owned
U.S. subsidiary, Farma U.S. (FUS). The basic rule is that a transfer of funds from FS to
FUS is included in the U.S. tax base of FUS, and a transfer from FUS to FS is deductedfrom the U.S. tax base of FUS. For the same reason discussed above, these inclusions
and deductions would be run through basis accounting but that is primarily directed at the
problem of time-varying tax rate. We can more easily trace the logic of the system byusing the straight inclusion and deduction approach. To simplify, assume the interest rate
is zero (and that investments earn exactly the market rate of interest). If FS transfers $1m
to FUS and earns the going rate of return, FUS will be liable for tax on the $1m inboundinvestment and will get a deduction of equal discounted value when it returns theinvestment, plus profit, to FS.
Now suppose FS sells $1m worth of cosmetics to FUS for $1.3m. The
immediate impact is a deduction of $1.3m from the FUS U.S. tax base. But a further
impact is a reduction, by $.3m, of the deduction for profit remitted by FUS to FS,47compared to the accounting at the arm’s length price. So there is no tax benefit frommanipulating the transfer price.
As in the example of the U.S. parent and Canadian sub, because there would be
an advantage from this sequence of transactions in the event of time-varying U.S. tax
rate, there is a U.S. tax system stake in getting the transfer price right. The possibility oftime-varying tax rates also means that the treatment of transfers would run through basis.
In the example, when If FS transfers $1m to FUS, there will be no current U.S. tax
consequences but FUS will have a negative basis (i.e., liability) in the amount of $1m.
When there is a positive rate of interest, FUS will be charged for holding the negativebasis (possibly by additions to the negative basis). When FUS transfers to FS, there is aconceptual deduction but this is replaced by an addition to basis in the amount of therebated profit.
Mark to Market?
The potential to profit from timing of transactions (sale of assets in the simple
domestic setting) is eliminated by true mark-to-market accounting. The use of
conventional depreciation accounting is necessarily accepted for ordinary business assets
because market values are not available. (Reminder: With constant tax rate, these timing
issues are of no significance in a present value sense.) In the international setting, theanalogy would call for adjusting basis in foreign subsidiaries by the amount ofaccounting profit or loss. In present-system terms, there would be no deferral of foreign
income or loss. Unrepatriated earnings of a subsidiary would be taxed currently to theparent but added to basis. (Losses of a subsidiary would result in a current deduction by
the parent and subtraction from basis.) Because basis earns an interest allowance, there

48
would be no present-value significance to getting this exactly right over time spans withconstant tax rate. Getting it right is significant only with changing tax rate.
Treatment of Loans and Transition
Among details to be resolved in implementation of the suggested system is theidentification of the transfers between related parties that are brought into the system andtreatment of positions of firms prior to its introduction. I can do no more here thansuggest approaches to these issues. As to the first, transactions labeled “debt” between
parent and subsidiary could be used to exploit differences between the domestic andforeign tax rates. As in the case of the domestic installment sale example, erring on theside of bringing too much into the comprehensive accounting (so taxing all payments forthe car) is, in principle, a safe course. The result is a wash if the transaction is on arm’s
length terms. Questions of monitoring and administrative costs would probably dominate
in evaluating alternative rules.
As for the second issue, in the transition to a purely domestic X tax, companies
would carry basis in their real business assets into the new system. Exactly analogously,a U.S. company’s basis in ownership claims to affiliates (and perhaps for debt claims,
depending on the treatment chosen for related-party debt), treated like basis in real assets.
For a foreign-owned U.S. company, the relevant basis would be negative, reflecting theequity claim of the foreign parent.
Conclusion
I conclude from this exercise that, judged by traditional tax policy criteria, ageneral regime of national X taxes has much to offer. It has the potential to cut through anumber of policy knots. At the same time, both “pure” variants, destination- and origin-49
based, have drawbacks in implementation. Absent special rules to deal with it, theorigin-based tax makes even more serious the transfer-pricing problem that plagues theexisting international tax system. The destination-based tax imposes a requirement tomonitor imports by individuals, creates incentives for people to locate their consumption
in low-tax jurisdictions, and sets up distorting incentives upon transition – both upontransition into the X tax system from the present system and upon transition to a changed
tax rate in an ongoing system.
Although I have not dwelled on it here, there is no denying the simplicity
advantage of the straight cash-flow treatment of sales and purchases of goods andservices in the purely domestic context, or of the destination-principle extension tointernational transactions. The main justification for considering the modification in thedomestic rules, involving capital accounts for businesses and a deduction for the capitalthus tied up, is to neutralize the system with respect to changes in the business tax rateover time, especially the change that would occur as the new system is introduced. The
same justification applies to the attempt describe in this paper to use an analogous
approach to implementing origin-principle treatment of sales and purchases that crossinternational boundaries.
The main challenge in implementing the origin approach is dealing with transfer
pricing – the ability of companies to manipulate the terms of transactions among
commonly owned entities located in different countries, so as to locate the tax base where
the rate of tax is lowest. The basic tax planning tool is to manipulate the boundary
between real (taxed) and financial (normally not taxed) transactions. The remedy
suggested here builds on an analogy with an installment sale to a consumer in the purely

50
domestic context, which presents the opportunity, through non-arm’s lengths terms of thefinancial part of the contract, to convert taxable to tax free payments. In the case ofcommonly owned domestic and foreign companies, the line is between domestic andforeign tax jurisdictions, and the details of the aggregation, involving the use of capital
accounts and a corresponding deduction for business capital, are somewhat more
involved.
There is no doubt that the approach I have outlined is more complicated than thedestination principle’s exclusion of goods and services transactions. On the other hand,the fact that it relies on basically familiar concepts from income tax accounting is astrength. If successful, it would open the possibility for achieving the advantages of theorigin-based approach without its principle disadvantage.

51

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