On the Incentive Compatibility of Universal Adoption of Destination-Based Cash Flow Taxation

We analyze the incentives for an individual country to deviate from destination-based cash flow taxation (DBCFT) in a two-country model in which both countries have adopted DBCFT. A change in a country’s corporate tax rate, degree of taxation of capital income, and/or level of border adjustment generates welfare effects that can be decomposed into fiscal effects, a price level effect, and relative price effects. We establish that at least one country will have an incentive to deviate from universal DBCFT by reducing the deduction for capital investments, even with asymmetric countries. For the deviations involving reduction in border adjustments, we show that both countries will have an incentive to deviate in the symmetric case. Universal DBCFT will not be incentive compatible in a one-shot tax setting game, so commitment mechanisms will be required to sustain it as an equilibrium.