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Individuals and firms sometimes receive money that they are required to partially or fully repay in a later year. If the initial receipt is subject to income tax, how should the income tax system treat the subsequent repayment? Conversely, individuals and firms sometimes make payments for which they later receive reimbursement (or a refund from the initial recipient). If the initial outlay is deductible under the income tax, how should the income tax system treat the subsequent reimbursement? Both situations, which can generally be analyzed symmetrically, involve cash flows that are later reversed.

It seems plausible that the income tax system should account for the cash fl ow reversal in some manner. An additional question arises, however, if the taxpayer’s marginal income tax rate changes between the time of the initial cash flow and the time of its reversal. Should the adjustment for the cash flow reversal then be based on the reversal year's tax rate or the tax rate at which the initial cash flow was recognized?

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Alan D. Viard is a resident scholar at AEI.