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TAXATION OF CORPORATE INCOME
C h a p t e r 15
Corporations
A corporation is a business that is legally established under state laws that grant it an identity separate from that of its owners.
Law views the corporation as if it were a person:
Granted right to engage in litigation, own property in its name, incur debts
Also treated as a person from point of view of taxation
Owners are shareholders, or stockholders.
Stockholders have limited liability for debts; their liability limited to amount of funds invested.
Measuring Business Income
Annual business income measured by subtracting business costs from business receipts over a one-year period
Business income includes normal profit (opportunity costs of owner-supplied inputs) and economic profit (surplus of revenues over opportunity cost of all inputs)
Equity of a corporation is difference between value of assets and value of outstanding debt
Portion of profit paid out to stockholders called dividends
Portion kept by corporation called retained earnings
Economic Depreciation
Measures the decrease in market value of durable physical capital used by firms in the productive process as that capital is “used up”
Capital equipment used up in the sense that it wears out and becomes obsolete over time
Depreciation sometimes called a “capital consumption allowance”
Its inclusion in cost provides means for firm to accumulate a fund so as to recover capital cost and replace assets (machines, buildings) as they wear out, become obsolete
Accelerated Depreciation
Accelerated depreciation allows a firm to deduct more than the actual economic depreciation from its income each year
Expensing a capital asset is deduction of full purchase price of an asset in the year of its acquisition
Straight-line depreciation is deduction of the same fraction of the cost of an asset each year over its useful economic life
Depreciation and Inflation
Depreciation based on historic cost, or acquisition price of the asset
During inflation, depreciation calculated on basis of historic cost understates replacement cost of capital, overstates profits of firm
Inflation also benefits firms by decreasing value of debt outstanding
Experience capital gains on outstanding debt balances, real value declines
Separate Taxation of Corporate Income
Argued that separate corporate income tax is necessary to make corporations pay for special privileges obtained from corporate charters
Under a comprehensive personal income tax, corporate income would be allocated to shareholders on a pro rata basis according to percentage of stock owned
Integrating corporate tax with personal income could create problems such as, if realized capital gains taxable, such gains could be double-taxed
Double Taxation of Dividends
Current policy of separate taxation of corporate income and portion paid as dividends subjects portion of corporate income to double-taxation
Corporate income subject to taxation when earned, dividends subject to taxation under personal income tax for shareholders
If corporate and personal income taxes are integrated, no double-taxation
Corporate profits would be distributed to shareholders on a pro rata basis according to their share of ownership
Debt Finance
There is concern that corporate finance biased toward debt finance because dividends cannot be deducted from income, but interest can
Leveraged buyouts (LBOs) usually involve heavy borrowing by acquiring company, leaving corporation heavily in debt
Corporation can always borrow to purchase its own shares on the market
No longer has to pay dividends on those shares
Exchanges obligation to pay dividends for tax-deductible interest costs
Debt Financing
Tax Rate Structure
As of 2009, progressive with three brackets:
Effective Tax Rates
Measure of effective corporate tax rate shows tax rate paid by corporations on economic profits
Effect of inflation must be accounted for in calculating effective tax rates
Effective tax rate lowered by tax preferences in corporate income tax code allowing investment subsidies, accelerated depreciation, and expensing of capital assets
State Corporate Income Tax
Corporate income taxes averaged 6.5% of total state revenue in 2008.
All but three states had some sort of corporate income tax as of 2008.
Excluding Nevada, Texas, Washington, and Wyoming
Most states tax corporate income at flat rate.
MTRs applied to corporate income by states must be added to federal tax rates when analyzing impact of corporate income taxes.
As with personal income tax, many states tie corporate tax to federal tax base.
International Comparisons
U.S. has second highest tax rate on corporations, after Japan.
Trend toward lowering corporate taxation in some countries to provide incentives for increasing investment by U.S. multinational corporations
Boom in foreign investment in Ireland may be due to low corporate tax rates
Nations with relatively high tax rates can lose investment to foreign nations with lower tax rates.
Corporate Tax Rates
Short-Run Impact
Corporate income tax can be seen as discriminatory tax on income of one particular form of business organization.
Therefore expected to reduce net return to investment in corporate business in short run unless corporations can adjust to shift the tax
Adjust output in response to tax, as to raise prices
Short-run impact on stockholder income influences corporate long-run adjustments
Tax on Economic Profits
Long-Run Impact
Long-Run Impact
Corporate income tax causes reduction in investment in the corporate sector (B). Assuming perfectly inelastic supply, this implies increase in the supply of investable funds in the noncorporate sector (C). This lowers the return to these investments. In the long-run equilibrium, net return in the corporate sector is r*N = r2, the return to noncorporate investment. The tax reduces the return to all investment.
Long-Run Impact
Excess Burden of Corporate Income Tax
Incidence of Corporate Income Tax
Impact on output
Over time, output by corporate sector falls relative to that produced in noncorporate sector because of reduction in corporate investment
Changes in supply of goods could result in increase in price of goods from corporate sector, decrease in price of goods from noncorporate sector
Households spending large part of budgets on corporate goods experience reduction in real income relative to other households
Incidence of Corporate Income Tax
Impact on wages, income
If labor and capital used in fixed proportions in corporate sector, reduction in investment reduces capital input in long run, and a corresponding reduction in labor results
General level of wages may fall as result of tax
If corporate sector more labor-intensive than noncorporate, wages would fall to induce noncorporate sector to absorb labor from corporate
Corporate income tax can also affect real income of those who own noncapital inputs
Incidence of Corporate Income Tax
Impact on income distribution
Harberger states that corporate income tax is borne according to ownership of capital
Individuals benefit as much by price decreases of noncorporate goods caused by tax as they suffer increases of corporate goods
Burden of tax distributed in progressive way with respect to income because distribution of ownership of capital in U.S. is unequal
Portion of burden of tax could be shifted to workers in form of lower wages

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