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THE CORPORATION TAX
Chapter 19
I’ll probably kick myself for having said this, but when are we going to have the courage to point out that in our tax structure, the corporation tax is very hard to justify
President Ronald W. Reagan
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Corporations
Corporation – A state-chartered form of business organization, usually with limited liability for shareholders (owners) and an independent legal status
Limited liability
Corporations are “artificial legal persons”
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Why Tax Corporations
Only real people can pay a tax
Justifications
Corporations are distinct entities
Corporations receive special privileges from society
Protects integrity of personal income tax
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Structure
Revenue
- Expenses incurred earning revenues
Taxable Income
* Tax rate (15% - 35%)
Tax
- Credits
Total Tax
Alternative Minimum Tax
Treatment of Losses
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Allowable Expenses
Employee Compensation
Except compensation in excess of $1,000,000
Options do not have to be included
Cost of Material Inputs
Taxes including employer contributions to Social Security
Repairs and advertising
Interest but not dividends
Depreciation
No investment tax credit
k = investment tax credit
q = acquisition price of asset
(1 – k)q = effective price of asset
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Considerations
Depreciation
Economic depreciation: The extent to which an asset decreases in value during a period of time
Accelerated depreciation: Taking depreciation allowances faster than true economic depreciation
Expensing: deducting the asset’s full cost at time of acquisition
Tax life: the # of years an asset can be depreciated
3, 5, 7, 10, 15, 20, 27.5, and 39 years
Most 5 years
Intangibles
Treatment of Dividends versus Retained Earnings
Double taxation
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General Analysis of Depreciation Tax Savings
T = tax life
D(n) = proportion of asset that can be written off against taxable income in nth year
θ = corporate tax rate
Present value of tax savings:
ψ = θ * D(1) + θ * D(2) + … + θ * D(T) 1 + r (1 + r)2 (1 + r)T
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Calculating the Value of Depreciation Allowances – Straight-Line Depreciation, 10 year tax life
Year Write-off Tax Savings Present Value of Tax Savings
1 $10,000.00 $3,500.00 $3,181.82
2 $10,000.00 $3,500.00 $2,892.56
3 $10,000.00 $3,500.00 $2,629.60
4 $10,000.00 $3,500.00 $2,390.55
5 $10,000.00 $3,500.00 $2,173.22
6 $10,000.00 $3,500.00 $1,975.66
7 $10,000.00 $3,500.00 $1,796.05
8 $10,000.00 $3,500.00 $1,632.78
9 $10,000.00 $3,500.00 $1,484.34
10 $10,000.00 $3,500.00 $1,349.40
Total $100,000.00 $35,000.00 $21,505.98
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Calculating the Value of Depreciation Allowances – Straight-Line Depreciation, 5 year tax life
Year Write-off Tax Savings Present Value of Tax Savings
1 $20,000.00 $7,000.00 $6,363,64
2 $20,000.00 $7,000.00 $5,785.12
3 $20,000.00 $7,000.00 $5,259.20
4 $20,000.00 $7,000.00 $4,781.09
5 $20,000.00 $7,000.00 $4,346.45
Total $100,000.00 $35,000.00 $26,535,51
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Effective Tax Rate on Corporate Capital
Statutory rate versus effective rate
Interest deductibility
Depreciation allowances
Inflation
Double taxation
White House and Department of Treasury Report [2012]
Effective corporate rate = 29%
Sensitivity of estimate
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Incidence and Excess Burden
A tax on corporate capital
Incidence in a general equilibrium model
Excess burden on a general equilibrium model
A tax on economic profits
Incidence and excess burden of a tax on economic profits
Actual corporate profits versus economic profits
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Incidence and Excess Burden
Stiglitz Model
G = before-tax value of output produced by machine
r = interest rate
Firm buys machine if: G – r > 0
Assume corporate tax
(1) net income taxed at rate θ
(2) net income = G – r
(1 – θ)(G – r) > 0
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Effects on Behavior
Types of Assets
Tax system encourages purchase of assets that receive relatively generous depreciation allowances
Total Physical Investment
Accelerator Model
Neoclassical Model
Cash Flow Model
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Neoclassical Model
User cost of capital = (r + δ)
After tax rate of return = (1 – θ) * (1 – t)
(1 – θ) * (1 – t) * C = (r + δ)
C = (r + δ) (1 – θ) * (1 – t)
C = (r + δ) * (1 – ψ –k) (1 – θ) * (1 – t)
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Effect of User Cost on Investment
Econometric problems
Role of expectations
Elasticity of supply curve of capital goods
Open economy problems
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Cash Flow Model
What is cash flow
Irrelevancy of cash flow in neoclassical model
Cost of internal versus external funds
Empirical results
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Effects on Behavior
Corporate Finance: How to finance and whether to retain or distribute profits
Why do firms pay dividends
Dividends as a signal of firm’s financial strength
Clientele effect
Effect of taxes on dividend policy
Empirical evidence – Chetty and Saez [2004]
Effect on savings
Debt versus Equity Finance
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State Corporation Taxes
State taxes have similar incidence and efficiency problems as federal taxes
Variation of tax rates across state lines
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Taxation of Multinational Corporations
Structure
U. S. corporations pay tax at standard rate on global taxable income
Credit for foreign taxes paid
Subsidiary status
Deferral of taxes on income from foreign enterprise
Repatriation
Income allocation
Arm’s length system
Transfer-pricing problem
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Global vs. Territorial Taxation
Global Taxation: a system that taxes all income of a multinational company at the rate of the company’s home country, regardless of the nation in which the income is earned
rf = rUS
(1 – tf)rf = (1 – tUS)rUS
Full credit versus limited credit
Territorial Taxation: a system that taxes the income of a multinational company at the rate of the nation in which the income is earned
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Corporation Tax Reform
Full Integration
Issues
Nature of the corporation
Administrative feasibility
Effects on efficiency
Effects on saving
Effect on distribution of income
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Effects on Efficiency of Full Integration
Misallocation of resources between corporate and non-corporate sectors eliminated
Tax-induced distortions in savings decisions reduced
Remove incentive for “excessive” retained earnings
Reduce bias toward debt financing
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Corporation Tax Reform
Dividend Relief
Allow corporation to deduct dividends
Exclude dividends from individual taxation
2003 legislation – 15% maximal tax rate on dividends
2013 legislation – 23.8% maximal tax rate on dividends for high income families
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Chapter 19 Summary
The U.S. Corporate Income Tax of 35%, accounting for about 10% of all federal revenues, is controversial due to double taxation arising from the dividend income tax component of the personal income tax
Economic analysis centers on the effect of the tax on amount of physical investment, dividend income payments, debt financing, state taxes, and tax avoidance, particularly concerning multinational corporations
Tax reforms include full integration of corporate and personal income taxes, and dividend relief
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