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 TaxTreatment 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 $3,181.822 $10,000.00 $3,500.00 $2,892.563 $10,000.00 $3,500.00 $2,629.604 $10,000.00 $3,500.00 $2,390.555 $10,000.00 $3,500.00 $2,173.226 $10,000.00 $3,500.00 $1,975.667 $10,000.00 $3,500.00 $1,796.058 $10,000.00 $3,500.00 $1,632.789 $10,000.00 $3,500.00 $1,484.34

10 $10,000.00 $3,500.00 $1,349.40Total $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 $4,781.095 $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 BurdenStiglitz 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 ReformFull 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 ReformDividend 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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