1
Chapter 17 – The Corporation
Tax
Public Economics
2
Introduction
? A corporation is a form of business
organization in which ownership is
usually represented by transferable stock
certificates
– Stockholders have limited liability
– Corporations are independent legal entities
? Can make contracts,hold property,incur debt,
sue,and be sued
3
Why Tax Corporations?
? Only real people can pay a tax,so why not just
tax incomes of corporation owners via the
personal income tax?
– Justification #1,Corporations are distinct entities,and
ownership and control are separated
– Justification #2,Corporations receive a number of
special privileges,such as limited liability,
Corporation tax simply a user fee.
– Justification #3,Corporation tax protects the integrity
of the personal income tax,Cannot simply
accumulate income within the corporation to defer tax
payments.
4
Structure
? Tax system can safely be presented as a
flat rate of 35%
? Statutory rate gives relatively little
information about the effective burden,
because we must know what deductions
are allowed
5
Structure,Deductions
? Employee compensation
? Interest payments,not dividends
? Depreciation
? No Investment Tax Credit
? Treatment of Dividends versus Retained
Earnings
6
Structure
? Employee compensation
– Wages and benefits are excluded from
taxable income
7
Structure
? Interest payments,not dividends
– When corporations borrow,interest
payments to lenders are excluded from
taxable income.
– When corporations finance activities by
issuing stock,dividends are not deductible.
8
Structure
? How should durable goods be treated in
determining taxable income?
? Buying a drill press (that lasts for 10 years) is
initially just an exchange of assets,not an
economic cost.
? As it is used,it is subject to wear and tear,
which decreases its value,This decrease in
value,called economic depreciation,is an
economic cost to the firm.
9
Structure
? Each year’s worth of depreciation should be
deductible from that year’s gross income.
? Difficult to measure true depreciation,or even
the useful life of durable goods,Instead,the tax
law specifies a tax life:
– For each asset,what proportion of its acquisition
value can be depreciated each year,and over how
many years.
10
Structure
? To calculate the value of the depreciation
allowances in the tax code,compute the present
value of the stream of depreciation allowances.
? Generally,the present value of these
allowances for a $1 asset would be:
? ?
? ?
? ?
? ?
? ?
? ?
?
? ? ?
?
?
?
?
?
?
? ?
?
?
D
r
D
r
D T
r T
1
1
2
1 12
.,,
11
Structure
? Thus,the presence of depreciation
allowances lowers the effective price of
acquiring durable assets from $q to $(1-
Ψ)q.
? Tax savings depends on value of T and
the function D(n).
– Tax benefits are more valuable the lower T is,
and the more front-loaded D(n) is.
12
Structure
? Accelerated depreciation is a scheme
to write off assets faster than true
economic depreciation.
? Expensing allows a firm to deduct from
current taxable income the asset’s full
cost at the time of acquisition.
13
Structure
? Under current law,T varies from 3 to 39
years.
– Racehorses are depreciated over 3 years
– Computers are depreciated over 5 years
– Nonresidential structures are depreciated
over 31.5 years
? Generally tax lives are shorter than actual
useful lives.
14
Structure
? Intangible assets – some spending,
such as an advertising campaign,may
increase sales over a number of years.
– Computing appropriate depreciation is
difficult.
15
Structure
? No Investment Tax Credit (ITC)
– Prior to 1986,ITC permitted a firm to subtract
some portion of the purchase price of an
asset from its tax liability at the time the asset
was acquired.
– ITC did not depend on corporate tax rate (in
contrast to depreciation allowances)
– Subtracted directly from tax liability,not
taxable income
16
Structure
? Discussion so far has focused on taxed directly
paid by corporation,Another issue is the total
tax rate on income generated by corporations.
– Corporate profits may either be retained by the firm
(retained earnings) or paid to stockholders (dividends)
– Dividends not deductible expense from corporations
viewpoint,and taxed in the personal income tax code
too.
17
Structure
? Recent legislation has moved toward
eliminating this double taxation of
dividends.
– Maximum tax rate on dividends received is
now 15% at the individual level.
18
Structure
? Retained earnings increase the value of
the corporation,and this increase should
be valued into the stock price.
? These increased capital gains are not
taxed until those gains are realized.
? Thus,tax system creates incentives for
firms to retain earnings rather than pay
them out in dividends.
19
Incidence and Excess Burden
? Economic consequences of the
corporation tax are very controversial.
? Not a consensus on just what kind of tax
it is.
– Tax on Corporate Capital
– Tax on Economic Profits
20
Incidence and Excess Burden:
Tax on Corporate Capital
? Firm is not allowed to deduct from taxable
income the opportunity cost of capital
supplied to shareholders.
? Therefore,the corporation tax is a partial
factor tax.
? Tax leads to migration of capital from the
corporate sector until the after-tax rates
of return are equalized.
21
Incidence and Excess Burden:
Tax on Corporate Capital
? As capital moves to the non-corporate
sector,the rate of return on capital to all
owners of capital is depressed.
? Reallocation also affects return to labor.
? Ultimate incidence depends on
production technology and structure of
consumers’ demands.
22
Incidence and Excess Burden:
Tax on Economic Profits
? Alternative view is that corporation tax is
tax on economic profits.
– Tax base = gross corporate income – costs
? Incidence of profits tax is straightforward,
no shifting of tax,Tax is borne by owners
of firm,no misallocation of resources.
23
Incidence and Excess Burden:
Tax on Economic Profits
? Problems:
– Base of pure profits tax is computed by subtracting
from gross earnings the value of all inputs including
the opportunity cost of the inputs supplied by the
owners.
– Not the case here.
? Under certain circumstances,corporation tax is
equivalent to profits tax (when corporation can
deduct interest payments to creditors).
24
Effects on Behavior
? Total Physical Investment
? Types of Asset
? Corporate Finance
25
Effects on Behavior:
Total Physical Investment
? Total Physical Investment
– Do features like accelerated depreciation and
the investment tax credit stimulate
investment demand?
– Will discuss three types of models:
? Accelerator model
? Neoclassical model
? Cash flow model
26
Effects on Behavior:
Total Physical Investment
? Accelerator model
– Main determinant of the amount of
investment is changes in the level of output
demanded.
– Depreciation allowances and investment tax
credits basically irrelevant
27
Effects on Behavior:
Total Physical Investment
? Neoclassical model
– Key variable is user cost of capital – the
cost the firm incurs as a consequence of
owning an asset.
– Includes direct costs like depreciation and
taxes
– Includes opportunity costs of forgoing other
investments
28
Effects on Behavior:
Total Physical Investment
? An investment will only be undertaken if
its return exceeds the user cost of capital.
? Define:
– r = return in capital market
– δ = depreciation
– θ = corporate tax rate
– t = personal tax rate
29
Effects on Behavior:
Total Physical Investment
? The user cost of capital is then defined as:
? ?
? ? ? ?
C
r
t
?
?
? ? ?
?
?1 1
? Thus,a company would only undertake a
project if the return where greater than C.
30
Effects on Behavior:
Total Physical Investment
? Previous equation did not account for
depreciation allowances (Ψ) or investment tax
credits (k),User cost of capital becomes:
? ?? ?
? ? ? ?C
r k
t
? ? ? ?
? ? ?
? ?
?
1
1 1
? By taxing corporate income,tax make capital
investment more expensive,but depreciation
allowances and ITCs lower the user cost.
31
Effects on Behavior:
Total Physical Investment
? How do user costs affect investment? If the
neoclassical model is correct,investment does
respond to depreciation allowances and ITCs.
? Econometrically,role of policy expectations in
the investment process is critical.
– Current investment depends on future values of the
user cost of capital.
– Elasticity around 0.4 seems reasonable.
32
Effects on Behavior:
Total Physical Investment
? Cash Flow Model
– Cash flow is the difference between revenues and
expenditures for inputs
– The more money on hand,the greater the capacity
for investment
– In neoclassical model,internal funds and borrowed
money had the same opportunity cost,In cash flow
model,cost of internal funds is lower than external
funds.
? For example,lenders may view a project as being more
uncertain than the management.
33
Effects on Behavior:
Types of Asset
? Tax system encourages the purchase of
certain types of assets,for example those
with generous depreciation allowances.
? Table 17.1 shows that the Tax Reform
Act of 1986 reduced the gap between tax
rates on equipment and structures.
Table 17.1
35
Effects on Behavior:
Corporate Finance
? Owners must decide how to finance a
firm’s operations,and whether to
distribute or retain profits.
36
Effects on Behavior:
Corporate Finance
? Why do firms pay dividends?
– If outcomes of all investments are known in advance
and there are no taxes,then the owners of a firm are
indifferent between a dollar of dividends or retained
earnings.
– In reality,tax system is not neutral – dividends are
more highly taxed,Surprisingly,in a typical year,
almost 79% of after-tax corporate profits are paid out
as dividends.
37
Effects on Behavior:
Corporate Finance
? Several explanations:
– Signal of firm’s financial strength
– Marginal tax rates of investors vary – some
firms,specialize” in attracting low marginal
tax rate investors,known as the clientele
effect.
38
Effects on Behavior:
Corporate Finance
? Several econometric studies have found
that when the opportunity cost of retained
earnings decreases,dividend payments
go down.
? Thus,tax system increases amount of
retained earnings.
39
Effects on Behavior:
Corporate Finance
? In raising money,firm can either borrow
money and pay interest (issue debt) or it
can issues shares of stock and pay
dividends (issue equity).
? U.S,tax system allows deductibility of
interest payments,but not dividend
payments,Thus,built in bias toward debt
financing.
40
Effects on Behavior:
Corporate Finance
? In one econometric study,Gordon and
Lee (2001) find that lowering the
corporate rate by 10 percentage points
lowers the percentage of the firm’s assets
financed by debt by 4 percent.
41
Effects on Behavior:
Corporate Finance
? Recent corporate scandals
– Number of firms,most notably Enron,used
deceptive and fraudulent practices to inflate
earnings and increase stock value.
– Is the tax system to blame?
? Dividend payments send a strong signal
about the profitability of a firm
? Tax code discourages firms from paying
dividends
42
State Corporation Taxes
? Almost all states levy their own corporation
income taxes
? Differ substantially with respect to the rate
structures and rules for defining taxable income
? Variation leads to many questions,If a state
levies a corporation tax,how much of the
burden is exported to citizens of other states?
– Immobile factors more likely to bear incidence of tax,
If capital is more mobile than labor,incidence tends
to fall on labor.
43
Taxation of Multinational
Corporations
? The value of assets invested in foreign
countries by U.S,firms was $6 trillion in
2001.
? U.S,multinational corporations are
allowed tax credits for taxes paid to
foreign governments.
44
Taxation of Multinational
Corporations
? Complications arise due to:
– Tax deferral using foreign subsidiaries
? A foreign subsidiary is a company owned by a
U.S,corporation but incorporated abroad.
– Tax avoidance via transfer pricing
? Price that one part of the company uses for
transferring resources to another part of the
company.
45
Recap of the Corporation Tax
? Structure
? Incidences
? Effects on Behavior
? State Taxes
? Multinational Corporations
Chapter 17 – The Corporation
Tax
Public Economics
2
Introduction
? A corporation is a form of business
organization in which ownership is
usually represented by transferable stock
certificates
– Stockholders have limited liability
– Corporations are independent legal entities
? Can make contracts,hold property,incur debt,
sue,and be sued
3
Why Tax Corporations?
? Only real people can pay a tax,so why not just
tax incomes of corporation owners via the
personal income tax?
– Justification #1,Corporations are distinct entities,and
ownership and control are separated
– Justification #2,Corporations receive a number of
special privileges,such as limited liability,
Corporation tax simply a user fee.
– Justification #3,Corporation tax protects the integrity
of the personal income tax,Cannot simply
accumulate income within the corporation to defer tax
payments.
4
Structure
? Tax system can safely be presented as a
flat rate of 35%
? Statutory rate gives relatively little
information about the effective burden,
because we must know what deductions
are allowed
5
Structure,Deductions
? Employee compensation
? Interest payments,not dividends
? Depreciation
? No Investment Tax Credit
? Treatment of Dividends versus Retained
Earnings
6
Structure
? Employee compensation
– Wages and benefits are excluded from
taxable income
7
Structure
? Interest payments,not dividends
– When corporations borrow,interest
payments to lenders are excluded from
taxable income.
– When corporations finance activities by
issuing stock,dividends are not deductible.
8
Structure
? How should durable goods be treated in
determining taxable income?
? Buying a drill press (that lasts for 10 years) is
initially just an exchange of assets,not an
economic cost.
? As it is used,it is subject to wear and tear,
which decreases its value,This decrease in
value,called economic depreciation,is an
economic cost to the firm.
9
Structure
? Each year’s worth of depreciation should be
deductible from that year’s gross income.
? Difficult to measure true depreciation,or even
the useful life of durable goods,Instead,the tax
law specifies a tax life:
– For each asset,what proportion of its acquisition
value can be depreciated each year,and over how
many years.
10
Structure
? To calculate the value of the depreciation
allowances in the tax code,compute the present
value of the stream of depreciation allowances.
? Generally,the present value of these
allowances for a $1 asset would be:
? ?
? ?
? ?
? ?
? ?
? ?
?
? ? ?
?
?
?
?
?
?
? ?
?
?
D
r
D
r
D T
r T
1
1
2
1 12
.,,
11
Structure
? Thus,the presence of depreciation
allowances lowers the effective price of
acquiring durable assets from $q to $(1-
Ψ)q.
? Tax savings depends on value of T and
the function D(n).
– Tax benefits are more valuable the lower T is,
and the more front-loaded D(n) is.
12
Structure
? Accelerated depreciation is a scheme
to write off assets faster than true
economic depreciation.
? Expensing allows a firm to deduct from
current taxable income the asset’s full
cost at the time of acquisition.
13
Structure
? Under current law,T varies from 3 to 39
years.
– Racehorses are depreciated over 3 years
– Computers are depreciated over 5 years
– Nonresidential structures are depreciated
over 31.5 years
? Generally tax lives are shorter than actual
useful lives.
14
Structure
? Intangible assets – some spending,
such as an advertising campaign,may
increase sales over a number of years.
– Computing appropriate depreciation is
difficult.
15
Structure
? No Investment Tax Credit (ITC)
– Prior to 1986,ITC permitted a firm to subtract
some portion of the purchase price of an
asset from its tax liability at the time the asset
was acquired.
– ITC did not depend on corporate tax rate (in
contrast to depreciation allowances)
– Subtracted directly from tax liability,not
taxable income
16
Structure
? Discussion so far has focused on taxed directly
paid by corporation,Another issue is the total
tax rate on income generated by corporations.
– Corporate profits may either be retained by the firm
(retained earnings) or paid to stockholders (dividends)
– Dividends not deductible expense from corporations
viewpoint,and taxed in the personal income tax code
too.
17
Structure
? Recent legislation has moved toward
eliminating this double taxation of
dividends.
– Maximum tax rate on dividends received is
now 15% at the individual level.
18
Structure
? Retained earnings increase the value of
the corporation,and this increase should
be valued into the stock price.
? These increased capital gains are not
taxed until those gains are realized.
? Thus,tax system creates incentives for
firms to retain earnings rather than pay
them out in dividends.
19
Incidence and Excess Burden
? Economic consequences of the
corporation tax are very controversial.
? Not a consensus on just what kind of tax
it is.
– Tax on Corporate Capital
– Tax on Economic Profits
20
Incidence and Excess Burden:
Tax on Corporate Capital
? Firm is not allowed to deduct from taxable
income the opportunity cost of capital
supplied to shareholders.
? Therefore,the corporation tax is a partial
factor tax.
? Tax leads to migration of capital from the
corporate sector until the after-tax rates
of return are equalized.
21
Incidence and Excess Burden:
Tax on Corporate Capital
? As capital moves to the non-corporate
sector,the rate of return on capital to all
owners of capital is depressed.
? Reallocation also affects return to labor.
? Ultimate incidence depends on
production technology and structure of
consumers’ demands.
22
Incidence and Excess Burden:
Tax on Economic Profits
? Alternative view is that corporation tax is
tax on economic profits.
– Tax base = gross corporate income – costs
? Incidence of profits tax is straightforward,
no shifting of tax,Tax is borne by owners
of firm,no misallocation of resources.
23
Incidence and Excess Burden:
Tax on Economic Profits
? Problems:
– Base of pure profits tax is computed by subtracting
from gross earnings the value of all inputs including
the opportunity cost of the inputs supplied by the
owners.
– Not the case here.
? Under certain circumstances,corporation tax is
equivalent to profits tax (when corporation can
deduct interest payments to creditors).
24
Effects on Behavior
? Total Physical Investment
? Types of Asset
? Corporate Finance
25
Effects on Behavior:
Total Physical Investment
? Total Physical Investment
– Do features like accelerated depreciation and
the investment tax credit stimulate
investment demand?
– Will discuss three types of models:
? Accelerator model
? Neoclassical model
? Cash flow model
26
Effects on Behavior:
Total Physical Investment
? Accelerator model
– Main determinant of the amount of
investment is changes in the level of output
demanded.
– Depreciation allowances and investment tax
credits basically irrelevant
27
Effects on Behavior:
Total Physical Investment
? Neoclassical model
– Key variable is user cost of capital – the
cost the firm incurs as a consequence of
owning an asset.
– Includes direct costs like depreciation and
taxes
– Includes opportunity costs of forgoing other
investments
28
Effects on Behavior:
Total Physical Investment
? An investment will only be undertaken if
its return exceeds the user cost of capital.
? Define:
– r = return in capital market
– δ = depreciation
– θ = corporate tax rate
– t = personal tax rate
29
Effects on Behavior:
Total Physical Investment
? The user cost of capital is then defined as:
? ?
? ? ? ?
C
r
t
?
?
? ? ?
?
?1 1
? Thus,a company would only undertake a
project if the return where greater than C.
30
Effects on Behavior:
Total Physical Investment
? Previous equation did not account for
depreciation allowances (Ψ) or investment tax
credits (k),User cost of capital becomes:
? ?? ?
? ? ? ?C
r k
t
? ? ? ?
? ? ?
? ?
?
1
1 1
? By taxing corporate income,tax make capital
investment more expensive,but depreciation
allowances and ITCs lower the user cost.
31
Effects on Behavior:
Total Physical Investment
? How do user costs affect investment? If the
neoclassical model is correct,investment does
respond to depreciation allowances and ITCs.
? Econometrically,role of policy expectations in
the investment process is critical.
– Current investment depends on future values of the
user cost of capital.
– Elasticity around 0.4 seems reasonable.
32
Effects on Behavior:
Total Physical Investment
? Cash Flow Model
– Cash flow is the difference between revenues and
expenditures for inputs
– The more money on hand,the greater the capacity
for investment
– In neoclassical model,internal funds and borrowed
money had the same opportunity cost,In cash flow
model,cost of internal funds is lower than external
funds.
? For example,lenders may view a project as being more
uncertain than the management.
33
Effects on Behavior:
Types of Asset
? Tax system encourages the purchase of
certain types of assets,for example those
with generous depreciation allowances.
? Table 17.1 shows that the Tax Reform
Act of 1986 reduced the gap between tax
rates on equipment and structures.
Table 17.1
35
Effects on Behavior:
Corporate Finance
? Owners must decide how to finance a
firm’s operations,and whether to
distribute or retain profits.
36
Effects on Behavior:
Corporate Finance
? Why do firms pay dividends?
– If outcomes of all investments are known in advance
and there are no taxes,then the owners of a firm are
indifferent between a dollar of dividends or retained
earnings.
– In reality,tax system is not neutral – dividends are
more highly taxed,Surprisingly,in a typical year,
almost 79% of after-tax corporate profits are paid out
as dividends.
37
Effects on Behavior:
Corporate Finance
? Several explanations:
– Signal of firm’s financial strength
– Marginal tax rates of investors vary – some
firms,specialize” in attracting low marginal
tax rate investors,known as the clientele
effect.
38
Effects on Behavior:
Corporate Finance
? Several econometric studies have found
that when the opportunity cost of retained
earnings decreases,dividend payments
go down.
? Thus,tax system increases amount of
retained earnings.
39
Effects on Behavior:
Corporate Finance
? In raising money,firm can either borrow
money and pay interest (issue debt) or it
can issues shares of stock and pay
dividends (issue equity).
? U.S,tax system allows deductibility of
interest payments,but not dividend
payments,Thus,built in bias toward debt
financing.
40
Effects on Behavior:
Corporate Finance
? In one econometric study,Gordon and
Lee (2001) find that lowering the
corporate rate by 10 percentage points
lowers the percentage of the firm’s assets
financed by debt by 4 percent.
41
Effects on Behavior:
Corporate Finance
? Recent corporate scandals
– Number of firms,most notably Enron,used
deceptive and fraudulent practices to inflate
earnings and increase stock value.
– Is the tax system to blame?
? Dividend payments send a strong signal
about the profitability of a firm
? Tax code discourages firms from paying
dividends
42
State Corporation Taxes
? Almost all states levy their own corporation
income taxes
? Differ substantially with respect to the rate
structures and rules for defining taxable income
? Variation leads to many questions,If a state
levies a corporation tax,how much of the
burden is exported to citizens of other states?
– Immobile factors more likely to bear incidence of tax,
If capital is more mobile than labor,incidence tends
to fall on labor.
43
Taxation of Multinational
Corporations
? The value of assets invested in foreign
countries by U.S,firms was $6 trillion in
2001.
? U.S,multinational corporations are
allowed tax credits for taxes paid to
foreign governments.
44
Taxation of Multinational
Corporations
? Complications arise due to:
– Tax deferral using foreign subsidiaries
? A foreign subsidiary is a company owned by a
U.S,corporation but incorporated abroad.
– Tax avoidance via transfer pricing
? Price that one part of the company uses for
transferring resources to another part of the
company.
45
Recap of the Corporation Tax
? Structure
? Incidences
? Effects on Behavior
? State Taxes
? Multinational Corporations
