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CHAPTER 19. THE CORPORATION TAX. 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. Corporations.

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chapter 19

CHAPTER 19

THE CORPORATION TAX

slide2

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

corporations
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”
why tax corporations
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
structure
Structure

Revenue

- Expenses incurred earning revenues

Taxable Income

* Tax rate (15% - 35%)

Tax

- Credits

Total Tax

Alternative Minimum Tax

Treatment of Losses

effective tax rate on corporate capital
Effective Tax Rate on Corporate Capital
  • Statutory rate versus effective rate
    • Interest deductibility
    • Depreciation allowances
    • Inflation
    • Double taxation
  • Gravelle [2004]
    • Effective corporate rate = 32%; noncorporate rate = 18%
    • Sensitivity of estimate
incidence and excess burden
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
    • Stiglitz [1973] model
effects on behavior total physical investment
Effects on Behavior – Total Physical Investment
  • Accelerator Model
  • Neoclassical Model
  • Cash Flow Model
effects on behavior type of asset
Effects on Behavior-Type of Asset
  • Tax system encourages purchase of assets that receive relatively generous depreciation allowances
effects on behavior corporate finance
Effects on Behavior-Corporate Finance
  • 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
  • Did the tax system cause the corporate accounting scandals?
state corporation taxes
State Corporation Taxes
  • State taxes have similar incidence and efficiency problems as federal taxes
  • Variation of tax rates across state lines
taxation of multinational corporations
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
evaluation of tax treatment of multinational firms
Evaluation of Tax Treatment of Multinational Firms
  • Maximization of world income
  • Maximization of national income
corporation tax reform
Corporation Tax Reform
  • Full Integration (Partnership Method)
  • Issues
    • Nature of the corporation
    • Administrative feasibility
    • Effects on efficiency
    • Effects on saving
    • Effect on distribution of income
dividend relief
Dividend Relief
  • Allow corporation to deduct dividends
  • Exclude dividends from individual taxation
  • 2003 legislation – 15% maximal tax rate on dividends
allowable expenses
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
depreciation
Depreciation
  • What is depreciation?
  • Tax life of an asset
    • 3, 5, 7, 10, 15, 20, 27.5, and 39 years
    • Most 5 years
calculating the value of depreciation allowances straight line depreciation 10 year tax life
Calculating the Value of Depreciation Allowances – Straight-Line Depreciation, 10 year tax life
calculating the value of depreciation allowances straight line depreciation 5 year tax life
Calculating the Value of Depreciation Allowances – Straight-Line Depreciation, 5 year tax life
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Calculating the Value of Depreciation Allowances – Double Declining Balance Depreciation, 10 year tax life
general analysis of depreciation tax savings
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

more on depreciation
More on Depreciation
  • Accelerated depreciation
  • Expensing
  • Intangible Assets
investment tax credit
Investment Tax Credit

k = investment tax credit

q = acquisition price of asset

(1 – k)q = effective price of asset

stiglitz model
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

neoclassical model
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)

effect of user cost on investment
Effect of User Cost on Investment
  • Econometric problems
    • Role of expectations
    • Elasticity of supply curve of capital goods
    • Open economy problems
cash flow model
Cash Flow Model
  • What is cash flow?
  • Irrelevancy of cash flow in neoclassical model
  • Cost of internal versus external funds
  • Empirical results
maximization of world income
Maximization of World Income

rf = rUS

(1 – tf)rf = (1 – tUS)rUS

Full credit versus limited credit

maximization of national income
Maximization of National Income

this one

(1 – tf)rf = rUS

rf = rUS/(1 – tf)

if tf < 1, then rUS < rUS/(1 – tf)

Deduction of foreign tax payments from domestic income:

rf(1 – tf)(1 – tUS) = rUS(1 – tUS)

Note: this equation equivalent to …

effects on efficiency of full integration
Effects on Efficiency of Full Integration
  • Misallocation of resources between corporate and noncorporate sectors eliminated
  • Tax-induced distortions in savings decisions reduced
  • Remove incentive for “excessive” retained earnings
  • Reduce bias toward debt financing
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