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TO POLICY, Seventh Edition by David N. Hyman as an assigned textbook may reproduce material from this publication for classroom use or in a secure electronic network environment that prevents downloading or reproducing the copyrighted material. Otherwise, no part of this work covered by the copyright hereon may be reproduced or used in any form or by any means—graphic, electronic, or mechanical, including, but not limited to, photocopying, recording, taping, Web distribution, information networks, or information storage and retrieval systems—without the written permission of the publisher.
Printed in the United States of America
ISBN 0-03-033652-X
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 Sole Proprietorships
 Partnerships
 Corporations
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 Corporations are granted the legal status of people.
 This means that they can own property and borrow money.
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Corporations are owned by shareholders. Each share entitles its holder to a fraction of the
 dividends declared;
 of the vote at shareholders’ meetings that determine the operations of the corporation;
 proceeds if the corporation were to dissolve.
The fraction that applies is the reciprocal of the number of shares of the corporation that exists.
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 Corporations are subject to a corporate income tax in the U.S.
 Since the corporation is not really a person, the people who bear the burden of this tax depend on the shifting of the tax.
 The tax could be shifted backwards to employees, shifted forward to consumers or borne by the shareholders.
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 Using the comprehensive definition of income, business income is receipts + net capital gains income – labor, interest, material, and other business costs.
 In the U.S., only realized capital gains are included in net taxable income for corporations.
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 In a small business setting, the owner works for him or herself. The profit from the business is what this owner is “paid.”
 Some of this is normal profit, some economic profit.
 When there is a corporation there is no owner-supplied input so all profit, normal and economic, is taxed.
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 Corporate Profits = Corporate Taxes +
Retained Earnings + Dividends
 Retained Earnings are the portion of after-tax corporate profits that a company keeps to invest in the business.
 Dividends are the portion of after-tax corporate profits that are distributed to households.
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 Economic Depreciation is the amount that an asset devalues over time.
 When a business buys an expensive capital asset, it cannot deduct from corporate profits the entirety of the value of the asset.
 Because the asset will be productive for a substantial period of time, companies can only deduct a portion of the value of the asset.
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 Accelerated depreciation allows businesses to deduct the loss in the value of an asset before it occurs.
 The ultimate in accelerated depreciation is the allowance for expensing an asset in the year it is purchased.
 Typically assets are allowed to be depreciated on a straight-line basis, which means in equal increments for the life of an asset.
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 If inflation is running at a significant pace, then the replacement cost for a capital asset can be higher than the value remaining on the books.
 Depreciation is understated if firms are only allowed to use historic costs.
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 Corporate Income is considered to be double-taxed because it faces taxes on the same income twice.
 The Corporation must pay taxes on the profits then the shareholders must pay taxes on the amount they receive in either dividends or capital gains.
 Under a comprehensive income tax this would not happen. Corporate profits, either retained or paid in dividends, would enter individual income tax structures according to the percentage of the corporation owned by each shareholder.
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 Unrealized Capital Gains and the Stepped-Up
Basis:
 A major source of unrealized capital gains for individuals is corporate stocks. If the business profit were not taxed at the corporate level, it may never be taxed.
 Compensation for Bankruptcy Protection:
 Individuals are not liable for the bankruptcy of assets they hold in corporations whereas they are in cases of proprietorships and partnerships.
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 A corporation can raise money by borrowing or it can raise money by selling stock.
 The corporation can deduct from its profits the amount it pays in interest to its bondholders.
 It cannot deduct the dividends it pays to its stockholders. This encourages debt finance over equity finance.
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Assumptions:10% interest;
34% tax rate
Item
Balance Sheet
Total Assets
Debt
Shareholder’s Equity
All-Equity
$1,000,000
0
$1,000,000
50% Debt –
50% Equity
$1,000,000
$500,000
$500,000
Conclusion: The taxation of corporate profits combined with the deductibility of interest raises the after-tax return on equity to firms in greater debt thereby motivating firms to increase their debt burdens to an inefficiently high level.
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Income Statement
Operating Income
Interest Expense
Taxable Income
Income Tax
Income after
Corporate Tax
Return on Equity
$150,000
0
$150,000
$51,000
$99,000
9.9%
$150,000
$50,000
$100,000
$34,000
$66,000
13.2%

Taxable Income
Less than $50,000
$50K < income<$75K
$75K<income<$10
Mill
More than $10 Mill
Average Tax
Rate at the
Beginning of the
Bracket
0%
Marginal
Tax Rate
15%
15%
18%
34%
25%
34%
34%
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 The effective tax rate is the amount of corporate tax owed divided by the economic profit of the corporation.
 The effective tax rate can differ from the statutory tax rate because of accelerated depreciation rules.
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 The short-run economic incidence of the corporate tax can involve forward shifting (by raising prices) or backward shifting (by lowering wages).
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Figure 15.1 A Tax on Economic Profits
AC*
A
G
After-Tax Profits
MC
E
B
F
AC
MR = P
0
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Q*
Output per Year

 Investors can shift their money from corporate investments for non-corporate investments to maximize after-tax returns.
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Figure 15.2 Long-Run Impact of the Corporate
Income Tax
S
A i
1
E i
2 D
D’
B r
G
* i
1
= r
1 r
G
*(1 – t ) = r r
1
N
*
(1 – t ) = r’
0 I
C
+ I
N
Total Investment per Year
C
MSC
C
=MSR
N
=S
C
E
E
C1
C2
D
I
N
MSR
C
= D
C
= r
G
D’
C
=r
G
(1 – t )
0 I
C2
I
C1
Corporate Investment per Year
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E
N1
S
N
=MSC
N
=MSR
C
S
N
' r
1 r
2
B
E
N2
D
I
NC
MSR
N
0 I
N1
I
N2
Noncorporate Investment per Year

 This is a tax is on Corporate Revenue –
Expenditures on both current and capital inputs but interest payments would not be deductible.
 This would eliminate the bias toward debt.
 Would allow immediate expensing of capital assets.
 It would likely to be a revenue neutral change from the current system.
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Figure 15.3 Impact of the Corporate Income Tax When the
Supply of Savings is Not Perfectly Inelastic
S r r r
G
1
N
B
C
A
0
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D'
D
I
2
I
1
Investment per Year

 Depending on the elasticities of supply and demand in a multitude of markets (the sector of the economy for the output of the good, the local labor where the company does business etc.) the corporate income tax can be shifted innumerable places.
 Despite this, statistical studies support the conclusion that the net impact of the corporate income tax is such that it falls more greatly on the wealthy. This conclusion can be seen back in Figure 15.2 in that it falls on all capital that is generally held by the wealthy.
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