Chapter 15
Taxation of Corporate
Income
1
Forms of Business

Sole Proprietorships

Partnerships

Corporations
2
Corporations

Corporations are granted the legal
status of people.

This means that they can own property
and borrow money.
3
Corporate Ownership
Corporations are owned by shareholders. Each
share entitles its holder to a fraction of the
dividends
declared,
votes at shareholders’ meetings that determine the
operations of the corporation, and
proceeds if the corporation were to dissolve.
The fraction of all of the above that applies for each
shareholder is the number of shares held divided by
the total number of shares outstanding.
4
Corporate Taxes

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.
5
The Tax Base: Measuring Business Income

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.
6
Taxation of Owner-Supplied Inputs



In small business settings, owners work
for themselves. The profit from the
business is what each owner is “paid.”
Some of this is normal profit; some is
economic profit.
Corporations feature no owner-supplied
input so all profit, normal and
economic, is taxed.
7
Corporate Profits and Where They Go

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
shareholders.
8
Economic Depreciation

Economic Depreciation is the amount of
value that an asset loses over time.

When a business buys an expensive capital
asset, it cannot deduct from corporate profits
the entire 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.
9
Accelerated Depreciation

Accelerated depreciation allows businesses to
deduct the loss in the value of an asset before the
asset actually wears out.

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 the asset.
10
Inflation and Depreciation

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.
11
Undistributed Corporate Profits,
Dividends, And Interest Cost

Some argue that a separate corporate income
formula is necessary to reverse the tax preference
that comes from the exclusion of all unrealized
capital gains in calculating personal income tax.

Others counter that because payment on corporate
debt (interest) is deductible to the corporation but
payment on equity (dividends) is not, a separate
tax on corporate income is neutral.
12
Double Taxation of Corporate Income

Corporate Income is considered to be double-taxed,
because its income is taxed twice.

The Corporation must pay taxes on the profits, then
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.
13
Arguments in Favor of Double Taxing
Corporate Income
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
might never be taxed.
Compensation for Bankruptcy Protection:
 Individuals are not liable for the bankruptcy of
assets they hold in corporations, whereas they
are liable in cases of proprietorships and
partnerships. This poses a real advantage to
investing in corporations over the other business
forms.
14
The Consequence of Double Taxation: A
Bias Toward Debt Finance

A corporation can raise money by borrowing (taking
on debt), 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.
15
Demonstrating the Bias toward Debt Finance
Assumptions:10% interest;
34% tax rate
Item
Balance Sheet
Total Assets
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.
50% Debt –
50% Equity
All-Equity
$1,000,000
$1,000,000
0
$500,000
$1,000,000
$500,000
$150,000
$150,000
0
$50,000
$150,000
$100,000
Income Tax
$51,000
$34,000
Income after
Corporate Tax
$99,000
$66,000
9.9%
13.2%
Debt
Shareholder’s Equity
Income Statement
Operating Income
Interest Expense
Taxable Income
Return on Equity
16
Tax Treatment of Multinational Corporations

Large corporations with multinational operations
have foreign subsidiaries throughout the world.

The foreign subsidiaries are incorporated under the
laws of a foreign nation and are legally separate
from the parent corporation.

There are two ways of taxing multinationals:


Taxes only on “repatriated” profits.
Computing worldwide income and granting a credit for
tax payments made to other countries.
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Rate Structure
Average Tax
Rate at the
Beginning
of the
Bracket
Marginal
Tax Rate
0%
15%
$50K <
income<$75K
15%
25%
$75K<income<$10
Mill
18%
34%
More than $10 Mill
34%
35%
Taxable Income
Less than $50,000
18
Effective Tax Rates

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.
19
Short-Run Impact of Corporate Income
Taxation

The short-run economic incidence of
the corporate tax can involve forward
shifting (by raising prices) or backward
shifting (by lowering wages).
20
Figure 15.1 A Tax on Economic Profits
Price and Cost
MC
AC*
0
A
After-Tax Profits
E
B
G
F
Q*
Output per Year
AC
MR = P
21
Long-Run Impact of Corporate Income
Taxation

Investors may shift their money from
corporate investments to non-corporate
investments (like municipal bonds) to
maximize after-tax returns.
22
Interest Rate (Percent)
Figure 15.2 Long-Run Impact
of the Corporate Income Tax
A
S
i1
E
i2
D
D’
0
IC + I N
Return to Investment (Percent)
Total Investment per Year
B
C
MSCC=MSRN=SC
rG*
i 1 = r1
EC1
rG*(1 – t) = rN*
r1(1 – t) = r’
0
EN1
r1
r2
EC2
DIN
SN=MSCN=MSRC
B
MSRC = DC = rG
D’C=rG(1 – t)
IC2 IC1
Corporate Investment per Year
DINC
0
SN'
EN2
MSRN
IN1 IN2
Noncorporate Investment per Year
23
The Corporate Cash-Flow Tax




This is a tax is on corporate revenue –
expenditures on both current and capital
inputs, but interest payments would not be
deductible.
The Corporate Cash-Flow Tax would
eliminate the bias toward debt.
It would also allow immediate expensing of
capital assets.
It would likely be a revenue neutral change
from the current system.
24
Return to Investment (Percent)
Figure 15.3 Impact of the Corporate Income Tax When
the Supply of Savings is Not Perfectly Inelastic
S
rG
B
r1
rN
C
A
D
D'
0
I2 I1
Investment per Year
25
Incidence of Corporate Income Tax

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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