CHAPTER
19
The Corporation Tax
McGraw-Hill/Irwin
Copyright © 2010 by the McGraw-Hill Companies, Inc. All rights reserved.
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
19-2
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”
19-3
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
19-4
Structure
Revenue
- Expenses incurred earning revenues
Taxable Income
* Tax rate (15% - 35%)
Tax
- Credits
Total Tax
Alternative Minimum Tax
Treatment of Losses
19-5
Treatment of Dividends versus
Retained Earnings
• Double taxation
19-6
Effective Tax Rate on Corporate
Capital
• Statutory rate versus effective rate
–
–
–
–
Interest deductibility
Depreciation allowances
Inflation
Double taxation
• Gravelle [2004]
– Effective corporate rate = 32%; non-corporate rate = 18%
– Sensitivity of estimate
19-7
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
19-8
Effects on Behavior – Total
Physical Investment
• Accelerator Model
• Neoclassical Model
• Cash Flow Model
19-9
Effects on Behavior-Type of Asset
• Tax system encourages purchase of assets that
receive relatively generous depreciation
allowances
19-10
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
19-11
State Corporation Taxes
• State taxes have similar incidence and
efficiency problems as federal taxes
• Variation of tax rates across state lines
19-12
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
19-13
Evaluation of Tax Treatment of
Multinational Firms
• Maximization of world income
• Maximization of national income
19-14
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
19-15
Dividend Relief
• Allow corporation to deduct dividends
• Exclude dividends from individual taxation
• 2003 legislation – 15% maximal tax rate on
dividends
19-16
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
19-17
Depreciation
• What is depreciation?
• Tax life of an asset
– 3, 5, 7, 10, 15, 20, 27.5, and 39 years
– Most 5 years
19-18
Calculating the Value of Depreciation Allowances –
Straight-Line Depreciation, 10 year tax life
Year
Write-off
Tax Savings
1
2
3
4
5
6
7
8
9
10
Total
$10,000.00
$10,000.00
$10,000.00
$10,000.00
$10,000.00
$10,000.00
$10,000.00
$10,000.00
$10,000.00
$10,000.00
$100,000.00
$3,500.00
$3,500.00
$3,500.00
$3,500.00
$3,500.00
$3,500.00
$3,500.00
$3,500.00
$3,500.00
$3,500.00
$35,000.00
Present Value of
Tax Savings
$3,181.82
$2,892.56
$2,629.60
$2,390.55
$2,173.22
$1,975.66
$1,796.05
$1,632.78
$1,484.34
$1,349.40
$21,505.98
19-19
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
$4,781.09
5
$20,000.00
$7,000.00
$4,346.45
Total
$100,000.00
$35,000.00
$26,535,51
19-20
Calculating the Value of Depreciation Allowances –
Double Declining Balance Depreciation, 10 year tax life
Year
Write-off
Tax Savings
1
$20,000.00
$7,000.00
Present Value of
Tax Savings
$6,363.64
2
$16,000.00
$5,600.00
$4,628.10
3
$12,800.00
$4480.00
$3,365.89
4
$10,240.00
$3,584.00
$2,447.92
5
$6,826.67
$2,389.33
$1,483.59
6
$6,826.67
$2,389.33
$1,348.72
7
$6,826.67
$2,389.33
$1,226.11
8
$6,826.67
$2,389.33
$1,114.64
9
$6,826.67
$2,389.33
$1,013.31
10
$6,826.67
$2,389.33
$921.19
Total
$100,000.00
$35,000.00
$23,913.10
19-21
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
19-22
More on Depreciation
• Accelerated depreciation
• Expensing
• Intangible Assets
19-23
Investment Tax Credit
k = investment tax credit
q = acquisition price of asset
(1 – k)q = effective price of asset
19-24
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
19-25
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)
19-26
Effect of User Cost on Investment
• Econometric problems
– Role of expectations
– Elasticity of supply curve of capital goods
– Open economy problems
19-27
Cash Flow Model
•
•
•
•
What is cash flow?
Irrelevancy of cash flow in neoclassical model
Cost of internal versus external funds
Empirical results
19-28
Maximization of World Income
rf = rUS
(1 – tf)rf = (1 – tUS)rUS
Full credit versus limited credit
19-29
Maximization of National Income
this one
(1 – tf)rf = rUS
rf = rUS/(1 – tf)
if tf < 1, then rUS < rUS/(1 – tf)
Note: this
Deduction
of foreign
equation
equivalent to …
tax payments
from domestic income:
rf(1 – tf)(1 – tUS) = rUS(1 – tUS)
19-30
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
19-31