Taxes on corporations

Introduction Corporations owned by shareholders → ownership transferable by selling shares Investors are responsible up to the amount invested Revenues from these taxes is likely inferior to the EB they generate In the U.S. Tax o corporations generated 14% of all tax revenues in 2009 Several aspects of corporate taxes are examined Justifications Structure of tax Incidence and EB Effects on behaviour Taxation of multinational corporations European experiences Proposal for reforms

Why taxing corporations? Legal justification: corporation is a legal entity, just like individual → must pay taxes No economic meaning → only individual pay taxes Why not taxing only the income of shareholders? Separation between ownership and control (Jensen and Meckling, 1976) Corporation is a separate entity, imperfect control by owners → it does not mean that it must be taxed Limited responsibility is a benefit for owners → corporate taxes are a user fee that owners pay for this benefit Taxes are not correlated to limits to responsibility Y invested in corporation not taxed as personal Y Corporation tax is a way to make individual pay for this tax shelter There are more efficient ways to deal with this problem

Structure of the tax Mainly referred to U.S. corporate income tax large majority of corporations in the world are American U.S. system has inspired other legal systems (e.g. via OECD fiscal templates) In the U.S. corporate income is taxed at 35% for income < 10 million (15% rate when tax base is less → rare) Statutory tax gives little information about effective burden → many deductions

Taxing corporate incomes Often corporate income taxation distinguishes between legal types of firms/corporations Individual firms and noncorporate societies taxed via personal income tax Corporations taxed via corporation income tax System typical of most European countries (e.g. Italy) Corporate income=revenues-costs-depreciations(and provisions)- passive interests

Tax base of a typical corporation tax Liabilities Revenues from sales Changes in provisions Increases in value of corporation wealth Increases in values (e.g., changes in costs/cost structures) Dividends from owned shares or passive interest on capital lent Deductions Operating and actual costs Losses Decreases in values Passive interests paid on borrowed capital Depreciations

Deductions Employee compensations are deduced → principle that for tax purposes, income should be measured net of expenses incurred in earning it Interest payments on borrowed capital → same principle But: when corporations finance themselves by issuing stocks → dividends paid to stockholders NOT deductible (in the U.S.) → asymmetry Depreciations of assets Economic depreciation → certain inputs of production (e.g. computers, vans) wear out/become obsolete over time → a cost to the firm Difficult to evaluate effective depreciation →tax code assigns a tax life to each type of asset → often a (quite imprecise) estimate of actual depreciation

Calculating value of depreciation allowances - 1  

Calculating value of depreciation allowances - 2  

Integration between personal taxation and corporate taxation Important not only understanding corporation tax liability, but the total tax rate of income generated in the corporate sector → integration of the personal and corporate income taxation Corporate earnings can be either retained or paid to stockholders as dividends → tax treatment of dividends at the core of integration between personal and corporate income taxation 3 possible ways for integration Classic system Full integration (partnership criterion) Dividend relief

Classic system Tax burden rises with amount of distributed profits All corporate earnings taxed through corporation tax Personal Y tax only on distributed profits (dividends) Non neutral system Tax burden rises with amount of distributed profits Double taxation of dividends Why do firms distribute profits? Signal solidity of the firm Nobody really knows USA still adopt classic system

Partnership criterion (aka full integration) Corporation earnings (distributed or not) are - partly or fully - included in the tax base of the shareholder’s personal Y tax Taxed with tax rates of personal Y tax If corporation earnings are fully included in personal Y tax base → Corporation tax is de facto eliminated Neutral Administrative problems (e.g. how to tax corporation earnings of an individual who held the shares for less than 1 year?) → not unsurmountable Advantages are the elimination of the huge EB involved in corporate taxation

Dividend relief Source of problems of integration is double taxation of dividends Double taxation can be eliminated in 2 alternative ways Allow corporation to deduct dividends paid to stockholders just as it deducts interest payments to bondholders Exclude dividends from taxation at the individual level Less neutral than full integration but lower administrative costs Corporation tax would still exist

International effective tax rates on corporate capital income Djankov et al. (2008) estimate the effective MARTAX on corporate capital income in different countries Such comparisons require assumptions about the choice of discount rate, expected rate of inflation etc. Djankov et al. (2008) maintain that their estimates are robust The effective burden of corporation taxes depends crucially on how investments are financed Borrowing Issuing stocks Internal funds More generally, the EB of corporate income tax depends on what type of tax it is

International comparisons (Djankov et al. 2008) COUNTRY Statutory rate Effective rate 1 year 5 year AUSTRALIA 30.0 21.96 23;03 CANADA 36.12 21.78 25.93 CHINA 33.00 15.75 CROATIA 20.06 6.04 11.90 France 35.43 14.06 14.42 HONG KONG 17.5 0.00 12.25 INDIA 36.59 20.28 24.29 INDONESIA 30.00 20.84 21.01 ITALY 37.25 23.82 JAPAN 42.05 28.66 31.64 SINGAPORE 20.00 10.25 13.17 SLOVENIA 25.00 14.38 15.76 UK 18.61 21.44 USA 35.20 18.19 31.99 VIETNAM 28.00 18.37 18.79

A tax on corporate capital? Corporation not allowed to deduct the opportunity cost of dividends paid to shareholders BUT: opportunity cost of K is included in tax base → corporation tax = tax on K used in corporate sector 2 main effects → Migration of capital from corporate sector until after tax rates of return are equalized throughout the economy → Partial tax shifting from capital return to labour return, depending on K intensity of production By reducing K accumulation in the corporate sector → tax distorts K from most effective use → EB Jorgenson and Yun (2001) estimate that EB of corporate taxation is high (about 24% of revenues collected, without tax interaction effects)

A tax on profits? The tax on corporate income can be equivalent to a tax on profits because costs of production are deducted from gross corporate income → what remains are ‘profits’ As such, no EB → tax does not affect decisions on prices and production → no behavioural adjustments for the firm → no tax shifting Wrong → economic profits require that opportunity costs of all inputs (including those supplied by owners) be included → tax on corporation does not allow deduction of K supplied by shareholders Stiglitz (1973) shows that under perfect certainty about future net rates of return and costs of financing → corporation tax = profit tax Heroic hypotheses

Effects of taxes on individual choices Corporation tax may affect 3 margins (firm behaviour and decisions) Size of investment in K Type of K to purchase Ways to finance investments Most of these decisions are taken simultaneously by the firm

Size of the investment - 1 Do features of corporate income taxation (accelerated depreciation, I tax credit) stimulate I demand? It depends on how corporations make I decisions 3 models Accelerator model Neoclassical model Cash flow model Accelerator model→ K is a fixed % of Y, depending on the fixed technology (Leontiev) If Y grows, K grows, I do not dependent on P (only on output size), t (tax rate) is irrelevant

Size of the investment - 2  

Size of the investment - 3 The idea is that a firm invests in a given K (e.g. a machinery) only if the before tax rate of return of the machinery exceeds C Example: if r=10%, δ=2%, t=35% and τ=15% → C=21,7% Jorgenson (1982) shows that I are very sensitive to C and taxes can affect C, as the formula indicates Engen and Skinner (1996) estimate that the elasticity of I to C is between 0.25 and 1

Size of the investment - 4 Cash flow model → I depend on firm’s capacity to self finance them There is no perfect K markets hypothesis, the firm must consider the borrowing costs Cash flow model presupposes that costs of self financing are lower due to asymmetric information in the credit markets If cash flow model is correct → lump sum tax on corporations would reduce I because reduces the cash flow, while this is not the case in the neoclassical model Stein (2005) finds positive correlation between firms’ cash flow and I levels → identification problem: successful firms might have both high cash flow and I

Financial choices and taxation Taxes affect 2 margins of firm financial choices Dividend policy Debt vs. equity finance

Dividend policy Firm’s profits can be either Distributed to shareholders Retained by the company to finance future I Without uncertainty about future I returns, without taxes and provided perfect K markets, the two ways are equivalent for stockholders Either they have 1$ paid in dividends or the value of their stock increases by 1$ Since dividends are taxed immediately and K gains are not taxed until they are realized → distributing dividends should not be preferred Instead, in the U.S. 60% of realized dividends are distributed. Why? Signalling effect → firm wants to signal solidity since K markets are imperfect Clientele effect → untaxed institutions (e.g. pension funds) face a tax rate =0 → certain firms attract these investors by paying high dividends Chetty and Saez (2004) find that after the 2003 reduction of the top tax rate on dividends in the U.S. from 35% to 15%, dividends surged by 20% as well as the number of corporations that paid them (also to taxed individuals) Estimated elasticity is -0.5

Debt vs. equity finance - 1 Firms have two ways of financing themselves Debt → firm pays interests on borrowed capital then gives the capital back Selling shares → pays dividends according to profits and shares Tax system affects these financial choices because of Definition of depreciation rates (already seen) Tax treatment of passive interests and returns on risky capital assets

Debt vs. equity finance - 2 Modigliani-Miller theorem → barring taxes and uncertainty about returns on firms investments, the two ways are equivalent in a efficient markets world → the value of a firm is unaffected by how that firm is financed. Tax treatment on debt and risky capital (shares) may alter this fundamental equivalence

Debt vs. equity finance - 3 With corporation tax (correlated to profits) firms prefer debt to shares With debt financing and deduction of interest payments, no distortion Net return for creditor = Gross return → neutrality With own capital (selling shares) gross return is subject to taxation Net return lower than market (gross, before tax) return To guarantee equality (neutrality) firm must reach a higher gross return→ reduces investments Gordon and Lee (2001) test the hypothesis that, if taxes affect debt- equity ratios → corporations with lower tax rates should use less debt (lower advantage of deducting interest from corporate taxable income) Econometric evidence that this is the case

Taxation of multinational corporations General rule: tax paid abroad cannot exceed tax paid under national tax law → tax paid abroad generates a tax credit 2 main complications Subsidiary status: a foreign firm owned by a national one but incorporated abroad Profits earned by a subsidiary are taxed only if repatriated to the parent company → incentives to create firms in ‘tax heavens’ Especially important now with internet companies, which do not need of large K and L investments Income allocation: difficult to know what part of the total income of a multinational firm is produced in each country Arm length principle → tax code treats domestic and foreign branches as separate enterprises selling goods to each other Parent company distributes its income artificially to the various branches so to minimize total tax liability