Copyright © 2002 by Thomson Learning, Inc. Chapter 15 Taxation of Corporate Income Copyright © 2002 Thomson Learning, Inc. Thomson Learning™ is a trademark used herein under license. ALL RIGHTS RESERVED. Instructors of classes adopting PUBLIC FINANCE: A CONTEMPORARY APPLICATION OF THEORY 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 X

Copyright © 2002 by Thomson Learning, Inc. Forms of Business  Sole Proprietorships  Partnerships  Corporations

Copyright © 2002 by Thomson Learning, Inc. Corporations  Corporations are granted the legal status of people.  This means that they can own property and borrow money.

Copyright © 2002 by Thomson Learning, Inc. Corporate Ownership 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.

Copyright © 2002 by Thomson Learning, Inc. 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.

Copyright © 2002 by Thomson Learning, Inc. 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.

Copyright © 2002 by Thomson Learning, Inc. Taxation of Owner-Supplied Inputs  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.

Copyright © 2002 by Thomson Learning, Inc. 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 households.

Copyright © 2002 by Thomson Learning, Inc. Economic Depreciation  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.

Copyright © 2002 by Thomson Learning, Inc. Accelerated Depreciation  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.

Copyright © 2002 by Thomson Learning, Inc. 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.

Copyright © 2002 by Thomson Learning, Inc. Double Taxation of Corporate Income  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.

Copyright © 2002 by Thomson Learning, Inc. 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 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.

Copyright © 2002 by Thomson Learning, Inc. A Bias Toward Debt Finance  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.

Copyright © 2002 by Thomson Learning, Inc. Demonstrating the Bias toward Debt Finance ItemAll-Equity50% Debt – 50% Equity Balance Sheet Total Assets$1,000,000 Debt0$500,000 Shareholder’s Equity $1,000,000$500,000 Income Statement Operating Income$150,000 Interest Expense0$50,000 Taxable Income$150,000$100,000 Income Tax$51,000$34,000 Income after Corporate Tax $99,000$66,000 Return on Equity9.9%13.2% Assumptions:10% interest; 34% tax rate 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.

Copyright © 2002 by Thomson Learning, Inc. Rate Structure Taxable IncomeAverage Tax Rate at the Beginning of the Bracket Marginal Tax Rate Less than $50,0000%15% $50K < income<$75K 15%25% $75K<income<$10 Mill 18%34% More than $10 Mill34%

Copyright © 2002 by Thomson Learning, Inc. 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.

Copyright © 2002 by Thomson Learning, Inc. 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).

Copyright © 2002 by Thomson Learning, Inc. Figure 15.1 A Tax on Economic Profits Price and Cost Output per Year 0 Q* MR = P B After-Tax Profits AC MC E F A G AC*

Copyright © 2002 by Thomson Learning, Inc. Long-Run Impact of Corporate Income Taxation  Investors can shift their money from corporate investments for non-corporate investments to maximize after-tax returns.

Copyright © 2002 by Thomson Learning, Inc. Figure 15.2 Long-Run Impact of the Corporate Income Tax A i2i2 I C + I N i1i1 r 1 (1 – t) = r’ r2r2 I N2 I N1 rG*rG* r G *(1 – t) = r N * I C2 S N =MSC N =MSR C S MSR N D’ Return to Investment (Percent) Corporate Investment per Year MSC C =MSR N =S C D’ C =r G (1 – t) MSR C = D C = r G 0 B Noncorporate Investment per Year 0 SN'SN' C Interest Rate (Percent) Total Investment per Year 0 D ININ I C1  I NC E C1 E C2 E N2 E N1 r1r1 B i 1 = r 1 E

Copyright © 2002 by Thomson Learning, Inc. 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.