1. Taxation of Corporate Income
Chapter 15
Taxation of Corporate Income

2. Forms of Business
Sole Proprietorships
Partnerships
Corporations

3. Corporations Corporations are granted the legal status of people.
This means that they can own property and borrow money.

4. 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.

5. 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.

6. 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.

7. 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.

8. 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.

9. 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.

10. 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.

11. 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.

12. 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.

13. 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.

14. 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.

15. 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.

16. Demonstrating the Bias toward Debt Finance
Assumptions:10% interest;
34% tax rate
Item
All-Equity
50% Debt –
50% Equity
Balance Sheet
Total Assets
$1,000,000
Debt
$500,000
Shareholder’s Equity
Income Statement
Operating Income
$150,000
Interest Expense
$50,000
Taxable Income
$100,000
Income Tax
$51,000
$34,000
Income after Corporate Tax
$99,000
$66,000
Return on Equity
9.9%
13.2%
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.

17. 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.

18. Rate Structure Taxable Income
Average Tax Rate at the Beginning of the Bracket
Marginal Tax Rate
Less than $50,000 0%
15%
$50K < income<$75K
25%
$75K<income<$10 Mill
18%
34%
More than $10 Mill
35%

19. 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.

20. 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).

21. Figure 15.1 A Tax on Economic Profits
Price and Cost
Output per Year AC MC B
After-Tax Profits Q* E
MR = P A G F
AC*

22. 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.

23. Figure 15.2 Long-Run Impact of the Corporate Income TaxS D A
IC + IN i1
Interest Rate (Percent)
Total Investment per Year E i2 D’
EC1
EN1
IN1
SN=MSCN=MSRC
MSRN
Corporate Investment per Year
MSCC=MSRN=SC
MSRC = DC = rG B
Noncorporate Investment per Year C
IC1 r1
i1 = r1
rG*
rG*(1 – t) = rN*
IC2
D’C=rG(1 – t) r2
IN2
SN'
DINC
EN2 B
Return to Investment (Percent)
r1(1 – t) = r’
DIN
EC2

24. 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.

25. Figure 15.3 Impact of the Corporate Income Tax When the Supply of Savings is Not Perfectly Inelastic
Return to Investment (Percent)
Investment per Year r1 I1 S D C rG D' I2 rN B A

26. 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.