Economic subjects | Taxation » Public Finance

Source: http://www.doksinet Economics 309: Public Finance Northwestern University, Witte Corporate Taxation I. Putting a special tax on income earned on production done through the form of a “corporation” creates various effects, most of them bad. a. Less production occurs through this form than otherwise would b. Corporations are run to maximizing after-tax profits i. Which means reducing reported profits (and even actual profits) ii. DWL from interfering with paying out of income to owners I. Why tax corporations? Here are some possible reasons. a. Progressivity? Corporations are generally owned by wealthier people b. Broad tax base; tax everything a little bit c. Low DWL source of revenue? (Doubtful!) II. What does it mean to tax corporations? a. In the year 2000what was Fed Chairman Alan Greenspan’s great fear? Budget surpluses! Why? i. His fear of expanding the role of government If budget surpluses got big enough and lasted long enough so that the US paid off all of its

debt, then the Fed would not be able to buy and sell government bonds when it did its Open Market Operations. Instead, it might have to (return to) buying private securities if it wanted to expand the monetary base. b. Should government own private securities? Right now the private sector has claims on the government; would it be bad if it where the other way around and the government was a net owner of the private economy? Would it affect government policy to favor the corporate sector in order to increase corporate profits? c. MTR = 35% for profits of firms above a certain size (about $100,000 in annual net income). i. If government has claims to 35% of corporate profit, this is equivalent to 35% of the ownership of the corporate sector (although without the voting control of the companies involved). ii. As such, Greenspan’s fears seem silly d. Corp taxes equaled 232% of federal revenue in 1960, but only about 7% now. (This is in contrast to the huge rise over that period of

payroll taxes e. In theory, taxing profits should be virtually zero DWL f. In practice, the DWL result is pretty ugly g. Why not integrate corporate and personal income taxes? i. If I own 1% of Microsoft, why not say that my income includes 1% of Microsoft’s profits and tax me on that? ii. Complication one: Differing personal MTR’s would affect interest in holding income earning stocks iii. Complication two: Liquidity problems If Microsoft has a great year with lots of income, but doesn’t pay it out to me, I just get the tax Source: http://www.doksinet burden but not the income to pay it (although I could borrow against the rising value of my shares, or sell some of them). III. Corporate taxation: What goes wrong? a. Four big distortions i. Nominal interest payments are deductible from corporate income ii. Capital depreciation for tax purposes is not equal to true economic depreciation. iii. The tax code gives preferential treatment to retained earnings that leads a

preference for capital gains (taxed only at realization) over dividends. iv. The tax code favors debt over equity finance b. True profits = sales - materials – labor compensation (wages, salaries, benefits) - real interest - replacement cost depreciation c. Should tax economic profit but we tax accounting profit, this distorts incentives d. Should deduct economic depreciation (the amount that the capital stock wears out, becomes worse over time) but we deduct accounting depreciation (following made-up rules), to the extent these differ, it distorts incentives to build up capital e. Wedges between paying for financing through equity (stock) or debt (bonds), interest on bonds is expensed by the corporation and thus reduces taxable income, dividends are paid out of after-tax corporate profit (and then both are often taxed at the personal level by the investors who receive them) f. Glenn Hubbard and Bush temporary cut in tax on dividends at the personal level – a mess! g. Tax on

dividends creates an incentive for corporations to retain earnings and create capital gains h. Effects on corporate form, the corporate income tax discourages a lot of economic activity that might be better handled through corporations from making use of this handy legal form. IV. History of Corporate Taxation a. Like the personal income tax, the corporate income tax in the US began as a temporary measure during the Civil War but was adopted on a permanent basis in 1909. b. It did not have the Constitutional problems faced by the personal income tax because Congress decided the corporate income tax was a form of a legal "excise" tax and was favored as a tax primarily on the wealthy. The top marginal tax rate was 1% through 1915 then rose into the mid-teens before jumping upward to 40% in 1942 and then a bit over 50% from 1951 to 1970 (with a brief Kennedy tax cut in there). Reagan cut the rate in 1986 and the current top rate is 35%. c. It made some sense to cut rates

because as a share of GDP, corporate tax revenues have been in decline. They were 14% of GDP in 1939, jumped to 7.1% in 1943 (due to higher tax rates and a better economy) but began to fall Source: http://www.doksinet after the tax rate increase in 1950, and they are now about 2.5% of GDP This is largely due to the decline in the taxable income of corporations (from 13.5% of GDP in 1950 to less than 5% today) due partially to increased deductibility of depreciation and investment tax credits but also to the rise in deductible interest expense. d. Net interest payments by corporations were 03% of GDP in 1950 before the corporate tax rate went over 50%, and now they are nearly 2.5% of GDP, due to this favoring of debt by the tax code. e. For the overall government budget, this decline in revenues from the corporate income tax has been more than balanced out by increased collections of the payroll tax. V. Effects of Incorporation a. Many forms for a firm to take i. Sole proprietorship

(not a corporation) ii. Partnership (not a corporation) iii. S-corporation (S for “small”, profits taxed as ordinary income on the owners’ income tax form) To be an S-corp, five conditions must be met: 1. No more than 35 shareholders (must be small) 2. No corporate shareholders (can’t just be the profit center for some larger corporation) 3. Not part of some affiliated group (again, not just a loophole to avoid taxes on some corporations profits) 4. Only one class of stock (no preferred or non-voting shares), 5. Not just a domestic outlet for some international sale corporation (dont want Honda selling its cars here without paying lots of taxes). iv. C-corporation (C for “corporation”, profits taxed at rising MTRs at the corporate level, then also at the individual level when paid out as dividends) v. For a C-corp, when we tax dividends at the personal level, it creates a lot of DWL. Example: $1 of earnings paid as a dividend to a wealthy person taxed at 35% at the

corporate level, and then 35% again at the individual level, for an effective after tax return of $1*(1.35)*(1-.35) = $042, or a 58% MTR Ouch! vi. Most corporations are small enough that their profits are taxed as personal incomes of their proprietors (S-corporations). Only "Ccorporations" are taxable at the corporate rate and these made up only about 10% of corporations, but about 60% of all business income. The corporate tax is graduated by the size of the companys income at rates running from 15% to 35% for companies with taxable incomes over $75,000, with most companies in the 35% bracket. (Actually it’s much worse than it sounds Gruber’s graph on page 699 shows how crazy things are with this.) Source: http://www.doksinet b. Choosing to be a corporation brings with it the cost of corporate profits taxation, which leads one to wonder why any firm would choose to incorporate. c. There are benefits to being a corporation as well The principal one of these seems to be

the ability to raise lots of money from many investors through an initial offering of stock for sale on the market, which is important for large of modern enterprises. i. Continuity of life - Sole proprietorships and partnerships die with the death of one of the partners (although they can be reformed with new ownership right away). ii. Centralized management - Is the company really one enterprise or just part of some larger organization? iii. Easy transferability of shares - Not necessarily publicly traded, do members buy each other out from time to time? iv. Limited liability - Thus the personal assets of the owners of the company are not automatically at risk of being grabbed to make up any unpaid debts by the company. This restriction or advantage is weaker than it seems. Liability can be avoided or reduced by noncorporations through purchases of insurance Liability of personal assets can be increased through clauses written into contracts and loan or bond covenants. This is often

done if the corporation is so small and has so few assets that other companies and lenders dont want to deal with it since theres so little there to sue for if things go wrong. d. There are even tax benefits to being a corporation as well involving fringe benefits and the treatment of losses against other income. VI. Corporate Taxation and Corporate Investment in Business Capital a. Compensation to capital: i. Stocks: Dividends (share of the profit) and capital gains (retained earnings), dividends are taxed at the firm level and then again at the personal level (double taxation!), capital gains are taxed at realization (maybe). ii. Bonds: Interest payments are deductible by the firm, but are taxable income by the individual iii. Tax wedge at the firm level in favor of debt and interest over equity and dividends because interest is deductible b. Neoclassical model of investment: i. Dale Jorgenson, Martin Feldstein ii. Firms will invest up to the point that the after tax marginal

product of capital is equal to the cost of financing investment, that is (1-t)*MP K = (real interest rate + economic depreciation rate*(1-(tz)-ITC)). “t” is the corporate tax rate, z is the PDV of depreciation tax deductions, and ITC is the investment tax credit. Here changes in marginal tax rates should have clear and strong effects. (DO NOT Source: http://www.doksinet TAKE THIS FORMULA PARTICULARLY SERIOUSLY, the data don’t.) iii. Lesson: Keep corporate MTR rates low to avoid large DWL and slow economic growth. iv. Note: These formulate start to get very complicated when we take account of the effects of inflation, and effective tax rates can even be negative! c. Accelerator model of investment: i. Northwestern economists Eisner & Strotz (1963) in one of the first big econometric studies of investment behavior found that marginal tax rates had little effect on firm investment behavior, and instead it was firm sales that mattered. ii. Lesson: Tax corporations a lot,

revenue with little DWL d. Cash Flow Model of Investment: i. Firms have a low opportunity cost to funds from retained earnings, and so are apt to invest all of them internally, but face much higher costs of financing once those funds are used up. ii. As such, changing the corporate MTR has little effect on their investment demand from changing the marginal return on investment, but rather has effects through changing the amount of money firms have left over after paying their taxes, money that they can then invest. As such, here the average tax rate (the share of profits left after taxes) matters much more than the MTR, because it sets where the jump in the supply of funds falls. iii. This combines many of the results from the two previous models Below is the effective supply curve of funds in this model. Changing the corporate tax rate shifts the kink in the supply curve of funds, and so changes the “hurdle rate” for how productive investment must be to be worth building by the

firm. Source: http://www.doksinet VII. Recent Changes in Taxing Dividends a. Compensation to capital: i. Stocks: Dividends (share of the profit) and capital gains (retained earnings), dividends are taxed at the firm level and then again at the personal level (double taxation!), capital gains are taxed at realization (maybe). ii. Bonds: Interest payments are deductible by the firm, but are taxable income by the individual iii. Tax wedge at the firm level in favor of debt and interest over equity and dividends because interest is deductible b. Bush/Hubbard 2003 tax reform greatly reduces the tax on dividends at the individual level i. According to Gruber, before this, dividends were taxed at an effective rate of 38.6%, while most capital gains on stocks were taxed at 20%, while interest payments were taxed at whatever the investors’ MTR on income was. ii. After the tax cut, both capital gains and dividends are taxed at 15% (10% for people with really low incomes), while interest is

still taxed at the investors’ MTR. iii. This new set of tax rates lasted, in the law, only until 2009, when they reverted to the old rates. What a train wreck Source: http://www.doksinet iv. Almost all the benefit from this tax cut went to very wealthy people, and in a way that may well increase total DWL. 1. Much interest and dividend income is paid to non-taxed foundations, or to people who hold them in tax sheltered pensions and savings vehicles like 401Ks and IRS. 2. As such, the Bush/Hubbard reform did not change the tax wedge at the corporate level between interest (deductible) and dividends (not deductible), and increased it at the personal level (but only for those who are so rich that their dividends are too large to be sheltered) 3. Why didn’t Bush/Hubbard just make dividends deductible at the corporate level in the way that interest expense is? Think about it. I. A Bit More on How Corporate Income is Taxed Costs of Capital and the effects of Inflation a. Ideally, a

capital investment would need to pay enough to cover the interest on the capital (the opportunity cost of funds) plus the depreciation of that same capital. b. However, the tax code imposes the need for some depreciation schedule for capital. c. The presence of inflation reduces the real value of the historical or purchase price of the capital and so reduces the value of a firms depreciation deduction. d. So with taxation and inflation, firms can only invest in projects which will return enough to cover the real interest rate, the depreciation rate, and enough extra to cover the effects of inflation reducing the real tax deductible value of depreciation. i. Ideal World Cost of Capital = r + delta = Real Interest + Depreciation ii. Tax World Cost of Capital = r + delta + delta*p iii. delta = historical cost of depreciation, need to spend (1+p)*delta to replace item iv. p = rate of inflation e. Example: i. Suppose that a firms cost of funds was r=3% ii. It buys a machine that depreciates

by 20% per year iii. The profit rate on this investment should be at 23% for this investment to break even. iv. What if inflation is 10%? This will reduce the value of the 20% depreciation allowance to a real value of only 18%, so after taxes this project is only paying 21% and so is not keeping up with the firms real capital and depreciation costs. v. To break even, the machine would have to have a profit rate = r + delta + delta*p = 3% + 20% + 20%10% = 25% Source: http://www.doksinet f. So inflation increases the break-even profit level of investment, which is another way of saying it increases firms costs of capital, and so reduces investment and the capital stock. II. Taxation and Corporate Capital Structure a. The tax code favors debt over equity b. It is often the case that shifting from heavy use of stock finance to bond finance will increase after tax rates of return, even if it reduces pre-tax rates of return. => DWL! c. Simple Example: A company with capital worth

$400,000 This company has $300,000 of stock and $100,000 of bonds outstanding. With so little debt, the firm is able to borrow at an interest rate of 10%. Net revenue from operations $100,000 Interest expense (i=10%) $ 10,000 Profits before taxes $ 90,000 Tax (34%= Corporate rate) $ 30,600 Profit after tax $ 59,400 = 0.10*$100,000 d. The firms return on equity is $59,400/$300,000 = 198% e. What if this firm goes through a leveraged buy-out (LBO) where money is borrowed to buy up and retire much of the outstanding stock? i. This will reduce the firms net of interest profits but will also reduce its taxes. ii. Suppose that the firm issues $200,000 to buy up an equal value of stock. iii. This still leaves the firm worth $400,000 but now with only $100,000 of stock outstanding and with $300,000 of bonds. iv. Since the firm has borrowed so much more, its interest costs have risen to 14%. Net revenue from operations $100,000 Interest expense (i=14%) $ 42,000 Profits before

taxes $ 58,000 Tax (34%= Corporate rate) $ 19,720 Profit after tax $ 38,280 = 0.14*$300,000 v. The firms return on equity is $38,280/$100,000 = 3828% vi. So by changing the firms capital structure to one more heavily relying upon debt, the firms’ remaining stockholders have increase the return on their portfolio, but also the riskiness of the asset since there are now higher interest payments. Source: http://www.doksinet vii. Note: When the firm becomes more heavily indebted and so therefore riskier, new bond holders get a higher interest rate on the new bonds, as is appropriate for the greater level of risk. However, the old bond-holders are very unhappy. They paid a lot for what they thought would be low risk bonds, but are now bonds in a highly leverage firm. As such, when the firm become heavily leveraged, the existing bonds lose value, to the distress of their holders. I. II. Corporate Income Tax Reform Why didn’t we just scrap the tax code on corporations? a.

Economists generally consider the corporate income tax to be a very inefficient way of raising revenue. i. Ballard, Shoven, and Whalley (AER 1985) estimate the marginal excess burden of the corporate income tax to be 49 cents for every dollar of revenue raised. ii. Their estimate is fairly conservative, other estimates go as high as $1 of excess burden (DWL) for every dollar of revenue collected. This has lead many economists from a range of ideological perspectives to recommend that the corporate income tax should be scrapped. iii. Given how much DWL it generates and how relatively little tax revenue it generates, is it worth keeping? b. Ending the corporate income tax while keeping revenues constant would likely mean raising taxes where the DWL costs would likely be high, but probably not as high as from the corporate income tax. c. The corporate income tax clearly discourages firms from paying out dividends, and anything that discourages firms from paying out profits to shareholders

will generate huge amounts of crazy incentives and corporate misbehavior. d. It would have been very hard for Bush to get Congress to vote for an elimination of the corporate tax code, think of the newspaper headlines on that one. e. Maybe a simpler, imperfect improvement would be to go with a cash-flow tax on corporations. i. Cash flow taxation: Make taxes match up with economic events ii. Define corporate income as (sales – costs of labor and inputs – costs of newly purchased capital - dividends and interest payments) iii. Deduct dividends and interest payments equally at the corporate and individual level. iv. Deduct capital expenditures at the time of purchase and not worry about depreciation expenses. Great gain in simplicity, since only this year’s revenues and costs would matter, not past history on when each piece of capital was bought. Corporations and State Taxes Source: http://www.doksinet a. The issues raised by state taxation of corporations mirror those of

international taxation. b. “Tax competition” effect on businesses and location decisions i. Lots of DWL here ii. Time consistency problem iii. Solution at federal level? c. Many companies are fairly elastic in their choice of place to set up a plant Firms know that cities and states face a time consistency problem with setting corporate profits and property tax rates. The local governments realize that if they dont give the firm a tax break, the firm will take its jobs and investment and locate elsewhere. So firms which are considering building new plants play local governments off against each other to get highly preferential treatment in the form of low (or zero) taxes, zoning variances, loans, and often the right to issue tax free bonds under the local governments authorization. Illinois "won" just such battles to lure the GMs Saturn plant to this state (How did that work out?) and the corporate headquarters of Boeing and Miller-Coors to Chicago. d. While this may have

been optimal for Illinois, for all the states and localities together, this results in lower tax revenues than if all state and local governments would stick to their original tax codes. This would leave companies to make their location decisions based on given economic realities and not on their ability to engage in lobbying and rent-seeking activities. e. “Transfer pricing” problem when production takes place across multiple tax jurisdictions. Where does the taxable value added occur? i. Incentives for businesses to structure themselves as separate units in separate tax jurisdictions (say, in different countries). ii. Then they sell the various states of production (cotton to thread to cloth to shirts to packaged final goods) as these semi-autonomous units within the firm selling to each other, at “transfer prices” set by the firm. iii. Firms will want to set these transfer prices so that the value added all seems to occur in the tax jurisdiction with the lowest rates. iv.

The IRS fights back to comparing these transfer prices to prices the firm sets for when it sells similar goods to other companies, and to prices of similar goods from other firms. And it all ends up in a fight in court