Pub Econ Lecture 24 Corporate Taxes

8/3/2019 Pub Econ Lecture 24 Corporate Taxes

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Public Finance

Dr. Katie Sauer

Corporate Taxes


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2 Types of Corporations

1. S-Corporations (S-corps)

For tax purposes, they resemblepartnerships.

-income, deductions, and tax credits flow through toshareholders annually

-income is taxed at the shareholder level and not at

the corporate level- reported on individuals income tax


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+benefits of partnership taxation

+ limited liability protection from creditors


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2. C-Corporations

Income from C-Corporations is subject to the corporateincome tax.

2010 Corporate Tax RatesTaxable Income Tax Rate

0 to 50,000 15%

50,000 to 75,000 $7,500+25% Of the amount over 50,000

75,000 to 100,000 $13,750+ 34% Of the amount over 75,000

100,000 to 335,000 $22,250+ 39% Of the amount over 100,000

335,000 to 10,000,000 $113,900+ 34% Of the amount over 335,000

10,000,000 to 15,000,000 $3,400,000+ 35% Of the amount over 10,000,000

15,000,000 to 18,333,333 $5,150,000+ 38% Of the amount over 15,000,000

18,333,333 and up 35%

Taxable income is a firms net earnings.

In Colorado, corporations are subject to a tax of 4.63%.


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Taxes = (net earnings)(tax rate) investment tax credit

Net Earnings = revenues expenses

Expenses

1. cash-flow costs of doing business

2. interest payments

3. depreciation on capital investments- dont get to deduct the full cost of a

machine in the year it is purchased


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Depreciation

In theory, the tax code should allow firms to deduct the

deterioration in value of the capital good as an expense

in each period.

- calculate the true deterioration in value ofcapital each period (economic depreciation)

In practice, the true rate of economic depreciation is

unobserved and varies.- use a series of depreciation schedules for

different types of assets


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Straight-line depreciation:

asset cost / typical asset life

Ex. $100

,000

machine that last for 10

years onaverage

100,000 / 10 = 10,000

The firm would deduct $10,000 of depreciation each

year for 10 years.


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Accelerated Depreciation

- deduct the cost over a shorter time frame

- front-loaded depreciation


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The value of depreciation deductions rises

with thespeedwith which they are allowed.

Suppose for PDV, the discount rate is 10%.

$100,000 machine, straight-line depreciation for 10 years.

PDV = 10,000+ 10,000 +10,000 + + 10,000

(1.1)1 (1.1)2 (1.1)9

= $67,590


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Now allow the machine to be depreciated over 5 years.

PDV = 10,000+ 10,000 +10,000 + + 10,000

(1.1)1 (1.1)2 (1.1)4

= $83,397

In present value terms, the firm with accelerated

depreciation can deduct $15,807 more from its taxableincome.


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Investment Tax Credit

This is a credit that allows firms to deduct a percentageof their annual qualified investment expenditures from

the taxes they owe.


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Why do we tax corporations?

Reasons for not taxing the factors separately:

1. Because corporations have market power,

they can earnpure profits.

- returns exceed payments to factors

A pure profits tax does not distortthe decision

making of the producer. (taxes on labor and

capital have distortionary effects)- choice of profit maximizing level of

output and price does not depend on taxes


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Side note: the corporate tax doesnt really work like a

tax on pure profits

Corporate taxes are not pure profit taxes.- can reduce tax burden by changing use of inputs

- distortion

- Pure profit taxes would be levied on economicprofits. Corporate taxes are paid on accounting

profits.


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2. If corporations were not taxed on earnings, earnings

would be retained instead of being paid out.

- savings accumulate tax-free

- PDV of tax burden is lower


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The Corporate Tax and Investment Decisions

Modeling the firms investment decision:

- each dollar of investment in a machine produces MPKcents of additional output in each period

- machine depreciates linearly by per dollar in each

period

- to finance the purchase of the machine, a firm sells

shares of stock and will pay dividend payments of per

dollar


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- total cost of machine in each period is +

If the depreciation rate is 10% and the dividend rate is8%, then the per period cost of investing $1 in a machine

is:

0.10+0.08 = $0.18


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Cost and Return

per dollar of

investment per

period ($)

Q of investment ($)

MC = +

MB = MPK

K*

At K*, the marginal benefits of the

investment equal the marginal costs.


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Cost and Return

per dollar of

investment per

period ($)

Q of investment ($)

MC = +

MB = MPK

K*

Introduce a corporate tax on earnings.

Earnings per dollar spent on the machinefall to

(MPK)(1 )

The level of investment falls.

MB2 = (MPK)(1-)

K2


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Now allow depreciation to be deducted from taxes.

z is the value of any given depreciation allowance

schedule

z = PDV of the stream of depreciation allowances

purchase price of machine

Ex: z = 67,590 / 100,000 = 0.675

z = 83,397 / 100,000 = 0.83397


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Depreciation is subtracted from taxable income.

- each dollar of depreciation saves the firm $ of

corporate tax payments

- depreciation allowances are worth $(z) to the

firm


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Cost and Return

per dollar of

investment per

period ($)

Q of investment ($)

MC = +

MB = MPK

K*

The depreciation allowances off-set the

cost of investing in new capital.

The level of investment rises.

MB2 = (MPK)(1-)

K2

MC2 = ( + )(1 z)

K3


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Cost and Return

per dollar of

investment per

period ($)

Q of investment ($)

MC = +

MB = MPK

K*

An investment tax credit () would

further reduce the cost of investment.

MB2 = (MPK)(1-)

K2

MC2 = ( + )(1 z)

K3

MC3 = ( + )(1 z )


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Suppose the following:

10% depreciation rate

8% dividend0.5 is z

35% is the corporate tax rate

10% investment tax credit

MC = (0.1 +0.08)[1 (0.35)(0.5) 0.1)

= (0.18)(0.725)

= 0.1305

The rate of return required (MPK) by an investor is $0.13

for every dollar invested.


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The effect of taxes is summarized by the effective

corporate tax rate.

- the percentage increase in the rate of pre-taxreturn to capital that is necessitated by taxation


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No taxes case:

10% depreciation rate

8% dividend

MC = 0.18 investors require a rate of return (MPK)

of 18%

Since there are no taxes, the actual rate of return doesnot differ from the required rate of return.


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With corporate taxes of 35% and no depreciation or ITC:

The firms actual rate of return (MPK)must be

0.18 / (1 0.35) = 0.2769

27.7% in order to meet the required rate of return of

18%.


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ETR = after-tax MPK - before tax MPKafter-tax MPK

= 27.7 18

27.7

= 0.35 = 35%

Firm must earn 35% higher pre-tax rate of return.


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Allow depreciation and ITC:

z = 0.5 ITC = 10%

ETR = z

1 - z

ETR =0

.35 - (0

.35)(0

.5) -0

.11 (0.35)(0.5) 0.1

= 0.075

0.7

25

= 0.103

Firm must earn 10.3% higher pre-tax rate of return.


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With a large enough z or , the ETR can be negative.

This is more likely to happen when the firm finances

using debt, not equity.

interest payments are tax-deductible

equity financing cost per dollar:

debt financing cost per dollar: (1 )


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Cost and Return

per dollar of

investment per

period ($)

Q of investment ($)

MC = +

MB = MPK

K*

A negative ETR means the MC falls so

much that more investment occurs with

taxation than when there was no

taxation.

MB2 = (MPK)(1-)

K2

MC2 = ( + )(1 z )


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Impact of Taxes on Financing Decisions

Suppose a firm needs $10 for an investment that will

yield $1 in corporate income each year.

The firm wants to finance this through debt or equity

(not retained earnings).

The firm will return the $1 to the investors.


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Firm earns $1

pays $1 to

bondholders

pays corporate tax on income

and distributes after-tax income

to stockholders

after taxes there is $1(1 c)

bondholders pay

income tax on

interest received

bondholders keep:

$1(1 inc)

stockholders payincome tax

on dividends

get to keep:$1(1 c)(1 div)

individuals paycapital gains tax

when sell

get to keep:$1(1 c)(1 ecg)

Debt Financed Equity Financed

retain earnings pay dividend


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The statutory rate for capital gains and dividends is the

same: 15%

The effective capital gains tax rate is much less.

This suggests it is better for a firm to reinvest the

earnings than pay dividends.

- yet about 20% of publicly traded firms paydividends


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Why do firms pay dividends?

1.Agency Theory

Investors are willing to live with the tax inefficiency of

dividends to get the money out of the hands of the

managers.

2. Signaling Theory

Investors have imperfect information about how well afirm is doing.

Managers pay dividends to signal the firm is doing well.


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The tax system treats corporate income differently

depending on how it is returned to shareholders.

Alternative approach:

corporate tax integration

- remove the corporate tax and tax all corporate

income at the individual level

- basically just like partnerships and S-corps

This would reduce federal tax receipts.

- income is taxed only once


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International Corporate Income

Territorial SystemPay income tax to the government of the nation

in which the income is earned.

Global System

Pay income taxes to the home countrys

government.

- used by half of the OECD nations

- used by the US


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US firms pay US taxes, regardless of where the income

is earned.

They must also pay any taxes in the country whereincome is earned.

- can claim these payments as a credit against

US taxes (foreign tax credit)


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There is a tax advantage to earning income in other

nations.

1. not taxed in US on the income until it is repatriated(similar to tax advantage of paying capital gains

tax on realization)


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2. ability to shift profits from high-tax to low-tax nations

When a good is produced using inputs from many

nations, it is difficult to appropriately attribute the profits

earned on that good to any particular nation.

- incentive to report profits earned in low-tax

nations

- use transfer pricingto achieve this


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Ex: AnAmerican computer company has a French

subsidiary that produces microchips for $100 each.

The chips are transferred to the US where the firmspends $500 on the rest of the computer.

The computer is sold for $1000.

Profit = 1000 500 100 = $400


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Suppose France levies a 50% tax on corporate profits.

The US has a 35% tax on corporate profits.

How does the firm decide how to allocate the $400 in

profit for tax purposes?


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a.All $400 attributed to French subsidiary

US firm transfers $100+ $400 to French subsidiary foreach chip received.

On paper, the subsidiary earns:

$500 - $100 = $400 in profits

pays (400)(0.5) = $200 in taxes

after-tax earnings = $200

On paper, the US firm earns:

$1000 - $500 - $500 = $0 so pays no taxes


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b.All $400 attributed to US firm

US firm transfers $100 to French subsidiary for eachchip received.

On paper, the subsidiary earns:

$100 - $100 = $0 in profits so pays no taxes

On paper, the US firm earns:

$1000 - $500 - $100 = $400

pays (400)(0.35) = $140 in taxes

after-tax earnings = $260


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By transferring only $100 to subsidiary, the firm can

lower its tax burden by $60.

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Pub Econ Lecture 24 Corporate Taxes

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