chapter 15

Copyright © 2002 by Thomson Learning, Inc.

Chapter 15

Taxation of Corporate Income

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ISBN 0-03-033652-X


Forms of Business Sole Proprietorships Partnerships Corporations


Corporations Corporations are granted the legal

status of people. This means that they can own property

and borrow money.


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.


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.


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.


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.


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.


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.


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.


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.


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.


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.


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.


Demonstrating the Bias toward Debt Finance

Item All-Equity 50% Debt – 50% Equity

Balance Sheet

Total Assets $1,000,000 $1,000,000

Debt 0 $500,000

Shareholder’s Equity $1,000,000 $500,000

Income Statement

Operating Income $150,000 $150,000

Interest Expense 0 $50,000

Taxable Income $150,000 $100,000

Income Tax $51,000 $34,000

Income after Corporate Tax

$99,000 $66,000

Return on Equity 9.9% 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.


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

15% 25%

$75K<income<$10 Mill

18% 34%

More than $10 Mill 34% 34%


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.


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).


Figure 15.1 A Tax on Economic ProfitsPr

ice

and

Cos

t

Output per Year 0 Q*

MR = P B

After-Tax Profits AC

MC

E

F

A

GAC*


Long-Run Impact of Corporate Income Taxation

Investors can shift their money from corporate investments for non-corporate investments to maximize after-tax returns.


Figure 15.2 Long-Run Impact of the Corporate Income Tax

A

i2

IC + IN

i1

r1(1 – t) = r’r2

IN2IN1

rG*

rG*(1 – t) = rN*

IC2

SN=MSCN=MSRC

S

MSRN

D’

Ret

urn

to In

vest

men

t (Pe

rcen

t)

Corporate Investment per Year

MSCC=MSRN=SC

D’C=rG(1 – t)

MSRC = DC = rG

0

B

Noncorporate Investment per Year 0

SN'

C

Inte

rest

Rat

e (P

erce

nt)

Total Investment per Year

0

D

IN

IC1

INC

EC1

EC2 EN2

EN1r1

B

i1 = r1

E


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.

chapter 15

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