Ec426 Public Economics Lecture 8: Taxation and...

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© Jonathan Leape, 2011Ec426 Lecture 8 Taxation and companies 1

Ec426 Public EconomicsLecture 8: Taxation and companies

1. Introduction2. Incidence of corporation tax3. The structure of corporation tax4. Taxation and the cost of capital5. Modelling investment decisions and the impact of

taxes6. The effects of uncertain tax policy7. Empirical studies

Annex: Alternative approaches to corporate taxation


1. Introduction

Distortions of two-tier “__________________” corporation tax (compared to one level of tax for partnerships and sole proprietorships) have led to calls for the integration of individual and corporate tax systems (see, for example, US Treasury, 1992)

Why tax companies?– Corporation tax (CT) as an easier point of tax collection

– CT as a way to extend tax base (foreign shareholders, capital gains)

– CT as a _____________________

– CT as a _____________________

– CT and tax capitalisation

– CT and growing versus mature companies

– Efficiency considerations?

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1. Introduction

Current and future reforms

– Role of a ____________________ tax?– Alternative approaches to corporate taxation (see Annex)

– International issues (Lecture 9)

Empirical background on corporate taxation

– Statutory corporate tax rates

– Corporate tax revenues

– Marginal effective tax rates on investment


Statutory corporate tax rates

Source: Auerbach, Devereux and Simpson (2010)

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Corporate tax revenues as percent of total revenues



Marginal effective tax rates on investment

Source: Auerbach (2006)

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Corporate tax base: Role of financial corporations

Taxes on financial corporations as a share of corporate tax revenues



2. The incidence of corporation tax

Burden of corporation tax borne by:

– Shareholders?

– ____________________?

– Employees?

Determined by ____________________ of responses

Impact of globalisation

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3. The structure of corporation tax

Taxable profits = income – costs– where income includes revenue from sales, capital gains, increases in

value of stocks (inventories)

Costs = ____________________+ cost of capital

Cost of capital =

____________________ (“physical” cost of capital)

+ financial cost of capital

Financial cost of capital– ______________

– New share issues

– Retained earnings (retained profits)


4. Taxation and the cost of capital

Taxes and the cost of capital

Conditions for ____________________

– True economic depreciation

– Expensing

The ____________________tax rate on capital

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Definitions:

p required (real pre-tax) rate of returnμ marginal rate of returnδ exponential rate of depreciationρc (nominal) discount rate of firm for net-of-tax dollarsπ inflationτ corporation tax rateV value to firm of £1 capital assetC net-of-tax cost of £1 capital assetA value of tax allowances for £1 capital assetAD present discounted value of future stream of depreciation

deductions



A simple model of the cost of capital

We assume:

A1. No transaction costs

A2. Perfect competition (which implies that firms maximise profits)

A3. Full and symmetric information

A4. ____________________

A1-A4 imply the capital markets are perfect in the sense that individuals and firms can borrow and lend at a unique market interest rate i.

A5. Tax rates (and all prices) are constant over time (and across individuals)

A1-A5 imply that the firm has a determinate revenue function, R(t)=R(K(t), τ(t)). We define μ as the marginal rate of return, μ =∂R/∂K (where K is the capital stock or, more generally, productive capacity).

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The no-tax situation

Suppose the firm is pursuing an optimal investment policy and consider a marginal deviation from that policy. It must be true that:

μ = i + δ

the return from employing an extra unit of capital must equal the marginal cost of capital services or "cost of capital“, which consists of two components:- i : financial cost (the cost of committing financing for a period of time)- δ: ____________________ (the change in the value of the physical asset over the period).

The "required rate of return", p, is defined as: p = μ – δ

Note that in the absence of taxes the required rate of return equals the market interest rate:

p = i



Taxes and the cost of capital (see, e.g., King, 1977; Mintz, 1995)

The value to a firm of a £1 marginal investment in the presence of corporation taxation is:

The after-tax cost to a firm of a £1 capital asset is

C = 1 - A

where A is the (present discounted) value of all available _________________, tax credits and investment grants.

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A key determinant of the cost of investment assets to the firm is the value of the relevant capital (____________________) allowances, investment tax credits and investment grants:

A = f1AD + f2 τ + f3g

where– f1 represents the proportion of the invested amount that is eligible for capital

(depreciation) allowances;

– f2 is the proportion eligible for expensing (or tax credits);

– f3 is the proportion eligible for an investment grant at rate g, and



At the optimum, the firm invests until the value of the marginal investment is just equal to its net-of-tax cost (that is, V = C). This implies that the marginal rate of return, m, and hence the cost of capital at the optimum is:

and that the required rate of return - the "financial cost of capital" - is

Since, in the absence of taxes, the ____________________ equals the market interest rate (that is, p = i), we can assess the effects of alternative tax systems by comparing the resulting cost of capital with the market rate of interest.

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The firm's discount rate, ρc is affected by its choice of finance:

ρc = βi Debt finance (bank loans or bonds), where β =1- τ if interest payments are tax deductible and β =1 if not.

ρc = i / θ New share issues, where 1/ θ is the opportunity cost of dividends in terms of net-of-corporate-tax earnings

foregone. Thus, θ =1 for "classical" corporation tax systems such as in the US and θ=1/(1-s) for imputation systems (with rate of imputation s) such as in the UK.

ρc = γi _____________________, where γ =(1-m)/(1-z) with m the marginal rate of personal income tax and z the

effective accrued marginal rate of capital gains tax.



The impact of alternative tax regimes for investment on the cost of capital

Assuming no inflation, the expression for the cost of capital simplifies to:

Case 1. No taxes: A = 0, τ = 0

p = ρc = i

Thus, the cost of capital in the absence of taxes is simply the market interest rate. We can use this result, p=i, as a __________________ to assess the impact of the tax system on the cost of capital under alternative tax regimes.

A tax regime is “_______________” with respect to the cost of capital if p=i.

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Case 2. True economic depreciation: a = δ, f1=1, f2=f3 = 0

e.g., Debt finance: ρc= βi p = βi/(1- τ). If β=1- τ, then p = i NEUTRALITY

Case 3. _________________: f2=1, f1=f3 = 0 A= τ

_______________: ρc= βi p = βi. If β=1, then p = i NEUTRALITY

New share issues: ρc= i/θ p = i/θ. If θ=1, then p = i NEUTRALITY



____________________ can be calculated from the expression for the cost of capital

From Leape (1993) “Tax Policies in the 1980s and 1990s: The United Kingdom” in Taxation in the United States and Europe.

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5. Modelling investment decisions and the impact of taxes

Accelerator model

____________________ production technology

Optimal capital stock (from FOCs)

Optimal investment (It = Kt – Kt-1)

Comments: – Empirical evidence of “accelerator effects”

– Important role of expected output

– Assumption of ____________________ technology (implying zero elasticity of substitution between capital and labour) not supported empirically; cost of capital does matter.


5. Modelling investment

Neoclassical model (Jorgenson, 1963; Hall and Jorgenson, 1967)

Derived from FOCs for profit maximisation which imply that firms invest until the marginal product of capital equals its ____________________

– Model effect of taxes on the “user” cost of capital, c

– Production function

– Profit function

– FOC (profit max) →

– Relate Δs in K* to It

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Neoclassical model

Hall and Jorgenson (AER, 1967) findings:Tax policy “highly effective” in changing level and timing of investment.

For example, the adoption of accelerated depreciation (in the ADR system) in 1954 explains 70.8% of net investment in manufacturing equipment in 1955 and 16.5% over 10 years; also explains the shift from structures to equipment

Methodological problems

– ____________________ problem

– ____________________ problem

– Theory of optimal K not I



“q-theory” model (Brainard & Tobin, 1968)Firms will invest if the market value of the project exceeds the ______________________ of the capital assets.

Comments:

– If q > 1, firm invests (and if q < 1 firm divests or is taken over)

– Summers (1981) extended model to include taxes

– Finite investment requires adjustment cost function`

– marginal q versus ______________________

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The modern theory of investment (Hayashi, 1982; Abel, 1990) is conceptualised as an internal market in the firm for installed capital, where

– The _________________________ for installed capital arises from the Jorgenson equation equating the marginal product of capital to the user cost, where the price of capital goods used in the latter is not the price charged by an outside supplier but, instead, the shadow value of installed capital, q.

– The _________________________ arises from Tobin’s conception of the optimising firm equating the marginal cost of purchasing and installing capital goods to the shadow value of installed capital, q.

See discussion in Hall (1995)


6. Effects of uncertain tax policy

Hassett and Metcalf, Economic Journal 1999 :

Questions:– Would eliminating uncertainty increase investment?– Can governments ____________________ uncertainty (in a

revenue-neutral way) to increase investment?

Key issues: – Increasing uncertainty, lost tax revenue and the option to wait

Modelling uncertainty in tax policy

– A random walk (GBM) or a _____________________ (Poisson)?

– Increased uncertainty in the form of mean preserving spreads

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Modelling the effects of uncertainty on investment decisions

Uncertainty in the output price

Uncertainty in the cost of capital (due to tax policy)

– GBM: increase in instantaneous volatility (σ2) – e.g., Pindyck (1988), Dixit and Pindyck (1994)

– Poisson: increase in “______________” (λ)



Modelling the effects of uncertainty on investment decisions

– Given the randomness in output price and capital costs, the firm wants to determine the optimal investment rule to maximise discounted profits net of investment costs:

– In effect, the rule provides an optimal stopping time and the level of investment conditional on stopping.

Effects on ______________ and ____________ of investment

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Effects of increased uncertainty on investment decisions

Findings:

– Average cost of capital

– Government tax revenue

– ______________ of investmentRandom walk (GBM)

Jump process

– ______________ of investmentRandom walk (GBM)

Jump process


7. Empirical studies

Empirical approaches

– Time series evidence____________________ of tax policy?

Identification problems?

– Alternative approaches

Cummins, Hassett & Hubbard (1995)

Chetty and Saez (2006)

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7. Empirical studiesAlternative approaches: Time-series versus cross-section variation

Problem: time series variation in tax rates is ____________________if policy-makers respond to low investment rates

CHH (1994, 1995):Use _______________ variation to identify effects of cost of capital on investment


7. Empirical studiesAlternative approaches: Tax-loss carryforwards

Problem: Identifying impact of changes in tax rates on investment difficult because: - endogeneity of tax change- other simultaneous changes

CHH (1995): Split sample into firms with and without ________________________With group unable to benefit from tax incentives

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Question: Did the 2003 US tax cut on dividends cause an increase in dividend payouts?

Key events:

– ______________________ was first proposed on 7th January 2003

– Tax cut was signed into law on 28th May 2003, and made retroactive to 1st

January 2003 and set to expire at end-2008

– Reelection of George W Bush in 2004 removed uncertainty regarding possible early repeal.

7. Empirical studiesAlternative approaches: Chetty and Saez (2006)



Background

Regular dividends of non-financial, non-utility US firms had remained stable at $20bn 1980-1994 then again at $25bn 1998-2002

Between 2003 and 2005, total regular dividends rose to _______

– a large fraction of the increase took place in last two quarters of 2003, after tax cut was signed.

CRSP data, “core” sample, presented in Chetty and Saez (2006)

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Julio and Ikenberry (2004) argue that rise in dividends pre-dated 2003 dividend tax cut (data from core sample)

Chetty and Saez (2006) compare dividend paying by ‘core’ sample with that of a sample of ______________ ______________. Rise in dividends starts in 2003:1.



Why the discrepancy between the core and constant-size samples?

Dot-com bust caused a sharp drop in number of traded firms: from 5,429 in 2000:3 to 3,785 in 2005:2.– BUT, only 2% of exiting

firms were dividend payers

Key: ___________________

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Research question: Did the tax cut induce more ___________ _____________ of investment funds across firms?

Chetty and Saez dividend firms into quintiles by forecasted earnings growth

Compare percentage initiating dividends pre-reform and post-reform

Greater efficiency?


ReferencesAbel, A (1990), “Consumption and investment”, in Handbook of Monetary Economics, volume 2.Auerbach, A J (2006), “The future of capital income taxation”, IFS Annual Lecture, September

(http://www.ifs.org.uk/conferences/auerbach06.pdf )Auerbach, A J, M Devereux and H Simpson (2008), “Taxing corporate income”, paper prepared for The Mirrlees Review,

March. (http://www.ifs.org.uk/mirrleesreview/press_docs/corporate.pdf)Brandon, J, and D Ikenberry (2004) “Reappearing dividends”, Journal of Applied Corporate Finance, 16(4), 89-100Chetty, R and E Saez (2006) “The Effects of the 2003 Dividend Tax Cut on Corporate Behavior:Interpreting the

Evidence”, American Economic Review, 96(2), 124-129.Clark, J. (1917), ‘Business acceleration and the law of demand: a technical factor in economic cycles’, Journal of Political

Economy, vol. 25, pp. 217–35.Cummins, J G, Hassett, K. A., and Hubbard, R. G. (1995), “Have tax reforms affected investment?,” Tax Policy and the

Economy, 9, 131-149.Hall, R (1995) “Comment” on Cummins, Hassett and Hubbard, Brookings Papers on Economic Activity, volume 2, 1-74.Hall, R E, and D Jorgenson (1967), “Tax policy and investment behavior”, American Economic Review , 57, 391-414.Hassett, K. and G Metcalf (1999), “Investment with uncertain tax policy: Does random tax policy discourage

investment?”, Economic Journal, 109 (July), 372-393. Hayashi, F (1982), “Tobin’s Marginal q and Average q: A Neoclassical Interpretation”, Econometrica, vol. 50(1), 213-24. Jorgenson, D (1963), ‘Capital theory and investment behavior’, American Economic Review, vol. 53, pp. 247–59.Mintz, J (1995), “The corporation tax: A survey”, Fiscal Studies, 16:4 (November), 23-68.

(http://www.ifs.org.uk/fs/articles/fsmintz.pdf)Brainard, W C, and J Tobin (1968), “Pitfalls in financial model building”, American Economic Review (Papers and

Proceedings), 58, May, 99-122. U.S. Department of the Treasury (1992) Integration of the Individual and Corporate Tax Systems: Taxing Business

Income Once, Washington DC: US Government Printing Office. . http://www.ustreas.gov/offices/tax-policy/library/integration-paper/

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Tax the full return on capital?

Comprehensive Business Income Tax (CBIT)US Treasury (1992) “Integration of the individual and corporate tax systems”

Objectives:– Eliminate “double” taxation of corporate income– Equalise treatment of corporate debt and equity (“classical” corporation

tax only taxes the return on equity)

Key elements:– All businesses (corporate and non-corporate) taxed at the same rate– Eliminate tax deduction for interest payments– Broader base allows reduction in statutory rate– Interest and equity income exempt from tax at individual level


Dual income tax

Objectives– Achieve tax neutrality while taxing the full return on capital

– Simplify the taxation of capital income

Key elements:– Flat tax on all corporate income (corporate and non-corporate)

– Progressive tax on labour income

– Introduced in Nordic countries in early 1990s


Tax the full return on capital?

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Allowance for corporate equity (ACE) proposal(IFS Capital Taxes Group, 1991)

Objectives– Tax neutrality towards corporate financing decisions (eliminate the tax

penalty to equity finance)– Eliminate distortions caused by differences between true economic

depreciation and tax depreciation allowances

Key elements– Introduce an “allowance for corporate equity” (based on the imputed cost

of equity finance) to match the interest deduction on debt finance.– Result is a tax on pure rents (“excess returns”)


Tax only economic rents?

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