Public Economics Dr.

Sauer

Chapter 24: Corporate Taxation 2 Types of Corporations 1. S-Corporations (S-corps) For tax purposes, they resemble _______________________________. -income, deductions, and tax credits flow through to shareholders annually -income is taxed at the shareholder level and not at the corporate level - reported on individuals income tax + benefits of partnership taxation + limited liability protection from creditors 2. C-Corporations Income from C-Corporations is subject to the corporate income tax. 2010 Corporate Tax Rates
Taxable Income 0 to 50,000 50,000 to 75,000 75,000 to 100,000 100,000 to 335,000 335,000 to 10,000,000 10,000,000 to 15,000,000 15,000,000 to 18,333,333 18,333,333 and up Tax Rate 15% $7,500 + 25% Of the amount over 50,000 $13,750 + 34% Of the amount over 75,000 $22,250 + 39% Of the amount over 100,000 $113,900 + 34% Of the amount over 335,000 $3,400,000 + 35% Of the amount over 10,000,000 $5,150,000 + 38% Of the amount over 15,000,000 35%

Taxable income is a firms net earnings. In Colorado, corporations are subject to a tax of 4.63%. ______________________________________________________________________________ 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 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 of capital each period (_________ depreciation) In practice, the true rate of economic depreciation is unobserved and varies. - use a series of depreciation schedules for different types of assets a. Straight-line depreciation: asset cost / typical asset life

Ex. $100,000 machine that last for 10 years on average The firm would deduct $______________________ of depreciation each year for 10 years.

b. Accelerated Depreciation - deduct the cost over a shorter time frame - front-loaded depreciation c. The _______of depreciation deductions rises with the _______ with which they are allowed. Ex. 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 = $__________________

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 = $__________________

In present value terms, the firm with accelerated depreciation can deduct $____________ more from its taxable income. Investment Tax Credit This is a credit that allows firms to deduct a percentage of their annual qualified investment expenditures from the taxes they owe. ____________________________________________________________________________________ Why do we tax corporations? Reasons for not taxing the factors separately: 1. Because corporations have __________________, they can earn _____________________. - returns exceed payments to factors A pure profits tax does not __________________the 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 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 ________________ profits. Corporate taxes are paid on _______________________ profits. 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

The Corporate Tax and Investment Decisions Modeling the firms investment decision: - each dollar of investment in a machine produces MPK cents 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 - total cost of machine in each period is + Ex: If the depreciation rate is 10% and the dividend rate is 8%, then the per period cost of investing $1 in a machine is: Graphically:
Cost and Return per dollar of investment per period ($)

At K*, the marginal benefits of the investment equal the marginal costs.

Q of investment ($)

A. Introduce a corporate tax on earnings. Earnings per dollar spent on the machine fall to ______________________. The level of investment __________________.

B. 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

Depreciation is subtracted from taxable income. - each dollar of depreciation saves the firm $ ofcorporate tax payments - depreciation allowances are worth $( z) to the firm 3

Cost and Return per dollar of investment per period ($)

The depreciation allowances off-set the cost of investing in new capital.

MC = +

The level of investment ____________.

MB = MPK MB2 = (MPK)(1- ) K2 K* Q of investment ($)

C. An investment tax credit ( ) would further reduce the cost of investment. _________________________________________________________________________________ Suppose the following: 10% depreciation rate 8% dividend 0.5 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) =

The rate of return required (MPK) by an investor is $______________ for every dollar invested. _________________________________________________________________________________ The effect of taxes is summarized by the __________________ corporate tax rate. - the percentage increase in the rate of pre-tax return to capital that is necessitated by taxation No taxes case: 10% depreciation rate 8% dividend MC = ______________ investors require a rate of return (MPK) of _________% Since there are no taxes, the actual rate of return does not differ from the required rate of return. 4

With corporate taxes of 35% and no depreciation or ITC: The firms actual rate of return (MPK)must be ________% in order to meet the required rate of return of 18%.

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

Firm must earn ___________% higher pre-tax rate of return. Allow depreciation and ITC: z = 0.5 ITC = 10%

ETR = z 1- z

ETR =

Firm must earn ___________% higher pre-tax rate of return. 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 )
Cost and Return per dollar of investment per period ($)

A negative ETR means the MC falls so much that more investment occurs with taxation than when there was no taxation.
MC = +

MB = MPK K* Q of investment ($)

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. Firm earns $1

pays $1 to bondholders

pays corporate tax on income and distributes after-tax income to stockholders after taxes there is

bondholders pay income tax on interest received bondholders keep:

individuals pay capital gains tax when sell get to keep:

stockholders pay income tax on dividends get to keep:

The statutory rate for capital gains and dividends is the same: 15% The ______________ 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 pay dividends 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 a firm is doing. Managers pay dividends to signal the firm is doing well. The tax system treats corporate income differently depending on how it is returned to shareholders. Alternative approach: corporate tax _________________________ - 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 6

International Corporate Income Territorial System Pay 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 US firms pay US taxes, regardless of where the income is earned. They must also pay any taxes in the country where income is earned. - can claim these payments as a credit against US taxes (foreign tax credit) 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) 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 ____________________________ to achieve this

Ex: An American computer company has a French subsidiary that produces microchips for $100 each. The chips are transferred to the US where the firm spends $500 on the rest of the computer. The computer is sold for $1000. Profit = 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? a. All $400 attributed to French subsidiary US firm transfers _________________________ to French subsidiary for each chip received. On paper, the subsidiary: Profits = Taxes = after-tax earnings = On paper, the US firm:

b. All $400 attributed to US firm US firm transfers ________ to French subsidiary for each chip received. On paper, the subsidiary: Profits=

On paper, the US firm: Profits = Taxes = after-tax earnings =

By transferring only $100 to subsidiary, the firm can lower its tax burden by $60.