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Power Point Slides to Accompany:
Public Finance
by John E. Anderson
Chapter 14
Corporate Income
Taxes
Introduction

Organizing a business.

Rationale for corporate taxation.

Effects of profit taxation.
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Organizing a Business

Legal form for business:
– Sole proprietorship.
– Partnership.
– Corporation.
Issue of incorporation involves limited
liability and taxation.
 Hybrid forms of business include:

– Limited liability partnerships (LLP).
– Professional corporations (PC).
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4
Rationale for Corporate Taxation
Under a classical system, corporate
income taxation is based on a benefitsreceived justification.
 The corporation is a legal entity separate
and distinct from any person or group of
persons involved.
 It receives benefits afforded by that legal
status.
 Taxation is justified on that basis.

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5
Issues Arising

Tax arbitrage.
– Differences between the personal income
tax rate, corporate income tax rate, and the
capital gains tax rate provide opportunities to
arbitrage.

Double taxation.
– Dividend income is taxed twice, at the
corporate level and again at the individual
level.
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6
Effects of a Profits Tax

A tax on economic profit would be
perfectly efficient, since it would not
change firm behavior.

But, the corporate income tax is not a tax
on economic profit.
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Tax Base and Rates

Net income—the tax base.

Profits: economic and accounting.

Corporate income tax rates
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Net Income—the Tax Base

Gross profit = gross receipts - cost of
goods sold.

Total income = gross profit - dividends interest - gross rents - gross royalties capital gain net income + other income.
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Net Income—the Tax Base,
[continued]

Taxable income = Total income - Total
deductions.

Total deductions = compensation of officers +
salaries and wages + repairs and maintenance
+ bad debts + rents + taxes and licenses +
interest paid + charitable contributions +
depreciation + depletion + advertising +
pension and profit-sharing plans + employee
benefit programs + other deductions + NOL
deduction.
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Figure 14.1: U.S.
Corporate Income Tax
Return – Form 1120
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Profits: Economic and Accounting

Accounting profit is the difference
between revenue generated by sales and
costs incurred for inputs.

Economic profit is the difference between
revenue and cost, including the
opportunity cost of capital.
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Figure 14.2: Competitive Firm Profits
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Figure 14.3: Monopolist Profit
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Corporate Income Tax Rates

Corporate income tax rates in the U.S.
are progressive, depending upon the net
income of the corporation.

Most corporations pay a rate of 35%.
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Incidence of the Corporate
Income Tax

Incidence of a partial factor tax.

Evidence on incidence.
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Incidence of a Partial Factor Tax

The corporate income tax is a partial
factor tax.

It applies to one factor, capital,

In one sector of the economy, the
corporate sector.
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Evidence on Incidence

Harberger conclusion on incidence
evidence:
– It is hard to avoid the conclusion that
plausible alternative sets of assumptions
about the relevant elasticities all yield results
in which capital bears very close to 100
percent of the tax burden. The most
plausible assumptions imply that capital
bears more than the full burden of the tax.
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20
Taxation and the Capital
Structure of the Firm

Capital structure of the firm.

Tax effects on the capital structure of the
firm.

Capital gains and the market value of the
firm.
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Capital Structure of a Firm

The firm’s choice of alternative forms of
long-term financing is called its capital
structure.

We consider how the income tax affects
its capital structure in terms of retained
earnings and borrowing.
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Fundamental Accounting
Relationship of the Firm
 t  ( Bt 1  Bt )  ( E t 1  E t )  Dt  rBt  I t ,
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Fundamental Accounting
Relationship of the Firm [continued]

The left-hand-side of this equation sums
the three sources of receipts (profit, new
bonds issued, and new equity issued),

and the right-hand-side of the equation
sums the three disbursements (dividends
paid, interest paid on bonds, and
investment).
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25
Fundamental Accounting
Relationship of the Firm [continued]

Notice that the basic accounting identity
of the firm in equation (4) implies that at
least two financial variables must be
changed at a time, one on each side of
the equation.

For example, a decrease in the firm’s
profit this period (on the left-hand-side)
must be balanced by some reduction in
dividends paid, or new fixed investment
(on the right-hand-side).
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26
Implications

The flow of financing to individuals is
determined by the real variables in the
model and is not affected by the firm’s
financial structure.
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Implications,

[continued]
The real variables measure the firm’s
real assets–assets used to produce
goods and services (in contrast to
financial assets, or securities, that are
claims to the firm’s income, which is
generated by its real assets).
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28
Implications,

[continued]
This result is known as the ModiglianiMiller (MM) Theorem, named after the
two economists who discovered the
result. The MM Theorem says that in the
absence of taxation and bankruptcy,
corporate financial policy is irrelevant and
has no effect on the value of the firm.
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Implications,
[continued]

The implication of the MM Theorem is
that the firm is indifferent to its choice of
financial policy, or capital structure.

It makes no difference whether the firm
finances new investment from the
issuance of bonds or new equity.
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30
Implications,
[continued]

If financial policy has no impact on the
value of the firm, it simply does not
matter how the firm is financed.

Of course, the presence of a corporate
income tax may change this result, as we
will see.
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31
Effects of Corporate Income
Taxation

First, consider the effect of a change in
the way funds are transferred to
households.

Suppose that the firm reduces its
dividends paid to households by one
dollar and also reduces its outstanding
equity by one dollar.
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Effects of Corporate Income
Taxation, [continued]

In effect, the firm is taking a dollar of its
net income and using it to buy back a
dollar’s worth of outstanding shares
rather than paying out a dollar in
dividends.
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Effects of Corporate Income
Taxation, [continued]

In so doing, the firm is not paying out
dividends directly to shareholders but is
rather increasing the value of
shareholders stock.

That is, Dt = -1 and (Et+1 - Et) = -1.
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Effects of Corporate Income
Taxation, [continued]

What is the impact on households?

The reduced dividend results in an aftertax loss of income of 1-tp to the
household.
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Effects of Corporate Income
Taxation, [continued]

On the other hand, the reduced equity
outstanding benefits the household by
the amount 1-tg.
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36
Effects of Corporate Income
Taxation, [continued]

Recall that the tax rate applied to capital gains
is generally less than that applied to ordinary
income: tg. < tp.

If that is the case, this change benefits the
household that owns stock in the firm.
Bondholders are unaffected.

Hence the corporate repurchase of stock is
beneficial to some households and harmless to
the rest–on balance an improvement.
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Effects of Corporate Income
Taxation, [continued]

So why do firms pay dividends rather
than repurchase stock?

As long as the tax rate on capital gains is
less than that on ordinary income, it
makes sense for the firm to buy back
shares rather than pay out dividends,
even though this generates capital gains.
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38
Effects of Corporate Income
Taxation, [continued]

Even so, many corporations still pay
dividends. But, why would they? This is
one of the major puzzles of corporate
finance.

An alternative to the repurchase of
shares is the acquisition of another firm.
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Effects of Corporate Income
Taxation, [continued]

The increasing frequency of mergers and
acquisitions is due, in part, to tax policy.

Suppose that Firm A is in the position to
pay out $100 million in dividends. As an
alternative, suppose that Firm.
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Effects of Corporate Income
Taxation, [continued]

A can buy Firm B for $100 million.
Shareholders benefit from the acquisition
since Firm A is now worth $100 million
more than it was before.

Hence, shareholders have a potential
capital gain that is taxed at a preferential
rate, as compared to dividend income.
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Effects of Corporate Income
Taxation, [continued]

Hence, the two alternatives (paying out
dividends and buying another firm) are
equivalent in terms of the impact on
shareholders.
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Effects of Corporate Income
Taxation, [continued]

It might seem like that equivalence only
holds when the two firms are owned by
the same person or group of people, but
it holds more generally.

As long as there is another firm in the
world with the same riskiness as the one
making the acquisition the equivalence
still holds. The key is that shareholders
adjust their portfolios.
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43
Effects of Corporate Income
Taxation, [continued]

Consider another possible change in financial
policy on the part of the firm.
 Suppose that the firm increases dividends in
the current period by borrowing.
 Of course, the loan has to be paid back in the
future with interest.
 Table 4 provides a summary of the impacts on
shareholders and bondholders in a simple twoperiod model where the tax rate on capital
gains is zero.
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Taxation and Investment
Fundamentals of depreciation.
 Bond-financed investment.
 Investment financed from retained
earnings.
 Taxation and market imperfections.
 Empirical studies of taxation and
investment.

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Fundamentals of Depreciation

Capital assets such as building,
machinery, and equipment, generate
income streams over time.

Those assets wear out over time also.
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Fundamentals of Depreciation,
[continued]

If we are concerned with the net stream
of income generated by these assets, we
need to reduce the gross income stream
they generate by some measure of the
extent to which they wear out each year.
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Fundamentals of Depreciation,
[continued]

This is the process of deducting depreciation.

If we could deduct true economic
depreciation, the actual replacement cost of
the physical wear and tear on the asset, then
the process of allowing depreciation
deductions would not affect the investment
behavior of the firm.

The depreciation method would be neutral in
this sense, having no impact on investment.
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MACRS

The U.S. corporate income tax currently
provides a method of depreciation known
as the modified accelerated cost
recovery system (MACRS).
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MACRS,
[continued]

This depreciation method permits higher
tax deductions in early years of an
asset’s life and lower deductions in later
years.

Real assets are put into one of six
categories of asset life ranging from three
years to twenty years.
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51
MACRS,

[continued]
For example, an asset with seven-year
life is depreciated using the following
percentages starting in year one: 14.29%,
24.49%, 17.49%, 12.49%, 8.93%, 8.93%,
8.93%, and 4.45%.
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MACRS,
[continued]

There are eight years listed in the seven-year
asset life because the asset is assumed to be
placed in service midway through year one and
continue in use through the midpoint of year
eight.

The depreciation percentage is lower in the
first year since the asset is assumed to be in
service for just half the year. The MACRS
pattern is one of declining depreciation
percentages over the years.
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53
Bond-Financed Investment

We can also consider the case where the firm
chooses to finance its investment with bond
financing rather than from borrowing.

In years when investment exceeds retained
earnings the firm borrows, but in years when
retained earnings exceed investment the
surplus can be used to reduce the firm’s debt.
In this situation the marginal cost of capital is
r(1 - tc) reflecting the after-tax interest cost,
assuming that interest is deductible.
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Taxation and Global Business

Globalization

Taxation and trade issues

Apportionment issues
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56
Globalization

Globalization refers to the increasing
tendency of business firms to operate
across national borders or combine with
firms in other countries in mergers or
strategic alliances.

It also refers to the reality that most product
markets and factor markets are now global
rather than local.

What are the implications of increasing
globalization of business for taxation?
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Globalization,

[continued]
Does increasing international competition
mean that the opportunities for
governments to collect revenue from
firms in their jurisdictions are now more
limited because taxation may drive the
firm away?
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Globalization,
[continued]

Put in more colorful terms, we might
recall the advice of Jean-Baptiste Colbert
to Louis XIV.

He said that the art of taxation consists in
so plucking the goose as to obtain the
largest possible amount of feathers with
the smallest possible amount of hissing.

In the global economy, we may have to
worry not so much about the hissing as
the goose flying away!
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59
Policy Study: Less Than Zero—Enron’s
Corporate Income Tax Payments 1996-2000.

Analysis of the corporate income tax situation
for Enron over the period from 1996 through
2000 by Citizens for Tax Justice (CTJ) reveals
that the corporation effectively used more than
800 such tax havens along with stock options
and other tax loopholes to reduce its tax
liability substantially.

In fact, the CTJ analysis illustrates that Enron
paid tax in only one year and was effectively
able to reduce its corporate tax liability to less
than zero.
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