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CHAPTER 15 Taxes On Business Income and Wealth PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Corporate Income Tax Tax rate is about 35% for most corporations Dividends paid out of after tax income Dividends taxed multiple times PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-2 Federal Corporate Income Tax Rates, 2003 Table 15.1 Federal Corporate Income Tax Rates, 2003 Marginal Tax Rate Income Range 15% $0-$50,000 25% $50,000-$75,000 34% $75,000-$100,000 39% $100,000-$335,000 34% $335,000-$10,000,000 35% $10,000,000-$15,000,000 38% $15,000,000-$18,333,333 35% Over $18,333,333 Source: http://www.irs.gov/pub/irs-psf/i1120_a.pdf. PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-3 Interaction Between Corporate and Personal Income Taxes Trade-off between corporate payment of dividends or reinvestment of funds Dividends face higher tax cost than interest payments when corporate and income taxes are counted Trend toward lower corporate dividends in last half of 20th century PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-4 Fringe Benefits Can be legally deducted by corporation as a business expense for tax purposes Employee not required to declare value of benefit as income PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-5 Depreciation Accounting depreciation - decline in value over time of capital equipment Economic depreciation – reduction in value of assets Accounting and economic depreciation may differ in practice Cost of capital equipment cannot be deducted when expenditure is made Fraction of cost of equipment taken each year as depreciation expense PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-6 Straight-line and Accelerated Depreciation Straight-line depreciation – life of asset determined and equal fraction of cost of asset allowed as depreciation expense each year Accelerated depreciation – larger amount of depreciation allowed in early years, offset by smaller amount in later years PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-7 Straight-line and Accelerated Depreciation Firms prefer accelerated depreciation Firms prefer the most accelerated depreciation schedule allowed Firms prefer to depreciate over fewer years rather than more Inflation affects the real amount of depreciation expenditures PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-8 Burden of the Corporate Income Tax Corporations do not pay income tax Corporate income tax ultimately borne by individuals Principles of tax shifting suggest corporation may be able to shift tax burden Relative elasticities of supply and demand determine who bears the tax burden PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-9 Competitive Markets Elastic market demand Tax burden shifted toward suppliers Causes inward shift of supply curve Inelastic market demand Tax burden shifted toward demanders Causes outward shift of supply curve Relative shares of tax burdens are equal in each market in long run PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-10 Competitive Markets The Effect of a Corporate Income Tax in Different Markets PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-11 Monopoly Income tax on firm making monopoly profits may have no real effects in short run If tax is constant fraction of corporation’s profits, monopolist’s profit-maximizing level of output will not change PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-12 Monopoly Monopoly Response to a Proportional Tax on Net Income PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-13 Income Tax and Return to Bearing Risk Saving/Investing behavior entails risk Income tax lowers return to risk bearing Government shares in gains of bearing risk, does not share in losses Incentive against risk taking built into tax system PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-14 Taxation of Capital Gains Capital gain – increase in wealth caused by an appreciation of value of an asset an individual or corporation owns Capital gains income treated similarly to ordinary income in corporate and personal income tax system PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-15 Unrealized Capital Gains Occurs when value of individual’s property increases but has not been sold Current U.S. tax system does not levy taxes on unrealized capital gains Liable for taxes when property is sold Capital gains tax discourages selling of assets with unrealized capital gain Creates an inefficiency PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-16 Capital Gains Taxation as a Double Tax Capital gains tax represents a double tax Assets bought with after-tax income and capital gain on appreciation of asset also taxed Capital gains taxed at higher rate than ordinary income if asset bought with after-tax income PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-17 Inflation and Capital Gains If taxes are placed on nominal value of asset, an individual may be liable for capital gains tax although the real value has declined Phantom capital gain – a capital gain in nominal terms that is not a real capital gain Capital gains not indexed for inflation Inflation increases tax bills for taxpayers realizing capital gains PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-18 Wealth and Property Taxation Wealth is another possible tax base Property tax is most common tax on wealth Close relationship between income taxation and wealth taxation PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-19 Incentives in Income Taxes and Wealth Taxes Flow of income – return on individual’s stock of human capital along with work effort Can tax individual’s income earning potential as wealth Incentive to accumulate less human capital and work harder Can tax individual’s actual income as a flow Incentive to under utilize human wealth PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-20 Unrealized Capital Gains and Wealth Taxation Renter and homeowner treated equally under wealth tax Some sources of wealth more easily taxed if flow of income from wealth is taxed Example: human capital Some sources of wealth more easily taxed directly Example: real estate PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-21 The Property Tax Major source of revenue for local governments Primarily a local government tax Real estate major source of property tax revenue Taxed components of real estate: Land Improvements made to taxed site Provides disincentive for improving value of property PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-22 Locational Decisions and the Property Tax Differences in property taxes among locations influence locational decisions of businesses Businesses view taxes as price paid for government goods/services Examine mix of public sector output and level of taxation Excess burden of property taxation PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-23 Property Tax Limitations California’s Proposition 13 Limits level of property taxation Restricts future increases in property tax rates Effect of charging different property owners with identically valued property different tax rates Creates disincentive to sell property PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-24 Differing Property Tax Rates Different tax rates depending on use of property Can be used to price government services for different types of consumers PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-25 Site Value Taxation Tax placed only on value of site Ownership of property implies ownership of asset and stream of future tax liabilities Tax has effect of being lump sum tax on wealth of property owner at time it is levied Entire site tax borne by owner of land PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-26 Site Value Taxation Versus Property Taxation Present owner bears entire tax burden on existing property in both cases Property tax on improvements discourage improvement Lowers market value of land by present value of tax Site value taxation provides no disincentive PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-27 Site Value Taxation and Value of Land Placement of tax on site value only provides incentive to develop property Market value of land lower under site value taxation when a national policy Market value of land rises in a locality under site value taxation if surrounding area uses a property tax PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-28 Inheritance Tax Provides incentive to live longer to postpone payment of tax Relatively insignificant source of tax revenue Federal estate tax being phased out PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-29 Avoiding the Tax Trust funds to shield estate from taxation Pass wealth on through gifts while living Spend wealth before death PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-30 Justifications for an Inheritance Tax Not fair to benefit from wealth earned by someone else Fosters goal of creating a more equal distribution of income Closes a loophole in current income tax structure PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-31 Severance Taxes Charged on extraction of natural resources Comprise less than 1% of total state government revenues Similar to a property tax - owner of resource owns value of resource less tax liability to be paid if resource extracted Owners of resource have ability to shift some of tax burden to demanders of resource by slowing rate at which resource extracted PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-32