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Chapter 15

Taxation of Corporate
Income
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Printed in the United States of America
ISBN 0-03-033652-X
Copyright 2002 by Thomson Learning, Inc.

Forms of Business
Sole Proprietorships
Partnerships
Corporations

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Corporations
Corporations are granted the legal
status of people.
This means that they can own property
and borrow money.

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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.

Copyright 2002 by Thomson Learning, Inc.

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.

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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.
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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.

Copyright 2002 by Thomson Learning, Inc.

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.

Copyright 2002 by Thomson Learning, Inc.

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.

Copyright 2002 by Thomson Learning, Inc.

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.

Copyright 2002 by Thomson Learning, Inc.

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.

Copyright 2002 by Thomson Learning, Inc.

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.

Copyright 2002 by Thomson Learning, Inc.

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.

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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.

Copyright 2002 by Thomson Learning, Inc.

Demonstrating the Bias toward


Debt Finance
Assumptions:10% interest;
34% tax rate

Item

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50% Debt
50% Equity

Balance Sheet
Total Assets

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.

All-Equity

$1,000,000

$1,000,000

$500,000

$1,000,000

$500,000

$150,000

$150,000

$50,000

$150,000

$100,000

Income Tax

$51,000

$34,000

Income after
Corporate Tax

$99,000

$66,000

9.9%

13.2%

Debt
Shareholders Equity

Income Statement
Operating Income
Interest Expense
Taxable Income

Return on Equity

Rate Structure
Average Tax
Rate at the
Beginning
of the
Bracket

Marginal
Tax Rate

0%

15%

$50K <
income<$75K

15%

25%

$75K<income<$10
Mill

18%

34%

More than $10 Mill

34%

34%

Taxable Income

Less than $50,000

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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.

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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).

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Figure 15.1 A Tax on Economic Profits

Price and Cost

MC

AC*

After-Tax Profits
E
B

0
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Q*
Output per Year

AC

MR = P

Long-Run Impact of Corporate


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

Copyright 2002 by Thomson Learning, Inc.

Interest Rate (Percent)

Figure 15.2 Long-Run Impact of the Corporate


Income Tax
A

S
i1

i2

D
D
0

IC + IN

Return to Investment (Percent)

Total Investment per Year


B

MSCC=MSRN=SC
rG*
i 1 = r1

EC1

IN
0

IC2 IC1

EN1
B

MSRC = DC = rG
DC=rG(1 t)

Corporate Investment per Year


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SN=MSCN=MSRC
r1
r2

EC2

rG*(1 t) = rN*
r1(1 t) = r

INC
0

SN'

EN2
MSRN

IN1 IN2

Noncorporate Investment per Year

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.

Copyright 2002 by Thomson Learning, Inc.