CHAPTER 19

THE
CORPORATION
TAX

McGraw-Hill/Irwin Copyright © 2008 by The McGraw-Hill Companies, Inc. All rights reserved.
I’ll probably kick myself for having said this,
but when are we going to have the courage to
point out that in our tax structure, the
corporation tax is very hard to justify?
President Ronald W. Reagan

19-2
Corporations
 Corporation – A state-chartered form of
business organization, usually with limited
liability for shareholders (owners) and an
independent legal status
 Limited liability
 Corporations are “artificial legal persons”

19-3
Why Tax Corporations?
 Only real people can pay a tax
 Justifications
 Corporations are distinct entities
 Corporations receive special privileges from
society
 Protects integrity of personal income tax

19-4
Structure

Revenue
- Expenses incurred earning revenues
Taxable Income
* Tax rate (15% - 35%)
Tax
- Credits
Total Tax
Alternative Minimum Tax
Treatment of Losses 19-5
Treatment of Dividends versus Retained Earnings

 Double taxation

19-6
Effective Tax Rate on Corporate Capital
 Statutory rate versus effective rate
 Interest deductibility
 Depreciation allowances
 Inflation
 Double taxation
 Gravelle [2004]
 Effective corporate rate = 32%; noncorporate rate = 18%
 Sensitivity of estimate

19-7
Incidence and Excess Burden

 A tax on corporate capital

 Incidence in a general equilibrium model
 Excess burden on a general equilibrium model
 A tax on economic profits
 Incidence and excess burden of a tax on
economic profits
 Actual corporate profits versus economic profits
 Stiglitz [1973] model

19-8
Effects on Behavior – Total Physical Investment

 Accelerator Model
 Neoclassical Model
 Cash Flow Model

19-9
Effects on Behavior-Type of Asset
 Tax system encourages purchase of assets that
receive relatively generous depreciation
allowances

19-10
Effects on Behavior-Corporate Finance
 Why do firms pay dividends?
 Dividends as a signal of firm’s financial strength
 Clientele effect
 Effect of taxes on dividend policy
 Empirical evidence – Chetty and Saez [2004]
 Effect on savings
 Debt versus Equity Finance
 Did the tax system cause the corporate accounting
scandals?

19-11
State Corporation Taxes
 State taxes have similar incidence and
efficiency problems as federal taxes
 Variation of tax rates across state lines

19-12
Taxation of Multinational Corporations
 Structure
 U. S. corporations pay tax at standard rate on global
taxable income
 Credit for foreign taxes paid
 Subsidiary status
 Deferral of taxes on income from foreign enterprise
 Repatriation
 Income allocation
 Arm’s length system
 Transfer-pricing problem

19-13
Evaluation of Tax Treatment of Multinational Firms

 Maximization of world income

 Maximization of national income

19-14
Corporation Tax Reform
 Full Integration (Partnership Method)
 Issues
 Nature of the corporation
 Administrative feasibility
 Effects on efficiency
 Effects on saving
 Effect on distribution of income

19-15
Dividend Relief
 Allow corporation to deduct dividends
 Exclude dividends from individual taxation
 2003 legislation – 15% maximal tax rate on
dividends

19-16
Allowable Expenses
• Employee Compensation
• except compensation in excess of $1,000,000
• Options do not have to be included
• Cost of Material Inputs
• Taxes including employer contributions to Social Security
• Repairs and advertising
• Interest but not dividends
• Depreciation
• No investment tax credit
19-17
Depreciation
 What is depreciation?
 Tax life of an asset
 3, 5, 7, 10, 15, 20, 27.5, and 39 years
 Most 5 years

19-18
Calculating the Value of Depreciation Allowances –
Straight-Line Depreciation, 10 year tax life
Year Write-off Tax Savings Present Value of
Tax Savings
1 $10,000.00 $3,500.00 $3,181.82
2 $10,000.00 $3,500.00 $2,892.56
3 $10,000.00 $3,500.00 $2,629.60
4 $10,000.00 $3,500.00 $2,390.55
5 $10,000.00 $3,500.00 $2,173.22
6 $10,000.00 $3,500.00 $1,975.66
7 $10,000.00 $3,500.00 $1,796.05
8 $10,000.00 $3,500.00 $1,632.78
9 $10,000.00 $3,500.00 $1,484.34
10 $10,000.00 $3,500.00 $1,349.40
Total $100,000.00 $35,000.00 $21,505.98

19-19
Calculating the Value of Depreciation Allowances –
Straight-Line Depreciation, 5 year tax life

Year Write-off Tax Savings Present Value of

Tax Savings
1 $20,000.00 $7,000.00 $6,363,64
2 $20,000.00 $7,000.00 $5,785.12
3 $20,000.00 $7,000.00 $5,259.20
4 $20,000.00 $7,000.00 $4,781.09
5 $20,000.00 $7,000.00 $4,346.45
Total $100,000.00 $35,000.00 $26,535,51

19-20
Calculating the Value of Depreciation Allowances –
Double Declining Balance Depreciation, 10 year tax life
Year Write-off Tax Savings Present Value of
Tax Savings
1 $20,000.00 $7,000.00 $6,363.64
2 $16,000.00 $5,600.00 $4,628.10
3 $12,800.00 $4480.00 $3,365.89
4 $10,240.00 $3,584.00 $2,447.92
5 $6,826.67 $2,389.33 $1,483.59
6 $6,826.67 $2,389.33 $1,348.72
7 $6,826.67 $2,389.33 $1,226.11
8 $6,826.67 $2,389.33 $1,114.64
9 $6,826.67 $2,389.33 $1,013.31
10 $6,826.67 $2,389.33 $921.19
Total $100,000.00 $35,000.00 $23,913.10
19-21
General Analysis of Depreciation Tax Savings

T = tax life
D(n) = proportion of asset that can be written off
against taxable income in nth year
θ = corporate tax rate
Present value of tax savings:
ψ = θ * D(1) + θ * D(2) + … + θ * D(T)
1+r (1 + r)2 (1 + r)T

19-22
More on Depreciation
 Accelerated depreciation
 Expensing
 Intangible Assets

19-23
Investment Tax Credit

k = investment tax credit

q = acquisition price of asset
(1 – k)q = effective price of asset

19-24
Stiglitz Model

G = before-tax value of output produced by machine

r = interest rate
Firm buys machine if: G – r > 0
Assume corporate tax
(1) net income taxed at rate θ
(2) net income = G – r
(1 – θ)(G – r) > 0

19-25
Neoclassical Model
User cost of capital = (r + δ)
After tax rate of return = (1 – θ) * (1 – t)
(1 – θ) * (1 – t) * C = (r + δ)
C= (r + δ)
(1 – θ) * (1 – t)
C = (r + δ) * (1 – ψ –k)
(1 – θ) * (1 – t)

19-26
Effect of User Cost on Investment
 Econometric problems
 Role of expectations
 Elasticity of supply curve of capital goods
 Open economy problems

19-27
Cash Flow Model
 What is cash flow?
 Irrelevancy of cash flow in neoclassical model
 Cost of internal versus external funds
 Empirical results

19-28
Maximization of World Income

rf = rUS
(1 – tf)rf = (1 – tUS)rUS
Full credit versus limited credit

19-29
Maximization of National Income
this one
(1 – tf)rf = rUS
rf = rUS/(1 – tf)
if tf < 1, then rUS < rUS/(1 – tf)
Note: this
Deduction of foreign
equation tax payments
equivalent to …
from domestic income:
rf(1 – tf)(1 – tUS) = rUS(1 – tUS)
19-30
Effects on Efficiency of Full Integration
 Misallocation of resources between corporate
and noncorporate sectors eliminated
 Tax-induced distortions in savings decisions
reduced
 Remove incentive for “excessive” retained
earnings
 Reduce bias toward debt financing

19-31