Chapter 15

Taxation of Corporate
Income

1
 Forms of Business

 Sole Proprietorships

 Partnerships

 Corporations

2
 Corporations

 Corporations are granted the legal

status of people.

 This means that they can own property

and borrow money.

3
 Corporate Ownership
Corporations are owned by shareholders. Each
share entitles its holder to a fraction of the

dividends declared,
votes at shareholders’ meetings that determine the
operations of the corporation, and
proceeds if the corporation were to dissolve.

The fraction of all of the above that applies for each

shareholder is the number of shares held divided by
the total number of shares outstanding.
4
 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.

5
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.

6
 Taxation of Owner-Supplied Inputs
 In small business settings, owners work for
themselves. The profit from the business is
what each owner is “paid.”
 Some of this is normal profit; some is
economic profit.
 Corporations feature no owner-supplied input
so all profit, normal and economic, is taxed.

7
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
shareholders.

8
 Economic Depreciation
 Economic Depreciation is the amount of
value that an asset loses over time.

 When a business buys an expensive capital

asset, it cannot deduct from corporate profits
the entire 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.
9
 Accelerated Depreciation
 Accelerated depreciation allows businesses to deduct the
loss in the value of an asset before the asset actually
wears out.

 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 the asset.

10
 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.

11
 Undistributed Corporate Profits,
Dividends, And Interest Cost

 Some argue that a separate corporate income

formula is necessary to reverse the tax preference
that comes from the exclusion of all unrealized
capital gains in calculating personal income tax.

 Others counter that because payment on corporate

debt (interest) is deductible to the corporation but
payment on equity (dividends) is not, a separate
tax on corporate income is neutral.
12
Double Taxation of Corporate Income
 Corporate Income is considered to be double-taxed,
because its income is taxed twice.

 The Corporation must pay taxes on the profits, then

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.

13
 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
might never be taxed.
Compensation for Bankruptcy Protection:
 Individuals are not liable for the bankruptcy of
assets they hold in corporations, whereas they
are liable in cases of proprietorships and
partnerships. This poses a real advantage to
investing in corporations over the other business
forms.
14
The Consequence of Double Taxation: A
Bias Toward Debt Finance
 A corporation can raise money by borrowing (taking on
debt), 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.

15
Demonstrating the Bias toward Debt Finance
Assumptions:10% interest; Item All-Equity 50% Debt –
50% Equity
34% tax rate Balance Sheet

Total Assets $1,000,000 $1,000,000

Conclusion: The taxation of Debt 0 $500,000

corporate profits combined Shareholder’s Equity $1,000,000 $500,000

with the deductibility of

Income Statement
interest raises the after-tax
Operating Income $150,000 $150,000
return on equity to firms in Interest Expense 0 $50,000
greater debt, thereby Taxable Income $150,000 $100,000
motivating firms to increase Income Tax $51,000 $34,000
their debt burdens to an Income after $99,000 $66,000

inefficiently high level. Corporate Tax

Return on Equity 9.9% 13.2%

16
Tax Treatment of Multinational Corporations
 Large corporations with multinational operations have
foreign subsidiaries throughout the world.

 The foreign subsidiaries are incorporated under the

laws of a foreign nation and are legally separate from
the parent corporation.

 There are two ways of taxing multinationals:

 Taxes only on “repatriated” profits.
 Computing worldwide income and granting a credit for tax
payments made to other countries.

17
Rate Structure
Taxable Income Average Tax Marginal
Rate at the Tax Rate
Beginning
of the
Bracket
Less than $50,000 0% 15%

$50K < 15% 25%

income<$75K

$75K<income<$10 18% 34%

Mill

More than $10 Mill 34% 35%

18
 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.

19
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).

20
 Figure 15.1 A Tax on Economic Profits

MC
After-Tax Profits
AC
Price and Cost

E
MR = P
A B
AC*
G F

0 Q*
Output per Year
21
Long-Run Impact of Corporate Income
Taxation

 Investors may shift their money from

corporate investments to non-corporate
investments (like municipal bonds) to
maximize after-tax returns.

22
 Figure 15.2 Long-Run Impact
of the Corporate Income Tax
S

Interest Rate (Percent)

A
i1 E

i2 D
D’

0 IC + IN
Total Investment per Year
B C
Return to Investment (Percent)

MSCC=MSRN=SC
SN=MSCN=MSRC
rG* SN'
EC1 EN1
i1 = r1 r1
rG*(1 – t) = rN* EC2 r2
B EN2
r1(1 – t) = r’
MSRC = DC = rG
∆ IN MSRN
D’C=rG(1 – t) ∆ INC

0 IC2 IC1 0 IN1 IN2

Corporate Investment per Year Noncorporate Investment per Year
23
 The Corporate Cash-Flow Tax
 This is a tax is on corporate revenue –
expenditures on both current and capital
inputs, but interest payments would not be
deductible.
 The Corporate Cash-Flow Tax would
eliminate the bias toward debt.
 It would also allow immediate expensing of
capital assets.
 It would likely be a revenue neutral change
from the current system.

24
Figure 15.3 Impact of the Corporate Income Tax When
the Supply of Savings is Not Perfectly Inelastic

Return to Investment (Percent)

S

rG B
r1 C
rN A

D
D'

0 I2 I1
Investment per Year 25
 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.

26