This document is posted to help you gain knowledge. Please leave a comment to let me know what you think about it! Share it to your friends and learn new things together.
Ec426 Public EconomicsLecture 8: Taxation and companies
1. Introduction2. Incidence of corporation tax3. The structure of corporation tax4. Taxation and the cost of capital5. Modelling investment decisions and the impact of
taxes6. The effects of uncertain tax policy7. Empirical studies
Annex: Alternative approaches to corporate taxation
Distortions of two-tier “__________________” corporation tax (compared to one level of tax for partnerships and sole proprietorships) have led to calls for the integration of individual and corporate tax systems (see, for example, US Treasury, 1992)
Why tax companies?– Corporation tax (CT) as an easier point of tax collection
– CT as a way to extend tax base (foreign shareholders, capital gains)
p required (real pre-tax) rate of returnμ marginal rate of returnδ exponential rate of depreciationρc (nominal) discount rate of firm for net-of-tax dollarsπ inflationτ corporation tax rateV value to firm of £1 capital assetC net-of-tax cost of £1 capital assetA value of tax allowances for £1 capital assetAD present discounted value of future stream of depreciation
A2. Perfect competition (which implies that firms maximise profits)
A3. Full and symmetric information
A4. ____________________
A1-A4 imply the capital markets are perfect in the sense that individuals and firms can borrow and lend at a unique market interest rate i.
A5. Tax rates (and all prices) are constant over time (and across individuals)
A1-A5 imply that the firm has a determinate revenue function, R(t)=R(K(t), τ(t)). We define μ as the marginal rate of return, μ =∂R/∂K (where K is the capital stock or, more generally, productive capacity).
Suppose the firm is pursuing an optimal investment policy and consider a marginal deviation from that policy. It must be true that:
μ = i + δ
the return from employing an extra unit of capital must equal the marginal cost of capital services or "cost of capital“, which consists of two components:- i : financial cost (the cost of committing financing for a period of time)- δ: ____________________ (the change in the value of the physical asset over the period).
The "required rate of return", p, is defined as: p = μ – δ
Note that in the absence of taxes the required rate of return equals the market interest rate:
A key determinant of the cost of investment assets to the firm is the value of the relevant capital (____________________) allowances, investment tax credits and investment grants:
A = f1AD + f2 τ + f3g
where– f1 represents the proportion of the invested amount that is eligible for capital
(depreciation) allowances;
– f2 is the proportion eligible for expensing (or tax credits);
– f3 is the proportion eligible for an investment grant at rate g, and
At the optimum, the firm invests until the value of the marginal investment is just equal to its net-of-tax cost (that is, V = C). This implies that the marginal rate of return, m, and hence the cost of capital at the optimum is:
and that the required rate of return - the "financial cost of capital" - is
Since, in the absence of taxes, the ____________________ equals the market interest rate (that is, p = i), we can assess the effects of alternative tax systems by comparing the resulting cost of capital with the market rate of interest.
The firm's discount rate, ρc is affected by its choice of finance:
ρc = βi Debt finance (bank loans or bonds), where β =1- τ if interest payments are tax deductible and β =1 if not.
ρc = i / θ New share issues, where 1/ θ is the opportunity cost of dividends in terms of net-of-corporate-tax earnings
foregone. Thus, θ =1 for "classical" corporation tax systems such as in the US and θ=1/(1-s) for imputation systems (with rate of imputation s) such as in the UK.
ρc = γi _____________________, where γ =(1-m)/(1-z) with m the marginal rate of personal income tax and z the
effective accrued marginal rate of capital gains tax.
The impact of alternative tax regimes for investment on the cost of capital
Assuming no inflation, the expression for the cost of capital simplifies to:
Case 1. No taxes: A = 0, τ = 0
p = ρc = i
Thus, the cost of capital in the absence of taxes is simply the market interest rate. We can use this result, p=i, as a __________________ to assess the impact of the tax system on the cost of capital under alternative tax regimes.
A tax regime is “_______________” with respect to the cost of capital if p=i.
5. Modelling investment decisions and the impact of taxes
Accelerator model
____________________ production technology
Optimal capital stock (from FOCs)
Optimal investment (It = Kt – Kt-1)
Comments: – Empirical evidence of “accelerator effects”
– Important role of expected output
– Assumption of ____________________ technology (implying zero elasticity of substitution between capital and labour) not supported empirically; cost of capital does matter.
Hall and Jorgenson (AER, 1967) findings:Tax policy “highly effective” in changing level and timing of investment.
For example, the adoption of accelerated depreciation (in the ADR system) in 1954 explains 70.8% of net investment in manufacturing equipment in 1955 and 16.5% over 10 years; also explains the shift from structures to equipment
“q-theory” model (Brainard & Tobin, 1968)Firms will invest if the market value of the project exceeds the ______________________ of the capital assets.
Comments:
– If q > 1, firm invests (and if q < 1 firm divests or is taken over)
The modern theory of investment (Hayashi, 1982; Abel, 1990) is conceptualised as an internal market in the firm for installed capital, where
– The _________________________ for installed capital arises from the Jorgenson equation equating the marginal product of capital to the user cost, where the price of capital goods used in the latter is not the price charged by an outside supplier but, instead, the shadow value of installed capital, q.
– The _________________________ arises from Tobin’s conception of the optimising firm equating the marginal cost of purchasing and installing capital goods to the shadow value of installed capital, q.
Modelling the effects of uncertainty on investment decisions
– Given the randomness in output price and capital costs, the firm wants to determine the optimal investment rule to maximise discounted profits net of investment costs:
– In effect, the rule provides an optimal stopping time and the level of investment conditional on stopping.
Effects on ______________ and ____________ of investment
7. Empirical studiesAlternative approaches: Chetty and Saez (2006)
Julio and Ikenberry (2004) argue that rise in dividends pre-dated 2003 dividend tax cut (data from core sample)
Chetty and Saez (2006) compare dividend paying by ‘core’ sample with that of a sample of ______________ ______________. Rise in dividends starts in 2003:1.
ReferencesAbel, A (1990), “Consumption and investment”, in Handbook of Monetary Economics, volume 2.Auerbach, A J (2006), “The future of capital income taxation”, IFS Annual Lecture, September
(http://www.ifs.org.uk/conferences/auerbach06.pdf )Auerbach, A J, M Devereux and H Simpson (2008), “Taxing corporate income”, paper prepared for The Mirrlees Review,
March. (http://www.ifs.org.uk/mirrleesreview/press_docs/corporate.pdf)Brandon, J, and D Ikenberry (2004) “Reappearing dividends”, Journal of Applied Corporate Finance, 16(4), 89-100Chetty, R and E Saez (2006) “The Effects of the 2003 Dividend Tax Cut on Corporate Behavior:Interpreting the
Evidence”, American Economic Review, 96(2), 124-129.Clark, J. (1917), ‘Business acceleration and the law of demand: a technical factor in economic cycles’, Journal of Political
Economy, vol. 25, pp. 217–35.Cummins, J G, Hassett, K. A., and Hubbard, R. G. (1995), “Have tax reforms affected investment?,” Tax Policy and the
Economy, 9, 131-149.Hall, R (1995) “Comment” on Cummins, Hassett and Hubbard, Brookings Papers on Economic Activity, volume 2, 1-74.Hall, R E, and D Jorgenson (1967), “Tax policy and investment behavior”, American Economic Review , 57, 391-414.Hassett, K. and G Metcalf (1999), “Investment with uncertain tax policy: Does random tax policy discourage
investment?”, Economic Journal, 109 (July), 372-393. Hayashi, F (1982), “Tobin’s Marginal q and Average q: A Neoclassical Interpretation”, Econometrica, vol. 50(1), 213-24. Jorgenson, D (1963), ‘Capital theory and investment behavior’, American Economic Review, vol. 53, pp. 247–59.Mintz, J (1995), “The corporation tax: A survey”, Fiscal Studies, 16:4 (November), 23-68.
(http://www.ifs.org.uk/fs/articles/fsmintz.pdf)Brainard, W C, and J Tobin (1968), “Pitfalls in financial model building”, American Economic Review (Papers and
Proceedings), 58, May, 99-122. U.S. Department of the Treasury (1992) Integration of the Individual and Corporate Tax Systems: Taxing Business
Income Once, Washington DC: US Government Printing Office. . http://www.ustreas.gov/offices/tax-policy/library/integration-paper/
Annex: Alternative approaches to corporate taxation
Tax the full return on capital?
Comprehensive Business Income Tax (CBIT)US Treasury (1992) “Integration of the individual and corporate tax systems”
Objectives:– Eliminate “double” taxation of corporate income– Equalise treatment of corporate debt and equity (“classical” corporation
tax only taxes the return on equity)
Key elements:– All businesses (corporate and non-corporate) taxed at the same rate– Eliminate tax deduction for interest payments– Broader base allows reduction in statutory rate– Interest and equity income exempt from tax at individual level