Lecture 7: Corporate income taxation

Transcription

1 Lecture 7: Corporate income taxation Economics 336 Economics 336 (Toronto) Corporate taxation 1 / 19

2 Introduction Figure: Federal corporate tax rates, Canada, Federal statutory corporate tax rates have fallen from 39% to 19% since Also increases in tax deductions. Yet effective tax rates on profits are fairly stable. Economics 336 (Toronto) Corporate taxation 2 / 19

3 The corporate income tax Corporate tax rates in Canada have declined dramatically in the past 25 years. How do we evaluate such big changes? Key questions for this lecture: What is the structure of the corporate tax? What are its economic effects? Who bears the burden of the corporate tax? Why does it exist? What is the future of the corporate tax? Economics 336 (Toronto) Corporate taxation 3 / 19

4 Structure of the CIT Levied on incorporated businesses only. Tax paid = τ ( Revenues Non-capital expenses Capital cost allowances Interest on debt ) Notes: Since non-capital costs deductible, these production inputs are not taxed through CIT. CCA deduction represents economic depreciation i.e. opportunity cost of owning capital assets for one year. While costs of corporate debt (i.e. interest) are deductible, corporate equity (i.e. dividends, capital gains) are not. However, personal income tax system include a Dividend Tax Credit that offsets equity costs in part. Economics 336 (Toronto) Corporate taxation 4 / 19

5 Investment effects of the corporate tax Since CIT base deducts everything except the cost of capital, then it is a tax on capital with potentially large effects on investment and productivity (excess burden). But some capital costs (interest, CCA) are deductible so effects on investment are unclear. We first consider a very simple model of capital: A firm rents capital K for one year to generate revenues F(K ). No capital purchases, and no non-capital expenses. Firm borrows K to finance operations and pays interest rk to creditors. Corporate tax rate τ. Economics 336 (Toronto) Corporate taxation 5 / 19

6 The firm maximizes profits by choosing K to max(1 τ)[f(k ) rk ]. The first-order condition is (1 τ)f (K ) = (1 τ)r, or F (K ) = r for all τ 0 In this model, the CIT is neutral: no change in investment. return to capital r F (K) K* K Economics 336 (Toronto) Corporate taxation 6 / 19

7 The firm maximizes profits by choosing K to max(1 τ)[f(k ) rk ]. The first-order condition is (1 τ)f (K ) = (1 τ)r, or F (K ) = r for all τ 0 In this model, the CIT is neutral: no change in investment. return to capital effect of tax (1 t) F (K) r (1 t) r F (K) K* Economics 336 (Toronto) Corporate taxation 7 / 19 K

8 Discussion: Why have a corporate tax? Policy discussions of CIT are often framed as fair taxation of business. But in the theory of tax incidence we look at tax burdens on shareholders, workers, and consumers. Why not tax shareholders directly, through personal income tax system? Our simple model suggests several roles for the corporate tax: 1 A tax on supranormal profits: Some investments earn higher than required rate of return. Key examples: resource firms, monopoly profits. 2 A tax on foreign investors: Interest paid to foreign capitalists is not generally taxable through PIT. 3 A tax on retained earnings: Without CIT, income could be retained in corporation and tax deferred indefinitely potential for tax avoidance. Economics 336 (Toronto) Corporate taxation 8 / 19

9 Depreciation, equity, and investment A more complete theory, with capital assets and equity finance. Economic depreciation is the opportunity cost of owning a capital asset for a period of time. Example: Studies show that computers depreciate 50% er year. So a $1 million computer generates a stream of depreciation expenses ($500K, $250K, $125K,...) Under the CIT, purchases cannot generally be deducted (expensed) in the year of purchase. Instead, Capital cost allowance (or tax depreciation) is a stream of deductions (D 0, D 1, D 2,...) permitted in years following purchase, per dollar spent. Let Z denote the PDV of future depreciation deductions per dollar. Economics 336 (Toronto) Corporate taxation 9 / 19

10 The cost of capital to the firm depends on whether it uses debt finance (deductible) or equity finance (non-deductible). Let the after-tax financial cost of capital be { (1 τ)r with debt finance r f = r with equity finance Now the marginal investment earns after-tax return (1 τ)g per year, and it costs (r f + δ)(1 τz ). So invest if G UCC = (r f + δ)(1 τz ) 1 τ The RHS is the hurdle rate for new investment, or the user cost of capital. Economics 336 (Toronto) Corporate taxation 10 / 19

11 Figure: Effects of CIT on investment: The general case return to capital effect of tax (1 t) F (K) r+d (r +d)(1 tz) f F (K) K* 1 K* 0 K Economics 336 (Toronto) Corporate taxation 11 / 19

12 An investment-neutral CIT Can we still design the CIT to be neutral for investment? 1 Suppose that investment is 100% debt financed, and that CCA equals true economic depreciation. A $1 investment generates a stream of deductions The PDV of deductions is Z = (0, δ, δ(1 δ), δ(1 δ) 2,...) δ δ(1 δ) δ(1 δ) r f (1 + r f ) 2 (1 + r f ) = δ r f + δ Then if r f = (1 τ)r (debt finance), ( ) (r f + δ) 1 τδ r f +δ UCC = 1 τ = r f 1 τ + δ = r + δ Economics 336 (Toronto) Corporate taxation 12 / 19

13 1 (Continued) With debt finance and CCA equal to economic depreciation, the CIT is neutral for investment. But it would be difficult to set CCA appropriately for each asset, and not all firms can use deductible debt. 2 Suppose that investment is expensed: fully deductible immediately on purchase. Then Z = 1. If there is no deduction for interest costs, then r f = r, and UCC = (r + δ)(1 τ) 1 τ = r + δ With expensing of cpaital costs and no deduction for financial cost of capital, the CIT is neutral for investment. A corporate tax system of this type is known as cash-flow taxation. (Why?) The result shows that the system would be investment-neutral for all assets but would still generate positive tax revenues. Why isn t cash-flow taxation used in practice? Economics 336 (Toronto) Corporate taxation 13 / 19

14 Incidence of the corporate tax Who ultimately bears the burden of the corporate tax? Capital or labour? Our standard incidence model provides some insights. 1 In the short run, the stock of capital available to invest is roughly fixed. Taxes on capital investment should be shifted back to investors. 2 In the longer run, investors can avoid the domestic CIT by investing abroad (or in non-corporate assets). As domestic investment falls, the pre-tax return rises, restoring equilibrium. The burden of the tax is borne by: workers, in the form of lower productivity and lower wages owners of internationally immobile assets (like resource rents) Exercise: Consider a withholding tax on corporate payments to foreign investors. What is the incidence of this tax on foreign and domestic capitalists, and domestic workers? Economics 336 (Toronto) Corporate taxation 14 / 19

15 Taxes and multinational corporations In our model so far, firms choose how much to invest in the domestic economy possibly financed by foreign potrfolio investors. In reality, much of investment is chanelled through multinational corporations that choose between investing in country of residence, or in subsidiaries in foreign countries. Foreign investments of MNCs are subject to taxation both in host country and in their country of residence. Approaches to alleviating double taxation: 1 credit system (used by US): foreign income of MNC is subject to taxation at home, with a credit for foreign taxes paid. 2 exemption system (used by Canada and most other rich countries): foreign income is exempt from taxation at home. Economics 336 (Toronto) Corporate taxation 15 / 19

16 Credit vs. exemption and Capital Export Neutrality So Canadian MNCs pay tax in Canada on investments in Canada, but they not on investments abroad. Does this make sense? MNC chooses between investment in domestic assets (domestic tax rate τ d ) and assets in a tax haven (foreign tax rate τ f = 0). Assets have pre-tax return (productivity) R i, i = d, f. 1 Credit system, MNC invests at home if (1 τ d )R d (1 τ d )R f or R d R f which maximizes worlwide productivity of capital. We say the credit system leads to capital export neutrality. 2 Exemption system, MNC invests at home if (1 τ d )R d R f or R d R f 1 τ d > R f The exemption system may lead to offshoring of MNC investment into foreign subsidiaries. Economics 336 (Toronto) Corporate taxation 16 / 19

17 Multinational corporations and profit shifting Why do Canada and other countries not adopt the credit system, like the US? One reason is that MNCs can use financial and accounting transactions to shift profits out of US and other high-tax countries to tax havens, even without relocating their physical investments and production. Examples of profit shifting activities: Transfer pricing: Affiliates in low-tax countries sell inputs to parent company at an elevated price, reducing taxable income at home. Expatriation of intellectual property: Patents are held by affiliates in low-tax countries, and sales in high-tax countries are offset by tax-deductible royalty payments to offshore affiliates. Offshore financing: Parent borrows from financing affiliate in a low-tax country, generating deductible interest payments. Economics 336 (Toronto) Corporate taxation 17 / 19

18 International profit shifting: A case study Source: New York Times, 2012 Economics 336 (Toronto) Corporate taxation 18 / 19

19 Implications of profit shifting As MNCs grow in importance and profit shifting becomes more widespread, strong implications for the future of the corporate tax: Domestic taxable income becomes very sensitive to the domestic tax rate. leads to tax competition among countries who seek to benefit instead of lose from profit shifting by having low corporate tax rate. Potential for a race to the bottom in tax rates. as tax rates fall, more of tax burden may be borne by labour, not capital Potential for offshoring investment/jobs may become lower not higher. Google can still invest in US, because it doesn t pay much tax there, despite high US tax rate. Corporate tax burden shifts from investors in large MNCs to smaller, domestic-only corporations. Economics 336 (Toronto) Corporate taxation 19 / 19