Keywords: corporate income tax, source of finance, imputation tax system, full imputation tax system, split rate system.

Transcription

1 Ilija Gruevski; Corporate taxes an their potential effects on investment Ilija GRUEVSKI * UDC : Professional paper CORPORATE TAXES AND THEIR POTENTIAL EFFECTS ON INVESTMENT Abstract The following aicle is aime to explore the potential (theoretical effects from corporate taxes on investment accoring to the source of finance. The purpose is to analyze the investment ecision in the case of isolate implementation of corporate taxes through the methoological frame of the effective marginal tax rates. It explains that these conitions generate uneven istribution of the buren across the projects covere with ifferent sources of finance. Also, some corporate tax systems with abilities to alleviate the buren are aitionally presente an aequately analyze. For example, a special attention is given to the following corporate tax systems, frequently met in the practice: the comprehensive business income tax system (CBIT, the imputation corporate tax system (ICT, the full imputation corporate tax system (FICT an the split rate corporate tax system (SRCT. Hopefully, this analysis will prove that some corporate tax systems o have theoretical abilities to prouce higher egree of neutrality an are effective for elimination of the istoion between the alternative sources of finance. Keywors: corporate income tax, source of finance, imputation tax system, full imputation tax system, split rate system. JEL Classification Numbers: H25, H32, D92 * Ph.D., Goce Delcev University, Stip, Republic of Maceonia ilija.gruevski@ug.eu.mk 153

2 Economic Development No1-2/2013 p.( Introuction Corporate taxation is very complicate matter if we consier the single fact that the corporate tax base (i.e. the corporate income cannot be limite only at the corporation observe as a form of a legal entity. Usually, after the initial taxation at corporate level, corporate profits are istribute to the shareholers in a form of iviens, capital gains or interest payments, an are subject to aitional taxation at personal level. Consequently, the effects from corporate taxation, very often epen on the cross-effects from the personal taxation. But, regarless the interaction with the personal income tax, the process of corporate taxation on itself, might result with some interesting effects emerging from its nature. One of them is the privilege treatment of ebt as a source of finance, as a result of the usual an wiely excepte treatment of the interest expenses. Normally, since interest payments are tax euctible from the corporate tax base, the system subsiizes the ebt source investment by reucing the iscount rate. So, ebt is consiere as tax preferre as compare to equity. The last triggers unfavourable behaivour of the corporation, to use more borrowe capital, thus increasing the risk of bankruptcy an insolvency of the firm. Similarly, retaine earnings are more preferre to new equity issues since capital gains are usually taxe upon realization or eventually exempte from taxation when reinveste. This commonly creates better position for the ol mature companies as they possess more abunant accumulate reserves, as compare to their young inferior competitors. In the following aicle, I explore the potential effects from the corporate taxes through the methoological frame of the effective marginal tax rates. The general intention is to analyze the investment ecision in the case of isolate implementation of the corporate taxes, which implies a conition of total abstraction of the personal taxes 1. I hope to prove that these conitions generate uneven istribution of the buren across the projects covere with ifferent sources of finance. Also, the intention is to analyze the effects from the implementation of the corporate tax systems which have abilities to alleviate the buren, as 1 This conition ignores the effect from the integrate - ouble taxation. As a result, measurements of the effective corporate tax buren are expresse usually, at corporate level. 154

3 Ilija Gruevski; Corporate taxes an their potential effects on investment well as, to prouce higher egree of neutrality in the process of taxation. They are: the comprehensive business income tax system (CBIT, the imputation corporate tax system (ICT, the full imputation corporate tax system (FICT an the split rate corporate tax system (SRCT. Hopefully, this will contribute to the full picture of the effects from the process of taxation on investment at corporate level. 1. The propose methoology Most of the authors agree that the best way to evaluate the effects from taxation on investment is through the measurement of the effective marginal tax rate (EMTR. Accoring to Mervyn A. King & Don Fulleon 2 (1984, the measurement of effective tax rates may not be straightforwar, but since the incentive for aitional investment is function of the marginal tax rate, this requires a precise efinition of the margin involve. They establishe the marginal investment as: a small increase in the level of real investment in the omestic nonfinancial corporate sector, finance by an increase in the savings of omestic househols (King & Fulleon, 1984: 8. The authors propose the effective marginal tax rate as a ratio between the tax wege an the pretax rate of return: ~ p s [1] EMTR ~ p Constructe as it s shown, the EMTR etermines the share of return on a marginal unit of investment which is cut by taxation. Actually, EMTR represents a relevant inicator of the system s efficiency propeies as it etermines the extent of the available incentives built in the system. The most impoant component of the EMTR is term (p ~ s which is also calle tax wege an it is an expression of the ifference between the preference to invest an the preference to save. This term (the total tax wege can be ivie into 2 pas: a the investment tax wege an b the savings tax wege. 2 The basic stuy on marginal effective tax rates was performe by King & Fulleon (1984. Because of its explicit theoretical founations it s consiere as a pioneer methoology in this fiel. 155

4 156 Economic Development No1-2/2013 p.( (Leibfritz, Thornton, Bibbie, The secon term is measure as (r s an it represents the effective tax buren on the saver s income. The first term which is crucial for our analysis is measure as a ifference between the investor s rate of return before taxes (the cost of capital an the real interest rate (p ~ r an it s an expression for the effective tax buren on the investor s (or company s capital income. Depening on the relation between p ~ an r, we can istinct 3 (three ifferent conitions. The first conition is when the effective tax buren is positive (p ~ > r an as a result of that, the tax system epresses the investment activities.the secon one is when the effective tax buren is equal to 0 (p ~ = r, when the tax system is neutral to the investment ecision. The thir an the most preferrable conition from the investor s point of view is when the effective tax buren is negative (p ~ < r, when the tax system suppos the overall investments. In perfect economies without presence of taxes, the cost of capital is ientical with the real interest rate (p ~ = r an the economic agents are completely inifferent between the investment ecision an the ecision to save. The existence of the national tax system iverges the ifference between the cost of the capital an the interest rate an therefore creates a positive tax wege (p ~ > r. Ientical concept of the EMTR is also avocate by the authors Devereux & Griffith (1999, 2002, The methoology evelope by Devereux & Griffith extene the alreay existing concept propose by King & Fulleon, which resulte in stanarize methoology accepte by most of the economic organizations an institutions. The effective marginal tax rate on corporate income is efine ientically as previously mentione, where p ~ is the cost of capital (pre -tax rate of return on investment efine as: [2] ~ (1 A{ (1 } F (1 p (1 (1 where: - symbol t is the corporate income tax rate; - symbol ρ is known as the shareholers iscount rate, which in abcence of personal taxes generates value equal to the nominal interest rate (ρ = i; - symbol γ is the tax iscrimination variable evelope to measure tax iscrimination between new equity an istributions. Uner the conition of absence of the personal taxes, this variable has value of 1 (γ = 1;

5 Ilija Gruevski; Corporate taxes an their potential effects on investment - symbol π is the inflation rate in the curent perio; - symbol A is the net present value of tax epreciation allowances; - symbol δ is the economic (true epreciation rate; an - symbol F from the expression above represents the financial constraints variable an its value epens from the source of finance. Accoring to Devereux & Griffith (1999, if the project is finance by reinvestment of retaine earnings, the financial constraints variable F RE will always generate value of zero ( F RE = 0. If the project is finance through new equity issues, than the financial constraints variable F NE is measure as: NE (1 [3] F (1 but since the value of tax iscrimination variable is 1, this implies also that F NE = 0 (F NE = F RE = 0. If the firm borrows external ebt (bons or bank loans to finance its project, in that case than the financial constarints variable F DE is measure as: ( i(1 t i(1 t [4] F DE (1 (1 In orer to simplify the calculation for the purpose of a better illustration of the effects, I propose some simple, but very useful assumptions. For example, if the net-present value of epreciation allowancess is asume 0 (A = 0, there is no inflation in the economy (π = 0, ρ = r an the rate of economic epreciation is also assume to be 0 (δ = 0, than expression [2] for the cost of capital will automatically transform to: [5] ~ r F (1 r p an expression [4] for the financial constarints variable F DE will obtain value of: r r(1 t r r [6] F DE (1 r (1 r (1 r 157

6 Economic Development No1-2/2013 p.( The effects from corporate taxes on investment In the following section I use these analytical components to calculate an investigate the effects from the implementation of corporate taxes on economic performance of the firm. It must be notice once again, that the measurements of the effective tax buren on investment are expresse only at corporate level, uner the assumption of ignorance of the personal taxes. First, the usuall, normal treatment of investment will be presente, in orer to etermine the most common tax practicies. Than, the effects from the implementation of the comprehensive business income tax system (CBIT, the imputation corporate tax system (ICT, the full imputation corporate tax system (FICT an the split rate corporate tax system (SRCT will be analyze aitionally The usuall, normal treatment of investment Debt. Lets analyze the case of ebt finance investment. For example, if the project is finance with ebt, than the most common practice allows the corporation to euct the interest payments from its corporate tax base. This means that the value of financial constraints variable F DE from expression [6] will occur in expression [5] for the cost of capital: (1 r ~ r F (1 r r (1 r r [7] p r(1 t r From here, it is easy to etermine the value of the investment tax wege: [8] ~ p r r r 0 This inicates on the fact, that when the investment project is finance with external ebt, the corporate tax system is neutral to the investment ecision. New equity issue an retaine earnings. Since the tax iscrimination variable γ is equal to 1, this implicates ientical values of the financial constraints variables in the cases when the project is covere with new equity issues an retaine earnings (F NE = F RE = 0. This will 158

7 Ilija Gruevski; Corporate taxes an their potential effects on investment result with elimination of the secon term of expression [5], thus generating value for the cost of the capital of only: [9] ~ r p If term [9] is integrate in term [8], than the investment tax wege will generate value of: [10] ~ r r r r(1 t r r p r r r The result implicates that there is a positive tax buren on corporate income in every case of equity finance investments. Actually, this is the exact reason why, it is thought for the corporate income tax to be a tax on the return on equity. Simply, since interest payments are in fact tax euctible from the corporate income tax base, ebt source of finance is consiere as tax preferre as compare to the equity source of finance. The key factor influencing this conition is calle tax shiel effect seen in term r(1 - t from expression [6]. Actually, the system subsiizes the ebt source investment by reucing the iscount rate (which in this case in ientical with the real interest rate in propoion of the corporate income tax rate. The value maximizing firm will always ten to use more frequently borrowe capital as a pa of its strategy for optimization of the capital structure, but in terms of the economic efficiency, this is a classical istoion because it increases the risk of bankruptcy an insolvency of the firm Comprehensive business income tax system (CBIT The question which is raise here is: What might the authorities o, to eliminate this equity-ebt relate istoion an to equalize the treatment between ebt an equity. One of the answers is to implement the so-calle Comprehensive business income tax system - CBIT. This regime successfully eliminates the nee for integration between the corporate an personal taxes on equity by creating a restriction on the possibility for euction of the interest expenses. In fact, interest expenses are no longer euctible from the corporate income tax base. The corporation is therefore inifferent between ebt, newly issue equity an retaine earnings as source of finance of its investment uner the CBIT (OECD, 2007: 89. In orer to express the effect from the 159

8 Economic Development No1-2/2013 p.( implementation of the CBIT system, the possibilities for euction of the interest payment must be eliminate in term [6]: r(1 - t = r(1-0 = r. As a result, the value of F DE will generate value of zero (F DE = F RE = F NE = 0, thus equalizing the tax treatment of ebt, new equity issues an retaine earnings Imputation corporate tax system (ICT Another great example for neutral corporate tax system is the socalle Imputation corporate tax system - ICT. Basically, with an imputation system of corporation tax, pa of the company's tax bill is impute to the stockholers (King & Fulleon, 1984: 22. If c is consiere to be the tax creit rate (or the rate of imputation, than the tax iscrimination variable in absence of the personal taxes will be rewritten as: 1 [11] (1 c This will have ceain implications on the other relevant variables, such as the cost of capital, where in expression [5], the tax iscrimination variable γ will reappear: [12] ~ r F (1 r p Now, let s analyze the effects on the ifferent alternative investments. Debt source of finance. The financial constraints variable for the investments finance with external ebt uner the conitions of the imputation tax system is calculate as: [ r r(1 t] [ r r ] [13] F DE (1 r (1 r (1 r If term [13] is impute in expression [12], the result for the cost of capital will be: (1 r r r r t [14] ~ r (1 (1 p r 160

9 Ilija Gruevski; Corporate taxes an their potential effects on investment From here, if the investment tax wege is calculate, it is obvious that the ICT system oes not generate any other signifficant effect for the investments covere with ebt. [15] ~ p r r r 0 New equity issues: Since γ has value ifferent from 1, the financial constraints variable in case of investment suppoe with new equity issues is measure as: r(1 [16] F NE (1 r Inseing the term [16] in the expression [12], the cost of capital will generate value of: r(1 (1 r ~ r (1 r r r(1 p [17] r r(1 r r r r For the value of the tax iscrimination variable from expression [11], the cost of capital will transform to: [18] ~ r r r(1 c p 1 (1 c (1 c An the investment tax wege to: ~ r(1 c r(1 c r(1 t r rc r p r r [19] rc r( t c This means that the corporate tax buren on investments finance with new equity issues, uner the conitions of this system epens from the interrelation of the corporate income tax rate t an the rate of imputation c. Also, it inicates on the negative correlation between the tax buren an the imputation rate. As a conclusion, corporate systems with higher egree of imputation will suppo investments covere with new equity issues. Retaine earnings. It is very interesting that in this paicular case, the imputation tax system oes not generate any aitional effect. Because, the financial constraints variable for the alternative finance 161

10 Economic Development No1-2/2013 p.( with retentions is always zero (F RE = 0, the result for the investment tax wege is ientical as the one from expression [10]. If the last three 3 alternatives are compare, it can be notice that the imputation system is effective only for the secon one. So, it is especially esigne for alleviation of the buren for the projects primarily finance with equity issues Full imputation corporate tax system (FICT In theory, this system treats the corporation as a pass through entity an allocates all the corporate profits at the shareholer level, where it is subject to the personal income tax. Uner full integration (full imputation, all corporate earnings istribute iviens, retaine profits an interest payments are allocate to shareholers an bonholers an are taxe at the personal level at the personal income tax rate (OECD, 20 07: 86. Actually this system represents another variant of the imputation corporate tax system, where the imputation rate c (or the available tax creit rate is equal to the tax liabilities pai at corporate level t (c = t: 1 1 [20] (1 c It is alreay mentione that these systems (the imputation systems o not affect the investment finance with ebt an retentions. Consequently, the results for these investment alternatives are the same as in the previous section. Yet in the following paragraph I present the analytical proof only for the alternative with new equity issues. New equity issues. If the conitions for the FICT ( c = t are implemente, the investment tax wege from expression [19] will become: [21] ~ r( t c r( t t p r 0 This implies on the conclusion that the FICT system effectivelly removes the tax ifferences between external equity (new equity issues an ebt an at the same time favours external equity instea of retentions. 162

11 Ilija Gruevski; Corporate taxes an their potential effects on investment 2.5. Split rate corporate tax system (SRCT Another option for alleviation of the corporate tax buren is the split rate corporate tax system SRCT. Uner a split rate system there are 2 ifferent statutory tax rates, one that applies to retaine earnings, the other to istribute earnings (Devereux & Griffith, 1999: 48. Tax authorities might choose between the 2 ifferent strategies concerning the split rate system. First, is the strategy to apply a lower rate (alternatively zero rate on istribute profits which will serve to compensate for the personal tax pai on ivien income. The other strategy is to levy a lower split rate (optionally zero rate on retaine accumulate earnings instea on istribute profits. In the following section, the effects from the alternative strategies escribe above are aitionally analyze Taxation of istributions, retaine profits exempt from taxation (t, t = 0 The first option is the strategy of taxation of istribute profits with retaine profits exempt from taxation, which implies the conition of (t, t = 0. The implementation of the terms of this conition generates value for the tax iscrimination variable of: (1 t (1 t [22] (1 t (1 0 An aequatelly, ifferent value for the cost of capital: [23] ~ r F (1 r r F (1 r F (1 r p r (1 0 (1 t (1 0 (1 t In practice, Republic of Maceonia an Estonia alreay have an experience with this variant of split corporate tax system. 3 The aim of this strategy is to generate strong incentives for reinvestment of retaine profits, an reuce the chances for their consumption in a form of ivien istributions. Now the effects on ifferent investment alternatives are compare, to see if the previous thesis can be properly confirme. 3 In Maceonia, corporate profits are only taxe, if they are istribute with a 10% tax rate. This measure is which is originally calle Tax exemption on unistribute earnings, was implemente in

12 Economic Development No1-2/2013 p.( Debt. The financial constraints variable for investments finance with ebt uner the conitions of the split tax system (t, t = 0 is calculate as: [ r r(1 t] [ r r(1 0] [24] F DE 0 (1 r (1 r For the cost of capital as: [25] ~ F (1 r 0(1 r p r r r 0 r (1 t (1 t An for the investment tax wege: [26] ~ p r r r 0 This is an obvious confirmation that even the split rate system that allows taxation of istribute profits an at the same time exempts the retaine profits, will not affect the neutral position of the external ebt as a source of finance. Retaine earnings (F NE = F DE = 0. Since F NE = 0, then the result for the investment alternative finance with retaine earnings is ientical with the case of ebt finance investments. New equity issues. Similarly, since γ has value ifferent from 1, the financial constraints variable in case of investment finance with new equity issues is measure as: r(1 [27] F NE (1 r If the value of tax iscrimination variable from expression [22] is consiere, than: [28] F NE r(1 (1 r r[1 (1 t (1 r ] r(1 1 t (1 r (1 r By inseing it in expression [23], the cost of capital will obtain value of: (1 r ~ F (1 r (1 r p r r r [29] (1 t (1 t (1 t (1 t r r r (1 t (1 t (1 t (1 t 164

13 Ilija Gruevski; Corporate taxes an their potential effects on investment An the investment tax wege: [30] ~ r r p r r (1 t (1 t (1 t r (1 t r r (1 t (1 t An interpretation can be given to the previous that this variant of the split rate system ( t, t = 0, generates a positive tax buren on the investment finance with external equity which epens generally from the corporate tax rate applie on istribute profits t. With this approach in the tax policy, the authorities try to convince the investor not to istribute the profit, but to reinvest it, since the tax buren for the secon alternative is significantly lower. Also, this approach in the policy restores the neutrality between ebt an retaine earnings Taxation of retaine profits, istributions exempt from taxation (t = 0, t The secon option is the strategy of taxation of retentions (retaine profits with profit istributions exempt from taxation, which in this case implies the conition of (t = 0, t. The implementation of the terms above, generates value for the tax iscrimination variable of: [31] (1 t (1 0 1 An once again, aequatelly, ifferent value for the cost of capital: [32] ~ r F (1 r r F (1 r r p F (1 r 1 Many of the evelope countries, especially the ones with excessively high tax buren, such as Germany an Japan, very often use or use this variant of split rate taxation, as an appropriate metho for compensation of the personal tax levie on ivien income. Aitionally, the effects from its implementation are given for every investment alternative. Debt. The financial constraints variable for investments finance with external ebt uner the conitions (t = 0, t is measure as: 165

14 Economic Development No1-2/2013 p.( [ r r(1 t] [ r r(1 t] [ r r(1 t] (1 t (1 t F DE [33] (1 r (1 r (1 r [ r r ] (1 r (1 r By integrating the value for F DE in expression [32] for the cost of capital, the result will be: [34] ~ r r p F (1 r (1 r(1 t r An for the investment tax wege: [35] ~ p r r r 0 r (1 r t(1 r (1 t Once again, it has been prove that the neutral position of the external ebt as a source of finance is unaffecte by the process of corporate taxation in absence of personal taxes, regarless the implemente type of corporate tax system. New equity. If the value of tax iscrimination variable from expression [31] is consiere for the purpose of calculation of the financial constraints variable F NE, it will result in: [36] F NE 1 1 r[1 ] r[ ] r(1 (1 r (1 r (1 r (1 t 1 r (1 r (1 r (1 r (1 r This result from the calculation clearly inicates on the ientical values between the financial constraints variable F DE an F NE (F DE = F NE. As a consequence, a total ientity will be establishe between the values of the investment tax wege p ~ r, for the investment alternatives finance with ebt an new equity issues. 166

15 Ilija Gruevski; Corporate taxes an their potential effects on investment Retaine earnings. In this alternative, since F RE = 0, then the value of cost of capital will become: [37] ~ r r r p F (1 r 0(1 r An the one for investment tax wege: [38] ~ r r r r(1 t r r p r r r If a conclusion is mae from the implementation of the split rate system with the terms of taxation of retaine profits an exemption of istribute profits (t = 0, t it will inicate that this variant generates a positive tax buren on the investment finance with retentions. With this approach in the tax policy, the authorities actually equalize the treatment between ebt an new equity with intention to eliver a ceain compensation for the excessive tax buren levie on ivien istributions. The following Table 1 presents the summary of all analyze effects an conclusions. Table 1: The effects from taxation on investment performance (Only corporate taxes The usuall, normal treatment Investment tax wege (p ~ - r Debt 0 New equity issues ( 1 t Retaine earnings ( 1 t Coprehensive business income tax system (CBIT Debt ( 1 t New equity issues ( 1 t Retaine earnings ( 1 t 167

16 Economic Development No1-2/2013 p.( Imputation corporate tax system (ICT Debt 0 r( t c New equity issues Retaine earnings ( 1 t Full imputation corporate tax system (FICT Debt 0 New equity issues 0 Retaine earnings ( 1 t Split rate corporate tax system (SRCT Taxation of istribute profits, retaine profits exempt from taxation (t, t = 0 Debt 0 New equity issues ( 1 t Retaine earnings 0 Taxation of retaine profits, istribute profits exempt from taxation (t = 0, t Debt 0 New equity issues 0 Retaine earnings ( 1 t Source: Summary an review of the author s calculations 168 Conclusions This aicle explore the potential effects that arise from the isolate implementation of corporate taxes with the help of the marginal analysis. With an appropriate application of its analytical components, it manage to investigate the investment ecision an the economic performance of the firm.

17 Ilija Gruevski; Corporate taxes an their potential effects on investment The first step was focuse on the usuall, normal treatment of investment. The result implicate that the implementation of the corporate taxes create uneven istribution of the buren across the projects covere with ifferent sources of finance. Actually, in the case of equity finance investments there was a positive tax buren on corporate income, while the ebt covere investments took neutral position. In the secon step, the effects from the alternative corporate tax systems were analyze. For example, the comprehensive business income tax system (CBIT successfully eliminates the tax ifferences between ebt an equity by elimination of the possibility for euction of the interest expenses. In the imputation corporate tax system (ICT, pa of the company's tax bill is impute to the stockholers, an the effect from the imputation epens from the interrelation of the corporate income tax rate an the rate of imputation. The full integration corporate tax system (FICT system represents a variant of the imputation corporate tax system, where the imputation rate is equal to the tax liabilities pai at corporate level. Uner a split rate corporate tax system (SRCT there are two ifferent statutory tax rates, one that applies to retaine earnings, the other to istribute earnings. The first policy option is the strategy of taxation of istribute profits with retaine profits exempt from taxation, which is aime to generate strong incentives for reinvestment of retaine profits. The secon option is the strategy of taxation of retentions (retaine profits with profit istributions exempt from taxation, which is usually intene to eliver a ceain compensation for the excessive tax buren levie on ivien istributions. References 1. Corporate Income Tax Coe of RM; 2. Devereux M.P., Griffith R., Klemm A. (2002 Corporate Income Tax Reforms an International Tax Competition, Economic Policy publications, no. 35; 3. Devereux M.P., Griffith R. (1999 The taxation of iscrete investment choices, The institute of fiscal stuies, Warwick University; 169

18 Economic Development No1-2/2013 p.( Devereux, M.P., Griffith R. (2003 Evaluating tax policy for location ecisions, International Tax an Public Finance, 2003; 5. King M.A., Fuleon D. (1984 The taxation of income from capital: A comparative stuy of the Unite States, the Unite Kingom, Sween an Germany, University of Chicago Press; 6. King, M.A. (1983 " The relative taxation of capital an labor income", Consultancy stuy for the Economics an Statistics Depament, OECD; 7. Leibfritz W., Thornton J., Bibbie A. (1997 Taxation an economic performance An OECD stuy; 8. OECD (2007 Funamental corporate tax reform, Paris; 9. OECD (2000 Alternative tax buren measures, Paris; 10. Оveresch M. (2005 The effective tax buren of companies in Europe, CESifo DICE Repo; 11. Salanie B. (2000: The economics of taxation, The MIT Press Cambrige, Massachusetts; 170