The Corporate Asset Tax: Its Effect on Capital Structure, Investment, and Tax Revenues

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1 The Corporate Asset Tax: Its Effect on Capital Structure, Investment, and Tax Revenues Mark Swanstrom, Northwestern State University of Louisiana Abstract: This paper compares the tax on corporate income to an alternative tax on corporate assets. The corporate income tax results in several economic inefficiencies including malinvestment, high levels of leverage, cyclical tax revenues, and international tax avoidance. A corporate asset tax would reduce these incentives. A corporate asset tax set to maximize tax revenues may also affect firm size and tax revenues, but it is unclear whether average firm size and revenues would increase or decrease compared to a revenue maximizing corporate income tax. Additionally, results suggest that the revenue maximizing rate for corporate income taxes is far lower than existing corporate tax rates. Introduction: Toder and Viard (2014) argue that one purpose for the corporate income tax is to ensure that retained earnings does not escape (or permanently delay) taxation at the individual level. However, the corporate income tax has four main disadvantages. First, the corporate tax rate is the same for all investors. A second problem is the double taxation resulting from taxing dividends and capital gains at the individual investor level. A third problem is that U.S. investors can avoid the corporate tax by buying shares in foreign corporations. However, this is offset by foreign investors of U.S. companies. Finally, U.S. multinational corporations can avoid the corporate income tax by shifting profits to low-tax rate jurisdictions. One suggestion is to eliminate the corporate income tax completely and taxing dividends and capital gains at ordinary income tax rates. Indeed, sole proprietorships, S corporations, and other flow-through businesses are taxed in this manner. It is suggested that taxies on unrealized gains (and losses) be done on an annual basis.

2 While taxes on corporate income are the norm, some countries include a tax on corporate assets as a method for insuring that corporations are paying at least something. Argentina has a tax on minimum presumed income with a standard rate of 1%. Colombia has a minimum presumptive income equal to 3% of net assets resulting in a minimum tax equal to.75% of net assets based on their corporate tax rate of 25%. The presumptive minimum income is compared to their regular taxable income to determine the actual taxes due. Corporations consider many factors in their decision making. Graham (2003) reviews how taxes affect a variety of decisions including financing, dividends, and investment. While taxes are certainly a consideration, it does not seem to be an overriding factor in many of the cases. This paper examines how an alternative taxation on assets instead of income would affect these decisions. Since Interest Expense, but not dividends, is deductible from taxes, there is an incentive for companies to use more debt if tax rates are high. Indeed, Modigliani and Miller (1963) suggest that debt ratios should approach 100% if the tax rate is positive. However, the evidence on this is mixed as pointed out in Myers (1984). The tax benefits of debt may be offset by bankruptcy costs (Kraus and Litzenberger 1973), agency costs (Jensen and Meckling 1976), and underinvestment (Myers 1977). De Mooij (2011) reviews several papers and finds evidence that higher corporate tax rates lead to higher debt levels. Several early papers investigated whether a firm s capital structure affected firm value. Masulis (1980) examined exchange offers and found that leverage increasing offers had positive returns to shareholders while leverage increasing offers had negative returns. However, other research such as Myers and Maljuf (1984) suggest that the exchange offer may be signaling information and that this new information is the cause of the change in firm value. Firms may have different expected tax rates which may affect their choice of capital structure. Bradley, Jarrell, and Kim (1984) hypothesize that firms with more nondebt tax shields such as depreciation or investment tax credits will receive less benefit from using debt and will therefore use less debt. However, they found a positive correlation between the use of debt and these other shields.

3 MacKie-Mason (1990) examined 1,747 issuances of debt and equity from The primary finding is that firms with higher marginal tax rates were more likely to issue debt instead of equity. As an additional finding, firms with nondebt tax shields that were near tax exhaustion were less likely to issue debt suggesting that the surprising results in Bradley et al. were the result of profitable, high tax rate firms benefitting from both debt and nondebt tax shields. Faccio and Xu (2015) examine nearly 500 changes in corporate and personal tax rates to address whether tax rates affect capital structure. These tax rate changes include 184 corporate tax rate changes and 298 personal tax rate changes in OECD countries from By using a firm and year-fixed effects approach, they are able to eliminate cross sectional correlations that affect both debt and taxes. Their primary findings are that firms increase leverage following increases in corporate taxes or personal taxes on dividends. Leverage is reduced following increases in the personal tax rate on interest income. Research Design: This paper introduces a model that represents how firms react to different tax rates. The overall goal is to see how much tax revenue would be generated under different tax rates by using simulations to create hypothetical firms. From these simulations, we are able to compare tax revenues generated by a tax on corporate income vs. a tax on corporate assets. Firms are characterized by two variables that reflect profitability (1.25 < prof <1.75) and scalability (.8 < scal <.9). Each firm is then analyzed under different income tax rates ranging from 5% to 20%, asset taxes from.5% to 1.5%, and regimes that include both an income tax and an asset tax. Tax rates affect firms capital structure decision which in turn affects their costs of debt and equity. Equation (1) has the weight on debt being positively related to profitability and rising at an increasing rate as taxes and scalability rise. Equations (2) and (3) have the costs of debt and equity declining with profitability but rising with the level of debt. Wd =(Prof-1)*0.2*e (IncTaxRate*5*Scal) (1)

4 rd=(0.08/prof)*e (wd) (2) re=(0.15/prof)*e (wd) (3) Each firm will choose a level of investment (Assets) that maximizes their Net Present Value that depends on the tax rate. Equation (4) shows how each firms Net Income is calculated while equation (5) is the NPV formula that each firm is trying to maximize. NI = (Assets (Prof*Scal) (Assets * Wd * rd))* (1-Inc Tax Rate) (Assets * Asset Tax Rate) (4) NPV = (NI/re)-Assets*(1-wd) (5) While each firm is choosing a level of investment that maximizes NPV where that NPV is affected by the tax rate, the government is trying to find the tax rate that maximizes revenues where those tax revenues is affected by each firm s level of investment. Total tax revenues includes taxes collected on corporate income, corporate assets, and taxes on individual investors for dividends and capital gains. Total Tax = Net Income*(Inc Tax Rate/(1-Inc Tax Rate)) + Net Income*(Personal Tax Rate) + Assets *(Asset Tax Rate) (6) Initial Results: As part of a preliminary investigation, the model was used on several sample firms for several different income and asset taxes. Table 1 shows the results for a sample firm with a profitability factor of 1.5 and a scalability factor of.8. As income tax rates rise, firms use more debt and have higher costs of debt and equity. The NPV maximizing level of Assets also falls resulting in lower levels of Net Income and NPVs. As a result, the income tax rate that maximizes income tax receipts is 10%, but the tax rate that maximizes total taxes is 5%. Similarly, the asset tax rate that maximizes the asset tax is 1.5% while the rate that maximizes total taxes is.5%. The asset tax also results in higher overall tax revenues, lower levels of debt, and greater investment.

5 Conclusions: Taxes on corporations have a major impact on firm decisions. Higher income tax rates result in higher levels of leverage due to the deductibility of interest expense. Higher rates also result in reduced firm size. Replacing the corporate income tax with a tax on corporate assets results in similar levels of tax revenues and firm size depending on the tax rates. A tax on corporate assets may have other advantages as well including reduced bankruptcy costs, more stable tax revenues, and international tax competition. Lower levels of leverage may reduce the risk of bankruptcy. Bankruptcy has costs beyond the cost to firms as employees, customers, and suppliers are disrupted. There are also the costs of the legal system which is borne by tax payers. The government may have a legitimate interest in reducing bankruptcy by using a tax based on assets. Corporate assets are also more stable than corporate income and less susceptible to fraud resulting in lower drops in tax revenue during economic downturns. There would also be less incentive for firms to shift profits overseas as a domestic parent would still own the assets of a foreign subsidiary.

6 References Bradley, M. G. (1984). On the Existence of an Optimal Capital Structure: Theory and Evidence. Journal of Finance, Faccio, M. a. (2015). Taxes and Capital Structure. Journal of Financial and Quantitative analysis. Graham, J. (2003). Taxes and Corporate Finance. Review of Financial Studies. Jensen, M. a. (1976). Theory of the Firm: Managerial Behavior, Agency costs, and Ownership Structure. Journal of Financial Economics, Kraus, A. a. (1973). A State-Preference Model of Optimal Financial Leverage. Journal of Finance, MacKie-Mason, J. (1990). Do Taxes Affect Corporate Financing Decisions. Journal of Finance, Masulis, R. (1980). Stock Repurchase by Tender Offer: An Analysis of the Causes of Common Stock Price Changes. Journal of Finance, Modigliani, F. a. (1963). Corporate Income Taxes and the Cost of Capital: A Correction (in Communications). The American Economic Review, Myers, S. (1977). Determinants of Corporate Borrowing. Journal of Financial Economics, Myers, S. (1984). The Capital Structure Puzzle. Journal of Finance, Myers, S. a. (1984). Corporate Financing and Investment Decisions When Firms Have Information That investors Do Not Have. Journal of Financial Economics, Todar, E. a. (2014). Major Surgery Needed: A Call for Structural Reform of the U.S. Corporate Income Tax. American Enterprise Institute.