Annex: Alternative approaches to corporate taxation Ec426 Lecture 8 Taxation and companies 1

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1 Ec426 Public Economics Lecture 8: Taxation and companies 1. Introduction 2. Incidence of corporation tax 3. The structure of corporation tax 4. Taxation and the cost of capital 5. Modelling investment decisions and the impact of taxes 6. The effects of uncertain tax policy 7. Empirical studies Annex: Alternative approaches to corporate taxation Ec426 Lecture 8 Taxation and companies 1 1. Introduction 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) CT as a CT as a CT and tax capitalisation CT and growing versus mature companies Efficiency considerations? Ec426 Lecture 8 Taxation and companies 2 1

2 1. Introduction Current and future reforms Role of a tax? Alternative approaches to corporate taxation (see Annex) International issues (Lecture 9) Empirical background on corporate taxation Statutory corporate tax rates Corporate tax revenues Marginal effective tax rates on investment Ec426 Lecture 8 Taxation and companies 3 Statutory corporate tax rates Source: Auerbach, Devereux and Simpson (2010) Ec426 Lecture 8 Taxation and companies 4 2

3 Corporate tax revenues as percent of total revenues Source: Auerbach, Devereux and Simpson (2010) Ec426 Lecture 8 Taxation and companies 5 Marginal effective tax rates on investment Source: Auerbach (2006) Ec426 Lecture 8 Taxation and companies 6 3

4 Corporate tax base: Role of financial corporations Taxes on financial corporations as a share of corporate tax revenues Ec426 Lecture 8 Taxation and companies 7 Source: Auerbach, Devereux and Simpson (2010) 2. The incidence of corporation tax Burden of corporation tax borne by: Shareholders?? Employees? Determined by of responses Impact of globalisation Ec426 Lecture 8 Taxation and companies 8 4

5 3. The structure of corporation tax Taxable profits = income costs where income includes revenue from sales, capital gains, increases in value of stocks (inventories) Costs = + cost of capital Cost of capital = ( physical cost of capital) + financial cost of capital Financial cost of capital New share issues Retained earnings (retained profits) Ec426 Lecture 8 Taxation and companies 9 4. Taxation and the cost of capital Taxes and the cost of capital Conditions for True economic depreciation Expensing The tax rate on capital Ec426 Lecture 8 Taxation and companies 10 5

6 4. Taxation and the cost of capital Definitions: p required (real pre-tax) rate of return μ marginal rate of return δ exponential rate of depreciation ρ c (nominal) discount rate of firm for net-of-tax dollars π inflation τ corporation tax rate V value to firm of 1 capital asset C net-of-tax cost of 1 capital asset A value of tax allowances for 1 capital asset A D present discounted value of future stream of depreciation deductions Ec426 Lecture 8 Taxation and companies Taxation and the cost of capital A simple model of the cost of capital We assume: A1. No transaction costs 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). Ec426 Lecture 8 Taxation and companies 12 6

7 4. Taxation and the cost of capital The no-tax situation 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: p = i Ec426 Lecture 8 Taxation and companies Taxation and the cost of capital Taxes and the cost of capital (see, e.g., King, 1977; Mintz, 1995) The value to a firm of a 1 marginal investment in the presence of corporation taxation is: The after-tax cost to a firm of a 1 capital asset is C = 1 - A where A is the (present discounted) value of all available, tax credits and investment grants. Ec426 Lecture 8 Taxation and companies 14 7

8 4. Taxation and the cost of capital 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 = f 1 A D + f 2 τ + f 3 g where f 1 represents the proportion of the invested amount that is eligible for capital (depreciation) allowances; f 2 is the proportion eligible for expensing (or tax credits); f 3 is the proportion eligible for an investment grant at rate g, and Ec426 Lecture 8 Taxation and companies Taxation and the cost of capital 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. Ec426 Lecture 8 Taxation and companies 16 8

9 4. Taxation and the cost of capital The firm's discount rate, ρ c is affected by its choice of finance: ρ c = βi Debt finance (bank loans or bonds), where β =1- τ if interest payments are tax deductible and β =1 if not. ρ c = 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. ρ c = γi effective, where γ =(1-m)/(1-z) with m the marginal rate of personal income tax and z the accrued marginal rate of capital gains tax. Ec426 Lecture 8 Taxation and companies Taxation and the cost of capital 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 = ρ c = 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. Ec426 Lecture 8 Taxation and companies 18 9

10 4. Taxation and the cost of capital Case 2. True economic depreciation: a = δ, f 1 =1, f 2 =f 3 = 0 e.g., Debt finance: ρ c = βi p = βi/(1- τ). If β=1- τ, then p = i NEUTRALITY Case 3. : f 2 =1, f 1 =f 3 = 0 A= τ : ρ c = βi p = βi. If β=1, then p = i New share issues: ρ c = i/θ p = i/θ. If θ=1, then p = i NEUTRALITY NEUTRALITY Ec426 Lecture 8 Taxation and companies Taxation and the cost of capital can be calculated from the expression for the cost of capital From Leape (1993) Tax Policies in the 1980s and 1990s: The United Kingdom in Taxation in the United States and Europe. Ec426 Lecture 8 Taxation and companies 20 10

11 5. Modelling investment decisions and the impact of taxes Accelerator model production technology Optimal capital stock (from FOCs) Optimal investment (I t = K t K t-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. Ec426 Lecture 8 Taxation and companies Modelling investment Neoclassical model (Jorgenson, 1963; Hall and Jorgenson, 1967) Derived from FOCs for profit maximisation which imply that firms invest until the marginal product of capital equals its Model effect of taxes on the user cost of capital, c Production function Profit function FOC (profit max) Relate Δs in K* to I t Ec426 Lecture 8 Taxation and companies 22 11

12 5. Modelling investment Neoclassical model 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 Methodological problems problem problem Theory of optimal K not I Ec426 Lecture 8 Taxation and companies Modelling investment 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) Summers (1981) extended model to include taxes Finite investment requires adjustment cost function` marginal q versus Ec426 Lecture 8 Taxation and companies 24 12

13 5. Modelling investment 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. See discussion in Hall (1995) Ec426 Lecture 8 Taxation and companies Effects of uncertain tax policy Hassett and Metcalf, Economic Journal 1999 : Questions: Would eliminating uncertainty increase investment? Can governments uncertainty (in a revenue-neutral way) to increase investment? Key issues: Increasing uncertainty, lost tax revenue and the option to wait Modelling uncertainty in tax policy A random walk (GBM) or a (Poisson)? Increased uncertainty in the form of mean preserving spreads Ec426 Lecture 8 Taxation and companies 26 13

14 6. Effects of uncertain tax policy Modelling the effects of uncertainty on investment decisions Uncertainty in the output price Uncertainty in the cost of capital (due to tax policy) GBM: increase in instantaneous volatility (σ 2 ) e.g., Pindyck (1988), Dixit and Pindyck (1994) Poisson: increase in (λ) Ec426 Lecture 8 Taxation and companies Effects of uncertain tax policy 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 Ec426 Lecture 8 Taxation and companies 28 14

15 6. Effects of uncertain tax policy Effects of increased uncertainty on investment decisions Findings: Average cost of capital Government tax revenue of investment Random walk (GBM) Jump process of investment Random walk (GBM) Jump process Ec426 Lecture 8 Taxation and companies Empirical studies Empirical approaches Time series evidence of tax policy? Identification problems? Alternative approaches Cummins, Hassett & Hubbard (1995) Chetty and Saez (2006) Ec426 Lecture 8 Taxation and companies 30 15

16 7. Empirical studies Alternative approaches: Time-series versus cross-section variation Problem: time series variation in tax rates is if policy-makers respond to low investment rates CHH (1994, 1995): Use variation to identify effects of cost of capital on investment Ec426 Lecture 8 Taxation and companies Empirical studies Alternative approaches: Tax-loss carryforwards Problem: Identifying impact of changes in tax rates on investment difficult because: - endogeneity of tax change - other simultaneous changes CHH (1995): Split sample into firms with and without With group unable to benefit from tax incentives Ec426 Lecture 8 Taxation and companies 32 16

17 7. Empirical studies Alternative approaches: Chetty and Saez (2006) Question: Did the 2003 US tax cut on dividends cause an increase in dividend payouts? Key events: was first proposed on 7 th January 2003 Tax cut was signed into law on 28 th May 2003, and made retroactive to 1 st January 2003 and set to expire at end-2008 Reelection of George W Bush in 2004 removed uncertainty regarding possible early repeal. Ec426 Lecture 8 Taxation and companies Empirical studies Alternative approaches: Chetty and Saez (2006) Background Regular dividends of non-financial, non-utility US firms had remained stable at $20bn then again at $25bn CRSP data, core sample, presented in Chetty and Saez (2006) Between 2003 and 2005, total regular dividends rose to a large fraction of the increase took place in last two quarters of 2003, after tax cut was signed. Ec426 Lecture 8 Taxation and companies 34 17

18 7. Empirical studies Alternative 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. Ec426 Lecture 8 Taxation and companies Empirical studies Alternative approaches: Chetty and Saez (2006) Why the discrepancy between the core and constant-size samples? Dot-com bust caused a sharp drop in number of traded firms: from 5,429 in 2000:3 to 3,785 in 2005:2. BUT, only 2% of exiting firms were dividend payers Key: Ec426 Lecture 8 Taxation and companies 36 18

19 7. Empirical studies Alternative approaches: Chetty and Saez (2006) Research question: Did the tax cut induce more of investment funds across firms? Chetty and Saez dividend firms into quintiles by forecasted earnings growth Compare percentage initiating dividends pre-reform and postreform Greater efficiency? Ec426 Lecture 8 Taxation and companies 37 References Abel, 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 ( ) Auerbach, A J, M Devereux and H Simpson (2008), Taxing corporate income, paper prepared for The Mirrlees Review, March. ( Brandon, J, and D Ikenberry (2004) Reappearing dividends, Journal of Applied Corporate Finance, 16(4), Chetty, R and E Saez (2006) The Effects of the 2003 Dividend Tax Cut on Corporate Behavior:Interpreting the Evidence, American Economic Review, 96(2), Clark, J. (1917), Business acceleration and the law of demand: a technical factor in economic cycles, Journal of Political Economy, vol. 25, pp Cummins, J G, Hassett, K. A., and Hubbard, R. G. (1995), Have tax reforms affected investment?, Tax Policy and the Economy, 9, Hall, R (1995) Comment on Cummins, Hassett and Hubbard, Brookings Papers on Economic Activity, volume 2, Hall, R E, and D Jorgenson (1967), Tax policy and investment behavior, American Economic Review, 57, Hassett, K. and G Metcalf (1999), Investment with uncertain tax policy: Does random tax policy discourage investment?, Economic Journal, 109 (July), Hayashi, F (1982), Tobin s Marginal q and Average q: A Neoclassical Interpretation, Econometrica, vol. 50(1), Jorgenson, D (1963), Capital theory and investment behavior, American Economic Review, vol. 53, pp Mintz, J (1995), The corporation tax: A survey, Fiscal Studies, 16:4 (November), ( Brainard, W C, and J Tobin (1968), Pitfalls in financial model building, American Economic Review (Papers and Proceedings), 58, May, 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.. Ec426 Lecture 8 Taxation and companies 38 19

20 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 Ec426 Lecture 8 Taxation and companies 39 Annex: Alternative approaches to corporate taxation Tax the full return on capital? Dual income tax Objectives Achieve tax neutrality while taxing the full return on capital Simplify the taxation of capital income Key elements: Flat tax on all corporate income (corporate and non-corporate) Progressive tax on labour income Introduced in Nordic countries in early 1990s Ec426 Lecture 8 Taxation and companies 40 20

21 Annex: Alternative approaches to corporate taxation Tax only economic rents? Allowance for corporate equity (ACE) proposal (IFS Capital Taxes Group, 1991) Objectives Tax neutrality towards corporate financing decisions (eliminate the tax penalty to equity finance) Eliminate distortions caused by differences between true economic depreciation and tax depreciation allowances Key elements Introduce an allowance for corporate equity (based on the imputed cost of equity finance) to match the interest deduction on debt finance. Result is a tax on pure rents ( excess returns ) Ec426 Lecture 8 Taxation and companies 41 21