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PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe

15CHAPTER

Taxes On Business Income and Wealth

PUBLIC SECTOR ECONOMICS: The Role of Government in the American EconomyRandall Holcombe 15-2

Corporate Income TaxCorporate Income Tax Tax rate is about 35% for most Tax rate is about 35% for most

corporationscorporations Dividends paid out of after tax Dividends paid out of after tax

income income Dividends taxed multiple timesDividends taxed multiple times


Federal Corporate Federal Corporate Income Tax Rates, 2003Income Tax Rates, 2003

Table 15.1 Federal Corporate Income Tax Rates, 2003Income Range Marginal Tax Rate$0- $50,000 15%$50,000- $75,000 25%$75,000- $100,000 34%$100,000- $335,000 39%$335,000- $10,000,000 34%$10,000,000- $15,000,000 35%$15,000,000- $18,333,333 38%Over $18,333,333 35%Source: http: / /www.irs.gov/pub/ irs- psf/ i1120_a.pdf.


Interaction Between Interaction Between Corporate and Personal Corporate and Personal

Income TaxesIncome Taxes Trade-off between corporate Trade-off between corporate

payment of dividends or payment of dividends or reinvestment of fundsreinvestment of funds

Dividends face higher tax cost than Dividends face higher tax cost than interest payments when corporate interest payments when corporate and income taxes are countedand income taxes are counted

Trend toward lower corporate Trend toward lower corporate dividends in last half of 20th centurydividends in last half of 20th century


Fringe BenefitsFringe Benefits Can be legally deducted by Can be legally deducted by

corporation as a business expense corporation as a business expense for tax purposesfor tax purposes

Employee not required to declare Employee not required to declare value of benefit as incomevalue of benefit as income


DepreciationDepreciation Accounting depreciationAccounting depreciation - decline in value - decline in value

over time of capital equipmentover time of capital equipment Economic depreciationEconomic depreciation – reduction in value – reduction in value

of assetsof assets Accounting and economic depreciation Accounting and economic depreciation

may differ in practicemay differ in practice Cost of capital equipment cannot be Cost of capital equipment cannot be

deducted when expenditure is madededucted when expenditure is made Fraction of cost of equipment taken each Fraction of cost of equipment taken each

year as depreciation expenseyear as depreciation expense


Straight-line and Straight-line and Accelerated DepreciationAccelerated Depreciation Straight-line depreciation – life of

asset determined and equal fraction of cost of asset allowed as depreciation expense each year

Accelerated depreciation – larger amount of depreciation allowed in early years, offset by smaller amount in later years


Straight-line and Straight-line and Accelerated DepreciationAccelerated Depreciation Firms prefer accelerated depreciationFirms prefer accelerated depreciation Firms prefer the most accelerated Firms prefer the most accelerated

depreciation schedule alloweddepreciation schedule allowed Firms prefer to depreciate over fewer Firms prefer to depreciate over fewer

years rather than moreyears rather than more Inflation affects the real amount of Inflation affects the real amount of

depreciation expendituresdepreciation expenditures


Burden of the Corporate Burden of the Corporate Income TaxIncome Tax

Corporations do not pay income taxCorporations do not pay income tax Corporate income tax ultimately Corporate income tax ultimately

borne by individualsborne by individuals Principles of tax shifting suggest Principles of tax shifting suggest

corporation may be able to shift tax corporation may be able to shift tax burdenburden

Relative elasticities of supply and Relative elasticities of supply and demand determine who bears the demand determine who bears the tax burdentax burden


Competitive MarketsCompetitive Markets Elastic market demand Elastic market demand

Tax burden shifted toward suppliersTax burden shifted toward suppliers Causes inward shift of supply curveCauses inward shift of supply curve

Inelastic market demand Inelastic market demand Tax burden shifted toward demandersTax burden shifted toward demanders Causes outward shift of supply curveCauses outward shift of supply curve

Relative shares of tax burdens are Relative shares of tax burdens are equal in each market in long runequal in each market in long run


Competitive MarketsCompetitive Markets

The Effect of a Corporate Income Tax in Different Markets


MonopolyMonopoly Income tax on firm making monopoly Income tax on firm making monopoly

profits may have no real effects in profits may have no real effects in short runshort run

If tax is constant fraction of If tax is constant fraction of corporation’s profits, monopolist’s corporation’s profits, monopolist’s profit-maximizing level of output will profit-maximizing level of output will not changenot change


MonopolyMonopoly

Monopoly Response to a Proportional Tax on Net

Income


Income Tax and Return Income Tax and Return to Bearing Riskto Bearing Risk

Saving/Investing behavior entails riskSaving/Investing behavior entails risk Income tax lowers return to risk Income tax lowers return to risk

bearingbearing Government shares in gains of Government shares in gains of

bearing risk, does not share in lossesbearing risk, does not share in losses Incentive against risk taking built into Incentive against risk taking built into

tax systemtax system


Taxation of Capital GainsTaxation of Capital Gains Capital gain – increase in wealth Capital gain – increase in wealth

caused by an appreciation of value of caused by an appreciation of value of an asset an individual or corporation an asset an individual or corporation ownsowns

Capital gains income treated Capital gains income treated similarly to ordinary income in similarly to ordinary income in corporate and personal income tax corporate and personal income tax systemsystem


Unrealized Capital GainsUnrealized Capital Gains Occurs when value of individual’s Occurs when value of individual’s

property increases but has not been property increases but has not been soldsold

Current U.S. tax system does not levy Current U.S. tax system does not levy taxes on unrealized capital gainstaxes on unrealized capital gains

Liable for taxes when property is soldLiable for taxes when property is sold Capital gains tax discourages selling of Capital gains tax discourages selling of

assets with unrealized capital gainassets with unrealized capital gain Creates an inefficiencyCreates an inefficiency


Capital Gains Taxation as Capital Gains Taxation as a Double Taxa Double Tax

Capital gains tax represents a double Capital gains tax represents a double taxtax Assets bought with after-tax income and Assets bought with after-tax income and

capital gain on appreciation of asset capital gain on appreciation of asset also taxedalso taxed

Capital gains taxed at higher rate Capital gains taxed at higher rate than ordinary income if asset bought than ordinary income if asset bought with after-tax incomewith after-tax income


Inflation and Capital Inflation and Capital GainsGains

If taxes are placed on nominal value of If taxes are placed on nominal value of asset, an individual may be liable for capital asset, an individual may be liable for capital gains tax although the real value has gains tax although the real value has declineddeclined

Phantom capital gain – a capital gain in Phantom capital gain – a capital gain in nominal terms that is not a real capital gainnominal terms that is not a real capital gain

Capital gains not indexed for inflationCapital gains not indexed for inflation Inflation increases tax bills for taxpayers Inflation increases tax bills for taxpayers

realizing capital gainsrealizing capital gains


Wealth and Property Wealth and Property TaxationTaxation

Wealth is another possible tax baseWealth is another possible tax base Property tax is most common tax on Property tax is most common tax on

wealthwealth Close relationship between income Close relationship between income

taxation and wealth taxationtaxation and wealth taxation


Incentives in Income Incentives in Income Taxes and Wealth TaxesTaxes and Wealth Taxes

Flow of income – return on individual’s Flow of income – return on individual’s stock of human capital along with work stock of human capital along with work efforteffort

Can tax individual’s income earning Can tax individual’s income earning potential as wealth potential as wealth Incentive to accumulate less human capital Incentive to accumulate less human capital

and work harderand work harder Can tax individual’s actual income as a Can tax individual’s actual income as a

flowflow Incentive to under utilize human wealthIncentive to under utilize human wealth


Unrealized Capital Gains Unrealized Capital Gains and Wealth Taxationand Wealth Taxation

Renter and homeowner treated equally under wealth tax

Some sources of wealth more easily taxed if flow of income from wealth is taxed Example: human capital

Some sources of wealth more easily taxed directly Example: real estate


The Property TaxThe Property Tax Major source of revenue for local Major source of revenue for local

governmentsgovernments Primarily a local government taxPrimarily a local government tax Real estate major source of property tax Real estate major source of property tax

revenuerevenue Taxed components of real estate:Taxed components of real estate:

LandLand Improvements made to taxed siteImprovements made to taxed site

Provides disincentive for improving value of Provides disincentive for improving value of propertyproperty


Locational Decisions and Locational Decisions and the Property Taxthe Property Tax

Differences in property taxes among Differences in property taxes among locations influence locational locations influence locational decisions of businessesdecisions of businesses

Businesses view taxes as price paid Businesses view taxes as price paid for government goods/servicesfor government goods/services

Examine mix of public sector output Examine mix of public sector output and level of taxationand level of taxation

Excess burden of property taxationExcess burden of property taxation


Property Tax LimitationsProperty Tax Limitations California’s Proposition 13California’s Proposition 13

Limits level of property taxationLimits level of property taxation Restricts future increases in property tax Restricts future increases in property tax

ratesrates Effect of charging different property Effect of charging different property

owners with identically valued property owners with identically valued property different tax ratesdifferent tax rates

Creates disincentive to sell propertyCreates disincentive to sell property


Differing Property Tax Differing Property Tax RatesRates

Different tax rates depending on use Different tax rates depending on use of propertyof property

Can be used to price government Can be used to price government services for different types of services for different types of consumersconsumers


Site Value TaxationSite Value Taxation Tax placed only on value of siteTax placed only on value of site Ownership of property implies Ownership of property implies

ownership of asset and stream of ownership of asset and stream of future tax liabilitiesfuture tax liabilities

Tax has effect of being lump sum tax Tax has effect of being lump sum tax on wealth of property owner at time on wealth of property owner at time it is leviedit is levied

Entire site tax borne by owner of landEntire site tax borne by owner of land


Site Value Taxation Site Value Taxation Versus Property TaxationVersus Property Taxation Present owner bears entire tax burden Present owner bears entire tax burden

on existing property in both caseson existing property in both cases Property tax on improvements Property tax on improvements

discourage improvementdiscourage improvement Lowers market value of land by present Lowers market value of land by present

value of taxvalue of tax Site value taxation provides no Site value taxation provides no

disincentivedisincentive


Site Value Taxation and Site Value Taxation and Value of LandValue of Land

Placement of tax on site value only Placement of tax on site value only provides incentive to develop provides incentive to develop propertyproperty

Market value of land lower under site Market value of land lower under site value taxation when a national policyvalue taxation when a national policy

Market value of land rises in a Market value of land rises in a locality under site value taxation if locality under site value taxation if surrounding area uses a property taxsurrounding area uses a property tax


Inheritance TaxInheritance Tax Provides incentive to live longer to Provides incentive to live longer to

postpone payment of taxpostpone payment of tax Relatively insignificant source of tax Relatively insignificant source of tax

revenuerevenue Federal estate tax being phased outFederal estate tax being phased out


Avoiding the TaxAvoiding the Tax Trust funds to shield estate from Trust funds to shield estate from

taxationtaxation Pass wealth on through gifts while Pass wealth on through gifts while

livingliving Spend wealth before deathSpend wealth before death


Justifications for an Justifications for an Inheritance TaxInheritance Tax

Not fair to benefit from wealth Not fair to benefit from wealth earned by someone elseearned by someone else

Fosters goal of creating a more equal Fosters goal of creating a more equal distribution of incomedistribution of income

Closes a loophole in current income Closes a loophole in current income tax structuretax structure


Severance TaxesSeverance Taxes Charged on extraction of natural resourcesCharged on extraction of natural resources Comprise less than 1% of total state Comprise less than 1% of total state

government revenuesgovernment revenues Similar to a property tax - owner of Similar to a property tax - owner of

resource owns value of resource less tax resource owns value of resource less tax liability to be paid if resource extractedliability to be paid if resource extracted

Owners of resource have ability to shift Owners of resource have ability to shift some of tax burden to demanders of some of tax burden to demanders of resource by slowing rate at which resource resource by slowing rate at which resource extractedextracted

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