CHAPTER

15
Taxes On Business Income
and Wealth
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe

Corporate Income Tax

Tax

rate is about 35% for most

corporations
Dividends paid out of after tax income
Dividends taxed multiple times

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

15-2

Federal Corporate Income Tax

Rates, 2003

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

15-3

Interaction Between Corporate

and Personal Income Taxes
Trade-off

between corporate payment of

dividends or reinvestment of funds
Dividends face higher tax cost than
interest payments when corporate and
income taxes are counted
Trend toward lower corporate dividends
in last half of 20th century
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe

15-4

Fringe Benefits
Can

be legally deducted by corporation as

a business expense for tax purposes
Employee not required to declare value
of benefit as income

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe

15-5

Depreciation

Accounting depreciation - decline in value over

time of capital equipment
Economic depreciation reduction in value of
assets
Accounting and economic depreciation may
differ in practice
Cost of capital equipment cannot be deducted
when expenditure is made
Fraction of cost of equipment taken each year
as depreciation expense
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe

15-6

Straight-line and Accelerated

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

15-7

Straight-line and Accelerated

Depreciation
Firms

prefer accelerated depreciation

Firms prefer the most accelerated
depreciation schedule allowed
Firms prefer to depreciate over fewer
years rather than more
Inflation affects the real amount of
depreciation expenditures
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe

15-8

Burden of the Corporate

Income Tax
Corporations

do not pay income tax

Corporate income tax ultimately borne by
individuals
Principles of tax shifting suggest
corporation may be able to shift tax
burden
Relative elasticities of supply and
demand determine who bears the tax
burden
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe

15-9

Competitive Markets
Elastic

market demand

Tax

burden shifted toward suppliers

Causes inward shift of supply curve
Inelastic

market demand

Tax

burden shifted toward demanders

Causes outward shift of supply curve
Relative

shares of tax burdens are equal

in each market in long run
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
15-10

Competitive Markets

The Effect of a Corporate Income Tax in Different

Markets
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe

15-11

Monopoly
Income

tax on firm making monopoly

profits may have no real effects in short
run
If tax is constant fraction of corporations
profits, monopolists profit-maximizing
level of output will not change

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe
15-12

Monopoly

Monopoly Response to a
Proportional Tax on Net
Income

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe
15-13

Income Tax and Return to

Bearing Risk
Saving/Investing

behavior entails risk

Income tax lowers return to risk bearing
Government shares in gains of bearing
risk, does not share in losses
Incentive against risk taking built into tax
system

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe
15-14

Taxation of Capital Gains

Capital

gain increase in wealth caused

by an appreciation of value of an asset an
individual or corporation owns
Capital gains income treated similarly to
ordinary income in corporate and
personal income tax system

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe
15-15

Unrealized Capital Gains

Occurs

when value of individuals

property increases but has not been sold
Current U.S. tax system does not levy
taxes on unrealized capital gains
Liable for taxes when property is sold
Capital gains tax discourages selling of
assets with unrealized capital gain
Creates

an inefficiency

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe
15-16

Capital Gains Taxation as a

Double Tax
Capital

gains tax represents a double tax

Assets

bought with after-tax income and

capital gain on appreciation of asset also
taxed

Capital

gains taxed at higher rate than

ordinary income if asset bought with
after-tax income

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe
15-17

Inflation and Capital Gains

If taxes are placed on nominal value of asset,

an individual may be liable for capital gains tax
although the real value has declined
Phantom capital gain a capital gain in nominal
terms that is not a real capital gain
Capital gains not indexed for inflation
Inflation increases tax bills for taxpayers
realizing capital gains
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
15-18

Wealth and Property Taxation

Wealth

is another possible tax base

Property tax is most common tax on
wealth
Close relationship between income
taxation and wealth taxation

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe
15-19

Incentives in Income Taxes

and Wealth Taxes

Flow of income return on individuals stock of

human capital along with work effort
Can tax individuals income earning potential as
wealth

Incentive to accumulate less human capital and work

harder

Can tax individuals actual income as a flow

Incentive to under utilize human wealth

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe
15-20

Unrealized Capital Gains and

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

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe
15-21

The Property Tax

Major source of revenue for local governments

Primarily a local government tax
Real estate major source of property tax
revenue
Taxed components of real estate:
Land
Improvements made to taxed site

Provides disincentive for improving value of

property
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
15-22

Locational Decisions and the

Property Tax
Differences

in property taxes among

locations influence locational decisions of
businesses
Businesses view taxes as price paid for
government goods/services
Examine mix of public sector output and
level of taxation
Excess burden of property taxation
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
15-23

Property Tax Limitations

Californias

Proposition 13

Limits

level of property taxation

Restricts future increases in property tax
rates
Effect of charging different property owners
with identically valued property different tax
rates
Creates disincentive to sell property
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
15-24

Differing Property Tax Rates

Different

tax rates depending on use of

property
Can be used to price government services
for different types of consumers

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe
15-25

Site Value Taxation

Tax

placed only on value of site

Ownership of property implies ownership
of asset and stream of future tax
liabilities
Tax has effect of being lump sum tax on
wealth of property owner at time it is
levied
Entire site tax borne by owner of land
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
15-26

Site Value Taxation Versus

Property Taxation
Present

owner bears entire tax burden on

existing property in both cases
Property tax on improvements discourage
improvement
Lowers

of tax

market value of land by present value

Site

value taxation provides no

disincentive
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
15-27

Site Value Taxation and Value

of Land
Placement

of tax on site value only

provides incentive to develop property
Market value of land lower under site
value taxation when a national policy
Market value of land rises in a locality
under site value taxation if surrounding
area uses a property tax
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
15-28

Inheritance Tax
Provides

incentive to live longer to

postpone payment of tax
Relatively insignificant source of tax
revenue
Federal estate tax being phased out

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe
15-29

Avoiding the Tax

Trust

funds to shield estate from taxation

Pass wealth on through gifts while living
Spend wealth before death

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe
15-30

Justifications for an
Inheritance Tax
Not

fair to benefit from wealth earned by

someone else
Fosters goal of creating a more equal
distribution of income
Closes a loophole in current income tax
structure

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy

Randall Holcombe
15-31

Severance Taxes

Charged on extraction of natural resources

Comprise less than 1% of total state government
revenues
Similar to a property tax - owner of resource
owns value of resource less tax liability to be
paid if resource extracted
Owners of resource have ability to shift some of
tax burden to demanders of resource by slowing
rate at which resource extracted
PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy
Randall Holcombe
15-32