1. Università Bocconi, A.A: 2005-2006 1 Mec – Comparative public economics 1 Università Bocconi A.A. 2005-2006 Comparative public economics Giampaolo Arachi

2. Università Bocconi, A.A: 2005-2006 2 Mec – Comparative public economics 2 Alternative organizational forms References: M. Scholes, M. A. Wolfson, M. Erickson, E. L. Maydew, T. Shevlin (SWEMS), Taxes and business strategy: a planning approach, Pearson Prentice Hall, third edition, 2005, ch. 4

3. Università Bocconi, A.A: 2005-2006 3 Mec – Comparative public economics 3 Alternative organizational forms

4. Università Bocconi, A.A: 2005-2006 4 Mec – Comparative public economics 4 Pass-through vs. Non-pass-through organizations PARTNERSHIP Assumptions: no capital gain or loss on the liquidation of the partnership interest; at time n partners receive a liquidating distribution of all after-tax partnership income generated over n periods, plus the initial dollar invested; tp: partner’s marginal income tax rate After-tax accumulation for an initial $K investment: $K [1+R(1-tp)] n (savings vehicle I)

5. Università Bocconi, A.A: 2005-2006 5 Mec – Comparative public economics 5 Pass-through vs. Non-pass-through organizations CORPORATION Assumptions: no interim dividends; at time n the firm liquidates or shareholders sell their shares; tg: capital gains tax rate at shareholder level tc: corporate tax rate After-tax accumulation for an initial $K investment: $K {[1+R(1-tc)] n – tg[(1+R(1+tc)) n -1]} $K {[1+R(1-tc)] n (1-tg) + tg $K (savings vehicle II)

6. Università Bocconi, A.A: 2005-2006 6 Mec – Comparative public economics 6 Pass-through vs. Non-pass-through organizations PARTNERSHIP VS CORPORATION $K {[1+R(1-tp)] n $K {[1+R(1-tc)] n (1-tg) + tg $K One period: (1-tp) (1-tc)(1-tg) Several periods Value of tax deferral is greater –the higher is the after-tax accumulation in the corporation –the longer the deferral period If tg<tp omitting dividends is an optimal policy

7. Università Bocconi, A.A: 2005-2006 7 Mec – Comparative public economics 7 Pass-through vs. Non-pass-through organizations REQUIRED AFTER CORPORATE TAX RETURN Let: rp partnership after personal taxes return rc corporate after-tax return $K {[1+R p (1-tp)] n = $K {[1+R c (1-tc)] n (1-tg) + tg $K (1+r p )n = (1+r c *) n (1-tg) + tg r c * = {[(1+ r p ) n –tg]/(1-tg)} 1/n - 1

8. Università Bocconi, A.A: 2005-2006 8 Mec – Comparative public economics 8 Pass-through vs. Non-pass-through organizations REQUIRED AFTER CORPORATE TAX RETURN Let: rp partnership after personal taxes return rc corporate after-tax return $K {[1+R p (1-tp)] n = $K {[1+R c (1-tc)] n (1-tg) + tg $K (1+r p )n = (1+r c *) n (1-tg) + tg r c * = {[(1+ r p ) n –tg]/(1-tg)} 1/n - 1

9. Università Bocconi, A.A: 2005-2006 9 Mec – Comparative public economics 9 Pass-through vs. Non-pass-through organizations EFFECTIVE ANNUALIZED TAX RATE ON SHARES The hypothetical annual tax rate that shareholders could pay each year on their pretax stock returns that would be equivalent to paying the shareholder-level tax they actually pay when they sell their shares r c * (1-ts) = r p ts = 1 – r p /r c *

10. Università Bocconi, A.A: 2005-2006 10 Mec – Comparative public economics 10 Pass-through vs. Non-pass-through organizations REQUIRED BEFORE-TAX RATE OF RETURN r c * = R c * (1-tc) substituting into r c * (1-ts) = r p R c * (1-tc) (1-ts) = r p = R p (1-tp)

11. Università Bocconi, A.A: 2005-2006 11 Mec – Comparative public economics 11 US experience – Rp = 10%, n=10 Periodtctptgrc*rc*tsRc*Rc* Pre-198146%70%28%3.98%24.7%7.37% 1982-198646%50%20%5.97%16.3%11.06% 198740%39%28%7.81%21.9%13.02% 1988-199034%28% 9.12%21.1%13.82% 1991-199234%31%28%8.77%21.3%13.29% 1993-199635%39.6%28%7.77%22.0%11.91% 1997-200035%39.6%20%7.16%15.7%11.02% 2001-200235%38.6%18%7.14%14.0%10.99% 2003-35% 15%7.34%11.5%11.30%