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

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-2 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 15-3 Federal Corporate Income Tax Rates, 2003

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 15-4 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 15-5 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 15-6 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 15-7 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 15-8 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 15-9 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 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 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 Monopoly  Income tax on firm making monopoly profits may have no real effects in short run  If tax is constant fraction of corporation’s profits, monopolist’s profit-maximizing level of output will not change

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe Monopoly Monopoly Response to a Proportional Tax on Net Income

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 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 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 Unrealized Capital Gains  Occurs when value of individual’s 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 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 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 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 Incentives in Income Taxes and Wealth Taxes  Flow of income – return on individual’s stock of human capital along with work effort  Can tax individual’s income earning potential as wealth  Incentive to accumulate less human capital and work harder  Can tax individual’s actual income as a flow  Incentive to under utilize human wealth

PUBLIC SECTOR ECONOMICS: The Role of Government in the American Economy Randall Holcombe 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 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 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 Property Tax Limitations  California’s 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 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 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 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 market value of land by present value of tax  Site value taxation provides no disincentive

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