Econ7008 Economics of Tax Policy
The major taxes: economic issues (2)
Corporation tax
Professor Stephen Smith
UCL Department of Economics
UK fiscal revenues, 2003-04
£ billion Percentage
of total
revenues
Income tax 122.1 30.0
Corporation tax 30.8 7.6
National Insurance contributions 74.5 18.3
Other Inland Revenue taxes 13.0 3.2
VAT 66.6 16.4
Excise duties - motor fuel 23.0 5.6
- tobacco 8.0 2.0
- alcohol 7.4 1.8
Other Customs and Excise 7.8 1.9
Business rates 18.6 4.6
Council tax 18.6 4.6
Vehicle excise duties 4.8 1.2
Other misc. taxes 11.9 2.9
Total taxes and NI contributions 407.1 100.0
Source: HM Treasury (2003) Financial Statement and Budget Report 2003. Table C7
Current receipts, outturn 2001-02
http://www.hm-treasury.gov.uk/budget/bud_bud03/budget_report/bud_bud03_repbc.cfm
Corporate income taxes
• Paid by incorporated businesses (eg limited liability companies)
– Unincorporated businesses usually subject to personal income tax
• Tax base: Income minus business costs
– Generally based on company accounts, though often with adjustments
– Countries use various procedures for treatment of interest (usually deductible), treatment of
trading losses (carry-back or carry-forward for certain periods, to allow offset against tax on
profits), treatment of inflation gains, capital gains and losses, depreciation allowances, changes
in value of stocks.
• Rates vary widely across countries.
– Within EU, the "headline" rate of CIT generally 30 – 55 %, except in Ireland where for
manufacturing and internationally-traded services rates can be as low as 10%
Corporation tax in the UK
• contributes less than 10% of total revenue from taxes and NI contributions in UK
• Highly-volatile revenue source
• Revenue yield depends on swings in business profitability
• And accounting decisions about the allocation of income and costs between tax years
Types of corporation tax system
• Classified according to how they relate to personal income tax
– Is there "double taxation" of dividends?
• Classical
– no relief for distributed profits (at either company or shareholder
level)
– tax liability of company completely independent of that of its
shareholders
– distributed profits taxed twice
– once through corporation tax, once as income of shareholder
• Imputation
– shareholder receives credit for (some or all) tax paid by company
– "full imputation" means all the domestic corporation tax paid on
distributed profits is credited to shareholder
• Split-Rate
– corporate tax levied at lower rate on distributed profits
– provides some relief for double taxation at the company level
Classical and imputation corporation taxes – a (very)
simple example
CLASSICAL FULL IMPUTATION
Corporation as before
Corporation
Profits before tax 1000 Shareholder
Corp. tax @ 30% 300 Dividend received 700
Profits after tax 700 + Imputed corp. tax 300
= Taxable div. income 1000
Shareholder Income tax @ 40% 400
Dividend income 700 - Imputed corp.tax 300
Income tax @ 40% 280 = Net tax payable 100
Net income 420 Net income 600
TOTAL TAX PAID 580 TOTAL TAX PAID 400
Distortionary effects of corporation tax - 1
• Effect on level of
investment
• Corp. tax drives a "tax wedge"
between post-tax rate of return
(which is paid to suppliers of
capital) and pre-tax rate of
return.
• a higher pre-tax rate of return is
then needed to achieve a given
post-tax rate
• some projects become
unprofitable and are not • The diagram shows the case of tax on capital
undertaken in a closed economy
• An open economy (small) faces infinitely-
elastic supply of capital at world rate of
interest, and tax would have a larger effect on
investment quantity
Distortionary effects of corporation tax - 2
• Effect on the financing of investment
• Does corporation tax affect the choice between debt, equity and retained earnings to
finance new investment?
• In practice most corporation tax systems tend to favour debt finance over equity
– Payments of interest are treated as a business cost, and are fully-deductible in
computing corporate profits
– But dividend payments are made out of taxed profits
– IFS "ACE" (Allowance for Corporate Equity) proposal aims to overcome this bias, by
reducing taxable profits “as if” dividends were interest payments.
• Effect of corporation tax on incentives for financing investment from retained
earnings depends on the capital gains tax position of shareholders (relative to
income tax treatment of dividends)
– (Financing investment from retained earnings will lead to a rise in value of each
share, compared with paying dividends)
– If capital gains taxes are low relative to personal income taxes, classical system
favours retentions over dividends
Incidence of corporation tax
• Complex, opaque, controversial.
• Ultimately corporation taxes are borne by individuals, including
o customers (through higher prices)
o employees (through lower wages)
o shareholders (through lower profits)
• General equilibrium effects may be important:
• The impact of the corporation tax may extend beyond the corporate sector
(Harberger, 1962).
– Corporation tax applies to firms in the corporate sector, but not to unincorporated
businesses.
– But the effects of corporation tax are felt in the unincorporated sector, in various
ways
• Incidence of corporation tax will depend, inter alia, on
– the aggregate elasticity of supply of capital
– mobility of capital between corporate and unincorporated sectors
– capital:labour substitutability
– elasticity of demand for output
Incidence of corporation tax
Harberger's model 1962
• Looked at long-run effects of corporation
tax
– assuming a fixed total stock of capital
– but mobility of capital between corporate
and unincorporated sectors
• Tax on corporate profits reduces return to
capital in the corporate sector
– Capital shifts to the unincorporated sector
– Effects on output prices
– Effects on labour demand in both sectors
through factor substitution and output
effects
• In long-run, market equilibrates after-tax
return in corporate and unincorporated
sectors.
• The general equilibrium perspective is
essential if the incidence of the
corporation tax is to be properly
understood.
Incidence of corporation tax: A simple case where the supply of
capital is perfectly elastic
(see Stiglitz “Tax incidence” chapter)
• Effects of corporation tax:
• Increases output prices in the corporate sector
– leading to reduced demand for corporate sector output
– and consumer substitution towards output of unincorporated sector.
– If prices rise, consumers bear some of the burden of the corporation tax
• Corporate-sector firms will change use of labour and capital
– reduced output may reduce demand for all factors
– they may also substitute labour for capital.
• Impact on wage rates will depend on the impact on overall
labour market.
• Wages may rise or fall, depending on
• Infinite supply of capital at
– substitutability of labour for capital, and
r* means that after-tax – relative labour intensity of corporate and unincorporated sectors.
return to capital must be r*
in both the corporate and • eg Overall demand for labour (and hence wages) may rise if
unincorporated sectors corporations can easily substitute labour for capital, and the
unincorporated sector is relatively labour intensive.
• so the before-tax return to
– If wages rise, burden of the corporation tax lies on
capital in the corporate consumers
sector must rise to r* + t – If wages fall, some part of corporation tax is incident on
workers (in all sectors)