Taxing firms

Question 1

How does a company calculate their tax liability?

Answer 1

Tax rate * (Sales - wages - inputs bough - depreciation of assets - interest of owed debt - other)

In other words:
Tax rate *return on equity * invested equity

Question 2

What is the participation exemption of the Dutch Corporate Income tax?

Answer 2

Income received from other foreign taxed corporations is not taxed - only income earned in NL (at source) is taxed

Question 3

Global vs. territorial tax system (and capital export vs. import neutrality)

Answer 3

Global system: taxing income of residents and companies who are headquartered in the country, irrespective of where it is earned -> also known as capital export neutrality

Territorial system: taxing income of residents and companies earned within the country itself -> capital import neutrality

Question 4

How are residents vs. companies usually taxed - global or territorial?

Answer 4

Most countries tax residents on global income, but firms on the income earned within the country’s borders

Question 5

Why are firms usually only taxed on income earned within the country?

Answer 5

Tax competition - firms are mobile and can change location if unhappy with tax rate
Only a small number of individuals are willing to do the same to avoid paying high taxes

Question 6

What is interest deductibility?

Answer 6

If you have debt and are paying interest on it, the interest can be deducted from your tax liability

But if someone invests in your company and you have to pay them interest, it is not deductible

Question 7

What 2 things does interest deductibility cause?

Answer 7

1. Too much reliance on debt financing (e.g., taking on more debt to pay less taxes)
2. Debt-shifting

Question 8

Why is interest expenses deductible but dividend expenses not?

Answer 8

For smaller, closely-held companies, they do not have the freedom to get all the funds they need, so they are forced to take on debt

For widely-held companies, they have much better access to funds -> do not need to subtract dividends paid to shareholders

Question 9

What is a depreciation allowance and why is it necessary?

Answer 9

Businesses do not often record an “income” per year since large investments are often made before sales and revenues. But you need for tax purposes to have an annual income to be taxed - what to do about investments?

While an investment in an asset is made in one year, it is expected to last longer -> so instead of deducting the entire investment spending in one year, you can do it over several

E.g., if an asset is expected to last for 10 years, you can deduct 10% of the investment costs each year for 10 years to represent the depreciation

Question 10

What is accelerated depreciation?

Answer 10

More of an investment is allowed to be deducted in the first years, since firms prefer money today above money later in time

Question 11

4 effects caused by profit-shifting

Answer 11

1. Separate accounting: multinationals have to make an account for every country they invest in -> but what is an internal transaction worth? E.g., if an affiliate in NL sells an asset to an affiliate in US, how much income/cost should be reported in each country? (=arm’s length system)
2. “Debt-shifting” due to “thin-capitalization”: subsidiaries in high-tax countries borrow from and pay interest to subsidiaries in low countries to deduct interest and have lower income in high-tax countries
3. Intangible assets are har to value and easy to shift to most favorable location -> trying to get returns in intangible assets to go to a low-tax country
4. Manipulating the internal “transfer-prices”, e.g., increasing the interest rate above market-price to record lower profits in high-tax country and higher in low-tax country

Question 12

How much is corporate income tax underreported?

Answer 12

4-10%

Question 13

How is corporate income volatile?

Answer 13

Business cycles are volatile -> some years have higher income, others lower. Investment and returns cycles are also asymmetric, meaning you have a high cost of investment in one year but high revenue in another

Question 14

What is the loss offset rules?

Answer 14

If the government takes part in a loss from a firm, the government becomes a silent partner and shares in the risk -> encouraging risky investments

Question 15

Do government usually do loss offsets?

Answer 15

No, they generally do not pay negative taxes -> managers would figure out how to have book losses to get money from the government

Instead, losses can be deducted from upcoming profits for a restricted number of years

Question 16

The marginal euro invested should after tax at least return to the investor…

Answer 16

The opportunity cost, meaning the alternative after-tax return that can be obtained elsewhere, e.g., abroad

And account for economic depreciation of assets

Question 17

The required return can go down if…

Answer 17

You are allowed to deduct investment costs more and faster and if you finance more by debt which you are allowed to deduct from your tax liability

Question 18

How can we divide the surplus of an investment between capital owners and laborers?

Answer 18

Find the equilibrium where supply and demand meet. Go from there straight to the y-axis and straight to the x-axis = return for capital owners (a square).
The remaining triangle goes to wages

Question 19

What happens to the surplus for capital owners and laborers of an investment if a tax is introduced?

Answer 19

Leftward shift of demand-curve -> some investments do not happen as they are no longer higher than the opportunity costs of investing elsewhere

Question 20

How can we find the labor and capital owner surplus + tax revenue after a tax is introduced on investments?

Answer 20

Same procedure for return for capital owners, but from new equilibrum - square

Tax returns are from new equilibrium straight up to meet the demand curve and from there straight to the y-axis - rectangle

Wages is remaining triangle above that

Question 21

Who is affected most by a tax on returns from investments?

Answer 21

Laborers and their wages (trickle-down economics)

Question 22

What are the two popular arguments against a CIT (that is not supported by empirical evidence)

Answer 22

1. If the supply of capital is perfectly elastic, then the incidence of the CIT is completely on workers (but it is not elastic)
2. If there are no market failures, then it is better to not impose regulation that affects corporate decisions (markets are not perfectly efficient on their own)

Question 23

What is the tax incidence of a CIT in a partial equilibrium?

Answer 23

Workers share in the burden of a CIT, and even more so if the capital supply elasticity is large

Question 24

Tax incidence in a general equilibrium: factor substitution and output effect of a CIT

Answer 24

Factor substitution effect: CIT reduces worldwide return of capital as capital is relocated from taxed to non-taxed sectors with lower returns on investments

Output effect: products sold by companies from a specific country becomes more expensive -> capital owners and workers suffer from the output effect. Who suffers more depends on if the sector is labor-intensive or capital-intensive

Question 25

How to tax companies in case of market power?

Answer 25

If the rent is pure, it is perfectly inelastic in supply and will bear the full burden of the tax -> efficient to tax it A monopolist company will maximize profits after the tax is imposed, but at least with the tax society shares in the profits

Question 26

4 reasons to have a corporate income tax

Answer 26

1. Equity: owners of firms have on average high ability to pay, protecting the progressivity and equity of the income tax 2. Equity: Taxing foreign owners of income yields an equity gain abroad, contributing to a global common good of a more equitable society 3. Tax administration: taxing at source is the first opportunity to tax -> taxing there and taxing income (double taxation) helps increase the odds of entrepreneurs being taxed 4. Efficiency: If profits originate from pure rents, taxing it has no excess burden

Question 27

How is a CIT related to the prisoner's dilemma?

Answer 27

Two countries are better off both taxing their companies (who are mobile and can move to the country with the lowest taxes) but since the countries lack information and trust about the other, it leads them to defect which is a suboptimal outcome

Question 28

The common good of an equitable society requires...

Answer 28

Collective action

Question 29

3 Advantages of decentralization of (international) government responsibilities?

Answer 29

1. Tailoring outputs to local tastes - if population of country 1 wants to redistribute more than country 2, there should be higher levels of taxation in country 1 2. Competition between countries forces governments to be efficient -> wanting higher tax burdens must be coupled with better public goods and services to satisfy firms and people 3. Governments can learn from each other

Question 30

3 advantages of centralization of (international) government responsibilities?

Answer 30

1. Being able to take spillover of externalities into account 2. A higher level of government can organize policy more efficiently in terms of administration costs 3. Tax competition leading to a raise to the bottom

Question 31

According to the globalization paradox, we can only choose 2 out of 3 of these

Answer 31

1. Democracy/equity: a fair distribution of income 2. Sovereign state/local administration over own tax system 3. Full benefits from globalization/efficiency: cheap products, cheap labor, free travel

Question 32

If we want global equity, we have to either give up...

Answer 32

Complete sovereignty or full benefits from globalization

Question 33

What is the future EU Common Consolidated Corporate Tax Base?

Answer 33

One EU-wide tax base for multinationals where the consolidated tax base is shared amongst countries using a formula depending on sales and employment

Question 34

What are the two pillars of BEPS?

Answer 34

I: formula apportionment for residual profits (very high profits) II: global minimum corporate tax rate of 15%

Question 35

The US government provides a corporate tax exemption to the aircraft industry - what is the factor-substitution and output effect?

Answer 35

Factor-substitution effect implies that employing capital in the aircraft sector in the US becomes more attractive (the net-of-tax return is increased) <-> scarce capital flows from the other sectors to this sector until after-tax returns are equalized at a higher level. All owners of capital benefit from the exemption, as capital is mobile and will flow to this sector (from both US and Chinese capital holders). All capital owners gain relatively (Chinese and American). Workers in China and in the consumer electronics sector lose, as they have less capital to work with (and lower wages) Output-effect implies that aircraft production in the US is expanded. As the production of aircraft is capital-intensive, this relatively benefits capital.

Question 36

What do economists recommend - capital import or export neutrality? And what is most often the case?

Answer 36

Economists recommend capital export neutrality as it does not distort the location of investment. You are taxed on the country in which you are headquartered, meaning you do not hunt after the country with the lowest tax to invest in Usually, countries have capital import neutrality as it is easier to manage