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Jonathan Gruber, Public Finance and Public Policy, 3 Rd Edition, 2010

Jonathan Gruber, Public Finance and Public Policy, 3 Rd Edition, 2010

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Sections

  • Why Study Public Finance?
  • ADVANCED QUESTIONS
  • Theoretical Tools of Public Finance
  • QUESTIONS AND PROBLEMS
  • Empirical Tools of Public Finance
  • HIGHLIGHTS
  • Budget Analysis and Deficit Financing
  • Externalities: Problems and Solutions
  • Externalities in Action: Environmental and Health Externalities
  • Conclusion
  • Public Goods
  • Cost-Benefit Analysis
  • Political Economy
  • State and Local Government Expenditures
  • Education
  • Social Insurance: The New Function of Government
  • Social Security
  • Income Distribution and Welfare Programs
  • Taxation in the United States and Around the World
  • The Equity Implications of Taxation:Tax Incidence
  • Tax Inefficiencies and Their Implications for Optimal Taxation
  • Inverse Elasticity Rule
  • The Model
  • Taxes on Labor Supply
  • Taxes on Savings
  • Taxes on Risk Taking and Wealth
  • Taxation and Risk Taking
  • Capital Gains Taxation
  • Transfer Taxation
  • Property Taxation
  • Corporate Taxation
  • The Structure of the Corporate Tax
  • Revenues
  • Expenses
  • What Is Economic Depreciation? The Case of Personal Computers
  • Fundamental Tax Reform

24.1What Are Corporations
and Why Do We Tax Them?

24.2The Structure of the
Corporate Tax

24.3The Incidence of the
Corporate Tax

24.4The Consequences of the
Corporate Tax for Investment

24.5The Consequences of the
Corporate Tax for Financing

24.6Treatment of
International Corporate
Income

24.7Conclusion

1

“Havens No More.” Editorial, The Economist,May 7, 2009. Accessed at http://www.economist.com/
world/unitedstates/displaystory.cfm?story_id 13611669.

2

“Leveling the Playing Field: Curbing Tax Havens and Removing Tax Incentives for Shifting Jobs Overseas.”
Press release, the White House.

3

Donmoyer, Ryan. “Obama’s Tax Proposal Won’t Create U.S. Jobs, GE and Microsoft Say.” Bloomberg.

May 21, 2009.

abroad.4

Drew Lyon of PriceWaterhouse Coopers laments that the effects of
Obama’s proposals could be drastic: “It’s really hitting most Fortune 100 com-
panies that depend a great deal on growth of foreign markets for growing
their total earnings.”5
The technology sector in particular showed its disapproval of Obama’s pro-
posal. Microsoft Chief Executive Officer Steven Ballmer threatened to move
their employees offshore if Congress followed through with Obama’s plans to
impose higher taxes on foreign profits.6

Phil Bond, president ofTechAmerica,
the nation’s largest high-technology advocacy group, said “This [current tax
provisions facing companies doing business abroad] is the linchpin in Ameri-
can competitiveness...The tax provisions around overseas income are criti-
cal to allowing our companies to go overseas to compete and succeed.”7
The strong feelings inspired by the debate over corporate taxation were due
in part to the realization that the role of corporate taxation in government
revenue has changed dramatically in recent years. Corporations in the United
States are taxed on their net earnings,the difference between what they earn
and what they spend on factors of production. By statute, most corporations
face a marginal tax rate of 35%. In practice, numerous features of the corpo-
rate tax system (sometimes referred to as loopholes) make effective tax rates
much lower than this, and increased use of these loopholes has at least partly
led to the significant decline in corporate tax revenues. In 1960, for example,
almost one -quarter of federal revenues was raised through the corporate tax, as
is shown in the left panel of Figure 24-1.This share has changed dramatically
over the past several decades, with corporate taxes bringing in 11.3% of federal
revenues today, as the right panel shows.
To its detractors, the corporate tax is a major drag on the productivity of
the corporate sector, and the reduction in the tax burden on corporations has
been a boon to the economy that has led firms to increase their investment in
productive assets. To its supporters, the corporate tax is a major safeguard of
the overall progressivity of our tax system. By allowing the corporate tax sys-
tem to erode over time, supporters of corporate taxation argue, we have
enriched capitalists at the expense of other taxpayers.
In this chapter, we evaluate these arguments. We begin by discussing the
nature of corporations and the arguments for having a corporate tax. We
introduce the structure of the corporate tax in the United States and consider
the difficulties in defining corporate expenses. We also discuss how to apply
the principles of Chapter 19 to assess the ultimate incidence of corporate
taxation.

We then focus on two important behavioral effects of the corporate tax.
The first is the impact of corporate taxation on a firm’s investment decisions.

702PART IV ■

TAXATION IN THEORY AND PRACTICE

4

McKinnon, John D. “President’s Tax Proposal Riles Business.”Wall Street Journal.May 5, 2009.

5

Bohan, Caren, and Kim Dixon. “Obama Vows Tougher Overseas Tax Policies.” Thomson Reuters. May 4,

2009.

6

Donmoyer, Ryan. “Ballmer Says Tax Would Move Microsoft Jobs Offshore.” Bloomberg.June 3, 2009.

7

CongressDaily PM, August 11, 2009.

The second is the combined impact of corporate and individual taxation on a
firm’s decisions about how to finance its business ventures. Finally, we discuss
the set of difficult issues raised by taxing corporations that earn their income
in many different nations.

24.1

What Are Corporations and Why Do We Tax Them?

In analyzing corporate taxation, it is important to note that not all goods and
services are produced by the corporate sector in the United States. There is also
a large and robust noncorporate sector consisting of self -employed individuals,
partnerships, and other organizational forms that do not seek the protections
of incorporation. The noncorporate sector accounts for about one -quarter of
sales in the United States.
Within the corporate sector, most of the production is by firms owned by
a large number of shareholders,individuals who have purchased ownership
stakes in a company. The major advantage of incorporation is that it offers the
guarantee of limited liability,which means that the owners of a firm cannot be
held personally responsible for the obligations of the firm. If a corporation
fails, the shareholders are not required by law to use their personal assets (such

CHAPTER 24 ■

CORPORATE TAXATION

703

The Shrinking Corporate Tax Pie •As originally noted in Chapter 1, the share of federal revenue
coming from the corporate tax has been greatly decreased over time, from 22.8% of revenues in
1960 to 11.3% of revenues in 2008.

Source: Bureau of Economic Analysis (2006), Table 3.2.

Excise tax
(2.6%)

Other
(2.9%)

1960

Federal revenues (% of total revenue)

2008

Income tax
(44.5%)

Payroll tax
(17.0% )

Corporate tax
(22.8%)

Excise tax
(12.8%)

Other
(4.5%)

Corporate tax
(11.3%)

Income tax
(43.7%)

Payroll tax
(37.8%)

FIGURE 24-1

shareholders Individuals who
have purchased ownership
stakes in a company.

as their homes, jewelry, and so on) to pay the debts of the failed company.
The most that shareholders can lose is the amount they have invested in the
corporation.

There are two classifications of corporations: S-corporations and C-
corporations (the letters refer to the tax schedule used to file tax returns).
The major difference between these classifications is the tax system that
applies to the firm. Income from an S-corporation is treated as personal
income as it is earned and is subject to the individual income tax; income
from C-corporations is subject to the corporate income tax as it is earned
and may be subject to the individual income tax again as it is distributed to
a corporation’s shareholders. Our discussion of corporate taxation will focus
on C-corporations, which account for most of the production of the corporate
sector.

Ownership vs. Control

Most corporations separate ownershipof the firm from control(or management)
of the firm. Some corporations are publicly traded on a stock exchange, so any
investor can purchase or sell ownership shares in the company. Other corpora-
tions are privately held, so only select individuals are able to have an owner-
ship stake.

In either case, shareholders typically do not make the day -to-day decisions
on how to run the corporation. Those decisions are made by managers,who
are hired by the shareholders to run the company. This separation of owner-
ship from control is certainly necessary for large corporations; the thousands
of owners of a large company could never get together to make all the deci-
sions needed to run that company on a day -to-day basis. This separation of
ownership from control has the disadvantage, however, of giving rise to what
economists call an agency problem:a misalignment of the interests of the
owners and the managers.
Consider, for example, the decision of a corporate manager to buy a jet
airliner for his corporate travel. Suppose that the manager knows that it
would be much less expensive for him to take commercial flights for all of
his travel than for the company to own its own jet. Thus, it is in the share-
holders’ interests for the manager to use commercial flights because that
would be the best thing for the profitability of the firm. Yet the manager
may prefer the jet for comfort and convenience, reasons that have nothing
to do with the profitability of the company. Moreover, if the manager has
control of the accounting process, he can undoubtedly produce calculations
to show the firm’s owners that a jet is less costly than commercial flights
(by using the most expensive commercial airline prices for comparison
rather than the lower prices he would be likely to pay). Thus, the manager
may convince the owners to let him buy a jet, even though it is not in their
best interests.

This is just a small example of the havoc that the agency problem can cause
in corporate settings. Later in this chapter we will discuss the implications of
the separation of ownership and control for corporate tax policy.

704PART IV ■

TAXATION IN THEORY AND PRACTICE

agency problem A misalign-
ment of the interests of the
owners and the managers of
a firm.

Executive Compensation and the Agency Problem

Anumberofcorporateexecutiveshavemadethenewsinrecentyearsfor
receivingcompensationpackagesthatseemwildlyoutofproportionto
theexecutives’actualvalue.Howcanexecutivesreceivesuchhighcom-
pensation?Therearetwopossiblereasons.First,theymaybeworthit:after
all,theseindividualsarerunningsomeofthemostimportantcompaniesin
theworld.Nonetheless,thishighcompensationdoesn’tseemtoberelated
tosuperiorperformanceinmanycases.Forexample,in2004,netincome
atEliLillyfell29%anditsreturntoshareholdersdropped17%.Inthat
sameyear,thecompany’schiefexecutiveenjoyeda41%payraisethat
pushedhissalaryupto$12.5million.Similarly,intheperiodfrom2001to
2004,theelectronicscontractmanagerSanmina -SCLlostmoneyinevery
singleyearanditsshareholders’totalreturnfellby27%injust2004—yet
inthatsameyear,thepayofitschiefexecutivejumpedfrom$1.2million
to$15million.8

The second possible reason for high executive compensation is that owners
of firms have a hard time keeping track of the actual compensation of the
firm’s managers, and the managers exploit this limitation to compensate them-
selves well. Owners of corporations try to keep control of executive misman-
agement through the use of a board of directors,a set of (supposedly
independent) individuals who meet periodically to review decisions made by
the firm and report back to the broader set of owners on management’s per-
formance. Yet these boards of directors are very imperfect control devices. For
example, when Richard Grasso retired as head of the New York Stock
Exchange and claimed a $187 million severance package, a subsequent report
suggested that few directors of the company actually understood Grasso’s
complicated contract and thus were surprised to find themselves owing him
that much money. Other executives may conveniently place their friends and
allies on the board of directors, reducing the board’s ability to effectively mon-
itor those same executives.
At times, executive compensation crosses the line from outrageous to
illegal. In March 2006, the Wall Street Journalpublished a report examining
the practice of granting stock optionsto top executives in several major com-
panies. Stock options are designed to give managers the incentive to per-
form well by providing them the right to buy a block of their company’s
stock at a fixed price, such as the current price (the “strike price”). Thus, if
the company’s stock price rises, presumably due in some part to good man-
agement, the manager can buy his stock at the promised low price, sell at
the higher price, and make money; if the stock price falls, the manager sim-
ply doesn’t “exercise” his option in this way. Thus, companies use stock
options a way of motivating managers to improve company performance

APPLICATION

CHAPTER 24 ■

CORPORATE TAXATION

705

board of directors A set of
individuals who meet periodically
to review decisions made by a
firm’s management and report
back to the broader set of
owners on management’s
performance.

8

Deutsch (2005).

that has no cost to the company if those managers fail and the company
does worse.9

Stock options have the disadvantage, however, that the “strike price” can be
manipulated to maximize the value of the options. In several cases, the Journal’s
analysis exposed a suspiciously consistent pattern: stock -option grants were
often dated just beforea rise in the company’s stock price and often at the bot-
tom of a steep drop, suggesting that the options had been backdated—that is,
the grants’ dates had been changed to earlier dates on which share prices were
low. This backdating is not in the company’s interest—the company wants to
motivate executives to raise stock prices, not raise executives’ rewards because
prices were lower at some point in the past. But it is certainly in the interests of
executives, whose options are more valuable the lower the strike price.
In one particularly flagrant example, all six of the stock -option grants awarded
to Affiliated Computer Services chief executive Jeffrey Rich from 1995 to 2002
were dated directly before a rise in the stock price, yielding a 15% higher return
than if they had been granted at each year’s average share price. Though Rich and
ACS insisted it had been “blind luck,” according to the Journal’s computations,
the odds of this happening by chance were around one in a billion.10
Spurred by the Journal’s report, the SEC opened an investigation into the
practice of backdating stock options at several U.S. companies and, by May 2006,
ten executives or directors at affected companies had been forced to resign.11

By
September 2006, the federal investigation had brought to light possible improper
stock-options practices at nearly 100 U.S. companies. In one particularly bizarre
example, Cablevision Systems Corp., the country’s fifth largest cable operator,
was found to have granted and possibly backdated options in the period from
1997 to 2002 for its Vice Chairman, Marc Lustgarten. The twist? Mr. Lustgarten
had died in 1999 of pancreatic cancer. Though an investigation is ongoing, many
suspect that the posthumously awarded options were meant to enrich Mr. Lust-
garten’s heirs who were entitled to exercise all stock options upon his death.
While awarding options has traditionally been justified as a means of giving
executives a greater stake in the company’s success, the Cablevision example is a
striking demonstration of how far the practice has departed from its original
purpose. As John Coffee, a professor of law at Columbia University, wryly noted,
“Trying to incentivize a corpse suggests they were not complying with the spirit
of shareholder -approved stock -option plans.”12
The issue of executive compensation came to a head in 2008–2009 as
thousands of traders and bankers on Wall Street were awarded huge bonuses
and pay even as their employers were battered by the financial crisis. For
example, the top 200 bonus recipients at JP Morgan Chase & Co. received

706PART IV ■

TAXATION IN THEORY AND PRACTICE

9

For example, suppose that a company’s current stock price was $100 per share. Company A grants its
CEO 1 million stock options, so that she has the right to buy up to 1 million shares at $100 per share,
regardless of the actual stock price. If the stock price falls, she will never exercise (use) these options—they
are worthless. But if the stock price rises, say, to $150, then she can buy 1 million shares for $100 a share and
sell them for $150, making $50 million in profit.

10

Forelle and Bandler (2006).

11

Wall Street Journal (2006a).

12

Grant, Bandler, and Forelle (2006).

$1.12 billion last year, while the top 200 at Goldman Sachs received $995 mil-
lion, the top 149 at Merrill Lynch received $858 million, and the top 101 at
Morgan Stanley received $577 million. Those 650 people received a com-
bined $3.55 billion, or an average of $5.46 million each. Citigroup and Merrill
Lynch suffered losses of more than $27 billion each, the report said. Yet Citi-
group paid out $5.33 billion in bonuses, and Merrill paid out $3.6 billion.13
These large compensation packages were viewed as particularly offensive at
a time when banks were receiving hundreds of billions of taxpayer-financed
bailout funds. As New York Attorney General Andrew Cuomo wrote, “When
the banks did well, their employees were paid well. When the banks did poorly,
their employees were paid well. When the banks did very poorly, they were
bailed out by taxpayers and their employees were still paid well.”14

Congress
and the public expressed outrage at these packages and voted to limit the
compensation that could be paid by firms accepting bailout funds, but com-
pensation remains uncapped at the vast majority of financial and other firms
in the United States.

Firm Financing

Firms grow by making investments and reaping the rewards of those invest-
ments. To make investments in capital such as new machinery, however, a firm
must finance,or raise the funds for, the investment. There are three possible
channels of corporate financing, as shown in Figure 24-2. The firm can borrow
from lenders such as banks; this type of financing is called debt finance.This
borrowing is often done by selling corporate bonds,which are promises by

CHAPTER 24 ■

CORPORATE TAXATION

707

Sources of Corporate Finance•If a firm wants to finance an investment, it can either use its own retained
earnings, or raise new funds from the capital market in one of two ways. The first is to issue bonds that pay
bondholders periodic interest payments (debt finance). The other is to issue ownership (equity) shares that
pay shareholders either through dividends or through capital gains earned on increases in the value of the
firm (equity finance).

Firm raises
money by

Issuing bonds
(debt finance)

Shareholders receive
dividends

Bondholders receive
interest dividends

Shareholders receive
capital gains

Issuing shares of stock
(equity finance)

Firm wants to finance
an investment

Firm uses funds from
retained earnings

FIGURE 24-2

debt finance The raising of
funds by borrowing from
lenders such as banks, or by
selling bonds.

bondsPromises by a corpora-
tion to make periodic interest
payments, as well as ultimate
repayment of principal, to the
bondholders (the lenders).

13

http://www.nytimes.com/2009/07/31/business/31pay.html?_r=1&hp and http://www.bloomberg.com/
apps/news?pid=20601087&sid=aIgUh3Tv5ycg.

14

http://www.bloomberg.com/apps/news?pid=20601087&sid=aIgUh3Tv5ycg.

the corporation to make periodic interest payments (along with an ultimate
repayment of principal) to the bondholders (the lenders).
The second source of investment financing is to sell a share(a small piece)
of ownership in the company for money that can be used to make invest-
ments; this type of financing is called equity finance.Investors who buy
shares in a company can be rewarded in two different ways. One is by receiv-
ing a dividend,a periodic payment from the company per share owned. The
other is by earning a capital gainon the shares held as the price rises above
the purchase price of the stock.
Finally, firms can finance their investment out of their own retained earn-
ings, which are any net profits that are kept by the company rather than paid
out to debt or equity holders. Indeed, in recent years there is increasing evi-
dence that a large share, perhaps a majority, of new investment is financed
from retained earnings.15

Why Do We Have a Corporate Tax?

Why do we have a corporate income tax? After all, as we emphasized in
Chapter 19, firms are not entities but combinations of factors. So when we tax
“firms,” we ultimately tax the factors of production that make up those firms.
Wouldn’t it be more straightforward to tax the factors (labor and capital)
directly, rather than get revenue from them through the convoluted (and
uncertain) mechanism of corporate taxation? There are at least two reasons
why we might want a separate corporate tax.

Pure Profits TaxationTo the extent that corporations have market power,
they will earn pure profits,returns that exceed payouts to their factors of pro-
duction (labor and capital). As established by the important analysis of
Diamond and Mirlees (1971), a pure profits tax is a much better way to raise
revenues than is a tax on factors of production. This is because a pure profits
tax does not distort the decision making of a producer, while taxes on labor or
capital have distortionary effects of the types discussed in Chapters 21–23
(such as lowering labor supply, savings, or risk taking).
A firm chooses prices and production levels to maximize profits. If the gov-
ernment were to announce tomorrow that it was taking some part of those
profits, the optimal choice of price and quantity for the firm would not
change; the decision that maximizes pre-tax profits also maximizes after -tax
profits: (1 – tax) profits. Pure profits taxes therefore collect revenue without
distorting behavior. In addition to being distortion -free, a pure profits tax is
very progressive because those receiving the profits from production are likely
to be well -off.

While the pure profits tax seems like a good idea, it is not the way the cor-
porate tax works, for two reasons. First, as we see later in the chapter, corpo-
rate taxes are not pure profits taxes: firms can minimize their corporate tax
burdens by changing their use of inputs. Since corporate taxes cause firms to

708PART IV ■

TAXATION IN THEORY AND PRACTICE

equity finance The raising of
funds by sale of ownership
shares in a firm.

dividendThe periodic payment
that investors receive from the
company, per share owned.

capital gain The increase in
the price of a share since its
purchase.

retained earnings Any net
profits that are kept by the com-
pany rather than paid out to
debt or equity holders.

15

See Rauh (2006) for compelling evidence, as well as a review of past literature in this area.

substitute away from their optimal production pattern, there is a distortion
that causes inefficiency.
Second, a pure profits tax should be levied on economic profits,the dif-
ference between firm revenues and economic costs. It would involve using the
type of cost calculations discussed in Chapter 8, appropriately valuing resources
at their opportunity cost(their use in the next best alternative activity). Yet firms
pay taxes on accounting profits,the difference between revenues and reported
costs. Reported costs can differ from economic costs both because they use prices
rather than opportunity costs and because firms can manipulate their account-
ing practices to vary the amount they report as costs.

Retained EarningsAnother rationale for corporate taxation is similar to the
arguments we discussed for capital gains: if corporations were not taxed on
their earnings, then individuals who owned shares in corporations could sim-
ply avoid taxes by having the corporations never pay out their earnings. These
earnings would accumulate tax -free inside the corporation, leading to a large
tax subsidy to corporate earnings relative to other forms of savings (or other
economic activity in general). If corporations paid out those earnings many
years later, the present discounted value of the tax burden would be quite low.

24.2

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