Intermediate Microeconomics and Its Application 12th Edition by Walter Nicholson,Christopher Snyder

Exercise 28

Corporate Profits Taxes and Firms' Financing Decisions
Corporate income taxes were first levied in the United States in 1909, about 4 years before the personal income tax was put into effect. In 2013, corporate income tax revenues amounted to nearly $300 billion, about 10 percent of total federal tax collections. Many people view the tax as a natural complement to the personal income tax. Under U.S. law, corporations share many of the same rights as do people, so it may seem only reasonable that corporations should be taxed in a similar way. Some economists, however, believe that the corporate profits tax seriously distorts the allocation of resources, both because of its failure to use an economic profit concept under the tax law and because a substantial portion of corporate income is taxed twice.
Definition of Profits
A large portion of what are defined as corporate profits under the tax laws is in fact a normal return to shareholders for the equity they have invested in corporations. Shareholders expect a similar return from other investments they might make: if they had deposited their funds in a bank, for instance, they would expect to be paid interest. Hence, some portion of corporate profits should be considered an economic cost of doing business because it reflects what owners have forgone by making an equity investment. Because such costs are not allowable under tax accounting regulations, equity capital is a relatively expensive way to finance a business.
Effects of the Double Tax
The corporate profits tax is not so much a tax on profits as it is a tax on the equity returns of corporate shareholders. Such taxation may have two consequences. First, corporations will find it more attractive to finance new capital investments through loans and bond offerings (whose interest payments are an allowable cost) than through new stock issues (whose implicit costs are not an allowable cost under the tax law). A second effect occurs because a part of corporate income is double taxed-first when it is earned by the corporation and then later when it is paid out to shareholders in the form of dividends. Hence, the total rate of tax applied to corporate equity capital is higher than that applied to other sources of capital.
The Leveraged Buyout Craze
These peculiarities of the corporate income tax are at least partly responsible for the wave of leveraged buyouts (LBOs) that swept financial markets in the late 1980s. Michael Milken and others made vast fortunes by developing this method of corporate financing. The basic principle of an LBO is to use borrowed funds to acquire most of the out standing stock of a corporation. Those involved in such a buyout are substituting a less highly taxed source of capital (debt) for a more highly taxed form (equity). Huge deals such as the $25 billion buyout of RJR Nabisco by the Kohlberg, Kravis, Roberts partnership were an attempt to maximize the true economic profits that can be extracted from a business (some involved in these deals also used questionable financial practices).
Changing Patterns of Leverage
Leverage buyouts declined after 1991 in part because stock prices rose and in part because taxes on dividends and capital gains were reduced. Hence, the advantages of debt-financing over equity financing were diminished. Most buyouts between 1995 and 2005, therefore, were primarily financed by cash purchases of a company's outstanding stock. The low interest rate environment caused by expansionary monetary policy after the Great Recession of 2008-2009, however, changed the calculation once again. The emergence of debtfinancing of buyouts was given an added boost when tax rates on capital gains and dividends were raised significantly in early 2013. As a result, many buyout firms used low interest rate loans to pay "dividends" to themselves as a way of reducing their equity stakes. As might have been expected, clever accounting methods made many of these dividends nontaxable to the equity owners. Undoubtedly, the complex structure of the U.S. income tax system will continue to pose such profitable opportunities for changing capital structures in the future.
Does a separate corporate tax make sense when a comprehensive income tax is already in place? Are there advantages in collecting taxes on income from capital at the corporate level rather than at the individual level? Or does the presence of a two-tier tax system just make the tax collection process more complicated and distorting than it needs to be?