Chapter 4 Corporate Taxation

Transcription

1 Chaper 4 Corporae Taxaion 4.1 Inroducion The corporaion is reaed as a separae eniy for ax purposes in all developed counries. I has been subjec of numerous ax insrumens wih a variey of differen moivaions. The ransfers beween he corporaion and is sock-holders resul in he behavior of he corporaion also being influenced by he srucure of he personal ax sysem, mos noably hrough he favorable ax reamen of capial gains. There are wo raionales for corporae axaion: 1. If he corporaion is seen merely as earning income and ransmiing his o is ulimae owners, hen here is no reason why he corporaion should be axed. Insead, he ax liabiliy should be placed upon is owners alone. This argumen reflecs he view ha he corporaion does no have a personaliy or exisence of is own oher han ha given o i in law. In simple seing where shareholders exercise direc conrol, he corporaion canno be idenified as an eniy disinc from is owners. A coheren ax srucure would hen involve a comprehensive income ax on owners, covering all sources of earnings, wih no need for separae axaion of he corporaion. 2. The alernaive perspecive is ha incorporaion carries legal and economic privileges and ha he corporaion ax is a ax upon he gains enjoyed from he benefi of hese privileges, in paricular ha of limied liabiliy. Anoher privilege is ha he ax falls primarily on pure profis and hence is less disorionary han axes on oher kinds of income. Perhaps mos imporan in poliical erms is he belief ha i is borne by corporaions raher han individuals and is herefore relaively painless. Ulimaely (pracically), he effec of a ax depends upon how i affecs he individuals in he economy and he correcness, or oherwise, of axing he corporaion depends upon he final incidence of he ax. If he ax can achieve objecives ha oher axes canno, and so raise social welfare, hen here is a jusificaion for is exisence. 4.2 Types of Taxes There are many differen ypes of ax ha are imposed on firms. 1. Taxes on individual facors Lecures on Public Finance Par2_Chap4, 2015 version Page 1 of 47

2 The mos common kind of ax on labor is a payroll ax, usually levied as a fixed percenage of he wage bills (e.g. he social securiy ax). The converse of a payroll ax is where he governmen provides wage subsidies. The corporae profi ax is someimes viewed as a ax on he reurn o capial in he corporae secor. Bu he ineres deducibiliy implies ha he ax falls primarily on pure profis, no on he reurn o capial. As here are wage subsidies, here are subsidies for invesmen: invesmen ax credis or grans. Taxes on facors may be general axes or confined o paricular forms of inpu or o paricular aciviies. Thus paymens o bond holders are generally exemp from corporae profis ax and reurns in he form of an increase in he value of an asse (capial gains) are reaed differenly from oher reurns. Dividends are axed. 2. Taxes on oal oupu or oal inpu. The Value Added Tax (VAT), a proporionae ax on he value added by he firm. On an income base, value added is defined as wage paymen plus he reurn o capial (ne of depreciaion) (equivalen o a uniform payroll ax plus an equal rae profis ax). There are he produc base and he consumpion base, which is equivalen o a uniform payroll ax plus an equal rae profis ax wih free depreciaion. Producion and urnover axes are levied on he value of gross oupu of a firm (e.g. The impac on he degree of inegraion in he economy needs o be considered. Gross urnover axes may provide an incenive for verical inegraion). 4.3 Changing Views of Corporae Income Tax 1 In Table 1 I have ried o summarize he mos well-known compeing heories of corporae income axaion 2. The saemens regarding he cos of capial assume ha axable profis are equal o he rue economic profis, i.e., ha depreciaion for ax purposes corresponds o he rue economic depreciaion of he firm s asses 3. The following secions provide some explanaory remarks o he able. 1 This par is drawn from Sørensen (1999) 2 For more deailed surveys, see Auerbach (1983), Poerba and Summers (1985), Sinn (1991a), or Sørensen (1995). 3 In he nex par of he paper, we shall consider he complicaions arising from deviaions beween axable profis and rue economic profis. Lecures on Public Finance Par2_Chap4, 2015 version Page 2 of 47

3 Table 1 Alernaive Views of he Classical Corporae Tax Sysem Theory Influence of Nonax Facors on Corporae Financing Decisions Marginal Source of Finance Marginal Use of Profis Old view b Imporan New equiy imporan Dividend paymens Neuraliy view c Unimporan Deb Financial invesmen in capial marke New view d Unimporan Reained earnings Dividend paymens Nucleus heory of he firm e Growh phase Mauriy phase Unimporan A ime of esablishmen: new equiy afer ime of esablishmen: reained earnings Reinvesmen in real capial Unimporan Reained earnings Dividend paymens Cos of Corporae Capial a High above marke ineres rae Equal o marke ineres rae Slighly above marke ineres rae Saring very high above marke ineres rae, bu falling over ime Slighly above marke ineres rae Effec of Dividend Tax Relief Significan simulus o corporae invesmen No simulus o invesmen Windfall gains o exising shareholders; no invesmen simulus Significan simulus o he esablishmen and growh of new corporaions Windfall gains o exising shareholders; no invesmen simulus a The saemens in his column assume rue economic depreciaion. b Elaboraed by numerous wriers over he years, bu heavily influenced by Harberger (1962, 1966). c Reaching is mos developed form in Sigliz (1973). d Developed and elaboraed by King (1974a, b, 1977), Auerbach (1979), Bradford (1980, 1981) and Sinn (1985). e Developed by Sinn (1991b). The Old View of he Corporaion Tax According o he radiional view also referred o as he old view a classical corporae ax sysem will disor he financing as well as he real invesmen decisions of corporaions. Since ineres paymens are deducible from he corporae income ax base, hence escaping double axaion, here is a endency for deb finance o be subsiued for equiy finance. Moreover, since he shareholder s personal ax on capial gains is deferred unil he ime of realizaion, whereas his dividend income is axed immediaely, corporaions are induced o generae capial gains o shareholders by reaining par of heir profis raher han paying hem ou as dividends. To some exen, he subsiuion of deb finance for equiy finance and he replacemen of new equiy by reained profis will reduce he impac of axaion on he cos of corporae capial. However, according o he old view, corporaions will sill wish o rely on some amoun of equiy finance a he margin, including some amoun of new equiy. The double axaion of corporae equiy income will herefore reduce he overall level of saving and invesmen and drive he required preax rae of reurn on corporae invesmen above he preax rae of reurn required in he noncorporae secor. As a resul, oo lile capial is allocaed o he corporae secor, and oo much is allocaed o he noncorporae secor, as seen from sociey s viewpoin. To explain why corporaions would wan o use some amoun of equiy finance a he margin despie he ax-preferred saus of deb finance, he holders of he old view ypically argue ha high deb equiy raios generae cerain invisible coss semming from he risks of Lecures on Public Finance Par2_Chap4, 2015 version Page 3 of 47

4 financial disress and bankrupcy. A some leverage raio well below a hundred percen he rise in hese coss will ouweigh he ax benefis of increased reliance on deb finance. The old view also assumes ha shareholders have a nonax preference for dividends over capial gains on shares. Oher hings equal, shareholders will hus require a lower afer-ax reurn on shares in corporaions wih higher dividend pay-ou raios. Up o a poin, he corporaion is herefore able o reduce is cos of equiy finance by raising is pay-ou raio. Since new share issues increase he abiliy of he corporaion o pay dividends o exising shareholders, i becomes opimal for he value-maximizing corporaion o rely o some exen on new equiy raher han using only reained profis as he source of equiy finance. In principle, he corporaion will raise is dividend pay-ou raio o he poin where he marginal nonax benefis from increased dividend paymens are jus offse by he ax penaly on dividends, wih he ax penaly being equal o he difference beween he personal ax rae on dividends and he effecive personal ax rae on (accrued) capial gains on shares. Proponens of he old view do no always make very clear why shareholders would require lower ne reurns on shares wih higher dividend pay-ou raios. The mos popular hypohesis is ha dividends serve as a signal o he sock marke ha he corporaion is financially healhy and faces brigh earnings prospecs. Criics have found his heory raher unconvincing, arguing ha a corporaion faced wih profiable invesmen opporuniies should reain and reinves is profis raher han paying hem ou. The Neuraliy Hypohesis The criics of he old view end o downgrade he imporance of nonax facors for corporae financing decisions. The poin of deparure for hese skepics is he so-called Modigliani-Miller heorem, according o which shareholders would be indifferen o he corporaion s financial policy in a world wihou axes, since invesors would always be able o neuralize he effecs of he firm s borrowing and dividend policy on he risk-reurn profiles of heir personal porfolios by selling from or borrowing agains heir porfolios. If he various modes of finance are in fac equally aracive from a nonax poin of view, i follows ha he corporaion should rely exclusively on he source of finance ha is mos favored by he ax sysem. In mos counries, he mode of finance would be deb, because equiy-financed invesmen ends o be subjec o double axaion. If deb is used as he marginal source of finance, and axable profis coincide wih acual profis, i will be profiable for he corporaion o carry is real invesmen o he poin where he risk-adjused marginal preax rae of reurn is jus equal o he (deducible) marke rae of ineres before ax. In oher words, he opimal invesmen policy of he corporaion would be idenical o he opimal policy in a hypoheical world of Lecures on Public Finance Par2_Chap4, 2015 version Page 4 of 47

5 zero axes, and he corporaion ax would be neural, falling only on he inframarginal profis exceeding he marke ineres rae. Sigliz (1973) argued ha he corporae income ax will also be neural if he oal corporae and personal ax burden on reained earnings is lower han he personal ax on ineres income so ha finance by reenions is ax-preferred o deb finance. In his siuaion which Sigliz believed o prevail in he U.S. before he 1981 ax reform he corporaion should underake reenions-financed real invesmen unil he marginal rae of reurn becomes equal o he marke ineres rae, and he remaining profis (if any) should be used for financial invesmen in he capial marke. In he absence of nonax benefis from dividend paymens, i is no raional o pay ou any dividends if disribuions are penalized by he ax sysem, and if financial invesmen underaken hrough he corporaion is axed more lighly han financial invesmen underaken direcly by he shareholders hemselves 4. Furhermore, i would obviously no be raional for he corporaion o carry ou real invesmen wih a reurn below he marke ineres rae when i could alernaively inves in financial asses. I should be clear ha such a ax regime is really equivalen o a regime of deb finance: o increase is real invesmen by one dollar, he corporaion will have o reduce is financial invesmen by one dollar, so he opporuniy cos of real invesmen is he ineres rae ha migh have been earned in he capial marke. In shor, he cos of corporae capial equals he going ineres rae, and again he corporaion ax falls only on he inframarginal invesmens wih reurns above he marke rae of ineres. The New View The neuraliy hypohesis does no square wih he observaions ha mos corporaions do end o pay dividends on a regular basis and ha hey rarely rely exclusively on deb finance a he margin. The so-called new view of he corporaion ax assumes ha corporaions pay dividends and acceps he fac ha firms will ypically wish o use some amoun of equiy finance a he margin. However, according o he new view here is no convincing reason why shareholders should prefer a dollar of ne dividend o a dollar of ne capial gain on shares. Insead, i is argued ha a maure corporaion earning sufficien profis should mee all of is need for equiy finance hrough reenions and should pay ou only he remaining profi as dividends. A maure corporaion operaing under a classical corporae ax sysem should never subsiue new share issues for reained earnings, since his would ransform lighly axed capial gains on shares ino more heavily axed dividends. Since he new view assumes ha reained profis are he marginal source of corporae 4 For he corporaion o have a posiive marke value, i mus ulimaely reurn cash o is shareholders. Sigliz (1973) assumed ha his would be done by liquidaing he firm a some poin. Lecures on Public Finance Par2_Chap4, 2015 version Page 5 of 47

6 finance, i implies ha he corporaion s marginal invesmen will generae an addiional capial gains liabiliy for shareholders, because increased reenions will end o raise he marke value of ousanding shares. If he combined corporae and personal ax burden on reenions (i.e., he sum of he corporae income ax on reenions and he personal ax on capial gains on shares) exceeds he shareholder s personal ax on ineres income, he required rae of reurn on corporae invesmen will exceed he marke ineres rae. On he oher hand, he new view has he sriking implicaion ha axes on disribued profis are neural. While i is rue ha dividend axes reduce he shareholder s income from addiional invesmen, hey also reduce his opporuniy cos of allowing he firm o reain profis for furher invesmen. Thus, if he oal corporae and personal ax burden on a dollar of disribued profis is 50 cens, he shareholder only has o give up a ne income of 50 cens for each dollar reained for invesmen by he corporaion. This 50 percen reducion of he opporuniy cos of invesmen fully compensaes for he 50 percen dividend ax levied when he profis on he exra invesmen are ulimaely paid ou, leaving he shareholder s ne reurn unaffeced by he ax burden on disribuions. Hence, axes on dividends have no influence on he cos of corporae capial, bu are merely capialized in share prices in order o ensure ha invesmen in shares is jus as aracive as invesmen in ineres-bearing asses, despie he double axaion of dividends. One may also say ha equiy is rapped wihin he corporaion in he sense ha he funds accumulaed wihin he firm will ineviably have o bear he dividend ax, wheher disribuions are made now or laer. For a consan dividend ax rae, an invesmen policy ha maximizes he presen value of disribuions before dividend ax will herefore also maximize he presen value of dividends afer ax. Hence he neuraliy of he dividend ax. The new view hus implies ha measures o alleviae he double axaion of dividends will no simulae corporae invesmen, leading only o a windfall gain o exising shareholders and a corresponding loss of governmen revenue. According o he new view, policymakers should focus insead on he double axaion of reained earnings resuling from he coexisence of he corporae income ax and he personal ax on capial gains on shares. However, since he effecive ax rae on accrued capial gains is ypically raher low because he ax is deferred unil he ime of realizaion of he gain, he new view also suggess ha he problem of double axaion is no very serious and ha he cos of corporae capial is probably no very far above he marke ineres rae, even in counries like he Unied Saes where realized long-erm capial gains on shares are included in he personal income ax base 5. 5 Criics have argued ha he surge in share repurchases observed in he Unied Saes during he las decade undermines he assumpion underlying he new view ha cash disribuions o shareholders ake he form of dividends. However, as Sinn (1991a, sec. 7.1) has demonsraed, a corporaion financing is marginal invesmen by new share issues (or, equivalenly, by a reducion in share repurchases) and using is marginal profis o Lecures on Public Finance Par2_Chap4, 2015 version Page 6 of 47

7 Reconciling he Old and he New View: The Nucleus Theory of he Firm If revenue-generaing dividend axes are neural, one migh be emped o conclude ha policy makers should increase he ax burden on dividends raher han worry abou measures o alleviae he exising double axaion. This conclusion would be oo hasy, however, since he new view explained above applies only o maure firms earning sufficien profis o be able o mee heir need for equiy finance hrough reained earnings. Holders of he new view do no deny ha newly esablished firms or rapidly growing firms ha have o rely on new share issues will face a higher cos of capial when dividends are subjec o double axaion. Since shareholders are no eniled o a ax deducion for heir purchase of shares, heir opporuniy cos of invesmen will no be reduced by he dividend ax rae, as is he case when he firm finances invesmen by wih-holding dividends. The ne reurn o invesmen will herefore be reduced by he full amoun of he dividend ax, and he cos of capial will be correspondingly higher, when new equiy is he marginal source of finance and marginal profis are paid ou as dividends. I would hus seem ha he old view may be relevan for immaure or rapidly growing firms even if he new view provides a correc descripion of maure firms. Ye, i has been argued by Sinn (1991b) ha he cos of capial for an immaure firm will be even higher han prediced by he old view. The old view suggess ha a corporaion ha is abou o be se up should immediaely issue he amoun of shares necessary o carry invesmen o he poin where he marginal reurn jus compensaes for he exra ax on dividends relaive o ineres income. However, Sinn (1991b) poins ou ha if reenions are axed more lighly han disribuions, i may be opimal for a corporaion in he sar-up phase o issue a smaller amoun of shares han his invesmen rule would sugges. The reason is ha he ax sysem provides an incenive o pospone invesmen unil he firm begins o make profis so ha i can finance invesmen ou of ax-preferred reenions. If i only has a limied number of invesmen projecs wih above-normal raes of reurn, he new firm foregoes he possibiliy of financing hese invesmens by cheaper capial (reenions) a a laer dae if i raises new equiy oday in order o implemen all projecs a once. The loss of he opporuniy o use a cheaper mode of finance a a laer sage represens an addiional opporuniy cos of curren invesmen for he immaure firm ha mus be added o he cos of capial. According o Sinn (1991b), a new corporaion should herefore issue only a limied amoun of new shares a he ime of foundaion i.e., i should sar only wih a small nucleus of equiy in order o carry ou only he mos profiable of is planned invesmen projecs. The remaining projecs wih relaively high reurns should be financed exclusively ou of reained repurchase shares would in fac have exacly he same cos of capial as implied by he new view. Lecures on Public Finance Par2_Chap4, 2015 version Page 7 of 47

8 earnings in he subsequen growh phase of he firm, and no dividends should be paid during his phase, since his would ransform lighly axed capial gains ino heavily axed dividends. The greaer he ax discriminaion agains disribuions relaive o reenions, he lower should be he iniial injecion of equiy, and he greaer should be he volume of invesmen financed by reenions in he subsequen growh phase. The growh phase comes o an end when he capial sock has expanded o he poin where addiional invesmen no longer yields above-normal raes of reurn. The corporaion hen eners he sage of mauriy, where ne invesmen becomes zero and where profis are paid ou as dividends. In his phase, he rapped-equiy argumen applies, i.e., he dividend ax becomes neural, and he cos of capial becomes equal o he value implied by he new view. The poin is, however, ha under very mild condiions he iniial cos of capial is even higher han suggesed by he old view a he ime he firm is se up. Moreover, he cos of capial remains above he value prediced by he new view during he drive o mauriy. The reason is ha he gradual fall in he marginal produciviy of capial during he growh phase will generae a gradual capial loss o shareholders for which hey mus be compensaed by an above normal rae of reurn on he corporaion s real invesmen. Noice he paradoxical implicaion of his dynamic heory of he corporae firm: he double axaion of dividends will drive up he cos of capial during he growh phase where he firm does no pay dividends and no dividend ax is colleced, whereas he dividend ax will be neural in he mauriy phase where dividends are acually paid and he ax begins o yield revenue! Table 2 Effecs of he Corporae Tax Sysem under Alernaive Accouning Regimes a Accouning Regime Uniform reporing ( One-book sysem) Separae reporing ( Two-book sysem) Unimporan Corporae income ax rae neural Dividend axaion neural Invesmen simulaed by acceleraed depreciaion Role of Monioring Coss Significan monioring cos savings from deb finance Corporae income ax rae neural Dividend axaion neural Acceleraed depreciaion ineffecive Corporae income ax rae non-neural ( axaion paradox ) dividend axaion neural Significan monioring cos savings from exernal finance Corporae income ax rae non-neural Dividend axaion non-neural Acceleraed depreciaion ineffecive Corporae income ax rae non-neural Dividend axaion non-neural Invesmen simulaed by acceleraed depreciaion Invesmen simulaed by acceleraed depreciaion a The able summarizes he finding of Kanniainen and Södersen (1994a, b) and Sørensen (1994, 1995). All resuls repored in he able are based on he assumpion ha marginal profis are paid ou as dividends. The recen heories sressing he imporance of accouning convenions for he cos of Lecures on Public Finance Par2_Chap4, 2015 version Page 8 of 47

9 corporae capial are summarized in Table 2. As saed in he able, he presence of monioring cos savings from deb finance does no eliminae he firm s incenive o ake full advanage of allowances for acceleraed depreciaion under separae reporing (see Sørensen, 1994, Appendix). The reason is ha his accouning regime does no consrain he use of deb finance o he same exen as he regime of uniform reporing. I should be added ha he monioring-cos heory skeched here is no he only possible explanaion why corporaions in one-book (uniform-reporing) counries may no wish o exploi all available depreciaion allowances. As Cummings, Harris, and Hasse (1994) has poined ou, firms in one-book counries may also be relucan o claim all poenial ax benefis if reducions in axable income may be misinerpreed by financial markes as signals of lower profiabiliy. Indeed, hese auhors find empirical evidence ha invesmen in one-book counries is less sensiive o ax-law changes han invesmen in wo-book counries allowing separae reporing. This underscores he imporance of analyzing a counry s accouning regime when evaluaing he incenive effecs of he corporaion ax. Profi ax Wih full allowance for capial expendiure, he firm will opimize, by choice of capial and labor, he level of afer-ax profis are given by [ ] π = ( 1 c ) pf( K, L) wl rk (1) As he firs-order condiions for profi maximizaion, p F k = r p F = w L he firm s opimal choice of inpus is unaffeced by he imposiion of he ax. The resuls are modified if paymens o capial can no be deduced before ax. [ ] π = ( 1 c ) pf( K, L) wl rk (2) rk can be inerpreed as he cos of capial, The definiion of ax base is he key. There are difficulies in depreciaion, depleion, invenory accumulaion, capial gains and losses, and inercorporae dividends. Lecures on Public Finance Par2_Chap4, 2015 version Page 9 of 47

10 4.4 Financial Srucure The analysis focuses on he fundamenal financial ideniy of he firm. 1. gross profis π = pf wl 2. New bond issues B + 1 B 3. New equiy issues θ + 1 θ We can idenify he following disbursemens: 1. dividends D 2. ineres paymens o bondholders rb 3. invesmen I The fundamenal relaionship is ha revenues equal disbursemens are period. π + B + 1 B + θ + 1 θ = D + I + rb (3) Reained earnings, RE = π rb D (4) Then (3) becomes I = RE + ( B B ) + ( θ θ ) (5) Invesmen is financed by reained earnings, borrowing or new equiy issues. In he absence of axaion, he ne financial flow from he corporaion o he personal secor is Y = D + rb ( B B ) ( θ θ ) (6) This is equal o Y = π I. The ne flow is deermined by he real variables and does no depend a all on he financial srucure. I is formally saed in he following: The Modigliani-Miller Theorem: in he absence of axaion and bankrupcy, corporae financial policy is irrelevan and has no effec on he value of he firm. Lecures on Public Finance Par2_Chap4, 2015 version Page 10 of 47

11 We inroduce he ax sysem (he classical sysem) 1. corporae profis ax c 2. ineres paymens by corporaions are deducible. 3. ineres paymens by individuals are deducible a he personal ax rae, p. 4. dividends and ineres received are axable a p. 5. capial gains are axable a g < p. One problem wih he classical sysem is he double axaion of dividends: hey are axed once as corporae profi and hen again as personal income. The impuaion sysem aemps o avoid his double axaion by inegraing he corporae and personal ax sysems. I does his by giving each shareholder a credi for he ax paid by he company on he profi ou of which dividends are paid. In essence, any profis disribued as dividends are deemed o have already been subjec o personal ax a wha is known as he rae of impuaion. The shareholder receiving he dividend is hen only liable for he difference beween he rae of impuaion and heir personal ax rae. is, Wih his ax sysem, he corporae ax liabiliy is π rb ) and he financial ideniy c ( π ) B (7) ( 1 c ) + ( B+ 1 B ) + ( θ + 1 θ ) = D + I + r(1 c For he personal secor, here is liabiliy o income ax and capial gains ax, so ha he ne financial flow afer ax is Y = ( D + rb )( ) ( B B ) ( θ θ ) (8) 1 p A furher alernaive sysem ha has been employed in U.K., Germany and Japan is he wo-rae (spli-rae) sysem. Under his sysem, differen ax raes apply o disribued and undisribued profis wih he laer being axed a a higher rae. The main reason for his sysem is no o alleviae he double axaion of dividends in view of inegraion, bu o improve he working of he securiies markes and encourage saving and invesmen. Lecures on Public Finance Par2_Chap4, 2015 version Page 11 of 47

12 Table 3 Types of Corporae Taxaion in OECD, 1987 Type of Taxaion Separae Corporae Tax (X) Pure Classical sysem Sligh alleviaion a company level (X1) Sligh alleviaion a shareholder level (X2) Parial Inegraion (Y) A company level (spli rae) (Y1) A shareholder level (impuaion) (Y2) Credi for company ax acually wihheld (Y2(a)) Credi for domesic ax deemed o have been paid (Y2(b)) Full Assimilaion (Z) A company level (Z1) A shareholder level (Z2) Source: OECD (1987) p.86. Counry Ausralia Sweden USA (Japan) Japan (Germany) UK Canada Greece Germany Table 3 illusraes many ways of avoiding he double axaion of dividends in As we discussed above, here are hree broad ypes of he corporae ax sysem: he separae sysem (X), he spli rae sysem (Y1), and he impuaion sysem (Y2). The full assimilaion (full inegraion) does no seem o be a pracical mehod of inegraion. According o Ishi (1993, pp.187-8), Japan is characerized by a hybrid ype of inegraion sysem combining X2 and Y1. Under he X2 mehod he shareholder can receive a credi for par of he corporae ax paid on dividends, while he Y1 mehod admis o ax disribued profis a a lower rae han reained profis. I is ofen explained ha he double axaion of dividends is parially alleviaed a boh he shareholder and he company level. In 1990, his hybrid sysem was parially changed ino he presen form, i.e., he Y1 mehod was abandoned and he X2 mehod alone was reained o lighen he double axaion of dividends. For deails in relaive advanages in means of finance under he differen ax sysems and he differen raes (see Akinson and Sigliz (1980), pp ). Taxaion and Corporae Finance 6 Deb financing has one imporan advanage under he corporae income ax sysem in many counries. The ineres ha he company pays is a ax-deducible expense. Dividends and reained earnings are no. Thus he reurn o bondholders escapes axaion a he corporae level. Table 4 shows simple income saemens for firm U, which has no deb, and firm L, which has borrowed $1,000 a 8 percen. The ax bill of L is $28 less han ha of U. This is he ax shield provided by he deb of L. In effec he governmen pays 35 percen of he ineres 6 This secion draws heavily from Brealey and Myers (1996, Chaper 18). Lecures on Public Finance Par2_Chap4, 2015 version Page 12 of 47

13 expense of L. The oal income ha L can pay ou o is bondholders and sockholders increases by ha amoun. Tax shields can be valuable asses. Suppose ha he deb of L is fixed and permanen (ha is, he company commis o refinance is presen deb obligaions when hey maure and o keep rolling over is deb obligaions indefiniely). I looks forward o a permanen sream of cash flows of $28 per year. The risk of hese flows is likely o be less han he risk of he operaing asses of L. The ax shields depend only on he corporae ax rae 7 and on he abiliy of L o earn enough o cover ineres paymens. The corporae ax rae has been prey sable (i did fall from 46 o 34 percen afer he Tax Reform Ac of 1986, bu ha was he firs maerial change since he 1950s). And he abiliy of L o earn is ineres paymens mus be reasonably sure oherwise i could no have borrowed a 8 percen 8. Therefore we should discoun he ineres ax shields a a relaively low rae. Table 4 The ax deducibiliy of ineres increases he oal income ha can be paid ou o bondholders and sockholders. Income Saemen of Firm U Income Saemen of Firm L Earnings before ineres and axes $1,000 $1,000 Ineres paid o bondholders 0 80 Preax income 1, Tax a 35% Ne income o sockholders $650 $598 Toal income o boh bondholders and sockholders $0+650=$650 $80+598=$678 Ineres ax shield (.35 x ineres) $0 $28 Bu wha rae? The mos common assumpion is ha he risk of he ax shields is he same as ha of he ineres paymens generaing hem. Thus we discoun a 8 percen, he expeced rae of reurn demanded by invesors who are holding he firm s deb: 28 PV (ax shield) = = $ In effec he governmen iself assumes 35 percen of he $1,000 deb obligaion of L. Under hese assumpions, he presen value of he ax shield is independen of he reurn on he deb r D. I equals he corporae ax rae T c imes he amoun borrowed D: 7 Always use he marginal corporae ax rae, no he average rae. Average raes were ofen much less han ha because of acceleraed depreciaion and various oher adjusmens. 8 If he income of L does no cover ineres in some fuure year, he ax shield is no necessarily los. L can carry back he loss and receive a ax refund up o he amoun of axes paid in he previous 3 years. If L has a sring of losses, and hus no prior ax paymens ha can be refunded, hen losses can be carried forward and used o shield income in subsequen years. Lecures on Public Finance Par2_Chap4, 2015 version Page 13 of 47

14 Ineres paymen = reurn on deb amoun borrowed = r D D corporae ax rae expeced ineres paymen PV (ax shield) = Tc ( rd D) = = Tc D r D r D Of course, PV (ax shield) is less if he firm does no plan o borrow permanenly, or if i may no be able o use he ax shields in he fuure. Modigliani and Miller (MM) s heorem I amouns o saying ha he value of a pie does no depend on how i is sliced. The pie is he firm s asses, and he slices are he deb and equiy claims. If we hold he pie consan, hen a dollar more of deb means a dollar less of equiy value. Bu here is really a hird slice, he governmen s. Look a Table 4. I shows an expanded balance shee wih preax asse value on he lef and he value of he governmen s ax claim recognized as a liabiliy on he righ. MM would sill say ha he value of he pie in his case preax asse value is no changed by slicing. Bu anyhing he firm can do o reduce he size of he governmen s slice obviously makes sockholders beer off. One hing i can do is borrow money, which reduces is ax bill and, as we saw in Table 4, increases he cash flows o deb and equiy invesors. The afer-ax value of he firm (he sum of is deb and equiy values as shown in a normal marke value balance shee) goes up by PV (ax shield). MM and Taxes We have jus developed a version of MM s heorem I as correced by hem o reflec corporae income axes 9. The new proposiion is Value of firm = value if all - equiy - financed + PV (ax shield) In he special case of permanen deb, Value of firm = value if all - equiy - financed + T c D MM were no ha fanaical abou i. No one would expec he formula o apply a exreme deb raios. Bu ha does no explain why firms no only exis bu hrive wih no deb a all. I is hard o believe ha he managemen is simply missing he boa. Therefore we have argued ourselves ino a corner. There are jus wo ways ou: 1. Perhaps a fuller examinaion of corporae and personal axaion will uncover a ax disadvanage of corporae borrowing, offseing he presen value of he corporae ax 9 MM s original aricle Modigliani F. and M.H. Miller (1958), recognized ineres ax shields bu did no value hem properly. They pu hings righ in heir 1963 aricle Modigliani F. and M.H. Miller (1963). Lecures on Public Finance Par2_Chap4, 2015 version Page 14 of 47

15 shield. 2. Perhaps firms ha borrow incur oher coss bankrupcy coss, for example offseing he presen value of he ax shield. We will now explore hese wo escape roues. Corporae and Personal Taxes When personal axes are inroduce, he firm s objecive is no longer o minimize he corporae ax bill; he firm should ry o minimize he presen value of all axes paid on corporae income. All axes include personal axes paid by bondholders and sockholders. Figure 1 illusraes how corporae and personal axes are affeced by leverage. Depending on he firm s capial srucure, a dollar of operaing income will accrue o invesors eiher as deb ineres or equiy income (dividends or capial gains). Tha is, he dollar can go down eiher branch of Figure 1. Noice ha Figure 1 disinguishes beween T p, he personal ax rae on ineres, and T pe, he effecive personal rae on equiy income. The wo raes are equal if equiy income comes enirely as dividends. Bu T pe can be less han T p if equiy income comes as capial gains. Afer 2004, he op rae on ordinary income, including ineres and dividends, was 35 percen. The rae on realized capial gains was 15 percen 10. However, capial gains axes can be deferred unil shares are sold, so he op effecive capial gains rae can be less han 15 percen. The firm s objecive should be o arrange is capial srucure so as o maximize afer-ax income. You can see from Figure 1 ha corporae borrowing is beer if 1 Tp is more han 1 T ) (1 T ) ; oherwise, i is worse. The relaive ax advanage of deb over equiy is ( pe c 1 Tp Relaive ax advanage of deb = (1 T )(1 T ) pe c This suggess wo special cases. Firs, suppose all equiy income comes as dividends. Then deb and equiy income are axed a he same effecive personal rae. Bu wih T pe = T p, he relaive advanage depends only on he corporae rae: 10 Noe ha we are simplifying by ignoring corporae invesors, for example, banks, ha pay op raes of 35 percen. Of course, banks shield heir ineres income by paying ineres o lenders and deposiors. Lecures on Public Finance Par2_Chap4, 2015 version Page 15 of 47

16 Figure 1 The firm s capial srucure deermines wheher operaing income is paid ou as ineres or equiy income. Ineres is axed only a he personal level. Equiy income is axed a boh he corporae and he personal levels. However, T pe, he personal ax rae on equiy income, can be less han T p, he personal ax rae on ineres income. Operaing income $1.00 Paid ou as ineres Or paid ou as equiy income Corporae ax None T c Income afer corporae ax $1.00 $ 1.00 Tc Personal ax T T 1.00 T ) p pe ( c Income afer all axes 1.00 T ) ( p To bondholder 1.00 T c T = (1.00 T pe pe (1.00 T ) )(1.00 T ) To sockholder c c Relaive advanage = 1 Tp 1 = (1 T )(1 T ) 1 T pe c c In his case, we can forge abou personal axes. The ax advanage of corporae borrowing is exacly as MM calculaed i 11. They do no have o assume away personal axes. Their heory of deb and axes requires only ha deb and equiy be axed a he same rae. This case can happen only if T c' he corporae rae, is less han he personal rae T p and if T pe, he effecive rae on equiy income, is small. Meron Miller s Deb and Taxes How does capial srucure affec firm value invesors have differen ax raes? There is one model ha may help us hink hrough ha quesion. I was pu forward in Deb and 11 Of course, personal axes reduce he dollar amoun of corporae ineres ax shields, bu he appropriae discoun rae for cash flows afer personal ax is also lower. If invesors are willing o lend a a prospecive reurn before personal axes of r D, hen hey mus also be willing o accep a reurn afer personal axes of rd ( 1 Tp ), where T p is he marginal rae of personal ax. Thus we can compue he value afer personal axes of he ax shield on permanen deb: Tc ( rd D) (1 Tp ) PV(axshie ld) = = Tc D. This brings us back o our previous formula for firm rd (1 Tp ) value: Value of firm = value if all-equiy-financed + T c D. Lecures on Public Finance Par2_Chap4, 2015 version Page 16 of 47

17 Taxes Meron Miller s 1976 presidenial address o he American Finance Associaion 12. Miller was considering deb policy before he 1986 Tax Reform Ac. He sared by assuming ha all equiy income comes as unrealized capial gains and nobody pays any ax on equiy income; T pe is zero for all invesors. Bu he rae of ax on ineres depends on he invesor s ax bracke. Tax-exemp insiuions do no pay any ax on ineres; for hem is zero. A he oher exreme, millionaires paid ax a a rae of 50 percen on bond ineres; for hem T p was.50. Mos invesors fell somewhere beween hese wo exremes. Consider a simple world wih hese ax raes. Suppose ha companies are iniially financed enirely by equiy. If financial managers are on heir oes, his canno represen a sable siuaion. Think of i in erms of Figure 1. If every dollar goes down he equiy branch, here are no axes paid a he personal level (remember T = 0 ). Thus he financial manager need consider only corporae axes, which we know creae a srong incenive for corporae borrowing. As companies begin o borrow, some invesors have o be persuaded o hold corporae deb raher han common sock. There should be no problem in persuading ax-exemp invesors o hold deb. They do no pay any personal axes on bonds or socks. Thus, he iniial impac of borrowing is o save corporae axes and o leave personal axes unchanged. Bu as companies borrow more, hey need o persuade axpaying invesors o migrae from socks o bonds. Therefore hey have o offer an incenive in he form of a higher ineres rae on heir bonds. Companies can afford o incenive invesors o migrae as long as he corporae ax saving is greaer han he personal ax loss. Bu here is no way ha companies can give millionaires an incenive o hold heir bonds. The corporae ax saving canno compensae for he exra personal ax ha hose millionaires would need o pay. Thus he migraions sop when he corporae ax saving equals he personal ax loss. This poin occurs when T p, he personal ax rae of he migraing invesor, equals he corporae ax rae T c. Le us pu some numbers on his. The corporae ax rae T c was 46 percen. We coninue o assume ha T pe, he effecive rae of ax on equiy income, is zero for all invesors. In his case, companies will incenivize invesors wih ax raes below 46 percen o hold bonds. Bu here is nohing o be gained (or los) by persuading invesors wih ax raes equal o 46 percen o hold bonds. In he case of hese invesors $1 of operaing income will produce income afer all axes of $.54, regardless of wheher he dollar is ineres or equiy income: pe T p Income Remaining afer All Taxes Income paid ou as ineres 1 T p = 1.46 = $. 54 Income paid ou as equiy income ( 1 T pe )(1 Tc ) = (1 0)(1.46) = $ See Miller (1977). Lecures on Public Finance Par2_Chap4, 2015 version Page 17 of 47

18 In his equilibrium axes deermine he aggregae amoun of corporae deb bu no he amoun issued by any paricular firm. The deb-equiy raio for corporaions as a whole depends on he corporae ax rae and he funds available o individual invesors in he various ax brackes. If he corporae ax rae is increased, migraion sars again, leading o a higher deb-equiy raio for companies as a whole. If personal ax raes are increased, he migraion reverses, leading o a lower deb-equiy raio. If boh personal and corporae ax raes are increased by he same amoun 10 percenage poins, say here is no migraion and no change. Tha could explain why here was no subsanial increase in he deb-equiy raio when he corporae income ax rose drasically a he sar of World War II. Personal ax raes were simulaneously increased by abou he same amoun. The companies in our example ha firs sold bonds o ax-exemp invesors may have gained an advanage. Bu once he low-ax invesors have bough bonds and he migraions have sopped, no single firm can gain an advanage by borrowing more or suffer any penaly by borrowing less. Therefore here is no such hing as an opimal deb-equiy raio for any single firm. The marke is ineresed only in he oal amoun of deb. No single firm can influence ha. One final poin abou Miller s ax equilibrium: Because he assumes equiy reurns escape personal ax ( T = 0 ), invesors are willing o accep lower raes of reurn on low-risk pe common sock han on deb. Consider a safe (zero-bea) sock. The sandard capial asse pricing model would give an expeced reurn of r = r f, he risk-free ineres rae. Bu he invesor migraing from equiy o deb gives up r and earns r 1 T ), he afer-ax ineres f ( p rae. In equilibrium, he migraing invesor is conen wih eiher deb or equiy, so r = r f ( 1 Tp ). Moreover, ha invesor s T p equals he corporae rae T c. Therefore, r = r f 1 T ). If we accep Miller s argumen lock, sock, and barrel, he securiy marke ( c line should pass hrough he afer-ax risk-free ineres rae. The Boom Line on Deb and Taxes Miller s model was inended no as a deailed descripion of he Unied Saes ax sysem bu as a way of illusraing how corporae and personal axes could cancel ou and leave firm value independen of capial srucure. Neverheless, he model s predicions are plausible only if he effecive ax rae on equiy income is subsanially lower han ha on ineres, enough lower o offse he corporae ineres ax shield. Under oday s ax sysem, i s hard o see how Miller s model could work ou as he originally inended. Even if here were no ax advanage o borrowing before he 1986 ax low changes, here ough o be one now. The majoriy of financial managers and economiss believe our ax sysem favors corporae Lecures on Public Finance Par2_Chap4, 2015 version Page 18 of 47

19 borrowing. Bu i s easy o overesimae he advanage. Analyses which calculae he presen value of a safe, perpeual sream of corporae ineres ax shields, mus overesimae deb s ne value added. As Miller s paper shows, he aggregae supplies of corporae deb and equiy should adjus o minimize he sum of corporae and personal axes; a he resuling equilibrium he higher personal ax rae on deb income should parially offse he ax deducibiliy of ineres a he corporae level. We should also reconsider he assumpion ha he corporae ax shield on deb is a consan 35 percen regardless of he amoun borrowed. In pracice few firms can be sure hey will show a axable profi in he fuure. If a firm shows a loss and canno carry he loss back agains pas axes, is ineres ax shield mus be carried forward wih he hope of using i laer. The firm loses he ime value of money while i wais. If is difficulies are deep enough, he wai may be permanen and he ineres ax shield los forever. Noice also ha borrowing is no he only way o shield income agains ax. Firms have acceleraed wrie-offs for plan and equipmen. Invesmen in many inangible asses can be expensed immediaely. So can conribuions o he firm s pension fund. The more ha firms shield income in hese oher ways, he lower he expeced ax shield from borrowing 13. Thus corporae ax shields are worh more o some firms han o ohers. Firms wih pleny of nonineres ax shields and uncerain fuure prospecs should borrow less han consisenly profiable forms wih los of axable profis o shield. Firms wih large accumulaed ax-loss carry-forwards shouldn borrow a all. Why should such a firm incenivize axpaying invesors o hold deb when i can use ineres ax shields? We believe here is a moderae ax advanage o corporae borrowing, a leas for companies ha are reasonably sure hey can use he corporae ax shields. For companies ha do no expec o be able o use he corporae ax shields we believe here is a moderae ax disadvanage. Cos of Financial Disress Financial disress occurs when promises o crediors are broken or honored wih difficuly. Someimes financial disress leads o bankrupcy. Someimes i only means skaing on his ice. As we will see, financial disress is cosly. Invesors know ha levered firms may fall ino financial disress, and hey worry abou i. Tha worry is refleced in he curren marke value of he levered firm s securiies. Thus, he value of he firm can be broken down ino hree 13 For a discussion of he effec of hese oher ax shields on company borrowing, see DeAngelo and Masulis (1980). For some evidence on he average marginal ax rae of Unied Saes firms, see Cordes and Sheffrin (1981). Lecures on Public Finance Par2_Chap4, 2015 version Page 19 of 47

20 pars: Value of firm = Value if all - equiy - financed + PV (ax shield) - PV (coss of financial disress) The coss of financial disress depend on he probabiliy of disress and he magniude of coss encounered if disress occurs. Figure 2 shows how he rade-off beween he ax benefis and he coss of disress deermines opimal capial srucure. PV (ax shield) iniially increases as he firm borrows more. A moderae deb levels he probabiliy of financial disress is rivial, and so PV (cos of financial disress) is small and ax advanages dominae. Bu a some poin he probabiliy of financial disress increases rapidly wih addiional borrowing; he coss of disress begin o ake a subsanial bie ou of firm value. Also, if he firm can be sure of profiing from he corporae ax shield, he ax advanage of deb is likely o dwindle and evenually disappear. The heoreical opimum is reached when he presen value of ax savings due o addiional borrowing is jus offse by increases in he presen value of coss of disress. Coss of financial disress cover several specific iems. Now we idenify hese coss and ry o undersand wha causes hem. Figure 2 The value of he firm is equal o is value if all-equiy-financed plus PV (ax shield) minus PV (coss of financial disress). The manager should choose he deb raio ha maximizes firm value. Marke value PV (ax shield) PV (coss of financial disress) Value if all-equiy financed Opimal deb raio Deb raio Bankrupcy Coss Lecures on Public Finance Par2_Chap4, 2015 version Page 20 of 47

21 You rarely hear anyhing nice said abou corporae bankrupcy. Bu here is some good in almos everyhing. Corporae bankrupcies occur when sockholders exercise heir righ o defaul. Tha righ is valuable; when a firm ges ino rouble, limied liabiliy allows sockholders simply o walk away from i, leaving all is roubles o is crediors. The former crediors become he new sockholders, and he old sockholders are lef wih nohing. Financial Disress wihou Bankrupcy No every firm which ges ino rouble goes bankrup. As long as he firm can scrape up enough cash o pay he ineres on is deb, i may be able o pospone bankrupcy for many years. Evenually he firm may recover, pay off is deb, and escape bankrupcy alogeher. When a firm is in rouble, boh bondholders and sockholders wan i o recover, bu in oher respecs heir ineress may be in conflic. In imes of financial disress he securiy holders are like many poliical paries unied on generaliies bu hreaened by squabbling on any specific issue. Financial disress is cosly when hese conflics of ineres ge in he way of proper operaing, invesmen, and financing decisions. Sockholders are emped o forsake he usual objecive of maximizing he overall marke value of he firm and o pursue narrower self-ineres insead. They are emped o play games a he expense of heir crediors. We will now illusrae how such games can lead o coss of financial disress. Here is he Circular File Company s book balance shee: Circular File Company (Book Values) Ne working capial $20 $50 Bond ousanding Fixed asses Common sock Toal asses $100 $100 Toal liabiliies We will assume here are only one share and one bond ousanding. The sockholder is also he manager. The bondholder is somebody else. Here is is balance shee in marke values a clear case of financial disress, since he face value of Circular s deb ($50) exceeds he firm s oal marke value ($30): Circular File Company (Marke Values) Ne working capial $20 $25 Bond ousanding Fixed asses 10 5 Common sock Toal asses $30 $30 Toal liabiliies If he deb maured oday, Circular s owner would defaul, leaving he firm bankrup. Bu suppose ha he bond acually maures 1 year hence, ha here is enough cash for Circular o limp along for 1 year, and ha he bondholder canno call he quesion and force bankrupcy before hen. The 1-year grace period explains why he Circular share sill has value. Is owner is being Lecures on Public Finance Par2_Chap4, 2015 version Page 21 of 47

22 on a sroke of luck ha will rescue he firm, allowing i o pay off he deb wih somehing lef over. The be is a long sho he owner wins only if firm value increases from $30 o more han $ Bu he owner has a secre weapon: he conrols invesmen and operaing sraegy. Risk Shifing: The Firs Game Suppose ha Circular has $10 cash. The following invesmen opporuniy comes up: Now Inves $10 Possible Payoffs Nex Year $120 (10% probabiliy) $0 (90% probabiliy) This is a wild gamble and probably a lousy projec. Bu you can see why he owner would be emped o ake i anyway. Why no go for broke? Circular will probably go under anyway, and so he owner is essenially being wih he bondholder s money. Bu he owner ges mos of he loo if he projec pays off. Suppose ha he projec s NPV is -- $2 bu ha i is underaken anyway, hus depressing firm value by $2. Circular s new balance shee migh look like his: Circular File Company (Marke Values) Ne working capial $10 $20 Bond ousanding Fixed asses 18 8 Common sock Toal asses $28 $28 Toal liabiliies Firm value falls by $2, bu he owner is $3 ahead because he bond s value has fallen by $5 15. The $10 cash ha used o sand behind he bond has been replaced by a very risky asse worh only $8. Thus a game has been played a he expense of Circular s bondholder. The game illusraes he following general poin: Sockholders of levered firms gain when business risk increases. Financial managers who ac sricly in heir shareholders ineress (and agains he ineress of crediors) will favor risky projecs over safe ones. They may even ake risky projecs wih negaive NPVs. This warped sraegy for capial budgeing clearly is cosly o he firm and o he economy as a whole. Why do we associae he coss wih financial disress? Because he empaion o play is sronges when he odds of defaul are high. Exxon Mobil would never inves in our negaive-npv gamble. Is crediors are no vulnerable o his ype of game. Refusing o Conribue Equiy Capial: The Second Game 14 We are no concerned here wih how o work ou wheher $5 is a fair price for sockholders o pay for he be. 15 We are no calculaing his $5 drop. We are simply using i as a plausible assumpion. Lecures on Public Finance Par2_Chap4, 2015 version Page 22 of 47