DividendTxnLecture

DividendTxnLecture - Corporate and Dividend Taxation The...

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1 Corporate and Dividend Taxation The Corporate Income Tax and Distortions due to “Double Taxation”: Organizational form Capital structure (debt v. equity) Payout decisions (retention v. dividends) Corporate Tax Integration Impact of the Corporate and Dividend Taxes on Firms’ Investment Decisions “Old” View “New” (or “Trapped Equity”) View
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2 Corporate Income Tax Imposed on corporations, but not other types of business organizations such as: Partnerships Sole proprietorships “S” corporations Thus, dividends paid out by corporations to their shareholders are subject to 2 levels of taxation: corporate and personal
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3 Corporate Income Tax Suppose the corporate tax rate t C = 35% and the dividend tax rate t D = 15% Then, for each $1 earned by the firm, the shareholder receives: (1 – 0.35)
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4 Corporate Income Tax Suppose the corporate tax rate t C = 35% and the dividend tax rate t D = 15% Then, for each $1 earned by the firm, the shareholder receives: (1 – 0.35)(1 – 0.15) = 0.55
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5 Corporate Income Tax In contrast, partnership income is “passed through” to the individual partners Suppose your personal tax rate t P = 25% Then, you are taxed once and receive: (1 – 0.25) = 0.75 for each $1 earned by the partnership
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6 Distortions due to Double Taxation Organizational form Capital structure: Payout policy
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7 Distortions due to Double Taxation Organizational form Noncorporate forms are tax-favored Capital structure: Debt is tax-favored because interest payments are deductible Payout policy Retention of earnings is tax-favored because of the extra tax on dividends (relative to capital gains)
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8 Capital Structure Suppose a corporation earns $1 If this is a return on debt-financed investment, the interest paid is tax- deductible to the firm It pays interest of $1 to the lender The lender ends up with: (1 - t P ) Before 2003, t P = t D = 38.6% (top bracket)
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9 Capital Structure Suppose a corporation earns $1 If this is a return on equity-financed investment, the firm pays corporate tax, leaving it with (1 - t C ) It pays a dividend of $(1 - t C ) to the shareholder The shareholder ends up with: (1 - t C )(1 - t D ) = (1 – 0.35)(1 – 0.386) = 0.4 (v. 0.614 from debt)
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10 Capital Structure Puzzle Why don’t firms use more debt? Bankruptcy costs? Agency costs of debt? Higher personal taxes on interest income?
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11 Dividend Policy Suppose a corporation earns $1 (from equity-financed investment) It pays the corporate tax, leaving (1 - t C ) It pays a dividend (1 - t C ) to the shareholder The shareholder ends up with: (1 - t C )(1 - t P ) Before 2003, t P = 38.6%, but the tax rate on capital gains t G = 20%
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12 Dividend Policy Suppose a corporation earns $1 (from equity-financed investment) It pays the corporate tax, leaving (1 - t C ) It retains (1 - t C ) The shareholder ends up with: (1 - t C )(1 - t G ) = (1 – 0.35)(1 – 0.2) = 0.52 (v. 0.4 from receiving a dividend)
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Dividend Puzzle Why do firms pay dividends?
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This note was uploaded on 05/09/2008 for the course ECON 253 taught by Professor Damika during the Spring '08 term at UConn.

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DividendTxnLecture - Corporate and Dividend Taxation The...

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