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Updated: 8 Feb 2012

ECON 635:PUBLIC FINANCELecture 12

Topics to be covered:1. Tax Incentives2. Types of Tax Incentives3. Tax Credit4. Tax Neutrality5. International Tax Harmonization6. Tax Treatment of Branches and Subsidiaries by the Home

Country

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Tax Incentives

•Tax incentives are provided by governments in order to encourage additional investments which would not otherwise be coming forth. •The design of incentives requires a good deal of care so that it does not affect the "neutrality" of the tax. •Neutrality is achieved when an incentive does not induce new covered investments with low rates of social yield, while failing to induce covered investments with higher rates of social yield.

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Tax IncentivesIf, before a tax incentive, three projects are ranked according to their social yield as:

• Project A 15% rate of return• Project B 10% rate of return• Project C 8% rate of return

so that project A is preferred to B and B to C. After the tax incentive, projects A, B, and C should have rates of return such that their ranking remains unaltered, that is,

• Project A 18% rate of return• Project B 12% rate of return• Project C 10% rate of return

such a tax incentive is neutral.

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Tax IncentiveIf the ranking of the projects changes after the tax incentive, it is not neutral. For example, if rates of return of the projects A, B, and C become:

• Project A 15% rate of return• Project B 17% rate of return• Project C 8% rate of return

so that project B would be preferred to project A and project A to C, the tax system is not neutral.

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Types of Tax Incentives

1. Tax Credit2. Accelerated Depreciation

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Types of Tax Incentives

Tax credit • Tax credits can be given as an incentive to encourage

investment in a particular sector of the economy. • In order to take the benefit of a tax credit, the individual

or the company must have tax liabilities somewhere else.

• Investments tax credit = s• If the purchase price of an asset A is = K, then the

investment tax credit is sK where s is a fraction equal to or less than one.

• The net investment then becomes K-sK=K(1-s). This would increase the rate of return on the investment I.

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Tax Incentives (Investment Tax Credit)Ex. Two year bond

Before tax credit

Year 0 1 2 Investment 1000 Yield 150 150 Maturity 1000 -1000 150 1150

IRR = 15%

After tax credit Year 0 1 2 Investment 1000 Tax Credit 200 Yield 150 150 Maturity 1000 -800 150 1150

IRR = 29.64%

A credit of 20% is given if investment is undertaken. Credit can be used to reduce taxes by 200

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Tax Incentives

One year bond

Before tax credit Year 0 1 Investment 1000

Yield 120 Maturity 1000

-1000 1120

IRR = 12%

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Tax Incentive

Before tax credit Year 0 1 Investment 1000 Tax Credit 200 Yield 120 Maturity 1000 -800 1120

IRR = 40% In this case, the tax credit has changed the ranking of investments in bonds. While the two year bond was preferred before the tax credit, the ranking changes and the one year bond becomes preferable after the tax incentive.

Give a 20% tax credit or 200 when one year bond is purchased.

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Types of Tax Incentives

Accelerated depreciation • Accelerated depreciation will reduce the

taxable income and hence the tax liability during early years and this would improve the viability and yield of the project.

• Consider an asset which has 5 years of life and whose purchase price is $1,000. Corporate income tax (tc) is 40%.

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Types of Tax Incentives

Ex. Straight Line DepreciationEXAMPLE

Straight Line Depreciation

Year 0 1 2 3 4 True economic depreciation

200 200 200 200 200

Tax savings due to depreciation

200t c 200t c 200t c 200t c 200t c

Savings for a tax rate tc of 40%

80 80 80 80 80

PV of tax savings at 8% discount rate

80 74.07 68.59 63.51 58.80

Total PV 344.97

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Types of Tax IncentivesEx. Accelerated Depreciation

Accelerated Depreciation Year 0 1 2 3 4 Accelerated depreciation

400 400 200 0 0

Tax savings due to depreciation

160 160 80 0 0

PV of tax savings at 8% discount rate

160 148 68.59 0 0

Total PV 376.59 Thus, the present value of tax savings is more with an accelerated depreciation as compared to a straight line depreciation. Obviously, an accelerated depreciation would encourage investment.

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Accelerated depreciation encourages projects with long term investments. Consider a project with investment Io which generates revenues for ten years. The same stream of revenue could be obtained with two investments, each equal to I o /2, one repeated after the other. The first investment takes place in year 0 and the second one in year 5 and each project has a life of 5 years. Figure 1(a) shows the tax liability if the depreciation deduction is calculated by the straight line depreciation method. B and C stand for benefit and cost respectively. When the depreciation deductions are accelerated with all deductions completed within the first five years, the tax liability decreases in the initial years and increases in later years as shown by shaded area in figure 1(b). Now if two projects of shorter duration are implemented sequentially, instead of one project of a longer duration so as to yield the same stream of revenues (taxable income), then the tax liability with the straight line depreciation and accelerated depreciation will be as in figure 2 (a) and figure 2(b). In figure 2(a) the tax liability has been shown as uniform in the straight line depreciation case. When the accelerated depreciation is used, the tax liability changes with less tax payments in the initial years of the investment (figure 2(a)). Now, if the tax liability in figure 1(b) and figure 2(b) are compared, the present value of the tax liability in figure 1(b) would be less, as compared to that of figure 2(b). This brings out clearly how the accelerated depreciation provides an incentive for making long term investments.

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FIGURE 1

Accelerated Depreciation vs. Equal Depreciation

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FIGURE 2

Accelerated Depreciation vs. Equal Depreciation for Two Projects

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Immediate expensing Immediate expensing means a deduction of the full amount of depreciation in the first year of production so as to give maximum benefit in terms of tax reduction. Ex. An investment of $1,000 takes place in year zero and the project gives an annual revenue of $400 for next five years. Then this project is repeated with another investment in year 5 and the benefits continue up to year ten. Now, if depreciation is deducted every year, yearly deduction is $200 and the saving in tax every year is $200tc. In immediate expensing, the $1,000 depreciation is deducted in the year of investment. The savings in tax value due to immediate expensing is 1000tc given by the shaded areas in figure 3, abcd and efgh. If the depreciation expenses were deducted equally over the life of the asset, then the annual tax value saved is $200tc, given by area lmnpqr. Here, the

PV (area abcd) + PV (area efgh) > PV (area lmnpqr) Immediate expensing provides the largest tax savings and, therefore, encourages investment most.

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FIGURE 3 Immediate Expensing

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Tax Neutrality

a) Musgrave neutrality. b) Samuelson neutrality. c) Harberger-Bradford neutrality. d) Auerback-Jorgenson neutrality.

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Profile of investment with constant economic depreciation

Revenue Expense

Investment

Ex.1000 (10%)

D I D+I

1 200 100 300 Then we should consider

2 200 80 280 PVD, PVY and PV(D+I)

3 200 60 260

4 200 40 240

5 200 20 220

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Musgrave neutrality Musgrave neutrality involves: immediate deduction (expensing) of investment from taxable income,

and full taxation of future income streams and no depreciation allowed. In this scheme, immediate expensing provides a neutral tax incentive and does not change the project ranking. With immediate expensing, the project gains t(PVY+PVD) at the very outset. Since there is nothing to depreciate in future, it pays tax on Y+D: t(PVY+PVD) during its life time. The loss to the project entity in taxes is, therefore, = PV(-tY-tD). Therefore, the net gain/loss of the project with this type of incentive is

= PV(tY) + PV(tD) - PV(tY) - PV(tD)

= 0 In case of Musgrave neutrality, if there is a 50% tax rate and all investment is immediately expensed, the government in effect becomes a 50% partner in the venture. It contributes half the amount invested in the corporation by off-setting 50% of taxes which the company would have paid otherwise. From the stream of benefits generated by the project every year, the government takes exactly half of it period by period. If the tax rate is "t", then the government pays a fraction of "t" of the investment cost and also gets back the same fraction of "t" benefit over time.

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Samuelson neutrality (figure 5). In Samuelson neutrality, there is no immediate deduction of the investment, and tax is applied to income net of economic depreciation. The tax impact on the project = PV (-tY) The PV of project after tax = PV( Y-tY) = PVY (1-t) Therefore, in Samuelson neutrality, the PV of income decreases by the same fraction as the tax rate among all projects. As IRR is found out based on income, the IRRs of all the projects decrease by the same fraction and hence the ranking of the projects does not change. If a project has an internal rate of return "r", then the net of tax IRR becomes r(1-t).

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FIGURE 5

Samuelson Neutrality

Revenue Expense

Investment

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Harberger-Bradford neutrality Harberger-Bradford neutrality combines immediate expensing (Musgrave neutrality) with economic depreciation (Samuelson neutrality). A fraction of the investment cost (say ) is immediately expensed and the remaining (1-) part is allowed to be deducted as economic depreciation over the asset's life.

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In this case, the tax impact of immediate expensing of fraction of the investment is,

= -t(PVD + PVY) The negative sign shows that there is a saving. In subsequent years, the tax is

= t[(D+Y) - (1-)D] = t[D+Y]

The present value of taxes in later periods is:

= PV (t[D+Y])

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Net impact on depreciation The effect of allowing fraction as initial deduction is -t(PVD) as tax saving. The effect of the remaining (1-) fraction of deductions on tax payment in later periods is: = PV [tD-(1-)Dt] Therefore, total impact on deductions is: = -t(PVD) + PV [tD-(1-)Dt] = -t PVD + tPVD - tPVD + tPVD = 0 Thus, under the scheme of Harberger-Bradford neutrality, the net effect of tax on depreciation is zero.

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Impact on Y First, the corporation gets tPV(Y) from the government (society), and then in later years pays a tax PV(tY). Therefore the net impact on income Y = - t PV(Y) + PV(tY) = PV (1-)Yt This implies that the impact of tax is lower in Harberger-Bradford neutrality as compared to Samuelson neutrality. This is because in Samuelson neutrality the tax revenue was "tY" while in this case it is (1-)tY. The ranking of projects will not change, if the Harberger-Bradford neutrality is applied.

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Auerback-Jorgenson Neutrality In this case, an initial tax offset is given for the present value of all depreciation and in later years taxes are paid on income as well as on economic depreciation.

Initial tax offset = t (PVD) Later on tax payments on income and depreciation are:

= PV(tY+tD) The net effect is:

= - t (PVD) + PV(tY+tD) = - PV(dt) + PV(tY)+PV(Dt) = + PV (tY)

This is like Samuelson neutrality as the net effect is the reduction in income by the tax rate "t". The other difference is that, in this case, the benefit is taken up front and if the project incurs losses later on, it might be difficult to pay taxes on what is essentially depreciation.

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International Tax Harmonization• Some companies, called multinationals, carry out business in more than one

country.• The place where the company has its headquarters, is called the “home

country”, while other countries where it conducts business are called “host countries”.

• The subsidiary is incorporated in the host country and has an independent legal existence.

• The subsidiary is usually wholly owned by the parent company and pays dividends to its shareholders in the home country.

• A branch, on the other hand, is un-incorporated and is more like a field office of the parent company.

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International Tax Harmonization• For the purpose of the income tax, the difference between a

subsidiary and a branch is that in the case of a subsidiary, the host country can tax profits as well as the dividends distributed to the shareholder by imposing a withholding tax on dividends, while in the case of a branch, the host country can only tax the profits.

• In order to capture the same amount of revenue from the two alternatives, the rate of tax has to be higher for a branch than for a subsidiary.

• The taxable income of a subsidiary or a branch is again: sales-cost of goods sold-depreciation-interest payments-overheads.

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1. Cost of goods sold: Issue of Transfer Pricing

• An increase in the cost of goods sold will affect the taxable income recorded in the host country.

• The host country should make sure that the prices used by the company to calculate the cost of goods sold are not inflated.

• The subsidiary may be purchasing inputs and raw materials from the parent company at prices that do not reflect the market prices.

• The internal fixation of prices between the parent company and the subsidiary is termed “transfer pricing”

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2. Overheads

• The subsidiary may be utilizing the services of consultants from the parent company and may be paying very high fees.

• The subsidiary may be receiving product samples from the parent company at very high prices.

• It may also be paying unusually high management fees to the parent company, thereby inflating the overhead expenses and reducing the tax liability.

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3. Interest Payments

• The subsidiary can borrow funds from the parent company or from a company owned by the parent company at a very high interest rate and thus increase the interest deductions.

• This again erodes the tax base.• A provision to tax the interest payments before they are repatriated

to the home country would discourage this tendency.

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Alternative Tax Treatments of Branches and Subsidiaries by the Home country

a. Exemption of foreign source incomeb. No consideration of taxes paid in the foreign countryc. Foreign tax creditd. Deduction of foreign taxes paide. Tax holidayf. Tax holiday with tax sparing

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a. Exemption of foreign source incomeTax is levied by the home country on the basis of source of income. Only income that is generated in the home is taxed. If the income comes from a foreign source, it is exempted.

Ex. Suppose the income of a subsidiary or a branch is $1000. The home country tax rate is 40% and the host country tax rate is 35%.The tax liability will be $350 in the host country, and $0 in the home country, leaving a total of $650 in profits.

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b. No consideration of taxes paid in the foreign country

• The home country does not give any consideration to taxes paid in the host country.

• The company has to pay taxes in both the countries.

Ex. Consider the example given in part a.The tax liability would be $350 in the host country. As the taxes paid in the host country are not considered at all, the home country will impose a tax of $400, leaving a net profit of $250.(1000-350-400=250)

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c. Foreign tax credit

• The home country gives a tax credit to the parent company for the taxes paid in the host country.

Ex.in part a. The tax liability would be $350 in the host country and $400 in the

home country. With the tax credit, the company must pay only the difference (400-350=50). The total tax liability is $400, leaving a net profit of $600 to the company. Effectively, the tax liability is the same as in the home country.

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d. Deductions of foreign taxes paid

Taxes paid in the foreign country are deducted from the tax base before calculations of tax liability in the home country.

Ex. The tax liability in the host country would be $350. The taxable income in the home country would be ($1000-$350=$650). Thus tax liability in the home country would be $260. Total tax liability is therefore $650, leaving a net profit of $390.(1000-350-(1000-350)*0.4=390)

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e. Tax holiday under a Foreign Tax Credit System

If the host country gives a tax holiday to the branch or subsidiary, the tax is levied only in the home country. The tax liability in the host country would be $0. In the home country, the tax liability would be $400, leaving a net of tax profit of $600. The company does not get any benefit from tax holiday in the host country.

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f. Tax holiday with tax sparingThere is an agreement between the two countries by which the host country gives a tax holiday while the government of the home country gives a tax credit to the company as if taxes were paid in the host country. This would give an incentive to the parent company to do business in the host country because the tax liability of the company is reduced drastically.

Ex. The tax liability in the host country would be $0. In the home country, tax liability would be $400. The company gets a tax credit as if it paid a tax of $350 in the host country. Its net tax liability is $50, leaving a net profit of $950 to the company.