Corporate Tax Theories For Literature Review

Classical Theory of Taxation

Discuss about the Corporate Tax Theories for Literature Review.

Taxes are involuntary charges levied on individuals or institutions, enforced by government entities for the purposes of generating revenues to finance government activities. Most government entities have set revenue authorities that ensure tax compliance by individuals and companies. Legal dictionary (2013), state that “levies charged to corporates and individuals are as an exchange of government protection to tax payer’s life and property.” This paper reviews pieces of literature and empirical studies studied on corporate tax with attempts of understanding corporate taxes. The reviews of literature cover the classical, dual and fiscal transparency systems of taxation.

Under the classical theory of taxation, corporates are termed as separate legal entities from its owners. This definition demystifies the corporates requirement for double taxation from the corporate entity and its owners. According to Harberger (1962), “the classical system propagates corporates discernment as it confines business concepts and shareholders financing from the corporate systems to incorporate systems resulting to a negative effect on a country’s economy.” King (1974, 1977) in his literature he demonstrated the old properties of the classical tax system as “a tax that restricts dividends, accrued debt interest expenses and capital gains as deductions”. The classical system translates the revenues from corporates and debt and equity gains as avenues of tax. As for multinationals, the foreign corporates do not accumulate corporate tax where foreign income is credited or the company receives a tax exempt by the domestic country. Empirical studies have shown negative effects of the classical system of taxation. Gravelle (1991), stated the effects of classical taxation being “significant macroeconomic resulting to lower Gross National Product.” There have been a number of trials identified from the classical systems of taxation i.e. biases to profit retention, debt preferences to equity and low investments related to double taxation.

The primary variables used in research and practice to representing the financial performance construct are the accounting measures. These measures rely on financial information reported in income statements, balance sheets, and statements of cash flows. Accounting measures can be further subcategorized into profitability measures, growth measures, leverage, liquidity, and cash flow measures, and efficiency measures. Normally for commercial and manufacturing entities profitability measures include values and ratios that incorporate net income or a component of net income such as operating income or earnings before taxes are used. To illustrate the classical system of taxation, assume a corporate that has a profit before dividends payout and tax of $500, in a state that levies 30% tax on corporate institutions and the remaining earnings are recited as the shareholders’ earnings taxable at 16%. The company’s net profits after tax before dividends payout will result to $350. This will translate to the shareholders’ earnings account accruing an income tax of $63. The effective rate of tax is 43%. This means that the company is subjected to 27% over taxation. Illustration: Classical System of Taxation;

Income Statement Save Time On Research and Writing Hire a Pro to Write You a 100% Plagiarism-Free Paper. Get My Paper	Classical System	Imputed System	Dividend Exempt System
Profit Before Dividends & Tax	500	500	500
Corporate Tax- 30%	150	150	150
Profit Before Dividends After Tax	350	350	350
Dividend Income	350	350	350
Income Tax Rate – 16% Before Imputation	63	63	63
Imputed Tax – (2/5)*Dividend Income		140
Dividend Exempt (20%)			70
Dividend Income – (Dividend Income + Imputed Tax)		203	133
Income Tax Rate		32	21
Net Income Tax	63	31	42
Total Taxable pay	213	181	192
Effective Tax Rate	43%	36%	38%
Over Taxation	27%	20%	22%

Dual System Of Taxation

The effects of double taxation necessitated the invention and adoption of imputation system. The system was to eliminate the distortions accounted by double taxation from the classical system by refunding corporate levies through credit validations on dividend payments. This was done through from tax reforms Acts.  Literature reviews on effects of the adoption of dividend imputation – tax reforms showed positive impacts on the economy. According to Belamy (1994), “there was a positive correlation between tax credits and growth in shareholders dividends.” Empirical results shared by Heming (1994) showed statistically “dividend imputation resulted to higher payout ratios.” A comparative study done to distinguish between the effects of classical system and imputation system adopted in the United States of America and Australia carried out by Bhavish J, Mark S, and Roberts B (2013), concluded that “minimizing double taxation can be done through dividend imputation”. The difference cited in the European journal of finance – Buckle (1995) between the classical and imputation system was the cost of capital, the journal stated: “cost of capital under the classical tax system is gross of personal taxes whereas the cost of capital under the imputation system is net of personal taxes.” An imputation system is achieved by requiring the shareholders to gross up the net dividends with attributable tax. Using the above illustration, the dividend income is grossed up to $203 with an assumption of 40% dividend imputation. This translates to a net income tax of $31 and a total taxable pay of $181 as opposed to $213. The effective rate of taxation is hence 36% leading to an over taxation of 20%.

The other invention was the dividend exemption method, where the dividend income is fully or partially tax exempted. According to Vann (1986), “the dividend exempt method facilitates shareholders in preventing double taxation.” Using the same illustration as an example, assuming the dividend exemption was 20% then the taxable pay will be equal to $192 translating to an effective tax rate of 38% hence an over taxation of 22%. Split rate system and dividend deduction methods were also used similarly to the dividend exemption method.

Peter B (2010), defined a dual system of taxation “as a system that separates taxation of labor income from capital income.” Dual income combines labor and transfers income tax with mild capital income tax. The mild capital income tax is a flat tax rate aligned capital income.  The genesis of the dual corporate tax was to provide tax relief to small pressed legal entities with an added advantage of collecting taxes even from loss-making companies. The capital income entails proceeds received from assets, financial instruments, rent, and capital gains, accrued interests on savings whereas the non-capital income includes proceeds from pension and transfers from the government. According to Richard (2010), “dual income tax seeks to levy wages and labor income attributable to businesses at a progressive tax rate and capital income at a determined flat rate”. Noor (2014) stated that “the impact of the dual system on corporates is profits distribution to shareholders to retained earnings”. Nielsen and Sorensen (1997), argued that “dual system equalizes tax treatment for human and non-human intensive investments. Assume a potential tax payer has an income of $100 and initiates an investment program as a consultant which earns him $210 implying a tax rate of 30% on the income will still yield a return of capital of 10%. This means that income tax does not reduce the return on human capital investments and offers a fair tax treatment. Under the dual system, criticism has been raised that it usually a contrast to taxation principle “ability of pay” as labor is taxed heavily. In some countries like Germany, taxation is seen as a factor of human capital mobility as their citizen attempt to escape from tax burdens. Using Germany as an example, the taxable earnings income is taxed in a linear progressive rate given by a tax schedule whereas the other income is taxed at fixed rate of 25%. Debt income is usually taxed under the capital income. Dual taxation distinguishes income into 3 types; income from employment, business activities and capital investments. Dual taxation system has been embraced in Nordic countries. According to Oliver (1977), “the system has brought about improvement in compliance in dividends withholding and payment of interest.” The research from the countries has revealed equity within countries is a fruit of dual taxation.

Fiscal Transparency System

The complexity in tax systems has led to companies being able to set up easily multifarious networks of companies that are tax harbors and avoid by channeling the taxes into profits. The complex networks created prohibits the tax assessors in determining the number of tax requirements and also the paid taxes. With this reasons in mind inventions of fiscal transparency system, erupted as the government attempted to have corporates deduce statements of corporate taxes paid in a way of tax amateurs would understand.  Under this system, companies are treated as intermediaries of shareholders in income collection. A taxation system comparable to that of a partnership is used where the shareholders are granted profits. The system disintegrates the notion of companies bear legal and separate entity from its owners. According to Amilcare (1903), the tax transparency is a mitigant of “fiscal illusion”.  James (1960), termed “fiscal illusion “a logical misconception of government expenditure and revenue policy”.

Understanding of fiscal transparency, terminologies like fiscal expenditure, accountability should be understood. According to international accepted principles, fiscal accountability is defined as a state being responsible for its public funds to the public. Campos (1996), “fiscal accountability consists of three main agendas i.e. overall control, financial discipline in compliance with the budgetary process, strategic resource allocations with a prioritized approach and cost effective and efficient programs.” Fiscal transparency requires dependable government’s fiscal policy and forecasts, detailed information on its operations and budgets and behavioral aspects of the mandated officials of the state. Shende and Benet (2004), stated the “IMF transparency principles as; government structures and responsibilities clarity, comprehensive information on state financials, budgets disclosures and audit scrutiny.” For example, the U.S treasury normally publicizes its estimated tax expenditure, other examples are GAO who publish their expenditures in public domain. In Germany, we see subsidies report that entails the government’s tax provisions and estimates. 

Efforts have been seen primarily by governments in fostering transparency in government budgets. For example, governments have created websites that show state spending. Other measures that have been used is the application of learning tools for budgetary process. Countries like San Francisco allow citizens to participate in the budgetary processes by enabling a forum where citizens give ideas through proposals of government spending. The government enjoys fiscal transparency by understanding the country’s tax burdens, fees and costs related to licenses. Strategies embraced in the uplifting transparency of the revenues is having one level government using the revenue instruments, limiting the number of channels used in each government, increasing property taxes as opposed to sales taxes, increasing citizen education and adopting a taxpayers receipt. According to Collier and Venables (2010), “involving the public in fiscal capacity leads to fiscal transparency.”            Besley and Persson (2009), showed that “legal and fiscal capacity contributes to countries wealth.” This means that lack of fiscal transparency results in a low generation of investments and hence low revenues related to tax. The transparency in government fiscal results to low levels of corruption as state fellows are conscious of their jobs. In both low and high-income countries, taxes incentives are seen to foster tax revenue collection. Stanely (1985) stated that “To understand the tax expenditure of a country, then tax incentives must be analyzed.” The revenues obtained from tax are functions of tax expenditure.

Conclusion

Building Blocks that have been used to foster the transparency and accountability is tax structures, tax expenditure projections, integration of projections of tax in the budgetary process and auditing tax expenditure. The primary goal of any government is the provision of the essential goods and services to the citizens. Corporations have however encountered eminent doubts on their reliability, integrity or obligation to public affairs perpetuated by poor corporate governance.  The neglect of use of accounting information has also been an ongoing concern with deficiencies noted in budgeting and budgetary control systems.  Efficient management control system has then been recommended with state corporations adopting the budgeting processes. The adoption of the budgeting process has been sighted as a key instrument in increasing the financial stands within organizations.  Reviews of literature on the salient issues about the budgeting process and performance measurements and the performance in the firms; studied from theories and past empirical studies perspective has shown the significance of budgets and the positive effects on improving performance in institutions. Tax experts have therefore a big role to play in ensuring the fiscal policy is aligned to transparency and accountability principles. In addition, the tax experts should recognize tax expenditures and comprehend the building blocks of ensuring a fiscal policy that propagates transparency and accountability.

Conclusion

The classical theory of taxation is reviewed as the ancient model of taxation where the classical system that propagates discrimination against corporates. Empirical studies have shown negative effects of the classical system of taxation related to double taxation as it harbors capital investments. Inventions to counter classical taxation have erupted dividend imputation and exemptions. Under the dual taxation, labor income and capital income are separated in the taxation model where capital income is levied at a flat rate and labor income is levied at a progressive rate. The fiscal transparency dictates any government economic flourishment. Tax structures, tax expenditure projections, integration of projections of tax in the budgetary process and auditing tax expenditure have been sighted as building blocks of taxation.

References

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Besley, T., and Persson, T. (2009). The origins of state capacity: Property rights, taxation and politics. American Economic Review 99: 1218-1244.

Bhavish J., Mark S, and Roberts B (2013), Dividend Taxation and Corporate Investment, RMIT University, School of Economics and Finance, Melbourne 3000, Australia, 19-20.

Buckley A, (1995), The classical tax system, imputation tax and capital budgeting.

The European Journal of Finance Volume 1, 1995 – Issue 2  Collier, P., and Venables, A. J. (2010). Natural resources and state fragility. European University Institute, RSCAS Working Paper 2010/36, Florence, Italy.

Gravelle, G. (1991). Corporate tax integration: Issues and options, Congressional Research Services report for congress: Washington D.C.

Harberger, A.C. (1962), The Incidence of the Corporation Income Tax, Journal of Political Economy 70, 215-240.

Heming, T. (1994). The effect of dividend imputation on the payout ratios of Australian companies. Australian Tax Forum 11, 203-227.

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Noor (2014), Taxation II, Open University Malaysia, OUM Business School, 46-49,

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