Question 1: Different forms of corporation tax: advantages and disadvantages
Among the laws and regulations governing companies in any country in the world is a requirement for the companies to pay tax or taxes. In most cases, the taxes paid are reserved for the central government (Birla Institute of Scientific Research 2003). These taxes paid by companies are called corporation taxes. The Birla Institute of Scientific Research (2003) defines corporation tax as any tax charged on a company or corporation based on its income.
Corporation tax is a form of income tax and takes different forms in different countries depending on the laws of each country. In some cases, the forms of taxes may be almost similar, showing only slight differences. Corporation tax is paid by incorporated businesses, for example, limited liability companies (Smith 2007). A point to note here is that unincorporated businesses are usually subjected to personal income tax just as individuals (Smith 2007). Another salient feature of corporation tax is the tax base. The tax is charged with reference to a company’s accounts, although it is usually accompanied with some adjustments (Smith 2007). Different countries have different procedures based on capital gains and losses, depreciation of assets, changes in value of stocks and so on (Smith 2007). The rates for corporation taxes also vary widely across different countries. For example, in the European Union the general rate of corporate income tax by the year 2007 was in the range of 30-55 per cent except in Ireland where the rates for manufacturing and services traded in the international market was as low as 10 per cent (Smith 2007)..
Corporation tax is classified based on how it relates to personal income tax. The various forms and their advantages and disadvantages are discussed below.
Classical form of tax
Classical tax is a form of double taxation of dividends. It first takes into consideration a company’s profits and then taxes the dividend income that accrues to the company (Shome 1995). Classical tax system allows companies or corporations and their owners to be liable for taxation as separate entities. This therefore implies that a company’s taxed income is paid out to the company’s stockholders, but the stakeholders are in turn taxed again. This form of corporation tax is commonly used in countries such as the United States and in the Netherlands. However, in United Kingdom the classical tax system was replaced by the imputation system in 1973 (Kari and Ylä-Liedenpohja 2002).
The classical form of corporation tax has both merits and demerits. To highlight the advantages, a noticeable feature of the system is that since there is double taxation, there is a high propensity to retain profits (Weldeau & Landau 1993). In addition, classical taxation procedures are simple and the system can be designed so that it becomes neutral with respect to the finance and share decisions of multinational corporations. The broad tax base and flat-rate tax on personal income from a company’s capital as well as low statutory rates of taxation are well advocated for in this system, which supports its simplicity (Kari and Ylä-Liedenpohja 2002).
In spite of the advantages conferred by classical tax system, it has some obvious demerits. It is noteworthy that since there is double taxation, an extra burden results on a company’s income and triggers undesirable deformations in the economic setting (Partington & Chenhall 2005). In addition, the classical tax system limits the tax aid to a tax charge for corporate tax paid, that is, personal tax is imposed based on the wholesome amount a company’s income before tax rather than the real corporate tax amount (Organisation for Economic Co-operation and Development Working Party on Tax Policy Analysis and Tax Statistics 2000).
Imputation form of tax
This a form of corporation tax in which the investors who receive dividends also benefit from the tax credit for corporate taxes that a company has paid (Thorunyi 1996). The tax is levied from a company upon distribution of profits in order to harmonize the charges at stakeholder level in case the distributed profit has not been taxed with the corporation tax.
Among the advantages of imputation system of tax include the fact that individuals in a company receive a tax credit thus they do not feel much pinch of the tax. However, since the imputation tax system allows reduction denials to individuals, a situation is created whereby a company may incur higher expenses in the form of taxes that would have been paid by individuals (Thuronyi 1996). Moreover, the system is no longer compliant with the requirements of international markets and on a wider scale, it is blamed for violating community law (Ault & Arnold 1997).
Split-rate form of tax
Split-rate system of tax involves imposing higher tax rates on retained earnings and lower charges on subsequent earnings that are shared as dividends in a company (Shome 1995). Therefore, if the difference between the distributed profits and retained earnings is quite small, the split-rate system approaches the classical system described above (Shome 1995).
The split-rate form of tax is particularly important to companies involved in the construction industry. For instance, higher taxation on land creates and incentive to develop areas where land values are high, such as those next to central business districts of urban areas. In essence, split-tax rates are usually applied with support information from environmental organizations in order to avoid sprawl conditions in towns (Reed 2004).
While the split-rate tax policy requires that foreign subsidiaries of multinational corporations should have the full benefit of lower tax rates (James 2002) there is no substantial justification for such a requirement. This therefore puts foreign companies in a country at loggerheads with the local companies.
The different forms of taxes are applicable depending on company decisions and the laws governing the companies. The classical form of tax encourages retention of profits by individuals but tend to impose extra burden on the companies involved. Imputation tax relieves the individuals in a company of tax burden, but in the end the burden has to be shouldered by the company and the system is no longer compliant with the current international markets. Finally, split rate form of tax imposes differential charges on different dividends in various situations. Nevertheless, it does not have clear stipulations, which may put local and foreign companies at loggerheads.
Question 2: Impact of increase in the rate of corporation tax upon a corporation’s investment decision
Corporation tax is one on the many factors that affect a company’s management decisions in that it affects the margin of profit enjoyed by the company. It therefore influences a company’s decisions such as whether to plough back profits, invest in expansion or maintain the same size of the firm. Increased rates of corporation tax may result in delayed investment to do avoidance by companies to pay tax. As such, there is a decline investment that ultimately results in slow economic growth in the countries imposing the high corporation tax rates (Sarkar & Goukasian 2006). Very high corporation taxes may also result in early exists of companies that cannot meet the targets (Sarkar & Goukasian 2006). In this context, some companies, even those that could just have managed the taxes exit the market early enough in order to avoid any instances of loss. Alternatively, the firms that remain in the market shy from investing and therefore tend to retain profits at the expense of investment (Beach & Hederman 2008). Ultimately, there is usually a tendency for markets to operate below their optimal potential, and the quality of investment declines (Beach & Hederman 2008). The major impacts of increase in the rate of corporation tax are discussed below.
Shrinkage in investment
A notable effect of high corporation tax is that it holds down a company in its prospects to invest. To begin with, a company subjected to high taxation may not be able to sustain its day-to-day activities such as effective advertising and promotions (Sarkar & Goukasian 2006). In addition, as the impact the high tax rate becomes profound in the long term, the company may have no option but to downsize its workforce so that its expenses are commensurate with what it earns as revenue (Beach & Hederman 2008). While downsizing may be viable option for a company to absorb the effect of high tax, it may mot be a panacea for growth since growth encompasses investment in both expansion and the workforce, coupled with effective research.
As a company grapples with high corporation tax, it ceases its investment prospects and gets less involved in corporate risk taking (Beach & Hederman 2008). This is a compromise to expansion since the growth of business enterprises involves taking of risks in new fields where many uncertainties are projected (Sarkar & Goukasian 2006). The delayed investment may cause a company to eat into its earlier investments in order to support areas that are observed to be adversely affected. For example, a supermarket chain may have to dispose of one of its branches in order to sustain the continuity of a prominent chain. This is not a good idea in the light of investment.
For investors that are involved in selling of taxable assets, high tax rates may arouse a decision not to sell the assets since doing so would attract more tax. However, this not only acts to retard economic growth but also hinders the reallocation of profits (Sarkar & Goukasian 2006). Furthermore, a company’s desire to open more branches in order move closer to the customer is curtailed by the high taxation rate, which increases as the capital base increases.
Distortion effect on dividends
High corporation tax rate implies that a company’s dividends are impacted upon in that the company cannot look into the future with esteem (Sarkar & Goukasian 2006). In such a situation, a company spends most of its dividends on tax. The effect is that a company may not be able to raise start-up capital for other ventures that fall in its plan. As companies have a desire to expand, high corporation tax forces small companies to plough back most of their profits (Nobes 1997). On the other hand, established and fast growing firms may want to achieve fast growth by sourcing finance outside their coffers. If the future becomes more unpredictable, debt due to borrowing is one of the factors that could cause early exist of companies from business (Sarkar & Goukasian 2006). Borrowing leaves a company in a very vulnerable situation should profits tumble (Hockley 1979). On the other hand, companies may try to avoid borrowing by retaining the earnings they make instead of paying them to stockbrokers (Beach & Hederman 2008). In doing so, the influence of stockbrokers is reduced as firms become more concerned with seeking resources independently of the marketplace investors. Such investment decisions are bound to bring doom to a company since stockholders in such companies become wary of the management’ decisions.
Early exist from the market
While the motive of venturing into business is to make profit, a company may find itself weighed down by a high corporation tax rate. As such, managers may have no option but to pull out of business to avoid getting into debt or compromising the standard of their goods and services. Coupled with slow growth and distortion in dividends withdrawal of a firm’s operations may be the only salient decision to salvage a company from getting into unredeemable debt. In a setting such as a multinational corporation, investment decisions are usually biased towards long-term plans (Kiesling 1992). Therefore, a projection that high corporation tax will have adverse consequences on a company only serves to hasten the withdrawal procedure. Ultimately, the managers of the multinational corporation may plan not inject more capital in the firms involved in order to resuscitate them but in a bid to salvage what can be used as starting capital elsewhere.
Even though tax is a source of revenue to governments, increase in corporation tax hinders growth and investment by firms. High taxes instigate firms to shy from investment, which not only curtails their growth but also affects the investment projects already in progress. The ultimate decision by companies riddled by high corporation tax is to pull out of business in order salvage the existing assets and eschew potential debt.
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