Chapter 4: Neutral Income Tax Systems

Question 1

Decision Neutrality

Answer 1

Systematic absence of tax effects
Neutrality Conditions:

NPV(without tax)=0 —> NPV (with tax)= 0

NPV(without tax)>0 —> NPV (with tax)=>0

NPV(without tax cond.1)>NPV(without tax cond.2)—>NPV(with tax cond.1)>NPV(with tax cond.2)

Question 2

Why is absence of tax effects desirable?

Answer 2

*The idea of tax neutral systems:
decisions of investments and financing are not affected by tax.
*Macroeconomic perspective:
The efficient allocation of resources (capital, manpower..) is not distorted by taxation. No excess burden.
*Individual investor’s perspective:
there are no tax planning costs

Question 3

Special cases of “decision neutrality”

Answer 3

1. Neutrality of organisational form (partnership vs. corporation)
2. Investment neutrality (X or Y)
3. Financing neutrality (debt vs. equity)
4. Consumption neutrality (today vs. tomorrow)

Question 4

Why countries do not have neutral tax system?

Answer 4

1. Accrual accounting. Difference between profits and CF’s .
2. Tax liability on income level for corporation and owner.
3. Tax-empt income elements
4. Reduce tax rates on certain income elements.
   …

Question 5

How could we guarantee decision neutrality on taxation?

Answer 5

*Lump-sum tax (pool tax)- everyone is taxed the same.
NOT socially and politically desirable and realisable.
Trade-off between simplicity and fairness.

*By levying tax proportional to investor’s target figures.
Guarantees that before-tax order of investment projects accordingly to the profitability (unchanged by taxation)
In finance–> NPV as the target figure.

Question 6

“Cash Flow tax”

Answer 6

Taxing CFs with full loss-offset.
No accruals, CFs are taxed immediately.
No depreciation!!!
<How we did in chapter 3 with partnerships>
Neutrality fulfilled.

Question 7

Reasons against “Cash Flow” tax

Answer 7

1.Immediate full loss offset required.
–> Government has to give full refunds (not capped)
2. Unusual design for accounting system.
3. Refunds cause very volatile tax revenues for the government
–>hard to plan
4. Very pro-cyclical tax revenues
–>When in recession government has to pay a lot of refunds.

Question 8

“ACE tax”

Answer 8

“Adjusted Corporate Equity” tax

Interest-adjusted tax system that taxes EVA not profits.
Transformation of “cash flow tax”, so it is consumption based tax system.
Suited for accounting systems.

!! Accounting rules do not affect NPV

Question 9

Reasons against “ACE” tax

<Croatia>
</Croatia>

Answer 9

1. Finding the right interest rate
   –>government bond+premium, but is this realistic?
2. International complication
   –>compatibility between countries
3. To make up for revenue losses we need high tax rates.