Saturday, July 28, 2007

Effects of income tax changes

Changes to the corporate income tax affect all businesses in important and divergent ways. The main tax change that affects Singapore businesses was tax is reduced from 20% to 18%. This change obviously affects businesses positively.

Over the years, there has been a lot of fuzzy and often partisan commentary about who really pays income taxes – businesses or their customers. The argument, of course, has usually hovered around tax increases, not decreases. Those people resisting increases in corporate rates frequently argue that corporations in reality pay none of the taxes levied on them but, instead, act as a sort of economic pipeline, passing all taxes through to customers. According to these advocates, any corporate-tax increase will simply lead to higher prices that, for the corporation, offset the increase. Having taken this position, proponents for the “pipeline” theory must also conclude that a tax decrease for corporations will not help profits but will instead flow through, leading to correspondingly lower prices for consumers.

Conversely, others argue that corporations not only pay the taxes levied on them, but absorb them as well. Consumers, this school says, will be unaffected by changes in corporate rates.
What really happens? When the corporate rate is cut, do companies themselves soak up the benefits, or do these companies pass the benefits along to their customers in the form of lower prices? This is an important question for investors and managers, as well as policymakers.

The more logical conclusion is that in some cases the benefits of lower corporate taxes fall exclusively, or almost exclusively, upon the corporation and its stakeholders, and that in other cases, the benefits are entirely, or almost entirely, passed through to the customers. What determines the outcome is the strength of the corporation’s business franchise and whether the profitability of that franchise is regulated.

For example, when the franchise is strong and after-tax profits are regulated in a relatively precise manner, as is the case with electric utilities, changes in corporate tax rates are largely reflected in prices, not in profits. When taxes are cut, prices will usually be reduced in short order. When taxes are increased, prices will raise, though often not as promptly.

A similar result occurs in a second arena – in the price-competitive industry, whose companies typically operate with very weak business franchises. In such industries, the free market “regulates” after-tax profits in a delayed and irregular, but generally effective, manner. The marketplace, in effect, performs much the same function in dealing with the price-competitive industry as the Commission for Public Utilities does in dealing with electric utilities. In these industries, therefore, tax changes eventually affect prices more than profits.

In the case of unregulated businesses blessed with strong business franchises, however, it is a different story: the corporation and its stakeholders are then the major beneficiaries of tax cut. These companies benefit from a tax cut much as the electric company would if it lacked a regulator to force down prices.

Many of such businesses, like P&G, Coca Cola, Wrigleys, Kelloggs, possess such franchises. Consequently, reductions in their taxes largely end up in the stakeholders pocket rather than the pockets of their customers. While this may be impolitic to state, it is impossible to deny. If you are tempted to believe otherwise, think for a moment of the most able brain surgeon or lawyer. Do you really believe the fees of this expert (the “franchise-holder in his or her specialty) will be reduced now that his top personal income tax rate has been cut?

No comments: