THE IMPORTANCE OF A CONTRACTUAL PERSPECTIVE
Morality issues aside, let us now return to the first of the three key themes that
run throughout the book, namely, that to organize production to maximize after-tax
return requires that the tax positions of all parties to the contract be considered, both
at the time of contracting and in the future. To avoid operating at a competitive
disadvantage, managers must understand how changes in tax rules influence the
behavior of their customers, their employees, their suppliers, and their competitors.
Among other things, this observation exposes the naiveté of distinguishing between
business tax planning and personal tax planning, or of tax planning for one type of
business in isolation from tax planning for all other types of business. For example, as
we will see in later chapters, it is costly to prescribe an effective compensation policy
for a firm without simultaneously conducting some personal tax-planning analysis for
each of its employees. Similarly, it is costly to prescribe an effective capital structure
policy for a firm (that is, determining whether operations should be financed with debt,
preferred stock, common stock, or other financial instruments) without simultaneously
considering how the returns to prospective lenders and shareholders of the firm will
be taxed.
To be more concrete, consider the decision of whether business equipment
should be bought or leased. In the United States, as in most countries around the
world, the government encourages capital investment by permitting rapid depreciation
on buildings, equipment, and machinery. That is, the business can deduct the cost of
the investment from its taxable income using a schedule in which the write-off rate for
tax purposes exceeds the rate of economic depreciation of the investment.
Alternatively, if a business entity rented plant and equipment over its economic life, the
rental payments could be deducted only as they were made. The present value of
rental deductions is often far less than the present value of depreciation deductions.
We cannot conclude, however, that owning assets minimizes the taxes of all firms
using machinery and equipment in their businesses. Once we analyze the tax
positions of both low-tax-bracket and high-tax-bracket taxpayers, we might find low-
tax-bracket taxpayers are better off passing up tax savings and renting. The reason is
that low-tax-bracket and high-tax-bracket businesses will find it desirable to enter into
a contract that arranges property rights so that the low-tax-bracket businesses
effectively sell their tax benefits to high-tax-bracket businesses. This is accomplished
by reducing the rental rate to the low-tax bracket taxpayer in exchange for the right to
take rapid depreciation, for tax purposes, on the equipment.
Why do Tax Rules Influence Before-Tax Rates of Return and Investment
Decisions?
Tax rules affect the before-tax rates of return on assets. By before-tax rate of
return, we mean the rate of return earned from investing in an asset before any taxes
are paid to domestic and foreign federal, state, and local taxing authorities. To illustrate
our point, let r = R (1 – t) where R is the before-tax rate of return, t is the tax rate, and
r is the after-tax rate of return. A superficial analysis of this relation suggests that if we
increase the tax rate, that is, increase t, then the after-tax rate is lowered (and vice
versa). However, this analysis ignores the possibility that the tax rules affect the
before-tax rate of return. If we expand the analysis to include multiple taxpayers facing
different tax rates and multiple assets with their returns being taxed differently, then
this simple result is no longer valid. Consider two bonds, a tax-exempt municipal bond
where the interest on the bond is tax exempt at the federal level and a fully taxable
corporate bond where the interest is fully taxed at the federal level. Further assume
there are taxpayers facing a low tax rate and others facing a high tax rate. Taxpayers
facing a high tax rate are expected to bid up the price of the tax-exempt municipal
bond because this bond or cash flow stream is tax favored to them. Bidding up the
price for a given promised cash flow stream will lower the before-tax rate of return, R.
Thus, the tax rules affect before-tax rates of return. This simple example explains why
some taxpayers select investments with high before-tax rates of return whereas others
select assets with low before-tax rates of return even when both types of investments
are available to all taxpayers. On the assets side of the economic balance sheet, we
emphasize that before-tax rates of return differ because (1) the returns on different
types of assets are taxed differently, (2) the returns on similar assets are taxed
differently if they are located in different tax jurisdictions, (3) the returns on similar
assets located in the same tax jurisdiction are taxed differently if they are held through
different legal organizational forms (such as a corporation versus a sole
proprietorship), and (4) the returns on similar assets located in the same tax
jurisdiction and held through the same legal organizational form are taxed differently
depending on such factors as the operating history of the organization, the returns to
other assets held by the organization, and the particular characteristics of the
individual owners of the organization. Tax rules also influence the financing decisions
of firms through their effect on the cost of financing the firms’ activities. A firm is said
to make a “capital structure decision” when it decides how it will finance its activities.
The capital structure of a firm is composed of various types of ownership claims, some
called debt and others called equity. We emphasize that the cost of issuing a capital
structure instrument depends on the tax treatment it is accorded, which, in turn,
depends on whether the instrument (1) is debt, equity, or a hybrid; (2) is issued to an
employee, a customer, a related party, a bank, or a number of other special classes of
suppliers of capital; and (3) is issued by a corporation, partnership, or some other legal
organizational form. It also depends on the tax jurisdiction in which the capital structure
instrument is issued.
