Posted by Fred Lake

Taxes and Subsidies: How Do They Work?

Taxes and Subsidies: How Do They Work?

Tax subsidies are the end result of selective tax legislation that is advantageous particularly to groups of people or industries in the economy. By decreasing the costs associated with taxation, tax subsidies are able to increase expected returns. There are four main ways to accomplish this, by providing tax credits, changing the statutory tax rate, taxable basis, and taxable entity. We will further discuss the additional variants involve in each of these methods of subsidizing private activity via the tax code. 

Tax Credits

The net taxes owed may be deduction with a portion of certain expenditures. 

Changing the Tax Rate

A financial advantage can be conveyed to the firm with the lower tax rate by allowing one type of entity to pay a lower tax than others. To accomplish this end, three approaches are used. 

  • Activities Exempt from Taxation. Taxes may not be given to certain activities or products such as the alcohol fuel partial exemption from motor fuels taxes, changed with a tax credit at the federal level, but in a number of states still existent, or tax-exempt on certain types of bonds interest’, although similar or substitute activities or products are taxed fully.
  • Entities Exempt from Taxation. Taxation may not be given to the entire entities including some publicly-owned utilities although they may compete with other providers of the same taxed product or service.
  • Lower Tax Rate. A lower percentage tax is being paid by a particular type of firm or activity including capital gains taxes.

Changing the Taxable Basis

The actual percentage tax rate may remain constant, however, the intervention of the government may redefine which activities must be included in the taxable basis in order for the resultant net profit figure to be reduced to which that percentage tax is applied. Taxpayers are encouraged by these policies to shift spending to the activities that will help them reduce their tax bill that’s already final. When the timing or the size of tax deductions are altered, the government makes incentives to engage in certain behaviour. An example of this type of provision is the current deduction for intangible drilling costs associated with oil, gas, and mineral exploration.

  • Timing. A company may be allowed to deduct investment or construction costs by policies at a rate that’s faster than the rate at which the assets are actually consumed. This intervention goes against accounting methods of capital recovery tradition. A subsidy is being conveyed when current deductions are allowed by reducing current taxes instead of future taxes. A dollar is worth more than a dollar in the future since it can be invested today and earn interest.
  • Amount. When certain portions of income are excluded from taxation, benefit methods that produce that type of income is being conveyed. The tax-free dividend re-investment allowance for certain electric utilities is an example of this. In some cases, the deduction of items that were not actually incurred as a cost may be allowed by the government. An example of this phenomenon is the percentage depletion deductions which are based on the gross value of ore mined instead of the investment to mine it.

Changing the Taxable Entity

The government may facilitate the offset of taxable income in one area with losses from another area by allowing taxpayers to consolidate their tax returns in ways generally restricted by the IRS. In some instances, consolidation may be used by taxpayers to earn more in reduced taxes than they had actually put into the enterprise that is losing money. Tax subsidies rises more when the taxable entity is redefined in at least two ways.

  • General Rules of Taxation Exceptions. A tax subsidy ensues when Congress makes exceptions to these general guidelines of consolidation. An example of such a variance is the oil and gas exemption from the passive loss rules. 
  • Shifting Profits within Entities in a Corporation that’s Vertically-Integrated. Corporations may shift “profits” among divisions through the use of transfer prices when the taxable entity is difficult to define and transactions between divisions are not “arms-length” transactions. This is to reduce the total tax burden. The truth is, it’s difficult to measure this category of tax subsidies. Some historical data, however, suggests that profit “management” and off-shore shipping subsidiary arrangements in the oil industry were utilized in the conjunction with the provisions of the Foreign Tax Credit to practically remove taxes in that industry for a long period of time. The driving force behind revisions to rules government income earned in foreign subsidiaries are these concerns and behind the concerns that occur all the time on the adequacy of taxes paid by corporations owned by foreign individuals operating within the United States.
Fred Lake
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