Problem 1-1

a. Calculate the tax disadvantage to organizing a U.S. business today as a corporation, as compared to a partnership, under the following conditions. Assume that all earnings will be paid out as cash dividends. Operating income (operating profit before taxes) will be $500,000 per year under either organizational form. The tax rate on corporate profits is 35% (T=0.35), the average personal tax rate for the partners is also 35% (T=0.35), and the capital gains tax rate on dividend income is 15% (T=0.15).
If the firm is organized as a partnership, operating income will be taxed once $500,000 x (1-0.35) = $325, 000. Operating income will be taxed once at the corporate level, leaving $500,000 x (1-0.35) = $325,000 available for distribution to investors. This yields net disposable income of $325,000 x (1-0.15) = $276.250. Partners pay a total tax rate of 35% on business income, while corporate shareholders pay a combined tax rate of 44.75% (1-(1-0.35)(1-0.15)) on this income, the corporate tax wedge is the difference between these two rates, or 9.75 percentage points
(44.75% - 35%).

b. Now recalculate the tax disadvantage using the same income but with the maximum tax rates that existed before 2003. (These rates were 35% (T=0.35) on corporate profits and 38.6% (T=0.386) on personal investment income).
If the firm is organized as a partnership, operating income will be taxed only once, so investors will receive $500,000 x (1-0.386) = $307,000. Income will be taxed once at the corporate level and again at the personal level, so investors will receive only $500,000 x (1 – 0.35)(1 – 0.386) = $199,550. Total tax rate of 38.6% on business income, while corporate shareholders pay a combined tax rate of 60.09% (1 –(1 – 0.35)(1 – 0.386)) on this income, the corporate tax wedge is the difference between these two rates, or 21.49 percentage points