(d) Now assume tax is the only market imperfection, suppose the average personal tax rate on equity income (such as dividend and capital gain) is 20% and personal tax rate on interest income is 30%. How high must the marginal corporate tax rate be for debt to offer a tax advantage (i.e. positive tax shield) if you consider both corporate and personal taxes?Answer to (d): The marginal corporate tax rate must be higher than % for debt to offer a tax advantage.
Question
(d) Now assume tax is the only market imperfection, suppose the average personal tax rate on equity income (such as dividend and capital gain) is 20% and personal tax rate on interest income is 30%. How high must the marginal corporate tax rate be for debt to offer a tax advantage (i.e. positive tax shield) if you consider both corporate and personal taxes?Answer to (d): The marginal corporate tax rate must be higher than % for debt to offer a tax advantage.
Solution
To determine the marginal corporate tax rate that would make debt offer a tax advantage, we need to consider both corporate and personal taxes.
Step 1: Understand the tax rates given. The average personal tax rate on equity income (such as dividend and capital gain) is 20% and personal tax rate on interest income is 30%.
Step 2: Understand the concept of tax shield. A tax shield is the reduction in income taxes that results from taking an allowable deduction from taxable income. For debt, the tax shield equals the amount of interest paid multiplied by the corporate tax rate.
Step 3: To make debt offer a tax advantage, the tax shield from debt must be greater than the tax on equity. This means that the corporate tax rate must be high enough to make the tax shield from interest payments on the debt exceed the tax on equity income.
Step 4: Set up the inequality. Let Tc be the corporate tax rate. We need to find the Tc that satisfies the following inequality:
Tc * Interest > 0.20 * Equity
Step 5: Solve for Tc. Unfortunately, without knowing the exact amounts of interest and equity, we cannot solve for a specific Tc. However, we can say that the corporate tax rate must be higher than 20% for debt to offer a tax advantage, given the personal tax rates provided.
Please note that this is a simplified explanation and actual tax calculations can be more complex due to various factors such as different tax rates for different types of income, tax credits, deductions, etc.
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