Exercise Scholes and Wolfsons Implicit and Explicit Taxes In perfect capital and product markets, investors will bid up the price of tax favored assets until the after tax returns on all assets (within the same risk class) are the same (tax arbitrage) The marginal investor is then indifferent between investing in a fully taxed asset, a partially taxed asset, or a tax exempt asset Consider the following valuation model with taxes The market value of equity (MVE) is given by (1) MVE B After tax Income where B is some valuation multiplier that equals 1 r and where r is Scholes and Wolfsons (expected) rate of return Note, in the SW model r will be the same for all assets r r The after tax Income is given by (2) After tax Income Pre tax Income Tax Expense The tax expense equals the product of the Effective Tax Rate and Pre tax Income (3) Tax Expense ETR Pre tax Income where ETR is the Effective Tax Rate Substitution of (3) in (2) for Tax Expense, and this transformed equation into (1) for After tax Income solves to the following valuation model (4) MVE (1 r) (1 ETR) Pre tax Income Suppose further there are three firms A, B, and C Each firm has a pre tax income of 100 Firms A (benchmark firm) Effective Tax Rate equals the statutory tax rate (ETR str) and equals 0 35 Firms B Effective Tax Rate equals 0 25 and firms C Effective Tax Rate equals 0 (Zero Tax Firm) Finally, Firms A MVE equals 500 Assume that Scholes and Wolfsons tax arbitrage works perfectly and implicit taxes fully offset explicit tax benefits Exercise Calculate the after tax returns, pre tax returns, implicit taxes, explicit taxes, total taxes, and their respective tax rates for all three firms if the SW model holds Discuss the practical implications of SWs implicit tax concept How can a practitioner measure identify whether implicit taxes are existent And if so, how can she he assess how strong this effect is Many high tax countries such as the US or France are concerned that multinational companies will artificially shift income from high tax to foreign low tax countries in order to save taxes and reduce their ETRs As a consequence, high tax countries fear a loss in tax revenue and that they will lose investors to foreign countries Discuss these concerns in the light of SWs implicit tax model Imagine you are a professional investment banker How would your knowledge about implicit taxes affect your investment decisions Many governments are issuing tax exempt bonds Why Arent they simply losing tax revenues in doing so Hints for the solution You always start with the benchmark asset You have all info given to calculate the after tax return for the benchmark asset r ((1 str)PI) MVE which will give you a rate of 0,13 ( ((1 0 35)100) 500 You also have all info you need to calculate the benchmark firms pre tax return For this purpose simply calculate what the firms return would have been if the firm had paid no tax 0,2 ( ((1 0)100) 500 You also know that if SW model holds all firms have the same after tax return of 0 13 Further, if the SW model holds, you know that the benchmark firm will not be paying any implicit taxes So, the implicit tax and the implicit tax rate will both be 0 From this, it follows that the benchmark firms explicit tax rate (which is the statutory tax rate) will equal the total tax rate (Total tax Rate Explicit Tax Rate 0) Having solved the case for the benchmark firm, you just need to apply the formulas explained in the lecture to calculate implicit taxes (tax rate) and explicit taxes (tax rates) NOTE These metrics for the two alternative assets (partially taxed and tax exempt) are always calculated relative to the benchmark asset as outlined in the SW equations

The Answer is in the image, click to view ...

Answered step by step

Verified Expert Solution

Link Copied!

Question

1 Approved Answer

Posted on Oct 19, 2024

Exercise: Scholes and Wolfsons Implicit and Explicit Taxes In perfect capital and product markets, investors will bid up the price of tax-favored assets until the

Exercise: Scholes and Wolfsons Implicit and Explicit Taxes

In perfect capital and product markets, investors will bid up the price of tax-favored assets until the after-tax returns on all assets (within the same risk class) are the same (tax arbitrage). The marginal investor is then indifferent between investing in a fully taxed asset, a partially taxed asset, or a tax-exempt asset. Consider the following valuation model with taxes.

The market value of equity (MVE) is given by:

(1) MVE = B After-tax Income

where B is some valuation multiplier that equals 1/r and where r is Scholes and Wolfsons (expected) rate of return. Note, in the SW-model r will be the same for all assets r=r*. The after-tax Income is given by:

(2) After-tax Income = Pre-tax Income Tax Expense

The tax expense equals the product of the Effective Tax Rate and Pre-tax Income:

(3) Tax Expense = ETR Pre-tax Income

where ETR is the Effective Tax Rate. Substitution of (3) in (2) for Tax Expense, and this transformed equation into (1) for After-tax Income solves to the following valuation model:

(4) MVE = (1/r) (1 ETR) Pre-tax Income

Suppose further there are three firms A, B, and C. Each firm has a pre-tax income of 100. Firms A (benchmark firm) Effective Tax Rate equals the statutory tax rate (ETR=str) and equals 0.35. Firms B Effective Tax Rate equals 0.25 and firms C Effective Tax Rate equals 0 (Zero-Tax Firm). Finally, Firms A MVE equals 500.

Assume that Scholes and Wolfsons tax arbitrage works perfectly and implicit taxes fully offset explicit tax benefits.

Exercise:

Calculate the after-tax returns, pre-tax returns, implicit taxes, explicit taxes, total taxes, and their respective tax rates for all three firms if the SW-model holds.
Discuss the practical implications of SWs implicit tax concept.
How can a practitioner measure/identify whether implicit taxes are existent? And if so, how can she/he assess how strong this effect is?
Many high-tax countries such as the US or France are concerned that multinational companies will artificially shift income from high-tax to foreign low-tax countries in order to save taxes and reduce their ETRs. As a consequence, high-tax countries fear a loss in tax revenue and that they will lose investors to foreign countries. Discuss these concerns in the light of SWs implicit tax model.
Imagine you are a professional investment banker. How would your knowledge about implicit taxes affect your investment decisions?
Many governments are issuing tax-exempt bonds. Why? Arent they simply losing tax revenues in doing so?

Hints for the solution

You always start with the benchmark asset. You have all info given to calculate the after-tax return for the benchmark asset: r*=((1 str)PI)/MVE which will give you a rate of 0,13 (=((1 0.35)100)/500
You also have all info you need to calculate the benchmark firms pre-tax return. For this purpose simply calculate what the firms return would have been if the firm had paid no tax: 0,2 (=((1 0)100)/500
You also know that if SW-model holds all firms have the same after-tax return of 0.13
Further, if the SW-model holds, you know that the benchmark firm will not be paying any implicit taxes. So, the implicit tax and the implicit tax rate will both be 0.
From this, it follows that the benchmark firms explicit tax rate (which is the statutory tax rate) will equal the total tax rate (Total tax Rate = Explicit Tax Rate + 0)
Having solved the case for the benchmark firm, you just need to apply the formulas explained in the lecture to calculate implicit taxes (tax rate) and explicit taxes (tax rates). NOTE: These metrics for the two alternative assets (partially taxed and tax-exempt) are always calculated relative to the benchmark asset as outlined in the SW equations.