Option 4 (Business Unit): Flat Tax at Marginal Rate

The simplest way to establish taxes at the business unit level is to charge them a flat tax at the marginal rate of taxation on their income. This marginal rate should include the top tax rates likely to be imposed on taxable income at the federal, state, and local levels.

This method will drive desirable behavior in that decisions at the margin are likely to have marginal tax rate consequences. Thus, this rate will encourage the most economical trade-offs for most projects.

The drawback of this method is that it does not account for exclusions to taxable income or temporary differences that would result in lower actual taxes. For example, if the business unit generated foreign tax credits, they would not be recognized in a flat rate regime even though the corporation and its shareholders would benefit. Also, if the business unit were able to defer taxes, those would be reflected neither as reductions to capital nor as cash benefits in the current period. Since no company actually pays taxes on total income equal to the marginal statutory rates, a business unit using this method would invariably report a lower EVA than it is contributing to the company.

© 2015 by Hodak Value Advisors, LLC