Jan Södersten

Tax policy uncertainty and corporate investment: A theory of tax-induced investment spurts

Abstract The anticipatory effects of a corporate tax reform of the tax-cut cum base-broadening variety are analyzed in a dynamic stochastic adjustment model of firm behavior, focusing on the case where the firm is uncertain both about the timing and the contents of the expected reform. The value of the firm is solved prior to and after the reform. The existence of investment spurts prior to the implementation of the tax reform is established. Rigorous results are derived under constant returns and the effects of diminishing returns are explained. The expectation of a future tax cut causes the firm to accelerate optimal investment, while the expectation of a reduction in the tax base (the rate of fiscal depreciation) has the opposite effect. For a firm which updates information, timing uncertainty interacts with the expectation effect; moreover, increased timing uncertainty may accelerate or decelerate investment as an optimal response to an expected tax cut. Futhermore, for reasonable assumptions, it is shown that a rate-cut cum base-broadening tax reform of the type implemented in several OECD-countries in the 1980s and 1990s cannot be revenue neutral.

The importance of reporting conventions for the theory of corporate taxation

Abstract This paper shows that for the analysis of a tax policy, it is important to be explicit about the reporting convention to which a corporation tax is required (or allowed) to adhere. The paper shows that the corporation tax cannot be used to alter capital formation under uniform reporting, a convention required by the majority of the OECD countries. This tax is, however, a more useful policy tool in those OECD countries that have created the privilege of separate reporting. Fiscal depreciation makes the marginal valuation of equity differ from the marginal valuation of capital. Use of tax allowances directed to investment stimulus operates rather differently under the two reporting conventions.

Costs of monitoring and corporate taxation

Abstract A new approach to understanding the real effects of corporate taxation is suggested. Essentially, by claiming that corporate debt means discipline for the executives, the debt policy of a firm is endogenised. It is then proved that the effective profits tax rate is tied to current and expected future profitability, reflected in the marginal valuation of equity. A theoretically correct effective marginal profits tax rate cannot be estimated from historical figures. Moreover, a new tax neutrality result is suggested. For the first time, the paper provides a choice-theoretical explanation for corporations in the Nordic countries having quite systematically chosen to abstain from maximising their interest-free tax debt capacity.

Corporate Tax Policy in the Nordic Countries

The corporate tax systems in the Nordic countries have undergone radical changes in recent years. At the end of the 1980s the Nordic corporate tax systems were still characterized by a combination of narrow tax bases and high statutory tax rates. However, within a few years in the early 1990s, the corporate income tax base in the four major Nordic countries was broadened dramatically, the statutory corporate tax rates were almost cut in half, and the relationship between the corporate and the personal income tax was changed significantly.

Personal Taxation and Investment Incentives in a Small Open Economy

A simple portfolio model is used to investigate the effects of personal taxes on real investment incentives in a small open economy with large and small firms. When shares in large firms can be traded internationally and their rate of return is exogenously determined on international equity markets, a tax on the return on riskless bonds will induce a portfolio shift from bonds to shares in large firms. This shift reduces the impact of the bond tax on the required rate of return on shares in domestically owned small firms, provided that returns on shares in small and large firms are positively correlated. The total impact of the bond tax may even change from a negative to a counter-intuitive positive one if the “beta” between the returns on small and large firms is above unity. A personal tax on equity returns does in general have an ambiguous impact on the pre-tax rate of return requirement of domestically owned firms. An exogenous rate of return on large company shares is shown to enhance the possibility for the equity tax to reduce the required pre-tax rate of return in small domestic firms. A sufficient condition for a negative relationship is again that the “beta” between the returns in small and large firms is above unity.

Manufacturing investment and taxation in the Nordic countries

The accumulation of fixed productive capital in the manufacturing industries of Denmark, Finland, Norway, and Sweden is analyzed for the period 1965-90. Particular attention is given to the effect of taxes on this process. The following conclusions appear fairly robust across countries: cointegrating long-run relationships can be found within the framework of the neoclassical model; the error-correction estimations indicate that investment is relatively sensitive to economic shocks; and taxes do not seem to have had significant effects on either long-run capital levels or the timing of investment. Copyright 1994 by The editors of the Scandinavian Journal of Economics.

THE INVESTMENT FUNDS SYSTEM RECONSIDERED

This paper studies the effects of the Swedish investment funds system on the cost of capital. It is shown that the incentive effects critically depend on which regime it expects to be in in the future. For quite reasonable assumptions, investment funds system releases turn out to have much less impact on the incentive to invest than conventionally assumed. Copyright 1989 by The editors of the Scandinavian Journal of Economics.

Do Tax Allowances Stimulate Investment

Considerable empirical work on investment behavior makes use of a capital cost variable to capture the effects of various corporate tax allowances. The assumption behind most of this work is that all available tax allowances may be claimed by the firms. However, there are several reasons why this may not be true. One purpose of this paper is to explore the effect on capital cost of assuming that firms have unused tax allowances and that the investment funds system (IF system) is not used to finance marginal investments during periods of IF releases. Another purpose is to construct econometric investment functions in order to compare the performance of alternative definitions of capital cost. In fact, the hypothesis that tax allowances do not have the effect on capital cost implied by a mechanical interpretation of statutory tax rules cannot be rejected. In particular, IF releases may raise the return on intramarginal investment rather than create investment incentives.

Accelerated Depreciation and the Cost of Capital

The effects of various investment incentives-particularly accelerated depreciation-on the cost of capital of a profit-maximizing firm have been widely discussed during the last few years. Recent contributions include those of Sandmo (1974), Bergstrom (1976), Boadway (1978) and Alworth (1979). A shortcoming of these contributions, however, is that few efforts are made to provide economic interpretations of the results obtained. In this note, I derive the cost of capital in a simplified way in terms of a standard marginal investment project. The emphasis is on explaining the effects of accelerated depreciation on capital cost in economic terms. The deferral of corporation tax brought about by acceleration of depreciation allowances is often compared to the acquisition of an interest-free loan from the Treasury. The deferred corporate tax is thus regarded as a source of finance to the firm. It turns out that the effects of accelerated depreciation on capital cost may well be interpreted in a way that conforms to this intuitive view of tax deferral. By means of a general expression for capital cost as a weighted average of the costs of debt and equity, the deferred corporate tax may be conceived of as a substitute for either equity or debt (or both).

Approaches to the Theory of Capital Cost: An Extension

In a recent issue of this Journal, Villy Bergstrom demonstrates how the cost of capital for a firm maximizing stockholders wealth may be expressed as a weighted average of the cost of equity and the cost of debt, with due adjustments for tax laws. Bergstr6ms interest is confined to the profit taxes paid by the firm, and consequently he abstracts from the tax situation of the shareholders. This leads, inter alia, to the implicit conclusion that the way equity capital is obtained-through the retention of earnings or through the issue of new shares-makes no difference to the before-tax cost of capital. This is clearly unrealistic. The common view that retained earnings are a less expensive source of equity capital than the issue of new shares can, however, easily be demonstrated within Bergstroms theoretical framework. In this note, this is accomplished by including taxes paid directly by the shareholders-personal income tax on dividends and capital gains tax-into the analysis.2 This approach also makes it possible to identify the effects on the cost of capital, of different measures currently in use in many countries to reduce the so-called double taxation of dividends.