Impact of the Changing Tax Environment on Investments and Productivity: Financial Structure and the Corporation Income Tax

Abstract

This paper explores the consequences of the corporation income tax when firms face financial constraints; that is, they are either credit- or equity-rationed. (These financial constraints can, in turn, be explained as the natural consequences of informational asymmetries that are pervasive in the capital market.) The paper shows that the effect of such taxes may be more related to average tax rates than to the marginal effective tax rates on which recent literature, analyzing the incidence of such taxes in neoclassical firms, has focused. For firms that are equity- (but not credit-) constrained, the reduction in retained earnings reduces their willingness to undertake risky investments, including R&D expenditures which enhance productivity in the long run. More generally, the impact of the tax depends on the structure of taxes as much as it does on the level (the provisions for tax deductibility of interest, the tax treatment of capital gains, and so forth), and an analysis requires taking into account the combined effects of the corporation and individual income tax structures. For instance, for firms that are neither equity-nor credit-constrained, the fact that interest payments are tax-deductible implies that there are no marginal distortions with respect to the level of investment. Higher differential taxes on equity may induce some firms to decide not to issue equity. This financial decision will be accompanied by a discrete reduction in the level of investment.