Profit Taxation and Finance Constraints

Christian Keuschnigg and Evelyn Ribi ()

University of St. Gallen Department of Economics working paper series 2009 from Department of Economics, University of St. Gallen

Abstract: In the absence of financing frictions, profit taxes reduce investment by their effect on the user cost of capital. With finance constraints due to moral hazard, investment becomes sensitive to cash-flow and own equity of firms. The impact of taxes changes fundamentally. Taxes reduce investment because they erode cash flow and, thereby, a firm's pledgeable income available for repayment to outside investors, and not because they reduce the user cost of capital. We propose a corporate finance model of investment and derive three central results: (i) Even small taxes impose first order welfare losses on financially constrained firms; (ii) ACE and cash-flow tax systems, which are investment neutral in the neoclassical model, are no longer neutral when firms are finance constrained. (iii) When banks are active and provide external finance together with monitoring services, the two systems not only reduce investment, but are also no longer equivalent. With active banks, investment is subject to double moral hazard and the timing of tax payments becomes important. The ACE system gives tax relief at the return stage and provides better incentives than a cashflow tax which gives tax relief upfront.

Keywords: Finance constraints; profit tax; cash-flow tax; ACE tax (search for similar items in EconPapers)
JEL-codes: G38 H25 (search for similar items in EconPapers)
Pages: 27 pages
Date: 2009-03
New Economics Papers: this item is included in nep-cta, nep-pbe and nep-pub
References: View references in EconPapers View complete reference list from CitEc
Citations: View citations in EconPapers (9)

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Related works:
Working Paper: Profit Taxation and Finance Constraints (2010)
Working Paper: Profit Taxation and Finance Constraints (2009)
Working Paper: Profit Taxation and Finance Constraints (2009)
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