Paper Spotlight: The Effect of Taxation on Corporate Financing and Investment

Hong Chen

Murray Z. Frank

Despite the large theoretical literature that asserts the importance of taxes on corporate investment and financing decisions, the empirical literature often fails to demonstrate the effects of taxes in a convincing way. One reason for the discrepancy could be measurement error in variables. In “The Effect of Taxation on Corporate Financing and Investment,” Hong Chen and Murray Z. Frank take issue with the theoretical predictions themselves. They construct a model with a household and a firm that are both infinitely-lived. The government collects taxes from both parties. In the steady-state equilibrium of the model, many personal taxes are irrelevant to corporate decision-making, and other forms of taxation affect particular corporate decisions only. Specifically, (i) a small change in many personal taxes (including on consumption, dividend, or capital gains) has no effect on the firm’s investment or financing policies, (ii) a small change in the personal tax on interest income affects leverage but not investment, and (iii) a small change in the corporate tax rate affects leverage and investment, but not the interest rate on corporate debt. The first-order conditions pin down the optimal policies of the firm and the consumer, and the authors show that in a steady-state equilibrium, these conditions are not affected by some of the tax rates (significantly, including the dividend tax rate). A numerical example shows the change in the steady-state equilibrium outcomes to a change in various tax rates. If the theory on tax effects does not match the data, perhaps the theory needs to be reconsidered, and this paper represents an important step in that direction.

Spotlight by Uday Rajan
Photos courtesy of Hong Chen and Murray Z. Frank

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