Firm Investment, Corporate Finance, and Taxation
IMF Working Papers, December 1, 2002
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- Firm Investment, Corporate Finance, and Taxation
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Bibliographic details
- Authors: Geremia Palomba
- Published: December 1, 2002
- Series: IMF Working Papers
- DOI: https://doi.org/10.5089/9781451875720.001
Summary
- Examines the intertemporal effect of corporate income taxation on the investment behavior of a firm that faces imperfect capital markets.
- Shows that when capital markets are imperfect, the optimizing firm goes through different phases of growth.
- In this dynamic setting, the effect of a corporate tax on profits varies over time.
- An increase in the corporate profit tax rate initially reduces investment, but the effect is reversed over time as the firm adjusts its financing policy to the new tax rate.
Main findings
- Firms in imperfect capital markets experience multiple growth phases that alter how tax changes influence investment decisions.
- The immediate effect of an increase in the corporate profit tax rate is a reduction in investment.
- Over time, as firms modify their financing policy, the initial negative effect of a higher corporate profit tax rate can be reversed.
Dynamics and mechanisms
- Imperfect capital markets create intertemporal trade-offs in the firm’s optimization problem.
- The evolving co-state variables and cash flow conditions drive stage-dependent responses to tax changes.
- Financing decisions and financing policy adjustments are central to the reversal of the initial investment response to higher corporate profit tax rates.
Policy implications
- Static analyses of corporate taxation may misstate the long-run impact on firm investment when capital markets are imperfect.
- Policymakers should consider dynamic firm behavior and financing constraints when assessing the investment consequences of corporate profit tax rate changes.
- Tax policy evaluation should account for phase-dependent investment responses and potential eventual reversals of short-run effects.
Subject classification and keywords
- Subject: Capital accumulation, Corporate income tax, Financial institutions, Financial services, Investment policy, Market interest rates, National accounts, Stocks, Taxes
- Keywords: A. firm investment, Capital accumulation, cash flow, co-state variable, Corporate income tax, Corporate Income Taxation, decision process, financing decision, financing policy, Firm Investment, Imperfect Capital Markets, Investment policy, investment strategy, Market interest rates, maximization problem, mover accent, Stocks, tax rate, WP
“Firm Investment, Corporate Finance, and Taxation”, Geremia Palomba, December 1, 2002, IMF Working Paper No. 2002/237.