Corporate Limited Liability and the Design of Corporate Taxation

Abstract:     
Corporate limited liability can create agency conflicts between the public and private sectors. The resulting distortion may induce overinvestment in risky technologies relative to the social optimum. This paper examines the role of a well-designed corporate tax structure in aligning private investment choices with socially optimal levels. An appropriate constant tax rate imposed on the positive cash flows provides sufficient investment disincentives to offset the overinvestment incentives of limited liability. However, the optimal tax rate is specific to the technology of individual firms. It is shown that a tax structure designed with an economy-side single tax rate when combined with other features such as an initial zero tax bracket, investment-based deductions, tax credits and tax deductibility of debt can replicate the same incentives as that of an economy with multiple technology-specific tax rates. Institutional features observed in many advanced economies are consistent with such a design of taxation.

JEL Classifications: G30, G38, H21

Working Paper Series