Investment, Financing Decisions, and Tax Policy

Abstract

Studies of tax policy and corporate investment have been prominent in public finance and macroeconomic research. By integrating corporate income tax rates, investment tax credits, and the value of depreciation allowances into the "cost of capital," economists have analyzed the effects of taxes on capital spending. Most studies assume that firms respond to prices set in centralized securities markets, such as market interest rates of Tobin's q, and firms undertake all profitable investment projects. Firms choose the mix or finance among internal funds, debt, and new equity independently; the availability of finance does not limit investment. The implications for tax policy are clear: the marginal tax rate on returns from a new project matters for investment, not the firm's average tax burden on returns from its investments in place.

For firms that face imperfect markets for external finance, however, it is no longer sufficient to focus only on the cost of funds determined in centralized securities markets. In particular, if the cost of internal finance differs substantially from external finance for some firms, their investment depends on available cash flow. For these firms, the amount of earnings devoted to taxes - and therefore the average tax rate on returns from existing projects - matters for investment, possibly along with incentive effects of marginal tax rates. We build on recent research that analyzes asymmetric information between firms and suppliers of external capital to examine the link between finance and investment, and, correspondingly, the role played by average as opposed to marginal tax rates in the investment process.

Our approach emphasizes firm heterogeneity; some firms can obtain low-cost external funds to respond completely to signals from centralized securities markets, while internal finance constrains the investment of others. In Sections I and II, we consider a q investment model for two types of firms: (i) firms that face essentially no cost disadvantage of external finance, and (ii) firms that must pay a significant premium to raise funds from external sources because of information asymmetries. In both cases, we evaluate the relative influence of average and marginal tax rates on investment. Section III summarizes empirical evidence on the link between internal finance and investment across heterogeneous groups of firms. Section IV concludes and discusses implications for tax policy.