Arguments in Favor of Tax Neutral Cost Allocation

Abstract

When considering corporate taxes in a cost allocation context a tradeoff is generated for shareholders: On the one hand, accelerated depreciation increases the value of a project due to the depreciation tax shield. On the other hand, accelerated depreciation most likely does not induce robust goal congruency between managers and shareholders when utilizing residual income as incentive system and, as a consequence, over- or underinvestment could be the result. The literature suggests in this context the application of particular allocation rules. When extending the relative marginal benefit cost allocation rule (Reichelstein, 1997, Rogerson, 1997) to include corporate taxes we find it to be tax neutral and to maintain its properties of generating robust incentives. As a consequence the over-/underinvestment problem is solved, but the depreciation tax shield is often not maximized. However, we illustrate that in competitive markets shareholders ought to prefer a tax neutral allocation scheme over an accelerated depreciation schedule. Thus, we show that shareholders as well as regulators have – although for different reasons – a preference for tax neutral cost allocation.

Keywords: Cost Allocation, Neutral Taxation, Over-/Underinvestment, Relative Marginal Benefits Allocation Rule, Residual Income