| Abstract: |
In the absence of financing frictions, profit taxes reduce investment by their
effect on the user cost of capital. With finance constraints due to moral
hazard, investment becomes sensitive to cash-flow and own equity of firms. The
impact of taxes changes fundamentally. Taxes reduce investment because they
erode cash flow and, thereby, a firm's pledgeable income available for
repayment to outside investors, and not because they reduce the user cost of
capital. We propose a corporate finance model of investment and derive three
central results: (i) Even small taxes impose first order welfare losses on
financially constrained firms; (ii) ACE and cash-flow tax systems, which are
investment neutral in the neoclassical model, are no longer neutral when firms
are finance constrained. (iii) When banks are active and provide external
finance together with monitoring services, the two systems not only reduce
investment, but are also no longer equivalent. With active banks, investment
is subject to double moral hazard and the timing of tax payments becomes
important. The ACE system gives tax relief at the return stage and provides
better incentives than a cashflow tax which gives tax relief upfront. |