Arguments in Favour of Tax Neutral Cost Allocation

Abstract

When considering corporate taxes in a cost allocation context a trade‐off 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 an incentive system and, as a consequence, over‐ or underinvestment could result. In this context, the literature suggests the application of particular allocation rules. When extending the relative marginal benefits 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—for different reasons—a preference for tax neutral cost allocation.