Corporate Investment, Taxation, and Tobin's Q: Evidence from Japanese Firms and Industries

Abstract

The paper addresses a question of how taxation affects the cost of capital of firms and the value of firms as measured by Tobin's q. We construct a type of Real Business Cycle model and derive our original unlevered q on an after tax base after removing the financial tax shield effects in order to clearly distinguish between the real operating profitability of firms and their financing decisions. Our model is an extended version of the two-sector model originally developed by Christiano and Fisher (1995) and can incorporate both corporate taxation and individual taxation. In our model both homogenous expectations in the capital market and labor immobility are assumed as in Christiano and Fisher and the unlevered q-value is derived from our partial equilibrium solutions. Some comparative static results are demonstrated and model predictions are presented. In a latter empirical part of our paper, we investigate how the unlevered after-tax q-values versus the conventional Tobin's q vary between the two business sectors in Japan according to the differences in the marginal tax rates and the leverage ratios of firms as well as over the different phases of business cycles. Overall, the data supports the model predictions and rationalizes the use of our unlevered q.