Effects of Tax Rate Cut on Firm Investment and Valuation: A Micro Simulation Approach

Abstract

This paper investigates the changes in firm value triggered by hypothetical corporate tax rate changes in which effects on both investment to fixed assets and current assets are well taken care of. With this framework we assess the effects of government tax rate cuts. Firm investment decisions change over time through the accumulated process of retained earnings. The study is based on micro foundation simulations of all the firms listed in Japan, excluding financial firms. Our data covers the period 2000 to 2008. In order to explore the effects on valuation by corporate tax rate changes we pay particular attention to the tax loss carry-forward allowances as well as net changes in the deferred tax liabilities, which appear on the equity account and the contra account of the deferred tax assets in financial statements. Our results demonstrate that the changes in corporate tax rates can enhance market value of firm equity in most cases, while there are some cases in which the effects are neutral or even detrimental for firm values. We interpret that these different results are caused by mixed effects of current provisions that allow firms to carry their tax loss forward and the net balance of tax deferred accounts. We claim that past and future profitability or non-profitability of firms are crucial to hit the exact threshold points at which firms experience value appreciation or not, on which both firm financial managers and government regulators must watch closely.