On the Bias of the Corporate Tax Against High-Risk Projects

Abstract

This paper demonstrates that the impact of the existing tax law is not uniform across proj? ects with different variances of payoffs. A bias exists against projects with greater uncer? tainty of payoffs, which leads to an underinvestment in high risk projects. The bias against higher variance projects offers a theoretical justification for such tax incentives as the research and development tax credit. I. Introduction The impact of corporate taxes on firms' investment decisions is a problem that has interested economists for years. When taxes are levied on income rather than economic profits, a wedge is driven between private benefits and social ben? efits. Firms will invest to the point that after-tax marginal net present value is zero, whereas the socially desirable level is generally the one at which the be? fore-tax marginal net present value is zero. This paper shows that in a world of certainty, adjusting the depreciation amount is sufficient to remove the distor? tion. However, under uncertainty, the current tax regime with assymetric treat? ment of gains and losses creates a bias against projects with high variances of payoffs that cannot be removed simply by juggling the depreciation amount. This bias against high risk projects suggests that tax incentives such as the research and development tax credit may be needed to encourage investment in risky projects. It is also shown that the favored tax treatment of debt capital may intensify the disincentive to invest in higher variance projects. In Section II, a model of the firm under taxation and uncertainty is de? veloped. Section III presents the major results of this research, while Section IV offers a brief summary of the results.