The effects of tax convexity on default and investment decisions

Abstract

The objective of this article is to examine how default and investment triggers change under different levels of tax asymmetry when firms face nonlinear tax schedules. Under a convex tax schedule, profits are taxed at a higher rate, while losses are taxed (or rebated) at a lower rate, thus reducing the risk shared by the government. This article presents a dynamic model based on the contingent-claims framework to explore the impacts of tax convexity on the triggers, and we find that the impacts vary significantly depending on several countervailing forces. Tax convexity has a nonmonotonic relationship with both the default and investment triggers, because of the government’s risk-sharing role. The default trigger is higher when tax convexity increases, while the growth option exerts a counteracting effect that lowers this trigger, creating an ambiguity in the investment trigger when changing the level of tax asymmetry.