The impact of tax uncertainty on irreversible investment

Abstract

Traditional models of capital budgeting with taxes are based on deterministic tax rates and tax bases. In reality, however, there are multiple sources of tax uncertainty. Frequent tax reforms make future taxation of investments a stochastic process. Fiscal authorities and tax courts create additional tax uncertainty by interpreting current tax laws differently. Moreover, simplified models that anticipate the actual tax base incorrectly contribute to tax uncertainty as perceived by investors. I analyze the effects of stochastic taxation on investment behavior in a real options model. The investor holds an option to invest in an irreversible project with stochastic cash flows and stochastic tax payments. Pre-tax cash flows and tax payments are assumed to be correlated. Increased tax uncertainty has an ambiguous impact on investment timing. For low tax uncertainty, high cash flow uncertainty and high correlation of cash flows and tax payments, increased tax uncertainty is likely to accelerate investment. A higher expected tax payment delays investment. A higher after-tax discount rate affects investment timing ambiguously.