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A Simple Explanation for the Unfavorable Tax Treatment of Investment Costs

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  • Paolo Panteghini

Abstract

The evidence shows that in most countries the present value of depreciation allowances is less than 100% of the cost of capital. In this article we use a real-option model with debt financing, and show that less favorable depreciation allowances are offset by tax benefits arising from debt financing. Allowing partial deduction of capital cost is thus a necessary condition for investment neutrality to hold.

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Paper provided by CESifo Group Munich in its series CESifo Working Paper Series with number 1784.

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Date of creation: 2006
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Handle: RePEc:ces:ceswps:_1784

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Keywords: capital structure; irreversibility; real options and taxation;

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  1. Paolo Panteghini, 2005. "S-Based Taxation under Default Risk," Working Papers, University of Brescia, Department of Economics ubs0506, University of Brescia, Department of Economics.
  2. Haufler, A. & Schjelderup, G., 1999. "Corporate Tax Systems and Cross Country Profit Shifting," Papers, Norwegian School of Economics and Business Administration- 1/99, Norwegian School of Economics and Business Administration-.
  3. Stiglitz, Joseph E., 1973. "Taxation, corporate financial policy, and the cost of capital," Journal of Public Economics, Elsevier, Elsevier, vol. 2(1), pages 1-34, February.
  4. Rainer Niemann, 1999. "Neutral Taxation under Uncertainty - a Real Options Approach," FinanzArchiv: Public Finance Analysis, Mohr Siebeck, Tübingen, Mohr Siebeck, Tübingen, vol. 56(1), pages 51-66, March.
  5. John R. Graham, 2003. "Taxes and Corporate Finance: A Review," Review of Financial Studies, Society for Financial Studies, Society for Financial Studies, vol. 16(4), pages 1075-1129.
  6. Johannes Becker & Clemens Fuest, 2009. "Optimal tax policy when firms are internationallly mobile," Working Papers, Oxford University Centre for Business Taxation 0907, Oxford University Centre for Business Taxation.
  7. Goldstein, Robert & Ju, Nengjiu & Leland, Hayne, 2001. "An EBIT-Based Model of Dynamic Capital Structure," The Journal of Business, University of Chicago Press, University of Chicago Press, vol. 74(4), pages 483-512, October.
  8. Branch, Ben, 2002. "The costs of bankruptcy: A review," International Review of Financial Analysis, Elsevier, Elsevier, vol. 11(1), pages 39-57.
  9. Michael P. Devereux & Rachel Griffith & Alexander Klemm, 2002. "Corporate income tax reforms and international tax competition," Economic Policy, CEPR;CES;MSH, CEPR;CES;MSH, vol. 17(35), pages 449-495, October.
  10. Paolo M. Panteghini, 2001. "Corporate Tax Asymmetries under Investment Irreversibility," FinanzArchiv: Public Finance Analysis, Mohr Siebeck, Tübingen, Mohr Siebeck, Tübingen, vol. 58(3), pages 207-, July.
  11. Hayne E. Leland., 1994. "Corporate Debt Value, Bond Covenants, and Optimal Capital Structure," Research Program in Finance Working Papers, University of California at Berkeley RPF-233, University of California at Berkeley.
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