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Progressive taxation and corporate liquidation policies with mean-reverting earnings

  • Chu, Kai Cheung
  • Wong, Kit Pong
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    This paper develops a real options model of an all-equity financed firm that receives mean-reverting earnings and is subject to progressive taxation. Tax progression arises from an exogenously given tax exemption threshold such that the firm pays no corporate income taxes should its earnings be less than this threshold. The firm possesses a perpetual option to liquidate its operation for a deterministic salvage value at any time. We show that the firm optimally exercises the liquidation option at the first instant when its earnings reach an endogenously determined threshold (the liquidation trigger) from above. Using numerical analysis, we show that the liquidation trigger is higher or lower than the exogenously given tax exemption threshold, depending on whether the tax exemption is below or above a unique critical level, respectively. We further show that the liquidation trigger is strictly decreasing for all tax exemption thresholds less than the critical level, and can be hump-shaped for all tax exemption thresholds greater than the critical level, especially when the salvage value is small. Corporate income taxes as such are not neutral when tax schedules are progressive.

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    File URL: http://www.sciencedirect.com/science/article/B6VB1-4Y9C1C9-3/2/cefed193440b193846721e7626bf53ce
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    Article provided by Elsevier in its journal Economic Modelling.

    Volume (Year): 27 (2010)
    Issue (Month): 3 (May)
    Pages: 730-736

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    Handle: RePEc:eee:ecmode:v:27:y:2010:i:3:p:730-736
    Contact details of provider: Web page: http://www.elsevier.com/locate/inca/30411

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    1. Kormendi, Roger & Lipe, Robert, 1987. "Earnings Innovations, Earnings Persistence, and Stock Returns," The Journal of Business, University of Chicago Press, vol. 60(3), pages 323-45, July.
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    6. Metcalf, Gilbert E. & Hassett, Kevin A., 1995. "Investment under alternative return assumptions Comparing random walks and mean reversion," Journal of Economic Dynamics and Control, Elsevier, vol. 19(8), pages 1471-1488, November.
    7. Wong, Kit Pong, 2007. "The effect of uncertainty on investment timing in a real options model," Journal of Economic Dynamics and Control, Elsevier, vol. 31(7), pages 2152-2167, July.
    8. Bessembinder, Hendrik, et al, 1995. " Mean Reversion in Equilibrium Asset Prices: Evidence from the Futures Term Structure," Journal of Finance, American Finance Association, vol. 50(1), pages 361-75, March.
    9. Agliardi, Elettra, 2001. "Taxation and Investment Decisions: A Real Options Approach," Australian Economic Papers, Wiley Blackwell, vol. 40(1), pages 44-55, March.
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    11. Wong, Kit Pong, 2009. "Progressive taxation, tax exemption, and corporate liquidation policy," Economic Modelling, Elsevier, vol. 26(2), pages 295-299, March.
    12. Wong, Kit Pong, 2008. "Does market demand volatility facilitate collusion?," Economic Modelling, Elsevier, vol. 25(4), pages 696-703, July.
    13. Lund Diderik, 1993. "The Lognormal Diffusion Is Hardly an Equilibrium Price Process for Exhaustible Resources," Journal of Environmental Economics and Management, Elsevier, vol. 25(3), pages 235-241, November.
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