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The effect of leverage on the tax-cut versus investment-subsidy argument

  • Danielova, Anna
  • Sarkar, Sudipto

Two common methods of attracting corporate investment are investment incentives and tax incentives. It is important to use the two incentives in the correct proportions, otherwise the government will give up too much value in the process of attracting investment. This paper examines the effect of tax cut and investment subsidy on the government's net benefit from a project. Earlier studies concluded that it was optimal to use only investment subsidy and no tax cuts. We show that this is not true when debt financing is possible, and it is generally optimal (from the government's perspective) to use a combination of tax reduction and investment subsidy. The optimal tax rate and optimal investment subsidy are identified and analyzed in the paper. It is shown that using a sub-optimal combination of incentives can result in substantial reduction of benefits for the government.

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Article provided by Elsevier in its journal Review of Financial Economics.

Volume (Year): 20 (2011)
Issue (Month): 4 ()
Pages: 123-129

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Handle: RePEc:eee:revfin:v:20:y:2011:i:4:p:123-129
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  1. Pennings, Enrico, 2000. "Taxes and stimuli of investment under uncertainty," European Economic Review, Elsevier, vol. 44(2), pages 383-391, February.
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  8. Givoly, Dan, et al, 1992. "Taxes and Capital Structure: Evidence from Firms' Response to the Tax Reform Act of 1986," Review of Financial Studies, Society for Financial Studies, vol. 5(2), pages 331-55.
  9. Morrisset, Jacques & Pirnia, Neda, 2000. "How tax policy and incentives affect foreign direct investment - a review," Policy Research Working Paper Series 2509, The World Bank.
  10. Mintz, Jack M, 1990. "Corporate Tax Holidays and Investment," World Bank Economic Review, World Bank Group, vol. 4(1), pages 81-102, January.
  11. Chang Woon Nam & Doina Maria Radulescu, 2004. "Types of Tax Concessions for Attracting Foreign Direct Investment in Free Economic Zones," CESifo Working Paper Series 1175, CESifo Group Munich.
  12. Kim, Se-Jik, 1998. "Growth effect of taxes in an endogenous growth model: to what extent do taxes affect economic growth?," Journal of Economic Dynamics and Control, Elsevier, vol. 23(1), pages 125-158, September.
  13. Goldstein, Robert & Ju, Nengjiu & Leland, Hayne, 2001. "An EBIT-Based Model of Dynamic Capital Structure," The Journal of Business, University of Chicago Press, vol. 74(4), pages 483-512, October.
  14. Zee, Howell H. & Stotsky, Janet G. & Ley, Eduardo, 2002. "Tax Incentives for Business Investment: A Primer for Policy Makers in Developing Countries," World Development, Elsevier, vol. 30(9), pages 1497-1516, September.
  15. Sudipto Sarkar & Levon Goukasian, 2006. "The Effect of Tax Convexity on Corporate Investment Decisions and Tax Burdens," Journal of Public Economic Theory, Association for Public Economic Theory, vol. 8(2), pages 293-320, 05.
  16. Pennings, Enrico, 2005. "How to maximize domestic benefits from foreign investments: the effect of irreversibility and uncertainty," Journal of Economic Dynamics and Control, Elsevier, vol. 29(5), pages 873-889, May.
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