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Optimal Corporate Taxation Under Financial Frictions

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  • Eduardo Dávila
  • Benjamin Hébert

Abstract

This article studies the optimal design of corporate taxes when firms have private information about future investment opportunities and face financial constraints. A government whose goal is to efficiently raise a given amount of revenue from its corporate sector should attempt to tax unconstrained firms, which value resources inside the firm less than financially constrained firms. We show that a corporate payout tax (a tax on dividends and share repurchases) can both separate constrained and unconstrained firms and raise revenue and is therefore optimal. Our quantitative analysis implies that a revenue-neutral switch from profit taxation to payout taxation would increase the overall value of existing firms and new entrants by $7\%$. This switch could be implemented in the current US tax system by making retained earnings fully deductible.

Suggested Citation

  • Eduardo Dávila & Benjamin Hébert, 2023. "Optimal Corporate Taxation Under Financial Frictions," The Review of Economic Studies, Review of Economic Studies Ltd, vol. 90(4), pages 1893-1933.
    • Handle: RePEc:oup:restud:v:90:y:2023:i:4:p:1893-1933.
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    File URL: http://hdl.handle.net/10.1093/restud/rdac068
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    Cited by:

    1. Ken Tabata, 2025. "The Effects of Financial Frictions on Optimal Corporate Income and Consumption Taxation in an R&D-Driven Growth Model," Discussion Paper Series 304, School of Economics, Kwansei Gakuin University.

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    Keywords

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    JEL classification:

    • G18 - Financial Economics - - General Financial Markets - - - Government Policy and Regulation
    • G33 - Financial Economics - - Corporate Finance and Governance - - - Bankruptcy; Liquidation
    • K35 - Law and Economics - - Other Substantive Areas of Law - - - Personal Bankruptcy Law

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