Corporate Taxation, Corporate Finance and Investment: Theory and Applications in Dynamic CGE Modelling

Dynamic computable general equilibrium (CGE) models, such as the MONASH model developed at the Centre of Policy Studies, typically use complex dynamic investment mechanisms to generate dynamic growth paths. Even so, these models don’t account for corporate finance and corporate taxation in determining investment outcomes. This paper provides final results from a work program aimed at imposing corporate finance and corporate taxation on investor choices in an inter-temporal model of investment, and then describes the process of modifying the MONASH model to take on-board this new theory. The paper will proceed in two parts. Firstly, we briefly outline the development of an investment model that links corporate taxation and corporate finance to investment behaviour. Firms seek to maximise shareholder wealth, and firm and investor optimising-behaviour leads to a set of rate-of-return expressions that are determined by financing and investment policies, both of which, themselves, are the result of optimising decisions. Firms in this model optimise across two dimensions – they optimise the present value of shareholder distributions across time (i.e. dynamic optimisation), which they achieve by determining an optimal choice of inputs (including an investment policy) and an optimal method of financing these inputs (involving an optimal financial policy and dividend policy). The solution to the firm’s optimal growth path takes account of: various company and personal income tax regimes; various capital-gains taxes regimes (including realisation-basis capital gains taxation); depreciation allowances; investment allowances; debt accumulation; transactions costs on external financing; and interest rates on debt linked to financial leverage. The resulting rate-of-return expressions highlight the complex nature of the taxation of capital income and the ways in which taxation reform can influence investment behaviour. Secondly, we explain the implementation of this investment approach in MONASH, and report on a series of simulations. A key feature of the model in application is that firms choose their financial and dividend policies endogenously, in every period of the simulation, from eight potential alternatives. The impact of two different tax reforms are simulated using a version of MONASH-Australia aggregated to 32 industries and 33 commodities. The two experiments are: (1) a cut to the dividend-tax rate, such as that currently under debate in the US; and, (2), a cut in a realisation-basis capital gains tax. Each experiment is run twice, with recursive/backward-looking expectations and rational/forward-looking expectations imposed. The simulations show that a GE approach is necessary to gain full insight into the investment behaviour of corporations, as these tax cuts have two immediate and contradictory effects - the tax cuts reduce the taxation of capital income, increasing the rate of return, while also increasing the cost of finance and the user-cost of capital, thereby decreasing the rate of return. Furthermore, we find that anticipation effects are important in the determination of firm behaviour and investment outcomes. A comparison of these results highlights the ways in which different capital-income tax regimes influence firm behaviour and outcomes in a dynamic setting, including the different adjustment paths that result.