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Tax exhaustion, firm investment, and leasing; a test of the Q model of investment

  • Michael P. O'Malley
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    Standard models of investment usually incorporate various tax factors but often overlook "tax exhaustion," the case when a firm has negative taxable income and cannot claim immediately its tax deductions or credits. However, tax exhausted firms face a higher cost of capital, and evidence shows that tax exhaustion is not uncommon. This paper incorporates tax exhaustion into a "Q" model of investment to see whether its performance is improved. In addition, leased investment is fully incorporated into the model, in part because tax exhaustion creates incentives to lease investment products and because investment models explain decisions to use equipment, not the decision about how to finance them. The results show that accounting for leasing improves significantly the performance of the Q model, whereas accounting for tax exhaustion does not affect the results meaningfully.

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    File URL: http://www.federalreserve.gov/pubs/feds/1996/199631/199631abs.html
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    File URL: http://www.federalreserve.gov/pubs/feds/1996/199631/199631pap.pdf
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    Paper provided by Board of Governors of the Federal Reserve System (U.S.) in its series Finance and Economics Discussion Series with number 96-31.

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    Date of creation: 1996
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    Handle: RePEc:fip:fedgfe:96-31
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    1. Lawrence H. Summers, 1981. "Taxation and Corporate Investment: A q-Theory Approach," Brookings Papers on Economic Activity, Economic Studies Program, The Brookings Institution, vol. 12(1), pages 67-140.
    2. Mayer, Colin, 1986. "Corporation Tax, Finance and the Cost of Capital," Review of Economic Studies, Wiley Blackwell, vol. 53(1), pages 93-112, January.
    3. Hayashi, Fumio & Inoue, Tohru, 1991. "The Relation between Firm Growth and Q with Multiple Capital Goods: Theory and Evidence from Panel Data on Japanese Firms," Econometrica, Econometric Society, vol. 59(3), pages 731-53, May.
    4. Altshuler, Rosanne & Auerbach, Alan J, 1990. "The Significance of Tax Law Asymmetries: An Empirical Investigation," The Quarterly Journal of Economics, MIT Press, vol. 105(1), pages 61-86, February.
    5. Fumio Hayashi, 1981. "Tobin's Marginal q and Average a : A Neoclassical Interpretation," Discussion Papers 457, Northwestern University, Center for Mathematical Studies in Economics and Management Science.
    6. Edwards, J. S. S. & Mayer, C. P., 1991. "Leasing, taxes, and the cost of capital," Journal of Public Economics, Elsevier, vol. 44(2), pages 173-197, March.
    7. Edwards, J S S & Keen, M J, 1985. "Taxes, Investment and Q," Review of Economic Studies, Wiley Blackwell, vol. 52(4), pages 665-79, October.
    8. Hayashi, Fumio, 1985. "Corporate finance side of the Q theory of investment," Journal of Public Economics, Elsevier, vol. 27(3), pages 261-280, August.
    9. Devereux, Michael P. & Keen, Michael & Schiantarelli, Fabio, 1994. "Corporation tax asymmetries and investment : Evidence from U.K. panel data," Journal of Public Economics, Elsevier, vol. 53(3), pages 395-418, March.
    10. Arellano, Manuel & Bond, Stephen, 1991. "Some Tests of Specification for Panel Data: Monte Carlo Evidence and an Application to Employment Equations," Review of Economic Studies, Wiley Blackwell, vol. 58(2), pages 277-97, April.
    11. Alan J. Auerbach, 1983. "The Dynamic Effects of Tax Law Asymmetries," NBER Working Papers 1152, National Bureau of Economic Research, Inc.
    12. Yolanda K. Henderson & Jeffrey B. Liebman, 1992. "Capital costs, industrial mix, and the composition of business investment," New England Economic Review, Federal Reserve Bank of Boston, issue Jan, pages 67-92.
    13. Poterba, James M. & Summers, Lawrence H., 1983. "Dividend taxes, corporate investment, and `Q'," Journal of Public Economics, Elsevier, vol. 22(2), pages 135-167, November.
    14. Alan J. Auerbach & James M. Poterba, 1986. "Tax Loss Carryforwards and Corporate Tax Incentives," NBER Working Papers 1863, National Bureau of Economic Research, Inc.
    15. Devereux, Michael P, 1989. "Tax Asymmetries, the Cost of Capital and Investment: Some Evidence from United Kingdom Panel Data," Economic Journal, Royal Economic Society, vol. 99(395), pages 103-12, Supplemen.
    16. Tobin, James, 1969. "A General Equilibrium Approach to Monetary Theory," Journal of Money, Credit and Banking, Blackwell Publishing, vol. 1(1), pages 15-29, February.
    17. Chirinko, Robert S., 1987. "Tobin's Q and financial policy," Journal of Monetary Economics, Elsevier, vol. 19(1), pages 69-87, January.
    18. Cordes, Joseph J & Sheffrin, Steven M, 1983. " Estimating the Tax Advantage of Corporate Debt," Journal of Finance, American Finance Association, vol. 38(1), pages 95-105, March.
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