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Capital Gains Taxes, Irreversible Investment, and Capital Structure

  • Norman Schuerhoff

Personal taxation can be an important determinant of corporate investment and financing decisions if the marginal investor is taxed. I develop a dynamic capital budgeting model under realization-based capital gains taxation that highlights distinct cross-sectional and time-series implications. Capital gains taxation creates an embedded tax timing option that reduces investors’ uncertainty about after-tax payoffs in downstates. The inherent asymmetry in personal taxation diminishes the value of the firm’s option to delay, and ceteris paribus lowers the initial threshold for making an irreversible investment compared to the zero tax rate case. However, the asymmetry disappears gradually and the investment threshold shifts up, if investors reset their tax basis before the firm exercises its investment option. Hence, firms that are ex-ante identical can have different investment policies ex-post depending on their stock price evolution. The lock-in effect of embedded capital gains also alters the debt-equity tradeoff. Firms employ more equity financing, the lower the basis to price ratio of their owners. As a result, capital structure is path-dependent on past firm performance. The combined effect is consistent with cross-sectional evidence on the relation between leverage and Tobin’s Q. Lagged external-financing weighted market-to-book has explanatory power for leverage in the cross-section

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Paper provided by Society for Economic Dynamics in its series 2004 Meeting Papers with number 688.

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Date of creation: 2004
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Handle: RePEc:red:sed004:688
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Society for Economic Dynamics Marina Azzimonti Department of Economics Stonybrook University 10 Nicolls Road Stonybrook NY 11790 USA

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