Taxation and the Cost of Capital

Abstract

The way in which taxation affects corporate financial policy, and the level of investment through the structure of the cost of capital, is still a bone of contention. Various specifications of the cost of capital have been used in econometric models (for example, Jorgenson [3]) although in a recent theoretical paper Stiglitz [10] has claimed that, ignoring uncertainty, the cost of capital is simply the rate of interest.3 In this paper we shall analyse the effect of personal and corporate taxation on both the firm's choice of financial policy and its investment decision. We shall see that the latter is influenced by the former because the cost of capital depends upon the optimal financial policy. The results have implications for the specification of the neoclassical investment model which has come to play such an important part in the econometric study of investment behaviour, because the cost of capital is a good deal more complicated than most of this work allows for. Another problem which will be examined is how expectations of future changes in tax rates affect the firm's policy. In recent years governments have often announced tax changes in advance, and increasing attention is being paid to the use of announcements of future tax changes as a policy tool in its own right. These announcement effects can have a significant impact on investment behaviour. To make it easier to see the role of taxation we shall assume a world of perfect certainty. There are three justifications for this neglect of uncertainty. First, when tax changes are announced in advance, expectations that these changes will take place are held with a very high degree of certainty. Secondly, this assumption makes our results directly comparable with those of the neoclassical investment model. Finally, in a world of certainty we know that the firm will, if it is acting in the shareholders' interests, maximize the market value of the stock. But in a world of uncertainty which does not have a complete set of Arrow-Debreu markets it is not clear just what the firm should be trying to maximize. This is because shareholders have different subjective beliefs about what the best policy is, and there are no contingent commodity markets for them to hedge on. If one shareholder believes that the firm would make enormous profits by drilling for oil in the North Sea and nobody else believes that this would be successful, then for this shareholder the optimal policy is to drill even though the market value of the firm's stock would slump in the short run.4 Section 2 discusses a model of the valuation of the company and the way in which this is influenced by taxation. This brings out the interaction between the systems of personal and corporate taxation. In Section 3 we analyse the firm's optimal financial policy where it has a choice between financing investment by using retentions, borrowing, or