Corporate Income Taxation and Signaling

A signaling model is developed to investigate the consequences of corporate income taxation in the presence of adverse selection in the equity market. The model obtains a unique, informationally constrained efficient equilibrium in which a better quality firm retains more inside equity, and, as in the complete information case, only profitable firms are supported The corporate income tax affects signaling costs and the profitability of projects. Numerical experiments with exponential utility functions find that the inside equity position of a better quality firm increases as the corporate income tax rate rises. This reaction is, however, insensitive to the tax rate change due to the risk sharing with the government, which leads to the interesting result that the corporate income tax only incurs a lower welfare cost than the lump sum tax with the same tax revenue.