Tax Policy Uncertainty and the Corporation - Theory of Tax-induced Investment Spurts

January 1997The anticipatory effects of a corporate tax reform of the tax-cut-cum-base-broadening variety are analysed in a dynamic stochastic adjustmentmodel of firm behavior, focusing on the case where the firm is uncertain both about the timing and the contents of the expected reform. The value of the firm is solved prior to and after the reform. The existence of investment spurts prior to the implementation of the tax reform is established. Rigorous results are derived under constant returns and the effects of diminishing returns are explained. The expectation of a future tax cut causes the firm to accelerate optimal investment, while the expectation of a reduction in the tax base (the rate of fiscal depreciation) has the opposite effect. For a firm which updates information, timing uncertainty interacts with the expectation effect; moreover, increased timing uncertainty may accelerate or decelerate investment as an optimal response to an expected tax cut. Furthermore, for reasonable assumptions, it is shown that a rate cut cum base broadening tax reform of the type implemented in several OECD-countries in the 1980’s and 1990’s cannot be revenue neutral.