On Financial Adjustment and Investment Booms: Lessons from Tax Reforms

The US and US tax reforms of the 1980s created tendencies in the OECD countries to cut tax rates and broaden tax bases. Though several studies have indicated the efficiency gains of such reforms, our results suggest that a policy of rate-cut-cum-base-broadening may actually reduce long-run capital formation. Moreover, given that a tax reform is anticipated, there is room for speculative investment behaviou. We suggest hence that there may be a trade-off between long-run efficiency gains and short-run costs in terms of additional volatility and increased indebtedness. Our model assumes constant returns and convex costs of adjustment. The financial and investment policy of firm is studied under various constraints on dividend policy, arising from the existing reporting conventions. It is shown that under uniform reporting requirement, an internal financial equilibrium exists and that the corporation income tax is equivalent to a cash-flow tax while under separate reporting, it is optimal to finance by debt and tax debt only. Some positive implications for international capital flows are pointed out and some normative issues are raised.