The effects of tax convexity on default and investment decisions

Adrian C.H. LEI, Martin H.Y. YICK, Keith S. K. LAM

Research output: Journal PublicationsJournal Article (refereed)peer-review

Abstract

The objective of this article is to examine how default and investment triggers change under different levels of tax asymmetry when firms face nonlinear tax schedules. Under a convex tax schedule, profits are taxed at a higher rate, while losses are taxed (or rebated) at a lower rate, thus reducing the risk shared by the government. This article presents a dynamic model based on the contingent-claims framework to explore the impacts of tax convexity on the triggers, and we find that the impacts vary significantly depending on several countervailing forces. Tax convexity has a nonmonotonic relationship with both the default and investment triggers, because of the government's risk-sharing role. The default trigger is higher when tax convexity increases, while the growth option exerts a counteracting effect that lowers this trigger, creating an ambiguity in the investment trigger when changing the level of tax asymmetry.
Original languageEnglish
Pages (from-to)1267-1278
Number of pages12
JournalApplied Economics
Volume46
Issue number11
Early online date7 Feb 2014
DOIs
Publication statusPublished - 2014

Keywords

  • contingent-claims model
  • default option
  • growth option
  • investment option
  • tax convexity

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