Investment incentives and corporate tax asymmetries

a r t i c l e i n f o Recent facts on the importance of corporate losses motivate more careful study of the impact of tax incentives for investment on firms that lose money. I model firm investment decisions in a setting featuring financing constraints and carrybacks and carryforwards of operating losses. I estimate investment responses to tax incentives allowing effects to vary with cash flows and taxable status. Results suggest that asymmetries in the corporate tax code could have made recent bonus depreciation tax incentives at most 4% less effective than they would have been if all firms were fully taxable. Cash flows have more important effects on the impact of tax incentives. Recent declines in cash flows would predict a 24% decrease in the effectiveness of bonus depreciation. Results thus suggest that tax incentives have the smallest impact on investment exactly when they are most likely to be put in place — during downturns in economic activity when cash flows are low. In 2002, U.S. corporations that lost money reported $418 billion in losses on their tax returns. This amount is more than 60% of the $676 billion in profits reported by profitable corporations. Also in 2002, President Bush signed the Job Creation and Worker Assistance Act, which included " bonus depreciation " provisions that allowed firms to deduct a larger portion of their spending on new capital equipment from their taxable income. Similar incentives were enacted in response to recession in 2008 and remained in place through the end of 2009. Bonus depreciation was intended to encourage firms to increase their investment, but several observers have found that it had little effect. 2 In this paper, I model and estimate how corporate losses may mitigate the impact of tax incentives like bonus depreciation. I adapt the tax-adjusted Q model of Hayashi (1982) and Summers (1981) to a setting featuring financing constraints and carrybacks and carryforwards of operating losses. I consider the effects of investment incentives on two groups of firms. The first, taxable firms, pay the statutory tax rate on a marginal increase in income, either in the form of an increased tax liability or a decreased carryback refund. The second, nontaxable firms, face a tax rate of zero on a marginal increase in income. I show how investment choices depend on a familiar tax-adjusted Q expression, modified by the shadow values to the firm …