Cash-Flow Business Taxation Revisited: Bankruptcy, Risk Aversion and Asymmetric Information

Abstract

It is well-known that cash-flow business taxes with full loss-offset, and their present-value equivalents, are neutral with respect to firms’ investment decisions when firms are risk-neutral and there are no distortions. We study the effects of cash-flow business taxation when there is bankruptcy risk, when firms are risk-averse, and when financial intermediaries face asymmetric information problems in financing heterogeneous firms. In these circumstances, investment decisions are distorted, with investment being less than in the full-information case. Cash-flow taxation corrects the distortion by inducing more investment in rent-generating projects and increasing social welfare. An ACE tax is equivalent to a cashflow tax but is easier to implement under asymmetric information.