Pro…t Taxation, Innovation and
the Financing of Heterogeneous Firms
Christian KEUSCHNIGG and Evelyn RIBI
University of St. Gallen
IFF-HSG
June 2010
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Motivation
Question: how do pro…t taxes a¤ect
innovation, investment and …nancing of heterogeneous …rms?
tax reform when …rms di¤er w.r.t. R&D/…nancial dependence?
Heterogeneity: …rm growth driven by innovation
1
R&D spending => little own funds, large investment opportunities
…nance constrained, excess return, innovative growth companies
2
no R&D spending => more own funds, small investment scale
unconstrained, …rst best investment, low return equal to user cost
Theoretical framework: innovation and …nancial dependence
discrete R&D investment, self-…nanced, creates heterogeneity
innovative …rms …nance constrained, underinvestment
less innovative …rms, unconstrained, as in neoclassical theory
should tax system redistribute to constrained, innovative …rms?
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Empirical Evidence
Macro: RajanZingales98 and subsequent literature
industrial sectors di¤er in external …nancial dependence of …rms
…nancial development boosts mainly …nancially dependent sectors
Firm level evidence: …rm characteristics induce …nance constraints
young, small …rms more likely to be credit constrained: Schaller93,
JaramilloSchiantarelliWeiss96, BeckDemirguc-KuntMaksimovic05,
BeckDemirguc-Kunt06, AghionFallyScarpetta07
innovative …rms face tighter …nancing restrictions:
Guiso98, HyytinenToivanen05, Ughetto09, HallLerner09
young and innovative …rms boost economic growth:
Audretsch02, CarreeThurik03, Roper97, KortumLerner00
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Empirical Evidence: Investment Elasticities
Neoclassical investment theory: unconstrained …rms
investment exclusively driven by user cost of capital
investment elasticities w.r.t. between -0.5 and -1.0,
HallJorgensen67; Auerbach83; HassettHubbard 02
Corporate …nance theory: large investments constrained
excess return, user cost not directly relevant
investment sensitive to cash-‡ow, collateral, institutions...
cash-‡ow elasticities of capital investment 0.5, survey Hubbard98;
Schaller93, ChirinkoSchaller95, HoshiKashyapScharfstein91
cash-‡ow elasticities of total working capital higher, 0.8-1.3:
FazzariPetersen93, CalomirisHubbard95, CarpenterPetersen02
Public economics: small literature on agency problems in large …rms
overinvestment, misuse of ‘too much’own funds,
ChettySaez09, DesaiDyckZingales07, DesaiDharmapala08
but even large …rms constrained when large investments emerge
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Key Contributions and Results
Theoretical model: extends HolmstromTirole97, Tirole06
…rm heterogeneity and …nancial frictions in equilibrium
2 stages: (i) discrete R&D, (ii) variable expansion investment
R&D boosts productivity, but drains own funds, …nancial dependence
dichotomy: innovative/constrained vs. standard/unconstrained
composition endogenous, depends on tax policy, institutions...
transmission channel for tax policy entirely di¤erent across …rms
Novel results: di¤erent from neoclassical theory
1
2
3
4
R&D subsidy boosts innovation, but also expansion investment!
strengthens cash-‡ow after R&D and relaxes …nancing constraint
‘neutral’taxes reduce constrained investment (via cash-‡ow e¤ect),
1st order welfare loss, discriminate against innovative …rms, less R&D
rev. neutral increase in pro…t taxes to …nance larger R&D subsidy
redistributes to innovative …rms and boosts productivity/welfare
rev. neutral tax cut cum base broadening boosts innovation and welfare
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The Model: Overview
Two stage investment: can fail/close down in each stage
1 early stage: success probability q 0 2 [0, 1], close down with 1
q0
R&D k > 0: high productivity θ > 1, large expansion investment Ic
no R&D k = 0: low productivity θ = 1, small expansion investment In
2
expansion stage: …xed success prob. p, close down with 1
p
invest Ij : if successful, output xj = θ j f Ij , expected pro…t π j
spend e¤ort to keep success prob. p > pL high (moral hazard)
Firm heterogeneity: …rms di¤er by innate innovation potential
Rq
…rm types q 0 distributed with G (q ) = 0 g (q 0 ) dq 0
high potential …rms have high expected value Vj (q 0 ) = π j q 0 kj
…xed cost kc = (1 σ ) kR, subsidy σ, safe deposit rate R = 1 + r
…rm of type q 0 innovates and invests in …xed R&D cost if
πc q 0
(1
σ ) kR
πu q 0
Expected net value ex ante:
πE =
Keuschnigg & Ribi (IFF-HSG)
Z q
0
π u q 0 dG q 0 +
Z 1
q
πc q 0
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kc dG q 0 .
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Financing Expansion Investment
Expected pro…t: start with own funds A, after early stage
after R&D, …rms di¤er by productivity θ j and own funds Aj
innovative …rms with higher productivity, less own funds
Expected pro…t: surplus over Aj , need debt Dj = Ij
π ej
π bj
πj
= p [Ij + xj
( 1 + i ) Dj
= p (1 + i ) Dj RDj = 0
= p (Ij + xj Tj ) RIj .
Tj ]
)
Aj
RAj ,
p (1 + i ) = R
…rm needs external funds/debt Dc = Ic Ac > Dn , innovative …rm
invests more, has less own funds, is …nancially more dependent!
Tax liability: Tj = τ (xj
λiIj ), ACE tax when λ = 1
deduct share λ of …nancing costs iIj , debt plus equity Ij = Dj + Aj
Standard …rms: unconstrained, investment driven by user cost
π u = maxIu (1
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τ ) p (xu
uIu ) ,
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f 0 (Iu ) = u
1 λτ
i
1 τ
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Financing Expansion Investment
Moral hazard: entrepreneur’s income
vje
Ij + xj (1 + i ) Dj Tj in good state, vje = 0 in bad state
private bene…ts bIj , e¤ort choice/incentive compatibility:
IC e :
pvje
pL vje + bIj
, vje
βIj ,
β
b/ (p
pL )
incentive income vje limits pledgeable income to repay debt
Constrained/unconstrained …rms:
standard …rms: low In , high own funds A, unconstrained
innovative …rms: high Ic , low own funds A kc , constrained
binding constraint pvce = pβIc determines feasible debt and investment
π c = (1
τ ) p [θf (Ic )
Prop. 1: excess return ρ = (1
uIc ] = pβIc
τ ) [θf 0 (Ic )
R (A
kc )
)
Ic
u ] of constrained …rms
underinvestment, more investment raises surplus d π c /dIc = p ρ > 0
standard …rms: e¢ cient investment, d π n /dIn = 0, Figure 1
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Figure 1: Incentive Compatible Investment
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Figure 2: Discrete Innovation Decision
Innovation: invest in R&D if π c q 0
q=
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kc
π u q 0 , cut-o¤
(1 σ) kR
<1
πc πu
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Equilibrium and Welfare
Composition: prob’s/survival rates of E …rms starting
sk E innovate, survival sj E early stage, psj E expansion
su =
Z q
0
q 0 dG q 0 ,
sc =
Z 1
q
q 0 dG q 0 ,
sk =
Z 1
q
dG q 0
Net …rm value: expected at beginning
π E = su π u + sc π c
sk ( 1
σ) kR
Tax revenue: TE per …rm, TE E in total
TE = ∑j psj Tj
σsk kR,
Tj = τ (xj
λiIj )
Equilibrium and welfare:
R …xed by alternative linear technology
welfare changes with gross expected value
vE = AR + π E + TE
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Results: R&D Subsidy and Pro…t Tax
Prop. 2: R&D Subsidy
1
2
3
boosts innovation and share of constrained …rms, extensive margin
boosts investm./pro…t of constr.…rms, Ic and π c , intensive margin
small R&D subsidy yields …rst order welfare gains
dvE = ρ psc dIc > 0
Prop. 3: ‘neutral’pro…t tax (no impact on user cost of capital)
1
2
reduces investment of innovative …rms only: dIu = 0, dIc < 0
harms innovative …rms more and discourages innovation
d πu =
3
π u d τ,
d πc =
π c d τ + ρp dIc < d π u < 0
small tax causes …rst order welfare loss:
dvE = ρ psc dIc < 0
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Results: Revenue Neutral Tax Reform
Prop. 4: R&D subsidy self-…nanced with higher pro…t tax
1
2
3
redistributes to innovative …rms, boosts innovation
if few innovative …rms, tax reform boosts constrained investment
and thereby yields …rst order welfare gain
Prop. 5: starting with neutral tax (ACE tax, λ = 1)
revenue neutral tax cut cum base broadening reform
1
2
3
redistributes to innovative …rms, dTc < 0 < dTu , boosts innovation
raises (reduces) investment of constr. (unconstr.) …rms, dIc > 0 > dIu
boosts welfare, in proportion to excess return of innovative …rms
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Summary and Main Results
This paper: on taxes, …rm heterogeneity and …nance constraints
R&D drains internal funds and creates large investment opportunities
innovative …rms: little funds, constrained, earn excess return,
investment becomes sensitive to cash-‡ow, collateral, institutions...
standard …rms: unconstrained, normal return equal to user cost
Tax policy: should redistribute to …rms with above normal return
1
2
3
4
R&D subsidy boosts innovation, plus investment of constrained …rms
‘Neutral’pro…t tax reduces investment and pro…ts of innovative …rms,
reduces share of R&D intensive …rms, …rst order welfare loss
Revenue neutral pro…t tax increase to …nance R&D subsidy,
boosts constrained investment of innovative …rms, raises welfare
Revenue neutral tax cut cum base broadening also
favors innovative …rms and raises welfare
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Appendix: Redistribution by Pro…t Taxation
Redistribution: 2 …rms only, λ = 1 initially
Tj = τ [xj
λiIj ] = τπ gj
) dTj = π gj d τ
τiIj d λ
Revenue neutrality: dTc + dTu = 0, use π̄ g = π gc + π gu
π̄ g
d τ = τi d λ
Ī
Individual tax: substitute τid λ
#
" g
πj
π̄ g
Ij d τ
dTj =
Ij
Ī
Tax cut cum base broadening: d τ < 0 implies
π gc
π̄ g
π gu
>
>
Ic
Iu
Ī
– tax cut dTc < 0 strengthens cash-‡ow, boosts investment Ic
Both …rms unconstrained: π gj /Ij = i is same, no redistribution
dTc < 0 < dTu
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,
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