New NBER Paper Finds Corporate Taxes Affect Risk-Taking

January 15, 2016

A new NBER working paper discusses the effects of corporation taxation on corporate risk-taking. The researchers find that corporations respond to tax increases by investing in fewer risky projects. Interestingly, they did not find that tax cuts incentivized corporations to increase their appetite for risk. They attribute this counterintuitive result to a set of shareholder constraints, which reduces a corporation's ability to assume more risk.

Corporations invest based on their expected after-tax profits. Consider a simple example: Project X has an equal chance (50%) of generating either a $150 profit or a $60 loss. Project Y has an 80% chance of generating a $150 loss but a 20% chance of generating a large windfall of $1000. Absent any taxation, the expected profits of Projects X and Y are $45 and $80 respectively.[1] The firm would select the riskier Project Y because of its larger expected profit. Now suppose the government imposes a tax rate of 35% on corporate profits. Let’s also assume the government does not allow corporations to partially offset their tax burden with losses. The expected after-tax profits on Projects X and Y fall to $18.75 and $10 respectively.[2] Economic theory predicts the firm will now shift its investment to the less risky Project X because its expected after-tax profits are larger than those of Project Y. In reality, most corporate tax regimes allow firms to at least partially offset their tax burdens with losses from a prior year, which partly mitigates the effects of corporate taxation on risk-taking.

As the authors note, a measurement problem arises when a firm’s future tax rate depends on investments it will undertake presently. To overcome this potential for mismeasurement, the empirical literature either estimates the effects of changes in the federal corporate tax rate across time, or uses cross-country differences in tax policies to assess the effects of corporation taxation. However, the federal corporate tax rate has not changed in over 25 years, and researchers have been unable to adequately control for variables that could explain differences in risk-taking across countries. In this paper, the authors attempt to overcome this methodological challenge by using state level data from 1990-2011, allowing them to capture over 100 corporate tax changes in their sample.

With respect to tax increases, their findings confirm economic theory. State tax increases in the corporate income tax led the average firm to reduce its exposure to risk by 2.6%. The authors were however unable to find a statistically significant relationship for tax cuts. Credit rationing through covenants and contracts likely prevents firms from increasing risk in response to favorable tax changes.

Some policymakers may wish to discourage risk-taking, given the harm overleveraged firms can pose to the economy. But not all risk-taking is mere financial speculation. Risk-taking leads to new start-ups and new products that benefit all citizens. Corporate investment has been weak since the Great Recession, and remains one of the primary reasons why economic growth has been less than stellar in recent years. Policymakers should explore options for increasing investment and innovation. A corporate tax rate reduction may achieve both these goals.

[1] X: 0.5(150) – 0.5(60) = $45
Y: 0.2(1000) – 0.8(150) = $80

[2] X: (1 – 0.35)(0.5)(150) – 0.5(60) = $18.75
Y: (1 – 0.35)(0.2)(1000) – 0.8(150) = $10


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