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A Tax Paradox for Investment Decisions under Uncertainty

Authors


  • Prof. Dr. Thomas Gries, University of Paderborn, Faculty of Business Administration and Economics, Warburger Straβe 10, 33098 Paderborn, Germany (thomas.gries@notes.upb.de). Ulrich Prior, University of Paderborn, Faculty of Business Administration and Economics, Warburger Strae 100, 33098 Paderborn, Germany (ufprior@web.de). Prof. Dr. Caren Sureth, University of Paderborn, Faculty of Business Administration and Economics, Warburger Straβe 100, 33098 Paderborn, Germany (csureth@notes.upb.de).

    We are indebted to two anonymous referees, the associate editor, and Myrna Wooders for their very valuable suggestions which improved the paper considerably. We thank the participants of the American Accounting Association Annual Congress in 2007 in Chicago, the European Accounting Association Annual Congress in 2007 in Lisbon and 2008 in Rotterdam, the Annual Congress of the International Institute of Public Finance in 2007 in Warwick, and the Research Seminar on Economics at the Free University of Berlin. We are particularly grateful for very helpful comments from Giacomo Corneo, Rainer Niemann, Richard Sansing, Guttorm Schjelderup, and Jack Stecher. The usual disclaimer applies. Financial support by the German Research Foundation (DFG, SU 501/1-1, SU 501/4-1) is gratefully acknowledged.

Abstract

In this paper we use a real option model for assessing uncertain investment projects and we show that—due to a flexibility premium—taxes asymmetrically affect the option value of projects that differ in their riskiness. Hence, this may generate distortions. We analytically identify a set of neutral tax rates (a tax regime) that preserve the post-tax investment threshold if taxes change, and determine normal and paradoxical settings for investments. Unlike other tax paradoxes neither depreciation rules nor loss offset restrictions cause these paradoxical reactions. Taxes affect each project individually, depending on the project risks involved. This implies that, for a variety of uncertain projects, taxes cannot be neutral on aggregate.

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