Taxes, leverage, and stimuli of investment under uncertainty

Abstract

This paper examines the effect of leverage on the effectiveness of a self-financed tax-subsidy program offered by a government in stimulating a firm’s investment. We show that the firm, be it levered or unlevered, has an incentive to hasten its investment because of the agency conflicts arising from the commitment made by the government on the terms of the tax-subsidy program. We further show that the levered firm has a countervailing incentive to defer its investment due to the deadweight loss when bankruptcy occurs, which would be absent should the firm be unlevered. The former incentive is likely to be dominated by the latter incentive, in particular when the corporate income tax rate is sufficiently high and the bankruptcy cost is sufficiently low so that the firm relies heavily on debt. In this case, the tax-subsidy program induces the levered firm to defer, not hasten, its investment. Finally, we show that the levered firm is made worse off with than without the program because of the presence of agency and bankruptcy costs.