Progressive taxation, tax exemption, and corporate liquidation policy

Abstract

This paper develops a real options model of a firm that operates in continuous time with an infinite horizon. The firm receives stochastic profit flows that are subject to progressive taxation. Tax progression arises from an exogenously given tax exemption threshold that makes the average tax rate increase with the tax base. The firm possesses an option to liquidate its operation, which is optimally exercised when the firm's profit flow reaches an endogenously determined threshold level (the liquidation trigger) from above. We show that the firm's liquidation trigger under progressive taxation increases with either a reduction in the tax exemption threshold or an increase in the corporate income tax rate. Corporate income taxes are thus not neutral when tax schedules are progressive. © 2008 Elsevier B.V. All rights reserved.