The Effect of Tax Convexity on Corporate Investment Decisions and Tax Burdens

This paper examines the effect of convexity in the corporate tax schedule on corporate investment decisions and tax burdens. Using a contingent-claims model, we show that greater tax convexity results in (i) earlier exit, (ii) delayed investment (except for small entry cost), and (iii) reduced corporate risk taking (except for small entry cost and unfavorable operating conditions). Also, the effective tax burden is an increasing function of tax convexity. The convexity of the tax schedule has a nontrivial impact on corporate investment decisions and investment levels. These results are relevant for economic growth, which depends (at least partly) on investment levels, and tax policy makers should be aware of these effects when making adjustments that might impact the convexity of the corporate tax schedule. Copyright 2006 Blackwell Publishing Inc..