Asset Substitution Incentives and Uncertain Tax Choices

R. Thomas Godwin, Purdue University

Abstract

The equity holders of a firm typically control investment choices but enjoy limited liability, since the value of equity is the firm’s value in excess of the value of debt and other fixed claims. The asset substitution problem allows equity holders to expropriate value from other claimants by shifting downside risk from failed projects. To do so, equity holders substitute riskier investments for those with less risk. In the context of tax choices, firms pursue uncertain tax projects to reduce their current or future tax payments. Given the negative consequences of tax uncertainty documented by prior studies, understanding why firms pursue more uncertain tax projects is important for both internal and external stakeholders. In this study, I construct a model of the firm that highlights how asset substitution incentives influence the adoption of uncertain tax projects. I confirm the inferences from this model empirically to illustrate when firms are more likely to prefer more uncertain tax projects due to the investment distortion created by asset substitution incentives. Specifically, I find that firms in financial distress, firms with high growth potential, and loss firms adopt more uncertain tax projects than other firms. These results provide relevant insight for debt holders, regulators, and enforcement bodies.

Degree

Ph.D.

Advisors

Watts, Purdue University.

Subject Area

Economics

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