Cash-flow Business Taxation Revisited: Bankruptcy, Risk Aversion And Asymmetric Information

It is well-known that cash-flow business taxes with full loss-offset, and their present-value equivalents, are neutral with respect to firms' investment decisions when firms are risk-neutral and there are no distortions. We study the effects of cash-flow business taxation when there is bankruptcy risk, when firms are risk-averse, and when financial intermediaries face asymmetric information problems in financing heterogeneous firms. Cash-flow taxes remain neutral under bankruptcy risk alone, but can distort the entry and investment decisions of firms under both risk-aversion and asymmetric information. We characterize the nature of such distortions and show that cash-flow taxes can increase social welfare in this context. An ACE tax is equivalent to a cash-flow tax but is easier to implement under asymmetric information.