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. 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. The ACE tax distorts firms’ decisions when bankruptcy risk exists. We characterize the nature of such distortions and consider how cash-flow taxes would have to be amended to achieve neutrality.