The effects of tax-deductible reserves on investment incentives

Abstract

This paper investigates how tax-deductible reserves affect the incentive to invest. We consider two different variants: a periodization reserve (PER), which allows the firm to defer tax payments for a certain number of years, and an investment reserve (IVR), which postpones tax payments but has the particular goal of allowing the firm to finance investments from untaxed funds. The latter is assumed to include a penalty levied if the reserve is not used to cover investment. We find that PER lowers the effective tax rate and produces a smaller reduction in the firm’s cost of capital. The impacts of IVR are more complex. With a low penalty, its effects equal those of PER. In both cases they could be mimicked more easily by a reduction in statutory tax rate. However, with a high penalty and high ceiling for allocations, IVR equals a neutral cash flow tax. Similarly, if the firm distributes maximum dividends (binding dividend constraint), both PER and IVR are investment neutral. These neutrality results only concern investment financed from retained profits.