The income tax structure's impact on corporate valuation, and investments: A three stakeholder perspective

We extend Modigliani and Miller's capital structure models by allowing for growth opportunities and adding government as the third major financial stakeholder. Government, through collection of taxes, joins equityholders and debtholders as recipients of the firm's net operating income. Assuming no new investment opportunities, we demonstrate the conservation of aggregate value among the three financial stakeholders. In an intertemporal model, we allow reinvestment of earnings to investigate the effects of tax structure on aggregate firm value and investment policy. We demonstrate that the burden of corporate taxation eventually falls on stockholders. We recommend that all corporate taxation be shifted to individuals instead of the current practice of corporate taxes and personal taxes on dividends and capital gains. By shifting the tax incidence to individuals, government's tax revenues rise through corporate growth despite its declining proportional stake in firms. This strategy may be structured to be tax neutral and it frees the engines of corporate growth leading to a win-win situation for all stakeholders. Allowing corporations to increase capital investment as a result of reduced corporate taxes increases government's tax revenues despite a declining proportional stake in firms. Our empirical analysis of economic data from 107 countries during 1991 to 2004 finds a strong inverse relationship between tax rates and valuation and capital investment. One percent increase in corporate tax rates result in 1.2-1.3 percent decrease in valuation and 0.2-0.3 percent decrease in investment. The effect of personal income taxes on growth is less significant than that of corporate taxes.