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Investment Timing and Intensity under Progressive Taxation

This paper examines a firm’s investment intensity and timing decisions using a real options approach. The firm is endowed with a perpetual option to invest in a project at any time by incurring an irreversible investment cost at that instant. The amount of the irreversible investment cost determines the intensity of investment with decreasing returns to scale. The project generates a stream of profit flows that is stochastic over time and increases with the intensity of investment. The firm’s investment policy is characterized by an endogenously determined profit flow such that the investment option is exercised at the first instant when the firm’s profit flow reaches this threshold level from below. Tax progression arises from an exogenously given tax exemption threshold that makes the average tax rate increase with the tax base. We show that corporate income taxes are not neutral when tax schedules are progressive. JEL classification: D21; G31; H25