Government as the Firm’s Third Financial Stakeholder: Impact on Capital Investment Decisions, Capital Structure, Discount Rates, and Valuation

Abstract

We extend Myers’ (1974) adjusted present value method and modify Modigliani and Miller's (1958, 1963) capital structure propositions by adding government as the firms’ third major financial stakeholder. Government is a major stakeholder because it collects income taxes, is instrumental in establishing the business environment, and provides business infrastructure to corporations. We assume that government's stake is an implicit form of capital and, consequently, any return or benefit derived by the firm from this implicit capital will affect firm value. As a result, tax structure significantly impacts relative stakeholder values, capital investment decisions, and capital formation. Only in the special case when the firm receives explicit benefits and when the return on government's implicit capital is equal to the firm's cost of equity capital will corporate taxes not impact firm value and capital investment decisions. Although tax irrelevance and the conservation of value principle may hold true within a domestic economy with a homogenous tax structure, our three-stakeholder model demonstrates that corporate income taxes become relevant for investment decisions in a globally competitive economy with heterogeneous tax structures. Thus, our model addresses the apparent inconsistencies between existing theory, which characterizes corporate taxes as nondistortionary, and empirical findings, which demonstrate that taxes reduce investments, growth, and valuation ratios.

Acknowledgments

We thank the participants at the Southern Finance Association 2006 and 2010 Annual Meetings, Midwest Finance Association 2008 Annual Meeting, Financial Management Association 2008 Annual Meeting, the Center for Economics and Politics (Prague), the Indian Institute of Management (Bangalore) Finance seminar series, and a number of other seminars for excellent comments and suggestions. We are grateful to David Kemme for his comments. Financial support from university summer research grants and the Center for International Business Education and Research (CIBER) is gratefully acknowledged.

Notes

We use shareowner instead of stockholder in order to avoid confusing the latter with stakeholder, used extensively throughout the article.

U.S. President Obama stated in his 2011 State of the Union address that he is asking Congress to reduce the corporate income tax rate. In addition, the recent report of the National Commission on Fiscal Responsibility and Reform (Bowles and Simpson, 2010) recommended reducing the maximum personal tax rate to 23%, with very few personal deductions, and to reduce corporate tax rates to a maximum of 26%.

Discussion of economic equilibrium and disequilibrium abound in the economic literature; however, we posit that a general equilibrium rarely exists in even a closed, homogeneous economic system. Most economic systems never achieve equilibrium but are seeking equilibrium. In a globally competitive economy with heterogeneous intercountry tax rates, labor costs, and other costs of production, these heterogeneous factors create disequilibrium-induced capital flows and, to a lesser extent, labor flows. Capital and labor both flow respectively to countries with higher risk-adjusted returns and higher real labor rates. It is highly improbable that equilibrium with respect to capital and labor will ever be attained; however, aggregate capital formation and labor costs will seek an equilibrium, resulting in relative changes in capital formation, labor rates, and living standards across countries.

Although the United States may have a low average corporate income tax rate, it should be recognized that marginal income tax rates are most important in new investment decisions that will not be undertaken if they are expected to show losses. The World Bank (2010) published a report in November 2010 containing the effective corporate tax rates of 183 nations. The United States had an effective corporate tax rate of 27.6%.

Note that both equity holder and government cash flows must use k_su as the discount rate to preserve the real asset intrinsic value of the firm, whereas public finance theory would suggest that a social discount rate should be used for public cash flows.

Accounting firm KPMG found that taking into account both national and subnational taxes, the average tax rate for U.S. firms is 40% when considering U.S. federal and state corporate combined rates (see Edwards and de Rugy 2002).

For the purposes of this study, we assume that interest rates and firm risk remains unchanged; thus, market value and book value of debt are always the same.

Corporate versus personal taxes analysis applies to corporate entities because some other forms such as partnerships are not subject to taxation at those two levels.

Bondholders have very heterogeneous personal tax rates ranging from zero for some pension funds and sovereign investment funds to in excess of 40% for high-income individuals when considering both federal and state income taxes.

For further discussion and definitions of risk-free rate on debt and equity, see p. 12 and footnote 9 in Taggart (1991).

In this case, we assume 35% federal corporate income tax rate, up to 6% state income tax rate, and up to 35% tax rate on personal income from dividends and capital gains if tax cuts offered by the Jobs and Growth Tax Relief Reconciliation Act of 2003 are allowed to expire.

Subsequently, we also consider taxes at the personal level on dividend or debt interest income.