The Impact of Tax Uncertainty on Irreversible Investment

Traditional models of capital budgeting including taxes are based on deterministic tax ratesand tax bases. In reality, however, there are multiple sources of tax uncertainty. Tax reformsinduce frequent changes in both tax rates and tax bases, making future taxation of investmentsa stochastic process. Fiscal authorities and tax courts create additional tax uncertainty byinterpreting current tax laws differently. Apart from fiscal tax uncertainty, there is modelspecifictax uncertainty, because investors use simplified models for computing an investmentproject’s tax base and anticipate the actual tax base incorrectly.I analyze the effects of stochastic taxation on investment behaviour in a real options model.The potential investor holds an option to invest in an irreversible project with stochastic cashflows. To cover the combined effects of tax base and tax rate uncertainty, the investment’s taxpayment is modelled as a stochastic process that may be correlated with the project’s cashflows.I show that increased uncertainty of tax payments has an ambiguous impact on investmenttiming. Thus, the popular view that tax uncertainty depresses real investment can be rejected.For low tax uncertainty, high cash flow uncertainty and high correlation of cash flows and taxpayment, increased tax uncertainty may even accelerate investment. A higher expected taxpayment delays investment. Surprisingly, a higher tax rate on interest income affectsinvestment timing ambiguously.