Capital Charge Rates, Investment Incentives and Taxation

This paper studies the impact of personal and corporate income taxation on capital charge rates in a delegation setting with a risk-averse manager. If the investment level influences the riskiness of the investment project, the capital charge rate deviates from the firm's cost of capital and depends crucially on the manager's personal income tax rate. Contradicting conventional wisdom, we find that a higher personal income tax rate induces higher investment expenditures and, surprisingly, increases the capital charge rate. The countervailing effect that a higher capital charge rate induces higher and not lower investment expenditures persists for pre-tax and after-tax performance measures as well as when the tax deductibility of managerial compensation is limited. Corporate income tax causes a similar effect only in the case of limited tax deductibility of compensation. Our insights remain valid regardless of the financing structure and the risk attitude of the investors.