Optimal Corporate Taxation Under Financial Frictions

Eduardo Dávila, Yale University and Benjamin Hébert, Stanford University

This paper studies the optimal design of corporate taxes when firms have private information about future investment opportunities and face financial constraints. A government whose goal is to efficiently raise a given amount of revenue from its corporate sector should attempt to tax unconstrained firms, which value resources inside the firm less than financially constrained firms. We show that a corporate payout tax (a tax on dividends and share repurchases) can both separate constrained and unconstrained firms and raise revenue, and is therefore optimal. Our quantitative analysis implies that a revenue-neutral switch from profit taxation to payout taxation would increase the overall value of existing firms and new entrants by 7%. This switch could be implemented in the current U.S. tax system by making retained earnings fully deductible.