Introduction

Corporations with losses in a given tax year typically receive less than a full offset, or rebate of their ‘negative tax liability’, from the government. While losses may be carried back or carried forward, and while some mechanisms exist for marketing unused losses, it seems unlikely that firms can plan on recovering the full present value of redundant tax shields.

The structure of the tax code is an important determinant of the allocation of capital across the corporate and private sectors of the economy, across industries, and indeed across alternative activities within the firm. Thus, it is not surprising that the effects of the asymmetric treatment of gains and losses on corporate investment incentives have long been of concern to researchers in public economics and have drawn increasing attention in the finance literature. As an approximate representation of the tax asymmetry, one may assume taxes are paid at a constant rate for positive earnings, and that the tax liability is zero when deductions, such as depreciation and interest payments, exceed cash flows from operations. In this situation the government's tax claim on the firm can be viewed as a call option on the cash flows. Several recent papers have exploited this analogy to value the firm's tax liability using contingent claims valuation methods.

In a paper closely related to this one, Green and Talmor (1985) studied the effects of the option–like structure of the tax liability on the firm's choices over its mix of projects.