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Corporate Taxes And Investment: The Cash Flow Channel

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Executive Summary

Existing literature focuses on how corporate taxation affects firms' investment decisions by altering after-tax returns. This paper instead examines how corporate taxation affects investment by reducing the cash flow a firm has available to invest in the current period. The author uses a sharp nonlinearity in the mapping from pre-tax profitability to taxes created by the tax loss carryforward feature of the tax code to identify the cash flow effect of taxes. The results indicate that firms reduce investment when they pay more taxes, especially when unfavorable capital market conditions create a greater dependence of investment on internal sources of cash.

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