Effects of Progressive Taxes under Decentralized Bargaining and Heterogeneous Labor

We consider changes in income tax progressivity in an economy where workers' productivities differ and workers and firms bargain individually over wages. With given employment a pure increase in tax progressivity reduces wages by reducing workers' relative bargaining power. When average taxes also increase, after-tax wages are unambiguously reduced, while the effects on gross wages and firm profitability are ambiguous. We next endogenize employment and firm entry under a uniform worker productivity distribution and the government's only policy instrument is a linear income tax. While a first-best solution then is ruled out, a second-best solution can be implemented using a family of linear tax functions, where a more progressive tax implies a higher tax revenue to the government. We show that the government can increase its tax revenue, and reduce after-tax income differences, without any additional disturbance to allocation.     

A NOTE ON TAXATION AND THE LEASING DISCOUNT RATES

It is demonstrated that the discount rate for taxes in the traditional formula for the after-tax cost of debt is misspecified for the UK situation. Several new formulae are derived for the after-tax costs for specific periods, including the accounting period and the tax lag. Iterative solution methods are not required.     

The impact of a partial borrowing limit on financial decisions

We consider a consumption, investment, life insurance, and retirement decision problem in which an economic agent is allowed to borrow against only a part of future income. The closed-form solution is attained by applying a dual approach that directly imposes the conditions for the borrowing limit on a dual value function. We provide analytic comparative statics for optimal strategies with rigorous proofs. It is confirmed that a more stringent borrowing limit leads to less consumption and less life insurance purchase. However, even with a tighter borrowing limit, an agent with weak incentive to retire can invest more when the wealth level is high enough. We also show that a more stringent borrowing limit can delay or hasten the optimal retirement timing depending on the agent's current wealth level.     

TWO DCF APPROACHES FOR VALUING COMPANIES UNDER ALTERNATIVE FINANCING STRATEGIES (AND HOW TO CHOOSE BETWEEN THEM)

This is the sequel to the authors' 1989 article discussing the two basic discounted cash flow approaches for valuing debt-financed transactions and corporations: weighted average cost of capital (WACC) and adjusted present value (APV). The WACC method discounts all after-tax (but pre-interest) cash flows at the company's weighted average cost of capital. The APV method treats the value of a levered firm as the value of the same firm if financed entirely with equity plus the discounted value of the interest tax shields from the debt its assets will support. The authors argue that the WACC approach is more practical if the firm intends to hold its (market) leverage ratio relatively constant over time, but that the APV technique is the preferred method if the firm plans to reduce its leverage ratio according to a pre-determined schedule (as tends to be the case in highly leveraged transactions).     

Taming animal spirits: risk management with behavioural factors

In several countries a major factor contributing to the current economic crisis was massive borrowing to fund investment projects on the basis of, in retrospect, grossly optimistic valuations. The purpose of this paper is to initiate an approach to project valuation and risk management in which ‘behavioural’ factors—Keynes’ ‘animal spirits’ or Greenspan’s ‘irrational exuberance’—can be explicitly included. An appropriate framework is risk-neutral valuation based on the use of the numéraire portfolio—the ‘benchmark’ approach advocated by Platen and Heath (A benchmark approach to quantitative finance. Springer, Berlin, 2006). In the paper, we start by discussing the ingredients of the problem: ‘animal spirits’, financial instability, market-consistent valuation, the numéraire portfolio and structural models of credit risk. We then study a project finance problem in which a bank lends money to an entrepreneur, collateralized by the value of the latter’s investment project. This contains all the components of our approach in a simple setting and illustrates what steps are required. In a final section, we briefly discuss the econometric problems that need to be solved next.     

Numerical methods for dynamic Bertrand oligopoly and American options under regime switching

Bertrand oligopolies are competitive markets in which a small number of firms producing similar goods use price as their strategic variable. In particular, each firm wants to determine the optimal price that maximizes its expected discounted lifetime profit. The oligopoly problem can be modeled as nonzero-sum games which can be formulated as systems of Hamilton–Jacobi–Bellman (HJB) partial differential equations (PDEs). In this paper, we propose fully implicit, positive coefficient finite difference schemes that converge to the viscosity solution for the HJB PDE from dynamic Bertrand monopoly and the two-dimensional HJB system from dynamic Bertrand duopoly. Furthermore, we develop fast multigrid methods for solving these systems of discrete nonlinear HJB PDEs. The new multigrid methods are general and can be applied to other systems of HJB and HJB-Isaacs PDEs arising from American options under regime switching and American options with unequal lending/borrowing rates and stock borrowing fees under regime switching, respectively. We provide a theoretical analysis for the smoother, restriction and interpolation operators of the multigrid methods. Finally, we demonstrate the effectiveness of our method by numerical examples from the dynamic Bertrand problem and pricing American options under regime switching.     

Income Shifting and International Transfer Pricing: A Three-Country Example

There is a long held belief that international transfer pricing (ITP) is used by multinational enterprises (MNEs) to minimize global tax liability. On the one hand, this is a rational economic response to market imperfections created by national governments. An alternative view decries such actions as anti-competitive and an abuse of power. This article ex-amines the potential benefit to enterprises of ITP manipulation when a real world combination of fiscal rules are simultaneously applied in practice. The countervailing impact of different national rules appears to result in ITP having a minor significance on parent after-tax income. Differential rates cause minor benefits but the absence of a form of tax, such as withholding tax, can provide substantial opportunities to maximize global after-tax income through the choice of transfer price. ITP can therefore provide benefits when national jurisdictions do not have consistent forms of taxation. In all the scenarios explored, major variations are apparent in the after-tax income of subsidiaries operating under different combinations of fiscal regimes and ITP policies. The tension between head-quarter and subsidiary management may be most pronounced when a subsidiary is located in a jurisdiction not having a complete range of tax forms.     

Discounting and the Treatment of Taxes in Impairment Reviews

Abstract:  IAS 36 requires an asset's recoverable amount to be measured by discounting its pre-tax rather than post-tax cash flows. Although defined so as to produce the same value, the pre-tax approach is claimed to be simpler and more reliable. The paper demonstrates that an appropriate pre-tax discount rate varies between assets with different tax depreciation schedules and that it changes over time. Hence, pre-tax discounting is likely to become complex. The paper advocates an amendment of the standard such that value in use is measured by company-specific after-tax cash flows, and such that deferred taxes are included in the impairment review.     

Global Liquidity,House Prices,and the Macroeconomy: Evidence from Advanced and Emerging Economies

In this paper, we first compare house price cycles in advanced and emerging economies using a new quarterly house price data set covering the period 1990–2012. We find that house prices in emerging economies grow faster, are more volatile, less persistent, and less synchronized across countries than in advanced economies (AEs). We also find that they correlate with capital flows more closely than in AEs. We then condition the analysis on an exogenous change to a particular component of capital flows: global liquidity, broadly understood as a proxy for the international supply of credit. We identify this shock by aggregating bank‐to‐bank cross‐border credit and by using the external instrumental variable approach introduced by Stock and Watson (2012) and Mertens and Ravn (2013). We find that in emerging markets (EMs) a global liquidity shock has a much stronger impact on house prices and consumption than in AEs. We finally show that holding house prices constant in response to this shock tends to dampen its effects on consumption in both AEs and EMs, but possibly through different channels: in AEs by boosting the value of housing collateral and hence supporting domestic borrowing; in EMs, by appreciating the exchange rate and hence supporting the international borrowing capacity of the economy.